Copula (probability theory)
In probability theory and statistics, a copula is a multivariate cumulative distribution function for which the marginal probability distribution of each variable is uniform. Copulas are used to describe the dependence between random variables. Their name comes from the Latin for "link" or "tie", similar but unrelated to grammatical copulas in linguistics. Copulas have been used widely in quantitative finance to model and minimize tail risk[1] and portfoliooptimization applications.[2]
Sklar's theorem states that any multivariate joint distribution can be written in terms of univariate marginal distribution functions and a copula which describes the dependence structure between the variables.
Copulas are popular in highdimensional statistical applications as they allow one to easily model and estimate the distribution of random vectors by estimating marginals and copulae separately. There are many parametric copula families available, which usually have parameters that control the strength of dependence. Some popular parametric copula models are outlined below.
Twodimensional copulas are known in some other areas of mathematics under the name permutons and doublystochastic measures.
Mathematical definition
Consider a random vector . Suppose its marginals are continuous, i.e. the marginal CDFs are continuous functions. By applying the probability integral transform to each component, the random vector
has uniformly distributed marginals.
The copula of is defined as the joint cumulative distribution function of :
The copula C contains all information on the dependence structure between the components of whereas the marginal cumulative distribution functions contain all information on the marginal distributions.
The importance of the above is that the reverse of these steps can be used to generate pseudorandom samples from general classes of multivariate probability distributions. That is, given a procedure to generate a sample from the copula distribution, the required sample can be constructed as
The inverses are unproblematic as the were assumed to be continuous. The above formula for the copula function can be rewritten to correspond to this as:
Definition
In probabilistic terms, is a ddimensional copula if C is a joint cumulative distribution function of a ddimensional random vector on the unit cube with uniform marginals.[3]
In analytic terms, is a ddimensional copula if
 , the copula is zero if one of the arguments is zero,
 , the copula is equal to u if one argument is u and all others 1,
 C is dnondecreasing, i.e., for each hyperrectangle the Cvolume of B is nonnegative:
 where the .
For instance, in the bivariate case, is a bivariate copula if , and for all and .
Sklar's theorem
Sklar's theorem, named after Abe Sklar, provides the theoretical foundation for the application of copulas.[4][5] Sklar's theorem states that every multivariate cumulative distribution function
of a random vector can be expressed in terms of its marginals and a copula . Indeed:
In case that the multivariate distribution has a density , and this is available, it holds further that
where is the density of the copula.
The theorem also states that, given , the copula is unique on , which is the cartesian product of the ranges of the marginal cdf's. This implies that the copula is unique if the marginals are continuous.
The converse is also true: given a copula and margins then defines a ddimensional cumulative distribution function.
Stationary Condition
(This section seems much less related to the main article)
Copulas mainly work when time series are stationary[6] and continuous[7]. Thus, a very important preprocessing step is to check for the autocorrelation, trend and seasonality within time series.
When time series are autocorrelated, they may generate a non existence dependence between sets of variables and result in incorrect Copula dependence structure.
Fréchet–Hoeffding copula bounds
The Fréchet–Hoeffding Theorem (after Maurice René Fréchet and Wassily Hoeffding[8]) states that for any Copula and any the following bounds hold:
The function W is called lower Fréchet–Hoeffding bound and is defined as
The function M is called upper Fréchet–Hoeffding bound and is defined as
The upper bound is sharp: M is always a copula, it corresponds to comonotone random variables.
The lower bound is pointwise sharp, in the sense that for fixed u, there is a copula such that . However, W is a copula only in two dimensions, in which case it corresponds to countermonotonic random variables.
In two dimensions, i.e. the bivariate case, the Fréchet–Hoeffding Theorem states
 .
Families of copulas
Several families of copulas have been described.
Gaussian copula
The Gaussian copula is a distribution over the unit cube . It is constructed from a multivariate normal distribution over by using the probability integral transform.
For a given correlation matrix , the Gaussian copula with parameter matrix can be written as
where is the inverse cumulative distribution function of a standard normal and is the joint cumulative distribution function of a multivariate normal distribution with mean vector zero and covariance matrix equal to the correlation matrix . While there is no simple analytical formula for the copula function, , it can be upper or lower bounded, and approximated using numerical integration.[9][10] The density can be written as[11]
where is the identity matrix.
Archimedean copulas
Archimedean copulas are an associative class of copulas. Most common Archimedean copulas admit an explicit formula, something not possible for instance for the Gaussian copula. In practice, Archimedean copulas are popular because they allow modeling dependence in arbitrarily high dimensions with only one parameter, governing the strength of dependence.
A copula C is called Archimedean if it admits the representation[12]
where is a continuous, strictly decreasing and convex function such that . is a parameter within some parameter space . is the socalled generator function and is its pseudoinverse defined by
Moreover, the above formula for C yields a copula for if and only if is dmonotone on .[13] That is, if it is times differentiable and the derivatives satisfy
for all and and is nonincreasing and convex.
Most important Archimedean copulas
The following tables highlight the most prominent bivariate Archimedean copulas, with their corresponding generator. Not all of them are completely monotone, i.e. dmonotone for all or dmonotone for certain only.
Name of Copula  Bivariate Copula  parameter 

Ali–Mikhail–Haq[14]  
Clayton[15]  
Frank  
Gumbel  
Independence  
Joe 
name  generator  generator inverse 

Ali–Mikhail–Haq[14]  
Clayton[15]  
Frank  
Gumbel  
Independence  
Joe 
Expectation for copula models and Monte Carlo integration
In statistical applications, many problems can be formulated in the following way. One is interested in the expectation of a response function applied to some random vector .[16] If we denote the cdf of this random vector with , the quantity of interest can thus be written as
If is given by a copula model, i.e.,
this expectation can be rewritten as
In case the copula C is absolutely continuous, i.e. C has a density c, this equation can be written as
and if each marginal distribution has the density it holds further that
If copula and margins are known (or if they have been estimated), this expectation can be approximated through the following Monte Carlo algorithm:
 Draw a sample of size n from the copula C
 By applying the inverse marginal cdf's, produce a sample of by setting
 Approximate by its empirical value:
Empirical copulas
When studying multivariate data, one might want to investigate the underlying copula. Suppose we have observations
from a random vector with continuous margins. The corresponding "true" copula observations would be
However, the marginal distribution functions are usually not known. Therefore, one can construct pseudo copula observations by using the empirical distribution functions
instead. Then, the pseudo copula observations are defined as
The corresponding empirical copula is then defined as
The components of the pseudo copula samples can also be written as , where is the rank of the observation :
Therefore, the empirical copula can be seen as the empirical distribution of the rank transformed data.
Applications
Quantitative finance
Typical finance applications:

In quantitative finance copulas are applied to risk management, to portfolio management and optimization, and to derivatives pricing.
For the former, copulas are used to perform stresstests and robustness checks that are especially important during "downside/crisis/panic regimes" where extreme downside events may occur (e.g., the global financial crisis of 2007–2008). The formula was also adapted for financial markets and was used to estimate the probability distribution of losses on pools of loans or bonds.
During a downside regime, a large number of investors who have held positions in riskier assets such as equities or real estate may seek refuge in 'safer' investments such as cash or bonds. This is also known as a flighttoquality effect and investors tend to exit their positions in riskier assets in large numbers in a short period of time. As a result, during downside regimes, correlations across equities are greater on the downside as opposed to the upside and this may have disastrous effects on the economy.[19][20] For example, anecdotally, we often read financial news headlines reporting the loss of hundreds of millions of dollars on the stock exchange in a single day; however, we rarely read reports of positive stock market gains of the same magnitude and in the same short time frame.
Copulas aid in analyzing the effects of downside regimes by allowing the modelling of the marginals and dependence structure of a multivariate probability model separately. For example, consider the stock exchange as a market consisting of a large number of traders each operating with his/her own strategies to maximize profits. The individualistic behaviour of each trader can be described by modelling the marginals. However, as all traders operate on the same exchange, each trader's actions have an interaction effect with other traders'. This interaction effect can be described by modelling the dependence structure. Therefore, copulas allow us to analyse the interaction effects which are of particular interest during downside regimes as investors tend to herd their trading behaviour and decisions. (See also agentbased computational economics, where price is treated as an emergent phenomenon, resulting from the interaction of the various market participants, or agents.)
The users of the formula have been criticized for creating "evaluation cultures" that continued to use simple copulæ despite the simple versions being acknowledged as inadequate for that purpose.[21] Thus, previously, scalable copula models for large dimensions only allowed the modelling of elliptical dependence structures (i.e., Gaussian and Studentt copulas) that do not allow for correlation asymmetries where correlations differ on the upside or downside regimes. However, the recent development of vine copulas[22] (also known as pair copulas) enables the flexible modelling of the dependence structure for portfolios of large dimensions.[23] The Clayton canonical vine copula allows for the occurrence of extreme downside events and has been successfully applied in portfolio optimization and risk management applications. The model is able to reduce the effects of extreme downside correlations and produces improved statistical and economic performance compared to scalable elliptical dependence copulas such as the Gaussian and Studentt copula.[24]
Other models developed for risk management applications are panic copulas that are glued with market estimates of the marginal distributions to analyze the effects of panic regimes on the portfolio profit and loss distribution. Panic copulas are created by Monte Carlo simulation, mixed with a reweighting of the probability of each scenario.[25]
As regards derivatives pricing, dependence modelling with copula functions is widely used in applications of financial risk assessment and actuarial analysis – for example in the pricing of collateralized debt obligations (CDOs).[26] Some believe the methodology of applying the Gaussian copula to credit derivatives to be one of the reasons behind the global financial crisis of 2008–2009;[27][28][29] see David X. Li § CDOs and Gaussian copula.
Despite this perception, there are documented attempts within the financial industry, occurring before the crisis, to address the limitations of the Gaussian copula and of copula functions more generally, specifically the lack of dependence dynamics. The Gaussian copula is lacking as it only allows for an elliptical dependence structure, as dependence is only modeled using the variancecovariance matrix.[24] This methodology is limited such that it does not allow for dependence to evolve as the financial markets exhibit asymmetric dependence, whereby correlations across assets significantly increase during downturns compared to upturns. Therefore, modeling approaches using the Gaussian copula exhibit a poor representation of extreme events.[24][30] There have been attempts to propose models rectifying some of the copula limitations.[30][31][32]
Additional to CDOs, Copulas have been applied to other asset classes as a flexible tool in analyzing multiasset derivative products. The first such application outside credit was to use a copula to construct a basket implied volatility surface,[33] taking into account the volatility smile of basket components. Copulas have since gained popularity in pricing and risk management[34] of options on multiassets in the presence of a volatility smile, in equity, foreign exchange and fixed income derivatives.
Civil engineering
Recently, copula functions have been successfully applied to the database formulation for the reliability analysis of highway bridges, and to various multivariate simulation studies in civil engineering,[35] reliability of wind and earthquake engineering,[36] and mechanical & offshore engineering.[37] Researchers are also trying these functions in the field of transportation to understand the interaction between behaviors of individual drivers which, in totality, shapes traffic flow.
Reliability engineering
Copulas are being used for reliability analysis of complex systems of machine components with competing failure modes. [38]
Warranty data analysis
Copulas are being used for warranty data analysis in which the tail dependence is analysed [39]
Turbulent combustion
Copulas are used in modelling turbulent partially premixed combustion, which is common in practical combustors. [40] [41]
Medicine
Copula functions have been successfully applied to the analysis of neuronal dependencies [42] and spike counts in neuroscience [43]
Geodesy
The combination of SSA and Copulabased methods have been applied for the first time as a novel stochastic tool for polar motion prediction. [44]
Hydrology research
Climate and weather research
Copulas have been extensively used in climate and weatherrelated research.[46][47]
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Further reading
 The standard reference for an introduction to copulas. Covers all fundamental aspects, summarizes the most popular copula classes, and provides proofs for the important theorems related to copulas
 Roger B. Nelsen (1999), "An Introduction to Copulas", Springer. ISBN 9780387986234
 A book covering current topics in mathematical research on copulas:
 Piotr Jaworski, Fabrizio Durante, Wolfgang Karl Härdle, Tomasz Rychlik (Editors): (2010): "Copula Theory and Its Applications" Lecture Notes in Statistics, Springer. ISBN 9783642124648
 A reference for sampling applications and stochastic models related to copulas is
 JanFrederik Mai, Matthias Scherer (2012): Simulating Copulas (Stochastic Models, Sampling Algorithms and Applications). World Scientific. ISBN 9781848168749
 A paper covering the historic development of copula theory, by the person associated with the "invention" of copulas, Abe Sklar.
 Abe Sklar (1997): "Random variables, distribution functions, and copulas – a personal look backward and forward" in Rüschendorf, L., Schweizer, B. und Taylor, M. (eds) Distributions With Fixed Marginals & Related Topics (Lecture Notes – Monograph Series Number 28). ISBN 9780940600409
 The standard reference for multivariate models and copula theory in the context of financial and insurance models
 Alexander J. McNeil, Rudiger Frey and Paul Embrechts (2005) "Quantitative Risk Management: Concepts, Techniques, and Tools", Princeton Series in Finance. ISBN 9780691122557
External links
 Hazewinkel, Michiel, ed. (2001) [1994], "Copula", Encyclopedia of Mathematics, Springer Science+Business Media B.V. / Kluwer Academic Publishers, ISBN 9781556080104
 Copula Wiki: community portal for researchers with interest in copulas
 A collection of Copula simulation and estimation codes
 Thorsten Schmidt (2006) "Coping with Copulas"
 Copulas & Correlation using Excel Simulation Articles
 Chapter 1 of JanFrederik Mai, Matthias Scherer (2012) "Simulating Copulas: Stochastic Models, Sampling Algorithms, and Applications"