Contents

## Introduction

The assumption of independent and identically distributed random variables, short i.i.d., my be quite handy since it simplifies several statistical methods. The strong law of large numbers as well as the central limit theorem, for instance, assume independent variables. Benefiting from the independence while being able to incorporate dependency structures between random variables would therefore be very useful. And indeed, there is a way how to sneak in correlations in a given setting of i.i.d. random variables. One of those techniques are mixture models such as the binomial- and the Poisson-mixture model that are both studied in this post. The following is mainly based on [1].

Let be a suitable probability space and assume that we are interested in a set of random variables .

## Bernoulli-Mixture Model

A Bernoulli trial (or binomial trial) is a random experiment with exactly two possible outcomes which we can call “success” and “failure”. The “success” outcome, often represented by 1, appears with probability , while the “failure” state, represented by 0, appears with complement probability .

One of the simplest stochastic processes, the so-called Bernoulli process, is simply a set of Bernoulli trials.

Example 1:

Let us assume that represents the creditworthiness of counterparty of a credit portfolio . It is natural to model the two states “survival” and “default” by using a Bernoulli process with for all counterparties . That is, can take on the following two states:

- with probability , if the counterparty goes bankrupt, and,
- with probability , if the counterparty survives.

Here, is the probability of default of counterparty which is usually derived from a corresponding credit rating and suitable historical default rates.

Another popular example of a Bernoulli trial/process is tossing a coin, where one side appears with probability .

More formally, a *Bernoulli process* is a (finite) sequence of independent random variables with

(1)

as Bernoulli trial with probability .

A Bernoulli process is therefore a sequence of independent identically distributed Bernoulli trials. Given the discrete nature of the Bernoulli trial, the expectation as well as the variance for counterparty is given by

(2)

In the next sections we will have a closer look at the Bernoulli process and we will relax the assumption of independence between them.

##### Sum of i.i.d. Bernoulli Random Variables with constant Parameter

For the sake of illustration let us assume that all random variables are mutually independent and that all random variables do have the same probability assigned. That is, is a Bernoulli process with probability . In this case the distribution of the sum

(3)

is governed by the binomial distribution .

Example 2:

We continue Example 1 and consider the sum of the corresponding Bernoulli process that is distributed according to . The probability that out of counterparties are going to default (“success”) is .

For instance, if and then two defaults will occur with probability .

As illustrated, it is easy to calculate any feature of the distribution of . For instance, the expectation, the variance as well as the probability of a specific value is given by:

(4)

Beside that, it would also be quite simple to determine as well as the variance by just knowing (2) and applying the additivity of the expectation and variance.

In the next step we are going to incorporate correlation between the variables by using the distribution parameters . Notice that is a probability.

##### Sum of Independent Bernoulli Random Variables with Random Parameter

By treating the distribution parameters of the outlined Bernoulli process as random variables , it is possible to incorporate a correlation. That is, we assume that follows a joint distribution represented by the distribution function with support in . Correspondingly, we assume , where itself is considered to be a random variable.

This kills two birds with one stone. First, we drop the assumption that all Bernoulli trials do have the same probability applied. Second, we can incorporate a correlation between the random variables since the correlation only depends on and .

In more mathematical terms, let

(5)

Conditional on the realization of the parameters , the random variables are still independent. One could, for instance, assume that is uniformly distributed on as in the `R`

code example below.

The joint distribution of is given by

(6)

where {“failure”, “success”}. The representation (6) is possible since we can leverage on the independence.

The covariance between the marginal random variables equals

(7)

and therefore the correlation can be determined by

(8)

That is, the correlation between the two variables and is fully determined by the variables and . We can therefore use this backdoor to sneak in correlation using conditional independence.

The binomial-mixture model is analytically. Nonetheless, we can simulate both sides of the equations to double-check it by example. The following `R`

code is one way to do so.

# Binomial Mixture Model: # --------- # Produce dependent uniform distributed variables by starting with multi-variate # normal variables. We therefore need the following package library(mvtnorm) m <- 20 #nbr of variables simulation.nbr <- 1000000 #nbr of simulations # get correlated normal random variables sigma <- diag(1, nrow = m, ncol = m) # variable 2 and 3 shall be correlated with 0.5 sigma[2,3] <- 0.5 sigma[3,2] <- 0.5 # variable 12 and 20 shall be correlated with 0.8 sigma[12,20] <- 0.8 sigma[20,12] <- 0.8 # simulate the m-dimensional joint normal distribution X <- rmvnorm(n=simulation.nbr, mean = rep(0,m), sigma = sigma) # transform data into correlated prob on [0,1]^m P <- pnorm(X) # prepare data structure for variables L <- matrix(nrow = simulation.nbr, ncol=m) # simulate the Bernoulli distribution for each variable i for(i in 1:m){ L[,i] <- ifelse(runif(simulation.nbr) < P[,i], 0, 1) } # By construction the following covariances should be in the same order cov(P[,2],P[,3]) cov(L[,2],L[,3]) cov(P[,12],P[,20]) cov(L[,12],L[,20]) # By construction the following correlations should be in the same order cov(P[,2],P[,3])/( sqrt(mean(P[,2])*(1-mean(P[,2]))) * sqrt(mean(P[,3])*(1-mean(P[,3])))) cor(L[,2],L[,3]) cov(P[,12],P[,20])/( sqrt(mean(P[,12])*(1-mean(P[,12]))) * sqrt(mean(P[,20])*(1-mean(P[,20])))) cor(L[,12],L[,20])

Please notice that we simulate a suitable Bernoulli process using the code `ifelse(runif(simulation.nbr) < P[,i], 0, 1)`

, where `P[,i]`

carries the correlation information of the parameter already in it.

## Poisson-Mixture Model

A similar pattern is also used for Poisson-distributed random variables. Let us therefore assume that our random variables are distributed according to the Poisson distribution with intensity parameter , denoted by . The expectation as well as the variance of a Poisson-distributed random variable is given by its intensity parameter, i.e.,

(9)

The distribution of the sum of independent Poisson-distributed variables is determined by

(10)

Given that we know the distribution of , it is easy to derive any feature such as expectation and variance:

(11)

Just as in the binomial case we introduce correlation between the variables and with by assuming that is a random vector with distribution function and support in .

Further we assume that conditionally on a realization of the variables with are independent:

(12)

The joint distribution of is given by

(13)

where .

The covariance between the marginal random variables equals

(14)

and therefore the correlation can be determined by

(15)

That is, the correlation between the two variables and is fully determined by the variables and . We can therefore use this backdoor to sneak the correlation in using conditional independence.

The Poisson-mixture model is analytically. Nonetheless, we simulate both sides of the equations to double-check it by example. The following `R`

code is one way to do so.

# Poisson Mixture Model: # --------- # Produce dependent variables on positive reals using multivariate discrete # random variables and a Gaussian copula. To this end we use the GenOrd package: library(GenOrd) m <- 20 #nbr of variables simulation.nbr <- 1000000 # since we want to have correlated random variables we need a corr matrix sigma <- diag(1, nrow = m, ncol = m) # variable 2 and 3 shall be correlated with 0.2 sigma[2,3] <- 0.2 sigma[3,2] <- 0.2 # variable 12 and 20 shall be correlated with 0.7 sigma[12,20] <- 0.7 sigma[20,12] <- 0.7 # to make it reproduceable set.seed(1) # list of m vectors representing the cumulative probabilities defining # the marginal distribution of the i-th marginal distribution via the CDF # that are all the same in our simple example marginal.CDF <- rep(list(bquote()), m) for(i in 1:m){ marginal.CDF[[i]] <- c(0.1, 0.3, 0.5, 0.6, 0.75) } # checks the lower and upper bounds of the correlation coefficients. # in our case the two correlations lie within the thresholds corrcheck(marginal.CDF) # create correlated sample with given marginals Lambda <- ordsample(n = simulation.nbr, marginal = marginal.CDF, Sigma = sigma) # prepare data structure for the Poisson-distributed variables # using the realized lambdas from variable Lambda L <- array(0,dim=c(simulation.nbr*10, m)) # simulate the Poisson distribution for each variable i for(i in 1:m){ # do for all variables L.i L[,i] <- rpois(n = simulation.nbr*10, lambda = Lambda[,i]) } # By construction the following covariances should be in the same order cov(Lambda[,2],Lambda[,3]) cov(L[,2],L[,3]) cov(Lambda[,12],Lambda[,20]) cov(L[,12],L[,20]) # By construction the following correlations should be in the same order cov(Lambda[,2],Lambda[,3])/( sqrt(var(Lambda[,2])+ mean(Lambda[,2])) * sqrt(var(Lambda[,3])+ mean(Lambda[,3])) ) cor(L[,2],L[,3]) cov(Lambda[,12],Lambda[,20])/( sqrt(var(Lambda[,12])+ mean(Lambda[,12])) * sqrt(var(Lambda[,20])+ mean(Lambda[,20])) ) cor(L[,12],L[,20])

Please notice that `rpois(n=20, lambda=c(1,500))`

, for instance, generates a random variate using the two different intensity parameter and sharing the sample space of size . We therefore multiply the variable `simulation.nbr`

by 10 to increase the quality of the approximation.

**Literature:**

**[1]**

*Introduction to credit risk modeling*. 2nd ed. Boca Raton, FL: Chapman & Hall/CRC (Chapman & Hall/CRC financial mathematics series).