Tail Dependence of Factor Models

Details Tail Dependence of Factor Models Tail Dependence of Factor Models

2002-02-20

arxiv.org/abs/cond-mat/0202356v1

The Journal of Risk 6 (3), 71-116 (2004)

Physics

Condensed Matter

Statistical Mechanics

Latex document of 29 pages including 10 tables

Scientific paper

Using the framework of factor models, we establish the general expression of the coefficient of tail dependence between the market and a stock (i.e., the probability that the stock incurs a large loss, assuming that the market has also undergone a large loss) as a function of the parameters of the underlying factor model and of the tail parameters of the distributions of the factor and of the idiosyncratic noise of each stock. Our formula holds for arbitrary marginal distributions and in addition does not require any parameterization of the multivariate distributions of the market and stocks. The determination of the extreme parameter, which is not accessible by a direct statistical inference, is made possible by the measurement of parameters whose estimation involves a significant part of the data with sufficient statistics. Our empirical tests find a good agreement between the calibration of the tail dependence coefficient and the realized large losses over the period from 1962 to 2000. Nevertheless, a bias is detected which suggests the presence of an outlier in the form of the crash of October 1987.

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