A Nonparametric Bayesian Approach to Copula Estimation

Abstract

We propose a novel Dirichlet-based P\'olya tree (D-P tree) prior on the copula and based on the D-P tree prior, a nonparametric Bayesian inference procedure. Through theoretical analysis and simulations, we are able to show that the flexibility of the D-P tree prior ensures its consistency in copula estimation, thus able to detect more subtle and complex copula structures than earlier nonparametric Bayesian models, such as a Gaussian copula mixture. Further, the continuity of the imposed D-P tree prior leads to a more favorable smoothing effect in copula estimation over classic frequentist methods, especially with small sets of observations. We also apply our method to the copula prediction between the S\&P 500 index and the IBM stock prices during the 2007-08 financial crisis, finding that D-P tree-based methods enjoy strong robustness and flexibility over classic methods under such irregular market behaviors.