Chapter 6 Correlations and Copulas

Correlations and
Copulas
Chapter 10
Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
Correlation and Covariance
The coefficient of correlation between two

variables V1 and V2 is defined as
E (V1V2 ) E (V1 ) E (V2 )
SD(V1 ) SD(V2 )
The covariance is
E(V1V2)E(V1 )E(V2)
Independence
V1 and V2 are independent if the

knowledge of one does not affect the
probability distribution for the other
f (V2 V1 = x) = f (V2 )
where f(.) denotes the probability density

function
Independence is Not the Same as

Zero Correlation
Suppose V1 = 1, 0, or +1 (equally
likely)
If V1 = -1 or V1 = +1 then V2 = 1
If V1 = 0 then V2 = 0
V2 is clearly dependent on V1 (and vice
versa) but the coefficient of correlation
is zero
Types of Dependence (Figure 10.1, page 204)

E(Y)
E(Y)
X
(a)
(b)
E(Y)
X
(c)
Monitoring Correlation Between

Two Variables X and Y
Define xi=(XiXi-1)/Xi-1 and yi=(YiYi-1)/Yi-1
Also
varx,n: daily variance of X calculated on day n-1
vary,n: daily variance of Y calculated on day n-1
covn: covariance calculated on day n-1
The correlation is
cov n
varx ,n vary ,n
Covariance
The covariance on day n is

E(xnyn)E(xn)E(yn)
It is usually approximated as E(xnyn)
Monitoring Correlation continued

EWMA:
cov n = cov n 1 + (1 ) xn 1 yn 1
GARCH(1,1)
cov n = + xn 1 yn 1 + cov n 1
Positive Finite Definite Condition

A variance-covariance matrix, , is
internally consistent if the positive semidefinite condition
w w 0
T
holds for all vectors w

Example
The variance covariance matrix
1
0.9
0
1
0.9
0.9
0.9
is not internally consistent
10
V1 and V2 Bivariate Normal
Conditional on the value of V1, V2 is normal with

mean
V1 1
2 + 2
1
and standard deviation 2 1 2 where 1,, 2, 1,

and 2 are the unconditional means and SDs of
V1 and V2 and is the coefficient of correlation
between V1 and V2
11
Multivariate Normal Distribution
Fairly easy to handle

A variance-covariance matrix defines
the variances of and correlations
between variables
To be internally consistent a variancecovariance matrix must be positive
semidefinite
12
Generating Random Samples for

Monte Carlo Simulation (pages 207-208)
=NORMSINV(RAND()) gives a random

sample from a normal distribution in
Excel
For a multivariate normal distribution a
method known as Choleskys
decomposition can be used to generate
random samples
13
Factor Models (page 209)
When there are N variables, Vi (i = 1,

2,..N), in a multivariate normal distribution
there are N(N1)/2 correlations
We can reduce the number of correlation
parameters that have to be estimated with
a factor model
14
One-Factor Model continued
If Ui have standard normal distributions

we can set
U i = ai F + 1 ai2 Z i
where the common factor F and the

idiosyncratic component Zi have
independent standard normal
distributions
Correlation between Ui and Uj is ai aj
15
Gaussian Copula Models:

Creating a correlation structure for variables that are not
normally distributed
Suppose we wish to define a correlation structure between

two variable V1 and V2 that do not have normal distributions
We transform the variable V1 to a new variable U1 that has a
standard normal distribution on a percentile-to-percentile
basis.
We transform the variable V2 to a new variable U2 that has a
standard normal distribution on a percentile-to-percentile
basis.
U1 and U2 are assumed to have a bivariate normal
distribution
Risk Management and Financial Institutions 2e, Chapter 10,
Copyright John C. Hull 2009
16
The Correlation Structure Between the Vs is

Defined by that Between the Us
-0.2
0.2
0.4
0.6
0.8
1.2
-0.2
0.2
0.4
0.6
0.8
1.2
V2
V1
One-to-one
mappings
-6
-4
-2
-6
-4
-2
U2
U1
Correlation
Assumption
17
Example (page 211)
V1
V2
18
V1 Mapping to U1
V1
Percentile
U1
0.2
20
-0.84
0.4
55
0.13
0.6
80
0.84
0.8
95
1.64
19
V2 Mapping to U2
V2
Percentile
U2
0.2
1.41
0.4
32
0.47
0.6
68
0.47
0.8
92
1.41
20
Example of Calculation of Joint

Cumulative Distribution
Probability that V1 and V2 are both less

than 0.2 is the probability that U1 < 0.84
and U2 < 1.41
When copula correlation is 0.5 this is
M( 0.84, 1.41, 0.5) = 0.043
where M is the cumulative distribution
function for the bivariate normal
distribution
21
Other Copulas
Instead of a bivariate normal distribution

for U1 and U2 we can assume any other
joint distribution
One possibility is the bivariate Student t
distribution
22
5000 Random Samples from the

Bivariate Normal
5
4
3
2
1
0
-5
-4
-3
-2
-1
-1
-2
-3
-4
-5
23
5000 Random Samples from the

Bivariate Student t
10
0
-10
-5
10
-5
-10
24
Multivariate Gaussian Copula
We can similarly define a correlation

structure between V1, V2,Vn
We transform each variable Vi to a new
variable Ui that has a standard normal
distribution on a percentile-to-percentile
basis.
The Us are assumed to have a
multivariate normal distribution
25
Factor Copula Model

In a factor copula model the correlation
structure between the Us is generated by
assuming one or more factors.
26
Credit Default Correlation
The credit default correlation between two

companies is a measure of their tendency
to default at about the same time
Default correlation is important in risk
management when analyzing the benefits
of credit risk diversification
It is also important in the valuation of some
credit derivatives
27
Model for Loan Portfolio
We map the time to default for company i, Ti, to a

new variable Ui and assume
U i = ai F + 1 a Z i
2
i
where F and the Zi have independent standard

normal distributions
Define Qi as the cumulative probability distribution
of Ti
Prob(Ui<U) = Prob(Ti<T) when N(U) = Qi(T)
28
The Model continued

U a F
i
Prob(U i < U F ) = N
2
1 ai
Hence
N 1 [Q (T )] a F
i
i
Prob(Ti < T F ) = N
2
1 ai
Assuming the Q' s and a' s are the same for all companies
N 1 [Q(T )] F
Prob(Ti < T F ) = N
where is the copula correlation
29
The Model continued
The worst case default rate for portfolio for a

time horizon of T and a confidence limit of X is
N 1[Q(T )] + N 1 ( X )
WCDR(T,X) = N
The VaR for this time horizon and confidence

limit is
VaR(T , X ) = L (1 R ) WCDR(T , X )
where L is loan principal and R is recovery rate
30

Chapter 6 Correlations and Copulas

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Chapter 6 Correlations and Copulas

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Correlations and

Correlation and Covariance

The coefficient of correlation between two

V1 and V2 are independent if the

where f(.) denotes the probability density

Independence is Not the Same as

Types of Dependence (Figure 10.1, page 204)

Monitoring Correlation Between

The covariance on day n is

Monitoring Correlation continued

Positive Finite Definite Condition

holds for all vectors w

is not internally consistent

V1 and V2 Bivariate Normal

Conditional on the value of V1, V2 is normal with

and standard deviation 2 1 2 where 1,, 2, 1,

Multivariate Normal Distribution

Fairly easy to handle

Generating Random Samples for

=NORMSINV(RAND()) gives a random

Factor Models (page 209)

When there are N variables, Vi (i = 1,

One-Factor Model continued

If Ui have standard normal distributions

where the common factor F and the

Gaussian Copula Models:

Suppose we wish to define a correlation structure between

The Correlation Structure Between the Vs is

Example (page 211)

Example of Calculation of Joint

Probability that V1 and V2 are both less

Instead of a bivariate normal distribution

5000 Random Samples from the

5000 Random Samples from the

Multivariate Gaussian Copula

We can similarly define a correlation

Factor Copula Model

Credit Default Correlation

The credit default correlation between two

Model for Loan Portfolio

We map the time to default for company i, Ti, to a

where F and the Zi have independent standard

The Model continued

where is the copula correlation

The Model continued

The worst case default rate for portfolio for a

The VaR for this time horizon and confidence

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