Recovering copulas from limited information and an application to asset allocation

This paper proposes an entropy-based method to construct a new class of copulas - the most entropic canonical copulas (MECC). Our empirical study focuses on an investment problem for an investor with a constant relative risk aversion (CRRA) utility function allocating wealth between the Dow Jones Large-Cap and Small-Cap indices, of which the contemporaneous dependence can be modeled by the MECC or other commonly-used copulas. Both the theoretical analysis of the method and the empirical study indicate the potential for enormous statistical and economic gains as a result of using the MECC. (C) 2010 Elsevier B.V. All rights reserved.