i=1
i
S
n,i
.
In nancial statistics one often tries to nd a statistical model for the evolution
of the stock prices, e.g. a model for S
n+1,i
S
n,i
, to be able to compute the
loss distribution L
n+1
. However, it is often the case that the socalled log
returns X
n+1,i
= ln S
n+1,i
lnS
n,i
are easier to model than the dierences
S
n+1,i
S
n,i
. With Z
n,i
= ln S
n,i
we have S
n,i
= expZ
n,i
so the portfolio loss
L
n+1
= (V
n+1
V
n
) may be written as
L
n+1
=
d
i=1
i
(expZ
n+1,i
expZ
n,i
)
=
d
i=1
i
expZ
n,i
(expX
n+1,i
1)
=
d
i=1
i
S
n,i
(expX
n+1,i
1).
6
The relation between the modeled variables X
n+1,i
and the loss L
n+1
is nonlin
ear and it is sometimes useful to linearize this relation. In this case this is done
by replacing e
x
by 1 +x; recall the Taylor expansion e
x
= 1 +x +O(x
2
). Then
the linearized loss is given by
L
n+1
=
d
i=1
i
S
n,i
X
n+1,i
.
n+1
=
_
f
t
(t
n
, Z
n
)t +
d
i=1
f
z
i
(t
n
, Z
n
)X
n+1,i
_
.
Here f
t
(t, z) = f(t, z)/t and f
z
i
(t, z) = f(t, z)/z
i
. The corresponding
operator given by
l
[n]
(x) =
_
f
t
(t
n
, Z
n
)t +
d
i=1
f
z
i
(t
n
, Z
n
)x
i
_
is called the linearized lossoperator.
7
Example 2.2 (Portfolio of stocks continued) In the previous example of a
portfolio of stocks the riskfactors are the logprices of the stocks Z
n,i
= ln S
n,i
and the riskfactorchanges are the log returns X
n+1,i
= lnS
n+1,i
ln S
n,i
. The
loss is L
n+1
= l
[n]
(X
n+1
) and the linearized loss is L
n+1
= l
[n]
(X
n+1
), where
l
[n]
(x) =
d
i=1
i
S
n,i
(expx
i
1) and l
[n]
(x) =
d
i=1
i
S
n,i
x
i
are the loss operator and linearized loss operator, respectively.
The following examples may convince you that there are many relevant ex
amples from nance that ts into this general framework of riskfactors and
lossoperators.
Example 2.3 (A bond portfolio) A zerocoupon bond with maturity T is a
contract which gives the holder of the contract $1 at time T. The price of the
contract at time t < T is denoted B(t, T) and by denition B(T, T) = 1. To a
zerocoupon bond we associate the continuously compounded yield
y(t, T) =
1
T t
lnB(t, T),
i.e.
B(t, T) = exp(T t)y(t, T).
To understand the notion of the yield, consider a bank account where we get a
constant interest rate r. The bank account evolves according to the dierential
equation
dS
t
dt
= rS
t
, S
0
= 1
which has the solution S
t
= exprt. This means that in every innitesimal time
interval dt we get the interest rate r. Every dollar put into the bank account
at time t is then worth expr(T t) dollars at time T. Hence, if we have
expr(T t) dollars on the account at time t then we have exactly $1 at time
T. The yield y(t, T) can be identied with r and is interpreted as the constant
interest rate contracted at t that we get over the period [t, T]. However, the
yield may be dierent for dierent maturity times T. The function T y(t, T)
for xed t is called the yieldcurve at t. Consider now a portfolio consisting of
d dierent (default free) zerocoupon bonds with maturity times T
i
and prices
B(t, T
i
). We suppose that we have
i
units of the bond with maturity T
i
so
that the value of the portfolio is
V
n
=
d
i=1
i
B(t
n
, T
i
).
8
It is natural to use the yields Z
n,i
= y(t
n
, T
i
) as riskfactors. Then
V
n
=
d
i=1
i
exp(T
i
t
n
)Z
n,i
= f(t
n
, Z
n
)
and the loss is given by (with X
n+1,i
= Z
n+1,i
Z
n,i
and t = t
n+1
t
n
)
L
n+1
=
d
i=1
i
_
exp(T
i
t
n+1
)(Z
n,i
+X
n+1,i
) exp(T
i
t
n
)Z
n,i
_
=
d
i=1
i
B(t
n
, T
i
)
_
expZ
n,i
t (T
i
t
n+1
)X
n+1,i
1
_
.
The corresponding lossoperator is then
l
[n]
(x) =
d
i=1
i
B(t
n
, T
i
)
_
expZ
n,i
t (T
i
t
n+1
)x
i
1
_
and the linearized loss is given by
L
n+1
=
d
i=1
i
B(t
n
, T
i
)
_
Z
n,i
t (T
i
t
n+1
)X
n+1,i
_
.
n
)
T
The value of the portfolio is then V
n
= C(t
n
, S
n
, r
n
,
n
) and the linearized loss
is given by
L
n+1
= (C
t
t +C
S
X
n+1,1
+C
r
X
n+1,2
+C
X
n+1,3
).
The partial derivatives are usually called the Greeks. C
t
is called theta; C
S
is called delta; C
r
is called rho; C
[X,w]
= maxw
1
l
[n]
(x
1
), . . . , w
N
l
[n]
(x
N
)
These risk measures are frequently used in practice (example: Chicago Mercan
tile Exchange).
Example 3.2 (The SPAN rules) As an example of a scenario based risk
measure we consider the SPAN rules used at the Chicago Mercantile Exchange
[1]. We describe how the initial margin is calculated for a simple portfolio con
sisting of units of a futures contract and of several puts and calls with a common
expiration date on this futures contract. The SPAN margin for such a portfolio
is compute as follows: First fourteen scenarios are considered. Each scenario
is specied by an up or down move of volatility combined with no move, or an
up move, or a down move of the futures prices by 1/3, 2/3 or 3/3 of a specic
range. Next, two additional scenarios relate to extreme up or down moves
of the futures prices. The measure of risk is the maximum loss incurred, using
the full loss of the rst fourteen scenarios and only 35% of the loss for the last
two extreme scenarios. A specied model, typically the Black model, is used
to generate the corresponding prices for the options under each scenario.
The account of the investor holding a portfolio is required to have sucient
current net worth to support the maximum expected loss. If it does not, then
extra cash is required as margin call, an amount equal to the measure of risk
involved.
Loss distribution approach
This is the approach a statistician would use to compute the risk of a portfolio.
Here we try model the loss L
n+1
using a probability distribution F
L
. The
11
parameters of the loss distribution are estimated using historical data. One can
either try to model the loss distribution directly or to model the riskfactors
or riskfactor changes as a ddimensional random vector or a multivariate time
series. Risk measures are based on the distribution function F
L
. The next
section studies this approach to risk measurement.
3.2 Risk measures based on the loss distribution
Standard deviation
The standard deviation of the loss distribution as a measure of risk is frequently
used, in particular in portfolio theory. There are however some disadvantages
using the standard deviation as a measure of risk. For instance the standard
deviation is only dened for distributions with E(L
2
) < , so it is undened for
random variables with very heavy tails. More important, prots and losses have
equal impact on the standard deviation as risk measure and it does not discrim
inate between distributions with apparently dierent probability of potentially
large losses. In fact, the standard deviation does not provide any information
on how large potential losses may be.
Example 3.3 Consider for instance the two loss distributions L
1
N(0, 2)
and L
2
t
4
(standard Students tdistribution with 4 degrees of freedom).
Both L
1
and L
2
have standard deviation equal to
2. The probability density
is illustrated in Figure 1 for the two distributions. Clearly the probability of
large losses is much higher for the t
4
than for the normal distribution.
5 0 5
0
.0
0
.1
0
.2
0
.3
3 4 5 6 7
0
.0
0
0
0
.0
0
5
0
.0
1
0
0
.0
1
5
0
.0
2
0
0
.0
2
5
0
.0
3
0
0
.0
3
5
0 2 4 6 8 10
0
5
1
0
1
5
2
0
x
lo
g
r
a
tio
Figure 1: Left/Middle: The density function for a N(0, 2) and a t
4
distribution.
The t
4
is highly peaked around zero and has much heavier tails. Right: The
logratio ln[P(L
2
> x)/ P(L
1
> x)] is plotted.
ValueatRisk
We now introduce the widely used risk measure known as ValueatRisk.
12
Denition 3.1 Given a loss L and a condence level (0, 1), VaR
(L) is
given by the smallest number l such that the probability that the loss L exceeds
l is no larger than 1 , i.e.
VaR
4 2 0 2 4
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
95% VaR
Figure 2: Illustration of VaR
0.95
.
We might think of L as the (potential) loss resulting from holding a portfolio
over some xed time horizon. In market risk the time horizon is typically one day
or ten days. In credit risk the portfolio may consist of loans and the time horizon
is often one year. Common condence levels are 95%, 99% and 99.9% depending
on the application. The BIS (Bank of International Settlements) proposes, for
market risk, to compute tenday VaR with condence level = 99%. The time
horizon of ten days reects the fact that markets are not perfectly liquid.
Denition 3.2 Given a nondecreasing function F : R R the generalized
inverse of F is given by
F
= F
1
, i.e. the usual inverse. Using the
generalized inverse we dene the quantile of F by
q
(F) = F
(F) = q
(L) +b.
Hence, the risk measured in VaR for a shares of a portfolio is a times the risk of
one share of this portfolio. Moreover, adding (b < 0) or withdrawing (b > 0) an
amount [b[ of money from the portfolio changes this risk by the same amount.
Example 3.4 Suppose the loss distribution is normal, L N(,
2
). This
means that L
d
= +L
t
, where L
t
N(0, 1). Since VaR
(L
t
) =
1
(), where
is the distribution function of a standard normal random variable, we may
compute the ValueatRisk as VaR
(L) = +
1
().
Example 3.5 Suppose that the distribution function F is given by
F(x) =
_
_
_
0 x < 0,
1/2 x [0, 1),
1 x 1.
Then F
100
), where L
100
denotes the loss
from today until 100 days from today and L
100
denotes the corresponding lin
earized 100day loss.
We have
L
100
= S
0
(e
X
100
1
),
where X
100
is the 100day log return. Notice that
X
100
= lnS
100
/S
0
= lnS
100
ln S
0
= lnS
1
/S
0
+ + ln S
100
/S
99
,
i.e. X
100
is a sum of 100 independent normally distributed random variables
with mean zero and standard deviation 0.1. Hence, X
100
d
= Z, where Z is
normally distributed with zero mean and standard deviation one. We have
VaR
0.99
(L
100
) = 500(1 e
F
1
Z
(0.99)
)
500(1 e
2.3
).
Using Figure 4 we nd that e
2.3
= 1/e
2.3
0.1. Hence, VaR
0.99
(L
100
)
500(1 e
2.3
) 450.
We have L
100
= 500Z. Hence, VaR
0.99
(L
100
) = 500F
1
Z
(0.99) 500 2.3 =
1150. One sees that using the linearized loss here gives a very bad risk estimate.
16
Expected shortfall
Although ValueatRisk has become a very popular risk measure among practi
tioners it has several limitations. For instance, it does not give any information
about how bad losses may be when things go wrong. In other words, what is
the size of an average loss given that the loss exceeds the 99%ValueatRisk?
Denition 3.3 For a loss L with continuous loss distribution function F
L
the
expected shortfall at condence level (0, 1) is given by
ES
(L)).
(L))
=
E(LI
[q
(L),)
(L))
P(L q
(L))
=
1
1
E(LI
[q
(L),)
(L))
=
1
1
_
q
(L)
ldF
L
(l),
where I
A
is the indicator function: I
A
(x) = 1 if x A and 0 otherwise.
Lemma 3.1 For a loss L with continuous distribution function F
L
the expected
shortfall is given by
ES
(L) =
1
1
_
1
VaR
p
(L)dp.
For a discrete distribution there are dierent possibilities to dene expected
shortfall. A useful denition called generalized expected shortfall, which is a
socalled coherent risk measure, is given by
GES
(L) =
1
1
_
E(LI
[q
(L),)
(L)) +q
(L)
_
1 P(L q
(L))
_
_
.
If the distribution of L is continuous, then the second term vanishes and GES
=
ES
.
Exercise 3.1 (a) Let L Exp() and calculate ES
(L).
(b) Let L have distribution function F(x) = 1 (1 +x)
1/
, x 0, (0, 1),
and calculate ES
(L).
Answer: (a)
1
(1 ln(1 )). (b)
1
[(1 )
(1 )
1
1].
17
Example 3.7 Suppose that L N(0, 1). Let and be the density and
distribution function of L. Then
ES
(L) =
1
1
_
1
()
ld(l)
=
1
1
_
1
()
l(l)dl
=
1
1
_
1
()
l
1
2
e
l
2
/2
dl
=
1
1
_
2
e
l
2
/2
_
1
()
=
1
1
_
(l)
_
1
()
=
(
1
())
1
.
Suppose that L
t
N(,
2
). Then
ES
(L
t
) = E(L
t
[ L
t
VaR
(L
t
))
= E( +L [ +L VaR
( +L))
= E( +L [ L VaR
(L))
= + ES
(L)
= +
(
1
())
1
.
Exercise 3.2 Let L have a standard Students tdistribution with > 1 degrees
of freedom. Then L has density function
g
(x) =
(( + 1)/2)
(/2)
_
1 +
x
2
_
(+1)/2
.
Show that
ES
(L) =
g
(t
1
())
1
_
+ (t
1
())
2
1
_
,
where t
k=1
I
[X
k
,)
(x).
The empirical quantile is then given by
q
(F
n
) = infx R : F
n
(x) = F
n
().
If we order the sample X
1
, . . . , X
n
such that X
1,n
X
n,n
(if F is con
tinuous, then X
j
,= X
k
a.s. for j ,= k), then the empirical quantile is given
by
q
(F
n
) = X
[n(1)]+1,n
, (0, 1),
where [y] is the integer part of y, [y] = supn N : n y (the largest integer
less or equal to y). If F is strictly increasing, then q
(F
n
) q
(F) a.s. as
n for every (0, 1). Thus, based on the observations x
1
, . . . , x
n
we may
estimate the quantile q
(F) = x
[n(1)]+1,n
.
The empirical estimator for expected shortfall is given by
ES
(F) =
[n(1)]+1
k=1
x
k,n
[n(1 )] + 1
which is the average of the [n(1 )] + 1 largest observations.
The reliability of these estimates is of course related to and to the number
of observations. As the true distribution is unknown explicit condence bounds
can in general not be obtained. However, approximate condence bounds can be
obtained using nonparametric techniques. This is described in the next section.
19
4.2 Condence intervals
Suppose we have observations x
1
, . . . , x
n
of iid random variables X
1
, . . . , X
n
from an unknown distribution F and that we want to construct a condence
interval for the risk measure (F). That is, given p (0, 1) we want to nd a
stochastic interval (A, B), where A = f
A
(X
1
, . . . , X
n
) and B = f
B
(X
1
, . . . , X
n
)
for some functions f
A
, f
B
, such that
P(A < (F) < B) = p.
The interval (a, b), where a = f
A
(x
1
, . . . , x
n
) and b = f
B
(x
1
, . . . , x
n
), is a con
dence interval for (F) with condence level p. Typically we want a doublesided
and centered interval so that
P(A < (F) < B) = p, P(A (F)) = P(B (F)) = (1 p)/2.
Unfortunately, F is unknown so we cannot nd suitable functions f
A
, f
B
. How
ever, we can construct approximate condence intervals. Moreover, if (F)
is a quantile of F (ValueatRisk), then we can actually nd exact condence
intervals for (F), but not for arbitrary choices of condence levels p.
4.2.1 Exact condence intervals for ValueatRisk
Suppose we have observations x
1
, . . . , x
n
from iid random variables X
1
, . . . , X
n
with common unknown continuous distribution function F. Suppose further
that we want to construct a condence interval (a, b) for the quantile q
(F),
where a = f
A
(x
1
, . . . , x
n
) and b = f
B
(x
1
, . . . , x
n
) such that
P(A < q
(F)) = P(B q
(F)) = (1 p)/2,
where p is a condence level and A = f
A
(X
1
, . . . , X
n
) and B = f
B
(X
1
, . . . , X
n
).
Since F is unknown we cannot nd a and b. However, we can look for i > j and
the smallest p
t
p such that
P(X
i,n
< q
(F) < X
j,n
) = p
t
,
P(X
i,n
q
= #X
k
> q
(F).
It is easily seen that Y
(F)) = P(Y
= 0),
P(X
2,n
q
(F)) = P(Y
1),
. . .
P(X
j,n
q
(F)) = P(Y
j 1).
Similarly, P(X
i,n
q
(F)) = 1 P(Y
(F). First
an estimator
(x
1
, . . . , x
n
) of is constructed, e.g.
(x
1
, . . . , x
n
) = x
[n(1)]+1,n
.
Now we want to construct a condence interval for with condence level p
(for instance p = 0.95). To construct a condence interval we need to know
the distribution of
(X
1
, . . . , X
n
). If F was known this distribution could be
approximated arbitrarily well by simulating from F many (N large) times to
construct new samples
X
(i)
1
, . . . ,
X
(i)
n
, i = 1, . . . , N, and compute the estimator
for each of these samples to get
i
=
(
X
(i)
1
, . . . ,
X
(i)
n
), i = 1, . . . , N. As N
the empirical distribution
1
N
N
i=1
I
[
e
i
,)
(x)
of
(X
1
, . . . , X
n
) will converge to the true distribution of
(X
1
, . . . , X
n
). The
problem is that F is not known.
What is known is the empirical distribution F
n
which puts point masses 1/n
at the points X
1
, . . . , X
n
. If n is relatively large we expect that F
n
is a good
approximation of F. Moreover, we can resample from F
n
simply by drawing
with replacement among X
1
, . . . , X
n
. We denote such a resample by X
1
, . . . , X
n
.
Then we may compute
=
(X
1
, . . . , X
n
). Since F
n
approximates the true
distribution F we expect the distribution of
(X
1
, . . . , X
n
) to approximate the
true distribution of
(X
1
, . . . , X
n
). To obtain the distribution of
(X
1
, . . . , X
n
)
we resample many (N large) times to create new samples X
(i)
1
, . . . , X
(i)
n
, i =
1, . . . , N. For each of these samples we compute the corresponding estimate of
, i.e.
i
=
(X
(i)
1
, . . . , X
(i)
n
). The empirical distribution F
N
, given by
F
N
(x) =
1
N
N
i=1
I
[
i
,)
(x),
is then an approximation of the true distribution of
(X
1
, . . . , X
n
) denoted F
.
A condence interval is then constructed using A = q
(1p)/2
(F
N
) and B =
22
q
(1+p)/2
(F
N
). This means that A =
[N(1+p)/2]+1,N
and B =
[N(1p)/2]+1,N
,
where
1,N
N,N
is the ordered sample of
1
, . . . ,
N
.
The nonparametric bootstrap to obtain condence intervals can be summa
rized in the following steps: Suppose we have observations x
1
, . . . , x
n
of the
iid random variables X
1
, . . . , X
n
with distribution F and we have an estimator
(x
1
, . . . , x
n
) of an unknown parameter .
Resample N times among x
1
, . . . , x
n
to obtain new samples x
(i)
1
, . . . , x
(i)
n
,
i = 1, . . . , N.
Compute the estimator for each of the new samples to get
i
=
(x
(i)
1
, . . . , x
(i)
n
), i = 1, . . . , N.
Construct a condence interval I
p
with condence level p as
I
p
= (
[N(1+p)/2]+1,N
,
[N(1p)/2]+1,N
),
where
1,N
N,N
is the ordered sample of
1
, . . . ,
N
.
4.3 Historical simulation
In the historical simulation approach we suppose we have observations of risk
factors Z
mn
, . . . , Z
m
and hence also the riskfactor changes X
mn+1
, . . . , X
m
.
We denote these observations by x
mn+1
, . . . , x
m
. Using the loss operator we
can compute the corresponding observations of losses l
k
= l
[m]
(x
mk+1
), k =
1, . . . , n. Note that l
k
is the loss that we will experience if we have the risk
factor change x
mk+1
over the next period. This gives us a sample from the
loss distribution. It is assumed that the losses during the dierent time intervals
are iid. Then the empirical VaR and ES can be estimated using
VaR
(L) = q
(F
L
n) = l
[n(1)]+1,n
ES
(L) =
[n(1)]+1
i=1
l
i,n
[n(1 )] + 1
where l
1,n
l
n,n
is the ordered sample.
Similarly we can also aggregate over several days. Say, for instance, that we
are interested in the ValueatRisk for the aggregate loss over ten days. Then
we simply use the historical observations given by
l
(10)
k
= l
[m]
_
_
10
j=1
x
mn+10(k1)+j
_
_
, k = 1, . . . , [n/10],
to compute the empirical VaR and ES.
Advantage: This approach is easy to implement and keeps the dependence struc
ture between the components of the vectors of riskfactor changes X
mk
.
Disadvantage: The worst case is never worse than what has happened in history.
We need a very large sample of relevant historical data to get reliable estimates
of ValueatRisk and expected shortfall.
23
4.4 VarianceCovariance method
The basic idea of the variancecovariance method is to study the linearized loss
L
m+1
= l
[m]
(X
m+1
) = (c +
d
i=1
w
i
X
m+1,i
) = (c +w
T
X
m+1
)
where c = c
m
, w
i
= w
m,i
(i.e. known at time m), w = (w
1
, . . . , w
d
)
T
are weights
and X
m+1
= (X
m+1,1
, . . . , X
m+1,d
)
T
the riskfactor changes.
It is then assumed that X
m+1
N
d
(, ), i.e. that the riskfactor changes
follow a multivariate (ddimensional) normal distribution. Using the properties
of the multivariate normal distribution we have
w
T
X
m+1
N(w
T
, w
T
w).
Hence, the loss distribution is normal with mean cw
T
and variance w
T
w.
Suppose that we have n+1 historical observations of the riskfactors and the risk
factor changes X
mn+1
, . . . , X
m
. Then (assuming that the riskfactor changes
are iid or at least weakly dependent) the mean vector and the covariance
matrix can be estimated as usual by
i
=
1
n
n
k=1
X
mk+1,i
, i = 1, . . . , d,
ij
=
1
n 1
n
k=1
(X
mk+1,i
i
)(X
mk+1,j
j
), i, j = 1, . . . , d.
The estimated VaR is then given analytically by
VaR
(L) = c w
T
+
_
w
T
w
1
().
Advantage: Analytic solutions can be obtained: no simulations required. Easy
to implement.
Disadvantage: Linearization not always appropriate. We need a short time
horizon to justify linearization (see e.g. Example 3.6). The normal distribution
may considerably underestimate the risk. We need proper justication that the
normal distribution is appropriate before using this approach. In later chapters
we will introduce elliptical distributions, distributions that share many of the nice
properties of the multivariate normal distribution. The VarianceCovariance
method works well if we replace the assumption of multivariate normality with
the weaker assumption of ellipticality. This may provide a model that ts data
better.
4.5 MonteCarlo methods
Suppose we have observed the riskfactors Z
mn
, . . . , Z
m
and riskfactor changes
X
mn+1
, . . . , X
m
. We suggest a parametric model for X
m+1
. For instance, that
X
m+1
has distribution function F and is independent of X
mn+1
, . . . , X
m
.
24
When an appropriate model for X
m+1
is chosen and the parameters esti
mated we simulate a large number N of outcomes from this distribution to
get x
1
, . . . , x
N
. For each outcome we can compute the corresponding losses
l
1
, . . . , l
N
where l
k
= l
[m]
( x
k
). The true loss distribution of L
m+1
is then ap
proximated by the empirical distribution F
L
N given by
F
L
N(x) =
1
N
N
k=1
I
[l
k
,)
(x).
ValueatRisk and expected shortfall can then be estimated by
VaR
(L) = q
(F
L
N) = l
[N(1)]+1,N
ES
(L) =
[N(1)]+1
k=1
l
k,N
[N(1 )] + 1
Advantage: Very exible. Practically any model that you can simulate from is
possible to use. You can also use time series in the MonteCarlo method which
enables you to model time dependence between riskfactor changes.
Disadvantage: Computationally intensive. You need to run a large number of
simulations in order to get good estimates. This may take a long time (hours,
days) depending on the complexity of the model.
Example 4.2 Consider a portfolio consisting of one share of a stock with stock
price S
k
and assume that the log returns X
k+1
= lnS
k+1
ln S
k
are iid with
distribution function F
(L
1
) = S
0
(1 expF
(1 )),
i.e. the quantile of the distribution of the loss L
1
= S
0
(expX
1
1). How
ever, the expected shortfall may be dicult to compute explicitly if F
has
a complicated expression. Instead of performing numerical integration we may
use the MonteCarlo approach to compute expected shortfall.
Example 4.3 Consider the situation in Example 4.2 with the exception that
the log return distribution is given by a GARCH(1, 1) model:
X
k+1
=
k+1
Z
k+1
,
2
k+1
= a
0
+a
1
X
2
k
+b
1
2
k
,
where the Z
k
s are independent and standard normally distributed and a
0
, a
1
and b
1
are parameters to be estimated. Because of the recursive structure it is
very easy to simulate from this model. However, analytic computation of the
tenday ValueatRisk or expected shortfall is very dicult.
25
5 Extreme value theory for random variables
with heavy tails
Given historical loss data a risk manager typically wants to estimate the prob
ability of future large losses to assess the risk of holding a certain portfolio.
Extreme Value Theory (EVT) provides the tools for an optimal use of the loss
data to obtain accurate estimates of probabilities of large losses or, more gen
erally, of extreme events. Extreme events are particularly frightening because
although they are by denition rare, they may cause severe losses to a nan
cial institution or insurance company. Empirical estimates of probabilities of
losses larger than what has been observed so far are useless: such an event will
be assigned zero probability. Even if the loss lies just within the range of the
loss data set, empirical estimates have poor accuracy. However, under certain
conditions, EVT methods can extrapolate information from the loss data to ob
tain meaningful estimates of the probability of rare events such as large losses.
This also means that accurate estimates of ValueatRisk (VaR) and Expected
Shortfall (ES) can be obtained.
In this and the following two chapters we will present aspects of and estima
tors provided by EVT. In order to present the material and derive the expres
sions of the estimators without a lot of technical details we focus on EVT for
distributions with heavy tails (see below). Moreover, empirical investigations
often support the use of heavytailed distributions.
Empirical investigations have shown that daily and higherfrequency returns
from nancial assets typically have distributions with heavy tails. Although
there is no denition of the meaning of heavy tails it is common to consider
the right tail F(x) = 1 F(x), x large, of the distribution function F heavy if
lim
x
F(x)
e
x
= for every > 0,
i.e. if it is heavier than the right tail of every exponential distribution. It is
also not unusual to consider a random variable heavytailed if not all moments
are nite. We will now study the useful class of heavytailed distributions with
regularly varying tails.
5.1 Quantilequantile plots
In this section we will consider some useful practical methods to study the
extremal properties of a data set. To illustrate the methods we will consider
a dataset consisting of claims in million Danish Kroner from re insurance in
Denmark. We may observe that there are a few claims much larger the every
day claim. This suggests that the claims have a heavytailed distribution. To
get an indication of the heaviness of the tails it is useful to use socalled quantile
quantile plots (qqplots).
Suppose we have a sample X
1
, . . . , X
n
of iid random variables but we dont
know the distribution of X
1
. One would typically suggest a reference distri
bution F and want to test whether it is reasonable to assume that the data is
26
0 500 1000 1500 2000
0
5
0
1
0
0
1
5
0
Figure 6: Claims from re insurance in Denmark in million Danish Kroner.
distributed according to this distribution. If we dene the ordered sample as
X
n,n
X
n1,n
X
1,n
, then the qqplot consists of the points
__
X
k,n
, F
_
n k + 1
n + 1
__
: k = 1, . . . , n
_
.
If the data has a similar distribution as the reference distribution then the qq
plot is approximately linear. An important property is that the plot remains
approximately linear if the data has a distribution which is a linear transforma
tion of the reference distribution, i.e. from the associated locationscale family
F
,
(x) = F((x)/). Thus, the qqplot enables us to come up with a suitable
class of distributions that ts the data and then we may estimate the location
and scale parameters.
The qqplot is particularly useful for studying the tails of the distribution.
Given a reference distribution F, if F has heavier tails than the data then the
plot will curve down at the left and/or up at the right and the opposite if the
reference distribution has too light tails.
Exercise 5.1 Consider the distribution functions F and G given by F(x) =
1 e
x
(x > 0) and G(x) = 1 x
2
(x > 1). Plot
__
F
_
n k + 1
n + 1
_
, G
_
n k + 1
n + 1
__
: k = 1, . . . , n
_
and interpret the result.
27
0 50 100 150
0
2
4
6
0 50 100 150
0
5
0
0
1
0
0
0
1
5
0
0
2
0
0
0
0 50 100 150
0
5
0
1
0
0
1
5
0
0 50 100 150
0
1
0
2
0
3
0
4
0
Figure 7: Quantilequantile plots for the Danish re insurance claims. Upper
left: qqplot with standard exponential reference distribution. The plot curves
down which indicates that data has tails heavier than exponential. Upper right,
lower left, lower right: qqplot against a Pareto()distribution for = 1, 1.5, 2.
The plots are approximately linear which indicates that the data may have a
Pareto()distribution with (1, 2).
5.2 Regular variation
We start by introducing regularly varying functions.
Denition 5.1 A function h : (0, ) (0, ) is regularly varying at with
index R (written h RV
) if
lim
t
h(tx)
h(t)
= x
, then h(x)/x
RV
0
. Hence, setting
L(x) = h(x)/x
h(tx)
h(t)
x
= 0.
The most natural examples of slowly varying functions are positive constants
and functions converging to positive constants. Other examples are logarithms
and iterated logarithms. The following functions L are slowly varying.
(a) lim
x
L(x) = c (0, ).
(b) L(x) = ln(1 +x).
(c) L(x) = ln(1 + ln(1 +x)).
(d) L(x) = ln(e +x) + sin x.
Note however that a slowly varying function can have innite oscillation in the
sense that liminf
x
L(x) = 0 and limsup
x
L(x) = .
Example 5.1 (1) Let F(x) = 1x
.
(2) Let
Denition 5.2 A nonnegative random variable is said to be regularly varying
if its distribution function F satises F RV
for some 0.
Remark 5.1 If X is a nonnegative random variable with distribution function
F satisfying F RV
) < if < ,
E(X
) = if > .
Although the converse does not hold in general, it is useful to think of regularly
varying random variables as those random variables for which the moment
does not exist for larger than some > 0.
Example 5.2 Consider two risks X
1
and X
2
which are assumed to be nonneg
ative and iid with common distribution function F. Assume further that F has
a regularly varying right tail, i.e. F RV
P(X
1
+X
2
> l)
P(2X
1
> l)
2 P(X
2
> (1 )l) + P(X
1
> l)
2
P(2X
1
> l)
. .
h(,,l)
.
We have
lim
l
g(, , l) = 2 lim
l
P(X
1
> l)
P(X
1
> l/2)
= 2
1
and similarly lim
l
h(, , l) = 2
1
(1 )
+ 0
as x . At the second to last step above, Markovs inequality was used.
Since this is true for every (0, 1), choosing arbitrarily small gives
lim
x
P(X +Y > x)
P(X > x)
= 1.
Hence,
lim
x
P(X > x [ X +Y > x) = lim
x
P(X > x, X +Y > x)
P(X +Y > x)
= lim
x
P(X > x)
P(X +Y > x)
= 1.
We have found that if the insurance company suers a large loss, it is likely that
this is due to a large loss in the re insurance line only.
32
6 Hill estimation
Suppose we have an iid sample of positive random variables X
1
, . . . , X
n
from
an unknown distribution function F with a regularly varying right tail. That
is, F(x) = x
L(x)dx ( + 1)
1
u
+1
L(u) as u ,
where means that the ratio of the left and right sides tends to 1. Using
integration by parts we nd that
1
F(u)
_
u
(lnx ln u)dF(x)
=
1
F(u)
_
_
(lnx lnu)F(x)
_
u
+
_
u
F(x)
x
dx
_
=
1
u
L(u)
_
u
x
1
L(x)dx.
Hence, by the Karamata Theorem,
1
F(u)
_
u
(ln x lnu)dF(x)
1
as u . (6.1)
To turn this into an estimator we replace F by the empirical distribution func
tion
F
n
(x) =
1
n
n
k=1
I
[X
k
,)
(x)
and replace u by a high data dependent level X
k,n
. Then
1
F
n
(X
k,n
)
_
X
k,n
(lnx lnX
k,n
)dF
n
(x) =
1
k 1
k1
j=1
(ln X
j,n
lnX
k,n
).
If k = k(n) and k/n 0 as n , then X
k,n
a.s. as n and
by (6.1)
1
k 1
k1
j=1
(ln X
j,n
ln X
k,n
)
P
as n .
The same result holds if we replace k 1 by k. This gives us the Hill estimator
(H)
k,n
=
_
1
k
k
j=1
(lnX
j,n
ln X
k,n
)
_
1
.
33
6.1 Selecting the number of upper order statistics
We have seen that if k = k(n) and k/n 0 as n , then
(H)
k,n
=
_
1
k
k
j=1
(ln X
j,n
ln X
k,n
)
_
1
P
as n .
In practice however we have a sample of xed size n and we need to nd a
suitable k such that
(H)
k,n
is a good estimate of . The plot of the pairs
_
(k,
(H)
k,n
) : k = 2, . . . , n
_
is called the Hill plot. An estimator of is obtained by graphical inspection
of the Hill plot and an estimate of should be taken for values of k where the
plot is stable. On the one hand, k should not be chosen too small since the
small number of data points would lead to a high variance for the estimator.
On the other hand, k should not be chosen too large so the estimate is based on
sample points from the center of the distribution (this introduces a bias). This
is illustrated graphically in Figure 9. We now construct an estimator for the
0 50 100 150 200 250 300 350 400 450 500
1
1.5
2
2.5
3
3.5
4
4.5
5
Figure 9: Hill plot of the Danish re insurance data. The plot looks stable for
all k (typically this is NOT the case for heavytailed data). We may estimate
by
(H)
k,n
= 1.9 (k = 50) or
(H)
k,n
= 1.5 (k = 250).
tail probability F(x), for x large, based on the sample points X
1
, . . . , X
n
and
the the Hill estimate
(H)
k,n
. Notice that
F(x) = F
_
x
X
k,n
X
k,n
_
_
x
X
k,n
_
F(X
k,n
)
_
x
X
k,n
_
(H)
k,n
F
n
(X
k,n
)
k
n
_
x
X
k,n
_
b
(H)
k,n
.
34
This argument can be made more rigorously. Hence, the following estimator
seems reasonable:
F(x) =
k
n
_
x
X
k,n
_
b
(H)
k,n
.
This leads to an estimator of the quantile q
p
(F) = F
(p).
q
p
(F) = inf
_
x R :
F(x) 1 p
_
= inf
_
x R :
k
n
_
x
X
k,n
_
b
(H)
k,n
1 p
_
=
_
n
k
(1 p)
_
1/b
(H)
k,n
X
k,n
.
More information about Hill estimation can be found in [8] and [12].
35
7 The Peaks Over Threshold (POT) method
Suppose we have an iid sample of random variables X
1
, . . . , X
n
from an unknown
distribution function F with a regularly varying right tail. It turns out that the
distribution of appropriately scaled excesses X
k
u over a high threshold u
is typically well approximated by a distribution called the generalized Pareto
distribution. This fact can be used to construct estimates of tail probabilities
and quantiles.
For > 0 and > 0, the generalized Pareto distribution (GPD) function
G
,
is given by
G
,
(x) = 1 (1 +x/)
1/
for x 0.
Suppose that X is a random variable with distribution function F that has a
regularly varying right tail so that lim
u
F(u)F(u) =
= G
1/,1
(x).
The excess distribution function of X over the threshold u is given by
F
u
(x) = P(X u x [ X > u) for x 0.
Notice that
F
u
(x) =
F(u +x)
F(u)
=
F(u(1 +x/u))
F(u)
. (7.1)
Since F is regularly varying with index < 0 it holds that F(u)/F(u)
uniformly in 1 as u , i.e.
lim
u
sup
1
[F(u)/F(u)
[ = 0.
Hence, from expression (7.1) we see that
lim
u
sup
x>0
[F
u
(x) G
,(u)
[ = 0, (7.2)
where = 1/ and (u) u/ as u .
We now demonstrate how these ndings lead to natural tail and quantile
estimators based on the sample points X
1
, . . . , X
n
. Choose a high threshold u
and let
N
u
= #i 1, . . . , n : X
i
> u
be the number of exceedances of u by X
1
, . . . , X
n
. Recall from (7.1) that
F(u +x) = F(u)F
u
(x). (7.3)
36
If u is not too far out into the tail, then the empirical approximation F(u)
F
n
(u) = N
u
/n is accurate. Moreover, (7.2) shows that the approximation
F
u
(x) G
,(u)
(x) G
b ,
b
(x)
=
_
1 +
x
_
1/b
,
where and
are the estimated parameters, makes sense. Relation (7.3) then
suggests a method for estimating the tail of F by estimating F
u
(x) and F(u)
separately. Hence, a natural estimator for F(u +x) is
F(u +x) =
N
u
n
_
1 +
x
_
1/b
. (7.4)
Expression (7.4) immediately leads to the following estimator of the quantile
q
p
(F) = F
(p).
q
p
(F) = infx R :
F(x) 1 p
= infu +x R :
F(u +x) 1 p
= u + inf
_
x R :
N
u
n
_
1 +
x
_
1/b
1 p
_
= u +
_
_
n
N
u
(1 p)
_
b
1
_
. (7.5)
The POT method for estimating tail probabilities and quantiles can be summa
rized in the following recipe. Each step will be discussed further below.
(i) Choose a high threshold u using some statistical method and count the
number of exceedances N
u
.
(ii) Given the sample Y
1
, . . . , Y
N
u
of excesses, estimate the parameters and
.
(ii) Combine steps (i) and (ii) to get estimates of the form (7.4) and (7.5).
The rest of this section will be devoted to step (i) and (ii): How do we choose a
high threshold u in a suitable way? and How can one estimate the parameters
and ?
7.1 How to choose a high threshold.
The choice of a suitable high threshold u is crucial but dicult. If we choose
u too large then we will have few observations to use for parameter estimation
resulting in poor estimates with large variance. If the threshold is too low then
we have more data but on the other hand the approximation F
u
(x) G
,(u)
(x)
37
will be questionable. The main idea when choosing the threshold u is to look at
the meanexcess plot (see below) and choose u such that the sample meanexcess
function is approximately linear above u.
In the example with the Danish re insurance claims it seems reasonable to
choose u between 4.5 and 10. With u = 4.5 we get N
4.5
= 101 exceedances
which is about 5% of the data. With u = 10 we get N
10
= 24 exceedances
which is about 1.2% of the data. Given the shape of the meanexcess plot we
have selected the threshold u = 6 since the shape of the meanexcess plot does
not change much with u [4.5, 10] we get a reasonable amount of data.
7.2 Meanexcess plot
If E(X) < , then we can dene the mean excess function as
e(u) = E(X u [ X > u) =
E((X u)I
(u,)
(X))
E(I
(u,)
(X))
.
For the GPD G
,
, with < 1, integration by parts gives
E((X u)I
(u,)
(X)) =
_
(x u)(1 +x/)
1/
_
u
+
_
u
(1 +x/)
1/
dx
=
_
u
(1 +x/)
1/
dx
=
1
(1 +u/)
1/+1
.
Moreover, E(I
(u,)
(X)) = P(X > u) = (1 +u/)
1/
. Hence,
e(u) =
+u
1
.
In particular, the mean excess function is linear for the GPD. A graphical test
for assessing the tail behavior may be performed by studying the sample mean
excess function based on the sample X
1
, . . . , X
n
. With N
u
being the number of
exceedances of u by X
1
, . . . , X
n
, as above, the sample meanexcess function is
given by
e
n
(u) =
1
N
u
n
k=1
(X
k
u)I
(u,)
(X
k
).
The meanexcess plot is the plot of the points
(X
k,n
, e
n
(X
k,n
)) : k = 2, . . . , n.
If the meanexcess plot is approximately linear with positive slope then X
1
may
be assumed to have a heavytailed Paretolike tail.
38
0 0.5 1 1.5 2 2.5 3 3.5 4
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
Figure 10: Meanexcess plot of data simulated from a Gaussian distribution.
0 1 2 3 4 5 6 7 8 9
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
Figure 11: Meanexcess plot of data simulated from an exponential distribution.
0 500 1000 1500 2000 2500 3000 3500
0
500
1000
1500
2000
2500
Figure 12: Meanexcess plot of data simulated from a Pareto(1) distribution.
7.3 Parameter estimation
Given the threshold u we may estimate the parameters and in the GPD
based on the observations of excesses Y
1
, . . . , Y
N
u
over u. We assume that
39
the excesses have distribution function G
,
and hence the likelihood function
becomes
L(, ; Y
1
, . . . , Y
N
u
) =
N
u
i=1
g
,
(Y
i
), g
,
(y) =
1
_
1 +
y
_
1/1
.
Instead of maximizing the likelihood function we can maximize the loglikelihood
function given by
ln L(, ; Y
1
, . . . , Y
N
u
) = N
u
ln
_
1
+ 1
_
N
u
i=1
ln
_
1 +
Y
i
_
.
Maximizing the loglikelihood numerically gives estimates and
. The MLE
is approximately normal (for large N
u
)
_
,
1
_
N
2
(0,
1
/N
u
),
1
= (1 +)
_
1 + 1
1 2
_
Using the threshold u = 6 (gives N
u
= 56) we obtain the following estimates
for the Danish re insurance data:
= 0.58,
= 3.60.
Having estimated the parameters we can now visually observe how the approx
imation (7.4) works, see Figure 14.
7.4 Estimation of ValueatRisk and Expected shortfall
Recall that ValueatRisk at condence level p for a risk X with distribution
function F is, by denition, the quantile q
p
(F). Hence, the POT method gives
the ValueatRisk estimator
VaR
p,POT
= u +
_
_
n
N
u
(1 p)
_
b
1
_
.
Similarly, the POT method leads to an estimator for Expected shortfall. Recall
that
ES
p
(X) = E(X [ X > VaR
p
(X)) =
E(XI
(q
p
,)
(X))
E(I
(q
p
,)
(X))
,
where q
p
= VaR
p
(X)) and we have E(I
(q
p
,)
(X)) = F(q
p
). For a nonnegative
random variable Z with distribution function F, integration by parts show that
E(Z) =
_
0
zdF(z) =
_
0
zd(1 F)(z) =
_
0
zdF(z)
=
_
zF(z)
_
0
+
_
0
F(z)dz =
_
0
P(Z > z)dz.
40
0 20 40 60 80
0
2
0
4
0
6
0
8
0
Figure 13: Meanexcess plot of the Danish re insurance data. The plot looks
approximately linear indicating Paretolike tails.
10 15 20 25
0
.
0
0
5
0
.
0
1
0
0
.
0
1
5
0
.
0
2
0
0
.
0
2
5
0
.
0
3
0
10 15 20 25
0
.
0
0
5
0
.
0
1
0
0
.
0
1
5
0
.
0
2
0
0
.
0
2
5
0
.
0
3
0
Figure 14: The empirical tail of the Danish data and the POT approximation.
If p is suciently large so that q
p
> 0, then this can be applied to the nonnegative
random variable XI
(q
p
,)
(X). This gives
E(XI
(q
p
,)
(X)) = q
p
F(q
p
) +
_
q
p
F(t)dt
= q
p
F(q
p
) +
_
q
p
F(u)F
u
(t u)dt.
41
Hence,
ES
p
(X) = q
p
+
F(u)
F(q
p
)
_
q
p
F
u
(t u)dt = q
p
+
_
q
p
F
u
(t u)dt
F
u
(q
p
u)
.
We may now use the estimator
F
u
(t u) = G
b ,
b
(t u) to obtain, with q
p
=
VaR
p,POT
,
ES
p,POT
= q
p
+
_
b q
p
(1 + (t u)/
)
1/b
dt
(1 + ( q
p
u)/
)
1/b
= q
p
+
+ ( q
p
u)
1
.
More information about the POT method can be found in [8] and [12].
42
8 Multivariate distributions and dependence
We will now introduce some techniques and concepts for modeling multivariate
random vectors. We aim at constructing useful models for the vector of risk
factor changes X
n
. At this stage we will assume that all vectors of risk factor
changes (X
n
)
nZ
are iid but we allow for dependence between the components
of X
n
. That is, typically we assume that X
n,i
and X
n,j
are dependent whereas
X
n,i
and X
n+k,j
, are independent (for k ,= 0).
8.1 Basic properties of random vectors
The probability distribution of ddimensional random vector X = (X
1
, . . . , X
d
)
is completely determined by its joint distribution function F
F(x) = F(x
1
, . . . , x
d
) = P(X
1
x
1
, . . . , X
d
x
d
) = P(X x).
The ith marginal distribution F
i
of F is the distribution of X
i
and is given by
F
i
(x
i
) = P(X
i
x
i
) = F(, . . . , , x
i
, , . . . , ).
The distribution F is said to be absolutely continuous if there is a function
f 0, integrating to one, such that
F(x
1
, . . . , x
d
) =
_
x
1
. . .
_
x
d
f(u
1
, . . . , u
d
)du
1
. . . du
d
and then f is called the density of F. The components of X are independent if
and only if
F(x) =
d
i=1
F
i
(x
i
)
or equivalently if and only if the joint density f (if the density exists) satises
f(x) =
d
i=1
f
i
(x
i
).
Recall that the distribution of a random vector X is completely determined by
its characteristic function given by
X
(t) = E(expi t
T
X), t R
d
.
Example 8.1 The multivariate normal distribution with mean and covari
ance matrix has the density (with [[ being the absolute value of the deter
minant of )
f(x) =
1
_
(2)
d
[[
exp
_
1
2
(x )
T
1
(x )
_
, x R
d
.
Its characteristic function is given by
X
(t) = exp
_
i t
T
1
2
t
T
t
_
, t R
d
.
43
8.2 Joint log return distributions
Most classical multivariate models in nancial mathematics assume that the
joint distribution of log returns is a multivariate normal distribution. How
ever, the main reason for this assumption is mathematical convenience. This
assumption is not well supported by empirical ndings. To illustrate this fact
we study daily log returns of exchange rates. Pairwise log returns of the Swiss
franc (chf), German mark (dem), British pound (gbp) and Japanese yen (jpy)
quoted against the US dollar are illustrated in Figure 15. Now we ask whether
a multivariate normal model would be suitable for the log return data. We
estimate the mean and the covariance matrix of each data set (pairwise) and
simulate from a bivariate normal distribution with this mean and covariance
matrix, see Figure 16. By comparing the two gures we see that although the
simulated data resembles the true observations, the simulated data have too
few points far away from the mean. That is, the tails of the log return data are
heavier than the simulated multivariate normal data.
Another example shows that not only does the multivariate normal distri
bution have too light tails but also the dependence structure in the normal
distribution may be inappropriate when modeling the joint distribution of log
returns. Consider for instance the data set consisting of log returns from BMW
and Siemens stocks, Figure 17. Notice the strong dependence between large
drops in the BMW and Siemens stock prices. The dependence of large drops
seems stronger than for ordinary returns. This is something that cannot be
modeled by a multivariate normal distribution. To nd a good model for the
BMW and Siemens data we need to be able to handle more advanced depen
dence structures than that oered by the multivariate normal distribution.
8.3 Comonotonicity and countermonotonicity
Let (X
1
, X
2
) be a bivariate random vector and suppose there exist two monotone
functions , : R R and a random variable Z such that
(X
1
, X
2
)
d
= ((Z), (Z)).
If both and are increasing, then X
1
and X
2
are said to be comonotonic. If
the distribution functions F
1
and F
2
are continuous, then X
2
= T(X
1
) a.s. with
T = F
2
F
1
.
If is increasing and is decreasing, then X
1
and X
2
are said to be coun
termonotonic. If the distribution functions F
1
and F
2
are continuous, then
X
2
= T(X
1
) a.s. with T = F
2
(1 F
1
).
8.4 Covariance and linear correlation
Let X = (X
1
, . . . , X
d
)
T
be a random (column) vector with E(X
2
k
) < for
every k. The mean vector of X is = E(X) and the covariance matrix of X
is Cov(X) = E[(X)(X)
T
]. Here Cov(X) is a d d matrix whose (i, j)
entry (ith row, jth column) is Cov(X
i
, X
j
). Notice that Cov(X
i
, X
i
) = var(X
i
),
i.e. the variance of X
i
.
44
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
g
b
p
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
chf
d
e
m
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
c
h
f
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
gbp
c
h
f
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
d
e
m
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
gbp
d
e
m
Figure 15: log returns of foreign exchange rates quotes against the US dollar.
Covariance is easily manipulated under linear (ane) transformations. If B
is a constant k d matrix and b is a constant kvector (column vector), then
Y = BX+b has mean E(Y) = B +b and covariance matrix
Cov(Y) = E[(YE(Y))(YE(Y))
T
] = E[B(X)(X)
T
B
T
]
= B[E(X)(X)
T
]B
T
= BCov(X)B
T
.
45
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
g
b
p
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
chf
d
e
m
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
c
h
f
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
gbp
c
h
f
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
jpy
d
e
m
0.04 0.02 0.00 0.02 0.04
0
.
0
4
0
.
0
2
0
.
0
0
0
.
0
2
0
.
0
4
gbp
d
e
m
Figure 16: Simulated log returns of foreign exchange rates using bivariate normal
distribution with estimated mean and covariance matrix.
If var(X
1
), var(X
2
) (0, ), then the linear correlation coecient
L
(X
1
, X
2
)
is
L
(X
1
, X
2
) =
Cov(X
1
, X
2
)
_
var(X
1
) var(X
2
)
.
If X
1
and X
2
are independent, then
L
(X
1
, X
2
) = 0 but the converse is false;
46
BMW
S
i
e
m
e
n
s
0.15 0.10 0.05 0.0 0.05 0.10

0
.
1
0

0
.
0
5
0
.
0
0
.
0
5
Figure 17: log returns from BMW and Siemens stocks.
L
(X
1
, X
2
) = 0 need not imply that X
1
and X
2
are independent.
Example 8.2 If X
1
N(0, 1) and X
2
= X
2
1
, then
Cov(X
1
, X
2
) = E[(X
1
0)(X
2
1)] = E(X
1
X
2
) 0 1
= E(X
3
1
) =
_
x
3
1
2
e
x
2
/2
dx = 0.
Hence,
L
(X
1
, X
2
) = 0 but clearly X
1
and X
2
are strongly dependent.
Moreover [
L
(X
1
, X
2
)[ = 1 if and only if X
1
and X
2
are perfectly linear depen
dent. That is, if and only if there exist a R and b ,= 0 such that X
2
= a+bX
1
.
The linear correlation coecient is invariant under strictly increasing linear
transformations. In particular, for a
1
, a
2
R and b
1
, b
2
,= 0 we have
L
(a
1
+b
1
X
1
, a
2
+b
2
X
2
) = sign(b
1
b
2
)
L
(X
1
, X
2
),
where sign(b
1
b
2
) = b
1
b
2
/[b
1
b
2
[ if b
1
b
2
,= 0 and 0 otherwise. However, linear
correlation is not invariant under nonlinear strictly increasing transformations
T : R R. That is, for two random variables we have in general
L
(T(X
1
), T(X
2
)) ,=
L
(X
1
, X
2
).
This is a weakness of linear correlation as a measure of dependence. If we trans
form X
1
and X
2
by a strictly increasing transformation we have only rescaled
the marginal distributions, we have not changed the dependence between X
1
and X
2
. However, the linear correlation between T(X
1
) and T(X
2
) may have
changed (falsely) indicating that the dependence has changed.
47
Proposition 8.1 Let (X
1
, X
2
) be a random vector with marginal distribution
functions F
1
and F
2
, and an unspecied dependence structure. Assume further
that var(X
1
), var(X
2
) (0, ). Then
(1) The set of possible linear correlations is a closed interval [
L,min
,
L,max
]
with 0 [
L,min
,
L,max
].
(2) The minimum linear correlation
L,min
is obtained if and only if X
1
and
X
2
are countermonotonic; the maximum
L,max
if and only if X
1
and X
2
are comonotonic.
The following example illustrates Proposition 8.1.
Example 8.3 Let X
1
Lognormal(0, 1) and X
2
Lognormal(0,
2
) with >
0. Let Z N(0, 1) and note that
X
1
d
= e
Z
,
X
2
d
= e
Z d
= e
Z
.
Note that e
Z
and e
Z
are comonotonic and that e
Z
and e
Z
are countermono
tonic. Hence, by Proposition 8.1,
L,min
=
L
(e
Z
, e
Z
) =
e
1
_
(e 1)(e
2
1)
,
L,max
=
L
(e
Z
, e
Z
) =
e
1
_
(e 1)(e
2
1)
.
In particular,
L,min
0 and
L,max
0 as . See Figure 18 for a
graphical illustration of these bounds as functions of .
8.5 Rank correlation
Rank correlations are measures of concordance for bivariate random vectors.
Given two points in R
2
, (x
1
, x
2
) and ( x
1
, x
2
), we say that the two points are
concordant if (x
1
x
1
)(x
2
x
2
) > 0 and discordant if (x
1
x
1
)(x
2
x
2
) < 0.
Hence, concordance (discordance) means that the line connecting the two points
have a positive (negative) slope. Now consider two independent random vectors
(X
1
, X
2
) and (
X
1
,
X
2
) with the same bivariate distribution. The Kendalls tau
rank correlation is given by
(X
1
, X
2
) = P
_
(X
1
X
1
)(X
2
X
2
) > 0
_
P
_
(X
1
X
1
)(X
2
X
2
) < 0
_
.
If X
2
tend to increase with X
1
we expect the probability of concordance to be
high relative to the probability of discordance, giving a high value of
(X
1
, X
2
).
Another measure of concordance/discordance is Spearmans rho rank corre
lation where one introduces a third independent copy of (X
1
, X
2
) denoted by
48
Sigma
C
o
r
r
e
l
a
t
i
o
n
v
a
l
u
e
s
0 1 2 3 4 5

0
.
5
0
.
0
0
.
5
1
.
0
Figure 18: Bounds for the linear correlation coecient.
(
X
1
,
X
2
) and consider the concordance/discordance of the pairs (X
1
, X
2
) and
(
X
1
,
X
2
). Spearmans rho is dened by
S
(X
1
, X
2
)=3
_
P
_
(X
1
X
1
)(X
2
X
2
) > 0
_
P
_
(X
1
X
1
)(X
2
X
2
) < 0
__
.
Kendalls tau and Spearmans rho have many properties in common listed below.
They also illustrate important dierences between Kendalls tau and Spearmans
rho on the one hand and the linear correlation coecient on the other hand.
(X
1
, X
2
) [1, 1] and
S
(X
1
, X
2
) [1, 1]. All values can be obtained
regardless of the marginal distribution functions, if they are continuous.
If the marginal distribution functions are continuous, then
(X
1
, X
2
) =
S
(X
1
, X
2
) = 1 if and only if X
1
and X
2
are comonotonic;
(X
1
, X
2
) =
S
(X
1
, X
2
) = 1 if and only if X
1
and X
2
are countermonotonic.
If X
1
and X
2
are independent then
(X
1
, X
2
) = 0 and
S
(X
1
, X
2
) = 0,
but the converse is not true in general.
If T
1
, T
2
are strictly increasing then
(T
1
(X
1
), T
2
(X
2
)) =
(X
1
, X
2
) and
S
(T
1
(X
1
), T
2
(X
2
)) =
S
(X
1
, X
2
).
Estimation of Kendalls tau based on iid bivariate random vectors X
1
, . . . , X
n
49
is easy. Note that
(X
k,1
, X
k,2
) = P((X
k,1
X
l,1
)(X
k,2
X
l,2
) > 0)
P((X
k,1
X
l,1
)(X
k,2
X
l,2
) < 0)
= E(sign((X
k,1
X
l,1
)(X
k,2
X
l,2
))).
Hence, we obtain the following estimator of Kendalls tau
(X
k,1
, X
k,2
)
=
_
n
2
_
1
1k<ln
sign((X
k,1
X
l,1
)(X
k,2
X
l,2
))
=
_
n
2
_
1 n1
k=1
n
l=k+1
sign((X
k,1
X
l,1
)(X
k,2
X
l,2
)).
We will return to the rank correlations when we discuss copulas in Section 10.
8.6 Tail dependence
Motivated by the scatter plot of joint BMW and Siemens log returns above we
introduce a notion of dependence of extreme values, called tail dependence.
Let (X
1
, X
2
) be a random vector with marginal distribution functions F
1
and F
2
. The coecient of upper tail dependence of (X
1
, X
2
) is dened as
U
(X
1
, X
2
) = lim
u,1
P(X
2
> F
2
(u) [ X
1
> F
1
(u)),
provided that the limit
U
[0, 1] exists. The coecient of lower tail dependence
is dened as
L
(X
1
, X
2
) = lim
u0
P(X
2
F
2
(u) [ X
1
F
1
(u)),
provided that the limit
L
[0, 1] exists. If
U
> 0 (
L
> 0), then we say that
(X
1
, X
2
) has upper (lower) tail dependence.
See Figure 19 for an illustration of tail dependence.
50
25 20 15 10 5 0 5 10 15 20 25
25
20
15
10
5
0
5
10
15
20
25
Figure 19: Illustration of lower tail dependence.
4 2 0 2 4
5
0
5
4 2 0 2 4
5
0
5
Figure 20: Illustration of two bivariate distributions with linear correlation
L
= 0.8 and standard normal marginal distributions. The one to the left
has tail dependence
U
=
L
= 0.62 and the one to the right has
U
=
L
= 0.
9 Multivariate elliptical distributions
9.1 The multivariate normal distribution
Recall the following three equivalent denitions of a multivariate normal distri
bution.
(1) A random vector X = (X
1
, . . . , X
d
)
T
has a normal distribution if for every
vector a = (a
1
, . . . , a
d
)
T
the random variable a
T
X has a normal distribution.
The notation X N
d
(, ) is used to denote that X has a ddimensional
normal distribution with mean vector and covariance matrix .
(2) X N
d
(, ) if and only if its characteristic function is given by
X
(t) = E(expit
T
X) = exp
_
it
T
1
2
t
T
t
_
.
(3) A random vector X with E(X) = and Cov(X) = , such that [[ > 0,
satises X N
d
(, ) if and only if it has the density
f
X
(x) =
1
_
(2)
d
[[
exp
_
(x )
T
1
(x )
2
_
Next we list some useful properties of the multivariate normal distribution.
Let X N
d
(, ).
Linear transformations. For B R
kd
and b R
k
we have
BX+b N
k
(B +b, BB
T
).
Marginal distributions. Write X
T
= (X
T
1
, X
T
2
) with X
1
= (X
1
, . . . , X
k
)
T
,
X
2
= (X
k+1
, . . . , X
d
)
T
and write
T
= (
T
1
,
T
2
), =
_
11
12
21
22
_
.
Then X
1
N
k
(
1
,
11
) and X
2
N
dk
(
2
,
22
).
Conditional distributions. If is nonsingular ([[ > 0), then X
2
[X
1
=
x
1
N
dk
(
2,1
,
22,1
), where
2,1
=
2
+
21
1
11
(x
1
1
) and
22,1
=
22
21
1
11
12
.
Quadratic forms. If is nonsingular, then
D
2
= (X)
T
1
(X)
2
d
.
The variable D is called the Mahalanobis distance.
Convolutions. If X N
d
(, ) and Y N
d
( ,
(Chisquare distribution
with degrees of freedom), then X has the multivariate tdistribution with
degrees of freedom. We use the notation X t
d
(, , ). Note that is not
the covariance matrix of X. Since E(W
2
) = /( 2) (if > 2) we have
Cov(X) = [/( 2)].
9.3 Spherical distributions
Many results on spherical (and elliptical) distributions can be found in the book
[9].
Denition 9.2 A random vector X = (X
1
, . . . , X
d
)
T
has a spherical distribu
tion if there exists a function of a scalar variable such that the characteristic
function of X satises
X
(t) = (t
T
t) = (t
2
1
+ +t
2
d
).
We write X S
d
() to denote the X has a spherical distribution with charac
teristic function (t
T
t).
Proposition 9.1 The following statements are equivalent.
(1) X has a spherical distribution.
(2) For every vector a R
d
, a
T
X
d
= aX
1
with a
2
= a
2
1
+. . . a
2
d
.
(3) X has the stochastic representation X
d
= RS, where S is uniformly dis
tributed on the unit sphere S
d1
= x R
d
: x = 1 and R 0 is
independent of S.
The implication (1) (2) can be shown as follows. Recall that two random
variables (and vectors) have the same distribution if and only if their character
istic functions are the same. Let X S
d
(). Then
a
T
X
(s) = E(expisa
T
X) = E(expi(sa)
T
X) = (s
2
a
T
a).
Note that aX
1
= t
T
X with t
T
= (a, 0, . . . , 0). Hence,
aX
1
(s) = E(expist
T
X) = E(expi(st)
T
X) = (s
2
t
T
t)
= (s
2
a
2
) = (s
2
a
T
a).
54
Example 9.2 Let X N
d
(0, I). Then X S
d
() with (x) = expx/2.
The characteristic function of the standard normal distribution is
X
(t) = exp
_
it
T
0
1
2
t
T
It
_
= expt
T
t/2 = (t
T
t).
From the stochastic representation X
d
= RS we conclude that X
2
d
= R
2
and
since the sum of squares of d independent standard normal random variables
has a chisquared distribution with d degrees of freedom we have R
2
2
d
.
The stochastic representation in (4) is very useful for simulating from spheri
cal distributions. Simply apply the following algorithm. Suppose the spherically
distributed random vector X has the stochastic representation X
d
= RS.
(i) Simulate s from the distribution of S.
(ii) Simulate r from the distribution of R.
(iii) Put x = rs.
This procedure can then be repeated n times to get a sample of size n from
the spherical distribution of X. We illustrate this in Figure 21. Note that a
convenient way to simulate a random element S that has uniform distribution on
the unit sphere in R
d
is to simulate a ddimensional random vector Y N
d
(0, I)
and then put S = Y/Y.
9.4 Elliptical distributions
Denition 9.3 An R
d
valued random vector X has an elliptical distribution if
X
d
= +AY, where Y S
k
(), A R
dk
and R
d
.
When d = 1 the elliptical distributions coincide with the 1dimensional sym
metric distributions. The characteristic function of an elliptically distributed
random vector X can be written as
X
(t) = E(expit
T
X)
= E(expit
T
( +AY))
= expit
T
E(expi(A
T
t)
T
Y)
= expit
T
(t
T
t),
where = AA
T
. We write X E
d
(, , ). Here is called the location
parameter, is called the dispersion matrix and is called the characteris
tic generator of the elliptical distribution. If E(X
k
) < , then E(X) = .
If E(X
k
) < , then Cov(X) = c for some c > 0. Note that elliptically
distributed random vectors are radially symmetric: if X E
d
(, , ), then
X
d
= X. If A R
dd
is nonsingular with AA
T
= , then we have the
following relation between elliptical and spherical distributions:
X E
d
(, , ) A
1
(X) S
d
(), A R
dd
, AA
T
= .
55
1 0.5 0 0.5 1
0.5
0
0.5
4 2 0 2 4
3
2
1
0
1
2
3
Figure 21: Simulation from a spherical distribution using the stochastic rep
resentation. First we simulate independently n times from the uniform dis
tribution on the unit sphere to obtain s
1
, . . . , s
n
(above). Then, we simulate
r
1
, . . . , r
n
from the distribution of R. Finally we put x
k
= r
k
s
k
for k = 1, . . . , n
(below).
It follows immediately from the denition that elliptical distributed random vec
tors have the following stochastic representation. X E
d
(, , ) if and only if
there exist S, R, and A such that X
d
= +RAS with S uniformly distributed on
the unit sphere, R 0 a random variable independent of S, A R
dk
a matrix
with AA
T
= and R
d
. The stochastic representation is useful when simu
lating from elliptical distributions. Suppose X has the stochastic representation
X
d
= +RAS.
(i) Simulate s from the distribution of S.
(ii) Multiply s by the matrix A to get As.
(iii) Simulate r from the distribution of R and form rAs.
(iv) Put x = +rAs.
This procedure can then be repeated n times to get a sample of size n from the
elliptical distribution of X. We illustrate this in Figure 22.
Example 9.3 An R
d
valued normally distributed random vector with mean
and covariance matrix has the representation X
d
= +AZ, where AA
T
=
56
1 0.5 0 0.5 1
0.5
0
0.5
1 0.5 0 0.5 1
0.5
0
0.5
2 0 2
3
2
1
0
1
2
3
8 10 12
7
8
9
10
11
12
13
Figure 22: Simulation from a spherical distribution using the stochastic repre
sentation. First we simulate independently n times from the uniform distribu
tion on the unit sphere to obtain s
1
, . . . , s
n
(above, left). Then, we multiply each
sample by A to get the points As
1
, . . . , As
n
(above, right). Next, we simulate
r
1
, . . . , r
n
from the distribution of R to obtain r
k
As
k
for k = 1, . . . , n (below,
left). Finally we add to obtain x
k
= +r
k
As
k
for k = 1, . . . , n (below, right).
and Z N
k
(0, I). Since Z has a spherical distribution it has representation
Z
d
= RS, where R
2
2
k
. Hence, X has the representation X
d
= + RAS and
we conclude that X E
d
(, , ) with (x) = expx/2.
Example 9.4 A random vector Z N
d
(0, I) has a spherical distribution with
stochastic representation Z
d
= V S. If X is a normal variance mixture, then
we see from the denition that it has representation X
d
= + V WAS, with
V
2
2
d
. Hence, it has an elliptical distribution with R
d
= V W. An example
given earlier is the multivariate t
distribution where W
2
d
= /S with S
2
.
This means that for the multivariate tdistribution R
2
/d
d
= V
2
W
2
/d has an
F(d, )distribution (see e.g. Problem 10, Chapter 1 in [11]).
9.5 Properties of elliptical distributions
Next we list some useful properties of elliptical distributions. Many of them
coincide with the properties of the multivariate normal distribution. This is
perhaps the most important argument for using the elliptical distributions in
applications. Let X E
d
(, , ).
57
Linear transformations. For B R
kd
and b R
k
we have
BX+b E
k
(B +b, BB
T
, ).
Marginal distributions. Write X
T
= (X
T
1
, X
T
2
) with X
1
= (X
1
, . . . , X
k
)
T
,
X
2
= (X
k+1
, . . . , X
d
)
T
and write
T
= (
T
1
,
T
2
), =
_
11
12
21
22
_
.
Then X
1
E
k
(
1
,
11
, ) and X
2
E
dk
(
2
,
22
, ).
Conditional distributions. Assuming that is nonsingular, X
2
[X
1
= x
1
E
dk
(
2,1
,
22,1
,
), where
2,1
=
2
+
21
1
11
(x
1
1
) and
22,1
=
22
21
1
11
12
.
Typically
is a dierent characteristic generator than the original .
Quadratic forms. If is nonsingular, then
D
2
= (X)
T
1
(X)
d
= R
2
.
The variable D is called the Mahalanobis distance.
Convolutions. If X E
d
(, , ) and Y E
d
( , ,
) are independent,
then X + Y E
d
( + , , ), with (x) = (x)
i=1
w
i
= 1 and P
r
= Z = w
T
X : w W
r
.
58
Hence, P
r
is the set of of all linear portfolios with expected return r with the
normalization constraint
d
i=1
w
i
= 1.
How can we nd the least risky portfolio with expected portfolio return r?
The meanvariance (Markowitz) approach to portfolio optimization solves this
problem if we accept variance (or standard deviation) as our measure of risk.
The minimum variance portfolio is the portfolio that minimizes the variance
var(Z) = w
T
w over all Z P
r
. Hence, the portfolio weights of the minimum
variance portfolio is the solution to the following optimization problem:
min
wW
r
w
T
w.
This optimization problem has a unique solution, see e.g. p. 185 in [3]. As al
ready mentioned, the variance is in general not a suitable risk measure. We
would typically prefer a risk measure based on the appropriate tail of our port
folio return. It was shown in [7] that the minimumrisk portfolio, where risk
could be e.g. VaR or ES, coincides with the minimumvariance portfolio for
elliptically distributed return vectors X. Hence, the meanvariance approach
(Markowitz) to portfolio optimization makes sense in the elliptical world. In
fact we can take any risk measure with the following properties and replace
the variance in the Markowitz approach by . Suppose is a risk measure that
is translation invariant and positively homogeneous, i.e.
(X +a) = (X) +a for r R and (X) = (X) for 0.
Moreover, suppose that (X) depends on X only through its distribution. The
risk measure could be for instance VaR or ES.
Since X E
d
(, , ) we have X
d
= + AY, where AA
T
= and Y
S
d
(). Hence, it follows from Proposition 9.1 that
w
T
X = w
T
+w
T
AY = w
T
+ (A
T
w)
T
Y
d
= w
T
+A
T
wY
1
. (9.1)
Hence, for any Z P
r
it holds that
(Z) = r +A
T
w(Y
1
) and var(Z) = A
T
w
2
var(Y
1
) = w
T
wvar(Y
1
).
Hence, minimization with respect to and minimization with respect to the
variance give the same optimal portfolio weights w:
argmin
ZP
r
(Z) = argmin
wW
r
A
T
w
= argmin
wW
r
A
T
w
2
= argmin
ZP
r
var(Z).
Example 9.5 Note also that (9.1) implies that for w
1
, w
2
R
d
we have
VaR
p
(w
1
X+w
2
X) = w
T
1
+w
T
2
+A
T
w
1
+A
T
w
2
 VaR
p
(Y
1
)
w
T
1
+w
T
2
+A
T
w
1
 VaR
p
(Y
1
) +A
T
w
2
 VaR
p
(Y
1
)
= VaR
p
(w
T
1
X) + VaR
p
(w
T
2
X).
Hence, ValueatRisk is subadditive for elliptical distributions.
59
Example 9.6 Let X = (X
1
, X
2
)
T
be a vector of log returns, for the time
period todayuntiltomorrow, of two stocks with stock prices S
1
= S
2
= 1 today.
Suppose that X E
2
(, , ) (elliptically distributed) with linear correlation
coecient and that
= 0, =
_
2
2
2
_
.
Your total capital is 1 which you want to invest fully in the two stocks giving
you a linearized portfolio loss L
= L
(w
1
, w
2
) where w
1
and w
2
are portfolio
weights. Two investment strategies are available (long positions):
(A) invest your money in equal shares in the two stocks: w
A1
= w
A2
= 1/2;
(B) invest all your money in the rst stock: w
B1
= 1, w
B2
= 0.
How can we compute the ratio VaR
0.99
(L
A
)/ VaR
0.99
(L
B
), where L
A
and L
B
are linearized losses for investment strategies A and B, respectively?
We have
L
= w
T
X
d
= w
T
X
since X E
2
(0, , ). Moreover, by (9.1) it holds that
w
T
X
d
=
w
T
wZ,
where Z E
1
(0, 1, ). Hence, VaR
p
(w
T
X) =
w
T
wVaR
p
(Z). This yields
VaR
0.99
(w
T
A
X)
VaR
0.99
(w
T
B
X)
=
_
w
T
A
w
A
_
w
T
B
w
B
.
We have w
T
A
w
A
=
2
(1 +)/2 and w
T
B
w
B
=
2
. Hence
VaR
0.99
(L
A
)
VaR
0.99
(L
B
)
=
VaR
0.99
(w
T
A
X)
VaR
0.99
(w
T
B
X)
=
_
(1 +)/2.
60
10 Copulas
We will now introduce the notion of copula. The main reasons for introduc
ing copulas are: 1) copulas are very useful for building multivariate models
with nonstandard (nonGaussian) dependence structures, 2) copulas provide an
understanding of dependence beyond linear correlation.
The reader seeking more information about copulas is recommended to con
sult the book [13].
10.1 Basic properties
Denition 10.1 A ddimensional copula is a distribution function on [0, 1]
d
with standard uniform marginal distributions.
This means that a copula is the distribution function P(U
1
u
1
, . . . , U
d
u
d
)
of a random vector (U
1
, . . . , U
d
) with the property that for all k it holds that
P(U
k
u) = u for u [0, 1].
A bivariate distribution function F with marginal distribution functions is
a function F that satises
(A1) F(x
1
, x
2
) is nondecreasing in each argument x
k
.
(A2) F(x
1
, ) = F
1
(x
1
) and F(, x
2
) = F
2
(x
2
).
(A3) For all (a
1
, a
2
), (b
1
, b
2
) R
2
with a
k
b
k
we have:
F(b
1
, b
2
) F(a
1
, b
2
) F(b
1
, a
2
) +F(a
1
, a
2
) 0.
Notice that (A3) says that probabilities are always nonnegative. Hence a copula
is a function C that satises
(B1) C(u
1
, u
2
) is nondecreasing in each argument u
k
.
(B2) C(u
1
, 1) = u
1
and C(1, u
2
) = u
2
.
(B3) For all (a
1
, a
2
), (b
1
, b
2
) [0, 1]
2
with a
k
b
k
we have:
C(b
1
, b
2
) C(a
1
, b
2
) C(b
1
, a
2
) +C(a
1
, a
2
) 0.
Let h : R R be nondecreasing. Then the following properties hold for the
generalized inverse h
of h.
(C1) h is continuous if and only if h
is strictly increasing.
(C2) h is strictly increasing if and only if h
is continuous.
(C3) If h is continuous, then h(h
(y)) = y.
(C4) If h is strictly increasing, then h
(h(x)) = x.
61
Recall the following important facts for a distribution function G on R.
(D1) Quantile transform. If U U(0, 1) (standard uniform distribution), then
P(G
(U) x) = G(x).
(D2) Probability transform. If Y has distribution function G, where G is con
tinuous, then G(Y ) U(0, 1).
Let X be a bivariate random vector with distribution function F that has con
tinuous marginal distribution functions F
1
, F
2
. Consider the function C given
by
C(u
1
, u
2
) = F(F
1
(u
1
), F
2
(u
2
)).
It is clear that C is nondecreasing in each argument so (B1) holds. Moreover,
C(u
1
, 1) = F(F
1
(u
1
), ) = P(X
1
F
1
(u
1
))
= P(F
1
(X
1
) F
1
(F
1
(u
1
))) = P(F
1
(X
1
) u
1
)
= u
1
and similarly C(1, u
2
) = u
2
. Hence, (B2) holds. Since F is a bivariate distribu
tion function (B3) holds. Hence, C is a copula.
The following result known as Sklars Theorem is central to the theory of
copulas. It also explains the name copula: a function that couples the joint
distribution function to its (univariate) marginal distribution functions.
Theorem 10.1 (Sklars Theorem) Let F be a joint distribution function
with marginal distribution functions F
1
, . . . , F
d
. Then there exists a copula C
such that for all x
1
, . . . , x
d
R = [, ],
F(x
1
, . . . , x
d
) = C(F
1
(x
1
), . . . , F
d
(x
d
)). (10.1)
If F
1
, . . . , F
d
are continuous, then C is unique. Conversely, if C is a copula
and F
1
, . . . , F
d
are distribution functions, then F dened by (10.1) is a joint
distribution function with marginal distribution functions F
1
, . . . , F
d
.
Denition 10.2 Let F be a joint distribution function with continuous margi
nal distribution functions F
1
, . . . , F
d
. Then the copula C in (10.1) is called the
copula of F. If X is a random vector with distribution function F, then we also
call C the copula of X.
By (C3) above, if F
k
is continuous, then F
k
(F
k
(u)) = u. Hence, if F is
a joint distribution function with continuous marginal distribution functions
F
1
, . . . , F
d
, then the unique copula of F is given by
C(u
1
, . . . , u
d
) = F(F
1
(u
1
), . . . , F
d
(u
d
)).
Much of the usefulness of copulas is due to the fact that the copula of a ran
dom vector with continuous marginal distribution functions is invariant under
strictly increasing transformations of the components of the random vector.
62
Proposition 10.1 Suppose (X
1
, . . . , X
d
) has continuous marginal distribution
functions and copula C and let T
1
, . . . , T
d
be strictly increasing. Then also the
random vector (T
1
(X
1
), . . . , T
d
(X
d
)) has copula C.
Proof. Let F
k
denote the distribution function of X
k
and let
F
k
denote the
distribution function of T
k
(X
k
). Then
F
k
(x) = P(T
k
(X
k
) x) = P(X
k
T
k
(x)) = F
k
(T
k
(x)),
i.e.
F
k
= F
k
T
k
is continuous. Since
F
1
, . . . ,
F
d
are continuous the random
vector (T
1
(X
1
), . . . , T
d
(X
d
)) has a unique copula
C. Moreover, for any x R
d
,
C(
F
1
(x
1
), . . . ,
F
d
(x
d
)) = P(T
1
(X
1
) x
1
, . . . , T
d
(X
d
) x
d
)
= P(X
1
T
1
(x
1
), . . . , X
d
T
d
(x
d
))
= C(F
1
T
1
(x
1
), . . . , F
d
T
d
(x
d
))
= C(
F
1
(x
1
), . . . ,
F
d
(x
d
)).
Since, for k = 1, . . . , d,
F
k
is continuous,
F
k
(R) = [0, 1]. Hence
C = C on [0, 1]
d
.
k
(U
k
) has distribution function F
k
(the quantile transform). More
over, for each k, F
k
is strictly increasing (C1). Hence, the random vector
(F
1
(U
1
), . . . , F
d
(U
d
)) has marginal distribution functions F
1
, . . . , F
d
and, by
Proposition 10.1, copula C.
Example 10.2 Let (X
1
, X
2
) be a random vector with continuous marginal
distribution functions F
1
, F
2
and copula C Let g
1
and g
2
be strictly decreasing
functions. Determine the copula
C of (g
1
(X
1
), g
2
(X
2
))?
The distribution and quantile function of g
k
(X
k
) is given by
F
k
(x) = P(g
k
(X
k
) x) = P(X
k
g
1
k
(x)) = 1 F
k
(g
1
k
(x)),
k
(p) = g
k
(F
k
(1 p)).
Hence,
C(u
1
, u
2
) = P(g
1
(X
1
)
F
1
1
(u
1
), g
2
(X
2
)
F
1
2
(u
2
))
= P(X
1
F
1
(1 u
1
), X
2
F
2
(1 u
2
))
= P(F
1
(X
1
) 1 u
1
, F
2
(X
2
) 1 u
2
)
= 1 (1 u
1
) (1 u
2
) +C(1 u
1
, 1 u
2
)
= C(1 u
1
, 1 u
2
) +u
1
+u
2
1.
63
Notice that
C(u
1
, u
2
) = P(F
1
(X
1
) u
1
, F
2
(X
2
) u
2
),
C(u
1
, u
2
) = P(1 F
1
(X
1
) u
1
, 1 F
2
(X
2
) u
2
).
See Figure 23 for an illustration with g
1
(x) = g
2
(x) = x and F
1
(x) = F
2
(x) =
(x) (standard normal distribution function).
3 2 1 0 1 2 3
1
0
1
2
3
X1
X
2
3 2 1 0 1 2 3
1
0
1
2
3
X1
X
2
0.0 0.2 0.4 0.6 0.8 1.0
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
.
0
U1
U
2
0.0 0.2 0.4 0.6 0.8 1.0
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
.
0
1U1
1
U
2
Figure 23: (U
1
, U
2
) has the copula C as its distribution function. (X
1
, X
2
) has
standard normal marginal distributions and copula C. Samples of size 3000
from (X
1
, X
2
), (X
1
, X
2
), (U
1
, U
2
) and (1 U
1
, 1 U
2
).
Example 10.3 Let X N
d
(0, R) where R is a correlation matrix. Denote by
R
and the distribution functions of Xand X
1
respectively (the ddimensional
standard normal distribution function and the 1dimensional standard normal
distribution function). Then X has the socalled Gaussian copula C
Ga
R
given by
C
Ga
R
(u) = P((X
1
) u
1
, . . . , (X
d
) u
d
) =
R
(
1
(u
1
), . . . ,
1
(u
d
)).
(10.2)
64
Let Y = + X, where for some
1
, . . . ,
d
> 0,
=
_
_
_
_
1
0 . . . 0
0
2
0 . . . 0
. . .
0 . . . 0
d
_
_
_
_
.
Then Y N
d
(, R). Note that Y has linear correlation matrix R. Note
also that T
k
(x) =
k
+
k
x is strictly increasing and that
Y = (T
1
(X
1
), . . . , T
d
(X
d
)).
Hence if C
Y
denotes the copula of Y, then by Proposition 10.1 we have C
Y
=
C
Ga
R
. We conclude that the copula of a nondegenerate ddimensional normal
distribution depends only on the linear correlation matrix. For d = 2 we see
from (10.2) that C
Ga
R
can be written as
C
Ga
R
(u
1
, u
2
) =
_
1
(u
1
)
_
1
(u
2
)
1
2(1
2
)
1/2
exp
_
(x
2
1
2x
1
x
2
+x
2
2
)
2(1
2
)
_
dx
1
dx
2
,
if = R
12
(1, 1).
The following result provides us with universal bounds for copulas. See also
Example 10.5 below.
Proposition 10.2 (Frechet bounds) For every copula C we have the bounds
max
_
d
k=1
u
k
d + 1, 0
_
C(u
1
, . . . , u
d
) minu
1
, . . . , u
d
.
For d 2 we denote by W
d
the Frechet lower bound and by M
d
the Frechet
upper bound. For d = 2 we drop the subscript of W
2
and M
2
, i.e. W = W
2
and
M = M
2
.
Example 10.4 Let W
d
be the Frechet lower bound and consider the set func
tion Q given by
Q([a
1
, b
1
] [a
d
, b
d
]) =
2
k
1
=1
2
k
d
=1
(1)
k
1
++k
d
W
d
(u
1k
1
, . . . , u
dk
d
),
for all (a
1
, . . . , a
d
), (b
1
, . . . , b
d
) [0, 1]
d
with a
k
b
k
where u
j1
= a
j
and u
j2
=
b
j
for j 1, . . . , d. W
d
is a copula (distribution function) if and only if Q is
its probability distribution. However,
Q([1/2, 1]
d
) = max(1 + + 1 d + 1, 0)
d max(1/2 + 1 + + 1 d + 1, 0)
+
_
d
2
_
max(1/2 + 1/2 + 1 + + 1 d + 1, 0)
. . .
+max(1/2 + + 1/2 d + 1, 0)
= 1 d/2.
65
Hence, Q is not a probability distribution for d 3 so W
d
is not a copula for
d 3.
The following result shows that the Frechet lower bound is the best possible.
Proposition 10.3 For any d 3 and any u [0, 1]
d
, there exists a copula C
such that C(u) = W
d
(u).
Remark 10.1 For any d 2, the Frechet upper bound M
d
is a copula.
For d = 2 the following example shows which random vectors have the
Frechet bounds as their copulas.
Example 10.5 Let X be a random variable with continuous distribution func
tion F
X
. Let Y = T(X) for some strictly increasing function T and denote by
F
Y
the distribution function of Y . Note that
F
Y
(x) = P(T(X) x) = F
X
(T
1
(x))
and that F
Y
is continuous. Hence the copula of (X, T(X)) is
P(F
X
(X) u, F
Y
(Y ) v) = P(F
X
(X) u, F
X
(T
1
(T(X))) v)
= P(F
X
(X) minu, v)
= minu, v.
By Proposition 10.1 the copula of (X, T(X)) is the copula of (U, U), where
U U(0, 1). Let Z = S(X) for some strictly decreasing function S and denote
by F
Z
the distribution function of Z. Note that
F
Z
(x) = P(S(X) x) = P(X > S
1
(x)) = 1 F
X
(S
1
(x))
and that F
Z
is continuous. Hence the copula of (X, S(X)) is
P(F
X
(X) u, F
Z
(Z) v) = P(F
X
(X) u, 1 F
X
(S
1
(S(X))) v)
= P(F
X
(X) u, F
X
(X) > 1 v)
= P(F
X
(X) u) P(F
X
(X) minu, 1 v)
= u minu, 1 v
= maxu +v 1, 0.
By (a modied version of) Proposition 10.1 the copula of (X, S(X)) is the copula
of (U, 1 U), where U U(0, 1).
10.2 Dependence measures
Comonotonicity and countermonotonicity revisited
Proposition 10.4 Let (X
1
, X
2
) have one of the copulas W or M (as a possible
copula). Then there exist two monotone functions , : R R and a random
variable Z so that
(X
1
, X
2
)
d
= ((Z), (Z)),
66
with increasing and decreasing in the former case (W) and both and
increasing in the latter case (M). The converse of this result is also true.
Hence, if (X
1
, X
2
) has the copula M (as a possible copula), then X
1
and X
2
are comonotonic; if it has the copula W (as a possible copula), then they are
countermonotonic. Note that if any of F
1
and F
2
(the distribution functions of
X
1
and X
2
, respectively) have discontinuities, so that the copula is not unique,
then W and M are possible copulas. Recall also that if F
1
and F
2
are continuous,
then
C = W X
2
= T(X
1
) a.s., T = F
2
(1 F
1
) decreasing,
C = M X
2
= T(X
1
) a.s., T = F
2
F
1
increasing.
Kendalls tau and Spearmans rho revisited
To begin with we recall the denitions of the concordance measures Kendalls
tau and Spearmans rho.
Denition 10.3 Kendalls tau for the random vector (X
1
, X
2
) is dened as
(X
1
, X
2
) = P((X
1
X
t
1
)(X
2
X
t
2
) > 0) P((X
1
X
t
1
)(X
2
X
t
2
) < 0),
where (X
t
1
, X
t
2
) is an independent copy of (X
1
, X
2
). Spearmans rho for the
random vector (X
1
, X
2
) is dened as
S
(X
1
, X
2
) = 3 (P((X
1
X
t
1
)(X
2
X
tt
2
) > 0) P((X
1
X
t
1
)(X
2
X
tt
2
) < 0)) ,
where (X
t
1
, X
t
2
) and (X
tt
1
, X
tt
2
) are independent copies of (X
1
, X
2
).
An important property of Kendalls tau and Spearmans rho is that they are
invariant under strictly increasing transformations of the underlying random
variables. If (X
1
, X
2
) is a random vector with continuous marginal distribution
functions and T
1
and T
2
are strictly increasing transformations on the range
of X
1
and X
2
respectively, then
(T
1
(X
1
), T
2
(X
2
)) =
(X
1
, X
2
). The same
property holds for Spearmans rho. Note that this implies that Kendalls tau
and Spearmans rho do not depend on the (marginal) distributions of X
1
and
X
2
. This is made clear in the following two results.
Proposition 10.5 Let (X
1
, X
2
) be a random vector with continuous marginal
distribution functions and with copula C. Then
(X
1
, X
2
) = 4
_
[0,1]
2
C(u
1
, u
2
)dC(u
1
, u
2
) 1 = 4 E(C(U
1
, U
2
)) 1,
S
(X
1
, X
2
) = 12
_
[0,1]
2
u
1
u
2
dC(u
1
, u
2
) 3 = 12
_
[0,1]
2
C(u
1
, u
2
)du
1
du
2
3
= 12 E(U
1
U
2
) 3,
where (U
1
, U
2
) has distribution function C.
67
Remark 10.2 Note that by Proposition 10.5, if F
1
and F
2
denotes the distri
bution functions of X
1
and X
2
respectively,
S
(X
1
, X
2
) = 12
_
[0,1]
2
u
1
u
2
dC(u
1
, u
2
) 3
= 12 E(F
1
(X
1
)F
2
(X
2
)) 3
=
E(F
1
(X
1
)F
2
(X
2
)) 1/4
1/12
=
E(F
1
(X
1
)F
2
(X
2
)) E(F
1
(X
1
)) E(F
2
(X
2
))
_
var(F
1
(X
1
))
_
var(F
2
(X
2
))
=
l
(F
1
(X
1
), F
2
(X
2
)).
Hence Spearmans rho is simply the linear correlation coecient of the proba
bility transformed random variables.
Tail dependence revisited
We now return to the dependence concept called tail dependence. The concept
of tail dependence is important for the modeling of joint extremes, particularly
in portfolio Risk Management. We recall the denition of the coecient of tail
dependence.
Let (X
1
, X
2
) be a random vector with marginal distribution functions F
1
and F
2
. The coecient of upper tail dependence of (X
1
, X
2
) is dened as
U
(X
1
, X
2
) = lim
u,1
P(X
2
> F
2
(u) [ X
1
> F
1
(u)),
provided that the limit
U
[0, 1] exists. The coecient of lower tail dependence
is dened as
L
(X
1
, X
2
) = lim
u0
P(X
2
F
2
(u) [ X
1
F
1
(u)),
provided that the limit
L
[0, 1] exists. If
U
> 0 (
L
> 0), then we say that
(X
1
, X
2
) has upper (lower) tail dependence.
Proposition 10.6 Let (X
1
, X
2
) be a random vector with continuous marginal
distribution functions and copula C. Then
U
(X
1
, X
2
) = lim
u,1
(1 2u +C(u, u))/(1 u),
provided that the limit exists, and
L
(X
1
, X
2
) = lim
u0
C(u, u)/u,
provided that the limit exists.
That the limit need not exist is shown by the following example.
68
Example 10.6 Let Q be a probability measure on [0, 1]
2
such that for every
integer n 1, Q assigns mass 2
n
, uniformly distributed, to the line segment
between (1 2
n
, 1 2
n+1
) and (1 2
n+1
, 1 2
n
). Dene the distribution
function C by C(u
1
, u
2
) = Q([0, u
1
] [0, u
2
]) for u
1
, u
2
[0, 1]. Note that
C(u
1
, 0) = 0 = C(0, u
2
), C(u
1
, 1) = u
1
and C(1, u
2
) = u
2
, i.e. C is a copula.
Note also that for every n 1 (with C(u, u) = 1 2u +C(u, u))
C(1 2
n+1
, 1 2
n+1
)/2
n+1
= 1
and
C(1 3/2
n+1
, 1 3/2
n+1
)/(3/2
n+1
) = 2/3.
In particular lim
u,1
C(u, u)/(1 u) does not exist.
Example 10.7 Consider the socalled Gumbel family of copulas given by
C
(u
1
, u
2
) = exp([(lnu
1
)
+ (ln u
2
)
]
1/
),
for 1. Then
1 2u +C
(u, u)
1 u
=
1 2u + exp(2
1/
lnu)
1 u
=
1 2u +u
2
1/
1 u
,
and hence by lHospitals rule
lim
u,1
(1 2u +C
(u
1
, u
2
) = (u
1
+u
2
1)
1/
,
for > 0. Then C
(u, u) = (2u
1)
1/
and hence, by lHospitals rule,
lim
u0
C
1)
1/
/u
= lim
u0
(
1
)(2u
1)
1/1
(2(u
)
1/1
)
= lim
u0
2(2 u
)
1/1
= 2
1/
,
i.e.
L
= 2
1/
. Similarly one shows that
U
= 0. See Figure 24 for a graphical
illustration.
69
Gumbel
X1
Y
1
0 2 4 6 8 10 12 14
0
2
4
6
8
1
0
1
2
1
4
Clayton
X2
Y
2
0 2 4 6 8 10 12 14
0
2
4
6
8
1
0
1
2
1
4
Figure 24: Samples from two distributions with Gamma(3, 1) marginal dis
tribution functions, linear correlation 0.5 but dierent dependence structures.
(X1, Y 1) has a Gumbel copula and (X2, Y 2) has a Clayton copula.
10.3 Elliptical copulas
Denition 10.4 Let X E
d
(, , ) with distribution function F and with
continuous marginal distribution functions F
1
, . . . , F
d
. Then the copula C given
by C(u) = F(F
1
(u
1
), . . . , F
d
(u
d
)) is said to be an elliptical copula.
Note that an elliptical copula is not the distribution function of an elliptical
distribution, but rather the copula of an elliptical distribution.
The copula of the ddimensional normal distribution with linear correlation
matrix R is
C
Ga
R
(u) =
d
R
(
1
(u
1
), . . . ,
1
(u
d
)),
where
d
R
denotes the joint distribution function of the ddimensional standard
normal distribution function with linear correlation matrix R, and
1
denotes
the inverse of the distribution function of the univariate standard normal distri
bution. Copulas of the above form are called Gaussian copulas. In the bivariate
case the copula expression can be written as
C
Ga
R
(u
1
, u
2
) =
_
1
(u
1
)
_
1
(u
2
)
1
2(1
2
)
1/2
exp
_
(x
2
1
2x
1
x
2
+x
2
2
)
2(1
2
)
_
dx
1
dx
2
,
if = R
12
(1, 1).
Proposition 10.7 (i) If (X
1
, X
2
) is a normally distributed random vector, then
U
(X
1
, X
2
) =
L
(X
1
, X
2
) = 0.
(ii) If (X
1
, X
2
) has continuous marginal distribution functions and a Gaussian
copula, then
U
(X
1
, X
2
) =
L
(X
1
, X
2
) = 0.
70
If X has the stochastic representation
X =
d
+
S
AZ, (10.3)
where R
d
(column vector), S
2
and Z N
d
(0, I) (column vector)
are independent, then X has an ddimensional t
(u
1
), . . . , t
1
(u
d
)),
where R
ij
=
ij
/
_
ii
jj
for i, j 1, . . . , d and where t
d
,R
denotes the
distribution function of
AZ/
S, where AA
T
= R. Here t
denotes the
(equal) margins of t
d
,R
, i.e. the distribution function of
Z
1
/
S. In the
bivariate case the copula expression can be written as
C
t
,R
(u
1
, u
2
) =
_
t
1
(u)
_
t
1
(v)
1
2(1
2
)
1/2
_
1+
x
2
1
2x
1
x
2
+x
2
2
(1
2
)
_
(+2)/2
dx
1
dx
2
,
if = R
12
(1, 1). Note that R
12
is simply the usual linear correlation
coecient of the corresponding bivariate t
distribution if > 2.
Proposition 10.8 (i) If (X
1
, X
2
) has a tdistribution with degrees of freedom
and linear correlation matrix R, then
U
(X
1
, X
2
) =
L
(X
1
, X
2
) = 2t
+1
_
+ 1
_
1 R
12
/
_
1 +R
12
_
. (10.4)
(ii) If (X
1
, X
2
) has continuous marginal distribution functions and a tcopula
with parameters and R, then
U
(X
1
, X
2
) and
L
(X
1
, X
2
) are as in (10.4).
From this it is also seen that the coecient of upper tail dependence is increasing
in R
12
and decreasing in , as one would expect. Furthermore, the coecient of
upper (lower) tail dependence tends to zero as the number of degrees of freedom
tends to innity for R
12
< 1.
The following result will play an important role in parameter estimation in
models with elliptical copulas.
Proposition 10.9 (i) If (X
1
, X
2
) E
2
(, , ) with continuous marginal dis
tribution functions, then
(X
1
, X
2
) =
2
arcsin R
12
, (10.5)
where R
12
=
12
/
11
22
.
(ii) If (X
1
, X
2
) has continuous marginal distribution functions and the copula
of E
2
(, , ), then relation (10.5) holds.
71
10.4 Simulation from Gaussian and tcopulas
We now address the question of random variate generation from the Gaussian
copula C
Ga
R
. For our purpose, it is sucient to consider only strictly positive
denite matrices R. Write R = AA
T
for some dd matrix A, and if Z
1
, . . . , Z
d
N(0, 1) are independent, then
+AZ N
d
(, R).
One natural choice of A is the Cholesky decomposition of R. The Cholesky
decomposition of R is the unique lowertriangular matrix L with LL
T
= R.
Furthermore Cholesky decomposition routines are implemented in most mathe
matical software. This provides an easy algorithm for random variate generation
from the ddimensional Gaussian copula C
Ga
R
.
Algorithm 10.1
Find the Cholesky decomposition A of R: R = AA
T
.
Simulate d independent random variates Z
1
, . . . , Z
d
from N(0, 1).
Set X = AZ.
Set U
k
= (X
k
) for k = 1, . . . , d.
U = (U
1
, . . . , U
d
) has distribution function C
Ga
R
.
As usual denotes the univariate standard normal distribution function.
Equation (10.3) provides an easy algorithm for random variate generation
from the tcopula, C
t
,R
.
Algorithm 10.2
Find the Cholesky decomposition A of R: R = AA
T
.
Simulate d independent random variates Z
1
, . . . , Z
d
from N(0, 1).
Simulate a random variate S from
2
independent of Z
1
, . . . , Z
d
.
Set Y = AZ.
Set X =
S
Y.
Set U
k
= t
(X
k
) for k = 1, . . . , d.
U = (U
1
, . . . , U
d
) has distribution function C
t
,R
.
72
10.5 Archimedean copulas
As we have seen, elliptical copulas are derived from distribution functions for
elliptical distributions using Sklars Theorem. Since simulation from elliptical
distributions is easy, so is simulation from elliptical copulas. There are how
ever drawbacks: elliptical copulas do not have closed form expressions and are
restricted to have radial symmetry. In many nance and insurance applica
tions it seems reasonable that there is a stronger dependence between big losses
(e.g. a stock market crash) than between big gains. Such asymmetries cannot
be modeled with elliptical copulas.
In this section we discuss an important class of copulas called Archimedean
copulas. This class of copulas is worth studying for a number of reasons. Many
interesting parametric families of copulas are Archimedean and the class of
Archimedean copulas allows for a great variety of dierent dependence struc
tures. Furthermore, in contrast to elliptical copulas, all commonly encountered
Archimedean copulas have closed form expressions. Unlike the copulas discussed
so far these copulas are not derived from multivariate distribution functions us
ing Sklars Theorem. A consequence of this is that we need somewhat technical
conditions to assert that multivariate extensions of bivariate Archimedean cop
ulas are indeed copulas. A further disadvantage is that multivariate extensions
of Archimedean copulas in general suer from lack of free parameter choice in
the sense that some of the entries in the resulting rank correlation matrix are
forced to be equal. We begin with a general denition of Archimedean copulas.
Proposition 10.10 Let be a continuous, strictly decreasing function from
[0, 1] to [0, ] such that (0) = and (1) = 0. Let C : [0, 1]
2
[0, 1] be given
by
C(u
1
, u
2
) =
1
((u
1
) +(u
2
)). (10.6)
Then C is a copula if and only if is convex.
Copulas of the form (10.6) are called Archimedean copulas. The function is
called a generator of the copula.
Example 10.9 Let (t) = (lnt)
(u
1
, u
2
) =
1
((u
1
) +(u
2
)) = exp([(lnu
1
)
+ (ln u
2
)
]
1/
).
Furthermore C
1
= ((u
1
, u
2
) = u
1
u
2
) and lim
= M (M(u
1
, u
2
) =
min(u
1
, u
2
)). This copula family is called the Gumbel family. As shown in
Example 10.7 this copula family has upper tail dependence.
Example 10.10 Let (t) = t
(u
1
, u
2
) =
_
(u
1
1) + (u
2
1) + 1
_
1/
. = (u
1
+u
2
1)
1/
. (10.7)
73
Moreover, lim
0
C
= and lim
(X
1
, X
2
) = 1 + 4
_
1
0
(t)
t
(t)
dt.
Example 10.11 Consider the Gumbel family with generator (t) = (lnt)
,
for 1. Then (t)/
t
(t) = (t lnt)/. Using Proposition 10.11 we can calculate
Kendalls tau for the Gumbel family.
() = 1+4
_
1
0
t lnt
dt = 1+
4
_
_
t
2
2
ln t
_
1
0
_
1
0
t
2
dt
_
= 1+
4
(01/4) = 1
1
.
As a consequence, in order to have Kendalls tau equal to 0.5 in Figure 25 (the
Gumbel case), we put = 2.
Example 10.12 Consider the Clayton family with generator (t) = t
1,
for > 0. Then (t)/
t
(t) = (t
+1
t)/. Using Proposition 10.11 we can
calculate Kendalls tau for the Clayton family.
() = 1 + 4
_
1
0
t
+1
t
dt = 1 +
4
_
1
+ 2
1
2
_
=
+ 2
.
1
((u
1
) + +(u
d
)),
is a copula for d 3. The following results address this question and show why
inverses of Laplace transforms are natural choices for generators of Archimedean
copulas.
Denition 10.5 A function g : [0, ) [0, ) is completely monotonic if it
is continuous and if for any t (0, ) and k = 0, 1, 2, . . . ,
(1)
k
_
d
k
ds
k
g(s)
_
s=t
0.
74
BMWSiemens
15 10 5 0 5 10

1
5

1
0

5
0
5
1
0
t2
15 10 5 0 5 10

1
5

1
0

5
0
5
1
0
Gaussian
15 10 5 0 5 10

1
5

1
0

5
0
5
1
0
Gumbel
15 10 5 0 5 10

1
5

1
0

5
0
5
1
0
Figure 25: The upper left plot shows BMWSiemens daily log returns from
1989 to 1996. The other plots show samples from bivariate distributions with
t
4
margins and Kendalls tau 0.5.
Proposition 10.12 Let : [0, 1] [0, ] be continuous and strictly decreasing
such that (0) = and (1) = 0. Then, for any d 2, the function C :
[0, 1]
d
[0, 1] given by
C(u) =
1
((u
1
) + +(u
d
))
is a copula if and only if
1
is completely monotonic on [0, ).
The following result tells us where to look for generators satisfying the conditions
of Proposition 10.12.
Lemma 10.1 A function : [0, ) [0, ) is the Laplace transform of a
distribution function G on [0, ) if and only if is completely monotonic and
(0) = 1.
Proposition 10.13 Let G be a distribution function on [0, ) with G(0) = 0
and Laplace transform
(s) =
_
0
e
sx
dG(x), s 0.
Consider a random variable X with distribution function G and a set of [0, 1]
valued random variables U
1
, . . . , U
d
which are conditionally independent given
75
X with conditional distribution function given by F
U
k
]X=x
(u) = exp(x
1
(u))
for u [0, 1]. Then
P(U
1
u
1
, . . . , U
d
u
d
) = (
1
(u
1
) + +
1
(u
d
)),
so that the distribution function of U is an Archimedean copula with generator
1
.
Proof.
P(U
1
u
1
, . . . , U
d
u
d
)
=
_
0
P(U
1
u
1
, . . . , U
d
u
d
[ X = x)dG(x)
=
_
0
P(U
1
u
1
[ X = x) . . . P(U
d
u
d
[ X = x)dG(x)
=
_
0
expx(
1
(u
1
) + +
1
(u
d
))dG(x)
= (
1
(u
1
) + +
1
(u
d
)).
(u) = (u
1
+ +u
d
d+1)
1/
. Let X Gamma(1/, 1), i.e. let
X be Gammadistributed with density function f
X
(x) = x
1/1
e
x
/(1/).
Then X has Laplace transform
E(e
sX
) =
_
0
e
sx
1
(1/)
x
1/1
e
x
dx = (s + 1)
1/
=
1
(s).
Hence, the following algorithm can be used for simulation from a Clayton copula.
Algorithm 10.4
Simulate a variate X Gamma(1/, 1).
Simulate independent standard uniform variates V
1
, . . . , V
d
.
If (s) = (s + 1)
1/
, then U = ((ln(V
1
)/X), . . . , (ln(V
d
)/X)) has
distribution function C
Cl
.
This approach can also be used for simulation from Gumbel copulas. How
ever, in this case X is a random variable with a nonstandard distribution
which is not available in most statistical software. However, one can simu
late from bivariate Gumbel copulas using a dierent method. Take 1 and
let F(x) = 1 F(x) = exp(x
1/
) for x 0. If (Z
1
, Z
2
) = (V S
, (1 V )S
)
where V and S are independent, V is standard uniformly distributed and S has
density h(s) = (11/ +(1/)s) exp(s), then (F(Z
1
), F(Z
2
)) has distribution
function C
Gu
, where
C
Gu
(u
1
, u
2
) = exp([(lnu
1
)
+ (lnu
2
)
]
1/
).
This leads to the following algorithm for simulation from bivariate Gumbel
copulas.
Algorithm 10.5
Simulate independent random variates V
1
, V
2
U(0, 1).
Simulate independent random variates W
1
, W
2
, where W
k
Gamma(k, 1).
Set S = 1
V
2
1/]
W
1
+ 1
V
2
>1/]
W
2
.
Set (Z
1
, Z
2
) = (V
1
S
, (1 V
1
)S
).
U = (exp(Z
1/
1
), exp(Z
1/
2
)) has distribution function C
Gu
.
77
10.7 Fitting copulas to data
We now turn to the problem of tting a parametric copula to data. Clearly,
rst one has to decide which parametric family to t. This is perhaps best done
by graphical means; if one sees clear signs of asymmetry in the dependence
structure as illustrated in Figure 24, then an Archimedean copula with this
kind of asymmetry might be a reasonable choice. Otherwise, see e.g. Figure 26,
one might go for an elliptical copula. It is also useful to check whether the data
shows signs of tail dependence, and depending on whether there are such signs
choose a copula with this property.
Gaussian
X1
Y
1
4 2 0 2 4

4

2
0
2
4
t
X2
Y
2
4 2 0 2 4

4

2
0
2
4
Figure 26: Samples from two distributions with standard normal margins, R
12
=
0.8 but dierent dependence structures. (X1, Y 1) has a Gaussian copula and
(X2, Y 2) has a t
2
copula.
We will consider the problem of estimating the parameter vector of a
copula C
(F
1
(x
1
), . . . , F
d
(x
d
)).
We have seen that for Gaussian, t, Gumbel and Clayton copulas there are
simple relations between Kendalls tau and certain copula parameters:
C
Ga
R
(u) =
d
R
(
1
(u
1
), . . . ,
1
(u
d
)), R
ij
= sin((
)
ij
/2),
C
t
R
(u) = t
d
,R
(t
1
(u
1
), . . . , t
1
(u
d
)), R
ij
= sin((
)
ij
/2),
C
Gu
(u) = exp([(lnu
1
)
+ + (lnu
d
)
]
1/
), = 1/(1 (
)
ij
),
C
Cl
(u) = (u
1
+ +u
d
d + 1)
1/
, = 2(
)
ij
/(1 (
)
ij
),
where (
)
ij
=
(X
k,i
, X
k,j
). Hence parameter estimates for the copulas above
are obtained by simply replacing (
)
ij
by its estimate (
)
ij
presented in Sec
tion 8.5.
78
10.8 Gaussian and tcopulas
For Gaussian and tcopulas of high dimensions, it might happen that
R, with
R
ij
= sin(
ij
/2), is not positive denite. If this is the case, then one has to
replace
R by a linear correlation matrix R
T
which will be symmetric and positive denite but not
necessarily a linear correlation matrix since its diagonal elements might dier
from one.
Set
R = D
R
k,k
.
After having estimated R (with
R possibly modied to assure positive denite
ness) it remains to estimate the degrees of freedom parameter. We construct a
pseudosample
U
1
, . . . ,
U
n
of observations from the copula by componentwise
transformation with the estimated marginal distribution functions
F
1
, . . . ,
F
d
as
follows.
U
k
= (
F
1
(X
k,1
), . . . ,
F
d
(X
k,d
)), k = 1, . . . , n.
Either
F
k
can be taken as a tted parametric distribution function or as a
version of empirical distribution function:
F
k
(x) =
F
()
k
(x) =
1
n +
n
j=1
1
X
j,k
x]
,
where (0, 1] which guarantees that the pseudosample data lies within the
unit cube, i.e. that
U
k
(0, 1)
d
. Given a pseudosample from the tcopula,
the degrees of freedom parameter can be estimated by maximum likelihood
estimation (MLE). A ML estimate of is obtained by maximizing
lnL(,
U
1
, . . . ,
U
n
) =
n
k=1
ln c
,
b
R
(
U
k
),
with respect to , where c
,R
denotes the density of a tcopula with as degrees
of freedom parameter. The loglikelihood function for the tcopula is given by
ln L(, R,
U
1
, . . . ,
U
n
)
=
n
k=1
lng
,R
(t
1
U
k,1
), . . . , t
1
U
k,d
))
n
k=1
d
j=1
lng
(t
1
U
k,j
)),
79
where g
,R
denotes the joint density of a standard tdistribution with distri
bution function t
d
,R
and g
i=1
X
i
LGD
i
=
n
i=1
X
i
(1
i
)L
i
.
81
An important issue in quantitative credit risk management is to understand the
distribution of the random variable L. Given that we know the size L
i
of each
loan we need to model the multivariate random vector (X
1
, . . . , X
n
,
1
, . . . ,
n
)
in order to derive the loss distribution of L. Most commercial models in use
today assume the recovery rates
i
to be independent of X = (X
1
, . . . , X
n
)
and independent of each other. This leaves essentially the joint distribution of
default indicators X to be modeled.
The most simple model we may think of is when all loan sizes are equal
L
i
= L
1
, all recovery rates are deterministic and equal
i
=
1
and all default
indicators X
i
are iid with default probability p. Then the loss is given by
L = LGD
1
N, where N =
n
i=1
X
i
is Binomial(n, p)distributed. Below we will
study some more sophisticated models for the default indicators X.
11.2 Latent variable models
Since it is practically impossible to obtain historical observations of the default
indicator X
i
for a given obligor i (it is rather unusual that the rm has defaulted
many times before) it is a good idea to divide all obligors into m homogeneous
groups. Within each group all obligors (rms) have the same default probability.
Estimation of default probabilities can then be based upon how many obligors
that have defaulted within each group, leading to larger sample sizes. To this
end we may introduce a state variable S = (S
1
, . . . , S
n
), where S
i
represents
the state of the obligor i. We suppose that the state is an integer in the set
0, . . . , m with S
i
= 0 indicating that obligor i is in the default state. The
other states may be thought of as the obligor being in dierent rating classes.
We let X
i
denote the default indicator of obligor i, i.e.
X
i
=
_
0 if S
i
,= 0,
1 if S
i
= 0.
The vector X = (X
1
, . . . , X
n
) is the vector of default indicators and the default
probability is p
i
= P(X
i
= 1).
Often the state variables S = (S
1
, . . . , S
n
) are modeled using a vector of so
called latent variables Y = (Y
1
, . . . , Y
n
); Y
i
representing for instance the value
of the assets, or asset returns, of obligor i. Typically we have a number of
thresholds d
ij
, i = 1, . . . , n, j = 0, . . . , m+1, with d
i0
= and d
i(m+1)
= .
The state of S
i
is then given through Y
i
by
S
i
= j if Y
i
(d
ij
, d
i(j+1)
].
Let F
i
denote the distribution of Y
i
. Default occurs if Y
i
d
i1
and hence the
default probability is given by p
i
= F
i
(d
i1
). The probability that the rst k
obligors, say, default is then given by (the F
i
s are assumed to be continuous)
p
1...k
= P(Y
1
d
11
, . . . , Y
k
d
k1
)
= C(F
1
(d
11
), . . . , F
k
(d
k1
), 1, . . . , 1)
= C(p
1
, . . . , p
k
, 1, . . . , 1),
82
where C denotes the copula of Y. As the marginal default probabilities F
i
(d
i1
)
are small, the joint default probability will depend heavily on the choice of
copula C.
Example 11.1 Consider a loan portfolio with n = 100 obligors where the credit
risk is modeled using a latent variable model with copula C. Suppose that C is
an exchangeable copula, i.e. that
C(u
1
, . . . , u
n
) = C(u
(1)
, . . . , u
(n)
),
where is an arbitrary permutation of 1, . . . , n. Suppose further that the
individual default probability of each obligor is equal to p = 0.15, i.e. p
i
=
p = 0.15. Let N denote the number of defaults and let
(Y
i
, Y
j
) = , i ,= j
denote Kendalls tau between any two latent variables (which are assumed to
have continuous distribution functions). We assume that = 0 and we simulate
the number of defaults 10
5
times and illustrate the distribution of the number
of defaults in a histogram when
(a) C is a Gaussian copula and (b) C is a t
4
copula. The histograms are shown
in Figure 27. One clearly sees that zero correlation is far from independence if
the dependence structure is nonGaussian.
11.3 Mixture models
The random vector X = (X
1
, . . . , X
n
) follows a Bernoulli mixture model if
there is a random vector Z = (Z
1
, . . . , Z
m
), m < n, and functions f
i
: R
m
i=1
f
i
(Z)
x
i
(1 f
i
(Z))
1x
i
.
The unconditional distribution is then given by
P(X = x) = E(P(X = x [ Z)) = E
_
n
i=1
f
i
(Z)
x
i
(1 f
i
(Z))
1x
i
_
.
If all the functions f
i
are equal, f
i
= f, then, conditional on Z, the number of
defaults N =
m
i=1
X
i
is Bin(n, f(Z))distributed.
The random vector X = (X
1
, . . . , X
n
) follows a Poisson mixture model
if there is a random vector Z = (Z
1
, . . . , Z
m
), m < n, and functions
i
: R
m
i
(Z)
, x
i
N.
83
Histogram of ga0defaults
ga0defaults
F
r
e
q
u
e
n
c
y
5 10 15 20 25 30
0
2
0
0
0
4
0
0
0
6
0
0
0
8
0
0
0
1
0
0
0
0
Histogram of t0defaults
t0defaults
F
r
e
q
u
e
n
c
y
0 10 20 30 40 50 60
0
1
0
0
0
2
0
0
0
3
0
0
0
4
0
0
0
Figure 27: Histograms of the number of defaults: (a) Gaussian copula (upper)
and (b) t
4
copula (lower).
84
For x = (x
1
, . . . , x
n
) N
n
we then have
P(X = x [ Z) =
n
i=1
i
(Z)
x
i
x
i
!
e
i
(Z)
.
The unconditional distribution is then given by
P(X = x) = E(P(X = x [ Z)) = E
_
n
i=1
i
(Z)
x
i
x
i
!
e
i
(Z)
_
.
The use of Poisson mixture models for modeling defaults can be motivated as
follows. Suppose that
X = (
X
1
, . . . ,
X
n
) follows a Poisson mixture model with
factors Z. Put X
i
= I
[1,)
(
X
i
). Then X = (X
1
, . . . , X
n
) follows a Bernoulli
mixture model with
f
i
(Z) = 1 e
i
(Z)
.
If the Poisson parameters
i
(Z) are small then
N =
n
i=1
X
i
is approximately
equal to the number of defaulting obligors and conditional on Z,
N is Poisson()
distributed with (Z) =
n
i=1
i
(Z).
Example 11.2 A bank has a loan portfolio of 100 loans. Let X
k
be the default
indicator for loan k such that X
k
= 1 in case of default and 0 otherwise. The
total number of defaults is N = X
1
+ +X
100
.
(a) Suppose that X
1
, . . . , X
100
are independent and identically distributed with
P(X
1
= 1) = 0.01. Compute E(N) and P(N = k) for k 0, . . . , 100.
(b) Consider the risk factor Z which reects the state of the economy. Suppose
that conditional on Z, the default indicators are independent and identically
distributed with P(X
1
= 1 [ Z) = Z, where
P(Z = 0.01) = 0.9 and P(Z = 0.11) = 0.1.
Compute E(N).
(c) Consider the risk factor Z which reects the state of the economy. Suppose
that conditional on Z, the default indicators are independent and identically
distributed with
P(X
1
= 1 [ Z) = Z
9
,
where Z is uniformly distributed on (0, 1). Compute E(N).
Solution (a): We have N Binomial(100, 0.01). Hence, E(N) = 100 0.01 = 1
and
P(N = k) =
_
100
k
_
0.01
k
0.99
100k
.
85
Solution (b): We have N [ Z Binomial(100, Z). Hence,
E(N) = E(E(N [ Z)) = E(100Z) = 100 E(Z)
= 100(0.01 0.9 + 0.11 0.1) = 0.9 + 1.1 = 2.
Solution (c): We have N [ Z Binomial(100, Z
9
). Hence,
E(N) = E(E(N [ Z)) = E(100Z
9
) = 100 E(Z
9
)
= 100 0.1 = 10.
f(z)
k
(1 f(z))
nk
G(dz)
and the number of defaulting obligors N has unconditional distribution
P(N = k) =
_
n
k
__
f(z)
k
(1 f(z))
nk
G(dz).
Notice also that
Cov(X
i
, X
j
) = E(X
i
X
j
) E(X
i
) E(X
j
)
= E(E(X
i
X
j
[ Z)) E(E(X
i
[ Z)) E(E(X
j
[ Z))
= E(f(Z)
2
) E(f(Z))
2
= var(f(Z)).
We have N = E(N [ Z) +N E(N [ Z) and
E(N) = E(E(N [ Z)) = nE(f(Z)) = np
1
,
var(N) = E(var(N [ Z)) + var(E(N [ Z))
= E(nf(Z)(1 f(Z))) + var(nf(Z))
= nE(f(Z)(1 f(Z))) +n
2
var(f(Z)).
86
Notice that by Markovs inequality
P([N/n f(Z)[ > [ Z)
var(N/n [ Z)
2
=
f(Z)(1 f(Z))
n
2
.
Hence, for every > 0,
P([N/n f(Z)[ > ) = E(P([N/n f(Z)[ > [ Z))
E(f(Z)(1 f(Z)))
n
2
Hence, N/n
P
f(Z) as n which justies the approximation N/n f(Z)
for n large. (In fact it hold that N/n f(Z) a.s. as n .)
11.5 Probit normal mixture models
In several portfolio credit risk models (see the section about the KMV model
below) the default indicators X
i
, i = 1, . . . , n, have the representation X
i
= 1
if and only if
Z +
1 W
i
d
i1
, where [0, 1] and Z, W
1
, . . . , W
n
are iid and standard normally distributed. Assuming equal individual default
probabilities p = P(X
i
= 1) we have d
i1
=
1
(p) and hence
X
i
= I
(,
1
(p)]
(
Z +
_
1 W
i
).
This gives
f(Z) = P(X
i
= 1 [ Z) = P(
Z +
_
1 W
i
1
(p) [ Z)
=
_
1
(p)
1
+
1
_
.
This leads to
VaR
q
(f(Z)) =
_
1
(q) +
1
1
(p)
_
.
Setting q = 0.999 and using the approximation N/n f(Z) motivated above,
we arrive at the Basel formula for capital requirement as a fraction of the
total exposure for a homogeneous portfolio with individual default probabilities
p:
Capital requirement = c
1
c
2
_
1
(0.999) +
1
1
(p)
_
p
_
,
where c
1
is the fraction of the exposure lost in case of default and c
2
is a constant
for maturity adjustments. The asset return correlation coecient is assigned
a value that depends on the asset type and also the size and default probability
of the borrowers.
87
11.6 Beta mixture models
For the Beta mixing distribution we assume that Z Beta(a, b) and f(z) = z.
It has density
g(z) =
1
(a, b)
z
a1
(1 z)
b1
, a, b > 0, z (0, 1),
where
(a, b) =
_
1
0
z
a1
(1 z)
b1
dz =
(a)(b)
(a +b)
and hence, using that (z + 1) = z(z),
E(Z) =
1
(a, b)
_
1
0
z
a
(1 z)
b1
dz =
(a + 1, b)
(a, b)
=
(a + 1)(b)
(a +b + 1)
(a +b)
(a)(b)
=
a
a +b
,
E(Z
2
) =
a(a + 1)
(a +b)(a +b + 1)
.
We immediately get that the number of defaults N has distribution
P(N = k) =
_
n
k
__
1
0
z
k
(1 z)
nk
g(z)dz
=
_
n
k
_
1
(a, b)
_
1
0
z
a+k1
(1 z)
nk+b1
dz
=
_
n
k
_
(a +k, b +n k)
(a, b)
,
which is called the betabinomial distribution. This probability function is il
lustrated in Figure 28. The expected number of defaults is easily computed.
E(N) = E(E(N [ Z)) = nE(E(X
1
[ Z)) = nE(Z) = n
a
a +b
.
If we have estimated the default probabilities P(X
i
= 1) and P(X
i
= X
j
= 1),
i ,= j, then the parameters a and b can be determined from the relations
P(X
i
= 1) = E(Z) =
a
a +b
, P(X
i
= X
j
= 1) = E(Z
2
) =
a(a + 1)
(a +b)(a +b + 1)
.
Example 11.3 Notice that if we only specify the individual default probability
p = P(X
i
= 1), then we know very little about the model. For example,
p = 0.01 = a/(a + b) for (a, b) = (0.01, 0.99), (0.1, 9.9), (1, 99), but the dierent
choices of (a, b) leads to quite dierent models. This is shown in the table below
which considers a portfolio with n = 1000 obligors.
88
0 20 40 60 80 100
0
.
0
0
0
.
0
2
0
.
0
4
0
.
0
6
0
.
0
8
0
.
1
0
0
.
1
2
0
.
1
4
number of defaults
p
r
o
b
0 20 40 60 80 100
0
.
0
0
0
.
0
1
0
.
0
2
0
.
0
3
0
.
0
4
0
.
0
5
0
.
0
6
0
.
0
7
number of defaults
p
r
o
b
Figure 28: The probability function for the number of defaults in a Beta mixture
model with n = 100 obligors and a = 0.5, b = 10 (left), a = 2, b = 20 (right).
(a, b) p corr(X
i
, X
j
) VaR
0.99[9]
(N) VaR
0.99[9]
(nZ)
(1,99) 0.01 0.01 47 [70] 45 [67]
(0.1,9.9) 0.01 0.09 155 [300] 155 [299]
(0.01,0.99) 0.01 0.5 371 [908] 371 [908]
Notice also how accurate the approximation N nZ is!
89
12 Popular portfolio credit risk models
In this chapter we will present the commercial models currently used by prac
titioners such as the KMV model and CreditRisk
+
. Interesting comparisons of
these models are given in [6] and [10].
12.1 The KMV model
A popular commercial model for credit risk is the socalled KMV model provided
by Moodys KMV (www.moodyskmv.com). It is an example of a latent variable
model where the state variables S = (S
1
, . . . , S
n
) can only have two states
(m = 1). The latent variables Y = (Y
1
, . . . , Y
n
) are related to the value of the
assets of each rm in the following way.
The Merton model
It is assumed that the balance sheet of each rm consist of assets and liabilities.
The liabilities are divided into debt and equity. The value of the assets of the
ith rm at time T is denoted by V
A,i
(T), the value of the debt by K
i
and the
value of the equity of the rm at time T by V
E,i
(T). It is assumed that the
future asset value is modeled by a geometric Brownian motion
V
A,i
(T) = V
A,i
(t) exp
__
A,i
2
A,i
2
_
(T t) +
A,i
_
W
i
(T) W
i
(t)
__
(12.1)
where
A,i
is the drift,
A,i
the volatility and (W
i
(t); 0 t T) a Brownian
motion. In particular this means that W
i
(T) W
i
(t) N(0, T t) and hence
that ln V
A,i
(T) is normal with mean ln V
A,i
(t) + (
A,i
2
A,i
/2)(T t) and
variance
2
A,i
(T t). The rm defaults if at time T the value of the assets are
less than the value of the debt. That is, the default indicator X
i
is given by
X
i
= I
(,K
i
)
(V
A,i
(T)).
Writing
Y
i
=
W
i
(T) W
i
(t)
T t
we get Y
i
N(0, 1) and
X
i
= I
(,K
i
)
(V
A,i
(T)) = I
(,DD
i
)
(Y
i
)
with
DD
i
=
lnK
i
ln V
A,i
(t) + (
2
A,i
/2
A,i
)(T t)
A,i
T t
.
The quantity DD
i
is called the distancetodefault. In principle the default
probability can then be computed as P(V
A,i
(T) < K
i
) = P(Y
i
< DD
i
). Hence,
in the general setup of a two state latent variable model we have Y
i
N(0, 1)
and default thresholds d
i1
= DD
i
.
90
Computing the distancetodefault
To compute the distancetodefault we need to nd V
A,i
(t),
A,i
and
A,i
. A
problem here is that the value of the rms assets V
A,i
(t) can not be observed
directly. However, the value of the rms equity can be observed by looking
at the market stock prices. KMV therefore takes the following viewpoint: the
equity holders have the right but not the obligation, at time T, to pay o the
holders of the other liabilities and take over the remaining assets of the rm.
That is, the debt holders own the rm until the debt is paid o in full by the
equity holders. This can be viewed as a call option on the rms assets with a
strike price equal to the debt. That is, at time T we have the relation
V
E,i
(T) = max(V
A,i
(T) K
i
, 0).
The value of equity at time t, V
E,i
(t), can then be thought of as the price of a
call option with the value of assets as underlying and strike price K
i
. Under
some simplifying assumptions the price of such an option can be computed using
the BlackScholes option pricing formula. This gives
V
E,i
(t) = C(V
A,i
(t),
A,i
, r),
where
C(V
A,i
(t),
A,i
, r) = V
A,i
(t)(e
1
) K
i
e
r(Tt)
(e
2
),
e
1
=
ln V
A,i
(t) ln K
i
+ (r +
2
A,i
/2)(T t)
A,i
T t
e
2
= e
1
A,i
T t,
is the distribution function of the standard normal and r is the risk free inter
est rate (investors use e.g. the interest rate on a threemonth U.S. Treasury bill
as a proxy for the riskfree rate, since shortterm governmentissued securities
have virtually zero risk of default). KMV also introduces a relation between the
volatility
E,i
of V
E,i
and the volatility
A,i
of V
A,i
by
E,i
= g(V
A,i
(t),
A,i
, r),
where g is some function. Using observed/estimated values of V
E,i
(t) and
E,i
the relation
V
E,i
(t) = C(V
A,i
(t),
A,i
, r)
E,i
= g(V
A,i
(t),
A,i
, r)
is inverted to obtain V
A,i
(t) and
A,i
which enables computation of the distance
todefault DD
i
.
The expected default frequency
To nd the default probability corresponding to the distancetodefault DD
i
KMV do not actually use the probability P(Y
i
< DD
i
). Instead they use
91
historical data to search for all companies which at some stage in their history
had approximately the same distancetodefault. Then the observed default
frequency is converted into an actual probability. In the terminology of KMV
this estimated default probability p
i
is called Expected Default Frequency (EDF).
To summarize: In order to compute the probability of default with the KMV
model the following steps are required:
(i) Estimate asset value and volatility. The asset value and asset volatility of
the rm is estimated from the market value and volatility of equity and
the book of liabilities.
(ii) Calculate the distancetodefault.
(iii) Calculate the default probability using the empirical distribution relating
distancetodefault to a default probability.
The multivariate KMV model
In the Merton model above we did not introduce any dependence between the
value of the assets for dierent rms. We only considered each rm separately.
To compute joint default probabilities and the distribution of the total credit
loss it is natural to introduce dependence between the default indicators by
making the asset value processes V
A,i
dependent. The following methodology
is used by KMV. Let (W
j
(t) : 0 t T, j = 1, . . . , m) be m independent
standard Brownian motions. The evolution (12.1) of asset i is then replaced by
V
A,i
(T) = V
A,i
(t) exp
__
A,i
2
A,i
2
_
(T t) +
m
j=1
A,i,j
_
W
j
(T) W
j
(t)
__
,
where
2
A,i
=
m
j=1
2
A,i,j
.
Here,
A,i,j
gives the magnitude of which asset i is inuenced by the jth Brow
nian motion. The event V
A,i
(T) < K
i
that company i defaults is equivalent
to
m
j=1
A,i,j
(W
j
(T) W
j
(t)) < lnK
i
lnV
A,i
(t) +
_
2
A,i
2
A,i
_
(T t).
If we let
Y
i
=
m
j=1
A,i,j
(W
j
(T) W
j
(t))
A,i
T t
,
then Y = (Y
1
, . . . , Y
n
) N
n
(0, ) with
ij
=
m
k=1
A,i,k
A,j,k
A,i
A,j
92
and the above inequality can be written as
Y
i
<
lnK
i
ln V
A,i
(t) +
_
2
A,i
2
A,i
_
(T t)
A,i
T t
. .
DD
i
.
Hence, in the language of a general latent variable model the probability that
the rst k rms default is given by
P(X
1
= 1, . . . , X
k
= 1) = P(Y
1
< DD
1
, . . . , Y
k
< DD
k
)
= C
Ga
((DD
1
), . . . , (DD
k
), 1 . . . , 1),
where C
Ga
(EDF
1
, . . . , EDF
k
, 1 . . . , 1),
as the default probability of the rst k rms.
Estimating the correlations
Estimating the correlations of the latent variables in Y is not particularly easy
as the dimension n is typically very large and there is limited available histor
ical data. Moreover, estimating pairwise correlations will rarely give a positive
denite correlation matrix if the dimension is large. A way around these prob
lems is to use a factor model where the asset value, or more precisely the latent
variables Y is divided into k key factors and one rm specic factor. The key
factors are typically macroeconomic factors such as
Global economic eects
Regional economic eects
Sector eects
Country specic eects
Industry specic eects
If we write
Y
i
d
=
k
j=1
a
ij
Z
j
+b
i
U
i
, i = 1, . . . , n,
where Z = (Z
1
, . . . , Z
k
) N
k
(0, ) is independent of U = (U
1
, . . . , U
n
)
N
n
(0, I). then the covariance matrix of the right hand side is given by AA
T
+D
where A
ij
= a
ij
and D is a diagonal (n n) matrix with entries D
ii
= b
2
i
.
93
12.2 CreditRisk
+
a Poisson mixture model
This material presented here on the CreditRisk
+
model is based on [6], [10] and
[4].
CreditRisk+ is a commercial model for credit risk developed by Credit Suisse
First Boston and is an example of a Poisson mixture model. The risk factors
Z
1
, . . . , Z
m
are assumed to be independent Z
j
Gamma(
j
,
j
) and we have
i
(Z) =
i
m
j=1
a
ij
Z
j
,
m
j=1
a
ij
= 1, a
ij
0.
for i = 1, . . . , n. Here
i
> 0 are constants. The density of Z
j
is given by
f
j
(z) =
z
j
1
expz/
j
j
j
(
j
)
.
The parameters
j
,
j
are chosen so that
j
j
= 1 and then E(Z
j
) = 1 and
E(
i
(Z)) =
i
. Notice that the expected number of defaults, E(N), is given by
E(N) = E(E(N [ Z)) =
n
i=1
E(E(X
i
[ Z))
=
n
i=1
E(
i
(Z)) =
n
i=1
i
m
j=1
a
ij
E(Z
j
) =
n
i=1
i
.
The lossgivendefault LGD
i
of obligor i is modeled as a constant fraction 1
i
of the loan size L
i
,
LGD
i
= (1
i
)L
i
, i = 1, . . . , n.
Here
i
is the (deterministic) expected recovery rate. Each loss amount is then
expressed as an integer multiple v
i
of a xed base unit of loss (e.g. one million
dollars) denoted L
0
. Then we have
LGD
i
= (1
i
)L
i
_
(1
i
)L
i
L
0
_
L
0
= v
i
L
0
, i = 1, . . . , n,
where [x] denotes the nearest integer of x (x [x] (1/2, 1/2]). In this way
every LGD
i
can be expressed as a xed integer multiple v
i
of a predened base
unit of loss L
0
. The main idea here is to approximate the total loss distribution
by a discrete distribution. For this discrete distribution it is possible to compute
its probability generating function (pgf) g.
Recall the denition of the pgf for a discrete random variable Y with values
in y
1
, . . . , y
m
,
g
Y
(t) = E(t
Y
) =
m
i=1
t
y
i
P(Y = y
i
)
Recall the following formulas for probability generating functions.
94
(i) If Y Bernoulli(p) then g
Y
(t) = 1 +p(t 1).
(ii) If Y Poisson() then g
Y
(t) = exp(t 1).
(iii) If X
1
, . . . , X
n
are independent random variables then
g
X
1
++X
n
(t) =
n
i=1
g
X
i
(t).
(iv) Let Y have density f and let g
X]Y =y
(t) be the pgf of X[Y = y. Then
g
X
(t) =
_
g
X]Y =y
(t)f(y)dy.
(v) If X has pgf g
X
(t) then
P(X = k) =
1
k!
g
(k)
(0), with g
(k)
(t) =
d
k
g(t)
dt
k
.
The pgf of the loss distribution
Let us derive the pgf of the loss distribution
L =
n
i=1
X
i
v
i
L
0
.
First we determine the conditional pgf of the number of defaults N = X
1
+ +
X
n
given Z = (Z
1
, . . . , Z
m
). Given Z the default intensities
1
(Z), . . . ,
n
(Z)
are known so conditional on Z the default indicators are independent and
Poisson(
i
(Z))distributed. Hence
g
X
i
]Z
(t) = exp
i
(Z)(t 1), i = 1, . . . , n.
For N we now obtain
g
N]Z
(t) =
n
i=1
g
X
i
]Z
=
n
i=1
exp
i
(Z)(t 1) = exp(t 1),
=
n
i=1
i
(Z).
95
Next we use (iv) to derive the unconditional distribution of the number of de
faults N.
g
N
(t) =
_
0
_
0
g
N]Z=(z
1
,...,z
m
)
(t)f
1
(z
1
) f
m
(z
m
)dz
1
dz
m
=
_
0
_
0
exp
_
(t 1)
n
i=1
_
i
m
j=1
a
ij
z
j
_
_
f
1
(z
1
) f
m
(z
m
)dz
1
dz
m
=
_
0
_
0
exp
_
(t 1)
m
j=1
_
n
i=1
i
a
ij
. .
j
_
z
j
_
f
1
(z
1
) f
m
(z
m
)dz
1
dz
m
=
_
0
_
0
exp(t 1)
1
z
1
f
1
(z
1
)dz
1
exp(t 1)
m
z
m
f
m
(z
m
)dz
m
=
m
j=1
_
0
expz
j
(t 1)
1
j
j
(
j
)
z
j
1
expz/
j
dz.
Each of the integrals in the product can be computed as
_
0
1
j
j
expz
j
(t 1)z
j
1
expz/
j
dz
=
1
j
j
(
j
)
_
0
z
j
1
expz(
1
j
j
(t 1)dz
=
_
u = z(
1
j
j
(t 1))
_
=
(
j
)
j
j
(
j
)(
1
j
j
(t 1))
j
_
0
1
(
j
)
u
j
1
expudu
=
1
(1 +
j
j
(t 1))
j
=
_
1
j
1
j
t
_
j
,
where
j
=
j
j
/(1 +
j
j
). Finally we obtain
g
N
(t) =
m
j=1
_
1
j
1
j
t
_
j
. (12.2)
Similar computations will lead us to the pgf of the loss distribution. Conditional
on Z the loss of obligor i is given by
L
i
[Z = v
i
(X
i
[Z)
Since the variables X
i
[Z, i = 1, . . . , n, are independent so are the variables L
i
[Z,
i = 1, . . . , n. The pgf of L
i
[Z is
g
L
i
]Z
(t) = E(t
L
i
[Z) = E(t
v
i
X
i
[Z) = g
X
i
]Z
(t
v
i
).
96
Hence, the pgf of the total loss conditional on Z is
g
L]Z
(t) = g
L
1
++L
n
]Z
(t) =
n
i=1
g
L
i
]Z
(t) =
n
i=1
g
X
i
]Z
(t
v
i
)
= exp
_
m
j=1
Z
j
_
n
i=1
i
a
ij
(t
v
i
1)
_
_
.
Similar to the previous computation we obtain
g
L
(t) =
m
j=1
_
1
j
1
j
j
(t)
_
j
,
j
(t) =
1
j
n
i=1
i
a
ij
t
v
i
with
j
and
j
as above. The loss distribution is then obtained by inverting the
pgf. In particular, the pgf g
L
(t) uniquely determines the loss distribution.
Example 12.1 Consider a portfolio that consists of n = 100 obligors. Recall
the probability generating function (12.2) for the number of defaults N in the
CreditRisk
+
model. In order to compute the probabilities P(N = k), k 0, we
need to compute the derivatives
g
(k)
N
(0) =
d
k
g
N
dt
k
(0).
It can be shown that g
(k)
N
(0) satises the recursion formula
g
(k)
N
(0) =
k1
l=0
_
k 1
l
_
g
(k1l)
N
(0)
m
j=1
l!
j
l+1
j
, k 1
(show this!) Assume that
i
= = 0.15,
j
= = 1,
j
= = 1, a
ij
=
a = 1/m. To better understand the model we plot the function P(N = k) for
k = 0, . . . , 100 when m = 1 and when m = 5. The result is shown in Figure 29.
One can interpret the plot as follows. With only one risk factor, m = 1,
to which all default indicators are linked, we either have many default or we
have few defaults. Having approximately E(N) = 15 defaults is unlikely. With
m = 5 independent risk factors there is a diversication eect. In this case it is
most likely that we have approximately E(N) = 15 defaults.
97
0 20 40 60 80 100
0
.
0
0
0
.
0
1
0
.
0
2
0
.
0
3
0
.
0
4
0
.
0
5
0
.
0
6
0
.
0
7
k
P
(
N
=
k
)
0 20 40 60 80 100
0
.
0
0
0
.
0
1
0
.
0
2
0
.
0
3
0
.
0
4
0
.
0
5
0
.
0
6
0
.
0
7
k
P
(
N
=
k
)
Figure 29: P(N = k) for k = 0, . . . , 100 for m = 1 and m = 5. For m = 1 the
probability P(N = k) is decreasing in k, for m = 5 the probability P(N = k)
rst increasing in k and then decreasing.
References
[1] Artzner, P., Delbaen, F., Eber, J.M., Heath, D. (1999) Coherent Measures
of Risk, Mathematical Finance 9, 203228.
[2] Basel Committee on Banking Supervision (1988) International Convergence
of Capital Measurement and Capital Standards. Available at
http://www.bis.org/publ/bcbs04A.pdf.
[3] Campbell, J.Y., Lo, A.W. and MacKinlay, A. (1997) The Econometrics of
Financial Markets, Princeton University Press, Princeton.
[4] Credit Suisse First Boston (1997) CreditRisk
+
: a Credit Management
Framework. Available at
http://www.csfb.com/institutional/research/assets/creditrisk.pdf
[5] Crosbie, P. and Bohn, J. (2001) Modelling Default Risk. K.M.V. Corpora
tion. Available at
http://www.moodyskmv.com/research/whitepaper/Modeling Default Risk.pdf.
[6] Crouhy, M., Galai, D. and Mark, R. (2000) A comparative analysis of
current credit risk models, Journal of Banking & Finance 24, 59117.
[7] Embrechts, P., McNeil, A. and Straumann, D. (2002) Correlation and de
pendence in risk management: properties and pitfalls. In: Risk manage
ment: value at risk and beyond, edited by Dempster M, published by Cam
bridge University Press, Cambridge.
[8] Embrechts, P., Kl uppelberg, C. and Mikosch, T. (1997) Modelling Extremal
Events for Insurance and Finance, Springer Verlag, Berlin.
[9] Fang, K.T., Kotz, S. and Ng, K.W. (1987) Symmetric Multivariate and
Related Distributions, Chapman & Hall, London.
[10] Gordy, M.B. (2000) A comparative anatomy of credit risk models, Journal
of Banking & Finance 24, 119149.
[11] Gut, A. (1995) An Intermediate Course in Probability, Springer Verlag,
New York.
[12] McNeil, A., Frey, R., Embrechts, P. (2005) Quantitative Risk Management:
Concepts, Techniques, and Tools, Princton University Press.
[13] Nelsen, R.B. (1999) An Introduction to Copulas, Springer Verlag, New
York.
99
A A few probability facts
A.1 Convergence concepts
Let X and Y be random variables (or vectors) with distribution functions F
X
and F
Y
. We say that X = Y almost surely (a.s.) if P( : X() =
Y ()) = 1. We say that they are equal in distribution, written X
d
= Y , if
F
X
= F
Y
. Notice that X = Y a.s. implies X
d
= Y . However, taking X to be
standard normally distributed and Y = X we see that the converse is false.
Let X, X
1
, X
2
, . . . be a sequence of random variables. We say that X
n
converges to X almost surely, X
n
X a.s., if
P( : X
n
() X()) = 1.
We say that X
n
converges to X in probability, X
n
P
X, if for all > 0 it holds
that
P([X
n
X[ > ) 0.
We say that X
n
converges to X in distribution, X
n
d
X, if for all continuity
points x of F
X
it holds that
F
X
n
(x) F
X
(x).
The following implications between the convergence concepts hold:
X
n
X a.s. X
n
P
X X
n
d
X.
A.2 Limit theorems and inequalities
Let X
1
, X
2
, . . . be iid random variables with nite mean E(X
1
) = , and let
S
n
= X
1
+ +X
n
. The (strong) law of large numbers says that
S
n
/n a.s. as n .
If furthermore var(X
1
) =
2
(0, ), then the central limit theorem says that
(S
n
n)/(
n)
d
Z as n ,
where the random variable Z has a standard normal distribution.
For a nonnegative random variable V with E(V
r
) < Markovs inequality
says that
P(V > )
E(V
r
)
r
for every > 0.
For a random variable X with nite variance var(X) this leads to
P([X E(X)[ > )
E[(X E(X))
2
]
2
=
var(X)
2
for every > 0.
This inequality is called Chebyshevs inequality.
100
B Conditional expectations
Suppose that one holds a portfolio or nancial contract and let X be the payo
(or loss) one year from today. Let Z be a random variable which represents some
information about the state of the economy or relevant interest rate during the
next year. We think of Z as a future (and hence unknown) economic scenario
which takes values in a set of all possible scenarios. The conditional expectation
of X given Z, E(X [ Z), represents the best guess of the payo X given the
scenario Z. Notice that Z is unknown today and that E(X [ Z) is a function of
the future random scenario Z and hence a random variable. If we knew Z then
we would also know g(Z) for any given function g. Therefore the property
g(Z) E(X [ Z) = E(g(Z)X [ Z)
seems natural (whenever the expectations exist nitely). If there were only a
nite set of possible scenarios z
k
, i.e. values that Z may take, then it is clear
that the expected payo E(X) may be computed by computing the expected
payo for each scenario z
k
and then obtain E(X) as the weighted sum of these
values with the weights P(Z = z
k
). Therefore the property
E(X) = E(E(X [ Z))
seems natural.
B.1 Denition and properties
If X is a random variable with E(X
2
) < , then the conditional expectation
E(X [ Z) is most naturally dened geometrically as an orthogonal projection of
X onto a subspace.
Let L
2
be the space of random variables X with E(X
2
) < . Let Z be a
random variable and let L
2
(Z) be the space of random variables Y = g(Z) for
some function g such that E(Y
2
) < . Notice that the expected value E(X)
is the number that minimizes the expression E((X )
2
). The conditional
expectation E(X [ Z) can be dened similarly.
Denition For X L
2
, the conditional expectation E(X [ Z) is the random
variable Y L
2
(Z) that minimizes E((X Y )
2
).
We say that X, Y L
2
are orthogonal if E(XY ) = 0. Then E(X [ Z) is
the orthogonal projection of X onto L
2
(Z), i.e. the point in the subspace L
2
(Z)
that is closest to X. Moreover, X E(X [ Z) is orthogonal to all Y L
2
(Z),
i.e. E(Y (X E(X [ Z))) = 0 for all Y L
2
(Z). Equivalently, by linearity of
the ordinary expectation,
E(Y E(X [ Z)) = E(Y X) for all Y L
2
(Z). (B.1)
This relation implies the following three properties:
101
(i) If X L
2
, then E(E(X [ Z)) = E(X).
(ii) If Y L
2
(Z), then Y E(X [ Z) = E(Y X [ Z).
(iii) If X L
2
and we set var(X [ Z) = E(X
2
[ Z) E(X [ Z)
2
, then
var(X) = E(var(X [ Z)) + var(E(X [ Z)).
This can be shown as follows:
(i) Choosing Y = 1 in (B.1) yields E(E(X [ Z)) = E(X).
(ii) With Y replaced by
Y Y (with
Y L
2
(Z)), (B.1) says that E(
Y Y X) =
E(
Y Y X) = E(
Y Y E(X [ Z)) = E(