Applied Econometrics – 4th Edition

Solutions to End of Chapter Exercises

Dr Dimitrios Asteriou
Chapter 14: ARCH-GARCH Models

Exercise 14.1
a. The program attached with the database generates regression for autoregressive models from order
1 up to 15 for all 3 stocks and also the market index. Then, it summarizes the results by the means of
the t-statistics for its coefficients and also the Akaike Info Criterion and Schwarz Info Criterion to
have a wide view of all possible models and their significance. So, the results are in the 4 matrixes:
stock1, stock2, stock3 and ftse. The results of the regression can be found in the EViews data file, as
the tables are too big to include them in Microsoft Word.

b. In total, 60 regressions were done out of which I have selected the most significant ones for each
stock and also for the index, based on the t-statistics and also the info criterions. These models are:
- for stock 1 ar(3)
- for stock 2 ar(3)
- for stock 3 ar(2)
- for FTSE ar(1)

c. The equations for the 3 stocks and index are the following, using OLS:

Dependent Variable: R_FTSE

Method: Least Squares
Date: 05/16/16 Time: 11:51
Sample (adjusted): 1/03/1985 12/31/1999
Included observations: 3912 after adjustments
Convergence achieved after 2 iterations

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000420 0.000169 2.484039 0.0130

AR(1) 0.072569 0.015950 4.549655 0.0000

R-squared 0.005266 Mean dependent var 0.000420

Adjusted R-squared 0.005012 S.D. dependent var 0.009835
S.E. of regression 0.009810 Akaike info criterion -6.410334
Sum squared resid 0.376277 Schwarz criterion -6.407128
Log likelihood 12540.61 Hannan-Quinn criter. -6.409197
F-statistic 20.69936 Durbin-Watson stat 1.994158
Prob(F-statistic) 0.000006

Inverted AR Roots .07

Dependent Variable: R_STOCK1
Method: Least Squares
Date: 05/16/16 Time: 11:49
Sample (adjusted): 1/07/1985 12/31/1999
Included observations: 3910 after adjustments
Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000307 0.000241 1.275795 0.2021

AR(1) 0.042925 0.015953 2.690779 0.0072
AR(2) -0.037659 0.015953 -2.360599 0.0183
AR(3) -0.042219 0.015959 -2.645553 0.0082

R-squared 0.005204 Mean dependent var 0.000308

Adjusted R-squared 0.004440 S.D. dependent var 0.015660
S.E. of regression 0.015626 Akaike info criterion -5.478795
Sum squared resid 0.953682 Schwarz criterion -5.472379
Log likelihood 10715.04 Hannan-Quinn criter. -5.476518
F-statistic 6.810541 Durbin-Watson stat 2.000039
Prob(F-statistic) 0.000142

Inverted AR Roots .17+.33i .17-.33i -.30

Dependent Variable: R_STOCK2

Method: Least Squares
Date: 05/16/16 Time: 11:50
Sample (adjusted): 1/07/1985 12/31/1999
Included observations: 3910 after adjustments
Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000234 0.000251 0.930917 0.3520

AR(1) 0.008142 0.015986 0.509310 0.6106
AR(2) -0.018265 0.015991 -1.142218 0.2534
AR(3) -0.040215 0.015982 -2.516218 0.0119

R-squared 0.002041 Mean dependent var 0.000234

Adjusted R-squared 0.001275 S.D. dependent var 0.016503
S.E. of regression 0.016493 Akaike info criterion -5.370797
Sum squared resid 1.062445 Schwarz criterion -5.364381
Log likelihood 10503.91 Hannan-Quinn criter. -5.368520
F-statistic 2.663392 Durbin-Watson stat 2.000786
Prob(F-statistic) 0.046364

Inverted AR Roots .17+.31i .17-.31i -.32

 Dependent Variable: R_STOCK3
Method: Least Squares
Date: 05/16/16 Time: 11:50
Sample (adjusted): 1/04/1985 12/31/1999
Included observations: 3911 after adjustments
Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000540 0.000304 1.778671 0.0754

AR(1) 0.131047 0.015966 8.208014 0.0000
AR(2) -0.061409 0.015966 -3.846221 0.0001

R-squared 0.018958 Mean dependent var 0.000540

Adjusted R-squared 0.018456 S.D. dependent var 0.017842
S.E. of regression 0.017677 Akaike info criterion -5.232387
Sum squared resid 1.221098 Schwarz criterion -5.227576
Log likelihood 10234.93 Hannan-Quinn criter. -5.230680
F-statistic 37.75920 Durbin-Watson stat 2.003207
Prob(F-statistic) 0.000000

Inverted AR Roots .07+.24i .07-.24i

After this, each model was tested using the ARCH Heteroskedasticity test and was found to have
ARCH effects. The test were done using different levels for the lagged terms, and I chose the best
one based on the criterions together with R2.

d. The ARCH (p) models estimated can be found in the EViews data file under the names:
eq_ftse_arch7, eq_stock1_arch5, eq_stock2_arch9, eq_stock3_arch5. I haven’t added them here as
they are too big due to the high value for the lags, respectively 7, 5, 9, 5 and would be hard to view
as the programs have compatibility issues. If we compare the results with the previous ones, we can
see that regarding the R2, the ARCH models provides worse estimates, an irrelevant thing in our case,
as the maximum R2 obtained is 2%. Thus, this figure does not show an accurate image of the
reliability of the model. What is more important is the results for the Akaike Info Criterion and the
Schwarz Criterion, according to which the ARCH models estimated are much better, as they give
results which are a lot lower regarding these 2 factors.
e. The series were generated and are present in the database attached.
f. The GARCH models were estimated using the same approach as ARCH, focusing on the criterions.
The equations are in the database with relevant names, and also the conditional variance and
standard deviation series. Plotting the SD and VAR series together for the ARCH and GARCH models
resulted in the graphs from the database with the names: plot_*series_name*_sd and
plot_*series_name*_var. Looking at the graphs together, no big differences can be seen. What is
interesting is that the GARCH model provides more stability in estimations. The ARCH models are
more volatile to small changes, but on the other hand if there is an important disturbance, the
GARCH models capture it better. The very small differences are also due to the fact that the ARCH
models estimated were of very high order, and the differences will be naturally very small. Selecting
a high order ARCH model was a tedious job, and having gone in the first place with a GARCH model
would have been much more efficient and would have provided fairly good estimates for the model
at hand. Below are a couple of graphs that highlight the information described above.

.06

.05

.04

.03

.02

.01
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

SD_STOCK1_ARCH5
SD_STOCK1_GARCH11

.07

.06

.05

.04

.03

.02

.01

.00
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

SD_STOCK2_ARCH9
SD_STOCK2_GARCH22
 g. In all cases except stock 2, based on the t-statistic of the dummy variable, asymmetry effects exist.
Thus, in the 3 cases where the significance was high enough (in absolute terms), negative variations
have a far more persistent effect than positive ones as shocks in terms of the magnitude of the
volatility.
h. The EGARCH models further justify the result from point g. Thus, the probabilities for the t-statistic
for the term ut-1/(ht-1)^(1/2) are all less than 0.0000 expect for the second stock. This provides more
justification towards the fact that asymmetries exist and must be taken into account. What is
interesting this time though is that when estimating an EGARCH (2,2) model for the second stock,
the lag 1 term described above is not significant, but the lag 2 similar term is significant with a t-
statistic of approximately -6.9778. This means that asymmetries exist for the second stock as well,
but have a more delayed effect.
i. The main results are summarized in the table below.

FTSE Stock 1 Stock 2 Stock 3

AR 0.00042 + 0.0003+ 0.0002 + 0.0005 +
[AR(1)=0.07257] [AR(1)=0.043,AR(2)= [AR(1)=0.008,AR(2)=- [AR(1)=0.13,AR(2)=-
-0.038,AR(3)=-0.042] 0.018,AR(3)=-0.04] 0.06]

ARCH 3.4e-05 + GARCH = 0.0001 + 0.00012+ 0.00014 +

0.07*RESID(-1)^2 + 0.12*RESID(-1)^2 + 0.18*RESID(-1)^2 + 0.15*RESID(-1)^2 +
0.1*RESID(-2)^2 + 0.15*RESID(-2)^2 + 0.04*RESID(-2)^2 + 0.13*RESID(-2)^2 +
0.16*RESID(-3)^2 + 0.07*RESID(-3)^2 + 0.07*RESID(-3)^2 + 0.083*RESID(-3)^2 +
0.08*RESID(-4)^2 + 0.05*RESID(-4)^2 + 0.12*RESID(-4)^2 + 0.12*RESID(-4)^2 +
0.08*RESID(-5)^2 + 0.06*RESID(-5)^2 0.07*RESID(-5)^2 + 0.08*RESID(-5)^2
0.08*RESID(-6)^2 + 0.086*RESID(-6)^2
0.07*RESID(-7)^2

GARCH 2.27e-06 + 1.89e-05 + 1.8e-06 + 6.8e-06 +

0.08*RESID(-1)^2 + 0.1*RESID(-1)^2 + 0.15*RESID(-1)^2 - 0.08*RESID(-1)^2 +
0.9*GARCH(-1) 0.8*GARCH(-1) 0.12*RESID(-2)^2 + 0.9*GARCH(-1)
0.92*GARCH(-1) +
0.04*GARCH(-2)

TGARCH 2.18e-06 + 1.8e-05 + 1.81e-06 + 6.7e-06 +

0.04*RESID(-1)^2 + 0.12*RESID(-1)^2 - 0.15*RESID(-1)^2 + 0.066*RESID(-1)^2 +
0.06*RESID(- 0.04*RESID(- 0.008*RESID(- 0.022*RESID(-
1)^2*(RESID(-1)<0) 1)^2*(RESID(-1)<0) + 1)^2*(RESID(-1)<0) - 1)^2*(RESID(-1)<0)
+ 0.9*GARCH(-1) 0.009*RESID(- 0.12*RESID(-2)^2 + + 0.9*GARCH(-1)
2)^2*(RESID(-2)<0) + 0.93*GARCH(-1) +
0.83*GARCH(-1) 0.03*GARCH(-2)

EGARCH (for log -0.38 + -0.6+ -0.18+ -0.28 +

returns) 0.16*ABS(RESID(- 0.19*ABS(RESID(- 0.12*ABS(RESID(- 0.15*ABS(RESID(-
1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(-
1))) - 0.05*RESID(- 1))) + 0.03*RESID(- 1))) - 0.002*RESID(- 1))) - 0.017*RESID(-
1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(- 1)/@SQRT(GARCH(-
1)) + 1)) + 1)) + 1)) +
0.97*LOG(GARCH(- 0.94*LOG(GARCH(- 0.989*LOG(GARCH(- 0.98*LOG(GARCH(-
1)) 1)) 1)) 1))

EGARCH (for log -0.15 +

0.3*ABS(RESID(-
returns)
1)/@SQRT(GARCH(-
1))) -
0.19*ABS(RESID(-
2)/@SQRT(GARCH(-
2))) - 0.003*RESID(-
1)/@SQRT(GARCH(-
1)) +
0.82*LOG(GARCH(-
1)) +
0.17*LOG(GARCH(-
2))

The results show that as many financial data, the stock returns and the market index behave similarly and
consequently adjacent models will need to be used in order to explain the variation of the returns.
Exercise 14.2
a. A generalized autoregressive conditional heteroscedasticity model would be better suited than a
regular one as it provides better estimates than a similar order model (in this case 1) and
comparable to higher order ones. More than that, GARCH processes take into account past
volatilities in a more parsimonious way than ARCH processes. In stock return data past volatilities are
important as logarithmic differenced returns, even though are generally considered stationary
series, in a longer time span the condition of homoscedasticity is violated as the variance tends to
have lower and higher values depending on the smaller time frame. Thus, volatility clustering is an
important phenomenon that needs to be taken into account and a GARCH model further underlines
these disturbances.
b. Through mathematics, it can be proved that a GARCH (1,1) process is very similar to an infinite ARCH
(q) process. This proof can be viewed on page 299 of Chapter 14 in Asteriou and Hall (2007) Applied
Econometrics, Palgrave-McMillan.
c. The results for the ARCH(1) model are:

Dependent Variable: R_FTSE

Method: ML - ARCH (Marquardt) - Normal distribution
Date: 05/26/16 Time: 16:21
Sample (adjusted): 1/03/1985 12/31/1999
Included observations: 3912 after adjustments
Convergence achieved after 25 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(3) + C(4)*RESID(-1)^2

Variable Coefficient Std. Error z-Statistic Prob.

C 0.000488 0.000166 2.946242 0.0032

AR(1) 0.083418 0.014168 5.887730 0.0000

Variance Equation

C 7.58E-05 8.15E-07 92.97308 0.0000

RESID(-1)^2 0.164588 0.013796 11.93017 0.0000

R-squared 0.005108 Mean dependent var 0.000420

Adjusted R-squared 0.004854 S.D. dependent var 0.009835
S.E. of regression 0.009811 Akaike info criterion -6.500689
Sum squared resid 0.376337 Schwarz criterion -6.494276
Log likelihood 12719.35 Hannan-Quinn criter. -6.498413
Durbin-Watson stat 2.015021

Inverted AR Roots .08

The results for the GARCH (1,1) model are:

Dependent Variable: R_FTSE

Method: ML - ARCH
Date: 05/16/16 Time: 12:12
Sample (adjusted): 1/03/1985 12/31/1999
Included observations: 3912 after adjustments
Convergence achieved after 11 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

C 0.000572 0.000144 3.988018 0.0001

AR(1) 0.073055 0.017643 4.140746 0.0000

Variance Equation

C 2.27E-06 4.07E-07 5.565025 0.0000

RESID(-1)^2 0.075597 0.007453 10.14352 0.0000
GARCH(-1) 0.900875 0.009902 90.97826 0.0000

R-squared 0.005060 Mean dependent var 0.000420

Adjusted R-squared 0.004805 S.D. dependent var 0.009835
S.E. of regression 0.009811 Akaike info criterion -6.608426
Sum squared resid 0.376355 Schwarz criterion -6.600410
Log likelihood 12931.08 Hannan-Quinn criter. -6.605582
Durbin-Watson stat 1.994685

Inverted AR Roots .07

At a first glance, the efficiency of the models is similar. R 2s are very close to each other, but the AIC
and SBC criteria are a bit lower for the GARCH (1,1) process. Also, both the coefficients are
significant. This means the GARCH model is better suited to the variation of stock market returns, in
this case the stock market index FTSE.
By generating the conditional variance series for the two models and also the associated standard deviations
and plotting them accordingly, we obtain the following graphs.

.0030

.0025

.0020

.0015

.0010

.0005

.0000
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

VAR_ARCH1 VAR_GARCH11

.06

.05

.04

.03

.02

.01

.00
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

SD_ARCH1 SD_GARCH11
Exercise 14.3
We present here results for the DM variable (for the first 1500 observations only). Similar analysis can be
followed for all other series.

(a) In order to obtain the first logarithmic differences the command is

genr D_DM=log(DM)-log(DM(-1))

the plot of the differenced series is provided below:

The volatility clustering phenomenon is obvious from the graph.

(b) To estimate an AR(1) model the command is:

ls D_DM c AR(1)

The results are shown below:

To test for ARCH effects, we choose: View/Residual Diagnostics/Heteroskedasticity Tests/ and from the
resulting window we choose the ARCH test. We can define the number of lags as well. Here, for simplicity we
choose the defaulted option, which is of lag 1.

The results are shown below:

There is clear evidence of ARCH effects (F-stat=16.52; p-value: 0.0001). Thus ARCH/GARCH type models are
more appropriate in modelling the behaviour of the series.
 (c) We proceed by estimating various ARCH/GARCH type models. Some results are reported below. The
analysis and interpretation is as usual (refer to the book).

ARCH(1) model

GARCH(1,1) model
TGARCH(1,1,1) model – the significance of the TGARCH dummy suggests that there are asymmetries for
good and bad news.

(d) We go back to the excel file and we create five daily dummies (D_MON, D_TUE,…) with the IF
function using the values in the DAY column. Then, we copy/paste the dummies in EViews.

Next, we estimate a GARCH(1,1) with dummies in the mean equation (note that if we want to add all five
days as dummies the constant should be excluded from the mean equation to avoid the dummy variable
trap). The results are shown below:
We see that Monday is negative and statistically significant. So, there is a day of the week effect present
for the mean of the series (the returns of the exchange rate).

Finally, we add the dummies in the variance series (note that we need to exclude a day since the GARCH
variance series includes a constant). The results are reported below:
We see that Monday (for 10% sig level), Thursday and Friday (for 5% sig level) have statistically
significant positive effects in the variance series. Therefore, during those days the volatility in the
exchange rate market is higher.

More GARCH type models can be estimated and discussed, but we leave this for the reader.