ECON3350/7350

Volatility Models-II
Alicia N. Rambaldi

Week 8

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In this lecture
Readings
Introduction
ARCH(p) and GARCH(p,q)
Linear Models with ARCH Errors
Extensions to the Basic GARCH Model
EGARCH
TGARCH
Testing for Leverage Eects
Example
(G)ARCH-in Mean
IGARCH Models
Stochastic Volatility Models
Realised Volatility
Coming Up
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Reference Materials
Author

Title

Chapter

Call No

Enders, W

Applied
Econometric
Time Series,
3e
Introductory
Econometrics
for Finance,
3e
A Guide to
Modern
Econometrics,
4e

HB139 .E55
2015

HG173 .B76
2014

8.10

HB139
.V465 2012

Brooks,C

Verbeek, M

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ARCH(q) and GARCH(p,q)

I

ARCH(q) process
E {2t |=t

1}

= 0 + 1 2t
= 0 +

1+
2
(L)t 1

2 2t

+ ... + q 2t

where (L) is a lag polynomial of order q

0 > 0.
GARCH(p, q) process

h t = 0 +

q
X

j 2t j

j=1

= 0 + (L)2t

p
X

1, (1) < 1,

i ht i

i=1

+ (L)ht

For a GARH(1,1), a non-negative ht requires 0 , 1 and

be non-negative.

to
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Regressions and Autoregressions

I

Consider a regression for the mean of yt with ARCH(q) errors:

yt =

+ 2 x2,t + ... + K xK ,t + t
q
t = t 0 + 1 2t 1 + ... + q 2t q

where t N(0, 1), (1) < 1, 0 > 0 and

E [t t s ] = 0 8 t, s
Consider an autoregressive model, AR(1), of the mean of yt
with GARCH(1, 1) errors:

0 , 1 and

yt = a0 + a1 yt 1 + t |a1 | < 1
q
t = t 0 + 1 2t 1 + 1 ht 1

to be non-negative, 1 +

<1

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Extensions to the Basic GARCH Model

I

Since the GARCH model was developed, a huge number of

extensions and variants have been proposed.
I

Problems with GARCH(p,q) Models:

- Non-negativity constraints may still be violated
- GARCH models cannot account for leverage eects

Some of the most important extensions are:

I
I
I

Asymmetric Models TGARCH and EGARCH (account for

leverage eects),
(G)ARCH-M models (particularly suited to study asset
markets)
The IGARCH model (a constrained model that accounts for
the persistence of volatility)

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The EGARCH Model

I

EGARCH was suggested by Nelson (1991). The variance equation is

given by
log (ht ) = 0 +

1 loght 1

t 1
t 1
+ 1 0.5
ht0.51
ht 1

Advantage - Since we model the log (ht ), then even if the

parameters are negative, ht will be positive.
t 1
t 1
I st 1 =
and |st 1 | = 0.5 are iid standard normal. st 1 and
ht0.51
ht 1
p
|st 1 | E (|st 1 |) are zero mean iid. E (|st 1 |) = 2/ under
normality.

The eect of a shock in t on log (ht )

t 1
is positive, eect is (1 + )
ht0.51
t 1
If 0.5 is negative, eect is (1
)
ht 1
Leverage eect as long as 6= 0 and < 0.
If

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EGARCH notation in Enders

I

Note that Enders uses dierent notation. However, the

notation above is consistent with that used in EViews.

Enders notation of the EGARCH is as follows

log (ht ) = 0 +

+ 1

In this case the assumption is that

I
I

1 loght 1

t 1
+
ht0.51

t 1
ht0.51

> 0 and 1 < 0

If the random shock is t < 0 then the eect is

If the random shock is t > 0 then the eect is

1
1

1 (>>)
+ 1 (<<)

Leverage eect as long as 1 6= 0 and 1 < 0.

It is clear that either notation is fine as long as we

understand how to interpret the eect

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Representing The Leverage Eect

-When

< 0 positive shocks

generate less volatility than negative

shocks (bad news).

-The standardised t 1/ht0.51 is unit

free and permits a more natural
interpretation of the size and
persitence of the shocks.
Source: Enders (2015)

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The EGARCH model (cont.)

I

It is possible to extend the EGARCH model by including

additional lags.

Note that we can rewrite as:

log (ht ) = 0 +

1 loght 1

+ (1 + )st

if t

>0

log (ht ) = 0 +

1 loght 1

+ (1

if t

<0

1
)st 1

The logarithmic transformation guarantees that variances will

never become negative.

Typically

+ 1 > 0 while

< 0.

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Volatility Prediction - EGARCH

I

Assuming the parameters are known and the innovations are

Gaussian, we proceed with a natural predictor

ht = exp [log (ht )] = exp 0 +

1 loght 1

+ st

+ 1 st

Et ht+j = Et {exp [log (ht+j )]} j > 0

I

The Gaussian case can be re-written to find a more explicit

expression (see for example Tsay (2002), pp 105)
log (ht ) = (1
g (st

1)

1 )0

= st

+ 1 ( st

1 loght 1
1

The one-step ahead forecast is given by

ht+h = ht2

exp [(1

+ g (st

1)

2/)

s
1 ) 0 ] exp [g (t )]
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The TGARCH or GJR Model

I

Due to Glosten, Jaganathan and Runkle (1994), the

threshold-GARCH:
ht = 0 + 1 2t

+ dt

2
1 t 1

1 ht 1

where,
dt 1 = 1 if t 1 < 0
dt 1 = 0 otherwise
I

We require 1 +

The eect of an t

0 and 1
1

0 for non-negativity.

shock on ht

If t 1 0, eect is 1 2t 1 ;
If t 1 0, dt 1 = 1 eect is (1 + )2t
Leverage eect is when > 0.

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Testing for Leverage Eects

I

Estimate an ARCH or GARCH (Use a "diagnostic" approach

to the test)
I

Form the standardised residuals (from ARCH or GARCH)

st = et /ht0.5 for t = 1, ..., T
I

An F - statistic, H0 : a1 = a2 = .. = 0 using the regression

st2 = a0 + a1 st

+ a2 s t

+ ...

If there are no leverage eects the squared errors should be

uncorrelated with the level of the error term and the
computed F statistic will fail to reject the null hypothesis.
A t test H0 : a1 = 0 using the regression
st2 = a0 + a1 dt

+ "t

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Testing for Leverage Eects (cont.)

I

Estimate the TARCH or EGARCH model,

ht = 0 + 1 2t

+ dt

2
1 t 1

1 ht 1

or
log (ht ) = 0 +
I

1 loght 1

t 1
t 1
+ 1 0.5
0.5
ht 1
ht 1

Test:
H0 :
I
I

=0

using a t test
PLEASE NOTE TYPO IN ENDERS (It should read
H0 : 1 = 0, page 157)

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Example
An Example of the use of a GJR Model
Data: monthly S&P 500 returns, December 1979- June 1998.
Source: Brooks (2002)
yt = 0.172
(3.198)

(t

ht

= 1.243 + 0.0152t

stat)

(16.37) (0.44)

+ 0.498ht
(14.99)

+ 0.6042t 1 dt

(5.77)

Testing the leverage eect

H0 :

=0

Computed t = 5.77. The computed value is larger than 1.645 (for

a one-tail test) and thus we conclude that there are significant
leverage eects.
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Example
GJR Model (cont.)
I
I

Data: monthly S&P 500 returns, December 1979- June 1998.

The news impact curve plots the next period volatility (ht )
that would arise from various positive and negative values of 2t

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(G)ARCH-in Mean
I

We expect a risk to be compensated by a higher return. So

why not let the return of a security be partly determined by its
risk?

Engle, Lilien and Robins (1987) suggested the ARCH-M

specification.
yt = t + t
t =

+ ht

t =

+ (0 +

p
X

i 2t i )

i=1

where,
, , 0 and i are constants, and

> 0.
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(G)ARCH-in Mean (cont.)

In Engle, Lilien and Robins (ELR)

I
I
I

yt =excess return from holding a long-term asset relative to a

on-period treasury bill
t =risk premium necessary to induce the risk-averse agent to
hold the long-term asset rather than the one-period bond.
t = unforecastable shock to the excess return on the
long-term asset.

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The ELR ARCH-M Model (cont.)

The expected excess return from holding the long-term asset

must be just equal to the risk premium:
Et

1 yt

= t

The assumption is that the risk premium is an increasing

function of the conditional variance of t
I

The greater the conditional variance of returns, the greater the

compensation necessary to induce the agent to hold the
long-term asset .

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The (G)ARCH-M Model (cont.)

A general (G)ARCH-M model is given by:

yt = xt0 + g (ht ) + t +

r
X

j t

j=1

ht = 0 +

q
X

j 2t

j=1

p
X

i ht i

i=1

Usual g (ht ) are:

I

log (ht ),

ht , (ht )m m = 1, 2, ..

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Example
Example. ELR - Excess yields on six-month treasury bills
I

rt quarterly yield on a three-month treasury bill held from t to

t + 1.
I

Rolling over all proceeds, at the end of two quarters and

individual investing $1 at the beginning of the t will have
(1 + rt )(1 + rt+1 ) dollars.

Rt quarterly yield on a six-month treasury bill, buying and

holding the six-month bill for the full two quarters will result in
(1 + Rt )2 dollars.

The excess yield, yt , due to holding the six-month bill is

yt = (1 + Rt )2

(1 + rt+1 )(1 + rt )

which is approximately equal to:

yt = 2Rt

rt+1

rt
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Example
(cont.)
yt = 0.142 + t
(4.04)
The excess yield of 0.142% per quarter is more than four standard
deviations from zero.
LMARCH = 10.1 which is larger than the critical value from the
at 1% (6.635).

2
(1)

However, the post-1979 period showed higher volatility than the

earlier period.

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Example
The ARCH-M estimates are:
yt =

0.0241 + 0.687ht

( 1.29)
(5.15)

ht = 0.0023 + 1.64(0.42t
(1.08)

+ 0.32t

+ 0.22t

+ 0.12t 4 )

(6.30)

Results:
I

Risk premium are time-varying

Estimate of 1.64 implies the unconditional variance is infinite

(the conditional variance if finite)

During volatily periods, the risk premium rises as risk-averse

agents seek assets that are conditionally less risky.

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IGARCH Models

Sometimes when we estimate GARCH(1,1) models we find

that the sum of the estimated 1 and 1 coecients is close
to 1.

Due to Nelson (1990), constraining 1 + 1 = 1 yields the

Integrated-GARCH or IGARCH(1, 1) model
ht = 0 + (1

2
1 )t 1

1 Lht

It yields a more parsimonious representation of the error

process (there is one less parameter to estimate)
I

forces ht to act like a process with a unit root.

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IGARCH Models (cont.)

However, solving for ht

ht = 0/(1

1)

+ (1

1)

1
X

i 2
1 t 1 i

i=0

Unlike a true nonstationary process, ht is a geometrically

decaying function of current and past realisations of the 2t
sequence.

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IGARCH (cont.)
I

As it is a decaying function of current and past values of the

shocks it can be estimated like any other GARCH(p, q)

The one step-ahead forecast of the conditional variance is

E (ht+1 |=t ) = 0 + ht

The j step-ahead forecast of the conditional variance is

E (ht+j |=t ) = j0 + ht

Thus, appart from the intercept the forecast of the conditional

variance for the next period is the current value of the
conditional variance. The unconditional variance is infinite.

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Stochastic Volatility Models

An alternative class of models to those in the GARCH(p, q)

family are the stochastic volatility models (SV).

They dier principally because the conditional variance is not a

deterministic function of past information.

They are particularly designed to deal with volatility clustering.

SV models contain a second error term which enters the

conditional variance specification and are written as
state-space models

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Stochastic Volatility Models (cont.)

The simple forms can be estimated using maximum likelihood

or Monte Carlo methods via Kalman filtering

A SV model is defined as
at = h t t
(1

1L

...

mL

where at are returns, t N(0,

0 , 1 , . . . , m are parameters

) ln ht = 0 + t

2
),

t N(0, 1),

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Stochastic Volatility Models (cont.)

Example
A SV model for the daily returns of an asset price, yt is:
1
yt = a + exp( t )t t N(0, 1)
2
t+1 = t + t t N(0, 2 ) 0< <1
The signal or state, t , is the logarithmic volatility which we wish
to estimate. Volatility is mapped to observed daily returns, and it is
assumed to be a stationary AR(1) process in this case.

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Realised Volatility
I

The conditional variance is latent (ie not observed)

Models from the GARCH(p, q) family (and SV type models)

are estimates of the latent conditional variance

Criticism are that standard latent volatility models fail to

describe in an adequate manner the low, but slowly decreasing,
autocorrelations in the squared returns that are associated
with high excess kurtosis of returns.

Search for an adequate framework has led to the analysis of

high frequency intraday data.

Merton (1980) noted that the variance over a fixed interval

can be estimated arbitrarily, although accurately, as the sum of
squared realisations, provided the data are available at a
suciently high sampling frequency

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Realised Volatility (cont.)

I

Andersen and Bollerslev (1998) showed that ex-post daily

foreign exchange volatility is best measured by aggregating 288
squared five minute returns.

The five-minute frequency is a trade-o between accuracy,

which is theoretically optimized using the highest possible
frequency, and microstructure noise that can arise through the
bid-ask bounce, asynchronous trading, infrequent trading, and
price discreteness, among other factors

Ignoring the remaining measurement error, which can be

problematic, the ex-post volatility essentially becomes
observable.

As volatility becomes observable, it can be modeled directly,

rather than being treated as a latent variable

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Realised Volatility (cont.)

I

Consider a simple discrete time model in which the daily returns of

a given asset are typically characterized as
rt = ht0.5 t

where t is a sequence of independently and normally distributed

random variables with zero mean and unit variance, t NID(0, 1)
and ht0.5 is the (time-varying) standard deviation of daily returns.
I Suppose that, in a given trading day t, the logarithmic prices are
observed tick-by-tick.
I Consider a grid = { , ..., } containing all observation
t
0
nt
points, and
I p , i = 1, ..., n , to be the i th (logarithmic) price observation
t,i
t
during day t, where nt is the total number of observations at
day t.
I Furthermore, suppose that r
pt,i 1 is the i th
t,i = pt,i
intraperiod return of day t, such that
rt =

nt
X
i=0

ri,t
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Two unbiased estimators of RV

I

The realised variance is defined as the sum of all available

intraday high frequency squared returns given by
(all)
RVt

n
X

2
rt,i

i=0

The squared daily return can be written as

rt2 =

n
X
i=0

rt,i

!2

They are unbiased as it can be shown that

(all)
E (rt2 |=t,0 ) = E (RVt |=t,0 ) = ht (=t,0 is the information set
available prior to the start of day t).
Further reading, see for example:
I

McAleer, Michael and Medeiros, Marcelo C.(2008) Realized

Volatility: A Review, Econometric Reviews, 27: 1, 10 45
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Coming Up

Vector Autoregressive Models

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