ARCH Model

First we run ARCH-Mean model or ARCH-M model

For ARCH model the data should be stationary
Conditions to be fulfilled before ARCH model
• There should be clustering Volatility
• ARCH test should be rejected (Means that there
should be ARCH effect in the Model)
 There should be clustering
Volatility (First Condition)
Run Mean Model
R c (Where R is the Interest rate)
Steps
(i) Run the above regression and click on residual
icon on tool bar for checking Volatility Clustering
(ii) Click on Residual we will get the following diagram
 There should be clustering
Volatility (First Condition)
24

20

12 16

8 12

4 8

-4
I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV
1979 1980 1981 1982 1983 1984

Res idual A ctual Fitted

 There should be clustering
Volatility (First Condition)
In previous slide diagram, it is clear that low volatility
follow low volatility for extended period and high
volatility followed high volatility for extended period
of time. So, first condition of clustering volatility is
satisfied. For second condition see next slide
 There should be ARCH Effect(2nd
Condition)
H0: There is no ARCH effect
H1: There is ARCH effect
To check these hypothesis we apply ARCH test as
View Residual Diagnostic Heteroscedasticity
Test Test type ARCH Ok
Result on Next Slide
 There should be ARCH Effect(2nd
Condition)
Heteroskedasticity Test: ARCH

F-Statistics 5.816 Prob. F(1,21) .0251

Obs*R-Square 4.989 Prob, Chi-Sq .0255

As the result indicates that null hypothesis is rejected at 5% level of significance as

Obs*R-Squared prob. Is less than 5% and accept alternative hypothesis, so it shows that
second condition is also satisfied and now we are in a position to apply ARCH model
 ARCH Model
When second condition is also satisfied, and we are now
in position to run ARCH Model.
Quick=== equation estimate===Method==ARCH==Mean
equation==R c(interest rate and constant)==Variance
and Distribution specification ==ARCH=5(what ever you
want),GARCH=0,Threshold order=0, Variance
Regression= M1, P, GDP(if you want to check the effect
of other variable, otherwise leave it blank)
ARCH Model (Conti….)
Dependent Variable: R
Method: ML - ARCH (Marquardt) - Normal distribution
Date: 05/03/15 Time: 21:59
Sample: 1979Q1 1984Q4
Included observations: 24
Convergence achieved after 85 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-2)^2 + C(5)*RESID(-3)^2
        + C(6)*RESID(-4)^2 + C(7)*RESID(-5)^2 + C(8)*P + C(9)*GDP

Variable Coefficient Std. Error z-Statistic Prob.  

C 11.92792 0.489994 24.34301 0.0000

Variance Equation

C 9.673373 136.2993 0.070972 0.9434

RESID(-1)^2 1.148656 0.967748 1.186938 0.2353
RESID(-2)^2 -0.284140 0.690547 -0.411470 0.6807
RESID(-3)^2 0.182235 1.163880 0.156576 0.8756
RESID(-4)^2 -0.155018 0.801002 -0.193530 0.8465
RESID(-5)^2 -0.018448 0.564313 -0.032690 0.9739
P 0.002352 81.03272 2.90E-05 1.0000
GDP-2.19E-05 0.000593 -0.036923 0.9705

R-squared -0.132104     Mean dependent var 13.05833

Adjusted R-squared -0.132104     S.D. dependent var 3.177034
S.E. of regression 3.380376     Akaike info criterion 5.323444
Sum squared resid 262.8196     Schwarz criterion 5.765214
Log likelihood -54.88132     Hannan-Quinn criter. 5.440645
Durbin-Watson stat 0.329193
 ARCH Model (Conti…)
Now we will apply GARCH(1,1) model
Quick=== equation
estimate===Method==ARCH==Mean equation==R
c(interest rate and constant)==Variance and
Distribution specification ==ARCH=1(what ever you
want),GARCH=1,Threshold order=0, Variance
Regression= M1, P, GDP(if you want to check the
effect of other variable, otherwise leave it blank)
ARCH Model (Conti…)
Dependent Variable: R
Method: ML - ARCH (Marquardt) - Normal distribution
Date: 05/03/15 Time: 22:10
Sample: 1979Q1 1984Q4
Included observations: 24
Convergence achieved after 90 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*GARCH(-1) + C(5)*P + C(6)*GDP

Variable Coefficient Std. Error z-Statistic Prob.  

C 11.95876 0.500973 23.87106 0.0000

Variance Equation

C 13.03280 48.68731 0.267684 0.7889

RESID(-1)^2 1.159827 0.960397 1.207653 0.2272
GARCH(-1) -0.233691 0.268466 -0.870467 0.3840
P -2.040123 19.64624 -0.103843 0.9173
GDP-2.56E-05 0.000168 -0.152073 0.8791

R-squared -0.124995     Mean dependent var 13.05833

Adjusted R-squared -0.124995     S.D. dependent var 3.177034
S.E. of regression 3.369746     Akaike info criterion 5.099097
Sum squared resid 261.1693     Schwarz criterion 5.393610
Log likelihood -55.18916       Hannan-Quinn criter. 5.177232
Durbin-Watson stat 0.331273
 ARCH Model (Conti…)
Our third model is TARCH model
Quick=== equation
estimate===Method==ARCH==Mean equation==R
c(interest rate and constant)==Variance and
Distribution specification ==ARCH=1(what ever you
want),GARCH=1,Threshold order=1, Variance
Regression= M1, P, GDP(if you want to check the
effect of other variable, otherwise leave it blank)
ARCH Model (Conti…)
Dependent Variable: R
Method: ML - ARCH (Marquardt) - Normal distribution
Date: 05/03/15 Time: 22:23
Sample: 1979Q1 1984Q4
Included observations: 24
Convergence achieved after 100 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*RESID(-1)^2*(RESID(-1)<0) +
        C(5)*GARCH(-1) + C(6)*P + C(7)*GDP

Variable Coefficient Std. Error z-Statistic Prob.  

C 11.93541 0.630096 18.94223 0.0000

Variance Equation

C 17.14148 47.72459 0.359175 0.7195

RESID(-1)^2 1.197593 1.105068 1.083728 0.2785
RESID(-1)^2*(RESID(-1)<0) -0.273346 2.807641 -0.097358 0.9224
GARCH(-1) -0.238181 0.294014 -0.810102 0.4179
P -0.615306 26.60008 -0.023132 0.9815
GDP-4.08E-05 0.000179 -0.227861 0.8198

R-squared -0.130358     Mean dependent var 13.05833

Adjusted R-squared -0.130358     S.D. dependent var 3.177034
S.E. of regression 3.377769     Akaike info criterion5.175725
Sum squared resid 262.4144     Schwarz criterion 5.519324
Log likelihood -55.10870     Hannan-Quinn criter. 5.266882
Durbin-Watson stat 0.329701
 ARCH Model (Conti…)
Fourth Model is EGARCH Model
Quick=== equation
estimate===Method==ARCH==Mean equation==R
c(interest rate and constant)==Variance and
Distribution specification, Model=EGARCH,
==ARCH=1(what ever you want),Asymmetric Order=1,
Variance Regression= M1, P, GDP(if you want to check
the effect of other variable, otherwise leave it blank)
ARCH Model (Conti…)
Dependent Variable: R
Method: ML - ARCH (Marquardt) - Normal distribution
Date: 05/03/15 Time: 22:33
Sample: 1979Q1 1984Q4
Included observations: 24
Convergence achieved after 22 iterations
Presample variance: backcast (parameter = 0.7)
LOG(GARCH) = C(2) + C(3)*ABS(RESID(-1)/@SQRT(GARCH(-1))) + C(4)
        *RESID(-1)/@SQRT(GARCH(-1)) + C(5)*LOG(GARCH(-1)) + C(6)*P +
        C(7)*GDP

Variable Coefficient Std. Error z-Statistic Prob.  

C 12.15401 0.509721 23.84443 0.0000

Variance Equation

C(2) 2.233732 24.09649 0.092699 0.9261

C(3) 1.668136 1.306097 1.277192 0.2015
C(4) 0.400152 0.796200 0.502577 0.6153
C(5) 0.035281 0.601838 0.058622 0.9533
C(6) 0.361377 9.687393 0.037304 0.9702
C(7) -6.84E-06 8.77E-05-0.077992 0.9378

R-squared -0.084546    Mean dependent var 13.05833

Adjusted R-squared -0.084546     S.D. dependent var 3.177034
S.E. of regression 3.308612     Akaike info criterion5.215391
Sum squared resid 251.7790     Schwarz criterion 5.558990
Log likelihood -55.58469     Hannan-Quinn criter. 5.306548
Durbin-Watson stat 0.343628
 ARCH Model (Conti…)
Now question is which one is the best fitted model,
we see from the AIC and SIC value, GARCH(1,1)
carrying the lowest AIC and SIC value. So we will
proceed with GARCH(1,1) model.
 Now question is what about the Diagnosis
test of this GARCH(1,1) model

There are three test to be used for checking the

model:
1. Serial Correlation
2. ARCH Effect
3. Normality
 Now question is what about the Diagnosis
test of this GARCH(1,1) model

1. Serial Correlation
Null Hypothesis: There is no serial correlation in the
model
Alternative: There is serial correlation in the model
Procedure: After running GACH(1,1) go to
View==Residual Diagonastic==corrologram squared
residuals==ok
 Now question is what about the Diagnosis
test of this GARCH(1,1) model
1.Serial Correlation (conti…)
Date: 05/04/15 Time: 05:06
Sample: 1979Q1 1984Q4
Included observations: 24

Autocorrelation Partial Correlation AC   PAC  Q-Stat  Prob

     . |* . |      . |* . | 1 0.079 0.079 0.1695 0.681

     . *| . |      . *| . | 2 -0.119 -0.126 0.5708 0.752
     . *| . |      . *| . | 3 -0.199 -0.183 1.7505 0.626
     . |* . |      . |* . | 4 0.151 0.175 2.4595 0.652
     . | . |      . | . | 5 0.057 -0.013 2.5676 0.766
     . *| . |      . *| . | 6 -0.080 -0.097 2.7899 0.835
     . *| . |      . | . | 7 -0.129 -0.049 3.4025 0.845
     . *| . |      . *| . | 8 -0.153 -0.185 4.3187 0.827
     . |* . |      . |* . | 9 0.101 0.081 4.7407 0.856
     . | . |      . | . | 10 0.010 -0.048 4.7451 0.908
     . *| . |      .**| . | 11 -0.185 -0.235 6.3941 0.846
     .**| . |      . *| . | 12 -0.211 -0.116 8.7188 0.727
 Now question is what about the Diagnosis
test of this GARCH(1,1) model
1. Serial Correlation (conti…)\
We can see from the previous result the value of Q-stat and its probability.
The probability value for all the lags are greater than 5% so we accept null
hypothesis and reject alternative hypothesis . So there is no serial
correlation in the model, which is a good sign.
 Now question is what about the Diagnosis
test of this GARCH(1,1) model
2. ARCH effect
Null Hypothesis: There is no ARCH effect
Alternative: There is ARCH effect
View==Residual Diagonostic== ARCH LM test== test type==ARCH
OK

ARCH Test
F-stat 0.144 Prob F(1,21) 0.7079
Obs*R- 0.157 Prob. Chi- 0.6921
squares square
 Now question is what about the
Diagnosis test of this GARCH(1,1)
model
2. ARCH effect (Conti…)
Since the probability of Obs*R-square is greater than 5%(See result
from Previous Slide), so we can not reject null hypothesis meaning
that we accept null hypothesis and conclude that there is no ARCH
effect in the model, which is desirable.
 Now question is what about the
Diagnosis test of this GARCH(1,1)
model
3. Normality (Whether the Residual is normally distributed)
Null Hypothesis: The residual is normally distributed
Alternative: The residual is not normally distributed
View==Residual Diagnostic==Histogram-test for Normality
OK 5
Series: Standardized Residuals
Sample 1979Q1 1984Q4
4 Observations 24

Mean 0.158520
3 Median 0.139559
Maximum 1.742734
Minimum -1.544858
2 Std. Dev. 1.017721
Skewness 0.014954
Kurtosis 1.598582
1
Jarque-Bera 1.964868
Probability 0.374399
0
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
 Now question is what about the
Diagnosis test of this GARCH(1,1)
model
3. Normality (Whether the Residual is normally
distributed)
The probability is greater than 5% so we accept null hypothesis showing
that the residual is normally distributed which is also good sign.
 Now question is what about the
Diagnosis test of this GARCH(1,1)
model
3. Normality (Whether the Residual is normally
distributed)
The probability is greater than 5% so we accept null hypothesis showing
that the residual is normally distributed which is also good sign.
 GARCH (1,1)
Three types of distribution has been used for GARCH (1,1)
Discussion
1. Normal Gaussian distribution
2. Students’ t with fixed df
3. Generalized Error distribution Assumption
 GARCH (1,1)(conti…)
1. Normal Gaussian distribution
We have already run GARCH(1,1) and already got the results. Under this
procedure Variance equation result indicate that previous day interest rate
information which is ARCH can not influence present day interest rate volatility.
It is clear from the result that GARCH is also insignificant means that previous
day interest rate volatility which is also known GARCH effect cant effect present
day interest rate volatility. It means that interest rate volatility is not influence
by its own ARCH and GARCH factors or own shocks.
The M1, P and GDP are also not significance indicating that outside shocks cant
influence the volatility in interest rate.
 GARCH (1,1)(conti…)
2. Students’ t with fixed df
Under this procedure Variance equation result indicate that previous day
interest rate information which is ARCH can not influence present day interest
rate volatility. It is clear from the result that GARCH is also insignificant means
that previous day interest rate volatility which is also known GARCH effect cant
effect present day interest rate volatility. It means that interest rate volatility is
not influence by its own ARCH and GARCH factors or own shocks.
The M1, P and GDP are also not significance indicating that outside shocks cant
influence the volatility in interest rate.
 GARCH (1,1)(conti…)
3. Generalized Error distribution Assumption
Under this procedure Variance equation result indicate that previous day
interest rate information which is ARCH influence present day interest rate
volatility as the value of is less than 5%. It is clear from the result that GARCH is
also significant means that previous day interest rate volatility which is also
known GARCH effect can effect present day interest rate volatility as the value
of prob. Is less than 10%. It means that interest rate volatility is influence by its
own ARCH and GARCH factors or own shocks.
The M1, P and GDP are also not significance indicating that outside shocks cant
influence the volatility in interest rate.
 Model Selection
We have three models with three assumptions. Which one is the best one
depend upon the three assumptions
(1) No Serial Correlation
(2) No ARCH effect
(3) Normal Distribution
We see that all the three assumptions are fulfilled in all the three model, so
we can say that all the three are the best model on the basis of these
assumptions, but on the basis of result we can say that GARCH with
Generalized error Distribution Assumption is the best one because here in
this model ARCH and GARCH effect are significant.