Copula Representation of Joint Risk Driver Distribution

Why Copulas?
• Copulas provide a method of joining together individual (“marginal”) distributions along
with a dependence structure.
• Copulas provide a way to generalize multivariate distributions, but they have the
advantage that the input marginals are not all required to belong to the same
distribution family.
• For example:
– Suppose we are modeling the dependence between the risk factors OAS and volatility. If the
distributions of OAS and volatility are both normal, we can model the joint distribution of OAS
and Volatility by a bivariate normal distribution and evaluate the VaR as the tail risk.
– This method also works if the risk drivers are from, say, t-distributions having the same degree
of freedom (df, or tail weight).
– But what if the distributions of the risk drivers are not the same? If, for example, OAS is
distributed according to a normal distribution and volatility as a t-distribution? Multivariate
distribution theory fails us here.
• Copulas allow the flexibility of using different marginals to fit the empirical data.
• The distribution fits the data, instead of forcing the data to fit the distribution just for
model tractability.

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Example: Meta t Copula Representation of a Multivariate Distribution

The linear correlation matrix for the market risk drivers is shown below, with detail of a bivariate
meta t copula for the risk drivers OAS and Debt Spread (DS).
Construction of the optimal copula requires the following:
1) The inverse distributions resulting from the marginal distributions
2) Specification of the optimal form of the copula, based on variance minimization techniques
3) Estimates for the required parameters of the optimal copula, such as correlation matrix and degree of freedom.
As an example, the bivariate meta-t copula was constructed for the risk drivers OAS and DS.
Since both risk drivers OAS and DS were distributed as t distributions (17 df for OAS, 6 df for DS), a meta-t copula
was constructed using the correlation matrix below.
Bivariate t Distribution
OAS DS
OAS 1.0000 0.2678 -3
x 10
DS 0.2678 1.0000
6

General d-dimension Meta-t copula function: 5

4
 df  d  df  d
   x 1 x 

2 3
 2 
1 1

C ,  (u )  
Ga
t df ( u1 )

t df ( u d )
1   dx 2
   df   
  df  
d
 df  1
 2  0

2
Here d=2, Σ is the covariance matrix and df is a degrees of 0
2
0
freedom parameter. In instances where the marginal variables -2 -2
have been standardized,  is similar to a correlation matrix. DS OAS

2
 Implementation of the Copula Approach
• Individual marginal distributions are computed for each risk driver (no change
from present approach, but much more complex distributions can now be fit)
• The inverse distribution of each marginal and correlation matrix are computed
(new)
• The copula is constructed incorporating marginals, fitted parameters and
dependence structure (new)
• The Maximum Likelihood Estimation (MLE) method is used to determine
remaining parameters of the optimal copula best fitting the data to describe
the joint distribution (new)
• N random draws (N a sufficiently large number) resulting in d-dimensional
realizations of correlated risk drivers are drawn from copula (new)
• These random draws are transformed back to draws on the original risk
drivers and multiplied by the risk weight factors to derive the market value
sensitivity (no change from present approach)
• The joint distribution is simulated and tail risk evaluated at the 99.97th
percentile (no change from present approach)

3
New Estimates of Risk Driver Marginal Distributions and their
Dependence Structure (starting values for fitting of the copula)

Market Risk Driver Distributions and Correlations

t dist df=17
50 . . . .
OAS

-50 .

20 . t dist df=6 . . .

10
DS

-10

-20 .

. t dist df=8 . .

50 .
Vol

-50

5 . . . t dist .

df=100
PC1

-5

. gen EV
5 . . .
PC2

-5

-50 0 50 -20 -10 0 10 20 -50 0 50 -5 0 5 -5 0 5

OAS DS Vol PC1 PC2
4
Statistical Significance Tests for Risk Driver Correlation Matrix

The significance of the estimated correlation between risk drivers can be tested. Since the joint
distribution of the risk drivers is not elliptical, we apply tests based upon Spearman-type correlations.
In the following table, Spearman pairwise correlation coefficients appear on and above the diagonal,
while p values for testing the null hypothesis (the correlations are equal to zero) appear below the
diagonal.
The p value is computed by transforming the correlation to a t statistic having n-2 df, where n is the
number of data points. The p value may be interpreted as the probability of getting a correlation as
large as the observed value by chance, when the true correlation is zero. If p is small (say, less than
0.05), then the correlation i,j is significant.. All of the correlation coefficients are found to be
significant at the 95% confidence level, with the exception of PC1 and PC2, which are orthogonal by
construction.

OAS DS Vol PC1 PC2

OAS 1.0000 0.2408 0.1062 -0.1297 0.3082
DS 0.0000 1.0000 0.1670 -0.1711 0.1547
Vol 0.0000 0.0000 1.0000 -0.2888 0.2431
PC1 0.0000 0.0000 0.0000 1.0000 0.0079
PC2 0.0000 0.0000 0.0000 0.7511 1.0000
5
Simulated Aggregate Value Change Distribution

The aggregate market value change distribution computed via Monte Carlo
simulation is shown below. The 99.97th percentile is selected as the “worst
case” required economic capital.
4
x 10 Simulation of Aggregate Value Change Distribution
5

4.5

3.5

3
Draw

2.5

1.5

0.5

0
-20 -15 -10 -5 0 5 10 15
Market Value Change ($ bn)

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Aggregation via Copula Representation of the Multivariate Risk Distribution

• In the presence of correlation amongst the risk drivers, the aggregate portfolio value
change cannot simply be determined based upon the standalone marginal value
change distributions.

• To determine economic capital, we must:

– estimate and model the joint realization of risk drivers, and
– simulate the aggregate portfolio value change associated with joint realizations of risk driver
values.

• The problem of estimating the total portfolio loss distribution is actually one of
estimating the multivariate (with respect to risk type) probability distribution
F(r1,r2,…,rd) = Pr(R1<=r1,…,Rd<=rd)

• Most modeling approaches estimate the marginal risk distributions with respect to
individual risk types F1(r1), F2(r2), etc.

• The representation of the joint distribution using a copula – a multivariate distribution

with support over the unit intervals – promotes direct estimation of risk factor
correlations.

• Copula Representation F(r1,…,rd|) = CR(F1(r1|),…,Fd(rd |)|)

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 Example Fitting of an Optimal Copula by MLE

Likelihood function for Meta t copula

The maximum likelihood method is used to determine the copula parameters best fitting the data.
The log likelihood function (below) is minimized with respect to the parameters df and .

  df  d   df  d   df   
    0,    0, 
 df   2   2   2  
n  
 2   df 
 2  
 log l ( X ; )   2    nd   1
n
x 1 x   df  d  n x 1 x
df

 df  d   
2df  2 i 1
1  
df   2  i 1 df 2
 
 2 

For this example, the df parameter was estimated to be 7, and the estimated covariance matrix is given by
OAS DS
OAS 1.0000 0.2513
DS 0.2513 1.0000
log \ L df
df Derivative of Log Likelihood Function for t distribution

10

df
5 10 15 20

-5

-10
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 Distribution Plots for Market Risk Distributions

t distribution fit of DS data, d.f. = 8 t distribution fit of vol, d.f. = 12 t distribution fit of OAS data, d.f. = 17
0.12 Estimates: Estimates:
mean std d.f. 0.06 Estimates:
0.06 mean std d.f.
0.287 3.28 7.31 mean std d.f.
(0.573) 7.22 12
(3.1) (32.9) (5.6) (0.27) 6.7 17
(2.95) (31) (3.1)
0.1 (1.5) (33.4) (2.46)
0.05 0.05

0.08 0.04
0.04
Density

Density
Density
0.06 0.03
0.03

0.04 0.02
0.02

0.02 0.01
0.01

0 0
0 -20 -15 -10 -5 0 5 10 15 20 25
-15 -10 -5 0 5 10 15 -25 -20 -15 -10 -5 0 5 10 15 20 25
DS Vol
OAS

Normal distribution fit of PC1 data Generalized Extreme Value Fit of PC2
0.7 Estimates:
Estimates:
0.45 mean std k sigma mu
(0.193) 1.074 0.058 0.842 (0.571)
(0.18) (56) 0.6 (2.94) (47.7) (24)
0.4

0.35
0.5

0.3
0.4
Density
Density

0.25

0.2 0.3

0.15
0.2
0.1
0.1
0.05

0 0
-3 -2 -1 0 1 2 3 -2 -1 0 1 2 3
PC1 PC2

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Comparative Plots of Marginal Market Risk Drivers to Fitted Distributions

OAS vs t-distribution df= 17 DS vs t-distribution df = 8

40 20

10
20
0
OAS

DS
0
-10
-20
-20

-40 -30
-4 -2 0 2 4 -8 -6 -4 -2 0 2 4 6
t distribution t distribution
Vol vs t-distribution nu = 12 LIP vs t-distribution df = 8
40 20

10
20
0

LIP
Vol

0
-10
-20
-20

-40 -30
-4 -3 -2 -1 0 1 2 3 -4 -2 0 2 4 6
t distribution t distribution
PC1 vs t-distribution df = 100 PC2 vs Generalized Extreme Value Distribution
4 8

6
2
4
PC1

PC2

0 2

0
-2
-2

-4 -4
-4 -2 0 2 4 -4 -2 0 2 4 6 8
t distribution Extreme Value Distribution
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Example: Meta-t copula, graphed with uniform marginals

U1 U2
U1 1.0000 0.2678
U2 0.2678 1.0000

3
t copula PDF

-1
1

0.5

0.8 1
0 0.4 0.6
U2 0 0.2
U1

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Calculation of Expected Shortfall

While VaR provides an estimate of the loss most likely to occur at a given
confidence level, it provides no insight into how bad that loss might be. For
example, one might say “The portfolio is not expected to lose more than $2
million 9,997 days out of 10,000”, but this statement does not answer the
question “How bad could the expected loss be, given that a loss does occur?”
(Note that VaR is not designed to measure the worst loss, in fact, the VaR
should be exceeded a percent of the time.)
The expected shortfall provides the answer to this question. This measures
the average of the loss conditional on the fact that the loss is greater than that
predicted by VaR. If the VaR number is q, the expected shortfall (also referred
to as conditional VaR or CVaR) is:
q

E[ X | X  q] 

xf ( x)dx
q

f ( x)dx

where f(x) is the probability density function of the distribution.

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 Expected Shortfall Enjoys Desirable Risk Measure Properties
1. Monotonicity If a portfolio has lower returns than another portfolio for every state of the world, its risk measure
should be greater.
2. Translation Invariance If we add (subtract) an amount of cash K to a portfolio, the portfolio risk measured in the
same units as the cash should decrease (increase) by the amount K.
3. Positive Homogeneity changing the size of a portfolio by a factor (l) while holding the weighting of the portfolio
constituents constant should result in the risk measure being multiplied by l. (That is, for all l ≥ 0, (l X) = l
(X).)
4. Sub-additivity the risk measure for two portfolios after they have been merged should be no greater than the sum
of their risk measures before they were merged, that is, “Mergers do not create additional risk.” This is a very
important property for a risk measure that is to be used as the basis for allocation of capital to sub-
portfolios.

The fourth condition states that diversification helps reduce risks. When two risks are aggregated, the total of the
risk measures corresponding to the risks should either decrease or stay the same.

VaR satisfies the first three conditions, but it does not always satisfy the fourth.

Coherent risk measures: Risk measures satisfying all four of the conditions are referred to as coherent.

• A risk measure can also be characterized by the weights it assigns to quantiles of the loss distribution.
– VAR gives a 100% weighting to the Xth quantile and zero to other quantiles.
– Expected shortfall gives equal weight to all quantiles greater than the Xth quantile and zero weight to all
quantiles below the Xth quantile.
– We can define what is known as a spectral risk measure by making other assumptions about the weights
assigned to quantiles. A general result is that a spectral risk measure is coherent (that is, it satisfies the sub-
additivity condition) if the weight assigned to the qth quantile of the loss distribution is a non-decreasing
function of q. Expected shortfall satisfies this condition.
– VAR, however, does not because the weights assigned to quantiles greater than X are less than the weight
assigned to the Xth quantile.

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