Multivariate GARCH Models

November 2005
Luc Bauwens
bauwens@core.ucl.ac.be

´ Universite catholique de Louvain

MGARCH – p.1/106

Outline
Multivariate GARCH Models Introduction (p 3) Overview of Models (p 14) Estimation (p 50) Diagnostic Checking (p 70) Financial and Economic Applications (p 81) Conclusion (p 104) References: see forthcoming survey by Bauwens, Laurent and Rombouts (JAE 21/1, 2006).
MGARCH – p.2/106

Introduction

MGARCH – p.3/106

MGARCH: why?
Understanding and predicting the temporal dependence in the second order moments of asset returns is important for many issues in financial econometrics and management. It is now widely accepted that financial volatilities move together more or less closely over time across assets and markets. Recognizing this feature through a multivariate modelling framework should lead to more relevant empirical models than working with separate univariate models.

MGARCH – p.4/106

MGARCH: why?
From a financial point of view, it opens the door to better decision tools in various areas such as asset pricing models, portfolio selection, hedging, and Value-at-Risk forecasts. Several institutions have developed the necessary skills to use econometric models in a financial perspective. Although there is a huge literature on univariate models dealing with time-varying variance, asymmetry and fat-tails, much less papers are concerned with their multivariate extensions, but the field is expanding...

MGARCH – p.5/106

Two series of financial returns
Daily returns, DOW Jones (DJ) and NASDAQ (NQ) indices, 03/26/1990 - 03/23/2000
5.0 2.5 0.0 −2.5 −5.0
DJ

0 5

200
NQ

400

600

800

1000

1200

1400

1600

1800

2000

2200

0

−5

0

200

400

600

800

1000

1200

1400

1600

1800

2000

2200

MGARCH – p.6/106

Co-movement
5.0 2.5 0.0 −2.5 −5.0

DJ

2000 5
NQ

2050

2100

2150

2200

2250

2300

2350

0

−5

2000

2050

2100

2150

2200

2250

2300

2350

MGARCH – p.7/106

ACF of returns and squared returns
Returns
0.2 0.2

Dow Jones
0.1 0.1

Nasdaq

0.0 0 10 20 30

0.0 0 10 20 30

Squared returns
0.2 0.2

Dow Jones

Nasdaq

0.1

0.1

0.0 0 10 20 30

0.0 0 10 20 30

MGARCH – p.8/106

Densities
Density 0.6
DJ N(s=0.871)

0.4

0.2

−8 0.5 0.4 0.3 0.2 0.1

−7 Density
NQ

−6

−5

−4

−3

−2

−1

0

1

2

3

4

5

N(s=1.06)

−9

−8

−7

−6

−5

−4

−3

−2

−1

0

1

2

3

4

5

6

MGARCH – p.9/106

Portfolio
Consider a portfolio made up of assets. The euro amount invested in asset is , where is the total euro amount and is the share of asset in the portfolio. Let be the vector of shares, the vector of returns, the vector of expected returns and the variance-covariance matrix of the returns. Then,
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(1) (2)
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MGARCH – p.10/106

Value-at-Risk of a portfolio
The VaR at level of a portfolio worth is the smallest loss value that can occur with probability equal to :
 

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(4)

 

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where

is determined by
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(5)

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For example, if 

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(6) 

 



 

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with

the % left-quantile of the N(0,1) distribution.
 
MGARCH – p.11/106 



Conditional VaR with ARCH
Assuming that the mean vector and the variance matrix are constant over time is restrictive.
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A univariate GARCH model for can be fit for a given weight vector. If the weight vector changes, the model has to be estimated again. 

On the contrary, if a MGARCH model is fitted ( and instead of and ), the multivariate distribution of the returns can be directly used to compute the implied distribution and VaR at of any portfolio. There is no need to re-estimate the model for a different weight vector.
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MGARCH – p.12/106

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Remarks
It is important to account for the covariances in computing the VaR! When the correlations are smaller than 1, is smaller than the sum of the individual VaR measures, also called the undiversified VaR.
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The univariate GARCH approach is directly dependent on the portfolio allocation ( ), and it will require us to redo the volatility modelling every time the portfolio is changed if we want to study the impact on VaR of changing the portfolio allocation. This approach is appropriate for risk measurement but not for risk management: to do a sensitivity analysis and assess the benefits of diversification we need models that take account of the dependence between assets.
MGARCH – p.13/106 

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Overview of Models

MGARCH – p.14/106

Definition
A dynamic model with time-varying means, variances and covariances for the components of :
 
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matrix 

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(11)

  

where

is the information available at time . 
  

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, at least

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MGARCH – p.15/106

Remarks
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is any matrix such that is the conditional variance matrix of (e.g. may be obtained by a Cholesky factorization of ).
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and depend on unknown parameters but are otherwise known (parametric model), hence sometimes we write explicitly and . For example, may be a VARMA model.
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The " is IID" assumption may be relaxed to " is a martingale difference sequence (MDS) with respect to ", e.g. to show that Var . However, for ML estimation, the IID assumption is relevant. 

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MGARCH – p.16/106

Three challenges
State conditions on the parameters .
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such that that

Avoid too many parameters (to keep estimation feasible), but maintain enough flexibility in the dynamics of . Find Var stationarity.
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and the conditions for weak 

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For ease of exposition, we make a function of one lag of and one lag of itself, i.e. so-called GARCH(1,1) models.
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MGARCH – p.17/106

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VEC(1,1) (Bollerslev, Engle, and Wooldridge, 1988)
In this model, is a linear function of the lagged squared errors, cross products of errors, and lagged values of all the is defined as: elements of . The
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(12) 

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where vech vech
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(13) (14)

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and is a and and
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vector of parameters [with are matrices of parameters.
 
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MGARCH – p.18/106

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Vech and vec operators
vech is the operator that stacks the lower triangle of a matrix as an vector: 
         

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vech

vec is the operator that stacks a matrix as a column vector: vec 

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A useful property is vec vec 
 
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(15)

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MGARCH – p.19/106

Bivariate VEC(1,1)

(for
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the numbers of parameters is of order
 

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MGARCH – p.20/106

2, 3, 4 it is equal to 21, 78, 210 respectively). 

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(16)

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Equivalently, 

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Bivariate VEC(1,1)

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MGARCH – p.21/106
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Diagonal and Scalar VEC
To reduce the number of parameetrs, BEW (1988) suggest the diagonal VEC (DVEC) model in which the and matrices are diagonal.
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Each variance depends only on its own past squared error and its own lag .
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Each covariance depends only on its own past cross-products of errors , and its own lag.
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Quite restrictive: no "spillover effect". Big reduction: 9 parameters instead of 21 when 18 instead of 78 when =3... Scalar VEC: and where scalars and is a matrix of ones.
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2;

 

 

and

are
MGARCH – p.22/106

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Positivity conditions for VEC (Gouriéroux, 1997)

and since
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One can write also (see p 21)

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MGARCH – p.23/106

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Positivity conditions for VEC

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MGARCH – p.24/106

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Positivity conditions for VEC

We denote by the above built in the same way from .
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Putting the different parts together:
 
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matrix, and by

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MGARCH – p.25/106 

 
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the matrix

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Positivity conditions for VEC
A general matrix (rather than vech ) expression of VEC(1,1) case is: 
  

in the

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Hence, sufficient conditions for positivity of are that , , with at least one strict inequality.
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These restrictions are not easy to impose in estimation. Usually they are not imposed, but can be checked after unrestricted estimation.

 

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MGARCH – p.26/106

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BEKK(1,1,K) (Engle and Kroner, 1995)
The BEKK model is defined as:
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(17)  

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where and are matrices of parameters but is upper triangular. One can write as well .
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Positivity of

is automatically guaranteed if

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MGARCH – p.27/106

 

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Bivariate BEKK(1,1,1) 

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MGARCH – p.28/106
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parameters, against 21 in the VEC model.

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(18)

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Bivariate BEKK(1,1,1)

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Same linear structure as in VEC model...

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... but constraints on parameters (compare with p 21).

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MGARCH – p.29/106

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Remarks
Interpretation of the basic parameters not obvious, see previous equations. By increasing , one makes the specification more flexible (e.g. for , there are 19 parameters, against 21 in the bivariate VEC).
 

 

 

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Diagonal BEKK model: take and as diagonal matrices. It is a restricted DVEC model (check the covariance equation to see the restrictions).
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One can define a scalar BEKK model: .
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,

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MGARCH – p.30/106

Stationarity conditions: VEC
The VEC(1,1) model a VARMA(1,1) model for
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can be written as

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vech
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:
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where is a MDS. Consequently, the VEC(1,1) model is weakly stationary if the eigenvalues of are less than 1 in modulus. In this case,
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vech where 
 
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vech .   

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MGARCH – p.31/106

Stationarity conditions: BEKK
§ ¡

The BEKK(1,1,1) model can be written as a VEC model (subject to restrictions) using formula (15):
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vec

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Hence, the BEKK model is weakly stationary if the are smaller than 1 in eigenvalues of modulus, and then 
 
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vec

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MGARCH – p.32/106 

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Factor-GARCH(1,1,K) (Engle, Ng, and Rotschild, 1990b)
The Factor-GARCH(1,1,K) model can be viewed as a particular BEKK(1,1,K) model:
¢ 

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(19) 

 

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i.e. and are replaced by rank one matrices that are vectors and are proportional to one another. The subject to the restrictions:
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for for

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MGARCH – p.33/106

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(20)

Factor-GARCH(1,1,1)
Taking , the model can be written as: 

 

 

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(21)

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where
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is the GARCH(1,1) conditional variance of the factor

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.

 

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MGARCH – p.34/106

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where

 
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Bivariate Factor-GARCH(1,1,1)

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MGARCH – p.35/106

Remarks
The elements of obey the same dynamics, determined by the common element .
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¥
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If we write , and assume that common shock (a scalar r.v.) and , the idiosyncratic shocks (a vector), are uncorrelated, with Var and Var , we get
 

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, the

 

 

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¥

¡

¥

  

¢  

¢

¢

¢  

¢

¡

¢

¡

¤   

¦

§

 

 

Var

£ 

¢

¡

¢

¥ 

¢ 

as in eq. (21). 

Weak stationarity occurs if 

¢

.
MGARCH – p.36/106

¡

¡ 

 

£

£

© 

¢

¢

Other Factor-GARCH models
The orthogonal GARCH model (Kariya, 1988, Alexander and Chibumba, 1997) and the generalized orthogonal GARCH models of van der Weide (2002) and Vrontos et al. (2003) are also Factor-GARCH models. Lanne and Saikkonen (2005) propose "A Multivariate Generalized Orthogonal Factor GARCH Model", an interesting alternative to the previous papers.

MGARCH – p.37/106

VEC(1,1)

BEKK(1,1,1)

F-GARCH(1,1,1)

¥ £ £
 

# ¥ 0 ¨ (
 

# ' ¨ '
 

5 £ @A9
¡

1 © %¥ (  

Number of parameters

¡

11 ¡ 342 56
¡

¥¤ £ ! §¤ #" 

¥ % ¡  ¥  % 

¦¤ ¥ £ ¥ § $ ¨  ¥ © 
 

  ¡
¥

¥ £
  ¡ 

¥ ¤ !  §¤  % ¥ &" ¥% ¡ $
 

B ECD  5 5 ¨ C 57 £ 6 9 #¡ ¥  5 8 
¡ 

¥  % ¡   © ¨  #(  ¥  

¨

for 

 )
MGARCH – p.38/106
¡ 

)   
7, 12, 18, 25 11, 24, 42, 65

£
¡

# parameters

21, 78, 210, 465

¢
2, 3, 4, 5 

      

What next?
In the previous models, we specify the conditional covariances, in addition to the variances. Next, we review models where we specify the conditional correlations, in addition to the variances. This allows some flexibility in the specifications of the variances: they need not be the same for each component. For example a GARCH(1,1) for one component, an EGARCH for another, ... However, we face the problem of specification of a positive-definite conditional correlation matrix... For some choices, positivity conditions for are easily imposed and estimation is facilitated (2 steps).
¢
¥

MGARCH – p.39/106

Conditional correlations
For these models
¥

can generally be written as
¨

¢

¥

§¨

(22)
¦

¢

¥
¢

¢

¦ ¢

¡ 

¡

diag
 ¡ 

¢ ¦§

¢

¨

¢ 

¦

(23) (24)

¢

¥

¡

¡

¢ 

¢

with

¢ ¦ §

§  

¢

¥

 

£

£

¢

¢

££

is the matrix of conditional correlations, and is defined as a univariate GARCH model. Hence,
 
¤

§

¢

¢

££

¢

 

¢

¢

¢

¡

¡

£ 

¢ 

¥ 

(25)

¥ 

£

£

£

£

££

£

¢

¢

¢

£

Positivity of

follows from positivity of

¢

¥

and of each

.

¥

§

¢

¢

¢

MGARCH – p.40/106

¢

££

(Bollerslev, 1990)
In this case,
  ¡
¦§

§

§ 

(26)

¥

¥

 

£

£

¢

££ ¡
¡ £

¥
¢
¦

i.e. "constant conditional correlations" (CCC). Hence,
¢ ¢ ¢

(27)

¥ 

£

£

£

£

££

£

¢

¢

£

¢

and thus the dynamics of the covariance is determined only by the dynamics of the two conditional variances. NB: there are parameters in .
§       

¨ 

©

¦

¥

MGARCH – p.41/106

DCC of Tse & Tsui (2002)
DCC for "dynamic conditional correlations". 

  ¡¡

¤¢  £

¨

¡ 

 

  

 

§

§

¥

  

§

(28) (29) 

¥

¡ 

¡

¡  

¢ 


¢

§

£© 

¢

£

© 

¡

¨

¢

£ ¦

¤

¨

 

£

  

¢

¡

¥

§

 

£© 

§ 

¨   

¨ 

 

¢ ¨

¢

  

¤

¤

¨ 

¡

¡ 

¢

£

©

¨

¢ 

  

¢

¡

(30)

£©

¥

£

£

¢

with

and 


¢

££

.

is like in CCC.

 

 

 

 

©

  

¡ 

¡

¦

Notice that

££ ¦ 

 

¢

¡

¥

¡

¡ 

by construction.

© 

§

MGARCH – p.42/106

Remarks
is the sample correlation matrix of for . A necessary condition to ensure positivity of is that .
¥ 


¢

¢ 

£

£

¢

¥   

¦

¦

¥   

¦ 

£ 

¢

is a weighted average of correlation matrices ( , ). Hence, if any of the three components is .
§ §
  



¢

¡

 

 

  ¡£

¢

¡

,

§

¥ 


¢

§ 

¢

¡

If , the CCC model is obtained. Hence one can test for CCC against .
 

 

©

¥

¡ 

¥

©

¢

 

© 

 

¢

¡

¨

¡

MGARCH – p.43/106

¢

¡

DCC of Engle (2002) 

¡¡  

¦

£  

¨

¡ 

¦

¡ 

¡

diag

diag
    

¢

¢

§

¢  

¦

(31) 

¢

¥

¢

¢

¢ 

is a

matrix, symmetric and
© 
   

, given by
 

¢

 

 

¢

¤ 

¢

¢ 

 

© 

¢ 

(32) 

¥

¡ 

¡

©

¡  

¢ 

¢  

   

¢

¡

¢

where is a and and
© ¢
¢
 
 

, , matrix, symmetric and >0, of parameters, positive parameters satisfying ,
¢ ¨  

©

©

£©

¡

£

¥£

¥

¢

¢

¢

¢ 

¤

 

   

¢

¢

££ 

¦
 

¡ 

¡ 

¡

and

.

¢

©

§

 

¤

¢

¢

 

© 

© 

MGARCH – p.44/106

Remarks
is the covariance matrix of , since is not equal to 1 by construction. Then it is transformed into a correlation matrix by (31).
¢

©

¥

¢

¢

If , and , the CCC model is obtained. Hence one can test for CCC against .
   

©

¥

¥

¥

¡ 

££

¥ 

¢

££ 

In both DCC models, all the correlations obey the same dynamics. This saves a lot of parameters, compared to VEC and BEKK models, but is quite restrictive (especially when is large).
 

 

¢

¡

¨

¡

MGARCH – p.45/106

9" 

¨

¡ ¡ ¢ 
¡

and for the 
¥  
¡ 

¢

Comparison 

¡  ¡ ¡
¦ 


$
¡

¨

£ 9"
¢

¡

 

¡

¨
¡
¡

9" ¢
¡ ¢ 
¡ 

¢
¡ 

£ ¥   

¢
¨ 

 

 
¡

$ ¨
¢
¡

¢

, 

¨ $ 
¢
¡ ¡ 

  ¥
¡ 

£ ¥   

 

9" 
¡ ¡
¡

£ ¥   

¢
¨

¨ 

£ 

  £¤¥   
¡ 

¢
¨ ©

¨ ¢
¢ 
¡ ¡

£¤¥  
¡

"  ¨
¢
¡

B $  ¢
¨
¡ ¡ 

¡

¨
£¤¥  

£¤¥  
¡ 

 ¨
¢
¡

The correlation coefficient in the bivariate case: for the ,
¡

¦ E§¥ B  E§¥ ¦ ¨ £ ¥    ¨ £ ¥   ¦ $ " B ¤¦£ ¨ E ¥ ¥    ¨ ¦ £¤¥  
¡ ¡ 

¡

¦ £¤¥  
¡

$
MGARCH – p.46/106  

  3 2

' '
¤ ¥

 

' ' " $ '

' '

@ A9 " 9$
¦ 

¥   £
¡ ¡
¡

¥4 £ ¥¡ 9" £ ¡ " ¢  
© 

¥¡ £ 9" ¢
¢
¡

diag

¡ ¢
¡

Number of parameters

¨
¡

$  ¥  4$ 4
¢ 

'

¥  £ $ ¥¡ £

¥

#
diag 

¢ 

 (      !"  )  $ %# ! " $ %# 

¨ 
diag

¢

¡

¡ 

 ¥ §  ¨
¢ ¢
¡ ¡ 

¥ ¨ ¥ 4 "   ¥ ¨ ¡  ¥ 4 ¨ $ ¥ 4  
¡ 

¢ 
¡ 

!  &  01 $ %#  ! &  ) $ %# 

" £ ¤ ¥   £¥ ¢ £ ¥¡ £ ¥  ¤  ¢ ¥ $
¡  

¥ ¡  

   
¨
MGARCH – p.47/106
¡

for 

¡ 

   
¨

9, 14, 20, 27

9, 14, 20, 27

7, 12, 18, 25 

) 

# parameters 

£

¢
2, 3, 4, 5

Extensions of DCC
Recent and ongoing research aims at specifying more flexible dynamic correlations, avoiding the common dynamics restriction of all correlations. References: Billio, Caporin, and Gobbo (2003): a block-structure of DCC. Hafner and Franses (2003), "A Generalized Dynamic Conditional Correlation Model for Many Asset Retruns". Palandri (2005), "Sequential Conditional Correlations: Inference and Evaluation". Copula-MGARCH models combine GARCH for variances and copula for conditional dependence. Patton (2000), Jondeau and Rockinger (2001).
MGARCH – p.48/106

Other topics
Leverage effects in MGARCH models: -see section 2.4 of survey paper, and a well-done empirical study: -Peter de Goeij and Wessel Marquering (2004), Modeling the Conditional Covariance Between Stock and Bond Returns: A Multivariate GARCH Approach, Journal of Financial Econometrics 2, 531-564. Transformations of MGARCH models: -invariance of model type with respect to linear transformations; -marginalization; -temporal aggregation.
MGARCH – p.49/106

Estimation

MGARCH – p.50/106

ML Estimation
ML is convenient but it requires an assumption about the density of , denoted , where is an additional parameter vector.

§  

 ¤ 

¢

Maximize with respect to
  

 

¢

the function  

¤

¦ 

¤

  

¤

§ ¦ 

¥  

£¤¢

 

¡

§

(33)

 

¤

¥

¤

 

¢

with
 

¤

¢

¡ 

¦

¦

¦

¢

¡

¡

¡     

 

¦  

¦

¥

 

 

§

¥ 

¡

(34)

¢ 

¤

§

¢ 

¨ 

¢

¡

¥

¢

¦

¦

¢ 

¢

 ¤
¦

where the dependence with respect to and .
¢ ¢
¥

occurs through
MGARCH – p.51/106

¨

 

Gaussian likelihood
In many cases, is assumed (hence empty). Then, neglecting a constant, 
  

© §

is  

¢ 

 

 

¦

¢

¤

¡      

¡ 

 

£ ¤¢

¡

¥ 

¥ 

¡

(35)

¥ 

 

¨

 

 

¥

¢

¢

¢

¢  

¢ 

¢

¨
©
¤

This Gaussian log-lik. provides the QML estimator that is consistent for even if the true density is not (if and are correctly specified). 

 

¢

¡ 

 
© §

¢

¨

However, this QML estimator is less efficient than the ML estimator that would be obtained using the log-lik. based on the true density.
MGARCH – p.52/106

¢

¥

¦

¢ 

Remarks
For financial returns, normality is not realistic, like for univariate GARCH models. For financial applications (such as computing the VaR), it is important to use the most correct assumption about the density. Hence, normality is not useful in some applications... Alternative distributions: multivariate Student (to account for excess conditional kurtosis), multivariate skewed-Student or mixture of two multivariate Gaussian densities (for conditional skewness), generalized hyperbolic distribution. Danger of this approach: if the assumption is not correct, inconsistency of the estimator results. To what extent?
MGARCH – p.53/106

Student density
The multivariate Student density, denoted corresponds to ), is
¤
¤ ¥
 

( 

©

§

 ¡

¢ 

¦  


¡

¢

¦

¢

£

© 

¢  

§    

¢ 

¦

¢

§¨

(36) 

¢

¢

¥  

¤ ¥

 

¢

¨ 

£

©  

where 

¡  

¢

is the Gamma function. . 
 
§   



£

¢ 

   

¥

Here we impose , and Var while E Although uncorrelated, the elements of are not independent.
 

§ 

¡ 

¢

© 

¦

© 

¢

¥ 

¢

¢ 

When When thicker.

,

.   

§

 

©

 

¢ 

¢

¢

 

©

§

 ¡

¦

¦

, the tails of the density become thicker and
MGARCH – p.54/106

¢

 

©

¦

¢ 

¢

¢

¥

©

¢

Skewed-Student density (Bauwens and Laurent, 2005)
The multivariate skewed-Student density, denoted ( and correspond to ), is a skew version of the . 

 

  

¢

 

©

§

 

 ¡

¢

¦

¦

¢

¦ 

©

§

 ¡

¦

is a vector of skewness parameters, with
¥ ¨¦ § £¡ ¢ 

 

 

¥

¡

  

for all .
¡ £  

 

£

 

©  

¢ 

¦

¢

¢ 

¤

governs the skewness of If , the marginal of , it is right-skewed.
 
©

since . is left-skewed, while if
¥
¥ ¨¦ §

¤

£ 

¢

£

¥

©§ § 
MGARCH – p.55/106

¢ £¡

¤

 

©

©  

£

 

£

If , the skewed-Student reduces to the Student density. Hence, one can test the null hypothesis of symmetry.
  

  

£

¥

¡

¡

¢

£

¥ 

Univariate skewed-Student densities
ν=5 and ξ=1.3 ν=15 and ξ=1.3

0.4 0.2

Normal Student Skewed Student

0.4

Normal Student Skewed Student

0.2

−4 0.6 0.4 0.2

−2

0
ν=5 and ξ=1.5

2

4 0.4

−4

−2

ν=15 and ξ=1.5

0

2

4

Normal Student Skewed Student

Normal Student Skewed Student

0.2

−4 0.50

−2

0
ν=5 and ξ=2

2

4 0.4

−4

−2

ν=15 and ξ=2

0

2

4

Normal Student Skewed Student

Normal Student Skewed Student

0.25

0.2

−4

−2

0

2

4

−4

−2

0

2

4

MGARCH – p.56/106

SKST

¡ ¢ 

¥ ¤ ¦ ¢ 

§ ¤

0.2

f(z)

0.1

0.078 0.052 0.026

¥ ¨ © £
0.26 0.234 0.208 0.182 0.156 0.13 0.104

£

£ 

−4 −2 0

−2.5

0.0 z2 2.5 5.0

2 4

z1

MGARCH – p.57/106

¡  

©
4

£ ¥ ¤ ¦ ¢ 

Contours of SKST
£ § ¤ ¥ ¨ £
MGARCH – p.58/106

Panel A

2

0.025

0.0 25

0.0

25

0 0.0 0.055 .05

1

0.075

0.1
0.15

0.0 75 5 0.1 01 2 0..12 5

0. 1 5

z2 0

0.1

75

0.2

−2

−1

0.2.25 5 02 2 0.275 0.1

−4

−3

−2

−1

0

z1

1

2

3 

0.0 25
0. 05

Another way to get multivariate distributions
One can also define the density of as the product of independent univariate densities for each element of : 

¢ 

univariate Student (with their own degrees of freedom, not the same for each marginal); 

 ¡

© 

¦

univariate skewed-Student and Laurent, 2005); GED( ).
£
¢

¦

£

¢ 

(Bauwens 

 

 

© 

 

 ¡

£

¦

¦

Not much implemented up to now... This allows more flexibility, but may render estimation more difficult since there more parameters in .
¤

¦

£

¢ 

¢

MGARCH – p.59/106

¡  

¡©

£

¦©
1 2

£ ¥ ¤ ¦ ¢ 

SKST-IC
£ § ¤ ¥ ¨
3 0.023 0.02

Panel B

2

3

0.0 2

0.046
0
0

6 .04

0.0 46
0.0 23

1

.069

0.0
46 0.0

69 2 0.09 0. 50.115 092 0.11 .138 61 0 0.1
0. 13 8

z2 0

0.1 84

−2

−1

0.20707 0.284 0.161 0.1

−4

−3

−2

−1

0

£
z1 3 4 

MGARCH – p.60/106

Asymptotic properties of ML & QML
Consistency of QMLE is shown (Bollerslev and Wooldridge, 1992; Jeantheau, 1998). Asymptotic normality "assumed" in practice (or shown using high level assumptions). Hence, in practice one does inference as usual (asymptotic Wald and likelihood ratio tests). Recent work on these issues in univariate GARCH models has shown that usual asymptotics does not necessarily hold if does not have moments of low order (4 at least). See Hall and Yao (2003). 

  

¢

MGARCH – p.61/106

Two step estimation of DCC models
This approach uses the Gaussian likelihood (ML under the normality assumption, or QML otherwise). Substituting function (35) gives:
¥ ¨

in the Gaussian log-likelihood

¢

¥

¢

¢

§¨
¢ 

 

 

¡

©   

  

£ ¤¢

¨

§¨ 

¡

§

¢

(37)

¥  

 

¥

¢

¢

¢ 

¢

©

where
¡

¡

¤

¢

¡

, so that
¡ ¡ 

¨

© 

¢ 

¢

¥

¢

¡ 

©   

¡

¢

¨   



§

¨

§   

¨

©

¢ 

¨ 

¢  

¢

¢

¢

¢

¢ 

¨ ¢

¢

¥

¢

¢

¢

©

MGARCH – p.62/106

Two step estimation of DCC models
Hence, we can write: 

 

 

¡

©    

 

£ ¤¢

¡

¨

§¨ 

¥  

§

 

¥

¢

¢

¢ 

¢

© 

 

¤

¢

¡

 

© 

¢

¢

¢

©

¢

© 

 

¤

¢

¡

¢

 

¡

© 

© 

¢

¦ §§
    

£ ¤¢

¢¡

¢ 

¢

¤¥£

©

¨ 

¥

¥

©

  

¦ ¦ §§
 

¢

©

: parameters of the conditional variances (

¤

¢

¡

¢

¢

), ).
MGARCH – p.63/106

 

§

¨

¡

: parameters of the conditional correlations ( 

§

 

¢

§

¢

§§ ©
    

¤¢ £

¨¡

© ¢

¢  

¢

¤ ¥£

§  

§

¥

©

  

Two step estimation of DCC models 
       
§ 

§

§

§
     

¦

First step: estimate
 

by argmax 

§

¡

 

§

 

¢

¥ 

¡

 

¡

Easy: estimate separate univariate GARCH models if there is no spillover effects in conditional variances. Second step: estimate
 

by
§
 

argmax 

§ 

§

 

¡

 

Easy, since many parameters are fixed in this step. 

§  
 

 

¢ 

¥

 

©

¡

¦

¡

  

§

¦ 

§
 

¢

 

¢

¡

¡

¡ 

¥

 

 

¥

  

¡

¡

 
¡

©

¡

 

MGARCH – p.64/106

Remarks
These estimators are consistent but not efficient asymptotically, since some information in sacrificed (about in the first step).
¡
 

§

The variance matrix of the estimator has to be adjusted to take account of the first step (see Engle, 2002è and Newey and McFadden, 1994) but this is not important for VaR forecasts. 
§
 

 

MGARCH – p.65/106

Example of Bauwens and Laurent (2005)
2 datasets of daily returns: -3 stocks: Alcoa (AA), Caterpillar Inc. (CAT), and Walt Disney Company (DIS), from January 1990 to May 2002. -3 exchange rates with respect to US dollar: euro (DM before euro period), yen, and British pound, from January 1989 to February 2001. Conditional means: AR(0) or AR(1) with constant. Conditional variances: GARCH(1,1) for exchange rates, and GJR(1,1) for stocks: . 


¢

¤¢§ £¡  

 

 

£

¥

£

  

¢

¡

¢

¥  

DCC model of Engle (2002) for conditional correlation matrix, with skewed-Student distribution.
MGARCH – p.66/106 

¥   

¢

¢ 

§

¡

¡

¢

¡

Partial estimation results
AA-CAT-DIS 1 step 2 steps 0.0088 0.0095 (0.0021) 0.9846 0.9837 (0.0047) 0.1050 0.0977 (0.0257) 0.0786 0.0698 (0.0263) 0.0667 0.0591 (0.0276) 7.2858 7.4020 (0.5335) 3113 58.41 34.58 EUR-YEN-GBP 1 step 2 steps 0.0303 0.0294 (0.0033) 0.9684 0.9689 (0.0037) -0.0875 -0.0724 (0.0242) 0.0987 0.0983 (0.0253) -0.0677 -0.0353 (0.0238) 6.1928 6.4896 (0.3960) 3066 895.62 33.45

¢
¡

  ¡ ¦ ¢

£

Sample size

"
¨¡ § © 

¢ ¥£ ¤

¡

 

¡ 

£ $ '' $ " '

  § ¡

Note: For each parameter, the table reports the one step ML estimate and its standard error (in parantheses). The estimate of the two-step approach is also reported. and are respectively and likelihood ratio statistics for the hypotheses of constant correlations and symmetry with respect to the Student density.
¡

¨¡

¢ 

¢

"

'$

"

$

"

$

'

'

¨¡

§

¨¡

§

©     

"

¡

$

MGARCH – p.67/106

Variance and correlation targeting
The constant part of , if unrestricted, contains parameters, a number that increases fastly with . 
     

¨

This constant part, or a function of it, can sometimes be estimated consistently without doing ML or QML. Then this consistent estimate can be substituted for the corresponding parameter matrix in the (quasi-)log-likelihood function, rendering maximization easier by the reduction in the number of parameters. These estimators are consistent but not efficient asymptotically, since some information is sacrificed. Correlation targeting: a similar argument can be applied to estimate in (28) and in (32).
§

  

©

¢

¥

¢

 

MGARCH – p.68/106

Example of variance targeting
In the VEC model, we know that vech E vech Hence we can write (12) as vech 
 
£

©

¥

§ 

¦
¡  

¢

¡   

£ 

¤ ¥£

¦

¢

§

©

¥ 

¦ 

  

¢
¢ ¢£ ¢
 

¥

¥

¢

  

¢ 

¢

¢ 



   

¢

A consistent estimator of
 

is
 
£ 

©

©

¡

¥

where , with a consistent estimator of (usually easily available, e.g. by OLS).
   

¢ 

¨

¨ ¢

 

¤

¢

¡  

¡

£

¢

¥

¢

Hence we estimate and vech
£ 

from
¤ ¥£
¡   

£

¦ 

 

¦

¢

§

© 

¥

¢ 

¢

¦

¢ 

¢ 

   

¢ 

¡

MGARCH – p.69/106

¢

¨

Diagnostic Checking

MGARCH – p.70/106

Principles
After estimation, it is a standard practice to assess the specification of the model. This is done using diagnostic tests (also called specification tests) and related procedures, that are designed to indicate possible failures of some assumptions. Important departures from the basic assumptions should be remedied, if possible. Assumptions are: functional specification of , of , and the assumptions about (independence and the selected distribution).
¢

¨ 

¢

MGARCH – p.71/106

¢

¥

Principles
Some tests use the estimated MGARCH models,
¥
   

, i.e. the residuals. In 

¡ ¦ 

 

¢

(38) 

¢

¥

£

where a ‘hat’ denotes an estimated value (by QML). See Ding and Engle (2001). Other tests use the residuals standardized to have unit variance, but still correlated:
¢ ¨
    ¢  

¦ ¢

¢

(39)

£©

£

¥£

¢

See Tse (2002).
MGARCH – p.72/106 

¢

££

Principles
One can distinguish several kinds of specification tests: univariate tests applied separately to each or
 

, , to

 

£© 

¢

univariate tests applied separately to products test the covariance specification, multivariate tests applied to the vector All this is still in development... 

£©
¢
£

as a whole.

¢

 

MGARCH – p.73/106

¢

©

 

¢

£

 

Univariate tests
Several tests are those used for univariate GARCH models. They are applied to each series individually: -statistics on -statistics on or or , ,
¢
 

£© 

¢

£©  ¢

Jarque-Bera test of marginal normality, goodness-of-fit test (for the marginal density), ... They are very useful but they don’t tell us anything about the multivariate aspect of the specification.

£ ¢ 

¢

  

 

¢

£

 

¢

£©

 

MGARCH – p.74/106

Tests of Tse (2002)
Conditional variance test: for each ,
£©  ¢ £©  ¢ ¡

regress on a few lags of effects), but no constant term;
 

(and of 

for spillover

  

£

estimate this by OLS and test for nullity of the regression coefficients; the test statistic is a quadratic form in the OLS estimated coefficient vector, with weighting matrix adapted to take account that the regressors are actually estimated residuals (not the inverse of the usual OLS variance matrix); the test is asymptotically, where coefficients tested to be equal to 0.
  

is the number of
MGARCH – p.75/106 

  

 

¢

©

 

Tests of Tse (2002)
Conditional covariance test: for each pair regress term), where implied by ;
       

,

¡
¦
£

on a few lags of (no constant is the estimated conditional correlation
£©
¢ ¢ ¢

£©

©

 

£

¢ 

¢

£

 

 

£

estimate this by OLS and test for nullity of the regression coefficients; the test statistic is like in the previous case; a MC simulation shows that the finite sample size of the test is close to the nominal size even with only 200 observations, and that the test has reasonably good power properties.
MGARCH – p.76/106

¢

¥

 

¢

£

£

©

 

¢

Tests of Engle and Ding (2001)
These tests check some implications of a correct specification of the dynamics of the first two conditional moments. Specifically, if the elements of are mutually independent, then 

£    

©

¡

¡

£

Cov

¢

¢

(40)  

¥

¦¢

£

¢

¦

and if

is i.i.d.
£   

¢

Cov

for
¢
   

¡

¦
©
¢

¥

¡

¢

©

(41)  

¦¢

£ 

¢

£

¥

¦

¦

¦

 

For example, if 
£  ¦¢  
©

 

, and for
¡

, 

§

 ¡  

© 

¢

¦

¨

¦

¢ 

¢

¨ 

¦  

©

£

Cov  

¢ 

¢ 

¢

£

¢

¥

¥

¢

¦
.
MGARCH – p.77/106 

Tests of condition (40) 
£  ¦¢  £ 

Notice that Cov 

E

. vector
©
¤   

¨     

¥

¢ 

To test condition (40), let with typical element
£ ¢   

be a 

¢
£ 

¢

£

¢

£ 

 

 

¢

 

.   

Condition (40) is then equivalent to the moment condition E . 

 

¢

¥

© 

the sample moments should be close is defined like , but to 0 in large samples, where using estimated residuals , i.e. with typical element .
¢ ¨
     

    

¤

 

 

¥

 

 

¤

¢

¡

¡  

¨ 

¢ 

£     

  

  

¢ 

¢

£  

¢

 

¢

 

MGARCH – p.78/106

Test of condition (40)
The moment condition E can be tested by applying the conditional moment test principle (Newey, 1985; Tauchen, 1985). 

 

Let

denote the score vector at date .
¡

  ¡

 

¢

¥

©

¢

The test statistic is simply , is the uncentered -squared of a regression of where 1 on and .
¢
§ 
   

¢

¢

 

 

§

¤

§ 

£

The statistic is distributed asymptotically as with degrees of freedom under the null hypothesis. 
     

¨

Other tests can be designed by adding other relevant moment conditions.
MGARCH – p.79/106 

©

  

Tests of condition (41)
One can use the same principle as for the previous test: 
£  ¢ £    

Use a regression of 1 on , where
£ 
 

and
¢
¡ 

, for

 

 

 

 

   

¢ 

£
£  



 

£  ¨

. 


 

 

¡

¢  

¥

¥ 

¦

¦   

¦

from this regression has a large samples.
§
¤ 

¤

¢

¡ 

¡

 

  

 

distribution in

¢

£

  

MGARCH – p.80/106

Financial and Economic Applications

MGARCH – p.81/106

Topics
MGARCH models have been applied to: Dynamic asset pricing models Volatility transmission between assets and markets Futures hedging Impact of exchange rate volatility on trade and output Value-at-Risk.

MGARCH – p.82/106

Futures hedging
Futures contracts are used to hedge the risk incurred by holding a spot (short or long) position. For example: buy on the spot market one unit at some price (a long position), and sell in the futures market (a short position) at the same price to cover the risk of depreciation; the hedge ratio = 1 (quantity of futures position divided by the spot position). This is the right strategy if spot and futures returns have the same mean and variance and are perfectly correlated.
¤

MGARCH – p.83/106

Futures hedging
However, spot and futures prices are random and not perfectly correlated. One has therefore to account for this in order to decide about the hedge ratio, denoted by . The hedge return is , where return and the futures return.
  ¡¢ 
¢ ¢

is the spot

Minimizing the variance of yields Cov Var . 
¨ 
§
¡  

 £

¢

¥

 £

This rule can be generalized to take account of the expected return/risk tradeoff. It remains the same if expected utility E Var and E . 
   
©

¦

 £ 

 

¡  

¥ 

 £

¤

¥ 

 

¥

   

¥

 £

©

MGARCH – p.84/106

Futures hedging
Implicit in the moments Cov and Var that define the optimal hedge ratio is an information set on which they are conditional. 
 
¡    £
¦

As information accumulates, such as observation of realized values of the returns (or prices of spot and futures), the optimal hedge ratio changes, i.e. is indexed by : estimate Cov Var , where the information available at time , and includes the observed current and lagged values of and .  

 £ 

£

¢

§

is 

¨  

¢ §

¢

§

§ 

¤

¡   ¦ ¢

¥

 £

¡

 £ 

¢ 

¢

¡

¢

£

¡   ¢

¢

 £

¢

MGARCH – p.85/106

¢

§

Futures hedging
One can use a bivariate GARCH model for and , which provides estimates of the conditional moments required to compute at each . One can also predict future values.
¡   ¢  £
¢ §
¢

Several papers using the GARCH approach to hedging use a constant correlation specification. This is restrictive and current technology certainly allows to use more flexible specifications in the bivariate case. An exception is Bera et al. (1997) who use three specifications.

£

MGARCH – p.86/106

¢

Futures hedging
A traditional method consists of estimating a constant from time series data as the slope of the regression . 

¢ ¢

§

¡   ¢

¥

£ ¤

 

 £ 

When time-varying hedge ratios (TVHR) are computed, one can check the benefits of these compared to a constant HR. The TVHR are useful if they reduce the variance of the hedge. In Sephton (1993), this is found to be the case (in-sample), and in Bera et al. (1997) also, especially for the diagonal VEC specification (in-sample and out-of-sample). However these comparisons do not take account of the higher costs of using THR.
MGARCH – p.87/106

¢

¢

§

Asset pricing models
The static (or single period) CAPM model states that in market equilibrium, two numbers and exist such that:
 

§¨

E
£ §

Cov

for   

¦¨ §

£ §

 

£ §

§

¡ 

 

©

(42)
£ §

§¨ 

¥

¦

¥

¦   

¢

¦

where is the return of asset , and (with , being the share of asset in the market capitalization).
¡ § ¥ £

¨ 

£¦

is the expected return of a risk-free security.

 

§¨

is the ‘market price of risk’: the increase of expected return demanded per additional unit of risk (measured by the covariance).
MGARCH – p.88/106

£

£¦

¥

¡

¤

¡

£¦

¦

 

Asset pricing models
In a multi-period context, equation (42) is not compatible with non i.i.d. returns. If returns are not i.i.d., moments vary over time, and unconditional moments must be replaced by conditional ones. Thus, the CAPM means that at equilibrium there exists two processes and such that, at each ,
 

¢

§¨

¢

E

Cov

for   

¨¢ § ¦

£ §

 

£ §

§

£

¡ 

(43)  

§¨

¡

¥ 

¢

¢

¢

¢ 

¢

¡

¦ ¢

¥

¦   

£ 

¦

where is the return of asset between and , E is the conditional expectation operator, Cov is the conditional covariance operator, and is the return of the market portfolio, i.e. .
£ § ¡
£ ¢ 

¦

 

§

¢

¨¢

§

¨¢ 



¢

£

¤

¡

 

¢

£ §

£¦

¥

¡ 

¢

¡

MGARCH – p.89/106

¢

¡

Asset pricing models
The system of equations (43) can be written 
 §
 

E 
 §
¡ 

¥

(44)

§¨

  

¡

¥

¦
¢ ¢ ¢ ¢ 
 



¢

¢

where E E is the vector of conditional expectations of the returns at , is a vector of ones, is the conditional variance matrix of the vector of returns , and is the vector of asset shares at date .
§  ¥
¡ ¡

§

¢

¢ 

¢

¢   

¢

¢ 

¦

¡

 

¢

¥

¢

§

£ 

¦ ¢

We let

¡

E

, with

the risk-free rate. 

§ 

§¨

¥

¡

§

¢ 

¢

¢

¢

§

§

£ 

MGARCH – p.90/106

Asset pricing models
An econometric model compatible with (43) or (44) may be formulated as
§ §
 

¥

(45) (46) (47) (48) 

§ 

§

¥

¢

¢

¢

¢ 



¢

¡

£ ¤

 

 

¦   

   

 

 

¥

§ 

¢

¡    

E
£

©

Var

£

¥

£

¡ 

¢

¢ 

¢

¡

¢

¥
¢

i.i.d.

some distribution

where is specified according to a MGARCH formulation. Equation (45), the CAPM model, is a GARCH-in-mean model (GARCH-M), since the conditional variance appears in the conditional mean equation.
MGARCH – p.91/106

¢

¥

¢ 

¦

¥

¢

¥ 

¢

Asset pricing models
Notice two features: 1. a common intercept has been included, and 2. the specification of the market price of risk , which may be constant ( ) or time dependent (if ) through a function of the conditional variance matrix.
§ 

¢

 

 

 

£

¥

§

Most people use a constant price of risk: Otherwise 
 §
¢
 

. .
¥

 

¥

Var

may be specified as a function of , like
¦  ¦  
    

¥

¦ 

 

¨

¢

§

 

¥

¡

¡

¥

§

¡

¦
¢ 

¡ 

¢

¨¢

¢ 

¢

¢

¡ 

¢

Other risk factors may be included in (45), like macroeconomic factors (multifactor models). 

¢

¡

¢

MGARCH – p.92/106

¡

¥

©

Asset pricing models
By aggregating, for the market portfolio, relation (43) implies 
  § §
 

E

Var

¨¢ ¦ §

§

(49)

¡

§

¥ 



¢

¨¢

¢

¢ 

Therefore, 
£ § £ §

¦¥

hence:

E Var

¦

  

¢

¥

¦

¦¥

   

  

¡ ¥¢    

 

¢

E

Cov
¥ 

¢

¡  

¦ ¢

¨¢

§ 

¡ 

§

§

E
§
§

¡

§

¡ 

¢

¢

¢ 

¢

¨¢  

Var
¡ 

¢

¡ 

¨¢

§ 

E 



§ 

¢

§

§ 

(50)

¥ £
¢ 

¢

¡

¨¢ 

¢

MGARCH – p.93/106

Asset pricing models
The coefficient of asset measures the systematic risk of asset in relation with the market, during period .
¡

¢

£

¡

¡

These coefficients are of interest to investors, who may rely on them to choose their investments according to the asset riskiness relative to the market portfolio, since obviously .
¡

The CAPM with GARCH model is useful to generate time varying betas, instead of constant betas in the unconditional CAPM. Once has been estimated, can be easily computed.
¥

¨¢

¥ 

¢

MGARCH – p.94/106

¢

£

¡

£

Asset pricing models
Data requirement: excess returns (stocks, bonds) listed in a single country. The asset list may be extended to include foreign currencies. This is relevant when stocks or bonds are not denominated in the same currency, since there is a foreign currency risk in addition to the local market risk, unless purchasing power parity holds (international CAPM. DeSantis et al. (1998) find that the exchange rate risk varies over time, and that in some periods, a negative premium for foreign exchange risk more than offsets a positive premium for equity market risk.
MGARCH – p.95/106

Volatility transmission
This is the most obvious application of MGARCH models: the study of the relations between the volatilities and co-volatilities of several markets. Is the volatility of an asset transmitted to another directly (if the lagged conditional variance of the asset is significantly present in the conditional variance of the other asset) or indirectly (if the lagged conditional covariance between the asset and another enters in the other asset equation)? Does a shock on a market increase the volatility on another market, and by how much? Is the impact the same for negative and positive shocks of the same amplitude?
MGARCH – p.96/106

Volatility transmission
Another issue is whether the correlations between the returns of different markets change over time. Are the correlations higher during periods of higher volatility (sometimes associated with financial crises)? Are they increasing in the long run, perhaps because of the globalisation of financial markets?

MGARCH – p.97/106

Volatility transmission
Main problem: the large number of parameters that must be estimated. One cannot use too restrictive models, like diagonal models... No more than 5 assets in practice. Bollerslev (1990) uses a CCC model for 5 European currencies and finds that conditional correlations were significantly higher after the start of the European Monetary System (3.79-8.85) than before (7.73-3.79). Only the levels may be compared with a CCC model.

MGARCH – p.98/106

Volatility transmission
A second-best approach is to estimate several small size models bearing on different combinations of assets. For example, Kearney and Patton (2000) estimate 3-, 4and 5-variable models of returns on the most important currencies linked by the former EMS, instead of a 12-variable system (for all the currencies of the EMS) that is infeasible to estimate. The 3-variable system bears on the European currency unit (ECU), the mark (DM) and the French franc; the 4-variable model adds the lira; and the 5-variable model adds the pound.

MGARCH – p.99/106

Volatility transmission
The conditional mean vector is constant (implying no dynamics), and the conditional variance uses the BEKK formulation. This requires 70 parameters in the 5-variable model. Concerning volatility transmission using daily data, some robust conclusions emerge from the estimation of the three models: for example, all models indicate that the DM does not receive volatility directly from the other currencies (except the ECU in the 3-variable model), and with few exceptions, that the DM transmits its volatility directly to the other currencies.

MGARCH – p.100/106

Volatility transmission
Koutmos and Booth (1995) focus on the volatility spillovers across the London, New York and Tokyo stock markets around the October 1987 crash (September 86 to November 90). Conditional mean specification: -VMA(1) model with a constant term. -This enables to measure shock impacts in any market on the next expected return in all three markets. Such impacts are significant (at the 0.05 level) from New York to Tokyo (positive), as well as from Tokyo and New York to London (both negative).

MGARCH – p.101/106

Volatility transmission
Conditional variance specification: -An EGARCH equation for each variance, where the shock in each market enters the next conditional variance of every other market. -For example, a shock in New York, can increase the next conditional variance of New York (as in an univariate model), London and Tokyo. These effects are empiricallyvsignificant and work in all directions. -Moreover the impact of negative and positive shocks of equal absolute values can be larger for negative shocks than for positive ones. This is also implied by the estimates.
MGARCH – p.102/106

Volatility transmission
CCC for the correlations: -Because trading hours are not the same on the three markets, conditional correlations do not reflect contemporaneous correlations (in calendar time), but they capture (partly) intraday lead/lag relationships, rendering the interpretation of the moving average coefficients difficult. Estimations are repeated for the pre-crash and post-crash periods, and reveal that interdependence before the crash (which covers however a rather short spell of 13 months) was less important than after it (estimation for a period of about three years).
MGARCH – p.103/106

Conclusion

MGARCH – p.104/106

Limits of MGARCH models
Curse of dimensionality, but Palandri (2005) estimates a model for 69 series. Estimation software not yet enough developed. MG@RCH under development by Laurent and Rombouts (similar to G@RCH, belongs to OxMetrics). Otherwise, RATS, FinMetrics in S+, Fanpac in GAUSS include some models.

MGARCH – p.105/106

Other approaches to multivariate volatility
Stochastic volatility models. Realized volatility.

MGARCH – p.106/106

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