11/25/2020

Financial Risk Measurement and Management

Session 9

Dilip Kumar 1

Volatility forecast: GARCH Estimation

The GARCH (1,1) model can be summarized as:
= , ~ 0,1
=+ +
The returns are conditionally normally distributed, i.e., return for period
t+1 follows normal distribution with mean 0 and standard deviation .
Note, is based on information available up to time t.
It is also dependent on the three parameters : , ,
Estimate the GARCH model for the period under consideration using R.

Dilip Kumar 2

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Comparison of Variance Forecasts

0.2 0.003

0.15 0.0025

0.1
0.002
0.05
0.0015
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
0.001
-0.05

-0.1 0.0005

-0.15 0
Return 252D 126D RM GARCH

Dilip Kumar 3

Value at Risk: RiskMetrics & GARCH

800

600

400

200

0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
-200

-400

-600
PnL HS VaR 252D VaR 126D VaR RM VaR GARCH VaR

Dilip Kumar 4

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Value at Risk: RiskMetrics & GARCH

Now, let us compare Value at Risk number obtained using
various methodologies (for Nifty)
Comparision of VaR Methodologies: Breaches
Historical Simulation 146 (out of 2816) 5.185%
252D Variance 145 (out of 2816) 5.149%
126D Variance 147 (out of 2816) 5.220%
RM Model 150 (out of 2816) 5.327%
GARCH Model 134 (out of 2816) 4.758%

From the above table it is clear that, for the current example, GARCH
does a better job in terms of forecasting volatility for VaR estimates
Note, the results are typical of most scenarios. However, it cannot be taken as a
statement of fact; it needs to be verified for different settings.
Dilip Kumar 5

rugarch
ugarchspec: For specifying GARCH family of models

Variance models: sGARCH, eGARCH, gjrGARCH

Distribution.model: “norm”,”snorm”,”std”,”sstd”,”ged” “sged” etc.
ugarchfit: For fitting the specified GARCH model

Dilip Kumar 6

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Caveat: We are still in Normal world!

That returns are normally distributed is an assumption made by
many standard models. What explains the popularity of this
assumption?
Its popularity stems not from its accuracy, but from its simplicity
It allows for easy quantification of VaR at any confidence level, simply
by multiplying the standard deviation of returns by the required factor
(and of course, the portfolio value)
All the models that we have discussed till today are based on
normality. They just differ in their estimation of volatility. How
much of a difference does it make in terms of the underlying
normality assumption?
Dilip Kumar 7

The GJR-GARCH model

Due to Glosten, Jaganathan and Runkle
The GARCH (1,1) model can be written as:
=+ + +
where It = 1 if Rt < 0
= 0 otherwise

For a leverage effect, we would see  > 0.

We require  +   0 and   0 for non-negativity.

Dilip Kumar 8

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EGARCH model
Suggested by Nelson (1991). The variance equation is given by
2
log = + − + log +

Advantages of the model

- Since we model the log(t2), then even if the parameters are negative, t2
will be positive.
- We can account for the leverage effect: if the relationship between
volatility and returns is negative, , will be negative

Dilip Kumar 9