Selecting Copulas for Risk Management
AbstractCopulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favour of the Student’s t copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the Student’s t copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5652.
Date of creation: Apr 2006
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- C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
- C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-05-06 (All new papers)
- NEP-BEC-2006-05-06 (Business Economics)
- NEP-ECM-2006-05-06 (Econometrics)
- NEP-FIN-2006-05-06 (Finance)
- NEP-FMK-2006-05-06 (Financial Markets)
- NEP-RMG-2006-05-06 (Risk Management)
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