12/4/2020

Financial Risk Measurement and Management

Session 12

Dilip Kumar 1

Method III: The GARCH Approach

If we consider a multivariate time series rt
= , ~ 0, Σ
The conditional covariance matrix of returns is given by Σ .
Multivariate volatility modelling is concerned with the evolution
of Σ .
The conditional covariance matrix can be written as:
Σ =
Where D is a diagonal matrix consisting of conditional volatilities of
elements in the return series and  is the conditional correlation
matrix. It is symmetric with unit diagonal element.

Dilip Kumar 2

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 12/4/2020

Method III: The GARCH Approach

From a risk modeler’s perspective, the conditional volatility
forecasts can either be
Assumed to have been already estimated through univariate GARCH
techniques. In this case, the only thing that needs to be modeled is the
evolution of conditional correlation.
Estimated jointly with the conditional correlations. This is more
intensive process, as we will see shortly.
We will work with a bivariate case; the methodology easily extends to
higher dimensions.

Dilip Kumar 3

Method III: The GARCH Approach

In the bi-variate case, we start by defining a 3-dimensional
vector, t+1:
Φ = , , , , ,
Note that t+1 is determined by information available at time t.
We will consider two basic models:
Constant conditional correlation (CCC) model
Dynamic conditional correlation (DCC) model

Dilip Kumar 4

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Method III: The GARCH Approach

Let us start with the simplest specification: constant conditional correlation
t+1 is then specified thusly
, = + , + ,
, = + , + ,
Also, , is assumed to be constant.
Estimate the Constant Conditional Correlation model for Infosys and SBI
Use these estimates to calculate VaR and the breach percentage.
A key econometric aside: We are assuming that the conditional volatility
processes are not dynamically related; i.e., , is affected neither by
, nor , . These dynamic effects can be easily incorporated; however,
their estimation requires a more robust statistical package (and not EXCEL)

Dilip Kumar 5

Method III: The GARCH Approach

Let us now look at the dynamic conditional correlation model
t+1 is then specified thusly
, = + , + ,

, = + , + ,
−1
, =
+1
, ,
= + + ,
, ,

Dilip Kumar 6

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Method III: The GARCH Approach

Estimate the Dynamic Conditional Correlation model for Infosys and SBI
Use these estimates to calculate VaR and the breach percentage
With MS-Excel, one cannot estimate the DCC model for this dataset. The
joint estimation requires estimation of nine free parameters!
One alternative is to use a proper statistical package
Let us momentarily assume that even with a proper statistical package, joint
estimation turns out to be unviable.
What can a risk modeler do under such a circumstance?

Dilip Kumar 7

Method III: The GARCH Approach

Remember the conditional covariance matrix can be reparameterized as
Σ =
As discussed earlier, instead of jointly estimating all parameters, we can
assume that , the conditional volatility forecasts, have been estimated
independently using, say, GARCH(1,1). We can then focus on estimating just
the evolution of .
For Infosys and SBI data, estimate a dynamic conditional correlation model
Step 1: Fit a GARCH(1,1) model to both Infosys and SBI return series
Step 2: Using these conditional volatility estimates, estimate a dynamic conditional
correlation model.
Use these estimates to calculate VaR and the breach percentage.

Dilip Kumar 8