medium · Quantitative Finance prob-stats
A trader observes that two assets have a high Pearson correlation but no tail dependence.
Which copula model is likely being used, and why is this potentially dangerous for risk management?
- An Archimedean copula, which is valid only when both assets share an identical marginal distribution.
- Gaussian copula; it assumes that extreme events in the tails become independent, underestimating joint crash risk.
- A Student-t copula; it fails to capture linear correlation between the assets under calm market conditions.
- A Clayton copula, which overstates the correlation among positive returns while largely ignoring negative tail risk entirely.
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