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Numerical Techniques in Finance

Lecture 4 Multivariate GARCH

Multivariate GARCH

To date only been interested in univariate models.


Many applications in finance however require
estimates of covariances. For example

Futures hedge ratio estimation


Efficient frontier estimation
Beta (CAPM)
Value at risk for a portfolio of assets

Furthermore volatility may spillover from one market


to another.
Under these circumstances we require multivariate
models.

Multivariate GARCH - CAPM

The CAPM measures the beta of an


asset as
Cov ri , rm

Var rm
One may obtain this estimate via the
slope coefficient from an OLS
regression of the asset return on the
market return.

Multivariate GARCH - CAPM

However we know that variances (and


covariances) are generally time varying.
To allow for time varying
variances/covariances we may seek to
estimate dynamic betas via the
following

i ,t

im ,t
2
m ,t

Multivariate GARCH

The multivariate GARCH process can be


specified as follows
t t 1 0, H t

Where t is a N*1 vector, H t is a N*N


positive semi definite covariance matrix.

Multivariate GARCH
Positive Semi-Definiteness

The covariance matrix H t for the two


asset case is

This is a symmetric matrix

1,2t

21,t

12,t
2
2,t

A positive semi definite matrix is one


where its determinant >=0.

Multivariate GARCH
Positive Semi-definiteness

Clearly each of the variances must be non


negative.

1,2t

21,t

12,t
2
2,t

Non-negativity conditions are therefore


imposed on each variance.
The covariances however are allowed to be
positive or negative.

Multivariate GARCH
Positive Semi-Definiteness

H t must be positive semi definite for


two interrelated reasons.
1) By definition this must be the case.
To see this consider an alternative
representation
1,2t

21,t

12,t 1,2t

2

2,t t 1,t 2,t

t 1,t 2,t

2,2 t

Multivariate GARCH
Positive Definiteness

The determinant of
DT
2
1,t

2
2,t

1,2t

t 1,t 2,t

t 1,t 2,t

t 1,t 2,t

2,2 t

is

1,2t 2,2 t 1 2

Given that 1 1 , 1,2t 2,2 t 1 2 0


by definition!

Multivariate GARCH
Positive Definiteness

What about larger matrices?


A square 3x3 matrix (H) can be decomposed as
1 0

H 1 , 2 , 3 0 2
0 0

'
0 1
'
0 2
'
3

where 1 is the largest eigenvalue of the H matrix and 1 is


the associated eigenvector, 2 is the second largest eigenvalue
of the H matrix, etc..
Eigenvalues/characteristic roots, are equivalent to solving the
roots of a polynomial. The roots can be used to tell us about the
characteristics/qualities of a matrix.
We will revisit this decomposition in more detail next lecture
(easily done in Eviews).

Multivariate GARCH
Positive Definiteness

Positive definiteness implies all eigenvalues are non-negative.

A 21

31

12
1

32

13
23

Determinant is product of eigenvalues

Assume 12 23 1 then 13 1
If however13 1 the matrix is invalid
This can be seen if we calculate the eigenvalues of the matrix

1 1 1

A 1 1 1
1 1 1

Eigenvalues of A = {2,2,-1}

Multivariate GARCH
Positive definiteness
2) The log likelihood function is undefined
if any of the covariance matrices are
not positive definite. This is because the
log of a number <=0 is undefined.
(More on this later)

Multivariate GARCH

The specification on slide 5 allows for a wide


variety of models, the most popular being the
multivariate GARCH(p,q)
q

vech H t i vech t i t i i vech H t i


i 1

i 1

Where vech(.) is the vector half operator.


This operator stacks the lower portion of a
symmetric N*N matrix as a N N 1 2 *1
vector, is a N N 1 2 *1 vector and i i
are N N 1 2 * N N 1 2 matrices

Multivariate GARCH

To illustrate the vech operator consider


the 2 asset case

H t
21,t
2
1,t

1,t
'
t t 1,t
2,t

1,2t

vech H t 21,t
2
2,t

12,t

2,2 t

1,2t
2,t
2,t 1,t

1,t 2,t

2,2 t

1,2t

'
vech t t 2,t 1,t
2

2,t

Multivariate GARCH

The bivariate GARCH(1,1) can therefore


be expressed as

2
21,t 1

1,t 1
11
12
13
11

12,t 2 21 22 23 1,t 1 2,t 1 21


2

2

32
33 2,t 1
2,t 3 31

31

12
22
32

2
13 1,t 1

23 12,t 1
33 2 2,t 1

Multivariate GARCH

This bivariate specification allows for


volatility spillovers.
The model however requires estimates
of 21 parameters.
As N increases the framework is
unmanageable.
In particular ensuring positive semi
definiteness is very problemmatic.

Multivariate GARCH

This has lead to the development of a


number of models which place
restrictions on this model.

The diagonal vech GARCH


The constant correlation GARCH
The BEKK GARCH

Multivariate GARCH
Diagonal Vech

The diagonal vech model imposes the


restriction that the i and matrices
are diagonal
i

1,2t 1 111,2t 1 11 1,2t 1

12,t 2 221,t 1 2,t 1 22 12,t 1


2

2
2

2,t 3 33 2,t 1 33 2,t 1


Most references indicate that there are no conditions for positive
definiteness. Silberberg and Pafka (2004) provide analytical conditions

Multivariate GARCH Constant


correlation

The constant correlation GARCH(1,1)


model simplifies the diagonal vech
model even further
1,2t 1 111,2t 1 11 1,2t 1

12,t 1,t 2,t

2
2
2,t 3 33 2,t 1 33 2,t 1

The covariances are time varying, but the correlations are constant

Multivariate GARCH Constant


correlation

The conditions for positive definiteness


in the constant correlation model are
easily imposed
0, 0, 0

1 1

For each variance, ensures


non-negativity
This restriction combined with
the non-negativity restrictions
ensures positive definiteness

Multivariate GARCH - BEKK

The BEKK model ensures positive definiteness

H t t 1 t1 H t 1

Where are N*N parameter matrices.


may be unrestricted or diagonal.
may be either symmetric or lower
triangular. Eviews uses a lower triangular
matrix for so we will work with this.

Multivariate GARCH - BEKK

If are unrestricted this specification


allows for cross market volatility
spillovers.
If are diagonalised, this
specification does not allow for cross
market volatility spillover.

Multivariate GARCH

To illustrate consider a N=2 asset


model with diagonal and lower
triangular

H t t 1 t1 H t 1
1 0 1 2 1 0 1,t 1
1 0

1,t 1 2,t 1

0 2
2 3 0 3 0 2 2,t 1
2
1 0 1,t 1 12,t 1 1 0

0
0

2 21,t 1
2
2,t 1

Multivariate GARCH

This model imposes the following


specification

1,2t 12 121,2t 1 12 1,2t 1

2
12,t

2
2,t

12 1 21,t 1 2,t 1 1 2 12,t 1


2
2

2
3

2 2
2 2,t 1


2
2

2
2,t 1

Note how this is very similar to the vech diagonal model.


Try and repeat the exercise not imposing diagonality.

Multivariate GARCH - Estimation

Multivariate GARCH estimation is typically


performed using maximum likelihood.
Assuming conditional normality, the log
This is why the covariance matrix must be
likelihood function is
positive definite.
TN
1 T
l
log 2 log H t t' H t1 t
2
2 t 1

Where is the parameter vector, N is the


number of assets and T the number of
observations.

Multivariate GARCH
The estimation is performed in a similar fashion.
i) We assume starting values for each of the
parameters. This enables us to calculate the
value of the LL function.
ii) An algorithm is used to select the values for
the parameters that maximise the LL
function.
iii) This maximisation will be performed subject
to the constraints imposing non-negativity
and positive definiteness.

Multivariate GARCH: Options


i) Constant correlation model via univariate GARCH
Pretty good for really large systems

ii) Sophisticated computer programs.

DCC model of Engle (2002) employs 2 step procedure

1) Univariate GARCH equations for each asset.


2) Use the standardised residuals from each asset to estimate a
time varying correlation vector
Matlab code is available at Kevin Sheppards webpage.
Eviews code (bivariate) bit messy given not a matrix programming language

iii) BEKK via Eviews programs.


iv) MGARCH models in Eviews: Constant correlation,
Diagonal vech, Diagonal BEKK, Gaussian and Student
innovations

Multivariate GARCH Options

Seek to estimate a bivariate GARCH


model between the returns on the
S&P500 and US Treasury bonds from
2/3/94 to 25/8/2000.
See workfile intl_fin.wf1
Initially assume a constant mean for
each return equation.

Multivariate GARCH
CC GARCH Estimation

Recall the constant correlation GARCH(1,1)


1,2t 1 111,2t 1 11 1,2t 1

12,t 1,t 2,t

2
2

33 2,t 1
33 2,t 1
2,t 3

This approach is performed as follows


i) Estimate separate univariate GARCH(1,1) equations
ii) Estimate via the correlation between returns
(say via excel)
iii) Construct the covariance estimates using the
information obtained in steps i) and ii).

Multivariate GARCH
CC GARCH Estimation

This procedure will provide consistent


estimates (assuming that the model is
correctly specified).
The main disadvantage (relative to
estimating this model as a system) is
that the estimates will not be efficient.

CC GARCH - Univariate estimation

Dependent Variable: Y1
Method: ML - ARCH (Marquardt)
Date: 09/10/04 Time: 14:55
Sample: 3/01/1994 8/25/2000
Included observations: 1694
Convergence achieved after 22 iterations
Variance backcast: ON
C

Coefficient
0.000809

Std. Error
0.000197

z-Statistic
4.107813

Prob.
0.0000

C
ARCH(1)
GARCH(1)

Variance Equation
6.25E-07
1.85E-07
0.069502
0.006502
0.927838
0.006938

3.387475
10.68911
133.7393

0.0007
0.0000
0.0000

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood

-0.000140
-0.001916
0.009990
0.168674
5607.059

Univariate estimates are very close to


S&P500 estimates from BEKK & vech

Mean dependent var


S.D. dependent var
Akaike info criterion
Schwarz criterion
Durbin-Watson stat

0.000691
0.009981
-6.615182
-6.602348
1.996838

CC GARCH Univariate
estimation

Dependent Variable: Y2
Method: ML - ARCH (Marquardt)
Date: 09/10/04 Time: 14:55
Sample: 3/01/1994 8/25/2000
Included observations: 1694
Convergence achieved after 13 iterations
Variance backcast: ON

Univariate estimates are very close to


T-bond estimates from BEKK & vech

Coefficient
-0.000227

C
ARCH(1)
GARCH(1)

Variance Equation
1.26E-06
3.96E-07
0.026793
0.004977
0.952346
0.009072

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood

-0.000274
-0.002049
0.007928
0.106209
5818.882

Std. Error
0.000188

z-Statistic
-1.208396

Prob.
0.2269

3.181014
5.383916
104.9783

0.0015
0.0000
0.0000

Mean dependent var


S.D. dependent var
Akaike info criterion
Schwarz criterion
Durbin-Watson stat

-9.62E-05
0.007919
-6.865268
-6.852435
1.957241

CC GARCH Univariate
estimation

To obtain the fitted values for each of


these equations we use the procs/make
GARCH variance series.
This produces the following results

CC GARCH Univariate
estimation
.0007
.0006
.0005

S&P500

.0004
.0003
.0002
.0001
.0000
1994

1995

1996

1997

1998

1999

2000

GARCH01

Variance estimates are similar to BEKK & vech.

CC GARCH Univariate
estimation
.00014
.00012
.00010

T bonds

.00008
.00006
.00004
.00002
1994

1995

1996

1997

1998

1999

2000

GARCH02

The same can be said for the T-bond estimates

CC GARCH Univariate
estimation

To create the covariance estimates ;


i) Calculate the correlation between the
returns. This may be done using the correl
command in excel. We obtain a value of
-0.1932
ii) In Eviews: Quick/Generate series
cc-cov = (SP500^0.5)*(Tbond^0.5)*-0.1932

CC GARCH - Univariate
Estimation
.00000

We will see that


the constant correlation
assumption produces
very different covariance
estimates to the BEKK and
diagonal vech models.

-.00001

-.00002

-.00003

-.00004

-.00005
1994

1995

1996

1997
COV

1998

1999

2000

Multivariate GARCH
BEKK Estimation

To estimate the BEKK model we can


use two programs that are available
within Eviews.
BV_GARCH.PRG Bivariate BEKK
TV_GARCH.PRG Trivariate BEKK

Multivariate GARCH
BEKK Estimation
To run the program
i) Open Eviews
ii) File/Open/Program/bv_garch.prg
iii) Hit the run button
iv) Hit OK

Multivariate GARCH
BEKK Estimation

The model can be specified as


Rt t

t N 0, H t

H t t 1 t1 H t 1

Where Rt

are 2*1 vectors


are 2*2 diagonal matrices

is 2*2 lower triangular matrix

Multivariate GARCH
BEKK Estimation

Multivariate GARCH
BEKK Estimation

These estimates imply the following


R1,t 0.0009 1,t
R2,t 0.00027 2,t

t N 0, H t

Multivariate GARCH
BEKK Estimation

where

0
0.000731
0.000731 0.000724
Ht

0
0.001029
0.000724 0.001029
2
0
0
1,t 1 2,t 1 0.279522
0.279522
1,t 1

2
0
0.197234 2,t 11,t 1
0
0.197234
2,t 1

2
0
0
0.960078
1,t 1 12,t 1 0.960078

2
0
0.967834

0
0.967834

21,t 1
2,t 1

Multivariate GARCH
BEKK Estimation

The elements of the covariance matrix


can be expressed as
1,2t 5*107 0.0781,2t 1 0.9217 1,2t 1
2,2 t 1.6*106 0.0389 2,2 t 1 0.9367 2,2 t 1
12,t 5.3*107 0.0551,t 1 2,t 1 0.929 12,t 1

Multivariate GARCH
BEKK estimation

Multivariate VAR-GARCH-Diag Vech


1) Create returns
(Quick/generate series)
2) Highlight return icons
and right click
3) Open as system

Note: If cointegrated
estimate a VECM

Multivariate VAR-GARCH-Diag Vech

Assuming a VAR(1)
(I would determine this was
suitable beforehand).

Multivariate VAR-GARCH-Diag Vech

Estimate

Multivariate VAR-GARCH-Diag Vech


Enables you to restrict any
of the coefficient matrices
Useful for larger systems
(Indefinite is unconstrained)

Multivariate VAR-GARCH-Diag
Vech
View/Conditional covariance/
Graphs
(Displays the graphs on the
next 2 slides)

Improvement in Log Likelihood


Information criteria mixed
Re-estimate removing insignificant mean terms

Multivariate VAR-GARCH-Diag Vech

Multivariate VAR-GARCH-Diag Vech

Const correlation model appears


inappropriate

Multivariate VAR-GARCH-Diag Vech

View/Residual tests
Non normality and autocorrelation present in std resids

Multivariate GARCH

BEKK and diag vech allow for time varying


correlations. This is an advantage given that most
studies support this.
The BEKK code allows you to estimate models that
allow for mean and volatility spillover.
The disadvantage when using Eviews is that out of
sample forecasts are unable to be generated. You
must do this yourself, using the recursive techniques
discussed in lecture 3.

Multivariate GARCH

The CC GARCH suffers from the assumption


of constant correlation.
The 2 stage approach is not efficient.
Out of sample forecasts can be generated
easily using Eviews.
Sometimes it is interesting to use a variety of
approaches and compare the outcomes.
From a practical of view the two approaches
may yield very similar results.