Outline I

1 Stylized Facts

2 Moments
Mean and Variance
Skewness and Kurtosis
Covariance and Correlation
Autocorrelation

3 White Noise

4 GARCH Models

(FINA 5250) Lect 6: Financial Time Series Fall 2019 1 / 30

 Stylized Facts

Stylized Facts of Asset Returns

We consider the following list of so-called stylized facts which
apply to most financial returns.
We will use daily returns on the S&P500 to illustrate each of the
features in the following.

(FINA 5250) Lect 6: Financial Time Series Fall 2019 3 / 30

 Stylized Facts

Stylized Fact 1
Autocorrelations of Daily S&P Returns for Lags 0/1 through 20,
Jan 1997 to Dec 2001
Autocrelations of DSPLR from Autocrelations of DSPLR from
Jan 1997 to Dec 2001 Jan 1997 to Dec 2001
1.0

0.2
0.8

0.1
0.6
ACF

ACF

0.0
0.4

−0.1
0.2
0.0

−0.2
0 5 10 15 20 25 30 5 10 15 20

Lag Lag

 Daily returns have very little autocorrelation.

Corr (Rt+1 , Rt+1−τ ) ≈ 0 for τ = 1, 2, 3, · · ·
(FINA 5250) Lect 6: Financial Time Series Fall 2019 4 / 30
 Stylized Facts

Stylized Fact 2
Histogram of Daily S&P500 Returns Superimposed on the Normal
Distribution, Jan 1997 to Dec 2001
Histogram of DSPLR vs Fitted Normal Density
40
30
Density

20
10
0

−0.06 −0.04 −0.02 0.00 0.02 0.04

DSPLR

(FINA 5250) Lect 6: Financial Time Series Fall 2019 5 / 30

 Stylized Facts

Stylized Fact 2, ctd

 The unconditional distribution of daily returns have fatter tails than
the normal distribution.
Notice how the histogram has longer and fatter tails, in particular
in the left side, and how it is more peaked around zero than the
normal distribution.
QQ plot
Normal Q−Q Plot

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−3 −2 −1 0 1 2 3

Theoretical Quantiles

Fatter tails mean a higher probability of large losses than the

normal distribution would suggest.
(FINA 5250) Lect 6: Financial Time Series Fall 2019 6 / 30
 Stylized Facts

Stylized Fact 3
 The stock market exhibits occasional, very large drops but not
equally large up-moves.
Consequently the return distribution is asymmetric or negatively
skewed.
This is clear from the previous histogram as well. Other markets
such as that for foreign exchange tend to show less evidence of
skewness.
Daily S&P500 Returns, Jan 1997 to Dec 2001
Mean 0.04%
St. Deviation 1.27%
Skewness -0.237
Kurtosis 5.64

(FINA 5250) Lect 6: Financial Time Series Fall 2019 7 / 30

 Stylized Facts

Stylized Fact 4
 The standard deviation of returns completely dominates the mean of
returns at short horizons such as daily.
Our S&P500 data has a daily mean of 0.04% and a daily standard
deviation of 1.27% (there are 1257 trading days in Jan 1997 to
Dec 2001).
It is typically not possible to statistically reject a zero mean return.

(FINA 5250) Lect 6: Financial Time Series Fall 2019 8 / 30

 Stylized Facts

Stylized Fact 5
Autocorrelation of Squared Daily S&P500 Returns for Lags 1 through
20, Jan 1997 to Dec 2001
Autocrelations of Squared DSPLR from Jan 1997 to Dec 2001
0.2
0.1
ACF

0.0
−0.1
−0.2

5 10 15

Lag

(FINA 5250) Lect 6: Financial Time Series Fall 2019 9 / 30

 Stylized Facts

Stylized Fact 5, ctd

 Variance measured for example by squared returns, displays
positive correlation with its own past.
This is most evident at short horizons such as daily or weekly.
2 2
Corr (Rt+1 , Rt+1−τ ) > 0, for small τ

(FINA 5250) Lect 6: Financial Time Series Fall 2019 10 / 30

 Stylized Facts

Stylized Fact 6

SP500 Log Returns from Jan 1997 to Dec 2001

0.04
0.02
0.00
DSPLR

−0.02
−0.04
−0.06

0 200 400 600 800 1000 1200

Time

 Volatility clustering: Large returns (either positive or negative) tend to

be followed by large ones, and small returns tend to be followed by
small ones.
(FINA 5250) Lect 6: Financial Time Series Fall 2019 11 / 30
 Moments Mean and Variance

Moments
The k −th moment of a continuous random variable X is defined as
Z ∞
0 k
mk = E(X ) = x k f (x)dx
−∞

The first moment is the mean or expectation of X , denoted by µX .

The k −th central moment of X is defined as
Z ∞
mk = E[(X − µX )k ] = (x − µX )k f (x)dx
−∞

The second central moment, denoted by σX2 , measures the

variability of X and is called the variance of X

(FINA 5250) Lect 6: Financial Time Series Fall 2019 14 / 30

 Moments Skewness and Kurtosis

Skewness and Kurtosis

The third central moment measures the lopsidedness of the
distribution, whereas the 4th moment measures the tail heaviness.
Skewness is the normalized 3rd central moment of X . We can
denote it by γX .

(X − µX )3
γX = S(X ) = E[ ]
σX3

Kurtosis is the normalized 4th central moment of X :

(X − µX )4
K (X ) = E[ ]
σX4

Excess Kurtosis δX = K (X ) − 3

(FINA 5250) Lect 6: Financial Time Series Fall 2019 16 / 30

 Moments Skewness and Kurtosis

Skewness and Kurtosis for Normal Distributions

For any normally distributed random variable X ∼ N(µ, σ 2 ),
Skewness γX = 0
Excess Kurtosis δX = 0.
(Kurtosis K (X ) = 3).

(FINA 5250) Lect 6: Financial Time Series Fall 2019 17 / 30

 Moments Covariance and Correlation

Covariance and Correlation

Let X and Y be two random variables
Covariance
Cov(X , Y ) = E[(X − µX )(Y − µY )]
Correlation
Cov(X , Y )
ρX ,Y = Corr(X , Y ) =
σX σY
E[(X − µX )(Y − µY )]
=p
E[(X − µX )2 ]E[(Y − µY )2 ]

(FINA 5250) Lect 6: Financial Time Series Fall 2019 19 / 30

 Moments Autocorrelation

Autocorrelation Function (ACF)

Consider a time series {Xt }.
Assume (weak) stationarity:
(a) E(Xt ) is a constant
(b) Cov(Xt , Xt−k ) only depends on k
When the linear dependence between Xt and its past values Xt−k
is of interest, the concept of correlation is generalized to
autocorrelation.
The correlation coefficient between Xt and Xt−k is called the lag-k
autocorrelation of {Xt } and is commonly denoted by ρk .

Cov(Xt , Xt−k ) Cov(Xt , Xt−k )

ρk = p =
Var(Xt )Var(Xt−k ) Var(Xt )

(FINA 5250) Lect 6: Financial Time Series Fall 2019 21 / 30

 Moments Autocorrelation

Autocorrelation Function (ACF), ctd

ρk = Corr(Xt , Xt−k )
This is usually estimated by the Sample ACF
Pn
(Xt − X̄ )(Xt−k − X̄ )
ρ̂k = t=k +1Pn 2
, 0≤k <n−1
t=1 (Xt − X̄ )

(FINA 5250) Lect 6: Financial Time Series Fall 2019 22 / 30

 Moments Autocorrelation

Stylized Fact 1 and Stylized Fact 5 revisited

Fact ?: if {Xt }nt=1 is an independent identically distributed (iid)
sequence with finite variance, then the sample autocorrelations
ρ̂k , k > 0 are approximately iid N(0, n1 ) for n large.
Fact ? is used to test the null hypothesis H0 : ρk = 0. Many
statistical software packages plot the approximate 95% confidence
limits on the acf plots (two horizontal lines at approximately ± √2n ).

For the S&P500 1/1/97-12/31/01 daily return data, n = 1256,

√2 ≈ 0.055. Based on the figures on page 4 and page 9, we
n
conclude that
Corr (Rt+1 , Rt+1−τ ) ≈ 0 for τ = 1, 2, 3, · · · .
2 2
Corr (Rt+1 , Rt+1−τ ) > 0, for small τ.

(FINA 5250) Lect 6: Financial Time Series Fall 2019 23 / 30

 White Noise

White Noise
A series {Wt }t is said to be a white noise if it is a sequence of iid
mean zero random variables.
Notation: W ∼ WN(0, σ 2 ) for white noise with variance σ 2 .
White Noise is the end of the road in modelling:

We extract component, after component, after component, ......

until we get residuals forming white noise

Q: Is the S&P500 returns sequence white noise?

(FINA 5250) Lect 6: Financial Time Series Fall 2019 25 / 30

 White Noise

White Noise

> WN<-rnorm(1024, mean = 0, sd = 2)

> ts.plot(WN)
8
6
4
2
WN

0
−2
−4
−6

0 200 400 600 800 1000

Time

(FINA 5250) Lect 6: Financial Time Series Fall 2019 26 / 30

 White Noise

Testing for White Noise: acf Plot

acf(WN,40,"covariance",main="Auto-Covariance Function")
acf(WN,40,"correlation",main="Auto-Correlation Function")

Auto−Covariance Function
0 1 2 3 4
ACF (cov)

0 10 20 30 40

Lag

Auto−Correlation Function
0.8
ACF

0.4
0.0

0 10 20 30 40

Lag

(FINA 5250) Lect 6: Financial Time Series Fall 2019 27 / 30

 GARCH Models

GARCH Models
 The GARCH (Generalized AutoRegressive Conditional
Heteroskedastic) model and its extensions capture important features
of returns data and are flexible enough to accommodate specific
aspects of individual assets.

(FINA 5250) Lect 6: Financial Time Series Fall 2019 29 / 30

 GARCH Models

GARCH Models
A time series Xt = {Xt }t is said to be GARCH of order (p, q),
denoted by X ∼ GARCH(p, q), if

Xt = σt W t ,

where
1
p q
X X
σt2 = α0 + 2
βi σt−i + 2
αj Xt−j ,
i=1 j=1

where α0 > 0, βp > 0, αq > 0 and αj ≥ 0 for j = 1, 2, . . . , q − 1;

Pmax(p,q)
βi ≥ 0 for i = 1, 2, . . . , p − 1; and i=1 (αi + βi ) < 1
2 Wt ∼i.i.d. N(0, 1)
Only lower order GARCH models are used in most applications,
say GARCH(1,1), GARCH(2,1) and GARCH(1,2).

(FINA 5250) Lect 6: Financial Time Series Fall 2019 30 / 30