Exponential series estimation of empirical copulas with application to financial returns

Abstract

Knowledge of the dependence structure between financial assets is crucial to improve the performance in financial risk management. It is known that the copula completely summarizes the dependence structure among multiple variables. We propose a multivariate exponential series estimator (ESE) to estimate copula densities nonparametrically. The ESE has an appealing information-theoretic interpretation and attains the optimal rate of convergence for nonparametric density estimations in Stone (1982). More importantly, it overcomes the boundary bias of conventional nonparametric copula estimators. Our extensive Monte Carlo studies show the proposed estimator outperforms the kernel and the log-spline estimators in copula estimation. It also demonstrates that two-step density estimation through an ESE copula often outperforms direct estimation of joint densities. Finally, the ESE copula provides superior estimates of tail dependence compared to the empirical tail index coefficient. An empirical examination of the Asian financial markets using the proposed method is provided.

Citation

Chui, C. and Wu, X. (2009), "Exponential series estimation of empirical copulas with application to financial returns", Li, Q. and Racine, J.S. (Ed.) Nonparametric Econometric Methods (Advances in Econometrics, Vol. 25), Emerald Group Publishing Limited, Leeds, pp. 263-290. https://doi.org/10.1108/S0731-9053(2009)0000025011