Periodic Stochastic Volatility and Fat Tails

Ilias Tsiakas
University of Warwick
abstract
This article provides a comprehensive analysis of the size and statistical signifi-
cance of the day of the week, month of the year, and holiday effects in daily stock
index returns and volatility. We employ data fromthe DowJones Industrial Average
(DJIA), the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600 in order to
test whether the seasonal patterns of medium and small firms are similar to those
of large firms. Using formal hypothesis tests based on bootstrapping, we demon-
strate that there are more significant calendar effects in volatility than in expected
returns, especially for the two large cap indices. More importantly, we introduce the
periodic stochastic volatility (PSV) model for characterizing the observed seasonal
patterns of daily financial market volatility. We analyze the interaction between
seasonal heteroskedasticity and fat tails by comparing the performance of Gaus-
sian PSV and fat-tailed PSVt specifications to the plain vanilla SV and SVt bench-
marks. Consistent with our model-free results, we find strong evidence of seasonal
periodicity in volatility, which essentially eliminates the need for a fat-tailed condi-
tional distribution, and is robust to the exclusion of the crash of 1987 outliers.
keywords: stochastic volatility, calendar effects, seasonal heteroskedasticity,
bootstrapping, Bayesian MCMC estimation
It is widely documented that expected stock returns exhibit strong seasonal
patterns in the form of day of the week, month of the year, and holiday effects
[Lakonishok and Smidt (1988)]. For example, Keim (1983) and Reinganum (1983)
showed that small firms display abnormal returns [measured relative to the
doi:10.1093/jjfinec/nbi023
Advance Access publication August 18, 2005
ª The Author 2005. Published by Oxford University Press. All rights reserved. For permissions,
please e-mail: journals.permissions@oupjournals.org.
I am especially grateful to Angelo Melino for numerous insightful discussions. I also thank Tom McCurdy
and Roel Oomen for providing many useful comments on an earlier draft, as well as the editor (Eric
Renault), an associate editor, two anonymous referees, and seminar participants at the ISMA Centre,
University of Reading, and the 2003 Econometric Society summer meetings at Chicago and Stockholm.
This article was partially completed as a chapter in my PhD dissertation at the University of Toronto.
Address correspondence to Ilias Tsiakas, Warwick Business School, University of Warwick, Coventry CV4
7AL, UK, or e-mail: ilias.tsiakas@wbs.ac.uk.
Journal of Financial Econometrics, 2006, Vol. 4, No. 1, 90–135
capital asset pricing model (CAPM)] during the first two weeks of January. This
anomaly became known as the ‘‘turn-of-the-year effect’’ and is more frequently
referred to as the ‘‘January effect.’’ French (1980) and Keim and Stambaugh (1984)
observed that the average return of the S&P composite portfolio over weekends was
negative and statistically significant. This second calendar anomaly is known as the
‘‘weekend effect’’ or the ‘‘Monday effect.’’ French and Roll (1986) and Baillie and
Bollerslev (1989) found that volatility tends to be higher following nontrading days.
We refer to this third anomaly as the ‘‘holiday effect’’ or the ‘‘nontrading day’’ effect.
Subsequent to their discovery, there have been many attempts to justify these
seasonalities.
1
However, there is still no equilibrium model of asset prices that can
explain why expected returns should display calendar regularities. Possible
explanations include inventory adjustments of different traders [Ritter (1988)],
the timing of trades by informed and uninformed traders [Admanti and
Pfleiderer (1988)], specialists’ strategies in response to informed traders [Admanti
and Pfleiderer (1989)], the timing of corporate news releases [Penman (1987)],
tax-induced trading [Lakonishok and Smidt (1986)], and the window dressing
induced by periodic evaluation of portfolio managers [Haugen and Lakonishok
(1988)]. Other theories focus on the institutional arrangements in financial mar-
kets. For example, the January effect has been linked to year-end tax loss selling
pressure, which reduces stock prices in December, leading to a rebound in early
January as investors repurchase stocks to reestablish investment positions [Roll
(1983)]. Glosten, Jagannathan, and Runkle (1993) suggest that consumer sales
exhibit a pronounced quarterly seasonal pattern with the fourth quarter being
the important holiday season. January is the period when comprehensive and
reliable information about consumer spending typically becomes available.
Explanations offered for the Monday effect in stock returns include delays
between trading and settlements in stocks [Lakonishok and Levi (1982)], mea-
surement error [Keim and Stambaugh (1984)], institutional factors [Flannery and
Protopapadakis (1988)], and trading patterns [Lakonishok and Maberly (1990)].
This article provides a comprehensive analysis of the size and statistical
significance of the day of the week, month of the year, and nontrading day
seasonal effects in the daily returns, and more importantly, in the volatility of
four prominent U.S. stock indices: the Dow Jones Industrial Average (DJIA), the
S&P 500, the S&P MidCap 400, and the S&P SmallCap 600. Even though the
seasonal patterns of monthly, daily, and intraday returns have received much
attention in the finance and econometrics literature, there is surprisingly little
work on the seasonality of daily volatility, even within the broadly used general-
ized autoregressive conditionally heteroskedastic (GARCH) framework. Perhaps
the closest to providing a thorough examination of seasonal periodicity in both
the daily returns and the daily variance of the S&P 500 index is Gallant, Rossi, and
Tauchen (1992) in their investigation of return-volume comovements. Further,
Andersen and Bollerslev (1997) and Beltratti and Morana (1999) study the intraday
1
In fact, Sullivan, Timmermann, and White (2001) argue that such theories are "after the fact" rationaliza-
tios of observed phenomena.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 91
periodicity of asset returns. Bollerslev and Ghysels (1996) propose a periodic
GARCH (P-GARCH) model designed to capture the repetitive seasonal time
variation in volatility. Glosten, Jagannathan, and Runkle (1993) use a GARCH-
M model on monthly equity data, which only conditions on January and October
effects. Beller and Nofsinger (1998) examine only month of the year volatility
effects using monthly data. Balaban, Bayar, and Kan (2001), Berument and Kuy-
maz (2001), and Frances and Paap (2000) examine only the day of the week effect
on stock market volatility.
Our investigation has three main objectives: (i) to assess the size and statistical
significance of the three sets of seasonal effects in expected daily returns, and more
importantly, in the volatility of the four U.S. stock indices; (ii) to introduce, estimate,
and evaluate the performance of the periodic stochastic volatility model (PSV), which
is designed to explicitly condition on the observed seasonal heteroskedasticity; and
(iii) to formally analyze the interaction between seasonal heteroskedasticity and fat
tails by evaluating the performance of Gaussian and fat-tailed periodic stochastic
volatility specifications relative to the plain vanilla SV and SVt benchmarks. The
second and third objectives are novel contributions to the existing literature. We
investigate these objectives for the four indices in order to determine whether the
seasonal patterns of medium and small capitalization firms are similar to those of
large capitalization firms. This is the first study of seasonal heteroskedasticity that
distinguishes between the behavior of small, medium, and large firms.
Early work on the seasonal abnormalities in expected stock returns has found
overwhelming evidence of statistical significance for many calendar effects. For
example, Lakonishok and Smidt (1988) implement two-sided t-tests and joint
F-tests on 90 years of DJIA daily returns and find that the seasonal patterns in
the rates of return are highly significant. Two recent empirical studies offer
conflicting conclusions. On the one hand, Sullivan, Timmermann, and White
(2001) develop a new model-free bootstrap procedure that explicitly measures
the distortions on statistical inference induced by data mining. Using 100 years of
DJIA daily returns, they test the hypothesis of no calendar-specific anomalies by
analyzing whether a particular set of calendar-based trading rules yields a higher
return than a buy-and-hold strategy. They conclude that accounting for data
mining renders the calendar effects no longer statistically significant. On the
other hand, Hansen, Lunde, and Nason (2004) design a new generalized F-test,
also based on bootstrapping, which exploits the correlation structure of calendar
effects and is robust to data mining. Using stock indices from 10 countries, they
test the hypothesis of no calendar-specific anomalies as a two-sided hypothesis of
multiple equalities and find strong evidence that a large universe of calendar
effects is statistically significant in expected daily returns. Notably, none of these
studies model periodicity in volatility.
We motivate the new periodic stochastic volatility model by first establishing
the importance of explicitly modeling seasonal heteroskedasticity. Specifically,
we perform model-free formal hypothesis tests in order to assess the statistical
significance of seasonal abnormalities in both expected returns and volatility. We
use two types of tests, both of which are based on bootstrapping: two-sided t-tests
92 Journal of Financial Econometrics
and the data-mining robust F-test of Hansen, Lunde, and Nason (2004). The t-tests
isolate the significance of each individual calendar effect. The F-test considers the
full universe of calendar-specific anomalies. Our model-free analysis reveals that
there are more significant calendar effects in volatility than in expected returns,
especially for large cap indices. We also determine that our bootstrapping results
are not driven by the crash of 1987 outliers. In particular, all the results are robust
to the exclusion of the three most volatile days of October 1987: Monday, October
19, when the S&P 500 composite index plunged 22.9% (the minimum in our
sample) on the second highest volume ever recorded (604 million shares);
Tuesday, October 20, when the S&P 500 index rose by 5.2% on the highest volume
ever recorded (608 million shares); and Wednesday, October 21, when the S&P 500
rose 8.7% (the maximum in our sample) with the trading of 450 million shares.
The main contribution of this article is the introduction of the PSV model.
The PSV model generalizes the constants in both the conditional mean and the
conditional volatility functions in order to account for the day of the week,
month of the year, and holiday seasonal level effects. Specifically, the condi-
tional standard deviation of the periodic SV specification is subject to a periodic
seasonal level effect, which is separate from the dynamic SV component. Since
our study adopts a univariate discrete-time SV framework, we test the perfor-
mance of Gaussian PSV and fat-tailed PSVt specifications against two bench-
marks: (i) the plain vanilla SV model, which assumes conditionally Gaussian
innovations, an autoregressive conditional mean, and a persistent stochastic log-
variance process with a leverage effect; and (ii) the fat-tailed SVt model, which is
designed to capture the excess kurtosis of daily returns by assuming that daily
innovations conditionally follow a Student’s t-distribution. In total, we estimate
10 SV specifications. Unlike statistical jump processes specified in returns and
volatility, the timing and size of which are estimated ex post and are ex ante
unforecastable, the timing of seasonal periodicity is perfectly observed. Con-
ditioning on the set of calendar effects adjusts the daily level of the returns and
volatility processes so that the persistent stochastic volatility component can
better accommodate the shocks that may be specific (for example) to a Monday
in October. Our model-specific results support the null of seasonal heteroske-
dasticity as the parameter estimates of the PSV model match the seasonality of
the data for each separate calendar effect.
More importantly, we analyze the interaction between seasonal heteroskedas-
ticity and fat tails, and demonstrate that the PSV model essentially eliminates the
need for a fat-tailed SV specification. This result is also robust to the crash of 1987
outliers. In addition, we compute in-sample and out-of-sample one-step-ahead
density forecasts for assessing the adequacy of the conditional distribution of the
SV specifications. We pay particular attention to the quality of the left-tail quantiles
of the conditional one-step-ahead SV densities. Finally, we compute Bayes factors,
which provide a framework for model selection over the set of SV models. Bayes
factors account for estimation risk by integrating out parameter uncertainty. More
importantly, they measure the statistical cost of dimensionality due to conditioning
on a large number of seasonal periodic effects in returns and volatility.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 93
SV models have been used extensively in theoretical option pricing since the
contribution of Hull and White (1987) in generalizing the Black-Scholes option
pricing scheme. Like GARCH-type models, they are designed to capture the
persistent and hence predictable component of daily volatility [for a comparison
of GARCH and SV models see Fleming and Kirby (2003)]. However, SV is
fundamentally different to GARCH. The assumption of a stochastic second
moment introduces an additional source of risk that cannot be perfectly hedged
using t – 1 information. A GARCH specification describes the conditional dis-
tribution of returns as being a function of exclusively past information. In con-
trast, the SV model specifies the joint conditional distribution of both the return
and the volatility process. Intuitively, SV allows for the possibility of random
contemporaneous volatility shocks due to news events and policy changes. In
other words, there may exist unobserved contemporaneous variables that affect
the volatility process, which is not possible in GARCH.
2
Despite their parsimonious structure, intuitive appeal, and popularity in theore-
tical option pricing, SVmodels have been much less popular than GARCHin empiri-
cal applications. This is primarily due to the numerical difficulty associated with
estimating SVmodels using conventional classical econometric methods. Specifically,
models of discrete-time stochastic volatilitycannot be estimatedwithlikelihood-based
methods because the likelihood function is not available analytically.
3
Bayesian esti-
mation offers a substantial computational advantage over any classical approach
because it avoids tackling very difficult, if not intractable, numerical optimization
procedures. This has turned the development of fast and efficient Bayesian Markov
ChainMonte Carlo(MCMC) algorithms for the estimationof SVmodels intoone of the
more promisingandchallengingtasks of moderntime-series analysis. We estimate the
parameters of the SVmodels byimplementingthe MCMCalgorithmof Chib, Nardari,
and Shephard (2002), which builds on the procedures developed by Kim, Shephard,
and Chib (1998).
4
The specification and model selection tests are based on the filtering
methods of Pitt and Shephard (1999). The marginal likelihood input to the computa-
tion of Bayes factors is constructed as in Chib (1995) and Chib and Jeliazkov (2001).
The remainder of the article is organized as follows. Section 1 documents
the size and statistical significance of seasonal periodicity in the expected daily
returns and volatility of the four indices. Section 2 discusses the plain vanilla
Gaussian SV and the fat-tailed SVt benchmarks, and then introduces the PSV
model which conditions on day of the week, month of the year, and holiday
effects in both the conditional mean and the conditional variance. A sketch of
the MCMC algorithm is offered in Section 3. Section 4 examines the in-sample and
out-of-sample conditional dynamics of the SV models and considers Bayes factors
2
In fact, market microstructure theories of speculative trading [e.g., Tauchen and Pitts (1983) and Andersen
(1996)] provide strong arguments for modeling volatility as stochastic.
3
In the classical framework, Sandmann and Koopman (1998) propose a a Monte Carlo likelihood (MCL)
method for estimating plain vanilla SV models. For a simulated maximum likelihood (SML) estimation
method of fat-tailed SV models see Liesenfeld and Jung (2000).
4
For a general reference on MCMC methods in financial econometrics see Johannes and Polson (2003). For
an alternative Bayesian MCMC algorithm for estimating SV models see Jacquier, Polson, and Rossi (2002).
94 Journal of Financial Econometrics
as a diagnostic tool for model selection. Section 5 discusses the results and Section
6 concludes.
1 DAILY INDEX RETURNS DATA
In this section we document the size and statistical significance of the seasonal
variation in expected daily returns and volatility. We use absolute returns as a simple
model-free proxy to daily volatility. There is a clear statistical advantage in analyzing
average daily absolute returns rather than just the variance of daily returns; we can
use the time series of absolute returns for sampling with replacement, which is the
basis of the formal hypothesis tests using bootstrapping that we present next.
Furthermore, Ding, Granger, and Engle (1993) demonstrate that absolute daily
returns are a better model-free measure of daily volatility than squared daily returns
because the former are more persistent than the latter.
5
We will formally model daily
volatility in the next section.
This article uses daily returns data from four prominent U.S. stock indices:
the DJIA, the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600. The DJIA
is perhaps the most quoted market indicator in the financial press. It is a price-
weighted index composed of 30 large and actively traded industrial stocks, which
represent about 25% of the value of the U.S. equity market. The S&P 500 is a
value-weighted index of 500 leading companies in diverse industries of the U.S.
economy. It focuses on the large cap segment of the market and covers 80% of the
value of U.S. equities. The S&P MidCap 400 is also a value-weighted index of 400
medium cap stocks reflecting 7% of the value of U.S. equities. Finally, the S&P
SmallCap 600 is a value-weighted index of 600 small cap stocks covering 3% of the
value of U.S. equities.
6
The S&P 500 index is a standard proxy for the aggregate U.S. market portfo-
lio. We include the DJIA in our analysis because it is the most frequently cited
index in studies of calendar effects. The DJIA’s popularity in this literature is due
to fact that there is daily price data available dating back to September 1896
[Lakonishok and Smidt (1988)]. More importantly, the inclusion of the S&P Mid-
Cap 400 and the S&P SmallCap 600 in our analysis allows us to distinguish
between the behavior of small, medium, and large capitalization firms.
7
This
distinction is a crucial aspect of our study because there is evidence that
5
More recently, Forsberg and Ghysels (2004) provide a theoretical explanation of this finding and conclude
that both population and empirically sampled volatility measures based on absolute returns should
feature higher persistence than squared returns, be less degraded by sampling errors, and be immune
to jumps.
6
All the stocks from the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600 are combined to form
the S&P Composite 1500, which represents 90% of the value of U.S. equities.
7
All three S&P indices are maintained using a similar methodology and their only difference is in the
capitalization range. Specifically, additions to each index must be companies with a market capitalization
$300 million and $1 billion for the S&P SmallCap 600, between $1 billion and $4 billion for the S&P
MidCap 400, and in excess of $4 billion for the S&P 500. Firms from the S&P MidCap 400 can migrate up
from the S&P SmallCap 600 or down from the S&P 500.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 95
large cap indices may not be representative of either the kurtosis or the
seasonality of small firms. For example, Kim and Kon (1994) fit a
GARCH(1,3)-M model to the returns of both the S&P 500 and the 30
DJIA firms, and show that at least half of the Dow firms exhibit higher
excess kurtosis in their standardized residuals than the S&P 500. Further-
more, Hansen, Lunde, and Nason (2004) conclude that the international
evidence of calendar effects in small cap indices is stronger than for large
cap indices. Finally, discriminating by firm size will test earlier empirical
findings which suggest that some calendar effects, such as high returns in
January, are associated with small firms [Keim (1983) and Reinganum
(1983)].
Let P
t
denote the daily closing price of each of the four indices. Then, the
continuously compounded percent returns are constructed as
y
t
¼ 100 ln
P
t
P
tÀ1
. ð1Þ
The information available to the econometrician at time t is F
t
= {y
t,
y
tÀ1, . . . ,
y
1
}.
The S&P 500 sample starts on July 2, 1962. Even though there are more data
available for the DJIA, we also start our sample on the same date as the S&P
500 to be able to directly compare the results from the two popular large cap
indices. For the two lower cap indices there is substantially less data avail-
able. Specifically, the samples for the S&P MidCap 400 and the S&P SmallCap
600 start on June 2, 1991, and January 3, 1989, respectively. The end date for
all four data samples is December 31, 2003. The source of the data is Data-
stream.
We have not included dividends in the four return series for two reasons.
First, there are more daily price data available for all indices than total return
data, especially for the S&P MidCap 400 and the S&P SmallCap 600. Therefore,
including dividends would severely contract the time horizon under investiga-
tion for all indices. Second, Lakonishok and Smidt (1988) conduct a sensitivity
analysis that demonstrates that excluding dividends from the DJIA returns does
not affect their conclusions regarding the size and significance of calendar
effects.
Table 1 presents the descriptive statistics of both the daily return series y
t
and the daily absolute return series|y
t
|for the four indices. As is widely docu-
mented, the four daily return series exhibit negative skewness, high kurtosis,
and low short-lived serial correlation. The absolute returns are extremely noisy
and persistent; they have high positive skewness, immense kurtosis, and long-
lived positive serial correlation. There is a notable difference in the behavior of
the four indices. Skewness (negative for expected returns and positive for
volatility) and kurtosis are more pronounced for the DJIA than for the S&P
500, and are even lower (in fact, quite substantially) for the S&P MidCap 400 and
the S&P SmallCap 600.
96 Journal of Financial Econometrics
1.1 The Size and Statistical Significance of Calendar Effects
We investigate the size and statistical significance of the day of the week, month
of the year, and holiday calendar effects in the expected daily returns and
volatility of the four indices. The three sets of calendar effects are captured by
isolating the daily returns of each day (Monday to Friday), each month (January
to December), and the holidays. We distinguish between four mutually exclusive
holiday effects: (i) the preholidays (HOL
À
), which are the days before a nontrading
Table 1 Descriptive statistics for the four daily U.S. indices.
DJIA S&P 500
S&P MidCap
400
S&P SmallCap
600
Panel A: Daily percent returns
Start July 2, 1962 July 2, 1962 June 12, 1991 Jan 3, 1989
End Dec 31, 2003 Dec 31, 2003 Dec 31, 2003 Dec 31, 2003
Obs (T) 10398 10401 3160 3755
Mean 0.028 0.029 0.049 0.041
Std. Dev. 0.983 0.953 1.095 1.018
Min À25.6
(Oct 19, 1987)
À22.9
(Oct 19, 1987)
À7.33
(Apr 14, 2000)
À6.34
(Oct 27, 1997)
Max 9.67
(Oct 21, 1987)
8.71
(Oct 21, 1987)
5.97
(Mar 16, 2000)
5.45
(July 29, 2002)
Skewness À1.74 À1.40 À0.203 À0.256
Kurtosis 52.1 39.72 6.462 6.22
Corr (y
t
, y
t-1
) 0.064 0.078 0.055 0.121
Corr (y
t
, y
t-2
) À0.031 À0.025 À0.051 À0.005
Corr (y
t
, y
t-3
) À0.010 À0.017 0.012 0.048
Corr (y
t
, y
t-10
) 0.002 À0.004 À0.036 0.001
Corr (y
t
, y
t-25
) À0.030 À0.026 À0.044 À0.027
Panel B: Daily absolute percent returns
Mean 0.687 0.661 0.789 0.725
Std. Dev. 0.703 0.687 0.761 0.715
Min 0.002
(Feb 22, 2001)
0.0009
(Oct 31, 2001)
0.003
(Mar 11, 2002)
0.0009
(Feb 5, 2001)
Max 25.6
(Oct 19, 1987)
22.9
(Oct 19, 1987)
7.33
(Apr 14, 2000)
6.34
(Oct 27, 1997)
Skewness 6.49 5.46 2.18 2.11
Kurtosis 165.8 119.0 11.0 9.62
Corr (y
t
, y
t-1
) 0.192 0.218 0.236 0.271
Corr (y
t
, y
t-2
) 0.201 0.221 0.268 0.345
Corr (y
t
, y
t-3
) 0.211 0.224 0.242 0.283
Corr (y
t
, y
t-10
) 0.150 0.178 0.194 0.216
Corr (y
t
, y
t-25
) 0.121 0.149 0.164 0.185
Tsiakas | Periodic Stochastic Volatility and Fat Tails 97
holiday,
8
the postholidays (HOL
+
), which are the periods from the preholiday
close to the postholiday close, (iii) the pre-long weekends (LW
À
), which are the
days before the start of a long weekend,
9
and (iv) the post-long weekends (LW
+
),
which are the periods from the preholiday close to the postholiday close if the
holiday falls on either a Friday or a Monday. We separate holidays from long
weekends because if a nontrading day occurs either right before a weekend (on a
Friday) or right after a weekend (on a Monday), it is impossible to differentiate
the weekend effect from the holiday effect. Furthermore, our motivation for
including preholidays and pre-long weekends in our analysis is based on results
of previous studies which document very high returns before holidays.
10
Finally,
the day of the week and the holiday effects are defined such that there is no
overlap; for example, a Monday following a Friday holiday counts only as a post-
long weekend and neither as a Monday nor as a postholiday.
We assess the statistical significance of seasonal abnormalities using two
distinct tests, both of which are based on bootstrapping. First, we form two-
sided bootstrap t-tests for a model-free evaluation in both expected returns and
volatility of whether each day, month, and holiday is statistically different to its
complement. For example, we define the complement of the Monday expected
return as the average return of all days which are not Mondays. Similarly, the
complement of the January volatility is the volatility of the 11 months: February to
December. This setup is motivated by a simple question: Do Monday (or January)
expected returns and volatility need to be modeled separately from the rest of the
days (or months)? In other words, is there clear misspecification in assuming that
the returns and volatility of all days and months persist around the same mean? If
indeed the answer to these two questions is yes, then we need to be modeling the
seasonality in daily returns and volatility with a periodic specification, such as the
periodic stochastic volatility model that we propose in the next section. The two-
sided hypotheses are tested at 90%, 95%, and 99% confidence levels.
11
The details
on constructing the bootstrap t-tests are in Appendix A [also see Hansen (2004)].
The advantage of the bootstrap hypothesis tests is that they isolate the
significance of each individual calendar effect in expected returns and volatility.
However, even though the bootstrap t-tests are informative, they do not avoid
the distortions on statistical inference induced by data mining
12
discussed in
8
We define a holiday as a weekday when trading would normally have occured but did not. Note that during
the last six months of 1968, the New York Stock Exchange (NYSE) was closed so that brokers’ back office
operations could catch up with the volume of trading. We have excluded these days from our analysis.
9
The pre-long weekend days are either Thursdays for a Friday holiday or Fridays for a Monday holiday.
10
For example, Lakonishok and Smidt (1988) document immense returns before holidays. For the sample
period of 1897–1986, the DJIA preholiday average rate of return was 23 times larger than the regular
daily rate of return.
11
The appropriate testing procedure is to use a two-sided null hypothesis so that the ex ante significance
level is at least 90% and the result is not biased towards accepting seasonality.
12
The universe of possible calendar effects is not given ex ante by economic theory. Data mining may be
due to the extensive search across a large number of possible calendar effects, which can even yield a
significant result by pure chance. Even worse, theoretical explanations may reinforce data mining if they
are suggested only subsequent to the empirical ‘‘discovery’’ of the anomalies.
98 Journal of Financial Econometrics
Sullivan, Timmermann, and White (2001). In particular, classical hypothesis tests
assume that (i) we are conducting a single test, and (ii) the null hypothesis is
independent of the data used to conduct the test. Both conditions are violated by
the t-tests. We avoid these problems by implementing the new generalized F-test
of Hansen, Lunde, and Nason (2004). The test conditions on the full space of
possible calendar effects, and therefore produces results that are robust to data
mining. It is a generalized F-test in the sense that it exploits the correlation
between the returns of (for example) Monday and January due to the intersection
of their elements (i.e., some January days are Mondays). It is also based on
bootstrapping, which diminishes possible small sample problems. The hypothesis
that there are no calendar-specific anomalies is a two-sided hypothesis of multiple
equalities. Table 2 reports the bootstrap p-values of the test for four universes of
calendar effects: the full universe of all three sets of calendar effects, the universe
of day of the week effects, the universe of month of the year effects, and the
universe of holiday effects. The details on the F-test of Hansen, Lunde, and
Nason (2004) are in Appendix B.
Table 3 presents the size and statistical significance of the day of the week,
month of the year, and holiday effects in expected returns and volatility. As this
table considers each calendar effect individually, the results on significance are
based on bootstrap confidence intervals and t-statistics. Monday is clearly the
strongest day of the week effect in both expected returns and volatility. The average
return on Monday is very low; in fact, it is negative and very significant for three of
the four indices. Mondays also have the highest volatility, which is highly signifi-
cant in all four indices. In contrast, Wednesdays have the highest expected return in
all indices. Among the 12 months, January has one of the highest expected returns
in the two large cap indices, but it is not statistically significant. October is by far the
most volatile month and June the least volatile, both of them being highly signifi-
cant in all indices. In contrast, September is the month with the lowest expected
return in all indices, but is significant only for the DJIA and S&P 500. In general, for
all indices there tend to be more month of the year effects in volatility than in
expected returns. Finally, for the two lower cap indices, there is a substantially
lower number of significant effects in expected returns than volatility.
The most remarkable seasonal effects are the holidays. Specifically, preholi-
days, postholidays, and pre-long weekends have astonishingly high expected
returns in all indices, which are very significant for the DJIA and S&P 500. In
contrast, post-long weekends have consistently negative expected returns, which
are significant in the two lower cap indices. Furthermore, preholidays have very
low volatility and post-long weekends very high volatility and these two volati-
lity effects are significant in all indices. In order to illustrate the holiday phenom-
enon, consider the following example: for the S&P 500 index, preholidays have 6.6
times higher average return then their complement and 21% lower volatility,
whereas post-long weekends have 3.3 times lower average return than their
complement and 28% higher volatility. These are new results that deviate from
previously established stylized facts in at least one very important aspect.
Lakonishok and Smidt (1988), among others, show that postholiday average
Tsiakas | Periodic Stochastic Volatility and Fat Tails 99
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102 Journal of Financial Econometrics
returns are negative. We now demonstrate that separating long weekends from
the other holidays results in highly positive postholiday average returns. In fact,
Table 3 reveals that post-long weekends are drastically different to the rest of the
postholidays in both expected returns and volatility.
13
Table 4 assesses the sensitivity of calendar effects to the October 1987 crash by
excluding the three most volatile days from the DJIA and S&P 500 samples:
Monday, October 19, 1987 (the minimum return), to Wednesday, October 21,
1987 (the maximum return).
14
Excluding the three days only slightly reduces
the size of the Monday and October effects. More importantly, both effects main-
tain their significance at the same confidence levels. This is graphically illustrated
in Figures 1 and 2. The two figures enable a visual inspection of the lack of
overlap between the bootstrap distribution of each volatility effect and its com-
plement, with and without the crash outliers. For example, the volatility of the
S&P 500 October effect is 23% higher than that of its complement. Excluding the
three days of October 1987 reduces this month’s volatility to being 17% higher
than its complement. Still, both with and without the outliers, October remains
significant in volatility with 99% confidence.
We report next our data-mining robust results on the statistical significance
of the four universes of calendar effects. Table 2 presents the p-values from the
bootstrap F-tests. We investigate the results both for the full data samples and
for 10-year subsamples. In our analysis of expected returns for the full data
samples, we find that the full universe p-values are highly significant for all four
indices, ranging from 0.011 to 0.028. The month of the year effect is also sig-
nificant, as the p-values range from 0.054 to 0.110 and are in fact less than 0.100
for three of the four indices. In contrast, the day of the week effect is not as
highly significant and the p-values range from 0.110 to 0.230. In our subsample
analysis, the full universe tends to be more significant for the last two decades of
data. The strongest results of Table 2 are that the holiday effect in expected
returns and, more importantly, all volatility effects for all indices, universes, and
subsamples are very highly significant with near-zero p-values.
15
13
The higher post-long weekend volatility is actually consistent with the qualitative predictions of market
microstructure models. A basic tenet of these models is that volatility is driven by information releases [e.g.,
see Andersen (1996)]. For the trading session immediately following a market closure, part of the volatility is
due to the information released during the closure. This assumes that the opening price does not fully reflect
the information, and therefore trading is necessary for the information to be fully impounded [French and
Roll (1986)]. On average, we expect more information to be released during a long weekend than a weekend,
and during a weekend than an overnight closure. Thus, we should expect post-long weekend trading
sessions to be characterized by higher volatility than Mondays, which in turn should be more volatile
than the rest of the weekdays. This provides an economic argument for including calendar variable
covariates in volatility models, and more importantly, it also suggests that the timing of a holiday matters
(long weekends are distinct from the rest of the holidays simply because they are longer).
14
Recall that the data samples of both the S&P MidCap 400 and the S&P SmallCap 600 start after the October
1987 crash.
15
This is consistent with Tsiakas (2005), who uses daily returns data from 10 international stock indices and
demonstrates that there is a substantially higher number of statistically significant calendar effects in
volatility than in expected returns.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 103
In conclusion, there is strong quantitative model-free evidence that for the
four prominent U.S. indices under investigation, there is clear misspecification if
we assume that the volatility of all days, months, and holidays persists around
the same mean. It is important to note that we do not argue that the seasonal
effects remain constant over time or that the stronger effects are statistically
significant in every single time period. On average, however, seasonal effects in
expected returns, and especially in volatility, are sizable, statistically significant,
and hence must be modeled explicitly.
Table 4 The sensitivity of calendar effects to the October 1987 crash.
DJIA S&P 500
Full sample Reduced sample Full sample Reduced sample
Panel A: Average daily returns
ALL 0.028
(.009, .047)
0.029
(.011, .047)
0.029
(.001, .047)
0.030
(.012, .048)
MON À0.029
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(À.084, .023)
À0.015
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(À.062, .032)
À0.055
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(À.108, À.006)
À0.043
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(À.088, .002)
TUE 0.041
(À.001, .082)
0.038
(À.003, .079)
0.039
(À.001, .079)
0.036
(À.002, .075)
WED 0.061
ÃÃ
(.021, .103)
0.056
Ã
(.017, .096)
0.078
ÃÃÃ
(.039, .118)
0.074
ÃÃÃ
(.035, .112)
OCT 0.029
(À.072, .121)
0.040
(À.035), .118)
0.043
(À.050, .130)
0.052
(À.023, .127)
Panel B: Average daily absolute returns
ALL 0.687
(.674, .701)
0.683
(.671, .696)
0.661
(.648, .674)
0.657
(.645, .670)
MON 0.753
ÃÃÃ
(.715, .797)
0.740
ÃÃÃ
(.708, .773)
0.719
ÃÃÃ
(.681, .761)
0.707
ÃÃÃ
(.676, .740)
TUE 0.677
(.649, .705)
0.674
(.647, .702)
0.657
(.630, .684)
0.654
(.628, .682)
WED 0.673
(.645, .703)
0.669
(.641, .697)
0.645
(.617, .674)
0.641
(.614, .668)
OCT 0.831
ÃÃÃ
(.759, .917)
0.789
ÃÃÃ
(.736, .846)
0.797
ÃÃÃ
(.727, .876)
0.760
ÃÃÃ
(.706, .818)
The reduced sample excludes the three most volatile days from the full sample period: Monday, October
19, 1987 (the min), to Wednesday, October 21, 1987 (the max). The numbers in parentheses are the 2.5%
and 97.5% quantiles of the means generated by 10,000 bootstrap samples. The superscripts
Ã
,
ÃÃ
, and
ÃÃÃ
indicate that the two-sided null hypothesis is rejected at significance level a = 10%, a = 5%, and a = 1%,
respectively. Note that we only perform the sensitivity analysis for the DJIA and the S&P 500 indices
because the data samples of both the S&P MidCap 400 and the S&P SmallCap 600 start after the October
1987 crash.
104 Journal of Financial Econometrics
2 STOCHASTIC VOLATILITY
2.1 The Plain Vanilla SV model
In the stochastic volatility (SV) framework, the plain vanilla SV model presents
the benchmark against which model comparisons will be conducted. According
to the plain vanilla SV benchmark, the daily index returns are assumed to
follow a univariate discrete-time AR(1) process and are driven by Gaussian
innovations:
y
t
¼ c þuy
tÀ1
þ·
t
v
t
, ·
t
$ NIDð0,1Þ. ð2Þ
The persistence of the conditional volatility v
t
is captured by the dynamics of
the Gaussian stochastic log-variance process h
t
:
v
t
¼ expðh
t
,2Þ ð3Þ
h
t
¼ j þ¸y
tÀ1
þcðh
tÀ1
ÀjÞ þoj
t
, j
t
$ NIDð0,1Þ. ð4Þ
In the SV model, return and volatility innovations are independent:

t
g?fj
t
g. Furthermore, the model assumes (and the estimation algorithm
Figure 1 The Monday volatility effect in the DJIA and the S&P 500. These are the kernel densities
of the means of absolute daily returns generated by 10,000 bootstrap resamples. The vertical lines
are drawn at the sample means. The adjusted samples exclude the three most volatile days of the
data samples: Monday, October 19, 1987, to Wednesday, October 21, 1987.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 105
imposes) juj. jcj < 1 so that both returns and their volatility are stationary
processes. Note that if ¸ < 0, a negative return shock is followed by high volati-
lity, and vice versa. More importantly, the exponential conditional volatility
specification implies that if ¸ < 0, there is a leverage effect: negative return shocks
have a larger volatility effect than positive return shocks of the same absolute
magnitude. Finally, this simple specification allows for a level leverage compo-
nent measured by ¸y
tÀ1
, as well as a dynamic component measured by c
j
¸y
tÀj
. In
the following sections, the plain vanilla SV specification is generalized to account
for both the fat tails (excess kurtosis) and the seasonal periodicity of the daily
index returns and volatility.
2.2 The SVt Model
The observed excess kurtosis of daily equity returns is the most highly documen-
ted deviation from Gaussian behavior. A fat-tailed conditional distribution
assigns a positive probability to very large (positive or negative) return shocks.
For example, in the 42-year DJIA daily returns sample we examine in this article,
the Monday, October 19, 1987, shock was 26 standard deviations below the mean.
Figure 2 The October volatility effect in the DJIA and the S&P 500. These are the kernel densities
of the means of absolute daily returns generated by 10,000 bootstrap resamples. The vertical lines
are drawn at the sample means. The adjusted samples exclude the three most volatile days of the
data samples: Monday, October 19, 1987, to Wednesday, October 21, 1987.
106 Journal of Financial Econometrics
A standard way of modeling fat tails is by assuming that the daily innovations
follow a Student’s t-distribution:
y
t
¼ c þuy
tÀ1
þu
t
v
t
, u
t
$ i.i.d. tð0, 1, iÞ. ð5Þ
This equation, along with Equations (3) and (4) define the SVt model.
The univariate SV models with either Gaussian or Student’s t innovations
can be put in a convenient state-space form. Specifically, Kim, Shephard, and
Chib (1998) take a logarithmic transformation of the observed returns data
and approximate the log w
2
(1) distribution by a seven-component mixture of
normal densities. Then, both the transformed data and the log-variance equa-
tions are linear and conditionally Gaussian. This transformation to a condi-
tionally Gaussian state-space model via a mixture of normals approximation
allows the use of the Kalman filter and has been fundamentally important in
the development of efficient MCMC estimation procedures (see Appendix C
for some of the details).
2.3 Periodic Stochastic Volatility
This article introduces a set of periodic SV specifications in which the constants
(levels) in both the conditional mean and the conditional log-variance are general-
ized to account for three distinct types of seasonality: day of the week, month of
the year, and holiday effects. In the periodic SV framework, we explore the
following four specifications with both Gaussian and Student’s t innovations.
2.3.1 The PSV Model. The PSV model is a high-dimensional specification that is
designed to isolate the exact effect of each day, month, and holiday on the
conditional mean and volatility of daily returns. Therefore the PSV model pro-
vides a framework for testing whether adjusting the return and volatility levels to
fully account for seasonal periodicity results in superior performance. Specifi-
cally, the constant of the PSV conditional mean is generalized as follows:
y
t
¼ c þuy
tÀ1
þ·
t
v
t
, ·
t
$ NIDð0,1Þ ð6Þ
c ¼ c
t
¼ c
DAY,t
þc
MONTH,t
þc
HOL,t
ð7Þ
c
DAY,t
¼ c
0
þc
1
MON
t
þc
2
TUE
t
þc
3
WED
t
þc
4
THU
t
ð8Þ
c
MONTH,t
¼ c
5
JAN
t
þc
6
FEB
t
þc
7
MAR
t
þc
8
APR
t
þc
9
MAY
t
þc
10
JUNE
t
þc
11
JULY
t
þc
12
AUG
t
þc
13
SEP
t
þc
14
OCT
t
þc
15
NOV
t
ð9Þ
c
HOL,t
¼ c
16
HOL
À
t
þc
17
HOL
þ
t
þc
18
LW
À
t
þc
19
LW
þ
t
, ð10Þ
where MON
t
to THU
t
are the day dummy variables for Monday through
Thursday, JAN
t
to NOV
t
are the month dummy variables for January through
November, HOL
À
t
and HOL
þ
t
are the preholiday and postholiday dummies,
respectively, and finally LW
À
t
and LW
þ
t
are the pre-long weekend and post-
long weekend dummies, respectively. In this specification, the constant c
0
Tsiakas | Periodic Stochastic Volatility and Fat Tails 107
captures the effect of a Friday in December that is not one of the four
holidays.
Similarly the volatility process is generalized to account for the three sets of
seasonal effects:
v
t
¼ expððc
t
þh
t
Þ,2Þ ð11Þ
h
t
¼ j þ¸y
tÀ1
þcðh
tÀ1
ÀjÞ þoj
t
, j
t
$ NIDð0,1Þ ð12Þ
c
t
¼ c
DAY,t
þc
MONTH,t
þc
HOL,t
ð13Þ
c
DAY,t
¼ c
1
MON
t
þc
2
TUE
t
þc
3
WED
t
þc
4
THU
t
ð14Þ
c
MONTH,t
¼ c
5
JAN
t
þc
6
FEB
t
þc
7
MAR
t
þc
8
APR
t
þc
9
MAY
t
þc
10
JUNE
t
þ c
11
JULY
t
þc
12
AUG
t
þc
13
SEP
t
þc
14
OCT
t
þc
15
NOV
t
ð15Þ
c
HOL,t
¼ c
16
HOL
À
t
þc
17
HOL
þ
t
þc
18
LW
À
t
þc
19
LW
þ
t
. ð16Þ
Note that there is no need for a constant in c
t
because it is absorbed by j, which is
the ‘‘fundamental’’ or acyclical component of the log-variance h
t
. More importantly,
the conditional standard deviation of the PSV specification is subject to the seasonal
level effect expðc
t
,2Þ, which is separate from the dynamic component expðh
t
,2Þ.
For this PSV specification, the MCMC algorithm must provide estimates of the
three sets of parameters 0 ¼ f0
1
. 0
2
. 0
3
g. Here, 0
1
¼ fc
0
. ug is the set of nonseasonal
parameters of the conditional mean, 0
2
¼ fj. ¸. c. o
2
g is the set of nonseasonal
parameters of the Gaussian log-variance process, and 0
3
¼ fc
j
. c
j
g. 1 j 19, are
the seasonal dummy coefficients in the conditional mean and the conditional log-
variance, respectively. All 0 parameters are time invariant.
2.3.2 Three Parsimonious Periodic Specifications. In addition to the compre-
hensive PSV specification, we also define three parsimonious periodic SV speci-
fications for which the parameter vector to be estimated is of much lower
dimension. The three parsimonious specifications selectively account for some
of the stronger return and volatility seasonal effects.
2.3.2.1 The PSV
CYC
Model. The PSV
CYC
model replaces the dummy specification
of the month of the year effect with a parsimonious six-term cyclical component
based on a Fourier approximation:
16
16
Anyperiodic functionf m
t
ð Þ canbe representedbyf m
t
ð Þ ¼

6
j¼0
a
j
sin
2¬j
12
m
t
_ _
þb
j
cos
2¬j
12
m
t
_ _ _ _
. where a
j
and
b
j
are the Fourier coefficients. These are the regression coefficients obtained by regressing f m
t
ð Þ on sin
2¬j
12
m
t
_ _
and cos
2¬j
12
m
t
_ _
. In notation local to this footnote, we use the approximation f m
t
ð Þ ¼b
0
þa
1
sin

12
m
t
_ _
þ
b
1
cos

12
m
t
_ _
þa
2
sin

12
m
t
_ _
þb
2
cos

12
m
t
_ _
þa
3
sin

12
m
t
_ _
þb
3
cos

12
m
t
_ _
. where b
0
is absorbed by the constant
of the return equation. Clearly, the three frequencies used are w
j
¼
2¬j
12
for j ¼ 1. 2. 3 f g. The phase of this Fourier
process is equal tob
0
þb
1
þb
2
þb
3
. whichdenotes where the Fourier cycle is at m
t
=0. For flexible Fourier form
(FFF) modeling of intraday periodic volatility components, see Andersen and Bollerslev (1997) and Beltratti
and Morana (1999). For more details on the FFF in general, see Gallant (1981).
108 Journal of Financial Econometrics
c
MONTH,t
¼ c
5
sin

12
m
t
_ _
þc
6
cos

12
m
t
_ _
þc
7
sin

12
m
t
_ _
þc
8
cos

12
m
t
_ _
þc
9
sin

12
m
t
_ _
þc
10
cos

12
m
t
_ _
ð17Þ
and
c
MONTH,t
¼ c
5
sin

12
m
t
_ _
þc
6
cos

12
m
t
_ _
þc
7
sin

12
m
t
_ _
þc
8
cos

12
m
t
_ _
þc
9
sin

12
m
t
_ _
þc
10
cos

12
m
t
_ _
, ð18Þ
where m
t
2 f1. 2. . . . . 12g is the month index.
The PSV
CYC
model can still isolate the exact effect of each day, month, and
holiday, while requiring estimation of 10 fewer parameters. The key to this
specification is the six-term Fourier approximation of the month of the year effect.
The dimension of the Fourier approximation was chosen such that it fits the
monthly seasonality reasonably well, while using substantially fewer parameters
than a series of 11 monthly dummies.
17
Figure 3 illustrates how well the six-term
Fourier approximation fits the monthly mean of the four daily indices.
2.3.2.2 The PSV
LOW
Model. The PSV
LOW
model is a low-dimensional periodic
specification that isolates the calendar effects that are the strongest in the data
and the most prominent in the asset pricing literature: Monday, January, October,
and the four holiday effects. Hence, the constants in the mean and log-variance
are specified as follows:
c ¼ c
t
¼ c
0
þc
1
MON
t
þc
2
JAN
t
þc
3
OCT
t
þc
4
HOL
À
t
þc
5
HOL
þ
t
þc
6
LW
À
t
þc
7
LW
þ
t
ð19Þ
and
c
t
¼c
1
MON
t
þc
2
JAN
t
þc
3
OCT
t
þc
4
HOL
À
t
þc
5
HOL
þ
t
þc
6
LW
À
t
þc
7
LW
þ
t
. ð20Þ
Mondays and holidays are the strongest calendar effects reported by Sullivan,
Timmermann, and White (2001) and Lakonishok and Smidt (1988), respectively,
whereas the January and October factors are consistent with the GARCH-M speci-
fication of Glosten, Jagannathan, and Runkle (1993).
2.3.2.3 The PSV
HOL
Model. The PSV
HOL
model is the most parsimonious of all
periodic specifications, as it only conditions on the very large and highly statistically
significant holiday effects. This specification ignores the day of the week and
month of the year effects, and therefore the mean and log-variance levels are
simply given by
17
We thoroughly examined Fourier expansions with two, four, six, and eight terms and, based on their fit,
we decided that the six term cyclical FFF is best for this application.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 109
c ¼ c
t
¼ c
0
þc
1
HOL
À
t
þc
2
HOL
þ
t
þc
3
LW
À
t
þc
4
LW
þ
t
ð21Þ
and
c
t
¼ c
1
HOL
À
t
þc
2
HOL
þ
t
þc
3
LW
À
t
þc
4
LW
þ
t
. ð22Þ
2.3.3 Seasonal Periodicity and Fat Tails. All four periodic stochastic volatility
specifications presented so far assume Gaussian return innovations, but have an
equivalent fat-tailed representation that assumes Student’s t innovations. Hence
we specify four additional models: PSVt, PSVt
CYC
, PSVt
LOW
, and PSVt
HOL
. The
fat-tailed periodic specifications are instrumental in establishing a relationship
between fat tails and seasonal heteroskedasticity.
3 Bayesian MCMC Estimation
We perform Bayesian MCMC estimation by constructing a Markov chain
whose limiting distribution is the target posterior density. This Markov chain
Figure 3 The Fourier approximation to the month of the year effect in expected daily returns. We
have fitted the six-term Fourier approximation to the average month of the year effect by running
a simple ordinary least squares (OLS) regression of the daily returns on the six Fourier terms and
then using the estimated coefficients.
110 Journal of Financial Econometrics
is a Gibbs sampler in which all parameters are drawn sequentially from their
full conditional posterior distribution. The chain is then iterated thousands of
times and the sampled draws, beyond a burn-in period, are treated as variates
from the target posterior distribution. For example, in the case of the high-
dimensional PSVt model, the MCMC algorithm produces estimates of the
posterior means of (i) the nonseasonal parameters of the return equation
f0
1
. ig, where 0
1
¼ fc
0
. ug, (ii) the nonseasonal log-variance parameters
0
2
¼ fj. ¸. c. o
2
g, and (iii) the seasonal parameters 0
3
¼ fc
j
. c
j
g. j 19, for the
day of the weak, month of the year, and holiday effects in both the mean fc
j
g
and the variance fc
j
g.
The key to estimating the PSV models is the efficient sampling of the
seasonal level effects in the conditional variance. Our MCMC chain adds a
simple Gibbs step to the Chib, Nardari, and Shephard (2002) algorithm, in
which the fc
j
g vector is drawn conditionally on the sampled log-volatilities
fh
t
g using a precision-weighted average of prior information and the condi-
tional likelihood. Despite its simplicity, this method is numerically superior to
the sampling of fc
j
g in the same block as the log-variance parameters 0
2
because
it avoids the numerical problems that arise from high-dimensional optimization.
The MCMC diagnostics for the seasonal volatility parameter estimates indicate
that the additional Gibbs step is highly efficient. The details on sampling fc
j
g are
summarized in Appendix C.
3.1 MCMC Diagnostics
The mean of the MCMC draws is an asymptotically efficient estimator of
the posterior mean of 0 [see Geweke (1989)]. The numerical standard
error (NSE) is the square root of the asymptotic variance of the MCMC
estimator:
NSE ¼
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
1
I
·
0
þ2

B
I
j¼1
KðzÞ·
j
_
_
_
_
_
_
¸
¸
¸
¸
_ . ð23Þ
where I = 5000 is the number of iterations (beyond the initial burn-in of 1000
iterations), j = 1, . . . ,B
I
= 500 lags is the set bandwidth, z ¼
j
B
I
, and ·
j
is the sample
autocovariance of the MCMC draws for each estimated parameter cut according
to the Parzen kernel K (z).
The NSE diagnostic is distinct from the MCMC standard deviation. The
latter is simply a measure of the variation in the MCMC parameter draws. In
contrast, NSE is a measure of the variation in the posterior mean estimate across
many MCMC chains that we can potentially run. In other words, NSE measures
how much difference one should expect in the estimate of the posterior mean
if the estimation were to be repeated, and therefore provides a measure of
convergence.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 111
The relative numerical inefficiency (RNI) is given by
RNI ¼ 1 þ2

B
I
j¼1
KðzÞ,ðjÞ, ð24Þ
where ,ðjÞ is the autocorrelation in the MCMC draws at lag j for each estimated
parameter. RNI accounts solely for the variance inflation (inefficiency) due to the
serial correlation of the MCMC parameter draws [see Geweke (1992) for the
details]. In general, the lower the serial correlation, the lower the number of
iterations needed to attain a given level of numerical accuracy. For example, if
RNI were to be halved, one would need half the number of iterations to attain the
same level of numerical accuracy.
3.2 Volatility Estimates
The conditional dynamics of the SV models are primarily driven by the persistent
and stochastic log-variance process fh
t
g. The tools of Chib, Nardari, and
Shephard (2002) allow the simulation of three distinct estimates of the {h
t
} vector.
First is the smoothed volatility. The MCMC chain samples from the density
h
ðiÞ
F
T
. 0
ðiÞ
¸
¸
. In other words, it samples the h
ðiÞ
t
_ _
vector at a given iteration
i = 1, . . . , I conditional on the information F
T
from the full dataset (hence
smoothed) and the parameter vector draw 0
ðiÞ
.
Second is the filtered volatility. The auxiliary particle filter of Pitt and
Shephard (1999) samples from the density h
j
t
F
t
. 0 j . Specifically, it generates a
j = 1, . . . , M = 2000 vector of log-variances (the ‘‘particles’’) at each t, given the
information set F
t
and the true values of 0 proxied by the MCMC posterior mean
estimates. This is a nontrivial task performed by an auxiliary sampling-importance
resampling algorithm. The SV application of the algorithm is also detailed in Chib,
Nardari, and Shephard (2002).
Third is the one-step-ahead predictive volatility. This samples from h
j
t
F
tÀ1
. 0 j .
Given a vector of j = 1, . . . , M = 2000 particles from the filtered density h
j
tÀ1
F
tÀ1
. 0 j ,
it is straightforward to compute the one-step-ahead vector of particles from the
predictive density using the Gaussian evolution equation:
h
j
t
¼ j þ¸y
tÀ1
þc h
j
tÀ1
Àj
_ _
þoj
j
t
, j
j
t
$ NIDð0,1Þ. ð25Þ
3.3 Log-Likelihood
The likelihood function of the SV models is given by
Lð0; yÞ ¼ f ðy
1
, Á Á Á , y
T
jF
0
,0Þ ¼

T
t¼1
f ðy
t
jF
tÀ1
,0Þ. ð26Þ
This likelihood function is not available analytically and hence must be
simulated. Specifically, the log-likelihood function is evaluated under the predic-
tive density as
112 Journal of Financial Econometrics
log
^
L ¼

T
t¼1
log
^
f ðy
t
jF
tÀ1
,0Þ ¼

T
t¼1
log
^
f
t
ðy
t
jh
t
,0Þ, ð27Þ
where h
t
is the one-step-ahead predictive log-variance h
t
jF
tÀ1
. 0, and 0 is taken as
the posterior mean estimate from the MCMC simulations.
4 PERFORMANCE EVALUATION
Managing day-to-day risk involves making decisions conditional on all available
information at a given time period t. This requires a well-specified conditional dis-
tribution for daily returns. In this section we formally assess the conditional dynamics
of all the stochastic volatility models we have estimated. Specifically, we test whether
the PSV and PSVt models are better specified than the SV and SVt benchmarks,
respectively, in producing (i) better in-sample and out-of-sample return density fore-
casts, and (ii) higher Bayes factors, which are our main criterion for model selection.
4.1 Value-at-Risk and Density Forecasts
Value-at-risk (VaR) has emerged as a standard tool for measuring market risk.
The VaR measure collapses the entire distribution of portfolio returns into a single
number that is easy to interpret as a measure of market risk. Specifically, VaR
with coverage probability ¬ is the one-step-ahead conditional quantile f
tjtÀ1
ð¬Þ
(also known as the density forecast), which satisfies the condition:
Prðy
t
f
tjtÀ1
ð¬ÞjF
tÀ1
Þ ¼ ¬, ð28Þ
where F
tÀ1
is the time t –1 information set.
We form a set of diagnostic tests for assessing the adequacy of the conditional
distribution of the stochastic volatility specifications following the methods
of Diebold, Gunther, and Tay (1998) and Berkowitz (2001). Using the simple
Rosenblatt (1952) transformation, we define the probability integral transform
u
tjtÀ1
of y
t
with respect to the density forecast f
tjtÀ1
as
u
tjtÀ1
¼
_
y
t
À1
f
tjtÀ1
ðuÞdu
¯
UID 0,1 ½ Š, ð29Þ
where y
t
is the ex post realized return. The probability is evaluated under the
ex ante forecasted cumulative distribution function using the one-step-ahead pre-
dictive log-variance h
t
jF
tÀ1
. 0. Good density forecasts should satisfy two criteria: (i)
the nominal p percent VaR should be exceeded only p percent of the time, for all p,
and (ii) a violation of nominal p
1
percent VaR today should convey no information
as to whether nominal p
2
percent VaR will be violated tomorrow, for all p
1
and p
2
.
In other words, a correctly specified VaR measure should be efficient with respect
to the information set F
tÀ1
and the following must hold:
E½Iðy
t
f
tjtÀ1
ð¬ÞÞ À¬jF
tÀ1
Š ¼ 0, ð30Þ
where I (Á) is the indicator function.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 113
Following Berkowitz (2001), we evaluate the density forecasts by mapping the
uniform probability integral transforms to a normal distribution because there is a
larger battery of specification tests available for a normal random variable. There-
fore, under the null that the model is correctly specified, n
t|tÀ1
= g
À1
(u
t|tÀ1
) should
be Gaussian white noise. The Gaussian {n
t|tÀ1
} density forecasts contain the same
information as the uniform {u
t|tÀ1
} probability integral transforms. An important
advantage of both the uniform {u
t|tÀ1
} and the Gaussian {n
t|tÀ1
} is that there are as
many of them as data observations. In contrast, the VaR measure produces only a
few tail observations for reasonable sample sizes. Furthermore, density forecasts
also account for the size of observations, not just their frequency. In short, therefore,
density forecasts offer statistical power that is missing in VaR calculations, while
using information fromthe entire conditional distribution, not just a single quantile.
Table 5 reports the specification tests for the in-sample and out-of-
sample Gaussian density forecast diagnostics. We follow the notation of
Bowman and Shenton (1975) and define
ffiffiffiffiffi
b
1
p
¼ m
3
,m
3,2
2
andb
2
¼ m
4
,m
2
2
,
where m
j
is the jth centralized sample moment of {n
t|tÀ1
}. Then we define
SKEW and KURT to be the asymptotic standard normal test statistics of
ffiffiffiffiffi
b
1
p
and b
2
, respectively:
SKEW ¼
ffiffiffiffi
T
6
_
ffiffiffiffiffi
b
1
_
$ N 0,1 ð Þ ð31Þ
KURT ¼
ffiffiffiffiffi
T
24
_
b
2
À3 ð Þ $ N 0,1 ð Þ. ð32Þ
Assessing the degree of skewness and excess kurtosis of the Gaussian density
forecasts is very important because misspecification occurs more often at the tails
of the predictive density. Berkowitz (2001) has shown that if the observed data y
t
is fat tailed relative to a model, then the density forecast {n
t|tÀ1
} will be fat tailed
relative to the standard normal.
Finally, we assess the quality of the left tail quantiles of the one-step-ahead
probability integral transforms forecast by the stochastic volatility models. This is
equivalent to testing the ability of the models to produce the correct set of VaR
estimates at different coverage levels for four portfolios, each consisting of a long
position in one of the four indices with an investment horizon of 1 day. Specifi-
cally, following Andersen et al (2003), Table 6 presents the percentage of the
realized index returns that are less than each of three left-tail quantiles (1%, 5%,
and 10%) of the probability integral transforms forecast by the SV models. Then,
the best-performing model is the one for which the percentage of realized daily
returns that belong to the p-percent quantile of the conditional distribution is as
close to p percent as possible.
4.2 Model Risk and Bayes Factors
Model risk arises from the uncertainty over selecting a model specification. Bayes
factors account for model risk by providing a framework for specification diag-
114 Journal of Financial Econometrics
T
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Tsiakas | Periodic Stochastic Volatility and Fat Tails 115
nostics over a set of given models. Specifically, a Bayes factor offers a summary of
the evidence provided by the data in favor of one statistical model.
18
Consider the
two competing models M
1
and M
2
. Using Bayes theorem, it is straightforward to
show that the Bayes factor B
12
(in favor of model M
1
) is the ratio of posterior to
prior odds,
B
12
¼
pðM
1
jyÞ ¬ ðM
2
Þ
pðM
2
jyÞ ¬ ðM
1
Þ
, ð33Þ
and is computed as the ratio of the marginal likelihoods,
B
12
¼
pðyjM
1
Þ
pðyjM
2
Þ
. ð34Þ
The marginal likelihood of model M
1
is defined as
pðyjM
1
Þ ¼
_
0
pðy,0jM
1
Þd0 ¼
_
0
pðyj0,M
1
Þ ¬ 0jM
1
ð Þd0. ð35Þ
Table 6 Quantiles of one-day-ahead probability integral transform.
Panel A: In-Sample Panel B: Out-of-Sample
1% 5% 10% 1% 5% 10%
DJIA SV 0.027 0.065 0.107 0.000 0.040 0.079
PSV 0.027 0.064 0.107 0.004 0.040 0.075
SVt 0.021 0.062 0.107 0.000 0.024 0.087
PSVt 0.021 0.058 0.102 0.000 0.016 0.068
S&P 500 SV 0.031 0.070 0.108 0.012 0.056 0.099
PSV 0.031 0.070 0.111 0.008 0.064 0.107
SVt 0.025 0.066 0.109 0.000 0.060 0.103
PSVt 0.025 0.064 0.106 0.004 0.052 0.091
S&P MidCap 400 SV 0.029 0.073 0.112 0.016 0.075 0.119
PSV 0.027 0.072 0.113 0.016 0.068 0.111
SVt 0.026 0.072 0.114 0.004 0.068 0.099
PSVt 0.022 0.065 0.110 0.000 0.056 0.091
S&P SmallCap 600 SV 0.045 0.086 0.128 0.071 0.155 0.206
PSV 0.045 0.088 0.130 0.068 0.151 0.206
SVt 0.037 0.087 0.132 0.056 0.147 0.202
PSVt 0.036 0.082 0.130 0.056 0.139 0.194
Selected quantiles of the ex ante forecasted cumulative distribution function u
t|tÀ1
(probability integral
transform) for four SV specifications. The out-of-sample data period is January 1, 2004, through
December 31, 2004.
18
See Kass and Raftery (1995) for a review of Bayes factors.
116 Journal of Financial Econometrics
Note that the marginal likelihood is an averaged and not a maximized likelihood.
This implies that the Bayes factor is an automatic ‘‘Occam’s razor’’ in that it
integrates out parameter uncertainty.
19
Further, the marginal likelihood is simply
the normalizing constant of the posterior density. Suppressing the model index
for simplicity, the marginal likelihood can be written as
p ðyÞ ¼
f ðyj0Þ ¬ ð0Þ
¬ ð0jyÞ
, ð36Þ
where f(y|0) is the likelihood, p (0) is the prior density, p(0|y) is the posterior
density, and 0 is evaluated at the posterior mean estimate. Since 0 is drawn in the
context of Gibbs MCMCsampling, the posterior density p (0 | y) is computed using
the technique of reduced conditional MCMC runs of Chib (1995). For the parameter
blocks of 0 (the vector of log-variances {h
t
} and the degrees of freedom n) that are
sampled in the MCMC chain by implementing a Metropolis-Hastings algorithm,
the posterior density is computed as in Chib and Jeliazkov (2001).
To assess the information provided by a Bayes factor, it is useful to consider
twice its natural logarithm so as to be on the same scale as the likelihood ratio
statistics. To make the interpretation more familiar, panel A of Table 7 presents
the range of the values of 2 log (B
12
) that constitute evidence in favor of model
M
1
. Finally, note that model comparisons based on Bayes factors are asympto-
tically equivalent to evaluations based on the Schwartz (or equivalently the BIC)
criterion.
20
5 RESULTS AND DISCUSSION
In this section we report our empirical findings on the set of stochastic volatility
models by focusing on four aspects: (i) the posterior mean estimates of the new
PSV model parameters and whether they match the seasonal properties of the
data, (ii) the interaction between seasonal heteroskedasticity and fat tails, (iii) the
distribution of period-by-period density forecasts, and (iv) ranking the models
using the likelihood and Bayes factor criteria.
5.1 PSV Parameter Estimates
We begin the discussion of model-specific results by reporting on the size, sign, and
statistical significance of the posterior mean estimates of the parameters of the new
periodic stochastic volatility specifications. In the Bayesian MCMC framework, we
assess statistical significance by reporting the highest posterior density (HPD) region
for each parameter estimate. For example, the 95% HPD region is the shortest
19
Occum’s razor is the principle of parsimony which states that among two competing theories, which
make exactly the same prediction, the simplest one is best.
20
The Schwartz criterion is defined as S ¼ log p yj
^
0
2.
M
2
_ _
Àlog p yj
^
0
1
. M
1
_ _
À
1
2
d
2
Àd
1
ð Þ log T ð Þ. where d
j
is the dimension of 0
j
. As T ! 1. the Schwartz criterion satisfies
SÀlog B
21
log B
21
! 0 and thus may be viewed as
a rough approximation to the log of the Bayes factor. Note that BIC = À2S.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 117
interval that contains 95% of the posterior distribution. In addition, we also check
whether the 90%, 95%, and 99% HPD regions contain zero, which is equivalent to
two-sided hypothesis testing at the 10%, 5%, and 1% levels, respectively.
Table 8 presents all the MCMC parameter estimates for the high-dimensional
Gaussian PSV specification.
21
We first consider the four benchmark properties of
Table 7 Ranking the SV models using Bayes factors.
Panel A: Interpreting Bayes factors
2 log (B
12
) B
12
Evidence against model M
2
0 to 2 1 to 3 Not worth more than a bare mention
2 to 6 3 to 20 Positive
6 to 10 20 to 150 Strong
10 150 Very Strong
Panel B: Ranking the Gaussian PSV models
DJIA S&P 500 S&P MidCap 400 S&P SmallCap 600
PSV vs. SV 189 À236 À58 À361
PSV vs. PSV
CYC
346 À170 144 À82
PSV vs. PSV
LOW
9 À469 À69 À299
PSV vs. PSV
HOL
176 À259 À54 À332
Panel C: Ranking the SVt relative to the Gaussian PSV models
DJIA S&P 500 S&P MidCap 400 S&P SmallCap 600
SVt vs. SV 2021 2330 323 783
SVt vs. PSV 1832 2567 381 1143
SVt vs. PSV
CYC
2178 2397 525 1062
SVt vs. PSV
LOW
1841 2098 312 844
SVt vs. PSV
HOL
2008 2308 327 811
Panel D: Ranking the SVt relative to the PSVt models
DJIA S&P 500 S&P MidCap 400 S&P SmallCap 600
SVt vs. PSVt 781 1251 113 489
SVt vs. PSVt
CYC
754 1218 145 476
SVt vs. PSVt
LOW
759 853 72 360
SVt vs. PSVt
HOL
716 796 126 190
The interpretation of Bayes factors in panel A follows Kass and Raftery (1995). The entries in panels B, C,
and D are equal to 2 log B
12
so as to be on the same scale as the likelihood ratio statistics.
21
All seasonal and nonseasonal PSV parameters are well estimated as indicated by their low RNI and near-
zero NSE values. While not reported in Table 8, RNIs are typically less than 2 for most conditional mean
parameters and less than 20 for most conditional log-variance parameters. Most NSEs fall well below the
value of 0.001.
118 Journal of Financial Econometrics
Table 8 PSV posterior means.
Seasonal
effect
PSV
parameter DJIA S&P 500
S&P Mid
Cap 400
S&P Small
Cap 600
Panel A: Conditional mean parameter estimates
— a
0
0.081
ÃÃÃ
(.028, .133)
0.074
ÃÃÃ
(.028, .122)
0.096
Ã
(À.013, .208)
0.106
(.012, .200)
— b 0.094
ÃÃÃ
(.074, .114)
0.123
ÃÃÃ
(.104, .143)
0.125
ÃÃÃ
(.089, .161)
0.198
ÃÃÃ
(.164, .232)
MON a
1
À0.098
ÃÃÃ
(À.146,À.051)
À0.126
ÃÃÃ
(À.168, À.085)
0.008
(À.086, .099)
À0.096
ÃÃ
(À.171,À.022)
TUE a
2
À0.035
(À.081, .010)
À0.040
Ã
(À.081, .001)
À0.024
(À.112, .063)
À0.045
(À.113, .023)
WED a
3
0.002
(À.043, .045)
À0.002
(À.042, 037)
0.066
(À.019, .152)
0.054
(À.012, .120)
THU a
4
À0.058
ÃÃÃ
(À.101,À.015)
À0.051
ÃÃ
(À.090, .013)
À0.004
(À.090, .081)
À0.010
(À.078, .058)
JAN a
5
0.010
(À.058, .077)
0.025
(À.034, .083)
À0.068
(À.200, 066)
À0.042
(À.158, .074)
FEB a
6
À0.057
Ã
(À.124, .010)
À0.050
(À.110, .000)
À0.053
(À.195, .088)
À0.014
(À.129, .100)
MAR a
7
À0.018
Ã
(À.079, .046)
0.001
(À.057, .057)
À0.095
(À.225, .035)
À0.029
(À.133, .076)
APR a
8
0.034
(À.029, .097)
0.035
(À.025, .093)
0.025
(À.068, .118)
À0.022
(À.135, .089)
MAY a
9
À0.059
Ã
(À.126, 005)
À0.036
(À.095, .022)
À0.042
(À.173, .087)
0.036
(À.063, .133)
JUNE a
10
À0.078
ÃÃ
(À.143, À.015)
À0.043
(À.103, .017)
À0.114
Ã
(À.244, .020)
À0.086
(À.192, .020)
JULY a
11
À0.028
(À.092, .035)
À0.009
(À.059, .052)
À0.038
(À.163, .095)
À0.041
(À.151, .066)
AUG a
12
À0.029
(À.092, .035)
À0.009
(À.069, .049)
0.035
(À.151, .088)
0.001
(À.101, .102)
SEP a
13
À0.053
(À.116, .013)
À0.017
(À.076, .041)
À0.065
(À.192, .060)
À0.045
(À.155, .065)
OCT a
14
À0.018
(À.085, .047)
À0.007
(À.070, .052)
0.070
(À.202, .066)
0.088
(À.203, .030)
NOV a
15
À0.004
(À.070, .062)
À0.001
(À.062, .059)
À0.008
(À.143, .127)
À0.002
(À.111, .112)
HOL
À
a
16
0.032
(À.071, .133)
0.115
ÃÃ
(.017, .211)
0.082
(À.127, .288)
0.080
(À.067, .230)
HOL
þ
a
17
0.120
ÃÃ
(.004, .231)
0.135
ÃÃ
(.012, .256)
0.065
(À.191, .318)
À0.002
(À.187, .188)
LW
À
a
18
0.113
ÃÃ
(.026, .200)
0.073
Ã
(À010, .154)
0.014
(À.150, .186)
0.120
(À.030, .268)
LW
þ
a
19
À0.089
(À.203, .020)
À0.118
ÃÃ
(À.229, À.010)
À0.288
ÃÃ
(À528, À.066)
À0.226
ÃÃÃ
(À.396, À.052)
continued
Tsiakas | Periodic Stochastic Volatility and Fat Tails 119
Table 8 (continued)
Seasonal
effect
PSV
parameter DJIA S&P 500
S&P Mid
Cap 400
S&P Small
Cap 600
Panel B: Conditional log-variance parameter estimates
— m À0.563
ÃÃÃ
(À.769, À.354)
À0.664
ÃÃÃ
(À.907, À.414)
À0.088
(À.437, .263)
À0.407
ÃÃ
(À.832, À.017)
— g À0.073
ÃÃÃ
(À.085, À.062)
À0.086
ÃÃÃ
(À.099, À.075)
À0.102
ÃÃÃ
(À.127, À.076)
À0.082
ÃÃÃ
(À.106, À.060)
— f 0.984
ÃÃÃ
(.980, .988)
0.986
ÃÃÃ
(.962, 989)
0.974
ÃÃÃ
(.965, .983)
0.973
ÃÃÃ
(.963, .981)
— o
2
0.015
ÃÃÃ
(.012, .019)
0.017
ÃÃÃ
(.014, .021)
0.031
ÃÃÃ
(.022, .401)
0.045
ÃÃÃ
(.033), .060
MON d
1
0.216
ÃÃÃ
(.115, .315)
0.223
ÃÃÃ
(.130, .315)
0.179
ÃÃ
(.008, .357)
0.152
Ã
(À.007, .315)
TUE d
2
0.058
(À.038, .151)
0.117
ÃÃ
(.023, .210)
0.001
(À.179, .168)
À0.121
(À.280, .044)
WED d
3
0.027
(À.067, .117)
0.053
(À.038, .147)
À0.036
(À.205, .131)
À0.133
(À.301, .040)
THU d
4
À0.002
(À094, .090)
0.034
(À.058, .127)
0.029
(À.141, .197)
À0.085
(À.248, .078)
JAN d
5
0.372
ÃÃÃ
(.192, .545)
0.309
ÃÃÃ
(.132, .495)
0.093
(À.254), .430)
0.193
(À.158, .511)
FEB d
6
0.275
ÃÃÃ
(.084, .479)
0.274
ÃÃ
(.048, .494)
0.089
(À.330, .540)
0.214
(À.226, .625)
MAR d
7
0.287
ÃÃÃ
(.080, .524)
0.241
ÃÃ
(.004, .491)
À0.036
(À.496, .390)
0.037
(À.498, .465)
APR d
8
0.281
ÃÃ
(.060, .537)
0.275
ÃÃ
(.006, .516)
0.057
(À.413, .538)
0.139
(À.340, .662)
MAY d
9
0.223
ÃÃ
(.012, .472)
0.233
Ã
(À.027, .476)
À0.110
(À.583, .344)
À0.090
(À.600, .429)
JUNE d
10
0.074
(À.148, .309)
0.137
(À.121, .414)
À0.181
(À.645, .271)
À0.016
(À.517, .518)
JULY d
11
0.087
(À.119, .316)
0.145
(À.130, .407)
À0.001
(À.486, .433)
À0.133
(À.615, .402)
AUG d
12
0.100
(À.107, .311)
0.084
(À.199, .341)
À0.407
Ã
(À865, .083)
À0.338
(À.856, .180)
SEP d
13
0.104
(À.099, .302)
0.100
(À.154, .349)
À0.082
(À.503, .362)
À0.061
(À.535, .404)
OCT d
14
0.263
ÃÃÃ
(.076, .445)
0.266
ÃÃ
(À.067, .481)
0.108
(À.280, .502)
0.140
(À.296, .597)
NOV d
15
0.190
ÃÃ
(.018, .362)
0.174
Ã
(À.004, .357)
0.010
(À.314, .371)
À0.103
(À.465, .252)
HOL
À
d
16
À0.273
ÃÃ
(À.518, À.013)
À0.408
ÃÃ
(À.694, À.099)
À0.747
ÃÃ
(À1.28, À.156)
À0.497
ÃÃ
(À.923, À.058)
HOL
þ
d
17
À0.127
(À.379, .136)
0.054
(À.218, .335)
À0.312
(À.853, .270)
0.068
(À.347, .483)
continued
120 Journal of Financial Econometrics
all stochastic volatility models when applied to daily stock index returns. Using
the S&P 500 as our example, we determine that there is (i) low persistence in the
conditional mean (u = 0.123), (ii) very high persistence in the conditional
log-variance (c = 0.986), (iii) a leverage effect in the form of a negative relationship
between volatility and lagged returns (g = À0.086), and (iv) a sizable stochastic
component in the conditional log-variance (o
2
= 0.017 or o = 0.130). All of our SV
specifications exhibit similar properties for all indices.
As expected, the estimates of the seasonal PSV parameters presented in
Table 8 mirror closely the seasonal properties of the data. For example, the
Monday effect in the PSV return specification is negative and significant in the
same three indices as in the data. The parameter estimates for the HOL
À
, HOL
+
,
and LW
À
effects in returns are very high, positive, and significant (especially for
the large cap indices), whereas the estimates for LW
+
are negative and significant
(especially for the lower cap indices). In volatility, Monday, October, preholiday,
and post-long weekend are very sizable and significant effects. Surprisingly,
January is in the top two most volatile months in all indices. Using again the
S&P 500 as our example, LW
+
raises the level of the conditional variance by a
massive 82% (exp (c
19
) = 1.82). This is much greater than the Monday variance
effect (exp (c
1
) = 1.25), the January variance effect (exp (c
5
) = 1.36), and even the
October variance effect (exp (c
14
) = 1.30). In contrast, HOL
À
lowers the conditional
variance by 34% (exp (c
16
) = 0.66). Our strong post-long weekend and Monday
volatility effects are consistent with the findings of French and Roll (1986) and
Bollerslev and Ghysels (1996), who have recognized that volatility in stock and
foreign exchange (FX) markets, respectively, tends to be higher following non-
trading days. Finally, we must emphasize two important trends: (i) there are more
significant calendar effects in volatility than in expected returns, especially for the
month of the year effect, and (ii) there are more significant calendar effects in the
large cap indices than in the two lower cap indices for both expected returns and
volatility. The second finding runs against the model-free results of Hansen,
Lunde, and Nason (2004).
Table 8 (continued)
Seasonal
effect
PSV
parameter DJIA S&P 500
S&P Mid
Cap 400
S&P Small
Cap 600
LW
À
d
18
À0.058
(À.247, .146)
À0.049
(À.246, .159)
À0.047
(À.413, .338)
À0.036
(À.371, .332)
LW
+
d
19
0.510
ÃÃÃ
(.313, .714)
0.599
ÃÃÃ
(.398, .796)
0.568
ÃÃÃ
(.211, .955)
0.310
Ã
(À.038, .660)
The numbers in parentheses indicate the upper and lower bounds of the 95% highest posterior density
(HPD) region for each MCMC parameter estimate (i. e., the shortest interval that contains 95% of the
posterior distribution). We assess the statistical significance of the MCMC parameter estimates by report-
ing the superscripts
Ã
,
ÃÃ
and
ÃÃÃ
, which indicate that the 90%, 95%, and 99% HPD regions, respectively, do
not contain zero.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 121
5.2 Seasonality and Fat Tails
A crucial objective of this article is to perform a comparative examination of the
PSVt and SVt models, which allows us to make the novel contribution of estab-
lishing a relationship between seasonal heteroskedasticity and fat tails. In parti-
cular, we seek to determine whether the assumption of a fat-tailed conditional
distribution is required once we condition on calendar effects in both returns and
their volatility. Table 9 displays the posterior mean estimates of the Student‘s
t degrees of freedom parameter n for all the fat-tailed SV specifications. For the
DJIA and S&P 500 indices, we also evaluate the sensitivity of the n estimate for the
SVt model to (i) extreme outliers, by excluding the three most volatile days of the
sample period: Monday, October 19, 1987 (the minimum return), to Wednesday,
October 21, 1987 (the maximum return); and (ii) the selection of a shorter sample
range, which starts on January 1, 1989, and therefore is very similar to the sample
range of the S&P MidCap 400 and the S&P SmallCap 600. Starting the data in 1989
makes the estimates of n for all four indices directly comparable and hence
explicitly tests for the effect of firm size (market capitalization) on fat tails.
In Table 9, we report four sets of results. First, the SVt posterior mean
estimate of n for the full sample of the four indices ranges from the relatively
low values of n = 18 for the DJIA and n = 20 for the S&P 500 to the higher values of
n = 35 for the S&P SmallCap 600 and n= 54 for the S&P MidCap 400. For the short
subsample ranging from 1989 to 2003, the estimated n values for the SVt model
fall moderately from 18 to about 14 for the DJIA, and from 20 to about 15 for the
S&P 500. Having thus estimated the SVt model for a similar sample range across
all four indices, we conclude that the two large cap indices exhibit substantially
higher conditional kurtosis than the S&P SmallCap 600 index, which in turn is
more fat tailed than the S&P MidCap 400 index. Second, when we exclude the
October 1987 outliers, we observe only a small increase in the n estimate: it rises
from 18 to 21 for the DJIA and from 20 to 23 for the S&P 500. Therefore the degree
of conditional kurtosis for the two large cap indices is quite robust and insensitive
to the crash of 1987 outliers.
More importantly, our third result is that conditioning on seasonal hetero-
skedasticity essentially eliminates the need for a conditionally fat-tailed distribu-
tion, as it drastically increases the estimate of n. In the case of the PSVt model,
n = 56 for the DJIA, n = 60 for the S&P 500, n = 86 for the S&P MidCap 400, and
n = 80 for the S&P SmallCap 600. This new finding is critical because for such high
values of n the Student’s t-distribution becomes indistinguishable from the
Gaussian. For our fourth and final result, we consider all Student’s t specifications,
from the high-dimensional PSVt to the more parsimonious PSVt
HOL
, and we notice
that the lower the dimension of the seasonals the lower the n estimate, and hence
the less Gaussian the conditional distribution. Having said that, however, the n
estimate jumps to a very high value even if we only condition on the (sizable and
significant) holiday effects. For example, in the case of the S&P 500 index, n jumps
from a value of 20 in the SVt to a value of 56 in the PSVt
HOL
. Therefore, not only is
there strong evidence in favor of a periodic specification in general, but we also
122 Journal of Financial Econometrics
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Tsiakas | Periodic Stochastic Volatility and Fat Tails 123
have compelling evidence specifically on the importance of holiday return and
volatility effects. Finally, note that all of the results above are statistically significant,
as the NSE and RNI values for n reported in Table 9 are reasonably small.
5.3 Density Forecasts
We assess the conditional dynamics of the SV models by examining deviations of the
Gaussian density forecasts {n
t|t–1
} from the standard normal distribution. Table 5
displays the evidence for two sets of models: the PSV versus the plain vanilla SV
benchmark, and the PSVt versus the SVt benchmark. In addition to the in-sample
findings reported in panel A of Table 5, we also perform an out-of-sample exercise
usingone additional full year of returns data, beginningonJanuary1, 2004, andending
onDecember 31, 2004. The out-of-sample results conditiononthe in-sample parameter
estimates
22
for the full sample, which for all four indices ends on December 31, 2003.
Table 5 suggests that the PSV model tends to perform better in-sample
relative to the SV. The PSV density forecasts exhibit lower variance, skewness,
kurtosis, and serial correlation for three of the four indices, the exception being
the S&P SmallCap 600. In comparing the PSVt to the SVt benchmark, the evidence
is more mixed and slightly in favor of the SVt model. The PSVt density forecasts
tend to have lower variance but more kurtosis and serial correlation than those of
the SVt. Finally, in the out-of-sample exercise, the PSV and PSVt models perform
better than the SV and SVt benchmarks, especially in the kurtosis and serial
correlation of the Gaussian density forecasts.
In addition, we assess the quality of the left-tail quantiles of the one-step-
ahead probability integral transforms {u
t|t–1
}. As we explained in the previous
section, this is equivalent to testing the ability of the models to produce the
correct set of VaR estimates. Following Andersen et al. (2003), Table 6 presents
the percentage of the realized index returns that are less than each of three left-
tail quantiles (1%, 5%, and 10%) of the {u
t|t–1
}. Then, the best performing model
is the one for which the percentage of realized daily returns that belong to the
p-percent quantile of the conditional distribution is as close to p percent as
possible. In this context, Table 6 presents the strongest in-sample conditional
dynamics evidence in favor of the periodic specifications. The PSVt is almost
universally the best model for all three quantiles and all indices. At the same
time, the PSV is typically better than the SV, especially at the 5% level. As
expected, in the out-of-sample exercise, all models perform worse than in-
sample, but still the PSVt tends to perform better than its competitors.
5.4 Likelihood and Bayes Factors
We rank all stochastic volatility specifications by three criteria: the in-sample
likelihood, the out-of-sample likelihood, and the Bayes factor criterion. In
22
Unfortunately, it is not numerically feasible to update the posterior estimate of the parameters every day
a new out-of-sample observation is added because of the substantial time it takes to rerun the MCMC
algorithm.
124 Journal of Financial Econometrics
addition, Figure 4 illustrates the period-by-period evolution of the difference
in the log-likelihoods of two pairs of models: (i) the PSV minus the SV, and
(ii) the SVt minus the PSVt. The log-likelihood values for these four models
are displayed in panel A of Table 5. We find that the PSV model has higher
log-likelihood than the plain vanilla SV model for three of the four indices,
the exception being the S&P SmallCap 600. However, as shown in Figure 4,
the SV dominance for the S&P SmallCap 600 index only materializes in the
last six months of the sample. Furthermore, the PSVt model has a higher log-
likelihood than the SVt model only in the case of the S&P MidCap 400, which
by no coincidence is the index with the highest SVt estimate of n. In contrast
to the in-sample evidence, the SVt is less dominant out of sample, since it is
the model with the highest likelihood for only two of the indices — the DJIA
and the S&P SmallCap 600. In general, periodic specifications tend to perform
well out of sample, which is especially true for the more parsimonious
Gaussian models. Specifically, the best model for the S&P 500 is PSV
CYC
,
whereas for the S&P MidCap 400 index PSV
HOL
is the best, both of which
are Gaussian specifications.
Figure 4 The time evolution of the log-likelihoods. This is the cumulative period-by-period
difference in the predictive log-densities of (i) the PSV minus the plain vanilla SV model,
and (ii) the SVt minus the PSVt model. The final point is just the difference in the log-
likelihoods.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 125
Table 7 documents the Bayes factor evidence.
23
First, we determine the best
Gaussian model for each index. For the DJIA, the best Gaussian model is the PSV.
However, the penalty on the high dimension of the PSV for lack of parsimony
cancels out its likelihood advantage for the other three indices. Hence the PSV
LOW
model is best for both the S&P 500 and the S&P MidCap 400, whereas the plain
vanilla SVis best for the S&P SmallCap 600. Second, we identify the best periodic fat-
tailed specification. The lack of parsimony of the high-dimensional PSVt model still
dictates that the best periodic Student’s t model is PSVt
HOL
for three of the four
indices, the exception being the S&P MidCap 400, for which the PSVt
LOW
is best.
Consistent with the in-sample likelihood evidence, the Bayes factor criterion suggests
that the SVt model dominates over the Gaussian PSV and fat-tailed PSVt models.
Finally, Table 10 summarizes the likelihood-based evidence by reporting the best
model for each index according to the three criteria of the in-sample likelihood, the
out-of-sample likelihood, and the Bayes factors.
The log-likelihood and Bayes factor calculations present us with an interest-
ing result. The Bayes factor rankings are driven by the degrees of freedom
estimate: the lower the estimate of n, the higher the ranking of the model. This
explains why the SVt is ranked first and typically the PSVt
HOL
is second, the
PSVt
LOW
is third, and the PSVt
CYC
is fourth. Ironically, whereas our strongest
finding is that a Student’s t specification is not required once we explicitly model
seasonal heteroskedasticity, the log-likelihood and Bayes factor criteria favor the
model with the lowest n. In other words, it is precisely the conditioning on the
periodic volatility effects that raises the estimate of n, and therefore makes the
PSVt less attractive than the SVt benchmark from a likelihood point of view.
24
This is a general weakness of likelihood-based measures, which tend to magnify
the effect of a few outliers. We believe that this clearly does not invalidate the
main model-specific findings: (i) the size and significance of the PSV parameter
estimates, (ii) the effect of seasonal heteroskedasticity on fat tails, and (iii) the
superior performance of the PSV and PSVt density forecasts and quantiles of the
probability integral transforms.
6 CONCLUSION
This article provides a comprehensive analysis of the day of the week, month of the
year, and holiday seasonal effects in the daily returns and volatility of four promi-
nent U.S. stock indices: the DJIA, the S&P 500, the S&P Midcap 400, and the S&P
SmallCap 600. This enables the distinction between the behavior of small, medium,
and large firms. The analysis first provides a model-free assessment of the size and
23
For out-of-sample data, it is not possible to compute Bayes factors because the out-of-sample posterior
density ¬ 0jy ð Þ is not available analytically. The posterior density can only be simulated in sample using
the MCMC estimation algorithm and implementing the technique of reduced conditional runs of Chib
(1995) and Chib and Jeliazkov (2001).
24
For example, we recomputed a set of artificial values for the PSVt log-likelihood using the estimated
PSVt parameters and an artificial n value set to be equal to that of SVt. Then, the PSVt models dominated
the SVt (not reported in the tables) even from a likelihood point of view.
126 Journal of Financial Econometrics
statistical significance of the calendar effects. We employ bootstrap hypothesis
tests, which are robust to data mining, in order to demonstrate the importance of
explicitly modeling seasonal heteroskedasticity. The model-free results motivate
the introduction, estimation, and performance evaluation of Gaussian and Stu-
dent’s t periodic stochastic volatility models. In this context, we determine that
the PSV parameter estimates closely mirror the seasonal properties of the data.
Furthermore, it is interesting to note that we find more significant calendar effects
in volatility than in expected returns, especially for the two large cap indices. Both
the model-free tests and the model-specific results identify the same effects as the
strongest. In particular, holidays constitute the most remarkable return and volati-
lity calendar effects, both in size and significance.
More importantly, we formally assess the interaction between seasonal hetero-
skedasticity and conditional kurtosis. The strongest finding is that conditioning
on seasonal heteroskedasticity substantially increases the estimate of the degrees
of freedom parameter of the Student’s t-distribution, and therefore, essentially
eliminates the need for a fat-tailed specification. This conclusion is valid for all
indices (small, medium, and large cap), even though the large cap indices exhibit
substantially more conditional kurtosis. The results are robust to the exclusion of
the crash of 1987 outliers. Finally, the periodic stochastic volatility specifications
perform well in sample and out of sample, especially in capturing the left-tail
quantiles of the one-step-ahead predictive density.
In conclusion, the findings suggest that the Gaussian periodic stochastic vola-
tility model can be a powerful tool for modeling and forecasting financial market
volatility. We can potentially extend the analysis of this article in two interesting
directions. One possibility entails assessing the economic value of seasonal hetero-
skedasticity in the context of a short-horizon allocation strategy by investigating
Table 10 Best model.
DJIA S&P 500
S&P
MidCap 400
S&P
SmallCap 600
Panel A: Using the in-sample likelihood criterion
Best Gaussian model PSV PSV
LOW
PSV PSV
LOW
Best periodic Student’s t model PSVt PSVt
HOL
PSVt PSVt
HOL
Best model overall SVt SVt PSVt SVt
Panel B: Using the out-of-sample likelihood criterion
Best Gaussian model PSV
HOL
PSV
CYC
PSV
HOL
SV
Best periodic Student’s t Model PSVt PSVt
HOL
PSVt
LOW
PSVt
HOL
Best model overall SVt PSV
CYC
PSV
HOL
SVt
Panel C: Using the Bayes factor criterion
Best Gaussian model PSV PSV
LOW
PSV
LOW
SV
Best periodic Student’s t model PSVt
HOL
PSVt
HOL
PSVt
LOW
PSVt
HOL
Best model overall SVt SVt SVt SVt
Tsiakas | Periodic Stochastic Volatility and Fat Tails 127
whether a risk-averse investor is willing to pay for switching from the plain
vanilla SV model to a periodic SV specification. A second direction would be to
identify which portion of the strong weekend and holiday volatility effects is
driven by information accumulating during the market closure as opposed to
information revealed during the trading hours. We leave these questions for
future research.
APPENDIX A: TWO-SIDED BOOTSTRAP t-TESTS
We form two-sided hypothesis tests based on bootstrapping for evaluating in
both expected returns and volatility whether each day, month, and holiday is
statistically different to its complement. For example, we define the complement
of the Monday expected return as the average return of all days which are not
Mondays. We test the two-sided hypothesis:
H
0
: 0
1
¼ 0
2
or 0
1
À0
2
¼ 0
H
1
: 0
1
6¼ 0
2
or 0
1
À0
2
6¼ 0
ðA.1Þ
at size a. We construct the test statistic,
t ¼
^
0
1
À
^
0
2
se
^
0
1
À
^
0
2
_ _
, ðA.2Þ
and reject in favor of H
1
if |t| c. In testing for the difference between two means
of unequal sample sizes, different population variances, and independent groups,
the standard error is computed as
se
^
0
1
À
^
0
2
_ _
¼
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
^ o
2
1
T
1
À1
þ
^ o
2
2
T
2
À1
¸
. ðA.3Þ
The critical value c is selected so that Pr(|t| c) = a or c = q
1Àa
, where q
1Àa
is
the quantile of the empirical distribution of the test statistic t at the significance
level a and confidence level 1 – a. Since q
1Àa
is unknown, a bootstrap test replaces
it with the bootstrap estimate q
B
1Àc
and the test rejects if jtj q
B
1Àc
. Computation-
ally, the critical value can be estimated from a bootstrap simulation by sorting the
bootstrap t-statistics
t
B
¼
^
0
Ã
1,b
À
^
0
Ã
2,b
_ _
À
^
0
1
À
^
0
2
_ _
se
^
0
Ã
1
À
^
0
Ã
2
_ _
, ðA.4Þ
where
^
0
Ã
1.b
is the sample mean of y
1
in the bth of a total of B bootstrap samples. It
is important to note that the bootstrap test statistic is centered at the estimate
^
0
1
À
^
0
2
, and the standard error se
^
0
Ã
1
À
^
0
Ã
2
_ _
is calculated on the bootstrap
samples as
128 Journal of Financial Econometrics
se
^
0
Ã
1
À
^
0
Ã
2
_ _
¼
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
1
B

B
b¼1
^
0
Ã
1,b
À
^
0
Ã
2,b
_ _
À
"
^
0
Ã
1
À
"
^
0
Ã
2
_ _ _ _
2
¸
¸
¸
_
, ðA.5Þ
where
"
^
0
Ã
1
is the average of the bootstrap means across all the B bootstrap samples.
Note that even though we generate the same number of bootstrap samples B for
both variables,
^
0
1
and
^
0
2
(and hence
^
0
Ã
1.b
À
^
0
Ã
2.b
) are constructed using different
original sample sizes T
1
6¼ T
2
ð Þ. We set B = 10,000 bootstrap samples. The bootstrap
t-statistics t
B
are then sorted to find the estimated quantile q
B
1Àc
. For more details on
hypothesis testing using bootstrapping see Hansen (2004).
APPENDIX B: THE HANSEN, LUNDE, AND NASON (2004) F-TEST
Consider the daily return series y
t
$ j
t
. v
2
t
_ _
. t ¼ 1. . . . . T. where the variation in j
t
and v
2
t
is due to day of the week, month of the year, and holiday effects. We define
a universe of M calendar effects that belong to a set S
k
, k = 1, . . . , M, where S
k
comprises all the dates t that belong to the calendar effect k. For example, S
1
is all
the dates that are Mondays in January. The full sample is S
0
¼ 1. . . . . T f g. The
number of elements in S
k
is equal to n
k
.
Define ¸
k
¼ E "y
k
½ Š. The hypothesis that there are no calendar-specific anoma-
lies in y
t
is a two-sided hypothesis of multiple equalities:
H
0
: ¸
0
¼ ¸
1
¼ ... ¼ ¸
M
. ðB.1Þ
We assess the statistical significance of the null hypothesis using the
bootstrap F-test of Hansen, Lunde, and Nason (2004), which produces data-
mining robust results. The implementation of the test involves the following
steps:
1. Generate a set of b = 1, . . . ,B bootstrap resamples.
2. Use the original sample y
t
, t = 1, . . . ,T, to calculate the sample F-test
statistic
F
¸
¼
^
¸
0
i
?
i
0
?
^
V
T
i
?
_ _
þ
i
0
?
^
¸,q
¸
, ðB.2Þ
where
(a)
^
¸
k
¼ "y
k
. and
^
¸¼
^
¸
0
.
^
¸
1
. . . . .
^
¸
M
_ _
0
.
(b) i
?
is an (M + 1) Â M matrix, which is orthogonal to the MÂ 1 vector
of ones i.
(c) i
0
?
´
V
T
i
?
_ _
þ
is the Moore-Penrose inverse of the symmetric matrix
i
0
?
´
V
T
i
?
.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 129
(d) q
¸
¼ rank i
0
?
´
V
T
i
?
_ _
(e)
^
V
T
¼ A
0
diag ^v
2
1
. . . . . ^v
2
T
_ _
A, which is an (M + 1) Â (M + 1) matrix
estimated as follows:
(i) A is an T Â (M + 1) matrix with elements:
A
t.k
¼
n
À1
k
if t 2 S
k
0 otherwise
_ _
.
(ii) We divide the sample in Q distinct groups and assume that
within each group j
t
and v
t
2
are constant. We then define the
T Â Q matrix J of zeros and ones, where each column is
associated with a group such that J
t,i
= 1 if day t is in group i.
Each row of J has precisely one nonzero entry. Practically, we
use Q = 60 groups that are combinations of all weekdays and
months: for example, one group contains all the t’s that are
Mondays in January. Within each group, we estimate the
mean by "y
i
¼

T
t¼1
J
t.i
y
t
n
i
and the variance by v
2
i
¼

T
t¼1
J
t.i
^y
t
À"y
i ð Þ
2
n
i
À1
,
i = 1, . . . , Q, where n
i
¼

T
t¼1
J
t.i
is the number of t’s in group i.
Then, ^v
2
t
¼

Q
i¼1
J
t.i
^v
2
i
. t ¼ 1. . . . . T.
3. Use the bootstrap resamples y
tðtÞ.b
¼ ^v
t
y
tðtÞ.b
À"y
^v
tðtÞ.b
þ"y to calculate the
resampled F-test statistic
F
Ã
¸,b
¼
^
¸
Ã
0
b
i
?
i
0
?
^
V
Ã
T,b
i
?
_ _
þ
i
0
?
^
¸
Ã
b
,q
¸
. ðB.3Þ
4. The p-value of H
0
is given by
^p
H
0
¼
1
B

B
b¼1
1
fF
¸
F
Ã
¸,b
g
. ðB.4Þ
APPENDIX C: SAMPLING THE SEASONAL VOLATILITY EFFECTS
The parameters of all SV models examined in this article are estimated using the
Bayesian MCMC algorithm of Chib, Nardari, and Shephard (2002), which builds
on the procedures developed by Kim, Shephard, and Chib (1998). The periodic
specifications require estimation of a high-dimensional parameter vector. For
example, in the case of the PSVt model, the MCMC algorithm produces estimates
of the posterior means of (i) the nonseasonal parameters of the return equation y
1
= {c
0
, b}, (ii) the degrees of freedom parameter n of the Student’s t-distribution,
(iii) the nonseasonal log-variance parameters 0
2
= {m, g, f, s
2
}, and (iv) the seasonal
parameters 0
3
= {c
j,
c
j
}, j 19, for the day of the week, month of the year, and
holiday effects in both the mean {c
j
} and the variance {c
j
}.
130 Journal of Financial Econometrics
The key to estimating the high-dimensional periodic SV models is the effi-
cient sampling of the seasonal level effects in the conditional variance. This is
done using a simple Gibbs step where the c = {c
j
} vector is drawn conditional on
the log-variance vector {h
t
} using a precision-weighted average of prior informa-
tion and the conditional likelihood. Despite its simplicity, this method is numeri-
cally superior to the sampling of {c
j
} in the same block as the log-volatility
parameters 0
2
. Specifically, the estimation of 0
2
involves a numerical optimization
step that generates a proposal that is accepted according to the Metropolis-Hast-
ings algorithm. Sampling {c
j
} in the same block as 0
2
requires high-dimensional
optimization, which in turn may cause problems such as slowing the algorithm
considerably, returning a nonpositive definite numerical Hessian matrix, or pro-
ducing an unacceptably high Metropolis-Hastings rejection rate. Our results
indicate that the additional Gibbs step is highly efficient in that the posterior
mean estimates of {c
j
} have very low NSE and RNI values.
C.1 A Brief Sketch of the MCMC Algorithm
1. Initialize 0, s, `, i and transform the data into y
Ã
t
¼ ln
y
t
Àc
t
Àuy
tÀ1
ð Þ
`
À1
t
2
þc
_ _
,
c = 0.001 to put the model in state-space form. The ‘‘offset’’ constant c
eliminates the inlier problem.
2. Sample the log-variance parameters from their full conditional posterior
density: 0
2
| y
Ã
, s, c. This posterior is not available analytically. We use the
Kalman filter to compute the log-likelihood of the transformed data y
Ã
t
as a
function of 0
2
(conditional on s
t
) and then optimize this conditional log-
posterior. We generate a proposal froma t-distribution t (m, V, ¸), where m
is the mode, V is the inverse of the negative Hessian, and ¸ is a tuning
parameter. The proposal is then accepted according to the Metropolis-
Hastings algorithm. The optimization step makes this an independence
chain Metropolis-Hastings algorithmand contributes crucially to reducing
the serial correlation in the draws of the MCMCchain. For more details on
the Metropolis-Hastings algorithm see Chib and Greenberg (1995).
3. Sample the seasonal coefficients in the log-variance equation fromtheir full
conditional posterior c|y
Ã
, D, h, s using the Gibbs step (detailed below).
4. Sample the log-variance vector {h
t
} in one block from the full conditional
posterior distribution: h|y
Ã
, s, 0
2
. This step uses the de Jong and Shep-
hard (1995) simulation smoother, which is an algorithm designed for
efficient sampling of the state vector in a state-space model.
5. Sample the Student’s t degrees of freedom parameter from the full con-
ditional density: n|y, h, 0. We optimize the conditional log-posterior
with respect to n and then use the mode and a scaled inverse of the
negative Hessian to generate a proposal that is accepted according to the
Metropolis-Hastings algorithm.
Tsiakas | Periodic Stochastic Volatility and Fat Tails 131
6. Sample `|y, h, 0 directly from its posterior:
`
t
jy
t
,h
t
,0 $ Gamma
n þ1
2
,
2
n þ y
t
Àc
t
Àuy
tÀ1
ð Þ
2
,v
2
t
_ _
. ðC.1Þ
7. Sample all the conditional mean coefficients (including the seasonal
coefficients in the mean) 0
1
, a | y, D, h, c using a precision-weighted
average of a set of normal priors and the normal conditional likelihood.
Then update the transformed data y
Ã
t
¼ ln
y
t
Àc
t
Àuy
tÀ1
ð Þ
2
`
À1
t
þc
_ _
, c = 0.001.
8. Finally, sample the mixture indicator variable s|y
Ã
, h, 0 directly from its
posterior:
Pr s
t
jy
Ã
t
, h
t
_ _
!Pr s
t
ð Þf
N
y
Ã
t
jh
t
þc
0
D
t
þm
st
, v
2
st
_ _
, ðC.2Þ
where {m
st
,v
2
st
} are the means and variances of the seven-component mix-
ture of normal densities which are used to approximate the log w
2
(1)
distribution.
9. Go to step 2 and iterate.
C.2 The Gibbs Step for d
j
Consider the state-space representation of the periodic SV model:
y
Ã
t
¼ c
0
D
t
þh
t
þz
t
, c
0
D
t
¼

19
j¼1
c
j
D
j,t
, z
t
js
t
$ N m
st
,v
2
st
_ _
ðC.3Þ
h
t
¼ j þ¸y
tÀ1
þc h
tÀ1
Àj ð Þ þoj
t
, j
t
$ NID 0,1 ð Þ ðC.4Þ
We wish to sample the coefficients of the level volatility effects c = {c
j
}, j 19,
from c|y
Ã
, D, h, s using a precision-weighted average of the prior and
the conditional likelihood. Define the vector of priors c $ N c
0
. Á
À1
0
_ _
, where
c
0
= [0, . . . , 0]

2 <
19
and Á
À1
0
¼ I
19
. Consider the data transformation
^y
t
¼
y
Ã
t
Àh
t
Àm
st
v
st
,
^
D
j,t
¼
D
j,t
v
st
.
ðC.5Þ
Then, the posterior mean estimate for the vector c is simply given by
^
c ¼ V
c
Á
0
c
0
þ
^
D
0
^y
_ _
2 <
19
, V
c
¼ Á
0
þ
^
D
0
^
D
_ _
À1
2 <
19Â19
. ðC.6Þ
Received April 26, 2004; revised April 25, 2005; accepted June 8, 2005
132 Journal of Financial Econometrics
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