Chapter 4.

Model of Changing Volatility

75
Conditional and unconditional forecast

Assume the following model:

yt = a0 + a1 yt−1 +et

et ~N(0, 2) and E[eiej] = 0 for all i j

Conditional forecast of the value at t+1:

We can write the model for yt+1 yt+1 = a0 + a1 yt +et+1

The forecast of yt+1 given we observe yt Et[yt+1]= a0 + a1yt

Conditional forecast error, Xc: Xc = yt+1 − Et[yt+1] = et+1

76
Conditional forecast error variance: var(Xc) =var(et+1) = 2
Conditional and unconditional forecast
Unconditional forecast of the future value:
We can replace yt+1 by its past values from the model to eliminate yt for all t from
the right-hand side. (Forecast is not conditional on the value of y.)

yt+1 a0 + a1 yt +et+1

yt+1 a0 + a1 a0 + a1 yt−1 +et +et+1

yt+1 a0 + a1 a0 + a1 (a0 + a1 yt−2 +et−1)+et +et+1

77
Conditional and unconditional forecast

Unconditional forecast error:

Unconditional forecast error variance:

1
= =𝜎
1−𝑎

78
Because  
Volatility clustering

Return variance may vary 0.200

Return S&P 500

over time and have a so 0.100

called clustering pattern 0.000

(high volatility periods and -0.100

-0.200
low volatility periods).
Return square
0.010

0.000

To capture this pattern Engle 0.003

Variance:GARCH

(1982) suggests the

0.002
”Autoregressive Conditional
79
Heteroskedasticity” model
0.001

(ARCH) 0.000
Univariate ARCH (q):
Assume a simple mean model:

rt  μ  ηt 𝜂 |Ω ~𝑁 0, 𝜎 𝜎 =𝐸 𝜂 conditional variance

Note: 𝜎 ≡ 𝑣𝑎𝑟 𝜂 |Ω =𝐸 𝜂 − 𝐸 𝜂
=0

Motivation behind an ARCH specification:

 t      
1
2
1 t 1   2 2
t 2  ........   q 2
t q
2
t

The size of the effect from the shock depends

on the size of the past unexpected returns Shock
Unexpected
return  t ~ IID0,1 80
 Univariate ARCH (q):
 Conditional variance for ARCH (q):

𝜂 = 𝜔+𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂 𝜀

Square both sides: 𝜂 = 𝜔 + 𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂 𝜀

Cond. exp. of both sides: 𝐸 𝜂 =𝐸 𝜔+𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂 𝜀

𝜎 =𝐸 𝜂 = 𝜔+𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂 𝐸 𝜀
=1
𝜎 =𝜔+𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂

𝜔, 𝛼 , … , 𝛼 ≥ 0 for positive variance and 𝛼 + ⋯ + 𝛼 < 1 for stationarity

 By replacing the right-hand side of the previous equation with : 81


Univariate ARCH (q):
 Unconditional variances:

We showed that


=1
𝜎 =𝐸 𝜎 =𝐸 𝜔+𝛼 𝜂 +𝛼 𝜂 +. . . . . . . . +𝛼 𝜂

=𝜔+𝛼 𝐸 𝜂 +𝛼 𝐸 𝜂 +. . . . . . . . +𝛼 𝐸 𝜂
=𝜎 =𝜎 =𝜎
= 𝜔 + 𝛼 𝜎 + 𝛼 𝜎 +. . . . . . . . +𝛼 𝜎

= 𝜔 + 𝜎 𝛼 + 𝛼 +. . . . . . . . +𝛼

𝜎 1 − 𝛼 − 𝛼 −. . . . . . . . −𝛼 =𝜔
82
𝜔
 𝜎 =
1 − 𝛼 − 𝛼 −. . . . . . . . −𝛼
Univariate GARCH (1,1)

 Conditional variances:
𝜔, 𝛼, 𝛽 ≥ 0 to ensure positive variance

Condition for stationarity 𝛼 + 𝛽 < 1

 Unconditional variance:

𝜎 =𝐸 𝜎 = 𝐸 𝜔 + 𝛼𝜂 + 𝛽𝜎

= 𝜔 + 𝛼𝐸 𝜂 + 𝛽𝐸 𝜎

= 𝜔 + 𝛼 𝜎 + 𝛽𝜎

𝜎 1−𝛼−𝛽 =𝜔
83
𝜔
𝜎 =
1−𝛼−𝛽
 Note:

ARCH(4)
ARCH(1)

10
15
20
25
30
35
40
45
50
10
15
20
25
30
35
40
45
50

0
5
0
5
1 1
20 20
39 39
58 58
77 77
96 96
115 115
All series are generated using

134 134
153 153
172 172
191 191
210 210
229 229
248 248
267 267
286 286
305 305
𝜎 = 1 + 0.4𝜂
324 324
343 343
362 362
381 381
400 400
419 419
438 438
457 457
476 476
+ 0.3𝜂

495 495
514 514
𝜎 = ARCH(1)

ARCH(4)
Examples using simulated series

533 533
552 552
1 + 0.9𝜂

571 571
590 590
609 609
628 628
647 647
666 666
+ 0.15𝜂

685 685
with the same

704 704
723 723
742 742
761 761
780 780
799 799
818 818
837 837
and

856 856
+ 0.05𝜂

875 875
894 894
913 913
932 932
951 951
970 970
989 989
~N(0,1)

 Increase in the order (memory) of the ARCH(q) makes the variance smoother.
84
Examples using simulated series
All series are generated using with the same and ~N(0,1)
Note: and
𝜎 = 1 + 0.4𝜂 ARCH(4) + 0.15𝜂
+ 0.3𝜂 + 0.05𝜂
50
45
40
35
30
ARCH(4) 25
20
15
10
5
0
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
20
39
58
77
96
1

GARCH(1,1)+ 0.8𝜎
𝜎 = 1 + 0.1𝜂
50
45
40
35

GARCH(1,1) 30
25
20
15
10
5
0
85
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
1
20
39
58
77
96

 A GARCH(1,1) with a relatively large beta reflects more historical info can
result to a smoother variance series than that of an ARCH(q) with few lags.
 Examples using simulated series
All series are generated using with the same and ~N(0,1)
Note: and
GARCH(1,1)+ 0.8𝜎
𝜎 = 1 + 0.1𝜂
50
45
40
35

GARCH(1,1) 30
25
20
15
10
5
0
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
1
20
39
58
77
96

𝜎 = 1 +GARCH(1,1)
0.6𝜂 + 0.3𝜎
140

120

100

80
GARCH(1,1) 60

40

20

0 86
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
1
20
39
58
77
96

 The degree of smoothness depends on the relative value of alpha and beta in GARCH(1,1).
Higher beta results in higher persistence of effect of the past shocks (smoother variance series).
Univariate GARCH (1,1)
 Forecast of the future variances:

Information to estimate the model

𝐸 𝜎 ≡𝜎 𝐸 𝜎

t-2 t-1 t t+1 t+j-1 t+j

Proof of this equation is not required

but is available on the course website.

Because when

Note

87
Test for an ARCH/GARCH (Engle 1982)

i) Estimate the mean equation with OLS.

ii) Calculate the residuals using the estimated parameters

ii) Estimate the following model with OLS:

Under H0 “no Arch/GARCH effect”

Note that the test is not able to separate an ARCH effect from a GARCH
effect.
88
Other models ARCH/GARCH related models:
• IGARCH(1,1): a long-memory process

The model lacks finite unconditional

variance

The forecast for the future variances:

Information to estimate the model

𝜎 𝐸 𝜎

t-2 t-1 t t+1 t+j-1 t+j

89
𝐸 𝜎 = 𝑗𝜔 + 𝜎 𝑗→∞⇒𝐸 𝜎 →∞
 Other models ARCH/GARCH related models:
• IGARCH(1,1):

Proof of the equation

𝜎 = 𝜔 + 𝛼𝜂 + 𝛽𝜎 𝛼+𝛽 =1

For 𝑡 + 𝑗: 𝜎 = 𝜔 + 𝛼𝜂 + 𝛽𝜎

Cond. exp. : 𝐸 𝜎 = 𝜔 + 𝛼𝐸 𝜂 + 𝛽𝐸 𝜎

=𝜔+ 𝛼+𝛽 𝐸 𝜎 Since 𝐸 𝜂 =𝐸 𝜎

=𝜔+𝐸 𝜎

=𝜔+𝜔+𝐸 𝜎
……… 90
= 𝜔 + 𝜔 + ⋯ +𝜔 + 𝐸 𝜎  𝐸 𝜎 = 𝑗𝜔 + 𝜎
j times
 Examples IGARCH using simulated series
All series are generated using 𝜂 = 𝜎 𝜀 with the same 𝜀 and 𝜀 ~N(0,1)

GARCH(1,1)+ 0.8𝜎
𝜎 = 1 + 0.1𝜂
50
45
40
35

GARCH(1,1)
30
25
20
15
10
5
0
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
1
20
39
58
77
96

IGARCH 𝜎 = 1 + GARCH(1,1)
0.2𝜂 + 0.8𝜎
900
800
700
600
500
Integrated GARCH (1,1) 400
300
200
100
0

91
115
134
153
172
191
210
229
248
267
286
305
324
343
362
381
400
419
438
457
476
495
514
533
552
571
590
609
628
647
666
685
704
723
742
761
780
799
818
837
856
875
894
913
932
951
970
989
1
20
39
58
77
96

 The past information remains for a long time period and variances are much larger
(unconditional variance→ ∞).
Other models ARCH/GARCH related models:

• GARCH in mean: volatility is included in the mean

equation.

A simple example:

l is usually set to 1 or 1/2.

92
Leverage effect

A negative shock increases volatility more than a positive

shock. (Bad news increases uncertainty.)

Why is it called leverage effect?

A negative shock reduces the market value of equity and
increases the debt to equity ratio and therefore increases risk.

Good news (positive shocks)  returns and risk 

Bad news (negative shocks)  returns and risk 
A negative correlation between return and volatility
93
Leverage effect
is a symmetric model (no leverage effect)

• An example of an asymmetric GARCH Model (Ding et al, 1993):

 symmetric GARCH


Negative shocks increase volatility
more than positive shocks.



Positive shocks increase volatility
94
more than negative shocks.

 Leverage effect
• An alternative model, threshold GARCH (dummy variable approach of
Glosten et al., 1993):
𝜎 =𝜔+𝛼 𝜂 +𝛼 𝐼 𝜂 + 𝛽𝜎

1 for 𝜂 <0
𝐼 =
0 otherwise

𝛼 = 0 𝜎 =𝜔+𝛼 𝜂 + 𝛽𝜎 symmetric GARCH

𝜂 >0𝐼 = 0 𝜎 = 𝜔 + 𝛼 𝜂 + 𝛽𝜎
𝛼 captures the effect of positive shocks

𝛼 ≠0 𝜂 < 0 𝐼 = 1 𝜎 = 𝜔 + (𝛼 + 𝛼 )𝜂 + 𝛽𝜎
95
𝛼 + 𝛼 captures the effect of negative shocks.
𝛼 captures the additional effect of negative shocks. Leverage effect if 𝛼 > 0.
Multivariate GARCH
Consider an N×1 vector of returns at time t

rt  μ  ηt ηt  t 1 ~ N 0, H t 
Ht is a N× N pos. def. conditional covariance matrix of t.

𝑟 𝜇 𝜂 𝜎 , 𝜎 , . 𝜎 ,
𝑟 𝜇 𝜂 𝜎 , 𝜎 , . 𝜎 ,
. = . + . 𝑯 = . . . .
. . . . . . .
𝑟 𝜇 𝜂 𝜎 , 𝜎 , . 𝜎 ,

96
Multivariate GARCH

We assume that each element of Ht follows a multivariate GARCH process of the form:

𝜎 , = 𝑐 + 𝛼𝜂 , 𝜂 , + 𝛽𝜎 ,

VEC model (vectorizing upper/lower triangle of , since , , and no need to

model both)

ht  C  AΠt 1  Bht 1 where h t  vechH t 

and Π t  vechηt ηt 

N  1N 1 A and B are

N  1N  N  1N
C is
2 2 2

97
 Multivariate GARCH (Diagonal VEC model)

With N=2

, , 𝜂 𝜂 , 𝜂 , 𝜂 ,
𝜼𝜼 = 𝜂 𝜂 𝜂 =
, , 𝜂 , 𝜂 , 𝜂 ,

, , ,
Vectorizing: , ,
,
, , , ,

, , ,

, , ,
98

, , , ,
Multivariate GARCH (BEKK model) Only for lab

To ensure that Ht is positive definite we have to impose restrictions, which

can be very hard in practice.
Alternative, BEKK parametrization for Ht: H t  CC  Aηt 1ηt 1A  BH t 1B

where C is N× N upper triangular and A and B are N× N.

Example, bivariate BEKK:

, ,
, ,
, , ,

, , ,
, ,
, , 99

11, 11 , c11 and c22 should be positive for unique solution.
Estimation of the ARCH/GARCH Not for the exam

Univariate GARCH(1,1):

 t  t 1 ~ N 0,  t2 

100
Use a numerical algorithm to find parameter values that maximize lnL.
Estimation of the multivariate model Not for the exam

Multivariate GARCH(1,1)

ηt  t 1 ~ N 0, H t  Ht is multivariate GARCH(1,1)

In the bivariate case: , ,

Similarly, we can take the inverse of Ht and multiply it by residuals to avoid

the matrix notations in our estimations:

101
, , , ,