Copula
The copula is a probability model that represents a multivariate uniform distribution, which examines the association or dependence between many variables. The copula, therefore, has been applied to areas of finance such as option pricing and portfolio value-at-risk to deal with skewed or asymmetric distributions. Advancements in Monte Carlo simulation methods and copula functions offer an enhancement to the pricing of bivariate contingent claims, such as derivatives with embedded options. However, correlation works best with normal distributions, while distributions in financial markets are often non-normal in nature. Option theory, particularly options pricing is a highly specialized area of finance.
What Is Copula?
The copula is a probability model that represents a multivariate uniform distribution, which examines the association or dependence between many variables. Although the statistical calculation of a copula was developed in 1959, it was not applied to financial markets and finance until the late 1990s.
Understanding Copula
Latin for "link" or "tie," copulas are a mathematical tool used in finance to help identify economic capital adequacy, market risk, credit risk, and operational risk. The interdependence of returns of two or more assets is usually calculated using the correlation coefficient. However, correlation works best with normal distributions, while distributions in financial markets are often non-normal in nature. The copula, therefore, has been applied to areas of finance such as option pricing and portfolio value-at-risk to deal with skewed or asymmetric distributions.
Option theory, particularly options pricing is a highly specialized area of finance. Multivariate options are widely used where there is a need to hedge against a number of risks simultaneously; such as when there is an exposure to several currencies. The pricing of a basket of options is not a simple task. Advancements in Monte Carlo simulation methods and copula functions offer an enhancement to the pricing of bivariate contingent claims, such as derivatives with embedded options.
Related terms:
Correlation Coefficient
The correlation coefficient is a statistical measure that calculates the strength of the relationship between the relative movements of two variables. read more
Discrete Distribution
A discrete distribution is a statistical distribution that shows the probabilities of outcomes with finite values. read more
Economic Capital (EC)
Economic capital is the amount of capital that a firm, usually in financial services, needs to ensure that the company stays solvent given its risk profile. read more
Monte Carlo Simulation
Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted. read more
Multivariate Model
The multivariate model is a popular statistical tool that uses multiple variables to forecast possible investment outcomes. read more
Statistics
Statistics is the collection, description, analysis, and inference of conclusions from quantitative data. read more
Stochastic Modeling
Stochastic modeling is a tool used in investment decision-making that uses random variables and yields numerous different results. read more
Uniform Distribution
Uniform distribution is a type of probability distribution in which all outcomes are equally likely. Learn how to calculate uniform distribution. read more
Value at Risk (VaR)
Value at risk (VaR) is a statistic that quantifies the level of financial risk within a firm, portfolio, or position over a specific time frame. read more