Economics 350 Professor Tim Bollerslev

Spring 2011 Duke University

ARCH and GARCH Models

Advanced Information on the Bank of Sweden Prize in Economic Sciences to

Robert F. Engle in Memory of Alfred Nobel, October 8, 2003. Available at:
http://www.nobel.se/economics/laureates/2003/ecoadv.pdf

Andersen, T.G., T. Bollerslev, P. Christoffersen and F.X. Diebold (2006),

"Volatility and Correlation Forecasting," in Handbook of Economic Forecasting,
(eds. G. Elliott, A. Timmermann, and C.W.J. Granger). Amsterdam: North-
Holland.

Andersen, T.G., T. Bollerslev, P. Christoffersen and F.X. Diebold (201?).

Volatility and Correlation: Practical Methods for Financial Applications. In
progress.

Bollerslev, T., R.Y. Chou, and K.F. Kroner (1992), "ARCH Modeling in Finance:
A Review of the Theory and Empirical Evidence," Journal of Econometrics,
Vol.52, p.5-59.

Bollerslev, T., R.F. Engle, and D.B. Nelson (1994), "ARCH Models," in
Handbook of Econometrics, Vol.IV, (eds. R.F. Engle and D. McFadden).
Amsterdam: North-Holland.

Engle, R.F. (2004), "Risk and Volatility: Econometric Models and Financial
Practice," American Economic Review, Vol.94, p.405-420.
 ARCH and GARCH Models

C Basic structures and properties

C The ARCH(q) and GARCH(p,q) models
C GARCH(1,1) variance prediction
C ARMA representation in squares
C Maximum likelihood estimation and testing

C Variations on the basic GARCH model

C Asymmetric response and the leverage effect
C ARCH-M and time-varying risk premia
C Fat-tailed conditional densities
C Integrated volatility
C Long-memory
C Component GARCH
C Regime switching
C Other univariate GARCH models

C Multivariate GARCH models

C Vech and Diagonal GARCH
C Factor GARCH models
C Constant conditional correlation models
C Dynamic conditional correlation models
C Asymmetries in correlations
C Copulas
C Structural GARCH
 Basic Structure and Properties

C Standard time series models:

– ARMA(p,q) model:

– Conditional mean: varies with Ωt-1

– Conditional variance: constant

– k-step-ahead forecasts: generally depends non-trivially on Ωt-1

– k-step-ahead forecast error variance: depends only on k, not Ωt-1

– Unconditional mean: constant

– Unconditional variance: constant

C AutoRegressive Conditional Heteroskedasticity - ARCH
Engle (1982, Econometrica)

– Conditional mean: varies with Ωt-1

– Conditional variance: varies with Ωt-1

– k-step-ahead forecasts: generally depends on Ωt-1

– k-step-ahead forecast error variance: generally depends on Ωt-1

– Unconditional mean: constant

– Unconditional variance: constant

C How to parameterize ?

C ARCH(q) process:

C AR(1)-ARCH(1) process:

– Conditional mean:

– Conditional variance:

– Unconditional mean:

– Unconditional variance:
C Why ARCH(q)?

– Past residuals:

– Historical sample variance as of time t:

– Only q most recent observations:

– More weight to most recent observations:

– ARCH(q):

– Large q and too many “alpha’s”. What to do?

C Generalized ARCH, or GARCH
Bollerslev (1986, J. of Econometrics)

C GARCH(p,q) process:

C The simple GARCH(1,1) model often works very well:

– Conditional variance positively serially correlated

– Volatility clustering in financial markets

C Homoskedastic and normal GARCH(1,1) confidence bands for
AR(4) quarterly U.S. inflation rate forecasts:

Bollerslev (1986, Journal of Econometrics)

 Variance Prediction

C Future (predicted) variances depend (non-trivially) on Ωt

– GARCH(1,1):

– 1-step-ahead predictions:

– k-step-ahead predictions:

– Long-run predictions:
C GARCH(1,1) forecasts of Dow Jones Industrial Average:

Engle and Patton (2001, Quantitative Finance)

C k-period returns:

C k-period return variance:

C Dow Jones Industrial Average:

Engle and Patton (2001, Quantitative Finance)

C Scaling:

– Easy to calculate

– Correct on average

– Exaggerates volatility-of-volatility

C Simulated GARCH(1,1):

Diebold, Schuerman, Hickman and Inoue (1998, Risk)

Diebold, Schuerman, Hickman and Inoue (1998, Risk)
 ARMA Representation in Squares

C ARCH(1) implies an AR(1) representation for :

C GARCH(1,1) implies an ARMA(1,1) representation for :

C Important result - is a noisy indicator for :

 GARCH(1,1) Realization

10
8

6
4

0
-2

-4

-6

-8
-10

0 100 200 300 400 500

Time

Conditional Variance

40

35

30

25

20

15

10

0
0 100 200 300 400 500
Time

Squared GARCH(1,1) Realization

120

100

80

60

40

20

0
0 100 200 300 400 500
Time
 Maximum Likelihood Estimation and Testing

C Conditional normal GARCH process:

C Conditional densities:

C Prediction error decomposition:

C Log-likelihood function:
C Non-linear function in θ

– Numerical optimization techniques

C Testing and model diagnostics

– Likelihood ratio test:

– Autocorrelations of standardized residuals:

C Many different software packages available

– EViews
C Daily S&P500 returns:

C Autocorrelations:
C GARCH(1,1) estimates:

C Residual Diagnostics:
C GARCH(1,1) forecasts:
C Higher order GARCH models:
 Asymmetric Response and the Leverage Effect

C Standard GARCH model:

– Volatility respond symmetrically to past returns

C News impact curve:

Engle and Ng (1993, Journal of Finance)

C Asymmetric response I - GJR or TGARCH models:

Glosten, Jagannathan and Runkle (1993, Journal of Finance)

Zakoian (1994, Journal of Economic Dynamics and Control)

– Positive return (good news): α

– Negative return (bad news): α + γ

C Empirically: γ > 0

– “Leverage” effect
C Asymmetric response II - EGARCH model:

Nelson (1991, Econometrica)

– Like a GARCH model in logs

– Log specification ensures positivity of the variance

– Complicates forecasts of ht+k

– Volatility driven by both size and sign of shocks

– “Leverage” effect when γ < 0

C Daily SP500 returns:
 ARCH-M and Time-Varying Risk Premia

Engle, Lilien and Robins (1997, Econometrica)

C GARCH-in-Mean, or GARCH-M, model:

– Information matrix not block-diagonal

– Risk-return tradeoff

– Time-varying risk premium

– Other functional forms: δ @ f(ht)

C Daily SP500 returns:
 Fat-tailed Conditional Densities

C Standard GARCH models assume:

– If the model is correctly specified:

– In practice:

C GARCH(1,1) standardized residuals for daily SP500 returns:

C Two approaches for dealing with this problem

– Robust inference

– Fat tailed conditional distributions

Parametric
Non-Parametric

C Robust inference
Bollerslev and Wooldridge (1992, Econometric Reviews)

– “Sandwich form” of the covariance matrix

C Daily SP500 GARCH(1,1) estimates and standard errors:

C Fat tailed conditional distributions

– Important for VaR (quantile) predictions

C Parametric

– GARCH-t
Bollerslev (1987, Review of Economics and Statistics)

– GARCH-GED
Nelson (1991, Econometrica)

C Non Parametric

– Semiparametric GARCH
Engle and Gonzales-Rivera (1991, J. of Business and Economic Statistics)

– Semi Non Parametric (SNP) Density Estimation

Gallant and Tauchen (1989, Econometrica)
Gallant, Hsieh and Tauchen (1991, Proceedings)
C Volatility clustering produces unconditional fat tails

C Convergence to normality under temporal aggregation

C Asymmetry in distributions

Engle (2004, Am.Eco.Rev.)

 Integrated Volatility

Engle and Bollerslev (1986, Econometric Reviews)

Bollerslev and Engle (1993, Econometrica)
C “Integration in variance”

– Like a “unit root”

C For the GARCH(1,1) model this occurs when:

– Empirically:

C Daily SP500 GARCH(1,1) estimates:

C The IGARCH model imposes:

C Features of the IGARCH model:

– Corresponds to EWMA (RiskMetric) with ω = 0

– Squared process is ARIMA but strictly stationary

Nelson (1990, Econometric Theory)

– Likelihood-based inference may proceed in standard fashion

Lumsdaine (1996, Econometrica)
Lee and Hansen (1994, Econometric Theory)

– Continuous-record, or fill-in, asymptotics “justifies” IGARCH

Nelson (1990, 1992, J. of Econometrics)
Nelson and Foster (1994, Econometrica)

C Problems with IGARCH as a model:

– Infinite dependence on initial conditions

– Unconditional variance doesn’t exist

C Maybe dominant root is close to, but less than, unity

– Maybe long-memory!
 Long Memory

C ARFIMA model:

– d=0: ARMA model

– d=1: Unit root

– 0<d<1: Fractionally integrated

C Autocorrelations:

– d=0: Fast exponential decay

– d=1: Infinite persistence

– 0<d<½: Eventual but slow hyperbolic decay

C Can do the same for absolute or squared returns:

C Daily S&P returns 1928-1991:

Ding, Granger and Engle (1993, J. of Empirical Finance)

C FIGARCH and FIEGARCH models

Baillie, Bollerslev and Mikkelsen (1996, J. of Econometrics)
Bollerslev and Mikkelsen (1996, J. of Econometrics)

– GARCH(1,1) ~ ARMA(1,1)

– FIGARCH(0,d,1)
C FIGARCH(0,d,1):

– By Stirling’s Formula for large k

– Typically

C FIEGARCH:
 Component GARCH

Engle and Lee (1999, Festschrift for C.W.J. Granger)

C Standard GARCH(1,1) model:

– long-run volatility:

C Component GARCH:

– long-run volatility:

– Transitory dynamics governed by:

– Persistent dynamics governed by:

– Equivalent to non-linearly restricted GARCH(2,2)

– Looks “like” long-memory

Andersen and Bollerslev (1997, J. of Finance)
Gallant, Hsu and Tauchen (1999, Rev. Econ. Stat.)
 Regime Switching
Hamilton (1989, Econometrica)
C Markov-switching model:

– a two-state first-order Markov process with transition

probabilities:

– Conditional distribution:

– Like GARCH with only two states: “High” (H) and “Low”
(L) volatility

– GARCH and regime switching

Cai (1994, J. of Business and Economic Statistics)
Hamilton and Susmel (1994, J. of Econometrics)
Gray (1996, J. of Financial Economics)

– Intimately related to long-memory

Liu (2000, J. of Econometrics)
Park (2000, Rev. Econ. Stat.)
 Other Univariate GARCH Models

C An incomplete list:
Bollerslev (2010, Engle Festschrift)
ARCH Engle (1982)
GARCH Bollerslev (1986)
IGARCH Bollerslev and Engle (1986)
Log-GARCH Geweke (1986), Milhøj (1987), Pantula (1986)
TS-GARCH Taylor (1986), Schwert (1989)
GARCH-t Bollerslev (1987)
ARCH-M Engle, Lilien and Robins (1987)
MGARCH Bollerslev, Engle and Wooldridge (1998)
CCC GARCH Bollerslev (1990)
AGARCH Engle (1990)
CGARCH Engle and Lee (1990)
EGARCH Nelson (1991)
SPARCH Engle and Gonzalez-Rivera (1991)
LARCH Robinson (1991)
AARCH Bera, Higgins and Lee (1992)
NGARCH Higgins and Bera (1992)
QARCH Sentana (1992)
STARCH Harvey, Ruiz and Sentana (1992)
QTARCH Gourieroux and Monfort (1992)
GARCH-EAR LeBaron (1992)
GJR-GARCH Glosten, Jagannathan and Runkle (1993)
Weak GARCH Drost and Nijman (1993)
VGARCH Engle and Lee (1993)
APARCH Ding, Granger and Engle (1993)
SWARCH Hamilton and Susmel (1994)
β-ARCH Guegan and Diebolt (1994)
TGARCH Zakoian (1994)
GQARCH Sentana (1995)
HGARCH Hentschel (1995)
SGARCH Liu and Brorsen (1995)
PGARCH Bollerslev and Ghysels (1996)
GARCH-X Brenner, Harjes and Kroner (1996)
GRS-GARCH Gray (1996)
VS-GARCH Fornari and Mele (1996)
FIGARCH Baillie, Bollerslev and Mikkelsen (1996)
FIEGARCH Bollerslev and Mikkelsen (1996)
ANN-ARCH Donaldson and Kamstra (1997)
HARCH Müller, Dacorogna, Davé, Olsen, Pictet and Weizsäcker (1997)
ATGARCH Crouchy and Rockinger (1997)
AUG-GARCH Duan (1997)
STGARCH Gonzalez-Rivera (1998)
FIAPARCH Tse (1998)
SQR-GARCH Heston and Nandi (2000)
OGARCH Alexander (2001)
DCC GARCH Engle (2002)
ANST-GARCH Nam, Pyum and Arize (2002)
RGARCH Park (2002)
Flex-GARCH Ledoit, Santa-Clara and Wolf (2003)
GARJI Maheu and McCurdy (2004)
HYGARCH Davidson (2004)
COGARCH Klüppelberg, Lindner and Maller (2004)
LMGARCH Conrad and Karanasos (2006)
REGARCH Brandt and Jones (2006)
FCGARCH Medeiros and Veiga (2009)
....
Hansen and Lunde (2005, J. of Applied Econometrics)
 Multivariate GARCH Models

C Univariate GARCH models, scalar:

C Multivariate GARCH models, vector:

– Positive definite, N×N matrix:

C Maximum likelihood estimation and testing:

C How to parameterize ?
 Vech and Diagonal GARCH

Bollerslev, Engle and Wooldridge (1988, J. of Political Economy)

C General vech( @ ) model:

– Vech( @ ) ensures symmetry

– Not necessarily positive definite

– Large number of parameters,

C Diagonal model

– Ai and Bi matrices diagonal

– BEKK representation ensures positive definiteness

Engle and Kroner (1995, Econometric Theory)
2
– Still O(N ) parameters

C EWMA - RiskMetric

– W = 0, A1 = diag{γ} and B1 = diag{1- γ}

– Positive definite, but too simplistic

 Factor ARCH Models

Diebold and Nerlove (1989, J. of Applied Econometrics)

Engle, Ng and Rothschild (1990, J. of Econometrics)

C Commonalities in volatility

C One-Factor GARCH(1,1) model:

– Conditional distribution:
– Ht guaranteed to be positive definite

– jth time-t conditional variance:

– jkth time-t conditional covariance (for Γ diagonal):

– Parameters in one-factor GARCH(1,1) model, 2N + 3

– Parameters in k-factor GARCH(p,q) model, O(N)

 Engle, Ng and Rothschild (1990, J. of Econometrics)

C Drawbacks to the factor GARCH model

– What are the factor(s) ?

– Latent factor(s) complicates estimation

– Portfolios with no ARCH, λNb = 0 :

 Constant Conditional Correlation (CCC) Model
Bollerslev (1990, Review of Economics and Statistics)

C Unconditional correlation:

C Conditional correlation:

C Constant Conditional Correlations:

C Time-Varying Conditional Covariances:

C Constant conditional correlation GARCH model:

– diagonal matrix of conditional variances:

– R matrix of constant conditional correlations for :

C Easy to use and estimate

– N univariate GARCH models

– R estimated by sample cross correlations of

– Guaranteed to be positive definite

C So are the correlations constant ?
– Maybe in the short-run

– But probably not over longer horizons

C Rolling sample international equity market correlations:

Longin and Solnik (1995, J. of International Money and Finance)

 Dynamic Conditional Correlation (DCC) Models
Engle (2002, J. of Business and Economic Statistics)
Tse and Tsui (2002, J. of Business and Economic Statistics)

C Allow the correlations to be time-varying:

C Rt must be a correlation matrix for :

– Positive definite

– Ones along the diagonal

C Exponential smoothing - DCC_INT model:

C Could parameterize Rt in many other ways

C Equity volatilities and correlations:

Engle (2002, J. of Business and Economic Statistics)

C DCC-based Bond-Equity correlations:

Engle (2009, Anticipating Correlations)

C DCC-based T-Bond and AAA Corporate Bond correlations:

Buraschi,Porchia and Trojani (2009, manuscript, Imperial College, London)

 Asymmetries in Correlations

C Up- and down-markets

– Domestic
– International

C High and low volatility

C Recessions and expansions

C Benefits to diversification

– Least when you want it the most !

C US equity returns:

Ang and Chen (2002, J. of Financial Economics)

C How to model asymmetries in (covariances) correlations

– Multivariate vech GJR model

– Multivariate EGARCH model

– Regime switching GARCH

– DCC with asymmetric qij,t

– Copulas
C Asymmetric DCC covariance estimates:

Cappiello, Engle and Shephard (2007, Journal of Financial Econometrics)

 Copulas

C “Standard” univariate GARCH:

C “Standard” multivariate GARCH:

C Copulas:

– Marginal distributions (cdf)

– Joint distribution (cdf)

– Sklar’s Theorem:
The copula C is unique, although not necessarily time-
invariant
C Examples of copulas:

Patton (2005, International Economic Review)

 Structural GARCH
Sentana and Fiorentini (2001, J. of Econometrics)
Rigobon and Sack (2004, manuscript)
Andersen, Bollerslev, Diebold and Vega (2007, J.Int.Eco.)

C Structural (homoskedastic) VAR

– Reduced form

– Φ0 not identified (in general)

C Structural VAR-GARCH

– Reduced form errors

– Φ0 identified through heteroskedasticity