Disseration Report

Model risk of Copula-GARCH
financial time series models

submitted in partial fulfilment of the requirements
for the degree of
(Five Years Integrated M.Sc Course)

in
Mathematics
Submitted by :
Supriya Murdia
(Reg. No.: I14MA013)
Under the supervision of :

Dr. JAYESH M. DHODIYA
Associate Professor, AMHD
Co-supervisor :
Prof. Dr. GREGOR WEIß
Faculty of Economics and Management
Chair in Sustainable Finance and Banking
DEPARTMENT OF APPLIED MATHEMATICS AND HUMANITIES,

SARDAR VALLABHBHAI NATIONAL INSTITUTE OF TECHNOLOGY,
SURAT, GUJARAT -395007
2019
2
Department of Applied Mathematics & Humanities,

Sardar Vallabhbhai National Institute of Technology,
Surat-395 007, Gujarat, India.
CERTIFICATE OF EXAMINER’S APPROVAL
The dissertation entitled “Model risk of Copula-GARCH financial time series mod-
els ”, by Supriya Murdia is approved for the degree of Master of Science in Mathematics.
Prof. D. C. Joshi
(External Examiner)
Prof. V. H. Pradhan
(Internal Examiner)
Dr. Jayesh M. Dhodiya

(Supervisor)
Dr. Smita Jauhari

(Chairperson)
Date :
Place : Surat
3

DECLARATION
I hereby declare that the dissertation titled “Model risk of Copula-GARCH finan-
cial time series models” is a genuine record of research work carried out by me and no
part of this dissertation has been submitted to any university or institution for the award of
any degree or diploma.
Supriya Murdia
(I14MA013)
Applied Mathematics and Humanities Department
Sardar Vallabhbhai National Institute of Technology
Surat - 395007
Date:25-04-2019
Place: Surat
4

CERTIFICATE
This is to certify that the dissertation titled, “Model risk of Copula-GARCH financial
time series models ” is based on a part of research work carried out by Miss. Supriya
Murdia under my guidance and supervision at Sardar Vallabhbhai National Institute of
Technology, Surat and Faculty of Economics and Management, Universitat Leipzig, Ger-
many.
Supervisor:
Dr.Jayesh Dhodiya
Associate Professor
Department of Applied Mathematics and Humanities
Sardar Vallabhbhai National Institute of Technology
Surat, India.
5
6
ACKNOWLEDGEMENT
I would like to extend my heartfelt gratitude to Dr. Jayesh Dhodiya, for understanding my
fondness towards this topic, for supporting me and mentoring me, for making any resource
that I would require available at the speed of light and for bringing me out of gloom when I
thought I would fail to implement the factor copula. I would thank him for having us at the
lab throughout the semester, the only reason why we were able to complete our work and
make memories to last for a lifetime.
This dissertation has been one stupendous journey and I am grateful for every part of
it. I would like to thank Prof. Dr. Gregor Weiß for his relentless support and guidance
throughout the work, and for putting up with me for my doubts with the directions to the
study, with the theory even when they turned out to be naive, often. I would specially thank
him for taking out the time and the efforts, even against the unsteady network connection
to still motivate and guide me on the project. I hope I am much less trouble in future with
exploring this research question in full, and effectuating it into a worthwhile publication.
Most importantly, I would like to thank my mother for the selfless, undying attention,
support and love she fills me up with, to the brim and more. I would also like to thank
Surbhi Ma’am, Ankita Ma’am, Ankit Sir for helping me with software installations and
latex specifications and my batch mates Nagesh, Deevanshu and Saloni for lending me their
laptops for my simulations and keeping me updated on the semester proceedings.
7
PREFACE
Our study has the following structure:

Chapter 1 deals with the introduction to financial time series, incorporating the theory
on univariate and multivariate time series models, the need for multivariate modelling, the
BEKK, CCC and DCC multivariate time series models and a detailed description of the
copula-GARCH models. It also briefly discusses the various existing methods for comparing
a set of models.
Chapter II corresponds to an extensive literature review of the study we have performed.
It concludes with a comprehensive description of the objective of our study and it’s unique-
ness compared to the studies conducted so far.
Chapter III deals with the methodology implemented to obtain a model as an approxi-
mation of the true data generating process. Chapter IV deals with the detailed description
of Hansen’s model confidence set procedure that we employ.
Chapter IV presents a detailed study on the outcomes of the models implemented il-
lustrating their plots incorporating the financial crisis time horizon, the MCS results with
different loss functions and test statistics, the backtest results and final inferences from each
set of results. It also includes an extension to our main objective, regarding the effect of the
choice of marginal models on the quality of the forecasts.
Chapter V presents an overall conclusion of our work, making some major statements
about marginal modelling and choice of copula-GARCH model. Chapter VI, discusses further
extensions possible to this study that we are trying to incorporate in our working paper.
We end the dissertation thesis with the appendix that contains abstract codes to the
models we implement and a snippet of the data used.
Table of Contents
1 Introduction to financial time series 7

1.1 Time Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Time Series Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.1 Univariate time series models . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 Multivariate time series models . . . . . . . . . . . . . . . . . . . . . 11
1.2.3 Comparison of models . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2 Literature Review 18
2.1 Univariate time series modelling . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.1.1 Mean modelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.1.2 Volatility modelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.1.3 ARMA-GARCH modelling . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2 Multivariate time series modelling . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2.1 Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.3 Model Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.3.1 Loss Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.4 Similar Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5 Objective of research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3 Methodology for Model Fitting 24

3.1 Stock Indices Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.2 GARCH fitting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.3 Copula estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4 Methodology for Model Comparison 29

4.1 Loss Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2 Model Confidence Set Procedure . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.3 Sener’s penalty measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5 Results and Discussion 35

5.1 Phase I: Models with rolling window . . . . . . . . . . . . . . . . . . . . . . 35
5.2 Phase II: Models without rolling window . . . . . . . . . . . . . . . . . . . . 48
5.3 Phase III: Models with fixed copula and varying marginals . . . . . . . . . . 62
5.4 Phase IV: Models with fixed marginal and varying copulas . . . . . . . . . . 70
5.5 Drawbacks of Hansen’s Model Confidence Set procedure . . . . . . . . . . . 74
1
TABLE OF CONTENTS 2
6 Conclusion and Future Scope 75

6.1 Conclusion on copula-GARCH models . . . . . . . . . . . . . . . . . . . . . 75
6.2 Conclusion on comparison methods . . . . . . . . . . . . . . . . . . . . . . . 75
6.3 Conclusion on model risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
6.4 Future Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
7 Appendix 83
List of Figures
3.1 The process of fitting an ARMA(m,n)-GARCH(p,q) process. . . . . . . . . . . . 28

3.2 The process of estimating a copula and simulating from it. . . . . . . . . . . . . 28
4.1 Hansen’s model confidence set procedure for comparing models. . . . . . . . . . . 34
5.1 Vine copula-GARCH(1,1) with rolling window. . .. . . . . . . . . . . . . . . . 36

5.2 Clayton copula-GARCH(1,1) with rolling window. .
. . . . . . . . . . . . . . . . 37
5.3 Gaussian copula-GARCH(1,1) with rolling window.. . . . . . . . . . . . . . . . 37
5.4 . . . . . . . . . . . . .
Student-t copula-GARCH(1,1) with rolling window. . . . 38
5.5 Gumbel copula-GARCH(1,1) with rolling window. .. . . . . . . . . . . . . . . . 38
5.6 Frank copula-GARCH(1,1) with rolling window. . .
. . . . . . . . . . . . . . . . 39
5.7 Joe copula-GARCH(1,1) with rolling window. . . .
. . . . . . . . . . . . . . . . 39
5.8 GAS factor copula-ARMA(1,1)-GARCH(1,1) without rolling window. . . . . 40
5.9 DCC-GARCH(1,1) with rolling window. . . . . . . . . . . . . . . . . . . . . 40
5.10 Clayton-Normal mixture(1:2) copula-GARCH(1,1) with rolling window. . . . 41
5.11 Vine copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . . . 48
5.12 Clayton copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . 49
5.13 Gaussian copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . 50
5.14 Student-t copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . 51
5.15 Gumbel copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . 52
5.16 Frank copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . . 53
5.17 Joe copula-ARMA(1,0)-GARCH(1,1) without rolling window. . . . . . . . . . . . 54
5.18 Joe copula-ARMA(1,1)-GARCH(1,1) without rolling window. . . . . . . . . . . . 55
5.19 GAS Factor copula-ARMA(1,1)-GARCH(1,1) without rolling window. . . . . . . 56
5.20 Clayton+Normal mixture(1:2) copula-ARMA(1,0)-GARCH(1,1) without rolling win-
dow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.21 Clayton copula-ARMA(1,1)-various marginal models. . . . . . . . . . . . . . . . 63
5.22 MCS results of Clayton copula-various GARCH marginals. . . . . . . . . . . . . 64
5.23 MCS results of Clayton copula-Various GARCH marginals. . . . . . . . . . . . . 64
5.26 Gaussian copula-ARMA(1,1)-various marginal models. . . . . . . . . . . . . . . 66
5.27 MCS results of Gaussian copula-Various GARCH marginals. . . . . . . . . . . . 67
3
LIST OF FIGURES 4
5.31 Various copulas-ARMA(1,1)-eGARCH(1,1) models. . . . . . . . . . . . . . . . . 71

5.32 MCS results of various copula models-ARMA(1,1)-eGARCH(1,1). . . . . . . . . . 72
7.1 Stock Indices Data (Source : Datastream). . . . . . . . . . . . . . . . . . . . . . 83

7.2 Abstract code for varied marginal modelling. . . . . . . . . . . . . . . . . . . . 84
7.3 Code for various marginal specifications. . . . . . . . . . . . . . . . . . . . . . . 84
7.4 Code for various copula specifications. . . . . . . . . . . . . . . . . . . . . . . . 84
7.5 Code for initialising the vine copula-GARCH(1,1) model. . . . . . . . . . . . . . 85
7.6 Code for auxiliary functions and vine copula-GARCH(1,1) model fitting. . . . . . 86
7.7 Code for simulating and forecasting from a vine copula-GARCH(1,1) model. . . . 87
7.8 Abstract code for DCC-GARCH(1,1) model. . . . . . . . . . . . . . . . . . . . . 87
7.9 Abstract code for estimation of GAS Factor copula-GARCH(1,1) model parameters. 88
7.10 Abstract code for estimation of GAS Factor copula-GARCH(1,1) model density. . 89
7.11 Abstract code for simulation from GAS Factor copula-GARCH(1,1) model. . . . . 90
7.12 Abstract code for implementation of Sener’s penalisation measure. . . . . . . . . 91
List of Tables
5.1 Backtest results of models with rolling window for the entire duration: 2003-2013. 42
5.2 MCS results for models with rolling window for the entire duration: 2003-2013. . . 42
5.3 MCS results for the period of financial crisis: December,2008-March, 2012 for mod-
els with rolling window. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.4 MCS results for the entire period : 2003-2013 for models with rolling window. . . 43
5.5 MCS results for the entire period: 2003-2013 for models with rolling window. . . . 44
5.6 MCS results for the period of financial crisis: Dec, 2008-March, 2012 for models
with rolling window. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.7 Sener’s penalties for 1% VaRs of copula-GARCH models with rolling window through
2003-2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.8 MCS results for the entire duration: 2003-2006 including DCC-GARCH(1,1) for
models with rolling window. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
5.9 MCS results for the entire duration: 2003-2006 including the non copula DCC-
GARCH(1,1) model for models with rolling window. . . . . . . . . . . . . . . . . 46
5.10 Exceedances of models without rolling window for the entire duration: 2003-2013. 58
5.11 Backtest results of models without rolling window for the entire duration: 2003-2013. 59
5.12 MCS results for the entire duration: 2003-2013 for models without rolling window. 59
5.13 MCS results for the entire time for models without rolling window. . . . . . . . . 60
5.14 MCS results for the entire period : 2003-2013 for models without rolling window. . 60
5.15 MCS results for the entire duration: 2003-2013 for models without rolling window. 61
5.16 MCS results for the period of financial crisis: Dec, 2008-March, 2012 for models
without rolling window. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
5.17 Sener’s penalties for 1% VaRs of copula-GARCH models with rolling window through
2003-2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
5.18 Sener’s penalties for 1% VaRs of copula-eGARCH models with rolling window dur-
ing 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
5
List of abbreviations
Abbreviation Denotes
MA Moving Average
AR Auto-Regression
ARMA Auto-Regressive Moving Average
ARIMA Auto-Regressive Integrated Moving Average
ARFIMA Auto-Regressive Fractionally Integrated
Moving Average
ARCH Auto-Regressive Conditional Heteroskedasticity
GARCH Generalised Auto-Regressive Conditional
Heteroskedasticity
N (0, 1) Standard Normal Distribution
VARMA Vector Auto-Regressive Moving Average
CCC Constant Conditional Correlation
DCC Dynamic Conditional Correlation
BEKK Baba, Engle, Kraft and Kroner model
VaR Value-at-Risk
MCS Model Confidence Set
Chapter 1
Introduction to financial time series
1.1 Time Series

Time series is a sequence of data (numerical or ordinal) values indexed in successive equally
spaced time intervals. [4] It therefore, becomes a sequence of discrete-time data. Time series
is basically one-dimensional panel data. They are usually plotted via line charts, as that
makes it easy to easy to graphically identify the trends, seasonal variation or autocorrelation
in the underlying data. They have numerous applications in signal processing, pattern
recognition, financial (stock/index, option price) time series, sales forecasting, budgetary
analysis, weather forecasting, workload projections, earthquake prediction, astronomy, etc.
One can fit time series to a suitable model and then utilise it to forecast, monitor or obtain
feedbacks or derive feed-forward control measures.
Once we understand what a time series is, it becomes desirable to wonder how to replicate
the data generating process, to obtain models that could re-generate the time series. This
could be an ambitious task as an expansive range of models have been developed in this
regard.
Much of the theory for time series is developed on the following two fundamental cat-
egories: A Stationary process or an Ergodic process [11]. A stationary process is one
in which the unconditional joint distribution of the time series data does not vary when
shifted in time. An ergodic process is a stochastic process whose statistical properties can
be deduced from a sufficiently long, single, random sample of the process.
1.2 Time Series Models

Two types of time series models are used in practice [2]:
• Models in which the present value of time series data is related to the prior values of
time series data (mean and volatility) and past prediction errors which contribute to
the white noise in prediction. For instance, the ARIFMA model.
• Ordinary regression models in which time is considered to be the independent vari-

able, and the time series data value as the dependent variable. These provide a basic
understanding of the data and help in drawing simple forecasts.
7
1.2. TIME SERIES MODELS 8
When modelling time series we have to take care of the following in the data:
• Trends
• Seasonal variation
• Heteroskedasticity, if present
• Outliers
• Implicit exogenous shocks
1.2.1 Univariate time series models

Given a univariate time series, the following are the models used in-practice:
AR(p) model
Here AR stands for auto-regression. Auto-regression is nothing but regression on the
dependent variable’s own past values. [9] It is a form of multi-variable regression where the
independent variables are the series’ own past values, p determining the number of such,
lagged terms and the dependent variable is the present day value of the series. A general
AR(p) process is of the following nature:
p
X
Xt = c + ψi Xt−i + t . (1.2.1)
i=0
Here, the error terms t ∼ N (0, σ 2 ), where t is independent and identically distributed,
ψi are the target parameters that need to be estimated, c is a constant and Xt are the data
values to be modelled/ estimated.
MA(q) model
A q th order moving average model, denoted by M A(q) is of the form:
q
X
Xt = µ + θi wt−i , (1.2.2)
i=0
where wt ∼ independent and identically distributed N (0, 1), , θi are the parameters that
need to be estimated, and t−i are the white noise error terms and µ is the mean of the
series. Here q is the order of the moving average model, i.e., the number of lagged terms
considered in the model. Xt is the return or the time series value being modelled.
(Box Jenkin’s) ARMA(p,q) model

ARMA(p,q) models provide a tedious description of a stationary stochastic process or weakly
stationary stochastic process formulated in terms of 2 polynomials. The former part is for
an AR(auto regression) process of order p, and the latter is for an MA (moving average)
process part of order q
p q
X X
Xt = c + ψi Xt−i + θi t−i , (1.2.3)
i=0 i=0
where, the notations retain their former meaning. It was first described in 1951 in the thesis
of Peter Whittle.
ARIMA(p,d,q) model
ARIMA, as in, auto-regressive integrated moving average model is nothing but a
generalisation of ARMA(p,q) that has the capability to concern with non-stationarity. The
model is determined as given below:
p q
X X
i d i
1− φi L (1 − L) Xt = 1 + θi L t , (1.2.4)
i=1 i=1
where, θi s are the moving average parameters, L is lag operator, Xt is time-series data and
t is the corresponding time-index, αi s are the autoregressive parameters used to derive φi s
as gievn below:
p+d p
X X
i
1− αi L = 1 − i
φi L (1 − L)d . (1.2.5)
i=1 i=1
Here d denotes multiplicity of a unit root (L = 1) of the polynomial of on the left hand side
of the equation above. Hence, an ARIMA process with d > 0 is not wide-sense stationary.
Holt Winter’s Exponential Smoothing model

In 1957, Holt [49] discussed exponential smoothing, in which exponentially decreasing weights
are allocated as the observations get older. As compared to equal weights in a moving average
model, smoothing parameters are to be estimated here. We set S2 = y2 , Si are the EWMA
(exponentially weighted moving averages), yi are the original observations, i = 1, 2, . . . , t.
For a time instant t, a smoothed value is obtained as follows:
St = αyt−1 + (1 − α)St−1 , 0 ≤ α ≤ 1, t ≥ 3. (1.2.6)
Here α is the smoothing constant and t is the time instant being observed.
ARCH(q) model
Heteroskedasticity: Consider a first sequence of random variables, {Yt }nt=1 , and another
sequence of vectors of random variables, {Ŷt }nt=1 which is a regression fitting estimate of
the original sequence of random variables. If Yt varies unequally compared to Ŷt over the
range of time, even for some t, then such a circumstance is called heteroskedasticity. This
is why ordinary least squares method and other regression tools lack efficiency when dealing
heteroskedastic data.
The auto-regressive conditional heteroskedasticity model is a statistical model for time

series data that relates the variance of the current error term or in other words, the innovation
with the actual size of past periods’ error terms.
Let t denote the error term at time t, i.e. return residuals in de-meaned data series.
These t can be factorised into zt , a strong white noise stochastic process. Also, σt , denotes
time-dependent standard deviation. [3] Hence, we can write:
t = σt zt , (1.2.7)
q
X
σt2 = α0 + α1 2t−1 + ... + αq 2t−q = α0 + αi 2t−i , (1.2.8)
i=1
where α0 > 0 and αi ≥ 0, i > 0, q(≥ 0) denotes the number of the lagged innovations in the
model and the zt are independent and identically distributed N (0, 1). An ARCH(q) model
can be estimated via ordinary least squares method.
GARCH model
A GARCH(p,q) model is enhanced into the following by Bollerslev [16]:
yt = x0t b + t , (1.2.9)
t |ψt−1 v ℵ(0, 1),

q p
X X
σt2 = α0 + αi 2t−i + 2
βj σt−j ,
i=1 j=1
where, t denotes a real-valued stochastic discrete time process, ψt denotes the σ-field of
all information throughout the time range, p(≥ 0) is the number of lagged residual terms,
and βj (≥ 0, j = 1, . . . , p), the corresponding coefficients to be estimated. Evidently, it is a
generalisation of ARCH(q) model with an additional lag on the conditional variances being
estimated themselves.
Types of GARCH models

ziv [5] discusses the 18 kinds of GARCH models that exist in common practice. It is possible
to construct many more of them. We will briefly describe the ones we apply in our work.
The APARCH(p,q) model to model the conditional standard deviation holds the fol-
lowing specification:
p q
X X
σtδ =ω+ αi (|at−1 | − γi at−1 ) + δ δ
βj σt−j , (1.2.10)
i=1 j=1
where γj ∈ (−1, 1), j = 1, . . . , p, σt2 denotes the conditional variance at instant t, and at
are the white noise terms.
The EGARCH(p,q) also known as exponential GARCH is specified by:

q p
X X
log(σt2 ) = ω + βk g(Zt−k ) + 2
αk log(σt−k ), (1.2.11)
k=1 k=1
where the conditional variance is given by σt2 , g(Zt ) = θZt + λ(|Zt | − E(|ZT |)), ω, β, α, θ, γ
are coefficients, Zt follows the generalised error distribution.
Threshold GARCH also known as tGARCH(p,q) is given by
− −
σt = K + δσt−1 + α1+ +
t−1 + α1 t−1 , (1.2.12)
−
where + +
1 = t−1 if t−1 > 0, and 1 = 0 if t−1 ≤ 0 and likewise for t−1
Glosten-Jaggannathan-Runkel GARCH also known as gjrGARCH(p,q) is given by:
σt2 = K + δσt−1
2
+ α2t−1 + φ2t−1 It−1 , (1.2.13)
where It−1 = 0, if t−1 ≥ 0 and It−1 = 1, if t−1 < 0 , which helps measure asymmetry in
ARCH models.
The symmetric GARCH(p,q) or the sGARCH(p,q) is useful and relatively time saving
in modelling symmetric univariate GARCH marginals.
1.2.2 Multivariate time series models

In order to fit multivariate time series, the above models will not be able to couple
two series as they don’t have any dependence structure described. Multivariate models
have a greater economic significance over univariate models since, when it comes to actually
investing a sum, a diversified portfolio significantly helps in obtaining a net profit. In order
to study and make statistical, economic inferences from a diverse portfolio, only multivariate
modelling can help.
Multivariate GARCH (MGARCH), vector auto-regressive moving average-GARCH (VARMA-
GARCH), BEKK, Engle’s Dynamic conditional correlation and the constant conditional
correlation models are some multivariate time series models. However, studies show copula-
GARCH models are usually superior and we will base our study on those.
VARMA-GARCH
The VARMA-GARCH is simply the multivariate extension of the GARCH model in which
instead of auto-regressing on data values, it is performed on past data vectors (multi-auto-
regression).
BEKK model
Engle and Kroner(1995) discuss the following multivariate GARCH specification :
q
K X p
K X
X X
Ht = C0 C0T + ATki t−i Tt−i Aki + T
Bkj Ht−j Bkj , (1.2.14)
k=1 i=1 k=1 j=1
where, Aki and Bki are d × d-dimensional parameter matrices, C0 is lower-triangular matrix.
To simplify understanding, we can first take a look at the bivariate case, taking K = p = 1
and q = 0. The conditional variance ε1t can be given by the following:
h12,t = c211 + a211 ε21t + a212 ε22t + 2a11 a12 ε1t ε2t , (1.2.15)
where as the conditional variance is given by
h11,t = c11 c21 + a11 a21 ε22t + (a12 a21 + a11 + a22 )ε1t ε2t . (1.2.16)
BEKK stands for Baba, Engle, Kraft and Kroner (1990) on the names of those who first
proposed it. The BEKK specification consolidates that Ht is positive definite under weak
assumptions. However, the sufficient condition for positivity requires that at least one of C0
or Bki have full rank matrices as well as H9 , . . . , H1−p should be positive definite matrices.
A beneficial point of BEKK is that it permits casualties in variances to be modelled, as it
can handle the dependency of conditional variances on the lagged values of the other [12].
Constant Conditional Correlation model

Bollerslev et al. [19], (1990) introduced the so-called CCC model, CCC standing for Constant
Conditional Correlation model. As the name suggests, here, the conditional correlations
are considered constant. A GARCH(p,q) univariate process is used to fit the conditional
variances. It is quite different from the VARMA-GARCH in the nature of specification. To
begin with, the CCC(1,1) can be formulated as given below:
hii,t = ωi + αi ε2t−1 + βi hii,t−1 , (1.2.17)
p
hij,t = ρij hii,t hjj,t ,
for i, j = 1, . . . , d. Here ρij determines the constant correlation between εit and εjt . It is
superior to the MGARCH and VARMA-GARCH because of its unrestricted applicability and
considerably reduced parameters in large systems. However, assuming constant correlation
in itself is quite huge a restriction. To overcome this we have the Dynamic Conditional
Correlation model.
Dynamic Conditional Correlation model

Formulated by Engle [29], (2000) , the Dynamic Conditional Correlation model is a very
popular model for forecasting multivariate time series. The DCC proceeds like Bollerslev’s
CCC but Engle incorporated a method to capture the dynamics of observed correlations.
The DCC specification is given by:
p q
X X
0
Qt = R + αi (ννt−i − R) + βj (Qt−j − R), (1.2.18)
i=1 j=1
where p and q can be estimated by information criterion methods. Qi,j t is the correlation
between rti and rtj , νt are the standardised residuals given by νt = Dt−1 (rt − µ), µ i the vector
of expected returns, µ i the vector of expected returns, rt is the vector of returns,PDt , the
diagonal matrix of conditional volatilities, and the matrix R is defined as R = T1 Tt=1 νt νt0
[30].
Copula-GARCH models
The univariate GARCH marginals are coupled with copulas to obtain a multivariate model
of the diversified portfolio.
A Copula, derived from the theory of t-norms from metric spaces, is a function that
possesses the following properties:
C : [0, 1]2 → [0, 1], (1.2.19a)
(For, a d-dimensional copula, C : [0, 1]d → [0, 1])
C(u, 0) = 0 = C(0, v), (1.2.19b)

C(u, 1) = u, C(1, v) = v, (1.2.19c)
C is 2-increasing. For a, b, c, d ∈ [0, 1] with a ≤ b and c ≤ d:
VC ([a, b] × [c, d]) = C (b, d) − C (a, d) − C (b, c) + C (a, c) ≥ 0, (1.2.19d)
where u, v ∈ [0, 1]
It is a subclass of t-norms, as in metric spaces, constricted to the unit hypercube. This
function gives the cumulative joint probability distribution of the random variables involved.
Archimedean Copulas
Let ψ : [0, 1] → [0, ∞) be a strictly decreasing, continuous and convex function such that
ψ(1) = 0, ψ(0) ≤ ∞ and let ψ [−1] be the dynamics in the observed correlation. pseudo-
inverse of the above defined by: Nelson, (2006) showed that the following defines a family of
d-dimensional Archimedean copulas:
C(u1 , u2 , . . . , ud ) = ψ [−1] (ψ(u1 ) + ψ(u2 + . . . + ψ(ud )), (1.2.20)
for every d ≥ 2. ψ is known as the generator of the copula, additive for Archimedean copulas.
The copula is Archimedean only when the pseudo-inverse ψ [−1] of the generator, ψ of the
copula is absolutely monotonic on R+ . In other words, we can say ψ [−1] ∈ L∞ with
Lm ≡ {ψ : R+ → [0, 1], | ψ(0) = 1, ψ(∞) = 0, (−1)k ψ k (t) ≥ 0, k = 1, . . . , m}. (1.2.21)
The Gumbel copula is obtained from the following generator function :
ψ Gumbel (t) = (−ln(t))θ , θ ≥ 1. (1.2.22)
The generator for the Clayton copula is:
ψ Clayton (t) = θ−1 (t−θ − 1), θ > 0. (1.2.23)
The corresponding cumulative densities for the Gumbel and Clayton copulas are given by:
1
θ +(−log(u ))θ +···+(−log(u ))θ ) θ
CθGumbel (u) = e−((−log(u1 )) 2 d
, (1.2.24)
for θ ∈ [1, ∞)
1
CθClayton (u) = [max{u−θ −θ −θ
1 + u2 + . . . + ud − 1; 0}] ,
θ (1.2.25)
for θ ∈ [−1, ∞)\{0}, respectively. (refer [10])
The Frank copula is also an Archimedean copula. It’s density function is given by :
(e−θu1 − 1)(e−θu2 − 1) . . . (e−θud − 1)

Fr 1
Cθ (u) = − 1 + , (1.2.26)
θ e−θ − 1
with θ ∈ R\{0} and generator:
e−θt − 1
ψ F rank (t) = −log( ). (1.2.27)
e−θ − 1
Joe copula density is given by :
d
1
X
CθJoe (1 − ( (1 − ui )θ ) θ ), (1.2.28)
i=1
for θ ∈ [1, ∞). Its generator is given as :
ψ Joe (t) = −log(1 − (1 − t)θ ). (1.2.29)
Copulas can also be elliptical in nature. Gaussian copula and Student t-copula
are two most popular and commonly used elliptical copulas. They are distributions over
the unit hypercube [0, 1]d with multiplicative associativity. Given a parameter correlation
matrix A ∈ [−1, 1]d×d , an elliptical copula has the following structure:
CAGauss (u) = ψA (ψ −1 (u1 ), . . . , ψ −1 (ud )). (1.2.30)
It becomes a Gaussian copula if ψA is the joint cumulative density function of a multi-

variate normal distribution where the correlation matrix considered as the covariance matrix
and the mean is taken as zero , and the inverse of univariate standard normal distribution
is ψ −1 . It is said to be a Student’s t-copula if these distributions are Student t-type.
Vine Copula
The marginal density can only be estimated unless the true underlying data generat-
ing process is known. The process of estimating the multivariate density is by step-wise
decomposing the joint probability distribution into a factorisation of conditional and uni-
variate marginal. The conditional densities at the corresponding steps can be substituted
with suitable copulas. This method of obtaining the multivariate density was introduced by
Joe [50], who called it a Vine Copula. Let f denote the joint probability density function,
F denote the cumulative probability density function of the original vector. Let the joint
density function of X = (X1 , X2 , . . . , Xd )0 be given by:
f (x1 , x2 , . . . , xd ) = f (xd ) · f (xd−1 |xd ) · f (xd−2 |xd−1 , xd ) · . . . · f (x1 |x2 , . . . , xd ) . (1.2.31)
Since the following holds:
f (x1 , . . . , xd ) = c12...d (F1 (x1 ), . . . , Fd (xd )) · f1 (x1 ) · · · fd (xd ). (1.2.32)

Here c12...d determines the joint density function obtained from the copula description (i.e.
the f (xd |xd−1 )) which is nothing but the pair copula for the first two variables is given by:
c12 (F1 (x1 ), F2 (x2 )) · f1 (x1 )
Continuing in this fashion:
f (xd−2 |xd−1 ) = c(d−2)(d−1) (Fd−1 (xd−2 ), Fd−1 (xd−1 )) · fd−2 (xd−2 ), (1.2.33)
=⇒ f (xd−2 |xd−1 , xd ) = c(d−2)d|d−1 (Fd−2|d−1 (xd−2 |xd−1 ), Fd|(d−1) (xd , xd−1 )),
·c(d−2)(d−1) (Fd−2 (xd−2 ), Fd−1 (xd−1 )) · fd−2 (xd−2 ). (1.2.34)
However, this is not unique as the condition can be put on xd instead of xd−1 . The general
formula can be hence, given by:
f (x|v) = cxvj |v−j (F (x|v−j ), F (vj |v−j )) · f (x|v−j ), (1.2.35)
where v denotes a d-dimensional vector. vj denote the components v and v−j denotes the
components of v without including vj .
In this way, a d-dimensional conditional density can be decomposed into a conditional
d − 1-dimensional density and a pair copula. We can hence obtain decomposition constructs.
They can be sorted by regular vines resulting in a graphical model presenting the entire de-
composition structure. A D-Vine decomposition for the joint density function, f (x1 , . . . , xd )
is given as follows:
d d−j
d−1 Y
Y Y
f (xk ) ci,i+j|i+1,...,i+j−1 (F (xi |xi+1 , . . . , xi+j−1 ), F (xi+j |xi+1 , . . . xi+j−1 )). (1.2.36)
k=1 j=1 i=1
For instance, 4-dimensional D-Vine can be constructed as follows:
f (x1 , x2 , x3 , x4 ) = f (x1 ) · f (x2 ) · f (x3 ) · f (x4 ) · c12 (F (x1 ), F (x2 ))
·c23 (F (x2 ), F (x3 )) · c34 (F (x3 ), F (x4 ))

·c13|2 (F (x1 |x2 ), F (x3 |x2 ))
·c24|3 (F (x1 |x2 ), F (x3 |x2 ))
·c14|23 (F (x1 |x2 , x3 ), F (x4 |x2 , x3 )). (1.2.37)
GAS Factor Copula

Considering the unconditional distribution case first [65], let Y be a vector of n variables.
Let the marginals of Y be given by Fi , its copula by C and its joint distribution by Fy .
Then:
[Y1 , . . . , Yn ]0 ≡ Y v Fy = C(F1 , . . . , Fn ). (1.2.38)

Instead of estimating the joint distribution directly, Patton has focussed on the estimation
of marginals from existing methods and then, the fitting of the factor copula. This allows to
utilise of the vast literature on marginals models and more importantly, prevent compounding
of parameters to be estimated in higher dimensions and effectuates multi-stage estimation.

These reasons made it far superior than most existing models in higher dimensions.
The class of copulas is fitted in accordance with a factor copula. Let n be the number
of variables and let K denote number of factors, manually set prior to the fitting. So, the
copula we use is based on a set of K + n latent variables as in a factor structure. Let
PK
Xi = βik Zk + εi , for i = 1, 2, . . . , n. We can now write:
k=1
[X1 , . . . , Xn ]0 ≡ X = BZ + ε, (1.2.39)
where, X are latent variables corresponding to the original realisations, Y , εi v indepen-

dent and identically distributed Fε (γε ), Zk v independent and not identically distributed
FZk (γk ), Zk q εi ∀i, k. So,
X v Fx = C(G1 (θ), . . . , Gn (θ); θ), (1.2.40)

0 0
taking θ = [vec(B)0 , γε0 , γ10 , . . . , γK ] . C(θ) denotes the copula structure that describes the
dependencies of the latent variable, X, is, because of the factor structure, also the copula
for the original data frame, Y . Their marginals however, need not be same.
Patton [65] suggests that the estimation of factor copula is difficult via the maximum
likelihood estimation method as these copulas are not in a closed form. For these reasons,
Oh and Patton [63] proposed the simulation method of moments which is similar to the
former, but more efficiently applicable in the case of factor copulas. θ is estimated based on
simulations from a parametric joint distribution, Fx (θ) with copula, C(θ) and standardised
residuals, {η̂t ≡ σt−1 (φ̂)[Yt − µt (φ̂)]}Tt=1 . Consider m̃S (θ) to be a vector of order m × 1. Let
this vector determine the dependence measures evaluated from Fx (θ), {Xs }Ss=1 using the S
simulations. The simulation method of moments estimator is defined as:
θ̂ ≡ arg min QT,S (θ), (1.2.41)

θ∈Θ
where,
0
QT,S ≡ gT,S (θ)Ŵ gT,S (θ),
gT,S (θ) ≡ m̂T − m̃S (θ).
ŴT represents a positive definite matrix of coefficient weights. Oh and Patton [63] proved
that as T → ∞, if S/T → ∞ , under regulatory conditions, the simulation method of mo-
ments’ estimator is asymptotically normal, consistent. The simulation method of moments
is abbreviated as the SMM estimator.
√ d
T (θ̂T,S − θ0 ) →
− N (0, Ω0 ) as T, S → ∞. (1.2.42)
Here,
Ω0 = (G00 W0 G0 )−1 G00 W0 Σ0 W0 G0 (G−1 −1

0 W0 G0 ) .
Σ0 ≡ avar[m̂T ]; G0 ≡ ∇θ g0 (θ0 ). Also,g0 (θ) = p − limT,S→∞ gT,S (θ). W = p − limT →∞ ŴT .

Kindly refer to the appendix for the code script for estimation and simulation from a GAS
factor copula.
Mixture copula
Very often, multiple copulas can encompass the unit space of probabilities better than a
parametric class of one copula. For this purpose, we use a weighted mixture of few common,
flexible copulas in our study. They first appeared in literature in the works of NUMBER
[62], (1992). A sophisticated extension to this would be to use the popular Expectation-
Maximisation algorithm to estimate the weights corresponding to the mixture of copulas
according to the data.
1.2.3 Comparison of models

With the models described above, we then need to find a way to compare them in order to
conclude which models are good enough, how complex and time consuming is the process of
forecasting from them. Comparison using Akaike’s information criterion, abbreviated
as the AIC and Schwarz information criterion, abbreviated as the BIC are two popular
and common techniques. However, both of them do not take the informativeness of the data
into account and provide results on one model being the supreme best of all. This need not
be the true case, as the same kind of data, say the log SnP index will result into different
singular best models when taking a high volatility versus a low volatility period. Also, these
methods of pairwise comparison of models do not regard the possibility of all models being
poor performers and still result into one best model which might actually be a poor fitting
to the true DGP (data generating process).
To address these concerns, we use Hansen et al. [45] model confidence set procedure
It is based on sequential hypothesis testing, given a confidence level (1 − α). Analogous
to confidence intervals for random variables as in classical statistical theory, it produces a
confidence set of surviving models, technically, superior to the rest. We discuss the proce-
dure and its bootstrap algorithm later in Chapter 3. The model confidence set approach is
helpful for inferring statistical conclusions from the set of surviving models. An economical
perspective of which model is best, can be obtained better from Şener et al. [68] using
penalty for safe space and violation space. We have implemented Sener’s violation space
penalty to compare our models. He hope to implement the safe space violation penalty as
to come to economically more significant results.
We also employ several statistical tests such as Actual over Expected Exceedances
ratio, Kupiec [52] backtest for unconditional coverage formulated in 1995, and Christof-
fersen and Pelletier [24] backtest for conditional coverage, formulated in 2004. Backtests
are techniques to evaluate the predictive performance of a model by inputting past values
into a model and compare results with known values. We also conduct the Dynamic Quan-
tile backtest proposed by Engle and Manganelli [33] in 2004, and the very basic, actual over
expected exceedances ratio test.
We finally, qualitatively analyse our results to conclude about predictive efficiencies of
models during the period of financial crisis (2007-2009) and otherwise.
Chapter 2
Literature Review
We will now literature review that motivated our work. To approximate the distribution of
a single time series panel, we need to opt univariate time series. We begin with discussing
the vast literature on univariate time series modelling.
2.1 Univariate time series modelling

Univariate time series comprises of modelling the constituents of one time series data frame,
i.e. modelling the mean and variance. Modelling the variance could involve capturing the
heteroskedasticity if present.
2.1.1 Mean modelling

Evidence of existence of ARMA models dates back to the early 1900s. ARMA models date
back to before 1976 (Refer mixed ARMA models, Granger and Morris [41]) summarized by
Brockwell et al. [22] in their book called Introduction to time series and forecasting . It has
sought applications in agricultural studies, population prediction, as well as studies on role
of faculty representatives in field work studied via a corresponding time series of work versus
presence as in the work by Sentman [69].
ARMA would help mean prediction in case of non-stationary data but not with satisfac-
tory precision for it cannot, by itself absorb the error information. GARCH becomes of faint
use in case of non-stationary data. In an earlier study in 1993, Drost and Nijman [26] derive
this couple of low and high frequency models and estimate the respective parameters. As
one would suspect/ question, the next approach to fine-tune results,to sharpen them nearer
to the actual data,the best foot forward would likely be a coupled ARMA-GARCH process
or orers, one could vary. In an interesting study, the GARCH 101, Engle and Bollerslev [32]
2001 discuss this idea. ARMA models with GARCH errors are still a common practice till
date to model univariate time series and they find applications in not just financial tie series
but all kinds of non-stationary time series one could ponder about. For instance, in wind
speed forecasting by Lojowska et al. [58], (2010) as well as in forecasting solar irradiance by
David et al. [25], (2016).
18
2.2. MULTIVARIATE TIME SERIES MODELLING 19
2.1.2 Volatility modelling

Bollerslev et al. [17] introduced the ARCH models for forecasting the error part(/variance,
statistically speaking) in time series back in 1936, defining a simplest ARCH model. The
GARCH models, as studied by Engle and McFadden [31], are a generalisation of the ARCH
models, as we have seen in the theory above, came into practice, in modelling time series,
since as long ago as the 1980s, the first mention being by Bollerslev et al. [18], (1987).
Their applications have been studied by Geweke and Porter-Hudak [37]. Studies on their
estimation efficiency (Akgiray [13]; Li et al. [55], (2002); Lamoureux and Lastrapes [53] ),
and judgements on stationarity of GARCH processes. Bougerol and Picard [20] found their
way to consolidate this theory. As we must remark, these processes single handedly form a
major, and most popular way to model stationary time series to this date.
However, GARCH models seem to underperform in case of non-stationary processes which
makes sense as they are only capable of modelling errors. In cases, when the mean varies
with time, when the data is not centered about the mean, what one actually looks forward
to is the ARMA process.
2.1.3 ARMA-GARCH modelling

Another improvisation of this coupled method began attracting decent popularity in 2000s.
With the methods seen so far, we would be able to feed in some historic data and obtain
a single-time output for a desired number of days in the future. There is no adjustment
to exogenous shocks, to reflecting changes according to the trend, with the trend. The
prediction for the 100th day in the future could stray copiously far away from the actual
data value on the 100th day. To overcome this Hartz et al. [47], (2006) implemented a rolling
window mechanism was introduced, that would predict for a day (adjustable), and then take
in actual values for that day(s) and produce the next set of predictions. A better perspective
would be to remove an equal amount to oldest data to avoid the lag effect (baseline wandering,
technically speaking). This is the mechanism we employ in our models unless the parsimony
of the model exceeds practical limits. An important drawback of the GARCH processes as
observed by Francq and Zakoian [35], (2011) was that the conditional variance depends only
on the modulus of that of the past variables, the negative and the positive innovations cast
the same effect on the volatility being forecast .
2.2 Multivariate time series modelling

As, we discussed it could often be helpful to model multivariate time series than a univariate
one, from an economic perspective. The DCC (Dynamic conditional correlation model) with
integrated moving average, as studied by [30], (2002) also calls the drawback that in the mul-
tivariate cases, equal roots are unstable and difficult to estimate and the estimation process
is also not unique. A rather inconvenient disadvantage of the MGARCH also known as the
multivariate-GARCH model is the spiked up the target parameters for the fitting Minović
[60], (2009), especially in higher dimensions, making the model and the estimation process
tedious and difficult to handle. The couple : Copula-GARCH makes an efficient class of
models because of several reasons we find of significant relevance with our study. Contrary
to the MGARCH, the copula models coupled with GARCH, retain the GARCH marginal
2.2. MULTIVARIATE TIME SERIES MODELLING 20
distributions and describe a dependence structure appropriately. Patton [65], (2009) showed
that the amount of parameters modelled is manageable and the univariate conditional distri-
bution need not describe the multivariate distribution. However, it can be one, if that’s the
best fit anyway. This flexibility about copulas is undoubtedly the best thing about them.
Liu and Luger [57], (2009) determined how these copula-based models allow maximum like-
lihood to be estimated using the entire data instead of just the overlapping part between
elements relating only to marginals and elements relating to multivariate distribution . A
study by Weiß [71], (2013) illustrates that the copula-GARCH models do have a prediction
performance superiority over the DCC-GARCH model.
Copula models have been gaining immense popularity since the past decade, especially
in field of financial forecasting. Studies, for example, Minović [60] have shown copula models
to outperform several less complex (non-copula) models, and ones that do not take the
inter-dependency of variables into account.
2.2.1 Copulas
The term copula was coined by Sklar (1959), extending its primary definition from the the-
ory of metric spaces, a subclass of t-norms. The first works on this were more rudimentary,
based on the consolidation of the structure of copulas, for instance by Wassily Hoeffding
and Maurice Fretchet. Application of copulas to joint-life mortality was indirectly initiated
by the works of Clayton (1978). Oakes (1982), Cook and Johnson (1981) further extended
their study in this field. Copula literature in probability has been studied since 40 years
(Schweizer, 1991). The books by Joe (1997) and Nelson (1999) were exceptionally promi-
nent in imparting fundamental structural knowledge of copulas as a tool. The latter was in
fact my first book on copulas itself! The baby steps in finance and Actuarial science (see
Bowers et al, 1997) with this tool were laid in the books by Frees and Valdez (1998) and
Embrechts, McNeil and Straumann (1999) focussing on modeling using copula structures.
Copulas have also been used in biostatistics, for instance David Oakes (1989), and Houg-
gard (2001). Works in survival analysis by Jason Fine, Phillipe Lambertt, Joana Shih still
stand out. Profound contributions regarding the study of copulas in statistics have been
made by the Quebec group (Bruno Remillard, Louis-Pal Rivest, Philippe Caperaa, Belka-
cem Abdous, etc). Drauet-Mari and Kotz (2001) focused on correlation and dependence,
and the use of copulas as the corresponding measure. Research literature in copulas dates
back to the early 2000s, the first few pedagological works published during 2002-2004 by
Thierry Roncalli and his associates. Embrechts, McNeil and Straumann (1999) and Li(2000)
served as effective catalysts in developments in this field. As under risk measurement, an
early example of VaR studies applying copulas is observed in Embrechts, Hoing and Juri
(2003) , an area that’s received widespread recognition in the following years. Patton (2004)
proposed bivariate equity management using copulas stimulating its application in portfolio
management. Cherubini, Luciano and Vecciato (2004) have co-authored a remarkable book -
Copula Methods in Finance. Copulas in finance find their application in several areas, a chief
one being risk management. The book on extreme financial risks authored by Malevergne
and Sornette (2006) is a commendable contribution to the literature of copulas in finance.
As in Mikosch (2006), the amounts of Google hits for copulas struck 650,000 from an
initial figure of 10,000, between the years 2003 to 2005. And were in 2019 now! The
popularity of copulas is self-explanatory. C. Genest et al (2009) presented an elaborate
2.3. MODEL AVERAGING 21
review of copulas (in finance).

Roger B. Nelsons collaborators in America (Greg Frethrics, Jerry Frank, Berthold Schweizer),
his colleagues in Spain (Jose Antonio Rodriuguez-Lallena, Juan Quesada-Molina, Manuel
Ubeda-Flores, etc). His contributors in Italy (Fabrizio Durante, Carlo Sempi) have sig-
nificantly contributed to the copula literature, in developing its structures, formulating its
bounds, etc.
We acknowledge the extensive theory on copulas, and the advancements in multivari-
ate time series modelling. The need to move to multivariate modelling is but of practical
economic benefit and has barely drawn the attention of researchers. Our aim here is to
implement these copula-GARCH based models and compare them each other, and with
non-copula models. Extending a tiny foot in an undiscovered ocean, we also try to look
forward to precision differences in univariate vs multivariate modelling. We incorporate the
use of Elliptical copulas, introduced by Nelsen [61], (1997), Vine copulas, introduced by Joe
[50], (1994), Archimedian copulas, introduced by Embrechts et al. [28] (2011), dynamic cop-
ulas introduced by Albanese et al. [14], (2005) and Albanese and Vidler [15], (2007), mixture
copulas, introduced by McWilliam et al. [59], (2009), as well as A J Patton’s GAS(General
Autoregressive Score) factor copula introduced by Oh and Patton [64], (2018) coupled to
GARCH marginals.
To test the efficiency of copula models, we incorporate a competitive non-copula model,
the very popular Engle and Sheppard [34], (2001) Dynamic Conditional Correlation model.
A few univariate GARCH models are also considered.
2.3 Model Averaging

A common approach to compare copula models has been the CIC, i.e. the copula information
criterion. Under it are the two methods: In 1973, Petrov and Csáki [66] introduced the
Akaike’s information criterion (AIC). It is a numerical formula to measure the performance
of a model on the basis of the number of target parameters and the maximum value of
log likelihood as obtained from the model. An improvisation to the AIC is the Bayesian/
Schwarz Information Criterion (BIC) proposed by Schwarz [67], (1978). A drawback of the
CIC is that it can only be applied to copula models. Not forgetting to mention, Lindsay
[56] founded a rather lazy way to compare models back in 1998, by maximum likelihood
method or the pseudo maximum likelihood method . Christoffersen [23] developed the test
for unconditional convergence, (2010) and Engle’s test for unconditional convergence also
aid in the comparison of models. White [72], (2000) et al paper deploys the reality check to
test data snooping. It also describes the test for superior predictive ability(SPA) developed
by Hansen et al. [42], (2001). With a decent model space constructed, the question arises as
to how should one compare the models. Hansen and Lunde [43], (2005) compared a range
of volatility models to conclude the superiority of the GARCH(1,1). This paper also shows
evidence of the SPA test being more powerful over RC. Giacomini and White [38], (2006)
propose the even better Conditional Predictive Ability test. However, the one drawback
remains common, that all models could be inferior and there’s only one model capable of
being the best, which appears to be too strong an inference for the case of prediction.
However, a relatively different kind of model selection mechanism overpowers them all,
making relative statements more informative in the practical sense than all of the above
2.4. SIMILAR WORK 22
methods that give certain absolute outcomes. This is model confidence set approach. Ab-
breviated as MCS, it was introduced by Hansen et al. [46], (2010) As we actually implement
this mechanism, we would discuss the relevant theory and algorithm in Chapter 3.
For the MCS procedure to be able to compare models, we need to feed it with a relative
performance of the two models. This is obtained by obtaining a loss distribution of forecasts
from the model.
2.3.1 Loss Functions

To compare models, it is necessary to first extract their loss distribution. Hansen et al. [44]
employ the Mean Squared Error and the Mean Absolute Deviation loss functions in his study
(2003). We employ the asymmetric value-at-risk loss function proposed by González-Rivera
et al. [40], (2004) and the continuous ranked probability score loss function by Gneiting and
Ranjan [39], (2004). Both these loss functions are discussed in further detail in section 4.1.
2.4 Similar Work

The model confidence set (MCS) procedure as proposed by Hansen (2007) et al is then
applied to this set of competing models to obtain a final set of superior models with a closest-
to-actual-data predictive ability within an alpha-confidence level (a customizable constant
). A rather brute force implementation of selecting multivariate generalized autoregressive
conditional heteroskedastic (GARCH) models applying the model confidence set procedure
(MCS) of Hansen (2010b) was performed by Laurent et al. [54], (2012). (Our work would
be along similar lines, but testing the predictive efficiency of copula models instead.) The
results provide a discrete hint on model performances during turbulent and rather calm
market periods. A remarkable study of continuous and discrete time models of the SnP 500
index returns has been performed by Kaeck et al. [51], (2018) taking into account more than
forty models.
2.5 Objective of research

Our study addresses several objectives in the literature of financial time series modelling.
1. There have been several studies on comparing multivariate models for financial time-
series data. There have also been studies comparing multivariate Copula-GARCH
methods to model series. Our aim is to use Copula-GARCH models for a diverse
portfolio and compare them using Hansen’s model confidence set approach.
2. The Generalised autoregressive score factor copula, proposed by Patton and Oh (2010)
is a breakthrough model when it comes to large dimension. Our objective is to im-
plement Factor copula in R.
3. We apply Christoffersen’s backtest for conditional coverage, Kupeic’s backtest for un-
conditional coverage and Engle and Manganelli’s backtest. We compare these results
2.5. OBJECTIVE OF RESEARCH 23
with the MCS results and qualitatively analyse them aganist the time consumed in
forecasting from the models.
4. With this study we intend to arrive at economically significant models, which are less
parsimonious and time consuming and almost as efficient as the intricately sophisti-
cated ones. For this reason and to also capture effective profitability from a model,
we apply Sener’s violation space penalty to better rank the models based on their
predictive efficiency.
5. Our study also extends to study a less explored dimension of financial time series
modelling: the effect of marginal choice on the performance of the model. We
first answer which marginal models are superior based on the MCS comparison.
6. We also intend to answer the question: How harmful is an inferior marginal for
the overall model?
Chapter 3
Methodology for Model Fitting
The methodology we implement is the crux of our study as similar studies have been per-
formed but the application of copula-GARCH models to study the nature of the financial
time series and their application to figure out the statistically best and the economically
best models using Hansen’s model confidence set procedure Hansen et al. [45] and also apply
Sener’s penalty measure. The structure of the methodology implemented in our work is as
follows:
1. Obtain the dataset to model.
2. Fit the marginals of the dataset. We will fit multiple marginals to an index in order
to make comparisons on the basis of marginals as well.
3. Identify and fit the dependence structure using copula and non-copula models
4. Simulate from the fitted structure. We follow two processes of simulation.
The first mechanism employs simple simulation from the fitted structure to forecast
‘k’days in future (traditional out-of-sample forecasts).
We employ a second mechanism in which we take an estimation window (of say,
500 days) and predict one day in future. The estimation window is then updated to
contain the latest true value of the day for which the forecast was performed, and
one oldest value is removed, so that the window size remains constant and there is no
baseline-wandering like effect (or the long term memory effect).
5. We obtain the 5%, 1% and 0.1% quantiles or technically, the Value-at-Risk forecasts.
6. The loss associated with each model is obtained by applying the Asymmetric VaR
Loss function [40] and Continuous Rank Probability Score function [39] on
our VaR forecasts. These serve as measures of the predictive performance of a model.
7. On these loss distributions, we apply Hansen’s Model Confidence Set procedure [45] to
construct a superior set of models, for a given confidence interval.
8. In the end, we construct tables for the time taken by each model for the computations,
and its rank as obtained by the MCS algorithm to qualitatively analyse our results.
We extract the data, with the following description.
24
3.1. STOCK INDICES DATA 25
3.1 Stock Indices Data

We present a study of the logarithm of performance indices : DAXINDX, FTSE100,
SnPCOMP, REXINDX from 30-01-2000 : 31-05-2013, in the respective order. This
period also includes the financial crisis of 2007-2009, so we will also be able to present an
analysis of the behaviour of our models during that period and otherwise. The Deutscher
Aktien IndeX30 (DAX)consists of 30 major German firms trading on the Frankfurt Stock
Exchange. It is a blue chip stock market taking prices from the Xetra trading venue. The
Financial Times Stock Exchande, abbreviated as the FTSE 100 or the “Footsie”is a share
index of 100 highest market capitalisation companies listed on the London Stock Exchange.
The Standard & Poor Comp 500 is based on market capitalisations of 500 large companies
whose stocks are listed on NASDAQ, NYSE and Cboe BZX exchange. It is an American
stock market index. The REXINDEX is another German index calculated by Deutsche
Borse. It takes into account a weighted average price of 30 domestic German bonds. This
data has been download from Datastream [1] via the subscription of University of Leipzig,
Germany.
Once we have the data, we approximate the marginal distributions with a GARCH pro-
cess as discussed.
3.2 GARCH fitting

The GARCH(p,q) model specifications were defined in (1.2.9). The lag length, p can be
estimated as follows:
1. Estimate AR(q) model that fits the underlying data the best:
q
X
yt = α0 + αi yt−i + t , (3.2.1)
i=1
where, the notations retain their meaning from eqn. (1.2.9). This can be done using
ordinary least squares method or by method of moments (using Yule-Walker equations)
[8].
2. Compute and plot autocorrelations of 2 as follows:

T
(ˆ2t − σ̂t2 )(ˆ2t−1 − σ̂t−1
2
P
)
t=i+1
ρ= T
. (3.2.2)
(ˆ2t − σˆt2 )2
P
t=1
√
3. ρ(i)’s asymptotic standard deviation is given by 1/ T Individual values greater than
this are GARCH errors. The total number of lags can be estimated by the Ljung-
Box test [21], (1970) until say, 10% significance is achieved.If the squared residuals, 2t
are uncorrelated, the Ljung-Box Q-statistic follows χ2 distribution with n degrees of
freedom.
3.3. COPULA ESTIMATION 26
Maximum Likelihood Estimation method for GARCH processes:

1. Let Ut−1 = {u0 , u1 , . . . , uT −1 } denote a sequence of random variables. Assume u0 to
be taken from a known distribution or a constant. Then, for a GARCH process of a
finite stretch of time, its joint distribution, as suggested by Herwartz and Kascha [48],
is given by
f (u1 , . . . , uT ) = f (uT |UT −1 ) · f (UT −1 ),
= f (uT |UT −1 ) · f (uT −1 |UT −2 ) · · · f (u1 |U0 ) · f (U0 ). (3.2.3)
The GARCH specification in eqn(1.2.9) can be used to determine the conditional dis-
tributions.
2. The log likelihood function is conditioned on an initial σ0 which is given as follows:

T
X
l(θ|u1 , . . . , uT ) = lt ,
t=1
T
X 1 1 1 u2t
= (− ln(2π) − ln(σt2 ) − 2
). (3.2.4)
t=1
2 2 2 σt
θ̂ is the maximum likelihood estimator that maximizes the likelihood function.

√ Various
minimizers in ‘R’can be used to achieve this. θ̂ converges at the rate T as follows:
√ d
− ℵ(0, S −1 ),
T (θ̂ − θ) → (3.2.5)
where, S is the expectation of the outer product of scores of lt (θ). θ is asymptotically

normally distributed
T
1X ∂lt ∂lt
S= E . (3.2.6)
T t=1 ∂θ ∂θ0
(We assume that the conditional distribution is normal here, for simplicity.)
With the marginal distributions obtained, our next task is to capture the dependency
between the data which we do as discussed, using a copula.
Once we obtain the GARCH marginal approximations of the actual data, we can extract
the residuals and obtain pseudo-observations in the unit interval from them, and begin the
copula estimation process.
3.3 Copula estimation

This can also be done by the minimum-distance estimator or the maximum likelihood es-
timator or several others. However, the most common approach is to use the maximum
likelihood estimation as it yields “smaller estimation biases at less computational effort than
any of the MD-estimators (refer Weiß [70], (2011))”.
Let X be the given data and Fi be its approximated marginals, then the sample of
pseudo-observations U ≡ (Uij ) is constructed as below:
Ûi = (Ûi,1 , . . . , Ûi,d )0 = (F̂1 (Xi,1 ), . . . , F̂d (Xi,d ))0 , i = 1, . . . , n. (3.3.1)

Embrechts et al. [27] laid down an algorithm to estimate a copula as follows:
1. Let the copula density be c(u1 , . . . , ud ; θ ) = ∂u∂ 1 · · · ∂u∂ d C(u1 , . . . , ud ; θ ). Here θ denotes
the parameters that need to estimated corresponding to copula, C. The log-likelihood
function can then be constructed as follows:
n
X
l(θ; Û1 , . . . , Ûn ) = log(c(Ûi,1 , . . . , Ûi,d ; θ)). (3.3.2)
i=1
If Φ is parameter space of C, the parametric copula, then θ ∈ Θ ⊂ Rp (p ≥ 1).

Ui ≡ (Ui,1 , . . . , Ui,d )0 ∈ [0, 1]d is the ith sample and c(, θ) be the copula density function
given as follows:
∂C(u1 , . . . , ud |θ)
c(u1 , . . . , ud |θ) = , u1 , . . . , ud ∈ [0, 1]. 3.3.3
∂u1 · · · ∂ud
2. The Maximum likelihood (ML) estimator was constructed by Genest et al. [36] as
follows:
θ̂nM L (U) ≡ arg max lU (θ). (3.3.4)
θ∈Θ
It is asymptotically normal and consistent under certain regularity conditions. It’s

logarithm can be taken which is easier to maximize.
3. In this manner, likelihood of all candidate copula models can be constructed. Following
the log-likelihood estimation method to fit the copula, an optimal copula, i.e. the best
fit to the underlying data is the one with the lowest log-likelihood value.
We summarise the above methodology in the following flowcharts: Let rt be the realised
returns, LL be a vector of log-likelihoods to be computed, µ, φ be parameters of the ARMA
process, αi , βi are parameters that need to be estimated for the GARCH process and B, the
number of simulations to be performed.Let εt denote the residuals (errors), σt , the standard
deviation and T be the entire range (time window) for which the estimation is being done.
Figure 3.1 summarises the GARCH estimation process.
Once we have the VaR forecasts, we can proceed with the copula estimation. Let X be
the original vector of return indices, then the copula fitting procedure is given as in figure
3.2. In this manner, taking different copula densities or marginals, we will have a set of
models with different copulas and different marginals. Our objective is to compare these
models. We do this using Hansen’s model confidence set (MCS) procedure.
Figure 3.1: The process of fitting an ARMA(m,n)-GARCH(p,q) process.
Figure 3.2: The process of estimating a copula and simulating from it.
Chapter 4
Methodology for Model Comparison
In order to work out the MCS procedure for rankings, we will have to obtain a loss distri-
butions from the set of models.
4.1 Loss Functions

Loss function, as the name suggest, maps the values of several (or a single) variable onto a real
number, intuitively representing some “cost ”associated with the event. We use the following
loss functions to compute out-of-sample predictive performance of our VaR forecasts:
1. Asymmetric Value-at-Risk Loss Function : Proposed by González-Rivera et al.

[40], (2004), it is defined as follows:
LVi,taR = (rt − V aRi,t

α α
) × (α − δ{rt < V aRi,t }), (4.1.3)
α
where V aRi,t is the Value-at-risk, rt are the actual returns at time t. The relative
value-at-risk
P V aR loss of model i with respect to model j is given by the following: dij,t =
1 V aR
T
(L i,t − L j,t ). Practically, it can be understood as that the deviations from value
t
α
at risk are weighted relatively heavily, if rt < V aRi,t . This follows the basic principal
of formulating loss functions which is to prevent heavy losses.
2. Continuous Ranked Probability Score: Proposed by Gneiting and Ranjan [39],

(2004), it is given as follows:
Z 1
CRP S(fi,t , rt ) = 2 (δ{rt ≥ F −1 (α)} − α)(F −1 (α) − rt )dα, (4.1.1)
0
where rt denotes the realised returns, δ is the Kronecker delta function, forecasting
cumulative density function is given by F and α is the quantile of the forecasting
distribution. If CRP S i < CRP S j , model i is believed to provide better forecasts
over model j. The relative loss of model i w.r.t. model j, dij,t = CRP S(fi,t , rt ) −
CRP S(fj,t , rt ) and σˆi,j = T1
2
P 2
dij,t . We thus, arrive at the test statistic given by
t
√
tT = T (CRP S i − CRP S j )σ̂ij−1 . (4.1.2)
29
4.2. MODEL CONFIDENCE SET PROCEDURE 30
We now have the loss distributions from the different models obtained. We will use the
MCS procedure to compare the models.
4.2 Model Confidence Set Procedure

Hansen et al. [45] defined the Model Confidence Set procedure (MCS) proposed in 2011 to
make multiple comparisons. In this algorithm, a set of models compete with each other
to give a superior set of models or in simple words, the best model(s), given a confidence
level (1 − α), where for e.g. α = 10% or 25% A salient feature of the MCS is that it does
not determine a one true model but analyses models relative to one another. It allows for
multiple models to be best. It is desirable over most other comparison methods like the
information criteria as it acknowledges informativeness of data. The more informative the
data set, the more selective results will be obtained i.e. fewer models in the MCS.
Let M0 be the set of all competing models indexed from 1, . . . , m0 . Thus, m0 denotes
the total number of models in M0 . Li,t , loss distributions obtained froma user-defined loss
function measure performance of model i at time t. Relative performance of model i with
respect to model j at time t is given by
dij,t ≡ Li,t − Lj,t , ∀i, j, ∈ M0 (4.2.1)
The expected loss of model i relative to model j throughout time, T is given as follows:
µij = E(dij,t ). (4.2.2)
Since, Li,t are losses, model i is preferred to model j if
Li < Lj ,
=⇒ di,j < 0,
=⇒ µij < 0. (4.2.3)
Therefore, the model confidence set, i.e. the set of surviving models, given confidence level
(1 − α) is defined as
M∗ ≡ {i ∈ M0 : µij ≤ 0, ∀j ∈ M0 }. (4.2.4)
The model confidence set (MCS) is constructed by a process of sequential hypothesis testing
where competing models are tested for equal predictive ability (EPA) by an equivalence test,
δM . If this EPA hypothesis is rejected, inferior models are eliminated using an elimination
rule, eM . The null and alternative hypotheses are, respectively:
H0,M : µij = 0, ∀i, j ∈ M, (4.2.5)
HA,M : µij 6= 0, f or some i, j ∈ M,

where M ⊂ M0 . H0,M is tested using the equivalence test, δM , ∀i, j ∈ M and at each
step when H0,M is rejected, eM is used to eliminate an inferior model, thereby, leading to
a sequence of sets: M0 = M1 ⊃ M2 ⊃ . . . Mm0 where Mi = {eMi , . . . , eMm0 }. This
sequential testing is performed until H0,M is finally accepted under the given confidence
level, (1 − α).
The MCS p-values, analogous to those defined in classical statistical inference, are defined
as: PH0,Mi corresponding to the hypothesis, H0,Mi
PH0,Mi = 1 − Fi (ti ), (4.2.6)
where, Fi (ti ) is the c.d.f. i.e, the cumulative density function of the ith test statistic, ti .
Using these, the MCS p-values corresponding to each model can be evaluated as
p̂eMj = max PH . (4.2.7)

i≤j
This translates to the fact that, model i belongs to the MCS, M̂ ∗1−α if p̂eMi ≥ α. Hence, it
is unlikely that models with low p-values will make it to MCS.
To compare the performances of the candidate models i and j, [45] proposed a multiple
t-statistic approach using the following statistics:
TR,M = max |tij |, (4.2.8)

i,j∈M
q T
ˆ ij ) and dij = T −1
P
where tij = dij / var(d dij,t for i, j ∈ M.
t=1
An alternative test statistic, Tmax,M can be defined as:
Tmax,M = max ti , (4.2.9)

i∈M
T
where ti = √ di
, di = (Li − L) , Li ≡ T −1 Li,t and L = m−1
P P
0 Li for i, j ∈ M.
var(d
ˆ i) t=1 i∈M
The hypotheses for this alternative test statistics are a little different, given by:
H0,M : µi = 0, ∀i ∈ M, (4.2.10)
HA,M : µi 6= 0, f or some i ∈ M,
where µi = E(di ). Inferring from the equivalence between H0,M {Hij , ∀i, j ∈ M}and{Hi , ∀i, j ∈
M} where M = 1, . . . , m0 , we arrive at
µ1 = . . . = µi = . . . = µm0 ⇔ µij = 0, ∀i, j, ∈ M ⇔ µi = 0, ∀i ∈ M. (4.2.11)
An extension of these results helps us arrive at the test statistics TR,M and Tmax,M Since these
statistics depend on nuisance parameters, their asymptotic distributions are non-standard.
However, with estimation using the bootstrap algorithm, this becomes less of an issue.
The elimination rule should satisfy the assumption, limn→∞ P(eM ∈ M∗ |HA,M ) = 0 and
it should be coherent with the equivalence test, δM , i.e. P(δM = 1, eM ∈ M∗ ) ≤ P0 (δM = 1).
The elimination rule for the test statistic Tmax,M is
emax,M ≡ arg max ti . (4.2.12)

i∈M
Elimination rule for the test statistic, TR,M is:
eR,M ≡ arg max sup tij . (4.2.13)

i∈M j∈M
Justification of Bootstrap Implementation

Assumption: For some γ > 0 and r > 0, E|dij,t |r+γ < ∞∀i, j ∈ M holds and {dij,t }i,j∈M0
is strictly stationary. Let ι ≡ (1, . . . , 1)0 and Xt = ι0⊥ Lt and θ = E(Xt ). Then the null
√ d
hypothesis can be framed as θ = 0. Then using the above assumption, T (X −θ) → − N (0, Σ)
T
holds, where X ≡ T −1
P
Xt .
t=1
√ d
Let Zt = (d1,t , . . . , dm0 ,t )0 . From the above result, we have T (Z −ψ) →
− Nm0 (0, Σ) where
PT
Z≡ Zt . The covariance can be estimated analytically from the bootstrap mechanism, for
t=1
√ ∗ d
∗
instance, Ω̂∗n . {Zb,t } , the bootstrap variables can be generated s.t. n(Z b −Z) → − Nm0 (0, Σ).
The bootstrap implementation is based on Ω̂m0 ,B

m0
∗ ∗ ∗ 1 X ∗ ∗ ∗ ∗
ζb,i − ζb,· = Lb,i − Li − (Lb,i − Li ) = (Lb,i − Lb,· ) − (Li − L· ) = db,i − di· . (4.2.14)
m0 i=1
This identity shows that the diagonal elements of Ω̂ are given as follows:
B B B
T X ∗ 2 T X ∗ 2 T X ∗ ∗ 2
√
(Z b,i − Z i ) = (db,i − di ) = (ζb,i − ζb,· ) = var(
ˆ T (di )). (4.2.15)
B b=1 B b=1 B b=1
Therefore, the distribution of Tmax can be approximated under the null hypothesis as
follows:
p −1 √
∗ ∗
max( D̂ T (Z b − Z))i = max(diag(var(d ˆ 1 ))−1/2 (Z b − Z))i ,
ˆ 1 ), . . . , var(d
i i
∗ ∗ ∗
db,i − di ζb,i − ζb,·
= max q = max q = max t∗b,i ,
i i
var(d
ˆ i) var(d
ˆ i)
∗
= Tb,max . (4.2.16)
A detailed description of the bootstrap algorithm and the complete MCS algorithm can
be found in the working paper of Hansen et al (2005). [7] Let M0 be the set of all models
1, . . . , m0 and [Li,t ]Tt=1 , the loss distribution corresponding to each model. Then figure 3.3
presents a flowchart summarising the MCS mechanism we just discussed.
4.3. SENER’S PENALTY MEASURE 33
4.3 Sener’s penalty measure

Şener et al. [68] proposed a method to penalize and hence, compare models by also taking
their relative under-profitability into account. The penalisation is divided into two parts,
the safe space penalty and the violation space penalty. Sener considers only the negative
tail of value-at-risk forecasts since negative sentiments breed deeper in the market. One
can consider the upper tail as well. When the realised returns are negative, the safe space
comprises of time instants when the realised return is negative but lies above the value-at-
risk forecast at a desired confidence level. It is said to an exceedance if the value of the
realised return falls below the value-at-risk forecast at the desired confidence level. The time
instants at which this scenario occurs comprises of the violation space.
The penalty for the violation space is defined as follows:
α−1 X
X α−i
φ(x, V aR) = Ci × Ci+m (4.3.1)
i=1 m=1
α−1 X
α−i zi
Y Zi+m
X 1 Y
= (1 + b,i ) (1 + b,i+m ) − 1
i=1 m=1
ki,i+m b=1 i=1
Penalty for safe space is given as follows:

T
X
ψ(x, V aR) = [1(xt > V aRt |xt < 0)](xt − V aRt ) (4.3.2)
t=1
The complete penalty measure is given by the following:

1
P M (θ, x, V aR) = [(1 − θ)φ(x, V aR) + θψ(x, V aR)] (4.3.3)
T∗
Here, i, m denote time indices from 1, 2, . . . , T , t = V aRt − xt where xt are the actual
realised returns, V aRt is the value-at-risk estimate at the desired confidence level obtained
from a particular model. Ci is an ith cluster. An i-cluster occurs at the ith time instant and
has Zi exceedances occurring simultaneously, so the length of the ith cluster is zi . There
Qzi
can be 1-clusters as well. Ci = b,i − 1. ki,i+m denotes the time interval between the
b=1
occurrence of the i + mth cluster and the ith cluster.
Having stated the methodology, we proceed to implement it and present our analysis.
4.3. SENER’S PENALTY MEASURE 34
Figure 4.1: Hansen’s model confidence set procedure for comparing models.
Chapter 5
Results and Discussion
The initial objective of our study was to apply Copula-GARCH models to financial time-
series data and compare them using Hansen’s model confidence set procedure to be able to
make statements on significance valid in the traditional sense, as in classical statistical theory.
The results however, motivated us to study another aspect of this modelling process: the
marginal models. Copulas are so very famous, because of the added advantage they produce
by allowing to model the marginals and the dependence structure separately. As stated in
2.1, as an extension of our study, we will also address as to which marginals are superior over
the others and statistically determine how harmful could the choice of an inferior marginal
be.
Also, for all our models, we have performed out-of-sample forecasts (March 2003 to
May 2013). In-sample-forecasts are good to analyse the performance of a model, that test a
model’s efficiency at data points used to estimate the model itself. This technique however,
is not a true meter to analyse how the model adjusts to exogenous shocks. For this and for
actual economic utility, we employ out-of-sample forecasting method.
Our final results, i.e. the plots and the MCS results are based on an equi-weighted
portfolio of the four log indices we consider: DAXINDEX, FTSEINDEX, SnPIN-
DEX, REXINDEX. It economically makes sense only if can analyse the co-movement of
the indices together in order to construct a diverse portfolio with minimum loss on invest-
ment, the entire point of multivariate modelling.
Our computations have been performed using R 3.5.2, R Project for Statistical Com-
puting on a 32-bit processor, 2012 MB RAM and a 64-bit processor, 4GB RAM.
We will specify what models have been computed with what specifications, as we proceed.
Two processors have been used due to computational restraints, because of which, we will
not consider time as an absolute quantitative parameter to capture the complexity of the
models. However, these simulations have been performed a couple times over, using three
different processors, so a qualitative safe judgement would be made.
5.1 Phase I: Models with rolling window

In this first phase of analysis, following Hansen and Lunde [43], (2005) : “A forecast com-
parision of volatility models : Does anything beat a GARCH(1,1)?”, we fix the marginal
35
5.1. PHASE I: MODELS WITH ROLLING WINDOW 36
model as a GARCH(1,1) process with a skewed student t conditional distribution

(sstd) since it is an adequately flexible distribution. We also employ a rolling window
mechanism here i.e. we take a window of 500 trading days of available data (initial win-
dow: January, 2000 - March, 2003) and forecast for the 501st day with 10000 simulations
per day for a decent approximation of the estimate. Next, we update our rolling window
with realised returns of the 501st day and drop the returns for the oldest day, maintaining
the size of the window to 500 data points.
Figure 5.1: Vine copula-GARCH(1,1) with rolling window.
VaR forecasts for 3000 days in the future, updated daily with 10,000 simulations per day using a rolling
window of 500 days. GARCH(1,1) is fitted on demeaned data. Returns indicate log stock indices of an
equi-weighted portfolio of the four indices.
Note:
• ** As we see in figure 5.9, the Dynamic Conditional Correlation(DCC) model encoun-

ters solver convergence issues in the estimation of the model. So, we will apply the
model confidence set procedure, once with the copula models, and once with copula
models and the DCC model. The DCC is one of the most popularly used non-copula
model. Hence, this will give an insight as to who wins in a face-off between copula and
non-copula models.
• * The GAS Factor copula (figure 5.8) is enormously time taking for one update, hence,
this is an exceptional model that does not follow the rolling window mechanism. Also,
all simulations need to be stored for it’s processing, we are only able to take 500 sim-
ulations instead of the usual 10,000 because of R array size and our RAM limitations.
Figure 5.2: Clayton copula-GARCH(1,1) with rolling window.
Figure 5.3: Gaussian copula-GARCH(1,1) with rolling window.
Figure 5.4: Student-t copula-GARCH(1,1) with rolling window.
window of 500 days. GARCH(1,1) is fitted on demeaned data.Returns indicate log stock indices of an
Figure 5.5: Gumbel copula-GARCH(1,1) with rolling window.
Figure 5.6: Frank copula-GARCH(1,1) with rolling window.
Figure 5.7: Joe copula-GARCH(1,1) with rolling window.
Figure 5.8: GAS factor copula-ARMA(1,1)-GARCH(1,1) without rolling window.
VaR forecasts for 3000 days in the future with 500 simulations per day. GARCH(1,1) is fitted on demeaned
data.Returns indicate log stock indices of an equi-weighted portfolio of the four indices.
Figure 5.9: DCC-GARCH(1,1) with rolling window.
VaR forecasts for 3000 days in the future, updated daily with 10,000 simulations per day. GARCH(1,1) is
fitted on demeaned data. Returns indicate log stock indices of an equi-weighted portfolio of the four indices.
• The mixture copula (figure 5.10) is a 1 : 2 weighted combination of the Gaussian and
Clayton copulas. This combination has been chosen randomly via hit and trial and
Figure 5.10: Clayton-Normal mixture(1:2) copula-GARCH(1,1) with rolling window.
can be improvised using an expectation-maximization algorithm.
We focus on the negative tail of the VaR forecasts in our analysis since negative sentiments
breed deeper in the financial community. Backtests: This is a hindcasting technique in
which the credibility of a model is tested taking some points in the estimation window
space, and quantifying the model’s predictive ability. We use the backtestVaR() method in
R [6] to perform the unconditional coverage test of Kupeic (Lruc), conditional coverage test
of Christofferson’s (Lrcc) and the Dynamic Quantile test of Engel and Manganelli’s (DQ)
backtests. AD shows the mean absolute deviation and maximum absolute deviation in the
test determined by Da Veiga and McAleer(2008) measured from the actual observations and
the quantiles. AE stands for the actual over exceedance ratio for a model. It is counted as
one exceedance when the realised return falls below the Value-at-Risk (VaR) estimate.
Concluding remarks:
• Needless to say, the Vine copula-GARCH performs very well, given it’s superior flexi-
bility and relative ease of computation.
• Mixture copula-GARCH comes well as statistically the best, on average. This is also
predictable accrediting to the doubled flexibility (at least) compared to the rest of the
copulas. However, it’s better performance, as evident from the graph comes at the cost
of reduced profitability as is also reflected in Sener’s penalty meaasure, which is why
we would not weigh its god performance as an economically significant result.
Table 5.1: Backtest results of models with rolling window for the entire duration: 2003-2013.
Copula- Lruc Lrcc AE AD

GARCH(1,1) Test p-value Test p-value Mean Max
Vine 133.3606 0.0000 133.5235 0.0000 3.7333 0.0076 0.0603
Clayton 144.2698 0.0000 144.3312 0.0000 3.8667 0.0075 0.0605
Gaussian 138.7787 0.0000 138.8846 0.0000 3.8000 0.0076 0.0601
tCopula 133.3060 0.0000 133.5235 0.0000 3.7333 0.0078 0.0606
Gumbel 133.3606 0.0000 133.5235 0.0000 3.7333 0.0078 0.0610
Frank 138.7787 0.0000 138.8846 0.0000 3.8000 0.00076 0.00607
Joe 147.0423 0.0000 147.0860 0.0000 3.9000 0.0075 0.0598
GAS* 138.7787 0.0000 149.1611 0.0000 3.8000 0.0128 0.0614
Mixture 45.4310 1.58e-11 45.4336 1.36e-10 0.0667 0.0225 0.0390
DCC** 1.9060 0.1674 2.3971 0.3016 1.4226 0.0047 0.00127
Table 5.2: MCS results for models with rolling window for the entire duration: 2003-2013.
Sr. no Model eliminated At time

1. Joe copula-GARCH(1,1) 2019-04-23 14:50:10
2. Gumbel copula-GARCH(1,1) 2019-04-23 14:50:48
3. Frank copula-GARCH(1,1) 2019-04-23 14:51:21
4. Gaussian copula-GARCH(1,1) 2019-04-23 14:51:50
5. Student t-copula-GARCH(1,1) 2019-04-23 14:52:18
6. GAS Factor ARMA(1,1)-GARCH(1,1) 2019-04-23 14:52:43
7. Clayton copula-GARCH(1,1) 2019-04-23 14:53:03
Superior set of models
Sr.no Model Rank Model p-value MCS p-value Loss

1. Vine copula-GARCH(1,1) 1 -0.4785756 1.0000 0.001071667
2. Mixture copula-GARCH(1,1) 2 0.4785756 0.6216 0.001074526
MCS results have been computed taking an 80% confidence level, with the Asymmetric VaR loss
function and the test statistic TR. It took 3.8756 minutes to compute these MCS results.
Table 5.3: MCS results for the period of financial crisis: December,2008-March, 2012 for models
with rolling window.

1. Joe copula-GARCH(1,1) 2019-04-23 17:04:53
2. GAS factor-ARMA(1,1)-GARCH(1,1) 2019-04-23 17:05:18

1. Vine copula-GARCH(1,1) 2 0.606915 0.5494 0.001488884
2. Mixture copula-GARCH(1,1) 1 -0.606915 1.0000 0.001482024
function and the test statistic Tmax. It took 2.469419 minutes to compute these MCS results.
Table 5.4: MCS results for the entire period : 2003-2013 for models with rolling window.

3. Joe copula-GARCH(1,1) 2019-04-23 17:24:09
5. Vine Copula-GARCH(1,1) 2019-04-23 17:25:15
8. GAS Factor-ARMA(1,1)-GARCH(1,1) 2019-04-23 17:26:29

1. Mixture copula-GARCH(1,1) 1 -3.664813 1 -0.01083261
MCS results have been computed taking an 80% confidence level, with the Continuous ranked proba-
bility score loss function and the test statistic Tmax. It took 4.6868185 minutes to compute these MCS
results.
Table 5.5: MCS results for the entire period: 2003-2013 for models with rolling window.

2. Joe copula-GARCH(1,1) 2019-04-23 17:30:49
7. Vine copula-GARCH(1,1) 2019-04-23 17:33:23

1. Mixture copula-GARCH(1,1) 1 -3.743648 1 -0.01083261
MCS results have been computed taking an 80% confidence level, with the Continuous ranked prob-
ability score loss function and the test statistic TR. It took 4.562271 minutes to compute these MCS
results.
Table 5.6: MCS results for the period of financial crisis: Dec, 2008-March, 2012 for models with
rolling window.

1. Joe copula-GARCH(1,1) 2019-04-23 16:47:05
5. Student-t copula-GARCH(1,1) 2019-04-23 16:48:23

1. Vine copula-GARCH(1,1) 2 0.6110811 0.5354 0.001488884
2. Mixture copula-GARCH(1,1) 1 -0.6110811 1.0000 0.001482024
MCS results have been computed taking an 80% confidence level, with the Asymmetric VaR loss function
and the test statistic TR. It took 2.9667 seconds to compute these MCS results.
Table 5.7: Sener’s penalties for 1% VaRs of copula-GARCH models with rolling window through
2003-2013.
Model Computation Violation Safe space Net penalty

-GARCH(1,1) time (sec) space penalty penalty measure(θ = 0.4)
Vine copula 51379.98 0.5529216 15.452693 0.004602707
Clayton copula 2837.5 0.4183791 16.067165 0.004719359
Gaussian copula 2841.77 0.8131094 14.131011 0.004339413
Student-t copula 5575.0 0.6638706 14.771546 0.004457202
Gumbel copula 3419.65 1.6907070 11.734967 0.004034213
Frank copula 2520.28 0.9107691 11.570674 0.003657054
Joe copula 2679.86 1.6214897 9.607045 0.003403330
GAS Factor-ARMA(1,1) 37615.49 1.8254666 21.895038 0.006963460
Mixture copula 4596.29 0.0000000 51.446744 0.014543249
• The GAS Factor copula had our hopes set quite high, but it’s under-performance is,
but obvious, since it is not updated at all where as the others are updated regularly.
• We update them so frequently to infer how well the models can adjust to exogenous
shocks and trends. Evidently, from the plots, we see that of all models, the exceedances
increase manifold at the beginning of the financial crisis, about in 2007-2008 and reduce
gradually over time.
• An important result is that, the models in the superior set remain consistent even
during an extremely high period of volatility (during the financial crisis) i.e. to say,
that the models that perform well, do so in stable as well as volatile trends. This
is incredible as it directly proves that the models that survive are also capable to
adjusting to exogenous shocks.
• A striking result here is presented in the table 5.8. We rely on the MCS procedure
to help us find the best set of models, given an α confidence but it largely focusses
on the informativeness of the data, i.e. the loss distributions penalising losses only.
It fails to capture if a model is significantly reducing the profitability of the portfolio.
Sener’s penalty shows that Mixture copula performs best in violation space but has
the highest penalty in the safe space, making it the worst penalised model of all.
• The Vine copula, a fair competitor since the beginning has an adequate penalty and
is statistically superior as well, as shown by the MCS results.
We next consider those days of forecast until the DCC doesn’t converge.
Concluding remarks:
• The exemplary performance of the Vine copula-GARCH(1,1) has been attended in

the previous results as well. A significant result here, is that the DCC-GARCH(1,1)
Table 5.8: MCS results for the entire duration: 2003-2006 including DCC-GARCH(1,1) for models
with rolling window.

1. Joe copula-GARCH(1,1) 2019-04-23 20:27:23

1. Vine copula-GARCH(1,1) 1 -3.743648 1 -0.01083261
2. Clayton copula-GARCH(1,1) 2 -1.0267405 1.0000 0.0008275503
3. DCC-GARCH(1,1) 3 -0.8351948 1.0000 0.0008324594
4. Mixture copula-GARCH(1,1) 4 0.1637392 0.9944 0.0008574939
5. Gaussian copula-GARCH(1,1) 5 0.4979951 0.8624 0.0008600168
6. Student-t copula-GARCH(1,1) 6 0.7695756 0.6794 0.0008648294
7. Frank copula-GARCH(1,1) 7 1.5374228 0.2278 0.0008850633
Table 5.9: MCS results for the entire duration: 2003-2006 including the non copula DCC-
GARCH(1,1) model for models with rolling window.

2. Joe copula-GARCH(1,1) 2019-04-23 20:51:18
4. Mixture copula-GARCH(1,1) 2019-04-23 20:51:54
7. Student-t copula-GARCH(1,1) 2019-04-23 20:52:29
8. DCC-GARCH(1,1) 2019-04-23 20:52:37

1. Vine copula-GARCH(1,1) 1 -1.535339 1 0.003049582
results.
performs competitively with regard to the other copula models and even statistically,
outperforms the simple Arcchimedean copulas.
• Having performed these simulations, we can though state that working with Vine or
GAS factor or Mixture copulas is relatively easier as they encounter less convergence
issues compared to he DCC-GARCH(1,1).
• Due to convergence issues in optimisation, since it is rather computationally difficult in

DCC-GARCH(1,1), it is also more time-consuming which makes it a relatively difficult
choice from an economic perspective.
• It is not a surprise that the GAS Factor copula and the Gaussian copulas perform
adequately well, even though they do not make it to the model confidence set, judging
by the fact that the survive quite a few rounds of the sequential hypothesis testing
procedure we employ.
5.2. PHASE II: MODELS WITHOUT ROLLING WINDOW 48
5.2 Phase II: Models without rolling window

The GAS Factor copula is considered to be a breakthrough model when it comes to modelling
in high dimensions, with its speed and proficiency. We therefore find it a fairer comparison to
not update all the copula-GARCH models throughout the forecasting time range and then,
perform the model confidence set procedure to determine which model(s) are superior to the
others. It is also insightful to see how it performs, efficiency wise in smaller dimensions (in
our case, 4 dimensions)
Figure 5.11: Vine copula-ARMA(1,0)-GARCH(1,1) without rolling window.
VaR forecasts for 3000 days in the future, with 10,000 simulations per day. The data is not demeaned to fit
the ARMA(1,0)-GARCH(1,1) process for all models in this phase. Returns indicate log stock indices of an
Figure 5.12: Clayton copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.13: Gaussian copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.14: Student-t copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.15: Gumbel copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.16: Frank copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.17: Joe copula-ARMA(1,0)-GARCH(1,1) without rolling window.
Figure 5.18: Joe copula-ARMA(1,1)-GARCH(1,1) without rolling window.
Figure 5.19: GAS Factor copula-ARMA(1,1)-GARCH(1,1) without rolling window.
VaR forecasts for 3000 days in the future, with 500 simulations per day. The data is demeaned to fit the
ARMA(1,1)-GARCH(1,1) process for all models in this phase. Returns indicate log stock indices of an
Figure 5.20: Clayton+Normal mixture(1:2) copula-ARMA(1,0)-GARCH(1,1) without rolling win-

dow.
Table 5.10: Exceedances of models without rolling window for the entire duration: 2003-2013.
Model Exceedances
(Copula) DAXINDX FTSEINDX SnPCOMPINDX REXINDX
-ARMA(1,0) 0.1% 1% 5% 0.1% 1% 5% 0.1% 1% 5% 0.1% 1% 5%
-GARCH(1,1)
Vine 37 119 239 41 135 281 27 85 189 5 65 197
Clayton 35 122 238 38 134 279 25 87 189 6 64 196
Normal 32 122 237 43 132 277 28 86 89 5 63 198
Student t 33 123 237 39 138 281 25 88 189 6 64 199
Gumbel 35 123 238 43 131 280 26 87 187 5 60 199
Frank 33 120 237 42 132 276 27 87 189 7 62 197
Joe 33 123 239 39 134 277 27 85 189 6 59 199
Joe-ARMA(1,1) 32 118 236 42 134 282 25 85 188 6 64 196
GAS* 15 114 289 28 132 301 10 71 197 9 57 185
Mixture 0 14 157 0 21 181 0 11 132 0 2 108
Note:
• Here as well, the GAS factor copula-ARMA(1,1)-GARCH(1,1) incorporates conducting

500 simulations to forecasts return of each day as against the rest of the models that
perform 10,000 simulations to forecast returns for each day. However, none of the other
models are as parsimonious as the GAS factor in 4-dimensions.
• The mixture copula-ARMA(1,0)-GARCH(1,1) is a 1:2 mixture of the Clayton and the

Gaussian copulas coupled with an ARMA(1,0)-GARCH(1,1) process.
Concluding remarks: We get to conclude quite a few things from this part, where we
do not update the models throughout our time range.
• The VaR forecasts are not economically significant, as is evident from the graphs since
they cannot accustom themselves with exogenous shocks, which is but obvious since
we are not updating our realisations.
• The Vine copula and the mixture copula still perform adequately well but it is inter-
esting to notice how sensitive these results are to the choice of the loss distribution.
• As expected the performance of the GAS Factor considerably improves. However, this
leads us to certain drawbacks of the factor copula model. It is parsimonious and almost
equivalent in predictive performance to standard elliptical copulas for small number
of variables (in our case, 4). It is difficult to update the GAS factor because of its
computational complexity (at least in R).
Table 5.11: Backtest results of models without rolling window for the entire duration: 2003-2013.
Copula- Lruc Lrcc AE AD

GARCH(1,1) Test p-value Test p-value Mean Max
Vine 152.6405 0.0000 163.6695 0.0000 3.9667 0.0136 0.0645
Clayton 161.1687 0.0000 169.1659 0.0000 4.0667 0.0134 0.0654
Gaussian 162.1887 0.0000 173.5946 0.0000 4.3333 0.0133 0.0645
Student-t 164.0458 0.0000 178.5923 0.0000 4.1000 0.0132 0.0641
Gumbel 164. 0547 0.0000 178.5923 0.0000 4.100 0.0132 0.0626
Frank 155.4659 0.0000 166.1850 0.0000 4.0000 0.0135 0.0618
Joe 164.0458 0.0000 176.1400 0.0000 4.100 0.0134 0.0637
Joe-ARMA(1,1) 149.8325 0.0000 158.9034 0.0000 3.9333 0.0136 0.0644
GAS* 138.7787 0.0000 149.1611 0.0000 3.8000 0.0128 0.0614
Mixture 10.7461 0.0010 108774 0.00043 0.4667 0.0113 0.0333
Table 5.12: MCS results for the entire duration: 2003-2013 for models without rolling window.

2. Joe copula-ARMA(1,1)-GARCH(1,1) 2019-04-23 21:28:14
4. Gumbel copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 21:29:40
5. Frank copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 21:30:10
6. Clayton copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 21:30:38
7. Student t-copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 21:31:01
8. Gaussian copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 21:31:21

1. Mixture-ARMA(1,0)-GARCH(1,1) 1 -0.5311629 1.0000 0.001332959
2. Vine-ARMA(1,0)-GARCH(1,1) 2 0.5311629 0.5918 0.001361557
function and the test statistic TR. It took 5.244914 minutes to compute these MCS results.
Table 5.13: MCS results for the entire time for models without rolling window.


1. Mixture-ARMA(1,0)-GARCH(1,1) 1 -0.6787875 1.0000 0.001332959
2. Vine-ARMA(1,0)-GARCH(1,1) 2 -0.2471627 1.0000 0.001361557
3. Clayton-ARMA(1,0)-GARCH(1,1) 3 0.5957295 0.5748 0.001370171
4. Normal-ARMA(1,0)-GARCH(1,1) 4 0.8473881 0.4228 0.001373945
5. Student-ARMA(1,0)-GARCH(1,1) 5 1.1698237 0.2556 0.001379780
Table 5.14: MCS results for the entire period : 2003-2013 for models without rolling window.

6. Student-t copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 22:24:38
7. Vine copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 22:25:00
9. Mixture copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 22:25:40

1. GAS-ARMA(1,1)-GARCH(1,1) 1 -13.15721 1 -0.006752113
results.
Table 5.15: MCS results for the entire duration: 2003-2013 for models without rolling window.

6. Student t-copula-ARMA(1,0)-GARCH(1,1) 2019-04-23 22:24:38

1. GAS-ARMA(1,1)-GARCH(1,1) 1 -13.15721 1 -0.006752113
ability score loss function and the test statistic Tmax. It took 4.82749 minutes to compute these MCS
results.
Table 5.16: MCS results for the period of financial crisis: Dec, 2008-March, 2012 for models
without rolling window.

7. Student-t copula-ARMA(1,0)-GARCH(1,1) 2019-04-24 01:37:25

1. GAS-ARMA(1,1)-GARCH(1,1) 1 -8.198161 1 -0.007669328
ability score loss function and the test statistic TR. It took 2.9667 seconds to compute these MCS results.
5.3. PHASE III: MODELS WITH FIXED COPULA AND VARYING MARGINALS 62
Table 5.17: Sener’s penalties for 1% VaRs of copula-GARCH models with rolling window through
2003-2013.
Model Computation Violation Safe space Net penalty

-ARMA(1,0)-GARCH(1,1) time (sec) space penalty penalty measure(θ = 0.4)
Vine copula 37668.42 2.3336410 16.99435 0.005793587
Clayton copula 5895.28 2.1411346 17.54430 0.005867422
Gaussian copula 5924.98 2.7094192 15.43214 0.005511313
Student-t copula 126339.39 2.5266097 16.10896 0.005625122
Gumbel copula 47018.35 3.5459297 12.97854 0.005172418
Frank copula 47453.39 3.5388027 12.96768 0.005166327
Joe copula 10368.26 4.2936689 11.15019 0.004972633
Joe copula-ARMA(1,1) 22086.86 4.3329425 11.15102 0.004989521
GAS Factor-ARMA(1,1) 37615.59 1.8254666 21.89504 0.006963460
Mixture copula 6173.39 0.0461187 56.68471 0.016043502
• It is however, interesting to note than the GAS still performs better in high volatility
periods compared to the rest of the models which establishes its predictive superiority
over the others, even if it is not via a huge margin.
• The most remarkable result of this part is what the even MCS fails to capture. The
MCS constantly results in the Mixture copula as one of the best models where it
is one whose composition is chosen randomly. It is evidently not profitable because
forecasts from it are far below the realised returns, so although there are no losses
occurring statistically, from an economic perspective, we are losing far more as indirect
opportunity cost. As from table 5.18, for the mixture copula, the violation space
penalty is negligible but the safe space penalty is manifold, enough to allow the net
penalty for a Mixture copula three times that of the other models.
5.3 Phase III: Models with fixed copula and varying

marginals
We now study the nature of marginals in a Copula-GARCH couple. We fix the copula
model (Vine copula and Clayton copula) and vary the marginals and the GARCH order.
With this, we aim to answer which marginal is superior and which isn’t. Hansen and Lunde
[43] show that for univariate financial time series models, nothing beats a GARCH(1,1). We
intend to answer this for the multivariate case with GARCH marginals.
(a) Clayton copula-ARMA(1,1)-APARCH(1,1) (b) Clayton copula-ARMA(1,1)-eGARCH(1,1)
(c) Clayton copula-ARMA(1,1)-GARCH(1,1) (d) Clayton copula-ARMA(1,1)-gjrGARCH(1,1)
(e) Clayton copula-ARMA(1,1)-sGARCH(1,1) (f) Clayton copula-ARMA(1,1)-tGARCH(1,1)
Figure 5.21: Clayton copula-ARMA(1,1)-various marginal models.
equi-weighted portfolio of the 4 indices.
Figure 5.22: MCS results of Clayton copula-various GARCH marginals.
We take a confidence level 80% using the Asymmetric VaR loss distribution and test statistic TR. The order
of the models correspond to their order in Fig.5.21
Figure 5.23: MCS results of Clayton copula-Various GARCH marginals.
We take a confidence level 80% using the Asymmetric VaR loss distribution and test statistic Tmax. The
order of the models correspond to their order in Fig.5.21
We take a confidence level 80% using the Continuous ranked probability score loss distribution and test
statistic Tmax. The order of the models correspond to their order in Fig.5.21
statistic TR. The order of the models correspond to their order in Fig.5.21
(a) Normal copula-ARMA(1,1)-APARCH(1,1) (b) Normal copula-ARMA(1,1)-eGARCH(1,1)
(c) Normal copula-ARMA(1,1)-GARCH(1,1) (d) Normal copula-ARMA(1,1)-gjrGARCH(1,1)
(e) Normal copula-ARMA(1,1)-sGARCH(1,1) (f) Normal copula-ARMA(1,1)-tGARCH(1,1)
Figure 5.26: Gaussian copula-ARMA(1,1)-various marginal models.
Figure 5.27: MCS results of Gaussian copula-Various GARCH marginals.
Concluding remarks:
• Hansen and Lunde [43] showed that for univariate models, almost nothing beats a
GARCH(1,1) process. Our simple experiment here reinstates this for multivariate
copula-GARCH models as well, that the GARCH(1,1) is indeed best when coupled
with copulas in multi-dimensions.
• The sGARCH(1,1) is consistently the second best whereas the eGARCH marginal has
a considerably poor fitting. As we see in the MCS results, it almost always fails to
belong to the superior set of models.
• Based on the fact that quite a few marginals out of the 7 we employ get eliminated from
the superior set of models, indicates that not all the marginals are equally as good and
they do have some power in changing the quality of the model. The Vine-GARCH(1,1)
performs best where as Vine-eGARCH doesn’t. This answers our question that the
marginal choice does play a role in the overall quality of prediction form a multivariate
model.
5.4. PHASE IV: MODELS WITH FIXED MARGINAL AND VARYING COPULAS 70
Table 5.18: Sener’s penalties for 1% VaRs of copula-eGARCH models with rolling window during
2003.
Model Violation Safe space Net penalty

-ARMA(1,1)-eGARCH(1,1) space penalty penalty measure(θ = 0.4)
Vine copula 0.0000000000 12.83377 0.03055660
Clayton copula 0.0000000000 332.30385 0.79119965
Gaussian copula 0.0002082602 340.19380 0.80998597
Student-t copula 0.0000728295 344.02287 0.81910233
Gumbel copula 0.0026308364 12.33601 0.02938086
Joe copula 0.0026844422 12.44524 0.02964111
Frank copula 0.0046836193 11.97821 0.02853628
5.4 Phase IV: Models with fixed marginal and varying

copulas
From the plots, as well as from the MCS results, it is evident that the eGARCH(1,1) is quite
unsuitable for our kind of data where as, as expected the GARCH(1,1) is best. We know
copulas form a highly flexible class of models, but does this flexibility override the effect
of marginals? We now aim to determine how harmful could a wrong choice of marginals
be. We fix the marginal as eGARCH(1,1) and vary the copulas. Since, the Vine copula has
made it to the MCS with the best rank more often than any other copula, we should expect
Vine copula-eGARCH(1,1) to be the best, and probably the MCS, Gaussian and Student
t copula rank-wise before the remaining, if eGARCH weren’t a completely a bad choice.
This would imply that although eGARCH has inferior predictions compared to the rest of
the marginals, results from the eGARCH would be least inferior when coupled with a Vine
copula compared to the rest.
Concluding remarks:
We answer the final objective of our study: “How harmful is an inferior marginal for the
overall model?”and with the last part of our study and the MCS results (Fig.5.27-5.30) it
is but obvious to remark that an inferior marginal can do tremendous harm to the overall
model. Our MCS tests, backtests, and even Sener’s penalty measure and the vast literature
on Vine and Gaussian copulas indicates that the Vine should indeed be best for smaller
dimensions, however, with the choice of an inferior marginal, the best copula is no longer a
superior copula.
One could argue that maybe eGARCH fits better with some other copula and cancels out
the effect of Vine but we have the plots to our evidence that even if this is the case, because
of the choice of an inferior marginal, the overall performance of the model plummets.
We also see from Sener’s penalty table for copula-eGARCH models that the otherwise
best, Vine copula-GARCH(1,1) has a relatively higher penalty than the Joe and Frank which
which are otherwise inferior models.
(a) Vine copula-ARMA(1,1)-eGARCH(1,1) (b) Clayton-ARMA(1,1)-eGARCH(1,1)
(c) Normal-ARMA(1,1)-eGARCH(1,1) (d) Student-t-ARMA(1,1)-eGARCH(1,1)
(e) Gumbel-ARMA(1,1)-eGARCH(1,1) (f) Frank-ARMA(1,1)-eGARCH(1,1)
(g) Joe-ARMA(1,1)-eGARCH(1,1)
Figure 5.31: Various copulas-ARMA(1,1)-eGARCH(1,1) models.
window of 500 days. GARCH(1,1) is fitted on demeaned data. Returns indicate the log stock indices of an
Figure 5.32: MCS results of various copula models-ARMA(1,1)-eGARCH(1,1).
We take a confidence level 80% using the continuous ranked probability score loss distribution and test
We take a confidence level 80% using the continuous ranked probability score loss distribution and test
5.5. DRAWBACKS OF HANSEN’S MODEL CONFIDENCE SET PROCEDURE 74
5.5 Drawbacks of Hansen’s Model Confidence Set pro-

cedure
• The MCS procedure does a great job in comparing models relatively without setting
up a true benchmark model. However, in reality it is only a statistical test. Sener’s
backtest gives an economically better idea of the actual setback on choosing a poorer
model. The MCS might eliminate a model which does not account for a severe under
profitability, economically and is far less parsimonious to compute because a sophis-
ticated model might perform better, even if it does by a very small fraction of the
investment.
• The MCS takes only the losses incurred from a model as input. It does not consider
the time complexity of a model. In fact there exists no quantifier, to the best of
our knowledge, that would take into account, both computation time and prediction
efficiency of a model and optimize the criteria to converge to the best set of models.
• It is highly dependent on the nature of the loss function. This is not exactly a bane,
because loss functions are meant to focus on the aspect one is trying to control. How-
ever, when we reach at conclusions like, an X copula is best, this is all subject to the
loss criteria applied.
• A potential drawback, particular to our application could be than we only consider the
negative tail of VaR forecasts and the results might change to some extent when we
also consider the positive tail VaR forecasts, specially when modelling with asymmetric
copulas.
These drawbacks are well overcome by Sener’s penalisation measure and our results
show the precise pitfall they cover. Together with the MCS results and Sener’s penalisation
measure, we can safely conclude about the model risk posed by the copula-GARCH models.
Chapter 6
Conclusion and Future Scope
6.1 Conclusion on copula-GARCH models

After a thorough analysis of copula-GARCH models, their comparison with non-copula
GARCH processes with and without rolling window and the effect of marginals models
on the overall performance of the copula-GARCH models, we can now make some significant
remarks based on our results.
• Capturing the dependence between variables via copula models is a better approach
than multivariate con-copula models on the basis of time complexity, optimisation
simplicity, and predictive efficiency. (refer results from Phase I)
• We have been able to implement the GAS factor copula in R. This model is relatively
tedious compared to the others and it is not easy or economical to update this model
very frequently. Phase II shows that when models do not need to be updated frequently,
the GAS performs adequately well. However, the Vine copula-GARCH(1,1) is nearly
as good in small dimensions like ours.
• GARCH(1,1) is the unbeatable even when coupled as marginals in a multivariate

model. (refer Phase III)
• The choice of a wrong, so to say, an inferior marginal can do enough wrong to the overall
predictive ability of the model, for example our case study with the eGARCH(1,1) and
several elliptical and Archimedean copulas. (refer Phase IV)
6.2 Conclusion on comparison methods

• The MCS procedure is a good way to compare a set of models and given a confidence
level 1 − α, produce a superior set of models nut it is not the best. It only addresses
the losses incurred and fails to incorporate under-profitability. It can be best used as
a statistical indicator of the set of superior models.
• Sener’s penalisation measure gives remarkably fair conclusions on what models are
best, from the perspective of economic significance.
75
6.3. CONCLUSION ON MODEL RISK 76
• Our study qualitatively suggests that the model risk imposed by the marginals models
in multivariate models is significant.
6.3 Conclusion on model risk

Model risk is the risk of poor estimation from a model or the failure of a model to approximate
the data generating process. Thus the best way to analyse the model risk imposed by a model
is to check the performance of the model.
Having analysed the two ends of the spectrum, we can safely conclude, the results would
not change drastically, if the models were updated periodically. However, if we consider
the highest volatility period i.e. the time of the financial crisis of 2008, for example, on
16-08-2008, the loss incurred using a Vine copula-GARCH(1,1) (with the rolling window
mechanism) is -0.01867976 units, at 1% confidence where as the loss using a model out of
the MCS, Clayton copula-GARCH(1,1) (with rolling window) is -0.01733118 units , which
is a difference if 0.00134858. Also, using the second best model for this day, Student-t
copula-GARCH(1,1), the loss incurred is -0.01743925 units at 1% VaR, causing a difference
of 0.001240426 units.
So, on an investment of $10, 000, choosing a relatively inferior model which is not in
model confidence set (Clayton) over a superior model (Vine) causes a net additional loss
of $10, 000 ∗ 0.00134858 = $13.49, and choosing the statistically second best (Student-t
copula), the net additional loss incurred is $10, 000 ∗ 0.001240426 = $12.40 compared to
the loss incurred from a Vine copula-GARCH(1,1) model. This fact is evident via Sener’s
penalisation measure where the net penalty for a Vine copula model is 0.004602707, for a
Clayton copula model is 0.004719359 and for a Student-t copula model is 0.004457202, which
differ by a very small magnitude. (refer Table 5.8.)
However, by our value-at-risk estimates, during a long stretch of high volatility period
beginning from 1st January, 2008 to 31st January, 2008 the sum of actual returns of an
equi-weighted portfolio of the four indices: DAXINDX, FTSE100, SnP500, REXINDX is
0.01636508 units. Our 1% value-at-risk estimates using a Vine copula-GARCH(1,1) with
rolling window updating mechanism, the algebraic sum of losses for this duration is : -5.28737
units and that from a Clayton copula-GARCH(1,1) with rolling window updating mechanism
is: -5.459317 units. Using the vine copula-GARCH(1,1) gives us a profit of 0.171947 ×
$10000 = $1719.47 on an investment of $10000 which is not absolutely negligible and we
could support the idea of using a vine copula-GARCH(1,1) with rolling window updating
mechanism over a Clayton-GARCH(1,1) to avoid since the former isn’t such unnecessarily
tedious.
We would thus conclude that the choice of both the copula and the marginal model con-
tributes fairly to the model risk imposed by a model. Our overall results can be summarised
in the following table.
6.4. FUTURE SCOPE 77
6.4 Future Scope

• The conditional distribution of the marginals can be experimented with. We have
only used the skewed student t-distribution, one can also try the normal distribution,
etc.
• The mixture copula can be improvised to estimate the weights of copula constituents
via the Expectation-Maximization algorithm.
• The Dynamic copula are a recent addition to the literature of copulas and can also
be implemented and compared with.
• A very significant study could be performed on the comparison of model risk im-
posed via univariate modelling versus that by multivariate modelling(diverse
portfolio). In univariate modelling, the only source of model risk is the choices of the
marginals. However, for a diverse portfolio, model risk could emanate from the choice
of the marginal, as well as from the additional dependency structure, i.e. the copula.
Risks imposed from these two factors could mutually cancel out each other since, co-
movement of market trends will be better capture in this case, or it could compound
from the level of a univariate model. Statistically, it is possible to compare the two,
as the univariate model allows to forecast for an individual return, and even with a
multivariate model, one can forecast for individual constituents after the model fitting.
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Chapter 7
Appendix
I
Here is a snippet of the data we use, with specifications described in section 3.1
Figure 7.1: Stock Indices Data (Source : Datastream).
83
CHAPTER 7. APPENDIX 84
II
This section contains abstract codes of the various models we have implemented
Figure 7.2: Abstract code for varied marginal modelling.
Figure 7.3: Code for various marginal specifications.
Figure 7.4: Code for various copula specifications.

Figure 7.5: Code for initialising the vine copula-GARCH(1,1) model.

Figure 7.6: Code for auxiliary functions and vine copula-GARCH(1,1) model fitting.
Figure 7.7: Code for simulating and forecasting from a vine copula-GARCH(1,1) model.
Figure 7.8: Abstract code for DCC-GARCH(1,1) model.

Figure 7.9: Abstract code for estimation of GAS Factor copula-GARCH(1,1) model parameters.
Figure 7.10: Abstract code for estimation of GAS Factor copula-GARCH(1,1) model density.
Figure 7.11: Abstract code for simulation from GAS Factor copula-GARCH(1,1) model.
Figure 7.12: Abstract code for implementation of Sener’s penalisation measure.

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Model risk of Copula-GARCH

financial time series models

(Five Years Integrated M.Sc Course)

Under the supervision of :

DEPARTMENT OF APPLIED MATHEMATICS AND HUMANITIES,

Department of Applied Mathematics & Humanities,

CERTIFICATE OF EXAMINER’S APPROVAL

Dr. Jayesh M. Dhodiya

Dr. Smita Jauhari

Department of Applied Mathematics & Humanities,

Department of Applied Mathematics & Humanities,

Our study has the following structure:

1 Introduction to financial time series 7

3 Methodology for Model Fitting 24

4 Methodology for Model Comparison 29

5 Results and Discussion 35

6 Conclusion and Future Scope 75

3.1 The process of fitting an ARMA(m,n)-GARCH(p,q) process. . . . . . . . . . . . 28

4.1 Hansen’s model confidence set procedure for comparing models. . . . . . . . . . . 34

5.1 Vine copula-GARCH(1,1) with rolling window. . .. . . . . . . . . . . . . . . . 36

5.31 Various copulas-ARMA(1,1)-eGARCH(1,1) models. . . . . . . . . . . . . . . . . 71

7.1 Stock Indices Data (Source : Datastream). . . . . . . . . . . . . . . . . . . . . . 83

Introduction to financial time series

1.1 Time Series

1.2 Time Series Models

• Ordinary regression models in which time is considered to be the independent vari-

• Implicit exogenous shocks

1.2.1 Univariate time series models

(Box Jenkin’s) ARMA(p,q) model

Holt Winter’s Exponential Smoothing model

St = αyt−1 + (1 − α)St−1 , 0 ≤ α ≤ 1, t ≥ 3. (1.2.6)

The auto-regressive conditional heteroskedasticity model is a statistical model for time

t |ψt−1 v ℵ(0, 1),

Types of GARCH models

The EGARCH(p,q) also known as exponential GARCH is specified by:

Glosten-Jaggannathan-Runkel GARCH also known as gjrGARCH(p,q) is given by:

1.2.2 Multivariate time series models

Constant Conditional Correlation model

Dynamic Conditional Correlation model

C : [0, 1]2 → [0, 1], (1.2.19a)

(For, a d-dimensional copula, C : [0, 1]d → [0, 1])

C(u, 0) = 0 = C(0, v), (1.2.19b)

VC ([a, b] × [c, d]) = C (b, d) − C (a, d) − C (b, c) + C (a, c) ≥ 0, (1.2.19d)

C(u1 , u2 , . . . , ud ) = ψ [−1] (ψ(u1 ) + ψ(u2 + . . . + ψ(ud )), (1.2.20)

Lm ≡ {ψ : R+ → [0, 1], | ψ(0) = 1, ψ(∞) = 0, (−1)k ψ k (t) ≥ 0, k = 1, . . . , m}. (1.2.21)

The Gumbel copula is obtained from the following generator function :

ψ Gumbel (t) = (−ln(t))θ , θ ≥ 1. (1.2.22)

The generator for the Clayton copula is:

ψ Clayton (t) = θ−1 (t−θ − 1), θ > 0. (1.2.23)

for θ ∈ [1, ∞). Its generator is given as :

ψ Joe (t) = −log(1 − (1 − t)θ ). (1.2.29)

CAGauss (u) = ψA (ψ −1 (u1 ), . . . , ψ −1 (ud )). (1.2.30)

It becomes a Gaussian copula if ψA is the joint cumulative density function of a multi-

f (x1 , x2 , . . . , xd ) = f (xd ) · f (xd−1 |xd ) · f (xd−2 |xd−1 , xd ) · . . . · f (x1 |x2 , . . . , xd ) . (1.2.31)

Since the following holds:

f (x1 , . . . , xd ) = c12...d (F1 (x1 ), . . . , Fd (xd )) · f1 (x1 ) · · · fd (xd ). (1.2.32)

f (x|v) = cxvj |v−j (F (x|v−j ), F (vj |v−j )) · f (x|v−j ), (1.2.35)

For instance, 4-dimensional D-Vine can be constructed as follows:

f (x1 , x2 , x3 , x4 ) = f (x1 ) · f (x2 ) · f (x3 ) · f (x4 ) · c12 (F (x1 ), F (x2 ))

·c23 (F (x2 ), F (x3 )) · c34 (F (x3 ), F (x4 ))

GAS Factor Copula

[Y1 , . . . , Yn ]0 ≡ Y v Fy = C(F1 , . . . , Fn ). (1.2.38)

of parameters to be estimated in higher dimensions and effectuates multi-stage estimation.

t |ψt−1 v ℵ(0, 1),

2. Compute and plot autocorrelations of 2 as follows: