Hull RMFICh 06

Correlations and
Copulas
Chapter 6
Risk Management and Financial Institutions, Chapter 6, Copyright John C. Hull 2006
6.1
Coefficient of Correlation
The coefficient of correlation between two

variables V1 and V2 is defined as
E (V1V2 ) E (V1 ) E (V2 )

SD(V1 ) SD(V2 )
6.2
Independence
V1 and V2 are independent if the

knowledge of one does not affect the
probability distribution for the other
f (V2 V1 x) f (V2 )
where f(.) denotes the probability density
function
6.3
Independence is Not the Same as

Zero Correlation
Suppose V1 = 1, 0, or +1 (equally likely)

If V1 = -1 or V1 = +1 then V2 = 1
If V1 = 0 then V2 = 0
V2 is clearly dependent on V1 (and vice
versa) but the coefficient of correlation is
zero
6.4
Types of Dependence
E(Y)
E(Y)
X
(a)
(b)
E(Y)
X
(c)
6.5
Monitoring Correlation Between

Two Variables X and Y
Define xi=(Xi-Xi-1)/Xi-1 and yi=(Yi-Yi-1)/Yi-1
Also
varx,n: daily variance of X calculated on day n-1
vary,n: daily variance of Y calculated on day n-1
covn: covariance calculated on day n-1
The correlation is
covn
varx ,n vary ,n
6.6
Monitoring Correlation continued

EWMA:
covn covn 1 (1 ) xn 1 yn 1
GARCH(1,1)
covn xn1 yn1 covn 1
6.7
Positive Finite Definite Condition

A variance-covariance matrix, W, is
internally consistent if the positive semidefinite condition
w Ww 0
T
holds for all vectors w
6.8
Example
The variance covariance matrix
1
0.9
0
1
0.9
0.9
0.9
is not internally consistent
6.9
V1 and V2 Bivariate Normal
Conditional on the value of V1, V2 is normal with

mean
V1 m1
m2 r
s1
and standard deviation s 2 1 r2 where m1,, m2,
s1, and s2 are the unconditional means and SDs
of V1 and V2 and r is the coefficient of correlation
between V1 and V2
6.10
Multivariate Normal
Many variables can be handled

A variance-covariance matrix defines the
variances of and correlations between
variables
To be internally consistent a variancecovariance matrix must be positive
semidefinite
6.11
Generating Random Samples for

Monte Carlo Simulation
An approximate sample from a standard normal

distribution is
12
Ri 6
i 1
where the Ri are random numbers between 0

and 1
For a multivariate normal distribution a method
known as Choleskys decomposition can be
used to generate random samples
6.12
Factor Models
When there are N variables, Vi (i=1,2,..N),

in a multivariate normal distribution there
are N(N-1)/2 correlations
We can reduce the number of correlation
parameters that have to be estimated with
a factor model
6.13
Factor Models continued
If Ui have standard normal distributions we

can set
U i ai F 1 a Zi
2
i
where the common factor F and the

idiosyncratic component Zi have
independent standard normal distributions
In a multifactor model this becomes
2
U i ai1F1 ai 2 F2 aiM FM 1 ai21 ai22 aiM
Zi
6.14
Gaussian Copula Models:

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

between two variable V1 and V2 that do not have normal
distributions
We transform the variable V1 to a new variable U1 that
has a standard normal distribution on a percentile-topercentile basis.
We transform the variable V2 to a new variable U2 that
has a standard normal distribution on a percentile-topercentile basis.
U1 and U2 are assumed to have a bivariate normal
distribution
6.15
The Correlation structure between the

Vs is define by that between the Us
-0.2
0.2
0.4
0.6
0.8
1.2
-0.2
0.2
0.4
V2
V1
0.6
0.8
1.2
One-to-one
mappings
-6
-4
-2
-6
-4
-2
U2
U1
Correlation
Assumption
6.16
Other Copulas
Instead of a bivariate normal distribution

for U1 and U2 we can assume any other
joint distribution
One possibility is the bivariate Student t
distribution
6.17
5000 Random Samples from the

Bivariate Normal
5
4
3
2
1
0
-5
-4
-3
-2
-1
-1
-2
-3
-4
-5
6.18
5000 Random Samples from the

Bivariate Student t
10
0
-10
-5
10
-5
-10
6.19
Multivariate Gaussian Copula
We can similarly define a correlation

structure between V1, V2,Vn
We transform each variable Vi to a new
variable Ui that has a standard normal
distribution on a percentile-to-percentile
basis.
The Us are assumed to have a
multivariate normal distribution
6.20
Factor Copula Model

In a factor copula model the correlation
structure between the Us is generated by
assuming one or more factors.
6.21
Credit Default Correlation
The credit default correlation between two

companies is a measure of their tendency to
default at about the same time
Default correlation is important in risk
management when analyzing the benefits of
credit risk diversification
It is also important in the valuation of some
credit derivatives
6.22
The Model
We map the time to default for company i, Ti, to a

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

normal distributions
Define Qi as the cumulative probability distribution
of Ti
Prob(Ui<U) = Prob(Ti<T) when N(U) = Qi(T)
6.23
The Model continued

U a F
i
Prob(U i U F ) N
2
1 ai
Hence
N 1 Q (T ) a F
i
i
Prob(Ti T F ) N
2
1 ai
Assuming the Q ' s and a ' s are the same for all companies
N 1 Q(T ) r F
Prob(Ti T F ) N
1 r
In a large portfolio the1 - X percentile of F gives the X % worstcase

percentageof losses in time T
N 1 Q (T ) r N 1 ( X )
N
6.24

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Correlations and

The coefficient of correlation between two

E (V1V2 ) E (V1 ) E (V2 )

V1 and V2 are independent if the

Independence is Not the Same as

Suppose V1 = 1, 0, or +1 (equally likely)

Monitoring Correlation Between

Monitoring Correlation continued

Positive Finite Definite Condition

holds for all vectors w

is not internally consistent

V1 and V2 Bivariate Normal

Conditional on the value of V1, V2 is normal with

Many variables can be handled

Generating Random Samples for

An approximate sample from a standard normal

where the Ri are random numbers between 0

When there are N variables, Vi (i=1,2,..N),

Factor Models continued

If Ui have standard normal distributions we

where the common factor F and the

Gaussian Copula Models:

Suppose we wish to define a correlation structure

The Correlation structure between the

Instead of a bivariate normal distribution

5000 Random Samples from the

5000 Random Samples from the

Multivariate Gaussian Copula

We can similarly define a correlation

Factor Copula Model

Credit Default Correlation

The credit default correlation between two

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

where F and the Zi have independent standard

The Model continued

In a large portfolio the1 - X percentile of F gives the X % worstcase

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