An Introduction to Copulas : Which Copula is the right one?

Dependence Concepts Copula Families Elliptical Copula Archimedean Copula Kendalls tau Spearman Rho Dependency Structure

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Copula
Copula Copula Risk Factor (Dependency) (Non-linear dependency) Elliptical distributions - linear dependence structure - correlation coefficient meaningful Non-elliptical distributions - alternative measures of dependence needed Copulas Copula

1940's : Hoeffding studies properties of multivariate distributions 1959 : The word copula appears for the first time (Sklar) 1999 : Introduced to financial applications (Embrechts, McNeil, Straumann) 2006 : Several insurance companies, banks and other financial institutions apply copula as a Risk management, Credit Derivatives, CDO, Options etc

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Copula
Copula

Copula (dependence structure) (is a function that links univariate marginals to their full multivariate distribution)

Copula (margins) CDF

F ( x1 , x2 ) = P[ X 1 x1 , X 2 x2 ]
Copula fun (Sklars theorem)

F ( x2 ) = P[ X 2 x2 ]

F ( x1 ) = P[ X 1 x1 ]

C (u1 , u2 ) = F ( x1 , x2 )
Property of copula

C 2 ( F1 ( x1 ), F 2 ( x 2 )) = F ( x1 , x 2 )
xi = Fi (ui ) 1

C (u1 , u 2 ) C (u1 ,1) = u1

0 u1 , u2 1

0 C (u1 , u 2 ) 1
P[ X 1 x1 ] = u1 P[ X 2 x2 ] = 1

Fi ( xi ) = ui

C (1, u2 ) = u2

C (u1 ,1) = F ( x1 , x2 )

x2 =

C (u1 ,1) = F ( x1 , x2 ) = P[ X 1 x1 , X 2 ] = P[ X 1 x1 ] = u1

C(u1,0) = [0, u1 ][0,0] = 0

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Copula

Standard Normal function : N(0,1)

Copula Function

Fi ( xi ) = ui

45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%

A1

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

C(0.1,0.2) = F(1.28, 0.84) = F(x1, x2 ) = P[ X1 1.28, X 2 0.84] = 6.90% = [0, 0.1] [0, 0.2] /1000 product
Where
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F1 ( x1 ) = P[ X 1 x1 ] = 0.1

X 1 = 1.28
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Copula
2 2 dimension dimension copula copula

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Copula

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Copula

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Copula

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Copula
Copula function vs Cumulative Distribution :Normal case
Normal Dist

Copula Fn

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Copula
Multivariate Multivariate Copula Copula Function Function

C (F1( x1 ), F2 ( x2 ), L , Fm ( xm ), ) = Pr[U1 F1( x1 ), U2 F2 ( x2 ), L , Um Fm ( xm )]

1 = Pr[F11(U1 ) x1 , F21(U2 ) x2 , L , Fm (Um ) xm ]

= Pr[X1 x1 , X 2 x2 , L , X m xm ] = F ( x1 , x2 , L , xm )
The The marginal marginal ditribution ditribution of of X Xii

C(F1(+), F2(+),L, F2(xi ),L Fm(+), ) = Pr[F1(+), F2(+),L, Fi (xi )L Fm(+), ] = Pr[X1 +, X 2 +, L , X i xi , L X m +] = Pr[X i xi ] = F ( xi )

F ( x1 , x2 , L , xm ) = C (F1( x1 ), F2 ( x2 ), L , Fm ( xm ), )

C (u1 , u2 , L , um ) = m ( 1(u1 ), 1(u2 ), L , 1(um ); )

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Copula
:: Correlation Correlation Copula : (Uniform Distribution)

C (u1 , u2 ,........un ) = Pr[ X 1 x1 , X 2 x2 ....., X n xn ]

ui :

C (u1 , u2 ,.........un )
u1 , u2 ,........un [0,1]
n

F1 ( x1 ), F2 ( x2 )...............Fn ( xn )
Fi ( xi ) = ui xi = Fi (ui ) 1

F ( x1 , x2 ,.........xn ) = C[ F1 ( x1 ), F2 ( x2 )...............Fn ( xn )]
Sklar Representation

C ( x1 , x2 ,......... xn ) = F [ F11 ( x1 ), F2 1 ( x2 )...............Fn 1 ( xn )]

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Copula Definition (Definition of copula function)

N- Copula

C : [ 0 ,1] n [ 0 ,1]
[ 0 ,1 ] C i ( u ) = C (1,..., 1, u ,1,..., 1) = u

(1) C (grounded) n- (2) C u

(3) C n- (increasing function)

f ( x1 ,...., x n )

2 (1) (2)

(1) Correlation structure : find the co-movement between variables may be viewed as a part of
dependence structure

(2) the product of marginal probability density functions

be achieved using regular statistical methods

: fit the individual marginal distribution and estimate their parameters (which can

* Sklar copula 12
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Copula Theorem (Sklars Theorem)

F ( x1 ,..., x n ) = C ( F1 ( x1 ),..., Fn ( x n ))
F (x1,..., xn ) C (F1(x1 ),..., Fn (xn )) f (x1,..., xn ) = = x1...xn x1...xn C (u1,..., un ) Fi (xi ) = u1...un xi i
i

%) = c(u

f (x1,...., xn) fi(xi )

i

% ) fi (xi ) = c(u1,..., un ) fi (xi ) = c(u

i

f ( x1 ,...., xn ) F ()
% = (u1,..., u2 ) u
%) c(u
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(probability density function)

ui = Fi ( xi ) i = 1 ,..., n
**

Copula density function

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Copula

Copula function property (bi-variate)

C(u, v) is between [0,1] and u, v are uniformly distributed [0,1] C(0, v) = 0 C(u, 1) = u; C(u, v) is a 2-increasing function

Special copula functions

Minimum copula : C(u, v) = max(u+v-1, 0) Maximum copula : C(u, v) = min(u, v) Gaussian copula : C(u, v) = (-1(v), -1(u)) Student t-copula : C(u, v) = t,s(ts-1(u), ts-1(v)) And more

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Copula Example 1: Independence copula If U U(0, 1) and V U(0, 1) are independent, then C(u, v) = uv = = P(U u)P(V v) = P(U u, V v) = H(u, v), where H(u, v) is the distribution function of (U, V). C is called the independence copula.

Example 2: Gaussian copula

1 (u ) 1 (v )

C (u, v ) =

GA R

x 2 2R12 xy + y 2 1 exp{ }dxdy 2 1/2 2 2 (1 R12 ) 2(1 R12 )

Example 3: Students copula

C (u, v) =

t v ,R

1 1 tv (u) tv (v )

x2 2R12 xy + y2 (v +2) / 2 1 {1 + } dxdy 2 1/2 2 2 (1 R12 ) v(1 R12 )

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is the degrees of freedom and R is the linear correlation coefficient.

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Copula Gaussian copula Students copula

Ga m 1 1 1 C ( X ) = v (v ( x1 ), v ( x2 ), L , v ( xm )) T m 1 1 1 C ( X ) = tv (tv ( x1 ), tv ( x2 ), L , tv (xm ))

rho= 0.7

m=2

rho= 0.7, v = 4.

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Copula Archimedian Archimedian Copula Copula Archimedean copula ( Archimedean copula closed form expression )

: [0,1] [0, ]

1 :[0, ] [0,1]

copula

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Copula
Elliptical Copula

Archimedean Copula

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Copula Dependency Structure

Gaussian or t-Copula Dependent Symetary Clayton Copula Gumbel Copula

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Low tail dependence ( dependency) Upper tail dependence( dependency)

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Copula Example 4: Gumbel copula

C (u, v ) = exp{[( ln u) + ( ln v ) ]

Gu

1 /

(t ) = ( ln t )

1 <

1< <

=3

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Independence

1 1 1/1 CGu } =1(u, v) = exp{[( ln u) + ( lnv) ]

= exp{ln(u) + ln(v )} = uv =

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CGu = (u, v ) = min(u, v )

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Perfect Dependence

Copula Gumbel Gumbel Copula Copula

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Copula Example 5: Clayton copula (explicit)

CClayton (u, v ) = (u + v 1)1 /

(t ) =
1

t 1

>0

Bivariate Clayton copula ( = 3).

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Independence Perfect Dependence

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Copula Clayton Clayton Copula Copula

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Copula Example 5: Frank copula (explicit)

Frank

(e u 1)(e v 1) (u, v ) = ln 1 + (e 1) 1

e t 1 (t ) = ln e 1
1

< <

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Copula Dependency Dependency Structure Structure Upper tail dependence

upper = lim Pr(Y FY1 (u ) X FX1 (u ))

u 1

1 Pr(Y FX1 (u)) Pr(Y FY1 (u)) + Pr( X FX1 (u), Y FY1 (u)) = 1 Pr(Y FX1 (u)) 1 2 u + C (u , u ) 1 1 = lim Pr( Y F ( u )) = Pr( Y F (u )) = u X Y u 1 1 u 1 1
Lower tail dependence

Pr( X FX (u ), Y FY (u ) = C (u , u )

Lower = lim Pr(Y FY1 (u ) X FX1 (u ))

u 0

The tail area dependency measure depends on the copula and not on the marginal distribution
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P r ( X F X 1 ( u ) , Y F Y 1 ( u ) ) = P r ( Y F X 1 ( u ) ) C (u, u ) = lim u 0 u

Copula Gaussian Copula : the coefficients of lower tail and upper tail dependence Dependency Structure Structure Dependency
Proof
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U = L = 2lim x ( x 1 / 1 + ) = 0
T-copula : the coefficients of lower and upper tail dependence

U = L = 2t +1( + 1 1 / 1 + )
Clayton copula

U = 0

L = 2 1 /
L = 0

Gumbel copula

U = 2 21 /
Frank copula

U = 0

L = 0

1 2u + C (u , u ) 1 2u + exp{[( ln u ) + ( ln u ) ]1/ } U = lim = lim u 1 u 1 1 u 1 u 1/ 1 2u + exp{{2( ln u ) ] } = lim u 1 1 u 1/ 2 + 2 = lim = 2 21/ u 1 1 26

Copula Dependence Dependence

Dependence

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Copula Concordance Concordance function function

Data Set(two pairs)

(xi , y i ) ( xj, y j )
(concordance) (disconcordance)

(x1 x2 )(y1 y2 ) > 0

( x1 x2 )(y1 y2 ) < 0

Concordance function

= Pr[( x1 x2 )(y1 y2 ) > 0] Pr[(x1 x2 )(y1 y2 ) < 0]

= Pr[(x1 x2)(y1 y2) > 0] {1 Pr[(x1 x2)(y1 y2) > 0]}

= 2{Pr[x1 > x2, y1 > y2] + Pr[x1 < x2, y1 < y2] } 1
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Copula Spearman rank correlation

Nonparametric Correlation

S ( X , Y ) = 12
0

{C(u, v ) uv}dudv
0

S ( X , Y ) = (F1( X ), F2 (Y ))
= Cov[F1( X ), F2 (Y )]

2[F1( X )] 2[F2 (Y )]

Cov[F1( X ), F2 (Y )] 1 1 12 12

= 12Cov[F1( X ), F2 (Y )]
= 12
1 0 0 1 1

{C(x, y ) F
0 1

F1 ( x )

( x )FF2 ( x )(y )}dxdy

= 12

= 12
0

0 1

{C(x, y ) xy}dxdy C(x, y )dxdy 3

0

F1( X ), F2 (Y )
1 2

: Standard uniform distribution

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Cov[F1( X ), F2 (Y )] =

{F (x, y ) F (x)F (y )}dxdy

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Copula Kendall rank correlation

Nonparametric Correlation

( X , Y ) = 4
0

C(u, v )dC(u, v ) 1
0

( X , Y ) = 2Pr[(x1 x2 )(y1 y2 ) > 0] 1

= 2 E [1( x1 x 2 )( y 1 y 2 ) > 0 ] 1

= 2E[1( x1 x2 )> 0 1(y1 y2 )>0 + 1( x1 x2 )< 01(y1 y2 )< 0 ] 1

= 2[ 1( x1 x2 )> 0 1(y1 y2 )> 0 dF (x2 , y2 )dF (x1, y1 )
R

+ 1( x1 x2 )< 0 1(y1 y2 )< 0 dF (x2 , y2 )dF (x1, y1 )] 1

R

= 2 2 1( x1 x2 )> 0 1(y1 y2 )> 0 dF (x2 , y2 )dF (x1, y1 ) 1

R

= 4
R
1

F (x , y )dF (x , y ) 1
1 1 1 1

= 4
0

C (u, v )dC (u, v ) 1

0

Pr[( x1 x2 )(y1 y2 ) > 0] + Pr[( x1 x2 )(y1 y2 ) < 0] = 1

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Copula

Kendalls Tau for Archmedean Copula

(u) = 1 + 4 ' du 0 (u)

1

Clayton copula

2+

Gumbel copula

=1

Frank copula

=14

tdt exp(t ) 1

2
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Copula

Testing for Elliptic Distributions - Do we really need to worry about using Copulae at all?

Estimating Parametric and Non-parametric Copulae - Maximum Likelihood; Full MLE or sequential / concentrated ML - Semi-parametric estimation Impact of the misspecification of marginal distributions on the estimation of copula parameters and measures of dependence - Non-parametric methods How to choose the Correct Copula? - AIC - Goodness of Fit Tests - Simulated Cox Tests Copula Quantile Regression and Tail area Dependence - Quantile conditional relationships implied by a given copula - Quantile dependency measures
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Copula Gaussian Gaussian copula copula

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Copula Students Students t-copula t-copula

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