20

1 I ntroduction
An overriding theme in Cl i ve Granger' s long and insightful career inventing
time series analysis for economists, has been the study of long and short mem-
ory forecasting models. The most famous venue for this was the research on
unit roots, fractional integration and cointegration in the mean of a time series.
In less well known but very influential work on second moments, Granger
applied ideas of persistence and causality to variance processes. See for example
Di ng and Granger (1996), Ding, Granger, and Engle (1993) and Engl e,
Granger, and Robi ns ( 1986) . In these papers, evidence was presented showing
that volatilities were highly persistent, possibly requiring a long memory or
fractionally integrated process. Many researchers have followed this strategy,
and now there is a substantia] literature on F I CARCH, or fractionally integ-
rated GARCI I models. See for exampl e Baillie and Bollerslev (1994) and
Bollerslev and Mikkelsen (1996).
In this paper a different approach is taken. The long memory behavior of
the volatility process is modeled as the sum of two conventional models where
one has nearly a unit root, and the other has a much more rapid time decay
Thi s two component structure extends the rich and complicated dynamics of
French, Schwert and Stambaugh ( 1987) , Chou (1988), Nelson (1989, 1990b),
Pagan and Schwert ( 1990) , and Engl e, Bollerslev, and Nelson ( 1991) , among
others. By labeling these as permanent and transitory vol ati l i ty components,
substantial intuition is achieved and several natural hypotheses can be tested.
The decomposition of stock return volatility can also be moti vated by exam-
ining the term structure of implied volatilities derived from market prices of
traded stock options wi th a range of option expirations. It is well observed
Wc have benefited greatly from the comment of .John Conlisk, ('live Granger, Wonter Den Haan.
Bruce Lehmann and Alex Kane. Of course, all remaining errors are solely our responsibility. Tl i f
authors gratefully acknowledge NSF support in grants SES 91 22U!>(>, SHU !M22f)7.
r
, and SHU
97.TO0G2.
A Long-Run and Short-Run Component
Model of Stock Return Volatility
ROBERT F. ENGL E A N D GARY G. J . LEE
476
Rober t F. Engl e and Gar y G. J. Lee
that there are t wo domi nant scenarios describing the implied volatility term
structure movement in equi ty, foreign exchange and interest rate deri vati ves
markets. The dominant effect is the parallel movement of implied volatilities
of various maturities. However, the interesting second feature is that the ampli-
tude is much greater for the short maturities. The vol ati l i ty of short-term
vol ati l i ty is much greater than for long horizon volatility. In fact, the term
structure of implied volatilities can change slope within a short period of ti me
as the short volatilities move from abnormally low to abnormally high. For
such a model of implieds, see Xu and Tayl or (1994). Thi s phenomenon indi-
cates a mean-reverting property of implied vol ati l i ty where short-term volatil-
ities mean-revert more rapidly than long-term volatilities.
The decomposition of vol ati l i ty into components allows tests of many eco-
nomi c and asset pricing hypotheses. It is likely that the persistence of j umps
is different from ordinary news events. The component model allows shocks
t o be transitory; we investigate the impact of the October 1987 Crash on the
short-run and the long-run vol ati l i ty movement in the stock market. The
market risk premium is shown by Merton (1980) t o depend upon market
vol ati l i ty, an effect first estimated by French, Schwert, and Stambaugh ( 1987) ;
however it is not clear whether this is better modeled by the permanent or
the transitory component of vol ati l i ty. Similarly, the leverage effect first ad-
dressed by Black (1976) and Christie (1982) and modeled by Nelson (1990a)
may have either transitory or permanent effects.
The relationship between aggregate stock return vol ati l i ty and individual
stock return vol ati l i ty can also be investigated within this framework. As
pointed out by Black ( 1976) , much of the movement and hence vol ati l i ty of
an individual stock is associated wi th movements in the market. Fol l owi ng
the spirit of Schwert and Seguin ( 1990) , and Ng, Engle and Rothschild ( 1992) ,
we study the vol ati l i ty components of individual stocks in conjunction wi th
those of the market index in a C A P M or one-factor framework of the A P T of
Ross (1976, 1977). The one-factor setting implies that the time-varying indi-
vidual stock return vol ati l i ty is due either to the market factor, or to the
idiosyncratic shocks, or both. Each is given a component structure to allow a
flexible measurement of the persistence of stock volatilities.
The paper is arranged as follows: Section 2 introduces the component model
for the conditional variance and Section 3 discusses the statistical properties
of the component model. Section 4 reports estimates of the component model
and tests of vol ati l i ty persistence for US and Japanese index data and for large
US equities. Section 5 examines the 1987 crash period and the implications of
this model. Section 6 examines the long-run and the short-run structure of
the "leverage effect" in the stock market. Section 7 applies the component
model t o a study of the relationship between risk premia and stock return vol -
ati l i ty. Section 8 examines the vol ati l i ty process of the idiosyncratic component
of individual equi ty returns and Section 9 concludes.
A Co mp o n en t Mo d el of St ock Ret ur n Vol at i l i t y 473
2 A Volatility Component Model of Asset Returns
In financial econometrics, the conditional variance of asset returns, or the
equivalent conditional standard deviation, is often used a.s a forward looking
vol ati l i ty measure for the market under consideration. The volatility com-
ponent model proposed is defined as a member of the A RCH class of models
originated by Engle ( 1982) . Denote the information set containing the his-
torical information of the ti me series of interest available at time (/. 1) as
F^j , and the mathematical expectation conditional on Ft , as E[-\F, , ] , or
^ t - i M- T
n e
conditional mean of an asset return series { /J at time / is defined
by:
"t^Et-iM (2.1
and the conditional variance of { r t } by:
hl=Et.i[(n-mtY} = Et_l[ef} . (2.2)
where et = (rt- mt) is the residual or unexpected return.
The popular generalized A RCH model ( GARC1I ) developed by Bollerslev
( 1986) , in a slightly transformed form, specifies the dynami c structure of the
conditional variance as:
h, = a
1
+ a{eU ~ ^ ) + (3{h,_x - a
2
) ( 2. 3)
where cr
2
is the unconditional variance, and {e'j , - a
2
) serves as the shock to
asset return vol ati l i ty. When (a + 0) < 1, called the mean-reverting rate or
the persistent rate, the conditional variance will mean-revert to the uncondi-
tional variance at a geometri c rate of (a + (3). The smaller the mean-reverting
rate, the less persistent the sensitivity of the vol ati l i ty expectati on to market
shocks in the past.
Wi t h vast empirical findings in the A R C H literature about time-varying
and mean-reverting vol ati l i ty of equi ty, foreign exchange and interest rate
markets, we may well question whether the long-run vol ati l i ty represented by
a
2
in GA RCH( 1 , 1) , is truly constant over ti me.
In a more flexible specification, we replace a
2
with the long-run volatility
qt, which is gi ven a ti me series representation and allowed to evol ve slowly in
an autoregressive manner:
(ht -q,) = a{eU - </,_,) + - ) (
2
-
4
)
qt=u> + pqt,x + ip{el_
x
- ) . (2.5)
Equations (2.4) and (2.5) thus define the vol ati l i ty component model of asset
returns: the long-run ( trend) volatility component q\a stochastic, and the dif-
ference between the conditional variance and its trend, (h, - q,). is called the
478 Rober t F. Engl e and Gar y G. J . Lee
short-run ( transi tory) volatility component. Rewri ti ng these processes in an
al ternati ve form emphasizes the symmetry in the representation:
ht =qt +slt
sl=(a + p)sl_l+Q{el1-ht^),
qt=u> + pql-1+<p(eLl-hl_[),
where s is the transitory component. Noti ce that the vol ati l i ty innovation,
(e^_j - / i M ) , drives both the permanent and the transitory volatility components.
The interpretation of the volatility component dynamics is straightforward.
First, the short-run volatility component mean-reverts to zero at a geometric
rate of ( a + 0) if 0 < (a + 0) < 1. Secondly, the long-run vol ati l i ty component
itself evolves over ti me following an A R process, which, if 0 < p < 1, will con-
verge t o a constant level defined by u>/(l ~ P)- Thi rdl y, we assume that the
long-run component has a much slower mean-reverting rate than the short-
run component, or in other words, the long-run component is more persistent
than the short-run one, i.e., 0 < (a + 0) < p < I. Thi s simply identifies the
model since otherwise the t wo components would be interchangeable.
Forecasts from this model display many of its features. Define the multi-
step conditional expectation of the variance and the permanent component
as:
h
i +k/t-i - <-iNU]> <it+k/t-\ =
E
t-AQt+k]- (
2
-)
The forecast of the transitory vol ati l i ty component is
by ( 2. 4) . The sensitivity of the transitory component forecast to vol ati l i ty
shocks thus becomes:
fl(V*/<-i " <lt+k/t-i)/teli = ( + tf%l H ~ Qt)/teli = ( + PU- (2-8)
If 0 < ( a + 0) 1, the impact of vol ati l i ty shocks on the short-run vol ati l i ty
component is short-lived.
On the other hand, the forecast of the volatility trend is:
Qt+k/t-i -
u
+ P
(
l t+k-i /i -i +^-i [ Ef
2
+
j t-i - Vt-i l
= u + PQt+k-i /t-v (
2
-9)
by (2.5) and ( 2. 6) . If 0 < p < 1, the forecast in (2.9) becomes:
= W ( W ) + / > * < < & - / > ) ) , (2-10)
which converges to a constant level of u>/(l - p). The sensitivity of the long-
run component forecast to volatility shocks thus becomes:
A Co mp o n en t Model of St ock Ret urn Vol at i l i t y
If 0 < ((v + /i) < p < I , the impact, of vol ati l i ty shocks on the long-run volatility
component will diminish as well but will be more persistent, than that, of the
short-run component.
We would also expect that the i mmedi ate impact of vol ati l i ty shocks on tlicj
long-run component would be smaller than that on the short-run component,
or that a > <p by (2.8) and ( 2.11) .
In summary we have heuristically that hl+k tends to qn kaa k + oo and that
( ] L + K + CJ/( 1 - p) as k oo if 0 < ( o + (i) < p < 1. In this case, the contribution
of the vol ati l i ty component model to the literature is its decomposition of asset
return vol ati l i ty into long-run and short-run components, which are character-
ized by their different sensitivities to vol ati l i ty shocks and their different mean-
reversion rates.
3 Further Statistical Properties of the Component Model
3.1 The Stationarity Conditions of the Component Model
The stationarity properties of the vol ati l i ty component model are closely re-
lated to the mean-reversion features we discussed in Section 2. We derive condi-
tions for stationarity by examining the dynamic structure of the conditional
variance implied by the component model. The reduced form of the conditional
variance dynamics defined in (2.4) and ( 2. 5) can be shown to be:
h, = (1 - a - P)u> + (a + + \-tp(a + fi) - (*p}e'f-.-2
+(p + 0~ v?)/>,_, + (v>(a + fi) - Pp\K-2-
Obvi ousl y, the reduced form (3.1) follows a GARCI I ( 2, 2) process. Thi s is not
surprising, but the model is not fully equivalent as not all GARCl l ( 2 , 2) pro-
cesses have the component structure. Al though there are five parameters in
each representation, by constraining the parameters to be positive and real
in the component model parameteri zati on, there cannot be compl ex roots and
posi ti ve variances are insured. Thus the component model is a constrained
version of the G ARCH( 2 , 2) wi th constraints given by a set of inequalities.
By rewriting (3.1) as an A R MA ( 2 , 2) the stationarity conditions arc im-
mediately apparent.
ej = w( l - a - 0) + {a + fl + p)e}_x - {pa + p0)e'l
2
+i
U
-{p + 0 - - [ <K +0)- 0(>h.-2 (3-2)
where T/, = e'f - ht is a Marti ngal e difference sequence by construction. If and
only if the autoregressive roots lie in the unit circle, {s,} will be Covariance
stationary. Hence the condition that, p I and (a \- (i) I is sufficient.
480
Rober t F. Engl e and Gar y G. J . Lee
The case wi th p 1, the unit-root case, deserves special attention. Nelson
(1990a) proved that, for the 1GARCH( 1, 1) process, the mean series { r j is
not a covariance stationary process, however, it may still be a strictly station-
ary and ergodic process. Bougerol and Pi card (1992) discussed conditions for
{ r j to be strictly stationary and ergodic for general cases of the GARCH
model , but their results are limited to cases with only positive coefficients. As
can be seen from ( 3. 1) , the component model implies some negative coefficients.
So there is no known result in the literature which can be applied to the
component model directly, but it seems that similar statistical features should
hol d. Sin and Whi t e (1996) show that G ARCH( 2 , 2 ) is Near Epoch Dependent
( NED) and therefore a mixingale. If it is a mixingale, then it satisfies a SLLN.
I f it satisfies a SLLN and is stationary wi th finite mean, then it must be ergodic.
There is a vast literature on unit-root tests for the mean process, which
yi el ds a set of non-standard testing inferences. The problem of testing for unit-
roots in the conditional variance was solved for the first order case by
Lumsdaine ( 1996) , Lee and Hansen (1994) and Hong (1988) who showed that
classical tests have standard asymptoti c properties. So far, there is no known
unit-root testing procedure for high-order conditional variance processes like
the component model, although one might again conjecture that the results
would be the same.
If there is a unit root in the long-run component, then forecasts of future
variances grow wi th horizon as:
</(+* = It + "
k
- VM}
Commonl y, the drift is small and can be ignored unless distant horizons arc
considered, but the use of a model wi th infinite variance may prove awkward
if the objective is forecasting the second moment rather than simply forecasting
the full conditional distribution.
3.2 Non-Negativity of the Conditional Variance in the Component Model
One concern about model i ng vol ati l i ty movements is that the vol ati l i ty meas-
ure should remain non-negative over ti me. Wi t h respect to our volatility com-
ponent model, this requirement for a non-negative conditional variance and
its trend requires some constraints upon the parameters in (2.4) and ( 2. 5) .
The following sufficient conditions are developed in the Appendi x:
1 > p > ( a + j3) > 0, )8 > y > 0, a > 0, /3 > 0, u > 0, >p > 0, w > 0,
which are compati bl e wi th the stationarity conditions discussed above.
Not e that all these constraints are only sufficient conditions, not necessary
ones, and that non-negativity is not required for the transitory volatility com-
ponent, which can be positive or negati ve over time to reflect the self-correction
feature of the mean-reverting vol ati l i ty process towards its trend component.
A Co mp o n en t Mo d el of St ock Ret ur n Vol at i l i t y 481
4 Empirical Results of the Volatility Component Model
for Stock Returns
/,. 1 Data Selections
We use three daily stock indices: the S&l ' DUO index for the period l i Mhl
1991:1, the CUSP value-weighted index for (.lie period 1973:U 1991:12, and
the NI KKEI index for the period 1971:1 1991:9 to estimate the component
model. T o focus on the effect of the October 1987 Crash on the volatility esti-
mates, we also use the S&P 500 index lor the period 1971:1 1987:9 which ex-
cludes the crash period.
We also use fourteen daily individual stock series for the period 1973:0
1991:12 to estimate the component model. The companies include Amoco,
Beth Steel, Boeing, Chevron, Dow, DuPont , Ford, General Electric ( GE) ,
Hewl ett Packard ( HP ) , I BM, Johnson & Johnson ( JJ) , McDonnel l Douglasl
( MD) , Merck, Upjohn. These are all large capitalization Blue Chi p companies
in the Dow Jones Industrials and are chosen because they are highly liquid
and show little problem wi th non-synchronous closing prices.
4-2 Specifications of the Stock Return Process
Al l the daily returns of the stock indices and the individual stocks are calcu-
lated by taking the log difference of stock prices on two consecutive trading
days. The treatments of the expected returns across stock indices and indi-
vidual stocks, however, are quite different.
4-2.1 Expected Returns of Stock Indices
The treatments of the expected return on the S&P and the NI K K E I are simple.
The expected return is assumed constant over time: * ;
r
u = l
r
a] + emt =
c
+ e j (
4
- * ) '
The reason for this simplicity is that these indices do not incorporate stock'
dividends and, wi th respect to expected returns, there is little gain in more,
careful specification. Al so the return serial correlation is ignored assuming
that it is caused by the non-synchronous trading of securities as argued by;
Fisher (19GG) and others. In fact, the serial correlation is small and its impact
on the variance equation is trivial.
For the CRSP value-weighted index which incorporates stock dividends,;
we adopt the ARCH- M model of Engl e, Lilien and Robi ns (1987) to study t he;
expected market-index excess returns. The excess return, or the risk premium,',
on the index is calculated by deducting from the daily index return, the three-'
month USD London Inter-Bank Offering Rutv ( L I BOR) , which is taken as a
482
Rober t F. Engl e and Gar y G. J. Lee
close proxy of the risk-free rate. The excess return, is then assumed to be re-
l ated t o the expected return volatility represented by the conditional variance,
h
mi
, defined in (2. 4) and (2. 5):
r
mt = ^t-i fa \ + mi= Smhmt + emt. ( 4. 2)
So (6m'hm^ represents the expected risk premium which is, by Merton (1980),
proportional to the expected stock market variance. Using the GARCH- M to
describe the market risk premium has an interpretation in the C C A P M frame-
work as well as in the C A P M as discussed in Rothschild (1986) and Engl e,
Ng and Rothschild (1990).
4-2.2 A One-Factor Model for Individual Stock Returns
When estimating the component model for individual stocks, the C A P M or
the one-factor version of the A P T model of Ross ( 1976,1977) is explored. The
one-factor model assumes that individual stock excess return is governed
linearly by a single factor affecting the whole market:
r
u
= AJU+Co ( 4- 3)
where rit is the excess return on the iih individual stock under consideration,
i ( is the so-called "idiosyncratic" shock specific to the stock and uncorrelated
wi th the market factor.
In our empirical studies of this one-factor model , the CRSP value-weighted
i ndex is used as the market factor proxy ( and the three-month USD London
Inter-Bank Offering Rat e ( LI BOR) as the risk-free rate proxy) . So the con-
ditional expectation of the one-factor stock return model in (4. 3) can be written
as:
=A A i M +OVmt +Ca)
=&Aa+*i t, (4-4)
from (4. 2) where eit = {Pim'mt + Cu)
ls
shock to the one-factor-based expec-
tati on of the excess return of individual stocks, and Xmt = dm-hmt is the expected
excess return of the market factor aforementioned.
4.3 Estimation Results of the Volatility Component Model
We assume conditional normality for the standard residual, et/h^
2
, and esti-
mat e the component model using the Quasi -Maxi mum Likelihood Estimation
( QML E) procedure proposed by Engle (1982) and Bollerslev (1986). In the
A R C H literature, many researchers have pointed out that there is still excess
kurtosis after the residual is corrected by the A RCH specification. Wi t h the
true distribution for the residual being unknown, the estimation based on
QMLE at least gives consistent results asymptotically.
First, examine the autocorrelations of squared returns. Under the i.i.d. as-
A Co mp o n en t Model of St ock Ret ur n Vol at i l i t y 483
sumption for {e,}, the Ljung ami Box (1078) tests for {ef} and {ef/h,} each
follow the distribution. Autocorrel ati on in the squared residuals can be
caused by ARCH, and lack of autocorrelation in the squared standardised
residuals, indicates the success of A RCH modeling. As in most of the ARCH
literature, there are tremendous i mprovements in the Ljung- Box test statistics
of {ef/hi) over {ef}, indicating the success of the component model in capturing
the typical serial correlation pattern in {sf}- T o take the S&P index of
1941:1 -1991:9 as an exampl e, the Ljung Box statistic for fifteenth order serial
correlation of {j?//*J is 1G.93, as compared to that of 875.G7 from {ef}. Th|:
5 percent critical val ue of \
/ 2
( 15) is 25 indicating the success of the A RCR
model.
We use the Likelihood Rat i o test to show the performance of the compouen ,
model over the simple GA RCH( 1 , 1) model. The test is conservative in the
sense that a likelihood ratio statistic of a GARCH( p , q) against a compouen,
model GA RCH( ( p 4- k), (q + k)) like (3.1) will have parameters unidentified
under the null and a distribution wi th fewer than 2k degrees of freedom ( f o'
a discussion see Godf rey, 1978). The test shows, taking the stock indices a>
exampl es, the domi nance of the component model with the L R statistics being
as shown in Tabl e 1. These are much bigger than the 5 percent critical value
of a x
2
distribution wi th t wo degrees of freedom, 5.99.
Tabi c 1
Data set Li t statistic for
component model
SfcP 1941.1 -191)1.9 H9.(i
S&F 1941.1-1987.9 GO.S
NI KKEI 1971.1-1991.9 57.2
Now let us concentrate on the parameter estimates of the component model.
The results are reported in Tabl e 2. First, we examine the shock impacts on
the short-run and the long-run component represented by as and respect-
ively. These estimates are significant lor almost all the stock data, and as are
much larger than <|PS for the three indices and almost all of the individual
stocks (except Chevron) .
The mean-reverting parameters for the trend, /J S, arc all above 0.99 for all
the stock data except JJ and Merck, which are also over 0.98. For the indices,
the half-lives of the permanent response to a shock are 532 and 381 days for
the S&P full and pro-crash samples, 8G days for the CRSP, and 111 days
for the NI KKEI . The mean-reverting parameters of the transitory component,
(a + /?)s, are necessarily smaller than their corresponding pa. For individual
stocks, the highest ( a -I- (5) is 0.9738 for Chevron, the lowest, 0.2915 for Amoco,
and a common range from 0.5 to 0.7 applies t o most of the rest. For the indices.
4 8 4
Rober t F. Engl e an d Gar y G. J. Lee
Table 2. The volatility component model of daily returns on slock indices
and individual stocks
r, = c + e
t
(for S&P, NI KKEI ) (4 n
r
t
= 6J h + et (for CRSP) (4. 2)
r
t ~ 0m*mt + 1(for individual stocks) (4. 4)
(ht - qt) = a{el, - qt,{) + - </,_,) (2. 4)
It =<" + Pft-i +<?(4i - Vi ) (2.5)
Dataset
a
0 <P
P
S&P 500
0.0894
0.7991 0.0318
0.9982
1941.1-1991.9
(0.0192)"
(0.0376) (0.0058)
(0.0012)
S&P 500
0.0762
0.8455 0.0259
0.9987
1941.1-1987.9
(0.0105) (0.0233) (0.0044)
(0.0009)
NI KKEI

0.1815
0.5838 0.1239 0.9952
1971.1-1991.9
(0.0524)
(0.0962)
(0.0407)
(0.0099)
CRSP V- W 6m = 3.9859 0.0692
0.8199 0.0380
0.9920
1973.6-1991.12 (2.3868) (0.0380)
(0.0898) (0.0146) (0.0039)
Amoco
1.1459 0.1080
0.1835 0.0425
0.9954
Beth Steel
(0.6262) (0.0730)
(0.2659) *(0.0137)
(0.0030)
Beth Steel 0.7441 0.1178
0.7000
0.0208 0.9938
Boeing
(0.7593) (0.0282)
(0.0650) (0.0065)
(0.0042)
Boeing
1.0148 0.0951
0.3405 0.0184
0.9951
Chevron
(0.5900) (0.0266) (0.1661)
(0.0053) (0.0034)
Chevron 0.8012 0.0264
0.9474 0.0239
0.9973
Dow
(0.6567) (0.0121)
(0.0234) (0.0117)
(0.0023)
Dow
1.2606 0.0644
0.6119 0.0306 0.9904
DuPont
(0.6431) (0.0335) (0.2258) (0.0077)
(0.0035)
DuPont 0.4506 0.0791
0.5413 0.0229 0.9954
Ford
(0.5429) (0.0291)
(0.1323) (0.0052)
(0.0027)
Ford
0.6459 0.1092
0.4070 0.0289 0.9987
GE
(0.5980) (0.0267) (0.1634) (0.0051)
(0.0018)
GE
1.1183 0.0214
0.8785 0.0375 0.9931
HP
(0.6044) (0.0181)
(0.1205) (0.0120) (0.0034)
HP
1.1593 0.1006
0.7545 0.0164
0-9980
I BM
(0.7201) (0.0257)
(0.0537) (0.0058)
(0.0015)
I BM
0.6774 0.0686
0.6883
0.0320 0.9936
JJ
(0.5890) (0.0470) (0.1493) (0.0132)
(0.0077)
JJ 1.1361 0.1002
0.2752 0.0441
0.9876
MD
(0.5515) (0.0344)
(0.1628) (0.0091) (0.0040)
MD
0.3642 0.1810 0.6412
0.0167 0.9996
Merck
(0.5130) (0.0303) (0.0511) (0.0056) (0.0010)
Merck 1.0232 0.0677 0.6006
0.0373 0.9835
Upjohn
(0.5385) (0.0223) (0.1650)
(0.0106) (0.0000)
Upjohn
1.8454 0.0943 0.7726 0.0138 0.9954
(0.8426) (0.0275) (0.0541) (0.0051)
(0.0027)
In parentheses are the robust standard errors based on Bollerslev and Wooldridge (1991).
A Component Model of Stock Ret ur n Volatility 485
the transitory half-lives arc 6 or 8 clays for the S&P, 6 days for CRSP and 3
days for the NI KKEI .
The results indicate a common pattern in which tin; persistence of transitory
shocks is much less than permanent shocks, and the impact of transitory shocks
is much greater than permanent shocks.
. 5 The Effect of the October 1987 Crash on Stock Market
Volatility Changes
The October 1987 Crash was the largest stock market decline since the Great
Depression. It had a unique impact on market vol ati l i ty that we would like
to investigate using the volatility component model.
To isolate the crash effect, we use two sample periods of the S&P 500 index:
the period of 1941:1-1991:9 and the period of 1941:1-1987:9 since the latter
excludes the October 1987 Crash period. Compared wi th the long period
(almost fifty-one years) , the crash period (actually only a couple of weeks of
big fluctuations) is almost trivial. The estimation results should not differ;
significantly across the two sample periods if the crash effect is not dr amat i c!
First, we can see from Tabl e 1 that the shock effects on both of the com-
ponents turn out to be significantly larger by including the crash period in
the sample set: ( a , <p) are (0.0762, 0.0259) for the period of 1971:1-1987:9 and
(0.0894, 0.0318) for the period of 1941:1 1991:9. Thi s indicates the severity
of the market fall of about 20 percent on one day. Secondly, the mean-reverting
features of the volatility components arc also significantly affected. By includ-
ing the crash period, {a + 0) changes from 0.9217 to 0.8885, although p does'
not change much, declining from 0.9987 to 0.9982. Thi s suggests that the crash
is more transient than other shocks. These ideas motivate the robust volatility
model in Sakata and Whi t e (1998).
These results are consistent with market movements during the October
1987 Crash period. The volatility increase in the US stock market decayed
very quickly after the crash reaching a normal level of fluctuation within just
a few weeks. The findings also confirm those in Schwert (1990) and Engle and
Mustafa (1992) who noted that implied volatilities also fell rapidly after the
crash.
6 The Component Model with Asymmetric Structure to Shocks
Stock market vol ati l i ty responds to stock price movement asymmetrically:
" bad" news ( negati ve shocks) tends to increase investors' expectati on about
future market vol ati l i ty more than " good" news ( posi ti ve shocks). Thi s asym-
metric vol ati l i ty pattern, often called the "l everage effect." was first studied
486 Rober t F. Engl e and Gar y G. J . Lee
Table 3. Asymmetri c structure of stock return volatility to past market shocks of
the S&P 500 index 1941.1-1991.9"
corrl (et,
4*)
corr2(ev
k 1 2 3 4 5
Corrl -0.077 -0.079 -0.041 -0.010 -0.058 287.72
( -1. 46)
b
(-2.02) (-1.2G) (-0.52) (-1.81)
Corr2 -0.059 -0.043 -0.022 -0.037 -0.028 122.53
(-4.47) (-4-77) (-2.04) (-3.C4) (-3.59)
" The conditional variance is defined in the component model (2.5) and (2.(3).
b
In parentheses are the standard t-statistics.
by Black (1976) and Christie (1982) who attributed it to the failure of firms
to adjust their debt-equi ty ratio. A drop in the stock price will decrease the
fi rm' s market value and increase the debt-equi ty ratio, which thus increases
the risk to stock investors as residual claimants. Therefore, negative shocks
to, the price will increase future vol ati l i ty more than positive shocks.
We first examine this asymmetric pattern of stock return volatility by the
correlation between the squared residual and the past residual, correlation
fo> ( Cor r l ) , for S&P 500 1941:1-1991:9. When k > 0, the correlation
exhi bi ts the "leverage effect" if it is negati ve. In this case, the direction of re-
turns helps predict future volatilities. Tabl e 3 presents the correlation for the
raw data series used and also for the series, correlation (et, J+Jhl+k) ( Corr2) ,
whi ch is standardized by the conditional variance estimated by the component
model as in Tabl e 1. Correlation 1 shows the expected asymmetri c pattern of
stock return volatility j udgi ng from the overwhel mi ngl y negati ve correlation
values. Correlation 2 is to check whether the component model has corrected
t he asymmetry through the decomposition. The answer is no, since these show
the same pattern as the raw data. The Lj ung-Box tests significantly reject
the null hypothesis of no correlation. So we need to further modify the model .
We use the treatment of Glosten, Jagannathan and Runkl e (1993) to allow
shocks to affect the vol ati l i ty components asymmetrically. A similar treatment
is originally seen in the EGARCH model of Nelson ( 1990b) . Define a dummy
vari abl e Dt indicating the direction of the shock: Dt = 1 if et < 0 and Dt = 0
if et > 0. The component model wi th asymmetric structure can be specified
as:
ht = qt + a(eU ~ <fc-i) + tf2(A~]^
2
-i - ) + " fc-i)> (
G
- 0
9t =
w
+ Ptt-i + ~
f
h-\ ) + - ( 6. 2)
The factor, 0.5, reflecting the average effect of dummy variables, is based on
the symmetric assumption about the return distribution. The shock effects of
A Component Model of Stock Return Volatility 487
for the transitory component. Thus b{ and t>2 represent the long-run and the
short-run "l everage effects" in the asymmetric component model , respectively.
Tabl e 4 contains estimates of (6.1) and (G.2) for the S&P 500 index for the
period of 1941:1-1991:9. The estimation shows a tremendous i mprovement in
the likelihood val ue of the asymmetric component model over the original
symmetri c component model. Negati ve shocks predict higher volatility than
positive shocks, but the effect is mainly temporary. The "l everage" term is
significant in the transitory component for all the data sets, but not (or the
trend component. Furthermore, negati ve shocks domi nate the effects on the
transitory component and the effects of positive shocks almost vanish. The
estimation results using the short sample set of the S&P 500 index and the
NI KKEI index are very similar to the results listed here. Therefore, the
"leverage effect" addressed by Black (1976) and Christie (1982) seems to be
only a temporary behavior in the stock market. In a. recent work by Gallant,
Rossi and Tauchen (1993) using a non-parametric approach, the "leverage
effect" is also found to be heavily damped over time.
T o verify the correction by the asymmetric component model, Tabl e 5 esti-
mates the correlation for the series standardized by the conditional variance
defined in ( 6.1) and ( 6. 2) . The Lj ung-Box test now fails to reject the null
hypothesis of no correlation. So the component model is successful in correcting
Tabl e 4. The component model with asymmetric structure for the S&P 500
index 1941.1'-1991.9"
h, = q, +tt(ef i - (i,..,) + t>.2(D, ,e? , 0. 57 , ,) + H(h, , q, ,) ( CI )
q, = u) + + + < W A i
{)
^h i) M
<\ 4> &2 (\ ii
0.0006 0.0299 0.1593 0.0051 0.8070
(0.0080)
1
' (0.0050) (0.0220) (0.0138) (0.0250)
H
The initial estimations show that, />s are very close l,o unit as in Table 1; for
parsimonious parameterization, p = 1 is assumed for the estimation of (G. 1) and
(6 2) .
In the parenthesis are the robust, standard errors based on Bollerslev and
WooldridRu (1991).
the asymmetri c component model (0.1) and (G.2) with respect to " bad" news
and " good" news thus become:
dq, fdef_x = <p if > 0 . (G.3)
dqjde'
1
^ =v? + 'j i f et _ , < 0 v - ' (0.4)
for the trend component, and
<){ht -qt)/ik'fA a i f > 0 (0.5)
~<h)/ fe'f-i = tt + &j if Cj:..| < 0 ... (G.(i)
488 Rober t F. Engl e and Gar y G. J. Lee
Table 5. Correction for the asymmetry volatility component model (6.1) and (G.2)
for the S&P 500 i ndex
8
corr2{et,
e
?+*/^<+Jt)
k 1 2 3 4 5 LB( 15)
Corr2 -0.011
( -0. 98)
b
-0.004
(-0.48)
-0.015
(-1.42)
-0.009
(-0.99)
-0.004
(-0.5G)
15.37
* The conditional variance is defined in the component model (G.l) and (G.2).
h
In parentheses are the standard t-statistics.
the asymmetry of stock return vol ati l i ty after introducing the "l everage" terms
i nto the component model.
If the temporary asymmetry of stock return volatility t o market shocks can
be addressed by the "l everage effect," then the evidence of the long-run sym-
metry found here can be supported based on the same argument. The debt -
equi ty ratio may be hard to adjust in the short run, but there is no reason
that firms will not be able to adjust their capital structure over ti me towards
some long-run "target val ue. " Thus we woul d anticipate no asymmetric re-
sponse of the vol ati l i ty expectation to shocks in the long run. The empirical
results in this section, along with the finding in Gal l ant, Rossi and Tauchcn
( 1993) , strongly support this hypothesis.
7 The Relationship between Expected Stock Returns and
Volatility Components
Tabl e 2 also shows the estimation result for the CRSP data of the ARCH- M
model of Engle, Lilien and Robi ns ( 1987) , which links the expected excess
return, or the risk premi um, to the vol ati l i ty measured by the conditional
variance defined in the component model . The ARCH- M parameter, 6m, is
statistically significant and has a val ue of 3.9859. The result is consistent wi th
other empirical studies in the literature that stock returns generally support
the positive correlation between the expected risk premium and the ex ante
stock return vol ati l i ty (see, e.g., French, Schwert and Stambaugh, 1987; Chou,
1988).
It is natural to ask how the risk premi um is related to the long-run and the
short-run vol ati l i ty component. In response to such a question, we extend the
GARCH- M specification to incorporate the vol ati l i ty components:
r
mt ~
S
mPQmt +
6
m T (
h
m t ~ 9m!) +

mt (
7
'
l
)
Thus 6mP and 6mT represent responses of the risk premium to the long-run
vol ati l i ty and the short-run component, respectively.
A Co mp o n en t Mo d el of St ock Ret ur n Vol at i l i t y
Tabl e 6. The relationship between the risk premium and vol ati l i ty
components of the CUSP V- W index
V
mt ^mf'l ml + $mT'(Ka +

ml
(h, <],) = tt(?., - (Jn) + 0{kt i - </, ,)
q, = U+ pqt | + v K f ? . i - / , |)
(7.1)
(2.4)
(2.5)
<P P
7.40 3.14 0.0704
( 1. 46) " (6.21) (0.0372)
0.8160
(0.0880)
0.0380
(0.0138)
0.9956
(0.0037)
Tabl e 6 contains the estimation results of the model (7.1) plus the com-
ponent model (2.4) and (2.5) for the CRSP value-weighted index data used.
Whi l e the volatility parameter estimates are similar to those in Tabl e 2, the
results of 6mP and 6mT are very interesting: 6mP is highly significant but 6mT
is not. What is implied is that stock risk premia only respond to the long-run
movement of market vol ati l i ty. A recent independent study by den Her tog-
(1995) found the same result for long-term US and French government bonds,
based on a conditional variance decomposition method using the Kal man filter.
The explanation for the result may be straightforward. The conditional vari-
ance of stock returns, as a measure of the risk involved wi th stock investment,
changes over ti me. However, the trend component of vol ati l i ty may be vi ewed
by investors as reflecting the risk level over a long-run horizon since the
transitory component is largely driven by instant market shocks and, more
i mportantl y, dies out quite quickly as seen in Tabl es 1 anil 3. Therefore, only
the long-run movement of vol ati l i ty is priced. The findings in this section may
also be related to the "excessive vol ati l i ty" in financial markets addressed by
Shiller (1981) and others.
8 I diosyncratic Volatility Components of I ndividual Stock Returns
The one-factor setting for individual stocks as in (4.4) implies that the shock
to the excess return expectation of individual stocks is actually comprised of
two parts, the shock due to market factor changes and the shock due to idiosyn-
cratic noise. It also implies a similar relationship for the volatility structure:
, - K ) =
E
t-iMm,ni + C,)
2
} = (3L
E
t~il
E
lt} +
E
>-AC\-
since the market shock and the idiosyncratic shock are not correlated. There-
fore the success of the component model in describing individual stock volatil-
ity components as shown in Tabl e 2 is not surprising gi ven the evidence that
the market factor vol ati l i ty follows the component model. However, we wonder
* I n t he parent hesi s arc t he robust st andar d errors based on Bol l ersl ev and
Wcx)ldri<lji! (1<J91).
490
Rober t F. Engl e and Gar y G. J. Lee
whether the component structure of individual stock vol ati l i ty is inherited
f rom the market factor alone, or from the idiosyncratic noise as well.
To estimate the idiosyncratic volatility of individual stocks, we need to study
the idiosyncratic noise directly. Assume that the market factor information
is known and exogenous to individual stocks, so that the idiosyncratic noise
can be estimated from the one-factor model directly:
ie =Pimrmi+<if (8-2)
In our empirical study, the CRSP value-weighted index is again used as the
market factor proxy. Al so, the conditional variance of the idiosyncratic noise,
i t , is assumed to follow the component model (2.4) and ( 2. 5) . Thi s model
assumes that the only asymmetric effect is in the market factor. Probabl y,
this is too restrictive an assumption. Tabl e 7 contains the estimation results
for the individual stock data used.
It is interesting t o see that even the idiosyncratic volatilities of the individual
stocks are well fitted by the component model. The statistical features of the
idiosyncratic volatilities are very similar to the volatilities of the market indices
and of the individual stocks shown in Tabl e 1. The p estimates are well above
0.99 for all the individual stocks except Merck; ( a + P)s are much smaller
than ps, with the highest, 0.8514, for Upj ohn and the lowest, 0.1965, for GE;
and, as are much higher than ips for all the stocks. These results imply that
the long-run component of the idiosyncratic vol ati l i ty of individual stocks is
also highly persistent like that of the market factor, both contributing to the
high persistence of individual stock return vol ati l i ty. Al though initially sur-
prising, the claim is easy to moti vate. News of the illness of a CEO or a pending
lawsuit could be idiosyncratic and would likely affect vol ati l i ty of the stock
for an indefinite period. In fact, most types of firm-specific vol ati l i ty shocks
mi ght reasonably be thought to be persistent.
We can also observe that the estimates of (5im are around one as suggested
by the C A P M, but wi th much smaller standard errors than in Tabl e 2. Thi s
is because the expected stock return is always hard to measure, especially for
high frequency data.
Our study of the idiosyncratic volatility of individual stocks has some typical
implications in assessing the pricing biases of the well-known Black-Scholcs
( BS) model for individual stock options. A recent study in this area by Ami n
and Ng (1993) compared the pricing difference between the BS model and
their consumption-based equilibrium option pricing model. They found that
the less persistent is the idiosyncratic vol ati l i ty, the smaller the pricing bias
of the BS model for individual stock options, since the stationary mean-
reverti ng idiosyncratic component does not play an i mportant role in the long-
run movement of stock volatility. They also found that the pricing bias is
smaller when the market systematic vol ati l i ty component is larger. In other
words, for those high-risk individual stocks, the pricing bias of the BS model
A Co mp o n en t Mo d el of St ock Ret ur n Vol at i l i t y 491
Tabic 7. Estimating idiosyncratic volatility components of individual stocks
(1973.0 1991.12)
+ c
(8.2)
Vh </,) =
(2.4)
(l , = u) + /></, , + i p{C'f i " h,
i )
(2.5)
ft
a
V l >
Amoco 0.9700 0.1328 0.3691 0.0301 0.9966
( 30. 40) " (5.96) (3.29) (4.80) [1.78]
Both Steel 1/2238 0.0981 0.0972 0.0220 0.9905
(3G.0G) (4.60) (6.59) (3.04) [1.40]
Boeing 1.1914 0.1234 0.2550 0.0175 0.9951
Boeing
(21.37) (3.47) (1.80) (4.03) [2.10] .
Chevron 1.0806 0.0803 0.6892 0.0204 0.9971
(41.63) (4.41) (8.13) (3.98) [1.53]
Dow 1.3021 0.0622 0.4194 0.0296 0.9918
(50.73) (2.86) (1.83) (3,16) [2.27]
DnPont 1.1853 0.0917 0.5397 0.0195 0.9964
(58.51) (4.25) (4.15) (3.82) [1.50]
Ford 1.1370 0.0993 0.2166 0.0226 0.9985
(49.20) (4.27) (1.19) (4.97) [0.91]
GE 1.2095 0.1072 0.0893 0.0418 0.9915
(54.10) (4.52) (0.58) (5.58) [2.36]
HP 1.4042 0.0921 0.7174 0.0100 0.9989
(34.95) (4.58) (10.51) (2.15) [0.73]
I BM 1.1115 0.1840 0.5046 0.0275
0.9925
(44.51) (4.49) (5.18) (3.09) [2.59]
JJ 1.1262 0.1515 0.3615 0.0311 0.9927
(19.85) (4.72) (3.24) (4.36) [2.21]
MD 0.8162 0.1531 0.6790 0.0181 0.99%
(18.97) (6.01) (12.26) (3.15) [0.33]
Merck 1.0284 0.0958 0.5532 0.0256 0.9892
(43.81) (4.65) (3.62) (3.33) [2.08)
Upjohn 1.1072 0.1186 0.7328 0.0106 0.9971
(31.70) (3/12) (12.14) (2.23)
11.44|
* 111 parentheses arc th robust ('Statistics based on Bollerslev and \Vooldridt;e
(1991).
will be larger than those for low-risk individual stocks since the idiosyncratic
vol ati l i ty now plays an important role. Our study here surely can provide
some reference points for j udgi ng the persistence level of the idiosyncratic
vol ati l i ty and the significance level of the market factor.
9 Conclusion
In this paper, the conditional variance of stock returns Iwis I won decomposed
in a statistical unobserved component model to describe the long-run ( trend)
492 Rober t F. Engl e and Gar y G. J. Lee
and the short-run (transitory) movements of stock market volatility. The
empirical results for the S&P 500, the CRSP value-weighted index and the
NI KKEI index and fourteen individual stocks, support the decomposition and
reveal a general pattern of volatility component movement in stock markets.
The long-run vol ati l i ty component has a much slower mean-reverting (higher
persistence) rate and the short-run component is more sensitive to market
shocks. Application of the component model shows that the impact of the Oct-
ober 1987 Crash on volatility movements in the stock market was temporary,
mainly affecting the transitory vol ati l i ty component as reflected by the quick
market recovery after the crash. The expected excess return or the risk pre-
mi um in the stock market is found to be related only to the long-run movement
of stock return volatility, which may have fundamental economic explanations.
The observed "leverage effect" in the stock market is mainly a temporary
behavior; the long-run volatility component shows no asymmetric response to
market changes. Model i ng the CRSP value-weighted index and fourteen in-
di vi dual stocks in a one-factor model framework, we found the market factor,
represented by the index, and the idiosyncratic noise of the individual stocks
both show highly persistent volatility trends contributing to the persistence
of individual stock return volatility. Many other interesting issues, such as
volatility co-persistence, time-varying correlation across different asset returns
and its long-run forecast can be studied in a multivariate framework extended
from the component model introduced in this paper.
Nelson and Cao (1992) ( NC) derived inequality constraints for general GARCH
processes sufficient to ensure non-negative conditional variance. The central
idea of the derivation is to express the conditional variance in terms of an
infinite-order polynomial of the squared residuals and then find the conditions
ensuring non-negative coefficients in the polynomial. The conditions arc only
sufficient, not necessary. Thei r results can be applied to the volatility com-
ponent model:
to derive the corresponding sufficient conditions. We show below that the con-
ditions:
Appendi x
Conditions for Non-Negativity of the
Conditional Variance in the Component Model
(ht - qt) = o(e,
2
_, - q t i ) + p{ht_x - qt_t),
Qt = w + pqt^ + f(e]_i - Vi)<
(2.4)
(2.5)
1 > p > ( a + 0) > 0, /3 > <p > 0, a > 0,13 > 0, w > 0, y> > 0, w > 0, (A.l)
A Component Model of Stock Return Volatility 493
arc sufficient to guarantee the non-negativity of the conditional variance.
Let us first examine the conditional variance process. Substituting (2.5) into
( 2.4) , we have:
h, = u; + (p - a: - 0)qL_x + ( a + *p)ef. , + (/* - <p)ht ,. ( A. 2)
Equation ( A. 2) can be considered as a regular GARC1I ( 1, 1) process with a
time-varying intercept, (u; + (/> o fi)-<U \ )- The sufficient conditions,
conditional on the assumption of non-negative qt ) 5 will be like that for the
C. ARCI I ( 1, 1) that w > 0, {p o 0) 0, (n I ^) () and {0 y>) U.
These are all implied by ( A . l ) .
Now let us examine the trend component. Substituting (2.4) into (2.5) gives:
q, = (1 - 0)u +y>e
2
_, - v <t t + 0)e'l -2 + {p + 0 - v>)' //-i
+ M + / ^ ) - ^ k ( _ 2 . ( A.3)
The trend also reduces to a GARCH( 2, 2) process. In the following, we use
the results of NC to examine whether q, remains non-negative over time under
the constraints ( A . l ) .
First we need to examine the characteristic of the autoregressive polynomial
of qt. The roots of the autoregressive polynomial of q, in ( A. 3) can be solved
from:
Z
2
+ (-(, + 0 - <j>)]Z + {ftp - 0( a + ft)] = 0, ( A. 4)
so that
Zl = O.5(p + jtf-0) + O. 5A
1 / 2
, ( A.5)

A
=O. 5( /J + 0 - 0 ) - O . 5 A
,
'
2
> ( A. G)
where A = (p + 0 - 0 )
2
- 4[0p - 0( a + 0)\. T o ensure real roots, we require
that A is non-negative, which is always true since:
A = (p + 0 - 0)
2
- 4{0p - <p{a + (5)} = {p-0- 0)
2
+ 40 > 0. ( A .7)
So condition (19) of NC that the roots of ( A. 4) are real is satisfied. Al so, ( A. l )
implies that the signs of the coefficients of the quadratic form in ( A. 4) are:
Z{ + Z2 = p + 0-<f>>% ( A.8)
ZXZ2 = fip - <Jia + 0) > [0 - 0) ( a + 0) > 0. ( A.9)
Consequently, the two roots are both positive with Zx > Z2 > 0. So condition
(20) of NC that the bigger root is positive is satisfied. Condition ( 8) of NC
requires Zx and Z2 lie inside the unit circle. Check the bigger root:
Z, = 0.5(p + 0 - 0) + 0. 5A' /
2
< 0.5(p + 0-$) + 0.5(p - 0 + 4)
= p<h (A.10)
since A = (p - 0 - 0 )
2
+ 40o: < (p - 0 0 )
2
+ 40/) = (p ft + 0 )
2
by ( A. l ) .
So condition ( 8) of NC is satisfied. Condition ( 9) of NC that there is no common
494 Robert F. Engl e and Gar y G. J. Lee
root between the polynomial of q
t
and the polynomial of e\ in ( A. 3) is generally
satisfied. Satisfaction of the above conditions ensures that q
t
can be expressed
in terms of an infinite-order polynomial of e'fs.
Secondly, we need t o examine whether the coefficients of the infinite-order
polynomial of e
2
are non-negative under ( A . l ) . For the intercept,
u* = {l -0)u/{l -Zl -Z2+Zl Z2)>O,-. ( A . l l ) '
since
> ( l - p ) ( l - / ? ) + 0 ( l - a - / ? ) > O , ( A. 12)
by ( A. l ) . So condition ( 18) of NC is satisfied. Condition ( 21) of NC requires
0- 0( a + /?)/Zx > 0. ( A. 13)
By 0 > 0 and Zx > 0, it is the same as:
2, > ( " + /?), ( A. 14)
which is also true under ( A. l ) since:
Zx = O.5(/0 + P - 0) + 0. 5[ ( p- /3 - 0)
2
+ 4<H
1 / 2
> 0.5[(a + p) + P-(f>] + 0.5{[(a + p) - 0 - <j>]
2
+ 40a}
1
/
2
= 0.5[(a + P) + P - 4>\ + 0.5(a + 0)
= (a + P). ( A.15)
So condition ( 21) of NC is satisfied too. Fi nal l y let us check condition ( 22) of
N C for the first three coefficients of the dynamics in the pol ynomi al :
0 , = 0 > O (A.1G)
$
2
={p + p-
<
f
)
)Q
l
-(a + /?)0>O ( A. 17)
e
3
=(p + /3~<p)02+ (0(a + p) - Ppfo >0. ( A.18)
( A. 16) is true obviously. (A.17) is also true:
82 = {p + P~<p)<i>-(a + P)<p = {p-a-<t>)<t>>{{a + p)-a-<P}-a
= ( /?- 0) 0>O) ( A. 19)
under ( A. l ) . For (A.18):
^3 = (p + / ? - 0 ) ( p - a - 0 ) 0 + [0(a + /3)-j9p]0
= [ ( P - 4)
2
~ctp-ap + 2a0]0
> [(p - 0)(a + p - 0) - ap - ap + 2a0]0
= [ ( p - a - 0 ) ( 0 - 0 ) ] 0 > O, (A.20)
by ( A. l ) . So condition (22) of NC is satisfied.
All the conditions in Nelson and Cao (1992) for ( A. 3) are satisfied by the
inequalities in ( A. l ) . Therefore, the permanent component is non-negative
which in turn ensures non-negativity of the conditional variance.
A Co mp o n en t Model of St ock Ret ur n Vol at i l i t y 495
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