SS ts = - - _—

SSS - a | - ———— ee eee SS

VOLATILITY & ASSET

VOLATILITY MODELS
A K MISHRA
Sih) — Faculty, Department of Economics
K K Birla Goa Campus
Introduction
“* Predicting volatility is crucial for many functions in
financial markets.
“*Volatility is used by many for risk management
(e.g. VaR), options pricing, asset allocation, and
many other applications.
“*Understanding volatility is vital for virtually all
financial time series analysis.
“* In finance, volatility is a measure for variation (i.e.
risk) of the price of a financial instrument over time.
“* Before we go into the types of volatilities, let’s take
a step back and define it.
Introduction
“*In simple terms, risk measures how volatile an asset’s
return are.
“Volatility is a measure of how much the price of an asset
fluctuates around its mean.
“* The more volatile the asset, the greater the potential to
make large profits or large losses.
“* Investors sometimes begin a quantitative screening by
stating that they want a fund with a “low risk.”
“* Most often, investors equate high standard deviation with
high risk and then use standard deviation as a comparative
statistic.
Volatility Index
- Volatility Index is a measure of market’s expectation of
volatility over the near term.
¢ Usually, during periods of market volatility, market moves
steeply up or down and the volatility index tends to rise.
¢ As volatility subsides, volatility index declines.
¢ The Chicago Board of Options Exchange (CBOE) was the first
to introduce the Volatility Index (VIX) for the US markets in
1993 based on S&P 100 Index option prices over the next 30
days.
¢ The VIX, often termed as the "fear index".
Volatility Index
¢ Volatility Index is different from a price index such as
NIFTY-the price index- computed using the price
movement of the underlying stocks.
¢ Volatility Index is computed using the order book of
the underlying index options and is denoted as an
annualised percentage.
«India VIX indicates the investor’s perception of the
market’s volatility in the near term 1.e. it depicts the
expected market volatility over the next 30 calendar
days.
«Higher the India VIX values, higher the expected
volatility and vice versa.
Volatility measurement-Standard Deviation
¢ Volatility is commonly used to refer the standard deviation
(o,) of the underlying distribution.
¢ Suppose that r, is the value of a variable on day i. The
volatility per day is the standard deviation of In(r, /r,_,).
¢ An unbiased estimate of the population variance (a7) is
defined as follows:
a2 ea (ri —7)
|

¢ Where 7; is the holding period (e.g. daily, weekly, monthly,

etc.) for returns 7 is the mean of the return over the sample
period T.
¢ The volatility (or standard deviation) is defined by a
holding period, so a weekly volatility is different than
annual volatility.
Volatility Scaling
¢ To compare the value of single-period volatility against multi-period
volatility, we need a unified scale or unit-base.
¢ In practice, annual volatility is often implied when discussing values.
The question now becomes, how do we convert a monthly, weekly or
daily volatility to annual?
¢ For monthly volatility, we compute 12-month period volatility
assuming no serial correlation between returns: cy = 12 X Omo-
¢ For weekly volatility, we compute 52 week period volatility assuming
no serial correlation between individual weekly returns cy = 52 x ow.
¢ For daily volatility, the holding period is a trading day, so first we
compute the number of trading days in the current year (in US,
(52x5)-10=250 trading days), and then multiply by the square root of
this number: oy = ./250 x o,-
Volatility measurement-Standard Deviation
- An unbiased estimate of the population variance (07) is defined as
follows:
m2 Vea (ri _ r)?
OT 4
¢ Variance rate is the square of volatility.
¢ A daily volatility will be annualized by multiplying by ¥250 ~ 15.81
because there are approximately 250 trading days in a calendar
year.
¢ Likewise, monthly volatility will use an annualization factor
ofV¥12 ~ 3.46.
¢ Furthermore, the definition above calculates the average variance
over the sample period.
¢ Assuming the excess returns (i.e. 7;- 7) are stationary (or weak-
sense stationary), then o is a good forecast for future volatility.
Standard Deviation with a Moving Observation
Window
¢ The standard deviation as a measure of volatility provides a single
volatility estimate over an entire set of returns.
¢ Example: NIFTY-500(April 2019-March 2020)
FIGURE 1: Daily returns of the NIFTY-500 Index from April 2019 to March 2020
10

0 i j i h H r] , \ | " Pas Re : ‘ A fl

4-Feb-19 26-Mar-19 -May-19 4-JURL9 §3-Amg-19 -Oct-19 1-Dec-19 20-Jan-20 0 t 29-Apr-20

5 \
|

-10

-15

¢ The annualized volatility of the NIFTY-500 Index using the daily returns between April 2019
and March 2020 is 25.9%. In this example, standard deviation is 1.64%, which represents the
NIFTY-500's daily volatility for 2019-20.
Standard Deviation with a Moving Observation
Window
* Example: S&P 500 daily returns(Jan 2002 and June 2012)
¢ FIGURE 2: S&P 500 daily returns(Jan 2002 and June 2012)
15%
15%

10% 10%

5% 5%

O% - : 0%

“5% | -5%

7, Ss f FSF F SF FTF SF TF SF FT 5S F SF FTF SF 4 ye

s FSB FSB FSB EB F&F SB ES

¢ It is immediately clear that the dispersion exhibited by the returns are not
constant; there are periods where the returns are notably more volatile—for
example, in the third quarter of 2008 when the financial markets were under
significant duress.
Standard Deviation with a Moving Observation
Window
* Example: S&P 500 daily returns(Jan 2002 and June 2012)
“*The daily log return of S&P 500 Index exhibits common patterns
that are well-documented in financial literature:
1) Volatility Clusters — volatility may be high for a certain time
period (red-circles) and low for other periods
2) Volatility evolution — the volatility evolves over time in a
continuous manner; 1.e. volatility jumps are very rare.
3) Volatility does not diverge to infinity — the volatility may go high
(and stay high) in some time periods, but surely goes down to
some steady state value (long-run).
Standard Deviation with a Moving Observation
Window
* Example: S&P 500 daily returns(Jan 2002 and June 2012)
“* The daily log return of S&P 500 Index exhibits common patterns
that are well-documented in financial literature:
4) Volatility does not go down to zero — the volatility may be low for
a period of time, but it surely goes up to a steady state level.
5) Volatility reacts more to large negative returns than it does to
similar positive ones.
¢In short, volatility does change over time, but only as a more
stationary continuous mean-reverting process (Hint: ARMA
process).
¢ The main takeaway is that the volatility changes over time, so a
forecast using historical volatility (which ignores volatility
dynamics) may not be as robust or indicative for future ones.
Moving-window standard deviation
“*It is clear that a single measurement does not
capture the time-varying nature of volatility, and a
simple modification to the application of the
standard deviation method can yield far more
intuitive results.
«+Rather than use the entire set of returns data, it can
be useful to instead observe a smaller set of the
data such that the volatility measurement 1s more
relevant to the prevailing environment.
“* Using historical returns, we can compute the
standard deviation using a sliding window (width
h).
Moving-window standard deviation
¢Using historical returns, we can compute the
standard deviation using a sliding window (width
h).
¢ This approach is definitely an improvement over the
historical one, but we are still making one implicit
assumption:
¢ “The observed volatility in the last time window is
indicative for next-period volatility.”
Moving-window standard deviation
¢ The first volatility estimate is computed using the first M of the returns.
¢ The second volatility estimate moves the observation window along by 1 period
such that the first return is removed and the latest return is added.
¢ A simple example is illustrated in figure below, where the data set consists of N =
20 returns and a moving observation window of M = 10 returns.
¢ FIGURE 3: Comparing a moving window that observes 10 data points to an
inclusive volatility measure using all 20 data points.

Standard deviation using all available data

retunsdatal | | | TF tT tT rE oT EE EE TE cE cE TE
12 3 4 5 6 7 8 9 10 11 12 13 #14 #15 #16 17 #18 «#19 —=«(20

First observation window

Second observation window

Third observation window

Moving-window standard deviation
¢ It’s worth noting, however, that the level of structure observed in the
volatility over time will depend on the size of the observed window.
¢ What is the optimal size of the moving window?
¢ In principle, the shorter the window is, the more responsive the
moving standard deviation is to volatility changes; however, it can
be very noise too.
¢ On the other extreme, a /arger window is less noisy, but it is slower
to response to changes in volatility.
¢ With that in mind, what is the optimal value that can give us a good
volatility forecast?
¢ To answer this question, we need to develop a utility (or loss)
function that we opt to maximize (or minimize) by altering the
window size (h).
Moving-window standard deviation
¢ What is the optimal size of the moving window?
¢ Let’s formulate the problem:
a2 a (rei — 7)?
on h—1

7, =MA= ie h "ti

¢ Where is the volatility forecast using prior information {7;_1, "4-2...

r;-n} and r, is the moving average for the same window.
¢ To gauge how bad our forecast is, we will use the root mean squared
error (RMSE) as our loss-function (i.e. the smaller the RMSE the better).
T a2
igh (a; — r;)?
RMSE = Th

¢ Where r’, is used in place of the actual (realized) volatility & (T—h) is the
number of volatility forecasts available.
Moving-window standard deviation
¢ After computing the RMSE for different window sizes (let’s
say, between 2 and 30 days), we can evaluate the RMSE,
and pick the one with the minimal value.
¢ FIGURE 4: optimal size of the moving window

¢ In the figure above, a window size of 12-day has the lowest RMSE,
after which the RMSE stabilizes.
¢ The takeaway here is that the window size should not be less than 10
days for a good forecast.
Weighted Moving-window standard deviation
¢ The moving average method assigns an equal weight to
each data point in the observation window, thereby
placing equal importance on each.
¢A natural extension to the moving average is to assign
weights to observations in the window; recent
observations are given higher weight factors (similar to
weighted-moving average) than later ones.
¢ In practice, exponential weighted volatility (EWMA) is the
most commonly used.
¢ An exponential weighted volatility (EHWMA) is a commonly
used alternative, popularized by RiskMetrics.
Exponential-Weighted Moving Average
(EWMA)
¢In 1992, JP Morgan launched their RiskMetrics
methodology to the marketplace, making their
substantive research and analysis internally available to
market participants.
¢ EWMA is part of RiskMetrics methodology.
¢ The main objective of EWMA is to estimate the next-day
(or period) volatility of a time series and closely track
the volatility as it changes.
Exponential-Weighted Moving Average
(EWMA)
¢ Background:
¢ Let’s define o, as the volatility of a market variable on
day n, as estimated at the end of day n-1.
¢ The variance rate is the square of volatility,c7, on day n.
¢ Suppose the value of the market variable at the end of
day 11s s;.
¢ The continuously compounded rate of return during day
i (between end of prior day (i.e. i-1) and end of day i) is
expressed as:

Tr = In
Si-1
Exponential-Weighted Moving Average
(EWMA)
¢ The continuously compounded rate of return during day 1
(between end of prior day (i.e. i-1) and end of day i) is
expressed as:
Si
r, =In
Si-4
¢ Next, using the standard approach to estimate o,, from
historical data, we'll use the most recent m-observations
to compute an unbiased estimator of the variance:

* Wheres is the mean of rj: 7 =

Duin
~~
Tn-i
Exponential-Weighted Moving Average
(EWMA)
¢ Next, using the standard approach to estimate o, from
historical data, we'll use the most recent m-observations
to compute an unbiased estimator of the variance:
9 (tna — 7)
oi, =
m-1

¢ Where 7 is the mean of 7;:

° Next, let’s assume 7 =O and use the maximum likelihood
estimate of the variance rate:
m 2
9 Diet Tai
On =
m

¢ So far, we have applied equal weights to all r7, so the

definition above is often referred to as the equally-
weighted volatility estimate.
Exponential-Weighted Moving Average
(EWMA)
¢ Earlier, we stated our objective was to estimate the current level of
volatility o,, so it makes sense to give higher weights to recent data
than to older ones.
¢ To do so, let’s express the weighted variance estimate as follows:
m

a= ) a, xr,
e :
i=l

¢ Where:
¢ a; is the amount of weight given to an observation i-days ago
° a, 20
oa =1
So, to give higher weight to recent observations, a; = aj44
Exponential-Weighted Moving Average
(EWMA)
¢ Given the weighted variance estimate:
° Where: q; is the amount of weight given to an observation 1-days ago.
a; => 0; 4, a; = 1 & higher weight to recent observations, @; = @;41.
Long-run average variance
A possible extension of the idea above is to assume there is a long-run average
variance V,, and that it should be given some weight:
™m

o2 = yVz, + ) Qa; X re
i=1
Where:

y+ yea =1
°V,>0
Exponential-Weighted Moving Average
(EWMA)
¢ Long-run average variance
¢ A possible extension of the idea above is to assume there is a long-run
average variance V,, and that it should be given some weight:
m Where:

o2 = Wit> a xr?_; yt D0; =1

1 eV, >0

¢ The model above is known as the ARCH (m) model, proposed by Engle
In 1994.
m

o2 =W+ ) Qa; X re.

i=1
Exponential-Weighted Moving Average
(EWMA)
¢ Long-run average variance
¢ The model above is known as the ARCH (m) model, proposed by Engle
In 1994.
™m

oF =wt ) a, xr.
i=1
¢ EWMaA is a special case of the equation above.
¢ In this case, we make it so that the weights of variable a; decrease
exponentially as we move back through time.
e Aj41 = AQ; = Naj_1 eee Nan

¢ The EWMA includes all prior observations, but with exponentially

declining weights throughout time.
Exponential-Weighted Moving Average
(EWMA)
¢ The EWMA includes all prior observations, but with exponentially
declining weights throughout time.
¢ We apply the sum of weights such that they equal the unity
constraint:
° Soa; = a1 52x =]
i=1 i=1

¢ For |A|<1, the value of a, =1-A.

Exponential-Weighted Moving Average
(EWMA)
. Gh = Ax ,+(1-A) x re,

“*Where A is the exponential smoothing parameter (O<A<1).

“+ By expanding the above EWMA definition, we get:

6; =X Gy +(1—A)
x r?_, =A* Gg + (1—
A) x r?_,)
+ (1-42) x re 1

= 6; .+(1- A)(r7_1 + ATi_2) = NGe_3

+ (1—A)(r¢_, + Are_, + rr? _.)
=~

” af =Aot_, + (1—A) NO! x 2.

t—2
I|—_
i
Exponential-Weighted Moving Average
(EWMA)
¢ Thus, EWMA has the following favorable properties:
1) Weights sum up to one (1)

(Q-ayyraet=a-ayyryi= i

—
|
|
2) Higher weights are given to recent observations, declining
exponentially afterward.
3) The EWMA is an improvement over moving average (i.e. simplicity),
but it also suffers from a few drawbacks, including the fact that it is
Symmetric; that is, large negative returns have the same effect as
large positive ones.
4) As a result, it does not capture the volatility dynamics, but it
merely smooths the squared time series.
Exponential-Weighted Moving Average
(EWMA)
¢ IMPORTANT:
¢ The EWMA formula does not assume a long run average variance
level.
¢ Thus, the concept of volatility mean reversion is not captured by the
EWMA.
¢ The ARCH/GARCH models are better suited for this purpose.
¢ A secondary objective of EWMA is to track changes in the volatility, so
for small A values, recent observation affect the estimate promptly,
and for 4 values closer to one, the estimate changes slowly to recent
changes in the returns of the underlying variable.
¢ The RiskMetrics database (produced by JP Morgan) and made public
available in 1994, uses the EWMA model with A=0.94 for updating
daily volatility estimate.
Exponential-Weighted Moving Average
(EWMA)-Applications
“* Example: S&P 500 daily returns(Jan 2002 and June 2012)
“*An optimal value of A using the same RMSE methodology discussed
earlier.
<* FIGURE 5:

Bl”
SekoegenyiaavabaepaRage
GS
RMSE vs. Lambda

Fo
FoFoa
SFoe
Fo
eo Foe
FS oF
S2SF—e5
epsoo8
Seaes

“*The optimal value for A using the S&P 500 daily returns is found at
0.90, which is very close from the rule-of-thumb of 0.94 used by JP
Morgan.
 Time Series Volatility Model-The Stylized Facts
¢¢ The distribution of financial time series has heavier tails than the
normal distribution

“* Highly correlated values for the squared returns

«Changes in the returns tend to cluster.
“Until the early 80s econometrics had focused almost solely on
modeling the means of series, i.e. their actual values.
“*Recently however we have focused increasingly on the importance of
volatility, its determinates and its effects on mean values.
“* There are many volatility models available in the literature.
 Types of Univariate Time Series Volatility Model

“* ARCH/GARCH class of models

“* Engle (1982)- The autoregressive conditional heteroscedastic (ARCH) model
“Bollerslev (1986)- The generalized autoregressive conditional heteroscedastic
(GARCH) model
“Nelson (1991)- The exponential generalized autoregressive conditional
heteroscedastic (EGARCH) model
“* Glosten, Jaganathan, and Runkle (1993)- The threshold generalized
autoregressive conditional heteroscedastic (TGARCH) model
“+ Engle and Ng (1993) and Duan (1995)-The nonsymmetric generalized
autoregressive conditional heteroscedastic (VGARCH)
¢* Stochastic Volatility (Variance) model
“*Melino and Turnbull (1990), Harvey et al. (1994), Jacquier et al. (1994), Taylor
(1994) - The stochastic volatility (SV) models
“*We discuss advantages and weaknesses of few volatility models and consider some
applications of volatility.
Characteristics of Volatility-Recap
“Although volatility is not directly observable, it has some
characteristics that are commonly seen in asset returns.
“First, there exist volatility clusters (i.e., volatility is high for certain
time periods and low for other periods).
“* Second, volatility evolves over time in a continuous manner-—that is,
volatility jumps are rare.
“Third, volatility does not diverge to infinity—that is, volatility varies
within some fixed range. Statistically speaking, this means that
volatility is often stationary.
“*Fourth, volatility seems to react differently to a positive shocks(big
price increase) and a negative shocks (big price drop) with the latter
having a greater impact. This phenomenon is referred to as the
leverage effect.
Characteristics of Volatility-Reconsidered
“Although volatility is not directly observable, it has some
characteristics that are commonly seen in asset returns.
“*These properties play an important role in the development of
volatility models.
“*Some volatility models were proposed specifically to correct the
weaknesses of the existing ones for their inability to capture the
characteristics mentioned earlier.
“*For example, the EGARCH and TGARCH models were developed to
capture the asymmetry in volatility induced by big “positive” and
“negative” asset returns.
Characteristics of Volatility-Reconsidered
“In practice, we typically estimate the volatility of an asset using the
prices of its stock or derivatives or both.
“*Consider the daily volatility of TCS Ltd. What we observe are:
“* (i) the daily return for each trading day,
“¢(ii) tick-by-tick data for intraday transactions and quotes, and
“*(ii1) the prices of options contingent on TCS stock.
“*These three data sources give rise to three types of volatility measures
for TCS stock.
“*They are as follows:
“Volatility as the conditional standard deviation of daily returns: This
is the usual definition of volatility and is the focus of volatility models
Characteristics of Volatility-Reconsidered
“In practice, we typically estimate the volatility of an asset using the
prices of its stock or derivatives or both.
“* Let r, be the log return of an asset at time index t .
“*The basic idea behind volatility study is that the series {r,} is either
serially uncorrelated or with minor lower order serial correlations, but
it is a dependent series.
¢* For illustration, consider the daily simple & log stock returns of TCS
from 1 November 2013 to 25 September 2020 for 1737 observations.
“*Figure 6 shows the time plot of the returns.
“*From the plot, the return series appears to be stationary and random.
Characteristics of Volatility-Reconsidered
«+ Example: TCS daily returns(Nov 2013 and Sep 2020)
** FIGURE 6: Time plot of the daily simple and log returns of TCS
wt. =

wT, 4

NN 4

a
nw o
, 3
o
e oC
E
a oof
= a
&2 5
Oo
Ee
a

wo
3
a

8e zy,
=
So
oO
a
. F
+ J

s4 ©
T T T T T v T T T T T

01jan201401jul201501jan201701jul201801jan2020 01jan201401jul201501jan201701jul201801jan2020
daten daten

¢*From the plot, the return series appears to be stationary and random.
ARCH MODEL
“* The first model that provides a systematic framework for volatility modeling is
Engle’s autoregressive conditional heteroskedasticity (ARCH) model (1982).
“*This is a good model to start with due to its simplicity and relevance to other
models.
“*This model is pivotal to a solid understanding of financial time series volatility.
“* Background: ARCH and GARCH models of all stripes generally consist of
two equations:
“*(1)A mean equation describing the evolution of the main variable of interest, Y,
and
“*(2)A variance equation describing the evolution of Y’s variance.
“Y, will not even follow an AR(1) process, but will consist of a constant mean
plus some error.
“*Thus, these two equations establish a relationship between term structure (i.e.
multi-period) volatility and conditional means.
Time-Varying Volatility and ARCH Models
“A stylized fact about financial market is “volatility
clustering”. That is, a volatile period tends to be followed by
another volatile period, or volatile periods are usually
clustered.
“¢ Intuitively, the market becomes volatile whenever big
news comes, and it may take several periods for the market
to fully digest the news.
“Statistically, volatility clustering implies time-varying
conditional variance: big volatility (variance) today may
lead to big volatility tomorrow.
“*The ARCH process has the property of time-varying
conditional variance, and therefore can capture the
volatility clustering.
 Time-Varying Volatility and ARCH Models

“*The nonstationary nature of the variables studied earlier

implied that they had means that change over time.

“* Now we are concerned with stationary series, but with

conditional variances that change over time.

“*The model is called the autoregressive conditional

heteroskedastic (ARCH) model.

¢* Financial time series have characteristics that are well

represented by models with dynamic variances. 61

The ARCH Model

** Consider a model with an AR(1) error term:

“e Vi = DH Cpr nrnvn nnn nnn nnn nnn nnn nnn nnn nnn enn (1)

“ Cr = Pet-1 + Vt, lp| << 1----- —(2)

62
The ARCH Model

¢* The unconditional mean of the error is:

Eley] = E[ve + pvy_-1 + °M%-2 + +] = 0

** The conditional mean for the error is:

Elé¢|Ie-1] = Elpet—1|Ie-1] + Elve] = pees

The ARCH Model
“+ The unconditional variance of the error is:

E[e,-O] =E |v, +pV,,+p Vio +: |

=E | ve + pV + pV» re |

=o, |1+p?+p*+--|
2
—
oF V

1- 0°
“+ The conditional variance for the error is:

E[(ez — pee—1)*|/e-1) = Elvi le-i] = of

64
 The ARCH(1) Model
“* Suppose that instead of a conditional mean that changes
over time we have a conditional variance that changes over
time.

“¢ Consider a variant of the above model:

Ye = Bo+ ep ——-- === -(4)

65
 The ARCH(1) Model
*» Consider a variant of the above model:

* C+ |p ~N (0, hy) ----------------- n-nonane nnn nnn nnn (5)

hy = Xo + aye? 4, Xo > 0, O< Oy <1-- —(6)

Equations (5) and (6) describe the ARCH class of models.

The equation (5) says that the error term is conditionally normal where I,_, represents the
*, '*
+.

information available at time t — 1 with mean O and time-varying variance, denoted as h;.

The equation (6) models h, as a function of a constant term and the lagged error squared.
%e

The name ARCH conveys the fact that we are working with time-varying variances
(heteroskedasticity) that depend on (are conditional on) lagged effects (autocorrelation).
66
The ARCH(1) Model
*¢ The standardized errors are standard normal:

“¢ We can write:

“% E(e,) = E(z,)E (ao + ae? +) monn enn nnn nnn nnn nnn nn nnn (8)

“* And

SE (ef) = E(z7)E(ao + a, ef_4) = Ap + a,E(ef_1)

67
Testing for ARCH Effect
“*How do you know that your data even exhibit ARCH in the
first place?
“There are several different approaches to take.
“Two of the very important tests of autocorrelation in the
squared residuals.
“*The two tests we will discuss are: (1) the Ljung- Box test,
and (2) an autocorrelation (ACF) test using the test statistic
proposed by Engle (1982), the so-called “Engle LM test”
“*Both of these tests rely on the same first steps: (1) estimate
the mean equation: regressed on lags of itself or on some
exogenous variable X, (2) investigate the properties of the
residuals and the squared residuals.
Testing for ARCH Effect
“*How do you know that your data even exhibit ARCH in the
first place?
“*The two tests we will discuss are: (1) the Ljung- Box test,
and (2) an autocorrelation (ACF) test using the test statistic
proposed by Engle (1982), the so-called “Engle LM test”
“*(1) The Ljung-Box (Q) test investigates whether a variable is
white noise. If variables are white noise, they cannot be
autocorrelated.
“*(2)The LM or ACF test estimates the autocorrelation
function of e?, the squared residuals.
Testing, Estimating, and Forecasting

“* A Lagrange multiplier (LM) test is often used to test for the

presence of ARCH effects.

¢* To perform this test, first estimate the mean equation:

Cfa2 = Vo + M10 a2fia HOV prrrrnnn (10)

¢* The null and alternative hypotheses are:

H,:¥,=9 4#H,:y,4#0------------------ (11)
70
Testing for ARCH Effect
“Finding the Optimal Lag Length: How many lags
would belong in the Ljung-Box or LM tests?
“*If ARCH were to exist, it would be operative at a certain
number of lags; and then we have to test for ARCH effect
with that number of lags.
“*While there is no universally accepted answer to this
question, the most common approach is to estimate several
models, each with different lags, and then compare them
using either the Akaike Information Criterion, the Bayesian
Information Criterion, or another such criterion.
Example 1: ARCH Effect
“* Example: Continuously Compounded Daily Stock Returns
of TCS (November 2013 - September 2020)
+ st -
*

V T T T T

0 500 1000 1500 2000

time
 Testing for ARCH Effect
“*Example 1: Daily Stock Returns of TCS
“¢ Checking stationarity
Dickey-Fuller test for unit root Number of obs = 1357

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -35.433 -3.430 -2.860 -2.570

MacKinnon approximate p-value for Z(t) = 0.0000

 Testing for ARCH Effect
“*Example 1: Daily Stock Returns of TCS
“*Check for ARCH effect- LM test
LM test for autoregressive conditional heteroskedasticity (ARCH)

lags(p) chi2 df Prob > chi2

1 1.392 1 9.2381
2 @.871 2 @.6470
3 1.262 3 @.7383
4 2.984 4 @.5606

H@: no ARCH effects vs. H1: ARCH(p) disturbance

«+The LM test shows p-value greater than 0.23 which indicates that null hypothesis (no arch
effect) can’t be rejected. Therefore the log of stock returns doesn’t have ARCH effect.
 Testing for ARCH Effect
“*Example 1: Daily Stock Returns of TCS
“*Check for ARCH effect- Ljung-Box

Portmanteau test for white noise

Portmanteau (Q) statistic 10.9130

Prob > chi2(4@) 1.8000

«+ The LM test shows p-value of 1 which indicates that null hypothesis (no ARCH effect) can’t be
rejected. Therefore the log of stock returns doesn’t have ARCH effect.
Example: ARCH Effect
“Example 2: Continuously Compounded Daily Stock
Returns of Toyota Motors (JAN 2010 - September 2020)
+° “4
05
1
-.05
l

I 1 T q

0 1000 2000 3000

time
Example: ARCH Effect
“*Example 2: Daily Stock Returns of Toyota Motors (JAN
2010 - September 2020)
“* Checking stationarity
Dickey-Fuller test for unit root Number of obs = 2700

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -54.558 -3.430 -2.860 -2.570

MacKinnon approximate p-value for Z(t) = 0.0000

Testing for ARCH Effect
“*Example 2: Daily Stock Returns of Toyota Motors
“*Check for ARCH effect- LM test

lags(p) chi2 df Prob > chi2

1 168.277 1 8.28000
2 231.034 2 8.8000
3 312.356 3 8.0000
4 316.160 4 8.8000
5 341.155 5 8.0000
6 342.251 6 8.28000
7 348.999 7 8.0000
8 350.410 8 8.8000
9 351.926 9 8.8000
10 360.629 A) 8.20000

+ The LMdestoshews pryalue less than 0,00: wiateh sydacates-éhatanull hypothesis (no arch effect)
can be rejected. Therefore the log of stock returns does have ARCH effect.
 Testing for ARCH Effect
“*Example 2: Daily Stock Returns of Toyota Motors
“*Check for ARCH effect- Ljung-Box pre-estimation test

Portmanteau test for white noise

Portmanteau (Q) statistic 973.1473

Prob > chi2(4@) Q.8000

“*The Ljung-Box pre-estimation test shows p-value less than 0.01 which
indicates that null hypothesis (no ARCH effect) can be rejected.
Therefore the log of stock returns does have ARCH effect.
Estimation of ARCH Model
“*Example 2: Daily Stock Returns of Toyota Motors
** Given that there are arch effects of length at least equal to 10, let's estimate the
ARCH model:

OPG
™ Coef. Std. Err. z P>|z| [95% Conf. Interval]

™
_cons -86005281 - 0002261 2.34 Q@.019 -0800085 .9009711

ARCH
arch
Li. .1401461 .0211592 6.62 @.608 -0986748 - 1816173
L2. 1022892 -020831 4.91 @.600 -0614612 - 1431172
L3. .6779185 -0206332 3.78 8.608 -0374701 - 1183568
L4, -86738055 -0208365 3.54 8.608 .8329667 . 1146443
L5. -86496955 -0180745 2.75 Q@.006 -0142702 .9851209
L6. -6359586 -0152519 2.36 @.018 - 80060654 -9658518
L7. -8031011 .0169724 6.18 @.855 - .6301641 .9363663
L8. -0398799 -0151452 2.63 @.008 -0101958 .9695639
Lo. -6529347 .0129061 4.16 8.608 -0276391 - 0782303
L1e. .0315734 -0144532 2.18 @.629 -0032455 -9599012

_cons - 8808789 4.74e-06 14.96 8.608 - 8006616 - 9888882

Testing for the Stationarity of ARCH Coeff.
“*Example 2: Daily Stock Returns of Toyota Motors
** Do the coefficients indicate stationarity? i.e., Whether the estimated ARCH model
predicts a variance that is growing without bound?

. display [ARCH]L1.arch + [ARCH]L2.arch + [ARCH]L3.arch + [ARCH]L4.arch + [ARCH]L5.arch + [ARCH]L6.arc

> h + [ARCH]L7.arch + [ARCH]L8.arch + [ARCH]L9.arch + [ARCH]L1@.arch
. 60729438
“*The coefficients add to 0.61. Is this sufficiently far from one, statistically speaking?
. test [ARCH]L1.arch + [ARCH]L2.arch + [ARCH]L3.arch + [ARCH]L4.arch + [ARCH]L5.arch + [ARCH]L6.arch +
> [ARCH]L7.arch + [ARCH]L8.arch + [ARCH]L9.arch + [ARCH]L1@.arch = 1

( 1) [ARCH]L.arch + [ARCH]L2.arch + [ARCH]L3.arch + [ARCH]L4.arch + [ARCH]LS5.arch + [ARCH]L6.arch +

[ARCH]L7.arch [ARCH]L8.arch + [ARCH]L9.arch + [ARCH]L1@.arch = 1
+

chi2( 1) 98.19
Prob > chi2 8.8000

“*The hypothesis test verifies that 0.61 is sufficiently far from one. Thus, our estimated
ARCH model does not predict a variance that is growing without bound.
 Extensions-ARCH(q) Model
“* The ARCH(1) model can be extended in a number of ways.

“+ One obvious extension is to allow for more lags.

“* An ARCH(q) model would be:

hy = Yo + aye? 4 + Ae? >. .s + ag elt (12)

«* Testing, estimating, and forecasting, are natural extensions of the

case with one lag.

82
 Why are ARCH Models so popular?
“* The ARCH model has become a popular one because its variance
specification can capture commonly observed features of the time-series of
financial variables.

“* It is useful for modeling volatility and especially changes in volatility

over time.

“* The values of these series change rapidly from period to period in an

apparently unpredictable manner; we say the series are volatile.

“* There are periods when large changes are followed by further large
changes and periods when small changes are followed by further small
changes. 83
 Why are ARCH Models so popular?
“* The ARCH model is intuitively appealing because it seems
sensible to explain volatility as a function of the errors e,.

** These errors are often called “shocks” or “news” by financial

analysts.

“* According to the ARCH model, the larger the shock, the

greater the volatility in the series.

“* This model captures volatility clustering, as big changes in e,

are fed into further big changes in h, via the lagged effect e,..

84
ARCH Model-Drawbacks
“* ARCH models so far discussed can capture many of the
features of financial data, nevertheless it also requires many
lags in the variance equation.
“* The ARCH model requires estimation of the coefficients of many
autoregressive terms, which can consume several degrees of
freedom.
“elt is often difficult to interpret all the coefficients, especially if
some of them are negative.
“* Therefore, the literature suggests that an ARCH model higher
than ARCH (2/3) Is better estimated by the Generalized
Autoregressive Conditional Heteroscedasticity (GARCH) model.
GARCH Model
“* Bollerslev (1986) introduced a solution to this problem via a
generalization of the ARCH model and extended the ARCH
model to allowo/to have an additional autoregressive
structure within itself.
“*This new model, called a GARCH model, stands for
“generalized autoregressive conditional heteroskedasticity,”
or “generalized ARCH.”
“* The GARCH model allows us to capture the persistence of
conditional volatility in a parsimonious way.
 The GARCH Model—Generalized
ARCH
“* One of the shortcomings of an ARCH(q) model is that there are
q + 1 parameters to estimate.

“* If g is a large number, we may lose accuracy in the estimation.

“* The generalized ARCH model, or GARCH, is an alternative way

to capture long lagged effects with fewer parameters.

87
 The GARCH(1,1) Model
“* Consider Eq. (12) he = Ap + @yef_1 + Azef_p... +agef-g
“+ Let’s impose a geometric lag structure of the lagged coefficients of the
form: @,=@,
Bf |----------------------------
== 2a nnn nn nnn nnn nnn nnn (13
% hy = ay + aye7_1 + Byayep_ + Bpayeps 4 tenen-ne
nena (14)
«+ Add and subtract 6, a) and rearrange terms as follows:

% hy = (ao — Byao) + ay eF_1 + B1(@o + Ay ef_2 + Brayef_z +)

“+ Then, since hy_, = @ + @1e7_5 + B,a,e7_3 + Beajep 44°
“+ We may simplify to (12) hy = 6 + a,e7_, + By hy_1---------------------—- (15),
where 6 = (@—f1a) ee
 The GARCH(1,1) Model
“* This generalized ARCH model is denoted as GARCH(1,1).

“* The model is a very popular specification because it fits many

data series well.

“* It tells us that the volatility changes with lagged shocks (e?,_,) but
there is also momentum in the system working via h,.,.

“* One reason why this model is so popular is that it can capture

long lags in the shocks with only a few parameters.

89
Estimating Long-term Variance
. Given the equation for GARCH(1,1) of the form:
hy = 6+ ae7_4 + Byhe-1 = of =6+ aye7_4 + Bi O7-1 --TcTTT TT TTT TTT —(1)

*withd>0,0<a,<1,0<f, <1
“+ of is calculated from a long-run average variance rate, V,, as well as from e; and o;_1.
Thus, the above equation can be written as:
Sof
?
=yV, + ayef_1
_ 2
+ Byof_y
2
—----------—-------- —(2)
“swhere y is the weight assigned to V,, a, is the weight assigned to e7_,, and f, is the
weight assigned to of_,.
“* Because the weights must sum to one, i.e., y +a, +B, =17y=1-(a,4+ Bf).
.
“* The long-term variance V, can be calculated as: a
y= ath (3)
“* For a stable GARCH(1,1) model, we require a+$<1. Otherwise the weight
applied to the long-term variance is negative.
Estimating Long-term Variance
** Example: Suppose that a GARCH(1,1) model is estimated from daily data as numbered:
a7 = 0.00002 + 0.13e2., + 0.8602,
“*This corresponds to a, = 0.13, Bf; = 0.86, and 5 = 0.000002. Becausey = 1 — (a; + f;), t

—e
follows that y = 0.01 and because 6 = yV,, it follows that V, = ° = 0.0002.
y- 1-(a1+f3)
“In other words, the long-run average variance per day implied by the model is 0.0002.
“This corresponds to a volatility of ¥0.0002=0.014 or 1.4% per day.
“» Suppose that the estimate of the volatility on day t-1 is 1.6% per day so that o7_, = (0.016)?
0.000256, and that on day t-1 the market variable decreased by 1% so that e7_, = (0.01)?
0.0001.
“ Then:o2 = 0.00002 + (0.13 * 0.0001) + (0.86 * 0.000256)=0.00023516.
¢*The new estimate of the volatility is, therefore, V0.0002356=0.0153 or 1.53% per day.
+
+
Relationship between GARCH(1,1) & EWMA Model
Given the equation for GARCH(1,1) of the form:
hy = 6 + ayef_1 + Byht-1 9 of = 6 + aye7_1 + Bio, =yV, + ayef_1 + Biof_, -—— -(1)
* with >0,o0<a,<1,0<8,<1 &V, isthe long-run average variance rate.
“* Because the weights must sum to one, i.e., y +a@,+ 6; =17y=1-(a@,+f;).

“+ The long-term variance V, can be calculated as:o= BO (2)

yY 1-(@,+P1)

“* The exponentially weighted moving average (EWMA) model where the weights, a,;, decrease
exponentially as we move back through time.
& of= hogy + (1 —A)ef_1-------------------—------------------------------—- (3)
“+ where A is a constant between zero and one.
** Through recursive method, we can get
“ o2= (LA) Nee AO gy rnn nnn nnn nnn nnn ncn ncn ne ne nenens (4)
«* This implies the weights for the e; decline at rate \ as we move back through time. Each weight is A times
the previous weight.
¢* By comparing eq.(1) & (3), we observe that EWMA model is a particular case of GARCH(i,1) where y =
O, a, =1-A,and Bp, =)

** The GARCH(1,1) model is the same as the EWMA model except that, in addition to assigning weights
that decline exponentially to past e?, it also assigns some weight to the long-run average variance rate.
Relationship between GARCH(1,1) & EWMA Model
“+ The exponentially weighted moving average (EWMA) model where the weights, a;, decrease exponentially as we move back through time.
af = hogy + (1 — Nee yrnnnn-nn nnn nnn nnn nnn nnn nnn nn nnn nnn nnn nnn nnn n nnn (1)
** where A is a constant between zero and one.
“ Through recursive method, we can get
S oF= (1A) LEN hee tN OP gyrn n nnn nnn nnn nnn nnn nnn nnn (2)
** This implies the weights for the e; decline at rate A as we move back through time. Each weight is A times the previous weight.

&+,
Given the equation for GARCH(1,1) of the form:
hy = 6 + aye7_y + Byhy_y 7 of = 6 + aye?, + Biof_y = VV, + Me?_1 + Bio#, ——-— -(3)
“+ By comparing eq.(1) & (3), we observe that EWMA model is a particular case of GARCH(1,1) where y = 0, a, = 1-A, and f, =A.

«* Example: Based on equation(), suppose that A is 0.90, the volatility estimated for a market variable for day
t-1 is 1% per day, and during day t-1 the market variable increased by 2%.
«* This means that o7_, = (0.01)2= 0.0001 and e?7_, = (0.02)?= 0.0004.
+ Equation (1) gives of = (0.9*0.0001) + (1 — 0.9)*(0.0004)=0.00013
“* The estimate of the volatility for day t, 0,, is, therefore, V0.00013=0.0114 or 1.14% per day.
¢* Note that the expected value of e7_, is o7_, or 0.0001. In this example, the realized value of e7_, is greater
than the expected value, and as a result our volatility estimate increases.
“+ If the realized value of e7_, had been less than its expected value, our estimate of the volatility would have
decreased.
 Forecasting GARCH(1,1) Model
** The variance rate estimated at the end of day t-1 for day t, when GARCH(1,1) Is
used, Is:
of = 5 + ayef_1 + Byof_y = VV, + Qyef_1 + Biof_y ------—— —(1)
“+ with V, can be calculated as:°= eo ween nnn nn nnn nnn nnn nnn nnn nn nnn nanan nnnnn= (2)

* G2 = YV, + ayef_1 + Biof_, > of= (1 — a — B,)V, + aye#_1 + Brox, —— —(3)

* => of —V,= a (e¢_1—-V,) + Bi (o{_1-V_) ------------------— —(4)

¢* On day t+k in the future, we have

Of — Vp= oy (Cfsk- 1—Vi) + By (Of4."%-1-V_) ----------------- —(S)

#
PSS
Since,
i
E(ef,._1)
2
= Of¢x-1-
— ~2

** Hence,

E(f4n — Vi) = (@1 + BOE Gin-1-VL) —--- —(6) a

 Forecasting GARCH(1,1) Model-Contd...
The variance rate estimated at the end of day t-1 for day t, when GARCH{(1,1) is used, is:
+,
+

of = 6 + ayez_ + Biot, = YV, + ayef_y + Byoz_y —-------—---—-----— —()

= of —V, = a (ef_1-V,) + Bi (of1-V,) —-------—---------- —(4)

On day t+k in the future, we have

Oba — Vi = 1 (Cf4n-1 Vz) + Bie n-1-Vi) —---- 5 —(S)

Since, E(ef44~1) = Of+n-1-

Hence,
E(Of4~ — Vi) = (@1 + BE (6f4¢-1-Vi) ------------------- —(6)
Using this equation repeatedly yields

EC? — Vi) = (@1 + Bi)! (02 Wy) ~--- ===> == -(7)

This implies

E(of4n) = Vi + (ay + B1)* (Of -V_) —-—------------ 5 —(8)

95
 Forecasting GARCH(1,1) Model-Contd...
“ The variance rate estimated at the end of day t-1 for day t, when
GARCH(1,1) is used, ts:
+,
+

of = 6+ ae7 4 + Bog, =yV, + aef 4 + Bog, TTT —(1)

* E(otsi) = Vi + (@1 + Bi) (of -V,) ------------- —(8)

¢*¢ This equation forecasts the volatility on day t+k using the information
available at the end of day t-1.
“es In the EWMA model, a, + f,= 1 and equation (8) show that the
expected future variance rate equals the current variance rate.
“¢ When a, + 6, <1, the final term in the equation becomes progressively
smaller as k increases.

96
 Forecasting GARCH(1,1) Model-Contd...
Figure below shows the expected path followed by the variance rate for situations where the
current variance rate is different from long-run average variance rate, V,.
Variance Variance
Figure: Expected Path for the Variance Rate rate

(a) (b)

(a) When Current Variance Rate Is Above Long-Term Variance Rate and (b) When Current
Variance Rate Is Below Long-Term Variance Rate
As mentioned earlier, the variance rate exhibits mean reversion with a reversion level of the
long-run average variance rate, V, and a reversion rate of 1-a, — f, .
Our forecast of the future variance rate tends toward long-run average variance rate, V, as we
look further and further ahead.
This analysis emphasizes the point that we must have a, + 6, < 1 for a stable GARCH(1,1)
process.
When a, + £,>1, the weight given to the long-term average variance is negative and the 97
process is mean fleeing rather than mean reverting.
 Forecasting GARCH(1,1) Model-Contd...

” {E(of.n) = Vz + (ay + By)* (of -V,)}

«* Example: For the S&P 500 data say, a + § = 0.9935 and V, = 0.0002075.
Suppose that our estimate of the current variance rate per day is 0.0003(This
corresponds to 0,= V0.0003=0.01732 or 1.732% per day)
In 10 days, the expected variance rate is:

E(o#,10) = 0.0002075 + (0.9935)!° (0.0003 — 0.0002075) = 0.0002942 — —(1)

The expected volatility per day is 1.72%(since, 0,= V0.0002942=0.01715), still
well above the long-term’ volatility of 1.44% (since, 0o=
Vv 0.0002075=0.0144)per day.
“* However, the expected variance rate in 500 days is:

° E(d/,500) = 0.0002075 + (0.9935) (0.0003 — 0.0002075) = 0.0002110 — (2)

and the expected volatility per day is 1.45%(since, 0,= V0.0002110=0.0145),
very close to the long-term volatility.
98
The GARCH(p,q) Model

So Mean eq.: fF, = She,

Variance eq.:h, =a,+ >) an +>) Bik, ,

“* where,@g =yV; & V,= average of Long

Term(LT) variance

« Parameter constraints: a, > 0,

¥ ensuring variance to be positive 4% 29 Vi21,
B>0Vjz1

vy stationarity condition:
yi +4, <1

99
 The GARCH(p,q) Model

te Mean eq.: Fr, = hye,

Variance eq.:h, =a)+ >), +>), Bihy,

“* where,d@y = yYV; & V,= average of Long Term(LT)

variance.
** In GARCH (1,1) we assign some weight to the long-run
average variance rate:
v, =“
(l-a@,-f,)

“*Since weights must sum to equal to one (1.¢., «4-1 ),

100
Example: GARCH Model
“Example 2: Continuously Compounded Daily Stock
Returns of Toyota Motors (JAN 2010 - September 2020)
+° - 4

wo
O7
-.05
I

T T T T

0 1000 2000 3000

time
Example: GARCH Effect
“*Example 2: Daily Stock Returns of Toyota Motors (JAN
2010 - September 2020)
“* Checking volatility clustering (using a Ljung-Box test on
the unstandardized squared residuals):
+
+,

Portmanteau test for white noise

Portmanteau (Q) statistic 973.1473

Prob > chi2(460) 0.0000

“* The Ljung-Box test indicates that there is_ volatility

clustering: an ARCH or GARCH model would be useful.
Testing for GARCH Effect
“*Example 2: Daily Stock Returns of Toyota Motors
“* Checking volatility clustering: LM test
lags(p) chi2 df Prob > chi2

1 168.277 1 8.8000
2 231.034 2 8.8000
3 312.356 3 8.0000
4 316.160 4 8.8000
5 341.155 5 @.0000
6 342.251 6 Q@.0000
7 348.999 7 @.8000
8 350.410 8 @.0000
9 351.926 9 Q@.0000
18 360.629 198 Q.8000

H@: no ARCH effects vs. H1: ARCH(p) disturbance

“*The LM test shows p-value less than 0.01 which indicates that null
hypothesis (no arch effect) can be rejected. Therefore the log of stock
returns does have ARCH effect.
Estimation of GARCH Model
“*Example 2: Daily Stock Returns of Toyota Motors
“* Obtaining Optimal Lag-Length:
«> Following this, we need to determine what lag lengths would best fit
the ARCH/GARCH models.
“* Thus, we estimate p x(q +1) = 2x3 = 6 GARCH(p,q) models, and
estimate their AICs and BICs.
“*The results are summarized in the Table given in the next slide(with
df=p+q+2).
“*Both AIC & BIC select a GARCH(2,2) model. (Stock returns are quite
commonly found to resemble GARCH(2,2) processes.)
**Note: The better the independent variables in time series regression
model are in predicting the dependent variable, the more negative the
AIC/BIC becomes.
Estimation of GARCH Model
“*Example 2: Daily Stock Returns of Toyota Motors
** Obtaining Optimal Lag-Length:

1 0 Model N 11{null) 11(model) df AIC BIC

2,701 . -7899.942 3 -15793.88 -15776.18

1 1 Model N 11(null) 11(model) df AIC BIC

2,701 c 8005 .391 4 -16002.78 -15979.18

1 2 Model N 1](null) 11(mode1) dt AIC BIC

2,701 . 8006.499 5 -16803 -15973.49

2 O Model N 11(nul1) 11(mode1) df AIC BIC

2,701 . 7932.172 4 -15856.34 -15832.74

2 1 Model N 11(null) 11(mode1) df AIC BIC

2,701 . 8008.043 5 -16006.09 -15976.58

2 2 Model N 11(nul1) 11 (model) df AIC BIC

2,701 . 8016.189 6 -1602@.38 -15984.97
Estimation of GARCH Model
“*Example 2: Daily Stock Returns of Toyota Motors
**Let’s report the estimated GARCH(2,2) model:
“0°

OPG
™ Coef. Std. Err. z P>|z| [95% Conf. Interval]

T™
_cons - 8005065 -9002213 2.29 0.022 - 8000728 - 8809402

ARCH
arch
L1. -1175847 -0127686 9.21 0.800 -0925586 . 1426108
L2. -.1119591 -9123426 -9.07 0.800 -.1361501 - .987768

garch
L1. 1.710749 -047524 36.00 0.800 1.617604 1.803895
L2. -./178001 -9449972 -15.95 0.800 - .805993 - .6296072

_cons 2.40e-07 1.27e-@7 1.89 0.058 -8.46e-09 4.88e-07

Estimation of GARCH Model
“*Example 2: Daily Stock Returns of Toyota Motors
“¢ Is there no more detectable left-over volatility clustering?(Ljung-Box
test)
“*As a standard post-estimation step, we perform another Ljung-Box
test, this time on the standardized squared residuals. If there is no
detectable left-over volatility clustering, this indicates that the
estimated model is adequate.
Portmanteau test for white noise
+
+

4+
° a

Portmanteau (Q) statistic 25.5877

Prob > chi2(4@) 0.9627

“+ The Ljung-Box Q? test indicates that there is no significant volatility

clustering in the residuals.
“*That is, the model is able to capture the vast majority of the
conditional heteroskedasticity.
Testing for the Stationarity of GARCH
Coeff.
“*Example 2: Daily Stock Returns of Toyota Motors
** Are the coefficients significant?

“*The coefficients add to 0.998.

“*we test whether the estimated model is stationary?

chi2( 1) 3.39
Prob > chi2 8.0655

“*The hypothesis test verifies that only at 10% level of significance, the estimated
coefficient 0.998 is sufficiently far from one.
“* Thus, our estimated GARCH model does not predict a variance that is growing
without bound.
GARCH-t Model
“*Up until this point, our models have presumed that the errors were
drawn from a normal distribution.
“* Bollerslev (1987) developed a version of his GARCH model where the
errors come from at -distribution.
¢¢Distributions where there are more observations around the mean
and in the tails are said to be leptokurtic.
“* Bollerslev estimates the following model:
.
+°

Y; = Bot+¢

€r = Ofuyt

oF = a9 + 1e;_) +O
2 2 2

u~t(y),
GARCH-t Model
“* Bollerslev estimates the following model:
+
** Y; — Bo + Er

Er = Oru

2 2 2
O, =A + QE;_) + YO;_|
u~t(v),
“* For each variable, we will first establish that the variable likely has
GARCH effects and excess kurtosis, which justify estimating a
GARCH-t model.
*¢ Second, we estimate the model.
“*From the model, we generate the residuals and predicted variance.
“*We then show that the estimated GARCH-t model fits the data well,
by establishing that the standardized residuals and standardized
squared residuals do not exhibit any remaining GARCH effects or
excess kurtosis.
GARCH-t Model
¢* Example 2 Revisited: Daily Stock Returns of Toyota Motors
+ . .
** Portmanteau test for white noise

Portmanteau (Q) statistic = 973.1473

Prob > chi2(4@) = 8.0000

se variable kurtosis

™ 6.71539

**GARCH effects seem to be evident, and the large kurtosis implies

that errors from a t -distribution would yield a better fit than a
normal distribution.
GARCH-t Model
“* Example 2 Revisited: Daily Stock Returns of Toyota Motors
+.
+ OPG
™ Coef. Std. Err. z P>|z| [95% Conf. Interval]

™
_cons - 9003796 - 8802069 1.82 8.069 - ,0800301 - 0007893

ARCH
arch
Li. -0885677 - 9131063 6.76 8.000 - 0628798 -1142556
¢

garch
Li. - 8880973 -@157006 56.56 8.000 -8573247 - 9188699

_cons 4.67e-06 1.30e-06 3.60 @.000 2.13e-06 7.21e-06

/1indfm2 1.445435 . 1854437 7.79 8.000 1.081972 1.808898

df 6.243697 . 786967 4.950492 8.103717

ae GARCH effects seem to be evident, and the large kurtosis implies

t nat errors from a t -distribution would yield a better fit than a
normal distribution.
GARCH-t Model
“* Example 2 Revisited: Daily Stock Returns of Toyota Motors
“* Did GARCH(1,1)-t fit the data well?
“*To answer this, we calculate the standardized residuals. We then
subject the standardized residuals to the same tests (Q, Q?, and
kurtosis) to see whether we have properly accounted for time-
varying volatility and thick-tailed returns.
* |/Portmanteau test for white noise

Portmanteau (Q) statistic 21.3934

Prob > chi2(4@) 8.9930

“° variable kurtosis

eSqrtVv 4.659346
GARCH-t Model
“* Example 2 Revisited: Daily Stock Returns of Toyota Motors
“+ What about the conclusion?
“*There is no left-over autocorrelation in the standardized squared
residuals, so we draw the conclusion that GARCH(1,1) model
with t-errors describes the dynamics of the stock returns quite
well.
Portmanteau test for white noise

Portmanteau (Q) statistic 21.3934

Prob > chi2(4@) 8.9930
*,°
+

variable kurtosis

eSqrtVv 4.659346
GARCH-M or GARCH-IN-MEAN
+¢There are no free lunches in economics.
“*This truism also holds in finance: higher rewards require higher
risks.
**No one would undertake additional, unnecessary risk unless they
were compensated with the prospect of additional returns.
**When purchasing stocks, for example, risk is a direct function of
the conditional variance of the underlying stock.
“*A regression that was attempting to estimate the returns on a
stock must, therefore, have a term related to the conditional
variance (07) in Its mean equation.
“* In GARCH-M (otherwise known as GARCH-in-mean) models,
the variance is an explicit term in the mean equation:
GARCH-In-Mean and Time-Varying Risk
Premium

“* Thus, the popular extension of the GARCH model is the

“GARCH-in-mean” model. This model supports the usual

view in financial markets—high risk, high return.

‘. nnn
nnn nnn nnnnnnnnn
Ve = Bo + Og 4 Cy nnnnnnnnn (16)

n-nonane
(0, hy )---------
e+ |I¢_-4~N nnn
------- (17)

h, = 6 + ayef_, + Byhy-1,
ao 0>0,0<a,<1,0<f,<1 OT —(18)
116
GARCH-In-Mean and Time-Varying Risk
Premium
¢* Thus, “GARCH-in-mean” model: yz = fo + @hz + €¢----------- (16)

“* This equation is the mean equation; it now shows that the

effect of the conditional variance on the dependent variable.
In particular, note that the model postulates that the
conditional variance h, affects y, by a factor @.

“* The other two equations as before.

hp = 6 + aye7_, + Brhe-1,
0>0,0<a,<1,0<f,<1 -—-—- —(18) 117
GARCH-M or GARCH-IN-MEAN
“*In this example, we will explore the performance and implications of
the GARCH-M model in predicting excess returns in the equity
markets.
“*The reason why risk and return must balance each other is because
people are generally averse to risk.
¢* According to the standard Capital Asset Pricing Model(CAPM), there
is a linear relationship between mean return and variance; this
relationship is equivalent to the coefficient of relative risk aversion.
“* In GARCH-M models where the dependent variable y, is the mean
equity return, 6 estimates the linear relationship between mean return
and variance, and is therefore also an estimate of the coefficient of
relative risk aversion.
“*Risk averse investors will require higher average returns to
compensate for volatility, and will therefore have higher Qs.
GARCH-M or GARCH-IN-MEAN
“*Example 2 Revisited: GARCH-M in Stock Index Returns
“Daily Stock Returns of Toyota Motors
¢ In this example, we will explore the performance and implications of the GARCH-M
model in predicting excess returns in the equity markets. The reason why risk and return
must balance each other is because people are generally averse to risk.

OPG
TM Coef. Std. Err. Zz P>|z| [95% Conf. Interval]

TM
_cons .0003832 .0004501 0.85 0.395 -.0004989 -0012653

ARCHM
sigma2 1.006729 2.813329 0.36 0.720 -4,507294 6.520752

ARCH
arch
Lil. .0842369 .0073645 11.44 0.000 .0698028 .O0986711

garch
Lil. -8898362 .0102227 87.05 0.000 .8698001 .9098724

_cons 4.81le-06 9.10e-07 5.29 0.000 3.03e-06 6.60e-06

GARCH-M or GARCH-IN-MEAN
“*Example 2 Revisited: GARCH-M in Stock Index Returns
+
2°

OPG
TM Coef. Std. Err. P>|z| [95% Conf. Interval]

TM
_ cons -0003832 .0004501 0.85 0.395 -.0004989 -0012653

ARCHM
sigma2 1.006729 2.813329 0.36 0.720 -4,.507294 6.520752

ARCH
arch
L1. .0842369 .0073645 11.44 0.000 .0698028 -O986711

garch
Ll. - 8898362 .0102227 87.05 0.000 . 8698001 9098724

_ cons 4.81e-06 9.10e-07 5.29 0.000 3.03e-06 6.60e-06

«*\We estimate the coefficient of relative risk aversion to be 1.006,

but insignificant. On the other hand, mean term is significant.
«In general, the evidence supporting CAPM has been mixed.
Asymmetric Responses in GARCH
“*Let’s discuss a few variations to the standard GARCH model
which are designed to capture an asymmetric response to new
information.
“In finance, the arrival of new information is usually considered to
be an unexpected event and Is therefore a component of the error
term.
**Many researchers, and investors, for that matter, have noticed that
volatility can rise quite rapidly and unexpectedly, but it does not
dampen quite as quickly as it rises.
“*That is, there is an asymmetric volatility response to the error
term.
*“*The models that we discuss attempt to capture this phenomenon
in slightly different ways.
Asymmetric Responses in GARCH
= The leverage effect refers to the generally observed negative
correlation between an asset return and its volatility
changes.

= Another significant development is to allow the conditional

distribution of the error term to be non-normal.

= Because empirical distributions of financial returns generally

exhibit fat tails and clustering around zero, the t-distribution
has become a popular alternative to the assumption of
normality.
122
 innovate achieve

Thank You!!!

BITS Pilani, K K Birla Goa Campus