Financial

Econometrics 1
Part 2: Volatility Modelling and Forecasting
Sigit Wibowo

April 7, 2015

Contents
1 Motivations
1.1 Stylised Facts in Financial Data . . . . . . . . . . . . . . . . .
1.2 Types of Non-linear Models . . . . . . . . . . . . . . . . . . .
1.3 Non-linearity Tests . . . . . . . . . . . . . . . . . . . . . . . .

2
2
4
5

2 EWMA
2.1 EWMA Specication . . . . . . . . . . . . . . . . . . . . . . .
2.2 The Advantages . . . . . . . . . . . . . . . . . . . . . . . . . .

7
7
7

3 ARCH
7
3.1 ARCH Specication . . . . . . . . . . . . . . . . . . . . . . . . 7
3.2 ARCH Effect Tests . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.3 Problems with ARCH() Models . . . . . . . . . . . . . . . . . 10
4 GARCH
10
4.1 GARCH Specication . . . . . . . . . . . . . . . . . . . . . . . 10
4.2 The ML Estimation . . . . . . . . . . . . . . . . . . . . . . . . 12
5 ARCH/GARCH Model Extensions
18
5.1 EGARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . . 19
5.2 GJR-GARCH Model . . . . . . . . . . . . . . . . . . . . . . . . 19
5.3 GARCH-in Mean Model . . . . . . . . . . . . . . . . . . . . . 21

6 Volatility Forecasting
6.1 Overview . . . . . . . . . . .
6.2 Volatility Forecasting . . . . .
6.3 The Use of Volatility Forecasts
6.4 Testing Non-linear Restrictions

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7 Volatility Estimation Using OxMetrics

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References
[1] Chris Brooks Introductory Econometrics for Finance, 2nd edition. Cambridge University Press, 2008.
[2] Ronald J. Wonnacott and Thomas H. Wonnacott Econometrics, 2nd
edition. John Wiley & Sons, Inc., 1979.
Timetable
Week

Topics

References

8 Stylised facts of nancial time series volatility [1], Ch. 8

9 Exponential Weighted Moving Average
ARCH & GARCH Models
10 Asymmetric GARCH models
11 Integrated GARCH models
Other univariate ARCH/GARCH models

[1], Ch. 8

12 Volatility models using nancial data

13 Forecasting with ARCH/GARCH models

[1], Ch. 6, 7
[2], Ch. 18

14 Review (student presentation*)

Motivations

1.1

Stylised Facts in Financial Data

Non-linearity Features in Financial Data

The linear structural (and time series) models cannot explain a number
of important features common to much nancial data
Leptokurtosis or fat tails
Volatility clustering or volatility pooling
Leverage effects
Common traditional structural model

= + + ... + +

(1)

or

= +
where we assumed that (0, )
What is volatility?
Volatility is simply dened as standard deviation
Variance is often preferred because it measures in the same units
as original data
More denition:
Conditional volatility

=
( )
=
Realised volatility

[+ ]
Implied volatility, e.g. Black-Scholes model:

= (, , , , )
Annualised volatility, e.g.

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3

Financial Asset Returns Time Series

rjkse

10
2002
10

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

rsnp500

5
0
5

2002

2003

2004

Figure 1: Daily Returns of JKSE and S&P500, 2002-2014

Non-linear Models
Campbell, Lo and MacKinlay (1997)
A non-linear data generating process can be written

= ( , , , ...)

(2)

where is a non-linear function and is an iid error term

More specic denition

= ( , , ...) + ( , , ...)

(3)

where is a function of past error terms only and is a variance term

Models with nonlinear () are non-linear in mean, while those with
nonlinear () are non-linear in variance

1.2

Types of Non-linear Models

Types of Non-linear Models

Many non-linear relationships can be changed into linear using a specic transformation
However, many relationships in nance are intrinsically non-linear
Many types of non-linear models,
ARCH/GARCH
switching models
bilinear models

1.3

Non-linearity Tests

Testing for Non-linearity

The traditional tools of time series analysis may nd no evidence that
we could use a linear model, but the data still may not be independent
Portmanteau test for non-linear dependence
Ramseys RESET test can be used to test non-linear dependence:

= + + + ... + +
Other tests: the BDS test and the bispectrum test
Heteroscedasticity Revisited
A structural model can be written as follows:

= + + + +
where (0, )
The variance of errors is assumed to be constant and is known as homoscedasticity
or ( ) =
5

6
Time-varying Risk
Premium

Multivariate GARCH

GARCH-in-Mean

Diagonal-Vec MGARCH

Dynamic Conditional
Correlation (DCC)

Generalized ARCH

ARCH

Exponential Smoothing

Moving Average

Simple Regression

Historical Average

ARCH Class
Conditional Volatility

Baba, Engle, Kraft,

Kroner (BEKK)

Constant Correlation

Asymmetry

Smooth Transition

Exponentially Weighted
Moving Average

Auto-Regressive Moving
Average (ARMA)

Threshold
Auto-Regressive

Historical Standard
Deviation

Asymmetric Power
GARCH

Quadratic GARCH

Threshold or GJR ARCH

Exponential ARCH

Frationally Integrated
Auto-Regressive Moving
Average (ARFIMA)

Integrated
Auto-Regressive Moving
Average (ARIMA)

Random Walk

Volatility Forecast
Models

Time Series Volatility

Forecasting
Option-based
Volatility Forecating

Stochastic Volatility

Figure 2: Volatility Class, Source: Wibowo (2006)

 If ( ) , then heteroscedasticity exists and the standard error

estimates could be incorrect
For nancial data, the variance of the errors is not likely to be constant
overtime

EWMA

2.1

EWMA Specication

EWMA
Exponentially Weighted Moving Average

= (1 ) ( )

(4)

where
denotes the estimate of the variance for period and also becomes
the forecast of future volatility for all periods
denotes the average return estimated over the observations
denotes the decay factor which determines how much weight is given
to recent versus older observation

2.2

The Advantages

EWMA
Exponentially Weighted Moving Average
Two advantages:
Volatility is likely inuenced by recent events, which carry more
weights
The effect on volatility of a single observation declines at an exponential rate as weights attracted to recent events fall

ARCH

3.1

ARCH Specication

ARCH
Autoregressive Conditionally Heteroscedastic
If heteroscedasticity exists, use a model which does not assume the variance is constant
Recall the denition of the variance :

= ( | , , , ...)
= [( ( )) | , , ...]
The variance is usually assumed to be ( ) = 0

= ( | , , ...)
= [ | , , ...]
ARCH
Autoregressive Conditionally Heteroscedastic (contd)
What could the current value of the variance of the errors possibly depend upon?
Previous squared error terms
This leads to the AutoRegressive Conditionally Heteroscedastic model
for the variance of the errors:
(5)

= +
The equation (5) is known as an ARCH(1) model
ARCH
Autoregressive Conditionally Heteroscedastic (contd)
The full model can be written as

= + + ... + + ,
where = +
8

(0, )

(6)

 The ARCH model can be extended into the general case where the error
variance depends on lags of squared errors:

= + + + ... +

(7)

The equation (7) is known as an ARCH() model

ARCH
Autoregressive Conditionally Heteroscedastic (contd)
In many literature, is used to address the variance of the errors instead
of
Therefore,

= + + ... + + ,
= +

(0, )

+ ... +

(8)

ARCH
Autoregressive Conditionally Heteroscedastic (contd)
Instead of (8), we can write

= + + ... + +
=

= +

(0, 1)

(9)

(8) and (9) are different way to express exactly the same model
(8) is easier to understand
(9) is required to simulate an ARCH model

3.2

ARCH Effect Tests

Testing ARCH Effect

1. Run any postulated linear regression e.g. = + + ... + + ,
and then save the residuals,

2. Square the residuals, and regress them on own lags to test for ARCH
of order , for example

= + + + ... + +
where is iid. Also obtain from this regression
3. The test statistic is dened as or the number of observations multiplied by the coefcient of multiple correlation from the last regression
and is distributed as a ()
Testing ARCH Effect
(contd)
4. The null and hypotheses are

= 0 and = 0 and = 0 and ... and = 0

0 or 0 or 0 or ... or 0
If the value of the test statistic is greater than the critical value from the
distribution, then the null hypothesis is rejected
Note that the ARCH test is also sometimes applied directly to returns
instead of the residuals from Stage 1

3.3

Problems with ARCH() Models

Problems with ARCH() Models

How do we decide on ?
The required value of might be very large
Non-negativity constraints might be violated
Since the variance cannot be negative, we require > 0 =
1, 2, ..., to estimate an ARCH model
A natural expansion of an ARCH() model which gets around some of
these problems is a GARCH model

10

GARCH

4.1

GARCH Specication

Generalised ARCH (GARCH) Models

Bollerslev (1986) proposed a new model which allows variance to be
dependent upon previous own lag

= + +

(10)

which is now as a GARCH(1,1) model

We can also write

= + +
= + +
Substituting into (10) for

= + + + +
= + + + +

(11)

Generalised ARCH (GARCH) Models

(contd)
Substituting into (11) for

= + + + + + +
= + + + + + +
= 1 + + + 1 + + +
An innite number of successive substitutions would yield

= 1 + + + 1 + + +
Therefore, the GARCH(1,1) model can be written as an innite order
ARCH model

11

Generalised ARCH (GARCH) Models

(contd)
We can extend the GARCH(1,1) model to a GARCH(, ):

= + + + ... +
+ + + ... + +

= +

+
=

Generalised ARCH (GARCH) Models

(contd)
In general, a GARCH(1,1) model will be sufcient to capture the volatility clustering in the (nancial) data
Why is GARCH better than ARCH?
more parsimonious - avoids overtting
less likely to breach non-negativity constraints
GARCH Specication
The Unconditional Variance
The unconditional variance of is given by

( ) =

1 ( + )

(12)

when + < 1
Non-stationarity in variance is given by + 1
The conditional variance forecasts will not converge on their unconditional value as the horizon increases
Integrated GARCH is given by + = 1

12

4.2

The ML Estimation

Estimation of ARCH/GARCH Models

Because the model is non-linear form, OLS cannot be used
Therefore, maximum likelihood technique is utilised
The method works by nding the most likely values of the parameters given the actual data
We specically form a log-likelihood function and maximise it
Estimation of ARCH/GARCH Models
The Procedure
1. Specify the appropriate equations for the mean and the variance, for
example AR(1)GARCH(1,1) model:

= + + ,

(0, )

= + +
2. Specify the log-likelihood function to maximise:

1
1 ( )

log(2) log( )
2
2 =
2 =

3. The computer will maximise the function and generate parameter values
and their standard errors
Maximum Likelihood
Parameter Estimation
For simplicity, lets consider the bivariate regression case with homoscedastic errors:
= + +
Assume that (0, ) then ( + , )
Therefore, the probability density function for a normally distributed
random variable with the mean and variance is given by

1
| + , =
exp
(13)

13

Maximum Likelihood
Parameter Estimation (contd)
The implication of (13)
Successive values of would trace out the familiar bell-shaped
curve
Since the assumption of is iid, then will also be iid
The joint pdf for all the s can be expressed as a product of the individual
density functions:

, , ..., | + , = | + ,
| + , ...
| + ,

= | + ,

(14)

Maximum Likelihood
Parameter Estimation (contd)
Substituting into equation (14) for every from equation (13)

, , ..., | + , =

exp

=
2

(15)

Maximum Likelihood
Parameter Estimation (contd)
The typical situation we have is that the and are given and we want
to estimate , ,

14

 If this is the case, then () is known as the likelihood function, denoted

( , , ), therefore

( , , ) =
exp

(16)

2 =
2
Maximum likelihood estimation comprises of choosing parameter values ( , , ) that maximise this function
We want to differentiate (17) w.r.t. , , , but (17) is a product containing terms
Maximum Likelihood
Parameter Estimation (contd)
Since max () = max log(()), we can take logs of (17)
Using the various laws for transforming functions containing logarithms,
we get the log-likelihood function,

= log

1 ( )
log(2)
2
2 =

which is equivalent to

1 ( )
log log(2)
2
2
2 =

(17)

Maximum Likelihood
Parameter Estimation (contd)
Differentiating (17) w.r.t. , , , we get

1 ( )2 1
=

2 =

(18)

1 ( )2
=

2 =

(19)

1
1 ( )

2 2 =

(20)

15

Maximum Likelihood
Parameter Estimation (contd)
Setting (18)-(20) to zero to minimise the functions, and putting hats
above the parameters to denote the maximum likelihood estimators
From (18),

( ) = 0
= 0
= 0
1
1
= 0

(21)

Maximum Likelihood
Parameter Estimation (contd)
From (19),

( ) = 0
= 0
= 0
=
= ( )
= +
=

=

Maximum Likelihood
Parameter Estimation (contd)

16

(22)

 From (20),

( )

=
=

1
( )
=

(23)

The ML and OLS Estimators

How do these formulae compare with the OLS estimators
(21) and (22) are identical to OLS
(24) is different where the OLS estimator was

The ML estimator of the variance of the disturbances is consistent, but

it is biased
How does this help us in estimating heteroscedastic models?
Estimation of GARCH Models Using ML
Now we have

(0, )

= + + ,
= + +
=

1
1 ( )
log(2) log( )
2
2 =
2 =

However, the LLF for a model with time-varying variances cannot be

maximised analytically, except in the simplest of cases
Therefore, a numerical procedure is utilised to maximise the log-likelihood
function
A potential problem: local optima or multimodalities in the likelihood
surface
17

Local Optima in ML Estimation

()

Figure 3: The problem of local optima in ML estimation

Estimation of GARCH Models Using ML

Optimisation Procedure
1. Set up LLF
2. Use regression to get initial guesses for the mean parameters
3. Choose some initial guesses for the conditional variance parameters
4. Specify a convergence criterion - either by criterion or by value
Non-Normality and Maximum Likelihood
Recall that the conditional normality assumption for is essential
The normality test can be conducted as follows:

=
=

+ +

The sample counterpart is =

18

(0, 1)

 Typically are still leptokurtic, although less so than the

This is not really a problem, as we can use the ML with a robust
variance/covariance estimator
ML with robust standard errors is called Quasi-Maximum Likelihood or QML

ARCH/GARCH Model Extensions

Extensions to ARCH/GARCH Models

Three of the most important ARCH/GARCH model extensions/variants:
EGARCH model
GJR or TGARCH model
GARCH-M model
Problems with GARCH(, ) models
Non-negativity constraints may still be violated
GARCH models cannot account for leverage effects

5.1

EGARCH Model

The EGARCH Model

Nelson (1991) proposed the variance equation can be expressed as follows:

| |

(24)
+
log ( ) = + log ( ) +

The advantages of the model:
Because the model has log( ), will be positive even if the parameters are negative
The model accounts for the leverage effects: if the relationship between volatility and returns is negative, will be negative

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5.2

GJR-GARCH Model

The GJR-GARCH Model

Glosten, Jaganathan, and Runkle (1993) proposed GJR-GARCH (, , )
model
A GJR-GARCH (1, 1, 1) can be written as follows:

= + + +
where

1,
=
0,

(25)

if < 0
otherwise

A GJR-GARCH model is convariance stationary if and only if the parameter restrictions are satised and + + + < 1
For a leverage effect, > 0
+ 0 and 0 is required for non-negativity
The T-GARCH Model
Zakoian (1994) proposed TARCH(, , ) model
TARCH(1,1,1) can be written as follows:

= + | | + | | +
+ 0
where

1,
=
0,

The GJR Model

New Impact Curve

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if < 0
otherwise

(26)


0.2 0.3 0.4 0.5 0.6 0.7 0.8

GARCH
GJR-GARCH

-2

-1

5.3

GARCH-in Mean Model

GARCH-in Mean
The idea is to model the return of a security which is partly determine
by its risk
Engle, Lilien and Robins (1987) proposed the ARCH-M specication

= + +
(0, )

= +

(27)

can be interpreted as a sort of risk premium

It is possible to combine all or part of these models together to get
more complex hybrid models, for example an ARMA-EGARCH(1,1)M model

6
6.1

Volatility Forecasting
Overview

What Use Are GARCH-type Models

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 GARCH is able to model the volatility clustering effect because the conditional variance is autoregressive
Such models can be also used to forecast volatility
We could show that

| , , ... = ( | , , ...)
Therefore modelling will give us models and forecasts for as well
Variance forecasts are additive over time

6.2

Volatility Forecasting

Forecasting Variances Using GARCH Models

Consider the following GARCH(1,1) model:

= +

(0, )

= + +
We need to generate forecasts of

+ | , + | , ..., + |

(28)

where denotes all information available up to and including observation

Forecasting Variances Using GARCH Models
(contd)
Adding one to each of the time subscripts of the conditional variance
equation in (28), and then two, and then three would produce

+ = + +

(29)

+
+

(30)

= +
= +

22

+
+

+
+

+
+

(31)

Forecasting Variances Using GARCH Models

(contd)

Let , be the one step ahead forecast for made at time

, can be obtained by taking conditional expectation of (29):

(32)

, = + +

Given , , the 2-step ahead forecast for made at time can be obtained by taking the conditional expectations of (30)

, = + (+ | ) + ,

(33)

where (+ | ) is the expectation, made at date , of + , which is

the squared disturbance term
Forecasting Variances Using GARCH Models
(contd)
We get
(34)

(+ | ) = +

Since + is not known at date , it is replaced by the forecast for it,

,
Therefore, the 2-step ahead forecast is given by

, = + , + ,

(35)

= + + ,
Forecasting Variances Using GARCH Models
(contd)

Using similar arguments, the 3-step ahead forecast will be given by

, = + + +

= + + ,

= + + + + ,

= + + + + ,
23

(36)

 Any -step ahead forecast ( 2) can written as

, = +

+ +

(37)

6.3

The Use of Volatility Forecasts

What Use Are Volatility Forecasts

Option pricing

= (, , , , )
Conditional betas

, =

,
,

Dynamic hedge ratios

The size of the futures position to the size of the underlying exposure, i.e. the number of futures contracts to buy or sell per unit of
the spot good
What Use Are Volatility Forecasts
(contd)
Assume that the objective of hedging is to minimise the variance of the
hedged portfolio, the optimal value of the hedge ratio

where
= hedge ratio
= correlation coefcient between change in spot price () and
change in futures price ( )
= standard deviation of
= standard deviation of
For time-varying covariance and correlation, the hedge ratio is

=
24

,
,

6.4

Testing Non-linear Restrictions

Testing Non-linear Restrictions

Testing Hypothesis about Non-linear Models
The and tests are still valid in non-linear models, but these are not
exible enough
Three hypothesis testing procedures based on maximum likelihood principles:
Wald
Likelihood Ratio
Lagrange Multiplier
Lets consider a single parameter to be estimated, be the MLE, and
be a restricted estimate
Likelihood Ratio Tests
Estimate under the null hypothesis and under the alternative
Compare the maximised values of the LLF
Estimate the unconstrained model and achieve a given maximised value
of the LLF, denoted
Estimate the model imposing the constraint(s) and get a new value of
the LLF, denoted
Which will be bigger?
comparable to
The LR test statistic is given by

= 2( ) ()
Diagrammatic Representation

25

()
A

()
B

()
.

Figure 4: Comparison of testing procedures under maximum likelihood

Volatility Estimation Using OxMetrics

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28

125

JPY

120
115
110
105
2003
2

2004

2005

2006

2007

2004

2005

2006

2007

RJPY

1
0
1
2
2003

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Density
JPY

0.100

N(s=5.69)

0.075
0.050
0.025

100.0
102.5
Density

105.0

RJPY

N(s=0.44)

2.0

107.5

110.0

112.5

115.0

117.5

120.0

122.5

125.0

127.5

1.5
1.0
0.5

2.5

2.0

1.5

1.0

0.5

0.0

30

0.5

1.0

1.5

2.0

2.5

31

32

RJPY

Fitted

2
2003
5

2004

2005

2006

2007

2004

2005

2006

2007

2004

2005

2006

2007

r:RJPY (scaled)

5
2003
CondSD

0.6

0.4

2003

0.50

Forecasts

RJPY

0.25
0.00
0.25
0.50
2007624
0.0850

71

78

715

71

78

715

CondVar Forecasts

0.0825
0.0800
0.0775
0.0750
2007624

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34

35

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References
[1] Daniel B. Nelson Generalized Autoregressive Conditional Heteroskedasticity. Journal of Econometrics, Vol. 31, No. 2 (1991), 307?327.
[2] Robert F. Engle Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of
United Kingdom Ination. Econometrica, Vol. 50, No. 4 (1982), 987-1008
[3] Robert F. Engle, David M. Lilien and Russell P. Robins Estimating Time Varying Risk Premia in the
Term Structure: The Arch-M Model. Econometrica, Vol. 55, No. 2 (1987), 391-407.
[4] Lawrence R. Glosten, Ravi Jagannathan, David E. Runkle On the Relation between the Expected
Value and the Volatility of the Nominal Excess Return on Stocks. The Journal of Finance, Vol. 48,
No. 5 (1993), 1779-1801.
[5] Daniel B. Nelson Conditional Heteroskedasticity in Asset Returns: A New Approach. Econometrica,
Vol. 59, No. 2 (1991), 347-370.

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