ARCH

(Auto-Regressive Conditional Heteroscedasticity)

An approach to modelling time-varying variance of a time
series. (t2 : conditional variance)
Mostly financial market applications: the risk premium defined as
a function of time-varying volatility (GARCH-in-mean); option pricing;
leptokurtosis, volatility clustering.

More efficient estimators can be obtained if heteroscedasticity

in error terms is handled properly.
ARCH: Engle (1982), GARCH: Bollerslev (1986), Taylor (1986).

 ARCH(p) model:

Mean Equation: yt = a + t
ARCH(1):

or

yt = a + bXt + t

t2 = + 2t-1 + t

> 0, >0

t is i.i.d.

GARCH(p,q) model:

GARCH (2,1): t2 = + 1 2t-1 + 2 2t-2 + 2t-1 + t

> 0, >0, >0
Exogenous or predetermined regressors can be added to the
ARCH equations.
The unconditional variance from a GARCH (1,1) model:
2 = / [1-(+)] + < 1, otherwise nonstationary variance,
which requires IGARCH.

Use of Univariate GARCH models in Finance

Step 1: Estimate the appropriate GARCH

specification
Step 2: Using the estimated GARCH model,
forecast one-step ahead variance.
Then, use the forecast variance in option pricing,
risk management, etc.

Use of ARCH models in Econometrics

Step 1. ARCH tests

(H0: homoscedasticity)
Heteroscedasticity tests: White test, Breusch-Pagan test
(identifies changing variance due to regressors)
ARCH-LM test: identifies only ARCH-type (auto-regressive
conditional) heteroscedasticity. H0: no ARCH-type het.

Step 2. Estimate a GARCH model (embedded in

the mean equation)
Yt = 0 + 1Xt+ t
and
Var(t) = h2t = 0 + 1t2 + h2t-1 + vt where vt is i.i.d.
Now, the t-values are corrected for ARCH-type
heteroscedasticity.

Asymmetric GARCH (TARCH or GJR Model)

Leverage Effect: In stock markets, the volatility tends to increase
when the market is falling, and decrease when it is rising.
To model asymmetric effects on the volatility:

t2 = + 2t-1 + It-1 2t-1 + 2t-1 + t

It-1 = { 1 if t-1 < 0, 0 if t-1 > 0 }
If is significant, then we have asymmetric volatility effects. If
is significantly positive, it provides evidence for the leverage
effect.

Multivariate GARCH
If the variance of a variable is affected by the past shocks to
the variance of another variable, then a univariate GARCH
specification suffers from an omitted variable bias.
VECH Model: (describes the variance and covariance as a
function of past squared error terms, cross-product error
terms, past variances and past covariances.)
MGARCH(1,1) Full VECH Model

1,t2 = 1 + 1,121,t-1 + 1,222,t-1 + 1,31,t-12,t-1 + 1,121,t-1

+ 1,222,t-1 + 1,3Cov1,2,t-1 + 1,t
2,t2 = 2 + 2,121,t-1 + 2,222,t-1 + 2,31,t-12,t-1 + 2,121,t-1
+ 2,222,t-1 + 2,3Cov1,2,t-1 + 2,t
Cov1,2,t = 3 + 3,121,t-1 + 3,222,t-1 + 3,31,t-12,t-1 +
3,121,t-1 + 3,222,t-1 + 3,3Cov1,2,t-1 + 3,t
Two key terms:

Shock spillover, Volatility spillover

Diagonal VECH Model: (describes the variance as a function

of past squared error term and variance; and describes the
covariance as a function of past cross-product error terms
and past covariance.)
MGARCH (1,1) Diagonal VECH

1,t2 = 1 + 1,121,t-1 + 1,121,t-1 + 1,t

2,t2 = 2 + 2,222,t-1 + 2,222,t-1 + 2,t
Cov1,2,t = 3 + 3,31,t-12,t-1 + 3,3Cov1,2,t-1 + 3,t
This one is less computationally-demanding, but still cannot
guarantee positive semi-definite covariance matrix.
Constant Correlation Model: to economize on parameters
Cov1,2,t = Cor1,2

12,t 22,t

however, this assumption may be unrealistic.

BEKK Model: guarantees the positive definiteness

MGARCH(1,1)
1,t2 = 1 + 21,121,t-1 + 21,12,11,t-12,t-1 + 22,122,t-1 + 21,121,t-1 +
21,12,1Cov1,2,t-1 + 22,122,t-1 + 1,t
2,t2 = 2 + 21,221,t-1 + 21,22,21,t-12,t-1 + 22,222,t-1 + 21,221,t-1 +
21,22,2Cov1,2,t-1 + 22,222,t-1 + 2,t
Cov1,2,t = 1,2 + 1,1 1,2 21,t-1+(2,11,2+ 1,12,2)1,t-12,t-1 + 2,1
2,2 22,t-1 + 1,11,221,t-1 +(2,1 1,2+ 1,12,2)Cov1,2,t-1+
2,12,222,t-1 + 3,t
Interpreting BEKK Model Results: You will get:
3 constant terms: 1 , 2 , 1,2
4 ARCH terms: 1,1 , 2,1 , 1,2 , 2,2 (shock spillovers)
4 GARCH terms: 1,1 , 2,1 , 1,2 , 2,2 (volatility spillovers)