Working Paper: CEPR ID: DP5652
Authors: Erik Kole; Kees Koedijk; Marno Verbeek
Abstract: Copulas 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.
Keywords: copulas; distributional tests; financial dependence; risk management; tail dependence
JEL Codes: C12; C14; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| choice of copula (C52) | risk management practices (G22) |
| students t copula (Y40) | joint probability estimates (C13) |
| Gaussian copula (C46) | joint extreme downward movements (D10) |
| Gumbel copula (C46) | joint extreme downward movements (D10) |
| Gaussian copula (C46) | risk exposure (G22) |
| Gumbel copula (C46) | risk exposure (G22) |
| Gaussian copula (C46) | diversification benefits (G11) |
| Gumbel copula (C46) | diversification benefits (G11) |