Copula correlations

A fairly recent, famous as well as infamous correlation approach applied in finance is the copula approach. Copulas go back to Sklar (1959).^[9] Copulas were introduced to finance by Vasicek (1987)^[10] and Li (2000).^[11]

Copulas simplify statistical problems. They allow the joining of multiple univariate distributions to a single multivariate distribution. Formally, a copula function C transforms an n-dimensional function on the interval [0,1] into a unit-dimensional one:

${\displaystyle C:[0,1]^{n}\rightarrow [0,1]}$ (6).

More explicitly, let ${\displaystyle u_{i}}$ be a uniform random vector with ${\displaystyle u_{i}=u_{1},...,u_{n},u_{i}\in [0,1]}$ and ${\displaystyle i\in N}$. Then there exists a copula function ${\displaystyle C}$ such that

${\displaystyle C(u_{1},\ldots ,u_{n})=F[F_{1}^{-1}(u_{1}),\ldots ,F_{n}^{-1}(u_{n})]}$ (7)

where F is the joint cumulative distribution function and ${\displaystyle \ F_{i}}$, i = 1, ..., n_i are the univariate marginal distributions. ${\displaystyle F_{i}^{-1}}$ is the inverse of ${\displaystyle \ F_{i}}$. If the marginal distributions ${\displaystyle F_{i}^{-1}(u_{i})}$ are continuous, it follows that C is unique. For properties and proofs of equation (11), see Sklar (1959) and Nelsen (2006).^[12] Numerous types of copula functions exist. They can be broadly categorized in one-parameter copulas as the Gaussian copula, and the Archimedean copula, which comprise Gumbel, Clayton and Frank copulas. Often cited two-parameter copulas are student-t, Fréchet, and Marshall-Olkin. For an overview of these copulas, see Nelsen (2006). In finance, copulas are typically applied to derive correlated default probabilities in a portfolio,^{[according to whom?]} for example in a collateralized debt obligation, CDO. This was first done by Li in 2006. He defined the uniform margins ${\displaystyle u_{i}}$ as cumulative default probabilities Q for entity i at a fixed time t, ${\displaystyle Q_{i}(t)}$:

${\displaystyle \ u_{i}=Q_{i}(t)}$ (8).

Hence, from equations (7) and (8) we derive the Gaussian default time copula CGD,

${\displaystyle C_{GD}(u_{1},\ldots ,u_{n})=M_{n,R}[N_{1}^{-1}(Q_{1}(t)),\ldots ,N_{n}^{-1}(Q_{n}(t))]}$ (9).

In equation (9) the terms ${\displaystyle N_{i}^{-1}}$ map the cumulative default probabilities Q of asset i for time t, ${\displaystyle Q_{i}(t)}$, percentile to percentile to standard normal. The mapped standard normal marginal distributions ${\displaystyle N_{i}^{-1}Q_{i}(t)}$ are then joined to a single n-variate distribution ${\displaystyle M_{n,R}}$ by applying the correlation structure of the multivariate normal distribution with correlation matrix R. The probability of n correlated defaults at time t is given by ${\displaystyle M_{n,R}}$.

Copulae and the 2007–08 financial crisis

Numerous non-academic articles have been written demonizing the copula approach and blaming it for the 2007/2008 global financial crisis, see for example Salmon 2009,^[13] Jones 2009,^[14] and Lohr 2009.^[15] There are three main criticisms of the copula approach: (a) tail dependence, (b) calibration, (c) risk management.

(a) Tail dependence

In a crisis, financial correlations typically increase, see studies by Das, Duffie, Kapadia, and Saita (2007)^[16] and Duffie, Eckner, Horel and Saita (2009)^[17] and references therein. Hence it would be desirable to apply a correlation model with high co-movements in the lower tail of the joint distribution. It can be mathematically shown that the Gaussian copula has relative low tail dependence, as seen in the following scatter plots.^{[citation needed]}

Figure 1: Scatter plots of different copula models

As seen in Figure 1b, the student-t copula exhibits higher tail dependence and might be better suited to model financial correlations. Also, as seen in Figure 1(c), the Gumbel copula exhibits high tail dependence especially for negative co-movements. Assuming that correlations increase when asset prices decrease, the Gumbel copula might also be a good correlation approach for financial modeling.^{[citation needed]}

(b) Calibration

A further criticism of the Gaussian copula is the difficulty to calibrate it to market prices. In practice, typically a single correlation parameter (not a correlation matrix) is used to model the default correlation between any two entities in a collateralized debt obligation, CDO. Conceptually this correlation parameter should be the same for the entire CDO portfolio. However, traders randomly alter the correlation parameter for different tranches, in order to derive desired tranche spreads. Traders increase the correlation for ‘extreme’ tranches as the equity tranche or senior tranches, referred to as the correlation smile. This is similar to the often cited implied volatility smile in the Black–Scholes–Merton model. Here traders increase the implied volatility especially for out-of-the money puts, but also for out-of-the money calls to increase the option price.^{[citation needed]}.

In a mean-variance optimization framework, accurate estimation of the variance-covariance matrix is paramount. Thus, forecasting with Monte-Carlo simulation with the Gaussian copula and well-specified marginal distributions are effective.^[18] Allowing the modeling process to allow for empirical characteristics in stock returns such as auto-regression, asymmetric volatility, skewness, and kurtosis is important. Not accounting for these attributes lead to severe estimation error in the correlations and variances that have negative biases (as much as 70% of the true values).^[19]

(c) Risk management

A further criticism of the Copula approach is that the copula model is static and consequently allows only limited risk management, see Finger (2009)^[20] or Donnelly and Embrechts (2010).^[21] The original copulas models of Vasicek (1987) and Li (2000) and several extensions of the model as Hull and White (2004)^[22] or Gregory and Laurent (2004)^[23] do have a one period time horizon, i.e. are static. In particular, there is no stochastic process for the critical underlying variables default intensity and default correlation. However, even in these early copula formulations, back testing and stress testing the variables for different time horizons can give valuable sensitivities, see Whetten and Adelson (2004)^[24] and Meissner, Hector, and. Rasmussen (2008).^[25] In addition, the copula variables can be made a function of time as in Hull, Predescu, and White (2005).^[26] This still does not create a fully dynamic stochastic process with drift and noise, which allows flexible hedging and risk management. The best solutions are truly dynamic copula frameworks, see section ‘Dynamic Copulas’ below.

Irrational complacency

Before the global 2007–08 financial crisis, numerous market participants trusted the copula model uncritically and naively.^{[citation needed]} However, the 2007–08 crisis was less a matter of a particular correlation model, but rather an issue of "irrational complacency". In the extremely benign time period from 2003 to 2006, proper hedging, proper risk management and stress test results were largely ignored.^{[citation needed]} The prime example is AIG's London subsidiary, which had sold credit default swaps and collateralized debt obligations in an amount of close to $500 billion without conducting any major hedging. For an insightful paper on inadequate risk management leading up to the crisis, see “A personal view of the crisis – Confessions of a Risk Manager” (The Economist 2008).^[27] In particular, if any credit correlation model is fed with benign input data as low default intensities and low default correlation, the risk output figures will be benign, ‘garbage in garbage out’ in modeling terminology.^{[citation needed]}

Dynamic copulas

A core enhancement of copula models are dynamic copulas, introduced by Albanese et al. (2005)^[28] and (2007).^[29] The "dynamic conditioning" approach models the evolution of multi-factor super-lattices, which correlate the return processes of each entity at each time step. Binomial dynamic copulas apply combinatorial methods to avoid Monte Carlo simulations. Richer dynamic Gaussian copulas apply Monte Carlo simulation and come at the cost of requiring powerful computer technology.