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Assignment 1 Imagine you are a gold trader and specifically, you trade gold options.

As such you are very aware that volatility is critical to your understanding of option pricing. Your immediate supervisor asks you some questions concerning volatility in the market. Your supervisor has provided you with a time series of gold prices and the volume of gold trading. The data runs from Jan 2003 to May 2005 and can be found in Gold.xls in Assignment 1 folder. He has asked you to do the following. Question 1 1A) Provide a time series plot (chart) of the gold price. 1B) Estimate an AR(1) GARCH(1,1) model for him using the gold futures price data. He asks that you estimate the model using the changes in prices. Provide the output from the model. 1C) From the AR(1) GARCH(1,1) output answer the following: What is the GARCH1 parameter estimate and ARCH1 parameter estimate in the GARCH volatility equation? Are they statistically significant (what p value do each of them have)? Question 2 Your supervisor is convinced that volume of trading affects the GARCH variance and so he wants you to reestimate the AR(1) GARCH(1,1) model with price changes BUT include volume in the GARCH structure. Specifically, estimate an AR(1) GARCH(1,1,Volume). 2A) Is the volume term significantly different from zero? Provide the output. Question 3 Using the same differenced data (price changes), your boss asks you to estimate a GARCH in mean model from the AR(1) GARCH(1,1). He asks you to use the mean=sqrt function. 3A) Estimate this and show output. He asks you to use the mean=sqrt function. Question 4 4a) Using the Schwarzs Bayesian Criterion (SBC) for each of these three models, explain which is the best model of the three. Provide all 3 numbers. Question 5 5a) Using a basic AR(1), GARCH(1,1) with price changes determine whether or not there was a structural break in the volatility that you have estimated from this model. Recall from the class notes, you can use the CEV function in SAS for example to recover the time varying volatility estimates. You should check whether there was a structural break on 8/8/2005 (or observation 650). Use the Chow test to determine this and provide the output from the test. Note: to do this run a regression of the form CEVHATt = +CEVHATt-1+t, where CEVHAT is the Time Varying GARCH Variance.