Dependence and VaR EstimationAn

Empirical Study of Chinese Stock

Markets using Copula
Baoliang Li
WISE, XMU
Sep. 2009

Outline
z
z
z
z
z
z

Question: Dependence between Assets

Correlation and Dependence
Copula:Basics and Extensions
Dependence between SHSI and SZCI
Portfolio VaR: Copula-based MC Method
Future Study

Questions: Dependence between

Assets
z
z

Dependence structure beween assets is

important in financial decision-making.
Dependence Structure of SH and SZ Stocks
Tail Dependence?
VaR Estimation using Copula
Better Performance?

Correlation and Dependence

z

z
z

Correlation is an important concept in finance.

Optimal Porfolio Construction (Markowitz, 1952)
Pricing: CAPM and APT (Sharpe, 1963; Roll, 1971)
Portfolio VaR Estimation (Tsay,2006)
Pros: Simple to Calculate
Easy to understand
Cons: Finite Variance ( May not exist under fat tail distribution)
Linear (Correlation will change under nonlinear
transformation)
Tail Dependence (important for VaR, see below for
different tail behavior)

Bivariate Normal (Corr=0.8)

Same Corr, Same Marginal Distribution, Normal(L)

and Gumbel(R), (Embrechts,2002)

Correlation and Dependence

z

Correlation works well under multivariate

normal distribution (or more generally,
elliptical distribution)
Finance theory explicitly or implicitly
assumes asset returns follow multivariate
normal distribution (Embrechts,2002)
Yet, Empirical evidences show this is not true
(Mandelbrot ,1963;Ang and Chen 2002)

How to Describe association between

asset returns?
z

Copula is a better alternative. (Sklar, 1959)

Advantages of Copula (Embrechts,2002;

Patton, 2006; Nelson,2006) :
More reasonable multivariate distribution
Separating dependence from marginals
Can use to study tail behavior

Copula: Basics and Extensions

z
z
z
z
z

Definition and Properties

Measures of Dependence
Extension:Conditional Copula
Inference: Estimation and Selection of
Copulas
Application of Copula in Finance

Definition: Copula Function

H ( x1, , xd ) = P ( X1 x1 , , X d xd )

= P ( F1 ( X1 ) F1 ( x1 ) , , Fd ( X d ) Fd ( xd ) )
= C ( F1 ( x1 ) , , Fd ( xd ) )
= C ( u1 , , ud )

C ( u1 ,

, un ) = H ( F11 ( u1 ) ,

, Fn1 ( un ) )

Properties of Copula
z
z

Copula is essentially an multivariate

distribution function.
Same properties:

Sklars Theorm (1959)

z
z

Multivariate distribution can be separated

into two parts: marginals and Copula
Copula links Marginals to form new
multivariate distribution
Remarks: Most important Theorem in Copula
Continuous vs Discrete Variable

Copula Density
h ( x1 ,

, xd ) =

2C ( F1 ( x1 ) ,
F1 ( x1 )

= c ( F1 ( x1 ) ,

c ( F1 ( x1 ) ,

, Fd ( xd ) ) F1 ( x1 )

Fd ( xd )

x1
d

, Fd ( xd ) ) fi ( xi )

, Fd ( xd ) ) =

i =1

h ( x1 ,

, xd )

f (x )
i =1

Fd ( xd )
xd

1.5

Gaussian

Examples:Normal Copula and t Copula

(different behavior at (0,0) and (1,1))

0.5

0
1

0
1
1
0.5
u2

0.5
0

u1

1
0.5
u2

0.5
0

u1

Symmetrised Joe-Clayton Copula

(different behavior at (0,0) and (1,1))

5
symmetrised Joe-Clayton

symmetrised Joe-Clayton

5
4
3
2
1
0
1

4
3
2
1
0
1

1
0.5
u2

0.5
0

u1

1
0.5
u2

0.5
0

u1

Measures of Dependence
z

Rank Correlation Coeff

Spearmans rho
Kendalls tau
Tail Dependence:
U = limu 1 P ( F ( X ) > u | G (Y ) > u )

L = limu 0 P ( F ( X ) < u | G (Y ) < u )

+

Tail Dependence
U = limu 1 P ( F ( X ) > u | G (Y ) > u )

= limu 1
= limu 1
= limu 1

P ( F ( X ) > u, G (Y ) > u )
P ( G (Y ) > u )

P( X > F

(u ) ,Y > G (u ))
P (Y > G 1 ( u ) )
1 2u + C ( u, u )
1

1 u

L = limu 0 P ( F ( X ) < u | G (Y ) < u )

+

= limu 0+
= limu 0+
= limu 0+

P ( F ( X ) < u, G (Y ) < u )
P ( G (Y ) < u )

P ( X < F 1 ( u ) , Y < G 1 ( u ) )
P (Y < G 1 ( u ) )

C ( u, u )
u

Tail Coeff of Normal, t and SJC

z
z

Normal Copula: U =L =0
T Copula: U = L = 2tv +1 ( v + 1

1/

=
2

2
z SJC Copula: U

1 / 1+

L = 2 1/

Extensions: Conditional Copula

z
z

Extension to accommodate time series

Conditional Copula (Patton, 2001)
H t ( x, y | I t 1 ) = Ct ( Ft ( x | I t 1 ) , Gt ( y | I t 1 ) | I t 1 )

z
z

Remarks: Conditional Variables should be

the same for marginals and Copula
Sklars theorem for conditional Copula

Dynamic Conditional Copula

z

Patton (2001, 2004) : Exchange rate

Jondeau and Rockinger2006):

International stock markets

Chiou and Tsay2008): U.S. and Taiwan

Parameters Estimation
l ( x ; 1 ,

, d , ) = log c F1 ( x1 j ; 1 ) ,
n

j =1

, Fd ( xdj ; d ) ; + f i ( xij ; i )
n

j =1 i =1

EML
CML (Genest, 1995Shih andLouis,1995)
IFM (Joe and Xu1996Joe1997)

Remarks: Pros and Cons

z
z

IFM:Inference Function Method

ht ( x, y | I t 1 ; h ) = ct ( u , v | I t 1 ; c ) f t ( x | I t 1 ; f ) g t ( y | I t 1 ; g )

f = arg max L ( f ) = arg max log ft xt ; f

T

t =1

g = arg max L ( g ) = arg max log gt yt ; f

T

t =1

( (

) (

) )

c = arg max L ( c ) = arg max log ct Ft xt ;f , Gt yt ;g ; c

t =1

Selection of Copulas
z
z
z

How to select among different copulas?

Goodness of Fit (Genest, 2006)
Information Criteria (Manner,2007 )
AIC = 2 log(max .likelihood ) + 2k

BIC = 2 log(max .likelihood ) + k log(T )

z

Joe (1997): Computable and Explainable

Applications in Finance
z
z
z
z

Risk management: (Li, 1999;Embrechts et

al,1999,2002; McNeil, 2005; Alexander,2008)
Portfolio Construction: (Patton, 2004)
Pricing: Structured products (Cherubini and
Luciano,2000; Chiou and Tsay,2008)
Contagion: RS-Copula (Rodriguez,2007)

Dependence between SHSI and SZCI

z
z

Copulas in Domestic Academic Study

Model Specification
Marginal Specification
Copula Specification
Empirical Results
Compare with DCC Model

Copulas in Domestic Academic Study

z
z
z

Time lag (First introduced by Zhang, 2002)

Focus on introduction of Copula (Wei, 2004)
Empirical Application to Chinese stock
markets (Gong and Li, 2005;others ):
Marginals: Empirical Dist, t Dist, GARCH
Copula: Static Copula
Strange: they always get what they want!!
These can be improved to accommodate
stylized facts of Chinese stock markets

Data Preliminary Analysis

z
z
z
z
z

SHSI and SZCI: Jan. 2,1997-Mar. 30,2009

Fat tail
Autocorr
Volatility clustering
Leverage effect

Data: Leverage effect

Relative Daily Index Closings
7

A
A

In
d
e
xV
a
lu
e

0
1996

1998

2000

2002

2004

2006

2008

2010

2006

2008

2010

2006

2008

2010

A
0.1

Return

0.05
0
-0.05
-0.1
1996

1998

2000

2002

2004

A
0.1

Return

0.05
0
-0.05
-0.1
1996

1998

2000

2002

2004

Fat tail
QQ A

QQ A
0.1

Quantiles of Input Sample

Quantiles of Input Sample

0.1

0.05

-0.05

-0.1
-4

-2
0
2
Standard Normal Quantiles

0.05

-0.05

-0.1
-4

-2
0
2
Standard Normal Quantiles

Autocorr
Sample ACF of Returns: A

Sample ACF of Returns: A

0.8
Sample Autocorrelation

Sample Autocorrelation

0.8

0.6

0.4

0.2

-0.2

0.6

0.4

0.2

10
Lag

15

20

-0.2

10
Lag

15

20

Volatility clustering
Sample ACF of Squared Returns: A

Sample ACF of Squared Returns: A

0.8
Sample Autocorrelation

Sample Autocorrelation

0.8
0.6
0.4
0.2

0
-0.2

0.6
0.4
0.2

10
Lag

15

20

-0.2

10
Lag

15

20

Marginal Specification
ARMA-GJR-GARCH-t (BollerslevChristoffersen and
Diebold,2006)
z Mean: ARMA to alleviate autocorrelation
z Variance: GARCH to include Volatility Clustering
z Innovation term: t distribution to consider fat tail
z Leverage: GJR-GARCH or EGARCH

Copula Specification
z

Normal Copula
Cnorm ( u1 , u2 ) =

1 ( u1 ) 1 ( u2 )

z
z
z

s2 2 s s + s2
1 2
2
ds1s2
exp 1
2
2

2 (1 )
2 1

Parameter: Correlation (Same as traditional)

Zero tail dependence
Use as Benchmark

Copula Specification
z

t Copula:
Ct ( u1 , u2 ) = tv , ( tv1 ( u1 ) , tv1 ( u2 ) )

z
z

Natural extension of Normal Copula

Symmetric tail dependence

Copula Specification
z

Symmetrised Joe-Clayton Copula

+ 1 (1 u2 ) 1
CJC ( u1 , u2 ) = 1 1 (1 u1 )

1/

1/

CSJC ( u1, u2 ) = 0.5CJC ( u1, u2 ) + 0.5CJC (1u1,1u2 ) + u1 + u2 1

= 1/ log 2 ( 2 U )

= 1/ log 2 ( L )

U , L ( 0,1)

Allows asymmetric tail dependence

Dynamic Copula
z
z
z

Empirics show that correlation coeff is timevarying (Engel, 2002)

Dynamic conditional copula (Patton 2006)
Normal Cop and transplant to t Cop:

1 10 1
1
t = + t 1 + ( u1t j ) ( u2t j )
10 j =1

Dynamic Copula
z

Symmetrised Joe-Clayton Copula

1 10
Ut = U + U U t 1 + U u1t j u2t j
10 j =1

1 10
Lt = L + L Lt 1 + L u1t j u2t j
10 j =1

here ( x ) =

1
1 + e x

Empirical results
z

Marginal estimation

Copula estimation

Comparison and Evaluation

Marginal: SZCI
z

Marginal: SHSI

Diagnostic test

QQ-plot of Standard Residuals

Copula Estimation

Copula Estimation 2

Correlation of Normal Copula

Normal copula
1
0.95
0.9
0.85
0.8
time-varying
constant

0.75
0.7
0.65
0.6
0.55
0.5

500

1000

1500

2000

2500

3000

Corr and Tail Dependence of t Cop

rho of t copula
1

0.9
time-varying
constant

0.8

0.7

500

1000

1500

2000

2500

3000

2500

3000

tail dependence of t copula

1

0.8

0.6

0.4

time-varying
constant
0

500

1000

1500

2000

Upper and Lower Tail of SJC Cop

SJC copula - Average tail dependence
0.9
0.8
0.7
0.6
0.5

500

1000

1500

2000

2500

SJC copula - Difference between lower and upper tail

0.2
0.1
0
-0.1
-0.2
0

500

1000

1500

2000

2500

Selection of Copulas

Compare with DCC-MGARCH

1.2
1
0.8
0.6
0.4
0.2
0
-0.2

500

1000

1500

2000

2500

3000

Conclusions
High time-varying Corr Coeff
z Approximate symmetric tail dependence
z Economic Explanation: Same regulation, rapid
capital and information flow; Homogenuous
investors, Policy markets,
Closed investment environment, limited investment
intruments,lack of shortselling mechanism
z Economic Implication: Little benefit from
Diversification in SH and SZ; VaR (Tail dependence)
z

Portfolio VaR: Copula-based MC

Method
z

z
z

Traditional Methods:
HS, Analytic and MC; DCC
Method using Copulas
Modification based on dependence measures
MC using Copula
Backtesting: Compare with traditional Methods
Empirical Results

Traditional Methods
z

Analytic or DCC:
VaRt =

VaR
i =1

it

+ 2 ijtVaRitVaR jt
i< j

VaRt = 1.65 w2 h1t + (1 w) 2 h2t + 2 w(1 w) t h1t h2t

Pitfalls
z

Individual asset:
fat tail vs normal dist

Dependence:
asymmetric dependence (Ang and Chen,
2002)

Modification based on dependence

measures
z

Kendalls tau
VaRt =

VaR
i =1

it

+ 2 ijtVaRitVaR jt
i< j

Tail dependence
VaRt =

L
VaR
+
2

it ijt VaRitVaR jt
i =1

i< j

Remarks: No theoretical foundation

MC using Copula
Pr( Z zt ) = Pr( wX +(1w) Y zt )
=

wX+(1wY
) zt

Ct ( Ft ( x| It1) ,Gt ( y| It1) | It1)dxdy

1 1w
z y

+ w t w t

= ct ( Ft ( x| It1) ,Gt ( y | It1) | It1)i ft ( x| It1) dxgt ( y | It1) dy

Pr ( Z VaR

*
t

) = 1 p

MC using Copula
z

Hard to solve VaRt*

Using MC method

Backtesting Procedure
z

Kupiecs test (1995)

LRKupiec = 2 ln L ( p ) / L ( ) 12
Christoffersen s test (1998)

( )

2
LRcc = 2 ln L ( p ) / L
1
2

Loss Function (1998)

f ( rp ,t +1 , VaRt +1 ) rp ,t +1 < VaRt +1

Lt +1 =
g ( rp ,t +1 , VaRt +1 ) rp ,t +1 > VaRt +1

Empirical Results:95% VaR

10
t Copula
analytic
historical simulation
Monte Carlo
DCC

8
6
4
2
0
-2
-4
-6
-8
-10

100

200

300

400

500

600

700

800

900

1000

Backtest: 95% VaR

Empirical Results:95% VaR

10
t Copula
analytic
historical simulation
Monte Carlo
DCC

-5

-10

-15

100

200

300

400

500

600

700

800

900

1000

Backtest: 99% VaR

Future Study
z

Theory:
Extension to High-dimensional Copula
Selection of Copulas
Application:
There are potential applications where
Correlation is used

High-dimensional Copula:4 assets, 2 industries, 1

portfolio (Hierarchical Copula,Berg and Aas,2008)

Application obstacles
z

Diagnostic test

Computer sofeware