Copula statistics

In statistics, a copula is used as a general way of formulating a multivariate

distribution in such a way that various general types of dependence can be
represented.[1] The approach to formulating a multivariate distribution using a
copula is based on the idea that a simple transformation can be made of
each marginal variable in such a way that each transformed marginal variable
has a uniform distribution. Once this is done, the dependence structure can be
expressed as a multivariate distribution on the obtained uniforms, and a copula is
precisely a multivariate distribution on marginally uniform random variables.
When applied in a practical context, the above transformations might be fitted as
an initial step for each marginal distribution, or the parameters of the
transformations might be fitted jointly with those of the copula.

There are many families of copulas which differ in the detail of the dependence
they represent. A family will typically have several parameters which relate to the
strength and form of the dependence. Some families of copulas are outlined
below. A typical use for copulas is to choose one such family and use it to define
the multivariate distribution to be used, typically in fitting a distribution to a
sample of data. However, it is possible to derive the copula corresponding to any
given multivariate distribution.

The basic idea

Consider two random variables X and Y, with continuous cumulative distribution
functions FX and FY. The probability integral transform can be applied separately
to the two random variables to define X’ =FX(X) and Y’ = FY(Y). It follows
that X’ and Y’ both have uniform distributions but are, in general, dependent
if X and Y were already dependent (of course, if X and Y were
independent, X’ and Y’ remain independent). Since the transforms are invertible,
specifying the dependence between X and Y is, in a way, the same as specifying
dependence between X’ and Y’. With X’ and Y’ being uniform random variables,
the problem reduces to specifying a bivariate distribution between two uniforms,
that is a copula. So the idea is to simplify the problem by removing consideration
of many different marginal distributions by transforming the marginal variates to
uniforms, and then specifying dependence as a multivariate distribution on the
uniforms.
Definition
A copula is a multivariate joint distribution defined on the n-dimensional unit
cube [0, 1]n such that every marginal distribution is uniform on the interval [0, 1].

Specifically, C:[0,1]n→[0,1] is an n-dimensional copula (briefly, n-copula) if:

C(u)=0 whenever u∈[0,1]n has at least one component equal to 0;

C(u) = ui whenever u∈[0,1]n has all the components equal to 1 except
the ith one, which is equal toui;
C is n-increasing, i.e., for each hyperrectangle View formula on Wikipedia
View formula on Wikipedia
where the View formula on Wikipedia. View formula on Wikipedia is the so called C-
volume of B.
Sklar's theorem
The theorem proposed by Sklar[2] underlies most applications of the copula.
Sklar's theorem states that given a joint distribution function H for p variables,
and respective marginal distribution functions, there exists a copula C such that
the copula binds the margins to give the joint distribution.

For the bivariate case, Sklar's theorem can be stated as follows. For any
bivariate distribution functionH(x,y), let F(x) = H(x,∞) and G(y) = H(∞,y) be the
univariate marginal probability distribution functions. Then there exists a
copula C such that

(where the symbol C for the copula has also been used for with its cumulative
distribution function). Moreover, if the marginal distributions F(x) and G(y) are
continuous, the copula function C is unique. Otherwise, the copula C is unique on
the range of values of the marginal distributions.
To understand the density function of the coupled random variable YH it should
be noticed that

The expectation of a function g can be written in the following ways:

Fréchet–Hoeffding copula boundaries
Graphs of the Fréchet–Hoeffding copula limits and of the independence copula (in the middle).

Minimum (antimonotone) copula: This is the lower bound for all copulas. In the
bivariate case only, it represents perfect negative dependence between variates.

For n-variate copulas, the lower bound is given by

Maximum (comonotone ) copula: This is the upper bound for all copulas. It
represents perfect positive dependence between variates:

For n-variate copulas, the upper bound is given by

Conclusion: For all copulas C(u, v),

In the multivariate case, the corresponding inequality is

Families of copula
Gaussian copula

Cumulative distribution and probability density functions of Gaussian copula with ρ = 0.4

One example of a copula often used for modelling in finance—as introduced

by David X. Li in 2000—is the Gaussian copula,[3] which is constructed from the
bivariate normal distribution via Sklar's theorem. With Φρ being the standard
bivariate normal cumulative distribution function with correlation ρ, the Gaussian
copula function is

where and Φ denotes the standard normalcumulative distribution function.

Differentiating C yields the copula density function:

where

is the density function for the standard bivariate Gaussian with Pearson's product
moment correlation coefficient ρ and is the standard normal density.
Archimedean copulas
Archimedean copulas are an important family of copulas, which have a simple
form with properties such as associativity and have a variety of dependence
structures. Unlike elliptical copulas (e.g. Gaussian), most of the Archimedean
copulas have closed-form solutions and are not derived from the multivariate
distribution functions using Sklar’s Theorem.

One particularly simple form of a n-dimensional copula is

where Ψ is known as a generator function. Such copulas are known
as Archimedean. Any generator function which satisfies the properties below is
the basis for a valid copula:

Product copula: Also called the independent copula, this copula has no
dependence between variates. Its density function is unity everywhere.

Where the generator function is indexed by a parameter, a whole family of

copulas may be Archimedean. For example:

Clayton copula:

For θ = 0 in the Clayton copula, the random variables are statistically

independent. The generator function approach can be extended to create
multivariate copulas, by simply including more additive terms.

Gumbel copula:

Frank copula:
Periodic copula
In 2005 Aurélien Alfonsi and Damiano Brigo introduced new families of copulas
based on periodic functions.[4] They noticed that if ƒ is a 1-periodic non-negative
function that integrates to 1 over [0, 1] and F is a double primitive of ƒ, then both

are copula functions, the second one not necessarily exchangeable. This may be
a tool to introduce asymmetric dependence, which is absent in most known
copula functions.
Empirical copulas
When analysing data with an unknown underlying distribution, one can transform
the empirical data distribution into an "empirical copula" by warping such that the
marginal distributions become uniform[1]. Mathematically the empirical copula
frequency function is calculated by

where x(i) represents the ith order statistic of x.

Less formally, simply replace the data along each dimension with the
data ranks divided by n.
Applications
Dependence modelling with copula functions is widely used in applications of
financial risk assessment and actuarial analysis - for example in the pricing
of collateralized debt obligations (CDOs).[5] Some believe the methodology of
applying the Gaussian copula to credit derivatives to be one of the reasons
behind the global financial crisis of 2008–2009.[6][7] Despite this perception, there
are documented attempts of the financial industry, occurring before the crisis, to
address the limitations of the Gaussian copula and of Copula functions more
generally, specifically the lack of dependence dynamics and the poor
representation of extreme events[8]. The volume "Credit Correlation: Life After
Copulas", published in 2007 by World Scientific, summarizes a 2006 conference
held by Merrill Lynch in London where several practitioners attempted to propose
models rectifying some of the copula limitations. See also the article by Donnelly
and Embrechts [9] and the book by Brigo, Pallavicini and Torresetti [10].

Whilst the application of copulas in credit has gone through popularity as well as
misfortune during the global financial crisis of 2008-2009,[3][11] it is arguably an
industry standard model for pricing CDOs. Less arguably, copulas have also
been applied to other asset classes as a flexible tool in analyzing multi-asset
derivative products. The first such application outside credit was to use a copula
to construct an implied basket volatility surface,[12] taking into account the volatility
smile of basket components. Copulas have since gained popularity in pricing and
risk management [13] of options on multi-assets in the presence of volatility
smile/skew, in equity, foreign exchange and fixed income derivative business.
Some typical examples of application of copulas are listed below:

 Analyzing and pricing volatility smile/skew of exotic baskets, e.g.

best/worst of;
  Analyzing and pricing volatility smile/skew of less liquid FX cross, which is
effectively a basket: C = S1/S2 or C = S1*S2;
 Analyzing and pricing spread options, in particular in fixed income
constant maturity swap (CMS) spread options.
Recently, copula functions have been successfully applied to the database
formulation for the reliabilityanalysis of highway bridges, to the analysis of spike
counts in neuroscience [14] and to various multivariate simulation studies in civil,
mechanical and offshore engineering.[citation needed]
See also
 Joint probability distribution
References
Notes
1. ↑ 1.0 1.1 Nelsen, Roger B. (1999), An Introduction to Copulas, New York:

Springer, ISBN 0387986235.

2. ↑ Sklar, A. (1959), "Fonctions de répartition à n dimensions et leurs marges", Publ. Inst.

Statist. Univ. Paris 8: 229–231

3. ↑ 3.0 3.1 Li, David X. (2000), "On Default Correlation: A Copula Function Approach", Journal

of Fixed Income 9: 43–54

4. ↑ Alfonsi, A. & Brigo, D. (2005), "New families of Copulas based on periodic

functions",Communications in Statistics - Theory and Methods 34 (7): 1437–

1447, doi:10.1081/STA-200063351

5. ↑ Meneguzzo, David; Walter Vecchiato (Nov 2003), "Copula sensitivity in collateralized

debt obligations and basket default swaps", Journal of Futures Markets 24 (1): 37–

70, doi:10.1002/fut.10110

6. ↑ Recipe for Disaster: The Formula That Killed Wall Street Wired, 2/23/2009

7. ↑ MacKenzie, Donald (2008), "End-of-the-World Trade", London Review of Books, 2008-

05-08, retrieved 2009-07-27

8. ↑ Lipton, A., and A. Rennie, (Editors) (2007), Credit Correlation: Life after Copulas, World

Scientific

9. ↑ Donnelly, C, Embrechts, P, (2010), The devil is in the tails: actuarial mathematics and

the subprime mortgage crisis, ASTIN Bulletin 40(1), 1-33

10. ↑ Brigo, D, Pallavicini, A, and Torresetti, R, (2010), Credit Models and the Crisis: A

Journey into CDOs, Copulas, Correlations and dynamic Models, Wiley and Sons
 11. ↑ Jones, Sam (April 24, 2009), "The formula that felled Wall St", Financial Times

12. ↑ Qu, Dong, (2001), Basket Implied Volatility Surface, Derivatives Week, 4 June.

13. ↑ Qu, Dong, (2005), Pricing Basket Options With Skew, Wilmott Magazine, July.

14. ↑ Onken, A; Grünewälder, S; Munk, MH; Obermayer, K (2009), "Analyzing Short-Term

Noise Dependencies of Spike-Counts in Macaque Prefrontal Cortex Using Copulas and the

Flashlight Transformation", PLoS Computational Biology 5 (11):

e1000577,doi:10.1371/[Link].1000577, PMID 19956759, PMC 2776173

General
 David G. Clayton (1978), "A model for association in bivariate life tables
and its application in epidemiological studies of familial tendency in chronic
disease incidence", Biometrika 65, 141–[Link] (subscription)
 Frees, E.W., Valdez, E.A. (1998), "Understanding Relationships Using
Copulas", North American Actuarial Journal 2, 1–25. Link to NAAJ copy
 Roger B. Nelsen (1999), An Introduction to Copulas. ISBN 0-387-98623-5.
 S. Rachev, C. Menn, F. Fabozzi (2005), Fat-Tailed and Skewed Asset
Return Distributions. ISBN 0-471-71886-6.
 A. Sklar (1959), "Fonctions de répartition à n dimensions et leurs
marges", Publications de l'Institut de Statistique de L'Université de Paris 8,
229-231.
 C. Schölzel, P. Friederichs (2008), "Multivariate non-normally distributed
random variables in climate research – introduction to the copula approach",
Nonlinear Processes in Geophysics, 15, 761-772Copernicus (open access)
 W.T. Shaw, K.T.A. Lee (2006), "Copula Methods vs Canonical Multivariate
Distributions: The Multivariate Student T Distibution with General Degrees of
Freedom". PDF
 Srinivas Sriramula, Devdas Menon and A. Meher Prasad (2006),
"Multivariate Simulation and Multimodal Dependence Modeling of Vehicle
Axle Weights with Copulas", ASCE Journal of Transportation
Engineering 132 (12), 945–955. (doi 10.1061/(ASCE)0733-
947X(2006)132:12(945))ASCE(subscription)
 Genest, C.; MacKay, R.J. (1986), "The Joy of Copulas: Bivariate
Distributions with Uniform Marginals", The American Statistician (American
Statistical Association) 40 (4): 280–283,doi:10.2307/2684602
External links
  MathWorld Eric W. Weisstein. "Sklar's Theorem." From MathWorld—A
Wolfram Web Resource
 Copula Wiki: community portal for researchers with interest in copulas
 A collection of Copula simulation and estimation codes
 Recipe for Disaster: The Formula That Killed Wall Street By Felix Salmon,
Wired News
 Did math formula cause financial crisis? By Felix Salmon and Kai Ryssdal,
Marketplace, American
 Several short articles on copulas
 An introduction and some examples to modeling with copulas in Excel
Public Media

 Copula Functions and their Application in Pricing and Risk Managing

Multiame Credit Derivative Products