Estimation and Model Selection of Copulas with an Application to Exchange Rates

Abstract

Copulas are the part of a multivariate distribution function that fully captures the cross sectional dependence between the variables of interest and they have become a very popular tool to model dependencies different from the linear correlation of elliptical distributions. We review the theory of copula functions, present a number of examples and describe how to sample random data from these. Different techniques for estimation and model selection are discussed and compared in an extensive Monte Carlo study. We find that a test not considered in the literature, namely the Jarque-Bera test applied on transformed data from the conditional copula, has the best properties of the presented tests, but that the most reliable criterion for selecting the best fitting copula is the Akaike information criterion. We model exchange rate returns of Latin American currencies against the euro with copulas and we find evidence of symmetric dependence, excess upper tail dependence and excess lower tail dependence.econometrics;