Predicting tail events in a RIA-EVT-Copula framework

Abstract

Predicting the occurrence of tail events is of great importance in financial risk management. By employing the method of peak-over-threshold (POT) in extreme value theory (EVT) to identify the financial extremes, we perform a recurrence interval analysis (RIA) on these extremes. We find that the waiting time between consecutive extremes (recurrence interval) follows a q-exponential distribution, and the sizes of extremes above the thresholds (exceeding size) conform to a generalized Pareto distribution. We also find that there is a significant correlation between recurrence intervals and exceeding sizes. We thus model the joint distribution of recurrence intervals and exceeding sizes through connecting the two corresponding marginal distributions with the Frank and Ali-Mikhail-Haq (AMH) copula functions, and apply this joint distribution to estimate the hazard probability to observe another extreme in Δt time since the last extreme happened t time ago. Furthermore, an extreme predicting model based on RIA-EVT-Copula is proposed by applying a decision-making algorithm on the hazard probability. Both in-sample and out-of-sample tests reveal that this new extreme forecasting framework has better predicting performance than the forecasting model based on the hazard probability only estimated from the distribution of recurrence intervals. Our results not only shed a new light on understanding the occurring pattern of extremes in financial markets, but also improve the accuracy of predicting financial extremes for risk management.