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We know that some markets exhibit marginals well approximated by Student t distributions. But what is the dependence structure? Is the multivariate density really elliptical (as we all wish for) or are the marginals i.i.d, or something inbetween? Or does one of the other multivariate t models better apply?

Leading to a non-elliptical t the independence copula introduces directional "dependence", that's one tricky issue. How bad is the resulting fit in practice?

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A multivariate normal distribution can be thought of as normal margins with a normal copula. The multivariate t is the same way, but it has t margins with a t copula and they all have the same degrees of freedom. So it has t copula dependence. It is either a spherical or an elliptical distribution.

I can't think of a good reason to use a multivariate t. The degrees of freedom parameter is the same for both univariate and multivariate. You give yourself more options by fitting univariate t distributions for each series (so they could potentially have different degrees of freedom, more important when you're looking at a variety of different assets or factors).

The dependence can be handled by a copula. The normal copula is easy to use, but if you're concerned about tail dependence, then there are a number of options, including the t copula. Again, as with the multivariate t, the t copula has one degree of freedom parameter, which means that the tail dependence is assumed to be the same for everything. So if you're looking at data where it makes sense for all to be the same, perhaps such as U.S. equity sectors, then this is fine, but in the majority of cases it may not.

As an alternative, some people use grouped t copulas (where every series gets its own degree of freedom) and others use vine copulas (which allow an even greater potential for combinations to explain the dependence structure). One downside is that the more complicated the copula, then the more time-consuming it is to fit, especially if you want to fit a DCC copula. This also illustrates the importance of dimension reduction. I try to avoid just putting everything in a big multivariate distribution.

If I'm setting up a quantitative portfolio management model, more complicated tail dependence is pretty low on my list. I recall some benefit in backtests, but it was tiny compared to incorporating time-varying variance. You might be looking at different data, so do your own research and evaluate.

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  • $\begingroup$ I agree with your considerations, the different multivariate t-s do have many limits, but also some advantages, especially in dimension reduction one might want an elliptical density anyway, or in fast simulation. However the point is to clear up issues in the simpler setting first, since the mixed one is only more involved. One has to understand what are the issues with a certain dependence, be it in form of a copula or not. There are always better models. By the way, I've seen few robust copula calibrations... $\endgroup$ – Quartz Nov 12 '14 at 18:41
  • $\begingroup$ @Quartz I made a slight edit to throw in some basic background. I'm not sure how the elliptical point really helps you. I find that once I start working with heavy tail distributions, I typically just move to a Monte Carlo approach rather than work analytically. Any other issues I can help you with? $\endgroup$ – John Nov 12 '14 at 20:14
  • $\begingroup$ Added some more context, hope it clarifies my issue. Moving to copulae afaik complicates all tasks such as affine transforms, PCA&c, conditioning, fast simulation, stable calibration, which are most practical with elliptical densities (isn't the t copula defined&treated in terms of the multivariate density anyway?). But I'm certainly missing some cool shortcuts, I'm not up to date. $\endgroup$ – Quartz Nov 13 '14 at 10:22

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