Question:

Let Ω={a,b,c,d} and

Let I = {0,1,2} and define τ:Ω→I∪ {∞} by τ(w)=inf {n ∈ I: Xn (w)<10}

1. Find FX={FnX:n∈ I}={F0X,F1X ,F2X}

2. Calculate τ(w) for each w∈ Ω
3. Show that τ is a stopping time with respect to FX
4. Is X a martingale with respect to FX?
5. Define Z = { Z0, Z1, Z2} by Z0= E( Y/ FXn) for n ∈ I Show that Z is an FX – martingale
6. Find the stopped process Zτ

In econometrics, you studied GARCH models. The ideas of conditional expectations, Markov
processes, and martingales are all relevant for that discrete time econometrics
model. Specifically, let's consider the GARCH(1,1) model.

7. Starting with the definition of conditional expectation, derive the equation for the
conditional variance of a GARCH(1,1) model.
8. Similarly, starting with the definition of conditional expectation, derive the equation
for the unconditional variance in a GARCH(1,1) model.
9. Which of the 2 previous equations require time subscripts on some of the right-hand-
side terms?
10. In the GARCH(1,1) model, identify the variable that is a Markov process.

Answer:

1. FtX , the natural filtration of X is the smallest filtration that makes X adapted and is
defined by FtX:=σ({Xs: s ≤ t, s ∈ I,}), t ∈ I. It is the smallest σ – algebra that makes all Xs
measurable for s ≤ t.
a. We have a stochastic process in discrete time with index set I = {0,1,2} and the
stochastic processes defined as X0(w) as always equal to 12, X1(w) as 18, 18, 9,
9 and X2(w) as 36, 9, 12, 18
b. F0X is the trivial σ – algebra generated by ({X0}) since X0 is constant (12) and does
not distinguish between any of the elements (a, b, c, d)

This study source was downloaded by 100000839825666 from CourseHero.com on 03-06-2022 02:21:20 GMT -06:00

https://www.coursehero.com/file/101336032/CRT2pdf/
 c. F1X is a σ – algebra generated by ({X0 , X1}), X0 does not distinguish any of the
elements (a, b, c, d) while X1 does not distinguish between elements a and b
neither does it distinguish between elements c and d. Thus, σ – algebra F1X
generates a and b as one block and c and d as another block.
d. F2X is a σ – algebra generated by ({X0 , X1, X2}), distinguishes between all
elements (a, b, c, d)
e. The natural filtration of X therefore contains the 3 σ – algebras which are all
sub-σ – algebra of F, the powerset of Ω.
f. Therefore, FX=({a, b, c, d}, {a, b}, { c, d}, {a, b}, {c, d})

2. For { τ(a), τ(b), τ(c), τ(d)};

a. For a: X(a) = {12, 18, 36} ; None of X0(a) , X1(a) , X2(a) fulfils the condition
Xn(w)<10 . Therefore, τ(a)=∞=o
b. For b: X(b) = {12, 18, 9} ; None of X0(b) , X1(b) fulfils the condition Xn(w)<10 but
X2(b)=9 fulfils the condition Xn(w)<10 . Therefore, τ(b)=2
c. For c: X(c) = {12, 9, 12} ; X0(c) , X2(c) do not fulfil the condition Xn(w)<10 but
X1(c)=9 fulfils the condition Xn(w)<10 . Therefore, τ(c)=1
d. For d: X(d) = {12, 9, 8} ; X0(d) do not fulfil the condition Xn(w)<10 but X1(d)=9
and X2(d)=8 fulfils the condition Xn(w)<10 . Therefore, τ(d)={1,2}
e. Therefore, {τ(a), τ(b), τ(c), τ(d)} = (∞, 2, 1, {1, 2})

3. To show that τ is a stopping time with respect to FX, we need to evaluate the event {τ
≤ n ∈ I}
a. When τ=0, the event {τ ≤ n} is empty since τ is never less than or equal to 0.
X
This therefore belongs to F0
X
b. When τ=2 , the event {τ ≤ 1} is equal to {(a,b),(c,d)} which belongs to F1
c. Note that F2X is the powerset of Ω as it includes both F0X and F1X
d. Therefore, τ is a stopping time with respect to FX

4. Let:
a. Ω = {a, b, c, d}, F = 2Ω, F0 = {Φ, Ω}
b. F1 = σ {(a, b), (c, d)}
c. F2 = F
d. X = { X0 , X1 , X2 }
e. If X is a martingale, it should have constant mean
i. E(Xn)=μ=P({w})* Xn(w)
ii. E(X0)=(1/9*12)+ (2/9*12)+ (1/6*12)+ (1/2*12) = 12
iii. E(X1)=(1/9*18)+ (2/9*18)+ (1/6*9)+ (1/2*9) = 12
iv. E(X2)=(1/9*36)+ (2/9*9)+ (1/6*12)+ (1/2*8) = 12
f. Therefore, since E(X0)=E(X1)= E(X2)=12, X is a martingale with respect to FX as
it has constant mean (μ) of 12.

This study source was downloaded by 100000839825666 from CourseHero.com on 03-06-2022 02:21:20 GMT -06:00

https://www.coursehero.com/file/101336032/CRT2pdf/
 5. Zn = E(Y / F0X):

w Z0(w)=E(Y/F0X) Z1(w)=E(Y /F1X) Z1(w)=E(Y /F2X)

a ((1/9*12)/12) ((1/9*12)/18) ((1/9*12)/36)
b ((2/9*12)/12) ((2/9*12)/18) ((2/9*12)/9)
c ((1/6*12)/12) ((1/6*12)/9) ((1/6*12)/12)
d ((1/2*12)/12) ((1/2*12)/9) ((1/2*12)/8)
μ ~1 ~1.1 ~1.15

a. Therefore, since E(Z0)= E(Z1) = E(Z2) = 1, X is a martingale with respect to as it

has constant mean (μ)

τ τ
6. If τ is a stopping time we can define the stopping process Z =Z t :t∈I as Zτ :=Zτ

7. Derive the equation of conditional variance of GARCH (1, 1) model

a. Imagine that we have a daily return series denoted 𝑟𝑡 (which is assumed to be

stationary) and let's take a little time to define main concepts:
i. Mean Process (First moment process)
1. The conditional mean process refers to the expectation of the
series at time 𝑡 given previous information: 𝐸𝑡(𝑦𝑡|Ω𝑡−1). It is
time varying and that is the reason way we write it using a time
subscript: 𝑢. This process is usually estimated using
autoregressive–moving-average (ARMA) models. The intuition
is that we can detect some autocorrelations in the returns
series.
ii. Conditional variance Process (Second moment)
1. We may realize that the variance is in fact time varying : we
observe some "volatility clustering". In a same way that for the
conditional mean process we can build a conditional
variance process. To this end we use different tools : the Garch
family models which allows us to model a time-varying variance
: 𝜎2𝑡=𝑉𝑎𝑟𝑡(𝑟𝑡|Ω𝑡−1). (Others models exist such as Stochastic
volatility models).

8. Derive the equation of unconditional variance of GARCH (1, 1) model

a. Given the definition of conditional variance:
i. Mean Process (First moment process)
1. The unconditional mean of 𝑟𝑡 denoted 𝑢 is just its
expectation 𝐸(𝑟𝑡). It is not time varying. You can compute it
directly using the expectation formula.
ii. Conditional variance Process (Second moment)
1. Similarly that for the mean process, we are able to estimate
the unconditional variance of our return series using a simple
variance formula 𝜎2=𝑉𝑎𝑟(𝑟𝑡).

This study source was downloaded by 100000839825666 from CourseHero.com on 03-06-2022 02:21:20 GMT -06:00

https://www.coursehero.com/file/101336032/CRT2pdf/
 9. The conditional variance is time varying and that is the reason way we write it using
a time subscript.

10. The variable P (persistence) is a Markov process.

This study source was downloaded by 100000839825666 from CourseHero.com on 03-06-2022 02:21:20 GMT -06:00

https://www.coursehero.com/file/101336032/CRT2pdf/
Powered by TCPDF (www.tcpdf.org)