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GARCH Volatility Forecasting: Frequently Asked Questions

The Quantitative Trading Alerts and Quantitative Weekly Updates available on this website often use
GARCH volatility forecasting techniques to reinforce arguments that implied volatility is incorrectly valued.
However, due to its highly mathematical nature, many people feel that GARCH is best left to the
statisticians and as a result this valuable tool is not used as effectively as it could be. In this short note we
try and strip away the shroud of complexity around GARCH and answer some of the questions we often
hear regarding this valuable volatility forecasting technique. At its most technical level some serious
number crunching is indeed required, but the underlying model is both intuitive and accessible and many
market practitioners could benefit from interpreting and using the results generated by the model.

1. Without getting too technical, what is GARCH?

Short Answer: GARCH is an increasingly popular statistical technique used to forecast volatilities. It
stands for Generalised AutoRegressive Conditional Heteroskedasticity (which is actually more intuitive
than it may sound). The model's basic idea is that the hetero- (different-) skedasticity (scatter) of returns
conditional upon a baseline model shows an autoregressive pattern (relationship to their own past).
Volatilities tend to cluster--large moves are often followed by large moves and periods of calm tend to
persist, as well.
Long Answer: GARCH accounts for the clustering of volatilities using a model of lag effects. Its
forecasts can be viewed as weighted averages of past volatilities where the influences of the more
recent observations are weighted more heavily. A feature of the model is that it moderates its
predictions towards less extreme values. Also, the further ahead the model is asked to forecast the
stronger the reversion to the mean. While it is true to say, as mentioned above, that big moves tend to
be followed by big moves and small moves by small, the model is agnostic about the direction of the
moves. Say a currency has disappointing news one day and falls precipitously against other currencies.
The GARCH model will predict a big move the next day, too, but will not say whether it will be a rally in
response to over-correction or a continuation of the slide.

2. What's the difference between historical actual volatility and GARCH volatility?
Short Answer: Both historical actual volatilities and GARCH volatilities can be thought of as forecasts of
future actual volatilities. GARCH forecasts are typically the more accurate of the two. Historical actual
volatilities are estimated over a specified period of time and give equal weight to each fluctuation in the
sample. The ability of GARCH to train itself over historical data to find statistically optimal weights to apply
to its forecasts leads to better out-of-sample performance than the more simple-minded straight weighting
approach.

Long Answer: Actual volatilities are sample standard deviations of underlying spot returns. Each
fluctuation in the sample is given equal weight. Since FX volatilities tend to vary over time, weighting all
fluctuations equally can result in actual volatilities that may not reflect the market environment at the end
of the sample period. Reducing the length of the sample period may reduce this effect but it increases the
uncertainty in the estimate due to small sample size. GARCH estimates use longer spans of data but also
anticipate that the volatility may change over time. By attaching more importance to recent results,
GARCH accounts for volatility clustering within the sample period. The model parameters are determined
by maximum likelihood estimation, tailored to the data in question. If we view the true population volatility
as a time-varying process then it makes sense to use a model like GARCH, which attempts to capture
this time evolution explicitly.

3. How much data is needed for GARCH studies?

Short Answer: Typically 3 to 4 years of daily data-as much as 1000 trading days.

Long Answer: It depends on the convergence properties of the model estimation. A typical rule of thumb
is that 3 or 4 years of daily data will suffice. It can be less and can be more depending on whether the
parameter estimates from the optimisation routine are well behaved. With too little data the parameter
estimates may be imprecise. It should also be noted that the observations should be sampled at regularly
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spaced intervals. If some data points include 3 trading days of market movement and others includes just
one; GARCH will garble the proper weightings when giving its one-day forecast. Gaps in the data can
cause problems as well since a lagged value used in the model specification could include a gap that
should not be there.

4. Are GARCH volatilities related to implieds?

Short Answer: To the extent that both can be viewed as forecasts of future actual volatilities, there is
undoubtedly a positive relationship between the two. Implied volatilities are forward looking in that they
are based on market prices of options that will expire in the future, but they are usually fairly close in
magnitude to the backward looking GARCH vols. The market, as it forms its opinion about future volatility,
is very aware of recent historical volatility, just as GARCH is.

Long Answer: Implied volatilities hope to anticipate price fluctuations over the life of the option and can
foresee some market-moving events, but not all. In fact, they are statistically more closely related to the
recent historical volatility than to the actual volatility that ultimately ensues over the remaining term. For
that reason, they correlate rather highly with GARCH forecasts since GARCH is driven by the same
fluctuations. That being said, there is information that can be imputed in an implied volatility that a
standard GARCH model cannot use. For instance, if a G7 meeting, or Fed announcement, or influential
economic figure has the potential to move markets, option prices can reflect this. GARCH models, unless
they are modified to include indicator variables like the ones just mentioned, are unable to use this
information. GARCH, however, has the advantage of trained dynamics and optimised weightings on
previous fluctuations. In fact, GARCH models often win forecast tournaments against implieds. An idea
we're pursuing is combining information from both implieds and GARCH into a kind of composite forecast.
Preliminary evidence shows that the hybrid performs very well.

5. What should be done if the model parameter estimates fail to converge?

Short Answer: Often an approach that works is changing the initial parameter estimates used by the
optimisation algorithm. Changing the historical sample of data is also effective in most cases.

Long Answer: If GARCH parameters are updated in an automated system with initial values as inputs,
it's typically best to use the previous period's estimates as a starting point in the optimisation. If
convergence fails, different starting points should be tried. If problems persist, a different historical sample
is likely to work.

6. What does "population volatility" mean?

Short Answer: In short this is the true volatility of the underlying. More precisely it's the theoretical value
for the standard deviation of the probability distribution from which a spot return is drawn. Since we view
volatility as a time-varying process, this value will change as the distribution of returns narrows and
widens.

Long Answer: In real life market volatility is determined by the actions of individual participants in the
market. These in turn are determined by their views of the market, trading strategies and goals. Since all
of these participants interact in a complex and dynamic way it is a hopeless task to predict their effects on
the underlying in a deterministic way. One approach to this is to ignore these complexities and model
volatility as an evolving random variable. If we do this, each volatility in time is assumed to come from a
statistical probability distribution. GARCH characterises this by explaining or predicting the return
variance, the square root of which is standard deviation or volatility.
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7. Could we use an exponentially weighted sample standard deviation to forecast
volatility?
Short Answer: Indeed this would, in general, produce a better forecast of volatility than a simple equally
weighted sample standard deviation would. However, the exponential decay is not as flexible a functional
form as GARCH can be.

Long Answer: Exponentially declining weights have been used by RiskMetrics to forecast volatilities.
The parameter dictating the exponential decay is often held fixed across time and across products.
GARCH models are typically more customised to the data. They're updated frequently and differ by
product. With the richer parameterisation, GARCH models are also able to fit the observed historical
fluctuations better. A greater variety of relative weights are available through GARCH.

8. Can GARCH be used to forecast the volatility of implied volatilities?

Short Answer: Yes. GARCH can be used for measuring the volatility of any number of time series. In
fact GARCH was originally developed to measure the volatility of inflation data. We simply replace the
spot data with the implied volatility data.

Long Answer: Yes, but with problems. The volatility of implied volatility is less stable than that of spot
data. This causes problems for GARCH models at the parameter estimation stage. The problems of
convergence to good parameter estimates crop up more often.

9. Why do the studies take so long to run?

Short Answer: This is because the GARCH estimation involves a great deal of recursion in the optimiser.

Long Answer: Even with the most efficient optimisers, the maximum likelihood function requires a time
consuming recursive run through the data to incorporate the lag effects. Initial values for the parameter
estimates are provided, the likelihood function is evaluated, search directions are determined for the next
iteration, and the process continues until convergence to the optimum is achieved.

10. What's the difference between ARCH and GARCH?

Short Answer: The ARCH model pre-dates the GARCH model and is a special case of the more general
GARCH specification. ARCH relies on a series of lagged squared deviations to explain current squared
deviations.

Long Answer: GARCH, as the acronym implies, generalises the ARCH model. The effect is to simplify the
number of parameters needed to build a proper model of the conditional variance by accounting for
information not only in the lagged squared deviations as in ARCH, but in the lag(s) of the conditional
variance itself. In most cases, one lag of each is sufficient. In contrast, ARCH models often require quite a
few more lag terms to explain the same data. The parameter weightings applied to these ARCH lag terms
often must be constrained to ensure positive values and smooth decays, whereas the GARCH model is
parsimonious and well-behaved by nature.

11. What do GARCH models imply about the distribution of spot returns?
Short Answer: A model like GARCH, which features varying volatility over time, implies a more fat-tailed
distribution than the normal.

Long Answer: The usual assumption made by option pricing models like Black-Scholes is that the spot
returns are normally distributed. The empirical distributions, however, are almost always fatter in the tails,
meaning that more extreme moves are more common than the normal curve would suggest. GARCH
models are consistent with fatter tailed return distributions. Since a GARCH volatility may be 12% one
day and 10% the next and so on, varying through time, the returns drawn from those distributions of
varying widths, when aggregated, are non-normal.
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12. What are the more advanced models for?
Short Answer: The more advanced models are intended to explain additional features of the data that
GARCH itself may not capture.

Long Answer: Though a complete review of all the extensions to GARCH would be infeasible, there are
a few innovations that stand out for their potential in capturing observed market behaviour. One
interesting tangent is called EGARCH. This model allows the possibility that up moves and down moves
can have differing effects on the volatility that is likely to follow. Others recognise inherent nonlinearities in
the response of vols to spot moves. Different distributional assumptions can also be employed to account
for errors in the predicted variance equation that are fatter-tailed than the normal distribution would
suggest.
Answers provided by Jonathan Roberts, Currency Management and Advisory Service
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