Finance 625: Quantitative Methods in Finance

Homework 8

Due: December 7, 2023

Instructions: This homework assignment is worth five points. Please hand in

your answers at the start of class on the due date. Use four decimal places in
all calculations. You must show all your work, including equations used, to
receive full credit. Late assignments submitted less than or exactly one week
after the due date receive a one point deduction. Late assignments submitted
more than one week after the due date receive a two point deduction.

1
1. Suppose yt follows an ARCH(1) process:

yt = σt ut
σt2 = 0.4 + 0.6yt−1
2

ut ∼ IID(0, 1)

(a) Express yt2 as an AR(1) process and compute E(yt2 ).

2 2
(b) Compute Et (σt+2 ) and Et (σt+k ).The final answer should be a function of yt2 and/or
2
σt .

2. Suppose yt follows an GARCH(1, 1) process:

yt = σt ut
σt2 = 0.3 + 0.1yt−1
2 2
+ 0.6σt−1
ut ∼ IID(0, 1)

(a) Express yt2 as an ARMA(1, 1) process and compute E(yt2 ).

2 2
(b) Compute Et (σt+2 ) and Et (σt+k ). The final answer should be a function of yt2 and/or
σt2 .

3. Pick a stock and download historical data from Yahoo! finance. Download daily data
from April 2013 until May 2023. Compute returns from adjusted closing prices.

(a) Fit an ARCH(5), ARCH(10), GARCH(1, 1), and a GARCH(1, 2) model to each
return series. Use a t-distribution with unknown degrees of freedom. Report the
AIC and pick the best model.

(b) Using the best model, test whether the residuals are white noise.

(c) Using the best model, predict the next ten values of σ in the series.