A Theoretical Argument Why the t-Copula Explains Credit Risk Contagion Better than the Gaussian Copula.pdfVIP

Hindawi Publishing Corporation Advances in Decision Sciences Volume 2010, Article ID 546547, 29 pages doi:10.1155/2010/546547 Research Article A Theoretical Argument Why the t-Copula Explains Credit Risk Contagion Better than the Gaussian Copula Didier Cossin,1, 2, 3 Henry Schellhorn,1, 2, 3 Nan Song,1, 2, 3 and Satjaporn Tungsong1, 2, 3 1 IMD, 1001 Lausanne, Switzerland 2 Claremont Graduate University, Claremont, CA 91711, USA 3 Thammasat University, Bangkok, Thailand Correspondence should be addressed to Henry Schellhorn, henry.schellhorn@ Received 19 December 2009; Accepted 23 February 2010 Academic Editor: Chin Lai Copyright q 2010 Didier Cossin et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. One of the key questions in credit dependence modelling is the specfication of the copula function linking the marginals of default variables. Copulae functions are important because they allow to decouple statistical inference into two parts: inference of the marginals and inference of the dependence. This is particularly important in the area of credit risk where information on dependence is scant. Whereas the techniques to estimate the parameters of the copula function seem to be fairly well established, the choice of the copula function is still an open problem. We find out by simulation that the t-copula naturally arises from a structural model of credit risk, proposed by Cossin and Schellhorn 2007. If revenues are linked by a Gaussian copula, we demonstrate that the t-copula provides a better fit to simulations than does a Gaussian copula. This is