November 2005
Luc Bauwens
bauwens@core.ucl.ac.be
MGARCH – p.1/106
Outline
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).
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Introduction
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MGARCH: why?
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MGARCH: why?
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Two series of financial returns
Daily returns, DOW Jones (DJ) and NASDAQ (NQ) indices, 03/26/1990  03/23/2000
5.0 DJ
2.5
0.0
−2.5
−5.0
0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200
5 NQ
−5
0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200
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Comovement
5.0
DJ
2.5
0.0
−2.5
−5.0
5 NQ
−5
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ACF of returns and squared returns
Returns
0.2 0.2
Dow Jones Nasdaq
0.1 0.1
0.0 0.0
0 10 20 30 0 10 20 30
Squared returns
0.1 0.1
0.0 0.0
0 10 20 30 0 10 20 30
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Densities
Density
0.6 DJ N(s=0.871)
0.4
0.2
−8 −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5
Density
0.5 NQ N(s=1.06)
0.4
0.3
0.2
0.1
−9 −8 −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6
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Portfolio
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 variancecovariance matrix of
the returns. Then,
(1)
E (2)
Var (3)
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ValueatRisk of a portfolio
value that can occur with probability equal to :
(4)
where is determined by
Pr (5)
For example, if ,
(6)
with the % leftquantile of the N(0,1) distribution.
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Conditional VaR with ARCH
matrix are constant over time is restrictive.
A univariate GARCH model for can be fit for a given
instead of and ), the multivariate distribution of the
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Remarks
VaR measures, also called the undiversified VaR.
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.
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Overview of Models
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Definition
covariances for the components of :
(7)
a matrix
(8)
E Var (9)
E E (10)
Var Var (11)
containing .
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Remarks
is any matrix such that is the conditional
variance matrix of (e.g. may be obtained by a
Cholesky factorization of ).
and depend on unknown parameters but are
be a VARMA model.
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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Three challenges
Find and the conditions for weak
Var E
stationarity.
lag of and one lag of itself, i.e. socalled GARCH(1,1)
models.
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VEC(1,1) (Bollerslev, Engle, and Wooldridge, 1988)
errors, cross products of errors, and lagged values of all the
elements of . The is defined as:
(12)
where
vech
(13)
vech
(14)
and and are matrices of parameters.
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Vech and vec operators
vech
vec is the operator that stacks a matrix as a column
vector:
vec
A useful property is
vec vec
(15)
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(for
Bivariate VEC(1,1)
the numbers of parameters is of order
2, 3, 4 it is equal to 21, 78, 210 respectively).
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(16)
Equivalently,
Bivariate VEC(1,1)
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Diagonal and Scalar VEC
and matrices are diagonal.
crossproducts of errors
, and its own lag.
Quite restrictive: no "spillover effect".
Big reduction: 9 parameters instead of 21 when 2;
18 instead of 78 when =3...
Scalar VEC: and where and are
since
E
E
E
(
.
One can write also (see p 21)
),
Positivity conditions for VEC (Gouriéroux, 1997)
MGARCH – p.23/106
E
E
Positivity conditions for VEC
MGARCH – p.24/106
E
Putting the different parts together:
Positivity conditions for VEC
matrix, and by
the matrix
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Positivity conditions for VEC
VEC(1,1) case is:
E
Hence, sufficient conditions for positivity of are that ,
MGARCH – p.26/106
BEKK(1,1,K) (Engle and Kroner, 1995)
(17)
is upper triangular. One can write as well .
Positivity of is automatically guaranteed if .
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Bivariate BEKK(1,1,1)
parameters, against 21 in the VEC model.
MGARCH – p.28/106
(18)
Bivariate BEKK(1,1,1)
Same linear structure as in VEC model...
... but constraints on parameters (compare with p 21).
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Remarks
against 21 in the bivariate VEC).
Diagonal BEKK model: take and as diagonal
matrices. It is a restricted DVEC model (check the
covariance equation to see the restrictions).
One can define a scalar BEKK model: ,
.
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Stationarity conditions: VEC
a VARMA(1,1) model for vech :
where is a MDS.
vech vech
E
where .
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Stationarity conditions: BEKK
The BEKK(1,1,1) model
can be written as a VEC model (subject to restrictions) using
formula (15):
vec vec vec vec
Hence, the BEKK model is weakly stationary if the
eigenvalues of are smaller than 1 in
modulus, and then
vec vec vec
E
MGARCH – p.32/106
FactorGARCH(1,1,K) (Engle, Ng, and Rotschild, 1990b)
(19)
i.e. and are replaced by rank one matrices that are
subject to the restrictions:
for
(20)
for ,
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FactorGARCH(1,1,1)
(21)
where
is the GARCH(1,1) conditional variance of the factor .
MGARCH – p.34/106
where
Bivariate FactorGARCH(1,1,1)
MGARCH – p.35/106
Remarks
determined by the common element .
If we write , and assume that , the
common shock (a scalar r.v.) and
, the idiosyncratic shocks (a vector),
are uncorrelated,
with Var and
,
Var
we get
Var
as in eq. (21).
Weak stationarity occurs if .
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Other FactorGARCH models
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VEC(1,1)
BEKK(1,1,1)
FGARCH(1,1,1)
#
)(' !"
$#
Number of parameters
*
+, #
#
+ %
$#
'
#
&
for
7, 12, 18, 25
# parameters
21, 78, 210, 465
2, 3, 4, 5
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What next?
imposed and estimation is facilitated (2 steps).
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Conditional correlations
(22)
diag
(23)
with
(24)
is the matrix of conditional correlations, and
(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)
(28)
(29)
(30)
with and . is like in CCC.
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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
.
MGARCH – p.43/106
DCC of Engle (2002)
diag diag
(31)
is a matrix, symmetric and , given by
(32)
where , ,
and .
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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
'
for the
'
,
,
'
*

*

The correlation coefficient in the bivariate case:
*

MGARCH – p.46/106
!
()'
'
"
' '
diag
diag
"
"
Number of parameters
"
diag
"
"
for
9, 14, 20, 27
9, 14, 20, 27
7, 12, 18, 25
# parameters
2, 3, 4, 5
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Extensions of DCC
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ML Estimation
parameter vector.
Maximize with respect to the function
(33)
with
(34)
where the dependence with respect to occurs through
and .
MGARCH – p.51/106
Gaussian likelihood
empty). Then, neglecting a constant,
(35)
and are correctly specified).
MGARCH – p.52/106
Remarks
corresponds to ), is
(36)
Although uncorrelated, the elements of are not
independent.
When , .
thicker.
MGARCH – p.54/106
SkewedStudent density (Bauwens and Laurent, 2005)
version of the .
is a vector of skewness parameters, with
for all .
governs the skewness of since .
, it is rightskewed.
MGARCH – p.55/106
Univariate skewedStudent densities
ν=5 and ξ=1.3 ν=15 and ξ=1.3
Normal 0.4 Normal
Student Student
0.4 Skewed Student Skewed Student
0.2
0.2
−4 −2 0 2 4 −4 −2 0 2 4
0.6 ν=5 and ξ=1.5 ν=15 and ξ=1.5
Normal 0.4 Normal
Student Student
Skewed Student Skewed Student
0.4
0.2
0.2
−4 −2 0 2 4 −4 −2 0 2 4
ν=5 and ξ=2 ν=15 and ξ=2
Normal Normal
0.50 Student 0.4 Student
Skewed Student Skewed Student
0.25 0.2
−4 −2 0 2 4 −4 −2 0 2 4
MGARCH – p.56/106
SKST
0.26
0.234
0.208
0.182
0.2
0.156
0.13
f(z)
0.104
0.1
0.078
0.052
0.026
−4
−2
−2.5 0
z1
0.0 2
2.5
z2 5.0 4
MGARCH – p.57/106
Contours of SKST
Panel A
2
0.025 0.0
25
25
0
0.055 .05
0.0
0.0
0.0
25
1
0.
0.075 0.0
05
75
0.1 5 0.1
12
00..1 25
0.15 0.
15
75
0
0.1
z2
0.2 0.2
0.2 5
252
0.2
0.175
−1
−2
−4 −3 −2 −1 0 z1 1 2 3 4
MGARCH – p.58/106
Another way to get multivariate distributions
independent univariate densities for each element of :
univariate Student (with their own degrees of
freedom, not the same for each marginal);
univariate skewedStudent (Bauwens
and Laurent, 2005);
GED( ).
MGARCH – p.59/106
SKSTIC
Panel B
2
3 0.023
0.02
3
0.046
2
0.0
0.0
6 46
.04
0.0
0 0 .069
23
0.0
1
0.0
46
69
2
0.09 0.
50 . 0 9
0.11
115 2
.1 3 8
0 61
0.
0.1
13
8
0
z2
0.1 0.200.2707
84 0.18641
0.1
−1
−2
−4 −3 −2 −1 0 z1 1 2 3 4
MGARCH – p.60/106
Asymptotic properties of ML & QML
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Two step estimation of DCC models
function (35) gives:
(37)
where , so that
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Two step estimation of DCC models
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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
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)
.
(0.0021) (0.0033)
0.9846 0.9837 0.9684 0.9689
(0.0047) (0.0037)
0.1050 0.0977 0.0875 0.0724
(0.0257) (0.0242)
0.0786 0.0698 0.0987 0.0983
(0.0263) (0.0253)
0.0667 0.0591 0.0677 0.0353
(0.0276) (0.0238)
7.2858 7.4020 6.1928 6.4896
(0.5335) (0.3960)
Sample size 3113 3066
58.41 895.62
34.58 33.45
Note: For each parameter, the table reports the one step ML estimate and its standard error (in
parantheses). The estimate of the twostep 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
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)loglikelihood 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).
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Example of variance targeting
vech E vech
Hence we can write (12) as
vech
A consistent estimator of is
where , with a consistent estimator of
vech
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Diagnostic Checking
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Principles
and the assumptions about (independence and the
selected distribution).
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Principles
MGARCH models,
(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).
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Principles
univariate tests applied separately to products , to
test the covariance specification,
multivariate tests applied to the vector as a whole.
All this is still in development...
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Univariate tests
statistics on or ,
statistics on or ,
JarqueBera test of marginal normality,
goodnessoffit 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)
regress on a few lags of (and of for spillover
effects), but no constant term;
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);
regress on a few lags of (no constant
term), where is the estimated conditional correlation
implied by ;
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Tests of Engle and Ding (2001)
independent, then
Cov (40)
and if is i.i.d.
for
Cov (41)
For example, if , and ,
for .
Cov
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Tests of condition (40)
Notice that Cov .
E
To test condition (40), let be a vector
with typical element .
Condition (40) is then equivalent to the moment
condition E .
to 0 in large samples, where is defined like , but
using estimated residuals , i.e. with typical element
MGARCH – p.78/106
Test of condition (40)
applying the conditional moment test principle (Newey,
1985; Tauchen, 1985).
Let denote the score vector at date .
The test statistic is simply ,
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 and , for
, where .
from this regression has a distribution in
large samples.
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Financial and Economic Applications
MGARCH – p.81/106
Topics
MGARCH – p.82/106
Futures hedging
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Futures hedging
The hedge return is , where is the spot
return and the futures return.
Cov Var
Var
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Futures hedging
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 , where is
Cov Var
observed current and lagged values of and .
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Futures hedging
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.
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Futures hedging
from time series data as the slope of the regression
.
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Asset pricing models
that:
for
E Cov (42)
where is the return of asset , and
(with , being the share of asset in the
market capitalization).
is the expected return of a riskfree security.
for
E Cov (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. .
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Asset pricing models
E (44)
where E
is the vector of
E
conditional expectations of the returns at ,
is a vector of ones,
is the conditional variance matrix of the vector of
returns , and
We let , with the riskfree rate.
E
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Asset pricing models
(45)
(46)
E Var (47)
i.i.d. some distribution (48)
formulation.
Equation (45), the CAPM model, is a GARCHinmean
model (GARCHM), since the conditional variance
appears in the conditional mean equation.
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Asset pricing models
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 may be specified as a function of
, like .
Var
Other risk factors may be included in (45), like
macroeconomic factors (multifactor models).
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Asset pricing models
E Var (49)
hence:
Var
Therefore,
Cov
E E
Var
E (50)
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Asset pricing models
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 .
can be easily computed.
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Asset pricing models
MGARCH – p.95/106
Volatility transmission
MGARCH – p.97/106
Volatility transmission
MGARCH – p.98/106
Volatility transmission
MGARCH – p.99/106
Volatility transmission
MGARCH – p.100/106
Volatility transmission
MGARCH – p.101/106
Volatility transmission
MGARCH – p.103/106
Conclusion
MGARCH – p.104/106
Limits of MGARCH models
MGARCH – p.105/106
Other approaches to multivariate volatility
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