ARCH and GARCH MODELS

David Leblang
University of Colorado

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ARCH

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I.

Motivation: Why ARCH/GARCH Models?

1) What is ARCH/GARCH?
2) Generalizedmore general than ARCH
3) Autoregressivedepends on its past
4) Conditionalvariance depends on past
info
5) Heteroscedasticitynon-constant
variance.
6) EconometricOLS assumes:
7) No Serial Correlation: cov( t , t 1 ) 0 -- tests
and corrections are standard in the
literature.

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ARCH

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 t ~ NID( , ) -8) Homoscedastic

Errors:
errors are normally and independently
distributed. Usual for papers to test for
heteroscedasticity (i) in the cross-sectional
context but unusual in the time-series
context (t)

9) Consequences:
OLS
is
BLUE
and
consistent. HOWEVER, OLS is not efficient
(minimum variance) if we relax the class of
estimators to include nonlinear estimators.

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ARCH

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10) Empirical Regularities (S&P returns).

11) Volatility Clustering

100*[log(sp(t))-(log(sp(t-1)))]

4.65458

-6.00451
22dec1999

31mar2000

date

09jul2000

17oct2000

Volatility Clustering

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ARCH

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12) Fat/Heavy Tails (Kurtosis) [k=3]

Fraction

.113636

0
-6.00451

100*[log(sp(t))-(log(sp(t-1)))]

4.65458

Kurtosis

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ARCH

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13) TheoreticalVariance is of Interest

14) What causes volatility/variance of a
series? Finance literature (risk premium);
economics
literature
(target
zones).
Political
sciencepolitical
events/information influence variability of
asset prices (e.g., Leblang and Bernhard;
Freeman, Hays and Stix)
15) Are
some
events/periods/systems
conducive to more/less volatility than
others?

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ARCH

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16) Textbook References

17) Enders, Applied
Econometric Time Series
18) Patterson, An
Introduction to Applied
Series
19) Franses and van Dijk,
Linear Time Series Models
Empirical Finance

Time
Nonin

20) Software (others=PC-GIVE, RATS, TSP)

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ARCH

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Software
STATA
www.stata.com

EVIEWS
www.eviews.com

S+ GARCH
www.insightful.com

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ARCH

Advantages

Disadvantages

My favorite in
general
Lots of built in
models
Choice of algorithm
Easy to program

Only normal dist.

Few built-in
diagnostics

Lots of built in
models
Choice of algorithm
Lots of built in diag.
FAST!
Lots of built in
models
FIGARCH
MGARCH
t, ged, double exp

Only normal dist.

Difficult to program

Difficult to program
No choice of
algorithm
A bit clunky

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dist.
Terrific Graphics

II.

Preliminaries: Linear Time Series

1) Variable yt is observed for t=1,2,..,n
2) The error (t) is a white noise series if
3) E [ t ] 0
4) E[ 2t ] E[ 2t | t 1 ] 2 t .
The error is
unconditionally
and
conditionally
homoscedastic.
5) E[ t s ] 0; s t . Note: this says that the
information set t 1 does not contain
information to forecast t .

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ARCH

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6) A time series for yt can be thought of as

the sum of a predictable and an
unpredictable component: yt E[ yt | t 1 ] t .
III.

Relax assumption of homoscedasticity

1) Allow conditional variance of t to vary
E[ 2t | t 1 ] ht
over time:
for some
nonnegative function.
2) In general, this is expressed as: t zt ht ,
where zt is independently and identically
distributed normally with mean zero and
unit variance (this can be relaxeduse
student t and ged distributions to allow for
fatter tails).

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ARCH

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3) This means that the distribution of t

conditional upon the history t 1 is normal
with mean zero and variance ht. It also
means that the unconditional variance of t
is constant.
Using the law of iterated
expectations: 2 E[ 2t ] E[ E [ 2t | t 1 ]] E [ht ] .
4) We now need a model to specify how the
conditional variance of t evolves over
time.

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ARCH

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IV.

Autoregressive Conditional Heteroscedasticity

1) Invented by Engle (1982) to explain the
volatility of inflation rates.
2) Basic ARCH (1) model: conditional
variance of a shock at time t is a function of
the squares of past shocks: ht 1 2t 1 .
(Recall, h is the variance and is a shock,
news, or error).
3) Since the conditional variance needs to
be nonnegative, the conditions 0; 1 0
have to be met.
If 1 = 0, then the
conditional variance is constant and t is
conditionally homoscedastic.

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ARCH

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V.

Generalized ARCH (GARCH)

1) Because ARCH(p) models are difficult to
estimate,
and
because
( 2t 2 , 2t 3 ), ( 2t 3 , 2t 4 ), etc. decay very slowly,
Bollerslev (1986) developed the GARCH
model.
2) GARCH (1,1):

ht 1 2t 1 1ht 1 .

3) The variance (ht) is a function of an

intercept (), a shock from the prior period
() and the variance from last period ().

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ARCH

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4) Higher
p

ht j
j 1

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ARCH

order
2
t j

GARCH

models:

h
k t k .
k 1

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VI. Linear GARCH Variations.

1) Integrated GARCH (Engle and Bollerslev
1986).
2) Phenomena is similar to integrated series
in regular (ARMA-type) time-series.
3) Occurs when +=1. When this is the
case it means that there is a unit root in the
conditional variance; past shocks do not
dissipate but persist for very long periods
of time.
4) Fractionally Integrated GARCH (Baillie,
Bollerslev and Mikkelsen (1996)).
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ARCH

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5) GARCH in Mean
Robbins (1987).

(Engle,

Lilien

and

6) Idea is that there is a direct relationship

between risk and return of an asset.
7) In the mean equation, include some
function of the conditional variance
usually the standard deviation.
8) This allows the mean of a series to
depend, at least in part, on the conditional
variance of the series (more later)..

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ARCH

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VII. Non-Linear GARCH Variations (dozens in last 20

years). Linear GARCH models all allow prior
shocks to have a symmetric affect on ht. Nonlinear models allow for asymmetric shocks to
volatility. I will focus on the most common: the
Exponentional GARCH (1,1) (EGARCH) model
developed by Nelson (1991).
1) Conditional variance:

log(ht ) 1zt 1 1 (| zt 1 | E [| zt 1 |]) 1 log(ht 1 ) ,

where zt t / ht and is the standardized

residual. is the asymmetric component.

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ARCH

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2) News Impact Curvedifferential impact

of positive and negative shocks.

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ARCH

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Conditional Variance: GARCH

Conditional Variance: EGARCH

83.8448

.587194

.404425

Conditional Variance: GARCH

Conditional Variance: EGARCH

40.1751

-9.8

error (t-1)

9.8

News Impact Curve: dCPI w/ ARMA(1,1)

VIII. Testing for ARCH

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ARCH

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1) ARCH Tests (Engle 1982).

2) Regress Y on X and obtain some residuals
( t )
3) Regress 2t on p lags of
2t 0 1 2t 1 2 2t 2 .. p 2t p

2t ; that is,

a.
Assess joint significance of 1 p .
If the coefficients are different from zero
then
the
null
of
conditional
homoscedasticity can be rejected.
b. T*R2 is Engles LM test statistic. Under
the null of homoscedasticity it is
asymptotically distributed 2 (q )
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ARCH

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4) Graphical TestLjung-Box Q Statistic

5) LB (Q) used to diagnose serial correlation
in the residuals
6) LB(Q2) used to diagnose serial correlation
in
the
squared
residuals
heteroscedasticity

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ARCH

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IX. ExampleReturns on the S&P 500

. regress dlsp

/returns on the S & P 500 Index

Source |
SS
df
MS
-------------+-----------------------------Model |
0.00
0
.
Residual | 391.285893
219 1.78669358
-------------+-----------------------------Total | 391.285893
219 1.78669358

Number of obs
F( 0,
219)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

220
0.00
.
0.0000
0.0000
1.3367

-----------------------------------------------------------------------------dlsp |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------_cons |
.0096484
.0901184
0.11
0.915
-.167962
.1872588
-----------------------------------------------------------------------------. predict e if e(sample), resid / obtain residuals
. gen e2=e^2

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ARCH

/generate squared residuals

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. reg e2 l.e2 /regress squared residuals on a lag

Source |
SS
df
MS
-------------+-----------------------------Model |
72.087039
1
72.087039
Residual | 2684.92529
217 12.3729276
-------------+-----------------------------Total | 2757.01233
218 12.6468456

Number of obs
F( 1,
217)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

219
5.83
0.0166
0.0261
0.0217
3.5175

-----------------------------------------------------------------------------e2
|
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------e2
|
L1 |
.1616863
.0669855
2.41
0.017
.0296608
.2937118
_cons
|
1.49788
.2661034
5.63
0.000
.9734018
2.022358
-----------------------------------------------------------------------------. test l1.e2
( 1)

/test H0: homoscedastic residuals

L.e2 = 0.0
F(

1,
217) =
Prob > F =

5.83
0.0166

. display 219*.0261
5.7159
. display chiprob(1, 5.7159) /the value is the p-value to reject H0 of Homoscedasticity
.01681195

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ARCH

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Autocorrelation Function
. ac e2

/autocorrelation function of the squared residuals

Autocorrelations of e2

Bartlett's formula for MA(q) 95% confidence bands

1.00

1.00

0.75

0.75

0.50

0.50

0.25

0.25

0.00

0.00

-0.25

-0.25

-0.50

-0.50

-0.75

-0.75

-1.00

-1.00
0

10

20
Lag

30

40

Correlogram

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ARCH

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. corrgram e2 /correlegram gives the ac and pacs

-1
0
1 -1
0
1
LAG
AC
PAC
Q
Prob>Q [Autocorrelation] [Partial Autocor]
------------------------------------------------------------------------------1
0.1615
0.1617
5.8191 0.0159
||2
0.1511
0.1282
10.937 0.0042
||3
-0.0107 -0.0555
10.963 0.0119
|
|
4
0.0577
0.0505
11.715 0.0196
|
|
5
0.0724
0.0695
12.906 0.0243
|
|
6
0.1087
0.0765
15.603 0.0161
|
|
7
-0.0132 -0.0594
15.643 0.0286
|
|
8
0.0007 -0.0123
15.643 0.0478
|
|
9
-0.0317 -0.0189
15.876 0.0695
|
|
10
0.0070
0.0027
15.887 0.1029
|
|
. wntestq e2, lags(1)
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
5.8191
Prob > chi2(1)
=
0.0159

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ARCH

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Remedy: GARCH (1,1) Model

. arch dlsp, arch(1) garch(1) nolog
ARCH family regression
Sample:

4 to 223

Log likelihood = -366.1473

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
OPG
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0232815
.0826522
0.28
0.778
-.1387138
.1852768
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1652834
.045527
3.63
0.000
.0760521
.2545146
garch
|
L1 |
.7815966
.0783583
9.97
0.000
.6280172
.935176
_cons
|
.1121176
.0913255
1.23
0.220
-.066877
.2911122
------------------------------------------------------------------------------

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ARCH

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RESIDUAL TESTS
. predict e, resid
. predict v, variance
. gen s=sqrt(v)
. gen se=e/s
. gen se2=se^2
. wntestq se2
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
30.0623
Prob > chi2(40)
=
0.8735

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ARCH

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. corrgram se2
-1
0
1 -1
0
1
LAG
AC
PAC
Q
Prob>Q [Autocorrelation] [Partial Autocor]
------------------------------------------------------------------------------1
-0.0100 -0.0100
.02243 0.8810
|
|
2
0.0873
0.0875
1.7295 0.4212
|
|
3
-0.0914 -0.0911
3.6084 0.3070
|
|
4
0.0091
0.0009
3.6269 0.4588
|
|
5
-0.0114
0.0044
3.6562 0.5999
|
|
6
0.0214
0.0127
3.7612 0.7090
|
|
7
-0.0549 -0.0547
4.4529 0.7264
|
|
8
-0.0243 -0.0290
4.5894 0.8004
|
|
9
-0.0238 -0.0117
4.7205 0.8580
|
|
10
0.0067
0.0017
4.7311 0.9084
|
|

No Remaining ARCHBUT, what about normality??

Recall: Normal distribution has skewness of 0 and
kurtosis of 3 and we know that financial series tend
to be fat tailed.

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ARCH

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.graph se, norm bin(50)

Fraction

.1

0
-4.20146

se

2.73526

. sktest se
Skewness/Kurtosis tests for Normality
------- joint -----Variable | Pr(Skewness)
Pr(Kurtosis) adj chi2(2)
Prob>chi2
-------------+------------------------------------------------------se |
0.067
0.012
8.77
0.0125

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ARCH

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Solution: Use Robust Standard Errorsrobust to

departures from normality (Bollerslev & Wooldridge
1982)
. arch dlsp, arch(1) garch(1) nolog robust
ARCH family regression
Sample:

4 to 223

Log likelihood = -366.1473

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0232815
.0786518
0.30
0.767
-.1308732
.1774362
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1652834
.2083251
0.79
0.428
-.2430264
.5735931
garch
|
L1 |
.7815966
.3140995
2.49
0.013
.165973
1.39722
_cons
|
.1121176
.2578869
0.43
0.664
-.3933314
.6175666
------------------------------------------------------------------------------

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ARCH

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Inclusion of Exogenous Variables

. arch dlsp, arch(1) garch(1) nolog robust het(gore) bhhh
ARCH family regression -- multiplicative heteroskedasticity
Sample:

4 to 223

Log likelihood = -365.4092

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0135455
.080307
0.17
0.866
-.1438533
.1709443
-------------+---------------------------------------------------------------HET
|
gore
| -.1355259
.0615727
-2.20
0.028
-.2562061
-.0148457
_cons
|
5.006925
3.286556
1.52
0.128
-1.434607
11.44846
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1945511
.0973455
2.00
0.046
.0037575
.3853447
garch
|
L1 |
.6837859
.1219819
5.61
0.000
.4447057
.922866
------------------------------------------------------------------------------

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ARCH

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. wntestq se2
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
29.1930
Prob > chi2(40)
=
0.8965
. sktest se2
Skewness/Kurtosis tests for Normality
------- joint -----Variable | Pr(Skewness)
Pr(Kurtosis) adj chi2(2)
Prob>chi2
-------------+------------------------------------------------------se2 |
0.000
0.000
.
0.0000

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ARCH

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ARCH IN MEAN
. arch dlsp, arch(1) garch(1) nolog robust het(gore) archm archmexp(sqrt(X))
ARCH family regression -- multiplicative heteroskedasticity
Sample:

4 to 223

Log likelihood = -362.6718

Number of obs
Wald chi2(1)
Prob > chi2

=
=
=

220
4.84
0.0278

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
-.80408
.3986817
-2.02
0.044
-1.585482
-.0226782
-------------+---------------------------------------------------------------ARCHM
|
sigma2ex
|
.7068768
.3213948
2.20
0.028
.0769545
1.336799
-------------+---------------------------------------------------------------HET
|
gore
| -.1067959
.016462
-6.49
0.000
-.1390609
-.0745308
_cons
|
3.790934
.9837613
3.85
0.000
1.862797
5.71907
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1835399
.0981365
1.87
0.061
-.0088041
.3758838
garch
|
L1 |
.6634369
.1133509
5.85
0.000
.4412733
.8856006
------------------------------------------------------------------------------

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ARCH

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