Modelling Dependence in High Dimensions with Factor Copulas

FEDS Working Paper No. 2015-0511

http://dx.doi.org/10.17016/FEDS.2015.0511

42 Pages Posted: 26 Jul 2015

See all articles by Dong Hwan Oh

Dong Hwan Oh

Board of Governors of the Federal Reserve System

Andrew J. Patton

Duke University - Department of Economics

Date Written: May 18, 2015

Abstract

This paper presents flexible new models for the dependence structure, or copula, of economic variables based on a latent factor structure. The proposed models are particularly attractive for relatively high dimensional applications, involving fifty or more variables, and can be combined with semiparametric marginal distributions to obtain flexible multivariate distributions. Factor copulas generally lack a closed-form density, but we obtain analytical results for the implied tail dependence using extreme value theory, and we verify that simulation-based estimation using rank statistics is reliable even in high dimensions. We consider "scree" plots to aid the choice of the number of factors in the model. The model is applied to daily returns on all 100 constituents of the S&P 100 index, and we find significant evidence of tail dependence, heterogeneous dependence, and asymmetric dependence, with dependence being stronger in crashes than in booms. We also show that factor copula models provide superior estimates of some measures of systemic risk.

Keywords: copulas, correlation, dependence, systemic risk, tail dependence

JEL Classification: C31, C32, C51

Suggested Citation

Oh, Dong Hwan and Patton, Andrew J., Modelling Dependence in High Dimensions with Factor Copulas (May 18, 2015). FEDS Working Paper No. 2015-0511, http://dx.doi.org/10.17016/FEDS.2015.0511, Available at SSRN: https://ssrn.com/abstract=2631656 or http://dx.doi.org/10.2139/ssrn.2631656

Dong Hwan Oh (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Andrew J. Patton

Duke University - Department of Economics ( email )

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

HOME PAGE: http://econ.duke.edu/~ap172/

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