General Autoregressive Conditional Heteroskedastistic Model (GARCH) This model differs to the ARCH model in that it incorporates squared

conditional variance terms as additional explanatory variables. This allows the conditional variance to follow an ARMA process. If we write the residual as
ut = vt t! = vt ht

"here t! is written as ht and vt has a #ero mean and variance of one. "e can them write the conditional variance as

ht = % + i ut!i + i ht i
i =$ i =$

&or instance a 'ARCH($)$* process would be

. = %.- + %.,u ! + %.+h h t t $ t $

T/statistics and the usual dia0nostic tests could also be added to this model. If there was only the one la0 on the h variable) we would have a 'ARCH($)%* process which is the same as an ARCH($* process. Model Restrictions The principal restriction of this model is that all the explanatory variables in a 'ARCH and therefore ARCH model must be positive) this is 1nown as the non/ ne0ativity constraint) clearly it is impossible to have a ne0ative variance) as it consists of squared variables. Advantages of GARCH models compared to ARCH models The main problem with an ARCH model is that it requires a lar0e number of la0s to catch the nature of the volatility) this can be problematic as it is difficult to decide how many la0s to include and produces a non/parsimonious model where the non/ ne0ativity constraint could be failed. The 'ARCH model is usually much more parsimonious and often a 'ARCH($)$* model is sufficient) this is because the 'ARCH model incorporates much of the information that a much lar0er ARCH model with lar0e numbers of la0s would contain. ML Estimation of ARCH models in practice: $. 2pecify the model and its li1elihood function !. 3se 452 re0ression to 0et initial estimates (starting values* for $ ) $ etc. ,. Choose initial estimates for the parameters of the conditional variance function. Microfit (and other software* offers you #eros as startin0 values for these. In practice it is better to choose small positive values. 6. 2pecify a conver0ence criteria (usually the software has a default value for this*. +. Maximise the li1elihood by iteration until no further improvement in the model coefficients can be obtained (and the conver0ence criteria in step 6 is met*. Asymmetric GARCH

The 'ARCH model can be extended to include any number of la0s on the squared error term and conditional variance term. The 'ARCH (p)q* model has p la0s on the conditional variance term and q on the squared error term. However in 0eneral a 'ARCH($)$* model is sufficient. Asymmetric 'ARCH models due to the levera0e effect with asset prices) where a positive shoc1 has less effect on the conditional variance compared to a ne0ative shoc1. This can be incorporated into the 'ARCH model usin0 a dummy variable. This was introduced by 'losten) 7an0athann and Run1le ('7R*) and showed that asymmetric ad8ustment was an important consideration with asset prices. The model is of the form
t! = % + $ut!$ + t!$ + ut!$ I t $

"here I is a dummy variable that ta1es the value of $ when the shoc1 is less than % (ne0ative* and % otherwise. To determine if there is asymmetric ad8ustment) depends on the si0nificance of the last term) which can be determined usin0 the t/statistic. 'iven the followin0 set of results
t! = %.+ + %.-ut!$ + %.! t!$ + %.$-ut!$ I t $
. t $ = %.+ ) when the shoc1 is positive) t! u If we assume that t! $ 9%.- and 9( %.+: %.$-+:%.$6*9 %.;$+) if the shoc1 is ne0ative t! 9(%.+:%.$-+:%.$6 :%.%6!+*9%.;+-+.

The alternative to the above model is to use <'ARCH) which has a number of advanta0es over the basic 'ARCH model) as the non/ne0ativity constraint does not need to be imposed and the asymmetries are also allowed for usin0 this model
ln( t! * = + ln( t! $ * + u t $ + > u t $ ! =

t! $

t! $

GARCH in mean In this class of models) the conditional variance enters into the conditional mean equation as well as the usual error variance part.
y t = + t $ + u t

t! = % + $ut!$ + t! $

If yt is assumed to be an asset return) then in effect the first equation su00ests that the mean return is dependent on the ris1) if the parameter ? is positive and si0nificant) then it means that the mean return increases when there is 0reater ris1) in effect ? can be interpreted as a ris1 premium.