Copula Application in Euro Area Credit Default Swaps

Summary 

In the research we presented copula as measure of dependence that is particularly useful for identification of tail dependence between variables. We tested different copula functions for credit default swap (CDS) changes of selected euro area countries. We reached the conclusion that the Student’s t copula describes best the dependence structure of the variables. The results support the opinion that the Gaussian copula is not a suitable tool despite its widespread use. Student’s t copula has tail dependence and hence it is more useful than Gaussian copula (no tail dependence) to simulate events like joint defaults and stock market crashes. Another interesting result of the research is that in some cases we proved that certain types of Archimedean copulas provide second best fit to data (implying that the asymmetric tail dependence is also a good fit).We use the best fit copula to model market risk of CDS. 

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