One More Model Risk When Using Gaussian Copula for Risk Management

8 Pages Posted: 8 Dec 2009

See all articles by Massimo Morini

Massimo Morini

Algorand Foundation; Bocconi University

Date Written: April 25, 2009

Abstract

Gaussian Copula as a model for default correlation has been recently criticized for a number of fallacies in its application to pricing and risk management of financial liabilities.

Here we point out an element of model risk that appears to be overlooked. When the Gaussian Copula is applied to the computation of the probability of losses concentrated in time, it can give paradoxical and misleading results, where an increase of correlation reduces the model probability of loss concentration. This behaviour is dangerous since, if not taken into account, can lead to completely wrong model stress testing.

Here we show how this behaviour can affect three practical problems: the estimation of future liquidity risk due to clustered losses, the assessment of CDS counterparty risk and the computation of dynamic value-at-risk.

Suggested Citation

Morini, Massimo, One More Model Risk When Using Gaussian Copula for Risk Management (April 25, 2009). Available at SSRN: https://ssrn.com/abstract=1520670 or http://dx.doi.org/10.2139/ssrn.1520670

Massimo Morini (Contact Author)

Algorand Foundation ( email )

1 George Street
049145
Singapore
20144 (Fax)

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

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