Lorán Chollete, Andréas Heinen, Alfonso Valdesogo; Modeling International Financial Returns with a Multivariate Regime-switching Copula. Journal of Financial Econometrics 2009; 7 (4): 437-480. doi: 10.1093/jjfinec/nbp014
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.