Nonlinear term structure dependence: Copula functions,empirics, and risk implications |
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| Affiliation: | 1. Department of Finance and Accounting, University of Tunis El Manar, Tunis, Tunisia;2. Department of Economics and Finance, College of Economics and Political Science, Sultan Qaboos University, Muscat, Oman;3. Lebow College of Business, Drexel University, Philadelphia, United States;4. Energy and Sustainable Development (ESD), Montpellier Business School, Montpellier, France;5. College of Business and Economics, Qatar University, Qatar;6. Faculty of Business Administration, Bilkent University, Ankara 06800, Turkey;7. Department of Business Administration, Pusan National University, Busan, Republic of Korea;1. Department of Accounting and Finance, United Arab Emirates University, UAE;2. Department of Accounting and Finance, United Arab Emirates University, Al Ain, Abu Dhabi, UAE |
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| Abstract: | This paper documents nonlinear cross-sectional dependence in the term structure of US-Treasury yields and points out risk management implications. The analysis is based on a Kalman filter estimation of a two-factor affine model which specifies the yield curve dynamics. We then apply a broad class of copula functions for modeling dependence in factors spanning the yield curve. Our sample of monthly yields in the 1982–2001 period provides evidence of upper tail dependence in yield innovations; i.e., large positive interest rate shocks tend to occur under increased dependence. In contrast, the best-fitting copula model coincides with zero lower tail dependence. This asymmetry has substantial risk management implications. We give an example in estimating bond portfolio loss quantiles and report the biases which result from an application of the normal dependence model. |
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