Selecting Copulas for Risk Management

Kees Koedijk, Marno Verbeek and Erik Kole ()

No 5652, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favour of the Student?s t copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the Student?s t copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant.

Keywords: Financial dependence; Risk management; Copulas; Distributional tests; Tail dependence (search for similar items in EconPapers)
JEL-codes: C12 C14 G11 (search for similar items in EconPapers)
Date: 2006-04
New Economics Papers: this item is included in nep-bec, nep-ecm, nep-fin, nep-fmk and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Journal Article: Selecting copulas for risk management (2007)
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