QBUS6830 (S2, 2022); Module 4; 1

Module 4: Forecasting for Risk Management

References:
• Chapters 3 (forecasting) and 7 (Value at Risk) in Tsay
• Chapters 1, 2 and 6 in McNeil, Frey and Embrechts
• Taleb: The Black Swan
QBUS6830 (S2, 2022); Module 4; 2

Section 1:
Risk Measurement and Management
(1) Introduction to Risk, and its’ Management
• There are several types of risk for financial institutions, including:
– credit risk
– liquidity risk
– operational risk
– market risk
– systemic risk

• This unit is primarily concerned with market risk.

• The New Regulatory Order In 1974 the Central Bank Governors of the G10

established the Basel Committee of Banking Supervision

QBUS6830 (S2, 2022); Module 4; 3

• Following ’Black Monday’ October, 1987, in 1988 the G10 governments commis-
sioned the 1st Basel Accord on Banking Supervision, Basel I.

• The aim was to regulate and offer guidelines for risk measurement and manage-
ment, via minimum capital allocation.

• The focus was on credit risk, already the dominant source of banking risk, but
measures were coarse.

• In 1992 New York Federal Reserve President E. Gerald Corrigan said publicly:
“You had better all take a very, very hard look at off-balance-sheet activi-
ties. The growth and complexity of these activities and the nature of the
credit settlement risk they entail should give us cause for concern. I hope
this sounds like a warning, because it is. Off-balance-sheet activities [like
derivatives] have a role, but they must be managed and controlled carefully
and they must be understood by top management as well as by traders and
QBUS6830 (S2, 2022); Module 4; 4

rocket scientists.”

• In 1993 JPMorgan started the famous ’Weatherstone 4:15pm’ daily market risk
assessment for off-balance-sheet products.

• RiskMetrics and Value-at-Risk (VaR) were born from this report, as quantitative
risk management tools.

• In 1996, the 1st amendment to Basel I was commissioned, including VaR for
market risk management, by ’appropriate models’.

• By 2001, following the LTCM disaster in 1998, Basel II had been commissioned
and formally released in 2004. Again, the focus is on credit risk . . . .

• “More recently, instruments...such as credit default swaps, collateralized debt

QBUS6830 (S2, 2022); Module 4; 5

obligations and credit-linked notes have been developed and their use has
grown rapidly in recent years. The result? Improved credit risk management
together with more and better risk-management tools appear to have signifi-
cantly reduced loan concentrations in telecommunications and, indeed, other
areas and the associated stress on bank and other financial institutions. More
generally, such instruments appear to have effectively spread losses from de-
faults...to a wider set of banks than might previously have been the case in the
past, and from banks, which have largely short-term leverage, to insurance
firms, pension funds or others with diffuse long-term liabilities or no liabili-
ties at all. Many sellers of credit risk protection, as one might presume, have
experienced large losses, but because of significant capital, they were able to
avoid the widespread defaults of earlier periods of stress. It is noteworthy
that payouts in the still relatively small but rapidly growing market in credit
derivatives have been proceeding smoothly for the most part. Obviously this
market is still too new to have been tested in a widespread down-cycle for
credit, but, to date, it appears to have functioned well ”.
QBUS6830 (S2, 2022); Module 4; 6

• This comment was made by United States Federal Reserve Chairman Alan Greenspan
in 2002.

• By it’s very nature, risk management is about forecasting.

• Forecasting future risk from current investments and taking appropriate action to
’cover’ or protect against that risk.

• Volatility forecasts are used in many (market) risk management tools: option
pricing, hedging, portfolio allocation, etc.

• Quantile forecasts are also used to predict the magnitude and probability of pos-
sible future extreme adverse returns.

• Financial analysts often favour such single-number measures or tools. However,

QBUS6830 (S2, 2022); Module 4; 7

they each simply form one single part of the forecast distribution for investment
losses.

• It is this entire (forecast) loss distribution that should be used instead, or at least
as well as the single number measures.

• These measures of risk can be used to allocate capital to protect against extreme
or unlikely market movements.

• Extreme market movements are rare, but very important.

QBUS6830 (S2, 2022); Module 4; 8

• Examples include:
– ’Black Monday’ stock market crash of October 1987
– the terrorist attacks of September 11, 2001
– the collapse of the Russian ruble in August, 1998
– the bursting of the housing price bubble in the US in mid-2007
– the global financial crisis (GFC) in 2007-2009
– The covid-19 pandemic outbreak in Feb-March, 2020

• Value at Risk (VaR) became the widely accepted measure of market risk in the
financial industry, in the late 1990s and early 2000s to today.

• A related measure called expected shortfall or conditional VaR is becoming more

widely used in very recent years.

• VaR is used to allocate sufficient protective capital to ensure that financial insti-
QBUS6830 (S2, 2022); Module 4; 9

tutions are still in business after an extreme (market) event.

• VaR can be defined as the maximal loss of a financial position during a given
time period at a given probability level, under normal market conditions

• Suppose that at time t we are interested in the risk of a financial position for the
next h periods.

• Let ∆V (h) = V (t + h) − V (t) be the change in the value of the asset from time
t to time t + h.

• Risk measurement typically employs the probability distribution of the (future)

change in value
QBUS6830 (S2, 2022); Module 4; 10

• Usually, the distribution of the loss function is employed:

Loss = Lh ≡ −∆V (h)

• Risk is assessed by observing the distribution of future loss Lh or change in

asset value ∆V (h).

• Usually one aspect of the distribution is focused upon. e.g. variance, VaR, ES,
etc.

• Denote the CDF of ∆V (h) by Fh(.). We assume that Fh(.) is a continuous,

smooth function (as we have done for GARCH-type models so far)
QBUS6830 (S2, 2022); Module 4; 11

For an Institution with a Long Position:

• The VaR, from time t = T , over a time horizon h periods, at probability level p,
is defined as
p = P r(∆V (h) ≤ VaRp(h)|FT ) = Fh(VaRp(h)|FT )
≡ P r(Lh ≥ −VaRp(h)|FT )
or alternatively,
VaRp(h) = Fh−1(p|FT )

• Since a long position suffers a loss when ∆V (h) < 0, the VaR typically assumes
a negative value when p is small.

• Often -1 × VaR is used for long positions, so that a positive number results and
the usual definition of loss (≥ 0) applies.
QBUS6830 (S2, 2022); Module 4; 12

For an Institution with a Short Position:

• The holder of a short position suffers a loss when the value of the asset increases.

• In this case, the VaR is defined as

p = P r(∆V (h) ≥ VaRp(h)|FT )
= 1 − P r(∆V (h) < VaRp(h)|FT )
= 1 − Fh(VaRp(h)|FT )
≡ P r(Lh ≤ −VaRp(h)|FT )
or alternatively,
VaRp(h) = Fh−1(1 − p|FT )

• For a small p, the short position VaR typically assumes a positive value.

• VaR is thus concerned only with the tail behaviour of the distribution for ∆V (h).
QBUS6830 (S2, 2022); Module 4; 13

• For a long position, the left or lower side tail of Fh is important.

• Notice that the VaR for a short position is equivalent to that of the long position
when the distribution of −∆V (h) is employed.

• Therefore, we only consider cases where the position is long.

• VaR is the quantile, at probability level p, of the distribution of the change in

Asset Value over the time horizon T + 1, . . . , T + h.

• For example, if the change in Value distribution is specified as:

∆V (h)|FT ∼ N (µh, σh2 )
then the VaR is the pth quantile of this distribution:
VaRp(h) = µh + Φ−1(p)σh
QBUS6830 (S2, 2022); Module 4; 14

• ∆V (h) is measured by the subsequent return over the h-periods.

• To assess risk properties for h > 1 requires the conditional forecast distribution
for multiple-day returns:
Xh
rt[h]|Ft = rt+k |Ft
k=1

• Under our GARCH framework, this requires being able to forecast means, vari-
ances and distributions for future single and multi-day returns.

• VaR only shows the minimum amount that may be lost at probability level p.

• Financial analysts and rules insist on having a single number instead of looking
at the entire distribution of future returns.
QBUS6830 (S2, 2022); Module 4; 15

• Is the minimum loss the right number to use?

• VaR is also not a coherent or sub-additive risk measure, under the theory of
mathematical risk measures.

• VaR does not always give smaller risk under diversification, as would logically
make sense.

• In other words, the sum of the individual risks in a portfolio of assets can be less
than the risk of the whole portfolio, under VaR.

• A coherent and perhaps more logical risk measure is called expected shortfall.

• In the literature it is sometimes called conditional Value at Risk (CVaR) or tail

expectation or tail risk.
QBUS6830 (S2, 2022); Module 4; 16

• Expected shortfall (ES) can be defined as: the expected change in value (i.e.
loss) associated with negative market movements beyond probability level p.

• Mathematically we have:
ESp(h) = E [∆V (h)|∆V (h) ≤ V aRp(h)]

• which is equivalent to:

Z p
1
ESp(h) = V aRu(h)du
p 0

• It is not hard to show that, if ∆V (h)|Fn ∼ N (µh, σh2 ) then:

−1


ϕ Φ (p)
ESp(h) = µh − σh
p
where ϕ() is the standard normal pdf and Φ−1(p) is the inverse standard normal
cdf at probability level p.
QBUS6830 (S2, 2022); Module 4; 17

• Dynamic volatility models (e.g. GARCH) can thus provide a parametric means
to estimate and forecast VaR, leading into the next section.

• To do this, we must be able to forecast the return (i.e. value) distribution, includ-
ing its volatility.

• Basel II recommends that h = 1 and h = 10 should be employed for risk man-

agement purposes.

• If we employ ∆V (h) ∝ rt[h], then

Z V aRp (h)
ESp(h) = E [rt[h]|rt[h] ≤ V aRp(h)] = r ph(r|r ≤ V aRp(h))dr
−∞
QBUS6830 (S2, 2022); Module 4; 18

(2) Forecasting Volatility

(2a) ARCH models
• The distribution of (future) change in value is equivalent to the forecast distribu-
tion of returns; i.e. ∆V (h) ∝ rt[h].

• One relevant aspect of this distribution is volatility.

• Volatility forecasts are inputs into most risk measures and the management of
risk. Plus volatility is itself the traditional risk measure, e.g. Markowitz minimum
variance portfolio.

• The initial goal is to estimate (forecast)

σt2(h) = Var(rt+h|Ft)

• We denote the h-step ahead forecast variance, from forecast origin t, as σt2(h).
QBUS6830 (S2, 2022); Module 4; 19

• For a constant mean ARCH(p) model, the h = 1-step ahead volatility forecast,
from an origin t, is simply:
σt2(1) = α0 + α1a2t + α2a2t−1 + . . . + αma2t+1−p
where each term on the RHS is assumed known at time t.

• NB this sort of forecasting ignores parameter uncertainty and estimation risk

and model uncertainty

• parameter uncertainty: we don’t know the true parameters

• estimation risk : we may not be using the optimal estimator.

• model uncertainty: we don’t know the true model, i.e. ”all models are wrong,
but some are useful” (George Box)
QBUS6830 (S2, 2022); Module 4; 20

• The 2-step ahead volatility forecast (h = 2) is:

σt2(2) = Var(rt+2|Ft) = E(a2t+2|Ft)
= α0 + α1E(a2t+1|Ft) + α2E(a2t |Ft) + . . .
+αmE(a2t+2−p|Ft)
= α0 + α1σt2(1) + α2a2t + . . . + αma2t+2−p
since E(a2t+1|Ft) = σt+1
2
= σt2(1); known at time t.

• The result:
Var(rt+h|Ft) = E(a2t+h|Ft)
holds for h > 1 ONLY if the mean of rt is constant over time i.e.
only holds when returns are uncorrelated over time.

• Why?

• The general h-step ahead volatility forecast for a constant mean ARCH(m) model
QBUS6830 (S2, 2022); Module 4; 21

is thus:
m
X
σt2(h) = α0 + αiσt2(h − i) ; h > 0
i=1

where
σt2(h − i) = a2t+h−i for h − i ≤ 0
= σt2(h − i) for h − i > 0

• For an ARCH(1) model we have:

σt2(1) = α0 + α1a2t
σt2(2) = α0 + α1σt2(1) = α0(1 + α1) + α12a2t
:
σt2(h) = α0(1 + α1 + . . . + α1h−1) + α1ha2t
= α0 + α1σt2(h − 1)
QBUS6830 (S2, 2022); Module 4; 22

• As h → ∞
α0
σt2(h) →
1 − α1
if, and only if, α0 > 0, 0 ≤ α1 < 1.

• Does this result make sense?

• What would h-step-ahead volatility forecasts from an ARCH(1) model look like
as h increased?
QBUS6830 (S2, 2022); Module 4; 23

Example
• Using the ARCH(p) volatility forecast expressions, it is possible to make from 1
period ahead up to 50-period-ahead (and more) forecasts of volatility for the CBA
and WES (Wesfarmers) returns.

• We estimate Gaussian error constant mean ARCH(1)-N model, in each case leav-
ing out the last 50 returns in each sample. Why leave data out in this way?
QBUS6830 (S2, 2022); Module 4; 24

• Figure 1 shows the last 2 years of data in the two series, the last 50 days are
beyond the marked line at Dec 17, 2021.
6
4
2
0
2
4
6
8
2021-08 2021-09 2021-10 2021-11 2021-12 2022-01 2022-02 2022-03
4

8
2021-08 2021-09 2021-10 2021-11 2021-12 2022-01 2022-02 2022-03

Figure 1: CBA and WES daily returns from 2021 to 2022.

QBUS6830 (S2, 2022); Module 4; 25

• Parameter estimates, excluding the last 50 days, are as follows. For CBA:
rt = 0.059 + at
σt2 = 1.19 + 0.39a2t−1

• For WES:
rt = 0.051 + at
σt2 = 1.52 + 0.36a2t−1

• Note that volatility persistence is estimated as α̂1 = 0.39 for CBA and 0.36 for
WES here.
QBUS6830 (S2, 2022); Module 4; 26

• The CBA ARCH(1) forecasts are summarised in figures 2 and 3 for CBA, which
also show the last 150 in-sample estimates of volatility.

CBA ARCH(1) volatility forecasts, 1-50 steps ahead

ARCH(1)
1.8 ARCH(1) LR

1.7

1.6

1.5

1.4

0 10 20 30 40 50

Figure 2: One to Fifty period ahead volatility forecasts for CBA, from an ARCH(1)-N model.
QBUS6830 (S2, 2022); Module 4; 27

CBA ARCH(1) volatility forecasts, 1-50 steps ahead CBA volatility estimates, last 150 days, plus forecasts 1-50 steps ahead
1.8
3.5

1.7 3.0

2.5
1.6

2.0
1.5
1.5

1.4
1.0
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 3: In-sample volatility plus one to fifty period ahead volatility forecasts for CBA.

• The WES ARCH(1) forecasts are summarised in figures 4 and 5 for WES, which
also show the last 150 estimates of volatility.
QBUS6830 (S2, 2022); Module 4; 28

WES ARCH(1) volatility forecasts, 1-50 steps ahead

1.55

1.50

1.45

1.40

1.35

1.30

1.25
ARCH(1)
ARCH(1) LR
0 10 20 30 40 50

Figure 4: One to Fifty period ahead volatility forecasts for WES, from an ARCH(1)-N model.

• The ARCH(1) forecasts for CBA and WES indicate that volatility should decrease
(CBA) or increase (WES) over the subsequent 50 days and mean revert quickly,
i.e. in ≈ 5 days, towards the estimated long-run average volatility.
QBUS6830 (S2, 2022); Module 4; 29

WES ARCH(1) volatility estimates and forecasts

1.55

1.50 2.2

1.45 2.0

1.40
1.8

1.35
1.6

1.30
1.4
1.25
1.2
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 5: In-sample volatility plus one to fifty period ahead volatility forecasts for WES.

• The exercise above is repeated for ARCH(5) models

QBUS6830 (S2, 2022); Module 4; 30

• Parameter estimates, excluding the last 50 days, are as follows. For CBA:
rt = 0.079 + at
σt2 = 0.50 + 0.18a2t−1 + 0.12a2t−2
+ 0.15a2t−3 + 0.20a2t−4 + 0.12a2t−5

• For WES:
rt = 0.070 + at
σt2 = 0.83 + 0.15a2t−1 + 0.20a2t−2
+ 0.07a2t−3 + 0.14a2t−4 + 0.06a2t−5

P5
• Note that volatility persistence is estimated as i=1 α̂i = 0.77 for CBA and 0.63
for WES here; both larger than those for the ARCH(1) model.
QBUS6830 (S2, 2022); Module 4; 31

• The CBA ARCH(5) forecasts are summarised in figures 6 and 7 for CBA, which
also show the last 150 in-sample estimates of volatility.

CBA ARCH(5) volatility forecasts, 1-50 steps ahead

ARCH(5)
ARCH(5) LR
1.50

1.45

1.40

1.35

1.30

1.25
0 10 20 30 40 50

Figure 6: One to Fifty period ahead volatility forecasts for CBA, from an ARCH(5)-N model.
QBUS6830 (S2, 2022); Module 4; 32

CBA volatility estimates, last 150 days, plus forecasts 1-50 steps ahead
3.0
1.50

2.5
1.45

2.0
1.40

1.35 1.5

1.30
1.0

1.25
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 7: In-sample volatility plus one to fifty period ahead volatility forecasts for CBA.

• The WES ARCH(5) forecasts are summarised in figures 8 and 9 for WES, which
also show the last 150 estimates of volatility.
QBUS6830 (S2, 2022); Module 4; 33

WES ARCH(5) volatility forecasts

1.50

1.45

1.40

1.35

1.30

1.25

1.20
ARCH(5)
ARCH(5) LR
0 10 20 30 40 50

Figure 8: One to Fifty period ahead volatility forecasts for WES, from an ARCH(5)-N model.

• The ARCH(1), ARCH(5) forecasts are summarised in figure 10 for CBA and figure
11 for WES.
QBUS6830 (S2, 2022); Module 4; 34

WES ARCH(5) volatility estimates and forecasts

1.50
2.2
1.45
2.0
1.40
1.8
1.35
1.6
1.30
1.4

1.25
1.2

1.20
1.0

0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 9: In-sample volatility plus one to fifty period ahead volatility forecasts for WES.

• Are these forecasts any good? Logical? Accurate? Biased?

• How can we tell?

QBUS6830 (S2, 2022); Module 4; 35

10 Proxy3
IGARCH
GARCH

0
2014 2015 2016 2017 2018 2019 2020 2021

Figure 10: One to Fifty period ahead volatility forecasts for CBA.

(2b) GARCH models

• Recall the GARCH(1,1) model (with constant mean):
σt2 = α0 + α1a2t−1 + β1σt−1
2
QBUS6830 (S2, 2022); Module 4; 36

WES ARCH(1), ARCH(5) volatility forecasts

1.55

1.50

1.45

1.40

1.35

1.30

1.25

ARCH(1)
1.20 ARCH(5)
ARCH(1) LR
ARCH(5) LR
0 10 20 30 40 50

Figure 11: One to Fifty period ahead volatility forecasts for NWS.

• The 1-step ahead volatility forecast is simply σt+1

2
:
σt2(1) = α0 + α1a2t + β1σt2
QBUS6830 (S2, 2022); Module 4; 37

• The h-step ahead forecast for the constant mean GARCH(1,1) model.

• Consider:
2
σt+1 = α0 + α1a2t + β1σt2

• Using a2t = σt2ϵ2t this can be rearranged into:

2
σt+1 = α0 + (α1 + β1)σt2 + α1σt2(ϵ2t − 1)

• Taking expected values (E(ϵ2t ) = 1) and substituting t + h − 1 for t

σt2(h) = α0 + (α1 + β1)σt2(h − 1)

• Here we see again why α1 + β1 is called the persistence in volatility

QBUS6830 (S2, 2022); Module 4; 38

• Now by repeated substitution:

α0(1 − (α1 + β1)h−2)
σt2(h) = + (α1 + β1)h−1σt+1
2
1 − α1 − β1

• What happens as h → ∞?

• The results for σt2(h), h > 1 for ARCH/GARCH models hold only for models
with a constant mean equation, i.e. E(rt) = µ
QBUS6830 (S2, 2022); Module 4; 39

• When an ARCH or GARCH model has a ARMA mean, there are correlations for
h > 1 that add terms to these formulas.

• Consider the AR(1)-GARCH(1,1) model, where

µt = ϕ0 + ϕ1rt−1
Here it is still true that:
Var(at+h|Ft) = α0 + (α1 + β1)Var(at+h−1|Ft)
but
Var(at+1|Ft) = α0 + α1a2t + β1σt2 = σt2(1)

only holds when h = 1.

QBUS6830 (S2, 2022); Module 4; 40

• In an AR model, the returns are no longer uncorrelated, so

Var(rt+h|Ft) ̸= Var(at+h|Ft) ; for h > 1

• e.g. for an AR(1) model when h = 2,

Var(rt+2|Ft) = ϕ21Var(rt+1|Ft) + Var(at+2|Ft)
= ϕ21Var(at+1|Ft) + Var(at+2|Ft)

• e.g. for an AR(1) model, we can use back (or forward) substitution to show that:
h−1
X
rt+h = γ + ϕh1 rt + at+h + ϕi1at+h−i
i=1

where γ is a constant that depends only on ϕ0, ϕ1 and h.

• Proof
QBUS6830 (S2, 2022); Module 4; 41

• Hence, for h > 1, in an AR(1)-GARCH(1,1) model we have

h−1
X
Var(rt+h|Ft) = Var(at+h|Ft) + ϕ2i
1 Var(at+h−i |Ft )
i=1
= σt2(h)

• where
Var(at+h|Ft) = α0 + (α1 + β1)Var(at+h−1|Ft)

• As h → ∞ we have
Var(at+h) α0
σt2(h) → = = Var(rt)
1 − ϕ21 (1 − α1 − β1)(1 − ϕ21)

• Notice that this expression is always larger than that for a GARCH(1,1) with
constant mean (and the same parameter values).
QBUS6830 (S2, 2022); Module 4; 42

• Similar, but more complicated, expressions can be found for AR(p) and ARMA(p,q)
mean equation models.

• These are beyond the scope of this course, but Python uses them in forecast
calculations.
QBUS6830 (S2, 2022); Module 4; 43

Example
• Using the GARCH forecast expressions derived above, we make from 1 period
ahead up to 50-period-ahead forecasts of volatility for each of CBA and WES
returns.

• Now, we use a GARCH(1,1)-N model.

• CBA: GARCH
rt = 0.072 + at
2
σt2 = 0.030 + 0.096a2t−1 + 0.888σt−1

• WES: GARCH
rt = 0.075 + at
σt2 = 0.05 + 0.074a2t−1 + 0.902σt−1
2
QBUS6830 (S2, 2022); Module 4; 44

• The volatility persistence is estimated as 0.984 for CBA and 0.976 for WES; both
much higher than for both ARCH models.

• Figures 12 and 13 summarize the forecasts for CBA and WES respectively

• Figures 14 and 15 summarize the forecasts for CBA and WES respectively for all
models used so far.

• For CBA and WES, GARCH suggests a much higher volatility persistence (e.g.
0.984 compared to 0.77) and thus much slower mean reversion than the ARCH(5)
model

• How has that affected the forecast behaviour as h = 1, . . . , 50?

QBUS6830 (S2, 2022); Module 4; 45

CBA GARCH volatility estimates and forecasts

1.36 2.2

2.0
1.35
1.8

1.34 1.6

1.4
1.33
1.2

1.0
1.32
0.8

0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 12: CBA volatility estimates and forecasts: GARCH

• Which forecasts are better?

QBUS6830 (S2, 2022); Module 4; 46

WES GARCH volatility estimates and forecasts

1.40 1.6

1.5
1.35
1.4

1.30 1.3

1.2
1.25
1.1

1.0
1.20
0.9
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 13: WES volatility estimates and forecasts: GARCH

(2c) Assessing (volatility) forecast accuracy

• It is important to know and measure whether volatility forecasts are accurate.
QBUS6830 (S2, 2022); Module 4; 47

CBA ARCH and GARCH volatility forecasts

2.2
ARCH(1)
ARCH(5)
GARCH(1,1)
2.0 ARCH(1) LR
ARCH(5) LR
GARCH(1,1) LR

1.8

1.6

1.4

1.2

1.0

0.8
0 10 20 30 40 50

Figure 14: One to Fifty period ahead volatility forecasts for CBA: ARCH and GARCH models.
QBUS6830 (S2, 2022); Module 4; 48

WES ARCH and GARCH volatility forecasts

2.2
ARCH(1)
ARCH(5)
GARCH(1,1)
2.0 ARCH(1) LR
ARCH(5) LR
GARCH(1,1) LR

1.8

1.6

1.4

1.2

1.0

0.8
0 10 20 30 40 50

Figure 15: One to Fifty period ahead volatility forecasts for WES: ARCH and GARCH models.
QBUS6830 (S2, 2022); Module 4; 49

• How can we measure the accuracy of volatility forecasts for real financial data
sets?

• If we knew the true volatilities (σt2) of the data set, we could then compare these
to the forecasts.

• It is now standard to assess forecasts of conditional standard deviation (or volatil-

ity), σt.

• The comparison could be done using standard forecast measures, such as:
– Root Mean Square Error
v
u m
u1 X
RMSE = t (σ̂t − σt)2
m i=1
where m is the size of the forecast sample.
QBUS6830 (S2, 2022); Module 4; 50

– Mean Absolute Deviation

m
1 X
MAD = |σ̂t − σt|
m i=1
where σ̂t are the forecasts of volatility as estimated by the ARCH/GARCH type
models we have considered so far.

• However, we do NOT have the true volatilities for any real data set! Volatility
is an unobserved process.

• It is thus difficult to assess the accuracy of volatility forecasts, in general.

• Volatility proxies are often used in place of the true series {σt} to assess forecast
accuracy.

• These are alternative estimates of volatility, and often use other information, such
as intra-day price movements, or information not available at the time when the
QBUS6830 (S2, 2022); Module 4; 51

forecast was made.

• i.e. we assess forecast accuracy by ”waiting” for the forecast period to end and
then comparing the forecasts to proxies that use information available once the
forecast period has occurred.

• Some common volatility proxies are:

1. The squared mean-corrected daily return:
2(1)
σt = (rt − µt)2 = a2t
– This is an unbiased proxy. i.e.:
a2t = ϵ2t σt2 ; E(a2t |Ft−1) = σt2 ; E(a2t ) = E(σt2)
– However it is a very noisy or inefficient proxy, i.e.:
– a2t could be quite large or small, compared to σt2, depending on ϵ2t . By how
much?
QBUS6830 (S2, 2022); Module 4; 52

(1)
– The equivalent proxy for σt is |at|.

For many decades now, information on daily stock prices has included four to
six items: daily open, high, low and closing prices, plus volume and adjusted
closing price.
The daily close-close return uses only information from two distinct times.
The daily price range employs information over the entire trading day.

2. A range-based proxy, proposed by Parkinson (1980) is:

2(2) Rt2
σt = ≈ 0.3607Rt2
4ln(2)
where Rt = 100 ∗ log(Ht/Lt) is the percentage log intra-day range.
– Here Ht is the highest price at which the stock traded, and Lt is the lowest
price at which trading occurred, during the day.
(2) √
– The equivalent proxy for σt is 0.3607Rt.
QBUS6830 (S2, 2022); Module 4; 53

3. The (Parkinson) range proxy (2.) ignores any overnight movements in price,
which do occasionally occur. A 2nd range-based proxy is then:
2(3) 0.83 2(2) 0.17
σt = σt + {100log(Ot/Ct−1)}2
f 1−f
where Ot, Ct−1 are respectively the opening price on day t and the closing price
on day t − 1.
– f is the fraction of the day that the market is closed. For Australia and the
US, this is 18/24 = 0.75. Thus,
2(3) 2(2)
σt = 1.107σt + 0.68 × 100log(Ot/Ct−1)

4. 3rd range-based proxy: Alizadeh, Brandt and Diebold (2001) found that:
log(Rt) ≈ N (log(σt) + 0.43, 0.292)
which, via the properties of a log-normal density, leads to the proxy
2(4)
σt ≈ exp(2 log(Rt) − 0.86 + 2 ∗ 0.292)
(4)
– The equivalent proxy for σt is exp(log(Rt) − 0.43 + 0.292).
QBUS6830 (S2, 2022); Module 4; 54

5. Realized Volatility (RV) is the sum of the squares of intra-day returns, at a

chosen time frequency, e.g. 5 minutes, i.e.
d
X
2
RVt = rt,i
i=1

which is the sum of the consecutive x-minute squared log-returns on day t.

– For our data I use 5 minute returns. There are 75 of these per day on the
ASX. These returns often need ‘cleaning’.
(5) √
– The equivalent standard deviation proxy is σt = RVt.
– RV as a volatility measure was pioneered by Anderson, Bollerslev, Diebold
and Labys (2001, JASA; 2003, Econometrica)
– RV is known to be biased (market microstructure) and highly affected by
choice of frequency and to ignore overnight returns. However, it is also
known to be typically more efficient and more accurate than proxies 1-4.
QBUS6830 (S2, 2022); Module 4; 55

• Figure 16 shows the scaled intra-day range (proxy 2) and the absolute returns
(proxy 1) for CBA for the entire sample. Comments?
CBA volatility proxies
Proxy1:|r(t)|
12 Proxy2:Range 1

10

0
2000 2004 2008 2012 2016 2020

Figure 16: Intra-day Range and absolute returns for CBA, 2013-2021.
QBUS6830 (S2, 2022); Module 4; 56

• Garman and Klass (1980) illustrated that the 1st and 2nd range-based proxies
above were about 5.2 and 6.2 times more efficient than squared returns, for
approximating unobserved volatility.

• This was assuming a continuous time random walk Gaussian diffusion model for
intra-day prices and used:
2(1)
2(i) V ar(σt )
Efficiency(σt ) = 2(i)
V ar(σt )

• For other volatility proxies see Tsay (2010, page 163; 2005, pg 144).
QBUS6830 (S2, 2022); Module 4; 57

• Figures 17 and 18 show the volatility proxies 1-5 for CBA and WES returns
(square root proxies shown) .
CBA volatility proxies
Proxy1:|r(t)|
12 Proxy2:Range 1
Proxy3:Range 1+overnight
Proxy4:Range 2
10 Proxy5:Realised Volatility

0
2000 2004 2008 2012 2016 2020

Figure 17: Five volatility proxies for CBA return data, 2000-2022.
QBUS6830 (S2, 2022); Module 4; 58

Proxy1:|r(t)|
Proxy2:Range 1
25 Proxy3:Range 1+overnight
Proxy4:Range 2
Proxy5:Realised Volatility
20

15

10

0
2000 2004 2008 2012 2016 2020

Figure 18: Five volatility proxies for WES return data, 2000-2022.

Example
• The ARCH and GARCH model forecasts can now be directly compared by assess-
QBUS6830 (S2, 2022); Module 4; 59

ing their forecast accuracy as in Table 1 (CBA) and Table 2 (WES) using RMSE
and MAD and the volatility proxies, as described above.
QBUS6830 (S2, 2022); Module 4; 60

• Figure 19 shows the volatility proxies 1,5 for CBA (square root) returns for the
last 50 days, plus the ARCH and GARCH standard deviation forecasts.
CBA ARCH and GARCH volatility forecasts plus 2 proxies
ARCH(1)
ARCH(5)
5 GARCH
|r(t)|
RV
4

0
0 10 20 30 40 50

Figure 19: Fifty period ahead forecasts of volatility for CBA plus four volatility proxies.
QBUS6830 (S2, 2022); Module 4; 61

• Figure 20 shows the volatility proxies 2, 5 for WES (square root) returns for the
last 50 days, plus the ARCH and GARCH standard deviation forecasts.
WES ARCH and GARCH volatility forecasts plus 2 proxies
ARCH(1)
3.0 ARCH(5)
GARCH
Range 1
2.5
RV

2.0

1.5

1.0

0.5

0 10 20 30 40 50

Figure 20: Fifty period ahead forecast of volatility for WES plus 2 volatility proxies.
QBUS6830 (S2, 2022); Module 4; 62

Table 1: The forecast accuracy for the ARCH and GARCH models for CBA is in Table 1

RMSE Proxy
Model 1 2 3 4 5
ARCH(1) 4.426 1.564 3.066 2.213 0.917
ARCH(5) 4.409 1.552 3.040 2.190 0.915
GARCH(1,1) 4.431 1.551 3.079 2.221 0.888
MAD
ARCH(1) 2.027 1.011 1.545 1.270 0.712
ARCH(5) 2.019 1.014 1.518 1.254 0.727
GARCH(1,1) 2.002 0.967 1.532 1.246 0.659

• From table 1, the GARCH model usually has the best medium to long-term
forecast accuracy in volatility for CBA, using these proxies and this forecast origin,
when using MAD as the forecast accuracy measure.

• However, when using RMSE, the ARCH(5) model is marginally most accurate for
3 of the prioxies, whilst the GARCH is most accurate for proxies 2 and 5.

• The forecast period goes from Dec 18, 2021 to March 3, 2022.
QBUS6830 (S2, 2022); Module 4; 63

Table 2: The forecast accuracy for the ARCH and GARCH models for WES is in Table 2

RMSE Proxy
Model 1 2 3 4 5
ARCH(1) 9.180 1.972 3.370 2.885 1.135
ARCH(5) 9.191 1.968 3.389 2.899 1.118
GARCH(1,1) 9.231 2.016 3.468 2.973 1.158
MAD
ARCH(1) 3.337 1.122 1.809 1.600 0.649
ARCH(5) 3.310 1.088 1.801 1.586 0.620
GARCH(1,1) 3.289 1.108 1.872 1.645 0.638

• From table 2, the ARCH(1) model has the best medium to long-term forecast
accuracy in volatility for WES, for proxies 1, 3 and 4, whilst the ARCH(5) is most
accurate for proxies 2 and 5, when using RMSE as the forecast accuracy measure.

• This time the ARCH(5) is best when using RMSE for 4 of the proxies, whilst the
GARCH is most accurate for proxy 1 only, under MAD.

• Why consider so many volatility proxies? Isn’t 1 or 2 enough?

QBUS6830 (S2, 2022); Module 4; 64

• These results illustrate that one (alternative) model/method that can be hard to
beat in medium-long term forecasting. Which is that?
QBUS6830 (S2, 2022); Module 4; 65

IGARCH
• J.P Morgan developed the popular RiskmetricsT M technique, that assumes returns
follow an IGARCH model
rt = at
σt2 = βa2t−1 + (1 − β)σt−1
2

where at ∼ N (0, σt2)

• This is an integrated GARCH(1,1) model where µt = 0, α0 = 0 and α1 + β1 = 1.
• It is a non-stationary model with an infinite unconditional variance
• The parameter β can be estimated using conditional likelihood methods only (not
full likelihood). Why?
• Since 0 < β < 1 the variance process is an exponentially smoothed series of
squared shocks.
QBUS6830 (S2, 2022); Module 4; 66

• Figure 21 shows the IGARCH model volatility estimates for the CBA returns
when 1 − β = 0.94, plus the GARCH estimates and the 3rd proxy.

Proxy5
8 GARCH
IGARCH
7

0
2000 2004 2008 2012 2016 2020

Figure 21: Volatility estimates for CBA returns for IGARCH (blue) with 1 − β = 0.94 and GARCH(1,1) (red) models, plus 5th proxy.
QBUS6830 (S2, 2022); Module 4; 67

• The IGARCH model seems to potentially capture some low volatility periods
better than the GARCH model. It also ”recovers” more slowly than the GARCH
after (very) large return shocks.
• For GARCH(1,1) models with constant mean, recall that
σt2(h) = V ar(rt+h|Ft) = α0 + (α1 + β1)σt2(h − 1)
for any h > 1.
• For the IGARCH model this becomes
σt2(h) = σt2(h − 1)

• Thus the forecast variance remains exactly the same as the 1-step-ahead forecast,
for any forecast horizon h (i.e. no mean reversion).
QBUS6830 (S2, 2022); Module 4; 68

(2c) Forecasting with asymmetric models

• Recall the GJR-GARCH(1,1) model (with constant mean):
σt2 = α0 + (α1 + It−1γ)a2t−1 + β1σt−1
2

• The 1-step ahead volatility forecast is simply σt+1

2
:
σt2(1) = α0 + (α1 + Itγ)a2t + β1σt2

• The 2-step-ahead forecast is:

σt2(2) = E(α0 + (α1 + It+1γ)a2t+1 + β1σt+1
2
|Ft)
= 2
α0 + (α1 + E(It+1|Ft)γ)E(a2t+1|Ft) + β1E(σt+1 |Ft)
= α0 + (α1 + γ/2)E(ε2t+1σt+1
2
|Ft) + β1σt2(1)
= α0 + (α1 + γ/2 + β1)σt2(1)
QBUS6830 (S2, 2022); Module 4; 69

• The h-step ahead forecast for the constant mean GJR-GARCH(1,1) model is thus:
σt2(h) = α0 + (α1 + γ/2β1)σt2(h − 1)

• Here we see why α1 + γ/2 + β1 is the persistence in volatility for the GJR-
GARCH(1,1) model.

• Now by repeated substitution:

α0(1 − (α1 + γ/2 + β1)h−2)
σt2(h) = + (α1 + γ/2 + β1)h−1σt+1
2
1 − α1 − γ/2β1

• What happens as h → ∞?

• Recall the EGARCH(1,0) model (with constant mean):

ln σt2 = α∗ + β1 ln σt−1
2
+ (α1 + (−1)It−1 γ)|εt−1|
QBUS6830 (S2, 2022); Module 4; 70

• The 1-step ahead forecast E(ln σt+1

2
|Ft) is:
2
ln σt+1 = α∗ + β1 ln σt2 + (α1 + (−1)It γ)|εt|
Since all terms in this expression are known, this is not a random variable. Hence
we estimate:
σt2(1) = σt+1
2 2
= exp[ln σt+1 ]

• The story is different for k = 2, 3, . . . step ahead forecasting, i.e. for σt2(k), k > 1.

• We can work out the 2, 3 and general h-step ahead forecasts E(ln σt+h
2
|Ft), fol-
lowing the usual steps, eventually finding that:
ln σt2(h) = α0 + β1 ln σt2(h − 1)
for all h > 1.

• Where we see why β1 is the persistence in volatility for the EGARCH(1,0) model.
QBUS6830 (S2, 2022); Module 4; 71

• However, it is important to note that we require forecasts σt2(h) = E(σt+h

2
|Ft) and
2 2
that, in general, E(σt+h |Ft) ̸= exp[E(ln σt+h |Ft)] and so σt2(h) ̸= exp[ln σt2(h)],
except for h = 1.

• In fact E(X) = E(exp(ln X)) > exp[E(ln X)] in general for (almost) all rvs X.

• Note that
2 2
ln σt+2 = α∗ + β1 ln σt+1 + (α1 + (−1)It+1 γ)|εt+1|
is an rv when we only know information up to time t, since at that point εt+1 is
unknown (it is an rv), as also is It+1.

• Thus, exp[E(ln σt+2

2
|Ft)] < σt2(2), i.e. we will get a downwards biased forecast of
2
σt+2 using this method.

• For EGARCH models, then, Monte Carlo simulation is the conventional

QBUS6830 (S2, 2022); Module 4; 72

method used to forecast h > 1 steps ahead for volatility.

• In fact, as we shall see, for tail risk forecasting, simulation is the conventional
method used to forecast h > 1 steps ahead for (almost) all volatility models.

• To use simulation to estimate σt2(h) = E(σt+h 2

|Ft) for h > 1, we need to simulate
lots of samples of εt+1, εt+2, . . . , εt+h, e.g. from the N (0, 1) or t∗ν (0, 1) distribution.

• Then, we can form many simulated values (or paths or realizations) for rt+1, . . . , rt+h

• and also simulated values for ln σt+2

2 2
, . . . , ln σt+h 2
and transform these to be σt+2 2
, . . . , σt+h
using exp(·).

• Here we are transforming the rv directly, not its expectation. So . . .

QBUS6830 (S2, 2022); Module 4; 73

• Then we estimate σ̂t2(k) as the sample mean of the simulated values of σt+k
2
for
k = 2, . . . , h.

• How close this sample mean is to the true forecast (i.e. σt2(k)) will depend on how
many Monte Carlo samples we take. As per normal.

Example
• Using these expressions we can again form 1 up to 50-period-ahead forecasts
of volatility for each of CBA and NWS, now using Gaussian IGARCH, GJR-
GARCH(1,1) and EGARCH(1,0) models (via simulation).
• Note that the estimates of volatility persistence are 0.968 and 0.974 for GJR-
GARCH and EGARCH respectively.
• The forecasts are summarised in figures 22 and 23; the GJR-GARCH model fore-
casts are in blue.
• Note the slightly squiggly forecasts from the EGARCH model. This reflects the
QBUS6830 (S2, 2022); Module 4; 74

CBA volatility forecasts

2.2
GARCH
ARCH-5
2.0 EGARCH
GJR
1.8

1.6

1.4

1.2

1.0

0.8
0 10 20 30 40 50
Figure 22: One up to Fifty period ahead forecasts of volatility for CBA from GJR and EGARCH models.

sampling error in using simulation and a sample mean instead of the actual fore-
cast (whcih is not available). I used 5000 simulations here: fewer gives more
squiggles/variation but takes less time to run.
QBUS6830 (S2, 2022); Module 4; 75

1.35
2.25

1.30 2.00

1.75
1.25

1.50
1.20
1.25
1.15
1.00
GARCH
1.10 EGARCH
GJR 0.75
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 23: Volatility estimates and forecasts for CBA from GJR and EGARCH models.

• Once again CBA volatility is expected to revert to the long-run average in 50 days
or more, from its’ current estimated position.
• GJR-GARCH gives persistence as 0.981, EGARCH (for log-volatility persistence)
QBUS6830 (S2, 2022); Module 4; 76

Table 3: The forecast accuracy for the volatility models for CBA

RMSE Proxy
Model 1 2 3 4 5
ARCH(1) 4.426 1.564 3.066 2.213 0.917
ARCH(5) 4.409 1.552 3.040 2.190 0.915
GARCH(1,1) 4.431 1.551 3.079 2.221 0.888
GJR-GARCH 4.441 1.551 3.096 2.234 0.877
EGARCH(1,0) 4.440 1.540 3.088 2.227 0.856
RM 4.405 1.561 3.032 2.187 0.935
MAD
ARCH(1) 2.027 1.011 1.545 1.270 0.712
ARCH(5) 2.019 1.014 1.518 1.254 0.727
GARCH(1,1) 2.002 0.967 1.532 1.246 0.659
GJR-GARCH 1.992 0.942 1.534 1.240 0.631
EGARCH(1,0) 1.988 0.916 1.509 1.216 0.602
RM 2.036 1.041 1.528 1.269 0.762 height

0.979, for CBA.

• The GJR-GARCH, EGARCH models can also be directly compared by assessing
their forecast accuracy, as in Table 3 (CBA)
• From table 3, for CBA the Risk Metrics model now does best regarding long-term
forecast accuracy in volatility, using proxies 1, 3 and 4 and RMSE as forecast
QBUS6830 (S2, 2022); Module 4; 77

measure. The EGARCH is most accurate for proxies 2 and 5.

• However, the EGARCH model is most accurate for all 5 proxies when using MAD
for medium to long-term CBA volatility forecasting.
• Is this surprising?

We can see why from the plots

• The forecasts are summarised in figures 24 and 25; together with proxies 4 and 5.
• Clearly no model is too accurate at predicting the long-term volatility (proxies)
for WES or CBA. Why is this??
QBUS6830 (S2, 2022); Module 4; 78

1.50
2.25
1.45

1.40 2.00

1.35 1.75
1.30
1.50
1.25
1.25
1.20

1.15 GARCH 1.00

RM
EGARCH
1.10 GJR 0.75
0 10 20 30 40 50 0 25 50 75 100 125 150 175 200

Figure 24: Volatility estimates and forecasts for CBA

Table 4 compares all forecast models for WES

• ARCH models have done best overall at forecast WES volatility for up to 50 steps
ahead, under both RMSE and MAD.
QBUS6830 (S2, 2022); Module 4; 79

Table 4: The forecast accuracy for the volatility models for WES

RMSE Proxy
Model 1 2 3 4 5
ARCH(1) 9.180 1.972 3.370 2.885 1.135
ARCH(5) 9.191 1.968 3.389 2.899 1.118
GARCH(1,1) 9.231 2.016 3.468 2.973 1.158
GJR-GARCH 9.238 2.028 3.482 2.986 1.173
EGARCH(1,0) 9.208 1.988 3.422 2.931 1.130
RM 9.281 2.083 3.566 3.064 1.233
MAD
ARCH(1) 3.337 1.122 1.809 1.600 0.649
ARCH(5) 3.310 1.088 1.801 1.586 0.620
GARCH(1,1) 3.289 1.108 1.872 1.645 0.638
GJR-GARCH 3.287 1.125 1.892 1.665 0.662
EGARCH(1,0) 3.308 1.089 1.829 1.608 0.614
RM 3.264 1.160 1.973 1.724 0.706
QBUS6830 (S2, 2022); Module 4; 80

CBA volatility forecasts plus 2 proxies

3.5
GARCH
EGARCH
RM
Proxy 4
3.0 RV

2.5

2.0

1.5

1.0

0.5

0 10 20 30 40 50

Figure 25: Volatility forecasts for CBA plus proxies 4 and 5.

• The forecasts are summarised in figure 26, together with proxies 1, 3 and 5.
QBUS6830 (S2, 2022); Module 4; 81

WES volatility forecasts plus 2 proxies

8 ARCH(1)
ARCH(5)
7 EGARCH
RM
Proxy 1
6 RV
Range+overnight (3)
5

0
0 10 20 30 40 50

Figure 26: Volatility forecasts for WES plus proxies 1, 3 and 5.