Volatility

Forecasting with GARCH

Whatisthesignificanceofvolatility?First,thevolatility,orstandarddeviationisanimportantmeasure ofmarketrisk.Second,itisoftenusedtopricederivatives(e.g.options)instruments. Inthispaper,wewilldemonstratethefewstepsrequiredtoconvertthemarketindexS&P500datainto arobustvolatilityforecastusingtheNumXLAddinwithinExcel. Forourpurpose,weareusingtheS&P500ETF(akaSPDR)pricesasaproxyfortheUSlargecapequities market.Furthermore,weareusingthemonthlyprices(tabulatedatthebeginningofthemonth) rangingfromJan2000toFeb2012. Theobjectivehereistoconstructamodelbasedforecastforthevolatilityoverthenext12months(i.e., totheendofFeb.2013).

140 130 120 110 100 90 80 70

SPDR

60 Jan00 Jan01 Jan02 Jan03 Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 Jan10 Jan11 Jan12

Step 1: Monthly Returns

ThetimeseriesoftheSPDRpricesisnonstationary,and,thusisnotsuitableformanyeconometric analyses.Therefore,wefirstconvertedittomonthlyreturns.Furthermore,wechosethelogarithmic returnsoverthesimplereturnstospreadoutthevaluesofthetimeseriesasthesimplereturnsby definitioncantbelowerthanminus1(100%).

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15% 10% 5% 0% 5% 10% 15% 20%

Returns(%)

Inthegraphbelow,weplottedthe12monthweightedmovingaverage(WMA)andtheexponential weightedvolatility(EWMA)todemonstratethevariationofthemeanandthevolatilityovertime.
15% 10% 5% 0% 5% 10% 15% 20% %RET(LHS) EWMA(RHS) WMA(lhs) 8% 7% 6% 5% 4% 3% 2% 1% 0%

Pleasenotethatthevolatility(proxybyEWMA)movessmoothly(unlikereturns),butitismoresensitive tonegativereturnsthanitistoapositivereturnsmarket.

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Step 2: Summary Statistics

Letsnowcalculatesthedescriptivestatisticsofthemonthlyreturnssample:average,standard deviation,etc.,tohelpusbetterunderstandthedata.BuiltinfunctionsfromNumXLcanbeutilizedas showntogenerateasetofstatisticstosummarizepastmarkettrends. Usingthesummarystatisticswizard,entertheinputdataset(e.g.,returnscellsrangeincolumnH)into theTimeSeriestab,thestartingcellintotheoutputrange,andthenclickOK.

Thegeneratedoutputtableisshownbelow.Pleasenotethatcellsintheoutputtableareconnectedto theinputdatasources;theSummarystatisticswizardwritestheformulasofeachoutputusingthe labelsspecifiedinthefirstrowofeachdatacolumn.

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Examiningtheoutputtabledemonstratesthatthedistributionofthelogreturnsexhibitsnegativeskew (skewedtotheleft)andfattails.Furthermore,thewhitenoisetestresultindicatestheabsenceofany significantserialcorrelationbetweenreturns.Insum,theseresultsindicatethatthesedatacanbewell presentedbyaGARCHtypemodel.

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Step 3: GARCH Modeling

Earlyon,wenotedthatvolatility(proxyEWMA)reacteddifferentlytonegativereturns(downturn)than topositiveones.Fortunately,theexponentialGARCH(EGARCH)capturesthisphenomenon. NumXLsupportsthree(3)typesofdistributionsfortheresiduals:(1)Gaussian,(2)GeneralizedError Distribution(GED),and(3)Studentstdistribution.Thesampledataexhibitsrelativelylowexcess kurtosis,sotheGARCHmodelwillcapturetheentireexcesskurtosis,yet,permittingtheresidualstobe normallydistributed(i.e.Gaussian).

AfterenteringtheinputdatasetintoTimeSeriesandtheoutputrangecell,themodeltypecanbe selectedandmustbeprimedbyenteringsomemodelspecificparameters.Pleasenotethatwhilethese valuesarenotyetknown,acrudeandintelligentguessshouldbeentered.

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Asinthesummarystatistics,thecellsintheEGARCHoutputtableareconnectedtothesourceinput dataviatheformulas.

Step 4: EGARCH Calibration

Tofit(i.e.calibrate)themodelwithoursampledata:(1)selectthecelllabeledEGARCH(1,1),(2)click ontheCalibrateiconormenuitem,andfinally,(3)clickonSolvebutton.

TheMSExcelSolverwillmaximizetheloglikelihoodfunction(LLF)byalteringthecoefficientsvalues.

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Step 5: Residuals Diagnosis

OncetheEGARCHmodelscoefficientsarecalibrated,wecanexaminethemodelsstandardized residualstomakesurethattheysatisfytheunderlyingassumptionsofthemodel(i.e.,normally distributed).

Usingtheresidualsdiagnosistable,wenotealltestspasswiththemereexceptionoftheARCHtest whichsuggeststhepresenceofahigherorder(i.e.quadratic)dependency.Forthepurposeofthis paper,wewillacceptthecalibratedmodel. TheGARCHfamilyofmodelscapturesacommonandimportantphenomenonforvolatility:mean reversion.UsingourEGARCHmodel,thelongtermmonthlyvolatilityisestimatedat4.66%(or16.14% annually).

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Step 6: Volatility Forecast

TheGARCHfamilyofmodelsdescribesthevariationofonestep(i.e.,local)volatilityovertime,but,in practice,weneedvolatilityvaluesthatspanmultisteps(i.e.,globalorterm).Inthispaper,wewill prepareboththelocalandthetermvolatilitiesoverthenext12months. Toaccomplishthis,(1)selectthecellwithEGARCH(1,1)Text,(2)clickonForecasticonormenu, selectthelatest(3)realizedreturnsand(4)volatilities,(5)changetheforecasthorizonand(6)specify outputlocation.Finally,selectOK.

Notes 1. Theinputdatashouldrepresentthemostrecentobservations.FortheEGARCH(1,1)model,at leastoneortwoobservedreturnsarerequired. 2. TheRealizedvolatility(inputdata)isthemostrecentvolatility.Sincevolatilityisnotdirectly observed,youwouldneedtocomputeitusingyourpreferredmethod.Inthisexample,the12 monthwindowstandarddeviationwasused.

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ThetableoutputbytheNumXLforecastis:

TheEGARCHmodelstatesthatwearecurrentlyinahistoricallylowvolatilityarena,anditforecastsa rise(meanreversion)intheoverallvolatilitytoitshistoricallevel(4.66%/mo.Or16.14%/yr.).

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4.9% 4.8% 4.7% 4.6% 4.5% 4.4% 4.3% 4.2% GARCH(Local) TermStructure

Morespecifically,theseresultsindicatethatforthemonthofFebruary2012(i.e.,endingMarch1st, 2012),weforecastalowervolatilitythanJan2012becausethevalueislessthanthe4.66%baseline However,thisvolatilityisexpectedtoincreaseinMarchasitrevertstoitslongtermmeanof4.66%.

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