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SUMMARY
Risk managers use correlations or covariances to describe the relationship between
two variables. The daily covariance rate is the correlation between the daily returns
on the variables multiplied by the product of their daily volatilities. The methods for
monitoring a covariance rate are similar to those described in Chapter 10 for monitoring a variance rate. Risk managers often try to keep track of a variancecovariance
matrix for all the variables to which they are exposed.
The marginal distribution of a variable is the unconditional distribution of the
variable. Very often an analyst is in a situation where he or she has estimated the
marginal distributions of a set of variables and wants to make an assumption about
their correlation structure. If the marginal distributions of the variables happen to
be normal, it is natural to assume that the variables have a multivariate normal distribution. In other situations, copulas are used. The marginal distributions are transformed on a percentile-to-percentile basis to normal distributions (or to some other
distribution for which there is a multivariate counterpart). The correlation structure
between the variables of interest is then defined indirectly from an assumed correlation structure between the transformed variables.
When there are many variables, analysts often use a factor model. This is a way
of reducing the number of correlation estimates that have to be made. The correlation
between any two variables is assumed to derive solely from their correlations with the
factors. The default correlation between different companies can be modeled using
a factor-based Gaussian copula model of their times to default.
An important application of copulas for risk managers is to the calculation of
the distribution of default rates for loan portfolios. Analysts often assume that a onefactor copula model relates the probability distributions of the times to default for
different loans. The percentiles of the distribution of the number of defaults on a large
portfolio can then be calculated from the percentiles of the probability distribution
of the factor. As we shall see in Chapter 15, this is the approach used in determining
credit risk capital requirements for banks under Basel II.

FURTHER READING
Cherubini, U., E. Luciano, and W. Vecchiato. Copula Methods in Finance. Hoboken, NJ: John
Wiley & Sons, 2004.
Demarta, S., and A. J. McNeil. The t-Copula and Related Copulas. Working Paper,
Department of Mathematics, ETH Zentrum, Zurich, Switzerland.
Engle, R. F., and J. Mezrich. GARCH for Groups. Risk (August 1996): 3640.
Vasicek, O. Probability of Loss on a Loan Portfolio. Working Paper, KMV, 1987. (Published
in Risk in December 2002 under the title Loan Portfolio Value.)

PRACTICE QUESTIONS AND PROBLEMS

(ANSWERS AT END OF BOOK)
11.1 If you know the correlation between two variables, what extra information
do you need to calculate the covariance?

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11.2 What is the difference between correlation and dependence? Suppose that y =
x2 and x is normally distributed with mean zero and standard deviation one.
What is the correlation between x and y?
11.3 What is a factor model? Why are factor models useful when defining a correlation structure between large numbers of variables?
11.4 What is meant by a positive-semidefinite matrix? What are the implications
of a correlation matrix not being positive-semidefinite?
11.5 Suppose that the current daily volatilities of asset A and asset B are 1.6% and
2.5%, respectively. The prices of the assets at close of trading yesterday were
$20 and $40 and the estimate of the coefficient of correlation between the
returns on the two assets made at that time was 0.25. The parameter used
in the EWMA model is 0.95.
(a) Calculate the current estimate of the covariance between the assets.
(b) On the assumption that the prices of the assets at close of trading today
are $20.50 and $40.50, update the correlation estimate.
11.6 Suppose that the current daily volatilities of asset X and asset Y are 1.0%
and 1.2%, respectively. The prices of the assets at close of trading yesterday were $30 and $50 and the estimate of the coefficient of correlation between the returns on the two assets made at this time was 0.50. Correlations and volatilities are updated using a GARCH(1,1) model. The estimates
of the models parameters are = 0.04 and = 0.94. For the correlation
= 0.000001 and for the volatilities = 0.000003. If the prices of the two assets at close of trading today are $31 and $51, how is the correlation estimate
updated?
11.7 Suppose that in Problem 10.15 the correlation between the S&P 500 index (measured in dollars) and the FTSE 100 index (measured in sterling) is
0.7, the correlation between the S&P 500 index (measured in dollars) and
the dollar-sterling exchange rate is 0.3, and the daily volatility of the S&P
500 index is 1.6%. What is the correlation between the S&P 500 index
(measured in dollars) and the FTSE 100 index when it is translated to dollars? (Hint: For three variables X, Y, and Z, the covariance between X + Y
and Z equals the covariance between X and Z plus the covariance between
Y and Z.)
11.8 Suppose that two variables V1 and V2 have uniform distributions where all
values between 0 and 1 are equally likely. Use a Gaussian copula to define
the correlation structure between V1 and V2 with a copula correlation of 0.3.
Produce a table similar to Table 11.3 considering values of 0.25, 0.50, and
0.75 for V1 and V2 . (A spreadsheet for calculating the cumulative bivariate
normal distribution is on the authors website: www-2.rotman.utoronto.ca/
hull/riskman.)
11.9 Assume that you have independent random samples z1 , z2 , and z3 from a standard normal distribution and want to convert them to samples 1 , 2 , and 3
from a trivariate normal distribution using the Cholesky decomposition. Derive three formulas expressing 1 , 2 , and 3 in terms of z1 , z2 , and z3 and the
three correlations that are needed to define the trivariate normal distribution.
11.10 Explain what is meant by tail dependence. How can you vary tail dependence
by the choice of copula?

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11.11 Suppose that the marginal distributions of V1 and V2 are standard normal
distributions but that a Students t-copula with four degrees of freedom and
a correlation parameter of 0.5 is used to define the correlation between the
variables. How would you obtain samples from the joint distribution?
11.12 In Table 11.3, what is the probability density function of V2 conditional on
V1 < 0.1? Compare it with the unconditional distribution of V2 .
11.13 What is the median of the distribution of V2 when V1 equals 0.2 in the example in Tables 11.1 and 11.2?
11.14 Suppose that a bank has made a large number of loans of a certain type.
The one-year probability of default on each loan is 1.5% and the recovery
rate is 30%. The bank uses a Gaussian copula for time to default. Use Vasiceks model to estimate the default rate that we are 99.5% certain will not be
exceeded.
11.15 Suppose that the default rate for a portfolio of consumer loans over the past
10 years has been 1%, 9%, 2%, 3%, 5%, 1%, 6%, 7%, 4%, and 1%. What
are the maximum likelihood estimates of the parameters in Vasiceks model?

FURTHER QUESTIONS
11.16 Suppose that the price of Asset X at close of trading yesterday was $300 and
its volatility was estimated as 1.3% per day. The price of X at the close of
trading today is $298. Suppose further that the price of Asset Y at the close of
trading yesterday was $8, its volatility was estimated as 1.5% per day, and its
correlation with X was estimated as 0.8. The price of Y at the close of trading
today is unchanged at $8. Update the volatility of X and Y and the correlation
between X and Y using
(a) The EWMA model with = 0.94
(b) The GARCH(1,1) model with = 0.000002, = 0.04, and = 0.94.
In practice, is the parameter likely to be the same for X and Y?
11.17 The probability density function for an exponential distribution is ex where
x is the value of the variable and is a parameter. The cumulative probability distribution is 1 ex . Suppose that two variables V1 and V2 have exponential distributions with parameters of 1.0 and 2.0, respectively. Use a
Gaussian copula to define the correlation structure between V1 and V2 with a
copula correlation of 0.2. Produce a table similar to Table 11.3 using values
of 0.25, 0.5, 0.75, 1, 1.25, and 1.5 for V1 and V2 . (A spreadsheet for calculating the cumulative bivariate normal distribution is on the authors website:
www-2.rotman.utoronto.ca/hull/riskman.)
11.18 Create an Excel spreadsheet to produce a chart similar to Figure 11.5 showing
samples from a bivariate Students t-distribution with four degrees of freedom
where the correlation is 0.5. Next suppose that the marginal distributions of
V1 and V2 are Students t with four degrees of freedom but that a Gaussian
copula with a copula correlation parameter of 0.5 is used to define the correlation between the two variables. Construct a chart showing samples from
the joint distribution. Compare the two charts you have produced.