In this package, you will find:

The authors biography

A preview chapter from the book, Chapter 1 Time Series Analysis
A synopsis of the books content
More information on Mastering R for Quantitative Finance

About the Authors

Edina Berlinger has a PhD in economics from the Corvinus University of Budapest.
She is an associate professor, teaching corporate finance, investments, and financial risk
management. She is the head of the Finance department of the university, and is also the
chair of the finance subcommittee of the Hungarian Academy of Sciences. Her expertise
covers loan systems, risk management, and more recently, network analysis. She has led
several research projects in student loan design, liquidity management, heterogeneous
agent models, and systemic risk.
This work has been supported by the Hungarian Academy
of Sciences, Momentum Programme (LP-004/2010).

Ferenc Ills has an MSc degree in mathematics from Etvs Lornd University.
A few years after graduation, he started studying actuarial and financial mathematics,
and he is about to pursue his PhD from Corvinus University of Budapest. In recent
years, he has worked in the banking industry. Currently, he is developing statistical
models with R. His interest lies in large networks and computational complexity.
Miln Badics has a master's degree in finance from the Corvinus University
of Budapest. Now, he is a PhD student and a member of the PADS PhD
scholarship program. He teaches financial econometrics, and his main
research topics are time series forecasting with data-mining methods,
financial signal processing, and numerical sensitivity analysis on
interest rate models. He won the competition of the X. Kochmeisterprize organized by the Hungarian Stock Exchange in May 2014.

dm Banai has received his MSc degree in investment analysis and risk management
from Corvinus University of Budapest. He joined the Financial Stability department
of the Magyar Nemzeti Bank (MNB, the central bank of Hungary) in 2008. Since 2013,
he is the head of the Applied Research and Stress Testing department at the Financial
System Analysis Directorate (MNB). He is also a PhD student at the Corvinus University
of Budapest since 2011. His main research fields are solvency stress-testing, funding
liquidity risk, and systemic risk.
Gergely Darczi is an enthusiast R package developer and founder/CTO of an
R-based web application at Rapporter. He is also a PhD candidate in sociology
and is currently working as the lead R developer at CARD.com in Los Angeles.
Besides teaching statistics and doing data analysis projects for several years, he has
around 10 years of experience with the R programming environment. Gergely is the
coauthor of Introduction to R for Quantitative Finance, and is currently working on
another Packt book, Mastering Data Analysis with R, apart from a number of journal
articles on social science and reporting topics. He contributed to the book by reviewing
and formatting the R source code.
Barbara Dmtr is an assistant professor of the department of Finance at Corvinus
University of Budapest. Before starting her PhD studies in 2008, she worked for several
multinational banks. She wrote her doctoral thesis about corporate hedging. She lectures
on corporate finance, financial risk management, and investment analysis. Her main
research areas are financial markets, financial risk management, and corporate hedging.
Gergely Gabler is the head of the Business Model Analysis department at the
banking supervisory division of National Bank of Hungary (MNB) since 2014.
Before this, he used to lead the Macroeconomic Research department at Erste
Bank Hungary after being an equity analyst since 2008. He graduated from
the Corvinus University of Budapest in 2009 with an MSc degree in financial
mathematics. He has been a guest lecturer at Corvinus University of Budapest
since 2010, and he also gives lectures in MCC College for advanced studies.
He is about to finish the CFA program in 2015 to become a charterholder.

Dniel Havran is a postdoctoral research fellow at Institute of Economics, Centre

for Economic and Regional Studies, Hungarian Academy of Sciences. He also holds
a part-time assistant professor position at the Corvinus University of Budapest, where
he teaches corporate finance (BA, PhD) and credit risk management (MSc).
He obtained his PhD in economics at Corvinus University of Budapest in 2011.
I would like to thank the postdoctoral fellowship programme
of the Hungarian Academy of Sciences for their support.

Pter Juhsz holds a PhD degree in business administration from the Corvinus
University of Budapest and is also a CFA charterholder. As an associate professor,
he teaches corporate finance, business valuation, VBA programming in Excel, and
communication skills. His research field covers the valuation of intangible assets,
business performance analysis and modeling, and financial issues in public procurement
and sports management. He is the author of several articles, chapters, and books mainly
on the financial performance of Hungarian firms. Besides, he also regularly acts as
a consultant for SMEs and is a senior trainer for EY Business Academy in the
EMEA region.
Istvn Margitai is an analyst in the ALM team of a major banking group in the CEE
region. He mainly deals with methodological issues, product modeling, and internal
transfer pricing topics. He started his career with asset-liability management in Hungary
in 2009. He gained experience in strategic liquidity management and liquidity planning.
He majored in investments and risk management at Corvinus University of Budapest.
His research interest is the microeconomics of banking, market microstructure, and the
liquidity of order-driven markets.
Balzs Mrkus has been working with financial derivatives for over 10 years.
He has been trading many different kinds of derivatives, from carbon swaps to
options on T-bond futures. He was the head of the Foreign Exchange Derivative Desk
at Raiffesien Bank in Budapest. He is a member of the advisory board at Pallas Athn
Domus Scientiae Foundation, and is a part-time analyst at the National Bank of Hungary
and the managing director of Nitokris Ltd, a small proprietary trading and consulting
company. He is currently working on his PhD about the role of dynamic hedging at
the Corvinus University of Budapest, where he is affiliated as a teaching assistant.

Pter Medvegyev has an MSc degree in economics from the Marx Kroly University
Budapest. After completing his graduation in 1977, he started working as a consultant
in the Hungarian Management Development Center. He got his PhD in Economics in
1985. He has been working for the Mathematics department of the Corvinus University
Budapest since 1993. His teaching experience at Corvinus University includes stochastic
processes, mathematical finance, and several other subjects in mathematics.
Julia Molnr is a PhD candidate at the Department of Finance, Corvinus University
of Budapest. Her main research interests include financial network, systemic risk, and
financial technology innovations in retail banking. She has been working at McKinsey
& Company since 2011, where she is involved in several digital and innovation studies
in the area of banking.
Balzs rpd Szcs is a PhD candidate in finance at the Corvinus University of
Budapest. He works as a research assistant at the Department of Finance at the same
university. He holds a master's degree in investment analysis and risk management.
His research interests include optimal execution, market microstructure, and forecasting
intraday volume.

gnes Tuza holds an applied economics degree from Corvinus University

of Budapest and is an incoming student of HEC Paris in International Finance.
Her work experience covers structured products' valuation for Morgan Stanley
as well as management consulting for The Boston Consulting Group. She is an
active forex trader and shoots a monthly spot for Gazdasg TV on an investment
idea where she frequently uses technical analysis, a theme she has been interested
in since the age of 15. She has been working as a teaching assistant at Corvinus
in various finance-related subjects.
Tams Vadsz has an MSc degree in economics from the Corvinus University
of Budapest. After graduation, he was working as a consultant in the financial
services industry. Currently, he is pursuing his PhD in finance, and his main
research interests are financial economics and risk management in banking.
His teaching experience at Corvinus University includes financial econometrics,
investments, and corporate finance.

Kata Vradi is an assistant professor at the Department of Finance, Corvinus

University of Budapest since 2013. Kata graduated in finance in 2009 from Corvinus
University of Budapest and was awarded a PhD degree in 2012 for her thesis on the
analysis of the market liquidity risk on the Hungarian stock market. Her research areas
are market liquidity, fixed income securities, and networks in healthcare systems. Besides
doing research, she is active in teaching as well. She mainly teaches corporate finance,
investments, valuation, and multinational financial management.
gnes Vidovics-Dancs is a PhD candidate and an assistant professor at
the Department of Finance, Corvinus University of Budapest. Previously,
she worked as a junior risk manager in the Hungarian Government Debt
Management Agency. Her main research areas are government debt
management (in general) and sovereign crises and defaults (in particular).
She is a CEFA and CIIA diploma holder.

Mastering R for Quantitative Finance

Mastering R for Quantitative Finance is a sequel of our previous volume titled
Introduction to R for Quantitative Finance, and it is intended for those willing
to learn to use R's capabilities for building models in Quantitative Finance at
a more advanced level. In this book, we will cover new topics in empirical
finance (chapters 1-4), financial engineering (chapters 5-7), optimization
of trading strategies (chapters 8-10), and bank management (chapters 11-13).

What This Book Covers

Chapter 1, Time Series Analysis (Tams Vadsz) discusses some important concepts
such as cointegration (structural), vector autoregressive models, impulse-response
functions, volatility modeling with asymmetric GARCH models, and news
impact curves.
Chapter 2, Factor Models (Barbara Dmtr, Kata Vradi, Ferenc Ills) presents
how a multifactor model can be built and implemented. With the help of a principal
component analysis, five independent factors that explain asset returns are identified.
For illustration, the Fama and French model is also reproduced on a real market dataset.
Chapter 3, Forecasting Volume (Balzs rpd Szcs, Ferenc Ills) covers an intraday
volume forecasting model and its implementation in R using data from the DJIA index.
The model uses turnover instead of volume, separates seasonal components (U shape)
from dynamic components, and forecasts these two individually.
Chapter 4, Big Data Advanced Analytics (Jlia Molnr, Ferenc Ills) applies R to
access data from open sources, and performs various analyses on a large dataset. For
illustration, K-means clustering and linear regression models are applied to big data.
Chapter 5, FX Derivatives (Pter Medvegyev, gnes Vidovics-Dancs, Ferenc Ills)
generalizes the Black-Scholes model for derivative pricing. The Margrabe formula,
which is an extension of the Black-Scholes model, is programmed to price stock
options, currency options, exchange options, and quanto options.
Chapter 6, Interest Rate Derivatives and Models (Pter Medvegyev, gnes VidovicsDancs, Ferenc Ills) provides an overview of interest rate models and interest rate
derivatives. The Black model is used to price caps and caplets; besides this, interest
rate models such as the Vasicek and CIR model are also presented.
Chapter 7, Exotic Options (Balzs Mrkus, Ferenc Ills) introduces exotic options,
explains their linkage to plain vanilla options, and presents the estimation of their
Greeks for any derivative pricing function. A particular exotic option, the DoubleNo-Touch (DNT) binary option, is examined in more details.

Chapter 8, Optimal Hedging (Barbara Dmtr, Kata Vradi, Ferenc Ills)

analyzes some practical problems in hedging of derivatives that arise from
discrete time rearranging of the portfolio and from transaction costs. In order
to find the optimal hedging strategy, different numerical-optimization algorithms
are used.
Chapter 9, Fundamental Analysis (Pter Juhsz, Ferenc Ills) investigates how to build
an investment strategy on fundamental bases. To pick the best yielding shares, on one
hand, clusters of firms are created according to their past performance, and on the other
hand, over-performers are separated with the help of decision trees. Based on these,
stock-selection rules are defined and backtested.
Chapter 10, Technical Analysis, Neural networks, and Logoptimal Portfolios
(gnes Tuza, Miln Badics, Edina Berlinger, Ferenc Ills) overviews technical
analysis and some corresponding strategies, like neural networks and logoptimal
portfolios. Problems of forecasting the price of a single asset (bitcoin), optimizing
the timing of our trading, and the allocation of the portfolio (NYSE stocks) are also
investigated in a dynamic setting.
Chapter 11, Asset and Liability Management (Dniel Havran, Istvn Margitai)
demonstrates how R can support the process of asset and liability management
in a bank. The focus is on data generation, measuring and reporting on interest
rate risks, liquidity risk management, and the modeling of the behavior of
non-maturing deposits.
Chapter 12, Capital Adequacy (Gergely Gabler, Ferenc Ills) summarizes the
principles of the Basel Accords, and in order to determinate the capital adequacy
of a bank, calculates value-at-risk with the help of the historical, delta-normal, and
Monte-Carlo simulation methods. Specific issues of credit and operational risk are
also covered.
Chapter 13, Systemic Risk (dm Banai, Ferenc Ills) shows two methods that
can help in identifying systemically important financial institutions based on
network theory: a core-periphery model and a contagion model.
Gergely Darczi has also contributed to most chapters by reviewing
the program codes.

Time Series Analysis

In this chapter, we consider some advanced time series methods and their
implementation using R. Time series analysis, as a discipline, is broad enough
to fill hundreds of books (the most important references, both in theory and R
programming, will be listed at the end of this chapter's reading list); hence, the
scope of this chapter is necessarily highly selective, and we focus on topics that
are inevitably important in empirical finance and quantitative trading. It should
be emphasized at the beginning, however, that this chapter only sets the stage for
further studies in time series analysis.
Our previous book Introduction to R for Quantitative Finance, Packt Publishing,
discusses some fundamental topics of time series analysis such as linear, univariate
time series modeling, Autoregressive integrated moving average (ARIMA), and
volatility modeling Generalized Autoregressive Conditional Heteroskedasticity
(GARCH). If you have never worked with R for time series analysis, you might want
to consider going through Chapter 1, Time Series Analysis of that book as well.
The current edition goes further in all of these topics and you will become familiar
with some important concepts such as cointegration, vector autoregressive models,
impulse-response functions, volatility modeling with asymmetric GARCH models
including exponential GARCH and Threshold GARCH models, and news impact
curves. We first introduce the relevant theories, then provide some practical insights
to multivariate time series modeling, and describe several useful R packages
and functionalities. In addition, using simple and illustrative examples, we
give a step-by-step introduction to the usage of R programming language
for empirical analysis.

Time Series Analysis

Multivariate time series analysis

The basic issues regarding the movements of financial asset prices, technical analysis,
and quantitative trading are usually formulated in a univariate context. Can we predict
whether the price of a security will move up or down? Is this particular security in
an upward or a downward trend? Should we buy or sell it? These are all important
considerations; however, investors usually face a more complex situation and rarely
see the market as just a pool of independent instruments and decision problems.
By looking at the instruments individually, they might seem non-autocorrelated and
unpredictable in mean, as indicated by the Efficient Market Hypothesis, however,
correlation among them is certainly present. This might be exploited by trading
activity, either for speculation or for hedging purposes. These considerations justify
the use of multivariate time series techniques in quantitative finance. In this chapter,
we will discuss two prominent econometric concepts with numerous applications in
finance. They are cointegration and vector autoregression models.

Cointegration
From now on, we will consider a vector of time series yt , which consists of the
elements yt(1) , yt( 2)  yt( n ) each of them individually representing a time series, for
instance, the price evolution of different financial products. Let's begin with the
formal definition of cointegrating data series.
The n 1 vector yt of time series is said to be cointegrated if each of the series are
individually integrated in the order d (in particular, in most of the applications the
series are integrated of order 1, which means nonstationary unit-root processes, or
'
random walks), while there exists a linear combination of the series yt , which is
integrated in the order d 1 (typically, it is of order 0, which is a stationary process).
Intuitively, this definition implies the existence of some underlying forces in the
economy that are keeping together the n time series in the long run, even if they all
seem to be individually random walks. A simple example for cointegrating time
series is the following pair of vectors, taken from Hamilton (1994), which we will use
to study cointegration, and at the same time, familiarize ourselves with some basic
simulation techniques in R:

xt = xt 1 + ut , ut N ( 0,1)
yt = xt + vt , vt N ( 0,1)

[8]

Chapter 1

The unit root in yt will be shown formally by standard statistical tests. Unit root
tests in R can be performed using either the tseries package or the urca package;
here, we use the second one. The following R code simulates the two series of
length 1000:
#generate the two time series of length 1000

set.seed(20140623)

#fix the random seed

N <- 1000

#define length of simulation

x <- cumsum(rnorm(N))

#simulate a normal random walk

gamma <- 0.7

#set an initial parameter value

y <- gamma * x + rnorm(N)

#simulate the cointegrating series

plot(x, type='l')

#plot the two series

lines(y,col="red")

Downloading the example code

You can download the example code files from your account at
http://www.packtpub.com for all the Packt Publishing books
you have purchased. If you purchased this book elsewhere, you can
visit http://www.packtpub.com/support and register to have the
files e-mailed directly to you.

The output of the preceding code is as follows:

[9]

Time Series Analysis

By visual inspection, both series seem to be individually random walks. Stationarity

can be tested by the Augmented Dickey Fuller test, using the urca package;
however, many other tests are also available in R. The null hypothesis states that
there is a unit root in the process (outputs omitted); we reject the null if the test
statistic is smaller than the critical value:
#statistical tests
install.packages('urca');library('urca')
#ADF test for the simulated individual time series
summary(ur.df(x,type="none"))
summary(ur.df(y,type="none"))

For both of the simulated series, the test statistic is larger than the critical value at the
usual significance levels (1 percent, 5 percent, and 10 percent); therefore, we cannot
reject the null hypothesis, and we conclude that both the series are individually unit
root processes.
Now, take the following linear combination of the two series and plot the
resulted series:

zt = yt xt
z = y - gamma*x

#take a linear combination of the series

plot(z,type='l')

The output for the preceding code is as follows:

[ 10 ]

Chapter 1

zt clearly seems to be a white noise process; the rejection of the unit root is
confirmed by the results of ADF tests:
summary(ur.df(z,type="none"))

In a real-world application, obviously we don't know the value of ; this has to be

estimated based on the raw data, by running a linear regression of one series on
the other. This is known as the Engle-Granger method of testing cointegration. The
following two steps are known as the Engle-Granger method of testing cointegration:
1. Run a linear regression yt on xt (a simple OLS estimation).
2. Test the residuals for the presence of a unit root.
We should note here that in the case of the n series, the number of
possible independent cointegrating vectors is 0 < r < n ; therefore, for
n > 2 , the cointegrating relationship might not be unique. We will briefly
discuss r > 1 later in the chapter.

Simple linear regressions can be fitted by using the lm function. The residuals can
be obtained from the resulting object as shown in the following example. The ADF
test is run in the usual way and confirms the rejection of the null hypothesis at all
significant levels. Some caveats, however, will be discussed later in the chapter:
#Estimate the cointegrating relationship
coin <- lm(y ~ x -1)

#regression without intercept

coin$resid

#obtain the residuals

summary(ur.df(coin$resid))

#ADF test of residuals

Now, consider how we could turn this theory into a successful trading strategy.
At this point, we should invoke the concept of statistical arbitrage or pair trading,
which, in its simplest and early form, exploits exactly this cointegrating relationship.
These approaches primarily aim to set up a trading strategy based on the spread
between two time series; if the series are cointegrated, we expect their stationary
linear combination to revert to 0. We can make profit simply by selling the relatively
expensive one and buying the cheaper one, and just sit and wait for the reversion.
The term statistical arbitrage, in general, is used for many sophisticated
statistical and econometrical techniques, and this aims to exploit
relative mispricing of assets in statistical terms, that is, not in
comparison to a theoretical equilibrium model.

[ 11 ]

Time Series Analysis

What is the economic intuition behind this idea? The linear combination of time series
that forms the cointegrating relationship is determined by underlying economic
forces, which are not explicitly identified in our statistical model, and are sometimes
referred to as long-term relationships between the variables in question. For example,
similar companies in the same industry are expected to grow similarly, the spot and
forward price of a financial product are bound together by the no-arbitrage principle,
FX rates of countries that are somehow interlinked are expected to move together,
or short-term and long-term interest rates tend to be close to each other. Deviances
from this statistically or theoretically expected comovements open the door to various
quantitative trading strategies where traders speculate on future corrections.
The concept of cointegration is further discussed in a later chapter, but for that,
we need to introduce vector autoregressive models.

Vector autoregressive models

Vector autoregressive models (VAR) can be considered as obvious multivariate
extensions of the univariate autoregressive (AR) models. Their popularity in applied
econometrics goes back to the seminal paper of Sims (1980). VAR models are the
most important multivariate time series models with numerous applications in
econometrics and finance. The R package vars provide an excellent framework for R
users. For a detailed review of this package, we refer to Pfaff (2013). For econometric
theory, consult Hamilton (1994), Ltkepohl (2007), Tsay (2010), or Martin et al. (2013).
In this book, we only provide a concise, intuitive summary of the topic.
In a VAR model, our point of departure is a vector of time series yt of length n . The
VAR model specifies the evolution of each variable as a linear function of the lagged
values of all other variables; that is, a VAR model of the order p is the following:

yt = A1 yt 1 +  + A p yt p + ut
Here, A i are n n the coefficient matrices for all i = 1 p , and ut is a vector white
noise process with a positive definite covariance matrix. The terminology of vector
white noise assumes lack of autocorrelation, but allows contemporaneous correlation
between the components; that is, ut has a non-diagonal covariance matrix.

[ 12 ]

Chapter 1

The matrix notation makes clear one particular feature of VAR models: all variables
depend only on past values of themselves and other variables, meaning that
contemporaneous dependencies are not explicitly modeled. This feature allows us
to estimate the model by ordinary least squares, applied equation-by-equation. Such
models are called reduced form VAR models, as opposed to structural form models,
discussed in the next section.
Obviously, assuming that there are no contemporaneous effects would be an
oversimplification, and the resulting impulse-response relationships, that is, changes
in the processes followed by a shock hitting a particular variable, would be misleading
and not particularly useful. This motivates the introduction of structured VAR (SVAR)
models, which explicitly models the contemporaneous effects among variables:

Ayt = A1* yt 1 +  + A*p yt p + B t

*
Here, A i = AAi and B t = Aut ; thus, the structural form can be obtained from the
reduced form by multiplying it with an appropriate parameter matrix A , which
reflects the contemporaneous, structural relations among the variables.

In the notation, as usual, we follow the technical documentation of the

vars package, which is very similar to that of Ltkepohl (2007).

In the reduced form model, contemporaneous dependencies are not modeled;

therefore, such dependencies appear in the correlation structure of the error term,
'
that is, the covariance matrix of ut , denoted by u = E ( ut ut ) . In the SVAR model,
contemporaneous dependencies are explicitly modelled (by the A matrix on the
left-hand side), and the disturbance terms are defined to be uncorrelated, so the
E (t t' ) = covariance matrix is diagonal. Here, the disturbances are usually
referred to as structural shocks.
t

What makes the SVAR modeling interesting and difficult at the same time is
the so-called identification problem; the SVAR model is not identified, that is,
parameters in matrix A cannot be estimated without additional restrictions.
How should we understand that a model is not identified? This
basically means that there exist different (infinitely many) parameter
matrices, leading to the same sample distribution; therefore, it is not
possible to identify a unique value of parameters based on the sample.

[ 13 ]

Time Series Analysis

Given a reduced form model, it is always possible to derive an appropriate

parameter matrix, which makes the residuals orthogonal; the covariance matrix
E ( ut ut' ) = u is positive semidefinitive, which allows us to apply the LDL

decomposition (or alternatively, the Cholesky decomposition). This states that

there always exists an L lower triangle matrix and a D diagonal matrix such that
u = LDLT . By choosing A = L1 , the covariance matrix of the structural model
becomes

= E L1ut ut' ( L' )

) = L (L )

' 1

, which gives

L LT . Now, we conclude

that is a diagonal, as we intended. Note that by this approach, we essentially

imposed an arbitrary recursive structure on our equations. This is the method
followed by the irf() function by default.
There are multiple ways in the literature to identify SVAR model parameters,
which include short-run or long-run parameter restrictions, or sign restrictions on
impulse responses (see, for example, Fry-Pagan (2011)). Many of them have no native
support in R yet. Here, we only introduce a standard set of techniques to impose
short-run parameter restrictions, which are respectively called A-model, B-model,
and AB-model, each of which are supported natively by package vars:

In the case of an A-model, B = I n , and restrictions on matrix A are imposed

'
'
'
such that = AE ut ut A = A u A is a diagonal covariance matrix. To
make the model "just identified", we need n ( n + 1) / 2 additional restrictions.
This is reminiscent of imposing a triangle matrix (but that particular structure
is not required).

Alternatively, it is possible to identify the structural innovations based on the

restricted model residuals by imposing a structure on the matrix B (B-model),
that is, directly on the correlation structure, in this case, A = I n and ut = B t .

The AB-model places restrictions on both A and B, and the connection

between the restricted and structural model is determined by Aut = B t .

Impulse-response analysis is usually one of the main goals of building a VAR model.
Essentially, an impulse-response function shows how a variable reacts (response) to a
shock (impulse) hitting any other variable in the system. If the system consists of K
variables, K 2 impulse response functions can be determined. Impulse responses can
be derived mathematically from the Vector Moving Average representation (VMA) of
the VAR process, similar to the univariate case (see the details in Ltkepohl (2007)).

[ 14 ]

Chapter 1

VAR implementation example

As an illustrative example, we build a three-component VAR model from the
following components:

Equity return: This specifies the Microsoft price index from January 01, 2004
to March 03, 2014

Stock index: This specifies the S&P500 index from January 01, 2004 to
March 03, 2014

US Treasury bond interest rates from January 01, 2004 to March 03, 2014

Our primary purpose is to make a forecast for the stock market index by using the
additional variables and to identify impulse responses. Here, we suppose that there
exists a hidden long term relationship between a given stock, the stock market as
a whole, and the bond market. The example was chosen primarily to demonstrate
several of the data manipulation possibilities of the R programming environment
and to illustrate an elaborate concept using a very simple example, and not because
of its economic meaning.
We use the vars and quantmod packages. Do not forget to install and load those
packages if you haven't done this yet:
install.packages('vars');library('vars')
install.packages('quantmod');library('quantmod')

The Quantmod package offers a great variety of tools to obtain financial data directly
from online sources, which we will frequently rely on throughout the book. We use
the getSymbols()function:
getSymbols('MSFT', from='2004-01-02', to='2014-03-31')
getSymbols('SNP', from='2004-01-02', to='2014-03-31')
getSymbols('DTB3', src='FRED')

By default, yahoofinance is used as a data source for equity and index price series
(src='yahoo' parameter settings, which are omitted in the example). The routine
downloads open, high, low, close prices, trading volume, and adjusted prices. The
downloaded data is stored in an xts data class, which is automatically named
by default after the ticker (MSFT and SNP). It's possible to plot the closing prices
by calling the generic plot function, but the chartSeries function of quantmod
provides a much better graphical illustration.

[ 15 ]

Time Series Analysis

The components of the downloaded data can be reached by using the following
shortcuts:
Cl(MSFT)

#closing prices

Op(MSFT)

#open prices

Hi(MSFT)

#daily highest price

Lo(MSFT)

#daily lowest price

ClCl(MSFT)

#close-to-close daily return

Ad(MSFT)

#daily adjusted closing price

Thus, for example, by using these shortcuts, the daily close-to-close returns can be
plotted as follows:
chartSeries(ClCl(MSFT))

#a plotting example with shortcuts

The screenshot for the preceding command is as follows:

Interest rates are downloaded from the FRED (Federal Reserve Economic Data)
data source. The current version of the interface does not allow subsetting of dates;
however, downloaded data is stored in an xts data class, which is straightforward
to subset to obtain our period of interest:
DTB3.sub <- DTB3['2004-01-02/2014-03-31']

[ 16 ]

Chapter 1

The downloaded prices (which are supposed to be nonstationary series) should

be transformed into a stationary series for analysis; that is, we will work with log
returns, calculated from the adjusted series:
MSFT.ret <- diff(log(Ad(MSFT)))
SNP.ret

<- diff(log(Ad(SNP)))

To proceed, we need a last data-cleansing step before turning to VAR model fitting.
By eyeballing the data, we can see that missing data exists in T-Bill return series,
and the lengths of our databases are not the same (on some dates, there are interest
rate quotes, but equity prices are missing). To solve these data-quality problems, we
choose, for now, the easiest possible solution: merge the databases (by omitting all data
points for which we do not have all three data), and omit all NA data. The former is
performed by the inner join parameter (see help of the merge function for details):
dataDaily <- na.omit(merge(SNP.ret,MSFT.ret,DTB3.sub), join='inner')

Here, we note that VAR modeling is usually done on lower frequency data.
There is a simple way of transforming your data to monthly or quarterly frequencies,
by using the following functions, which return with the opening, highest, lowest,
and closing value within the given period:
SNP.M

<- to.monthly(SNP.ret)$SNP.ret.Close

MSFT.M <- to.monthly(MSFT.ret)$MSFT.ret.Close

DTB3.M <- to.monthly(DTB3.sub)$DTB3.sub.Close

A simple reduced VAR model may be fitted to the data by using the VAR() function
of the vars package. The parameterization shown in the following code allows a
maximum of 4 lags in the equations, and choose the model with the best (lowest)
Akaike Information Criterion value:
var1 <- VAR(dataDaily, lag.max=4, ic="AIC")

For a more established model selection, you can consider using VARselect(),
which provides multiple information criteria (output omitted):
>VARselect(dataDaily,lag.max=4)

The resulting object is an object of the varest class. Estimated parameters and
multiple other statistical results can be obtained by the summary() method or the
show() method (that is, by just typing the variable):
summary(var1)
var1

[ 17 ]

Time Series Analysis

There are other methods worth mentioning. The custom plotting method for the
varest class generates a diagram for all variables separately, including its fitted
values, residuals, and autocorrelation and partial autocorrelation functions of the
residuals. You need to hit Enter to get the new variable. Plenty of custom settings
are available; please consult the vars package documentation:
plot(var1)

#Diagram of fit and residuals for each variables

coef(var1)

#concise summary of the estimated variables

residuals(var1)

#list of residuals (of the corresponding ~lm)

fitted(var1)

#list of fitted values

Phi(var1)

#coefficient matrices of VMA representation

Predictions using our estimated VAR model can be made by simply calling the
predict function and by adding a desired confidence interval:
var.pred <- predict(var1, n.ahead=10, ci=0.95)

Impulse responses should be first generated numerically by irf(), and then they can
be plotted by the plot() method. Again, we get different diagrams for each variable,
including the respective impulse response functions with bootstrapped confidence
intervals as shown in the following command:
var.irf <- irf(var1)
plot(var.irf)

Now, consider fitting a structural VAR model using parameter restrictions described
earlier as an A-model. The number of required restrictions for the SVAR model that
K K 1
is identified is ( 2 ) ; in our case, this is 3.
See Ltkepohl (2007) for more details. The number of additional
K K + 1)
restrictions required is (
, but the diagonal elements are
2

normalized to unity, which leaves us with the preceding number.

The point of departure for an SVAR model is the already estimated reduced form
of the VAR model (var1). This has to be amended with an appropriately structured
restriction matrix.
For the sake of simplicity, we will use the following restrictions:

S&P index shocks do not have a contemporaneous effect on Microsoft

S&P index shocks do not have a contemporaneous effect on interest rates

T-Bonds interest rate shocks have no contemporaneous effect on Microsoft

[ 18 ]

Chapter 1

These restrictions enter into the SVAR model as 0s in the A matrix, which is
as follows:

1 a12

a13

0 1
0 a32

0
1

When setting up the A matrix as a parameter for SVAR estimation in R, the positions
of the to-be estimated parameters should take the NA value. This can be done with
the following assignments:
amat <amat[2,
amat[2,
amat[3,

diag(3)
1] <- NA
3] <- NA
1] <- NA

Finally, we can fit the SVAR model and plot the impulse response functions
(the output is omitted):
svar1 <- SVAR(var1, estmethod='direct', Amat = amat)
irf.svar1 <- irf(svar1)
plot(irf.svar1)

Cointegrated VAR and VECM

Finally, we put together what we have learned so far, and discuss the concepts of
Cointegrated VAR and Vector Error Correction Models (VECM).
Our starting point is a system of cointegrated variables (for example, in a trading
context, this indicates a set of similar stocks that are likely to be driven by the same
fundamentals). The standard VAR models discussed earlier can only be estimated
when the variables are stationary. As we know, the conventional way to remove
unit root model is to first differentiate the series; however, in the case of cointegrated
series, this would lead to overdifferencing and losing information conveyed by the
long-term comovement of variable levels. Ultimately, our goal is to build up a model
of stationary variables, which also incorporates the long-term relationship between
the original cointegrating nonstationary variables, that is, to build a cointegrated
VAR model. This idea is captured by the Vector Error Correction Model (VECM),
which consists of a VAR model of the order p - 1 on the differences of the variables,
and an error-correction term derived from the known (estimated) cointegrating
relationship. Intuitively, and using the stock market example, a VECM model
establishes a short-term relationship between the stock returns, while correcting
with the deviation from the long-term comovement of prices.
[ 19 ]

Time Series Analysis

Formally, a two-variable VECM, which we will discuss as a numerical example, can

be written as follows. Let yt be a vector of two nonstationary unit root series yt(1) , yt( 2)
where the two series are cointegrated with a cointegrating vector = (1, ) . Then, an
appropriate VECM model can be formulated as follows:

yt = ' yt 1 + 1yt 1 +  + 1yt p +1 + t

Here, yt = yt yt 1 and the first term are usually called the error correction terms.
In practice, there are two approaches to test cointegration and build the error
correction model. For the two-variable case, the Engle-Granger method is quite
instructive; our numerical example basically follows that idea. For the multivariate
case, where the maximum number of possible cointegrating relationships is ( n 1) ,
you have to follow the Johansen procedure. Although the theoretical framework for
the latter goes far beyond the scope of this book, we briefly demonstrate the tools for
practical implementation and give references for further studies.
To demonstrate some basic R capabilities regarding VECM models, we will use a
standard example of three months and six months T-Bill secondary market rates,
which can be downloaded from the FRED database, just as we discussed earlier.
We will restrict our attention to an arbitrarily chosen period, that is, from 1984 to
2014. Augmented Dickey Fuller tests indicate that the null hypothesis of the unit
root cannot be rejected.
library('quantmod')
getSymbols('DTB3', src='FRED')
getSymbols('DTB6', src='FRED')
DTB3.sub = DTB3['1984-01-02/2014-03-31']
DTB6.sub = DTB6['1984-01-02/2014-03-31']
plot(DTB3.sub)
lines(DTB6.sub, col='red')

We can consistently estimate the cointegrating relationship between the two series
by running a simple linear regression. To simplify coding, we define the variables
x1 and x2 for the two series, and y for the respective vector series. The other
variable-naming conventions in the code snippets will be self-explanatory:
x1=as.numeric(na.omit(DTB3.sub))
x2=as.numeric(na.omit(DTB6.sub))
y = cbind(x1,x2)
cregr <- lm(x1 ~ x2)
r = cregr$residuals

[ 20 ]

Chapter 1

The two series are indeed cointegrated if the residuals of the regression (variable r),
that is, the appropriate linear combination of the variables, constitute a stationary
series. You could test this with the usual ADF test, but in these settings, the
conventional critical values are not appropriate, and corrected values should be used
(see, for example Phillips and Ouliaris (1990)).
It is therefore much more appropriate to use a designated test for the existence of
cointegration, for example, the Phillips and Ouliaris test, which is implemented in
the tseries and in the urca packages as well. The most basic tseries version is
demonstrated as follows:
install.packages('tseries');library('tseries');
po.coint <- po.test(y, demean = TRUE, lshort = TRUE)

The null hypothesis states that the two series are not cointegrated, so the low p value
indicates rejection of null and presence of cointegration.
The Johansen procedure is applicable for more than one possible cointegrating
relationship; an implementation can be found in the urca package:
yJoTest = ca.jo(y, type = c("trace"), ecdet = c("none"), K = 2)

######################
# Johansen-Procedure #
######################

Test type: trace statistic , with linear trend

Eigenvalues (lambda):
[1] 0.0160370678 0.0002322808

Values of teststatistic and critical values of test:

r <= 1 |
r = 0

test 10pct

5pct

1.76

8.18 11.65

6.50

1pct

| 124.00 15.66 17.95 23.52

Eigenvectors, normalised to first column:

(These are the cointegration relations)

[ 21 ]

Time Series Analysis

DTB3.l2

DTB3.l2

DTB6.l2

1.000000

1.000000

DTB6.l2 -0.994407 -7.867356

Weights W:
(This is the loading matrix)

DTB3.l2

DTB6.l2

DTB3.d -0.037015853 3.079745e-05

DTB6.d -0.007297126 4.138248e-05

The test statistic for r = 0 (no cointegrating relationship) is larger than the critical
values, which indicates the rejection of the null. For r 1 , however, the null cannot
be rejected; therefore, we conclude that one cointegrating relationship exists. The
cointegrating vector is given by the first column of the normalized eigenvectors
below the test results.
The final step is to obtain the VECM representation of this system, that is, to run an
OLS regression on the lagged differenced variables and the error correction term
derived from the previously calculated cointegrating relationship. The appropriate
function utilizes the ca.jo object class, which we created earlier. The r = 1 parameter
signifies the cointegration rank which is as follows:
>yJoRegr = cajorls(dyTest, r=1)
>yJoRegr

$rlm

Call:
lm(formula = substitute(form1), data = data.mat)

Coefficients:
x1.d

x2.d

ect1

-0.0370159

-0.0072971

constant

-0.0041984

-0.0016892

x1.dl1

0.1277872

0.1538121

x2.dl1

0.0006551

-0.0390444

[ 22 ]

Chapter 1
$beta
ect1
x1.l1

1.000000

x2.l1 -0.994407

The coefficient of the error-correction term is negative, as we expected; a short-term

deviation from the long-term equilibrium level would push our variables back to the
zero equilibrium deviation.
You can easily check this in the bivariate case; the result of the Johansen procedure
method leads to approximately the same result as the step-by-step implementation
of the ECM following the Engle-Granger procedure. This is shown in the uploaded R
code files.

Volatility modeling
It is a well-known and commonly accepted stylized fact in empirical finance that
the volatility of financial time series varies over time. However, the non-observable
nature of volatility makes the measurement and forecasting a challenging exercise.
Usually, varying volatility models are motivated by three empirical observations:

Volatility clustering: This refers to the empirical observation that calm

periods are usually followed by calm periods while turbulent periods by
turbulent periods in the financial markets.

Non-normality of asset returns: Empirical analysis has shown that asset

returns tend to have fat tails relative to the normal distribution.

Leverage effect: This leads to an observation that volatility tends to react

differently to positive or negative price movements; a drop in prices
increases the volatility to a larger extent than an increase of similar size.

In the following code, we demonstrate these stylized facts based on S&P asset prices.
Data is downloaded from yahoofinance, by using the already known method:
getSymbols("SNP", from="2004-01-01", to=Sys.Date())
chartSeries(Cl(SNP))

Our purpose of interest is the daily return series, so we calculate log returns from the
closing prices. Although it is a straightforward calculation, the Quantmod package
offers an even simpler way:
ret <- dailyReturn(Cl(SNP), type='log')

[ 23 ]

Time Series Analysis

Volatility analysis departs from eyeballing the autocorrelation and partial

autocorrelation functions. We expect the log returns to be serially uncorrelated, but
the squared or absolute log returns to show significant autocorrelations. This means
that Log returns are not correlated, but not independent.
Notice the par(mfrow=c(2,2)) function in the following code; by this, we overwrite
the default plotting parameters of R to organize the four diagrams of interest in a
convenient table format:
par(mfrow=c(2,2))
acf(ret, main="Return ACF");
pacf(ret, main="Return PACF");
acf(ret^2, main="Squared return ACF");
pacf(ret^2, main="Squared return PACF")
par(mfrow=c(1,1))

The screenshot for preceding command is as follows:

[ 24 ]

Chapter 1

Next, we look at the histogram and/or the empirical distribution of daily log returns
of S&P and compare it with the normal distribution of the same mean and standard
deviation. For the latter, we use the function density(ret), which computes the
nonparametric empirical distribution function. We use the function curve()with an
additional parameter add=TRUE to plot a second line to an already existing diagram:
m=mean(ret);s=sd(ret);
par(mfrow=c(1,2))
hist(ret, nclass=40, freq=FALSE, main='Return histogram');curve(dnorm(x,
mean=m,sd=s), from = -0.3, to = 0.2, add=TRUE, col="red")
plot(density(ret), main='Return empirical distribution');curve(dnorm(x,
mean=m,sd=s), from = -0.3, to = 0.2, add=TRUE, col="red")
par(mfrow=c(1,1))

The excess kurtosis and fat tails are obvious, but we can confirm numerically
(using the moments package) that the kurtosis of the empirical distribution of our
sample exceeds that of a normal distribution (which is equal to 3). Unlike some other
software packages, R reports the nominal value of kurtosis, and not excess kurtosis
which is as follows:
> kurtosis(ret)
daily.returns
12.64959

[ 25 ]

Time Series Analysis

It might be also useful to zoom in to the upper or the lower tail of the diagram.
This is achieved by simply rescaling our diagrams:
# tail zoom
plot(density(ret), main='Return EDF - upper tail', xlim = c(0.1, 0.2),
ylim=c(0,2));
curve(dnorm(x, mean=m,sd=s), from = -0.3, to = 0.2, add=TRUE, col="red")

Another useful visualization exercise is to look at the Density on log-scale

(see the following figure, left), or a QQ-plot (right), which are common tools
to comparing densities. QQ-plot depicts the empirical quantiles against that of
a theoretical (normal) distribution. In case our sample is taken from a normal
distribution, this should form a straight line. Deviations from this straight line
may indicate the presence of fat tails:
# density plots on log-scale
plot(density(ret), xlim=c(-5*s,5*s),log='y', main='Density on log-scale')
curve(dnorm(x, mean=m,sd=s), from=-5*s, to=5*s, log="y", add=TRUE,
col="red")

# QQ-plot
qqnorm(ret);qqline(ret);

[ 26 ]

Chapter 1

The screenshot for preceding command is as follows:

Now, we can turn our attention to modeling volatility.

Broadly speaking, there are two types of modeling techniques in the financial
econometrics literature to capture the varying nature of volatility: the GARCH-family
approach (Engle, 1982 and Bollerslev, 1986) and the stochastic volatility (SV) models.
As for the distinction between them, the main difference between the GARCH-type
modeling and (genuine) SV-type modeling techniques is that in the former, the
conditional variance given in the past observations is available, while in SV-models,
volatility is not measurable with respect to the available information set; therefore, it
is hidden by nature, and must be filtered out from the measurement equation (see, for
example, Andersen Benzoni (2011)). In other words, GARCH-type models involve the
estimation of volatility based on past observations, while in SV-models, the volatility
has its own stochastic process, which is hidden, and return realizations should
be used as a measurement equation to make inferences regarding the underlying
volatility process.
In this chapter, we introduce the basic modeling techniques for the GARCH
approach for two reasons; first of all, it is much more proliferated in applied works.
Secondly, because of its diverse methodological background, SV models are not yet
supported by R packages natively, and a significant amount of custom development
is required for an empirical implementation.

[ 27 ]

Time Series Analysis

GARCH modeling with the rugarch package

There are several packages available in R for GARCH modeling. The most prominent
ones are rugarch, rmgarch (for multivariate models), and fGarch; however, the
basic tseries package also includes some GARCH functionalities. In this chapter,
we will demonstrate the modeling facilities of the rugarch package. Our notations
in this chapter follow the respective ones of the rugarch package's output and
documentation.

The standard GARCH model

A GARCH (p,q) process may be written as follows:

t = tt
q

i =1

j =1

t2 = + i t2i + j t2 j
Here, t is usually the disturbance term of a conditional mean equation (in practice,
usually an ARMA process) and t ~ i.i.d. ( 0,1) . That is, the conditional volatility process
2
is determined linearly by its own lagged values t j and the lagged squared

observations (the values of t ). In empirical studies, GARCH (1,1) usually provides

an appropriate fit to the data. It may be useful to think about the simple GARCH
(1,1) specification as a model in which the conditional variance is specified as a
weighted average of the long-run variance

2
, the last predicted variance t 1 ,

and the new information t 1 (see Andersen et al. (2009)). It is easy to see how the
2

GARCH (1,1) model captures autoregression in volatility (volatility clustering) and

leptokurtic asset return distributions, but as its main drawback, it is symmetric, and
cannot capture asymmetries in distributions and leverage effects.
The emergence of volatility clustering in a GARCH-model is highly intuitive; a large
positive (negative) shock in t increases (decreases) the value of t , which in turn
increases (decreases) the value of t +1 , resulting in a larger (smaller) value for t +1 .
The shock is persistent; this is volatility clustering. Leptokurtic nature requires some
derivation; see for example Tsay (2010).

[ 28 ]

Chapter 1

Our empirical example will be the analysis of the return series calculated from
the daily closing prices of Apple Inc. based on the period from Jan 01, 2006 to
March 31, 2014. As a useful exercise, before starting this analysis, we recommend
that you repeat the exploratory data analysis in this chapter to identify stylized
facts on Apple data.
Obviously, our first step is to install a package, if not installed yet:
install.packages('rugarch');library('rugarch')

To get the data, as usual, we use the quantmod package and the getSymbols()
function, and calculate return series based on the closing prices.
#Load Apple data and calculate log-returns
getSymbols("AAPL", from="2006-01-01", to="2014-03-31")
ret.aapl <- dailyReturn(Cl(AAPL), type='log')
chartSeries(ret.aapl)

The programming logic of rugarch can be thought of as follows: irrespective of

whatever your aim is (fitting, filtering, forecasting, and simulating), first, you have to
specify a model as a system object (variable), which in turn will be inserted into the
respective function. Models can be specified by calling ugarchspec(). The following
code specifies a simple GARCH (1,1) model, (sGARCH), with only a constant in
the mean equation:
garch11.spec = ugarchspec(variance.model = list(model="sGARCH",
garchOrder=c(1,1)), mean.model = list(armaOrder=c(0,0)))

An obvious way to proceed is to fit this model to our data, that is, to estimate
the unknown parameters by maximum likelihood, based on our time series of
daily returns:
aapl.garch11.fit = ugarchfit(spec=garch11.spec, data=ret.aapl)

The function provides, among a number of other outputs, the parameter estimations
, , 1 , 1 :
> coef(aapl.garch11.fit)
mu

omega

alpha1

beta1

1.923328e-03 1.027753e-05 8.191681e-02 8.987108e-01

[ 29 ]

Time Series Analysis

Estimates and various diagnostic tests can be obtained by the show() method of the
generated object (that is, by just typing the name of the variable). A bunch of other
statistics, parameter estimates, standard error, and covariance matrix estimates
can be reached by typing the appropriate command. For the full list, consult the
ugarchfit object class; the most important ones are shown in the following code:
coef(msft.garch11.fit)

#estimated coefficients

vcov(msft.garch11.fit)

#covariance matrix of param estimates

infocriteria(msft.garch11.fit)

#common information criteria list

newsimpact(msft.garch11.fit)

#calculate news impact curve

signbias(msft.garch11.fit)

#Engle - Ng sign bias test

fitted(msft.garch11.fit)

#obtain the fitted data series

residuals(msft.garch11.fit)

#obtain the residuals

uncvariance(msft.garch11.fit)

#unconditional (long-run) variance

uncmean(msft.garch11.fit)

#unconditional (long-run) mean

Standard GARCH models are able to capture fat tails and volatility clustering, but to
explain asymmetries caused by the leverage effect, we need more advanced models.
To approach the asymmetry problem visually, we will now describe the concept of
news impact curves.
News impact curves, introduced by Pagan and Schwert (1990) and Engle and Ng
(1991), are useful tools to visualize the magnitude of volatility changes in response to
shocks. The name comes from the usual interpretation of shocks as news influencing
the market movements. They plot the change in conditional volatility against shocks
in different sizes, and can concisely express the asymmetric effects in volatility. In
the following code, the first line calculates the news impacts numerically for the
previously defined GARCH(1,1) model, and the second line creates the visual plot:
ni.garch11 <- newsimpact(aapl.garch11.fit)
plot(ni.garch11$zx, ni.garch11$zy, type="l", lwd=2, col="blue",
main="GARCH(1,1) - News Impact", ylab=ni.garch11$yexpr, xlab=ni.
garch11$xexpr)

[ 30 ]

Chapter 1

The screenshot for the preceding command is as follows:

As we expected, no asymmetries are present in response to positive and negative

shocks. Now, we turn to models to be able to incorporate asymmetric effects as well.

The Exponential GARCH model (EGARCH)

Exponential GARCH models were introduced by Nelson (1991). This approach
directly models the logarithm of the conditional volatility:

t = tt
q

log t2 = + it i + ( t i E t i
i =1

) ) +
j =1

log ( t2 j )

where, E is the expectation operator. This model formulation allows multiplicative

dynamics in evolving the volatility process. Asymmetry is captured by the i
parameter; a negative value indicates that the process reacts more to negative shocks,
as observable in real data sets.

[ 31 ]

Time Series Analysis

To fit an EGARCH model, the only parameter to be changed in a model specification

is to set the EGARCH model type. By running the fitting function, the additional
parameter will be estimated (see coef()):
# specify EGARCH(1,1) model with only constant in mean equation
egarch11.spec = ugarchspec(variance.model = list(model="eGARCH",
garchOrder=c(1,1)), mean.model = list(armaOrder=c(0,0)))
aapl.egarch11.fit = ugarchfit(spec=egarch11.spec, data=ret.aapl)

> coef(aapl.egarch11.fit)
alpha1

beta1

gamma1

0.001446685 -0.291271433 -0.092855672

mu

omega

0.961968640

0.176796061

News impact curve reflects the strong asymmetry in response of conditional

volatility to shocks and confirms the necessity of asymmetric models:
ni.egarch11 <- newsimpact(aapl.egarch11.fit)
plot(ni.egarch11$zx, ni.egarch11$zy, type="l", lwd=2, col="blue",
main="EGARCH(1,1) - News Impact",
ylab=ni.egarch11$yexpr, xlab=ni.egarch11$xexpr)

[ 32 ]

Chapter 1

The Threshold GARCH model (TGARCH)

Another prominent example is the TGARCH model, which is even easier to interpret.
The TGARCH specification involves an explicit distinction of model parameters
above and below a certain threshold. TGARCH is also a submodel of a more general
class, the asymmetric power ARCH class, but we will discuss it separately because of
its wide penetration in applied financial econometrics literature.
The TGARCH model may be formulated as follows:

t = tt
q

i =1

j =1

t2 = + ( i + i I t i ) t2i + j t2 j
where

1 if t 1 < 0
I t i =
0 if t 1 0

The interpretation is straightforward; the ARCH coefficient depends on the sign of

the previous error term; if 1 is positive, a negative error term will have a higher
impact on the conditional volatility, just as we have seen in the leverage effect before.
In the R package, rugarch, the threshold GARCH model is implemented in a
framework of an even more general class of GARCH models, called the Family
GARCH model Ghalanos (2014).
# specify TGARCH(1,1) model with only constant in mean equation
tgarch11.spec = ugarchspec(variance.model = list(model="fGARCH",
submodel="TGARCH", garchOrder=c(1,1)),
mean.model = list(armaOrder=c(0,0)))
aapl.tgarch11.fit = ugarchfit(spec=tgarch11.spec, data=ret.aapl)

> coef(aapl.egarch11.fit)
mu

omega

alpha1

beta1

gamma1

0.001446685 -0.291271433 -0.092855672

0.961968640

0.176796061

[ 33 ]

Time Series Analysis

Thanks to the specific functional form, the news impact curve for a
Threshold-GARCH is less flexible in representing different responses, there is
a kink at the zero point which can be seen when we run the following command:
ni.tgarch11 <- newsimpact(aapl.tgarch11.fit)
plot(ni.tgarch11$zx, ni.tgarch11$zy, type="l", lwd=2, col="blue",
main="TGARCH(1,1) - News Impact",
ylab=ni.tgarch11$yexpr, xlab=ni.tgarch11$xexpr)

Simulation and forecasting

The Rugarch package allows an easy way to simulate from a specified model. Of
course, for simulation purposes, we should also specify the parameters of the model
within ugarchspec(); this could be done by the fixed.pars argument. After
specifying the model, we can simulate a time series with a given conditional mean
and GARCH specification by using simply the ugarchpath() function:
garch11.spec = ugarchspec(variance.model = list(garchOrder=c(1,1)),
mean.model = list(armaOrder=c(0,0)),
fixed.pars=list(mu = 0, omega=0.1, alpha1=0.1,
beta1 = 0.7))
garch11.sim = ugarchpath(garch11.spec, n.sim=1000)

[ 34 ]

Chapter 1

Once we have an estimated model and technically a fitted object, forecasting the
conditional volatility based on that is just one step:
aapl.garch11.fit = ugarchfit(spec=garch11.spec, data=ret.aapl, out.
sample=20)
aapl.garch11.fcst = ugarchforecast(aapl.garch11.fit, n.ahead=10,
n.roll=10)

The plotting method of the forecasted series provides the user with a selection menu;
we can plot either the predicted time series or the predicted conditional volatility.
plot(aapl.garch11.fcst, which='all')

[ 35 ]

Time Series Analysis

Summary
In this chapter, we reviewed some important concepts of time series analysis, such as
cointegration, vector-autoregression, and GARCH-type conditional volatility models.
Meanwhile, we have provided a useful introduction to some tips and tricks to start
modeling with R for quantitative and empirical finance. We hope that you find these
exercises useful, but again, it should be noted that this chapter is far from being
complete both from time series and econometric theory, and from R programming's
point of view. The R programming language is very well documented on the
Internet, and the R user's community consists of thousands of advanced and
professional users. We encourage you to go beyond books, be a self-learner, and do
not stop if you are stuck with a problem; almost certainly, you will find an answer
on the Internet to proceed. Use the documentation of R packages and the help files
heavily, and study the official R-site, http://cran.r-project.org/, frequently.
The remaining chapters will provide you with numerous additional examples to
find your way in the plethora of R facilities, packages, and functions.

References and reading list

Andersen, Torben G; Davis, Richard A.; Krei, Jens-Peters; Mikosh, Thomas

(ed.) (2009). Handbook of Financial Time Series

Andersen, Torben G. and Benzoni, Luca (2011). Stochastic volatility.

Book chapter in Complex Systems in Finance and Econometrics,
Ed.: Meyers, Robert A., Springer

Brooks, Chris (2008). Introductory Econometrics for Finance, Cambridge

University Press

Fry, Renee and Pagan, Adrian (2011). Sign Restrictions in Structural Vector
Autoregressions: A Critical Review. Journal of Economic Literature,
American Economic Association, vol. 49(4), pages 938-60, December.

Ghalanos, Alexios (2014) Introduction to the rugarch package

http://cran.r-project.org/web/packages/rugarch/vignettes/
Introduction_to_the_rugarch_package.pdf

Hafner, Christian M. (2011). Garch modelling. Book chapter in Complex

Systems in Finance and Econometrics, Ed.: Meyers, Robert A., Springer

Hamilton, James D. (1994). Time Series Analysis, Princetown, New Jersey

Ltkepohl, Helmut (2007). New Introduction to Multiple Time Series

Analysis, Springer

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Chapter 1

Murray, Michael. P. (1994). A drunk and her dog: an illustration of

cointegration and error correction. The American Statistician, 48(1), 37-39.

Martin, Vance; Hurn, Stan and Harris, David (2013). Econometric Modelling
with Time Series. Specification, Estimation and Testing, Cambridge
University Press

Pfaff, Bernard (2008). Analysis of Integrated and Cointegrated Time Series

with R, Springer

Pfaff, Bernhard (2008). VAR, SVAR and SVEC Models: Implementation

Within R Package vars. Journal of Statistical Software, 27(4)

Phillips, P. C., & Ouliaris, S. (1990). Asymptotic properties of residual based

tests for cointegration. Econometrica: Journal of the Econometric Society, 165-193.

Pole, Andrew (2007). Statistical Arbitrage. Wiley

Rachev, Svetlozar T., Hsu, John S.J., Bagasheva, Biliana S. and Fabozzi, Frank
J. (2008). Bayesian Methods in Finance. John Wiley & Sons.

Sims, Christopher A. (1980). Macroeconomics and reality. Econometrica:

Journal of the Econometric Society, 1-48.

Tsay, Ruey S. (2010). Analysis of Financial Time Series, 3rd edition, Wiley

[ 37 ]

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