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historical variance, the predicted variance for the period (second 1, also called the number of
GARCH terms) and the previous day squared residual (first 1, also called number of ARCH
terms). Or more formally:
Where h denotes variance, the squared residual, and t the period. The constants
must
be estimated and updated by the model every period using maximum likelihood. (The
explanation for this is beyond the scope of this blog, I recommend using statistical software like
R for implementation.) Additionally, one could change the order to change the number of ARCH
and GARCH terms included in your model. Sometimes more lags are needed to accurately
forecast volatility.
Caution is to be exercised by the user; this is not an end all be all method and it is entirely
possible for resulting prediction to be completely different than the true variance. Always check
your work and perform diagnostic tests like the Ljung box test to confirm that there is no autocorrelation left in the squared residuals.
Few, it was a long one, I hope that the first part of the post, made the GARCH model more
approachable and that this introduction was useful. I encourage you to comment if areas of the
post could be made clearer. Finally, stay tuned for part 2 where I am going to give another
example of GARCH(1,1) for a value-at-risk estimation (a fairly popular application in academic
literature) and part 3 on the EGARCH!