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# Using the GARCH model to analyze and predict the different

stock markets
AuthorWei Jiang

Supervisor: Lars Forsberg

2012/11/2

Master Thesis in Statistics
Department of Statistics
Uppsala University
Sweden

1

Using the GARCH model to analyze and predict the different
stock markets

December, 2012

Abstract

the conditional variance about the rate of return in different markets. This paper chooses the
GARCH model, E-GARCH model and GJR-GARCH model to analyze the rate of return and
considers using two different distributions on error terms: normal distribution and student-t
distribution. So this paper is mainly capturing the forecasting performance with volatility models
under different error distributions. Finally, after comparing the Root Mean Square Error (RMSE),
choose the best model to predict the conditional variance. This paper selects five global stock
markets indexes: NASDAQs daily index, Standard and Poors 500 daily index, FTSE100 daily
index, HANG SENG daily index and NIKKEI daily index.

Key words: conditional variance; volatility models; error distribution; Root Mean Square
Error (RMSE)

2

1. Introduction ...................................................................................................................... 4
2. Methodology .................................................................................................................... 4
2.1 ARCH model ................................................................................................................ 4
2.2 Generalized-ARCH (GARCH) model .............................................................................. 4
2.3 Exponential GARCH (EGARCH) model .......................................................................... 5
2.4 GJR-GARCH model....................................................................................................... 6
2.5 Distribution of the error term...................................................................................... 6
2.5.1 Normal distribution........................................................................................... 6
2.5.2 Student-t distribution ....................................................................................... 6
2.6 Root Mean Square Error (RMSE) ................................................................................. 7
3 Data................................................................................................................................ 7
3.1 NASDAQ analysis ......................................................................................................... 7
3.2 Standard & Poor 500 analysis ...................................................................................... 8
3.3 FTSE100 analysis ......................................................................................................... 8
3.4 NIKKEI analysis ............................................................................................................ 9
3.5 HANG SENG analysis ................................................................................................... 9
4 Results ........................................................................................................................ 11
4.1 Application in NASDAQ daily return........................................................................... 11
4.1.1 Selection of ARMA (p, q) model ...................................................................... 11
4.1.2 Result of GARCH model and GARCH family model for NASDAQ ....................... 11
4.2 Application in Standard &Poor 500 daily return ......................................................... 13
4.2.1 Selection of ARMA (p, q) model ...................................................................... 13
4.2.2 Result of GARCH model and GARCH family model for Standard &Poor 500 ..... 14
4.3 Application in FTSE100 daily return ........................................................................... 15
4.3.1 Selection of ARMA (p, q) model ..................................................................... 15
4.3.2 Result of GARCH model and GARCH family model for FTSE100 ........................ 16
4.4 Application in NIKKEI daily return .............................................................................. 17
4.4.1 Selection of ARMA (p, q) model ...................................................................... 17
4.4.2 Result of GARCH model and GARCH family model for NIKKEI .......................... 18
4.5 Application in HANG SENG daily return ..................................................................... 19
4.5.1 Selection of ARMA (p, q) model ...................................................................... 19
3

4.5.2 Result of GARCH model and GARCH family model for HANG SENG .................. 20
4.6 ARCH-LM test ............................................................................................................ 20
4.7 Out-of-sample forecasts ............................................................................................ 21
5 Conclusion .................................................................................................................... 24
6 Reference ..................................................................................................................... 25
6.1 Article resource ......................................................................................................... 25
6.2 Websites resource ..................................................................................................... 26
7 Appendix ...................................................................................................................... 27

4

1. Introduction

model. So it focuses on how to select the appropriate model and use it to predict the future
conditional variance.
Full text is organized as follows. In the section 1, its a brief introduction. Section2 introduces
the classic ARCH/GARCH model and the extension GARCH model, error distribution and Root
Mean Square Error. The data analysis is presented in Section 3. Section 4 shows the model
results, ARCH-LM test and the out-of sample forecast, and Section 5 points out the
conclusion. The reference and the appendix can be found at the end.

2. Methodology

2.1 ARCH model

Engle (1982) proposed the ARCH model (Auto-regressive Conditional Heteoskedastic Model).

t
2
=
0
+
1

t-1
2
+. . . +
q

t-q
2
=
0
+
I
q
I=1

t-I
2
(1)

Baillie and Bollerslev (1989) explained the variation on error terms has been changed from
the constant to be a random sequence. Tersvirta (2006) pointed out,
t
has a conditional
mean and variance based on the information set
t-1
.

E(
t
|
t-1
) = u.

t
2
= E(
t
2
|
t-1
)

Here,

t
= z
t

t

z
t
~N(u,1),

So {
t
} is a normal distribution which mean equals to zero and variance equals to
t
2
,

t
~N(u,
t
2
),

Assume
0
> u, and
I
u, i = 1, . . . , q,
1
+. . . +
q
< 1 for ensuring {
t
2
} as weak
stationary.

2.2 Generalized-ARCH model (GARCH)

5

Bollerslev (1986) and Taylor (1986) proposed the so-called generalized ARCH (GARCH) model
for substituting the ARCH model.

t
2
=
0
+
I
q
I=1

t-I
2
+
j

t-j
2
p
j=1
(2)

Alexander and Lazar (2006) assume
0
> u;
I
u, i = 1, . . . , q;

j
u, j = 1, . . . , p;
I
q
I=1
+
j
p
j=1
< 1 for ensuring {
t
2
] as weak stationary. Enocksson
and Skoog(2012) pointed out some limitations on GARCH model. The most important one is
GARCH model cannot capture the asymmetric performance.
Later, for improving this problem, Nelson (1991) proposed the EGARCH model and Glosten,
Jagannathan and Runkel (1993) proposed GJR-GARCH model.

2.3 Exponential GARCH (EGARCH) model

Nelson (1991) proposed the exponential GARCH (EGARCH) model.

log
t
2
= c + g(Z
t-I
)
p
I=1
+
j
log
q
j=1

t-j
2
,

Where,

g(Z
t-I
) =
I
Z
t-I
+
I
(|Z
t-I
| E(|Z
t-I
|))

Define Z
t-I
=
s
t-
o
t-
and the nature logarithm of the conditional variance equals to:

log(
t
2
) = c +
j
log
q
j=1

t-j
2
+
I
p
I=1
_
s
t-
o
t-
E[
s
t-
o
t-
_ +
I
p
I=1
s
t-
o
t-
(3)

Alexander (2004) presented represents the symmetric effect, measures the lagged
conditional variance and reflects the asymmetric performance.

E(|Z
t-I
|) =

2
, wcnZ
t-I
isnoimaluistiibution
|u.S( 1)]
|(u.S)]
, wcnZ
t-I
isstuuent tuistiibution

Wang, Fawson, Barrett and Mcdonald (2001) demonstrate E(|Z
t-I
|)is constant for all i
when Z
t
is normal distribution or is
vI|0.5(v-1)]
|I(0.5v)]
depended on different when Z
t
is
student-t distribution.

6

2.4 GJR-GARCH model

Glosten, Jagannathan and Runkle (1993) proposed GJR-GARCH model, another asymmetric
model. Define the sequence {
t
} equals to z
t

t
and {
t
} is a normal distribution.

t
~N(u,
t
2
)

So the GJR-GARCH model is written by

t
2
= c +
j

t-j
2
p
j=1
+
I

t-I
2
q
I=1
+
k

t-k
2
I
t-k
r
k=1
(
t-k
< u) (4)

In GJR-GARCH model, the sign of the indicator term captures the asymmetry and Patrick,
Stewart and Chris (2006) describes it in details in their article.

I
t
= _
1,if
t
< u
u,otheiwise
,

Where I
t
is an indicator function, when the residual (
t
) is smaller than zero, the indicator
term (I
t
) equals to one or equals to zero when the residual is not smaller than zero.

2.5 Distribution of the error term

This paper mainly introduces two distributions. One is normal distribution, the other one is
student-t distribution.

2.5.1 Normal distribution

The probability density function of Z
t
is given as follows,

f(Z
t
) =
1
2o
2
exp ]
1
2
(
Z
t
-
o
)
2
(5)

where is mean and is standard deviation.

2.5.2 Student t-distribution

The probability density function of Z
t
is given as follows,

f(Z
t
) =
I[
+1
2

I[

2
(-2)
(1 +
Z
t
2
-2
)
-
1
2
(+1)
(6)
Where is the number of degree of freedom, 2 < , and is gamma function.
When , the student-t distribution nearly equals to the normal distribution. The lower
7

the , the fatter the tails.

2.6 Root Mean Square Error (RMSE)

Root Mean Square Error (RMSE) measures the difference between the true values and
estimated values, and accumulates all these difference together as a standard for the
predictive ability of a model. The criterion is the smaller value of the RMSE, the better the
predicting ability of the model. This article uses this method to determine which model has
the best forecasting performance.
(http://en.wikipedia.org/wiki/Root-mean-square_deviation)

RNSE =
_

|r

2
-o

2
]
2
n
n
I=1
(7)

where i
I
2
is observed values and
I
2
is the predicted value of conditional variance at time i,
n is the number of forecasts.

3. Data

This paper uses the rate of return as data. So the stock returns should be required first by the
following function:

i
t
= 1uu(ln(p
t
) ln(p
t-1
)), (8)

where, i
t
is the rate of returns for each stock index and p
t
is the close price for each stock
index at time t.

3.1 NASDAQ analysis

NASDAQ Stock Market Daily Closing Price Index is the first application which includes 1260
observations from the 2007-1-3 to 2011-12-30.

8

3.2 Standard & Poor 500 analysis

Standard & Poor 500 Stock Market Daily Closing Price Index is the second application which
includes 1260 observations from the 2007-1-3 to 2011-12-30.

3.3 FTSE100 analysis

FTSE100 Stock Market Daily Closing Price Index is the third application, which includes 1263
observations from the 2007-1-2 to 2011-12-30.
-12
-8
-4
0
4
8
12
2007 2008 2009 2010 2011
The returns of NASDAQ daily close price index
N
A
S
D
A
Q
'
s

r
e
t
u
r
n
s
DATE
-12
-8
-4
0
4
8
12
2007 2008 2009 2010 2011
The returns of S&P500 daily close price index
DATE
S
&
P
5
0
0
'
s

r
e
t
u
r
n
s
9

3.4 NIKKEI analysis

NIKKEI Stock Market Daily Closing Price Index is the forth application which includes 1221
observations from the 2007-1-4 to 2011-12-30.

3.5 HANG SENG analysis

HANG SENG Stock Market Daily Closing Price Index is the last application which includes
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
2007 2008 2009 2010 2011
The returns of FTSE100 daily close price index
F
T
S
E
1
0
0
'
s

r
e
t
u
r
n
s
DATE
-15
-10
-5
0
5
10
15
2007 2008 2009 2010 2011
The returns of NIKKEI daliy close price index
N
I
K
K
E
I
'
s

r
e
t
u
r
n
s
DATE
10

1261 observations from the 2007-1-2 to 2011-12-30.

The descriptions of different data
NASDAQ S&P500 FTSE100 HANG SENG NIKKEI
Sample size 1259 1259 1262 1260 1220
Min -9.5880 -9.4700 -9.2650 -13.5800 -12.1100
Max 11.1600 10.9600 9.3840 13.4100 13.2300
Mean 0.0058 -0.0095 -0.0099 -0.0077 -0.0589
SD 1.7443 1.6816 1.5484 2.0443 1.8463
Skewness -0.1839 -0.2449 -0.0824 0.0898 -0.5057
kurtosis 4.8702 6.5112 5.5156 5.9732 7.8186
Jarque-Bera 1257.7560 2246.9660 1608.9580 1883.7880 3173.7360

From this table, the skewness is -0.1839, -0.2449, -0.0824, 0.0898 and -0.5057. They are not
zero which means all of the rates of returns are not symmetric. The kurtosis for different rate
of returns is 4.8702, 6.5112, 5.5156, 5.9732 and 7.8186. They are larger than three, which
means all stock returns have the fat-tail characteristic. Furthermore, the Jarque-Bera Test
tells us the higher value represents the non-normality of the rate of returns. From the last
line in the chart, all values are enough large (1257.7560, 2246.9660, 1608.9580, 1883.7880,
3173.7360), so the distributions of the rates of returns are not normal distribution.
Next table is Box-Ljung test, which helps us to check whether the rate of returns has the
ARCH effect or not, the null hypothesis is the rate of returns doesnt have ARCH effect, while
the alternative hypothesis is opposite. See Forsberg and Bollerslev (2002).

-15
-10
-5
0
5
10
15
2007 2008 2009 2010 2011
The returns of HANG SENG daily close price index
H
A
N
G

S
E
N
G
'
s

r
e
t
u
r
n
s
DATE
11

Box-Ljung
test
(for
returns)
NASDAQ S&P500 FTSE100 HANG SENG NIKKEI
test
value
12.8669 20.4826 2.2105 2.4674 2.1696
p-value 0.0003 0.0000 0.0137 0.0116 0.0141

Based on the assumption of 5% significance level, all of the p-values are smaller than 0.05,
which means the rates of returns have ARCH effect.

4. Result

In this part, GARCH models are used to estimate and forecast the different rates of returns
under the different error distributions, and then compare the results and choose the
appropriate model to forecast the conditional variance.

4.1 Application in NASDAQ daily return

4.1.1 Selection of ARMA (p, q) model

First step is selection of suitable ARMA (p, q) model for NASDAQ daily return. By observing
the autocorrelation and partial autocorrelation, the rough p and q can be acquired. After
comparing the value of AIC and BIC, the more accurate p and q will be picked up. Finally, p=0,
q=1. From the following function:

i
t
=
0
+
1
e
t-1
+ e
t

The estimated parameters are
0
= 1e u4,
1
= u.1461,and then calculate and
estimate GARCH model one
t
.

4.1.2 Result of GARCH models for NASDAQ

Compare MA (1)-GARCH (1, 1) model, MA (1)-EGARCH (1, 1) model and MA (1)-GJR-GARCH
(1, 1) model under different error terms distributions. All of the estimated parameters have
been shown in the Table 1.1.

12

Table 1.1: The results of all volatility models for NASDAQ
GARCH(1,1) EGARCH(1,1) GJR-GARCH(1,1)
Normal Student-t Normal Student-t Normal Student-t
0.0310 0.0211 0.0161 0.0067 0.0377 0.0320
(s.e.) (0.0124) (0.0129) (0.0065) (0.0056) (0.0121) (0.0128)
(p-value) (0.0125) (0.1027) (0.0139) (0.2327) (0.0019) (0.0124)

1
0.0924 0.1069 -0.1275 -0.1369 0.0000 0.0000
(s.e.) (0.0163) (0.0201) (0.0204) (0.0251) (0.0146) (0.0178)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (1.0000) (1.0000)

1
0.1232 0.1411 0.1532 0.1736
(s.e.) (0.0240) (0.0294) (0.0319) (0.0393)
(p-value) (0.0000) (0.0000) (0.0000) (0.0004)

1
0.8964 0.8921 0.9768 0.9796 0.9026 0.8954
(s.e.) (0.0174) (0.0181) (0.0059) (0.0065) (0.0180) (0.0187)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
7.1875 8.3603 8.2400
(s.e.) (1.7931) (2.3078) (2.3369)
(p-value) (0.0001) (0.0003) (0.0004)
(This data is NASDAQ daily return, from 2007-1-3 to 2011-12-30 in yahoo finance, a total of 1259 observations. Table 1.1 points
out all of the estimated parameters under different models.)

Based on the assumption of 5% significance level, for GARCH (1, 1) model, when the error
term is normal distribution, all of the estimated parameters are significant, while the error
term is student-t distribution, the estimated is not significant. For EGARCH (1, 1) model,
when the error term is normal distribution, all of the estimated parameters are significant,
while the error term is student-t distribution, the estimated is not significant. For
GJR-GARCH (1, 1) model, whatever the error term is normal distribution or student-t
distribution, the estimated parameters
1
are not significant.
In order to correct the problems in GJR-GARCH model, I attempt to use the high-order
GJR-GARCH model, and the results are shown in the Table 1.2.

13

Table 1.2: The results of high-order GJR-GARCH model for NASDAQ

GJR-GARCH (2, 1)
threshold=2
GJR-GARCH (1, 2)
threshold=2
GJR-GARCH (2, 2)
threshold=2
Normal Student-t Normal Student-t Normal Student-t
0.0481 0.0377 0.0704 0.0593 0.0190 0.0122
(s.e.) (0.0107) (0.0117) (0.0156) (0.0176) (0.0034) (0.0043)
(p-value) (0.0000) (0.0013) (0.0000) (0.0007) (0.0000) (0.0047)

1
-0.0821 -0.0914 -0.0314 -0.0321 -0.1085 -0.1231
(s.e.) (0.0139) (0.0185) (0.0201) (0.0251) (0.0258) (0.0220)
(p-value) (0.0000) (0.0000) (0.1180) (0.1997) (0.0000) (0.0000)

2
0.0913 0.1072 0.1180 0.1363
(s.e.) (0.0268) (0.0364) (0.0259) (0.0260)
(p-value) (0.0007) (0.0032) (0.0000) (0.0000)

1
0.1008 0.1242 0.0770 0.0946 0.1772 0.2378
(s.e.) (0.0358) (0.0446) (0.0446) (0.0531) (0.0380) (0.0416)
(p-value) (0.0048) (0.0054) (0.0844) (0.0748) (0.0000) (0.0000)

2
0.0735 0.0524 0.2207 0.2211 -0.1155 -0.1914
(s.e.) (0.0443) (0.0551) (0.0431) (0.0531) (0.0397) (0.0461)
(p-value) (0.0969) (0.3411) (0.0000) (0.0000) (0.0036) (0.0000)

1
0.8802 0.8772 0.3255 0.3143 1.6215 1.6737
(s.e.) (0.0199) (0.0228) (0.1961) (0.2323) (0.0073) (0.0753)
(p-value) (0.0000) (0.0000) (0.0969) (0.1761) (0.0000) (0.0000)

2
0.5217 0.5276 -0.6708 -0.7154
(s.e.) (0.1800) (0.2116) (0.0015) (0.0645)
(p-value) (0.0038) (0.0127) (0.0000) (0.0000)
10.1884 10.0496 10.2850
(s.e.) (2.8029) (2.8137) (2.7858)
(p-value) (0.0003) (0.0004) (0.0002)
(This data is NASDAQ daily return, from 2007-1-3 to 2011-12-30 in yahoo finance, a total of 1259 observations. This table points
out all of the estimated parameters under different higher-order GJR-GARCH models.)

Based on the assumption of 5% significance level, whatever the error term is normal
distribution or student-t distribution, the estimated parameters of GJR-GARCH (2, 2) model
are significant.

4.2 Application in Standard & Poor 500 daily return

4.2.1 Selection of ARMA (p, q) model

First step is selection of suitable ARMA (p, q) model for Standard & Poor 500 daily return.
By observing the autocorrelation and partial autocorrelation, the rough p and q can be
acquired. After comparing the value of AIC and BIC, the more accurate p and q will be picked
up. Finally, p=1, q=1. From the following function:
14

i
t
=
0
+
1
e
t-1
+
2
i
t-1
+ e
t

The estimated parameters are
0
= u.uu9S,
2
= u.2S96,
1
= u.4uuu, and then
calculate and estimate GARCH model one
t
.

4.2.2 Result of GARCH models for Standard & Poor 500

Compare ARMA (1, 1)-GARCH (1, 1) model, ARMA (1, 1)-EGARCH (1, 1) model and ARMA (1,
1)-GJR-GARCH (1, 1) model under different error terms distributions. All of the estimated
parameters have been shown in the Table 2.1.

Table 2.1: The results of all volatility models for S&P500

GARCH(1,1) EGARCH(1,1) GJR-GARCH(1,1)
Normal Student-t Normal Student-t Normal Student-t
0.0338 0.0213 0.0133 0.0062 0.0308 0.0222
(s.e.) (0.0108) (0.0121) (0.0059) (0.0070) (0.0093) (0.0096)
(p-value) (0.0018) (0.0781) (0.0231) (0.3789) (0.0010) (0.0212)

1
0.0994 0.1155 -0.1307 -0.1453 0.0000 0.0000
(s.e.) (0.0166) (0.0199) (0.0189) (0.0243) (0.0181) (0.0214)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (1.0000) (0.9999)

1
0.1240 0.1533 0.1478 0.1866
(s.e.) (0.0235) (0.0302) (0.0287) (0.0386)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000)

1
0.8863 0.8835 0.9766 0.9812 0.9047 0.8984
(s.e.) (0.0176) (0.0181) (0.0053) (0.0062) (0.0186) (0.0177)
(p-value) (0.0000) 0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
5.5449 5.6852 5.5915
(s.e.) (1.1064) (1.2529) (1.2337)
(p-value) (0.0000) (0.0000) (0.0000)
(This data is S&P500 daily return, from 2007-1-3 to 2011-12-30 in yahoo finance, a total of 1259 observations. This table points
out all of the estimated parameters under different models)

Based on the assumption of 5% significance level, for GARCH (1, 1) model, when the error
term is normal distribution, all of the estimated parameters are significant, while the error
term is student-t distribution, the estimated is not significant. For EGARCH (1, 1) model,
when the error term is normal distribution, all of the estimated parameters are significant,
while the error term is student-t distribution, the estimated is not significant. For
GJR-GARCH (1, 1) model, whatever the error term is normal distribution or student-t
distribution, the estimated parameters
1
are not significant.
In order to correct the problems in GJR-GARCH model, I attempt to use the high-order
GJR-GARCH model, and the results are shown in the Table 2.2.

15

Table 2.2: The results of high-order GJR-GARCH model for S&P500

GJR-GARCH (2, 1)
threshold=2
GJR-GARCH (1, 2)
threshold=2
GJR-GARCH (2, 2)
threshold=2
Normal Student-t Normal Student-t Normal Student-t
0.0358 0.0234 0.0502 0.0305 0.0457 0.0267
(s.e.) (0.0059) (0.0070) (0.0083) (0.0091) (0.0085) (0.0094)
(p-value) (0.0000) (0.0009) (0.0000) (0.0008) (0.0000) (0.0044)

1
-0.0736 -0.0878 -0.0519 -0.0548 -0.0727 -0.0876
(s.e.) (0.0132) (0.0182) (0.0187) (0.0243) (0.0156) (0.0188)
(p-value) (0.0000) (0.0000) (0.0056) (0.0242) (0.0000) (0.0000)

2
0.0626 0.0868 0.0483 0.0805
(s.e.) (0.0203) (0.0331) (0.0249) (0.0359)
(p-value) (0.0021) (0.0089) (0.0528) (0.0250)

1
0.0653 0.0896 0.0730 0.0783 0.0715 0.0905
(s.e.) (0.0153) (0.0377) (0.0346) (0.0444) (0.0280) (0.0374)
(p-value) (0.0048) (0.0174) (0.0351) (0.0779) (0.0107) (0.0156)

2
0.1273 0.1052 0.2430 0.2365 0.1908 0.1423
(s.e.) (0.0349) (0.0495) (0.0364) (0.0488) (0.0451) (0.0667)
(p-value) (0.0003) (0.0334) (0.0000) (0.0000) (0.0000) (0.0330)

1
0.8921 0.8891 0.2776 0.3647 0.5008 0.6847
(s.e.) (0.0166) (0.0007) (0.1243) (0.1908) (0.1903) (0.2948)
(p-value) (0.0000) (0.0000) (0.0255) (0.0560) (0.0085) (0.0202)

2
0.5836 0.5086 0.3630 0.1887
(s.e.) (0.1145) (0.1759) (0.1774) (0.2717)
(p-value) (0.0000) (0.0038) (0.0407) (0.4873)
6.4932 6.6775 6.5236
(s.e.) (1.3690) (1.4516) (1.3793)
(p-value) (0.0000) (0.0000) (0.0000)
(This data is S&P500 daily return, from 2007-1-3 to 2011-12-30 in yahoo finance, a total of 1259 observations. This table points
out all of the estimated parameters under different higher-order GJR-GARCH models.)

Based on the assumption of 5% significance level, whatever the error term is normal
distribution or student-t distribution, the estimated parameters of GJR-GARCH (2, 1) model
are significant.

4.3 Application in FTSE100 daily return

4.3.1 Selection of ARMA (p, q) model

First step is selection of suitable ARMA (p, q) model for FTSE100 daily return. By observing
the autocorrelation and partial autocorrelation, the rough p and q can be acquired. After
comparing the value of AIC and BIC, the more accurate p and q will be picked up. Finally, p=1,
q=1. From the following function:
16

i
t
=
0
+
1
e
t-1
+
2
i
t-1
+e
t

The estimated parameters are
0
= u.u1,
1
= u.7281,
2
= u.66S8, and then
calculate and estimate GARCH model one
t
.

4.3.2 Result of GARCH model and GARCH family model for FTSE100

Compare ARMA (1, 1)-GARCH (1, 1) model, ARMA (1, 1)-EGARCH (1, 1) model and ARMA (1,
1)-GJR-GARCH (1, 1) model under different error terms distributions. All of the estimated
parameters have been shown in the Table 3.1.

Table 3.1: The results of all volatility models for FTSE100
GARCH(1,1) EGARCH(1,1) GJR-GARCH(1,1)
Normal Student-t Normal Student-t Normal Student-t
0.0361 0.0364 0.0144 0.0089 0.0469 0.0441
(s.e.) (0.0135) (0.0158) (0.0071) (0.0073) (0.0127) (0.0138)
(p-value) (0.0073) (0.0209) (0.0231) (0.2239) (0.0002) (0.0014)

1
0.1292 0.1282 -0.1337 -0.1412 0.0000 0.0000
(s.e.) (0.0222) (0.0248) (0.0192) (0.0222) (0.0169) (0.0200)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (1.0000) (1.0000)

1
0.1499 0.1542 0.1888 0.1929
(s.e.) (0.0304) (0.0319) (0.0335) (0.0378)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000)

1
0.8603 0.8622 0.9718 0.9723 0.8795 0.8781
(s.e.) (0.0215) (0.0236) (0.0075) (0.0080) (0.0202) (0.0217)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
8.0252 10.6637 9.8946
(s.e.) (2.0368) (3.5244) (3.0625)
(p-value) (0.0001) (0.0025) (0.0012)
(This data is FTSE100 daily return, from 2007-1-2 to 2011-12-30 in yahoo finance, a total of 1262 observations. This table points
out all of the estimated parameters under different models.)

Based on the assumption of 5% significance level, for GARCH (1, 1) model, whatever the
error term is normal distribution or student-t distribution, all of the estimated parameters
are significant. For EGARCH (1, 1) model, when the error distribution is normal distribution,
all of the estimated parameters are significant, while the error term is student-t distribution,
the estimated is not significant. For GJR-GARCH (1, 1) model, whatever the error term is
normal distribution or student-t distribution, the estimated parameters
1
are not
significant.
In order to correct the problems in GJR-GARCH model, I attempt to use the high-order
GJR-GARCH model, and the results are shown in the Table 3.2.

17

Table 3.2: The results of high-order GJR-GARCH model for FTSE100

GJR-GARCH (2, 1)
threshold=2
GJR-GARCH (1, 2)
threshold=2
GJR-GARCH (2, 2)
threshold=2
Normal Student-t Normal Student-t Normal Student-t
0.0443 0.0426 0.0652 0.0656 0.0263 0.0007
(s.e.) (0.0087) (0.0105) (0.0130) (0.0148) (0.0063) (0.0005)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.1575)

1
-0.0786 -0.0813 -0.0537 -0.0634 -0.0820 -0.0759
(s.e.) (0.0117) (0.0132) (0.0194) (0.0227) (0.0314) (0.0147)
(p-value) (0.0000) (0.0000) (0.0057) (0.0052) (0.0091) (0.0000)

2
0.0671 0.0656 0.0776 0.0757
(s.e.) (0.0198) (0.0222) (0.0310) (0.0147)
(p-value) (0.0007) (0.0031) (0.0124) (0.0000)

1
0.2051 0.2131 0.1794 0.1895 0.2100 0.3272
(s.e.) (0.0493) (0.0558) (0.0405) (0.0442) (0.0502) (0.0499)
(p-value) (0.0000) (0.0001) (0.0000) (0.0000) (0.0000) (0.0000)

2
0.0115 0.0143 0.1722 0.1953 -0.0908 -0.3200
(s.e.) (0.0516) (0.0585) (0.0387) (0.0442) (0.0634) (0.0481)
(p-value) (0.8242) (0.8064) (0.0000) (0.0000) (0.0152) (0.0000)

1
0.8824 0.8811 0.1763 0.1403 1.3338 1.8224
(s.e.) (0.0188) (0.0214) (0.1650) (0.1469) (0.0688) (0.0363)
(p-value) (0.0000) (0.0000) (0.2855) (0.3395) (0.0000) (0.0000)

2
0.6688 0.6960 -0.4019 -0.8260
(s.e.) (0.1478) (0.1317) (0.0626) (0.0354)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000)
6.4932 12.5933 18.8548
(s.e.) (1.3690) (4.6137) (10.7172)
(p-value) (0.0000) (0.0063) (0.0785)
(This data is FTSE100 daily return, from 2007-1-2 to 2011-12-30 in yahoo finance, a total of 1262 observations. This table points
out all of the estimated parameters under different higher-order GJR-GARCH models.)

Based on the assumption of 5% significance level, when the error term is normal distribution,
the estimated parameters of GJR-GARCH (2, 2) model are significant.

4.4 Application in NIKKEI daily return

4.4.1 Selection of ARMA (p, q) model

First step is selection of suitable ARMA (p, q) model for NIKKEI return. By observing the
autocorrelation and partial autocorrelation, the rough p and q can be acquired. After
comparing the value of AIC and BIC, the more accurate p and q will be picked up. Finally, p=1,
q=1. From the following function:

18

i
t
=
0
+
1
e
t-1
+
2
i
t-1
+ e
t

The estimated parameters are
0
= u.uS89,
1
= u.7Su6,
2
= u.6812, and then
calculate and estimate GARCH model on e
t
.

4.4.2 Result of GARCH model and GARCH family model for NIKKEI

Compare ARMA (1, 1)-GARCH (1, 1) model, ARMA (1, 1)-EGARCH (1, 1) model and ARMA (1,
1)-GJR-GARCH (1, 1) model under different error terms distributions. All of the estimated
parameters have been shown in the Table 4.1.

Table 4.1: The results of all volatility models for NIKKEI

GARCH(1,1) EGARCH(1,1) GJR-GARCH(1,1)
Normal Student-t Normal Student-t Normal Student-t
0.0625 0.0500 0.0204 0.0168 0.0547 0.0504
(s.e.) (0.0239) (0.0238) (0.0081) (0.0083) (0.0193) (0.0197)
(p-value) (0.0090) (0.0352) (0.0122) (0.0416) (0.0045) (0.0104)

1
0.1339 0.1203 -0.1134 -0.1125 0.0178 0.0170
(s.e.) (0.0231) (0.0235) (0.0165) (0.0177) (0.0175) (0.0183)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.3091) (0.3516)

1
0.1515 0.1494 0.1493 0.1450
(s.e.) (0.0341) (0.0342) (0.0291) (0.0306)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000)

1
0.8496 0.8674 0.9773 0.9790 0.8854 0.8894
(s.e.) (0.0239) (0.0245) (0.0069) (0.0069) (0.0209) (0.0209)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
13.5599 26.9464 26.9883
(s.e.) (6.0712) (20.6503) (23.9434)
(p-value) (0.0255) (0.1919) (0.2597)
(This data is NIKKEI daily return, from 2007-1-4 to 2011-12-30 in yahoo finance, a total of 1220 observations. This table points
out all of the estimated parameters under different models.)

Based on the assumption of 5% significance level, for GARCH (1, 1) model, whatever the
error term is normal distribution or student-t distribution, all of the estimated parameters
are significant. For EGARCH (1, 1) model, when the error term is normal distribution, the
estimated parameters are significant, while the error term is student-t distribution, the is
not significant. For GJR-GARCH (1, 1) model, the estimated parameters
1
and are not
significant.
In order to correct the problems in GJR-GARCH model, I attempt to use the high-order
GJR-GARCH model, and the results are shown in the Table 4.2.

19

Table 4.2: The result of high-order GJR-GARCH model for NIKKEI

GJR-GARCH (2, 1)
threshold=2
GJR-GARCH (1, 2)
threshold=2
GJR-GARCH (2, 2)
threshold=2
Normal Student-t Normal Student-t Normal Student-t
0.0745 0.0705 0.0254 0.0243 0.0903 0.0817
(s.e.) (0.0180) (0.0198) (0.0402) (0.0475) (0.0230) (0.0306)
(p-value) (0.0000) (0.0004) (0.5273) (0.6087) (0.0025) (0.0077)

1
-0.0940 -0.1027 0.0111 0.0109 -0.0948 -0.1043
(s.e.) (0.0287) (0.0314) (0.0178) (0.0213) (0.0286) (0.0317)
(p-value) (0.0011) (0.0011) (0.5324) (0.6088) (0.0009) (0.0010)

2
0.1149 0.1237 0.1166 0.1254
(s.e.) (0.0285) (0.0329) (0.0293) (0.0338)
(p-value) (0.0001) (0.0002) (0.0001) (0.0002)

1
0.2981 0.2716 0.2183 0.1951 0.2982 0.2762
(s.e.) (0.0428) (0.0481) (0.0382) (0.0445) (0.0427) (0.0480)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)

2
-0.1029 -0.0847 -0.1551 -0.1351 -0.0549 -0.0520
(s.e.) (0.0522) (0.0564) (0.1078) (0.1290) (0.0874) (0.0868)
(p-value) (0.0485) (0.1337) (0.1502) (0.2950) (0.5301) (0.5490)

1
0.8522 0.8563 1.4846 1.4945 0.5912 0.6368
(s.e.) (0.0222) (0.0235) (0.5603) (0.7040) (0.3317) (0.3471)
(p-value) (0.0000) (0.0000) (0.0081) (0.0338) (0.0747) (0.0665)

2
-0.5368 -0.5452 0.2298 0.1959
(s.e.) (0.4807) (0.6082) (0.2895) (0.3053)
(p-value) (0.2641) (0.3700) (0.4273) (0.5211)
221305 24.0798 22.6387
(s.e.) (13.1145) (15.4397) (13.5151)
(p-value) (0.0915) (0.1189) (0.0939)
(This data is NIKKEI daily return, from 2007-1-4 to 2011-12-30 in yahoo finance, a total of 1220 observations. This table points
out all of the estimated parameters under different higher-order GJR-GARCH models.)

Based on the assumption of 5% significance level, when the error term is normal distribution,
the estimated parameters of GJR-GARCH (2, 1) model are significant.

4.5 Application in HANG SENG daily return

4.5.1 Selection of ARMA (p, q) model

First step is selection of suitable ARMA (p, q) model for HANG SENG return. By observing the
autocorrelation and partial autocorrelation, the rough p and q can be acquired. After
comparing the value of AIC and BIC, the more accurate p and q will be picked up. Finally, p=1,
q=0. From the following function:

20

i
t
=
0
+
1
i
t-1
+ e
t

The estimated parameters are
0
= u.uu77,
1
= u.u442,and then, calculate and
estimate GARCH model one
t
.

4.5.2 Result of GARCH model and GARCH family model for HANG SENG

Compare AR(1)-GARCH (1, 1) model, AR (1)-EGARCH (1, 1) model and AR (1)-GJR-GARCH (1, 1)
model under different error terms distributions. All of the estimated parameters have been
shown in the Table 5.

Table 5: The results of all volatility models
GARCH(1,1) EGARCH(1,1) GJR-GARCH(1,1)
Normal Student-t Normal Student-t Normal Student-t
0.0378 0.0344 0.0238 0.0212 0.0539 0.0517
(s.e.) (0.0184) (0.0187) (0.0087) (0.0090) (0.0209) (0.0213)
(p-value) (0.0405) (0.0655) (0.0061) (0.0185) (0.0100) (0.0154)

1
0.1062 0.1010 -0.0718 -0.0722 0.0445 0.0448
(s.e.) (0.0186) (0.0197) (0.0174) (0.0190) (0.0159) (0.0170)
(p-value) (0.0000) (0.0000) (0.0000) (0.0001) (0.0053) (0.0083)

1
0.1878 0.1877 0.1141 0.1135
(s.e.) (0.0277) (0.0294) (0.0298) (0.0324)
(p-value) (0.0000) (0.0000) (0.0001) (0.0005)

1
0.8867 0.8927 0.9807 0.9812 0.8836 0.8842
(s.e.) (0.0191) (0.0200) (0.0064) (0.0067) (0.0197) (0.0205)
(p-value) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
14.4903 20.9518 20.9108
(s.e.) (6.4354) (13.4634) (13.4721)
(p-value) (0.0243) (0.0119) (0.0206)
(This data is HANG SENG daily return, from 2007-1-2 to 2011-12-30 in yahoo finance, a total of 1260 observations. This table
points out all of the estimated parameters under different models.)

Based on the assumption of 5% significance level, for GARCH (1, 1) model, when the error
term is normal distribution, all of the estimated parameters are significant, while the error
term is student-t distribution, the except is not significant. For EGARCH (1, 1) and
GJR-GARCH (1, 1) models, whatever the error term is normal distribution or student-t
distribution, all of the estimated parameters are significant.

4.6 ARCH-LM test:

ARCH-LM test is used to check the model results and select the lag equals to 2, 5 and 10 in the
following table. see Engle (2001).

21

The ARCH-LM test of different models
p-value

ARCH-LM test
GARCH EGARCH GJR-GARCH
Normal Student-t Normal Student-t Normal Student-t
Lag2 0.0804 0.0804 0.0432 0.0804
GJR-GAR
CH(2, 2)
GJR-GAR
CH(2, 2)
0.0594 0.0536
Lag5 0.3184 0.3184 0.0727 0.3184 0.1987 0.1269
Lag10 0.0501 0.0501 0.0425 0.0501 0.3116 0.2615
S&P500
Lag2 0.0721 0.2849 0.7605 0.4148
GJR-GAR
CH(2, 1)
GJR-GAR
CH(2, 1)
0.1278 0.1151
Lag5 0.7645 0.6748 0.8663 0.6570 0.3313 0.2162
Lag10 0.1518 0.3317 0.1004 0.3228 0.3180 0.2753
FTSE100
Lag2 0.2570 0.2951 0.0586 0.0588
GJR-GAR
CH(2, 2)
GJR-GAR
CH(2, 2)
0.0514 0.0520
Lag5 0.1381 0.1337 0.2259 0.2424 0.0929 0.0960
Lag10 0.3824 0.3788 0.4200 0.4437 0.2150 0.2237
HANG SENG
Lag2 0.6274 0.7320 0.2336 0.2366
GJR-GAR
CH(2, 1)
GJR-GAR
CH(2, 1)
0.1118 0.0800
Log5 0.0776 0.0598 0.0131 0.0131 0.0702 0.0547
Lag10 0.0830 0.0692 0.0131 0.0127 0.0559 0.0540
NIKKEI
Lag2 0.0721 0.0844 0.1315 0.2212
GJR-GAR
CH(1, 1)
GJR-GAR
CH(1, 1)
0.1768 0.2604
Lag5 0.0703 0.0509 0.0509 0.0986 0.3768 0.4778
Lag10 0.1232 0.0880 0.0958 0.0689 0.4732 0.5170
(This table represents the p-value of lag2, lag5 and lag10 under different applications.)

Based on the assumption of 5% significance level, when the result is larger than 0.05, which
means the result doesnt have ARCH effect, while the result still has ARCH effect when result
is smaller than 0.05. From this table, S&P500, FTSE100 and NIKKEI, regardless of their models
or error distribution, do not have ARCH effect, but NADSAQ and HANG SENG are not.

4.7 Out-of-sample Forecasts

In order to acquire the appropriate model to forecast the conditional variance, this paper
use out-of-sample to calculate the root mean square error (RMSE), and the detail can be got
from Forsberg and Bollerslevs paper (2002).
Here, use NASDAQ as an example to explain the process in details. The NASDAQ stock return
includes 1259 observations, five years, and reserve the last year as out-of-sample, including
22

252 observations. Put in-sample data into a window, so the length of window is fixed which
equals to 1007. First, pick up the observations from 1 to 1007 into this fixed window and use
GARCH models to estimate and forecast. In this way, I get the first prediction conditional
variance. This process is called as one-step-ahead forecast. Second, repeat the first step
except pick up the observations from 2 to 1008 in the fixed window, and get the second
prediction conditional variance. Next, repeat the first step except pick up the observations
from 3 to 1009 in the fixed window, and get the third prediction conditional variance.
Repeat this step 252 times. We call such a process as multi-step-ahead forecast. Finally, use
the 252 prediction conditional variance to calculate the RMSE by the formula (7). Use this
same method to deal with the other applications. Because the specific process is the same,
so omit here and check the details from Appendix B.

23

Table 6The result of RMSE about five different stocks daily return
RMSE
NASDAQ GARCH (1,1)-Normal 5.4266
GARCH (1,1)-student-t 5.4559
EGARCH (1,1)-Normal 6.6210
EGARCH (1,1)-student-t 6.2907
GJR-GARCH (2,2)-Normal 5.3727
GJR-GARCH (2,2)-student-t 5.3980
RMSE
S&P500 GARCH (1,1)-Normal 4.9267
GARCH (1,1)-student-t 4.9545
EGARCH (1,1)-Normal 6.5879
EGARCH (1,1)-student-t 7.2929
GJR-GARCH (2,1)-Normal 4.9135
GJR-GARCH (2,1)-student-t 4.9410
RMSE
FTSE100 GARCH (1,1)-Normal 3.3983
GARCH (1,1)-student-t 3.3975
EGARCH (1,1)-Normal 5.9724
EGARCH (1,1)-student-t 4.1848
GJR-GARCH (2,2)-Normal 3.3695
GJR-GARCH (2,2)-student-t 3.3776
RMSE
HANG SENG GARCH (1,1)-Normal 5.2545
GARCH (1,1)-student-t 5.2585
EGARCH (1,1)-Normal 6.1322
EGARCH (1,1)-student-t 5.6013
GJR-GARCH (2,1)-Normal 5.3045
GJR-GARCH (2,1)-student-t 5.3063
RMSE
NIKKEI GARCH (1,1)-Normal 8.6513
GARCH (1,1)-student-t 8.7123
EGARCH (1,1)-Normal 9.4638
EGARCH (1,1)-student-t 9.3891
GJR-GARCH (1,1)-Normal 8.5685
GJR-GARCH (1,1)-student-t 8.5938

Boldfaced word represents the minimal value in each group. For each application, different
models have different RMSE. For different applications, the model with minimal RMSE is also
different.

24

5. Conclusion

This paper use different volatility models to analyze and forecast the conditional variance. At
the same time, choose the normal distribution and the student-t distribution as the error
terms distribution. Table 6 illustrates which model has the smallest RMSE for different
applications. Choose it as the best appropriate one to forecast the conditional variance.
Different application has different appropriate model.
For NASDAQ stock return, GJR-GARCH (2, 2) model under normal distribution has the
smallest RMSE, so it will forecast the future conditional variance better than other models.
For S&P500 stock return, GJR-GARCH (2, 1) model under normal distribution has the smallest
RMSE, so it will predict the future conditional variance better than other models.
For FTSE100 stock return, GJR-GARCH (2, 2) model under normal distribution has the
smallest RMSE, so it will forecast the future conditional variance better than other models.
For NIKKEI stock return, GJR-GARCH (1, 1) model under normal distribution has the smallest
RMSE, so it will forecast the future conditional variance better than other models.
For HANG SENG stock return, GARCH (1, 1) model under normal distribution has the smallest
RMSE, so it will forecast the future conditional variance better than other models.

25

6. Reference

6.1 article resource

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Alexander, C. and Lazar, E., 2004, The equity index skew, market crashes and asymmetric
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Baillie, R. T. and Bollerslev, T., 1989, Common stochastic trends in a system of exchange
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Baillie, R. T., Bollerslev, T. and Mikkelsen, H. O., 1996, Fractionally integrated generalized
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Bollerslev, T., 1986, Generalized autoregressive conditional heteroskedasticity. Journal of
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Bollerslev, T. and Mikkelsen, H. O., 1996, Modeling and pricing long memory in stock market
volatility. Journal of Econometrics, Elsevier, vol. 73(1): 151-184.
Bollerslev, T., Chou, R. Y. and Kroner, K. F., 1992, ARCH modeling in finance: A review of the
theory and empirical evidence. Journal of Econometrics, 52: 5-59.
Engle, R. F., 1982, Autoregressive conditional heteroscedasticity with estimates of the
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6.2 websites resource

Wikipedia: Root-mean-square deviation,
http://en.wikipedia.org/wiki/Root-mean-square_deviation
Yahoo finance: S&P500 historical prices,
http://finance.yahoo.com/q/hp?s=%5EGSPC+Historical+Prices
Yahoo finance: NASDAQ historical prices,
http://finance.yahoo.com/q/hp?s=%5EIXIC+Historical+Prices
Yahoo finance: FTSE100 historical prices,
http://finance.yahoo.com/q/hp?s=%5EFTSE+Historical+Prices
Yahoo finance: HANG SENG historical prices,
http://finance.yahoo.com/q/hp?s=%5EHSI+Historical+Prices
Yahoo finance: NIKKEI historical prices,
http://finance.yahoo.com/q/hp?s=%5EN225+Historical+Prices

27

7. Appendix:
In the same way, the S&P500 stock return includes 1259 observations, five years, and
reserve the last year as out-of-sample, including 252 observations. Put in-sample data into a
window, so the length of window is fixed which equals to 1007. First, pick up the
observations from 1 to 1007 into this fixed window and use GARCH models to estimate and
forecast. In this way, I get the first prediction conditional variance. This process is called as
one-step-ahead forecast. Second, repeat the first step except pick up the observations from
2 to 1008 in the fixed window, and get the second prediction conditional variance. Next,
repeat the first step except pick up the observations from 3 to 1009 in the fixed window, and
get the third prediction conditional variance. Repeat this step 252 times. We call such a
process as multi-step-ahead forecast. Finally, use the 252 prediction conditional variance to
calculate the RMSE by the formula (7).
With the same method, the FTSE100 daily return includes 1262 observations, five years, and
reserve the last year as out-of-sample, including 251 observations. Put in-sample data into a
window, so the length of window is fixed which equals to 1011. First, pick up the
observations from 1 to 1011 into this fixed window and use GARCH models to estimate and
forecast. In this way, I get the first prediction conditional variance. This process is called as
one-step-ahead forecast. Second, repeat the first step except pick up the observations from
2 to 1012 in the fixed window, and get the second prediction conditional variance. Next,
repeat the first step except pick up the observations from 3 to 1013 in the fixed window, and
get the third prediction conditional variance. Repeat this step 251 times. We call such a
process as multi-step-ahead forecast. Finally, use the 251 prediction conditional variance to
calculate the RMSE by the formula (7).
Next, the HANG SENG daily return includes 1260 observations, five years, and reserve the
last year as out-of-sample, including 251 observations. Put in-sample data into a window, so
the length of window is fixed which equals to 1009. First, pick up the observations from 1 to
1009 into this fixed window and use GARCH models to estimate and forecast. In this way, I
get the first prediction conditional variance. This process is called as one-step-ahead forecast.
Second, repeat the first step except pick up the observations from 2 to 1010 in the fixed
window, and get the second prediction conditional variance. Next, repeat the first step
except pick up the observations from 3 to 1011 in the fixed window, and get the third
prediction conditional variance. Repeat this step 251 times. We call such a process as
multi-step-ahead forecast. Finally, use the 251 prediction conditional variance to calculate
the RMSE by the formula (7).
Last, the NIKKEI daily return includes 1220 observations, five years, and reserve the last year
as out-of-sample, including 244 observations. Put in-sample data into a window, so the
length of window is fixed which equals to 976. First, pick up the observations from 1 to 976
into this fixed window and use GARCH models to estimate and forecast. In this way, I get the
first prediction conditional variance. This process is called as one-step-ahead forecast.
Second, repeat the first step except pick up the observations from 2 to 977 in the fixed
window, and get the second prediction conditional variance. Next, repeat the first step
except pick up the observations from 3 to 978 in the fixed window, and get the third
prediction conditional variance. Repeat this step 244 times. We call such a process as
28

multi-step-ahead forecast. Finally, use the 244 prediction conditional variance to calculate
the RMSE by the formula (7).