THE ARCH and GARCH

MODEL
• US stock market in the wake of escalating oil prices in the first half of
2008.

• On June 6, 2008, Dow Jones Index dropped by almost 400 points,

when oil price jumped to $139 a barrel

• Toward the end of October, oil price dropped to $67 a barrel.

• September 29, 2008, Dow Jones Index fell by 777.7 points because of
the financial crisis

• October 3, 2008, stock market again fell by almost 800 points before
recovering and closing down by 369 points
• Such gyrations in oil prices have led to wide swings in stock prices

• Such Swings in oil prices and credit crises have serious effects on real
economy and financial markets

• It is important to measure asset return volatility

 lnex
dlnex
0.6
0.03
0.5

0.4 0.02

0.3
0.01
0.2

0.1 0
2 102 202 302 402 502 602 702 802 902 10021102120213021402150216021702180219022002210222022302

0
0 500 1000 1500 2000 2500 -0.01
-0.1

-0.2 -0.02

-0.3
-0.03
 ressqr
0.0008

0.0007

0.0006

0.0005

0.0004

0.0003

0.0002

0.0001

0
3 93 183 273 363 453 543 633 723 813 903 993 108311731263135314431533162317131803189319832073216322532343
 Clusters of periods when volatility
• Simple way of looking at volatility: is high and clusters of period when
volatility is low-indication of autocorrelation
 log(ex)  c  u t
ressqr
0.0008

0.0007

0.0006

0.0005

0.0004

0.0003

0.0002

0.0001

0
3 138 273 408 543 678 813 948 1083121813531488162317581893202821632298

Predict residuals Wide swings in squared residuals-indication of

Obtain residuals squared underlying volatility in the foreign exchange returns
Plot residuals squared against time
 How to measure volatility?
VARIANCE
• The variance of a random variable is a measure of the variability in the values
of the random variable. In our case it is the variance of daily exchange rate
returns. The value turns out to be 0.0000351
• Above measure is a single number for a given sample. Doesn’t take into
account the variance of past history of returns. Does not capture volatility
clustering

• Volatility clustering: Time varying volatility in asset returns-Periods of

turbulence in which prices show wide swings and periods of tranquility in
which there is relative calm.

• This results in correlation in error variance over time.

• The measure that takes into account the volatility of past history of returns is
 H 0 : 1   2  ......   p  2  2  2  2
u t   0  1u t 1   2 u t  2  ........   p u t  p   t

Compute (n-p)R2~χp2 r is the number of coefficients estimated

 THE ARCH MODEL
 t 2   0  1u t 1 2   2 u t  2 2  .....  8 u t 8 2

First three coefficients are not

significant but the last five are
There is an ARCH effect in the
dollar/euro exchange rate
That means, the error variances are
auto correlated
For example, L4 being significant
means that volatility 4 period back
is affecting current period.
That means, you may expect to
observe similar degree of volatility
in every 4 time period. Same
interpretation goes for L5, L6, L7
and L8
THE GARCH MODEL
• The GARCH model is just an extension of ARCH model to improve
upon some problems with ARCH model
• The main problem with ARCH model is that the ARCH model requires
estimation of p autoregressive terms. Determining the number of lags
and estimating large number of parameters is a problem.
• GARCH model reduces the p autoregressive terms in ARCH model into
one conditional variance. Essentially the conditional variance in the
GARCH model captures the influence of p autoregressive terms in the
ARCH model. Therefore it indicates the combined influence of p
autoregressive terms.
ARCH MODEL

GARCH MODEL

 t 2   0  1u t 1 2   2 t 1 2

Sigmat-1^2 captures the combined influence of ut-2^2, ut-3^2,………..

THE GARCH
MODEL
 t 2   0  1u t 1 2   2 t 1 2

U2t-1 is the residuals square from the

previous period- ARCH effect. Lambda1
gives the magnitude of the arch effect
Sigma2t-1 is the conditional variance at
time t-1, conditioned on future
variances-GARCH effect. Lambda 2 gives
the magnitude of the garch effect.
Lambda0 is interpreted as long term
volatility.

A large sum of these coefficients will

imply that a large positive or large
negative return/shock will lead future
forecasts of the variance to be high for a
protracted period.