Correlations and Copulas

Correlations and
Copulas
Chapter 9
Risk Management and Financial Institutions, Chapter 6, Copyright John C. Hull 2006
6.1
Coefficient of Correlation
The coefficient of correlation between two

variables V1 and V2 is defined as
E (V1V2 ) E (V1 ) E (V2 )

SD(V1 ) SD(V2 )
6.2
Independence
V1 and V2 are independent if the

knowledge of one does not affect the
probability distribution for the other
f (V2 V1 x) f (V2 )
where f(.) denotes the probability density

function
6.3
Independence is Not the Same as

Zero Correlation
Suppose V1 = 1, 0, or +1 (equally likely)

If V1 = -1 or V1 = +1 then V2 = 1
If V1 = 0 then V2 = 0
V2 is clearly dependent on V1 (and vice
versa) but the coefficient of correlation is
zero
Correlation measures linear dependence
6.4
Types of Dependence
E(Y\X )
E(Y\X )
X
(a)
(b)
E(Y\X )
X
(c)
6.5
Monitoring Correlation
Variance rate per day of a variable:

variance of daily returns
Covariance rate per day between two
variables: covariance between the daily
returns of the variables
6.6
X i and Yi values of two variables X

and Y at the end of day i, the returns
on day i are :
X i X i 1
Yi Yi 1
xi
, yi
,
X i 1
Yi 1
Covariance rate on day n :
cov n E ( xn yn ) E ( xn ) E ( yn )
E ( xn y n )
6.7
Monitoring Correlation Between

Two Variables X and Y
Define
varx,n: daily variance rate of X estimated on day n-1
vary,n: daily variance rate of Y estimated on day n-1
covn: covariance rate estimated on day n-1
The correlation is
cov n
varx ,n vary ,n
6.8
Monitoring Correlation continued

EWMA:
cov n cov n1 (1 ) xn1 yn1

GARCH(1,1)
cov n xn1 yn1 cov n1
6.9
Positive Finite Definite Condition

A variance-covariance matrix, W, is
internally consistent if the positive semidefinite condition
w Ww 0
T
holds for all N1 vectors w, W positivesemidefinite

6.10
Example
The variance covariance matrix
1
0.9
0
1
0.9
0.9
0.9
is not internally consistent
6.11
V1 and V2 Bivariate Normal
Conditional on the value of V1, V2 is normal with

mean
V1 m1
E (V2 | V1 ) m 2 rs 2
s1
and standard deviation s 2 1 r2 where m1,, m2,
s1, and s2 are the unconditional means and SDs
of V1 and V2 and r is the coefficient of
correlation between V1 and V2
6.12
Multivariate Normal
Many variables can be handled

A variance-covariance matrix defines the
variances of and correlations between
variables
To be internally consistent a variancecovariance matrix must be positive
semidefinite
6.13
Generating Random Samples for

Monte Carlo Simulation
6.14
6.15
6.16
Factor Models
When there are N variables, Vi (i=1,2,..N),

in a multivariate normal distribution there
are N(N-1)/2 correlations
We can reduce the number of correlation
parameters that have to be estimated with
a factor model
6.17
Factor Models continued
If Ui have standard normal distributions we

can set
U i ai F 1 ai2 Z i
F and Zi have independent standard

normal distributions, ai is a constant
between -1 and +1, Zi uncorrelated with
each other and F

All the correlation between Ui and Uj
arises from F
6.18
Factor Models continued
6.19
M-factor Model
U i ai1 F1 ai 2 F2 ... aiM FM 1 a a a Z i
2
i1
2
i2
2
iM
F1 ,..., FM standardized uncorrelat ed normal variables , Z i

uncorrelat ed with each other and Fi ' s
M
rij aim a jm
m 1
6.20
Gaussian Copula Models:

Creating a correlation structure for variables that are not
normally distributed
Suppose we wish to define a correlation structure

between two variable V1 and V2 that do not have normal
distributions
We transform the variable V1 to a new variable U1 that
has a standard normal distribution on a percentile-topercentile basis.
We transform the variable V2 to a new variable U2 that
has a standard normal distribution on a percentile-topercentile basis.
U1 and U2 are assumed to have a bivariate normal
distribution
6.21
6.22
6.23
6.24
6.25
The Correlation structure between the

Vs is define by that between the Us
-0.2
0.2
0.4
0.6
0.8
1.2
-0.2
0.2
0.4
V2
V1
0.6
0.8
1.2
One-to-one
mappings
-6
-4
-2
-6
-4
-2
U2
U1
Correlation
Assumption
6.26
Other Copulas
Instead of a bivariate normal distribution

for U1 and U2 we can assume any other
joint distribution
One possibility is the bivariate Student t
distribution
6.27
5000 Random Samples from the

Bivariate Normal
5
4
3
2
1
0
-5
-4
-3
-2
-1
-1
-2
-3
-4
-5
6.28
5000 Random Samples from the

Bivariate Student t
10
0
-10
-5
10
-5
-10
6.29
Multivariate Gaussian Copula
We can similarly define a correlation

structure between V1, V2,Vn
We transform each variable Vi to a new
variable Ui that has a standard normal
distribution on a percentile-to-percentile
basis.
The Us are assumed to have a
multivariate normal distribution
6.30
Factor Copula Model

In a factor copula model the correlation
structure between the Us is generated by
assuming one or more factors.
6.31
Credit Default Correlation
The credit default correlation between two

companies is a measure of their tendency to
default at about the same time
Default correlation is important in risk
management when analyzing the benefits of
credit risk diversification
It is also important in the valuation of some
credit derivatives
6.32
The Model
We map the time to default for company i, Ti, to a

new variable Ui and assume
U i ai F 1 a Z i
2
i
where F and the Zi have independent standard

normal distributions
Define Qi as the cumulative probability distribution
of Ti
Prob(Ui<U) = Prob(Ti<T) when N(U) = Qi(T)
6.33
The Model continued
U a F
i
Prob(U i U F ) N
1 ai2
Hence
N 1 Q (T ) a F
i
i
Prob(Ti T F ) N
1 ai2
Assuming the Q' s and a' s are the same for all companies
N 1 Q(T ) r F
Prob(Ti T F ) N
(*)
1 r
6.34
The Model continued

For a large portfolio of loans, equation (*)
provides a good estimate of the prercentag e
of loans defaulting by time T conditional on F,
the default rate.
1
P(F N (Y )) Y , so there is a probability of Y

that the default rate will be greater than
N 1[Q (T )] r N 1 (Y )
1
r
6.35
The Model continued

We call the default rate that we are X%
certain will not be exceeded in time T,
the " worst - case default rate". Substitute
Y 1 - X into the previous expression, then
N 1[Q(T )] r N 1 ( X )
WCDR (T , X ) N
6.36
Example
Suppose that a bank has a total of $100

million of retail exposures. The one-year
probability of default averages 2% and the
recovery rate averages 60%. The copula
correlation parameter is estimated as 0.1.
N 1 (0.02) 0.1N 1 (0.999)
WCDR(1,0.999) N
0
.
1
0.128
Losses in this case are
100 0.128 (1 0.6) $5.13 million
6.37
6.38

Correlations and Copulas

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Correlations and Copulas

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Correlations and

The coefficient of correlation between two

E (V1V2 ) E (V1 ) E (V2 )

V1 and V2 are independent if the

where f(.) denotes the probability density

Independence is Not the Same as

Suppose V1 = 1, 0, or +1 (equally likely)

Variance rate per day of a variable:

X i and Yi values of two variables X

Monitoring Correlation Between

Monitoring Correlation continued

cov n cov n1 (1 ) xn1 yn1

Positive Finite Definite Condition

holds for all N1 vectors w, W positivesemidefinite

is not internally consistent

V1 and V2 Bivariate Normal

Conditional on the value of V1, V2 is normal with

Many variables can be handled

Generating Random Samples for

When there are N variables, Vi (i=1,2,..N),

Factor Models continued

If Ui have standard normal distributions we

F and Zi have independent standard

each other and F

Factor Models continued

F1 ,..., FM standardized uncorrelat ed normal variables , Z i

Gaussian Copula Models:

Suppose we wish to define a correlation structure

The Correlation structure between the

Instead of a bivariate normal distribution

5000 Random Samples from the

5000 Random Samples from the

Multivariate Gaussian Copula

We can similarly define a correlation

Factor Copula Model

Credit Default Correlation

The credit default correlation between two

We map the time to default for company i, Ti, to a

where F and the Zi have independent standard

The Model continued

The Model continued

P(F N (Y )) Y , so there is a probability of Y

The Model continued

Suppose that a bank has a total of $100

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