This model is stationary when the sum of parameters ? = ? 1 + ?

are less than

unity. This sum is also called the persistence, as it defines the speed at which

shocks to the variance revert to their long-run values.

Figure 5.5 displays the one-day GARCH forecast for the S&P 500 index. The

GARCH long-run volatility has been around 1.1% per day. Volatility peaked in

September 2008, at the time of the Lehman Brothers bankruptcy, when it reached

5%. This reverted slowly to the long-run average later, which is a typical pattern

of this forecast. Also note that the GARCH model identifies extended periods of

low volatility, from 2004 to 2006.

To understand how the process works, consider Table 5.3. The parameters are

? 0 = 0.01, ? 1 = 0.03, ? = 0.95. The unconditional variance is 0.01/(1 − 0.03 −

0.95) = 0.5, or 0.7 daily volatility, which is typical of a currency series, as it

translates into an annualized volatility of 11%. The process is stationary because

? 1 + ? = 0.98 ? 1.

Attime0,westartwiththevarianceath 0 = 1.1(expressedinpercentsquared).

The conditional volatility is

√h

0 = 1.05%. The next day, there is a large return

of 3%. The new variance forecast is then h 1 = 0.01 + 0.03 × 3 2 + 0.95 × 1.1 =

1.32. The conditional volatility just went up to 1.15%. If nothing happens the fol-

lowing days, the next variance forecast is h 2 = 0.01 + 0.03 × 0 2 + 0.95 × 1.32 =

1.27. And so on.