Seasonal AR Modelling of the S&P 500

1
Question 1
Seasonal AR Modelling on the S&P 500
The time series ARIMA model is used to calibrate the above mentioned model. We utilize
the generalized model specified below which was obtained using a seasonal AR
factorization.
General Model:
[(1-
1
L-...-
12
L
12
) (1-
1
L
12
-...-
6
(L
12
)
6
)| AS
t
S
t-1
+

i=1 to 12

i
D
i

t

This can be formulated in SPSS as a SAR model of orders 12 (non seasonal) and 6(seasonal),
with explanatory variables s
t-1
and 12 dummies (without any constant). We should note that
D
i
represents fixed (calendar) seasonality while the seasonal part of SAR links any point to
the corresponding previous season.
Choice of I nformation Criterion and other model values:
SPSS utilizes Normalized BIC (Bayesian Information Criteria) and we have used the same
and have tried to come up with a model which optimizes the information criterion. We start
with a maximum of p =12 monthly and sp = 6 seasonal AR lags.
Procedure for I C-Modelling:
ST EP 1:
With the available data we run the regression as per the above equation (SAR model). While
running the initial regression we have set the values of p = 12 and np = 6.Initially we
include all the parameters in the regression. Below is the model fit and parameter estimate
for the regression that was run.
Model Fit
Fit Statistic
Mean SE Minimum Maximum
Percentile
5 10 25 50 75 90 95
Stationary
R-squared
.162 . .162 .162 .162 .162 .162 .162 .162 .162 .162
R-squared .162 . .162 .162 .162 .162 .162 .162 .162 .162 .162
RMSE .034 . .034 .034 .034 .034 .034 .034 .034 .034 .034
MAPE 158.963 . 158.963 158.963 158.963 158.963 158.963 158.963 158.963 158.963 158.963
MaxAPE 3184.715 . 3184.715 3184.715 3184.715 3184.715 3184.715 3184.715 3184.715 3184.715 3184.715
MAE .025 . .025 .025 .025 .025 .025 .025 .025 .025 .025
MaxAE .105 . .105 .105 .105 .105 .105 .105 .105 .105 .105
Normalized
BIC
-6.267 . -6.267 -6.267 -6.267 -6.267 -6.267 -6.267 -6.267 -6.267 -6.267
Table 1: Model fit when p=12 and p=6 without removing any parameters
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Table 2: ARIMA model parameters without removing any parameters when p=12 and np=6

ARI MA parameter estimates when p= 12 and sp=6:

ARI MA Model Parameters

Estimate SE t Sig.
dlnpt-Model_1 dlnpt No Transformation AR Lag 1 .310 .055 5.655 .000
Lag 2 -.130 .057 -2.262 .024
Lag 3 .042 .058 .728 .467
Lag 4 .001 .058 .020 .984
Lag 5 .092 .058 1.581 .115
Lag 6 -.078 .058 -1.342 .180
Lag 7 -.070 .058 -1.199 .232
Lag 8 .010 .058 .166 .868
Lag 9 -.017 .059 -.288 .773
Lag 10 -.041 .059 -.700 .484
Lag 11 .067 .058 1.152 .250
Lag 12 -.014 .154 -.093 .926
AR, Seasonal Lag 1 -.090 .162 -.553 .580
Lag 2 -.044 .057 -.773 .440
Lag 3 -.073 .058 -1.267 .206
Lag 4 -.078 .061 -1.289 .198
Lag 5 -.121 .063 -1.914 .057
Lag 6 -.144 .065 -2.222 .027
lnpt1 No Transformation Numerator Lag 0 .003 .004 .797 .426
d1 No Transformation Numerator Lag 0 .003 .018 .179 .858
d2 No Transformation Numerator Lag 0 -.008 .018 -.468 .640
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ST EP 2:
We observe from the previous table that the coefficient value of lnpt
1
is 0.003(which is close
to 0) and is not all that significant in terms of t-statistics. From this we can come to the
conclusion that we can remove the variable from the regression but before that we need to
conduct the unit root test on lnpt
1
and dlnpt
1
to test whether they are stationary or not. This
would give us empirical evidence as to what variables are to be included in the regression.
Augmented Dickey Fuller Test on lnpt
1:
Using EVIEWS we are able to conduct the augmented unit root test on lnpt
1.
The null
hypothesis is specified to be that lnpt
1
has a unit root. From the below table the value
marked in green is indicative that we will not be able to reject the null hypothesis. This is
indicative that the variable is non-stationary and we can remove the variable lnpt
1
from the
regression.
Table 3: Dickey Fuller test for unit root on lnpt
1

Null Hypothesis: LNPT1 has a unit root
Exogenous: None
Lag Length: 1 (Automatic - based on SIC,
maxlag=16)
t-Statistic Prob.*

Augmented Dickey-Fuller test statistic 1.853717 0.985
Test critical values: 1% level -2.571244
5% level -1.941685
10% level -1.616124

*MacKinnon (1996) one-sided p-values.
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(LNPT1)
Method: Least Squares
Date: 02/18/11 Time: 15:16
Sample (adjusted): 1960M04 1990M12
Included observations: 369 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

LNPT1(-1) 0.000698 0.000376 1.853717 0.0646
D(LNPT1(-1)) 0.281576 0.050055 5.625331 0

R-squared 0.079234 Mean dependent var 0.004693
Adjusted R-squared 0.076725 S.D. dependent var 0.035594
S.E. of regression 0.034201 Akaike info criterion -3.907728
Sum squared resid 0.429279 Schwarz criterion -3.886531
Log likelihood 722.9758 Hannan-Quinn criter. -3.899307
Durbin-Watson stat 1.940758
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Augmented Dickey Fuller Test on dlnpt:
We now go on to conduct the unit root test on dlnpt. The null hypothesis is stated as dlnpt
has a unit root. Below were the results obtained by conducting Dickey Fuller test. The value
marked in green in the below table is indicative that we will be able to reject the null
hypothesis that dlnpt follows a unit root process. We can conclude that this is stationary and
is important while running our regression.
Null Hypothesis: DLNPT has a unit root
Exogenous: None
Lag Length: 0 (Automatic - based on SIC,
maxlag=16)
t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -14.15817 0
Test critical values: 1% level -2.571227
5% level -1.941682
10% level -1.616125

*MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation
Dependent Variable: D(DLNPT)
Method: Least Squares
Date: 02/18/11 Time: 15:11
Sample (adjusted): 1960M03 1990M12
Included observations: 370 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

DLNPT(-1) -0.704226 0.04974 -14.15817 0

R-squared 0.351993 Mean dependent var 0.00022
Adjusted R-squared 0.351993 S.D. dependent var 0.042626
S.E. of regression 0.034314 Akaike info criterion -3.903844
Sum squared resid 0.434472 Schwarz criterion -3.893267
Log likelihood 723.2111 Hannan-Quinn criter. -3.899642
Durbin-Watson stat 1.941547
Table 4: Dickey Fuller test for unit root on dlnpt

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ST EP 3:
After having arrived at the best model to be considered, we now run the regression by
removing lnpt
1
and setting p=12 and np =6. Below is the parameter estimate of this model.

Estimate SE t Sig.
Lag 2 -.127 .057 -2.208 .028
Lag 3 .045 .058 .776 .438
Lag 4 .005 .058 .092 .927
Lag 5 .096 .058 1.656 .099
Lag 6 -.074 .058 -1.276 .203
Lag 7 -.066 .058 -1.142 .254
Lag 8 .013 .058 .231 .818
Lag 9 -.014 .059 -.246 .806
Lag 10 -.038 .059 -.643 .521
Lag 11 .071 .058 1.221 .223
Lag 12 -.009 .153 -.056 .956
AR, Seasonal Lag 1 -.090 .161 -.557 .578
Lag 2 -.040 .058 -.687 .493
Lag 3 -.071 .058 -1.223 .222
Lag 4 -.075 .061 -1.240 .216
Lag 5 -.117 .063 -1.848 .065
Lag 6 -.140 .065 -2.163 .031
d1 No Transformation Numerator Lag 0 .017 .005 3.799 .000
d5 No Transformation Numerator Lag 0 .000 .004 -.068 .946
Table 5: ARIMA Model parameters obtained by running the regression after removing lnpt
1

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STEP 4:
Value oI BIC as P` is reduced by 1 until P` is 0:
We obtained the normalized BIC value by reducing the value oI P` Irom 12 to 0. While
doing this we removed the AR lags as per their t-statistic significance. The lag which had
the least significance was removed first (in the order mentioned in column 3 in the below
table) and the process was continued till we reached P` 0.
S:NO Value of 'P' Lag removed Normalized BIC Value
1 12 N/A -6.285
2 11 12 -6.303
3 10 4 -6.322
4 9 8 -6.341
5 8 9 -6.360
6 7 10 -6.377
7 6 3 -6.393
8 5 11 -6.408
9 4 7 -6.424
10 3 6 -6.435
11 2 5 -6.448
12 1 2 -6.454
13 0 1 -6.396
Table 6: Normalized BIC values by reducing AR lags from 12 to 0
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STEP 5:
From Table 5 the values marked in green are indicative that the optimal model based on BIC
is the one which has the least BIC value. We can conclude that we obtain this model when
the non seasonal lag is 1(p=1), 6 seasonal lags and including all the 12 dummies. Below is
the table which has the IC-Optimal model by comparing only the BIC values.

Table 7: ARIMA Model parameters when p=1, np=6 and including 12 dummies.

Estimate SE t Sig.
AR, Seasonal Lag 1 -.072 .054 -1.345 .180
Lag 2 -.050 .054 -.918 .359
Lag 3 -.090 .056 -1.617 .107
Lag 4 -.072 .058 -1.248 .213
Lag 5 -.082 .059 -1.392 .165
Lag 6 -.140 .060 -2.349 .019
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Procedure for model estimation by analyzing parameter significance:
The model mentioned in (Table 7) was obtained only comparing the BIC values and
deciding the most optimal model based on the one which gives the least BIC values. Now in
this modelling we will be removing insignificant parameters based on its t-significance. We
will need to consider (Table 5) as the base reference table and start removing the
insignificant variables. We will remove insignificant AR lags, seasonal AR lags and
dummies. By doing so we obtain the best model presented below. We see that only two AR
lags, one seasonal lag and two dummies are significant. In (Table 5), t-ratio of AR lag1, AR
lag2, seasonal AR lag6, d1 and d4 are 5.75,-2.2,-2.1, 3.8 and 2.6 respectively and these are
significant variables considered with 5% two sided t-test.
Model Fit
Fit Statistic
Mean SE Minimum Maximum
Percentile
5 10 25 50 75 90 95
Stationary
R-squared
.111 . .111 .111 .111 .111 .111 .111 .111 .111 .111
R-squared .111 . .111 .111 .111 .111 .111 .111 .111 .111 .111
RMSE .034 . .034 .034 .034 .034 .034 .034 .034 .034 .034
MAPE 141.343 . 141.343 141.343 141.343 141.343 141.343 141.343 141.343 141.343 141.343
MaxAPE 2594.015 . 2594.015 2594.015 2594.015 2594.015 2594.015 2594.015 2594.015 2594.015 2594.015
MAE .025 . .025 .025 .025 .025 .025 .025 .025 .025 .025
MaxAE .112 . .112 .112 .112 .112 .112 .112 .112 .112 .112
Normalized
BIC
-6.696 . -6.696 -6.696 -6.696 -6.696 -6.696 -6.696 -6.696 -6.696 -6.696
Table 8: Model fit when p=2, np=1 and two dummies included


Estimate SE t Sig.
Lag 2 -.103 .052 -1.980 .048
AR, Seasonal Lag 6 -.112 .058 -1.910 .057
Table 9: ARIMA Model Parameters with p=2, np=1 and 2 dummies (January and April)
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Is the I C optimal model same as the one obtained by removing insignificant parameter
estimate?
No, the IC optimal model is not the same as the one obtained by removing insignificant
parameter estimates. We need to compare (Table 7) and (Table 9) and find that the dummies
are different. The coefficients of the dummies are indicative of the returns that you obtain
each month. From (Table 7) we see that January and April gives a return of 1.8% and 1.1%
respectively. From (Table 9) we see that January and April gives a return of 1.4% and 1.1%
respectively. In order to obtain financial interpretations we feel that the model obtained by
removing insignificant parameters proves to be more accurate and intuitive. Keeping
irrelevant variables makes the estimates unreliable. This would mean there will be higher
standard errors and problems pertaining to multi-co linearity.
Models:
We have presented two models. The first one (Table 10) is the one which was obtained by
reducing non-seasonal lags from 12 to 0 and finding out the model which has the lowest
normalized BIC. The second one (Table11) is the one which was obtained by removing all
insignificant parameter estimates from the model and obtaining the final model only with
those parameters which are significant.
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I C Optimal model based on comparing BI C values:
Table 10: ARIMA Model Parameters of IC-Optimal model

Optimal model based on removing insignificant parameters:

Estimate SE t Sig.
Lag 2 -.103 .052 -1.980 .048
AR, Seasonal Lag 6 -.112 .058 -1.910 .057
Table 11: ARIMA Model Parameters of optimal model based on removing insignificant parameters

Estimate SE t Sig.
AR, Seasonal Lag 1 -.072 .054 -1.345 .180
Lag 2 -.050 .054 -.918 .359
Lag 3 -.090 .056 -1.617 .107
Lag 4 -.072 .058 -1.248 .213
Lag 5 -.082 .059 -1.392 .165
Lag 6 -.140 .060 -2.349 .019
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Financial meaning of the resulting estimates:
1. There is clear indication of strong January effects which is supported by 1.8%
returns by IC optimal model. The model obtained after removing insignificant
parameters indicate a return of 1.4% in January. Both the models are also indicative
of returns being significant in the month of April. This is in accordance with the
large literature that`s available on calendar anomalies, most prominently the January
effect which highlights the large excess returns that are made in January.
2. There is short term momentum effect that can be observed in the stock market. Since
non-seasonal lag AR lag1 has significantly positive coefficient there seems to be a
systematic correlation wherein there is positive correlation for the first month
followed by a correction the next month. This is termed as the momentum effect.
3. Since only seasonal AR lag6 is significant, the model seems to predict the business
cycles suggesting that the cycle is about 6 years. So if one stays invested for 6 years
in the stock market then the returns on his/her portfolio would be good.
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Question 2
Model Selection:
To model the relationship between consumption and income, we have decided to follow the
equation used in Lecture 3 Part C, which includes an error correction mechanism. This
model is that of a time series plot, and it looks at different lags of both consumption and
income.

The equation chosen fits the data set perfectly since it tries to find the optimal relationship
between consumption and income in the long-term, and the error correction mechanism
included insures that deviations from the long run will return to normality. It is important to
note that time here is in quarters; hence, t-1 to t-4 represent one year.
The first step was to calculate both log and dlog of consumption and income, followed by
calculating the ECM which is simply = log(Consumption) log(Income). Once that is done,
the data is complete and the model can be run; however, the lag length must be decided.
Lag Length:
In order to decide the lag length of each variable, a general to specific approach has been
taken in order to identify insignificant parameters. The model looks at parameters of
consumption and income, which generally are closely linked to business cycle. These cycles
are usually between 4-7 years; thus, we have assumed a 6-year start, which translates into 24
lags for both Consumption and Income (See Appendix 2.1). With the use of Oxmetrics
automatic model selection, we ran a 10% confidence interval regression that maximises the
AIC with the choice of the best significant parameters.

Coefficient Std.Error t-value t-prob Part.R^2
DLCONS_1 0.190741 0.08268 2.31 0.0227 0.0402
DLCONS_5 -0.223155 0.08677 -2.57 0.0113 0.0495
DLCONS_21 -0.259646 0.1265 -2.05 0.0422 0.0321
Constant 0.370288 0.1286 2.88 0.0047 0.0613
DLINC_21 0.177679 0.08687 2.05 0.0429 0.0319
LINC_1 -0.054211 0.01889 -2.87 0.0048 0.0609
ECM_1 0.127644 0.04265 2.99 0.0033 0.0659

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As it can be seen, the parameters chosen by the automatic model selection are all significantly different than
zero, with their t-values being greater than 2. To ensure that these lags are the ones that are significant and
explain the model best, we also drew an ACF and PACF graph of dlog(Consumption) and dlog(Income).

When analysing both graphs, it can be seen that for dlog(Consumption), it is correct that
both lag 1 and lag 5 are significant; however, lag 21 seems to be under the significance
threshold. As for dlog(Income), lag 21 was given to be significant from the model, but that
does not show on the figure. Nevertheless, it is important to note that the AIC of this model
is -11.9882, which is higher than the 24 lag full model AIC of -11.6123.
On the other hand, to fully justify keeping both lag 21s, a model was ran with those two lag
variables omitted:

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DLCONS_1 0.206212 0.08329 2.48 0.0146 0.0454
DLCONS_5 -0.196365 0.08681 -2.26 0.0254 0.0381
Constant 0.354035 0.1288 2.75 0.0069 0.0553
LINC_1 0.0518382 0.01893 -2.74 0.007 0.0549
ECM_1 0.118167 0.04235 2.79 0.0061 0.0569

The model shows that all other coefficients are still significant; however, the AIC drops
from -11.9882 to -11.9806. Thus, there must be some explanatory variable in lag 21 that fits
the model and explains it better. It is also important to note that the ECM is significant;
however, it is positive. This is later on corrected when adding a dummy variable or inflation.
Parameter Stability:
To deduce whether the recursive parameters are stable or not, we have drawn a recursive LS
graph with 2 standard errors. When looking at these graphs, a stable relationship means
that in the long term the line is horizontal, with no sudden breaks or jumps. However, if
there is a break, than that means the model is inappropriate for the whole period, and an
event has occurred within that might affect the variables.
When drawing the RLS, breaks were found within the data, and they were all around 1973-
1975. This was expected since during October of 1974 an Oil Crisis occurred. The graphs
chosen below are the variables that were significant in the model above.

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Clearly, the ECM has a huge break between 73 and 74, since it is lagged by one time period.
Also, DLCONS_21 and DLINC_21 both start with a certain sign, but finish with the
opposite. Hence, it can be concluded that the recursive parameters are not stable over time if
only consumption and income are included in the model.
Dummy Variable
In October 1973 an oil crisis began as the Organization of Arab Petroleum Exporting
Countries (OAPEC) introduced an oil embargo. As a result of the parameter instability,
which takes place during the period between 1973 and 1975, we add a dummy variable to
try and account for the oil crisis that took place. We therefore go back to our original model
of consumption and income whilst adding a dummy variable from 1973 Q4 to the end of the
sample, which gives the following equation:

Again, we need to determine the lag length and we follow the general to specific approach
on more. Once more, 24 lags are used to estimate model (see Appendix 2.2). We use the
Automatic Model Selection tool since it removes an insignificant parameter, re-estimates the
model and then removes insignificant parameters again. This continues until only significant
parameters remain. We employ a 90% significance level and choose the model which
maximises the AIC value.

DLCONS_2 0.399018 0.1178 3.39 0.0009 0.0847
DLCONS_19 -0.30159 0.1111 -2.71 0.0076 0.0561
Constant 1.31296 0.2162 6.07 0 0.2292
DLINC_2 -0.22467 0.0798 -2.82 0.0057 0.0601
DLINC_4 0.122413 0.05194 2.36 0.02 0.0429
DLINC_18 -0.15248 0.05429 -2.81 0.0058 0.0598
DLINC_19 0.144456 0.07891 1.83 0.0695 0.0263
LINC_1 -0.19326 0.03182 -6.07 0 0.2293
ECM_1 -0.12878 0.05288 -2.44 0.0163 0.0456
dumm1973 -0.00539 0.000952 -5.67 0 0.2058

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The parameters chosen are all significantly different from 0. Also, the ECM term now has
the correct sign in front of its coefficient; it is now negative, which is in line with economic
theory. Noticeably, the dummy variable is highly significant and therefore, adds significant
value by allowing for the oil shock to be accounted for. The AIC value of this model is -
12.1916 whereas the value for the optimal consumption and income only model is -11.9882.
It can be concluded that the consumption and income model with a dummy variable and
significant parameters explains the data better than it does without a dummy variable.
Parameter Stability
Introducing a dummy variable improves the parameter stability within the model. The ECM
variable no longer has the large break which it had in the consumption and income only
model. LINC_1 is also more stable now as it remains just under the 0 line for the entire
sample period. However, there is still some instability amongst the parameters. This can be
seen within the DLCONS_2 and DLINC_2 parameters. DLCONS_2 initially starts below
the 0 line, however around 1973 it the begins to move above 0, and continues to stay there
for the rest of the sample period. DLINC_2 begins above the 0 line, and then, again, around
1973, it moves below the 0 line and remains there for the rest of the sample period. Thus,
although including the dummy variable significantly improves the parameter instability
problem, it does not solve it.

I nflation
We now estimate a model which includes consumption, income and inflation. We include
inflation in order to try and account for the oil crisis in 1973. The model now becomes:
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To determine the lag length of each of the variables, we once more use the general to
specific approach. This involves estimating the model with 24 lags initially for all 3
variables (see Appendix 2.3) and using automatic model selection to determine which lags
are significant and which are not, and thus can be removed. The model which is produced,
having removed insignificant parameters is below. We see that the ECM term is highly
significant here, and it now has the correct sign in front of the coefficient. The 1
st
lag of
inflation is highly significant and INFLAT_15, IFNLAT_17 and INFLAT_18 are also
significant. However, this model indicates that inflation from 15, 17 and 18 periods ago, has
a significant effect on consumption decisions today. We did not believe that this would be
the case, and thus decided to look at the ACF and PACF for inflation. The PACF indicates
that the 1
st
, 2
nd
and 3
rd
lag of inflation are all highly significant. Whereas, the lagged values
from 15, 17 and 18 periods ago are not significant according to the PACF.

DLCONS_23 -0.13506 0.08092 -1.67 0.0976 0.0216
DLINC_1 -0.08192 0.04886 -1.68 0.0961 0.0218
DLINC_5 -0.10066 0.05163 -1.95 0.0534 0.0293
ECM_1 -0.07673 0.02781 -2.76 0.0067 0.057
INFLAT_1 -0.00145 0.000199 -7.3 0 0.2974
INFLAT_15 0.000532 0.000286 1.86 0.0651 0.0268
INFLAT_17 -0.00161 0.000636 -2.52 0.0129 0.0481
INFLAT_18 0.001686 0.000496 3.4 0.0009 0.084

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Thus, we decide to re-estimate the model by removing the parameters INFLAT_15,
INFLAT_17 and INFLAT_18 and, instead, we include the 2
nd
and 3
rd
lagged parameters of
inflation.

DLCONS_23 -0.1122 0.08249 -1.36 0.1762 0.0144
DLINC_1 -0.09003 0.0549 -1.64 0.1035 0.0207
DLINC_5 -0.08438 0.05433 -1.55 0.1229 0.0186
ECM_1 -0.14617 0.0282 -5.18 0 0.1746
INFLAT_1 -0.00157 0.000552 -2.84 0.0053 0.0597
INFLAT_2 0.00056 0.000931 0.601 0.5489 0.0028
INFLAT_3 -0.00056 0.000567 -0.991 0.3238 0.0077

This model produces an ECM which has greater significance than the previous inflation
model. However, INFLAT_2 and INFLAT_3 are insignificant parameters. The AIC for this
model is lower than when we have INFLAT_15, INFLAT_17 and INFLAT_18 included.
However, we felt that this model, including lags 2 and 3 has a better economic explanation
than including lags 15, 17 and 18. This is because we would expect that consumers would
adjust their consumption decisions based on inflation rates from the most recent periods,
rather than from periods which are a long time in the past. However, the AIC for both of the
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inflation models is lower than the consumption and income only model as well as the model
which includes the dummy variable.
Parameter Stability
We look to see whether including inflation has improved the parameter instability which
was seen in the first model, or if it has improved on what the dummy variable did.

By including inflation, there is a remarkably large improvement in the stability of the
parameters in the model. There are very few breaks in the sample period for the parameters.
DLINC_5 looks to be trending upwards and as though it would continue above the 0 line,
however, at the end of the period, it begins to fall. It must be noted that again, the green
lines represent 2 standard deviations, either side of the parameters value. It can be seen here
that the size of 2 standard deviations for the parameters is extremely small. This is in
contrast to the dummy variable model which has a much larger standard deviation band.
Thus, inflation greatly improves the stability of the parameters, and it can be concluded that
it solves the parameter instability problem for most, if not all, of the parameters in this
model. This is because the jumps in the parameters are extremely small relative to the jumps
in the previous models estimated.
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Long Run Relationship
The long run relationship between the variables is estimated for all 3 models.

Coefficient Std.Error t-value t-prob
Constant 0.286588 0.1059 2.71 0.0077
DLINC 0.137516 0.05784 2.38 0.0189
LINC -0.0419571 0.01556 -2.7 0.0079
ECM 0.0987911 0.03273 3.02 0.0031

Above, all 3 variables and constant are significant, especially the ECM term. However, the
coefficient of the ECM term should be negative. Thus, although the variables are significant,
their economic interpretation is not what we would expect them to be. The negative
coefficient of the ECM term is necessary so that the ECM variable can push periods with
values which are above their long run values, back down, and those which are below, back
up. Also, we would expect that an increase in income to increase consumption, however,
LINC demonstrates that the opposite happens. However, a change in income, represented by
DLINC illustrates that a positive change in income, has the effect of increasing consumption,
which we would expect to happen.

Constant 1.4547 0.3213 4.53 0
DLINC -0.122186 0.1563 -0.782 0.4357
LINC -0.214125 0.04732 -4.52 0
ECM -0.142684 0.06881 -2.07 0.0401
dummy1973 -0.0059751 0.001448 -4.13 0.0001

The ECM term has the correct coefficient here and can fulfil its job in pushing back values
to the long run trend. However, the DLINC variable is insignificant but also, has a negative
coefficient. We would not expect a positive change in income to result in a reduction in
consumption. Also, LINC has a negative coefficient, and as it is significant, compounds the
fact that DLINC has a negative coefficient. Thus, we would expect the signs of DLINC and
LINC to be opposite, to those obtained in this model. However, the dummy variable is
highly significant, as we would expect because it was a key factor in the models estimated
earlier. However, although this model, with a dummy variable, produced a lower AIC than
the consumption and income model, in the short run, its long run relation is not what we
would expect it to be.

21

DLINC -0.16086 0.05946 -2.71 0.0077
ECM -0.0675958 0.02528 -2.67 0.0085
INFLAT -0.000741641 0.0002368 -3.13 0.0021

The 3 variables are significant again here, however, LINC is no longer included in the
model due to being insignificant. The ECM term has a negative coefficient. However,
DLINC has a negative coefficient, indicating that a positive change in income would have a
negative effect on the level of consumption. This is not consistent with economic theory.
The negative coefficient of INFLAT indicates that an increase in inflation would have a
negative effect on consumption. This is consistent with economic theory, since as inflation
rises, it reduces the purchasing power of consumers and thus, they consume less. This model,
in the short run, had the highest absolute AIC value. However, in the long run, although the
ECM and INFLAT variables have the correct economic meaning, we still see discrepancies
between this model and economic theory, namely in the DLINC variable.
22

Appendix 2.1

CoefflclenL SLd.Lrror L-value L-prob arL.8^2
uLCCnS_1 0.0930394 0.2217 0.429 0.6692 0.0022
uLCCnS_2 0.106867 0.2303 0.464 0.6441 0.0026
uLCCnS_3 -0.178602 0.2348 -0.761 0.4491 0.0069
uLCCnS_4 0.0339432 0.2298 0.233 0.813 0.0007
uLCCnS_3 -0.338899 0.2248 -1.6 0.1142 0.0298
uLCCnS_6 0.120989 0.2127 0.369 0.371 0.0039
uLCCnS_7 -0.261102 0.2124 -1.23 0.2224 0.0179
uLCCnS_8 -0.200747 0.2144 -0.936 0.3318 0.0103
uLCCnS_9 -0.162721 0.2013 -0.808 0.4213 0.0078
uLCCnS_10 -0.231037 0.202 -1.24 0.2173 0.0183
uLCCnS_11 -0.0748331 0.2023 -0.37 0.7124 0.0016
uLCCnS_12 -0.274386 0.2007 -1.37 0.1732 0.022
uLCCnS_13 -0.0348709 0.1983 -0.176 0.8608 0.0004
uLCCnS_14 0.116397 0.1944 0.6 0.3302 0.0043
uLCCnS_13 0.0077601 0.1938 0.0401 0.9681 0
uLCCnS_16 -0.337819 0.1868 -1.81 0.0741 0.0379
uLCCnS_17 -0.00731937 0.1886 -0.0388 0.9691 0
uLCCnS_18 -0.189444 0.1892 -1 0.3196 0.0119
uLCCnS_19 -0.236423 0.1892 -1.23 0.2148 0.0183
uLCCnS_20 -0.0633739 0.1892 -0.333 0.7383 0.0014
uLCCnS_21 -0.264116 0.1937 -1.36 0.1763 0.0219
uLCCnS_22 0.148149 0.2001 0.74 0.4612 0.0066
uLCCnS_23 -0.0112886 0.2004 -0.0363 0.9332 0
uLCCnS_24 -0.0243897 0.1932 -0.123 0.9009 0.0002
ConsLanL 0.482021 0.3672 1.31 0.193 0.0203
uLlnC_1 0.0794316 0.2044 0.389 0.6983 0.0018
uLlnC_2 -0.00398372 0.2016 -0.0297 0.9764 0
uLlnC_3 0.223431 0.2046 1.1 0.2736 0.0144
uLlnC_4 0.119836 0.2033 0.384 0.3609 0.0041
uLlnC_3 0.148213 0.1978 0.749 0.4339 0.0067
uLlnC_6 0.0398233 0.1868 0.213 0.8317 0.0003
uLlnC_7 0.200062 0.1813 1.1 0.273 0.0143
uLlnC_8 0.167016 0.1817 0.919 0.3607 0.0101
uLlnC_9 0.128732 0.174 0.74 0.4613 0.0066
uLlnC_10 0.139214 0.173 0.92 0.36 0.0101
uLlnC_11 0.144962 0.1708 0.848 0.3986 0.0086
uLlnC_12 0.232979 0.164 1.34 0.1268 0.0279
uLlnC_13 0.0338022 0.1613 0.346 0.7303 0.0014
uLlnC_14 -0.0236031 0.1374 -0.163 0.8712 0.0003
uLlnC_13 -0.0161239 0.1331 -0.103 0.9164 0.0001
23

uLlnC_16 0.28373 0.1437 1.97 0.0317 0.0448
uLlnC_17 0.0424214 0.1438 0.293 0.7688 0.001
uLlnC_18 0.011402 0.1373 0.0831 0.934 0.0001
uLlnC_19 0.233649 0.1336 1.73 0.0841 0.0333
uLlnC_20 0.0338087 0.1326 0.406 0.686 0.002
uLlnC_21 0.209328 0.1309 1.6 0.1134 0.0299
uLlnC_22 -0.0496386 0.1348 -0.368 0.7133 0.0016
uLlnC_23 -2.83L-02 1.36L-01 -0.209 0.8347 0.0003
uLlnC_24 0.000172683 0.1334 0.00129 0.999 0
LlnC_1 -0.0703367 0.03372 -1.31 0.1928 0.0203
LCM_1 0.176343 0.1428 1.24 0.2198 0.0181
!

24

Question 3
1. Procedure of estimates:
Our empirical exercise consists in the following steps:
i) Extract a time series data from Jan-78 to Feb-04, consisting of the excess returns
(R01s) and the forward premium (f-s).

ii) Estimate the system by following models by using PC-Gives in order to decide
which model is better to test the Uncovered Interest rate Parity;
- Ordinary Least Squares (OLS)
- GARCH
- Exponential GARCH (EGARCH)
- GARCH with t-distribution (GARCH_t)
- Asymmetric GARCH (AGARCH)
- AGARCH with t-distribution (AGARCH_t)
- Threshold GARCH (TGARCH)
- TGARCH with t-distribution (TGARCH_t)
Except for the OLS, all other models consider time-varying volatilities.

iii) Compare the results of time-varying models with that of the benchmark OLS results,
and find specification that we would use.

iv) Estimate the system by following models by using PC-Gives in order to decide
which model is better to estimate the system to measure the price of currency risk;
- GARCH-in-mean (GARCHM)
- EGARCH-in-mean (EGARCHM)
- GARCHM with t-distribution (GARCHM_t)
- AGRACH-in-mean (AGARCHM)
- AGARCHM with t-distribution (AGARCHM_t)
- TGARCH-in-mean (TGARCHM)
- TGARCH-in-mean with t-distribution (TGARCHM_t)

(We did not learn AGARCH, TGARCH and models used in step 4) without
GARCHM model in the lecture, but we consider them as well because they are
important extensions of GARCH model which due to the leverage effect with asset
prices, where a positive shock has less effect on the conditional variance compared
to a negative shock..)

OLS
Firstly, we estimated the following regression by using OLS in order to obtain
benchmark result.
r
t +1
*(f
t
-s
t
) + e
t +1
(1)

23

Table1: result of OLS
Constant -0.00454567 0.001782 -2.55 0.0112 0.0204
Svar13 () -3.68576 0.6524 -5.65 0 0.0928

sigma 0.0248889 RSS 0.193270312
R^2 0.0928081 F(1,312) 31.92 [0.000]**
Adj.R^2 0.0899005 log-likelihood 715.163
no. of observations 314 no. of parameters 2
mean(Svar15) 0.00157505 se(Svar15) 0.0260892
AR 1-2 test F(2,310) = 18.040 [0.0000]** ARCH 1-1 test F(1,312) = 24.363 [0.0000]**
Normality test Chi^2(2) = 53.684 [0.0000]** Hetero test F(2,311) = 11.291 [0.0000]**
Hetero-X test F(2,311) = 11.291 [0.0000]** RESET23 test F(2,310) = 3.6911 [0.0260]*
HAC adjusted t-ratio of beta coefficient = -3.27

The OLS model assumes that the error terms are uncorrelated (no autocorrelation) and
the volatility of excess return is constant (homoscedasticity). However, in practice,
there might be an autocorrelation in volatility. Also, the shocks that affect the returns
are likely to affect the volatility of returns, hence sample variance or standard deviation
would not be constant. In fact, the large difference between unadjusted t-ratio and HAC
adjusted t-ratio of OLS describes the existence of a lot of autocorrelation and
heteroskedasticity. In addition, RESET indicates substantial omitted nonlinearities in
the residuals.

Time-varying volatility model
Under time-varying volatility model such as GARCH model, the autocorrelation in
volatility and heteroskedasticity are modelled by allowing the conditional variance of
the error term (
2
t
) to depend on the previous value of the squared error.
2
t

0
*
2
t-1

1
*r
2
t-1

From this point of view, we estimated the regression (1) by using several types of time-
varying volatility model in order to test the UIP hypothesis.

<Lag Length>
So as to find the appropriate lag length of models, we considered the plot of ACF and
PACF as follows; (We used the square of series (r
2
t+1
) because the GARCH process for
r
t+1
is equivalent to an ARMA for r
2
t+1
.)

26

This figure also shows the existence of heteroscedasticity. Since there are significant
impact at the lag of 1 and 3, we estimated the regression for p = 1, 2, 3 and q = 1, 2, 3.

2. The results for each particular time-varying volatility model:
GARCH (1, 1)
If an autoregressive moving average model (ARMA model) is assumed for the error
variance, the model is a generalized autoregressive conditional heteroskedasticity
(GARCH) model. In that case, the GARCH(p, q) model (where p is the order of the
GARCH terms
2
t-i
and q is the order of the ARCH terms y
2
t-i
) is as follows;

In this case, we estimated the following regression by using GARCH (1,1);
r
t +1
*(f
t
-s
t
) + e
t +1
(e
t+1
is GARCH process;
2
t

0
*
2
t-1

1
*r
2
t-1
)

Table2: result of GARCH (1,1)
coefficient Std.Error robust-SE t-value t-prob
Constant X -0.00363419 0.001493 0.001428 -2.55 0.011
Svar13 X -3.84836 0.6039 0.6937 -5.55 0
alpha_0 H 9.09E-05 4.11E-05 4.69E-05 1.94 0.053
alpha_1 H 0.205291 0.07114 0.1161 1.77 0.078
beta_1 H 0.658822 0.1049 0.1509 4.37 0

27

log-likelihood 731.575055 HMSE 3.38775
mean(h_t) 0.000636922 var(h_t) 2.18309e-007
AIC.T -1453.15011 AIC -4.62786659
mean(Svar15) 0.00157505 var(Svar15) 0.000678479
alpha(1)+beta(1) 0.864113 alpha_i+beta_i>=0, alpha(1)+beta(1)<1

After checking GARCH (2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ), GARCH
(1,1) has the smallest AIC.

EGARCH (2,1)
The exponential general autoregressive conditional heteroskedastic (EGARCH) is
another form of the GARCH model.
r
t +1
*(f
t
-s
t
) + e
t +1
(e
t+1
is EGARCH process; log(
t
) *log(
t-1
) *g(e
t-1
))

Table3: result of EGARCH (2,1)
Coefficient Std.Error robust-SE t-value t-prob
ConstantX -0.00452641 0.002526 0.005 -0.905 0.366
Svar13 X -3.94563 1.28 2.797 -1.41 0.159
alpha_0H -1.07738 0.6095 0.8275 -1.3 0.194
eps[-1]H -0.0893646 0.0903 0.1612 -0.554 0.58
eps[-1]H| 0.389474 0.1191 0.1868 2.09 0.038
beta_1 H 0.223492 0.1317 0.1148 1.95 0.053
beta_2 H 0.631613 0.1424 0.1375 4.59 0

mean(h_t) 0.000610788 var(h_t) 1.17643e-007
AIC.T -1455.88355 AIC -4.63657182

After checking EGARCH (1,1), (2,2), (1,2), (3,3), (1,3), (2,3), (3,2), (3,1), EGARCH

GARCH_t (1,1)
We used the same system as GARCH model, but e
t
has student-t distribution.
After checking GARCH_t (2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ), GARCH_t
28

Table4: result of GARCH_t (1,1)
ConstantX -0.00435339 0.001533 0.00166 -2.62 0.009
Svar13 X -4.37628 0.6921 0.8425 -5.19 0
alpha_0H 9.32E-05 5.14E-05 4.57E-05 2.04 0.042
alpha_1H 0.179514 0.07519 0.07406 2.42 0.016
beta_1 H 0.674581 0.1175 0.09939 6.79 0
student-t df 7.39636 2.762 2.666 2.77 0.006

mean(h_t) 0.000627734 var(h_t) 1.86671e-007
AIC.T -1462.56983 AIC -4.65786569

AGARCH (1,1)
The asymmetric general autoregressive conditional heteroskedastic (AGARCH) is
another form of the GARCH model.
r
t +1
*(f
t
-s
t
) + e
t +1

(e
t+1
is AGARCH process;
2
t

0
*
2
t-1

1
*r
2
t-1
+ *
2
t-1
*I
t-1
)
where I is a dummy variable that takes the value of 1 when the shock is less than 0
(negative) and 0 otherwise.

Table5: result of AGARCH (1,1)
ConstantX
-
0.00416869 0.001784 0.002324 -1.79 0.074
Svar13 X -4.12479 0.8859 1.446 -2.85 0.005
alpha_0H 9.56E-05 4.63E-05 5.28E-05 1.81 0.071
alpha_1H 0.179147 0.08085 0.1436 1.25 0.213
beta_1 H 0.665725 0.1065 0.1489 4.47 0
asymmetry 0.00348092 0.006793 0.01142 0.305 0.761

mean(h_t) 0.000628148 var(h_t) 1.94733e-007
AIC.T -1451.51063 AIC -4.62264531

After checking AGARCH(2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ), AGARCH

AGARCH_t (1,1)
After checking AGARCH_t (2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ),
AGARCH_t (1,1) has the smallest AIC.
29

Table6: result of AGARCH_t (1,1)
ConstantX -0.00481526 0.001595 0.001764 -2.73 0.007
Svar13 X -4.54144 0.7035 0.8347 -5.44 0
alpha_0H 8.71E-05 4.84E-05 4.56E-05 1.91 0.057
alpha_1H 0.14278 0.07773 0.08904 1.6 0.11
beta_1 H 0.703535 0.114 0.1073 6.55 0
student-t df 7.2988 2.67 2.547 2.87 0.004
asymmetry 0.00641832 0.008616 0.01025 0.626 0.532

mean(h_t) 0.000621074 var(h_t) 1.6545e-007
AIC.T -1461.44284 AIC -4.65427655

TGARCH (1,1)
The threshold GARCH (TGARCH) is another form of the GARCH model.
r
t +1
*(f
t
-s
t
) + e
t +1
(e
t+1
is TGARCH process as follows;)

Table7: result of TGARCH (1,1)
Constant X -0.00504322 0.001587 0.0017 -2.97 0.003
Svar13 X -4.61959 0.7545 0.9229 -5.01 0
alpha_0 H 0.000107604 4.60E-05 5.56E-05 1.93 0.054
alpha_1 H 0.0231942 0.05919 0.06826 0.34 0.734
beta_1 H 0.677875 0.09654 0.1097 6.18 0
threshold H 0.2355 0.1195 0.1644 1.43 0.153

mean(h_t) 0.000642238 var(h_t) 3.62499e-007
AIC.T -1457.12511 AIC -4.64052581

After checking TGARCH (2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ), TGARCH

30

TGARCH_t (1,1)
After checking TGARCH_t (2,2), (1,2), (2,2), (3,3), (1,3), (2,3), (3,2), (3,1) ),
TGARCH_t (1,1) has the smallest AIC.

Table8: result of TGARCH_t (1,1)
Constant X -0.00509419 0.001556 0.001697 -3 0.003
Svar13 X -4.62896 0.6915 0.8063 -5.74 0
alpha_0 H 0.000106285 4.96E-05 4.75E-05 2.24 0.026
alpha_1 H 0.0425079 0.06919 0.06845 0.621 0.535
beta_1 H 0.676391 0.1011 0.08008 8.45 0
student-t df 8.04499 3.222 2.933 2.74 0.006
threshold H 0.203911 0.1343 0.1366 1.49 0.137

mean(h_t) 0.000636638 var(h_t) 3.25832e-007
AIC.T -1464.39069 AIC -4.6636646

According to the above tables, the level oI volatility (
2
t
) or the percentage of volatility
(log(
t
)) become smaller over time because the coeIIicients oI past volatility (
2
t-1
or
log(
t-1
)) and past return (r
2
t-1
) are less than 1 in residuals of all models.

3. Specification that we would use and the reason:

The following table is the summary of the results of all estimates.

Table9: summary of all results

Constant beta
AIC coefficient SE t-stats coefficient SE t-stats
GARCH(1,1) -0.0036342 0.001493 -2.55 -3.84836 0.6039 -5.55
-
4.62786659
EGARCH(2,1)
-
0.00452641 0.002526 -0.905 -3.94563 1.28 -1.41
-
4.63657182
GARCH_t(1,1) -0.0043534 0.001533 -2.62 -4.37628 0.6921 -5.19
-
4.65786569
AGARCH(1,1)
-0.0041687 0.001784 -1.79 -4.12479 0.8859 -2.85
-
4.62264531
AGARCH_t(1,1)
-0.0048153 0.001595 -2.73 -4.54144 0.7035 -5.44
-
4.65427655
TGARCH(1,1) -0.0050432 0.001587 -2.97 -4.61959 0.7545 -5.01
-
4.64052581
TGARCH_t(1,1) -0.0050942 0.001556 -3 -4.62896 0.6915 -5.74 -4.6636646

31

AIC
We use Akaike Information Criteria (AIC) in order to measure the goodness of fit of
models. According to the above table, AIC of TGARCH_t (1,1) is the smallest and
optimal. When we increase the lag for it, AIC becomes larger. Since the model having
the minimum AIC is the best, we would choose TGARCH_t (1,1) as the best model.
As the above table shows, EGARCH model and TGARCH model give more optimal
AIC compared with GARCH model. This is because GARCH model is more restricted
than EGARCH and TGARCH. GARCH models assume that positive and negative error
terms have a symmetric effect on the volatility, which means that good and bad news
have the same effect on the volatility. However, in practice, this assumption is violated
because the volatility increases more after bad news than after good news (which is
called Leverage effect). From this point of view, several extensions of the GARCH
model such as EGARCH model and TGARCH model heve been suggested. Since
EGARCH model and TGARCH model get rid of the restricted assumption of GARCH
model, the EGARCH model and TGARCH model seem to result in better fits than
GARCH model. Though AGARCH model also dues to the leverage effect, its AIC is
larger than that of GARCH model.
In addition, we have better results when we consider that error terms have student-t
distributions (GARCH_t model, AGARCH_t model and TGARCH_t model fit better
than GARCH model, AGARCH model and TGARCH model respectively). According
to this result, we can see the volatility of excess return from investing in foreign asset
would not follow the normal distribution but have a fatter tail.

coefficients
T-stats of constant coefficient is significant for TGARCH_t (1,1) (-3) and the
coefficient is significantly close to 0 (-0.0050942). This follows the Uncovered Interest
rate Parity. However, the beta coefficient for TGARCH_t (1,1) is highly negative (-
4.62896) and t-stats of it is significant (-5.74), which explains the coefficient estimates
well.
In addition, the beta coefficients obtained from all models are also significantly
negative. Beta coefficient obtained from GARCH(1,1) is the closest to 0 (-3.84836), but
still significantly different from 0. So, forward premium puzzle still remains even
taking into account of autocorrelation and heteroskedasticity.

4. Specification that can help us to measure the price of cur rency risk and its
intuition:

The relationship between risk and returns plays an important role. If the risk is not
constant over time, the conditional expectation of market returns is a function of the
conditional variance. The variation of GARCHM model adds the risk (volatility) as a
regressor, which means that the risk affects the level of excess return. The general
specification of the model is as follows:
Y
t
X
t

2
t
t

Where X
t
is the forward spread (f-s) in this question.
32

Therefore, the coefficient of volatility () can be interpreted as the price of a unit of
currency risk on excess return. There are several forms of the GARCHM model which
replace volatility (
2
t
) by standard deviation (
t
) or log of standard deviation (log(
t
)).
We can use these 3 possible volatilities depends on the type oI volatilities (e.g. log(
t
) is
the percentage of the volatility). Also we estimated the regression by using 3 bivariate
EGARCHM model, AGARCHM model and TGARCHM model in which error terms
follow EGARCH, AGARCH and TGARCH respectively.

The Table 10 summarises each model which has the smallest AIC.

Firstly, we will explain about GARCHM model which we learned in the class. We took
(p, q) = (3,1), because it has the smallest AIC after checking (p,q) = (1,1), (1,2), (2,1),
(2,2), (1,3), (2,3), (3,3), (3,2), (3,1).

Variation of GARCHM model
1) h_t in mean;
This model is denoted as follows;
r
t
= + (f
t
-s
t
)
2
t
+
t

The coeIIicient () denotes the price oI a unit oI currency risk. The coeIIicient is
statistically significant, so the relationship between excess returns and the risk is
strong. We expected ~ 0 because return usually increases as the risk increases.
However, according to the Table 10, is highly negative (-16.926). This means that
the higher the risk comes, the lower the return comes. Therefore, our findings
suggest that this regression is inadequate in explaining the financial risk-return
tradeoff.

2) Sqrt(h_t) in mean
r
t
= + (f
t
-s
t
)
t
+
t

The coeIIicient () oI sqrt (ht) denotes the investor's expected return rate increase in
accordance to the level increase of risk. The coefficient is statistically significant, so
the relationship between excess returns and the risk is strong, which is the same
result as 1). However, becomes better (-0.57), but is still negative. So we can
conclude that this regression is also inadequate in explaining the financial risk-return
tradeoff.

3) Log(h_t) in mean
r
t
= + (f
t
-s
t
) *log(
t
)

+
t

33

The coeIIicient () oI log (ht) is insigniIicant (t-ratio is -1.15), therefore we cannot
say that the relationship between excess returns and the percentage of volatility
(log(
t
)) is strong. Also, AIC is the largest among 3 specifications.

Considering each model in the same way, we obtained that the AIC of AGARCHM_t
(2,1,ht) model is the smallest (-4.7) (see the table 10). So, this model seems to be the
best specification among these models. The coeIIicient () oI volatility is statistically
significant and highly negative (-116.01). This result implies that there is a strong
relationship between excess returns and the risk, but this regression cannot explain the
financial risk-return tradeoff well.
According to Table 10, TGARCHM_t (3,3, ht) model also has small AIC (-4.6998) and
the coefficient () is significantly negative (-29.453). As same as the result of 2, AIC of
EGARCHM, AGARCHM and TGARCHM is better than that of GARCHM. This
seems to describe that expansion of GARCHM model such as EGARCHM,
AGARCHM and TGARCHM which include asymmetric errors estimate the system
well. In addition, we can find that each model with t-distribution has better AIC than
that with normal distribution.

5. Did adding these volatility dynamics alter the i nitial puzzle?

No effect (Beta still remains to highly negative and the forward premium puzzle still
remains intact)
T-stats of constant coefficient is significant for TGARCH_t (1,1) (-3) and the
coefficient is significantly close to 0 (-0.0050942). This follows the Uncovered Interest
rate Parity. However, the beta coefficient for TGARCH_t (1,1) is highly negative (-
4.62896) and t-stats of it is significant (-5.74), which explains the coefficient estimates
well. Compared with the benchmark OLS result, the coefficient of beta became more
negative and t-ratio
became more significant. The results became worse from the point of view of UIP.
In addition, the beta coefficients obtained from all models are also significantly
negative. Beta coefficient obtained from GARCH(1,1) is the closest to 0 (-3.7273), but
still significantly different from 0. the forward premium puzzle still remains intact even
taking into account of autocorrelation and heteroskedasticity.
34

Table10: summary of several GARCH-in-mean models

specification
constant beta
volatility
(2t,t,log(t))
AIC coefficient SE t-stats coefficient SE t-stats coefficient SE t-stats
GARCHM
GARCHM (3,1,ht)
0.00399 0.004 0.848 -5.1997 0.813 -5.08 -16.926 3E-07
-
4.53E+07
-
4.6356
GARCHM (2,1,sqrt)
0.00825 0.007 1.38 -4.5731 0.833 -4.05 -0.5652 0.169 -3.51
-
4.6326
GARCHM (1,1,log)
-0.0226 0.02 -1.35 -4.0333 0.773 -3.71 -0.0025 0.003 -1.15
-
4.6249
EGARCHM
EGARCHM (3,1,ht)
0.00733 0.003 1.22 -6.0434 0.809 -4.7 -27.987 3.104 -6.3
-
4.6681
EGARCHM (2,1,sqrt)
0.0104 0.003 3.74 -4.9102 0.84 -4.65 -0.7325 0.092 -13.7 -4.649
EGARCHM (1,1,log)
-0.0334 0.002 -27 -4.6908 0.724 -5.07 -0.0037 3E-04 -20.7
-
4.6342
GARCHM_t
GARCHM_t (1,1,ht)
0.00188 0.004 0.54 -5.2239 0.79 -5.15 -13.953 6E-06
-
2.13E+06
-
4.6694
GARCHM_t (1,1,sqrt)
0.01041 0.007 1.64 -5.1871 0.772 -5.37 -0.7036 0.155 -4.71
-
4.6688
GARCHM_t (1,1,log)
-0.0347 0.021 -1.59 -4.7017 0.738 -5.06 -0.0039 0.003 -1.42
-
4.6586
AGARCHM
AGARCHM(3,2,ht)
0.01495 0.006 1.67 -5.7413 0.841 -5.22 -41.635 1E-17
-
3.16E+18
-
4.6649
AGARCHM(3,1,sq)
0.03116 0.009 3.17 -5.5559 0.749 -6.6 -1.6476 0.077 -20.6
-
4.6563
AGARCHM(1,3,log)
-0.0385 0.038 -0.617 -4.3824 0.816 -3.64 -0.0045 0.005 -0.554 -4.621
AGARCHM_t
AGARCHM_t(2,1,ht)
0.05549 0.043 1.42 -4.9127 0.779 -5.2 -116.01 3E-49
-
3.78E+50
-
4.7009
AGARCHM_t(2,2,sq)
0.23792 0.387 0.514 -4.7361 0.743 -5.28 -10.616 4E-04
-
2.15E+04
-
4.6989
AGARCHM_t(1,1,log)
-0.0356 0.021 -1.57 -4.8235 0.739 -5.43 -0.004 0.003 -1.37
-
4.6554
TGARCHM
TGARCHM (3,3,ht)
0.00749
2E-
21 3.14E+18 -5.6999 3E-24
-
2E+24 -28.05 2E-12
-
1.38E+13
-
4.6791
TGARCHM (3,3,sqrt)
0.0186 0.007 2.32 -5.472 0.872 -4.54 -1.1169 0.11 -9.07
-
4.6668
TGARCHM (1,3,log)
-0.0947 0.059 -0.81 -4.5864 0.777 -4.04 -0.0118 0.008 -0.786 -4.644
TGARCHM_t
TGARCHM_t (3,3,ht)
0.00793 0.005 1.69 -5.8105 0.857 -5.16 -29.453 2E-12
-
1.94E+13
-
4.6998
TGARCHM_t (3,3,sqrt)
0.02115 0.008 2.64 -5.6703 0.841 -5.02 -1.2498 0.105 -11.9
-
4.6888
TGARCHM_t (1,3,log)
-0.121 0.03 -4.65 -5.079 0.784 -4.78 -0.015 0.004 -4.56 -4.671

Seasonal AR Modelling of the S&P 500

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