Stress Testing with Student's T Dependence

39 Pages Posted: 26 Aug 2006

See all articles by Erik Kole

Erik Kole

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM; Tinbergen Institute

Kees C. G. Koedijk

Tilburg University - Department of Finance

Marno Verbeek

Erasmus University - Rotterdam School of Management; Erasmus Research Institute of Management (ERIM); Netspar

Date Written: 24 2003 9,

Abstract

In this study we propose the use of the Student's t dependence function to model dependence between asset returns when conducting stress tests. To properly include stress testing in a risk management system, it is important to have accurate information about the (joint) probabilities of extreme outcomes. Consequently, a model for the behavior of risk factors is necessary, specifying the marginal distributions and their dependence. Traditionally, dependence is described by a correlation matrix, implying the use of the dependence function inherent in the multivariate normal (Gaussian) distribution. Recent studies have cast serious doubt on the appropriateness of the Gaussian dependence function to model dependence between extreme negative returns. The student's t dependence function provides an attractive alternative. In this paper, we introduce four tests to analyze the empirical fit of both dependence functions. The empirical results indicate that probabilities assigned to stress tests are largely influenced by the choice of dependence function. The statistical tests reject the Gaussian dependence function, but do not reject the Student's t dependence function.

Keywords: stress testing, dependence, extreme values, copulas, tail dependence

JEL Classification: M, M41, G3, C19

Suggested Citation

Kole, Erik and Koedijk, Kees G. and Verbeek, Marno, Stress Testing with Student's T Dependence (24 2003 9,). Available at SSRN: https://ssrn.com/abstract=450991

Erik Kole (Contact Author)

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 12 58 (Phone)

HOME PAGE: http://people.few.eur.nl/kole

ERIM

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kole

Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

Marno Verbeek

Erasmus University - Rotterdam School of Management ( email )

P.O. Box 1738
Room T09-53
3000 DR Rotterdam
Netherlands
+31 10 408 2790 (Phone)

HOME PAGE: http://www.rsm.nl/mverbeek

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Netspar

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
406
Abstract Views
2,910
rank
90,684
PlumX Metrics