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Multivariate GARCH Models

November 2005

Luc Bauwens
bauwens@core.ucl.ac.be

Université catholique de Louvain

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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).

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Introduction

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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.

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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...

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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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Co-movement

5.0
DJ

2.5

0.0

−2.5

−5.0

2000 2050 2100 2150 2200 2250 2300 2350

5 NQ

−5

2000 2050 2100 2150 2200 2250 2300 2350

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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

0.2 0.2 Nasdaq


Dow Jones

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

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,






(1)





E (2)









Var (3)

 





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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 :






(4)




where is determined by







Pr (5)



For example, if ,






















(6)














with the % left-quantile of the N(0,1) distribution.

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Conditional VaR with ARCH

Assuming that the mean vector and the variance


matrix are constant over time is restrictive.


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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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.
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

A dynamic model with time-varying means, variances and


covariances for the components of :








 






(7)












 


a matrix

(8)








 









E Var (9)











E E (10)






















Var Var (11)











where is the information available at time , at least





 




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




otherwise known (parametric model), hence sometimes


we write explicitly and . For example, may












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

State conditions on the parameters such that that


.






Avoid too many parameters (to keep estimation feasible),


but maintain enough flexibility in the dynamics of .



Find and the conditions for weak




Var E






stationarity.

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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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
elements of . The is defined as:















(12)









where

vech



(13)





vech

 

(14)






and is a vector of parameters [with  ]













and and are matrices of parameters.





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Vech and vec operators

vech is the operator that stacks the lower triangle of a


matrix as an vector:








 
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

To reduce the number of parameetrs, BEW (1988)


suggest the diagonal VEC (DVEC) model in which the


and matrices are diagonal.


Each variance depends only on its own past squared






 

error and its own lag .











Each covariance depends only on its own past







cross-products 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








scalars and is a matrix of ones.


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and



since


 


 




E
 

 
 


E

 

E

 
 
  
  

 
 

 
 

  

(
 
 
 



.
One can write also (see p 21)

 



  
 
),

   
  


  
   
  
 

 
 

 
  
 
 
 
Positivity conditions for VEC (Gouriéroux, 1997)

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E
E

 

 
  

 
 
 
 
 
 
 
 

 
 

   
 
 
 
 
 

 

   
    
  
   
  
  


   
  
Positivity conditions for VEC

   
   
    

   
   
 
   
     
 
 
   
   
MGARCH – p.24/106



 

E



  
  
    

     


  


  
  


 
    
 
 

We denote by the above


  

  



built in the same way from .


 
   
  

 

 

 


 
Putting the different parts together:

  
     

 
Positivity conditions for VEC

 
 

  


 

 
  
matrix, and by



  
  

 
 

 
  
the matrix
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Positivity conditions for VEC

A general matrix (rather than vech ) expression of in the



VEC(1,1) case is:






























E














Hence, sufficient conditions for positivity of are that ,








, , with at least one strict inequality.




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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BEKK(1,1,K) (Engle and Kroner, 1995)

The BEKK model is defined as:









 

 





















 


 

 




(17)







 


where and are matrices of parameters but
















 
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.

 
  
 
 
 
  
 
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(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

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).
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

The VEC(1,1) model can be written as

 














a VARMA(1,1) model for vech :





















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,



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









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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:








(19)


























 


 

i.e. and are replaced by rank one matrices that are







proportional to one another. The vectors and are








subject to the restrictions:


for 







(20)











for ,







 

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Factor-GARCH(1,1,1)

Taking , the model can be written as:






































(21)



 
where















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






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where


  
  


  
   
  

  
  



        


 
 

 
 

  

  


  
 



  
  
Bivariate Factor-GARCH(1,1,1)

MGARCH – p.35/106 
Remarks

The elements of obey the same dynamics,



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 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.

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VEC(1,1)

BEKK(1,1,1)

F-GARCH(1,1,1)
 
 
  
#  
   
    
  
)(' !"  


$#  
    
  


Number of parameters

 
   
    
*  

-+,  # 
#  
  
 
+ % 
  
 $# 
'     
  
 
# 
&
for

   



   

  
 



7, 12, 18, 25
# parameters

11, 24, 42, 65


21, 78, 210, 465
2, 3, 4, 5

 

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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)













with





(24)








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.


 









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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






. 

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 matrix, symmetric and >0, of parameters,




and and 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

'
for the
 


  

and for the


 
 


' 
  

Comparison



 

'  
,

  

   

    



 
,
 


   




  

 
 

 
    

 
  
   
 
' 



   
 *
 - 
 *
   

 -
 



      


 



  
  
  

 


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

MGARCH – p.47/106
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.
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Estimation

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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 occurs through
and .



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Gaussian likelihood

In many cases, is assumed (hence is








empty). Then, neglecting a constant,













(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 , the tails of the density become thicker and





thicker.
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 since .








 


 





If , the marginal of is left-skewed, while if




, it is right-skewed.



If , the skewed-Student reduces to the Student









density. Hence, one can test the null hypothesis of


symmetry.

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Univariate skewed-Student 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

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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

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 (Bauwens











and Laurent, 2005);
GED( ).


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











 
 
 
SKST-IC
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

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 in the Gaussian log-likelihood






function (35) gives:












(37)






where , so that















 









MGARCH – p.62/106
Two step estimation of DCC models

Hence, we can write:




















 















 























: parameters of the conditional variances ( ),







: parameters of the conditional correlations ( ).


 


MGARCH – p.63/106
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 EUR-YEN-GBP
1 step 2 steps 1 step 2 steps
0.0088 0.0095 0.0303 0.0294


(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 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 from


vech




 













MGARCH – p.69/106
Diagnostic Checking

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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 , i.e. the residuals. In


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).

MGARCH – p.72/106
Principles

One can distinguish several kinds of specification tests:


univariate tests applied separately to each or ,






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...

MGARCH – p.73/106
Univariate tests

Several tests are those used for univariate GARCH models.


They are applied to each series individually:



-statistics on or ,







 

 
-statistics on 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 (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);


the test is asymptotically, where is the number of





coefficients tested to be equal to 0.


MGARCH – p.75/106
Tests of Tse (2002)

Conditional covariance test: for each pair ,




regress on a few lags of (no constant






 






term), where is the estimated conditional correlation





implied by ; 


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.

 

for




Cov (41)










For example, if , and ,









 



for .




Cov








MGARCH – p.77/106
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 .





the sample moments should be close

 






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)

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 ,








where is the uncentered -squared of a regression of





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.

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 is the spot






return and the futures return.


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 and E .








Var





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 , where is




 



Cov Var






 







the information available at time , and includes the


observed current and lagged values of and .






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:

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 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 ,






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. . 


 










MGARCH – p.89/106
Asset pricing models

The system of equations (43) can be written





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
 

is the vector of asset shares at date .








We let , with the risk-free rate.




E 





MGARCH – p.90/106
Asset pricing models

An econometric model compatible with (43) or (44) may


be formulated as


(45)










(46)














E Var (47)












i.i.d. some distribution (48)


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 may be specified as a function of



, like .





Var




















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)











hence:





 



Var





Therefore,


 


Cov





 


 


E 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-, 4-
and 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