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Diversification evidence from international equity markets using extreme values and stochastic copulas

  • Bhatti, M. Ishaq
  • Nguyen, Cuong C.

Tail dependence plays an important role in financial risk management and determination of whether two markets crash or boom together. However, the linear correlation is unable to capture the dependence structure among financial data. Moreover, given the reality of fat-tail or skewed distribution of financial data, normality assumption for risk measure may be misleading in portfolio development. This paper proposes the use of conditional extreme value theory and time-varying copula to capture the tail dependence between the Australian financial market and other selected international stock markets. Conditional extreme value theory enables the model adequacy and the tail behavior of individual financial variable, while the time-varying copula can fully disclose the changes of dependence structure over time. The combination of both proved to be useful in determining the tail dependence. The empirical results show an outperformance of the model in the analysis of tail dependence, which has an important implication in cross-market diversification and asset pricing allocation.

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Article provided by Elsevier in its journal Journal of International Financial Markets, Institutions and Money.

Volume (Year): 22 (2012)
Issue (Month): 3 ()
Pages: 622-646

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Handle: RePEc:eee:intfin:v:22:y:2012:i:3:p:622-646
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  1. Andrew Patton, 2004. "Modelling Asymmetric Exchange Rate Dependence," Working Papers wp04-04, Warwick Business School, Finance Group.
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  13. Enzo Giacomini & Wolfgang Härdle, 2005. "Value-at-Risk Calculations with Time Varying Copulae," SFB 649 Discussion Papers SFB649DP2005-004, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
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