medium · Frm Part 2 Market Risk
A bank tries to adjust its credit risk model to capture the higher correlation between defaults observed during the 2008 financial crisis. The current model uses a Gaussian copula with ρ = 0.3. The analyst proposes raising ρ to 0.6 within the same Gaussian framework.
Why is this fix fundamentally limited?
- Raising ρ will decrease the probability of observing very few defaults, which is counter-intuitive for a crisis.
- Credit defaults are discrete events, and the Gaussian copula can only model continuous asset returns.
- The Gaussian copula has zero asymptotic tail dependence regardless of the correlation parameter value.
- The Pearson correlation ρ is not a valid parameter for Archimedean copulas.
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