Copula (probability theory)

Copula (probability theory)

In probability theory and statistics, a copula is a multivariate probability distribution for which the marginal probability distribution of each variable is uniform. Copulas are used to describe the dependence between random variables. They are named for their resemblance to grammatical copulas in linguistics. Sklar's Theorem states that any multivariate joint distribution can be written in terms of univariate marginal distribution functions and a copula which describes the dependence structure between the variables. Copulas are popular in high dimensional statistical applications as they allow one to easily model and estimate the distribution of random vectors by estimating marginals and copula separately. There are many parametric copula families available, which usually have parameters that control the strength of dependence. Some popular parametric copula models are outlined below. The formula was also adapted to Wall Street, where it took on a life of its own, used to estimate the probability distribution of losses on pools of loans or bonds. The users of the formula have been criticized for creating "evaluation cultures" that took the predictions of the formula as hard probabilities with which to make risk assessments.[1]

Mathematical definition
Consider a random vector the random vector has uniformly distributed marginals. The copula of is defined as the joint cumulative distribution function of : . Suppose its margins are continuous, i.e. the marginal CDFs are continuous functions. By applying the probability integral transform to each component,

The copula C contains all information on the dependence structure between the components of whereas the marginal cumulative distribution functions contain all information on the marginal distributions. The importance of the above is that the reverse of these steps can be used to generate pseudo-random samples from general classes of multivariate probability distributions. That is, given a procedure to generate a sample from the copula distribution, the required sample can be constructed as

The inverses

are unproblematic as the

were assumed to be continuous. The above formula for the copula

function can be rewritten to correspond to this as:

Definition
In probabilistic terms, In analytic terms, is a d-dimensional copula if C is a joint cumulative distribution with uniform marginals. is a d-dimensional copula if , the copula is zero if one of the arguments is zero, , the copula is equal to u if one argument is u and all others 1, the C-volume of B is function of a d-dimensional random vector on the unit cube

C is d-increasing, i.e., for each hyperrectangle non-negative:

Copula (probability theory)

where the For instance, in the bivariate case, , and and .

. is a bivariate copula if for all

Sklar's theorem
Sklar's theorem, named after Abe Sklar, provides the theoretical foundation for the application of copulas. Sklar's theorem states that every multivariate cumulative distribution function

of

random

vector can be written as

with

marginals
Density and contour plot of a Bivariate Gaussian Distribution

where

is a copula. , the copula is unique on , which is the cartesian product of the

The theorem also states that, given

ranges of the marginal cdf's. This implies that the copula is unique if the marginals are continuous. The converse is also true: given a copula margins then defines and a
Density and contour plot of two Normal marginals joint with a Gumbel copula

d-dimensional cumulative distribution function.

FrchetHoeffding copula bounds

The FrchetHoeffding Theorem (after Maurice Ren Frchet and Wassily Hoeffding ) states that for any Copula and any the following bounds hold:
Graphs of the bivariate FrchetHoeffding copula limits and of the independence copula (in the middle).

The function W is called lower FrchetHoeffding bound and is defined as

The function M is called upper FrchetHoeffding bound and is defined as

The upper bound is sharp: M is always a copula, it corresponds to comonotone random variables. The lower bound is point-wise sharp, in the sense that for fixed u, there is a copula such that .

However, W is a copula only in two dimensions, in which case it corresponds to countermonotonic random variables. In two dimensions, i.e. the bivariate case, the FrchetHoeffding Theorem states

Copula (probability theory)

Families of copulas
Several families of copulae have been described.

Gaussian copula
The Gaussian copula is a distribution over the unit cube constructed from a multivariate normal distribution over the probability integral transform. For a given correlation matrix parameter matrix can be written as
Cumulative and density distribution of Gaussian copula with =0.4

. It is by using

, the Gaussian copula with

where

is the inverse cumulative distribution function of a is the joint cumulative distribution function

standard normal and .

of a multivariate normal distribution with mean vector zero and covariance matrix equal to the correlation matrix The density can be written as

where is the identity matrix.

Archimedean copulas
Archimedean copulas are an associative class of copulas. Most common Archimedean copulas admit an explicit formula, something not possible for instance for the Gaussian copula. In practice, Archimedean copulas are popular because they allow modeling dependence in arbitrarily high dimensions with only one parameter, governing the strength of dependence. A copula C is called Archimedean if it admits the representation

where .

is a continuous, strictly decreasing and convex function such that . is the so-called generator function and is its

is a parameter within some parameter space

pseudo-inverse defined by

Moreover, the above formula for C yields a copula for if it is for all times differentiable and the derivatives satisfy and and

if and only if

is d-monotone on

. That is,

is nonincreasing and convex.

The following table highlights the most prominent bivariate Archimedean copulas with their corresponding generator. Note that not all of them are completely monotone, i.e. d-monotone for all or d-monotone for certain only.

Copula (probability theory)

Table with the most important generators

name Clayton Ali-Mikhail-Haq bivariate copula generator generator inverse parameter

Gumbel Frank

Joe Independence

Empirical copulas
When studying multivariate data, one might want to investigate the underlying copula. Suppose we have observations

from a random vector would be

with continuous margins. The corresponding "true" copula observations

However, the marginal distribution functions

are usually not known. Therefore, one can construct pseudo copula

observations by using the empirical distribution functions

instead. Then, the pseudo copula observations are defined as

The corresponding empirical copula is then defined as

The components of the pseudo copula samples can also be written as observation :

, where

is the rank of the

Therefore, the empirical copula can be seen as the empirical distribution of the rank transformed data.

Copula (probability theory)

Monte Carlo integration for copula models

In statistical applications, many problems can be formulated in the following way. One is interested in the expectation of a response function applied to some random vector .[2] If we denote the cdf of this random vector with , the quantity of interest can thus be written as

If

is given by a copula model, i.e.,

this expectation can be rewritten as

In case the copula C is absolutely continuous, i.e. C has a density c, this equation can be written as

If copula and margins are known (or if they have been estimated), this expectation can be approximated through the following Monte Carlo algorithm: 1. Draw a sample of size n from the copula C 2. By applying the inverse marginal cdf's, produce a sample of by setting 3. Approximate by its empirical value:

Applications
Quantitative finance
In risk/portfolio management, copulas are used to perform stress-tests and robustness checks that are especially important during downside/crisis/panic regimes where extreme downside events may occur (e.g., the global financial crisis of 20082009). During a downside regime, a large number of investors who have held positions in riskier assets such as equities or real estate may seek refuge in safer investments such as cash or bonds. This is also known as a flight-to-quality effect and investors tend to exit their positions in riskier assets in large numbers in a short period of time. As a result, during downside regimes, correlations across equities are greater on the downside as opposed to the upside and this may have disastrous effects on the economy. For example, anecdotally, we often read financial news headlines reporting the loss of hundreds of millions of dollars on the stock exchange in a single day; however, we rarely read reports of positive stock market gains of the same magnitude and in the same short time frame. Copulas are useful in portfolio/risk management and help us analyse the effects of downside regimes by allowing the modelling of the marginals and dependence structure of a multivariate probability model separately. For example, consider the stock exchange as a market consisting of a large number of traders each operating with his/her own strategies to maximize profits. The individualistic behaviour of each trader can be described by modelling the marginals. However, as all traders operate on the same exchange, each traders actions have an interaction effect with other traders'. This interaction effect can be described by modelling the dependence structure. Therefore, copulas allow us to analyse the interaction effects which are of particular interest during downside regimes as investors tend to herd their trading behaviour and decisions.

Copula (probability theory) Previously, scalable copula models for large dimensions only allowed the modelling of elliptical dependence structures (i.e., Gaussian and Student-t copulas) that do not allow for correlation asymmetries where correlations differ on the upside or downside regimes. However, the recent development of vine copulas (also known as pair copulas) enables the flexible modelling of the dependence structure for portfolios of large dimensions. The Clayton canonical vine copula allows for the occurrence of extreme downside events and has been successfully applied in portfolio choice and risk management applications. The model is able to reduce the effects of extreme downside correlations and produces improved statistical and economic performance compared to scalable elliptical dependence copulas such as the Gaussian and Student-t copula. Other models developed for risk management applications are panic copulas that are glued with market estimates of the marginal distributions to analyze the effects of panic regimes on the portfolio profit and loss distribution. Panic copulas are created by Monte Carlo simulation, mixed with a re-weighting of the probability of each scenario. As far as derivatives pricing is concerned, dependence modelling with copula functions is widely used in applications of financial risk assessment and actuarial analysis for example in the pricing of collateralized debt obligations (CDOs). Some believe the methodology of applying the Gaussian copula to credit derivatives to be one of the reasons behind the global financial crisis of 20082009.[3] Despite this perception, there are documented attempts of the financial industry, occurring before the crisis, to address the limitations of the Gaussian copula and of copula functions more generally, specifically the lack of dependence dynamicsWikipedia:Please clarify and the poor representation of extreme events. There have been attempts to propose models rectifying some of the copula limitations. While the application of copulas in credit has gone through popularity as well as misfortune during the global financial crisis of 20082009, it is arguably an industry standard model for pricing CDOs. Copulas have also been applied to other asset classes as a flexible tool in analyzing multi-asset derivative products. The first such application outside credit was to use a copula to construct an implied basket volatility surface, taking into account the volatility smile of basket components. Copulas have since gained popularity in pricing and risk management of options on multi-assets in the presence of volatility smile/skew, in equity, foreign exchange and fixed income derivative business. Some typical example applications of copulas are listed below: Analyzing and pricing volatility smile/skew of exotic baskets, e.g. best/worst of; Analyzing and pricing volatility smile/skew of less liquid FXWikipedia:Please clarify cross, which is effectively a basket: C = S1/S2 or C = S1S2; Analyzing and pricing spread options, in particular in fixed income constant maturity swap spread options.

Civil engineering
Recently, copula functions have been successfully applied to the database formulation for the reliability analysis of highway bridges, and to various multivariate simulation studies in civil, mechanical and offshore engineering.[citation
needed]

Reliability engineering
Copulas are being used for reliability analysis of complex systems of machine components with competing failure modes.[citation needed]

Copula (probability theory)

Medicine
Copula functions have been successfully applied to the analysis of neuronal dependencies and spike counts in neuroscience .

Weather research
Copulas have been extensively used in climate and weather related research.

Random vector generation

Large synthetic traces of vectors and stationary time series can be generated using empirical copula while preserving the entire dependence structure of small datasets. Such empirical traces are useful in various simulation-based performance studies.

References
[1] Donald MacKenzie and Taylor Spears, The Formula That Killed Wall Street? The Gaussian Copula and the Material Cultures of Modelling (http:/ / www. sps. ed. ac. uk/ __data/ assets/ pdf_file/ 0003/ 84243/ Gaussian14. pdf), June 2012 [2] Alexander J. McNeil, Rudiger Frey and Paul Embrechts (2005) "Quantitative Risk Management: Concepts, Techniques, and Tools", Princeton Series in Finance [3] Recipe for Disaster: The Formula That Killed Wall Street (http:/ / www. wired. com/ techbiz/ it/ magazine/ 17-03/ wp_quant?currentPage=all) Wired, 2/23/2009

Further reading
The standard reference for an introduction to copulas. Covers all fundamental aspects, summarizes the most popular copula classes, and provides proofs for the important theorems related to copulas Roger B. Nelsen (1999), "An Introduction to Copulas", Springer. ISBN 978-0-387-98623-4 A book covering current topics in mathematical research on copulas: Piotr Jaworski, Fabrizio Durante, Wolfgang Karl Hrdle, Tomasz Rychlik (Editors): (2010): "Copula Theory and Its Applications" Lecture Notes in Statistics, Springer. ISBN 978-3-642-12464-8 A reference for sampling applications and stochastic models related to copulas is Jan-Frederik Mai, Matthias Scherer (2012): Simulating Copulas (Stochastic Models, Sampling Algorithms and Applications). World Scientific. ISBN 978-1-84816-874-9 A paper covering the historic development of copula theory, by the person associated with the "invention" of copulas, Abe Sklar. Abe Sklar (1997): "Random variables, distribution functions, and copulas a personal look backward and forward" in Rschendorf, L., Schweizer, B. und Taylor, M. (eds) Distributions With Fixed Marginals & Related Topics (Lecture Notes Monograph Series Number 28). ISBN 978-0-940600-40-9 The standard reference for multivariate models and copula theory in the context of financial and insurance models Alexander J. McNeil, Rudiger Frey and Paul Embrechts (2005) "Quantitative Risk Management: Concepts, Techniques, and Tools", Princeton Series in Finance. ISBN 978-0-691-12255-7

Copula (probability theory)

External links
Hazewinkel, Michiel, ed. (2001), "Copula" (http://www.encyclopediaofmath.org/index.php?title=p/c110410), Encyclopedia of Mathematics, Springer, ISBN978-1-55608-010-4 Copula Wiki: community portal for researchers with interest in copulas (http://sites.google.com/site/ copulawiki/) A collection of Copula simulation and estimation codes (http://www.mathfinance.cn/tags/copula) Thorsten Schmidt (2006): "Coping with Copulas" (http://www.math.uni-leipzig.de/~tschmidt/ TSchmidt_Copulas.pdf) Copulas & Correlation using Excel Simulation Articles (http://www.crystalballservices.com/Resources/ ConsultantsCornerBlog/tagid/21/Correlation.aspx) Chapter 1 of Jan-Frederik Mai, Matthias Scherer (2012): "Simulating Copulas: Stochastic Models, Sampling Algorithms, and Applications" (http://www.worldscientific.com/doi/suppl/10.1142/p842/suppl_file/ p842_chap01.pdf)

Article Sources and Contributors

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File:Gaussian copula gaussian marginals.png Source: http://en.wikipedia.org/w/index.php?title=File:Gaussian_copula_gaussian_marginals.png License: Creative Commons Attribution-Sharealike 3.0 Contributors: Matteo Zandi File:Biv gumbel dist.png Source: http://en.wikipedia.org/w/index.php?title=File:Biv_gumbel_dist.png License: Creative Commons Attribution-Sharealike 3.0 Contributors: Matteo Zandi File:copule ord.svg Source: http://en.wikipedia.org/w/index.php?title=File:Copule_ord.svg License: Creative Commons Attribution-Sharealike 3.0 Contributors: Matteo Zandi File:Copula gaussian.svg Source: http://en.wikipedia.org/w/index.php?title=File:Copula_gaussian.svg License: Creative Commons Attribution-Sharealike 3.0 Contributors: Matteo Zandi

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