A review of the use of copulas in credit derivatives and the development of alternative methodologies

Lazic, Slavica
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Credit derivatives and their modelling have received a lot of attention in recent years. Dependence between assets is a crucial property where the contingent payment depends on a basket of underlying assets. Prior to the recent global economic crisis, copulas had earned the reputation of being key tools for capturing this dependence. However, their popularity has been subsequently lost. In this dissertation we will examine the theory surrounding copulas and their usefulness when applied to modelling credit derivatives. First, some general mathematical theory will be presented. Following this introduction, we will look at various copulas that have been suggested for the use in credit derivatives, such as the Gaussian copula, the t-copula and the Archimedean family of copulas. We will discuss the features of these copulas that may make them attractive for modelling credit derivatives. We will then turn our attention to the pitfalls of copulas that may have caused their recent lack of popularity. Finally, we will examine alternative models that have been put forward for capturing this dependence in credit derivatives