Modeling International Financial Returns with a Multivariate Regime-switching Copula

TLDR

Canonical vines, built from bivariate conditional copulas, offer a highly flexible way to characterize multivariate dependence. The authors aim to capture observed asymmetric dependence in international financial returns by constructing a multivariate regime‑switching copula model. They model dependence using a regime‑switching framework that incorporates both a Gaussian and a canonical vine copula, and apply it to G5 and Latin American return data. The findings show that canonical vine regimes outperform alternatives, that copula choice markedly influences Value‑at‑Risk and out‑of‑sample performance, and that ignoring asymmetric dependence and regime switching imposes significant costs on investors.

Abstract

In order to capture observed asymmetric dependence in international financial returns, we construct a multivariate regime-switching model of copulas. We model dependence with one Gaussian and one canonical vine copula regime. Canonical vines are constructed from bivariate conditional copulas and provide a very flexible way of characterizing dependence in multivariate settings. We apply the model to returns from the G5 and Latin American regions, and document three main findings. First, we discover that models with canonical vines generally dominate alternative dependence structures. Second, the choice of copula is important for risk management, since it modifies the Value-at-Risk (VaR) of international portfolios and produces a better out-of-sample performance. Third, ignoring asymmetric dependence and regime-switching in portfolio selection leads to significant costs for an investor.