April 2021

Dynamic Factor Copula Models with Estimated Cluster Assignments

Dong Hwan Oh and Andrew J. Patton

Abstract:

This paper proposes a dynamic multi-factor copula for use in high dimensional time series applications. A novel feature of our model is that the assignment of individual variables to groups is estimated from the data, rather than being pre-assigned using SIC industry codes, market capitalization ranks, or other ad hoc methods. We adapt the k-means clustering algorithm for use in our application and show that it has excellent finite-sample properties. Applying the new model to returns on 110 US equities, we find around 20 clusters to be optimal. In out-of-sample forecasts, we find that a model with as few as five estimated clusters significantly outperforms an otherwise identical model with 21 clusters formed using two-digit SIC codes.

Keywords: correlation, tail risk, multivariate density forecast

DOI: https://doi.org/10.17016/FEDS.2021.029

PDF: Full Paper

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Last Update: April 30, 2021