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Research article on stock market

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Research article on stock market

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Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK

Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/rafe20

David McMillan , Alan Speight & Owain Apgwilym

a b c a b c

Department of Economics, University of St Andrews, Fife, KY16 9AL Department of Economics, University of Wales, Swansea SA2 8PP, UK

Department of Management, University of Southampton, Southampton, SO171BJ Version of record first published: 07 Oct 2010.

To cite this article: David McMillan , Alan Speight & Owain Apgwilym (2000): Forecasting UK stock market volatility, Applied Financial Economics, 10:4, 435-448 To link to this article: http://dx.doi.org/10.1080/09603100050031561

PLEASE SCROLL DOWN FOR ARTICLE Full terms and conditions of use: http://www.tandfonline.com/page/terms-and-conditions This article may be used for research, teaching, and private study purposes. Any substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any form to anyone is expressly forbidden. The publisher does not give any warranty express or implied or make any representation that the contents will be complete or accurate or up to date. The accuracy of any instructions, formulae, and drug doses should be independently verified with primary sources. The publisher shall not be liable for any loss, actions, claims, proceedings, demand, or costs or damages whatsoever or howsoever caused arising directly or indirectly in connection with or arising out of the use of this material.

D A V I D M C MI L L A N , A L A N S PE I G H T * { and OW A I N A PG WI L Y M } Department of Economics, University of St Andrews, Fife, KY 16 9AL { Department of Economics, University of W ales, Swansea SA2 8PP, UK and } Department of Management, University of Southampton, Southampton, SO17 1BJ

The paper analyses the forecasting performance of a variety of statistical and econometric models of UK FTA All Share and FTSE100 stock index volatility at the monthly, weekly and daily frequencies under both symmetric and asymmetric loss functions. Under symmetric loss, results suggest that the random walk model provides vastly superior monthly volatility forecasts, while random walk, moving average, and recursive smoothing models provide moderately superior weekly volatility forecasts, and GARCH, moving average and exponential smoothing models provide marginally superior daily volatility forecasts. If attention is restricted to one forecasting method for all frequencies, the most consistent forecasting performance is provided by moving average and GARCH models. More generally, results suggest that previous results reporting that the class of GARCH models provide relatively poor volatility forecasts may not be robust at higher frequencies, failing to hold here for the crash-adjusted FTSE100 index in particular. I . I N T R OD U C T I ON Since the stock market crash of 1987, stock price volatility has been the focus of both empirical academic research and regulatory concern. This attention re ects three important considerations . First, the well-noted observation that stock market volatility has been higher in more recent than historical periods, and the perception that such increased volatility is due to institutional changes such as automated trading and the introduction of trading in derivative futures and options contracts which may have enhanced the likelihood of large swings in mean stock returns (Edwards, 1988a, b; Schwert, 1990; Robinson, 1994; Antoniou and Holmes, 1995). Second, although the tendency for stock market volatility to exhibit `clustering has long been recognized (Mandelbrot, 1963; Fama, 1965), it is only since introduction of the autoregressive conditional heteroscedasticity (ARCH) model by Engle (1982) and its subsequent generalization (GARCH) by Bollerslev (1986) that researchers have formally modelled the second and higher moments of nancial time series using econometric techniques. Third, increased recognition has been paid to the practical importance of accurate volatility estimates and forecasts in asset and option pricing models, and portfolio selection and market timing decisions (Gemmill, 1993; Vasilellis and Meade, 1996). These considerations have led to examinations of the stationarity and persistence of volatility over time and the accuracy of volatility forecasting techniques. In particular, the comparative forecasting performance of statistical procedures associated with `technical analysis 1 , other more na ve methods, and forecasts generated from extended models of the GARCH class (Bollerslev et al. , 1992). While the modelling and forecasting of US stock market conditional volatility has been extensively investigated, the analysis of conditional volatility in other international stock markets has only recently been undertaken, with con icting results. 2 For example, in forecasting monthly US stock market volatility, Akgiray (1989) nds that a GARCH(1, 1) model outperforms more traditional technical analysis. Tse (1991) and Tse and Tung (1992) examine the stock markets of Japan and

* Corresponding author. E-mail: a.speight@swan.ac.uk 1 For extended discussions of technical analysis and associated `chartism, and the formal underpinnings of such analysis, see Stewart (1966) and Plummer (1989) respectively. 2 Also see de Jong et al. (1992) , and Kearns and Pagan (1993).

Applied Financial Economics ISSN 0960 3107 print/ISSN 1466 4305 online # 2000 Taylor & Francis Ltd http://www.tandf.co.uk/journals

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Singapore respectively, and nd that an exponentially weighted moving average method is superior to the GARCH model in both cases. Franses and van Dijk (1996) compare the volatility forecasting performance of the GARCH, quadratic-GARCH (QGARCH, Engle and Ng, 1993), and threshold-GARCH (TGARCH, Glosten et al. , 1992) models to the random walk model using weekly German, Dutch, Italian, Spanish and Swedish stock index returns over the period 1986 to 1994. They report that the random walk model performs particularly well when the crash of 1987 is included in the estimation sample, while the QGARCH model performs better upon its exclusion. For the monthly volatility of Australian stock market data, Brailsford and Fa (1996) compare the predictive performance of several statistical methods with GARCH and TGARCH models. Using several loss functions, they are unable to identify a clearly superior model and suggest that the `best forecasting model depends upon the subsequent application, as the ranking of models is sensitive to the choice of loss function. However, to date, little evidence is available for the UK. Dimson and Marsh (1990) examine various technical methods of predicting the volatility of UK stock market returns over the period 1955 1989 and nd that exponential smoothing and simple regression models perform best according to their criteria, but do not consider the genre of ARCH models. Indeed, no analysis of the volatility forecasting performance of GARCH models for the UK stock market has yet been reported. Several issues therefore arise from the existing empirical literature. First, there is no clear consensus across international stock markets as to the superior conditional volatility forecasting method. Second, that these con icting results in part re ect di erences in the choice of classes of model for inclusion in the forecasting competition. Third, such results are obtained for di erent frequencies of observation of stock market prices, and with di ering treatments of the 1987 crash. Fourth, that the identi cation of a superior volatility forecasting method may not be invariant to the choice of loss function used in forecast appraisal. This paper therefore provides a comparative evaluation of the volatility forecasting ability of GARCH models, asymmetric TGARCH and exponential-GARCH (EGARCH, Nelson, 1991) models, and a wide range of more traditional methods associated with technical analysis, for the Financial Times Stock Exchange 100 index and the Financial Times Actuaries All Share index at the London Stock Exchange. A primary aim of the paper is to attempt to clarify the usefulness of GARCH type models in predicting volatility while using a di erent stock market setting from previous research, and to identify the `best forecasting models for the volatility of these indices of returns on the London stock exchange in particular. Additionally, and in extension of previous research investigating such models, we also examine the component-

D. McMillan et al.

GARCH model introduced by Engle and Lee (1993) which permits the separation of volatility into long-term and short-term e ects and has not previously been considered in the literature. In total, ten models are considered, these being the historical mean, moving average, random walk, exponential smoothing, exponentially weighted moving average, simple regression, GARCH, TGARCH, EGARCH, and component-GARCH models. Further, all forecast evaluations are performed for the monthly, weekly and daily data frequencies in order that the sensitivity of our results to the choice of sample frequency may be assessed. This exercise also has a practical motivation in that while tactical short-term investment decisions and valuations of short-lived derivatives frequently focus on short-term predictions of volatility, strategic decisions and the valuation of long-lived assets require longer-term predictions of volatility. The consideration of volatility forecasting performance over di erent frequencies and thereby di erent horizons, provides one means of accommodating such considerations and is an issue likely to be of interest to such market participants as managers of index tracking funds who need to be aware of the volatility of these indices at di erent frequencies. All forecasts are also conducted on the basis of in-sample conditional mean models both with and without adjustment of the 1987 crash. Finally, forecast evaluation is conducted with respect to a variety of loss functions. At a practical level it is unlikely that all market participants will attach equal importance to overpredictions and underpredictions of volatility, as in the pricing of call options on the buying and selling sides of the market for example, and both symmetric and asymmetric loss function results are therefore reported. The remainder of the paper is structured as follows. Section II describes the data series, source, sample period and methodology. Section III describes the volatility forecasting models employed and characteristics of their insample estimation. Section IV discusses the criteria on which the forecast performance of these models is assessed and Section V reports the outcomes of the comparative forecast exercise. Section VI summarizes our ndings and concludes. II. DA TA The Financial Times Stock Exchange 100 index (FTSE100) was launched in January 1984 and represents the stock prices of the 100 largest listed UK companies weighted by market capitalization. One of the main aims of launching the index was to enable the introduction of derivatives based on a single indicator of the equity market. It therefore constitutes the rst real-time index for the UK equity market which is small enough to be updated regularly and accurately but also comprehensive enough to act as an

e ective proxy for the UK equity market, and is now a widely used indicator of UK equity market conditions. 3 The FTSE100 is thus a blue-chip subset of the Financial Times Actuaries (FTA) All Share index introduced in 1962 which covers about 93% of the market capitalization of the UK equity market and is the long-standing benchmark index for the UK market. While the FTSE100 and FTA All Share index are closely correlated, the di erent composition of the two indices means there is always some scope for divergence between them and both are therefore analysed here. All data are obtained from the Datastream market information service. For the FTSE100 index we consider daily closing price data from 2 January 1984 to 31 July 1996, while for the FTA All Share index we study daily closing price data from 1 January 1969 to 31 July 1996. These price indices p are converted to returns r by the standard method of calculating the log-di erence, rt log pt =pt1 . Further, in order to examine the performance of the various volatility estimators over di erent forecast horizons, the data are re-sampled at a weekly and monthly returns frequency. Additionally, given the data period extends over the crash of October 1987, volatility estimation is conducted both including and excluding a dummy variable for this event in order that the sensitivity of our results to this extreme volatility event may be assessed. Finally, for each frequency the data are partitioned into the in-sample estimation periods 1969 1994 for the FTA data and 1984 1994 for the FTSE data, the out-of-sample forecast periods covering the remaining period 1995 1996 for both data sources. This separation provides in-sample

3

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(out-of-sample) observations of 312 (19), 1357 (82) and 6783 (413) for the monthly, weekly and daily FTA series, and 132 (20), 574 (83) and 2869 (413) for the monthly, weekly and daily FTSE series. In order to generate an historical `actual volatility series on the basis of which volatility forecasts may be generated using statistical methods, we follow Pagan and Schwert (1990) in representing true past volatility by the squared residuals from a conditional mean equation for returns estimated over the in-sample period. Examination of the in-sample returns data reveals signi cant serial correlation in the levels of the weekly and daily but not monthly series. 4 The in-sample conditional mean is therefore estimated using the autoregressive (AR) process :

L rt ut ; L 1 1 L

t 1;2;. . . ;T

k

where L is the orthodox lag operator L xtk xtk and T denotes the number of in-sample observations . 5 With estimates of the parameters of L and determined by minimization of the in-sample sum of squared residuals of Equation 1, historical volatility, 2 t using the conventional notation in the literature, is formally generated using: 2 t rt fT

;T

L 1rt g2 ;

t 1;2;. . . ;T

where denotes the number of out-of-sample observations, and the subscript T on a coe cient indicates that it is estimated conditional on the in-sample information set.6

The base level of the index was set at 1000. 0 on 31 December 1983, and it is now calculated on a rm basis by the London Stock Exchange every 60 seconds during market hours, currently 0830 1630 GMT. 4 For example, the Ljung Box Q-statistics for up to twelfth-order autocorrelation for the FTSE (FTA) series are 36.43 (71.74) for weekly returns and 47.04 (325.45) for daily returns. 5 Empirically, the lag length is determined by the Akaike and Schwarz information criterion. Additionally, dummies for Monday and holiday e ects are included in the AR model for daily data, while a January dummy is included for monthly data. Typically, low-order AR models are determined. In particular, for the FTSE, an AR(0) model is appropriate for monthly data, AR(2) for weekly data, AR(1) for daily data including a dummy for the 1987 crash, and AR(4) for daily data without a crash dummy. For the FTA series, an AR(2) model holds for monthly data, an AR (3) for weekly data and AR(10) for daily data. The AR(10) in daily FTA data is a result of the two week settlement-of-account period operating prior to reform in 1995. Thus an investor could have bought at the beginning of the settlement period but held both cash and the asset, and returns thus compensate for this (see Theobald and Price, 1984). In 1995 this was changed to a rolling settlement system. 6 Thus, historical volatility is generated by the application of a conditional mean model determined on in-sample data to both the insample and out-of-sample returns data. While not discussed in the text, for several of the forecasting methods described in Section III, we have also considered fully recursive variants of Equations 1 and 2 entailing re-estimation of the parameters L ; as the data sample is extended over the out-of-sample horizon. Indeed, this approach is required in the recursive estimation and forecasting of the GARCH class of models. However, this alternative, fully recursive, method of generating 2 t imposes severe computational burdens in the context of the moving average, smoothing and simple regression frameworks, since at each point in time over the out-of-sample forecast horizon the entire history of volatility must then be reassessed and revised. Given that one objective of the present study is to ascertain the relative bene ts of alternative forecasting mechanisms in a practical context entailing repeated forecasting exercises, it is likely that simplicity is a desirable feature of any recommended forecasting method, and the fully recursive approach may not be favoured under these methods on such grounds. Moreover, the conditional mean functions estimated exhibit inherent stability. For example, comparison of the in-sample conditional mean functions and full-sample conditional mean functions (the latter being employed in generating forecast error statistics, see Section IV), reveal only minor di erences in coe cient estimates beyond the fourth decimal place. Thus, for those statistical methods we have investigated using the fully recursive approach to the generation of historic volatility, whether that approach is employed or not yields little or no quantitative di erence with the forecast error statistics reported in section V, and no qualitative di erence in terms of relative forecasting performance across models.

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This notation is employed throughout the remainder of the paper.

D. McMillan et al.

data, two-and-one-hal f years and one-and-one-quarte r years for weekly data, and six months and three months for daily data, corresponding to T 120 and T 60 data points for the longer and shorter window lengths in each case. 7 Random walk The preceding models presume reversion to a stable or gradually shifting trend in volatility. However, if volatility uctuates randomly the optimal forecast of next periods volatility is simply current actual volatility: ht1 2 t; t T ;T 1;. . . ;T 1

I I I . V OL A T I L I T Y F OR EC A S T I N G M OD E L S Historical mean Extrapolation of the historical mean in volatility provides perhaps the most obvious means of forecasting future volatility. Moreover, if the distribution of volatility has a stationary mean, all variation in estimated volatility is attributabl e to measurement error and the historical - , computed as the unweighted average of volatility mean, observed in-sample, then gives the optimal forecast of volatility, h, for all future periods :

T X -2 1 ht1 2 ; T j 1 j

t T ;T 1;. . . ;T 1

Forecasts based on this mean also provide a benchmark for the comparative evaluation of the alternative forecasting models outlined below. In addition to this in-sample historical mean, we also consider the recursive assessment of the historical mean, iteratively updated with each incremental observation on volatility over the out-of-sample period: -2 1 ht1 t t

t X j 1

This `random walk model thus suggests that the optimal forecast of volatility is for no change since the last true observation. This model also provides us with an alternative benchmark for appraising the relative forecasting performance of methods considered here, being a standard comparative method in econometric forecast appraisal. Exponential smoothing Under exponential smoothing the one-step-ahead forecast of volatility is a weighted function of the immediately preceding volatility forecast and current actual volatility: ht1 T ht 1 T 2 t;

2 j;

t T ; T 1 ; . . . ; T 1 4

such that the mean of historic volatility and forecast of future volatility at any point in time during the out-ofsample period is based on all information on actual volatility available at that point in time. Moving average Under the moving average method volatility is forecast by an unweighted average of past observed volatilities over a particular historical time interval of xed length : -2 1 ht1 2 ; t ;T T jT T j

t X

where the `smoothing parameter is constrained such that 0 1. For 0 (or ht 2 t , an exactly correct past forecast) the exponential smoothing model collapses to the random walk, while as ! 1 major weight is given to the prior period forecast. As the subscripts indicate, the value of T is determined empirically as that which minimizes the in-sample sum of squared prediction errors. 8 Exponentially weighted moving average (EW MA) The exponentially weighted moving average model is similar to the exponential smoothing model, but where past observed volatility in Equation 7 is replaced with a moving average forecast as in Equation 5: ht1 T ht 1 T

t 1 X 2 ; T j T T j

t T ;T 1;. . . ;T 1 7

t T ; T 1;. . . ;T 1

where T is the moving average period or `rolling window. The choice of this interval is essentially arbitrary and two lengths are considered here for each frequency. These arbitrary choices are ten years and ve years for monthly

7 8

t T ;T 1;. . . ;T 1

Thus, approximately the same number of observations are used in constructing the moving averages over the three sample frequencies. The values estimated here lie in the range 0.001 0.1 for monthly and weekly data, and 0.14 0.83 for daily data. This contrasts with results reported elsewhere. For example, Dimson and Marsh (1990) using quarterly volatilities report a value of 0.66 in their preferred model, while Brailsford and Fa (1996 ) report values in the range 0.51 to 0.98 for monthly data.

with T speci ed as for the longer of two horizons considered for each frequency in the moving average model above. 9 F Simple ( mean ) regression The simple regression model provides one-step-ahead forecasts generated from the application of an in-sample estimated ordinary least squares regression of observed actual volatility upon immediately preceding actual volatility to out-of-sample data: ht1 T T 2 t1 ; t T ; T 1 ; . . . ; T 1 9 F

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quantifying volatility, out-of-sample forecasts of volatility are generated by the GARCHp ; q model:12

0 ;T 0 "t ; L rt T 0 ;T

L 1 F

0 1 ;T L

;T L ; t

1 ; 2 ; . . . ; T 10

"t N0 ; ht ht1 !T

q X i 1

11

i ;T "2 ti1

p X i 1

i ;T hti1 ;

Following Dimson and Marsh (1990), again assuming the stationarity of volatility over the longer term, if such forecasts are to be unbiased then the simple regression implicitly forecasts volatility as a weighted sum of recent volatility and long-run mean volatility, and such that volatility will regress from its most recent level, 2 t1 , towards its long-run mean h, with determining the speed of regression towards that mean. 10 ;11 Generalized autoregressive conditional heteroscedasticity ( GARCH) The GARCH model of Engle (1982) and Bollerslev (1986) requires joint estimation of the conditional mean and variance process, the former being represented by an autoregressive process for stock index returns as above in Equation 1. On the assumption that the resulting conditional mean stochastic error, "t , is normally distributed with zero mean and time-varying conditional variance

9

t T ; T 1 ; . . . ; T 1 12 P P where ! > 0, i , i 0, and i i i i < 1, the latter sum quantifying the persistence of shocks to volatility. 13 The GARCH(1, 1) model, for example, thus generates onestep-ahead forecasts of volatility, ht1 , as a weighted average of the constant long-run or average variance, !, the previously forecast variance for the current period, ht , and current volatility re ecting squared `news about the index return, "2 t . In particular, volatility forecasts are increased following a large positive or negative index return, the GARCH speci cation thus capturing the well-documented volatility clustering evident in nancial returns data. 14

T hreshold-GARCH ( T GARCH) The GARCH model, although non-linear in the conditional mean error term, "t , postulates a linear relationship between forecast volatility, previous forecasts of

As the subscript notation indicates, the value of is again determined empirically by minimization of the in-sample residual sum of squares and found to be 0.999 for both the FTSE and FTA series at all three frequencies, with the exception of the monthlysampled FTSE where the value is 0.4340 for data adjusted for the 1987 stock market crash and 0.5060 without such adjustment. This compares with a range of values reported by Brailsford and Fa (1996) of between 0.0 and 0.9. Additionally, it should be noted that models were also estimated for the shorter moving average intervals discussed, but with no qualitative di erence from the results reported here. 10 To see this, note that the expected value of both sides of Equation 9 must equal the long-run mean, h, for unbiasedness to hold. Hence, 2 may be replaced by 1 h by virtue of E t1 h, yielding: ht1 1 T h T 2 t T ; T 1; . . . ; T 1 9b t1 ;

11

In-sample estimates of are typically low and positive in the lower frequency data, at 0.05 (0.11) and 0.08 (0.12) in monthly and weekly FTA data (crash adjusted values in brackets), and 0.04 ( 70.06) and 0.01 (0.03) in monthly and weekly FTSE data. Only for the adjusted monthly FTA and unadjusted weekly FTSE series are these values statistically signi cantly di erent from zero. At the higher daily frequency all estimated coe cients are positive and statistically signi cant with values of 0.46 (0.35) and 0.63 (0.27) for the FTA and FTSE respectively. 12 2 Note that in the GARCH model, "2 t is the analogue of historic volatility, t , in the statistical forecasting models described above, the only essential di erence being that while 2 is generated as the squared residuals from the conditional mean function estimated alone, "2 t t is generated as the squared residuals from the conditional mean function estimated jointly with the conditional variance process in Equations 10 12. While alternative notation could be employed in clari cation of this connection, we retain the representation employing "2 t in keeping with conventions in the GARCH literature. 13 As Nelson and Cao (1992) have shown, the rst two inequalities stated need not necessarily hold in order to ensure non-negativity of the conditional variance. In the 2) case for example, 2 < 0 with 1 1 2 is su cient to ensure h2 t > 0. However, it is P GARCH(1, P necessary and su cient that i i i i < 1 in order P for a nite P unconditional variance to exist, that sum also de ning the limiting case of the integrated-GARCH (IGARCH) model for i i i i 1, such that current news has a permanent e ect on forecast volatility (Engle and Bollerslev, 1986). 14 Preliminary tests for the presence of ARCH e ects in in-sample conditional mean errors using Engles (1982) LM test indicate signi cant conditional heteroscedasticity in all cases other than the weekly FTSE series unadjusted for the 1987 crash, that event

440

volatility, and current and lagged measured volatility in response to news. However, it has been observed that positive and negative shocks of equal magnitude have a di erential impact upon stock price volatility, which may be attributabl e to a `leverage e ect (Black, 1976). Further, stock market returns series have been noted to display signi cant negative skewness, possibly due to the fact that market crashes are greater in absolute size and occur more frequently and more quickly than booms (Franses and van Dijk, 1996). One model that is able to capture these features is the TGARCH model (Glosten et al. , 1993) which, for a rst-order threshold, is expressed as (in conjunction with Equations 10 and 11) : ht1 !T

q X i 1 2 i ;T "2 ti1 T It "t p X i 1

D. McMillan et al.

log ht1 !T

q X i 1

i ;T hti1 ;

t T ; . . . ; T 1, where the 1 coe cient captures the volatility clustering e ect noted above and the coe cient 2 measures the asymmetric e ect, which if negative indicates that negative shocks have a greater impact upon conditional volatility than positive shocks of equal magnitude. Additionally, the use of logs allows the parameters i and i to be negative without the conditional variance becoming negative, while the Ppersistence of shocks to conditional variance is given by i i . 16 Component-GARCH ( CGARCH) The CGARCH model of Engle and Lee (1993) attempts to separate long-run and short-run volatility e ects in a similar manner to the Beveridge Nelson (1981) decomposition of conditional mean ARMA models for economic time series. Thus, while the GARCH model and its asymmetric TGARCH and EGARCH extensions exhibit mean reversion to !, the CGARCH model allows mean reversion to a time-varying level, !t . The CGARCH speci cation is: ht1 !t1 1 "2 t !t 1 ht !t ; !t1 ! !t "2 t ht t T ;T 1;. . . ;T 1

p X i 1

i ;T

14

t T ;T 1;. . . ;T 1

13

where It 1 if "t < 0, and It 0 if "t > 0. Thus, in the TGARCH(1, 1) case, for example, positive `news has an impact of 1 on volatility while negative news has an impact of 1 , positive (negative) news therefore having the greater impact on subsequent volatility for < 0 while shock persistence is quanti ed by > 0, P P = 15 i i i i 2. Exponential-GARCH ( EGARCH) The EGARCH model (Nelson, 1991) provides an alternative asymmetric model, the conditional variance being expressed as an asymmetric function of past errors (again in conjunction with Equations 10 and 11) :

15

where !t represents a time-varying trend or permanent component in volatility which is integrated if 1. The volatility prediction error "2 t1 ht1 serves as the driving

swamping all other conditional variance behaviour in that series. For all remaining series, in-sample AR-GARCH model orders ; p ; q are initially determined by application of the Akaike and Schwarz information criterion. However, as noted by Nelson (1991, p. 356), the asymptotic properties of the Schwarz criterion in the context of ARCH are unknown, while the Akaike criterion tends to prefer long lag models. Thus, examination of the residual diagnostics and maximization of the log-likelihood are also used to guide order selection. Estimation of GARCH models and extended GARCH models is performed jointly with the AR model throughout, and dummies for possible Monday and holiday e ects are again included in the AR model for daily data, while a January dummy is again included for monthly data. The resulting jointly estimated AR models orders remain the same as reported above under AR estimation alone, while joint GARCH(1, 1) models hold for all series other than FTA daily data where a GARCH(3, 1) model holds. Persistence measures for these models applied to FTA and FTSE data are found to be 0.90 0.93 for monthly data, 0.93 0.94 for weekly data and 0.95 0.97 for daily data, with the exception of the monthly FTSE data unadjusted for the 1987 crash where a persistence measure of 1.00 identi es an IGARCH process. Thus, GARCH volatility forecast mean reversion is absent for the latter series, and generally sluggish for the remaining series in view of their relatively high shock persistence measures. 15 Estimation and forecasting of the TGARCH model is conducted along the same lines as for the GARCH model, the AR-GARCH model orders reported above continuing to hold for jointly estimated AR-TGARCH models with rst-order thresholds imposed. The estimated asymmetric coe cient, , is everywhere positive and statistically signi cant in-sample for the 1987 crash-adjusted FTA series at all frequencies, the non-adjusted daily FTA series, the non-adjusted monthly FTSE series and the crash-adjusted weekly FTSE series. Persistence measures remain virtually unchanged relative to those for in-sample GARCH models, except for the IGARCH crashunadjusted monthly FTSE case where persistence falls to 0.50, and the crash-unadjusted monthly FTA case where persistence falls to 0.84. 16 Estimation and forecasting of the EGARCH model is conducted as for GARCH and TGARCH models, model orders continuing to hold for jointly estimated AR-EGARCH models. The asymmetric coe cient, 2 , is consistently negative and statistically signi cant insample for the 1987 crash-adjusted FTA series at all frequencies, the non-adjusted FTA series at the daily frequency, and the FTSE crash-adjusted series at both the monthly and weekly frequencies. Persistence measures con rm those obtained for GARCH and TGARCH models, with the exception of the monthly FTSE series where the previously integrated crash-unadjusted GARCH case

force for the time-dependent movement of the trend, and the di erence between the conditional variance and its trend ht qt de nes the transitory component of the conditional variance. The transitory component then converges to zero with powers of while the long-run component converges on ! with powers of . 17 Recursively estimated models In addition to recursive appraisal of the historical mean (see Equation 4 above) we also consider forecasts generated by recursive variants of the above models which involve parameters estimated using in-sample data. That is, those models involving parameters with a T subscript. These alternative recursively generated one-step-ahead forecasts are based on re-estimation of the underlying parameters at each data point over the out-of-sample period, that re-estimation utilizing all information available at that point in time. Thus, while not speci ed in full, the set of parameters T T ;T ; T ;T ; F 2 ;T ;T

;T

441

error (RMSE) and mean absolute error (MAE), de ned as follows: ME MAE

X 1 T ht s2 t tT 1 X 1 T jht s2 tj tT 1

17 18 19

; T ;!T ;i ;T ; i ;T ;T ;i ;T ;

in Equations 7 10 and 12 15 are correspondingly replaced by the set t t ;t ; . . . ;t for t T ; T 1 ; . . . ; T 1. 18 The criteria on which the forecast performance of the resulting and the foregoing models are assessed is discussed in the following section.

I V . F OR E C A S T E V A L U A T I ON In order to provide a measure of `true volatility against which to assess the forecast performance of the volatility estimators, we follow Pagan and Schwert (1990) in using the squared error term from a conditional mean model for returns estimated over the full data set comprising both the in-sample and out-of-sample data. That is, `true volatility generated by: s2 t rt f

2 ; L 1rt g

where is the number of forecast data points and s2 t is `true volatility as de ned above. The ME statistic is used here as a general guide to the direction of over- or underprediction on average. The MAE is an orthodox forecast appraisal criterion which does not permit the o setting e ects of overprediction and underprediction as in ME, while the RMSE is a conventional criterion which clearly weights greater forecast errors more heavily in the average forecast error penalty. These error statistics assume the underlying loss function to be symmetric. However, as noted in the introduction, it is probable that as a practical matter not all investors will attach equal weight to similar sized overpredictions and underpredictions of volatility. 19 Following previous research (Pagan and Schwert, 1990; Brailsford and Fa , 1996 ) we therefore also consider error statistics designed to account for potential asymmetry in the loss function. That is, mean mixed error statistics which penalize, rstly, underpredictions more heavily: " # O U q X 1 X jht s2 jht s2 MME U 20 tj tj i1 i 1 and secondly, overpredictions more heavily: " # O q U X 1 X 2 2 j h t st j jht st j MME O i1 i 1

v u u1 T t X RMSE ht s2 t tT 1

where the subscript on a coe cient indicates that it is estimated over the entire data sample. The ability of the above models to adequately forecast true volatility so measured in the FTSE and FTA stock index markets is evaluated using the mean error (ME), root mean squared

16

18

where O denotes the number of overpredictions and U the number of underpredictions among the out-of-sample forecasts. Finally, and again following previous research, we also report standardized values for all error statistics using the error statistic for the historical mean benchmark for

now obtains a persistence measure of 0:94, suggesting oscillation in conditional variance, and the corresponding crash-adjusted measure falls to 0.43. 17 In-sample estimates of generally con rm earlier persistence measures, at 0.83 (0.64), 0.92 (0.91), and 0.99 (0.99) in crash-adjusted (unadjusted) FTA monthly, weekly and daily series respectively, and 0.91 (0.68), 0.94 and 0.94 (0.92) in corresponding FTSE adjusted (unadjusted) series. Persistence in the transitory component, , is everywhere lower than in the permanent component, though only marginally for daily FTA data, and negative for the monthly crash-adjusted and weekly unadjusted FTA series and adjusted daily FTSE series, suggesting the oscillation of volatility about the long-run trend during convergence in those cases. 18 Note that, as mentioned in footnote 6, for the class of GARCH models such recursive estimation is `fully recursive in the sense that not only are the volatility forecasting equation parameters iteratively updated with the acquisition of out-of-sample information, but the

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each series. This has the advantage of allowing the error statistics to be more easily interpreted in a relative context.

D. McMillan et al.

ing average for FTSE data. Nevertheless, on the basis of the MAE forecast error statistic, the random walk model continues to dominate the forecasting performance for both indices, followed by the exponential smoothing model for the FTA series while the moving average and recursive EWMA models provide the next best forecasting performance on broadly similar forecast error statistics for both sets of FTA and FTSE data, followed by the GARCH and remaining smoothing models with broadly similar forecast error statistics. However, under the RMSE forecast error statistic, both moving average models and the recursive exponential smoothing and exponential EWMA models now provide equivalently superior forecasts for the FTA series, both including and excluding the crash period. Similarly, both moving average models and the recursive EWMA model provide equivalently superior forecasts for crash-unadjuste d FTSE data, while the 1.25 year moving average is singularly superior for the crash-adjusted FTSE. On these criteria the GARCH models perform comparably with the remaining smoothing methods, and more favourably in some instances, notably the recursive GARCH and EGARCH models. Finally, on both the MAE and RMSE criteria, the simple regression and historical mean models again provide the poorest forecasts for the FTA series, while the exponential smoothing model provides the poorest forecasts for the FTSE series, although the historical mean and simple regression models again perform poorly. Tables 3A and 3B report forecast error statistics for returns volatility on daily sampled unadjusted and crash-adjusted FTSE and FTA data. ME statistics indicate overprediction for all models except the random walk and recursive exponential smoothing in crash-adjusted series and, additionally, (non-recursive ) exponential smoothing in the crashunadjusted series. Recursive exponential smoothing also now gives the minimum ME statistic across all series other than the crash-adjusted FTA, where the 3 month moving average model is preferred. For the FTA series, the exponential smoothing and three-month moving average models provide the best forecasts on the MAE statistic for crashunadjusted and crash-adjusted data respectively, followed by the remaining smoothing models (excepting the non-recursive EWMA) and GARCH models thereafter. This ordering also holds for crash-unadjusted FTSE data on the MAE criterion, but not the crash-adjusted FTSE series, for which the

V . F OR E C A S T R E S U L T S Symmetric forecast error results Tables 1A and 1B report forecast ME, RMSE and MAE statistics for the FTSE and FTA indices sampled at the monthly frequency, unadjusted and adjusted for the 1987 crash respectively. The ME statistic indicates that all models overpredict volatility for both series, with the sole exception of the random walk, which also provides the forecast with the smallest absolute ME for both series. More substantively, the random walk model also dominates on both the RMSE and MAE statistics for both series, and both including and excluding the crash period. Additionally, as indicated by the standardized statistics, the gain in performance of the random walk model over all other models is considerable. The simple regression and historical mean perform generally poorly, particularly in forecasting FTA monthly volatility, providing the worst forecasts for that series. Among those other models, the performance of the GARCH and smoothing models (moving average, exponential smoothing, and EWMA) is similar across measures and series, with some notable exceptions: the good performance of recursive exponential smoothing for the FTA series; the poor performance of the non-recursive GARCH and TGARCH for the FTSE series, particularly evident where poorer relative to the historical mean benchmark; likewise the poor performance of the exponential smoothing models for the crash-unadjuste d FTSE series. Further, the rst of these exceptions apart, the ve-year moving average (and equally the recursive EWMA model for FTSE data) consistently marginally outperforms other models. 20 Tables 2A and 2B present ME, RMSE and MAE statistics for forecasts of weekly sampled FTA and FTSE returns volatility, again crash-unadjuste d and crashadjusted respectively. As for the monthly frequency, all models again generate overpredictions of volatility with the exception of the random walk, although minimum ME statistics are now obtained by the recursive exponential smoothing model for FTA data and the 1.25 year mov-

conditional mean function for stock index returns, which is used to generate historic volatility (i.e. "2 t in the GARCH context), is also iteratively updated. On the implementation of similar procedures for the class of statistical forecasting models, see footnote 6. 19 For example, consider the positive relationship between the volatility of underlying stock prices and call option prices previously noted by Brailsford and Fa (1996) . An underprediction of volatility will impart a downward bias to estimates of the call option price, which is likely to be of more concern to a seller than a buyer, while the reverse is true of overpredictions of stock price volatility. 20 As noted in the Introduction, Dimson and Marsh (1990) reject the random walk model for quarterly volatility forecasting of the FTA, preferring the simple regression and exponential smoothing models. One possible explanation for the divergence between their results and ours is that Dimson and Marsh compute actual volatility as annualized standard deviations of daily returns over non-overlapping calendar quarters, and generate one-step-ahead forecasts of that quarterly series. Nevertheless, their ndings receive some support here at the monthly frequency in terms of our recursive exponential smoothing model results for FTA data, which prove `second best to the random walk model.

Table 1. Forecast error statistics; monthly frequency FTA-All Model ME (1.00) (0.97) (0.40) (0.74) (0.13)* (0.46) (0.26) (0.76) (0.74) (0.96) (0.76) (0.56) (0.51) (0.62) (0.60) (0.47) (0.43) (0.62) (0.60) (1.00) (0.97) (0.47) (0.56) (0.16)* (0.53) (0.26) (0.58) (0.55) (0.89) (0.87) (0.47) (0.42) (0.56) (0.51) (0.64) (0.55) (0.51) (0.47) MAE 0.0035 0.0034 0.0012 0.0015 0.0004 0.0016 0.0010 0.0019 0.0026 0.0033 0.0027 0.0020 0.0018 0.0022 0.0021 0.0016 0.0015 0.0022 0.0021 0.0031 0.0030 0.0012 0.0015 0.0004 0.0016 0.0008 0.0020 0.0017 0.0028 0.0027 0.0015 0.0013 0.0017 0.0016 0.0020 0.0017 0.0016 0.0015 (1.00) (0.97) (0.34) (0.43) (0.11)* (0.46) (0.29) (0.54) (0.74) (0.94) (0.76) (0.57) (0.51) (0.63) (0.60) (0.46) (0.43) (0.63) (0.60) (1.00) (0.97) (0.39) (0.48) (0.13)* (0.52) (0.26) (0.65) (0.55) (0.90) (0.87) (0.48) (0.42) (0.55) (0.51) (0.65) (0.55) (0.52) (0.47) RMSE 0.0035 0.0034 0.0013 0.0015 0.0006 0.0017 0.0011 0.0019 0.0026 0.0034 0.0027 0.0020 0.0019 0.0022 0.0021 0.0018 0.0017 0.0022 0.0022 0.0031 0.0030 0.0013 0.0016 0.0006 0.0017 0.0010 0.0019 0.0018 0.0028 0.0027 0.0015 0.0014 0.0018 0.0018 0.0021 0.0019 0.0016 0.0016 FTSE ME MAE 0.0026 0.0024 0.0013 0.0025 0.0004 0.0032 0.0030 0.0026 0.0014 0.0025 0.0023 0.0021 0.0017 0.0028 0.0027 0.0024 0.0022 0.0028 0.0026 0.0018 0.0016 0.0014 0.0016 0.0004 0.0017 0.0017 0.0017 0.0014 0.0019 0.0017 0.0029 0.0016 0.0065 0.0022 0.0023 0.0019 0.0022 0.0018 (1.00) (0.92) (0.50) (0.96) (0.15)* (1.23) (1.15) (1.00) (0.54) (0.96) (0.88) (0.81) (0.65) (1.08) (1.04) (0.92) (0.85) (1.08) (1.00) (1.00) (0.89) (0.78) (0.89) (0.22)* (0.94) (0.94) (0.94) (0.78) (1.06) (0.94) (1.64) (0.89) (3.72) (1.22) (1.28) (1.06) (1.22) (1.00) RMSE 0.0026 0.0024 0.0014 0.0026 0.0005 0.0032 0.0030 0.0026 0.0014 0.0025 0.0023 0.0021 0.0019 0.0030 0.0027 0.0026 0.0024 0.0029 0.0026 0.0018 0.0017 0.0014 0.0017 0.0005 0.0017 0.0017 0.0017 0.0015 0.0019 0.0017 0.0030 0.0018 0.0067 0.0024 0.0024 0.0019 0.0022 0.0019

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A. Excluding dummy for 1987 crash Historical mean 0.0035 Recursive historical mean 0.0034 Moving average 5 years 0.0014 Moving average 10 years 0.0026 70.0005 Random walk Exponential smoothing 0.0016 Recursive exponential smoothing 0.0009 EWMA 0.0027 Recursive EWMA 0.0026 Simple regression 0.0033 Recursive simple regression 0.0027 GARCH 0.0020 Recursive GARCH 0.0018 TGARCH 0.0022 Recursive TGARCH 0.0021 EGARCH 0.0016 Recursive EGARCH 0.0015 C-GARCH 0.0022 Recursive C-GARCH 0.0021 B. Including dummy for 1987 crash Historical mean 0.0031 Recursive historical mean 0.0030 Moving average 5 years 0.0014 Moving average 10 years 0.0017 70.0005 Random walk Exponential smoothing 0.0016 Recursive exponential smoothing 0.0008 EWMA 0.0018 Recursive EWMA 0.0017 Simple regression 0.0028 Recursive simple regression 0.0027 GARCH 0.0015 Recursive GARCH 0.0013 TGARCH 0.0017 Recursive TGARCH 0.0016 EGARCH 0.0020 Recursive EGARCH 0.0017 C-GARCH 0.0016 Recursive C-GARCH 0.0015

(1.00) 0.0025 (1.00) (0.97) 0.0024 (0.96) (0.37) 0.0013 (0.55) (0.43) 0.0025 (1.03) (0.17)* 70.0004 (0.16)* (0.49) 0.0032 (1.30) (0.31) 0.0030 (1.20) (0.54) 0.0017 (0.71) (0.74) 0.0014 (0.56) (0.97) 0.0025 (1.00) (0.76) 0.0023 (0.92) (0.57) 0.0021 (0.84) (0.54) 0.0017 (0.68) (0.63) 0.0030 (1.22) (0.60) 0.0027 (1.08) (0.51) 0.0024 (0.96) (0.49) 0.0022 (0.88) (0.63) 0.0028 (1.15) (0.63) 0.0025 (1.00) (1.00) 0.0018 (1.00) (0.97) 0.0016 (0.89) (0.42) 0.0014 (0.78) (0.52) 0.0016 (0.89) (0.19)* 70.0004 (0.22)* (0.55) 0.0017 (0.94) (0.32) 0.0017 (0.94) (0.61) 0.0018 (1.00) (0.58) 0.0014 (0.78) (0.90) 0.0019 (1.06) (0.87) 0.0017 (0.94) (0.48) 0.0029 (1.64) (0.47) 0.0016 (0.89) (0.58) 0.0065 (3.72) (0.58) 0.0022 (1.22) (0.68) 0.0023 (1.28) (0.61) 0.0019 (1.06) (0.52) 0.0022 (1.22) (0.51) 0.0018 (1.00)

(1.00) (0.92) (0.54) (1.00) (0.19)* (1.23) (1.15) (1.00) (0.54) (0.96) (0.88) (0.81) (0.73) (1.15) (1.04) (1.00) (0.92) (1.12) (1.00) (1.00) (0.94) (0.78) (0.94) (0.28)* (0.94) (0.94) (0.94) (0.83) (1.06) (0.94) (1.67) (1.00) (3.72) (1.33) (1.33) (1.06) (1.22) (1.06)

Notes : FTA-ALL refers to the Financial Times-Actuaries All Share Index, and FTSE to the Financial Times Stock Exchange 100 index; ME is the mean error statistic de ned in (17). MAE is the mean absolute error statistic de ned in (18). RMSE is the root mean squared error statistic de ned in (19). Relative error statistics obtained by expressing the actual statistic for each model as a ratio to the corresponding error statistic for the historical mean are provided in parentheses, minimum values for which are indicated by asterisks. All forecast error statistics relate to the period 1/1/1995 31/7/1996. For forecasting model descriptions and de nitions see Section III of the text, expressions 3 15.

three-month moving average is marginally superior to the random walk and other (particularly recursive) smoothing models. On the basis of the RMSE criterion there is far less divergence in error statistics for both series for the majority of models considered, although the 3-month moving average model is marginally favoured for both FTA and FTSE data crash-unadjusted, exponential smoothing for the FTA adjusted series, and the GARCH model for the crashadjusted FTSE series. For all daily series, all of these models

are far superior (using RMSE) to the historical mean and simple regression models which again provide the poorest forecasts. Moreover, the random walk model performs poorly on the RMSE measure, both relative to the results for lower frequencies noted above and to other models for daily data, and for (particularly crash-adjusted ) FTSE data especially. In sum, on the basis of symmetric forecast error statistics, while the random walk model provides the most accurate volatility forecasts at the monthly and weekly

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Table 2. Forecast error statistics; weekly frequency FTA-All Model ME (1.00) (1.07) (0.11) (0.13) (0.37) (0.36) (0.06)* (0.13) (0.13) (1.09) (1.00) (0.50) (0.48) (0.49) (0.42) (0.31) (0.45) (0.50) (0.42) (1.00) (1.05) (0.12) (0.13) (0.38) (0.42) (0.03)* (0.35) (0.15) (0.92) (0.93) (0.34) (0.33) (0.31) (0.28) (0.22) (0.20) (0.35) (0.30) MAE 0.00050 0.00049 0.00020 0.00020 0.00016 0.00026 0.00019 0.00025 0.00020 0.00047 0.00046 0.00029 0.00028 0.00029 0.00028 0.00024 0.00024 0.00029 0.00028 0.00047 0.00046 0.00020 0.00019 0.00016 0.00026 0.00018 0.00025 0.00020 0.00042 0.00041 0.00025 0.00024 0.00024 0.00023 0.00022 0.00021 0.00025 0.00024 (1.00) (0.98) (0.40) (0.40) (0.32)* (0.52) (0.38) (0.50) (0.40) (0.94) (0.92) (0.58) (0.56) (0.58) (0.56) (0.48) (0.48) (0.58) (0.56) (1.00) (0.98) (0.43) (0.40) (0.34)* (0.55) (0.38) (0.53) (0.43) (0.89) (0.87) (0.53) (0.51) (0.51) (0.49) (0.47) (0.45) (0.53) (0.51) RMSE 0.00053 0.00051 0.00025 0.00025 0.00029 0.00029 0.00025 0.00029 0.00025 0.00049 0.00048 0.00033 0.00032 0.00032 0.00031 0.00029 0.00028 0.00033 0.00032 0.00049 0.00048 0.00025 0.00025 0.00029 0.00030 0.00025 0.00028 0.00025 0.00045 0.00044 0.00029 0.00028 0.00028 0.00027 0.00027 0.00027 0.00029 0.00028 FTSE ME MAE

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RMSE

A. Excluding dummy for 1987 crash Historical mean 0.00042 Recursive historical mean 0.00045 Moving average 1.25 years 0.00005 Moving average 2.5 years 0.00005 70.00016 Random walk Exponential smoothing 0.00015 Recursive exponential smoothing 0.00002 EWMA 0.00005 Recursive EWMA 0.00005 Simple regression 0.00055 Recursive simple regression 0.00042 GARCH 0.00021 Recursive GARCH 0.00020 TGARCH 0.00021 Recursive TGARCH 0.00019 EGARCH 0.00013 Recursive EGARCH 0.00012 C-GARCH 0.00021 Recursive C-GARCH 0.00020 B. Including dummy for 1987 crash Historical mean 0.00040 Recursive historical mean 0.00042 Moving average 1.25 years 0.00005 Moving average 2.5 years 0.00005 70.00016 Random walk Exponential smoothing 0.00017 Recursive exponential smoothing 0.00001 EWMA 0.00014 Recursive EWMA 0.00006 Simple regression 0.00037 Recursive simple regression 0.00037 GARCH 0.00014 Recursive GARCH 0.00013 TGARCH 0.00013 Recursive TGARCH 0.00011 EGARCH 0.00009 Recursive EGARCH 0.00008 C-GARCH 0.00014 Recursive C-GARCH 0.00012 Note : As Table 1.

(1.00) 0.00037 (1.00) 0.00040 (1.00) 0.00044 (1.00) (0.96) 0.00034 (0.92) 0.00038 (0.95) 0.00042 (0.95) (0.47)* 0.00010 (0.28)* 0.00020 (0.50) 0.00027 (0.61)* (0.47)* 0.00012 (0.33) 0.00021 (0.53) 0.00027 (0.61)* (0.55) 70.00016 (0.45) 0.00016 (0.40)* 0.00029 (0.66) (0.55) 0.00043 (1.17) 0.00046 (1.15) 0.00049 (1.11) (0.47)* 0.00036 (0.97) 0.00040 (1.00) 0.00044 (1.00) (0.55) 0.00017 (0.47) 0.00024 (0.60) 0.00030 (0.68) (0.47)* 0.00012 (0.32) 0.00021 (0.53) 0.00027 (0.61)* (0.93) 0.00036 (0.99) 0.00041 (1.03) 0.00044 (1.00) (0.91) 0.00034 (0.92) 0.00038 (0.95) 0.00042 (0.95) (0.62) NA NA NA (0.60) NA NA NA (0.60) NA NA NA (0.58) NA NA NA (0.55) NA NA NA (0.53) NA NA NA (0.62) NA NA NA (0.60) NA NA NA (1.00) 0.00027 (1.00) 0.00032 (1.00) 0.00036 (1.00) (0.98) 0.00026 (0.96) 0.00030 (0.94) 0.00034 (0.94) (0.51)* 0.00010 (0.38)* 0.00020 (0.63) 0.00025 (0.69)* (0.51)* 0.00013 (0.46) 0.00021 (0.66) 0.00026 (0.72) (0.59) 70.00016 (0.57) 0.00016 (0.50)* 0.00027 (0.75) (0.61) 0.00028 (1.03) 0.00033 (1.03) 0.00036 (1.00) (0.51)* 0.00012 (0.44) 0.00022 (0.69) 0.00027 (0.75) (0.57) 0.00018 (0.66) 0.00025 (0.78) 0.00029 (0.81) (0.51)* 0.00013 (0.48) 0.00021 (0.66) 0.00026 (0.72) (0.92) 0.00027 (0.97) 0.00031 (0.97) 0.00035 (0.97) (0.90) 0.00025 (0.93) 0.00030 (0.94) 0.00034 (0.94) (0.59) 0.00016 (0.59) 0.00024 (0.75) 0.00028 (0.78) (0.57) 0.00013 (0.48) 0.00022 (0.69) 0.00026 (0.72) (0.57) 0.00018 (0.67) 0.00025 (0.78) 0.00029 (0.81) (0.55) 0.00015 (0.56) 0.00023 (0.72) 0.00027 (0.75) (0.55) 0.00017 (0.62) 0.00024 (0.75) 0.00029 (0.81) (0.55) 0.00014 (0.52) 0.00022 (0.69) 0.00027 (0.75) (0.59) 0.00015 (0.53) 0.00023 (0.72) 0.00028 (0.78) (0.57) 0.00013 (0.48) 0.00022 (0.69) 0.00027 (0.75)

frequencies (especially monthly, where it dominates all others by a sizeable margin), it performs poorly in forecasting the volatility of daily returns. The exponential smoothing and moving average models provide some of the most accurate weekly and daily volatility forecasts, but poorer monthly volatility forecasts, the moving average models providing a consistently good relative forecasting performance. Similarly, the GARCH genre of models provide a consistently fair relative forecasting performance, GARCH and EGARCH models outperforming the TGARCH and CGARCH models. The performance of the remaining models, and especially the simple regression

and historical mean models, ranks poorly compared to the above models. Asymmetric forecast error results Finally, Tables 4 and 5 report MME(U) and MME(O) statistics for all series at the weekly and daily frequencies respectively. No such statistics are reported for monthly series, where all models other than the random walk consistently overpredict volatility throughout the out-ofsample data, (the MME(U) statistic in particular collapsing to the MAE statistic reported above in such circumstances). At the daily frequency, for both the FTA and

Table 3. Forecast error statistics; daily frequency

FTA-All Model ME (1.00) (0.97) (0.02) (0.04) (0.35) (0.05) (0.002)* (0.31) (0.04) (0.53) (0.52) (0.19) (0.18) (0.20) (0.19) (0.11) (0.12) (0.16) (0.14) MAE 7.87e-05 7.67e-05 2.45e-05 2.56e-05 2.56e-05 2.34e-05 2.65e-05 3.70e-05 2.58e-05 4.96e-05 4.86e-05 3.13e-05 3.10e-05 3.19e-05 3.12e-05 2.86e-05 2.89e-05 3.02e-05 2.93e-05 (1.00) (0.97) (0.31) (0.33) (0.33) (0.30)* (0.34) (0.47) (0.33) (0.63) (0.62) (0.40) (0.39) (0.41) (0.40) (0.36) (0.36) (0.38) (0.37) RMSE 8.32e-05 8.14e-05 3.93e-05 3.98e-05 4.68e-05 3.94e-05 4.17e-05 4.95e-05 4.01e-05 5.81e-05 5.74e-05 4.20e-05 4.19e-05 4.23e-05 4.20e-05 4.07e-05 4.07e-05 4.15e-05 4.12e-05 (1.00) (0.98) (0.47)* (0.48) (0.56) (0.47) (0.50) (0.60) (0.48) (0.70) (0.69) (0.51) (0.50) (0.51) (0.50) (0.49) (0.49) (0.50) (0.50) FTSE ME 5.41e-05 5.06e-05 7.96e-07 4.29e-06 73.57e-05 71.98e-05 71.42e-07 3.02e-05 4.36e-06 1.97e-05 1.85e-05 2.08e-05 1.90e-05 2.07e-05 1.89e-05 1.97e-05 1.76e-05 2.02e-05 1.67e-05 (1.00) (0.94) (0.01) (0.08) (0.66) (0.36) (0.003)* (0.56) (0.08) (0.36) (0.34) (0.38) (0.35) (0.38) (0.35) (0.36) (0.33) (0.37) (0.31) MAE 6.74e-05 6.45e-05 3.45e-05 3.57e-05 3.59e-05 3.09e-05 4.31e-05 4.96e-05 3.60e-05 4.65e-05 4.58e-05 4.42e-05 4.31e-05 4.39e-05 4.29e-05 4.35e-05 4.26e-05 4.39e-05 4.19e-05 (1.00) (0.96) (0.51) (0.53) (0.53) (0.46)* (0.64) (0.74) (0.53) (0.69) (0.68) (0.66) (0.64) (0.65) (0.64) (0.65) (0.63) (0.65) (0.62) RMSE 7.48e-05 7.23e-05 5.19e-05 5.24e-05 6.30e-05 5.54e-05 6.74e-05 5.99e-05 5.27e-05 6.47e-05 6.43e-05 5.63e-05 5.56e-05 5.59e-05 5.53e-05 5.59e-05 5.53e-05 5.61e-05 5.49e-05

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A. Excluding dummy for 1987 crash Historical mean 7.34e-05 Recursive historical mean 7.13e-05 Moving average 3 months 1.58e-07 Moving average 6 months 2.88e-06 Random walk 72.54e-05 Exponential smoothing 73.56e-05 Recursive exponential smoothing 71.17e-07 EWMA 2.30e-05 Recursive EWMA 2.94e-06 Simple regression 3.91e-05 Recursive simple regression 3.79e-05 GARCH 1.36e-05 Recursive GARCH 1.31e-05 TGARCH 1.46e-05 Recursive TGARCH 1.36e-05 EGARCH 8.40e-06 Recursive EGARCH 9.03e-06 C-GARCH 1.15e-05 Recursive C-GARCH 1.02e-05

(1.00) (0.97) (0.69)* (0.70) (0.84) (0.74) (0.90) (0.80) (0.70) (0.87) (0.86) (0.75) (0.74) (0.75) (0.74) (0.75) (0.74) (0.75) (0.73)

B. Including dummy for 1987 crash Historical mean 7.05e-05 (1.00) Recursive historical mean 6.84e-05 (0.97) Moving average 3 months 1.88e-07 (0.003)* Moving average 6 months 2.88e-06 (0.04) Random walk 72.53e-05 (0.36) Exponential smoothing 1.80e-06 (0.03) Recursive exponential smoothing 72.53e-07 (0.004) EWMA 2.29e-05 (0.32) Recursive EWMA 2.94e-06 (0.04) Simple regression 4.61e-05 (0.65) Recursive simple regression 4.46e-05 (0.63) GARCH 1.27e-05 (0.18) recursive GARCH 1.19e-05 (0.17) TGARCH 1.21e-05 (0.17) Recursive TGARCH 1.14e-05 (0.16) EGARCH 8.81e-06 (0.12) Recursive EGARCH 8.34e-06 (0.12) C-GARCH 9.90e-06 (0.14) Recursive C-GARCH 8.70e-06 (0.00)

7.60e-05 7.41e-05 2.45e-05 2.55e-05 2.55e-05 2.51e-05 2.57e-05 3.69e-05 2.57e-05 5.50e-05 5.38e-05 3.08e-05 3.04e-05 3.04e-05 3.00e-05 2.88e-05 2.86e-05 2.94e-05 2.88e-05

(1.00) (0.98) (0.32)* (0.34) (0.34) (0.33) (0.34) (0.49) (0.34) (0.72) (0.71) (0.41) (0.40) (0.40) (0.39) (0.38) (0.38) (0.39) (0.38)

8.07e-05 7.89e-05 3.94e-05 3.98e-05 4.68e-05 3.93e-05 4.06e-05 4.55e-05 4.01e-05 6.20e-05 6.09e-05 4.19e-05 4.17e-05 4.15e-05 4.14e-05 4.09e-05 4.07e-05 4.11e-05 4.09e-05

(1.00) (0.98) (0.49) (0.49) (0.58) (0.49)* (0.50) (0.56) (0.50) (0.77) (0.75) (0.52) (0.52) (0.51) (0.51) (0.51) (0.50) (0.51) (0.51)

4.46e-05 4.17e-05 9.14e-07 4.40e-06 73.52e-05 3.33e-06 71.57e-07 3.00e-05 4.47e-06 3.22e-05 3.02e-05 1.59e-05 1.58e-05 1.74e-05 1.56e-05 1.59e-05 1.43e-05 1.73e-05 1.53e-05

(1.00) (0.93) (0.02) (0.10) (0.79) (0.07) (0.004)* (0.67) (0.10) (0.72) (0.68) (0.36) (0.35) (0.39) (0.35) (0.36) (0.32) (0.39) (0.34)

5.98e-05 5.76e-05 3.45e-05 3.56e-05 3.54e-05 3.54e-05 3.58e-05 4.92e-05 3.60e-05 5.16e-05 5.01e-05 4.19e-05 4.16e-05 4.22e-05 4.14e-05 4.19e-05 4.11e-05 4.21e-05 4.13e-05

(1.00) (0.96) (0.58)* (0.60) (0.59) (0.59) (0.60) (0.82) (0.60) (0.86) (0.84) (0.70) (0.70) (0.71) (0.69) (0.70) (0.69) (0.70) (0.69)

6.84e-05 6.69e-05 5.25e-05 5.24e-05 6.32e-05 5.24e-05 5.41e-05 5.98e-05 5.33e-05 6.34e-05 6.24e-05 5.23e-05 5.52e-05 5.54e-05 5.50e-05 5.54e-05 5.50e-05 5.50e-05 5.50e-05

(1.00) (0.97) (0.77) (0.77) (0.92) (0.77) (0.79) (0.87) (0.78) (0.93) (0.91) (0.77)* (0.80) (0.81) (0.80) (0.81) (0.80) (0.80) (0.80)

Note : As Table 1.

FTSE series adjusted or unadjusted for the 1987 crash, the historical (or recursive historical) mean is the best volatility forecasting model if underpredictions are penalized more heavily, while the random walk model is massively preferred if overpredictions are penalized more heavily. These conclusions also hold for the FTA at the weekly frequency, although the simple regression model is also a preferred model on the MME(U) criterion. For the weekly FTSE series, the random walk continues to be heavily preferred on the MME(O) criterion penalizing overpredictions more heavily, while the exponential smoothing model is preferred on the MME(U) criterion.

V I . C ON C L U S I ON This paper provides a comparative evaluation of the ability of a variety of statistical and econometric models to forecast the volatility of the UK FTA All Share and FTSE100 stock indices, motivated by recognition of the practical need for accurate volatility forecasts in areas such as option pricing and the limited empirical evidence available to date for the UK. A total of ten volatility forecasting models are considered, including the historical mean, moving average, random walk, exponential smoothing, exponentially weighted moving average, simple regression, GARCH,

446

Table 4. Mean mixed forecast error statistics weekly frequency FTA-All Including 1987 crash dummy MME(U) 0.0014 0.0014 0.0041 0.0039 0.0094 0.0027 0.0046 0.0031 0.0040 0.0014 0.0015 0.0031 0.0033 0.0031 0.0033 0.0036 0.0037 0.0031 0.0033 (2.21) (2.86) (1.00)* (1.07) (2.21) (2.36) (2.21) (2.36) (2.57) (2.64) (2.21) (2.36) 0.0122 0.0096 0.0187 0.0186 0.0121 0.0119 0.0117 0.0115 0.0104 0.0103 0.0121 0.0118 (0.61) (0.48) (0.94) (0.93) (0.61) (0.60) (0.59) (0.58) (0.52) (0.52) (0.61) (0.59) 0.0023 (1.92) 0.0028 (2.33) 0.0012 (1.00) 0.0012 (1.00) NA NA NA NA NA NA NA NA (1.00)* (1.00)* (2.93) (2.79) (6.71) (1.93) (3.29) 0.0200 0.0200 0.0093 0.0094 0.0002 0.0129 0.0082 (1.00) (1.00) (0.47) (0.47) (0.01)* (0.65) (0.41) 0.0012 0.0012 0.0030 0.0028 0.0105 0.0010 0.0012 (1.00) (1.00) (2.50) (2.33) (8.75) (0.83)* (1.00) 0.0188 0.0181 0.0105 0.0113 0.0002 0.0205 0.0186 MME(O) MME(U) MME(O) (1.00) (0.96) (0.56) (0.60) (0.01)* (1.09) (0.99) 0.0129 (0.69) 0.0113 (0.60) 0.0188 (1.00) 0.0181 (0.96) NA NA NA NA NA NA NA NA Excluding 1987 crash dummy FTSE Including 1987 crash dummy MME(U) 0.0014 0.0015 0.0028 0.0026 0.0102 0.0013 0.0028 0.0021 0.0026 0.0014 0.0016 0.0023 0.0026 0.0022 0.0024 0.0023 0.0026 0.0025 0.0027 (1.00) (1.07) (2.00) (1.86) (7.29) (0.93)* (2.00) (1.50) (1.86) (1.00) (1.14) (1.64) (1.86) (1.57) (1.71) (1.64) (1.86) (1.79) (1.93) MME(O) 0.0161 0.0154 0.0105 0.0114 0.0002 0.0163 0.0111 0.0131 0.0114 0.0158 0.0151 0.0126 0.0115 0.0131 0.0120 0.0128 0.0118 0.0120 0.0114 (1.00) (0.96) (0.65) (0.71) (0.01)* (1.01) (0.69) (0.81) (0.71) (0.98) (0.94) (0.78) (0.71) (0.81) (0.75) (0.80) (0.73) (0.75) (0.71)

Excluding 1987 crash dummy MME(O) 0.0211 0.0208 0.0094 0.0095 0.0002 0.0126 0.0086 0.0095 0.0095 0.0202 0.0199 0.0142 0.0138 0.0141 0.0136 0.0118 0.0115 0.0142 0.0138 (0.45) (0.45) (0.96) (0.94) (0.67) (0.65) (0.67) (0.64) (0.56) (0.55) (0.67) (0.65) (1.00) (0.99) (0.45) (0.45) (0.01)* (0.60) (0.41)

Model (1.00)* (1.00)* (3.00) (2.86) (6.86) (2.14) (3.21) (2.86) (2.86) (1.00)* (1.00)* (1.71) (1.86) (1.71) (1.86) (2.29) (2.36) (1.71) (1.79)

MME(U)

Historical mean Recursive historical mean Moving average 1.25 years Moving average 2.5 years Random walk Exponential smoothing Recursive exponential smoothing EWMA Recursive EWMA Simple regression Recursive simple regression GARCH Recursive GARCH TGARCH Recursive TGARCH EGARCH Recursive EGARCH C-GARCH Recursive C-GARCH

0.0040 0.0040 0.0014 0.0014 0.0024 0.0025 0.0024 0.0026 0.0032 0.0033 0.0024 0.0025

Notes : As Table 1 additionally, MME(U) is the asymmetric mean error statistic de ned in Equation 20 which penalizes underpredictions more heavily than overpredictions ; and MME(O) is the asymmetric mean error statistic de ned in Equation 21 which penalizes overpredictions more heavily.

D. McMillan et al.

Table 5. Mean mixed forecast error statistics daily frequency FTSE Including 1987 crash dummy MME(U) 0.0004 0.0004 0.0017 0.0016 0.0040 0.0016 0.0018 0.0009 0.0016 0.0006 0.0006 0.0012 0.0013 0.0013 0.0013 0.0014 0.0014 0.0014 0.0014 (2.25) (4.00) (1.50) (1.50) (3.00) (3.25) (3.25) (3.25) (3.50) (3.50) (3.50) (3.50) 0.0049 0.0030 0.0066 0.0065 0.0040 0.0039 0.0039 0.0039 0.0036 0.0036 0.0037 0.0036 (0.60) (0.37) (0.80) (0.79) (0.49) (0.48) (0.48) (0.48) (0.44) (0.44) (0.45) (0.44) 0.0011 0.0019 0.0016 0.0017 0.0014 0.0015 0.0014 0.0015 0.0015 0.0015 0.0014 0.0015 (1.38) (2.38) (2.00) (2.13) (1.75) (1.88) (1.75) (1.88) (1.88) (1.88) (1.75) (1.88) (1.00)* (1.00)* (4.25) (4.00) (10.0) (4.00) (4.50) 0.0082 (1.00) 0.0081 (0.99) 0.0028 (0.34) 0.0030 (0.37) 0.00002 (0.002)* 0.0030 (0.37) 0.0028 (0.34) 0.0008 0.0008 0.0021 0.0019 0.0048 0.0032 0.0027 (1.00)* (1.00)* (2.63) (2.38) (6.00) (4.00) (3.38) MME(O) MME(U) MME(O) 0.0072 (1.00) 0.0070 (0.97) 0.0033 (0.46) 0.0036 (0.50) 0.00004 (0.005)* 0.0016 (0.22) 0.0030 (0.42) 0.0056 0.0036 0.0046 0.0045 0.0049 0.0047 0.0049 0.0047 0.0048 0.0047 0.0048 0.0046 (0.78) (0.50) (0.64) (0.63) (0.68) (0.65) (0.68) (0.65) (0.67) (0.65) (0.67) (0.64) Excluding 1987 crash dummy Including 1987 crash dummy MME(U) 0.0009 0.0009 0.0021 0.0019 0.0047 0.0019 0.0022 0.0011 0.0019 0.0011 0.0012 0.0016 0.0016 0.0015 0.0016 0.0016 0.0016 0.0015 0.0016 (1.00)* (1.00)* (2.33) (2.11) (5.22) (2.11) (2.44) (1.22) (2.11) (1.22) (1.33) (1.78) (1.78) (1.67) (1.78) (1.78) (1.78) (1.67) (1.78) MME(O) 0.0066 0.0064 0.0033 0.0036 0.0001 0.0036 0.0033 0.0056 0.0036 0.0057 0.0055 0.0045 0.0045 0.0046 0.0045 0.0045 0.0044 0.0046 0.0045 (1.00) (0.97) (0.50) (0.55) (0.02)* (0.55) (0.50) (0.85) (0.55) (0.86) (0.83) (0.68) (0.68) (0.70) (0.68) (0.68) (0.67) (0.70) (0.68)

FTA-All

Excluding 1987 crash dummy MME(O) 0.0084 (1.00) 0.0083 (0.99) 0.0028 (0.33) 0.0030 (0.36) 0.00002 (0.002)* 0.0025 (0.30) 0.0028 (0.33) 0.0049 0.0030 0.0061 0.0060 0.0041 0.0040 0.0042 0.0041 0.0036 0.0036 0.0039 0.0037 (0.58) (0.36) (0.73) (0.71) (0.49) (0.48) (0.50) (0.49) (0.43) (0.43) (0.46) (0.44)

Model (1.00)* (1.00)* (4.25) (4.00) (10.0) (4.75) (4.75) (2.25) (4.00) (1.75) (1.75) (3.00) (3.00) (3.00) (3.00) (3.50) (3.50) (3.25) (3.25)

MME(U)

Historical mean Recursive historical mean Moving average 3 months Moving average 6 months Eandom walk Exponential smoothing Recursive exponential smoothing EWMA Recursie EWMA Simple regression Recursive simple regression GARCH Recursive GARCH TGARCH Recursive TGARCH EGARCH Recursive EGARCH C-GARCH Recursive C-GARCH

0.0009 0.0016 0.0007 0.0007 0.0012 0.0012 0.0012 0.0012 0.0014 0.0014 0.0013 0.0013

Note : as Table 4.

447

448

TGARCH, EGARCH, and component-GARCH models, and, additionally, recursive variants of these models where appropriate. Forecast evaluations are performed for monthly, weekly and daily data frequencies, both with and without adjustment for the 1987 crash, and with respect to both symmetric and asymmetric loss functions. In summary of our results, when asymmetric loss is considered, the ranking of forecasting methods is dependent on the series, frequency and direction of that asymmetry, in keeping with the previous results of Brailsford and Fa (1996). If overpredictions are penalized more heavily than under predictions, the random walk model is favoured. However, if underpredictions are penalized more heavily than overpredictions, then the historical mean is favoured for the forecasting of daily FTA and FTSE volatility, while the historical mean and simple regression are jointly favoured for weekly FTA volatility, and exponential smoothing is favoured for forecasting weekly FTSE volatility. For the symmetric loss case, the random walk model is found to provide vastly superior monthly volatility forecasts, while the random walk, moving average, and recursive smoothing models provide moderately superior weekly volatility forecasts, and GARCH, moving average, and exponential smoothing models provide marginally superior daily volatility forecasts. Our ndings also lend some support to the results of Franses and van Dijk (1996) concerning the dominance of the random walk model when the crash of 1987 is included in the estimation sample, and the improvement in GARCH model forecasts obtained following its exclusion. Indeed, if attention is restricted to symmetric loss and the proposal of one forecasting method for all frequencies, the most consistent forecasting performance is provided by moving average and GARCH models. More generally, our results suggest that previous results reporting that the class of GARCH models provide relatively poor volatility forecasts, so limiting their practical usefulness, may be data speci c, holding more robustly at lower frequencies but failing to hold at higher frequencies, as here for the crash-adjusted daily FTSE100 index in particular. R E F E R E N C ES

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D. McMillan et al.

Bollerslev, T., Chou, R. Y. and Kroner, K. F. (1992) ARCH modelling in nance : a review of the theory and empirical evidence, Journal of Econometrics, 52, 61 90. Brailsford, T. J. and Fa , R. W. (1996 ) An evaluation of volatility forecasting techniques, Journal of Banking and Finance, 20 , 419 38. de Jong, F., Kemna, A. and Kloeck, T. (1992) A contribution to event study methodology with an application to the Dutch stock market, Journal of Banking and Finance, 16 , 11 36. Dimson, E. and Marsh, P. (1990) Volatility forecasting without data-snooping, Journal of Banking and Finance, 14 , 399 421. Edwards, F. R. (1988a) Does Futures trading increase stock market volatility? Financial Analysts Journal, 44, 63 9. Edwards, F. R. (1988b) Futures trading and cash market volatility: stock index and interest rate futures, Journal of Futures Markets, 8, 421 39. Engle, R. F. (1982) Autoregressive conditional heteroscedasticity with estimates of the variance of UK in ation, Econometrica , 50 , 987 1007. Engle, R. F. and Lee, G. G. J. (1993) A permanent and transitory component model of stock return volatility, UCSD, Department of Economics, Discussion Paper No: 92-44R . Engle, R. F. and Ng, V. K. (1993) Measuring and testing the impact of news on volatility, Journal of Finance, 48, 1749 78. Fama, E. F. (1965) The behaviour of stock market prices, Journal of Business, 38 , 34 105. Franses, P. H. and Dijk, D. van (1996) Forecasting stock market volatility using (non-linear) GARCH models, Journal of Forecasting, 15 , 229 35. Gemmill, G. (1993) Options Pricing, McGraw-Hill, Maidenhead. Glosten, L. R., Jagannathan, R. and Runkle, D. E. (1993) On the relation between the expected value and volatility of the nominal excess return on stocks, Journal of Finance, 48, 1779 801. Kearns, P. and Pagan, A. R. (1993) Australian stock market volatility: 1857 1987, T he Economic Record, 69, 163 78. Mandelbrot, B. (1963) The variation of certain speculative prices, Journal of Business, 36 , 394 419. Nelson, D. B. (1991) Conditional heteroscedasticity in asset returns : A new approach, Econometrica , 59, 347 70. Nelson, D. B. and Cao, C. Q. (1992) Inequality constraints in the univariate GARCH model, Journal of Business and Economic Statistics, 10, 229 35. Pagan, A. R. and Schwert, G. W. (1990) Alternative models for conditional stock market volatility, Journal of Econometrics, 45 , 267 90. Plummer, T. (1989) Forecasting Financial Markets : The T ruth Behind T echnical Analysis, Kogan Page, London. Robinson, G. (1994) The e ects of futures trading on cash market volatility; evidence from the London stock exchange, Review of Futures Markets, 13, 429 52. Schwert, G. W. (1990) Stock market volatility, Financial Analysts Journal , 46 , 23 34. Stewart, T. H. (1966) How Charts Can Make you Money: Technical Analysis For Investors, Woodhead-Faulkner, Cambridge. Theobald, M. and Price, V. (1984) Seasonality estimation in thin markets, Journal of Finance, 39, 377 92. Tse, Y. K. (1991) Stock return volatility in the Tokyo stock exchange, Japan and the W orld Econom y, 3, 285 98. Tse, Y. K. and Tung, S. H. (1992) Forecasting volatility in the Singapore stock market, Asia Paci c Journal of Management, 9, 1 13. Vasilellis, G. A. and Meade, N. (1996 ) Forecasting volatility for portfolio selection, Journal of Business Finance and Accounting , 23 , 125 43.

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