Multivariate copulas in financial market risk with particular focus on trading strategies and asset allocation

**Authors:**Stander, Yolanda Sophia**Date:**2012-11-05**Subjects:**Copulas (Mathematical statistics) , Variables (Mathematics) , Asset allocation , Financial risk**Type:**Thesis**Identifier:**uj:7351 , http://hdl.handle.net/10210/8099**Description:**D.Comm. , Copulas provide a useful way to model different types of dependence structures explicitly. Instead of having one correlation number that encapsulates everything known about the dependence between two variables, copulas capture information on the level of dependence as well as whether the two variables exhibit other types of dependence, for example tail dependence. Tail dependence refers to the instance where the variables show higher dependence between their extreme values. A copula is defined as a multivariate distribution function with uniform marginals. A useful class of copulas is known as Archimedean copulas that are constructed from generator functions with very specific properties. The main aim of this thesis is to construct multivariate Archimedean copulas by nesting different bivariate Archimedean copulas using the vine construction approach. A characteristic of the vine construction is that not all combinations of generator functions lead to valid multivariate copulas. Established research is limited in that it presents constraints that lead to valid multivariate copulas that can be used to model positive dependence only. The research in this thesis extends the theory by deriving the necessary constraints to model negative dependence as well. Specifically, it ensures that the multivariate copulas that are constructed from bivariate copulas that capture negative dependence, will be able to capture negative dependence as well. Constraints are successfully derived for trivariate copulas. It is, however, shown that the constraints cannot easily be extended to higher-order copulas. The rules on the types of dependence structures that can be nested are also established. A number of practical applications in the financial markets where copula theory can be utilized to enhance the more established methodologies, are considered. The first application considers trading strategies based on statistical arbitrage where the information in the bivariate copula structure is utilised to identify trading opportunities in the equity market. It is shown that trading costs adversely affect the profits generated. The second application considers the impact of wrong-way risk on counterparty credit exposure. A trivariate copula is used to model the wrong-way risk. The aim of the analysis is to show how the theory developed in this thesis should be applied where negative correlation is present in a trivariate copula structure. Approaches are considered where conditional and unconditional risk driver scenarios are derived by means of the trivariate copula structure. It is argued that by not allowing for wrong-way risk, a financial institution’s credit pricing and regulatory capital calculations may be adversely affected. The final application compares the philosophy behind cointegration and copula asset allocation techniques to test which approach produces the most profitable index-tracking portfolios over time. The copula asset allocation approach performs well over time; however, it is very computationally intensive.**Full Text:**

**Authors:**Stander, Yolanda Sophia**Date:**2012-11-05**Subjects:**Copulas (Mathematical statistics) , Variables (Mathematics) , Asset allocation , Financial risk**Type:**Thesis**Identifier:**uj:7351 , http://hdl.handle.net/10210/8099**Description:**D.Comm. , Copulas provide a useful way to model different types of dependence structures explicitly. Instead of having one correlation number that encapsulates everything known about the dependence between two variables, copulas capture information on the level of dependence as well as whether the two variables exhibit other types of dependence, for example tail dependence. Tail dependence refers to the instance where the variables show higher dependence between their extreme values. A copula is defined as a multivariate distribution function with uniform marginals. A useful class of copulas is known as Archimedean copulas that are constructed from generator functions with very specific properties. The main aim of this thesis is to construct multivariate Archimedean copulas by nesting different bivariate Archimedean copulas using the vine construction approach. A characteristic of the vine construction is that not all combinations of generator functions lead to valid multivariate copulas. Established research is limited in that it presents constraints that lead to valid multivariate copulas that can be used to model positive dependence only. The research in this thesis extends the theory by deriving the necessary constraints to model negative dependence as well. Specifically, it ensures that the multivariate copulas that are constructed from bivariate copulas that capture negative dependence, will be able to capture negative dependence as well. Constraints are successfully derived for trivariate copulas. It is, however, shown that the constraints cannot easily be extended to higher-order copulas. The rules on the types of dependence structures that can be nested are also established. A number of practical applications in the financial markets where copula theory can be utilized to enhance the more established methodologies, are considered. The first application considers trading strategies based on statistical arbitrage where the information in the bivariate copula structure is utilised to identify trading opportunities in the equity market. It is shown that trading costs adversely affect the profits generated. The second application considers the impact of wrong-way risk on counterparty credit exposure. A trivariate copula is used to model the wrong-way risk. The aim of the analysis is to show how the theory developed in this thesis should be applied where negative correlation is present in a trivariate copula structure. Approaches are considered where conditional and unconditional risk driver scenarios are derived by means of the trivariate copula structure. It is argued that by not allowing for wrong-way risk, a financial institution’s credit pricing and regulatory capital calculations may be adversely affected. The final application compares the philosophy behind cointegration and copula asset allocation techniques to test which approach produces the most profitable index-tracking portfolios over time. The copula asset allocation approach performs well over time; however, it is very computationally intensive.**Full Text:**

The use of copulas in risk management.

**Authors:**Stander, Yolanda Sophia**Date:**2012-08-15**Subjects:**Copulas (Mathematical statistics) , Dependence (Statistics) , Risk management**Type:**Mini-Dissertation**Identifier:**uj:9418 , http://hdl.handle.net/10210/5852**Description:**M.Sc. , In this dissertation we take a closer look at how copulas can be used to improve the risk measurement at a financial institution. The focus is on market risk in a trading environment. In practice risk numbers are calculated with very basic measures that are easy to explain to senior management and to traders. It is important that traders understand the risk measure as that helps them to understand the risk inherent in any deal and may assist them in deciding on the optimal hedge. The purpose of a hedge is to reduce the risk in a portfolio. As senior management is responsible for deciding on the optimal risk limits and risk appetite of the financial institution, it is important for them to understand what the risks are and how to measure these. The simplicity of the risk measures leads to certain inadequacies that can have very negative consequences for a financial institution. If the risk measure does not adequately capture the risk of a deal, the financial institution may suffer big losses when there are stress events in the market. Alternatively, when the risk measure overestimates the risk of a deal, too much economic capital is tied up in the deal. This inhibits the trader from adding more deals to a portfolio that may potentially lead to big profits. Economic capital is the capital that has to be held against positions to protect the financial institution if and when extreme market moves occur. In this dissertation the focus is on how copulas can be used to improve current risk measures. We focus on bivariate copulas. Bivariate copulas are easier to depict graphically than multivariate copulas with more than two dimensions. It is also easier to prove that the fitted bivariate copulae do adequately describe the underlying dependence structure between risk factors. Even though the focus is on the bivariate case, all methodologies can easily be extended to higher dimensions. In Chapter 1 copulas are defined and some basic copula properties are shown. We consider the definition of elliptical copulas and discuss some drawbacks to using them in a financial application. Some useful Archimedean copula properties are discussed and it is shown how to generate the copula function for n 2 dimensions. The various ways in which to estimate the parameters of a copula are also discussed as well as goodness-of-fit tests that are used to test whether the copula fits the underlying data adequately. Finally the chapter ends with an example that illustrates the theory. A back-test is done to establish whether the copula adequately describes the dependence structure over time. It is also shown how the fitted copula can be used to generate stress scenarios that are used as an alternative to historical scenarios when calculating a value-at-risk (VaR) number. In chapter 2 the properties of a dependence measure are discussed and it is argued that linear correlation does not conform to these desired properties. Rank correlation measures have some additional properties that make them more efficient than linear correlation measures in certain instances. We also consider their relationship to copulas. Finally it is shown how copulas can be used in practice to get another view on the dependence structure between risk factors. In risk measurement we are mainly concerned with extreme moves that market variables may show. In chapter 3 some of the techniques used in risk management are discussed as well as some of their shortcomings. The shortcomings are addressed by applying extreme value theory to calculate stress factors and using copulas to model the dependence structure between risk factors. The theory underlying bivariate extreme copulas is discussed and illustrated with a practical example.**Full Text:**

**Authors:**Stander, Yolanda Sophia**Date:**2012-08-15**Subjects:**Copulas (Mathematical statistics) , Dependence (Statistics) , Risk management**Type:**Mini-Dissertation**Identifier:**uj:9418 , http://hdl.handle.net/10210/5852**Description:**M.Sc. , In this dissertation we take a closer look at how copulas can be used to improve the risk measurement at a financial institution. The focus is on market risk in a trading environment. In practice risk numbers are calculated with very basic measures that are easy to explain to senior management and to traders. It is important that traders understand the risk measure as that helps them to understand the risk inherent in any deal and may assist them in deciding on the optimal hedge. The purpose of a hedge is to reduce the risk in a portfolio. As senior management is responsible for deciding on the optimal risk limits and risk appetite of the financial institution, it is important for them to understand what the risks are and how to measure these. The simplicity of the risk measures leads to certain inadequacies that can have very negative consequences for a financial institution. If the risk measure does not adequately capture the risk of a deal, the financial institution may suffer big losses when there are stress events in the market. Alternatively, when the risk measure overestimates the risk of a deal, too much economic capital is tied up in the deal. This inhibits the trader from adding more deals to a portfolio that may potentially lead to big profits. Economic capital is the capital that has to be held against positions to protect the financial institution if and when extreme market moves occur. In this dissertation the focus is on how copulas can be used to improve current risk measures. We focus on bivariate copulas. Bivariate copulas are easier to depict graphically than multivariate copulas with more than two dimensions. It is also easier to prove that the fitted bivariate copulae do adequately describe the underlying dependence structure between risk factors. Even though the focus is on the bivariate case, all methodologies can easily be extended to higher dimensions. In Chapter 1 copulas are defined and some basic copula properties are shown. We consider the definition of elliptical copulas and discuss some drawbacks to using them in a financial application. Some useful Archimedean copula properties are discussed and it is shown how to generate the copula function for n 2 dimensions. The various ways in which to estimate the parameters of a copula are also discussed as well as goodness-of-fit tests that are used to test whether the copula fits the underlying data adequately. Finally the chapter ends with an example that illustrates the theory. A back-test is done to establish whether the copula adequately describes the dependence structure over time. It is also shown how the fitted copula can be used to generate stress scenarios that are used as an alternative to historical scenarios when calculating a value-at-risk (VaR) number. In chapter 2 the properties of a dependence measure are discussed and it is argued that linear correlation does not conform to these desired properties. Rank correlation measures have some additional properties that make them more efficient than linear correlation measures in certain instances. We also consider their relationship to copulas. Finally it is shown how copulas can be used in practice to get another view on the dependence structure between risk factors. In risk measurement we are mainly concerned with extreme moves that market variables may show. In chapter 3 some of the techniques used in risk management are discussed as well as some of their shortcomings. The shortcomings are addressed by applying extreme value theory to calculate stress factors and using copulas to model the dependence structure between risk factors. The theory underlying bivariate extreme copulas is discussed and illustrated with a practical example.**Full Text:**

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