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# Solutions to the Review Questions at the End of Chapter 8

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

/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
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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

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
#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'

f
T
h
' 1
7 α
6
+ (α
1
9β)
h
T
f
1'
Fy similar arguments"
h
T
f
%'
7 ;
T

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
+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
#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
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0.06
0.08
0.1
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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
l
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