Using Copulas to Model

Extreme Events
by Donald F. Behan and Sam Cox
Georgia State University

Donald F. Behan
Society of Actuaries Meeting Phoenix

Overview

Research sponsored by the Society

of Actuaries
Paper to be posted on SoA web site
A tool for learning about and
applying copulas to the modeling of
extreme events

Donald F. Behan

Executive Summary

All multivariate distributions may be

analyzed as marginal distributions
and a copula.
Allows focus on dependence
relationship for known individual
distributions.
A tool for implementing this model
in Excel or Mathematica is to be
distributed.
Donald F. Behan

Copulas

A copula captures the dependence

relationship in a multivariate distribution.
Given the marginal distributions of a
multivariate distribution, the distribution
is completely determined by its copula.
This process may be carried out for any
multivariate distribution, without any
assumptions about the nature of the
distribution.

Donald F. Behan

Copula Example

Start with an arbitrary bivariate

distribution F(u,v): we chose a
standard bivariate normal
distribution with correlation
coefficient 0.6.
Let the cumulative marginal
distributions be X and Y.
Define C(X(u),Y(v)) = F(u,v).
C is the copula associated with F.
Donald F. Behan

Continuous and Discrete Distributions

Copulas are most easily visualized

for continuous distributions.
Discrete distributions can be viewed
as limits of continuous distributions.
If the marginals are not continuous,
the copula is not unique, but it is
unique for continuous distributions.

Donald F. Behan

Numerical Examples

As an example, let F be the standard

bivariate normal distribution with = 0.6.
Then F(0,0) = 0.352, i.e. the probability
that u and v are both less than zero is
0.352.
Under these assumptions, X and Y are
standard normal, so X(0) = Y(0) = 0.5.
Therefore, C(0.5,0.5) = 0.352.
F is reconstructed by the formula
F(u,v)=C(X(u),Y(v)).
Donald F. Behan

Mathematical Foundation

Sklars Theorem (bivariate case):

For any bivariate distribution F(u,v)
with marginal distributions X(u) and
Y(v) there exists a copula C such
that F(u,v) = C(X(u),Y(v)).
C is a copula if and only if it is a
bivariate probability distribution on
[0,1][0,1] with uniform marginals.
Donald F. Behan

Dependence Structure

The marginal distributions can be

changed while retaining the copula. This
retains the dependence structure.
Example: For (u,v) [0,1][0,1] let
C(u,v)=max(u,v). This is the x = y
copula.
If the marginal distributions are equal and
non-trivial, the correlation is 1.0.

Donald F. Behan

Dependence vs. Correlation

In the preceding example (x=y

copula) let X be uniform, but let Y
be the exponential distribution
Y(v) = 1 e-x. Then the correlation
coefficient is 0.866.
Conclusion: The correlation
coefficient is not uniquely
determined by the dependence.
Donald F. Behan

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Measures of Dependence

The copula uniquely determines the

rank correlation.
Spearmans rho is an example of a
measure of rank correlation. This is
used in our examples.

Donald F. Behan

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Structure of the Example

To provide an example of the use of

copulas to study dependence of
extreme events, we assume that
the marginals are known.
We assume that the dependence
structure is known for common
events, but not for extreme events.

Donald F. Behan

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Excel Tool

The Excel tool is intended as a

learning vehicle, and as the basis to
develop simulations.
The tool includes an assumed
structure to facilitate learning.
The structure can be modified to
simulate variables of interest.

Donald F. Behan

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Excel Tool, Continued

For illustration the marginal distributions

are assumed to be a normal distribution
and a lognormal distribution. Both have
mean 1,000,000 and standard deviation
50,000.
For events between the 5th and 95th
percentile the assumed dependence
structure is normal with correlation 0.6.

Donald F. Behan

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Excel Tool, Continued

The copula is displayed on a square

grid.
The number of cells was kept small
to facilitate manipulation rather
than accurate modeling, and can be
expanded.
The example provides for
manipulation of the dependence
structure.
Donald F. Behan

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Simulation Tool

Sim Tools, a free download provided

by Roger Myerson at the University
of Chicago, is used to simulate the
results of the assumed dependence.
@risk could be used as well.
Examples of alternative copulas and
of manipulation of the given copula
are provided in the Excel workbook.
Donald F. Behan

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Linearity of the Constraints

Constraints generated from the

properties of a copula are linear.
Spearmans rho depends on the
copula in a linear manner.
We have used the simplex method
to compute various extreme
configurations that are illustrated in
the workbook and paper.
Donald F. Behan

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Conclusion

A tool consisting of an Excel

workbook and an explanatory paper
will be posted on the Society of
Actuaries website.
While that is pending, the draft
documents are available at my
website www.behan.ws

Donald F. Behan

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