Example EXAM Econometrics for Quantitative Risk Manage-

ment 4.1/2
14 December 2015, 12:0014:45h

Question 1 (40 points) Price formation and variance

One theory of price formation on financial markets represents the price process as a Brownian
motion, possibly including some discrete jumps. In equations, the log-price p(t) = log P (t) is
taken to evolve according to
dp(t) = (t)dW (t) + (t)dq(t).
In this representation, dp(t) is the instantaneous change in log-price at time t, depending on
the volatility (t), on changes in the Brownian motion dW (t) and on a possible jump process
(t)dq(t). Here (t) is the size of the jump at time t, and dq(t) is the increment of a counting
process, which is only 1 at the precise time that a jump takes place, and zero otherwise.
(t) is the instantaneous volatility at time t, which for simplicity we may take as constant
throughout the day, (t) btc .
To understand the price process better, let us rewrite the model into discrete time. Assume
that prices form exactly once every hour, such that at times t = d + ni one has
P (t) Pd,i = exp (pd,i ) , (1)
r
1
pd,i+1 = pd,i + d d,i + d,i Jd,i . (2)
n
Here d stands for the (integer) day, and i = 0, . . . , 23 for the hour, and d,i N (0, 1). n = 24
indicates that there are 24 observations per day. Jd,i counts the jumps, such that for each
interval where a jump occurs we have Jd,i = Jd,i+1 Jd,i = 1, else Jd,i = 0. This jump
indicator multiplies with the jump size d,i . The jump size is supposed to come from a
distribution which for the moment is not specified.
For simplicity, one could write
rd,i pd,i+1 pd,i (3)
for the log-return over the interval (d + ni , d + i+1
n ). A possible path of returns and prices
with/without jumps is depicted in Figure 1, with daily varying variances btc d .
(a). [8 pt] Assuming there are no jumps in a specific day d, derive a simple estimator for d2
using the returns of that single day only. What quality of the estimator do you expect
when n = 24? Would it be better to have higher/lower frequency data?
(b). [8 pt] When one or more jumps are occurring in the sequence (as e.g. seen in days 1, 3,
4 in Figure 1), the bipower variation (BV) estimator
n
X
2
p
BVd = 1 |rd,i ||rd,i1 |, 1 = EN |z| = 2/,
i=2

can be used instead as an estimator for d2 . Derive why the standard realized variance
(RV) estimator is biased if a jump occurs during the day, and discuss if the BV estimator
is fully unbiased, only less biased or just as biased as RV. Clearly explain why, and
indicate the cause of any possible remaining bias.

2
 2.5
2 r
1.5

1
0.5
0
-0.5
-1
-1.5
-2
0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75

0
-2 jumps
-4
-6
-8
-10
-12
-14
-16
-18
0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5

10
5 p (no jumps)
0 p (with jumps)
-5
-10
-15
-20
-25
-30
-35
0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75

Figure 1: Returns, jumps and prices, over 5 days of 24 observations, with standard deviation
d superimposed

(c). [7 pt] Stock markets are not open all day. Hence, in practice, prices are not observed
every hour, but only from (say) 9-16. If you observe only 9 prices pd,9 , . . . , pd,16 each day,
how would your estimator of d2 of Question 2(a). have to be adapted?

Table 1: Estimation of GARCH-BV model on IBM 2011-2015 data

() ()
0.0510 (0.031) 0.0454 (0.031)
0 0.0735 (0.024) 0.0753 (0.039)
1 0.0918 (0.023) 0.0086 (0.029)
1 0.8387 (0.038) 0.6409 (0.093)
1 0.3603 (0.117)
LL -1317.257 -1298.213
T p-val T p-val
sk(ed ) 0.003 0.078
k(ed ) 4.081 4.094
JB(ed ) 45.387 0.00 47.432
LB(ed ) 3.401 0.64 2.915 0.71
LM(ed ) 3.347 0.65 2.826 0.73
LB(e2d ) 2.024 0.85 1.575 0.90
LM(e2d ) 1.916 0.86 1.545 0.91

Instead of using intraday data for estimating the (intra-)daily volatility, a daily GARCH model
could be used. This model links tomorrows volatility to todays surprise and todays volatility.
Koopman, Jungbacker, and Hol (2005) among others investigate whether it makes sense to
extend the GARCH model by linking tomorrows volatility also to the realized estimate of

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todays volatility, as in
rd = pd+1 pd = + ad ,
ad N (0, h2d ),
h2d+1 = 0 + 1 a2d + 1 h2d + 1 BVd .
In this model, BVd stands for the bipower variation of day d.
Table 1 displays estimation results on 932 daily percentage returns on the IBM stock, us-
ing adjusted close prices, over the period 2011-01-032014-09-30. Over these same days, the
bipower variation was calculated using 5-minute returns, and used as additional explana-
tory variable in the GARCH equation. Estimates and standard errors for both the GARCH
and GARCH-BV model parameters are reported, with loglikelihood, and the familiar statis-
tics/tests performed on either ed = ad /d , or on e2d .

(d). [9 pt] In the table it is seen that the parameter 1 is estimated relatively close to zero.
Discuss the implications of this findings, if it is possible that the parameter would indeed
fully become zero, and what this would imply for the behaviour of the GARCH model.
(e). [8 pt] (Not truly related to block 4.2...) If the true data generating process follows (1)
(3), can one derive the equation for the unconditional variance of the GARCH-BV model,
E(h2d ), as a function of the parameters? Hint: It might help to write E BVd cd2 , for a
constant c which might not be equal to 1. Hint 2: What would E(h2d ) measure?

Question 2 (30 points) Multivariate modelling

(a). [X pt] Several of the topics of the course concerned the multivariate modelling of cross-
section/time series, where univariate alternatives would exist. Indicate for each of the
topics Panel, VAR, and Cointegration where (in your opinion) the largest advantage of
multivariate modelling over univariate modelling is to be found.

Assume that both inflation, y1 , and the unemployment rate, y2 , are I(1) variables, and model
them together in a VAR(1) as
   
c1 (1 + ) 0
yt = + y + t , t = 0, 1, 2, ...
c2 t1
where c1 , c2 , , , and are the parameters of the model. The innovations t = (1t , 2t )0
are assumed to be generated by a Gaussian process with mean zero and fixed, nonsingular
covariance matrix,
 2 
1 0
 = .
0 22

(b). [X pt] Discuss the concept of Granger causality, what does it tell you? In the VAR(1)
model above, does inflation Granger cause unemployment, or does unemployment Granger
cause inflation, or both/none? Explain the necessary conditions.
(c). [X pt] Suppose data is available at the quarterly frequency, and you are asked to make a
prediction one year ahead. Derive the formula which delivers the best linear prediction.
What elements of the model influence the precision of the prediction?

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(d). [X pt] Possibly inflation and unemployment are cointegrated. To test for cointegration,
the model needs to be rewritten into VECM format. Write down the VECM format, and
specify the matrices in the VECM format as functions of the parameters in the VAR(1).

(End of Exam)

References
Koopman, S. J., B. Jungbacker, and E. Hol (2005). Forecasting Daily Variablility of the
S&P 100 Stock Index using Historical, Realised and Implied Volatility Measurements.
In: Journal of Empirical Finance 12.3, pp. 445475.