Volatility

• Volatility – conditional variance of the process

– Don’t observe this quantity directly (only one
observation at each time point)
• Common features
– Serially uncorrelated but a depended process
– Stationary
– Clusters of low and high volatility
– Tends to evolve over time with jumps being rare
– Asymmetric as a function of market increases or
market decreases

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 The basic models

• Consider a process r(t) where

r (t )   (t )  a(t )
Conditional mean
evolves as an
 (t )  E (r (t ) | F (t  1)) ARMA process
p q
 (t )  0    j r (t  j )    k a(t  k )
j 1 k 1

 (t )  Var (r (t ) | F (t  1))
2

How does the conditional

Spring 2004 variance evolve?
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Modeling the volatility

• Evolution of the conditional variance

follows to basic sets of models
– The evolution is set by a fixed equation
(ARCH, GARCH,…)
– The evolution is driven by a stochastic
equation (stochastic volatility models).
• Notation:
– a(t)=shock or mean-corrected return;
–  (t ) is the positive square root of the
volatility
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 ARCH model

• We have the general format as before

• The equation defining the evolution of
the volatility (conditional variance) is an
AR(m) process.
Why would this

a(t )   (t ) (t )
model yield
“volatility
clustering”?

 (t )   0  1a (t  1)     m a (t  m)
2 2 2

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 Basic properties ARCH(1)

Unconditional mean is 0.

E[a(t )]  E[ E (a (t ) | F (t  1))]
 E[ E ( (t ) (t ) | F (t  1))]
 E[ (t ) E ( (t )))
0

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 Basic properties, ARCH(1)
Unconditional variance

Var [a (t )]  Var [ E (a(t ) | F (t  1))]  E[Var (a(t ) | F (t  1)]

 0  E[ 2 (t )]
 E[ 0  1a (t  1)]
2

  0  1 E[a 2 (t  1)] What

  0  1Var [a (t  1)] constraint
does this
  0  1Var [a (t )] put on 1?
Var [a (t )]   0 /(1  1 )
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Basic properties of ARCH

• 01<1
• Higher order moments lead to additional constraints on
the parameters
– Finite positive (always the case) fourth moments
requires
0 12<1/3
• Moment conditions get more difficult as the order
increases – see general framework of equation 3.6
• Note – in general the kurtosis for a(t) is greater than 3
even if the ARCH model is built from normal random
variates.
• Thus the tails are heavier and you expect more “outliers”
than “normal”.

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ARCH Estimation, Model Fitting and
Forecasting
• MLE for normal and t-dist ’s is given on pages 88 and 89.
• The full likelihood is very difficult and thus the conditional
likelihood is most generally used.
• The conditional likelihood ignores the component of the
likelihood that involves unobserved values (in other
words, obs 1 through m)
• MLE for joint estimation of parameters and degree of the
t-distribution is given.
• Model selection
– Fit ARMA model to mean structure
– Review PACF to identify order of ARCH
– Check the standardized residuals – should be WN
• Forecasting – identical to AR forecasting but we forecast
volatility first and then forecast the process.

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 GARCH model

• Generalize the ARCH model by including

an MA component in the model for the
volatility or the conditional variance.
a(t )   (t ) (t )
m s
 2 (t )   0    j a 2 (t  j )    k 2 (t  k )

a(t )   (t ) (t ) j 1 k 1

m s
 (t )   0    j a (t  j )    k (t  k )
2 2 2

j 1 k 1

Proceed as before – using all you learned from ARMA models.

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