Model the Complex Dependence Structures of Financial Variables by Using Canonical Vine

Publication Type:
Conference Proceeding
The 21st ACM International Conference on Information and Knowledge Management, 2012, pp. 1382 - 1391
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Financial variables such as asset returns in the massive market contain various hierarchical and horizontal relationships forming complicated dependence structures. Modeling and mining of these structures is challenging due to their own high structural complexities as well as the stylized facts of the market data. This paper introduces a new canonical vine dependence model to identify the asymmetric and non-linear dependence structures of asset returns without any prior independence assumptions. To simplify the model while maintaining its merit, a partial correlation based method is proposed to optimize the canonical vine. Compared with the original canonical vine, the new model can still maintain the most important dependence but many unimportant nodes are removed to simplify the canonical vine structure. Our model is applied to construct and analyze dependence structures of European stocks as case studies. Its performance is evaluated by measuring portfolio of Value at Risk, a widely used risk management measure. In comparison to a very recent canonical vine model and the `full' model, our experimental results demonstrate that our model has a much better quality of Value at Risk, providing insightful knowledge for investors to control and reduce the aggregation risk of the portfolio.
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