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Volatility Clustering.pptx (1)

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kirthana22022001
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© © All Rights Reserved
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Applied Macro and Financial

Econometrics

Volatility Clustering

Course Coordinator:
Dr. Devasmita Jena
Volatility Clustering: An Introduction
Many economic TS (macro/financial variables) exhibit period of unusually large volatility
followed by period of relative tranquility
There are periods when a series shows higher or lower variance than other time periods
You will observe clustering: groups of high variance followed by groups of low variance
This is called volatility clustering => series exhibits time varying heteroscedasticity
That is, for a large class of models, the size of volatility is not constant and varies with time
In econometric sense, volatility measures the size of errors made in modelling TS variables
Varying volatility is predictable and hence can be modelled using appropriate methodology
Example: As a firm, you will be interested in both mean and variance (and may be entire
distribution) of the investments. Why?
• You face trade-off between returns and risks
• Assume a large shock to return at t-1, after which there is high probability of shock at t.
• The shock has upset the market and a large uncertainty on the future direction of returns follow
• This is volatility clustering : a reflection of high and low market uncertainty
Do not confuse between volatility and NS: volatility is time-varying but not function of time
Volatility Clustering: Visual Examples
Modelling Volatility Clustering: Intuition
•
What happens if you ignore volatility clustering?
What happens if we ignore conditional variance of {Yt}with time and that there is
volatility clustering?
• The standard error of forecasts of Yt will be large; substantially different for different
time periods
It is sometimes of interest to not only forecast the mean of the series but also its
variance over the study period
ARCH, GARCH, GJR-GARCH, TGARCH, EGARCH etc.
Example: Suppose you buy an asset at t and want to sell it at t+1.
• In this case, we’re interested in forecasting the conditional variance of Yt+1 given the
variance is known at t (or t-1, t-2, t-3,...)
• The unconditional variance which is the long run forecast variance of the series is not of
importance. Why?
• Because unconditional variance has to be constant and not a function of time!
What happens if you ignore volatility clustering?

This graph represents the forecasts


by 3 different models and the actual
values (represented by violet line).
ARIMA (4,1,0) (the red line) which
has the lowest BIC value seems to
perform better than other models.
Autoregressive conditionally heteroscedastic models
•
Non-Negativity constraint in ARCH models
•
Testing for ARCH Effects
•
Limitations of ARCH Model
Deciding lag of ARCH model
Lag of ARCH model and parsimony of the model
Non-negativity constraint may be violated
Generalized ARCH (GARCH) Model
•
GARCH is parsimonious
•
Lag lengths of GARCH model
•
The unconditional variance under GARCH
•
Estimation of Models with Volatility Clusters
OLS doesn’t work
• Usual suspect: Autocorrelation
• Full model is no longer of the usual linear form
• OLS minimizes the residual sum of squares.
o The RSS depends only on the parameters in the conditional mean equation, and not the conditional variance
o RSS minimization is no longer an appropriate objective.
So, resort to MLE
Steps
• Specify appropriate model
• Specify log-likelihood function to maximize under normality assumption of disturbances
o Function taking into account the sample size (time horizon), the mean equation and variance equation
• Maximize LLF to obtain the estimated parameters along with standard errors
Issues with GARCH
Non-negativity conditions may be violated by the estimated model
• place artificial constraints on the model coefficients in order to force them to be non-negative
Account for volatility clustering may not be enough, in the presence of leverage effect. GARCH
models cannot account for leverage effects
• GARCH enforce a symmetric response of volatility to +ve and –ve shocks
o Conditional variance is a function of the magnitudes of the lagged residuals and not their signs(squaring of lagged
errors leads to loss of sign/direction)
• -ve shock to macro-financial time series is likely to cause a greater extent of volatility clustering as compare
to a –ve shock of the same magnitude
• Good news (+ve shock) has less effect on conditional variance as compared to bad news (-ve shock)
GARCH cannot account for leptokurtosis in a series
• Many financial series, such as returns on stocks and foreign exchange rates, exhibit leptokurtosis
• GARCH model assume normality
GARCH does not allow for any direct feedback between the conditional variance and the
conditional mean
GJR-GARCH Model
•
Exponential-GARCH Model
•
Choosing order of GARCH model
The ARMA and GARCH orders need to be determined simultaneously
Neither the conditional mean nor the conditional variance model can be estimated consistently if taken
separately, unless under special condition: if MA part of ARMA is empty, the AR part can be estimated
consistently even if the GARCH model is neglected)
The task of jointly determining the ARMA-GARCH orders is difficult.
Idea is to find out order of autocorrelation in conditional variance. This will determine lag order
Following steps may be taken:
Check info criteria of the system as a whole
Estimate model on part sample and use the estimated model to predict the remainder of the sample
Pick the model that has lowest prediction error
Examine the residual properties of different models
Prefer a model with no remaining autocorrelation or ARCH patterns
Check likelihoods of the model
All the above steps amount to trials and error and not full proof
The good news is: GARCH(1,1) usually suffices

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