120 cawrnenssomouny Te senes Moves “The SBC incorporates the ler peat I + pg) nT. To ase the SBC, set he ali of pang 0 9510 mine Tio(SSR) + (+p + 9) WT) or any reasonable spe size f(T) > 2 Shut the marginal ost of ang rameters sing the SBC exond ht ofthe AIC Hence, the SBC wil select amore Pisin mol dn he I. ieee he SCs epee Shmple properties I is posible fo prove tat he SBC is asympsclly onsen ‘oils AIC i Based wovard selesting tn overparametarzed model. Howe, Moat Cato statin hve shown ha sal samples, the AIC can work beter than the SBC. MODELING VOLATILITY “Many ecoami tine series do ot havea constant mean and ot exibi pss of ‘ive tranulity followed by perio of high vali Mach ofthe enrent econo Intreesearch isconcemed with extending the Box-Sekis mesadaogy wo analyze those yes meses variables, Ths chapters te ims 1. Examine te so-called facts eanceming the properties of economic himesers data Casual itspacion of GDF, facial agrees, nest ae, tnd exnge ite supe hey do not have constant sna varie, “Many see o have decid upward rend, whe ther See o meer sod show pais of igh a ow vl Ache vara wit 1 the wncononal forcast as gente ain than the codons forecant, Thu, conditional frets ace they ake ino account he non erent snd past eintos of series) are preferable. “Sin if he varane of (emt constant, you ca stnat ny tendency for santind movements nthe ance sing on ARMA rood For example, (2 sncrocsses 127 ee te estate resus the model ‘ional vrtane ore i * vai saDD = los ~~ 09") Ete? otis point, we have set; othe costa o Now upp th the ondonal atin sot ons One simple sae i occas there ‘variance an AR(D) proces using sqore te estate sulk 4, ayy + that the on tata olla ot aby on vor i wit ise proces Ihe ves fea log 2th eine ance say the ons a, Oeste conden ane oy, elves cco tease resi pcs gen by (1) AS suk, You ea ute 1} foes te Cneons Eibbag = oy aE HEEL ot benny For ths reason an equation ie (1 is called an atoregresive coon beteroeate (ARCH) roel The ae sany pose aplcatos fo Aer! ‘ols ice the reid (0.1) en stefan aurepein, a ARMA ‘el or snd eres noe ‘nactaiy tinea seta f 2.) hemes ome Te so stat the lf ad cio ce est ea Seoul king maxinom eine sigur Moreover sea oth cen tiventy G.b,tismore acai to spenly vs mupcatve ise “Tie sinpls example ome css hice only rok ‘emo proposed by Engle D8} foe Vag oe 62) ete» = white-oise process such that = I a te independent ofeach oe, nd anda ae constants such tht p> Os = ay = | onside th properties ofthe (sequence. Sac is white ie ais inde Pendent ofr, it se 0 show thatthe eement of he sequence have mean of 20 and we ucorelted The poo ssighforwn Take the wtcosional ‘expectation of, Sige Er, = 0,1 flows that Bey = Eloy + aye!) = Bibl + a" Since yy = 01 as etlows tat a iso oy ‘The devon ofthe unconianl variance of ko sighfnwal Sure and take the unconditional exe 6 for et = Eva + ae) Bs}Rlay + a)128 owrrens moceunevouaiiny Since of =| ante uncondona aiance of seta that o 6-1 Gs 2 MEaE he uncnditonal variance 3 be) = ay — a) os “Tus the uncontonal mean aa iin are uteted by the presence the enor grver ie by (22) Si, ean oso ta he eandtonal mes of Eris eat sen, Given dt a, fe ndpende al tht Es 0, th con na ean of is Bleep a tea) = Beeinbeulag yeh! =O ‘Aris poit you mit be thinking tat he properties ofthe [a sequence are ox by (3) since the mean ear, he ysance sens al uoo- “riances ate 2. However the lafluene of (3.2) falls eniey on the conn ovine, esas 3 = the vance of conte an the ast isto of, Bletley seta ol | 8.6, he condoms vai of depen on the realized vale of Irth ald value of ys age the ontiona variance in wl be leas wel. (16) the cononalvriance fll stoner autoregressive process denote UyYARCHLI). Asoppaed toa anal asoresession, the coefcens anda have 0 terested In ert ere tthe cotiond varaee is ever agave ts feces to ase tht thay fe postive. Aral. a sepa, sf Tse sll alization fey wl rea hat (3.65) seatve. Silay as rome sfc) lg eakaon of ean tender a negative vale for the Cohfional ance. Moreover cause Ke stabil of the proces, fs neessty toes ay sch that = a Eaquatos (23) God), (33, and (3.6) llseate the ese Fentues of ay ‘ARCH process Inam ARCH node he conor! and ucondtiona expectatons of ‘crores seen oes Moreover, the [sequence sei uncorrelated enue forall #20, Besty = 0. The ky pois ht he ers re ner inde ‘ev ince they are te rth he second monet (call tha colton Tice elonship. The contol vane isl san autoregressive proces rest Ing incondnalhsternhedati cro. When he ealzd vie fs from eos thal (1 foreleg =the ince af lt fo be ge. As ‘ow witce moment te conalionl heron in (e) wil res ‘cing feeronhedaste self Th he ARCH model abe capure pigs of a ‘ql al vlan the [sre "Te ow pana of Figure 37 depict wo diferent ARCH mos. Pe (0 rp resenting the (sequence, shows 100 very ancora and normally dtd ‘elon deviate, Hom canal section, the {v7} sequence appears Yo cane ‘Sound mean of zm and have «constant variance. Note tbe mere incest in ‘omy between pris 30 al 60, Given the itl condition w= 0 these el om of the tv) sequence were anew const the next 100 ales f the [2 Selene wing equation (3.2)anfsetinaag = Sanday = 08 As ised in Parl), io Fae 66 sncarmocesses 129 toe prosne v ever ome, nats) ae {he fe sueee aoa mean of 6, Bt the vise apes exprence an increase in volatility around ¢ = SO. = "ow dos theo site ft he 3 sees ley, he are sive pmo ano otg ei Ts Panel) can be Seo pie ine ath oe 3) enforce = 0. Pl) at (© Show he bt ie) segue frees fy = 2 09 spect. The coal poi ata he ARCH ce since! asoaaioh Durance ofthe [9 process interatwith ea ete Corprng Pt) a “stats tha he vaio (rian nay sd Te explana it ins ny un ae be au) shock nl be mand ah ape Siena varines ne soc: tere ye gre peste190 cuarrens tones vOut Moreover th reser the auorepesive parameter the more persistent any ven ‘hung Te stonger he tendon for [10 vera aay to is mea, He reer the variance. "To Fxmaly examine de properties of he (,) sue, the condos! mean avast a given by Fane oot anies ond = Bs, a0~ ays? = Estey? = aot ae sty icnins Sine and camo be stv, he minimum vale fre conditional var ance is Fr any nonzero reaiation of the endo vara pos ‘ively rele to a. The econitionl mean tal variance of canbe bined by Solving the ference eaution for an hen taking expectation. If dhe process ean slice fr othe pas Go thatthe abiary conan A can aly be layed) the soto 0 sgt Sie on Sine Ee = 0 foal the uncon expectation of 3.7) s Ba ~ a) “The nso yaiace can Be obtained in salar fashion wing 37) Given ha eg seem forall» Othe unconditional vara lows diet fom (3.7) 38 vag = Satan ow the rest tht te nso vse of is eons Ue, vast) = arty) 9-2) = n= all ~ ah iol at =a) Cente varias ofthe |) sues ines nay anda tbe able vale of op Ahogh te leben 4 oy, th evapo at an ARCH eer ‘ro can be us Yo mode paid of vlaity within he wiv fanewor “The ARCH pos given y (3.2) been exended in several interesting ays Engl’ (1982) eign! contibtion conseed the ene css of high-oner ARGH) proses: ne nafent Sout on 1n(38)allsbcks fo e-1808- hea dis effet on 50th the conto ‘rans alike nutri procs reg tsa gn exer odors Ut he oes rE ang rom 1) preset sare tat fom 9), sroarmoctsses 191 ‘The GARCH Model Bote (986) exten Exg's erga) work by developing a tectniqe tha allows the cons variant bean ARMA proces Now let he eo poses Be veh hat enh, + enter Spa an Sine {yi white-noise proces, the conditions nd unconditional means of, se equal o zr, Taking the expected value a i ay 0 vey that o> Engh" = 0 “The importa pont i tate condional variance fe ven by 8 ~ fe “Thus, the conditional variance of th ARMA proces given bythe expression hy nso This generalized ARCH(p,¢} madet—callad GARCH(p, g)—sllows fot bith uoregresive nd movng-veage component the heteroakedae varats w Seip = Oandq = {tis cert the Rnt-oder ARCH model given by (32 sin. Diy'a GARCH(O, 1) model Hence ial ales of Pel tthe GAREH (p 9) ‘mode is equivalent to an ARCH) mel The beets the GARCH mel should bec a highender ARCH model may havea more parsimonious GARCH rene stn tht sch easier tien ad xine. Ths partly reine all efficients in (3.9) mus be pose. Moreover, o ene th the vance fn, A carci ots of.) te inside ici. Cy, he more pa nonious model wil eral ever oefient eicions® “The key letre of GARCH modes shat the contol vara of the ds ‘aces ofthe |) sequence consties an ARMA proses Hee, ts tos expected tha te Sqr residuals om a ited ARMA me shold dept ths characte pte To explain, spose you eae. a an ARMA proces, Lyon ‘of fy ade, the ACF and PACE ofthe esis shoul be net oa whi vse process uation (3.9) loks very mich ike stdard ARMIA(p 9) proces. [As sch, if thee is condiond!hetershedisty, the emeogram of the suaned resid shoud be suggestive of sch apres. The ectnige fo cst he cr Feogran ofthe squared residue Flows STEP 1: Estimate the sequence wing the “test ting” ARMA hal (or ep ‘son mode) al obtain the squires of te fted er 7) As eae the sample variance of the edule 0" died Dan mame of residuals.192, cuurrens wooeine vOLATN STEP 2; Csealate and plo te sample atoconelation ofthe sured eid es Bee 7 ye-v ‘STEP 3: nage samples the sana eation of can be approximated by 7. Ui ales of tht ae igi dierent fom 2er arisen teof GARCH errs Ljune-Box Q sais can be wed oe frees of sign oe A in Chapter 2, he eine o=nr+ ay Soir i as a aympsic x sbittion wih depres of adam ifthe (3) ‘sine still sored Resting ial yet ue 2) ‘Silly netlist eect the al pti no ARCH (F GARCH errs In prac, you should conse vals of up TH A more formal Lagrange mutipier test for ARCH eri he MeL. en Li (4983) est The metadata ivoes he folowing (v0 ep STEP 1; Use OLS to extn the most appropri repression equation oF ARMA rods, nde (2) dene the squares othe ite er STU 2; Regress tee sued eid on x contin acon the lagged ales FRE By soa 8 his, estimate a regression ofthe frm te hee ae 9 ARCH or GARCH ett, te etna acs of a trough a shoul be vem He, ths segeson wl hve iter perso he oe. ‘cient of dcemiaton Le, he ws) wl be gute ow. Using sample of Pei tls onde the mall pote of to ARCH eros, hfe stitie TR cress ax" tdsteson with degree of ato, TR sale age eon of he all tenet hough te yeu ze cgi oejetin of heal ‘np foo ARCH rts, On te tern Tsuen ts posible ‘to cov at hte eo ARCH ees, nth smal splenic sen ‘pled work, ap Fae forthe al hypothesis = = ty = Os een shown be sie one, Compre he ape ale of Ft the ales ina Fable with ‘pce ebkom in th amentorand 7 ¢ dees of fio it he denon 3. ARCH AND GARCH ESTIMATES OF INFLATION. [ARCH and GARCH modes hve become very poplar in tha thy enable he eno ‘ric etn the alge of ees pric point in ie. Ces set [ing mel inst that the rik pretium wil depend onthe expect tun and ‘he variance of hat return. The eleva meas she vk ove he ling pei, Arch AND caNEM ESTATES OF LANION 13 tthe usconitona isk.Simiaty, a portaiomanage who uses vals might be unviling Yo ele potaiowi 3 poset chan of lin min, Te sere ofthe isk shuld te dtemined sn th cnn! Jaan of ase tun as Engh example fhe importance of wing the cons vara Ite han the uote! yr, coir te stro he wage bsg ‘Protess Cleat, mea unions nc flesh tn te oe te drt {thelr coi Boonie Tet upbeat he rm te ape cna ‘il depend on the ination forests ate uncertain conceing he cacy these feasts Le dette contol expt ne oan fo | nd Ie det econo! vrs. 1 pars f the cont hve aoa pecans the tes of he ears wl Spend on Brey a ped To the unconditional men othe unonioa vee Thiceranp ists ery nortan po. The rion expectation hypo ‘sis soit ges do swat fl tra aoa ine se sont aget we the condor rath ha the ool, ston the Sis, Henn a est ofthe wg pining dl sbve tat wes the serie ‘arn ation ie woe ions withers hata aga ink wse fal vane infomation, coton meas wa aan) A stent ‘he economic of erty ean mest che nprtnce of ARCH and ‘GARCH motels Ther model xing trance at meee of i ach tmean-vriance analy) canbe etd wag the contol anc. As sch he {row nthe se of ARCHIGARCH meiosis en nating shor of mee Inc thre ae so man yes of mol coon! voli tacoma Practice elr the emir cls odes as ARCH GACH node Model of U.K. Inflation Anup Sestion 2 focused one eid of x pre ARMA mel is possible to ‘stmt te resid fa standard malipl eresson model sv ARCH or GARCHT Processes. nit Engl’ (982) seminal paper conser the iano sg Isl of he wage spel forthe U.K over te 1938Q2 197700 psi Lt p, denote te log of he UK. conser pice nox al depo the oe of the dex of ‘nomi wage rater. Th, the ae of lafaton i'm, Pa seat wage 1. 1, ~ Pe Engle repost er some expementton i he he following ‘model of he UK nla sate (tnd noe aren pees = 00257 + O34. + 0408-4 ~ 0404-5 + 108557, + (10) ©0065) (103) 110) @IM) O14) y= 89% 0 hee i the atace of ‘Te nature ofthe moda i such har nese inthe provous psa ea wage ieee the euret inflation rte Laggd ifstion ies st t= and = 3 ae Intended cpr seasonal fc Aleoefiients ave ttc greater than sea batty of diagno ess id ticle the prescce of serial corel, The ‘stint vance waste constant value 89 % 10" kn ttn for ARCH cr the124 cerns moosina veuruny Lagrange mer tes for ARCH) exo as pot sigan, but the fst fr an [ARCH coor process yielded val of TH equal a 152. Al the 0.0 signiseance eel th cial vale of x with ourdereso eed is 13.28; ence, Engl on ‘hes tha thee ae ARCH crore gle spied an ARCHU) provers forcing the following dectning se of sight on he emo by = ag t alOSeRy + OKs + ODEs + Oe) 610 “The lone for cosing 8 tpt vance Function asf ese the nonnegative satiny constants ha mig ma be sisi sing nu ‘ted esimaing equation Civen ths pericular set of weg the ecessry mn sf Fen condition fo the two contin 0 be sad ay Oa Oa = gle shows tht the estan oh ureters of (10 and (3.11) en be con sidered eprtly without fos of asymp elieey. One procedre fo estimate (8:10) wing OLS ato sve the resi rom thos esis, an estimate oF the Pramesers of (st) ean be conc an nse om these estates ne exes 1 (10) can be obtined, To esate bth wit al iene coined Kertions ‘i be check o determine whether the sopra estates are covering. Now tht ‘non ltt oftwine packages cots alter naximuthetiod esimation Foutnes the cuent roses imatimouly etal bth equations wig the ‘rehodeogy acumen Secon 8 "Engle naximom-ikelinood exits ofthe model ae = 025m,-5 + 0070 +e G12) = 00328 + 0.162m,- + 0264, (0005) (0.108) (0089) (005) (O12) y= 14% 10°? + 0955(04e2 + O36. + 02K + Ota (85x 0% 0298) ‘The eimatod ves of ar the conta fester variances. Al cot cients (eso the ire Igo the fiona) are sgiicant at convenional levels Fora pen el wage, the pot esimetes of 212) ply ha the lion ate 2 onetgen proces. Using the celts ales fhe (sequence, Egle ads hat the candar devia of nlaion sats more than doublet 9 the econ moved ton the “podcasts nto the tua Severies” The pon estimate of 0.955 inlets an extene amount of persieee Bollerslov's Estimates of U.S. Inflation Bolles (1986) estimate f US. lation ove an interesting comparison ofa stndard ovgresive time-series model (which asues a costar variance), 2 ‘ode wth ARCH en, ad a del with GARCH eos Hotes tha he ARCH Povetne ns ben sf n malig fret eeoome phenomena bu pols ot (seep. 307208): ‘Common tomes. ppliaions, howe isthe inteuton of ther “xb incr Sectnng ag strstr nth condor vrisce eatin ‘Anca CANO ESAT OF ELATON 196 {0 tke account ofthe fog menor ypicaly found in empirical work, sine esting tole ag ston often wl edo volton the nonegaivity conse, Th sno db a he ng ct Ee ed msl in (1) as 4st ths scm Unig ety Sa vert BEBO (DEN ps Bley (986 escino 1 hitaton te (oe Watch ne US°GNP det ete sinned uaegeon 0240 + O882m,.4 FOIE, 2+ 022m) ~ 020-4 +e, G.I (0.0%) (0Rs) (059) (G00) (0.080) y= 0282 nation 0.3) ems o have al te proprio wales timers ode Altec signin at come ees (he standard ert in ret) an he sae vale the sates coef ny ato Sri Balls rt ht be AC an PACK oot ca ny pe oe nos athe 5 pre sigifemce eve. However, pic of ARCH eros tc [ACF al PACT ofthe sured sil (6) show stgatcan corel The agree aire for ARCH, ARC, nt ARCA oop ‘Boller ae estimates be c rested ARCHES) od ally proposed Engle and Kr (1983). way of eompaion (13) hs fi 198+ 04294 - 4 02228)-2 + O3TTRu5~ OUTSmna te, GLIA) 0059) (00st) (e408) (oars) a.108) 258 + a8 S10 — nore (0.003) (0265) Note tat the regressive coffins of (3.13) a (2.1) are sini The mls f the vatiane, however, are que diferent, Equation (13) sume en sat vvane, whee (4) assumes th te vane (hs a geomet del ‘ng weighed merge of the variance inthe previo eight quarters Hetee, the inflation at preictions of th two mele hod be sir ut th condence ne ‘als suoudng the forecasts wil dies. Equation (13) ld constant ier oF ‘banging wih, Equation (3.14) yes confidence iva tht expands rng Peis of inflation velit an coetin eltiely tal perio, mn onder i es forthe presence of fitondet GARCT ten he conions ‘avian, spose etinate he equation ym aot a 39 608+ in a5) The nding tat = 0 would imply a absene of « GARCH ter inthe cond ‘inal vince. Given the difiuies of extimating (13), Bolly (198) uses the simpler Lagrange utile (LM) te. Fama the et ile cnstcting the196 canerena uoosine vourtuty resid ofthe condo! vrane of (314). The next tpi eres thee res tats a comtat andthe expression TR hs dst with one degree ‘tiem, Bolero finds thal TR = 57 at the 8 percent sgnieance evel aot et the presence fa fstorder GARCH proces He the estimates he a lowing GARCHG, 1 ode: = ISL + R31 4 02294, + 0349-3 ~ O16 4 +H (0060) (0081) LID) OTH (ODN (007 + 0135e2) + 0:829h.. (0.008) 07) (068) Diagnostic heck ht the ACF ad PACE ofthe squared residuals do ot revel my ones enceting 27 "°% LM es forthe presence fairl lags te and forthe presence oh oo signin a the S erent eve 4, TWO EXAMPLES OF GARCH MODELS ‘GARCH models have fond te eetest sein modeling financial dat wees, ths secion an Secon ae teed fo lowtate some abe ses of GARCH mod ‘tne fist example de ae whether tees Been ignition In the voi of etl GDP. Inthe second example, he neti oobi reasomble Cnsinal confide nev when feasting. The example also shows that ne ice in an ARMA (or regression) frame canbe improved by accounting. fr ‘GARCH eects Te example in Seton S uss & GARCH framework to mesure he ‘ides an Bebo toward isk the U.S ier make, Volatility Moderation “Thetis age body of Titre ding hte voailty of importa mato ‘ono wales the indus economies decreased in ea 1984, For ‘Sample Stock and Walon (2002) reported hatte andar deviation of ral US. ‘GDP grt during the 1984-2002 period was 61 percent sale than ht during the 19601983 period. As discussed in Romer (1989), soe have argued that better Ione polices enabled cena Bakers fo eter stabilize economic activi. (thes have argued ita mater of ack tha there have no been any majo eas tive ply shocks (sch opis shocks or widespread failures site the 1970s 'Athough hse elled "Great Moderation” probably eae tan end wih he fan al eri of 2008, we can ane the GARCH framework fo et whether ro there voit break a T9840 ‘Te le RGDEXLS conn he four series that were wed const gues 2. sd 42 You ca ae the dai the Het const the prowth rae of real US. {GP ay, = lnghRGDP,RGDP,). Wau going i dei you waked trough {Chaplet shoul clear that eatonable ode forthe pow ate fel GDP is 9, = 006 + 0331))-4+ 6 ua) an womumesoromnotiones 197 ‘The ise isto mens he exten of he vlad in 1984. AS prin inn text we can ty to determine if thre sy contol voli. Sine wea sing que das it makes sense oe te MeLand- (1983) est with ou ‘quer ag Coser 48 107% + OOBDE + OAS» — OOISH + 01402 ‘The sample vale ofthe Fait forte ul hypothesis hat he coetcents ‘tr a al equal I 3:4, Given tae se flr deres of edo. this Signifca tthe 00 ee. Hence, theres stong evidence ht | sare aie condonal oly. ‘Now eat the danny variable D, ach hat Di cl 0 eign 198401 ‘diel 0 before 198401. If yo etme the, ei allowing for ARCH) ‘ors and inl Dn th vases equation, you shuld find 9) = 0005 + 032135 +6 825) (510) 116 10° + 00863 ~ 9.34 x 10"%D, 35). 624) (lve thatthe colicin on pot itil life from 7, we ak eld th thre so vost sing Instead ee sh waa bk [Notice ta the isercpt ofthe variance equation was 16 10°" pio 18 indexperened igncant deine 205 10 (= 1.16 10°" 954% 10) beioning in 9840 Theestiated decline seven gree thn the 61 pect iat Indicted by Stock ad Watson 2002), 4 A GARCH Modo! of the Spread "To get abate de ofthe actual proces of fiting a GARCH model, reconsider the example ofthe interes ate send ed te ast chapter Real ht he Bonk ‘pci ed ws o give seus consideration othe ARMAQ, (I 7) model Ifyou ‘inte hema for the ete (96003200803 pero, you should on 5) 0293 + 037154 + 0455-2 +. + O8166,, ~ 018255 C16) 297 B49) (Is) (190) 3.13) As shown in Chapler2, te estimated model performed ite wel Alesina paraeters Wee gic at eretionl evel an both be AIC and SHC sl this specification. The ACF std PACF ofthe ress don indste ay sie ‘elation. Recall hat the MA term af lap 7 i sspeet Bocas there I Seems vey ‘nil hat evens alg 7 affect he cute value ofthe spread, bt that even fa aps 3-6 hve direct effets. The Ljung-Box Q-stttis for laps of 4, 8, and 72 quae aren sgnifcat ut curnetona ee, Moreover, here was Po ov ence of etucturl change inthe eatnaedcofcons, Nevethecs durin he Vy Tate 1970s and early 1980s, there wa period of usa vlaiy that could be ladles of ARCH proces The sim of hs ection io Haat ashy ep188 caarrena woot vourury alysis of « GARCH estimation ofthe sped. You shuld beable to follow along thing the dat in the He aled QUARTERLY.XLS. Formal Tests for ARCH Errors Aknoh (3.16) apes to be ite reasonable the volt ring the 19706 sug ets tha it spent to esuine the ACP and PACF ofthe guaed resus. The ‘tocorlatons ofthe squied resdvals ae sch that py — 0040, p, ~ 0221, fru OU83, and py = 0.257. Otbervales Tor pare generally 0.19 oF less. The Tng-Box Qt for the que vesduas re al igh sign: or exam pies 0G) = 2421 and OU) = 2845, which ae both highly sgnitea! a any eon "enon level Next et dente the eid of (3.16) an coeds the MoLod-Li (983) sing ag ego four ua: = 0.145 ~ M0012 + 01708}.s + 006K? 5 +0217. — GD, 246) 00 235) 9H “The vue of TR? = 18.51 otha tere i tong evidence of ARCH ers with four deres of fies, the Speen erical value of x1 949 apd the | pecent ‘cal vl 1325. tn small samples, common 0 use an F testo determine steht is posible to rejected yay == y= 0.1017} th {r= th sample vlue of Fis 5.0; with four depres of reson, ths highly Sein, "A tis point, you might be tempted to plt the ACF and PAC ofthe squared ‘ess an entnate the sued svn xing Box-fkins melodia, ‘parsimonious model of heer process could be oained Alo, yu might be on ‘Soe atone of the coefficients in (3-17) nepaive a yt sia the eq ‘on asig se other vale fr g However a wor of caution sore. The problem trith is statgy i hat (3.16) a8 estimated under the assumption tht he co Teal variance was consi, A ach it dos not make sense to use the esis of (G46) to estinate the time-varying cntionl variance Hence, equations Sih as {6.17 camel you wether ort tee are GARCH eros, but at the pecise ener para Alternative Estimates of the Model "The appropriate may oot the proper oder ofthe GACH proces isto estinte Ihe mdf the peat al the tal of he conditions variance siulaneusy. AS lch/GARCH proses tx Sply eit by makimakeloo!Yeehngies orto cain xine tht ar ally een A low-order ARCH) process eens Tike» reasonable string place fora modelo he condinalvaranee. Fr example, ‘ou cin bein wi an ARCH!) mel forthe contol vane 4, = 167 + 0615-4 + 0402 #, + 0.90054 ~ 00956 ey asn 639 64) G13) womammssoraanonionns 139 hy = 01156 + 053402 61) Gav, ‘The made! seems to be quite plusible ll ofthe coefcents ae sensible art highly sieifean. The autoregressive coefficients in the mol ofthe mes ingly comergence. The oefients in he eution ae bath posite an the ARCTHI) term is es than uy. Now for the standardized ror ete wesiuals divided by their conditional standard deviations, i form the series Qh The ‘mated stndndied residuals ae an estimate of the sere. Hf yu ches fo serial oneltion in he tundatized eid, yo wil ind tha he utooreation re sc that a a a rr air dos odo adr 00 2 Bos an ‘The Q-stiics ae OU) ~ 282 and O(8) = 5.8250 tht wean be conten that ‘heen ain sel conelton nthe sana els Now the se ter or nt the ARCH spetiction was sient apa al ofthe dy ies of the conditional varance To anv guestion, for he auloconeaens oF the squared stadadized esis: Ho ee foe 031 ols ois aor ads dis ow ‘The vale off suite lage and te Osan are 4) = 259 an OC) = 32.5, Hence tees sl sme rersining conditional voli wo that he ARCH(D) ‘process is iadequte. Next, simul te ARMA (ly 73) model slowing or ‘ARCHO) oon 9, = 0016 + 1084-1 ~ 6755-5 + 6, 028,14 OTHE 255 4085) 46) (17) a3) y= 006 + 03686 + 04126» 4m aa) Toren, the problematic MA(T) term is pt staisically sigiicant and an be eliminated If you go ono estate an ARMA, 1) with ARCH) ero, you wll a 4,5 0009 + 13865. ~ 06489.» ~ 0.3034, +6 2m) (5) 45) ELH 1h, = 01036 + 033667, + 043642» 4 ai 423) Although the mode! ofthe mean impish the pes is quite persistent (ihe su ofthe autoregressive coefiiens is 098), for eats dscused in Sesion 10 ‘of Chaps 2, we do not want © use the irs iference ofthe spread Noe tat he father small estate (© — 164) forthe evecen of ry mie lead 04 ‘escrchers to elimitate this ea The properties ofthe ert ae resonhly“Wo ouerens woczune vouaTuTY 00d, The aoconlatons of the standardized eon and the squared standardized rs ae given by Coneiaions pstmt ‘aie? 2 Olt obs 00s ~0o1 Os O08 a7 Hh, 007002 S021 00 GIT O08 as “The ACF forte standardize eid does ot cate any woubesome sri conrlton. The sample ales of (4) = 895 and QC) ~ 1013 ae not signicant 1 comertinal levels, Alough the auaconeaions of the squared standized Feld for ls aa somewhat ae, we d nt want spy ines he fale fg, As uch many researchers woul be cont wit the ARCH) specif ‘ion forthe conditional vavaoe, Te sot ine ia gue 3.8 shows the ne tepaead Forsnsof estan the ARMA 1) re with ARCH) ens Sine is ‘stint ofthe onal aig of (the sna eror ofthe o-ep ‘head forcast. Te dsb lies inthe Hite represent a bane of =2 sat Founding the ate sep abe! foreeatof 4. [n eootat tthe assmion of 2 ‘Sorta cnn trans, note tht the and wih increases inthe ate 1705 hh he i 1980 For our purposes is intr tory the GARCKI, ) specication aan ale rave othe ARCH) spetcaton. Unruly, f yo eximate « GARCHU, 1) Sou il ind athe sum ry + fy exceeds ny, Moore, you wl ind tect Stones ery small ate, However, ou rest he sam of ay + ‘oly adenine he MAC) fer nthe ode ofthe eas, you soul fed 0128 + 12754 O38D4-3 + a, (639) @3s8) (738) a aww woot orn 141 by = 0192425 + 080TH, a easy ‘The ein mode very prions des he dla well The uo comeaions ofthe starz eros ad the gue staan eno vey Conmaios oo tte hx ue? Gon 012 hop obo oo O11 oo ha ith, 001 0.16 00 oH 003 aor —nor —n02 ‘Shae the madeli ute parsimonious, a the autcoltons are reasonably sal his s-aled IGARCH mol (vith ay + By = 1) ena aeaive toh mode wi ARCH) ero. 5. A GARCH MODEL OF RISK ‘Av interesting application of GARCH modeling is provided by Hol and Arad (990) Ther reel amcwark sands i contrast to the cobweb rode (2 ‘Section 07 Chaper I) tha atonal expectations are xsd tpevs i thea altura cto The am ofthe sd texan he ester to wich pct athe US. tcler (chick) inn eaibt kare bv ths nthe ap iy fasion For the US. ole indy ast fon? 4) = ay a = ah ~ apes + atch. + aga tty BB) here 4y= quantity of beep in milion of pou) in [7 = expect eal pie of blest coioned on the infomation at 1140 tha p= Bp) 1h = epee varies ofthe pce for in entioned on the infor maton st? 1 peed = real pace of tor feed in cantsper por at | = Inleh of broertype cick i commercial this (ese! in "owns in prog? eu = spy shock nthe length the ee prod sone quarter, “The supply Fanci reed onthe logis fat tha te production cycle of trols i sbout two months Site Hinoatly dla ae unable the mode ‘sues at he supply decison pose ltd othe price expectation formed by produces inte previous quire Give tht feed accounts or the lk of prod tin cost ea Te pis apd one quater re negatively rele to ber ti in Obs the ach abl nt 1 iseass the numberof beers tha fan be matte in. The fourth lof oe pdt nce Yo accu for the posity Ha production a any pte iy ot ally aj to the desired Jv of puto, Fo our purposes, he most intresting pt ofthe tay is the negaive eft of the contol variance of peice on bro supply The timing of te produc Process such feed and ther peti oss mst be cared lore augM2 cunrrena mootunevoaniy sold in the wart tn be planing sas, podoers mst osc the price ta will ‘evil vo month ence, Te rete egret he numberof hicks that wll Feet and rove mae pie vail very lw, these orca ean be eld with confidence Inresed price varbiy decreases the accursy ofthe foe ‘sand decrees rile supply. Ri averse psucer il ot ora and mathe eer bor when th condtonal oat of price iph Tne ital age of the sy, bole rcs ae etimated asthe AR) process (1 BAL Bal? ~ Bal? ~ Bl = Boe eu) Longton O-saistics for vious ag Heng int that de residual sees pesto be wit oie athe 5 perenne, However, the Lng” Box Qsaistes forthe squared esiduls—a is the fe) —oF 324 ae sipica at he 3 percent level Tins aA onde tat the variance of he price condion tly heteoskedae. Inthe pecond sag of the stl, seer oy der GARCH etna of 19) ane coped, Goodness satis and ignfcance tee sugpest a GARCH(E, 1) rooens lathe thd sage, the suply eqation 3.18) and nGARCH, 1) paces ae “lanes estimated, The entinated pce equation (with standard errs rents i (1 OSLIL ~ 042902 — 0.2012 — O438L4%p, = 162+ my 20) (052) 0078) BH) OR) (L347) y= 1353+ 0.1620}, + 039104 oan (0747 80) 175) ution (2.20) and (3.21) ae wel shed in hat (1) estimate coins ae sincat a conventional slgnfcanee levels (2) all coeficens ofthe eon Tonal variance equation ae postive: and (3) the coetient all nply comegen processes Halt an Aradhyola ssi tht producers use (320) and (3.2) 1 fon thei wie eapcttions, Combining thes exes with (18) yl the ply equation 2761p, — OS21N, ~ A32Spfeed-. + LARTHAICh + 0604 «+ ey (0385) (0348) (1468) O05) KS) A estimated colicin te spicata cooetiona! feels and hve the sopoprite sign An inte nt expectel pie ceases bole tpl eens Uncrate by con variance, acto deste olp This aad ‘orn expectaon formulation rat de wide more tao cobweb ‘mode dicused in Chapter I note to compare the wo foun. Hot and ‘Aryan (1980) a eos an pve exgectatns formulation (se Exes 2 in Chapter 1), Under alptive expectations, price expects ae foaed scoring {0-4 weight aerge ofthe previous period's pce ad he previous pei’ rice expettion: osha i 1 mm se 4-080- Mow he 0 <1 and n-1-)~p.)isthe Ferecast-eno arin fo pei ‘Note that in 3.2} the expected measte of ska viewed By proceso neces the actual conta vance. The estimates of he to mods ier ‘omcerning the implied ng-un elasttesof spp ith espest to exposed price nd contol viriaes” Respatvly de exited lor eats of up ly with respet to epaced price re 0587 an 0.9 in the anal expen fd adaptive expectations fonmalations, Silay catlonal and adapve expecta ios formulations yet Yongzun sappy elastics of condonl vsiance. of 0.00 at ~0.013, respective. Not spiny th alepieexpsttons model sages more slgeish suply reponse than dos the forward looking ration xpettons model a 629) 6. THE ARCH-M MODEL gle Lien and Robins (1987) ented the bic ARCH freon allow the mca of Sequence to depen on its own cone wine, Ths clas of mes called the ARCH in meat (ARCH-M) mode is proud tote aly of ‘set markets. The bse might ita eavere ages mil rere compensation foc holding sky asset Given hata series canbe messed by the a nce of rus, the sk pres wl be an increasing fc the conn ‘arian of retums. gle, Lite, ad Robs express di idea by wring the exces et from holding a sky asset. yee, oa here: = ees tu from bling long ast eatin oa oe-erod ‘res bll 1, risk premio necessary fo induce the savers ago © old the longterm asset rather tha ene: band 16, = unfrecasablesock tthe exces ret the log et set To explain (2.23), note tat the expctd exces eta rom old the ng set mat be jute othe ik pei: Fame Engl, ila Robins asm tha the risk prema is ah inseasing ution ‘fe contoalvariane fe ther wend, he pester the conn variance ‘of retums he greater he compensation tacos t nce the age ool the{4 conerens mooie vanity longterm ast, Mathecatily if is he coon vance of the sk pe mean be expressed m= P+ 8>0 620) whee he ARCHLG proces: ot Saat ‘Asasetequtons (1.2) (20 (2.29 corte he se ARCHEM ote From (23) dh the cod han of depen the coil arene fom (323) thc yssn an ARCH pres soa te pote Sei ie ye soa = ‘RRCEEA mode! desea n nore al ae fans i rein Tig 39 iene to fle ARCHLM pees Pal (fe Re shoys 0 elt fc wee se ented To Ne {Eopwry ces ait ng ec 201090 By ning ey 0, Hea ‘toa varnce wa ont othe nnd ARCH paces: hate 0650) ‘As you can sein Pa (th vlatiity i [ast iat increases in ‘ondtonal variance. Note hat age positive and negative realizations of, et ina lage value of hg ti the square of each Le) reaiation thal enters the » 625) FLQUNE 2.9. Sites ARCH Prosser meantime 145 ontinal vance tp Patel), the ales of al ate sete o 4a “4, ‘especinely. As sh the agus conse sy, == th + ey You ca ‘heey seca is above is tng vl rng the prod of oat Inthe si ‘aon condkiona volts isl to treatin he vale (ln the late potion fhe sample he voli of ()ininses nd eve ich ool sound ther long el) eee he neice of ARCHLM ef by reducing the magi of {an (ee Exes atthe end of this hate Ovi, 30a are nO ‘ARCHEM effects a all. Ax you ea ce by computing the wo lower graph, nove ‘osely mines he sequen when te mage a 5s ciished fa 8 = a oe As in any ARCH or GARCH model, Lagrange multiple tt san be use to det th sens of snl lay, The LM ess areal snp ‘ct sipe they dona requ extination of tefl ml The tse TR symp ‘otal astute sy with degrees of fsa yuo the narrates [Nevetiless. ste mol forthe spend, sre land ero sey ve the mes appropri model f te condo variance, Implementation Using quarter data fom 196001 0198402, ae, Lion and Rain (1987 con sired he excess yell on int easy ill follows, Let, denote qu tel ye ona tcenont easy bill el fr #0 + 1). Reling ve a proceeds alte en of Wo ques an inv ivestng $1 atthe begining of ‘etiod will have (Lr) Fe dollars he sre ion, FR, dees he ‘quel yekon a sich esr il baying boing the on il or ‘he fll wo ques wil sulin (1+ dela. The ese yd yy due oho. Jn th simon i =O RE = Ctra tm) which epprosimstey equ to “The esl fom repesing the exces sik on const a falls, wth the ‘satin pense y= 0142 + 6, 625) 400) ‘Te exces yield of 0.142 percent per quater more than four sana deve tions from zero, Te problem wilh hs estimation method Is ha the pos 1979 ‘tod showed marke higher volatility than he err sample pei oe! for the presence of ARCH ero, the aquired eriduls were weqresaed on a weighted verge of pest sqused residuals an (3.11), The LA test forthe restrition ey = DO yields vale of TH" = 10.1, which asa distebuton with one degree oe om. Atthe percent significance level tho cel value of with obe dice146 curren wooeuma vousrury freedom is 6.635; ees, theres tong evidence of heterskedastciy, Ths there sppearto be ARCH eros aes (3.26) is wsspeeii inva demand {rk premium, ‘The maximum Ukelo! estimates of he ARCH-M model and the sci y= 00241 + 0687, + 19) 619) 1h, = 00023 + 1.64(04e?) + O36 2 + 0242.5 + te 4) (408) 630) “Tae estimated coins imply tine-arying rk pein. The stated pater ofthe ARCH equation of 54 spies tt the unconona varianoe i Inf, Ahough this oubesoe the conden via i Ge. Shocks, tf tereave the condo valance that here are periods of tguiily ad ‘oat, Dering von pero, he isk pretium rest inkevere ges Sek ‘st hate conitonaly les rik. Exercise a the end of fe copter ask outa etal such an ARCH-M mode sing sulted daa, The question wre despned guide you trough 3 typ esti 7. ADDITIONAL PROPERTIES OF GARCH PROCESSES ‘Whesever you etinate a GARCH proses, you wl be xiang theo need equations newt hate oI eddy + Bihar t+ Bebeg™® — 2) whee scan bean ARMA process fader (pg). Moreover, an cnn exoge- “Theft eqition ea model fd mens andthe second yes the mel ofthe ‘vince, "The synbols pang are ued to deote Ha the over ofthe ARMA ces fr the men td no cl he oder of he GARCH(p ) equation. Theo ‘Suton se ete in that I the contol variance f bees, the GARCH roc f 27) eth oonal varie of the ean eqn. Do mt make he Iino of suing it th cool vince tet Given hat y= fh) Follows tha the relationship Between land ei ath, = Hay + aed + dine Fl “Tus is the conta vriaoe of he sequence iia sooo mons oF cancnmcesses 147 [A GARCH(, 1) speciation ithe ost popular fon of conitonalvoai ity. This is espectlly tae fr final das where volalty shocks ve very pet ise As sth, it is worthwhile fo pay speci alten to this form of GARCH Properti of GARCH(1, 1) Error Processes ‘Given he lage numer of GARCH(, 1) models ou nthe Hear itis desible to eablih the properties of his atc spe of enor procs In dong, we i _perealie some ofthe dseussion of ARCH) mode presented in Section 3,1 you take te onda expectation of the GARCH, 1) proces you sould have mo ‘ube vying that im ay yeh + Bibi B= aah auth + Bah 62) ‘The mean of "The unconditional men of ea you ake he expected le 9 827, you dain be Lay") Since doe ot depen om aE iv immeditly flows tht B= 0 The variance of e7 Sinee Hag + cis + Baha) | follows that he unconditional variance of & GARCH(, 1 proes is Bel = Bilas + abel) + BEI) 629) ‘We can simplify this expression f we ocognie ta Ei? = Land Ee = By» ‘Tis secon eats flo rom the hw of Merated expectaons The fom of ie haw we nat gure Ee? = (6, )Inesence,theuncpdiina expectation ft soho warns isthe enor Asso we can a ‘esp one pid and wot ej, (Ea), 30 th Be = Bh). we sobs dhs candi st (3.29) flow at Bel = ay + (2s + NER 630) ‘Thus (3.0) yds the sluon for the unconditional vitae, Ge thy + £1 <0, the enconianalvrane i Fe} = anit ~ a1 ~ 8) For the move yer GARCH(p,4) mol i llows tha th variance wll be finite it Ba~ Saro148 curren ood vou ‘The autocorrelation funtion: Te slocorttions Fr. ae all eta 0 20, Consider gy = E104)! Ah") Sie yt ot depen he value of and By, = 0, follows tha al utocoatons ar 260 for #9. “The conditional vriance: The condos wavaneo theo ros ih, Coser Bau = Beth = he This simple elt is th een etre of GARCH modeling. The contol aan fhe eer process snot Constant. Wi the appropriate pitino the Rms of hie posible to made nd east the codon vance of he Ty proces ‘olay perience: In a GARCH process, the ors ae uncon in that came Siitowener, a sown ia (22 he squared eres of 2 GARCH, 1) rein are erelted, You shoud be bef sow that he degre of atreressve Aecay of te nr esis ( + hs In fk the ACF of he squared estas Gs GARCH(T 1) process ends behav ke ha of an ARMA, 1 proses ngs lcs ah yal ot neease te contol oily bat they do so india way Te espns fone foun snes i the magn ‘aa nce ry gy sosk Ras sabe eet one a, T is tat th pins two GARCHLT, 1) processes were simul ving the deel et of “mb he sequen ah eases, hand 2 were niles and he ‘Shining ves th series wee consid using the eons? ~ v7 art Mods: hy 1+ Ge? + 02h, Model2: y= 1-4 024}, +064 In one to avoid he effec of seleving the specific vals fr the nit! con tina sa 100 reaations were elmited He semaining 250 realization ae ‘nin Figure 10, Given the vale of i Tage v shock has is edit tec Beer Shee Model {sa larger vl of the ele of ths shook is very pro aed a perid (+ Forel, ea nly 0.2 oct peak inthe Uh) The art lange as hoe fo Model I However, since Mode 2s te lrg ‘Sisco ks coninal variance daplays mre atorepresive persistence “sade ta he vl of mtb icy poe, Hep, the nly teen the ACF ofthe une eid of 8 CARCH(L, 1) and th ACF ofthe esas om ARMEA(I gece nt pert Ie = iis possible to writ (2.28) 8 y= 20+ Bilis so hat there no wy the [eset ae the [series Asm tbe model forthe conto! vranc enna be ened. The ansogy eve ess ea in he ‘now gna ease of GARCH(p, process Bolles (1986) roves ta the ACF ‘Pi sje resdualsesing fm a GARCH(p, rows at ike ha of a ‘ARMAlw,p) process wee m= an, 4). This makes Wefan ofthe most soomonat mores or curenmocesees 49 ppp values of pang somewhat life, Question 3 the ed he caper ‘ules you tough a poof tht the ACF of « GARCHG, 1) hs the sae properties {the ACF of a GARCHO, 2) ode Assossing the Fit ‘One ny aes fe egy of GARCH sel ioc fw wl its th dt Satin eh AK SC so nC ‘Mewor se st sottwatepckaes rept hn ate pode t menses fry Ip of GARCH ‘sinalon Howes yosnet obec nepeng ee ets ted ‘olen Engl Neon 198)" tsa papi it ARCH texto ney kon? Cnt i of gare es SSR) wes ‘the goodiness of fit. Since SSR = Te, the sun of the squared residuals actually measures Sure drs oft nde Moree sae = 4) tea ‘hg ARC ey hy pene wa no IARCH mod remember a be oo te sse’= 3 Given hate, = vf" you ean also wie SSR as San “The point is tht SSR isa messueof the gue ers lative tothe ited va sf econ yriane. ine SSR il esl ithe ited vals fe "oso, you can seat the model tha ithe allen! value of SSR Anatee ‘nny lo make the same poise eegnie tei tnd esi in tat ‘heal of sve yt contonal standard ero Hens, SSR messes he su a quae of the stander resale, se180 currens oceans vor Ants goodies it messes spy th maxinized va ofthe Hsia fancton, scanned a more detain Seton you ase tha the err proses ‘Roma the maximized vali ofthe log Method anton can be wien such that 2ink ~~ ¥ tlh) + eh ~ Tham) == Yue) +81 Teen here = mainte vale of the kelood ft Hence, models with age vue of lead to have all values of anor sal ues of SI: Natta Les no inlet for he estimation of ‘Mion parameter However, you cn onsite AIC and SBC sing C= —2Ink +20 SWC = ~2Ink + mincT) whe is defined ove and th number of estimated parameters, As dacused Ji ehaper 2, sme programmes wil pot erga the expression ~T Inn) ino {hocalelaon a the ikelbood funtion when reporting eel selection nite Diagnostic Checks for Model Adequacy 1a ion to providing gon 6, an estinared GARCH mode soul epi al {ymumie spt the modelo te mew he ede of he variance, The exited ‘Rods sl be seialyuncelated al shold ot Silay any rnaning co ‘loli. Youn tex to erste at yur sel as cpa thee rope by ang the es as nated above Simpy vide by hw der obtain Tmestmate of what we hve bee alin tbe (sequence, Since sa 220 mean ‘Sula vraee of you cu nko ==) the sandaized vale fe The ‘lg aenes hich we wlll should ea tean of zr an vane of wit Ith any sei corelation inthe (sequen, he model ofthe mew 01 properly pei To tet he model the mean frm the Lang Box O-statsisFoe fhe Tn) sequence You should no be able eet the al hypothesis that he various (satin se lt “To tat for wnining GARCH ees, form dhe Ljong-Box Osan ofthe quate saris sb (Les?) The basic Hea that sa estimate of er Ven, he oper ofthe sf sequence shuld mine these of there theo remaining GARCH ef you shel no be able to eject the al ype ‘Sr tu the sample yates ofthe Oats are equal to 210, Orie, er is Femningsondtina voli. ‘Once you hive une saisicory mode, you can fret ue vas fy snl its omit! vriane, Moreover, jou can place coniense bunds aroun the rec unin the eis of oriona standard devon, Sie Ey = hat {ostndaddevinon conten inter for you Forecast can be constricted wing Boas * 20h ‘poomowa ROPERS OF cane oocessES T “Tre etn ge eset nee mean och val fe i ee op saleby dese dpe anh psec ef ARCH ars. Hower he sa of ary cone nc snd the floc dee pd ne cotton oa, Ce, cs whe the stl ental cui (shen fe gee vane of he ea rl be age Sirs pc we co ew cna cu seas in pen conn vol hie Forecasting the Conditional Variance “Tre neste fon of condo varie cy obi. we pa ‘by one period, we find Yaka we ape hos 00 ed + Bh Sine nd, ae known in paid Sie! andar kno in pet Ie op ae or spy a + aye Bul Us onl somewtt ore cl on tho bead fae To tei sie ct tof = 50 that y= yey 90m up By yrds soda te contol epi ofeach bh hat Eels = Bead) Sins independ of hyp | flo that = hy oan) We can we C31) to obtain the forecasts of the cantonal variance ofthe CGARCH{I 1) process. Update (3.28) by pends oan Inj aot autiej-1 + Biheors tnd ak he conitonl expectation igs = + a tapas + BiB IF you combine his lationship with (31, itis ey to vey hat Bay = a0 * (e+ BBs 639) {Given hy, can use (3.32) freca alsubsequet values ofthe conn Els fil + (ay +B) + Ca. BIE Ht Cas + BN + Ca + Bh, ay * By < 1th conditional forecasts of, wll eames oe agin vale FH, awit =a ~ 8) ‘Sina, we en forecast the conan variance ofthe ARCH) proces Wyma t ay ta thy aay) we update (3.3) by one pid, we oan182 ourrina wooene vouruny [As entiond sve a pia we ave lf the informtin cess toc cule the vale of ys fr any GARCH process. Now, i we update (3.3) by WO pi and ae the Sondtonl expectation, we aban Biya a9 + thay +t gra Sine ess Mit ows hat Bulga = ant hin, Hot mebgad ‘he pie is tht tis possible bin he /tepahend freon ofthe cond tial vrs rece Ashe alo > oe he foes fh, sho conerse tothe conn ean Be = all = 0) ~~) esol be lett necessary contin for comerpence is forte asf tie inverse coractie equation al ~~ agli ose he nit cle. This inanecesary colton fo fe langran acto hve the epeseatin iV ~ 2a) “Toerare tte variance salva postive we abo rege hat y= Oana, = 0 tlt Yeu shoul have no rouble generalizing these resus to the general GARCH (a) qoces Fotnately, mo sania ova packages can perfor Tes ‘alton stomatal. 8. MAXIMUM-LIKELIHOOD ESTIMATION. OF GARCH MODELS Many sofware pss oti bilson ht etinste GARCH an ARCTEM Dosh such the seach npy ees he one fhe ses a the am pur dus thtest ven if you have esto an aomated route, npr © Cuesta the nant pcos ue y your sft pce Other ecg ‘vie stint inte oof wala gain. Thr etn ex.s {ermmsimem bled mend roe fo andestad abd we « pogan fr CARCI ope det : ‘Suppose tht aloes of daw fom norma dsbatio avng @ mean fo tnd cons vesace Pom standard dation seo the toed ‘ation of \ o-oo) aval ne st otf Siete elton of) ann. he iene ites eyes on lind enc, al ae eae Sei si in alors Hel) suomure neLneonesrMATON or aaRCHtaceLs 153 vs fares 0 work wth samt wih a proc. As sc its coment ‘0 uke the mur og of each sie 50a 1 bin 1 a tne = Zinn) — Tine? Se 639) The procedue ase in mxinan-iteliood estination is 0 sels the dst ‘iol pares a8 © maximize the ieibood of caving he oseved spe Iy ‘Appendix Uf Chapter 2, we consered he ease where te [sequence a8 a [MAC1 proces. Ini example tan suppose ht x peered fo he mod: = Bl 635) nthe cause rprension model, the mean of i sumed to be eo th ii ance isthe eons, nd the varios reaizaions of fe) ae indpendet Using 9 Sample wih observations, we ean substi (.5) inthe lgtkelaad Feton en by G34) ain 0, - ana? G36) Maximising he log fielibod funtion (3.36) wih pet oo an ks 1, ine= Siren a op Sutin thse paral dvatvesequl a 260 a ovine forthe vals of ant (at yet the massa value of nL eats in he fiir OLS estimates of the ‘aviance and (denoted by rand), Hence, Ser 339) 637 od B= Sow De B39) All ofthis shuld be familiar pour snes most economies eased wi repression nays dacosmaxma-likelhon esimation, The point oomph ‘ia het sath Gator coon ae eal sled sine they are al aes, Calling the appropriate suns may’ be tous, butte methodology isso. ‘wad, Unfortnately, his wot he case In extinating an ARCH or GARCH mods tine the fint-olrequnon ae sane send, the solution requtes some sot fof scach alge. ‘The simplest way t ills the ive ist inode an ARCH) ear proces int the eression mel given by (3.35), Contin wo ssne tha the ror en in Tear equation J, ~~ ey Now lee, be ve by am ha154 cunrrena woosine vouury Although he conan vance of is conan, the necessary moe ton of (238 is ka Siow each eliza fea the eonitonl variance he Joa ikl elation ay trou es + HG) Gi) sta eo thao fn tnt Ewan ~03 0h -05 $ way Now suppose tht = )~ Banta th contin vance isthe ARCH proce yy 9, Sobatiting fe Band ,yieks nae) ~ 0.8 3 fag + oe.) we FE lor aria + au? 0) oe hth rl statin taney oie te sam On you suse er Bn) frete pote oman iw peso sem Sa tos ft beee e s a ce ‘enters maxman Fort, compere eo slt he pret vale thanx tin pela dnt notineneser sof pack he prone mete oie ch pga ate mp 9. OTHER MODELS OF CONDITIONAL VARIANCE _ Fail nals ae especialy Ke oon pei exists of he ons since ofan set price. Since GARCH models can forecast conditional volatility, They ae atten the of an suet ve i oling pes Arsh, terete ts be GARCH mt ave en develope tht eee sited coating te cna volar The IGARCH Mode! In final ine sees, he cts oly periet.b fc, fyou estimate a GGARCHA, 1) mode wing lng ine series fcr, yu wl il ha th sum ‘ka and) very che tun, Neon 1950) gud at constaiing a, Btoeal tty any vey pani repesenaton ofthe dsibaon ow ase at Insome respect ths onsale th onion vince oa ike aos with ‘at on Thi inert GARCH (IGARCH) has some very inset popes. From 022) fay +f = Ise onestep aad frcst of the conditns aan Fula = 00 +h, ud the ftp ahead orcas oth Eby omen inoa.s or conomiona nance 186 “Tis, 8c the inte te a he oes of he conditional vain or the next pre th ctr ae ofthe cond variance Moreover, th renee Soa variance icles infinite Neves, Neon (1980) sow ht he ogy teen the ARCH process and an ARIMA proce wth tr pee (ine hat +, = Ia ay ~ Ly we eam wit th condone as by = ag ~ Bois + Lh, an, slving for, y= agit ~ i Bn) Slabs ‘Tas, unlike a ive nasationay proces, the conta vias woot ‘ally decaying Fue ofthe cave al pst elztion ofthe |e) scene, As scan IGARCH mesel can be exited ike ay her GARCH mote Just the mode of te mean can coat explansony vals, the spicton of ‘aso allows fr exogenous vate. Section 4, yO sa expe concen ‘he Great Moderation. lteratively, spose tht you wat to determine whee the ‘erst tks of September 11, 201 nteased the vat of ase rts. One ‘way 0 accompli the task woul be to teste dry variable , eel oO before 1 and xu here. Coser the Following moeation of fe GARCH. 1 y= aot auth * Biko +, 1 ti ou thay > 0, iis posse 10 conch hat the tens tacks ince the mean of he conn vl. Mod with Asymmetry: TARCH and EGARCH ‘An interesting feature of asst pies tha “ba” news eet o have & more p= ‘ounce eet on oli it does “pro” news For mary wks tee si egtv colton between the cuenta he fare olay. Te eae) fo voll to dct when ret se a 1 se when eo fal oe alld the leverage eet. The ieao he leverage fect i cape in Figte 311, where new information” is mesure bythe sino Ir, = expt valli (Eh) isthe distance Oo. Any news increases voli Howeve, te news ipod” i, iff postive), vlityinerenses long ah tenes "bad volt incre. ‘ong Sine sepent a sleeper hana, pve hock wl ae «salle let on voli thanx negative shack ofthe sme magne ‘Gost, gana, and Runkle (1988) sowed ho tallow thefts oF rood dtd news the diferent effects o wl, Ina sen, "sO a eld Soh hat shocks greater dh te treo have ile essa shack Below ‘he tveshld. Coser he hvetolGARCH (TARCH) process y= aa ths + Aahth + Bs186 ciurrens wonsine voLaTy ‘whee ds in dummy variable at seul 9 on if) < a ise 0 2810 ity EO. “he inuton behind dhe TARCH mode sta pose ves of, are aso ste ih 200 ale fd Hence y= Oth eet of any sock on faehy. When; < Odes = ly and the effect of a, shock on fy is (a2 )e1 Hay > 0, mgntive tacks wil hve lager effets on volt than ostve shocks, You can cai reste mm variable and the pod d-6- Irie coeticiencAy is stats ferent fom zr, you can cole that Your dts tna teal eet, “Anse del hat allows fo te syne eet of ews i the exponent ‘GARCH (EGARCH) model One problem wih a sda GARCH model ith ‘ecesry 1 ernie tat lof he ei aetna postive. Neon (1991) Proposed a pifietion tat does nx require nonnegatvty ens, Coser Int) = 90+ aye) + Li V/APS Bilath-y) B40) Equation (3.40) eae the exponential GARCH or EGARCH noel, The are tee inteeting features toni abou the EGARCH mavel |The equation fr the codon vance eo lots on, Regal ofthe magi of nh) the plied vale of eat never be neat ence its permissible orth cocina be negative, 2 Instead of using the vale of the BGARCH model ges the evel of Stardized vale of -» divied by (89). Neon ages that ts standadaton allows or more at nerpetion of the see fan possonce of seks, Aral fe Sandarizd vale of, unt fre mettre 3. The EGARCH model allows fr leverage effets I 5h) 8 itv the elect ofthe sock the og ofthe conn alance pos Fray Aye If y/U Peto the ct of the shock on he fo ofthe contol tance isa A ‘omen onus oF conomowa winance 157 Altioug the EGARCH mode ss some advantages over te TARCH mode is alent feast he conionl vance of an EGARCH noel Forte TARCH Imo it makes senso astne that By, = OS. I ast ret ae syne ‘here i 30;80 chance hat the elie algo wl be poste. Testing for Leverage Effects ‘One way toes for eerge testa the TARCH or BGARCH mal sad eto 1 Fest forthe ul hyped Ay = 0 Hoeven the is speci gate tat lows you to determine weet ae ay overage eet youre Ae osetia an ARCH or GARCH wa, fr he sanded resale n= ait “Tus the (5} Sequence consists ofeach eid ved by its anal devin tion Test Tor vee eet, xmas a egesion ofthe Fh here are no leverage tes, the sured ents shld be cote with the level thc emor ems. Hene, yu an cola thee at veage effets if te a ple value of forth sul ypothesis a, ay =. evceeds the cic ale Dane tom an Fable Engle ant Ng (193) developed second way fo determine wheter postive and negative shocks hve eileen elfecs onthe conitona aac. gai let yy be ‘my ail ths gut 1 iF < O andi equal eos, = 6, The ‘ests to determine whole th estimsted que reds can be pried wing the (4.1) sequence. The Sign Biss est wes the eran equton of the on ot thy + 8 whee i repression resi Waestindens that a satiate fam zero the sgn of th ee ‘et peso shock pln pring the ction! wai To generale fe B= aot ands + atheriny Fas ~ dads te ‘The presence of dy an (1 ~ di designed to determine whither Ae efets of posite and negative shocks asa depo one size You cat ase a atti tox the al hypothesis op ~ 4) = 0.1304 cele tht thee leverage ef, you can etinat specif fom othe TARCH or EGARCH model For ost nancial assets, the dstibton funtion forthe rat of ret is fate 2 fast dstibaton has move weight inthe tl han 4 toemal istbaton Suppose th he rate fret on a parca stock he igh probability faery lage les (sin thn inate bythe nora dst, As sah yo lh want to perfonm a mamu-lkehood esimation using a normal astibtion188 urTen) tooeune voLenUTY FPigue 3.12 compares the standard normal tibtion toa istibaton with ‘ne depie of eed, You can seth the distin places preter teibood ‘lage realizations han does th nooaldsiibaton. As such, many compel packages illo yout estimate & GARCH model wing tation 10. ESTIMATING THE NYSE INTERNATIONAL 100 INDEX _ \Wecan lana he proces of fiting A GARCH model to fami dta by sing the Iogaithnie change inthe NYSE Index of 100 llerstonal Stocks shown Fue 3, You san follow along wsing the series Isbeled INTIOD in the dat se INYSEXLS. The sees cova of the dal cloning valies ofthe nex over the Perio ary 3 200 ough uly 0,208." The series god cand fo be INGARCH proces yo ca cles ee prada in which bet te nly mall hares {nthe seve (och athe 2003-2005 period) al oars where hee a clses of lage seuss and deteass inthe ine Tn Section 4th ai oes the example fhe inert ate spread wa et tna model ofthe mean sad o estimate the appropriate coninal confidence Inerae Her, he melo he mean f ie nres. Asa piesa wo bebe ‘trad walks ora rndom walk ith dit ert, Fo this es, tee ite [noatonl content inthe melo theme. stead ur oa to seul ap ‘ut the bye of the conditional volt, Accurately modeling the condinal ‘asance requires alge numberof cbvervaions, Moreover, sine financial dat re ‘ely svable, GARCH wos of set wie play ue ge datas ‘The Model of the Mean “The fist spin edeting any GACH poses iso etna th mode! of he mean Since the level of ender ister nnsany, we contin he dal et ‘thei a ‘The 2237 observations athe 7 series ve aman vale of 0.0657 a a st le ance of 14512, These 2237 burton re platen Figure 3 while the {isuiban of tho) seen i show ee sod ine in Figure 8.13 Yu canoe ‘ha theitibtion of ret more peaked tan «norm dition, The dashed line in he igure fa r-lstibuton wih tre depee fe, Yu case tha nak eset estimate the [seis sing 4 ction, Most profesional st ‘wae plage can etitate 8 OARCH proces wing dilute You do at eed "ospecty the epee of revo ince can be etimated along wih he heparan tte ofthe model, Since he rlstibatonapprouches the mma the the dere freedom incense late ale fr the depreer-f feedom eat nds that the sees appears to be noma died ‘Altough de autoconeations ofthe (r)sequens ae al vty sll wth sch lage number of observations, several appt obesity spice, Forex ley = 0061 and = —QOS2 Sine "(1880)" = 0.0456, bs of tose or elation respi al he 3 pore evel However, seems folio lve hat ‘Stock etars ate del affected by event ix days in hep A a ses pra ent focus only on hes fg yo form the (sere, you can ely tha te ‘AIC and the SBC select an MAI) model ver at ther law-oder specfaton, Comer the equation over he ete spl eid 0.0067 + «,~ 00613¢,-, aan (028) (-290) Nosce ta it is possible to limite the intesop ems fo the repens since the rts ae vlavety lowe Nevers, thre ae avenfapes To ane ‘ees conalinginterept ems, Aste aie an change ns We pos i ferent models forthe eonditonal Variance, iaerepts wil be nc inthe model oF160 wrens moose vouaruny the mean, Once we he oun eos! appropri GAR repesention oy We far consde sesiating a modal wot an nterep tr. Iya check the ACP of theres al ar sigifcart exept Tr the fat thal py = ~ 005, ‘Testing for GARCH Errors = 0721 + ONT, + OAMSH» + 01885 + OOS, + 0072 5 656) (175 6%) BBS) GAD “The ane stati forse mi hype ht al coset the sed ‘oles se eno eo 40.37, th four dees of feedon he ae Soran! 226 nih nominal (ne esate vous levee sible Sheeran) he pebonive O00. Hence, we can snlae ht thee re Ait qu How acy de he ge ne etna to por he est Te ba asver As carl as psi” as en: Clery, yu donot mt nt lags save ey sal aes ctaing ia a ae ea il vedas he power fh et 3 ag enh Sina yeu coud a ode th peice contol Here oar inte ster at nest, yo tl se GARCH ets ou cons n GARCH cect we psn dt Toke np eae, iyo in GAReH cece no ony ou en ctl he some =o ‘kel Altornative Estimates of the Model As inthe Box-enkns meta, we want estimate a pasimonious model. Not ly ane alr te Ing lng Tor the GARCH, 2) process, we can aso allow for ‘ARCH ees and or speitons with asyrmety. Oe the eInendous ter of posible spesfiaions it very cs) 10 overt the dats, Conse, ‘ta tt witha spl mode al dtemine wheter ornate, 11 falls laf the dagen check, posible touse amore complicated model. We Bein byestmaing (1 sing s GARCH, 1) ene oes. The est fom masinan- Tso estimation ssi neal are 1, = 0050 + e,~ 0052e,-, 230) 204) 4, = 0012 + 00004, +0932, 29m (691) (9808) Instead, if we use ftstbaton, 8 oben 1. 0054 + 6, ~ 0S, 00) (208) 4, = 0010 + 00632, + 19304, 219) (691) 26H whee he ema number of degrees of fetom for the shape ofthe tstrbuon F890, Since th two extn yl sch sla ress and the ested mer ‘of dies of freedom sigh, we wl prosced asauning oxmaiy. Sine the sum ofthe coef one and alte enally equ to unig, we can estimate the IGARCHC, 1) mode 4%) = 0050+ «,~ 00526, AIC ~ 6746.22, SHC = 6714.78 om "C220 4 = 0007 + 00642, + (1 ~ 00604 (299) (79) (11666) ‘The ofthe JGARCH inde! wl tes go that rom tbe GARCHG, 1) ‘moe sinc the ARCH mde apes n const the sino the eaeetei, However, the IGARCH model noe parsimonious thn the OAR 1) me you experiment wih aeatvevalles of pando q int GARCH(p. 4) ota IGARCHp ) mode, you wll that the oer lags te no staal sin ant, Moreover the ARCHLM speifiation sat fv he pest ht {he flu on the return onthe Lesion 10 consis sk prim, For ea le if we ase the CARCH, 1 pian fork, we Hi Wat te moe or the mein i 1,5 0065 + 6, ~ 0052e,-, ~ A013, 9p (229) 052) Diagnostic Checking ‘Now we nest know whee the IGARCH, 1) del asses he various dapos Yieceeks for model aequcy AS al dagosti ate ate performed on the saan ‘aed esd ein by Toeming the sere, = By A Remaining serial correlation: The atoortelations ofthe (4) seves ae al vey small: the Ljang-Box Q(3, QUID), and QUIS) statistics a 2.9, 1090, a 159 reserve Noe ofthese vals sigcat at comentonl levels ence, We cw ‘ae chat the standardized resis seraly uncon, Remaining GARCH effects appears IGARCH( 1) sient capt all of ‘he GARCH ces, The ACF ofthe squared standin ress su ha ee ee B04 00s ats odo cor ~05 -bo0 -027 cdo ds162 cxarens oom ma voueTY ‘Now use the tants quod esas fo esimate a eresson of he ov youu vos ales ou wil i at ane be hgh ssi ace ta ou eet ny sta eal poe eee Senet Metronet esate maesn = 097 —00%E +0032 Je prboaleot ox ind ate esti 2, =~ Ot an Fae of 28 an ro Facey cine hah eno eine GARE ce Leverage effects I doe ar verge ffers,fsoul te uneoreaed with the Topo eel of) However, coms the repression eon 0984 ~ 008-5 ~ 0.16552 634) CLI) 440) “Teco shy aii andthe Fats forthe al hypoth cist creas ne a yee 17 ‘SPhaluc of 00. Given tt the is te negative, ne contd hat nee SR Set rg cs fhe conan rane, Howse, we ned ‘brs th ely esto ew ped Mot sa ams ould ees et marks work qk enough nha ee shoul ote 8 -y a ihctnar con ove Te ss rire y the Enge-Nesien Cea ee sinned ~ Now 300 pon te pk Wises, You wi i = 0937 + 00824, a7) (LD) Since the coctcient of ds insignificant, we should be wary of concating tin et shacks ed nase he sonia variance of 30H a8 the a oof he est, ou wl fist = LOT ~ 04M ay OOP ~ ORAL ~ dian 1392)-039) 45) 276) the inplaton that there a erage fet sch fat postive shocks ae soa wit cine variance, Since (1~ d= ba td, ii ether ofthe leverage eet depends oe mapa ofthe shock (oot st the dro. ‘The Asymmetric Mi [A TARCH ods i unsaisfciory since the eoocient of ey is negative und ‘pnt The sired eqtion fr he coon varias is f= 0020 ~ 000122, + 00104. 1-1 + 0934 (645 COIN 6 104) 104s oot pssite to reestimate the model without the variable ey. Real the gument droning tha rat Be postive for # GARCH(, 1) sa fo be enified. You should be ale 1 show tut He ates reasoning apis (0 the TARCH model Oe possibly sto consi th coticians to be poste, Anat atv eo esimae an EGARCH mel. Cnsor = 01023 ~ 0038. +, (130) 278) Ini = ~0069 + 00826, ~ 0072-/APS| + 0982 nh) 48an, e830) a3) (203.1 Allo he coe ia the equation fr inch) me igly significant Given dhe value off, one-uniinereas in wilinoceseange in th I ofthe conde ‘al varance by 002 une (0092 0172 = O42]. However if fills by one uni the lop of coniona vl actully desis by 0164 units (0092 (6.072 = ~0. 161) The mpiation hat “god ae has alee the on tonal voli than “kad news.” "het plas model seem to be fs IGARCH and EGARCH mod. Not only ows the EGARCH mos cate th leverage tet, I al is daa Bete hat ‘he IGARCH mode The masinized ale of lplelbod fation pero he EGARCH mote! than othe IGARCH model (58673 > — 96811), The AIC and ‘SBC a tet the GARCH mol Ae i check onthe aequy ofthe EGARCHL node te follwing dagnsi checks were pero 1. Checks ofthe standardized resus: The sans residuals wore locked to dteaine whether they exiied nose consaton Simin the ques ofthe sandr esis were checked for sei oneatin.y coneaton nthe [sees pes tat terested ‘GARCH eects inthe reskduals Moreover, the sin bis est on id reveal ay remaining everae ees, 2 Alternative goodaesso1 measures: The valve SR oth GARCH ‘nodes sale ha tat of te BGARCH mel 21835 = 248-7, Hower al of he oer goose ot mesa elt the BGARCH rd ‘The ales AIC and SBC fem te IGARCH mode! 674622 an 67747, ‘respecte The sane values lo tne BGARCH mel AIC = 4705.46 od ‘SBC = 6739.4, Hen the IGARCH pode! seems oe] ois Bet ‘han he EGARCH od the EGARCH mde is br oell i Novels tit cle om oinerpet hese ese ice the sun of srs ot serene between poste and epi enan 3 Normally distributed eros: noe to determin whether the sso ‘aed enoe te nonaly distin, the tes of th (sequence can be Plone agaist tenets fhe normal dsbson Aer aly sw Sundardized soon dstaton, 0 percent sould below 2.54 28 cet ofthe vals sod be tlom = 14, SO pret shoud be neatine, 5 percent oul be above 4 stand eats, a 98.5 percent sha164 currens moceune vou E i si of sda ete te above 254, The point shat Li stay noma dstbte, he fe- len shoul i longa stigh ne wlpotied ogiie i fces te ova non A you can ee Figure 14 exept for some exten ‘craw gently below —3 sandal itons en 20) et dated esiuas do apes tbe normally issued, Nevers 10 ‘Shute he appopatencs of estas, when the EGARCH mol othe {lst estimated sing a stn, he ess ar vey ia tone shown sone Ths estnated utr of degrees of fo (= 1.13) ‘age enough testi lose to a noo sito Figure 1.13 shows the fie vues of fr te peo fom Jansary 3, 2000, ‘wo ly 30, 2008 You ean sce he very lee vale ofthe conionlwaianes ‘ning in ele sngu pero rom miG-208 vo mi-2006, ad ineetes in toward deed ofthe ape a wis hdl ‘suman ce 165 11, MULTIVARIATE GARCH IF you havea dnt et with seer vaibls, often makes sense 16 eae the E09 lol volte of he varblessimultapousy. Malvarte GARCH deste ‘nse ofthe fet tht he onteriporente seks to variables en be orate itech otc: Moreover, ultvariate GARCH modes allow for oat spies India wat sbocks tone vale might te wali of her elated vas tes, For esampl instead of ply endl the NYSE Unto 10, sppone that we als wate to model te NYSE Compose Inds. Although we could ep aly model he variance ofeach inde, we might expe he voli of the to Serie oe intersted Afr sock tht nerve the cea of ne ind ae Tikey wo incease the ance ofthe ote (you are comfortable with wat ‘lgeia, you may Want look a the st pa ofthe appends otis ape etre proceeding) To kep the analysis as simple spose, suppose ete te ase via, Sideroiy te to er proceses ft shea) ‘Asin heaves if we ane v4) = vet) = we can think of ‘nah the cnetionl variances of ey a 9 respectively. Since we want © ‘low forthe post thatthe socks are corel, denote a8 te coins ovarian tween theo shocks. Spillet = By ‘Arua way 0 const a multvarste GARCH(, 1) process alow all of ‘he sali tem 1 nrat wih each ex Consider ihe balled ye ode =e then + aatnastani + ethes Bhs + Beshaes* Brn en Iar= Get ani + arty + eth $F Bahsies + Behn + Baan as) tau = 6 ani + anette © Balint ® Bashons + Baa oan Hare, the condom vane ofeach abe (and) depends its ovn te contin conan baween the wa arise (ha) the lagged squared for ei at ea the podt of lgged err (eye) Nob a the ‘onions sovaince depen on these se of variables, Cleary hee i eh Interaction berwee te viable, For example fe one peed, Sock aes iin a ae ‘Although simple wo conceptualize, nulivaiate GARCH models inthe form of (0.42) (.44) ean be very dif etimae Noice: 1 The numberof paramere necessary to estimate can ge quite le athe 2valable case above, tae ae 21 peers The umber os ety {UEy as mre vcs we aed th ger ad the order of the166 cnerens wooeune voAnun GARCH proces nese If 900 vest ent af he ait tod store yo shuld ee toshow tt ARCH 1) ode cases smal fie ao pnt You an 0 {Sin th were cn CARH) moe conta Te Sais har we capt fr hn A te ead entra te eqn ena te ctinaion ot (2 eaetioen Pecos More e fave not begun spel he modes of ie ea. ne tase avs jar pose ocr He mean ec neat als sr Once aggd vale oy (rer teary vac olde mean eqn, ‘Bh bese tte ccmatn pole canbe gate cmp shoot unis cs te isnt aaa solution he mini ‘atrbiam Asst eects oe mer mend fd he tr tat anim ti cen, Unorat ch ne nse el to ida matin vale he motel oerpae Cee aman ita ccetfc somal aera err ret Ty alge condece ern Avoca ge an eee acca mye gh cng nh coaticen's in heey onthe whe Te eel al Sinbig eae tt compte ae ni soon rales Saint dite ping do te wir af ich cox Hence, ETiSning Seat an overated nfl ype ora ‘Shere melag winfet thruch grin i ot comer Stor cna vines nese postive, te ects or be ‘hvac cme we frre comple un fortis, The srltra hc maaiieion ot mt be sch cry on of EELS atta ey poste un at te tps coven sence gy hy ieee wenn and Inowertoceamvet hse relans, mich of te eet wok ioving mal saat CARCH motelng ole Teng stable reson one eer me Tr Guth, Oreo oles ha became poplar he ety erates sei anton sech ote Te Weis guise ye ah ha iy ‘Sto oy a of el thee ret of ee Fo exalt ago fender of a2)". hv = ew authes + Bubs hha = omits + Baines t= ation + Bhs Given te age none of estos, he le ately eto eine x dea Sane cote te Dat venaiate GARCH pts at cna ovate utente nel Te polenta sg al = pre Oto 2) mews tale ooo terctons Song the Yianse AN Frcs ie amok aera oy oe tf anna varnce tauuranare cone 167 ‘Notice that the yew estimation does have the advantage of controling foe the easenpaancoat corelation of he estas urs equations "Engle sd Kroner (1995) poplaied wha is now called te BEK (or BEKK.) ‘mode tht nue ht the cna vranes ae polve. The Hea so force all the amees to ee he model via quate forms esi ht lhe varianes ‘Me ponte, hough thre ae sever deen vars of te model, oer the specication where forthe 2a case conden in (3.42) ~C., es an) Uns atke= [es cuke-[ty teke= Es pa ny = (4st eb + Calitics + 2arereucyens tele $F Bidhes © Baath e+ Bish In general wil dpe on the gue rida, ros prods othe ei ul, andthe endtnalvrances al eovariaees fal variables ne yt, As ‘ch the mode allows for shocks to te vince of one ofthe variables to“ ‘verte thers. The problem eh the BEX formulation ean be qui iio ‘stint, The med hs age nuns of pares dat ae a plot iene. Changing the signs ofl elements 4, B oF C wl lave no eet on the vale of ts lito fupeton. As seh, emergence can equi difclw achieve. ‘Another popular sulvarste GARCH specication is constant condo ‘correlation model. As the ne suggests he constant corel oes (CCC) rol rests the conclation cof abe const, A sch, fr ech jhe {CCC model ssumes hy = phy) aa sense, he CC mol x eompromine in thar the vsance temas ned nt be diagonal, hut the eovaince fers We alas proportional (hug For example, COC rnd sould consist of (342), Gad, and hay ™ oan)? ence, th covariance equation ens ony one parameter insend othe sven parameters apeaing in 43) Telerler (190) sites the usefulness of tbe CCC spain by ean ing the weekly valves of th nominal exchange ates for five dere cous —the ‘German ark (OM) he Peach ane (FF the alia (IL), the Sis fre (SF), andthe Bets pou (BP)—rlaive the US, dolla Note that ve-eqtion ‘em would be oo unwieldy we esti nan anes frm, For the malo he ‘ei, he logo each exchange rat series we modsled a «don walk ps i. ys the preege change inthe nomial exchange a fo cou te ode ofthe mean foreach oun is imply y= mete eas)_Liene-Bo ets infeed each sere of esas dd contain any ei ee rsa Thins consistent wth the general foding tt when wing hghtequeney {i nominal exeiange rates teave an andor wa procescs, AS a teat MD Pollet (1989 ested the uted esd for serial dependence. He ep tha the stoconsiens of te squmed reside ae stonglyindicave of GARCHL Mfc, For example, forthe Bish poun, the QC20)-saistie as a vale of {rN tis siniicat 8 ny eoneional evel Given the presence of cond bona! Reerstedastity, Belly ext to Tindng te appropriate odes fr fhe Ive GARCHp,g) proves tidal, ea resid series could Be wel ‘Mhmatad tsa GARCHLIy1 posse, Ax och the pecifiion for he fall mods Ts the form of 45) pus ig = 6m + aathes + Bates =e one8) ag = pbc) wen ‘Novice hath fll mod suresh oly 30 paueters be extn (ive wa eso the ive equation fo yeah ve tes paracters,and eves of the Ja) He Seon hat ith 33 observations te requ number of mat versions i fed am 10393 o 31 Alene th the CCC mode has an porta aan tiger th separate extinaton of each xin. As in a secringly mld eres ‘Nn amevor th sytem wide ean provide bythe CCC model apares he ‘Sttcrpormenas coreltion been the ows eos. Ase, he cece ‘Shier of me GARCH proces re moe eflet tan those fom a eof snc ‘tdon cuimatons. The estimated corto fr the period Grog which the ropes Money System (EMS) preva pM Rk osm, T0886 0876 Sw 0917 0865 0816 BP 0674 O67 05220615 tis intresting fat conelton among continental European curses wer al far cate than hse forthe pou Moveover, the coreltons were such grees the tone of he re ENS prio, Cleary, EMS ace Yo gp the exchange rates of (Cera, Enel and Switzer thy ine pior we the inion of he Ba, yo ae fie with max lpr, the spat of Append 2.1 sows you aw ts peeralie Bless 0a 1 estinate cme-vrying (or si) cotton cotelatins Updating the Study ‘The fleabeled EXRATES(DAILY).XLS contains the 242 daly ales ofthe eu, Patsh ound and Sis tane over te Ja. 3, 200-Dee, 28, 2008 ered. Denote the U.S. dalle ale ofeach of hese nominal exchange aes as wee f= EU, BP, ‘tnd SW.If you plot the he cree, you wile ht al goer el ding the ary oto of th spl one Between mi 200 hough 2008, nfl shay ib 5006 "As prelinnaty sep, conact The logrtmie change of each nial ‘exchange it 3, = logy yA ay GARCH estimation the fist sep so ‘opeiy ena head of the en, I youfllow Bole (850) andesite yun inte form of G45), you should oan the means a se bP sr lao! 41s 1S 13610" Aug the residual atocneains ae all very sale mage few are tla sane. Fo example, the autoorlations fo the eur ase p See fas door Cdr ants ab. ~b36 ‘ih 7 = 2302, the vl ofp is sail signet and the value ofthe ‘jong Box QU) sate 12.7, Neveteless, most researc would ot ate {mode his smal ale ofthe fourth lag, Mrever, the SBC always selects odes with o lgged changes the men equation, othe ssond sp, you wuld check the squared residuals forthe presence of GARCH errs Since moe wing ily dt with five-day wee) Ses eon shleto begin sing a ode! of he for at Zaihs ‘The sample values of the Fstaistice for the null hypotesis tht tg = Cave 43.365, 89.74, and 2096 forthe ero, Bat SW espee= {ely Sino alo ewe values ie highly signin ts posbleto contd hat all the sre exhibit GARCH eons Tow the thi ep, yu shoul ryt fd the proper foam ofthe GARCH made foreach exchange rte series Aliough sme oer GARCH foes (sch a the IGARCH mrs) ight seem more aropate than Boles speciation, po ‘eed a ithe GARCHKI- 1) ode i appeopit foreach series, Ifyou estimate the thee series ox GARCHC, 1) process unin the COC resto you should ie the res ep in Table 3.1 7 = ea) Te) R901 an ane aon tan ane)1170 coverens woneuvsvOLATUY a a hee a2) un iarnaayt2t)18D ee) foam) on2 fo) ttoes) na ee wes) can) __@ansey tmz ese cancae) Ie welt the murs, 2, and 3 represent the er, pound and fae the come aon re pa OT ps ~ 0.92 pay = 06S. Asin Boles paper, he pound ‘nde fan soni ave te lowest colton coef ‘By way of consti incinerate the model sing te dagonl ech specication such tha each varanoe and covariance is estimated separately. The ‘Stimaton rests ae give in Table 32. Now, thecal cetcents ave ine “taplng, For example te sorltoncoefet fete the pound andthe rane ives by hy Una), The te pth of this colton colicin is shown in Frpue 3.16 Although the corelaton docs seem fo cae sud 0.64 (ihe vale found bythe COC method), thee are sobsanal departs om this average vale Begining in mit-200, ie colton betwee fe pound and he rane beg fone finda dclne ening in Match of 2008, The elation increas with es of 3 U.S recension and then starply fell with he onset on the U.S. nancial ris inthe fa of 2008 12, SUMMARY AND CONCLUSIONS: Many ecoomic ie wes ea perf wey: Coco ski mdse {ARC CARCI slo i no wn 1 rey ane tei onion aace vese! pera Fr stte poss. bce! tase wl sya ae summa anpconcucowe 17 eau dea ot lone (non) vals, Ax ah, ARCH ad GARCH ed ‘Shean cape ped tne nl ang. ‘2 isk vee coon! ple vay wl fest pot spl. Pes ny rae ‘eg by who po ns Sindy te Ia of sr ARCHA ae tal inpetoe f wt pg ode he mac ARCH and GARCH rn hve fen exec + me fers ‘he hveesing develo i he posi of GARCH odes «mote sig ns ae wit ati CAH hy pa [RATS ae able wus Engle and Krone’ (195) met and Bolles’ (1990) const con inean suaton wil sry oe ine ee gaan, Cer he ited (a) ‘i ys nts aso oe 2s ery easy “veri” teats you el wind p with vey copied ‘nm nen roe pre mal cy ep tr te a {Emin ces Pres he gd ese fore presence of ARCH er Sider spt toe evengs tes ARCH tp ales fps or 9 ito pb eh {every common ind hte sa fh hs be i yc oy. Sch gy erin wie dot thee for eel overs Hie) owed as ese sera weak he sla ‘erect aia hy ite oon iy Ne is he soon! dtiily pian However sacha chon st ty ory my ia ing he ‘sth nd ow velit, Marts a shown by Ma Neon an Seats he eit sa of ‘Ganchcntientcan io cle unt hen te te GARCH ets ey Sealer ea To xpi spose you sia CARCI, 1) 0 tater y= Lt be et el of ial slay ext 0 real th ue, Hower hi gp sn he acta gene roc isa sartOARCH pes or bce he ae lv ‘tay coat (oat = hy =o Be prety ene tot Bs fete far ml a cya pa "ican ope th GARCH mal lonanr ARCH) re sho172 courrena woosune vou’ Hosa nea hau of Co wy arly gue stl 4. Munutnte GARCH me can gue dificl exnae, Te we amber ater esteem ha cre bent pesiens he gps vck ‘ole citron ate tal inc nd oan BE spent The COC mos re BCE mse ‘Sores opp con Be sec pin ng se, QUESTIONS AND EXERCISES 1. Sapna be seapence te ARCH oes em vlan Hath as eg Sho he coil expo a has these fxm te cnton scan of 2 Cams the ARCHEM nl mosey uations (3.28) 2), Real hat ie banc sey et B= Bay = 1nd te nfo jan How oes angen 8 ale ean Uso ‘teesenpe ot Stn show at chain 8 8 om (4 ).0(~ 1,1) mcr the emt women. 1. Show ht he coo sae of when = ag + aye. does pent onfB.orue {lente (380 pos ha he ACF of te sure esi eagle ‘ARCA p 9 pees y (9) at an ARMA oS WEE fon uae tr hi ea ig texas Bln 10 Con he GARCHK.2) pres b= m9 + 8 + Bien Aa may meh ath Ali 8 Em) + (ay Beh an ~ Bes hed + EH Det = C= fh HB my ay Bile tae Bans {The eure aac a ARMA, ee 1 ome GARE, 1 pet = my + Bs + Ba» Sh + sa Bales Stow tat sing a abicing he es -s a 0 iid ‘as gen yr an ARMA. 2) races Prot minnie hee Lage ap ‘Ganson ernie spt CARCHp 9) ace” fuesnionsanoeeases 173 ingen ARCH) prs epee y (9) ce a an ARMA) roost m= ma 4, Lay = sane he ea i aon he) soe 1,1, =2, 1D Oya te ns 1 How dis he ARCHLM spss foe eto he sus ‘Whistance a be sabres n Mode 3 bh Forenshof he nor acacia snl met ad arin oy) 5 Thee ed ARCHXLS oni the 10 etn of the oat yee ilps teow nl nel Pp. Rol taste ny +e we the ARCH) ee pes = ih Oe) (ssi) hc hing ar hn ping he sil ale fF ‘plnaono why prt sta coelen abe (ste meh shit he Ste ey poe tsa sages Ohi be ACF an te PAC of te ale, Us Langton Qi we (04) = 231,009 = 638,00) = a. | Ofmin th ACF an be PACE of sare resin Yo shal ft tence = 280 anh 02 baie tec en of 000000, :174 cuerens sooeune voureY 1 Singhaousy xine he sequel te ARCH) ee proses sng am ay 46 Theos seine le ARCHLALS cine 10 eens of sled ‘Ente sence igh Boxes met. mn ay an (260 | lamin the ACP and Sh PAC the das fo th MAIS, 6) m0 sore ‘wip mis sooo coca et hepa fe wen? Now ‘ain te ACT PACE a the gu est Yow ee ier owe wast gas aN 00m ante PACr__0ap8 ond 0317 _—00KK -0041 O01 Falah gece a te ARCH-M pes = 09 + 428 +m 1809) (129 = 0108 +0597 2 339) @50) | Cesk ACE and th PACK of ene septs. Do appearo be 1 Conse ARCH) prs B= ao * 8s + 8» 1 Sipe che ein came ra he od ay 4 * 6 Fe con Tee ad wc vara yn eso pret ayaa 1 Sopne ht yan ARCH pps act at vet pose ‘a coin rns, or ens = ey heh say Tce ate inp gm tin 7) ane Se. YOU ti iso ht the pom seen nan aur =O) Lays newer pit bo pai ftowing re A saat es te AG} pte sl und there wee Ascend et iu ese ser rte ARCH M pce ay ey tant He ‘hy mith messy mae! Nw would ou ds hi i oxcsnonsanoeences 175 ‘Spin nexmen mi penetra Rewirh eater (Girt testa aes onesies hay = (Gh) + tacos + 2ayety- seven Nt inn + 2B + Bad {eal fees epost IF eel 0 Paps tances acy years # abies be eee 4 Supese is py = Dad y= 4. he COC mt ai 9 Char 1 of Progr Mana a sop iste coi ceca ‘fuente sara niet satin ou he tt ey Soe donb man fe Wey Wes Al dod date [MONEVDEMALS an! th propane Rogan teh see pea at Ihr oAs ina in he Perma ama ete thee ah ARC) rors eu tui i 4. OOIT6 + 080 = 028Io 3 4 625. Sow ate es pth tna ago ess lola = aot + 021, ~ ound + 01602 5 Deke ae of ih aon ‘Baie wren a an ARC) proce wih ARCH) eo. Assonwn n Prorat th send = ARMA, 1) se ih ‘GARCHIL, 1)eno. Sh at mode! peo a Pr176 curren woouune vane ENDNOTES _ 1 Soe gp ei ci rs em 2 le) pp te nope Le a er in te a = dyer Ali Tovsa Sts ep eae wi atc ta baa (4 se a CARON pty ia rte) = atl “Sty pnantenn np" Oler DH)» + Cy elm mii di ti a ai ‘in aa a0 Ap model how me Siri tc hth en ea ae on re em ea ye es be i te eee a Sy hg 9 ema ‘nue a tn Guin i evi he a a "ows tape a eo er te ner ety we ‘=i nrg rk Se 0 amy es APPENDIX 3.1: MULTIVARIATE GARCH MODELS. The Log-Likelihood Function 1 the sulivariate ese, the kethond fanton presented in Seton & aes tbe toed, Forte 2b cae suppose hata ero mean atom a "he that te oly aonaly dite, Forte time Being, we con Keep the aay ‘is snp we aime the vislances an the covariance es are ont As seh, ‘ve cand te time bers on the hy In such cca che fogUheliood Fanetion for teint eration of st ys savimeremse F aacap (ie ie Gras) ea here the eration coin between a a pa = dal Now if we define te marc H ch ha tn ha wf] prreronanauumanit atotucors 77 ‘he likeibod fanton can be writen nthe compet fm L's] wa = tree Beer whee, = (ey sand the detent of To sg tha he epee tons given by (A) and (A32 ae euler a = cas See ‘ng = lh fll that = CL (a Mes Moree, on 2eutuha + ehh Ths Ha Since fy = lh) fllons that : fe ae sy = [tae (Aha sh trae) = FO ha” Gahan) Sine the ealzatons f(s) ae conditionslly depend, the condition ks ino ofthe joint walizations of ey. == er he peeduet inthe invidn Tikelinods. Hence, ial ave the sme varios the conan elton ofthe jolt realizations same deur] es fr easier to rk with a sa than with produc. As seh its eomvenint ‘0 ake the rata log of each sides 1 ban 2% ‘The rocedute used in manimumisibood estimation so sles the isn inal parameters 0a 0 maximize the ikliond of dawing te served sample Given the elton in is posible eet By yy nd hs an For our purpose, We wa allow the valves of hy 1 be time-varying. you worked tv Seton 8, it sould be eeu owt may this esti i hs an hare tine varying Cons r 1 n= Livan) — Tiny, where Now, if we take the log the liked anton, ne = —Zncam) ~ Seen + eaten ay 2‘The cmenione of wring with (A82) and (A3.3) tate form of he ke ‘ino anton x Kota for model wi yas a sch cheurstanes, 8 sym kk rat, ef X U conn veo, he costa en (29) ‘sed othe power ‘Multivariate GARCH Specifications. Given the lgikeibood fenton even by (A33), i is acessty to spit he functional forms foreach of thee The most familiar specications ate given elon 1. The veo Model The veh apertr transforms the wpe ower angle ‘ots aymmce mati it olan vector Consider te syne wt) Ih sd ehh) hin ha Now conse the vector = fey al The pode ley ray ie 2 mac Hence, vee) = (ee rity #1 Ihe nowt C = eye Ate 3% Sma wih eens yaad 8 te 3% 3 marc with ‘ements By we en write ett) = C+ A vecte6-1) + Bech) you are fie wih atric operations it sould be lea at hi it pres the ptr eset by (842)-(4), The diagonal vec wes iy the igor element of 4a natal als fey = By = 0 feet #3. 2 The BEK Model: In sytem with karin, the BEK specication tas the fon My CCH AeA BH where Aan fare kmties, However, C mt be wayne & oni inode to eae ta th tropa he ff lagna ements hy Ine Ketel As sagged the x for the 2-arible ese, ny rt N+ Cahir + Rayeaiey-itora + abd ¥ Bidhics + 2BuBsdha-s + Bboy) peroon an Munim carorncons 17 Jy = een + 62) + ately + Cas + ys ayaa + Buch + Bubs * BeBe * Bassa Ira = (Ga + hd + (alot + Daz ttr + obs) + Bishinas + 281s + Baha) 3 Constant Contanal Correlations: The OCC fortion lst special ease ofthe more gener mulivaite GARCH sue Ine aisle cae, we can wie He =[oaatitys xy Pathan" hr [Noi al ate bth GARCHC, 1 processes these a seven Prete eis (he ix aes cy ya yp). Dynamic Coniional Correlations: Engle (202) showed owt gene: ize the CCC we! 5 tha he eomeations vary over tine Instead of ex ‘aig al he parameter simultaneously he Dearie Conditions Corelaion DCC) model ues 2 wo tp exination proces. Te fis sep isto use Boleses CCC modelo aan the GARCH estates othe Vavianes a he starred. Not th the sanded esd ky ~ fly ar exits ofthe. The secon Sp use he wanda inc esis estate the cpditonal coves. Specialy. nthe Seon sep Jou cet he comeains by smoothing the sere of anda ized sida aise fr the step. Hngle examine seer st Ing methods The simple isthe exponential monte y= (1A) jes ford Hence, each [gg Series ian exponntaly weighted ‘moving average ofthe cos podacs ofthe salaried esta The yn coional colts a cea rm egy 8 Pav = ala)? ay Engl shows that ao tp procedure yield conien eit of ‘he ime-varying coeaion courts However, tbe etn ot efficient ethos fon one sep pocedes och a he BEX nd egal ‘ech model Rsteting he eefiet ont equal (Ua Aes athe gy converge the wonton covariant, An aleratve soothing Fantini esate dy = (1 ~~ By 4 aes + By meri the uconioa covaiance betwen ya spb xi telbood estination Pag the estimated seins fam the fst step (onthe CCC mode) ine thei faeton at ‘oly and ect be enti, thse af yu wasting oral prof thatthe two-epprosedie feasible, you shoal be abe convince youl that ts posable owe 1, = RD,where By = te igonal mis with (onthe digonas ad she tui ef tie-aryingcomsations. Ts follows fom the deiiton of Covsation oailent consis of the eee p= (hhh Bor ampli he 2vaible cae is ay 0 vel y= DAD, oF (Oy WD) see we (O g) Ce ICE ag)” ( d a) ded u Now wit the iketinod fancon(A33) by substing BD, oH: 1S npn) + «(kD 4, tnt-= Zinc) = Dicom — LS eam) + tle + 24@9"'69 (A Favan ~ $3 nin + + eiRo“'e) 03.5 Nie ta Dan ae the ko separately aa th represent the squared tana resins. The final sep 10 ad and ‘stat the sr of fe seared standdizedvesduals 0 (AS39619 ‘event the anand resid y the suo he uae standized Feil ott aan poset show at = «1D, "Dy Ye Po SS nos, mae come AVE A “Tus, we can wit the Hiei! anton 3s “The poi ofthe exerci st sh th teste procul i appro vie Nove Da yer the ution spate, A seh te prune feof he no mates canbe xine. You can we he CCC ‘nal oes rete of Ds canbe de wot ay no ‘ge ofthe vals of Use hn exten ent he aloes Dy and the sendndna hal Plog fee volo it the ito funciona then sel th opi valves of Inesence, nthe ist ape, you manne =! Scam + aor) nn the econ age yo maiming £3 nie + 94", rd MODELS WITH TREND Inspection ofthe auoconlation fection serves a ough indctor of whether @ tend is preset in sees A slomly denying ACF ini of le characte ise moa tu it oo proses, Fw Wend tionary proces oral esc lp serine whtbe syste contin te and whee th nd densi oe Stochastic, However, the existing tess have ify disingushing, between eri ot al ui ot processes Thi hapless 1. Formlize simple mals of waables with ime dependent me, Ate ‘canbe completly detente or may contain soci component is ‘sei wo ropery med th re if yo ita fo do sy hypotiess testing tna tom frcating 2. Develop and ills te Dickey-Fullerand agent ickey-Plle fests forthe presence of uit root. Several vias of te test me pres, ineluing a es fr seasonal wait rns. nore devenp fe tt sacs iis pecesny to undestin the ate of Monte Cal xpi, Consider ests for ui root the presen of stata hung, Sit fang ean complicate the tet for tends «policy resect can ‘ul inastrctrl break hat makes an heise staonsy sees apes ‘oe tations 44 rate the lick of power f te standard Dicey ule es Unit ot tess ar sesite othe presence of daterinisc preston, su Inerep term oa determine tine to. The wo cle Genelaed ‘Lean Saute (GLS)detrening moods can eaance he power a he Dicke-uller tess, Panel nitro ests aslo he go power. [5 Decompose asees witha edn its sonaty ad tend empress. Sever metoologes hat can be used o decompose a rere it ie tempor and permanent eomponuas ae presented 1. DETERMINISTIC AND STOCHASTIC TRENDS 11 plo represent the genera sluion lina sachasticiferene equation 2 coniting of thse thee distin pars 21> tend + stationary component + nose Caper 2cxplietow o model te lions component sing the Box-Bekins mehndosy. Chater showed you how mde! the variance ote eno ie me) 181