Comparison of ARCH/GARCH family models (ARCH, GARCH,

EGARCH, TARCH, CGARCH, IGARCH)

Introduction
Financial markets data have become of great significance for financial investors and financial
market analysts in terms of knowing the behavior of data over the long run. Financial data series
often display volatility clustering in which the time series exhibit periods of high as well as low
volatility. In fact, financial and economic data mostly contain time-variant volatility rather than
constant volatility. Thus, it is important to accurately model time-varying volatility in financial
data series. Nonetheless, there are models to measure conditional variance such as ARMA
model, but such model measures the conditional variance given the past is constant.
As it is observed that stock returns follow a volatile behavior over the time. In order to better
capture the stock returns behavior involving volatility, we need to model volatility separately to
make the forecasts more accurate. ARCH/GARCH family models have been developed for this
purpose and are widely used in financial time series to model volatility. Below we give a brief
description of each ARCH family model and compare them to each other to determine the best
fitted model based on Akaike info criterion and Schwarz criterion values. We have HBL stock
price monthly data series from 2011 to 2021 and SNGP stock price quarterly data series from
2011 to 2020. Both of the data series are used in ARCH family modeling and a best fitted model
is chosen for each data series. This process is performed through the EViews software.

ARCH Model (Autoregressive Conditional Heteroskedastic)

The ARCH model is developed to estimate the weights of parameters. An ARCH(q) process has
a constant mean and a constant unconditional variance, but its conditional variance is not
constant. Two equations namely, mean equation and variance equations are estimated in an
ARCH process. In our case, we have estimated the mean equation as keeping stock price as
dependent variable and constant as independent i.e., CP= C. The ARCH effect was tested for
both series and the ARCH effect was found for both, so we ran the ARCH family models on both
series. The variance equation for ARCH model is given as follows:
n
σ = βVL + ∑ αiε 2t-1
t
2

i=1

The estimated ARCH models (variance equations) for monthly and quarterly data are given
below as, ARCH(5,0):
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-2)^2 + C(5)*RESID(-3)^2 +
C(6)*RESID(-4)^2 + C(7)*RESID(-5)^2
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-2)^2 + C(5)*RESID(-3)^2 +
C(6)*RESID(-4)^2 + C(7)*RESID(-5)^2
The above variance equations contain five arch terms and zero garch term for each. The AIC and
SIC values are reported in the last section.
GARCH Model (Generalized ARCH)
A disadvantage that an ARCH model has is of assigning equal weights to all squared residuals.
This assumption of equal weights seems unattractive because one would suppose that most
recent events would be most relevant and should be given higher weights. Therefore, a useful
generalization of ARCH model is GARCH model which also assigns weights to past squared
residuals, but those are declining weights which never reach completely to zero. The most widely
GARCH specification, GARCH(1, 1), shows that the next period variance is best predicted by a
weighted average of long run average variance. GARCH (1, 1) model is given as follows,
σt2 = βVL + αiεt-12 + ρσt-12
We have estimated the following GARCH(1, 1) models as,
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*GARCH(-1)
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*GARCH(-1)

TARCH Model (Threshold ARCH/GARCH)

TARCH model is used to divide the distribution of innovations (shocks) into separate intervals
and then a piecewise linear function is estimated for the conditional variance. Here the effects of
positive and negative shocks on the volatility is differentiated. TARCH model can be specified
n n
as, σ = β + ∑ αiε
t
ᵩ ᵩ
t-1 + ∑ αiε̄ ᵩt-1 (αiεt-1<0) where ᵩ
=1
i=1 i=1
In our case the specification is GARCH(1, 1) and a threshold of level 1 is applied to estimate the
TARCH models.
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-1)^2*(RESID(-1)<0) + C(5)*GARCH(-1)

GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-1)^2*(RESID(-1)<0) + C(5)*GARCH(-1)

EGARCH Model (Exponential GARCH)

GARCH models assume that only the magnitude of excess returns and not the positivity or
negativity determine the feature of variance/volatility. However, EGARCH assumes that
volatility tends to rise as a result of bad news which lowers the excess returns than expected.
Similarly, EGARCH assumes that volatility tends to fall due to good news which in turn
increases the excess returns than expected. In the EGARCH model, the conditional variance, is
an asymmetric function of lagged disturbances. Following is the EGARCH equation,
Ln(σt2) = ω + ∑i=1n βln(σt-i2) + ∑i=1n αi [Փzt-I + φ( |zt-i| - E| zt-i|)]
In this case, GARCH(1, 1) is estimated for EGARCH. The estimated models are:
LOG(GARCH) = C(2) + C(3)*ABS(RESID(-1)/@SQRT(GARCH(-1))) +
C(4)*RESID(-1)/@SQRT(GARCH(-1)) + C(5)*LOG(GARCH(-1))

LOG(GARCH) = C(2) + C(3)*ABS(RESID(-1)/@SQRT(GARCH(-1))) +

C(4)*RESID(-1)/@SQRT(GARCH(-1)) + C(5)*LOG(GARCH(-1))

Component ARCH/GARCH
Long-term volatility dependencies are an important feature of variance which are unaccounted
for by the GARCH/ARCH models. Hence, component GARCH model is developed to accurately
measure the long-term volatility dependencies. The component GARCH model is written as,
(σt2 - σ2) = α (εt-12 - σ2) + β (σt-i2 - σ2)
Here the component ARCH (1, 1) is estimated including threshold term as:
Q = C(2) + C(3)*(Q(-1) - C(2)) + C(4)*(RESID(-1)^2 - GARCH(-1))
GARCH = Q + (C(5) + C(6)*(RESID(-1)<0))*(RESID(-1)^2 - Q(-1)) +C(7)*(GARCH(-1) - Q(-
1))

Q = C(2) + C(3)*(Q(-1) - C(2)) + C(4)*(RESID(-1)^2 - GARCH(-1))

GARCH = Q + (C(5) + C(6)*(RESID(-1)<0))*(RESID(-1)^2 - Q(-1)) +C(7)*(GARCH(-1) -
Q(1))

IGARCH (Integrated GARCH)

GARCH model assumes that the covariance is stationary i.e., α(1) + β(1) <1, although practically
it is not. The IGARCH model restricts the coefficient values to equal one such as, α(1) + β(1)=1.
IGARCH model can be written as,
σt2 = α0 + (1 – β1) εt-12 + β1 σt-12
In our monthly data series the GARCH coefficients were already less than one, but in quarterly
data the coefficients were greater that one, so restriction was imposed through IGARCH.
Following model was estimated for IGARCH,

GARCH = C(2)*RESID(-1)^2 + (C(2))*GARCH(1)

Best Fitted Model (Monthly Series)

According to Akaike info criterion and Schwarz criterion, lower the value better the model fitted.
The ARCH family models were estimated for the HBL monthly time series data of stock prices.
GARCH (1, 1) model was found to be best fitted as per AIC and SIC criteria. The model was
further tested through diagnostic checking. We tested if there was serial correlation, and found
through correlogram squared residuals and Ljung Box criteria that there is no serial correlation
which is desirable. ARCH effect was also checked for the model and it was found that there is no
ARCH effect which is also desirable for the best fitted model. Finally, the residuals normality
test was applied to check if the residuals are normally distributed it was found that residuals are
not normally distributed which is not desirable. However, many experts say that if residuals are
not normally distributed, we can still work on that model. Based on this it can be stated that stock
price volatility can be best estimated through GARCH (1, 1) model.

Best Fitted Model (Quarterly Series)

We also applied AIC and SIC criteria for checking the best fitted model among the ARCH
family models. It was found that ARCH (5, 0) was the best fitted model as the AIC and SIC
values for this model were lowest. After choosing the best model we applied the diagnostic tests
to check whether the model fulfils the conditions for a best fitted model. It was found that there
is no serial correlation in the model. ARCH effect was not found in this model and the residuals
are also normally distributed in this model. All these features are desirable for a best fitted
model. Hence, it can be inferred that the forecast for stock price volatility can best be estimated
with the help of ARCH (5) model for this data series.
Following tables contain AIC and SIC values for ARCH family models on monthly and quarterly
series.
HBL Monthly Stock Price Series
Model AIC Values SIC Values
ARCH 10.23421 10.39682
GARCH 9.972901 10.06582
TARCH 9.989362 10.10551
EGARCH 9.984988 10.10113
CGARCH 9.980220 10.14282

Sui Northern Gas Pipeline Quarterly Stock Price Series

Model AIC SIC
ARCH 8.221679 8.520267
GARCH 8.597455 8.768077
TARCH 8.316667 8.529944
EGARCH 8.328088 8.541365
CGARCH 9.409813 9.708401
IGARCH

992.130
RESID(-1)^2 3 GARCH(-1) -991.1303