Economic Implications of Copulas and Extremes

Abstract

Recent events in financial markets and in nature have made it clear that it is vital to understand extremes. Such ’tail events’ occur in many aspects of economic life. As suggested by the subprime market spillover of 2007, the effects of which are still being felt, extreme events can spin out of control, so it is valuable to investigate how to characterise them. When extremes occur across several instruments or variables at the same time, the copula approach is one method of analysis. This article introduces and illustrates recent ideas on copulas and tail events. We also give examples of the relation of these concepts to investor choice and the potential implications for regulatory policy.