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ARCH/GARCH Models

Measuring volatility: Conditional

heteroscedastic Models

K.R. Shanmugam, MSE

Features of Financial Data (e.g

Stock returns)

1. Volatility Clustering: Some periods are highly

volatile while others are less. Big shocks

(residuals) tend to follow big shocks in either

direction and small shocks follow small. This

implies strong AC. In addition, constant variance

assumption is inappropriate

(If unconditional (or long-run) variance is

constant but there are periods in which the

variance is relatively high. Such series are called

conditionally heteroscedastic).

Features….

2. Leverage Effect: Volatility is higher in a

falling market than it is in a rising market

(there is a tendency for volatility to rise

more following a large price fall than

following a price rise of the same

magnitude).

Features

3. Leptokurtosis: They have distributions

which exhibit flatter tails and excess peakedness

(due to a large number of excessive values).

(a normal distribution is skewed (3

rd

moment)

and has a coefficient of kurtosis of 3 (it is

symmetric and said to be meso-kurtic)

• Leptokurtic is one which has flatter tails and is

more peaked at mean than normal with same

mean and variances.

NSE (2/1/1996 to 20/12/2002)

600

800

1000

1200

1400

1600

1800

1996 1997 1998 1999 2000 2001 2002

CLOSE

-.12

-.08

-.04

.00

.04

.08

.12

1996 1997 1998 1999 2000 2001 2002

RETURNS

Impact of special characteristics

• They lead to violations of

homoscedasticity as well as auto-

correlation assumptions of OLS

• (consequences of heteroscedasticity:

estimates of parameters are unbiased, but

SEs are large, CIs are very narrow, and

precision is affected)

• Linear Models are unable to explain these

special features

Tasks of the Asset Holder

• He may be interested in forecasting the rate of

return and the variance of the stock asset over

the holding period.

• ARMA models are useful to forecast mean

returns. But it ignores the risk factor (variance or

SD is a measure of risk or volatility)

• Some series are subject to fat tails, volatility

clustering and leptokurtic, the task is to specify

and forecast both mean and variance of the

series conditional on past information.

Historical Volatility

• Calculating the variance of the series in the

usual way over some historical period

(e.g. In option pricing model, historical average

variance is used as volatility measure)

• Rolling standard deviation (RSD): Studies such

as Tauchen and Pitts (1987) used this. They

calculate standard deviation using fixed number

of observations. That is, first calculate it using

most recent (say) 22 days data. Then drop first

day and add 23

rd

day data. This is also called

Officier’s approach.

Problems with RSD

• It uses equal weight for all cases (more

recent observations should be more

relevant and be given higher weight)

• Use of overlapping observations lead to

correlation issues

• Zero weight for other observations are

unattractive

Summary of Problems

• unconditional forecast has a greater

variance than the conditional forecast, plus

overlapping problem and usage of equal

weighting.

• So conditional forecast (since they take

into account the known current and past

realization of series) are preferable.

Engle (1982) ARCH Model

• It says that the variance of the error term at time

t depends on the squared error terms from

previous periods:

R

t

=m

t

+ e

t

and e

t

= N(0, o

t

2

) ……………….(1)

(or e

t

= v

t

o

t

; v

t

~ N(0, 1)) where

o

2

t

=o

0

+ o

1

e

t-1

2

+ o

2

e

t-2

2

+……+ o

p

e

t-p

2

…..(2)

(here the AC in volatility is modeled)

• this is an ARCH (p) model

• ARCH(1) Model: o

2

t

=o

0

+ o

1

e

t-1

2

ARCH TEST

ARCH (joint) TEST:

To choose number of lagged terms.

If we start with one lag, this test will tell us whether we

need to add any additional lag term.

Steps:

(i) Run mean regression R

t

=m

t

+ e

t

and save residuals e

t

(ii) Squared the residuals and regress it on its own lagged

term to test for ARCH (e

2

t

=o

0

+ o

1

e

t-1

2

+ o

2

e

t-2

2

+……+

o

p

e

t-p

2

(iii) Define TR

2

~ _

2

(p), where p is number of lagged term

on the right has side of second equation

(iv) Null Hypothesis: H

0

: o

1

=0; o

2

=0…. o

p

=0

Alternate Hypothesis: H

1

: o

1

≠0; o

2

≠ 0…. o

p

≠ 0

(v) If test value is greater than critical value, reject the null

Properties of ARCH (1) process

• e

t

= v

t

o

t

and o

2

t

=o

0

+ o

1

e

t-1

2

• o

t

= (o

0

+ o

1

e

t-1

2

)

1/2

• Since E v

t

=0; E e

t

= 0

• Since E v

t

v

t-i

= 0, E e

t

e

t-i

=0

• Unconditional variance:

E e

t

2

= E [v

t

2

(o

0

+ o

1

e

t-1

2

)]

Since E v

t

2

=1, E e

t

2

= o

0

+ o

1

Ee

t-1

2

o

2

= o

0

+ o

1

o

2

= o

0

/(1- o

1

)

Conditional Mean and Variance

• E [e

t

| e

t-1

, e

t-2……..

] =0

• E [e

t

2

| e

t-1

, e

t-2……..

] = E [v

t

2

(o

0

+ o

1

e

t-1

2

)]

• o

2

t

= 1. (o

0

+ o

1

e

t-1

2

)

• Thus, the conditional variance depends on

realized value of e

t-1

2

.

• If e

t-1

2

is larger, the conditional variance in t

will be larger as well.

ARCH (1) Model…

• Unconditional variance:

• E e

t

2

= o

0

/(1- o

1

) ; we restrict that o

0

>0

and |o

1

|<1 to make it positive and finite.

• Conditional variance

• E [e

t

2

| e

t-1….

] = o

0

+ o

1

e

t-1

2

• That is, e

t

is conditionally heteroscedastic

Conditional Forecast Vs

Unconditional Forecast

• Engle (1982): conditional is better than

unconditional

• Example: Consider an AR(1) Model:

y

t

= a

0

+ a

1

y

t-1

+ e

t

• Conditional Forecast of y

t+1

:

E (y

t+1

|t) = a

0

+ a

1

y

t

• Forecast Error Variance is:

E [(y

t+1

- a

0

- a

1

y

t

)

2

] = E e

t+1

2

=o

2

Unconditional Forecast of y

y

t

= a

0

+ a

1

y

t-1

+ e

1

y

t

(1-a

1

L)= a

0

+ e

t

y

t

= a

0

/( 1-a

1

L) + e

t

/(1-a

1

L)

y

t+1

= a

0

/(1-a

1

L) + e

t+1

/ (1-a

1

L)

E y

t+1

= a

0

/ (1-a

1

L) = a

0

/ (1-a

1

): Long run mean

Unconditional Forecast of Error Variance

E [y

t+1

- Ey

t+1]

]

2

= E (e

t+1

/(1-a

1

)) = o

2

/ (1-a

1

)

Estimation

• ML Estimation Method

• Log-Likelihood function using a normality assumption for

the disturbance is:

ln L = -T/2 ln (2t)-(1/2)E ln o

t

2

– (1/2)[E(y

t

– a

0

-a

1

y

t-1

)

2

(1/o

t

2

)]

• It is an updating formula: Observed variance of the

residuals is taken for 1

st

observation; then it calculates

variance for the second and so on for any given set of

parameter values; thus the entire time series of variance

forecast is constructed; then the likelihood function

provides a systematic way to adjust the parameter to

give the best fit.

Generalized ARCH

• Developed independently by Bollerslev (1986) and

Taylor (1986)

• Bollerslave’s GARCH Specification:

R

t

=m

t

+ e

t

, where e

t

~ N(0, o

t

2

)

• o

2

t

=o

0

+ o

1

e

t-1

2

+ o

2

e

t-2

2

+…+ ¸

1

o

t-1

2

+…

• It allows conditional variance to be dependent on

previous own lags

• It is a weighted average of long term average (variance),

information about volatility during previous years and

fitted variance in previous years.

• Such an updating formula is a simple description of

adaptive or learning behaviour.

• Estimation is same as ARCH

• However, we use parsimonious model; GARCH (1,1) is

sufficient

GARCH (1,1) Vs. ARCH

• Proof: Let o

2

t

=o

0

+ o

1

e

t-1

2

+ ¸ o

t-1

2

......(1)

• o

2

t-1

=o

0

+ o

1

e

t-2

2

+ ¸ o

t-2

2

….................(2)

• o

2

t-2

=o

0

+ o

1

e

t-3

2

+ ¸ o

t-3

2

………………(3)

• Substitute (2) in (1) and then (3) in…

• o

2

t

=o

0

(1+ ¸+ ¸

2

) + o

1

e

t-1

2

(1+ ¸ L+ ¸

2

L

2

) + ¸

3

o

t-3

2

• An infinite number of successive substitutions leads to

• o

2

t

=o

0

(1+ ¸+ ¸

2+….

) + o

1

e

t-1

2

(1+ ¸ L+ ¸

2

L

2+….

) + ¸

·

o

0

2

• The last term is almost zero

• The rest is similar to ARCH infinite specification

• Although GARCH (1,1) has 3 parameters in conditional variance

equation (parsimonious), it allows an infinite number of past squared

errors

(1) GARCH (1,1)

2

2 2 2

0 1 1 2 1

t t t

t t t

r µ v o

o o o c o o

÷ ÷

= +

= + +

where c

t-1

and o

t-1

are ARCH and GARCH

terms respectively.

The (G)ARCH-M Model

2 2

2 2 2

0 1 1 2 1

t t t t

t t t

r µ |o v o

o o o c o o

÷ ÷

= + +

= + +

In this application, the dependent variable in the mean

equation is determined by its conditional variance.

For instance, the expected return on an asset is related

to expected asset risk.

The Asymmetric ARCH Models

• Often, we notice that the downward movement in the

market are highly volatile than upward movement of the

same magnitude. In such case, symmetric ARCH model

undermine the true variance process. Engle and Ng

(1993) provide a news impact curve with asymmetric

response to good and bad news.

Good news Bad News

Volatility

two types of asymmetric ARCH

models: TARCH and EGARCH

2

2 2 2 2

0 1 1 2 1 1 1

t t

t t

1 1

where d 1if ε < 0 and 0 otherwise

ε 0 good news, ε 0 bad news

They have differential effects on conditional var.

Good (bad) news has an effect of ( )

If 0,

t t t

t t t t t

r

d

µ v o

o o o c o o ìc

o o ì

ì

÷ ÷ ÷ ÷

= +

= + + +

=

¬ ¬

+

there is leverage effect (bad news increases volatility).

if 0, the news impact is asymmetric. ì =

The TARCH or Threshold ARCH due to Zakoian

(1990) can be defined as:

The EGARCH Model (by Nelson

1991)

2 2

1 1

0 1 1 3

1 1

log log

t t

t t

t t

c c

o o o o o ì

o o

÷ ÷

÷

÷ ÷

= + + +

If 0, there is leverage effect.

if 0, the impact is asymmetric

ì

ì =

Log of conditional variance equation. This means that leverage effect is

exponential than quadratic. This guarantees that forecasts of conditional

variances are positive;

Power GARCH (PARCH)

• Taylor (1986) and Schwert (1989) developed

S.D GARCH model. The conditional variance is

not a linear function in lagged squared residuals

• where o>0.

• For symmetric model ¸=0; if ¸≠0, asymmetric

effects are present

• If o=2 and ¸=1 for all i, then the model is

standard GARCH

2 2

0 1

( ) ( ) ( )

t i t i t i j t

o

o

o

o o o c ¸c | o

÷ ÷ ÷

= + ¿ ÷ + ¿

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