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Selecting Copulas for Risk Management
Year Of Publication: 2006
Month Of Publication: September
Pages: 28
Download Count: 628
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Comment Num: 0
Language: EN
Who Can Read: Free
Date: 11-6-2006
Publisher: Administrator
Copulas offer financial risk managers a powerful tool to model the dependencebetween the different elements of a portfolio and are preferable to the traditional,correlation-based approach. In this paper we show the importance of selecting anaccurate copula for risk management. We extend standard goodness-of-fit tests tocopulas. Contrary to existing, indirect tests, these tests can be applied to any copulaof any dimension and are based on a direct comparison of a given copula with observeddata. For a portfolio consisting of stocks, bonds and real estate, these tests provideclear evidence in favor of the Student's t copula, and reject both the correlation-basedGaussian copula and the extreme value-based Gumbel copula. In comparison with theStudent's t copula, we find that the Gaussian copula underestimates the probability ofjoint extreme downward movements, while the Gumbel copula overestimates this risk.Similarly we establish that the Gaussian copula is too optimistic on diversificationbenefits, while the Gumbel copula is too pessimistic. Moreover, these differences aresignificant.
Kole, Erik Sign in to follow this author
Koedijk, Kees G. Sign in to follow this author
Verbeek, Marno Sign in to follow this author
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