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Calibrating and Simulating Copula Functions - An Application to the Italian Stock Market

Calibrating and Simulating Copula Functions - An Application to the Italian Stock Market

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CALIBRATING AND SIMULATING COPULA FUNCTIONS: AN
APPLICATION TO THE ITALIAN STOCK MARKET
Claudio Romano1
Abstract

Copula functions are always more used in financial applications to determine the dependence structure of the asset returns in a portfolio. Empirical evidence has proved the inadequacy of the multinormal distribution, commonly adopted to model the asset return distribution. Copulas are flexible instruments used to build efficient algorithms for a better simulation of this distribution.

The aim of this paper is describing the statistical procedures used to calibrate a copula function to real market data. Then, some methods used to choose which copula better fit data are presented. Finally a number of algorithms to simulate random variate from certain types of copula are illustrated.

The procedures described are applied to a portfolio of Italian equities. We show how to generate efficient Monte Carlo scenarios of equity log-returns in the bivariate case using different copulas.

Keywords: Copula Function, Dependence Structure, Multivariate Distribution
Function.
1 Corresponding author: Claudio Romano, Risk Management Function, Capitalia, Viale U.
Tupini, 180, 00144 \u2013 Rome, Italy. E-mail:c l a u di o.r om a n o @ c a pi t al i a. i t.
The author is grateful to Prof. G. Szeg\u00f6 for his valuable comments and suggestions that helped
improve the article substantially.
2
CALIBRATING AND SIMULATING COPULA FUNCTIONS: AN
APPLICATION TO THE ITALIAN STOCK MARKET
Claudio Romano
Introduction

Copula functions are used in financial application since 19992. Empirical evidence has proved that the multinormal distribution is inadequate to model portfolio asset return distribution under two points of view:

1) The empirical marginal distributions are skewed and fat tailed;

2) it does not consider the possibility of extreme joint co-movement of asset returns3. In other words, the dependence structure is different from the Gaussian one.

Copula functions are a useful tool to implement efficient algorithms to simulate asset return distributions in a more realistic way. In fact, they allow to model the dependence structure indipendently from the marginal distributions. In this way, we may construct a multivariate distribution with different margins and the dependence structure given from the copula function.

Therefore, a crucial step is the selection and the calibration of the copula function from real data. In this paper a collection of methods for calibrating, selecting and simulating copula functions are presented. Our aim is to collect in this article the principal contributions to the argument provided by the international literature cited in the references.

Most of the method presented are applied to an empirical data set of the log- returns of two Italian equities. When it is possible, we show as the copula approach performs better than the multinormal distribution in modelling real data.

The rest of this paper is structured as follows. In section one, a brief definition of copula function is given, describing the main families of copula used in practical applications4. In section two, some methods to estimate the parameters of a determined copula function from real data are presented. The

2 See Embrechts, McNeil and Straumann (1999).
3 As in the case of a market crash.
4 i.e.: the class of the elliptical copulas and the class of the Archimedean copulas.

3

procedures to select the type of copula which better fits empirical data are showed in section three. In section four, the algorithms to simulate random variates from some types of copula are reported. An application to a time series of the log-returns of two Italian equities if performed in section five. Finally, we draw some concluding remarks.

1. Definition of copula function
An n-dimensional copula5 is a multivariate distribution function (d.f.) , C, with
uniform distributed margins in [0,1] (U(0,1)) and the following properties:
1. C: [0,1]n\u2192[0,1];
2. C is grounded and n-increasing;
3. C has margins Ci which satisfy Ci(u) = C(1, ..., 1, u, 1, ..., 1) = u for all
u\u2208[0,1].

It is obvious, from the above definition, that if F1, ..., Fn are univariate distribution functions, C(F1(x1), ..., Fn(xn)) is a multivariate d.f. with margins F1, ..., Fn, because Ui= Fi(Xi), i = 1, ..., n, is a uniform random variable. Copula functions are a useful tool to construct and simulate multivariate distributions.

The following theorem is known as Sklar\u2019s Theorem. It is the most important theorem about copula functions because it is used in many practical applications.

Theorem6: Let F be an n-dimensional d.f. with continous margins F1, ..., Fn.
Then it has the following unique copula representation:
F(x1, \u2026, xn) = C(F1(x1), ..., Fn(xn)) .
(1)

From Sklar\u2019s Theorem we see that, for continous multivariate distribution functions, the univariate margins and the multivariate dependence structure can be separated. The dependence structure can be represented by a proper copula function. Moreover, the following corollary is attained from (1).

Corollary:Let F be an n-dimensional d.f. with continous margins F1, ..., Fn
and copula C (satisfying (1)). Then, for anyu=(u1,\u2026,un) in [0,1]n:
(
)
)
(
),...,
(
)
,...,
(
1
1
1
1
1
n
n
n
u
F
u
F
F
u
u
C
\u2212
\u2212
=
,
(2)
5 The original definition is given by Sklar (1959).
6 For the proof, see Sklar (1996).

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