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You are on page 1of 10

**1. (a). A number of stylised features of financial data have been suggested at
**

the start of Chapter 8 and in other places throughout the book:

- Frequency: Stock market prices are measured every time there is a trade or

somebody posts a ne !uote" so often the fre!uency of the data is very high

- Non-stationarity: #inancial data (asset prices) are covariance non$

stationary% but if e assume that e are talking about returns from here on"

then e can validly consider them to be stationary.

$ Linear Independence: &hey typically have little evidence of linear

(autoregressive) dependence" especially at lo fre!uency.

$ Non-normality: &hey are not normally distributed ' they are fat$tailed.

$ Volatility pooling and asymmetries in volatility: &he returns e(hibit

volatility clustering and leverage effects.

)f these" e can allo for the non$stationarity ithin the linear (A*+,A)

frameork" and e can use hatever fre!uency of data e like to form the

models" but e cannot hope to capture the other features using a linear model

ith -aussian disturbances.

(b) -A*C. models are designed to capture the volatility clustering effects in

the returns (-A*C.(1"1) can model the dependence in the s!uared returns" or

s!uared residuals)" and they can also capture some of the unconditional

leptokurtosis" so that even if the residuals of a linear model of the form given

by the first part of the e!uation in part (e)" the

t

uˆ

/s" are leptokurtic" the

standardised residuals from the -A*C. estimation are likely to be less

leptokurtic. Standard -A*C. models cannot" hoever" account for leverage

effects.

(c) &his is essentially a 0hich disadvantages of A*C. are overcome by

-A*C.1 !uestion. &he disadvantages of A*C.(q) are:

$ .o do e decide on q2

$ &he re!uired value of q might be very large

$ 3on$negativity constraints might be violated.

4hen e estimate an A*C. model" e re!uire α

i

56 ∀ i71"8"..."q (since

variance cannot be negative)

-A*C.(1"1) goes some ay to get around these. &he -A*C.(1"1) model has

only three parameters in the conditional variance e!uation" compared to q91

for the A*C.(q) model" so it is more parsimonious. Since there are less

1/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

parameters than a typical q

th

order A*C. model" it is less likely that the

estimated values of one or more of these : parameters ould be negative than

all q91 parameters. Also" the -A*C.(1"1) model can usually still capture all of

the significant dependence in the s!uared returns since it is possible to rite

the -A*C.(1"1) model as an A*C.(∞)" so lags of the s!uared residuals back

into the infinite past help to e(plain the current value of the conditional

variance" h

t

.

(d) &here are a number that you could choose from" and the relevant ones that

ere discussed in Chapter 8" inlcuding ;-A*C." -<* or -A*C.$,.

&he first to of these are designed to capture leverage effects. &hese are

asymmetries in the response of volatility to positive or negative returns. &he

standard -A*C. model cannot capture these" since e are s!uaring the

lagged error term" and e are therefore losing its sign.

&he conditional variance e!uations for the ;-A*C. and -<* models are

respectively

1

1

]

1

¸

− + + + ·

−

−

−

−

−

π

σ

α

σ

γ σ β ω σ

2

!o"# !o"#

1

1

1

1 2

1

2

t

t

t

t

t t

u

u

And

σ

t

8

7 α

6

+ α

1

u

t −1

2

9βσ

t-1

8

9γu

t-1

8

I

t$1

here I

t$1

7 1 if u

t$1

≤ 6

7 6 otherise

#or a leverage effect" e ould see γ 5 6 in both models.

&he ;-A*C. model also has the added benefit that the model is e(pressed in

terms of the log of h

t

" so that even if the parameters are negative" the

conditional variance ill alays be positive. 4e do not therefore have to

artificially impose non$negativity constraints.

)ne form of the -A*C.$, model can be ritten

y

t

7 µ 9other terms + δσ

t-1

+ u

t

" u

t

∼ 3(6"h

t

)

σ

t

8

7 α

6

+ α

1

u

t −1

2

9βσ

t$1

8

so that the model allos the lagged value of the conditional variance to affect

the return. +n other ords" our best current estimate of the total risk of the

asset influences the return" so that e e(pect a positive coefficient for δ. 3ote

that some authors use δσ

t

(i.e. a contemporaneous term).

(e). Since y

t

are returns" e ould e(pect their mean value (hich ill be

given by µ) to be positive and small. 4e are not told the fre!uency of the data"

but suppose that e had a year of daily returns data" then µ ould be the

2/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

average daily percentage return over the year" hich might be" say 6.6=

(percent). 4e ould e(pect the value of α

6

again to be small" say 6.6661" or

something of that order. &he unconditional variance of the disturbances

ould be given by α

6

>(1$(α

1

9α

8

)). &ypical values for α

1

and α

8

are 6.8 and 6.1=

respectively. &he important thing is that all three alphas must be positive" and

the sum of α

1

and α

8

ould be e(pected to be less than" but close to" unity"

ith α

8

5 α

1

.

(f) Since the model as estimated using ma(imum likelihood" it does not

seem natural to test this restriction using the F$test via comparisons of

residual sums of s!uares (and a t$test cannot be used since it is a test

involving more than one coefficient). &hus e should use one of the

approaches to hypothesis testing based on the principles of ma(imum

likelihood (4ald" ?agrange ,ultiplier" ?ikelihood *atio). &he easiest one to

use ould be the likelihood ratio test" hich ould be computed as follos:

1$ ;stimate the unrestricted model and obtain the ma(imised value of

the log$likelihood function.

2$ +mpose the restriction by rearranging the model" and estimate the

restricted model" again obtaining the value of the likelihood at the

ne optimum. 3ote that this value of the LLF ill be likely to be

loer than the unconstrained ma(imum.

%$ &hen form the likelihood ratio test statistic given by

LR 7 $8(L

r

$ L

u

) ∼ χ

8

(m)

here L

r

and L

u

are the values of the LLF for the restricted and

unrestricted models respectively" and m denotes the number of

restrictions" hich in this case is one.

&$ +f the value of the test statistic is greater than the critical value" re@ect

the null hypothesis that the restrictions are valid.

(g) +n fact" it is possible to produce volatility (conditional variance) forecasts

in e(actly the same ay as forecasts are generated from an A*,A model by

iterating through the e!uations ith the conditional e(pectations operator.

4e kno all information including that available up to time T. &he anser to

this !uestion ill use the convention from the -A*C. modelling literature to

denote the conditional variance by h

t

rather than σ

t

8

.

4hat e ant to

generate are forecasts of h

T91

|Ω

T

" h

T98

|Ω

T

" ..." h

T9s

|Ω

T

here Ω

T

denotes all

information available up to and including observation T. Adding 1 then 8 then

: to each of the time subscripts" e have the conditional variance e!uations

for times T91" T98" and T9::

h

T91

7 α

6

+ α

1

2

T

u 9β h

T

(1)

%/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

h

T98

7 α

6

+ α

1

2

1 + T

u 9β h

T91

(8)

h

T9:

7 α

6

+ α

1

2

2 + T

u 9βh

T98

(:)

?et

h

T

f

1'

be the one step ahead forecast for h made at time T. &his is easy to

calculate since" at time T" e kno the values of all the terms on the *.S.

-iven

h

T

f

1'

" ho do e calculate

h

T

f

2'

" that is the 8$step ahead forecast for h

made at time T2

#rom (8)" e can rite

h

T

f

2'

7 α

6

+ α

1

;

T

(

2

1 + T

u )9β

h

T

f

1'

(A)

here ;

T

(

2

1 + T

u ) is the e(pectation" made at time T" of

2

1 + T

u " hich is the

s!uared disturbance term. &he model assumes that the series ε

t

has Bero

mean" so e can no rite

Car(u

t

) 7 ;D(u

t

$;(u

t

))

8

E7 ;D(u

t

)

8

E.

&he conditional variance of u

t

is h

t

" so

h

t

¦ Ω

t

7 ;D(u

t

)

8

E

&urning this argument around" and applying it to the problem that e have"

;

&D

(u

T91

)

8

E 7 h

T91

but e do not kno h

T91

" so e replace it ith

h

T

f

1'

" so that (A) becomes

h

T

f

2'

7 α

6

+ α

1

h

T

f

1'

9β

f

T

h

' 1

7 α

6

+ (α

1

9β)

h

T

f

1'

4hat about the :$step ahead forecast2

Fy similar arguments"

h

T

f

%'

7 ;

T

(α

6

+ α

1

2

2 + T

u 9β h

T98

)

7 α

6

+ (α

1

9β)

h

T

f

2'

7 α

6

+ (α

1

9β)D α

6

+ (α

1

9β)

h

T

f

1'

E

And so on. &his is the method e could use to forecast the conditional

variance of y

t

. +f y

t

ere" say" daily returns on the #&S;" e could use these

volatility forecasts as an input in the Flack Scholes e!uation to help determine

the appropriate price of #&S; inde( options.

(h) An s$step ahead forecast for the conditional variance could be ritten

&/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

f

T

s

s

i

i f

T s

h h

' 1

1

1

1

1

1

1 0 '

# #

−

−

·

−

+ + + ·

∑

β α β α α

(()

#or the ne value of β" the persistence of shocks to the conditional variance"

given by (α

1

9β) is 6.18=19 6.G8 7 1.16=1" hich is bigger than 1. +t is obvious

from e!uation (()" that any value for (α

1

9β) bigger than one ill lead the

forecasts to e(plode. &he forecasts ill keep on increasing and ill tend to

infinity as the forecast horiBon increases (i.e. as s increases). &his is obviously

an undesirable property of a forecasting modelH &his is called 0non$

stationarity in variance1.

#or (α

1

9β)I1" the forecasts ill converge on the unconditional variance as the

forecast horiBon increases. #or (α

1

9β) 7 1" knon as 0integrated -A*C.1 or

+-A*C." there is a unit root in the conditional variance" and the forecasts ill

stay constant as the forecast horiBon increases.

8. (a) ,a(imum likelihood orks by finding the most likely values of the

parameters given the actual data. ,ore specifically" a log$likelihood function

is formed" usually based upon a normality assumption for the disturbance

terms" and the values of the parameters that ma(imise it are sought.

,a(imum likelihood estimation can be employed to find parameter values for

both linear and non$linear models.

(b) &he three hypothesis testing procedures available ithin the ma(imum

likelihood approach are lagrange multiplier (?,)" likelihood ratio (?*) and

4ald tests. &he differences beteen them are described in #igure 8.A" and are

not defined again here. &he ?agrange multiplier test involves estimation only

under the null hypothesis" the likelihood ratio test involves estimation under

both the null and the alternative hypothesis" hile the 4ald test involves

estimation only under the alternative. -iven this" it should be evident that the

?, test ill in many cases be the simplest to compute since the restrictions

implied by the null hypothesis ill usually lead to some terms cancelling out

to give a simplified model relative to the unrestricted model.

(c) )?S ill give identical parameter estimates for all of the intercept and

slope parameters" but ill give a slightly different parameter estimate for the

variance of the disturbances. &hese are shon in the Appendi( to Chapter 8.

&he difference in the )?S and ma(imum likelihood estimators for the

variance of the disturbances can be seen by comparing the divisors of

e!uations (8A.8=) and (8A.8J).

:. (a) &he unconditional variance of a random variable could be thought of"

abusing the terminology somehat" as the variance ithout reference to a

time inde(" or rather the variance of the data taken as a hole" ithout

conditioning on a particular information set. &he conditional variance" on the

other hand" is the variance of a random variable at a particular point in time"

conditional upon a particular information set. &he variance of u

t

"

2

t

σ "

conditional upon its previous values" may be ritten

2

t

σ 7 Car(u

t

| u

t-1

, u

t-8

"...)

(/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

7 ;D(u

t

$;(u

t

))

8

| u

t-1

" u

t-8

"...E" hile the unconditional variance ould simply be

Car(u

t

) 7 σ

8

.

#orecasts from models such as -A*C. ould be conditional forecasts"

produced for a particular point in time" hile historical volatility is an

unconditional measure that ould generate unconditional forecasts. #or

producing 1$step ahead forecasts" it is likely that a conditional model making

use of recent relevant information ill provide more accurate forecasts

(although hether it ould in any particular application is an empirical

!uestion). As the forecast horiBon increases" hoever" a -A*C. model that is

0stationary in variance1 ill yield forecasts that converge upon the long$term

average (historical) volatility. Fy the time e reach 86$steps ahead" the

-A*C. forecast is likely to be very close to the unconditional variance so that

there is little gain likely from using -A*C. models for forecasts ith very

long horiBons. #or approaches such as ;4,A" here there is no converge on

an unconditional average as the prediction horiBon increases" they are likely

to produce inferior forecasts as the horiBon increases for series that sho a

long$term mean reverting pattern in volatility. &his arises because if the

volatility estimate is above its historical average at the end of the in$sample

estimation period" ;4,A ould predict that it ould continue at this level

hile in reality it is likely to fall back toards its long$term mean eventually.

(b) ;!uation (8.116) is an e!uation shoing that the variance of the

disturbances is not fi(ed over time" but rather varies systematically according

to a -A*C. process. &his is therefore an e(ample of heteroscedasticity. &hus"

the conse!uences if it ere present but ignored ould be those described in

Chapter A. +n summary" the coefficient estimates ould still be consistent and

unbiased but not efficient. &here is therefore the possibility that the standard

error estimates calculated using the usual formulae ould be incorrect leading

to inappropriate inferences.

(c) &here are of course a large number of competing methods for measuring

and forecasting volatility" and it is orth stating at the outset that no research

has suggested that one method is universally superior to all others" so that

each method has its merits and may ork ell in certain circumstances.

.istorical measures of volatility are @ust simple average measures ' for

e(ample" the standard deviation of daily returns over a :$year period. As such"

they are the simplest to calculate" but suffer from a number of shortcomings.

#irst" since the observations are uneighted" historical volatility can be slo

to respond to changing market circumstances" and ould not take advantage

of short$term persistence in volatility that could lead to more accurate short$

term forecasts. Second" if there is an e(treme event (e.g. a market crash)" this

ill lead the measured volatility to be high for a number of observations e!ual

to the measurement sample length. #or e(ample" suppose that volatility is

being measured using a 1$year (8=6$day) sample of returns" hich is being

rolled forard one observation at a time to produce a series of 1$step ahead

volatility forecasts. +f a market crash occurs on day t" this ill increase the

measured level of volatility by the same amount right until day t98=6 (i.e. it

ill not decay aay) and then it ill disappear completely from the sample so

that measured volatility ill fall abruptly. ;(ponential eighting of

)/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

observations as the ;4,A model does" here the eight attached to each

observation in the calculation of volatility declines e(ponentially as the

observations go further back in time" ill resolve both of these issues.

.oever" if forecasts are produced from an ;4,A model" these forecasts ill

not converge upon the long$term mean volatility estimate as the prediction

horiBon increases" and this may be undesirable (see part (a) of this !uestion).

&here is also the issue of ho the λ parameter is calculated (see e!uation (8.=)

on page AA:" although" of course" it can be estimated using ma(imum

likelihood). -A*C. models overcome this problem ith the forecasts as ell"

since a -A*C. model that is 0stationary in variance1 ill have forecasts that

converge upon the long$term average as the horiBon increases (see part (a) of

this !uestion). -A*C. models ill also overcome the to problems ith

uneighted averages described above. .oever" -A*C. models are far more

difficult to estimate than the other to models" and sometimes" hen

estimation goes rong" the resulting parameter estimates can be nonsensical"

leading to nonsensical forecasts as ell. &hus it is important to apply a 0reality

check1 to estimated -A*C. models to ensure that the coefficient estimates

are intuitively plausible. #inally" implied volatility estimates are those derived

from the prices of traded options. &he 0market$implied1 volatility forecasts are

obtained by 0backing out1 the volatility from the price of an option using an

option pricing formula together ith an iterative search procedure. #inancial

market practitioners ould probably argue that implied forecasts of the future

volatility of the underlying asset are likely to be more accurate than those

estimated from statistical models because the people ho ork in financial

markets kno more about hat is likely to happen to those instruments in the

future than econometricians do. Also" an 0inaccurate1 volatility forecast

implied from an option price may imply an inaccurate option price and

therefore the possibility of arbitrage opportunities. .oever" the empirical

evidence on the accuracy of implied versus statistical forecasting models is

mi(ed" and some research suggests that implied volatility systematically over$

estimates the true volatility of the underlying asset returns. &his may arise

from the use of an incorrect option pricing formula to obtain the implied

volatility ' for e(ample" the Flack$Scholes model assumes that the volatility of

the underlying asset is fi(ed (non$stochastic)" and also that the returns to the

underlying asset are normally distributed. Foth of these assumptions are at

best tenuous. A further reason for the apparent failure of the implied model

may be a manifestation of the 0peso problem1. &his occurs hen market

practitioners include in the information set that they use to price options the

possibility of a very e(treme return that has a lo probability of occurrence"

but has important ramifications for the price of the option due to its sheer

siBe. +f this event does not occur in the sample period over hich the implied

and actual volatilities are compared" the implied model ill appear inaccurate.

Ket this does not mean that the practitioners/ forecasts ere rong" but rather

simply that the lo$probability" high$impact event did not happen during that

sample period. +t is also orth stating that only one implied volatility can be

calculated from each option price for the 0average1 volatility of the underlying

asset over the remaining lifetime of the option.

*/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

A. (a). A possible diagonal C;C. model ould be

1

]

1

¸

·

+ ·

+ ·

t

t

t

t t

t t

u

u

u

u y

u y

2

1

2 2 2

1 1 1

'

µ

µ

∼ 3(6" Σ

t

) "

,

_

¸

¸

· Σ

t t

t t

t

h h

h h

22 12

12 11

1 22 22

2

1 2 22 22 22

1 12 12 1 2 1 1 12 12 12

1 11 11

2

1 1 11 11 11

− −

− − −

− −

+ + ·

+ + ·

+ + ·

t t t

t t t t

t t t

h u h

h u u h

h u h

β α ω

β α ω

β α ω

&he coefficients e(pected ould be very small for the conditional mean

coefficients" µ

1

and µ

8

" since they are average daily returns" and they could be

positive or negative" although a positive average return is probably more

likely. Similarly" the intercept terms in the conditional variance e!uations

ould also be e(pected to be small since and positive this is daily data. &he

coefficients on the lagged s!uared error and lagged conditional variance in the

conditional variance e!uations must lie beteen Bero and one" and more

specifically" the folloing might be e(pected: α

11

and α

88

≈ 6.1$6.:% β

11

and β

88

≈

6.=$6.8" ith α

11

9 β

11

I 1 and α

88

9 β

88

I 1. &he coefficient values for the

conditional covariance e!uation are more difficult to predict: α

11

9 β

11

I 1 is

still re!uired for the model to be useful for forecasting covariances. &he

parameters in this e!uation could be negative" although given that the returns

for to stock markets are likely to be positively correlated" the parameters

ould probably be positive" although the model ould still be a valid one if

they ere not.

(b) )ne of to procedures could be used. ;ither the daily returns data ould

be transformed into eekly returns data by adding up the returns over all of

the trading days in each eek" or the model ould be estimated using the

daily data. Laily forecasts ould then be produced up to 16 days (8 trading

eeks) ahead.

+n both cases" the models ould be estimated" and forecasts made of the

conditional variance and conditional covariance. +f daily data ere used to

estimate the model" the forecasts for the conditional covariance forecasts for

the = trading days in a eek ould be added together to form a covariance

forecast for that eek" and similarly for the variance. +f the returns had been

aggregated to the eekly fre!uency" the forecasts used ould simply be 1$step

ahead.

#inally" the conditional covariance forecast for the eek ould be divided by

the product of the s!uare roots of the conditional variance forecasts to obtain

a correlation forecast.

(c) &here are various approaches available" including computing simple

historical correlations" e(ponentially eighted measures" and implied

correlations derived from the prices of traded options.

8/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

(d) &he simple historical approach is obviously the simplest to calculate" but

has to main drabacks. #irst" it does not eight information: so any

observations ithin the sample ill be given e!ual eight" hile those outside

the sample ill automatically be given a eight of Bero. Second" any e(treme

observations in the sample ill have an e!ual effect until they abruptly drop

out of the measurement period. #or e(ample" suppose that one year of daily

data is used to estimate volatility. +f the sample is rolled through one day at a

time" an observation corresponding to a market crash ill appear in the ne(t

8=6 samples" ith e!ual effect" but ith then disappear altogether.

;(ponentially eighted moving average models of covariance and variance

(hich can be used to construct correlation measures) more plausibly give

additional eight to more recent observations" ith the eight given to each

observation declining e(ponentially as they go further back into the past.

&hese models have the undesirable property that the forecasts for different

numbers of steps ahead ill be the same. .ence the forecasts ill not tend to

the unconditional mean as those from a suitable -A*C. model ould.

#inally" implied correlations may at first blush appear to be the best method

for calculating correlation forecasts accurately" for they rely on information

obtained from the market itself. After all" ho should kno better about

future correlations in the markets than the people ho ork in those

markets2 .oever" market$based measures of volatility and correlation are

sometimes surprisingly inaccurate" and are also sometimes difficult to obtain.

,ost fundamentally" correlation forecasts ill only be available here there is

an option traded hose payoffs depend on the prices of to underlying assets.

#or all other situations" a market$based correlation forecast ill simply not be

available.

#inally" multivariate -A*C. models ill give more eight to recent

observations in computing the forecasts" but maybe difficult and compute

time$intensive to estimate.

=. A nes impact curve shos the effect of shocks of different magnitudes on

the ne(t period/s volatility. &hese curves can be used to e(amine visually

hether there are any asymmetry effects in volatility for a particular set of

data. #or the data given in this !uestion" the ay + ould approach it is to put

values of the lagged error into column A ranging from '1 to 91 in increments

of 6.61. &hen simply enter the formulae for the -A*C. and ;-A*C. models

into columns 8 and : that refer to those values of the lagged error put in

column A. &he graph obtained ould be

+/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

&his graph is a bit of an odd one" in the sense that the conditional variance is

alays loer for the ;-A*C. model. &his may suggest estimation error in

one of the models. &here is some evidence for asymmetries in the case of the

;-A*C. model since the value of the conditional variance is 6.1 for a shock

of 1 and 6.18 for a shock of '1.

(b) &his is a tricky one. &he leverage effect is used to rationalise a finding of

asymmetries in e!uity returns" but such an argument cannot be applied to

foreign e(change returns" since the concept of a Lebt>;!uity ratio has no

meaning in that conte(t.

)n the other hand" there is e!ually no reason to suppose that there are no

asymmetries in the case of f( data. &he data used here ere daily MSLN-FO

returns for 1GPA$1GGA. +t might be the case that" for e(ample" that nes

relating to one country has a differential impact to e!ually good and bad nes

relating to another. &o offer one illustration" it might be the case that the bad

nes for the currently eak euro has a bigger impact on volatility than nes

about the currently strong dollar. &his ould lead to asymmetries in the nes

impact curve. #inally" it is also orth noting that the asymmetry term in the

;-A*C. model" α

1

" is not statistically significant in this case.

10/10 “Introductory Econometrics for Finance” © Chris Brooks 2008

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

-1 -0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Value of Lagged Shock

V

a

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o

f

C

o

n

d

i

t

i

o

n

a

l

V

a

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i

a

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GARCH

EGARCH

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