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Multiple risk factor dependence structures: Copulas and related properties

Jianxi Su and Edward Furman

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Abstract: Copulas have become an important tool in the modern best practice Enterprise Risk Management, often supplanting other approaches to modelling stochastic dependence. However, choosing the `right' copula is not an easy task, and the temptation to prefer a tractable rather than a meaningful candidate from the encompassing copulas toolbox is strong. The ubiquitous applications of the Gaussian copula is just one illuminating example. Speaking generally, a `good' copula should conform to the problem at hand, allow for asymmetry in the domain of definition and exhibit some extent of tail dependence. In this paper we introduce and study a new class of Multiple Risk Factor (MRF) copula functions, which we show are exactly such. Namely, the MRF copulas (1) arise from a number of meaningful default risk specification with stochastic default barriers, (2) are in general non-exchangeable and (3) possess a variety of tail dependences. That being said, the MRF copulas turn out to be surprisingly tractable analytically.

Date: 2016-10
New Economics Papers: this item is included in nep-rmg
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