FORECASTING VOLATILITY WITH SMOOTH TRANSITION EXPONENTIAL
SMOOTHING IN COMMODITY MARKET
By
TAN SUK SHIANG
Graduation School of Management,
University Putra Malaysia, Degree of Master of Science
2010
2
TABLE OF CONTENTS
CHAPTER 1 INTRODUCTION…..……………………………………………………. 3
1.1 Overview of the study ……………………………………………………………………………………………………..3
1.2 Problem Statements …………………………………………………………………………………………………………6
1.3 Objective of the Study ……………………………………………………………………………………………………..6
CHAPTER 2 LITERATURE REVIEW ………………………………………………7
2.1 Introduction of Smooth Transition Exponential Smoothing (STES) …………………………………7
2.2 Previous studies about Crude oil ………………………………………………………………………………………9
2.3 Previous studies about gold ………………………………………………………………………………………….…12
2.4 Previous Studies about the relationship between gold and crude oil ………………………….……14
2.5 Realized Volatility ………………………………………………………………………………………………………...15
2.6 SUMMARY ……………………………………………………………………………………………………………….….16
CHAPTER 3 DATA AND METHODOLOGY ……………………………………..….16
3.1 Data ………………………………………………………………………………………………………………………….…….16
3.2 Methodology …………………………………………………………………………………………………………….…….17
3.2.1 General …………………………………………………………………………………………………………….……..17
3.2.2 Ad Hoc Volatility models ………………………………………………………………………………….…….19
3.2.2.1 Adaptive Smooth Transition Exponential Smoothing (STES) …………………….……….19
3.2.3 GARCH Models …………………………………………………………………………………………….………..22
3.2.3.1 GARCH (1,1) …………………………………………………………………………………………….………..22
3.2.3.1.1 Regressor …………………………………………………………………………………………….…………23
3.2.3.1.1.1 Crude oil Vs Gold …………………………………………………………………….….……..….23
3.2.3.2 IGARCH ………………………………………………………………………………………………….………….24
3.2.3.3 POWER ARCH (PARCH) ……………………………………………………………………….………….24
3.2.3.4 EGARCH ……………………………………………………………………………………………………….……25
3.2.3.5 GJR (Threshold GARCH) ……………………………………………………………………………….…..26
CHAPTER 4 Empirical Results & Discussion ……………………………………….….27
4.1 InSample Estimation ……………………………………………………………………………………………………..27
4.2 OutSample Forecasting results ……………………………………………………………………………………….30
CHAPTER 5 CONCLUSION AND IMPLICATION ………………………………….35
3
CHAPTER 1 INTRODUCTION
1.1 Overview of the study
In recent years, commodities have receiving increase attention from investors, traders, policy
makers, speculators and producers. The significant large investments have flowing into the
commodity markets, particular crude oil and gold. This is mainly driven by the flare up of
price especially crude oil of which had reached the near recordhigh in July 2008, increase in
their economic uses and inelastic high global demand resulted from the speedily increase of
global population. Commodity markets exhibit different characteristics from financial
markets. It is well known that, the supply of commodities are highly inelastic and the large
demand shocks can easily lead to big swings in spot and future price over the short run.
Hence, it is right to say that, commodities are susceptible to sudden and large volatility
swings, especially crude oil (Wilson et la., 1996). Volatility is a measure of average deviation
from the mean. In the financial markets, volatility is associating with risk and uncertainty
which are the key attributes in investing, option pricing and risk management. Volatility
plays the same role in commodity markets for commodity investment portfolio determination,
physical commodities pricing and risk management. Since the magnitude of volatility in
commodity markets is much higher than financial market, the risk associate with investment
is relatively high. To ensure the risk is well managed, it is crucial and fundamental to predict
the volatility as accurate as possible.
The volatility forecasting models being used so far in commodity markets are implied
standard deviation (Namit, 1998), ARCHtype models (Foong and See, 2002; Giot and
Lauretn, 2003; Chin W.C, 2009), asymmetric threshold autoregressive (TAR) model (Godby
et al., 2000), and artificial based forecast methods (Fan et al., 2008; Moshiri, 2004); CAViaR
approach (Huang et al., 2009) However, the complexity of the model specification does not
4
guarantee high performance on outperformed outofsample forecasts. Sadorsky (2006)
found that the outofsample forecast of a single equation generalized ARCH model is more
superior to those of state space, vector autoregression and bivariate GARCH models in
predicting the price of petroleum futures. Among the ample forecasting methods, no model is
a clear winner. Different methods may be capturing the information set differently, and which
method is superior may depend on market conditions. In this paper, we would like to
introduce a new adaptive method namely Smooth Transition Exponential Smoothing (STES)
which was recommended by James W. Taylor in 2004. This approach was used in equity
markets with encouraging results. However, to our knowledge, it has not yet been applied in
commodity markets.
With STES method, we are going to examine the outofsample volatility forecasts for crude
oil and gold. This method allows the smoothing parameter to vary as a logistic function of
userspecified variables. The parameters in this method will then be optimised by minimising
the sum of squared insample onestepahead prediction errors, where prediction error is
defined as the difference between realized and forecast volatility. In our empirical work here,
we propose to use square error term and realized volatility separately as actual variance to
optimise the prediction error, we compare the accuracy of volatility forecasts between these 2
different types of prediction errors. Since the daily data is available, we estimate the
parameters for daily prediction error and sum up 5day prediction error on weekly basis to
compare with actual weekly volatility forecasts. The predictive power of STES will then
compare with variants of GARCH models with the predictive criterion of RMSE.
In view of the higher volatility found in the commodity markets, we would like to examine
every possible information that contribute to the return volatility of commodity products in
5
attempt to improve the prediction accuracy. In this premises, we proposed to examine
significant impacts of a crude oil return to the return volatility of gold. The purpose of this
examination is to test the role play by the return of crude oil as a regressor to improve the
return volatility forecasts of gold. We would like to find out does the information of gold can
explain the changes in the return volatility of crude oil and vice versa. The reason lies for this
test is that crude oil and gold has the most powerful historical commodity interrelationships.
Gold and crude oil prices tend to rise and fall in synchronicity with one another. One reason
is that, historically, oil purchases were paid for in gold. Even today, a sizeable percentage of
oil revenue ends up being invested in gold. As oil price rise, much of the increased revenue,
considered as surplus to current needs, is invested, and much of this is invested in gold or
other hard assets. Another reason is that rising oil prices place upward pressure on inflation
and this enhances the appeal of gold because it acts as an inflation hedge. Hence, crude oil
and gold are the most widely traded commodities. They are commodities that priced in US
dollar and are included in the commodity portfolios of most serious individual and
institutional investors. Investors switch between oil and gold or combine them in diversified
portfolios.
In the next section, we review the literature of volatility forecasting methods which have been
used in commodity markets; introduce the application of new adaptive exponential smoothing
methods. In the third section, we will describe the data and methodologies use in this study.
The forth section, we exhibit insample and outofsample empirical results to compare the
forecasting accuracy of the new method with variants GARCH models. The final section
provides a summary and concluding comment.
6
1.2 Problem Statements
To initiate the study, there are some problem statements which needed to be structured in
order to define the scope of research.
 Smooth Transition Exponential Smoothing (STES) a newly developed model which
was modelled by James W. Taylor (2004). It has been proven performed well with
encouraging results for 8 stock indices. This model has never been applied in
commodity market. Can Smooth Transition Exponential Smoothing (STES) models
forecast equally well in commodity market and hence superior than variants GARCH?
 Highfrequency data provide more accurate estimates for actual volatility and provide
more accurate volatility forecasts than lowfrequency data. Can weekly realized
volatility which constructed from the accumulation of 5 trading days squared errors
terms act as a better proxy of actual variance to outperformed actual weekly squared
error terms?
 To what extent does crude oil or gold price impacted to the return volatility of each
other? Can the existence of gold explain the changes in return volatility of crude oil
and vice versa?
1.3 Objective of the Study
• The objective of this paper is to compare the predictive accuracy of ad hoc method
namely Smooth Transition Exponential Smoothing (STES) with statistical models
namely the variants GARCH models in the commodity market.
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• To investigate the information contains in highfrequency data explainable to the
accuracy of volatility prediction.
• To investigate the significant impact of ε
t,CO1
of crude oil as regressor to the return
volatility of gold and vice versa. Does existence of crude oil return improve the
accuracy of return volatility forecasting for gold, and vice versa.
CHAPTER 2 LITERATURE REVIEW
2.1 Introduction of Smooth Transition Exponential Smoothing (STES)
Smooth Transition Exponential Smoothing (STES) model is an extension forecasting
volatility model to the established adaptive exponential smoothing model meant to improve
its application. It has overcome the problem of deliver unstable forecast found in established
adaptive exponential smoothing model. At the initial development stage of adaptive
exponential smoothing model, there have been many different attempts to avoid instability of
forecasts by enabling the exponential smoothing parameters to adapt over time according to
the characteristics of the series. This is conformed to William (1987) suggestion that only the
smoothing parameter for the level should be adapted in order to avoid instability. Among all
the proposals presented, there is no consensus as to the most useful adaptive approach except
Trigg and Leach (1967) model has been recognized as a best known and most widelyused
procedure. Their method defines the smoothing parameters as the absolute value of the ratio
of the smoothed forecast error to the smoothed absolute error. Unfortunately, it sometime still
generates unstable forecasts. The instability of forecasts still cannot be overcome thoroughly.
8
Hence following from the finding of weakness lied in the established adaptive model, James
W. Taylor (2004) has developed a new approach namely Smooth Transition Exponential
Smoothing (STES). He proposed the use of logistic function of a userspecified as adaptive
smoothing parameter. It is analogous to that used to model the timevarying parameter in
smooth transition model (See Terasvirta, 1998). STES adopts the essence of smooth
transition models where at least one parameter is modelled as continuous function of a
transition variable. The sign ε
t1
and size ε
t1
of past shocks were proposed to be used as
transition variables in STES which have also been used in smooth transition model. In the
empirical studies of James W. Taylor (2004), the reason for the sign of past shocks has been
used as a transition variable is to model the asymmetry in stock return volatility, known as
the “leverage effect”. This asymmetry is characterised by the tendency for negative returns to
be followed by periods of greater volatility than positive returns of equal size. The size of the
past shocks has also been used as a transition variable in order to allow a more flexible
modelling of the dynamics of the conditional variance. In short, Smooth Transition
Exponential Smoothing (STES) is the integration of the logistic function of a user specified
variable as adaptive smoothing parameter which analogous to smooth transition with the
simple exponential smoothing model.
In the empirical works of James W. Taylor(2004), the results have not only exhibited the
solution to unstable forecasts, but it also proved that STES has outperformed fixed parameter
exponential smoothing and variants of GARCH models in forecasting return volatility of 8
major stock markets namely Amsterdam (EOE), Frankfurt (DAX), Hong Kong (Hang Seng),
London (FTSE100), New York (S&P 500), Paris (CAC40), Singapore (Singapore all shares)
and Japan (Nikkei). In view of the excellent performance of STES in stock markets, we
would like to study its performance in commodity markets in this paper. If it excellent
9
performance is proven in commodity market too, we then confident to extend its application
to the wider fields other than financial markets.
2.2 Previous studies about Crude oil
Perry Sadorsky 2006 has modelled and forecasted the crude oil volatility by using a fiveyear
rolling window. The daily ex post variance is measured by squared daily return which is
conformed to approach of Brailsford and Faff, 1996; Brooks and Persand, 2002. Under the
rolling window, the estimation period is rolled forward by adding one new day and dropping
the most distant day. In this way the sample size used in estimating the models stays at a
fixed length and the forecasts do not overlap. Thus there are 2651 oneday volatility forecasts
for each oil future prices, included crude oil, heating oil unleaded gas and natural gas. A
number of univariate and multivariate models are used to model and forecast petroleum
future price volatility. The models applied included random walk, historical mean, moving
average, exponentially smoothing (ES), linear regression model (LS), autoregressive model
(AR), GARCH (1,1), threshold GARCH, GARCH in mean and bivariate GARCH. The out
ofsample forecasts are evaluated using forecast accuracy tests and market timing tests. No
one model fits the best for each series considered. Most models out perform a random walk
and for most models there is evidence of market timing. The TGARCH model fits well for
heating oil and natural gas volatility and GARCH model fits well for crude oil and unleaded
gasoline volatility. The result of crude oil was conformed to Bollerslev et al (1992), Jui
Cheng H., MingChih L., HungChun L., (2008). There are some other articles in the energy
literature have using GARCH models and its variants also to addressed the modelling and
forecasting of crude oil market volatility, such as Adrangi et al., 2001, Cabedo and Moya,
2003, Fong and See, 2002; Giot and Laurent, 2003; Morana, 2001; Narayan and Narayan,
2007; Sadeghi and Shavvalpour, 2006; however, there is currently no general consensus on
10
the modelling and forecasting of crude oil volatility, because the standard GARCH models
cannot capture persistence in the volatility of crude oil price.
Day and Lewis studied the predictive power of GARCH (1,1), EGARCH(1,1), implied
volatility and historical volatility for crude oil based on data from November 1986 to March
1991. They estimated the realized volatility on outofsample forecast by using OLS
regression, check the unbiasedness of the forecast by referring to coefficient estimates; and
evaluate the relative predictive power with reference to R
2
value. For the accuracy of outof
sample forecasts is compared using Mean Forecast Error (ME), Mean absolute Error (MAE)
and Root Mean Square Error (RMSE). From the outofsample results shown that, GARCH
forecasts and historical volatility do not add much explanatory power to forecast based on
implied volatilities. This would means that each method did not contribute unique
information not contained in the other in the composite forecast by using implied volatility
and GARCH model. They concluded that implied volatility alone is sufficient for market
professional to predict nearterm volatility.
Duffie and Gray (1995) applied GARCH (1,1), EGARCH(1,1) bivariate GARCH, regime
switching, implied volatility and historical volatility predictors to compared with the realized
volatility to construct insample and outofsample forecast volatility in the crude oil, heating,
oil and natural gas markets. The forecast accuracy was evaluated with the criterion of RMSE.
The result shown that, implied volatility yields the best forecasts in both the insample and
outofsample cases, and in the more relevant outofsample case, historical volatility
forecasts are superior to GARCH forecasts.
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The empirical studies of Sang H. Kang, SanMok Kang and SeongMin Yoon, 2009 were
focused on investigates the efficacy of a volatility model for 3 crude oil markets – Brent,
Dubai and West Texas Intermediate (WTI). They used CGARCH, FIGARCH, GARCH and
IGARCH to assess persistence in the volatility of the three crude oil prices. They presented
that the estimated value of the persistence coefficient α + β are quite close to unity in the
standard GARCH (1,1) model, a fact that favours the IGARCH (1,1) specification. As the
IGARCH (1,1) model nests the GARCH (1,1) models, the estimates of the IGARCH (1,1)
model are quite similar to those of the GARCH (1,1) model. In the case of CGARCH (1,1)
model, the estimated α + β is smaller than that of the GARCH model, thereby indicating that
the shortrun volatility component is weaker. Whereas in the case of FIGARCH (1,d,1) model
describe volatility persistence for the three crude oil returns. Hence, unlike the GARCH and
IGARCH models, the CGARCH and FIGARCH models are able to capture volatility
persistence due to the insignificance of diagnostic tests. Therefore, the CGARCH and
FIGARCH models are able to capture persistence in the volatility of crude oil. As a result,
CGARCH and FIGARCH models generate more accurate outofsample volatility forecasts
than do the GARCH and IGARCH models.
Chin Wen Cheong (2009) investigated the timevarying volatility of two major crude oil
markets, the West Texas Intermediate (WTI) and Europe Brent. A flexible autoregressive
conditional heteroskedasticity (ARCH) models is used to take into account the stylized
volatility facts such as clustering volatility, asymmetric new impact and long memory
volatility among others. The empirical results indicate that the intensity of longpersistency
volatility in the WTI is greater than in the Brent. It is also found that the WTI, the
appreciation and depreciation shocks of the WTI have similar impact on the resulting
volatility. However, a leverage effect is found in Brent. Although both the estimation and
12
diagnostic evaluations are in favour of an asymmetric long memory ARCH model, only the
WTI models provide superior in the outofsample forecasts. On the other hand, from the
empirical outofsample forecasts, it appears that the simplest parsimonious generalized
ARCH provides the best forecasted evaluations for the Brent crude oil data.
Other than variants GARCH models as forecasting model, Christopher J. Neely, 2003, tested
the predictive power of implied volatility. He conform the consistency of implied volatility as
a biased predictor of realized volatility of gold future to the findings in other markets. There
is no existing explanation – including a price of volatility risk – can completely explain the
bias, but much of this apparent bias can be explained by persistence and estimation error in
implied volatility. Statistical criteria reject the hypothesis that implied volatility is
informational efficient with respect to econometric forecasts. But delta hedging exercise
indicates that such econometric forecasts have no incremental economic value. Thus,
statistical measures of bias and information efficiency are misleading measure of the
information content of option prices.
2.3 Previous studies about gold
On the examination of the literature for gold, it is surprising to report that little research has
been carried out on gold volatility forecasting. Most of the gold studies did not relate to
volatility forecasting. E.g. ChristieDavid et al (2001), examination of macroeconomic news
release on gold and silver prices; Cai et al (2001), undertook an analysis of the effect of 23
macroeconomic announcements on the gold market, the market is impacted by employment
reports, GDP, CPI and personal income. Both studies were using gold futures intraday data;
Edel et al. (2007) investigated macroeconomic influences on gold using the asymmetric
power GARCH model (APGARCH); Lucia Morales (2007), using EGARCH to investigate
the nature of volatility spillover between precious metals returns (included gold, platinum,
13
palladium and silver) over the 1995 – July 2007 period. The results evidence the existence of
volatility persistence and spillovers among four precious metal return during price
fluctuations and strong impact of information on volatility from one market to another market.
Batten and Lucey (2006) analysed the volatility structure of gold, trading as a future contract
on the Chicago Board of Trading using intraday (high frequency) data from January 1999 to
December 2005. They used GARCH modelling and the Garman Klass estimator. They found
significant variations across the trading days consistent with microstructure theories, although
volatility is only slightly positively correlated with volume when measured by tickcount.
In the empirical studies of Ali M. Kuntan and Tansu Aksoy (2004), they employed a leadlag
model within a GARCH framework, allowing them to better capture observe timevarying
volatility of gold in emerging market, Istanbul Gold Exchange. By using standard GARCH
(1,1) model, gold returns were used to estimate the time varying variance of returns. They
include public information arrival data in both the mean and variance equations. The
statistical tests results (not reported) indicated no significant serial correlation in gold returns.
The result shows that the estimated ARCH and GARCH terms are statistically significant to
the 5 percent significance level or better. The only significant public information variable is
the industrial production with a lead effect. The sign is negative, indicating that the
conditional volatility of returns declines in response to such news. The diagnostic tests
reported suggest that the estimated model does not suffer from any serial correlation up to ten
lags. In addition, the estimated Qsquared tests indicate that the reported GARCH (1,1)
models well capture the observed timevarying volatility behaviour of gold market returns.
14
2.4 Previous Studies about the relationship between gold and crude oil
In this section, we are going to review the literature about gold volatility related to crude oil
price. The interest rate model proposed by Brenner, Harjes, Kroner (1996) (BHK hereafter) is
applied here to investigate gold volatility. Besides that, GARCH models have become
common tools for the time series heteroskedastic models; however, the data transformation
involved the use of a squared term. Ding, Granger, and Engle (1993) suggested a new class of
GARCH models, called the power GARCH (PGARCH) model, where the power term is
flexible rather than fixed arbitrarily. The PGARCH structure is flexible enough to nest both
the conditional variance (Bollerslev, 1986) and the conditional standard deviation (Taylor,
1986) models as particular cases. In the empirical results of Cheng, Su and Tzou (2009)
shown that, the effects of crude oil volatility on gold return and volatility are emphasized by
observing the coefficient φ1 to φ4. Most of them are significantly negative and it means that
the crude oil volatility is negative relative to either gold return or volatility. The higher the
crude oil volatility, the lower the gold return and volatility. They find that only the jump
volatility of crude oil exhibits a negative relationship to the gold return, while the GARCH
volatility of the crude oil does not. However, as to the gold volatility and both crude oil
volatility are significantly negative related to the gold volatility.
In the empirical study of Melvin and Sultan 1990, the shown that the political unrest and oil
price changes in South African are significant determinants of the conditional variance of
spot price forecasts errors (volatility) of gold futures. They applied ARCHinMean models
to estimate the forecast errors of gold futures. The empirical results shown that, the term
e
t1
2
is significant and positive in the spot price equation. The coefficient of the ARCH
e
t1
2
and the GARCH σ
t1
2
terms in the conditional variance equation indicate that GARCG
modelling of the time varying risk premium is appropriate.
15
2.5 Realized Volatility
In recent year, with the availability of highfrequency financial market data modelling
realized volatility has become a new and innovative research direction. The construction of
“observable” or realized volatility series from intraday transaction data and the used o
standard timeseries technique has lead to promising strategies for modelling and predicting
daily volatility. The use of highfrequency data has induced dramatic improvements in both
measuring and forecasting volatility. Andersen and Bollerslev (1998) firstly introduced
modelfree realized, or integrated, volatility measures defined by the summation of high
frequency intraday square returns. Forecasts from long memory models provide notable
improvements over daily GARCH forecasts at the 1 day and 10day horizons. The modelling
of the long memory property in volatility has the potential to improve forecasts particulars for
much longer horizons, needed to compete with option implied volatility forecasts. The results
for crude oil in this studies show that long memory forecasts dramatically improve upon daily
GARCH forecasts, confirming the results of Andersen et al. for exchange rates.
David and Alan (2004) applied the cumulative squared returns from intraday data to
supersede ex post daily squared returns as the measure of the “true volatility” in the
forecasting of exchange rate for 17 currencies relative to the US dollar over the period 1
January 1990 to 31 December 1996. The result indicates that the GARCH model outperforms
smoothing and moving average techniques which have been previously identified as
providing superior volatility forecasts.
Fulvio et al. (2008) shown that the residuals of commonly used timeseries models for
realized volatility and logarithmic realized variance exhibit nonGaussianity and volatility
clustering. He extend the explicitly account for these properties and assess their relevance for
16
modelling and forecasting realized volatility. In the empirical application for S&P 500 index
futures, the results shown that the realized volatility model which allowing for timevarying
volatility improves the fit substantially as well as predictive performance.
2.6 SUMMARY
We noticed from the literature review, there is very limited volatility forecasting method had
been applied in commodity market except variants of GARCH models. STES model has
proven never been used in commodity market except in equity market by Taylor, 2004. We
proposed to apply STES approaches for return volatility forecasting of crude oil and gold
which cover insample and outofsample in this study.
CHAPTER 3 DATA AND METHODOLOGY
3.1 Data
The daily spot crude oil price (US dollars per barrel) and spot gold prices (US dollar per kg)
were obtained from the Bloomberg L.P
R
databases. The data sets consist of daily closing
prices over the period from August 1995 to July 2009 with 3655 daily observations. In this
paper, the daily data have been converted into observed weekly data with 731 weekly
observations. 531 out of 731 observations were used to evaluate inofsample volatility
forecasts, and the balance for outofsample evaluation. The closing prices on each
Wednesday were adopted as weekly observation in this study.
The spot prices of crude oil have been profoundly influenced by event that has great impacts
to global economic. i.e. surged of crude oil price to $145 per barrel in July 2008;
Transmission of financial crisis from US to global until end of 2009.
17
Following Kanas (2000), the continuously compounded returns were used. We calculate the
first difference of the natural log for both series as follow:
R
i,t
= ln(P
i,t
/P
i,t1
) (1)
Where R
i,t
is the return for i( meant to crude oil and gold ) at time t, P
i,t
is the current weekly
price, and P
i,t1
are the previous week’s price. In accordance to with the study of Sadorsky
(2006), daily actual volatility (variance) is assessed by daily squared return ( r
t
2
). The
estimation methodology of GARCH family is using the maximum likelihood method which
allows the log returns and variance process to be estimated simultaneously. The estimation of
regression parameters µ for estimated errors ε
t
started from log return (lnret) of each series by
using OLS estimates. The errors terms ε
t
will then be squared for GARCH measurement as
the lag conditional variance in forecasting onestep ahead volatility.
3.2 Methodology
3.2.1 General
According to James W. Taylor (2004), even though many authors use volatilitybased cost
functions to evaluation volatility forecasts Boudoukh, Richardson, & Whitelaw (1997);
Jorion, 1995; Xu & Taylor, 1995), the use of a volatilitybased cost function to estimated
parameters is rare. The reason for this is that there is no simple proxy for actual volatility. In
the work on evaluating variance forecasts of Andersen and Bollerslev (1998), he shown that
higher frequency data can be used to construct realised variance, which is a better proxy for
true variance than e
ì
2
. Day and Lewis, 1992 adopted this approach in this works. He uses
daily data to calculate realized weekly variance in order to evaluate variance forecasts for
weekly data. In our case here, we propose the use of higher frequency data i.e., daily squared
18
error e
ì
2
to calculate weekly realized variance for use. The proposal amount to the parameters
being derived using the following minimisation:
Min Σo
Rì
2
 o´
ì
2
 (2)
Where o
Rì
2
is realized variance at period i calculated from the higher frequency data. We
calculated the realized weekly variance from the observation for the 5 trading days in the
week with formula as follow:
o
Rì
2
= ¿ e
11+
]
S
2 5
]=1
(3)
Hence, with squared errors e
ì
2
and realized variance o
Rì
2
as proxy for actual variance, the
prediction errors of every model are calculated with 2 different methods:
 Difference between squared errors and forecasted variance with formula shown below:
Σ (e
ì
2
 o´
ì
2
) (4)
The weekly square errors e
ì
2
were used as the proxy for actual variance.
 Difference between realized and forecasted variance.
Σo
Rì
2
 o´
ì
2
 (5)
The weekly realized variance o
Rì
2
act as proxy for actual variance.
Besides weekly forecasted volatility, the forecast for the volatility over a 5day hold period
would then serve as a forecast for weekly volatility also. We have DAILYGARCH, DAILY
IGARCH, DAILY GJRGARCH, DAILYEGARCH, DAILYPARCH, DAILYSTESSE,
DAILYSTESE, DAILYSTESAbsE, DAILYSTESE+AbsE and DAILYSTESESE.
When additional variance regressor or transition variable has been added to GARCH and
STES respectively, the parameters are estimated with Maximum Likelihood method in
19
GARCH models and optimize the parameters by minimizing the sum of squared insample
onestepahead prediction error in STES models.
The timedependent conditional heteroscedasticity is accounted for by the univariate GARCH
(1,1) specification, model of Bollerslev (1986). The conditional Student’s t density which
originally was suggested by Bollerslve (1987) and is useful for dealing with excess kurtosis is
applying in this study. Under the Student’s distribution, the loglikelihood contributions are
of the form:
ˬt =
1
2
log
n(v2)IӘ
v
2
ә`
I((v+1 )¡2)`

1
2
log o
t
2

(¡+1)
2
log (1 +
(ytXitθ)`)
c
t
2
(¡2)
(6)
Where the degree of freedom v>2 controls the tail behavior. The tdistribution approaches the
normal as v→∞.
Now, let look at the methodology used in each forecast models in next section.
3.2.2 Ad Hoc Volatility models
3.2.2.1 Adaptive Smooth Transition Exponential Smoothing (STES)
STES modelled by James W. Taylor in 2004. There is a smoothing parameter, α
t
which
defined as a logistic function of a userspecified transition variable, V
t
. The logistic function
is analogous to Smooth Transition model which is explainable by the formula of smooth
transition regression model (STR) below:
y
t
= a +b
t
x
t
+e
t
,
where b=
o
1+cxp (ß+yvt)
(7)
a, ω, β and γ are constant parameter, and b is a monotonically either increasing or decreasing
function of V
t,
depends on γ<0 and ω>0 and vice versa. V
t
will varies between 0 and ω to
20
model logistic function of a user specified variables. This logistic function model is then
applied to simple exponential smoothing as follow:
f
t+1
=α
t
y
t
+ (1  α
t
) f
t
,
α
t
=
o
1+cxp (ß+yvt)
(8)
The formula of STES is then shown below:
F
t+1
= α
t
y
t
+(1  α
t
)f
t
,
Where α
t =
1
1+cxp (β +γvt)
(9)
If γ < 0, α
t
is a monotonically increasing function of V
t
. Hence, as V
t
increases, the weight on y
t
rises,
and correspondingly the weight on f
t
decreases. The logistic function restricts α
t
to lie between 0 and
1. Although a wider range can be justified (Gardner, 1985). V
t
become a monotonically increasing
function if γ <0. The weight on y
t
rises as V
t
increase and relatively the weight on f
t
decreases.
The logistic function restrict α
t
lie between 0 and 1. Under this approach, the historical data is
used to calibrate the adaptive smoothing parameter, α
t
through the estimation of β and γ in
(13), (James W.T., 2004). In short, Smooth Transition Exponential Smoothing (STES) is the
integration of smooth transition with exponential smoothing where the logistic function in smooth
transition has been applied to exponential smoothing model.
There are 5 STES models have been introduced in this empirical work. The new model has
never been used in forecasting the volatility of any commodity products. This is the first time
it has been used for commodity product. The STES models using 5 different transition
variables: ε
t1
(STESE); ε
t1
 (STESAE); e
t1
2
(STESSE); ε
t1
and ε
t1
 together (STES
E&AE); ε
t1
and e
t1
2
together (STESESE). We optimised the STES parameters using the
minimisation equation (14 ) below:
21
Min Σo
Rì
2
 o´
ì
2
 (10)
The difference between o
Rì
2
 o´
ì
2
is defined as prediction errors of realized & forecasted errors
which had been minimised by using solver of Microsoft Excel.
When an additional transition variable of gold will added to the crude oil formulation to
examine does gold return significantly impact on return volatility of crude oil. The
formulation for STES is as follow:
F
t+1
= α
t
y
t
+(1  α
t
)f
t
,
Where α
t
,
oil
=
1
1+cxp (β,oìI+γvt,oìI)
(11)
α
t ,oil
is the adaptive smoothing parameters. β
oil
and
γ
oil
are coefficient of crude oil. V
t, oil
is
the transition variables of crude oil. When additional transition variable of gold is added to
the smoothing parameters , α
t
,
oil,
the modified formulation shown below:
α
t
,
oil
=
1
1+cxp (β,oìI+γvt,oìI+ 6t,goId)
(12)
Under the 5 modified formulations, the transition variables of crude oil ε
t,oil1
(STESE); ε
t,oil
1
 (STESAE); e
t,oìIì
2
(STESSE); ε
t,oil1
and ε
t,oil1
 together (STESE&AE); ε
t1
and e
t1
2
together (STESESE). Gold as additional transition variable will be added on to crude oil
STES formulation in the following manners:
ε
t,gold1
in (STESE);
ε
t,gold1
 in (STESAE);
e
t,goId1
2
in (STESSE);
ε
t,gold1
in (STESE&AE) and
e
t,goId1
2
in (STESESE)
22
3.2.3 GARCH Models
3.2.3.1 GARCH (1,1)
Bollerslev et al. (1992) showed that the GARCH(1,1) specification works well in most
applied situations, and Sadorsky (2006) also indicated that the GARCH(1,1) model fits well
of crude oil volatility(JuiCheng H., MingChih L., HungChun L., 2008).
The conditional mean and variance equations of GARCHN model can be written as follows:
R
t =
µ + ε
t
, ε
t =
σ
t
u
t
, u
t
Ω
t1~
N(0,1) (13)
o
t
2
= ω + αe
t1
2
+βo
t1
2
(14)
Where r
t
denotes the rate of return, and ω, α and β are non negative parameters with the
restriction of α + β<1 to ensure the positive of conditional variance o
t
2
and stationary as well.
In the empirical works of Claire Lunieski, (2009), GARCH is the better forecasting model to
explain the causes of volatility of commodity. This is because most of the commodity data
contains heteroskedastic errors resulting from varying risks associated with differing time
periods. Thus, “the expected value of the magnitude of error terms at some times is greater
than at other” (Engle 2001). Hence, GARCH models able to estimate the causal factors in
volatility by analyzing the heteroskedastic error term. Heteroskedasticity has been defined as
“the variance on the error term is not consistent over time.” The formula of GARCH is shown
below to illustrate how does heteroskedasticity as a variance to be modelled. (Engle 2001)
o
t
2
= æ + o
1
e
t1
2
+[
1
o
t1
2
(15)
GARCH models express the conditional variance as a linear function of lagged squared error
terms and also lagged conditional variance term (James W. Taylor 2004). The parameters of
ω, α and β should be equal to 1 where α + β <1. The variance o
t
2
at time t is conditional to
immediate past variance o
t1
2
, as a result the variance is changing over time (ie
heteroskedasticity).
23
Therefore, the GARCH model has emerged as a primary tool to estimate commodity price
volatility. Hammoundeh and Yuan (2008) employ multiple variations of the GARCH model
to examine the “ characteristics of the volatility behaviour of strategic [metal] commodities
in the presence of positive interest rate shocks and changes in short term interest rates” (609).
By using the GARCH and EGARCH, Hammoundeh and Yuan able to analyzed the impact of
past shocks, the effects of “good and bad news” on volatility and the effect of transitory and
persistent volatility in the short and long runs (Claire Lunieski 2009). He finds that the future
volatility can be predicted by past shocks and volatility. Especially past volatility provide
more strength to prediction of future volatility. Batten and Lucey (2006) used GARCH and
Garman Klass estimator to analyse the volatility of gold, they found out the volatility is only
slightly positive correlated with volume when measured by tickcount.
3.2.3.1.1 Regressor
3.2.3.1.1.1 Crude oil Vs Gold
We would like to investigate the effect of gold return on the return volatility of crude oil and
vice versa. Hence we consider the use of the lagged residual return of gold, Z
t1,goId
i
as an
element in the variance equation of GARCH models. The GARCH(1,1) model, presented in
equation (20) below:
o
t,oìI
2
= æ + ¿ [
q
]=1
j
o
t],oìI
2
+ ¿ o
p
ì=1
i e
t1,oìI
2
+ Z
t1,goId
i
n
(16)
where , 0 > w and 0 , ,
1 1
≥ λ β α . We term this model GARCHGold. Under this approach,
the standard GARCH (1,1) is extended to allow for the inclusion of exogenous or
predetermined regressors, z. In this case, o
t,oìI
2
is the conditional variance of crude oil.
Z
t,goId
i
n is the additional regressor, which is ε
t,gold1
of gold added into the crude oil
variance equation with purpose to examine how significant of gold price impact to the
24
volatility of crude oil. If the probability shown that it is less than 0.05 with 5% significant
testing, then gold price significant to volatility of crude oil price and otherwise.
3.2.3.2 IGARCH
Integrated GARCH (IGARCH) a model was originally developed by Engle and Bollerslev
(1986). The parameters under this model have been restricted to sum of one and drop the
constant term as describe below:
o
t
2
= ¿ β˪
q
]=1
o
t]
2
+ ¿ ×
p
ì=1
1
e
t1
2
(17)
Such that
¿ β˪
q
]=1
+ ¿ α
p
ì=1
1
= 1 (18)
The modified formulation of IGARCH with inclusion of gold as additional variance regressor
is shown below:
o
t,oìI
2
= ¿ β˪
q
]=1
o
t,oìI]
2
+ ¿ ×
p
ì=1
1
e
t,oìI1
2
+ Z
t,goId
i
n (19)
3.2.3.3 POWER ARCH (PARCH)
GARCH has been generalized in Ding et al(1993) with the Power specification. In this model,
the power parameter δ of the standard deviation can be estimated rather than imposed and the
optional γ parameters are added to capture asymmetry of up to order r. The advantage is that
“rather than imposing a structure on the data, the PARCH model allows a power
transformation term inclusive of any positive value and so permits a virtually infinite range of
transformations” (McKenzie et al. 2001). The power term is the means by which the data are
transformed. The power term captures volatility clustering by changing the influence of the
outliers. McKenzie and Mitchell (1999) highlights that volatility clustering is not just specific
to the use of squared asset returns but are also a component of absolute returns. The use of a
25
power term in these cases acts to emphasis the periods of tranquillity and volatility by
amplifying the outliers in the data set. The PARCH formulation is described as below:
o
t
δ
= ω + ¿ β˪
q
]=1
o
t]
δ
+ ¿ α
p
ì=1
i
(ε
t1
  γ
i
ε
t1
)
δ
(20)
Where δ >0, γ
i
 ≤1 for i=1,…..r, γ
I
= 0 for all i>r, and r≤p.
The symmetric model sets γ
i
=0 for all i. Note that if δ =2 and γ
i
=0 for all i, PARCH model is
simply a standard GARCH specification.
The modified formulation of PARCH with inclusion of gold as additional variance regressor
is shown below:
o
t,oìI
δ
= ω + ¿ β˪
q
]=1
o
t,oìI]
δ
+ ¿ α
p
ì=1
i
(ε
t,oil1
  γ
i
ε
t,oil1
)
δ
+ Z
t,goId
i
n (21)
3.2.3.4 EGARCH
The EGARCH model was developed by Nelson(1991). The model explicitly allows for
asymmetries in the relationship between return and volatility, which assumes the asymmetric
between positive and negative shocks on conditional volatility. The EGARCH(1,1) model is
expressed as follow:
Log (σ
t
2
) = ω +α ( e
t1
  Ε(ε
t1
)) + γε
t1
+ βlog(o
t1
2
) (22)
 e
t1
 and ε
t1
in the equation above meant to capture the size and sign effects of the
standardized shocks respectively. Exponential GARCH (EGARCH) has been used to test for
the presence of the leverage effect as per asymmetric GARCH. When the expected value of
γ<0, the positive shocks provide less volatility than the negative shocks. The asymmetric and
leverage effect has happened. Adrangi et al (2001b) has used it to show that conditional
heteroskedasticity is the source of nonlinearities in energy price data. In his study of crude
oil, heating oil, and unleaded gasoline futures Adrangi et al. (2001b) find that the crude oil
and unleaded gasoline series may be modelled by EGARCH (1,1) process:
26
Log(h
t
) = α
0
+ α
1
st1
V˨ˮ1
+ α
2

st1
V˨ˮ1
 + β
1
log(h
t1
) + β
2
TTM (23)
Where h
t
is the conditional variance, ε
t
is the interruption term, and TTM is the time to
maturity. The maturity effect is important for testing. The volatility tended to increase while
the delivery date is approached. The negative and significant parameter estimation of α
2
has
proven the existence of leverage effect. Lucia (2007) used EGARCH model to evidence the
existence of volatility persistence and spillovers among four precious metal return (gold,
palladium, platinum and silver) during price fluctuations and strong impact of information on
volatility from one market to another market. This is influential impact is particularly obvious
in gold market.
The modified formulation of EGARCH with inclusion of gold as additional variance
regressor is shown below:
Log (σ
t,oìI
2
) = ω +α ( e
t,oìI1
  Ε(ε
t,oil1
)) + γε
t,oil1
+ βlog(o
t,oìI1
2
) + Z
t,goId
i
n (24)
3.2.3.5 GJR (Threshold GARCH)
In the empirical work of Duong T.Le (2006), he was using GJR (TGARCH) model to
examine the differential impacts on the conditional variance between positive and negative
shocks of equal magnitude in the crude oil and natural gas market. The estimated mean and
variance equation being used are:
R
t
= µ + Φ
1
R
t1
+ ε
t
(25)
h
t
= ω +αe
t1
2
+ βh
t1
+ γ e
t1
2
I
t1
(26)
where ε
t
is a normally distributed random variable with conditional mean zero and
conditional variance h
t
; I
t1
=1 if ε
t1
<0 and 0 otherwise. The asymmetric impact is allowing by
the impact of positive and negative shocks on conditional variance. Asymmetric volatility
27
implies γ ≠0 in equation (8). γ>0 implies that conditional volatility was increased more by the
negative shocks than positive shocks at an equal size.
The modified formulation of TGARCH with inclusion of gold as additional variance
regressor is as follow:
h
t,oil
= ω +α e
t,oìI1
2
+ βh
t,oil1
+ γ e
t,oìI1
2
I
t,oil1
+ Z
t,goId
i
n (27)
CHAPTER 4 Empirical Results & Discussion
4.1 InSample Estimation
The results for 530 insample estimations of Crude oil and Gold price for variants GARCH
models are shown in table 2 & 3 below respectively. The tables reported the relevant
parameter estimates for the variant GARCH models. The diagnostic tools are Akaike
Information Criterion (AIC) and Log Likelihood (lnL). AIC is a measure of the goodnessof
fit of an estimated statistical model. It is grounded in the concept of entropy, in effect offering
a relative measure of the information lost when a given model is used to describe reality and
can be said to describe the trade off between bias and variance in model construction, or
loosely speaking that a accuracy and complexity of the model. The AIC is not a test of the
model in the sense of hypothesis testing; rather it is a test between models – a tool for model
selection. Given a data set, several competing models may be ranked according to their AIC,
with the one having the lowest AIC being the best.
As seen from the tables, the parameters α and β in GARCH (1, 1) models are significant at
the 5% level in gold; whereas in the case of crude oil, α shown insignificant but β significant
at 5% level. The constant variance model will be rejected as a consequent in gold. We also
28
noticed that, the sum values of α and β parameters are closed to unity for both cases under
GARCH (1, 1) model.
The parameters estimation for TARCH (GJR), IGARCH, EGARCH and PARCH are shown
below. In TARCH (GJR), if α>γ would indicates the present of the leverage effect. But the
parameter shown otherwise in both case, which indicates that if fail to capture leverage effect.
In IGARCH α + β = 1 indicates that the volatility shocks is permanent in both cases. In
EGARCH, when the expected value of γ<0, the positive shocks provide less volatility than
the negative shocks. The asymmetric and leverage effect has happened. But the parameter
shown below indicates that leverage effect did not happen for both cases. We report
parameter estimates δ in the PARCH model. The estimation of γ & δ parameters in these
models indicates that they are always relevance in estimation. The symmetric model sets γ
i
=0 for all i. If δ =2 and γ
i
=0 for all i, PARCH model is simply a standard GARCH
specification. But the parameter shown below indicates otherwise in both cases.
The values of lnL seems has confirmed the usefulness of nonlinear modifications to the
linear GARCH models, even though AIC value fail to spell it clear with the negative value
for both series. From the AIC value, TARCH exhibit the lowest value which indicates it is the
best performers among all variants of GARCH for crude oil and GARCH (1,1) shown to be
the best performer in gold.
29
Table1: Estimation results of variant GARCH models for Crude oil
Parameters estimates Diagnostics__
Products ω(x10
6
) α β γ δ AIC lnL
GARCH 59.90 0.002 0.974   3.2712 872.52
(0.009) (0.853) (0.0)
TARCH(GJR) 43.1 0.010 0.993 0.036  3.2760 874.85
(0.0) (0.530) (0.021) (0.0)
IGARCH  0.044 0.956   3.2380 861.69
(0.0) (0.0)
EGARCH 286998 0.016 0.002 0.954  3.2693 872.99
(0.008) (0.699) (0.929) (0.0)
PARCH 0.004 0.001 0.813 0.980 4.037 3.2711 874.89
(0.922) (0.992) (0.986) (0.0) (0.172)
The values in the parentheses represent the pvalue for the diagnostic test at 5% levels of significance.
Table 2: Estimation results of variant GARCH models for Gold Prices
Parameters estimates Diagnostics_
Products ω(x10
6
) α β γ δ AIC lnL
GARCH 2.89 0.040 0.955   5.4065 1439.43
(0.070) (0.015) (0.0)
TARCH (GJR) 2.93 0.413 0.954 0.001  5.4027 1439.43
(0.089) (0.043) (0.965) (0.0)
IGARCH  0.044 0.956   5.3969 1434.87
(0.0) (0.0)
EGARCH 363717 0.144 0.060 0.968  5.3710 1441.68
(0.004) (0.003) (0.075) (0.0)
PARCH 1569.0 0.081 0.479 0.915 0.725 5.3565 1440.97
(0.535) (0.002) (0.053) (0.0) (0.048)
The values in the parentheses represent the pvalue for the diagnostic test at 5% levels of significance.
30
4.2 OutSample Forecasting results
200 observations of outsample forecasting results are shown in tables from 4 to 7 below. The
outsample estimations for STES models were illustrated by theilu below. The value bolded
in red under column namely “TheilU” indicates the best performing methods for both
commodity products. The measurement of TheilU for each models is derived by divided the
RMSE value of each model by the lowest RMSE value among all the models. The lowest
value of TheilU the best model it is. The weekly volatility was forecasted by using e
t
2
and
realized volatility as a proxy of actual variance respectively. The parameters were estimated by
minimizing the sum of squared deviations between estimated or realized and forecast
variance. The size and sign of past shocks have been used as transition variables. Root mean
square error (RMSE) was used as evaluation tools as shown in table 4, 5, 6 and 7 below. The
formula of RMSE was defined as follow:
RMSE = √
1
200
¿ (
200
ì=t
e
ì
2
 o´
ì
2
)
2
(28)
In table 4, Daily STESE+AbsE without regressor ranked top for gold series. This is
conformed to Andersen and Bollerslev results that highfrequency data provide more accurate
return volatility forecasting. In overall, GARCH models or STES approaches are performed
pretty well with highfrequency data for both without and with regressor & additional
transition variable. However, this concept did not apply in crude oil where the return
volatility forecasts shown slightly better than weekly forecasts. The best performance of
DailySTESE+AbsE in the category without regressor or additional transition variables
indicates that crude oil return has insignificant impact to the prediction of return volatility in
gold. In another word, existence of crude oil return did not explain the return volatility of
gold. In the crude oil series, the weekly STESE+AbsE in categories with regressor and
additional transition variable outperformed all other methods. This result indicates that gold
31
return has impact to the return volatility of crude oil. It is an unexpected result, which also
means that, gold return help in improving the return volatility of crude oil. gold return can
explain the return volatility of crude oil. In overall, Daily STESE+AbsE under category
without regressor outperformed all other models as proven by lowest value of mean TheilU
scored at 11.
Table 3: RMSE for 200 outofsample volatility forecasts using s
t
2
as actual variance
Methods
Without regressor or additional
transition variable
MEAN
THEIL
U
GOLD PRICE CRUDE OIL
RMS
E
THEIL
U
RANKIN
G
RMS
E
THEIL
U
RANKIN
G
Ad hoc methods  weekly
STESSE 246 1.451 27 600 1.068 10 18.5
STESE 249 1.472 38 602 1.071 11 24.5
STESAbsE 245 1.449 24 603 1.072 12 18
STESE+AbsE 245 1.449 23 584 1.038 4 13.5
STESESE 245 1.450 26 582 1.035 3 14.5
Ad hoc methods  daily
DAILYSTESSE 177 1.048 9 687 1.221 26 17.5
DAILYSTESE 184 1.088 15 736 1.309 38 26.5
DAILYSTES
AbsE
174 1.027 3 701 1.246 32 17.5
DAILYSTES
E+AbsE
169 1.000 1 679 1.207 21 11
DAILYSTES
ESE
173 1.024 2 684 1.215 24 13
GARCH models  Weekly
GJR 247 1.461 33 685 1.217 25 29
GARCH 247 1.461 35 637 1.133 18 26.5
IGARCH 248 1.464 36 591 1.052 8 22
PARCH 246 1.456 29 626 1.112 14 21.5
EGARCH 246 1.451 28 633 1.126 17 22.5
GARCH models  Daily
DAILYGJR 188 1.113 18 700 1.245 31 24.5
DAILYGARCH 189 1.117 20 696 1.238 29 24.5
DAILYIGARCH 181 1.069 12 735 1.306 36 24
DAILYPARCH 183 1.084 14 690 1.226 27 20.5
DAILYEGARCH 174 1.031 6 678 1.205 20 13
OUTOF
SAMPLE
With regressor or additional transition variable
MEAN
THEIL
U
GOLD PRICE (GP) CO
(REGR)
CRUDE OIL (CO)  GP
(REGR)
RMS
E TheilU Ranking
RMS
E TheilU Ranking
32
Ad hoc methods  weekly
STESSE 245 1.446 21 612 1.088 13 17
STESE 257 1.516 40 644 1.145 19 29.5
STESAbsE 253 1.496 39 587 1.043 6 22.5
STESE+AbsE 245 1.448 22 562 1.000 1 11.5
STESESE 249 1.468 37 584 1.039 5 21
Ad hoc methods  daily
DAILYSTESSE 179 1.058 10 712 1.266 35 22.5
DAILYSTESE 188 1.112 16 735 1.307 37 26.5
DAILYSTES
AbsE 177
1.044 8
798
1.418 40 24
DAILYSTES
E+AbsE 174
1.027 4
707
1.257 34 19
DAILYSTES
ESE 176
1.037 7
680
1.209 23 15
GARCH models  Weekly
GJR 247 1.458 32 582 1.034 2 17
GARCH 247 1.458 31 596 1.060 9 20
IGARCH 247 1.461 34 590 1.048 7 20.5
PARCH 247 1.457 30 626 1.113 16 23
EGARCH 245 1.450 25 626 1.112 15 20
GARCH models  Daily
DAILYGJR 188 1.112 17 705 1.254 33 25
DAILYGARCH 189 1.115 19 700 1.244 30 24.5
DAILYIGARCH 181 1.068 11 737 1.310 39 25
DAILYPARCH 183 1.081 13 694 1.234 28 20.5
DAILYEGARCH 174 1.028 5 680 1.208 22 13.5
As shown in Table 4, weekly RVAR ranked at top for Gold series when there is no regressor or
additional transition variable. This results it conformed to James empirical results found in 2004
tested for 8 stocks markets. STESEAbsE outperformed other methods in Crude oil series. We notice
that, the highfrequency data provided better return volatility forecast for both series in both
categories of without and with regressor. We also found out that, both best performers fall under
category without regressor or additional transition variable. This result indicated that, the return of
other commodity product has no impact to the return volatility of either crude oil or gold when RV
was used as a proxy of actual variance. In overall, all daily STES approaches scored lowest mean
theilu at 3 indicated the best performing position in both series.
33
Table 4: RMSE for 200 outsample volatility forecasts using RV as actual variance
Without regressor or additional transition variable
MEAN
THEILU
GOLD PRICE CRUDE OIL
RMS
E
THEIL
U
RANKI
NG
RMS
E
THEIL
U
RANKI
NG
Ad hoc methods  weekly
STESSE 125 3.020 21 546 2.904 35 28
STESE 129 3.112 29 554 2.945 36 32.5
STESAbsE 127 3.071 25 464 2.471 26 25.5
STESE+AbsE 147 3.548 42 615 3.272 40 41
STESESE 125 3.022 22 452 2.403 22 22
Ad hoc methods  daily
DAILYSTES
SE
112 2.704 9 189 1.007 2 5.5
DAILYSTESE 116 2.801 14 189 1.007 8 11
DAILYSTES
AbsE
115 2.776 12 188 1.000 1 6.5
DAILYSTES
E+AbsE
126 3.042 23 191 1.018 10 16.5
DAILYSTES
ESE
122 2.945 20 189 1.007 8 14
GARCH models  Weekly
GJR 128 3.096 27 683 3.634 41 34
GARCH 129 3.118 31 529 2.815 32 31.5
IGARCH 130 3.142 34 536 2.850 34 34
PARCH 133 3.203 38 498 2.650 29 33.5
EGARCH 132 3.197 37 563 2.994 37 37
GARCH models  Daily
DAILYGJR 121 2.919 18 431 2.291 17 17.5
DAILY
GARCH
121 2.920 19 431 2.293 18 18.5
DAILY
IGARCH
135 3.255 41 418 2.222 13 27
DAILY
PARCH
112 2.697 8 423 2.247 16 12
DAILY
EGARCH
116 2.804 15 455 2.420 24 19.5
RVAR method  Weekly
RVAR 41 1.000 1 506 2.690 31 16
OUTOF
SAMPLE
With regressor or additional transition variable
MEAN
THEILU
GOLD PRICE (GP)  CO
(REGR)
CRUDE OIL (CO)  GP
(REGR)
MAE TheilU Ranking MAE TheilU
Rankin
g
Ad hoc methods  weekly
STESSE 126.97 3.066 24 392.01 2.085 12 18
34
STESE 131.67 3.179 35 475.72 2.530 28 31.5
STESAbsE 129.15 3.118 32 456.83 2.430 25 28.5
STESE+AbsE 131.75 3.181 36 467.64 2.487 27 31.5
STESESE 128.30 3.098 28 452.05 2.405 23 25.5
Ad hoc methods  daily
DAILYSTES
SE
79.11 1.910 3 189.38 1.007 3 3
DAILYSTESE 79.11 1.910 3 189.38 1.007 3 3
DAILYSTES
AbsE
79.11 1.910 3 189.38 1.007 3 3
DAILYSTES
E+AbsE
79.11 1.910 3 189.38 1.007 3 3
DAILYSTES
ESE
79.11 1.910 3 189.38 1.007 3 3
GARCH models  Weekly
GJR 128.09 3.092 26 690.42 3.672 42 34
GARCH 129.03 3.115 30 593.39 3.156 39 34.5
IGARCH 129.84 3.135 33 530.35 2.821 33 33
PARCH 132.85 3.207 39 505.47 2.689 30 34.5
EGARCH 133.36 3.220 40 575.57 3.062 38 39
GARCH models  Daily
DAILYGJR 117.54 2.838 16 434.06 2.309 20 18
DAILY
GARCH
112.08 2.706 10 433.38 2.305 19 14.5
DAILY
IGARCH
112.76 2.722 11 421.37 2.241 15 13
DAILY
PARCH
115.63 2.792 13 420.45 2.236 14 13.5
DAILY
EGARCH
118.83 2.869 17 448.11 2.384 21 19
RVAR Method
RVAR 42.08 1.016 2 326.69 1.738 11 6.5
35
CHAPTER 5 CONCLUSION AND IMPLICATION
In this paper, we had testing the accuracy of volatility forecasting of 5 types STES models in
commodity market. The transition variablese
t1
2
, ε
t1
and ε
t1
 were used to replicate the
conditional variance dynamics of the smooth transition GARCH models. The outperformance
of STES revealed that the specific characteristics such as seasonality volatility and inverse
leverage effect found in commodity markets have been captured and adjusted well into STES
models. The predictive power of STES has been proven stronger than the popular models
such as GARCH. The overall results revealed that, STES models performed very well in the
evaluation methods namely RMSE.
With this encouraging result, it proven that, STES has accurately forecast the volatility not
only in financial market, but also performed very well in commodity markets. It implies that,
STES might work well in most applied situations as long as there are specified transition
variables being provided.
The lower RMSE value shown in DailyGARCH and DailySTES while applied realized
variance as a proxy to actual variance indicated that high frequency data provide better return
volatility forecasts as compared to squared errors terms as actual variance. This would means
that daily events contribute sufficient information to the predictive process.
Whereas, the results for models without regressor or additional transition variable shown that,
the return of other commodity product has no impact to the return volatility forecasting for
either crude oil or gold in both RV and squared error was used as proxy of actual variance.
Nevertheless, only gold return has significant impact to return volatility of crude oil when
squared error was used as actual variance. The limitation of this research is that only 2
36
commodities were studied which would not reflect the whole picture of full commodity
markets. Hence, wider range of commodity products should be explore when study STES in
depth in the future research.
37
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TABLE OF CONTENTS
CHAPTER 1 INTRODUCTION…..……………………………………………………. 3
1.1 1.2 1.3 2.1 2.2 2.3 2.4 2.5 2.6 3.1 3.2 Overview of the study ……………………………………………………………………………………………………..3 Problem Statements …………………………………………………………………………………………………………6 Objective of the Study ……………………………………………………………………………………………………..6 Introduction of Smooth Transition Exponential Smoothing (STES) …………………………………7 Previous studies about Crude oil ………………………………………………………………………………………9 Previous studies about gold ………………………………………………………………………………………….…12 Previous Studies about the relationship between gold and crude oil ………………………….……14 Realized Volatility ………………………………………………………………………………………………………...15 SUMMARY ……………………………………………………………………………………………………………….….16 Data ………………………………………………………………………………………………………………………….…….16 Methodology …………………………………………………………………………………………………………….…….17 General …………………………………………………………………………………………………………….……..17 Ad Hoc Volatility models ………………………………………………………………………………….…….19 Adaptive Smooth Transition Exponential Smoothing (STES) …………………….……….19 GARCH Models …………………………………………………………………………………………….………..22 GARCH (1,1) …………………………………………………………………………………………….………..22
CHAPTER 2 LITERATURE REVIEW ………………………………………………7
CHAPTER 3 DATA AND METHODOLOGY ……………………………………..….16
3.2.1 3.2.2 3.2.2.1 3.2.3 3.2.3.1
3.2.3.1.1 Regressor …………………………………………………………………………………………….…………23 3.2.3.1.1.1 Crude oil Vs Gold …………………………………………………………………….….……..….23 3.2.3.2 3.2.3.3 3.2.3.4 3.2.3.5 4.1 4.2 IGARCH ………………………………………………………………………………………………….………….24 POWER ARCH (PARCH) ……………………………………………………………………….………….24 EGARCH ……………………………………………………………………………………………………….……25 GJR (Threshold GARCH) ……………………………………………………………………………….…..26
CHAPTER 4 Empirical Results & Discussion ……………………………………….….27
InSample Estimation ……………………………………………………………………………………………………..27 OutSample Forecasting results ……………………………………………………………………………………….30
CHAPTER 5 CONCLUSION AND IMPLICATION ………………………………….35
2
CHAPTER 1 INTRODUCTION
1.1 Overview of the study
In recent years, commodities have receiving increase attention from investors, traders, policy makers, speculators and producers. The significant large investments have flowing into the commodity markets, particular crude oil and gold. This is mainly driven by the flare up of price especially crude oil of which had reached the near recordhigh in July 2008, increase in their economic uses and inelastic high global demand resulted from the speedily increase of global population. Commodity markets exhibit different characteristics from financial markets. It is well known that, the supply of commodities are highly inelastic and the large demand shocks can easily lead to big swings in spot and future price over the short run. Hence, it is right to say that, commodities are susceptible to sudden and large volatility swings, especially crude oil (Wilson et la., 1996). Volatility is a measure of average deviation from the mean. In the financial markets, volatility is associating with risk and uncertainty which are the key attributes in investing, option pricing and risk management. Volatility plays the same role in commodity markets for commodity investment portfolio determination, physical commodities pricing and risk management. Since the magnitude of volatility in commodity markets is much higher than financial market, the risk associate with investment is relatively high. To ensure the risk is well managed, it is crucial and fundamental to predict the volatility as accurate as possible.
The volatility forecasting models being used so far in commodity markets are implied standard deviation (Namit, 1998), ARCHtype models (Foong and See, 2002; Giot and Lauretn, 2003; Chin W.C, 2009), asymmetric threshold autoregressive (TAR) model (Godby et al., 2000), and artificial based forecast methods (Fan et al., 2008; Moshiri, 2004); CAViaR approach (Huang et al., 2009) However, the complexity of the model specification does not
3
guarantee high performance on outperformed outofsample forecasts. Sadorsky (2006) found that the outofsample forecast of a single equation generalized ARCH model is more superior to those of state space, vector autoregression and bivariate GARCH models in predicting the price of petroleum futures. Among the ample forecasting methods, no model is a clear winner. Different methods may be capturing the information set differently, and which method is superior may depend on market conditions. In this paper, we would like to introduce a new adaptive method namely Smooth Transition Exponential Smoothing (STES) which was recommended by James W. Taylor in 2004. This approach was used in equity markets with encouraging results. However, to our knowledge, it has not yet been applied in commodity markets.
With STES method, we are going to examine the outofsample volatility forecasts for crude oil and gold. This method allows the smoothing parameter to vary as a logistic function of userspecified variables. The parameters in this method will then be optimised by minimising the sum of squared insample onestepahead prediction errors, where prediction error is defined as the difference between realized and forecast volatility. In our empirical work here, we propose to use square error term and realized volatility separately as actual variance to optimise the prediction error, we compare the accuracy of volatility forecasts between these 2 different types of prediction errors. Since the daily data is available, we estimate the parameters for daily prediction error and sum up 5day prediction error on weekly basis to compare with actual weekly volatility forecasts. The predictive power of STES will then compare with variants of GARCH models with the predictive criterion of RMSE.
In view of the higher volatility found in the commodity markets, we would like to examine every possible information that contribute to the return volatility of commodity products in
4
oil purchases were paid for in gold. The forth section. The final section provides a summary and concluding comment. 5 . we will describe the data and methodologies use in this study. Hence. a sizeable percentage of oil revenue ends up being invested in gold. They are commodities that priced in US dollar and are included in the commodity portfolios of most serious individual and institutional investors. we proposed to examine significant impacts of a crude oil return to the return volatility of gold.attempt to improve the prediction accuracy. We would like to find out does the information of gold can explain the changes in the return volatility of crude oil and vice versa. historically. and much of this is invested in gold or other hard assets. One reason is that. Another reason is that rising oil prices place upward pressure on inflation and this enhances the appeal of gold because it acts as an inflation hedge. we review the literature of volatility forecasting methods which have been used in commodity markets. Gold and crude oil prices tend to rise and fall in synchronicity with one another. In the next section. is invested. we exhibit insample and outofsample empirical results to compare the forecasting accuracy of the new method with variants GARCH models. introduce the application of new adaptive exponential smoothing methods. considered as surplus to current needs. In this premises. The reason lies for this test is that crude oil and gold has the most powerful historical commodity interrelationships. As oil price rise. Investors switch between oil and gold or combine them in diversified portfolios. crude oil and gold are the most widely traded commodities. much of the increased revenue. The purpose of this examination is to test the role play by the return of crude oil as a regressor to improve the return volatility forecasts of gold. In the third section. Even today.
It has been proven performed well with encouraging results for 8 stock indices. This model has never been applied in commodity market. 6 .  Smooth Transition Exponential Smoothing (STES) a newly developed model which was modelled by James W. Can weekly realized volatility which constructed from the accumulation of 5 trading days squared errors terms act as a better proxy of actual variance to outperformed actual weekly squared error terms?  To what extent does crude oil or gold price impacted to the return volatility of each other? Can the existence of gold explain the changes in return volatility of crude oil and vice versa? 1.2 Problem Statements To initiate the study.3 Objective of the Study • The objective of this paper is to compare the predictive accuracy of ad hoc method namely Smooth Transition Exponential Smoothing (STES) with statistical models namely the variants GARCH models in the commodity market.1. there are some problem statements which needed to be structured in order to define the scope of research. Can Smooth Transition Exponential Smoothing (STES) models forecast equally well in commodity market and hence superior than variants GARCH?  Highfrequency data provide more accurate estimates for actual volatility and provide more accurate volatility forecasts than lowfrequency data. Taylor (2004).
• To investigate the information contains in highfrequency data explainable to the accuracy of volatility prediction. Unfortunately.1 Introduction of Smooth Transition Exponential Smoothing (STES) Smooth Transition Exponential Smoothing (STES) model is an extension forecasting volatility model to the established adaptive exponential smoothing model meant to improve its application. 7 . there is no consensus as to the most useful adaptive approach except Trigg and Leach (1967) model has been recognized as a best known and most widelyused procedure. it sometime still generates unstable forecasts. CHAPTER 2 LITERATURE REVIEW 2. Does existence of crude oil return improve the accuracy of return volatility forecasting for gold. This is conformed to William (1987) suggestion that only the smoothing parameter for the level should be adapted in order to avoid instability.CO1 of crude oil as regressor to the return volatility of gold and vice versa. Their method defines the smoothing parameters as the absolute value of the ratio of the smoothed forecast error to the smoothed absolute error. there have been many different attempts to avoid instability of forecasts by enabling the exponential smoothing parameters to adapt over time according to the characteristics of the series. It has overcome the problem of deliver unstable forecast found in established adaptive exponential smoothing model. and vice versa. • To investigate the significant impact of ε t. The instability of forecasts still cannot be overcome thoroughly. At the initial development stage of adaptive exponential smoothing model. Among all the proposals presented.
This asymmetry is characterised by the tendency for negative returns to be followed by periods of greater volatility than positive returns of equal size.Hence following from the finding of weakness lied in the established adaptive model. we would like to study its performance in commodity markets in this paper. Paris (CAC40). known as the “leverage effect”. Taylor (2004). the results have not only exhibited the solution to unstable forecasts. In short. If it excellent 8 . Taylor(2004). In the empirical works of James W. New York (S&P 500). London (FTSE100). 1998). In view of the excellent performance of STES in stock markets. James W. In the empirical studies of James W. It is analogous to that used to model the timevarying parameter in smooth transition model (See Terasvirta. Smooth Transition Exponential Smoothing (STES) is the integration of the logistic function of a user specified variable as adaptive smoothing parameter which analogous to smooth transition with the simple exponential smoothing model. STES adopts the essence of smooth transition models where at least one parameter is modelled as continuous function of a transition variable. the reason for the sign of past shocks has been used as a transition variable is to model the asymmetry in stock return volatility. Hong Kong (Hang Seng). but it also proved that STES has outperformed fixed parameter exponential smoothing and variants of GARCH models in forecasting return volatility of 8 major stock markets namely Amsterdam (EOE). The size of the past shocks has also been used as a transition variable in order to allow a more flexible modelling of the dynamics of the conditional variance. He proposed the use of logistic function of a userspecified as adaptive smoothing parameter. The sign εt1 and size εt1 of past shocks were proposed to be used as transition variables in STES which have also been used in smooth transition model. Taylor (2004) has developed a new approach namely Smooth Transition Exponential Smoothing (STES). Singapore (Singapore all shares) and Japan (Nikkei). Frankfurt (DAX).
The models applied included random walk. 1996. Narayan and Narayan. 2002. the estimation period is rolled forward by adding one new day and dropping the most distant day. autoregressive model (AR). The result of crude oil was conformed to Bollerslev et al (1992). JuiCheng H. No one model fits the best for each series considered. GARCH (1. threshold GARCH. 2001. Sadeghi and Shavvalpour. we then confident to extend its application to the wider fields other than financial markets.2 Previous studies about Crude oil Perry Sadorsky 2006 has modelled and forecasted the crude oil volatility by using a fiveyear rolling window. there is currently no general consensus on 9 . Giot and Laurent. 2006. such as Adrangi et al. 2003. Brooks and Persand. 2002. The daily ex post variance is measured by squared daily return which is conformed to approach of Brailsford and Faff. HungChun L.performance is proven in commodity market too. 2001. moving average.. There are some other articles in the energy literature have using GARCH models and its variants also to addressed the modelling and forecasting of crude oil market volatility. Under the rolling window. The TGARCH model fits well for heating oil and natural gas volatility and GARCH model fits well for crude oil and unleaded gasoline volatility. A number of univariate and multivariate models are used to model and forecast petroleum future price volatility. 2. Thus there are 2651 oneday volatility forecasts for each oil future prices.. Cabedo and Moya. GARCH in mean and bivariate GARCH. exponentially smoothing (ES). Morana.1). 2003. Most models out perform a random walk and for most models there is evidence of market timing. The outofsample forecasts are evaluated using forecast accuracy tests and market timing tests. (2008). 2007. Fong and See. linear regression model (LS). MingChih L.. included crude oil. heating oil unleaded gas and natural gas.. historical mean. In this way the sample size used in estimating the models stays at a fixed length and the forecasts do not overlap. however.
1).the modelling and forecasting of crude oil volatility. regime switching. EGARCH(1. implied volatility and historical volatility for crude oil based on data from November 1986 to March 1991. Mean absolute Error (MAE) and Root Mean Square Error (RMSE). Duffie and Gray (1995) applied GARCH (1. heating. This would means that each method did not contribute unique information not contained in the other in the composite forecast by using implied volatility and GARCH model. They concluded that implied volatility alone is sufficient for market professional to predict nearterm volatility. From the outofsample results shown that. EGARCH(1. 10 . The result shown that. For the accuracy of outofsample forecasts is compared using Mean Forecast Error (ME).1) bivariate GARCH. GARCH forecasts and historical volatility do not add much explanatory power to forecast based on implied volatilities. implied volatility and historical volatility predictors to compared with the realized volatility to construct insample and outofsample forecast volatility in the crude oil. They estimated the realized volatility on outofsample forecast by using OLS regression. historical volatility forecasts are superior to GARCH forecasts. and in the more relevant outofsample case. check the unbiasedness of the forecast by referring to coefficient estimates. and evaluate the relative predictive power with reference to R2 value.1). The forecast accuracy was evaluated with the criterion of RMSE. oil and natural gas markets. Day and Lewis studied the predictive power of GARCH (1. because the standard GARCH models cannot capture persistence in the volatility of crude oil price. implied volatility yields the best forecasts in both the insample and outofsample cases.1).
1) model. Kang. the estimated α + β is smaller than that of the GARCH model. The empirical results indicate that the intensity of longpersistency volatility in the WTI is greater than in the Brent.1) model describe volatility persistence for the three crude oil returns.1) model are quite similar to those of the GARCH (1.1) model. the appreciation and depreciation shocks of the WTI have similar impact on the resulting volatility. the CGARCH and FIGARCH models are able to capture persistence in the volatility of crude oil. Therefore. A flexible autoregressive conditional heteroskedasticity (ARCH) models is used to take into account the stylized volatility facts such as clustering volatility. In the case of CGARCH (1. It is also found that the WTI. As a result. Although both the estimation and 11 .The empirical studies of Sang H. SanMok Kang and SeongMin Yoon. 2009 were focused on investigates the efficacy of a volatility model for 3 crude oil markets – Brent. the CGARCH and FIGARCH models are able to capture volatility persistence due to the insignificance of diagnostic tests. Dubai and West Texas Intermediate (WTI). Hence. However. They used CGARCH.d. GARCH and IGARCH to assess persistence in the volatility of the three crude oil prices. unlike the GARCH and IGARCH models. Whereas in the case of FIGARCH (1. a fact that favours the IGARCH (1. the estimates of the IGARCH (1. asymmetric new impact and long memory volatility among others. Chin Wen Cheong (2009) investigated the timevarying volatility of two major crude oil markets.1) specification. thereby indicating that the shortrun volatility component is weaker.1) model nests the GARCH (1.1) models. CGARCH and FIGARCH models generate more accurate outofsample volatility forecasts than do the GARCH and IGARCH models. the West Texas Intermediate (WTI) and Europe Brent. FIGARCH.1) model. They presented that the estimated value of the persistence coefficient α + β are quite close to unity in the standard GARCH (1. As the IGARCH (1. a leverage effect is found in Brent.
2003. undertook an analysis of the effect of 23 macroeconomic announcements on the gold market. 2. (2007) investigated macroeconomic influences on gold using the asymmetric power GARCH model (APGARCH). But delta hedging exercise indicates that such econometric forecasts have no incremental economic value. Other than variants GARCH models as forecasting model. E. 12 . Both studies were using gold futures intraday data. Edel et al. examination of macroeconomic news release on gold and silver prices. from the empirical outofsample forecasts. There is no existing explanation – including a price of volatility risk – can completely explain the bias. but much of this apparent bias can be explained by persistence and estimation error in implied volatility.g. Most of the gold studies did not relate to volatility forecasting. ChristieDavid et al (2001). Statistical criteria reject the hypothesis that implied volatility is informational efficient with respect to econometric forecasts. it is surprising to report that little research has been carried out on gold volatility forecasting. Thus. the market is impacted by employment reports. only the WTI models provide superior in the outofsample forecasts.diagnostic evaluations are in favour of an asymmetric long memory ARCH model. Christopher J. Cai et al (2001).3 Previous studies about gold On the examination of the literature for gold. On the other hand. CPI and personal income. tested the predictive power of implied volatility. it appears that the simplest parsimonious generalized ARCH provides the best forecasted evaluations for the Brent crude oil data. platinum. using EGARCH to investigate the nature of volatility spillover between precious metals returns (included gold. He conform the consistency of implied volatility as a biased predictor of realized volatility of gold future to the findings in other markets. statistical measures of bias and information efficiency are misleading measure of the information content of option prices. Lucia Morales (2007). GDP. Neely.
The results evidence the existence of volatility persistence and spillovers among four precious metal return during price fluctuations and strong impact of information on volatility from one market to another market. The result shows that the estimated ARCH and GARCH terms are statistically significant to the 5 percent significance level or better. In the empirical studies of Ali M. they employed a leadlag model within a GARCH framework. Batten and Lucey (2006) analysed the volatility structure of gold. The statistical tests results (not reported) indicated no significant serial correlation in gold returns. allowing them to better capture observe timevarying volatility of gold in emerging market. They used GARCH modelling and the Garman Klass estimator. The diagnostic tests reported suggest that the estimated model does not suffer from any serial correlation up to ten lags. The sign is negative. indicating that the conditional volatility of returns declines in response to such news. By using standard GARCH (1. gold returns were used to estimate the time varying variance of returns.1) model. Kuntan and Tansu Aksoy (2004). the estimated Qsquared tests indicate that the reported GARCH (1. In addition. trading as a future contract on the Chicago Board of Trading using intraday (high frequency) data from January 1999 to December 2005. The only significant public information variable is the industrial production with a lead effect. 13 . although volatility is only slightly positively correlated with volume when measured by tickcount.1) models well capture the observed timevarying volatility behaviour of gold market returns. Istanbul Gold Exchange. They found significant variations across the trading days consistent with microstructure theories. They include public information arrival data in both the mean and variance equations.palladium and silver) over the 1995 – July 2007 period.
the data transformation involved the use of a squared term. Ding. while the GARCH volatility of the crude oil does not. GARCH models have become common tools for the time series heteroskedastic models. Harjes. They find that only the jump volatility of crude oil exhibits a negative relationship to the gold return. as to the gold volatility and both crude oil volatility are significantly negative related to the gold volatility. called the power GARCH (PGARCH) model. Granger. we are going to review the literature about gold volatility related to crude oil price. and Engle (1993) suggested a new class of GARCH models. However. In the empirical study of Melvin and Sultan 1990. The PGARCH structure is flexible enough to nest both the conditional variance (Bollerslev. The empirical results shown that.4 Previous Studies about the relationship between gold and crude oil In this section. the term $ $ # is significant and positive in the spot price equation. the shown that the political unrest and oil price changes in South African are significant determinants of the conditional variance of spot price forecasts errors (volatility) of gold futures. where the power term is flexible rather than fixed arbitrarily. The higher the crude oil volatility. The interest rate model proposed by Brenner. They applied ARCHinMean models to estimate the forecast errors of gold futures. Su and Tzou (2009) shown that. 1986) models as particular cases. In the empirical results of Cheng. however. the lower the gold return and volatility.2. 14 . 1986) and the conditional standard deviation (Taylor. the effects of crude oil volatility on gold return and volatility are emphasized by observing the coefficient φ1 to φ4. Besides that. The coefficient of the ARCH terms in the conditional variance equation indicate that GARCG $ # and the GARCH σH # modelling of the time varying risk premium is appropriate. Kroner (1996) (BHK hereafter) is applied here to investigate gold volatility. Most of them are significantly negative and it means that the crude oil volatility is negative relative to either gold return or volatility.
The result indicates that the GARCH model outperforms smoothing and moving average techniques which have been previously identified as providing superior volatility forecasts. with the availability of highfrequency financial market data modelling realized volatility has become a new and innovative research direction. He extend the explicitly account for these properties and assess their relevance for 15 . Forecasts from long memory models provide notable improvements over daily GARCH forecasts at the 1. The results for crude oil in this studies show that long memory forecasts dramatically improve upon daily GARCH forecasts. David and Alan (2004) applied the cumulative squared returns from intraday data to supersede ex post daily squared returns as the measure of the “true volatility” in the forecasting of exchange rate for 17 currencies relative to the US dollar over the period 1 January 1990 to 31 December 1996.5 Realized Volatility In recent year. Andersen and Bollerslev (1998) firstly introduced modelfree realized. needed to compete with option implied volatility forecasts. The modelling of the long memory property in volatility has the potential to improve forecasts particulars for much longer horizons. Fulvio et al.2. The construction of “observable” or realized volatility series from intraday transaction data and the used o standard timeseries technique has lead to promising strategies for modelling and predicting daily volatility. The use of highfrequency data has induced dramatic improvements in both measuring and forecasting volatility. volatility measures defined by the summation of highfrequency intraday square returns.day and 10day horizons. confirming the results of Andersen et al. or integrated. (2008) shown that the residuals of commonly used timeseries models for realized volatility and logarithmic realized variance exhibit nonGaussianity and volatility clustering. for exchange rates.
The spot prices of crude oil have been profoundly influenced by event that has great impacts to global economic. 16 . The data sets consist of daily closing prices over the period from August 1995 to July 2009 with 3655 daily observations. i. 2. 2004.1 Data DATA AND METHODOLOGY The daily spot crude oil price (US dollars per barrel) and spot gold prices (US dollar per kg) R were obtained from the Bloomberg L. Transmission of financial crisis from US to global until end of 2009. the daily data have been converted into observed weekly data with 731 weekly observations. In the empirical application for S&P 500 index futures. the results shown that the realized volatility model which allowing for timevarying volatility improves the fit substantially as well as predictive performance. 531 out of 731 observations were used to evaluate inofsample volatility forecasts.6 SUMMARY We noticed from the literature review. and the balance for outofsample evaluation. In this paper. there is very limited volatility forecasting method had been applied in commodity market except variants of GARCH models.modelling and forecasting realized volatility. We proposed to apply STES approaches for return volatility forecasting of crude oil and gold which cover insample and outofsample in this study.P databases. STES model has proven never been used in commodity market except in equity market by Taylor. CHAPTER 3 3.e. surged of crude oil price to $145 per barrel in July 2008. The closing prices on each Wednesday were adopted as weekly observation in this study.
The estimation methodology of GARCH family is using the maximum likelihood method which allows the log returns and variance process to be estimated simultaneously. daily actual volatility (variance) is assessed by daily squared return ( J $ ). Jorion. the continuously compounded returns were used.1 General According to James W. even though many authors use volatilitybased cost functions to evaluation volatility forecasts Boudoukh.t is the return for i( meant to crude oil and gold ) at time t.e.Following Kanas (2000). Xu & Taylor. Taylor (2004). which is a better proxy for true variance than $ . he shown that higher frequency data can be used to construct realised variance. In the work on evaluating variance forecasts of Andersen and Bollerslev (1998)..2. In accordance to with the study of Sadorsky (2006). Day and Lewis.2 Methodology 3. daily squared 17 .t1) (1) Where Ri.t = ln(Pi.t is the current weekly price. 1995. 1995).t1 are the previous week’s price. The estimation of regression parameters µ for estimated errors εt started from log return (lnret) of each series by using OLS estimates. 3. He uses daily data to calculate realized weekly variance in order to evaluate variance forecasts for weekly data. & Whitelaw (1997). the use of a volatilitybased cost function to estimated parameters is rare. The reason for this is that there is no simple proxy for actual volatility. Richardson. We calculate the first difference of the natural log for both series as follow: Ri. and Pi. we propose the use of higher frequency data i.t /Pi. Pi. In our case here. 1992 adopted this approach in this works. The errors terms εt will then be squared for GARCH measurement as the lag conditional variance in forecasting onestep ahead volatility.
The proposal amount to the parameters being derived using the following minimisation: Min Σ Where $ $  $  (2) is realized variance at period i calculated from the higher frequency data. We calculated the realized weekly variance from the observation for the 5 trading days in the week with formula as follow: $ = $ ' (# # # (3) Hence. We have DAILYGARCH. DAILYSTESE. with squared errors $ and realized variance $ as proxy for actual variance. Difference between realized and forecasted variance. Besides weekly forecasted volatility.GJRGARCH. DAILYSTESSE. When additional variance regressor or transition variable has been added to GARCH and STES respectively. DAILYIGARCH. the forecast for the volatility over a 5day hold period would then serve as a forecast for weekly volatility also. DAILYSTESE+AbsE and DAILYSTESESE. the prediction errors of every model are calculated with 2 different methods: Difference between squared errors and forecasted variance with formula shown below: Σ( The weekly square errors $ $  $ ) (4) were used as the proxy for actual variance. DAILYEGARCH. Σ $  $  (5) The weekly realized variance $ act as proxy for actual variance. DAILY. DAILYPARCH.error $ to calculate weekly realized variance for use. DAILYSTESAbsE. the parameters are estimated with Maximum Likelihood method in 18 .
1 Adaptive Smooth Transition Exponential Smoothing (STES) STES modelled by James W. Vt will varies between 0 and ω to 19 . β and γ are constant parameter.2. αt which defined as a logistic function of a userspecified transition variable. The timedependent conditional heteroscedasticity is accounted for by the univariate GARCH (1.2 Ad Hoc Volatility models 3. Now. Taylor in 2004. The conditional Student’s t density which originally was suggested by Bollerslve (1987) and is useful for dealing with excess kurtosis is applying in this study.1) specification.GARCH models and optimize the parameters by minimizing the sum of squared insample onestepahead prediction error in STES models. Under the Student’s distribution. ω. There is a smoothing parameter. The logistic function is analogous to Smooth Transition model which is explainable by the formula of smooth transition regression model (STR) below: yt = a +btxt +et. 3. model of Bollerslev (1986). depends on γ<0 and ω>0 and vice versa. the loglikelihood contributions are of the form: t =$ log # ( $) % (( # )È$)% . and b is a monotonically either increasing or decreasing function of Vt. let look at the methodology used in each forecast models in next section. The tdistribution approaches the normal as v→∞. where b=# ( ) (7) a.2.2.log $ # $ (  $ #) log (1 + ( ( θ)%) $) (6) Where the degree of freedom v>2 controls the tail behavior. Vt.
Where ( ) (8) αt = # ?L (β γ # ) (9) If γ < 0.. 1985). The logistic function restrict αt lie between 0 and 1.T.αt) ft . Under this approach. αt is a monotonically increasing function of Vt. This is the first time it has been used for commodity product. εt1 and $ # $ # (STESSE). αt=# The formula of STES is then shown below: Ft+1 = αt yt +(1 . 2004). and correspondingly the weight on ft decreases. There are 5 STES models have been introduced in this empirical work. the historical data is used to calibrate the adaptive smoothing parameter. εt1 and εt1 together (STES together (STESESE). The logistic function restricts αt to lie between 0 and 1. Although a wider range can be justified (Gardner. E&AE). The STES models using 5 different transition variables: εt1 (STESE). Smooth Transition Exponential Smoothing (STES) is the integration of smooth transition with exponential smoothing where the logistic function in smooth transition has been applied to exponential smoothing model. as Vt increases. the weight on yt rises. This logistic function model is then applied to simple exponential smoothing as follow: ft+1=αt yt + (1 . εt1 (STESAE). (James W. The weight on yt rises as Vt increase and relatively the weight on ft decreases. The new model has never been used in forecasting the volatility of any commodity products.model logistic function of a user specified variables. Vt become a monotonically increasing function if γ <0. Hence. We optimised the STES parameters using the minimisation equation (14 ) below: 20 . αt through the estimation of β and γ in (13). In short.αt)ft .
oil(STESAE). Where αt. βoil and γoil are coefficient of crude oil.gold1 in (STESE). When additional transition variable of gold is added to the smoothing parameters . $ .Min Σ The difference between $ $  $  (10)  $ is defined as prediction errors of realized & forecasted errors which had been minimised by using solver of Microsoft Excel. εt.oil1 and εt.αt)ft . (STESSE).oil=# 1 γ .oil. ) (11) αt . $ . # in (STESESE) 21 . Vt.gold1 in (STESAE). αt. Gold as additional transition variable will be added on to crude oil STES formulation in the following manners: εt. the modified formulation shown below: ?L (β. εt. εt. The formulation for STES is as follow: Ft+1 = αt yt +(1 . . ) (12) Under the 5 modified formulations. εt1 and $ # together (STESESE). the transition variables of crude oil εt. # γ .oil= # ?L (β.gold1 in (STESE&AE) and $ . # αt. oil is the transition variables of crude oil. εt.oil1 together (STESE&AE).oil is the adaptive smoothing parameters.oil1 (STESE). # in (STESSE). When an additional transition variable of gold will added to the crude oil formulation to examine does gold return significantly impact on return volatility of crude oil.
1) model fits well of crude oil volatility(JuiCheng H. α and β are non negative parameters with the restriction of α + β<1 to ensure the positive of conditional variance $ and stationary as well. GARCH is the better forecasting model to explain the causes of volatility of commodity.” The formula of GARCH is shown below to illustrate how does heteroskedasticity as a variance to be modelled. The parameters of ω.3 GARCH Models 3. and Sadorsky (2006) also indicated that the GARCH(1. “the expected value of the magnitude of error terms at some times is greater than at other” (Engle 2001). 2008). The conditional mean and variance equations of GARCHN model can be written as follows: Rt = µ + εt. MingChih L. The variance immediate past variance heteroskedasticity). This is because most of the commodity data contains heteroskedastic errors resulting from varying risks associated with differing time periods. In the empirical works of Claire Lunieski.3..3. and ω.2. (2009).1) specification works well in most applied situations. GARCH models able to estimate the causal factors in volatility by analyzing the heteroskedastic error term.1 GARCH (1. Hence. HungChun L.. 22 $ # $ at time t is conditional to .2. εt = σtut. (Engle 2001) $ = + 1 $ # + 1 $ # (15) GARCH models express the conditional variance as a linear function of lagged squared error terms and also lagged conditional variance term (James W.. (1992) showed that the GARCH(1. α and β should be equal to 1 where α + β <1. Thus. utΩt1~ N(0. Heteroskedasticity has been defined as “the variance on the error term is not consistent over time.1) $ (13) (14) =ω+α $ # +β $ # Where rt denotes the rate of return. Taylor 2004). as a result the variance is changing over time (ie .1) Bollerslev et al.
1 Crude oil Vs Gold We would like to investigate the effect of gold return on the return volatility of crude oil and vice versa. I . Hammoundeh and Yuan able to analyzed the impact of past shocks.2.1) is extended to allow for the inclusion of exogenous or predetermined regressors. Under this approach.1 Regressor 3. We term this model GARCHGold. + I #.Therefore.1. The GARCH(1. the standard GARCH (1.1) model. By using the GARCH and EGARCH.1. + (# i $ #. the effects of “good and bad news” on volatility and the effect of transitory and persistent volatility in the short and long runs (Claire Lunieski 2009). λ ≥ 0 . Hammoundeh and Yuan (2008) employ multiple variations of the GARCH model to examine the “ characteristics of the volatility behaviour of strategic [metal] commodities in the presence of positive interest rate shocks and changes in short term interest rates” (609).3. (16) where w > 0. In this case. as an element in the variance equation of GARCH models. which is εt. the GARCH model has emerged as a primary tool to estimate commodity price volatility. and α 1 . 3.3. He finds that the future volatility can be predicted by past shocks and volatility. Batten and Lucey (2006) used GARCH and Garman Klass estimator to analyse the volatility of gold.1. is the conditional variance of crude oil. z. = + (# j $ . presented in equation (20) below: $ .gold1 of gold added into the crude oil variance equation with purpose to examine how significant of gold price impact to the 23 . Especially past volatility provide more strength to prediction of future volatility. β1 . they found out the volatility is only slightly positive correlated with volume when measured by tickcount. Hence we consider the use of the lagged residual return of gold. $ . is the additional regressor. I #.2.
The power term is the means by which the data are transformed. McKenzie and Mitchell (1999) highlights that volatility clustering is not just specific to the use of squared asset returns but are also a component of absolute returns. The use of a 24 . # + I .3 POWER ARCH (PARCH) GARCH has been generalized in Ding et al(1993) with the Power specification. the power parameter δ of the standard deviation can be estimated rather than imposed and the optional γ parameters are added to capture asymmetry of up to order r. = (# β $ . 3. In this model. (19) 3.2. then gold price significant to volatility of crude oil price and otherwise.volatility of crude oil. + (# 1 $ . The advantage is that “rather than imposing a structure on the data. the PARCH model allows a power transformation term inclusive of any positive value and so permits a virtually infinite range of transformations” (McKenzie et al.05 with 5% significant testing. The parameters under this model have been restricted to sum of one and drop the constant term as describe below: $ = (# β $ + (# 1 $ # (17) Such that (# β + (# α1 =1 (18) The modified formulation of IGARCH with inclusion of gold as additional variance regressor is shown below: $ .2 IGARCH Integrated GARCH (IGARCH) a model was originally developed by Engle and Bollerslev (1986).3.2. 2001). The power term captures volatility clustering by changing the influence of the outliers. If the probability shown that it is less than 0.3.
γi ≤1 for i=1. In his study of crude oil. and r≤p. Adrangi et al (2001b) has used it to show that conditional heteroskedasticity is the source of nonlinearities in energy price data. + (# αi (εt. =ω+ (# β δ . γI = 0 for all i>r.4 EGARCH The EGARCH model was developed by Nelson(1991). The symmetric model sets γi =0 for all i. (2001b) find that the crude oil and unleaded gasoline series may be modelled by EGARCH (1.γiεt. which assumes the asymmetric between positive and negative shocks on conditional volatility.Ε(εt1)) + γεt1 + βlog( $ #) (22) and εt1 in the equation above meant to capture the size and sign effects of the standardized shocks respectively. heating oil.1) process: 25 . When the expected value of γ<0.. The model explicitly allows for asymmetries in the relationship between return and volatility.oil1)δ + I .….γiεt1)δ (20) Where δ >0.1) model is expressed as follow: Log (σ$ ) = ω +α (  # # . The EGARCH(1. The PARCH formulation is described as below: δ =ω+ (# β δ + (# αi(εt1 .power term in these cases acts to emphasis the periods of tranquillity and volatility by amplifying the outliers in the data set.oil1 . the positive shocks provide less volatility than the negative shocks. Note that if δ =2 and γi =0 for all i. The modified formulation of PARCH with inclusion of gold as additional variance regressor is shown below: δ . PARCH model is simply a standard GARCH specification. (21) 3. The asymmetric and leverage effect has happened.2. and unleaded gasoline futures Adrangi et al. Exponential GARCH (EGARCH) has been used to test for the presence of the leverage effect as per asymmetric GARCH.3.r.
he was using GJR (TGARCH) model to examine the differential impacts on the conditional variance between positive and negative shocks of equal magnitude in the crude oil and natural gas market. The modified formulation of EGARCH with inclusion of gold as additional variance regressor is shown below: Log (σ$. Lucia (2007) used EGARCH model to evidence the existence of volatility persistence and spillovers among four precious metal return (gold. The negative and significant parameter estimation of α2 has proven the existence of leverage effect. (24) 3. The estimated mean and variance equation being used are: Rt = µ + Φ1Rt1 + εt ht = ω +α $ # (25) $ # It1 + βht1 + γ (26) where εt is a normally distributed random variable with conditional mean zero and conditional variance ht.oil1 + βlog( $ . platinum and silver) during price fluctuations and strong impact of information on volatility from one market to another market.2. Asymmetric volatility 26 .Log(ht) = α0 + α1 _H # . The asymmetric impact is allowing by the impact of positive and negative shocks on conditional variance. palladium. The maturity effect is important for testing.1 É + β1log(ht1) + β2TTM (23) Where ht is the conditional variance. εt is the interruption term. and TTM is the time to maturity. The volatility tended to increase while the delivery date is approached.1 + α2  _H # . ) = ω +α ( .Le (2006).oil1)) + γεt. #  .5 GJR (Threshold GARCH) In the empirical work of Duong T. It1=1 if εt1<0 and 0 otherwise.3. This is influential impact is particularly obvious in gold market.Ε(εt. # ) + I .
# It. AIC is a measure of the goodnessoffit of an estimated statistical model. several competing models may be ranked according to their AIC. #+ βht. The modified formulation of TGARCH with inclusion of gold as additional variance regressor is as follow: ht. whereas in the case of crude oil. Given a data set. γ>0 implies that conditional volatility was increased more by the negative shocks than positive shocks at an equal size. We also 27 .implies γ ≠0 in equation (8). rather it is a test between models – a tool for model selection. or loosely speaking that a accuracy and complexity of the model.1 InSample Estimation The results for 530 insample estimations of Crude oil and Gold price for variants GARCH models are shown in table 2 & 3 below respectively. with the one having the lowest AIC being the best. The tables reported the relevant parameter estimates for the variant GARCH models. It is grounded in the concept of entropy. in effect offering a relative measure of the information lost when a given model is used to describe reality and can be said to describe the trade off between bias and variance in model construction. (27) CHAPTER 4 Empirical Results & Discussion 4. As seen from the tables. 1) models are significant at the 5% level in gold. α shown insignificant but β significant at 5% level. The AIC is not a test of the model in the sense of hypothesis testing. The diagnostic tools are Akaike Information Criterion (AIC) and Log Likelihood (lnL). the parameters α and β in GARCH (1.oil1 + I . The constant variance model will be rejected as a consequent in gold.oil1 + γ $ .oil = ω +α $ .
We report parameter estimates δ in the PARCH model. From the AIC value. If δ =2 and γi =0 for all i.noticed that. the positive shocks provide less volatility than the negative shocks. In IGARCH α + β = 1 indicates that the volatility shocks is permanent in both cases. 1) model. In EGARCH. But the parameter shown otherwise in both case. The symmetric model sets γi =0 for all i. The asymmetric and leverage effect has happened. which indicates that if fail to capture leverage effect.1) shown to be the best performer in gold. PARCH model is simply a standard GARCH specification. EGARCH and PARCH are shown below. IGARCH. But the parameter shown below indicates that leverage effect did not happen for both cases. In TARCH (GJR). even though AIC value fail to spell it clear with the negative value for both series. TARCH exhibit the lowest value which indicates it is the best performers among all variants of GARCH for crude oil and GARCH (1. 28 . The estimation of γ & δ parameters in these models indicates that they are always relevance in estimation. if α>γ would indicates the present of the leverage effect. when the expected value of γ<0. the sum values of α and β parameters are closed to unity for both cases under GARCH (1. The parameters estimation for TARCH (GJR). But the parameter shown below indicates otherwise in both cases. The values of lnL seems has confirmed the usefulness of nonlinear modifications to the linear GARCH models.
29 .3565 1439.004) 1569.0) 0.004 (0.002 0.003) 0.0) 286998 (0.2712 872.85 861.044 (0.89 (0.144 (0.699) 0.974 (0.725 (0.479 (0.1 (0.075) 0.413 (0.955 (0.2380 3.986) 0.52 874.0) 0.Table1: Estimation results of variant GARCH models for Crude oil ω(x106) 59.0) δ 0.0) 0.954 (0.040 (0.015) 0.93 (0.070) Parameters estimates α β γ 0.4027 5.43 1439.002 (0.993 0.956 (0.009) 43.0) 0.172) 0.0) 0.87 TARCH (GJR) 2.97 The values in the parentheses represent the pvalue for the diagnostic test at 5% levels of significance.037 (0.2693 3.980 (0.968 (0.0)  3.036 (0.081 (0.0 (0.90 (0.002) 0.965) 0.4065 5.929) (0.001 (0.69 872.853) 0.89 The values in the parentheses represent the pvalue for the diagnostic test at 5% levels of significance. Table 2: Estimation results of variant GARCH models for Gold Prices 6 Products GARCH ω(x10 ) 2.0) Diagnostics__ AIC lnL 3.060 (0.0) 874.001 (0.0) 0.0) 0.3969 5.0) 0.922) Parameters estimates α β 0.021) (0.956 (0.3710 5.99 Products GARCH TARCH(GJR) IGARCH EGARCH PARCH γ  δ 4.535) 1441.053) 0.2711 0.954 (0.089) IGARCH EGARCH PARCH 363717 (0.2760 3.048) Diagnostics_ AIC lnL 5.530) 0.016 (0.68 1440.008) 0.43 1434.915 (0.043) 0.992) 0.044 (0.010 (0.813 (0.
The outsample estimations for STES models were illustrated by theilu below. In the crude oil series. existence of crude oil return did not explain the return volatility of gold. The weekly volatility was forecasted by using $ and realized volatility as a proxy of actual variance respectively. However.2 OutSample Forecasting results 200 observations of outsample forecasting results are shown in tables from 4 to 7 below. 6 and 7 below. The best performance of DailySTESE+AbsE in the category without regressor or additional transition variables indicates that crude oil return has insignificant impact to the prediction of return volatility in gold. The formula of RMSE was defined as follow: # $"" ( ( $ $ 2 RMSE = √ $""  ) (28) In table 4. GARCH models or STES approaches are performed pretty well with highfrequency data for both without and with regressor & additional transition variable. Root mean square error (RMSE) was used as evaluation tools as shown in table 4. The size and sign of past shocks have been used as transition variables. The measurement of TheilU for each models is derived by divided the RMSE value of each model by the lowest RMSE value among all the models. 5. In another word. The parameters were estimated by minimizing the sum of squared deviations between estimated or realized and forecast variance. The lowest value of TheilU the best model it is.4. Daily STESE+AbsE without regressor ranked top for gold series. In overall. this concept did not apply in crude oil where the return volatility forecasts shown slightly better than weekly forecasts. This result indicates that gold 30 . the weekly STESE+AbsE in categories with regressor and additional transition variable outperformed all other methods. The value bolded in red under column namely “TheilU” indicates the best performing methods for both commodity products. This is conformed to Andersen and Bollerslev results that highfrequency data provide more accurate return volatility forecasting.
112 14 1.052 8 1.5 13 MEAN THEIL U Y as actual variance MEAN THEIL U Methods GARCH models .5 18 13.048 9 687 1.weekly 1.217 25 1.5 17.245 31 189 1. gold return can explain the return volatility of crude oil.205 20 With regressor or additional transition variable GOLD PRICE (GP).449 24 603 1.472 38 602 1.STESE+AbsE under category without regressor outperformed all other models as proven by lowest value of mean TheilU scored at 11.450 26 582 Ad hoc methods . gold return help in improving the return volatility of crude oil.5 26.038 1.133 18 1.464 36 591 1.024 3 1 2 701 679 684 CRUDE OIL THEIL RANKIN U G 1.Weekly 1.000 1.238 29 181 1.207 1. It is an unexpected result.5 11 13 29 26.5 22.221 1.309 1.027 1.5 24.113 18 700 1.306 36 183 1.456 29 626 1.5 24 20.461 33 685 1.072 1.5 24.Daily 188 1.daily 1. Table 3: RMSE for 200 outofsample volatility forecasts using Without regressor or additional transition variable RMS E STESSE STESE STESAbsE STESE+AbsE STESESE DAILYSTESSE DAILYSTESE DAILYSTESAbsE DAILYSTESE+AbsE DAILYSTESESE GJR GARCH IGARCH PARCH EGARCH DAILYGJR DAILYGARCH DAILYIGARCH DAILYPARCH DAILYEGARCH OUTOFSAMPLE 246 249 245 245 245 177 184 174 169 173 247 247 248 246 246 GOLD PRICE THEIL RANKIN RMS U G E Ad hoc methods .071 1.068 1.GP (REGR) (REGR) RMS RMS E TheilU Ranking E TheilU Ranking 31 .088 15 736 1.451 27 600 1.215 10 11 12 4 3 26 38 32 21 24 18.117 20 696 1.5 22 21.246 1.035 1.5 14.031 6 678 1.461 35 637 1. Daily.CO CRUDE OIL (CO) .5 24.5 17.084 14 690 1.069 12 735 1. which also means that.126 17 GARCH models .449 23 584 1.451 28 633 1.226 27 174 1.return has impact to the return volatility of crude oil. In overall.
Daily 1. This result indicated that.5 22.000 1.448 22 562 1. all daily STES approaches scored lowest mean theilu at 3 indicated the best performing position in both series.457 30 626 1.060 1.5 21 22.418 1.5 24 19 15 17 20 20.145 1.113 1.088 1. We also found out that.112 1.037 8 4 7 798 707 1.516 40 644 1.027 1. weekly RVAR ranked at top for Gold series when there is no regressor or additional transition variable. 32 .048 1.068 11 737 1. the highfrequency data provided better return volatility forecast for both series in both categories of without and with regressor. STESEAbsE outperformed other methods in Crude oil series.446 21 612 1.266 1.5 11.5 23 20 25 24.112 17 705 1.daily 1.310 1.458 32 582 1. This results it conformed to James empirical results found in 2004 tested for 8 stocks markets.234 1.039 1.115 19 700 1.461 34 590 1.5 26.208 13 19 6 1 5 35 37 40 34 23 2 9 7 16 15 33 30 39 28 22 17 29.244 1.STESSE STESE STESAbsE STESE+AbsE STESESE DAILYSTESSE DAILYSTESE DAILYSTESAbsE DAILYSTESE+AbsE DAILYSTESESE GJR GARCH IGARCH PARCH EGARCH DAILYGJR DAILYGARCH DAILYIGARCH DAILYPARCH DAILYEGARCH 245 257 253 245 249 179 188 177 174 176 247 247 247 247 245 188 189 181 183 174 Ad hoc methods .307 1.5 680 GARCH models .5 13.Weekly 1.209 1.450 25 626 GARCH models .028 5 680 As shown in Table 4.044 1. the return of other commodity product has no impact to the return volatility of either crude oil or gold when RV was used as a proxy of actual variance.254 1. both best performers fall under category without regressor or additional transition variable.058 10 712 1.257 1.112 16 735 1.5 25 20. We notice that.081 13 694 1.458 31 596 1.468 37 584 Ad hoc methods .034 1.496 39 587 1. In overall.043 1.weekly 1.
5 16.776 3.5 34 33.Daily 2.022 22 452 2.291 2.255 2.5 41 22 GARCH models .Table 4: RMSE for 200 outsample volatility forecasts using RV as actual variance Without regressor or additional transition variable RMS E STESSE STESE STESAbsE STESE+AbsE STESESE DAILYSTESSE DAILYSTESE DAILYSTESAbsE DAILYSTESE+AbsE DAILYSTESESE GJR GARCH IGARCH PARCH EGARCH DAILYGJR DAILYGARCH DAILYIGARCH DAILYPARCH DAILYEGARCH RVAR 125 129 127 147 125 112 116 115 126 122 128 129 130 133 132 121 121 135 112 116 41 GOLD PRICE CRUDE OIL THEIL.945 9 14 12 23 20 189 189 188 191 189 1.066 24 392.5 27 12 19.007 1.Weekly 506 2.945 36 3.018 1.020 21 546 2.096 27 683 3.904 35 3.403 22 Ad hoc methods .5 25.690 1.804 19 41 8 15 431 418 423 455 RVAR method .000 1.042 2.697 2.222 2.daily 2.272 40 3.5 37 17.704 2.007 3.weekly 3.000 1 OUTOFSAMPLE STESSE With regressor or additional transition variable GOLD PRICE (GP) .5 14 34 31.815 2.01 2.CO CRUDE OIL (CO) .weekly 126.GP (REGR) (REGR) Rankin MAE TheilU Ranking MAE TheilU g Ad hoc methods .197 37 563 GARCH models .Weekly 3.112 29 554 2.RANKI U NG E U NG Ad hoc methods .085 12 MEAN THEILU 18 33 .203 38 498 3.5 16 MEAN THEILU 28 32.5 18.247 2.071 25 464 2.142 34 536 3.5 11 6.420 2 8 1 10 8 41 32 34 29 37 17 18 13 16 24 31 5.RANKI RMS THEIL.801 2.007 1.97 3.920 3.850 2.650 2.118 31 529 3.634 2.548 42 615 3.994 2.293 2.919 18 431 2.471 26 3.
869 1.207 39 505.57 GARCH models .85 133.54 112.38 189.76 115.STESE STESAbsE STESE+AbsE STESESE DAILYSTESSE DAILYSTESE DAILYSTESAbsE DAILYSTESE+AbsE DAILYSTESESE GJR GARCH IGARCH PARCH EGARCH DAILYGJR DAILYGARCH DAILYIGARCH DAILYPARCH DAILYEGARCH RVAR 131.11 79.64 28 452.5 39 18 14.118 3.38 189.689 3.5 GARCH models .11 RVAR Method 326.5 31.309 2.42 3.36 117.5 3 3 3 3 3 34 34.11 79.11 79.181 3.430 2.792 2.007 1.08 3.5 13 13.38 421.016 10 11 13 17 433.72 32 456.daily 3 3 3 3 3 189.5 28.487 2.63 118.910 1.Daily 2.06 2.05 Ad hoc methods .38 189.305 2.007 1.672 3.11 79.098 1.092 26 690.910 1.405 1.09 129.15 131.007 3.08 112.5 33 34.236 2.03 129.838 16 434.910 1.84 132.062 2.706 2.45 448.39 3.67 129.83 42.007 1.241 2.910 1.5 19 6.11 128.Weekly 3.75 128.821 2.156 2.220 40 575.722 2.007 1.115 30 593.38 189.69 2 34 .910 35 475.47 3.384 1.37 420.530 2.38 2.5 25.83 36 467.179 3.35 3.30 79.135 33 530.738 28 25 27 23 3 3 3 3 3 42 39 33 30 38 20 19 15 14 21 11 31.
It implies that. With this encouraging result. only gold return has significant impact to return volatility of crude oil when squared error was used as actual variance. The transition variables $ #. but also performed very well in commodity markets. The predictive power of STES has been proven stronger than the popular models such as GARCH. Whereas. STES might work well in most applied situations as long as there are specified transition variables being provided. This would means that daily events contribute sufficient information to the predictive process. the return of other commodity product has no impact to the return volatility forecasting for either crude oil or gold in both RV and squared error was used as proxy of actual variance. STES has accurately forecast the volatility not only in financial market. the results for models without regressor or additional transition variable shown that. STES models performed very well in the evaluation methods namely RMSE.CHAPTER 5 CONCLUSION AND IMPLICATION In this paper. Nevertheless. we had testing the accuracy of volatility forecasting of 5 types STES models in commodity market. The limitation of this research is that only 2 35 . εt1 and εt1 were used to replicate the conditional variance dynamics of the smooth transition GARCH models. The lower RMSE value shown in DailyGARCH and DailySTES while applied realized variance as a proxy to actual variance indicated that high frequency data provide better return volatility forecasts as compared to squared errors terms as actual variance. The overall results revealed that. The outperformance of STES revealed that the specific characteristics such as seasonality volatility and inverse leverage effect found in commodity markets have been captured and adjusted well into STES models. it proven that.
commodities were studied which would not reflect the whole picture of full commodity markets. 36 . Hence. wider range of commodity products should be explore when study STES in depth in the future research.
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