The joint distribution of stock returns is not elliptical

TL;DR

This paper investigates the limitations of elliptical models, including Student copulas, in accurately describing the joint distribution of stock returns, especially when stocks are weakly correlated, highlighting the need for more nuanced models.

Contribution

It demonstrates the systematic failure of elliptical models for stock returns with low correlation and proposes new visualization and comparison methods for copulas.

Findings

Student copulas fit strongly correlated stocks well

Elliptical models fail for weakly correlated stocks

Rescaled Gaussian copula differences effectively discriminate models

Abstract

Using a large set of daily US and Japanese stock returns, we test in detail the relevance of Student models, and of more general elliptical models, for describing the joint distribution of returns. We find that while Student copulas provide a good approximation for strongly correlated pairs of stocks, systematic discrepancies appear as the linear correlation between stocks decreases, that rule out all elliptical models. Intuitively, the failure of elliptical models can be traced to the inadequacy of the assumption of a single volatility mode for all stocks. We suggest several ideas of methodological interest to efficiently visualise and compare different copulas. We identify the rescaled difference with the Gaussian copula and the central value of the copula as strongly discriminating observables. We insist on the need to shun away from formal choices of copulas with no financial interpretation.