Financial Forecasting

By-
Kunal)
Rajan
Aakash \
Introduction
• Given the rapid growth in financial markets over the past 20 years,
along with the explosive development of new and more complex
financial instruments, an ever-growing need has emerged for accurate
and efficient volatility forecasting
• Use in numerous practical applications of financial data such as the
analysis of market timing decisions, assistance in portfolio selection,
and estimates of variance in option pricing models
Contd…
• Accurate volatility estimates are also vital in areas such as risk
management for the calculation of metrics in hedging and Value-at-
Risk (VaR) policies
• Given these facts, the quest for accurate forecasts appears to be still
going on in the recent years.
Objectives
• The primary objective is to fit an appropriate GARCH model to
estimate the conditional market volatility based on Sensex
• To find out the stationarity of all the closing indices
• To know the return characteristics of stock exchange through
descriptive statistics
• To measure the volatility of the market
Data and Methodology
• Scope of the study is limited to the past 23 financial years—i.e.,
January 1, 1990 to January 31, 2013
• The daily closing values of the exchange have been taken
• We have used BSE Sensex as a proxy for the stock market because it is
the major value based representative of the Indian stock market
• The study is based mainly on the secondary data which have been
collected from the official website of BSE (http://www.bseindia.com/)
for Sensex
Contd…
• Various statistical tools, ARCH-LM test, Augmented Dicker Fuller (ADF)
test, and Granger Causality test, are used in the study
• Descriptive statistics provides simple summaries about the sample
and about the observations that have been made
Measurement of Volatility
• Volatility, as described, refers to the fluctuation in the daily closing
values of BSE
• volatility has been measured as the standard deviation of the rates of
return
• The rates of returns have been computed by taking a logarithmic
difference of prices of two successive periods
Contd…
• Symbolically, it may be stated as follows:
• Rt = loge (pt/pt–1) = loge (pt) – loge (pt)
• where loge is the natural logarithm, pt and pt–1 are the closing prices
for the two consecutive periods
• The logarithmic difference is symmetric between up and down
movements and is expressed in percentage terms
ARCH and GARCH
• ARCH models are used to characterize and model observed time
series
• ARCH models assume the variance of the current error term or
innovation to be a function of the actual sizes of the previous time
periods’ error terms
• conditional variance h can be modeled as a function of the lagged E’s,
i.e., the expected volatility is dependent on past news
Contd…
• The model developed was the qth order ARCH model, which is written
as ARCH (q):

• q = Number of lags included in the model

• ht = Conditional variance at period t.
• Et = Innovation in return at time t.
Contd..
• An ARMA model is assumed for the error variance; the model is a
GARCH which generalized the ARCH(q) model to GARCH(p, q) model,
such that:

• ht = Conditional variance at period t

• Et = Innovation in return at time t
• q = Number of lags included in the model
Results and Discussion
• Descriptive investigation of the plot of daily returns on Sensex(Figure
1)
Volaitility of Daily Returns
0.05

0.04

0.03

0.02
DAILY RETURN

0.01

0
07-Apr-10 06-Dec-10 09-Aug-11 18-Apr-12 20-Dec-12 26-Aug-1306-May-14 14-Jan-15 18-Sep-15 01-Jun-16 06-Feb-17 13-Oct-17 20-Jun-18 26-Feb-19 11-Nov-19
-0.01

-0.02

-0.03

-0.04

DATE
Contd…
• Descriptive statistics on Sensex are summarized in Table 1
Daily Return

Time Period 1 April 2010- 1 April 2020

Mean -0.000504622
Standard Error 8.04799E-05
Median -0.000480775
Standard Deviation 0.004010289
Sample Variance 1.60824E-05
Kurtosis 9.142099482
Skewness 0.092702395
Range 0.068932989
Minimum -0.030485526
Maximum 0.038447463
Count 2483
Confidence Level(95.0%) 0.000157815
Jarque-Bera 8650.3952
Contd…
• The skewness statistics for daily return is found to be different from
zero, indicating that the return distribution is not symmetric
• the relatively large excess kurtosis suggests that the underlying data
are leptokurtic or heavily tailed, and sharply peaked about the mean
when compared with the normal distribution
• The Jarque-Bera statistics calculated to test the null hypothesis of
normality rejects the normality assumption
• The results authenticate the well-known fact that daily stock returns
are not normally distributed but are leptokurtic and skewed, which
depicts the volatility nature of stock markets
• The existence of a leptokurtic distribution and presence of volatility
clustering suggest an ARCH or GARCH process, which was confirmed
in Table 2 by computing the value of Lagrange Multiplier (LM) which
rejects the null hypothesis.

• Table2:
Unit Root Tests
• The presence of unit root in a time series is tested with the help of
ADF test
• It tests for a unit root in the univariate representation of time series

• where alpha is a constant

• beta the coefficient on a time trend and p the lag order
• Table 3:
Fitting ARCH and GARCH
• We use GARCH(1, 1) model which is the most popular of the ARCH
family to model the volatility of BSE returns
• Three types of distributions are used in this study to test the
robustness of the results
• They are, Normal Gaussian Distribution, Student’s t with fixed degrees
of freedom and GED
• Table 4:
Forecasts of Market Volatility
• Once the model has been fitted to market returns, it can be used to
forecast volatility.
• We use the following model to forecast volatility for one day ahead:
Conclusion
• Stock market volatility has many implications for the real economy
• Forecasting stock market is essential in finance areas such as option
pricing, VaR applications and selection of a portfolio
• Empirical results demonstrate that, there are significant ARCH effects
and it is appropriate to use the GARCH model to estimate the process