Beyond Correlations : The Use and Abuse of Copulas in Economic Capital Calculations

Despite extensive literature consisting of many excellent academic and practical papers, there are still many commonly heard fallacies in practice such as: “To aggregate risks, all I need are correlations”. “I assume dependence/independence, hence there is no copula”. “I need to use a Variance-Covariance approach with tail-end correlations to capture fat tails and tail dependence”. “The mere existence of the concept of copulas guarantees that economic capital (ECAP) calculations can always be made”. This confusion is partly due to the ubiquitous discussion of “correlations” but infrequent discussion of “copulas” amongst practitioners, and this memo aims at demystifying and clarifying the different concepts.