Financial Risk Management:

Volatility Modeling: ARCH and GARCH

Giacomo Morelli

March 9, 2022

1 / 62
Volatility Clustering

One of the most relevant empirical features of financial returns time

series is, the so called, volatility clustering.

The term volatility clustering is used to denote the fact that large
returns (in absolute value) tend to be followed by large returns (in
absolute value), and vice versa.
This stylized fact has been documented starting from at least the
1960’s but the first models able to capture volatility clustering were
proposed starting from the 1980’s.
In this lecture we are going to analyze volatility clustering and
introduce nonlinear dynamic models able to capture it.

2 / 62
Volatility Clustering

Figure: S&P 500 Returns

3 / 62
Volatility Clustering

Figure: S&P 500 Absolute Returns

4 / 62
Volatility Clustering

The inspection of the SP 500 return time series plot suggests that:

S&P 500 returns appear to have weak or no serial dependence.

S&P 500 absolute returns appear to have strong serial dependence.

5 / 62
Volatility Clustering

Figure: S&P 500 ACF Returns

6 / 62
Volatility Clustering

Figure: S&P 500 ACF Absolute Returns

7 / 62
Volatility Clustering

Figure: S&P 500 Squared Returns

8 / 62
Volatility Clustering

The inspection of the S&P 500 autcorrelograms suggests that:

S&P 500 returns appear to have weak or no serial dependence.

S&P 500 absolute and square returns appear to have strong serial
dependence.

9 / 62
Volatility Models

The strong evidence of serial dependence in absolute and square

returns suggest that the scale of returns changes in time..
In other words, the variance of the process is time varying.
n order to capture volatility clustering, we need to introduce
appropriate time series processes able to model this feature.

10 / 62
Notation

Consider the returns time series {rt }

Recall the definitions of the

conditional mean, µt

µt = Et−1 [rt ] = E[rt |rt−1 , rt−2 , . . . ]

conditional variance, σt2

σt2 = Vart−1 [rt ] = E[(rt − µt )2 |rt−1 , rt−2 , . . . ]

11 / 62
Volatility Modeling: Can we use ARMA models?

Consider the simple ARMA(1,1) model

rt = φ0 + φ1 rt−1 + "t − θ"t−1 "t ∼ D(0, σ!2 )

For the simple ARMA(1,1) we have that

µt = φ0 + φ1 rt−1 − θ"t−1

and
σt2 = σ!2
Thus, while the conditional mean of an ARMA is time varying, the
conditional variance of an ARMA is constant. In general an
ARMA(p,q) is not able to capture time varying volatility.

12 / 62
Volatility Modeling

In order to model volatility, the literature has proposed specific types

of time series models.

There are two approaches in modeling the conditional variance, σt2 .

1 ARCH approach: σt2 is deterministic.

2 Stochastic Volatility approach : σt2 is stochastic.

In practice, the ARCH approach is more popular. Stochastic Volatility
models are typically harder to work with.

13 / 62
ARCH Models

In order to capture volatility clustering, in 1982 Robert Engle proposed

the AutoRegressive Conditional Heteroskedasticity (ARCH) model.
This simple model has started the literature on nonlinear quantitative
modeling of financial time series.
In 2003 Robert Engle won the Nobel prize for economics. The ARCH
model was mentioned as one of his most significant contributions.

14 / 62
ARCH(1) Model

The ARCH(1) model is

!
rt = σt2 zt zt ∼ D(0, 1)

σt2 = ω + αrt−1
2

where ω > 0 and 0 ≤ α < 1.

15 / 62
Descriptive statistics

In other words, the current conditional variance of returns is

proportional to the past squared return.
The α coefficient needs to satisfy other regularities conditions to
ensure that the process is ”well behaved” (e.g. finite kurtosis).

16 / 62
ARCH(p) Model

The ARCH(p) model is

!
rt = σt2 zt zt ∼ D(0, 1)

σt2 = ω + α1 rt−1
2 2
+ α2 rt−2 2
+ · · · + αq rt−p
"
where ω > 0, αi > 0 and pi=1 αi < 1.

17 / 62
The ARCH Model: Historical Significance

In the early 1980’s, the simple idea of making the current conditional
variance of the process a deterministic function of the past history of
the process opened the door to a new way of modeling time series.
Since the original contribution of Engle, several alternative
specifications for the conditional variance of returns have been
proposed.

18 / 62
ARCH(1): Unconditional Moments

The unconditional mean of the process is

E(rt ) = µ = 0

The unconditional variance of the process is

ω
Var (rt ) = σ 2 = .
1−α
The covariance function of the ARCH(1) is

γk = Cov (rt , rt−k ) = 0 ∀k.

The ARCH(1) process is Covariance Stationary.

19 / 62
ARCH(1): Alternative Parameterization

Using the result of the unconditional variance of the ARCH(1) we can

reparameterize the variance equation as

σt2 = σ 2 + α(rt−1
2
− σ 2 ).

This alternative parameterization is sometimes more convenient for

derivations.

20 / 62
ARCH(1): ACF rt2

The ARCH(1) models defines a process in which returns are not

correlated
ρk (rt ) = 0.
However, the squared returns are positively correlated! The ACF of
the squared returns is
ρk (rt2 ) = αk .

21 / 62
ARCH(1): Forecasts

1-step ahead forecast of the variance is

σT2 +1|T = ET (ω + αrT2 ) = ω + αrT2 .

2-step ahead forecast of the variance is

σT2 +2|T = ET (ω + αrT2 +1 ) = ω(1 + α) + α2 rT2 .

3-step ahead forecast of the variance is

#k−1 %
$
σT2 +k|T = ET (ω + αrT2 +k−1 ) =ω α i
+ αk rT2 .
i=0

Forecast formulas of the variance of the ARCH(q) are analogous to

those of the AR(p)!

22 / 62
Detecting ARCH Effects

Engle (1982) introduces a simple test to detect the presence of ARCH

effects.
The ARCH-LM test is constructed as follows

1 Estimate the coefficients of the following autoregression by LS

rt2 = α0 + α1 rt−1
2 2
+ · · · + αp rt−p + ut ,
2 The null of no ARCH effects is formulated as

H0 : α 1 = α 2 = · · · = α p = 0
3 The test statistic for the ARCH-LM is

nR 2

where R 2 is the usual ”R squared” coefficient. Under the null of no

arch effects the test statistic is asym. distributed as a χp .
23 / 62
Estimating ARCH

ARCH models are typically estimated by ML.

The ML estimator has no closed form expression and needs to be
found numerically.
Using the prediction error decomposition and assuming D normal we
have that the likelihood is
n
$ 1 1 1 r2
log Ln (ω, α) = − log(2π) − log σt2 − t2
2 2 2 σt
t=2

MLE
(ω̂, α̂) = arg max log Ln (ω, α)
ω,α

24 / 62
Fitted Values and Residuals

Model adequacy can be check by inspection of the fitted values.

σ̂t2 = ω̂ + α̂rt2

and standardized residuals

rt
ẑt = &
σ̂t2

Note that the residuals ẑt are typically called standardized residuals in
this setting.

25 / 62
Fitted Values and Residuals

Typically, in an ARCH world we do not care excessively about µ̂t

since it is zero for all t!
(if the specification does not have a mean equation)
Note that when we plot the fitted volatility alone, we report it on an
annualized volatility scale, i.e. we plot
!
252σ̂t2

If the specification is correct, standardized residuals should

1 be approximately distributed according to distribution
2 not exhibit dependence in levels, absolute levels, square levels, etc...

26 / 62
ARCH(3): Simulation Illustration

Figure: Returns rt , ω = 0.5 α1 = 0.3 α2 = 0.2 α3 = 0.1, Normal innovations.

27 / 62
ARCH(3): Simulation Illustration

Figure: Volatility σt , ω = 0.5 α1 = 0.3 α2 = 0.2 α3 = 0.1, Normal innovations.

28 / 62
ARCH(3): Simulation Illustration

Figure: ACF rt , ω = 0.5 α1 = 0.3 α2 = 0.2 α3 = 0.1, Normal innovations.

29 / 62
ARCH(3): Simulation Illustration

Figure: ACF rt2 , ω = 0.5 α1 = 0.3 α2 = 0.2 α3 = 0.1, Normal innovations.

30 / 62
ARCH(3): Simulation Illustration

Figure: QQ Plot rt , ω = 0.5 α1 = 0.3 α2 = 0.2 α3 = 0.1, Normal innovations.

31 / 62
S&P 500 Volatility Analysis

As an empirical illustration, we are going to use an ARCH(3) model

(with intercept) to fit the SP 500 returns
The ARCH(3) with intercept is defined as
!
rt = c + σt2 zt zt ∼ N (0, 1)

σt2 = ω + α1 rt−1
2 2
+ α2 rt−2 2
+ α3 rt−3

32 / 62
S&P 500 Volatility Analysis: Returns

Figure: S&P 500 Absolute Returns. ARCH-LM Stat: 591.7782 - p-value ≤ 0.001

33 / 62
S&P 500 Volatility Analysis: Volatility

Figure: S&P 500 Annualized Volatility.

34 / 62
Std Residuals

Figure: S&P 500 Std Residuals.

35 / 62
Std Residuals

Figure: S&P 500 Returns (left) & Std. Residual (right) QQplot. Jarque-Bera Test
Before & After: 8714.9 & 781

36 / 62
Std Residuals

Figure: S&P 500 Abs. Returns (left) & Abs. Std. Residual (right) ACF.

37 / 62
Remarks

SP 500 exhibits strong evidence of volatility clustering.

The ARCH(3) model captures a substantial portion of clustering.
However, residual diagnostic signal that the specification is not fully
satisfactory.

38 / 62
GARCH Models

In practice, only rather rich ARCH parameterizations are able to fit

financial series adequately.
However, largely parameterized models can be unstable in forecasting
and a pain to estimate.
In order to overcome the shortcomings of the ARCH Tim Bollerslev
proposed a generalization of the ARCH model called GARCH
(Bollerslev (1986)).
The model allows to fit financial returns adequately while keeping the
number of parameters small.
The GARCH model is one of the most successfully employed volatility
models.

39 / 62
GARCH(1,1) Model

The GARCH(1,1) model is

!
rt = σt2 zt zt ∼ D(0, 1)

σt2 = ω + αrt−1
2 2
+ βσt−1
where ω > 0, α > 0, β ≥ 0 and α + β < 1.
The quantity α + β determines several key dynamic properties of the
GARCH(1,1). It is typically referred to as the persistence.

40 / 62
GARCH(p,q) Model

The GARCH(p,q) model is

!
rt = σt2 zt zt ∼ D(0, 1)

σt2 = ω + α1 rt−1
2 2
+ α2 rt−2 2
+ · · · + αq rt−p 2
+ βσt−1 2
+ βσt−2 2
+ βσt−q
" "
where ω > 0, αi > 0, βi > 0, and pi=1 αi + qi=1 βi < 1.

41 / 62
GARCH(1,1): Unconditional Moments

The unconditional variance of the process is

ω
σ2 = .
1−α−β

The kurtosis of the GARCH(1,1) is

3(1 − (α + β)2 )
Kurt = >3
1 − (α + β)2 − 2α2

42 / 62
GARCH(1,1): ACF rt2

The ACF of rt2 is

' (
α2 β
ρk (rt2 ) = α+ (α + β)k−1 .
1 − 2β − β 2

Notice that the degree of decay of the autocorrelation depends on the

persistence of the GARCH.

43 / 62
GARCH(1,1): EWMA/ARCH(∞) representation

The GARCH model can be seen as an infinite ARCH models

$ ∞
ω
σt2 = +α β i−1 rt−i
2
1−β
i=1

This representation shows how a GARCH(1,1) is a parsimonious way

of characterizing ARCH dynamics.
The conditional variance of a GARCH(1,1) can be seen as a weighted
average of recent returns such that the weight given to past
information decreases exponentially fast.

44 / 62
GARCH(1,1): ARMA representation

GARCH models can also be represented as an ARMA models.

In case of the GARCH(1,1), considering νt = rt2 − σt2

rt2 = ω + (α + β)rt−1
2
+ νt − βνt−1

Thus, a GARCH can be seen as an ARMA model for squared returns.

45 / 62
GARCH(1,1): Forecasts

The 1 step ahead forecast is

σT2 +1|T = ω + αrT2 + βσT2

The k step ahead forecast is

σT2 +k|T = σ 2 + (α + β)k−1 (σT2 +1 − σ 2 )

Notice that the degree of mean reversion of the predictions depends

on the persistence of the GARCH.

46 / 62
Inference

Inference for the GARCH is analogous to the one of the ARCH.

In particular, the model can be estimated by MLE. The MLE is not
available in closed form and the log likelihood needs to be maximized
numerically.

47 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 Returns, rt , ω = 0.01, α = 0.05, β = 0.949. Gaussian

innovation.
48 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 Volatility, σt , ω = 0.01, α = 0.05, β = 0.949. Gaussian

innovation.
49 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 ACF rt , ω = 0.01, α = 0.05, β = 0.949. Gaussian innovation.

50 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 ACF rt2 , ω = 0.01, α = 0.05, β = 0.949. Gaussian innovation.

51 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 QQPlot rt , ω = 0.01, α = 0.05, β = 0.949. Gaussian innovation.

52 / 62
GARCH(1,1): Simulation Illustration

Figure: S&P 500 Volatility Forecasts, ω = 0.01, α = 0.05, β = 0.949. Gaussian

innovation.
53 / 62
S&P 500 Volatility Analysis

As an empirical illustration, we are going to use a GARCH(1,1) model

(with intercept) to fit the S&P 500 returns.
The GARCH(1,1) with intercept is defined as
!
rt = c + σt2 zt zt ∼ N (0, 1)

σt2 = ω + αrt−1
2 2
+ βσt−1 .

54 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Returns. ARCH-LM Stat: 591.7782 - p-value ¡ 0.001.

55 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Annualized Volatility.

56 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Conditional Volatility.

57 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Std. Residuals.

58 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Returns (left) Std. Residual (right) QQPlot. Jarque-Bera Test
Before & After: 8714.9 & 266.55

59 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 Abs. Returns (left) Abs. Std. Residual (right) ACF.

60 / 62
S&P 500 Volatility Analysis

S&P 500 exhibits strong evidence of volatility clustering

The simple GARCH(1,1) model captures adequately conditional
heteroskedasticity in the data!
The hypothesis of normality of the standardized shocks however is still
forcefully rejected by the data. Standardized residuals exhibit fat tails.

61 / 62
S&P 500 Volatility Analysis

Figure: S&P 500 lagged returns vs squared returns

62 / 62