Chapter 8

Modelling volatility and correlation

Introductory Econometrics for Finance Chris Brooks 2008

A Sample Financial Asset Returns Time Series

Daily S&P 500 Returns for January 1990 December 1999
Return
0.06
0.04
0.02
0.00
-0.02
-0.04
-0.06
-0.08
1/01/90

11/01/93

Introductory Econometrics for Finance Chris Brooks 2008

Date

9/01/97

Non-linear Models: A Definition

Campbell, Lo and MacKinlay (1997) define a non-linear data

generating process as one that can be written
yt = f(ut, ut-1, ut-2, )
where ut is an iid error term and f is a non-linear function.

They also give a slightly more specific definition as

yt = g(ut-1, ut-2, )+ ut2(ut-1, ut-2, )
where g is a function of past error terms only and 2 is a variance
term.

Models with nonlinear g() are non-linear in mean, while those with
nonlinear 2() are non-linear in variance.

Introductory Econometrics for Finance Chris Brooks 2008

Heteroscedasticity Revisited
An example of a structural model is
yt = 1 + 2x2t + 3x3t + 4x4t + u t
with ut N(0, u2).
The assumption that the variance of the errors is constant is known as
homoscedasticity, i.e. Var (ut) = . u2
What if the variance of the errors is not constant?
- heteroscedasticity
- would imply that standard error estimates could be wrong.
Is the variance of the errors likely to be constant over time? Not for financial
data.

Introductory Econometrics for Finance Chris Brooks 2008

Autoregressive Conditionally Heteroscedastic

(ARCH) Models
So use a model which does not assume that the variance is constant.
Recall the definition of the variance of ut:
t2 t ut-1, ut-2,...) = E[(ut-E(ut))2 ut-1, ut-2,...]
= Var(u
We usually assume that E(ut) = 0
2
so t = Var(ut ut-1, ut-2,...) = E[ut2 ut-1, ut-2,...].
What could the current value of the variance of the errors plausibly
depend upon?
Previous squared error terms.
This leads to the autoregressive conditionally heteroscedastic model for
the variance of the errors:
= 0 + 1
t2
ut21
This is known as an ARCH(1) model.

Introductory Econometrics for Finance Chris Brooks 2008

Autoregressive Conditionally Heteroscedastic

(ARCH) Models (contd)

The full model would be

yt = 1 + 2x2t + ... + kxkt + ut , ut N(0, t2)
2
2
where t = 0 + 1 ut 1
We can easily extend this to the general case where the error variance
depends on q lags of squared errors:
2
2
2
t2 = 0 + 1 ut 1+2 ut 2+...+q ut q
This is an ARCH(q) model.

t
Instead of calling the variance
, in the literature it is usually called
ht, so the model is
yt = 21 + 2x2t2 + ... + kxkt2 + ut , ut N(0,ht)
ut 2
ut q
ut 1
where ht = 0 + 1 +2
+...+q

Introductory Econometrics for Finance Chris Brooks 2008

Another Way of Writing ARCH Models

For illustration, consider an ARCH(1). Instead of the above, we can

write
yt = 1 + 2x2t + ... + kxkt + ut , ut = vtt

t 0 1ut21

vt N(0,1)

The two are different ways of expressing exactly the same model. The
first form is easier to understand while the second form is required for
simulating from an ARCH model, for example.

Introductory Econometrics for Finance Chris Brooks 2008

Testing for ARCH Effects

1. First, run any postulated linear regression of the form given in the equation
above, e.g.
yt = 1 + 2x2t + ... + kxkt + ut
saving the residuals, ut.
2. Then square the residuals, and regress them on q own lags to test for ARCH
of order q, i.e. run the regression
ut2 0 1ut21 2ut2 2 ... qut2 q vt
where vt is iid.
Obtain R2 from this regression
3. The test statistic is defined as TR2 (the number of observations multiplied by
the coefficient of multiple correlation) from the last regression, and is
distributed as a 2(q).
Introductory Econometrics for Finance Chris Brooks 2008

Testing for ARCH Effects (contd)

4. The null and alternative hypotheses are

H0 : 1 = 0 and 2 = 0 and 3 = 0 and ... and q = 0
H1 : 1 0 or 2 0 or 3 0 or ... or q 0.
If the value of the test statistic is greater than the critical value from the
2 distribution, then reject the null hypothesis.

Note that the ARCH test is also sometimes applied directly to returns
instead of the residuals from Stage 1 above.

Introductory Econometrics for Finance Chris Brooks 2008

Problems with ARCH(q) Models

How do we decide on q?
The required value of q might be very large
Non-negativity constraints might be violated.
When we estimate an ARCH model, we require i >0 i=1,2,...,q
(since variance cannot be negative)

A natural extension of an ARCH(q) model which gets around some of

these problems is a GARCH model.

Introductory Econometrics for Finance Chris Brooks 2008

Generalised ARCH (GARCH) Models

Due to Bollerslev (1986). Allow the conditional variance to be dependent

upon previous own lags
The variance equation is now
t2 = 0 + 1 ut21 +t-12
(1)
This is a GARCH(1,1) model, which is like an ARMA(1,1) model for the
variance equation.
We could also write
t-12 = 0 + 1 ut22 +t-22

t-22 = 0 + 1 ut23 +t-32

Substituting into (1) for t-12 :

t2 = 0 + 1 ut21 +(0 + 1 ut22 + t-22)

= 0 + 1 ut21 +0 + 1 ut22 + t-22

Introductory Econometrics for Finance Chris Brooks 2008

Generalised ARCH (GARCH) Models (contd)

Now substituting into (2) for t-22

t2 = 0 + 1 ut21 +0 + 1 ut22 +2(0 + 1 ut23 +t-32)

t2 = 0 + 1 ut21 +0 + 1 ut22 +02 + 12 ut23 +3t-32

t2 = 0 (1++2) + 1 ut21 (1+L+2L2 ) + 3t-32

An infinite number of successive substitutions would yield
t2 = 0 (1++2+...) + 1 ut21 (1+L+2L2+...) + 02

So the GARCH(1,1) model can be written as an infinite order ARCH model.

We can again extend the GARCH(1,1) model to a GARCH(p,q):

t2 = 0 +1 ut21 +2 ut2 2 +...+q ut2 q +1t-1 2+2t-22+...+ pt-p2

t2

= 0 i u
i 1

2
t i

j t j

j 1

Introductory Econometrics for Finance Chris Brooks 2008

Generalised ARCH (GARCH) Models (contd)

But in general a GARCH(1,1) model will be sufficient to capture the

volatility clustering in the data.

Why is GARCH Better than ARCH?

- more parsimonious - avoids overfitting
- less likely to breech non-negativity constraints

Introductory Econometrics for Finance Chris Brooks 2008

The Unconditional Variance under the GARCH

Specification

The unconditional variance of ut is given by

Var(ut) =

0
1 (1 )

when 1 < 1

1 1 is termed non-stationarity in variance

1 = 1

For non-stationarity in variance, the conditional variance forecasts will

not converge on their unconditional value as the horizon increases.

is termed intergrated GARCH

Introductory Econometrics for Finance Chris Brooks 2008

Estimation of ARCH / GARCH Models

Since the model is no longer of the usual linear form, we cannot use OLS.
We use another technique known as maximum likelihood.
The method works by finding the most likely values of the parameters given
the actual data.
More specifically, we form a log-likelihood function and maximise it.

Introductory Econometrics for Finance Chris Brooks 2008

Estimation of ARCH / GARCH Models (contd)

The steps involved in actually estimating an ARCH or GARCH model are

as follows

1.

Specify the appropriate equations for the mean and the variance - e.g. an
AR(1)- GARCH(1,1) model:
yt = + yt-1 + ut , ut N(0,t2)
t2 = 0 + 1 ut21 +t-12

2.

Specify the log-likelihood function to maximise:

T
1 T
1 T
2
2
L log(2 ) log( t ) ( y t y t 1 ) 2 / t
2
2 t 1
2 t 1

3. The computer will maximise the function and give parameter values and
their standard errors
Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

Consider the bivariate regression case with homoscedastic errors for

simplicity:
y t 1 2 xt u t

Assuming that ut N(0,2), then yt N( 1 2 xt , 2) so that the

probability density function for a normally distributed random variable
with this mean and variance is given by
1 ( y t 1 2 xt ) 2
1
2
(1)
f ( y t 1 2 xt , )
exp

Successive values of yt would trace out the familiar bell-shaped curve.

Assuming that ut are iid, then yt will also be iid.

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
Then the joint pdf for all the ys can be expressed as a product of the individual
density functions
f ( y1 , y 2 ,..., yT 1 2 X t , 2 ) f ( y1 1 2 X 1 , 2 ) f ( y 2 1 2 X 2 , 2 )...
f ( yT 1 2 X 4 , 2 )

(2)
T

f ( yt 1 2 X t , 2 )
t 1

Substituting into equation (2) for every yt from equation (1),

(3)
1 T ( y t 1 2 xt ) 2
1
2
f ( y1 , y 2 ,..., yT 1 2 xt , ) T
exp

2
T
2

( 2 )
t 1

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
The typical situation we have is that the xt and yt are given and we want to
estimate 1, 2, 2. If this is the case, then f() is known as the likelihood
function, denoted LF(1, 2, 2), so we write
2
T

(
y

x
)
1
t
1
2
t
(4)LF ( , , )
exp

1
2
2
T
T

( 2 )
2 t 1

Maximum likelihood estimation involves choosing parameter values ( 1, 2,2)

that maximise this function.
We want to differentiate (4) w.r.t. 1, 2,2, but (4) is a product containing T
terms.

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
Since

max f ( x ) max log( f (,xwe

)) can take logs of (4).
x

Then, using the various laws for transforming functions containing logarithms, we
obtain the log-likelihood function, LLF:

T
1 T ( y t 1 2 xt ) 2
LLF T log log(2 )
2
2
2

1
which is equivalent to
(5)

2
T
(
y

x
)
T
T
1
1
2 t
LLF log 2 log(2 ) t
2
2
2 t 1
2

Differentiating (5) w.r.t. 1, 2,2, we obtain

(6)

LLF
1 ( y 1 2 xt ).2. 1
t
1
2
2

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
( y t 1 2 xt ).2. xt
LLF
1

2
2
2

(7)

LLF
T 1 1 ( y t 1 2 xt ) 2

(8)
22 2
2
4
Setting (6)-(8) to zero to minimise the functions, and putting hats above the
parameters to denote the maximum likelihood estimators,
From (6),

( y x ) 0
y x 0
y T x 0
t

(9)

1
T

1
y

t 1 2T

1 y 2 x

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
From (7),

( y x ) x 0
y x x x 0
y x x x 0
x y x ( y x ) x
x y x Tx y Tx
2 ( xt2 Tx 2 ) y t xt Tx y
t

1 t

2
t

2
t

(10)

2
From (8),

2
t

2
t

y x Tx y
( x Tx )

T
1

2 4

2
t

(y

1 2 xt ) 2

Introductory Econometrics for Finance Chris Brooks 2008

Parameter Estimation using Maximum Likelihood

(contd)
1
( y t 1 2 xt ) 2

T
1
2 ut2
T

Rearranging, 2
(11)

How do these formulae compare with the OLS estimators?

(9) & (10) are identical to OLS
(11) is different. The OLS estimator was
2

1
ut2

Tk

Therefore the ML estimator of the variance of the disturbances is biased,

although it is consistent.
But how does this help us in estimating heteroscedastic models?

Introductory Econometrics for Finance Chris Brooks 2008

Estimation of GARCH Models Using

Maximum Likelihood

Now we have yt = + yt-1 + ut , ut N(0, )

t2

t2 = 0 + 1 ut21 +t-12
T
1 T
1 T
2
2
L log(2 ) log( t ) ( y t y t 1 ) 2 / t
2
2 t 1
2 t 1

Unfortunately, the LLF for a model with time-varying variances cannot be maximised
analytically, except in the simplest of cases. So a numerical procedure is used to
maximise the log-likelihood function. A potential problem: local optima or
multimodalities in the likelihood surface.

The way we do the optimisation is:

1. Set up LLF.
2. Use regression to get initial guesses for the mean parameters.
3. Choose some initial guesses for the conditional variance parameters.
4. Specify a convergence criterion - either by criterion or by value.

Introductory Econometrics for Finance Chris Brooks 2008

Non-Normality and Maximum Likelihood

Recall that the conditional normality assumption for ut is essential.
We can test for normality using the following representation
ut = vtt
vt N(0,1)

0 1ut21

The sample counterpart is

vt

2 t21

ut
t

vt

ut
t

Are the
normal? Typically
are still leptokurtic, although less so than the . Is
vt
vt use the ML with a robust variance/covariance
this a problem?
Not really, as we can
estimator.
ML with robust standard errors is called Quasi- Maximum Likelihood or
ut
QML.

Introductory Econometrics for Finance Chris Brooks 2008

Extensions to the Basic GARCH Model

Since the GARCH model was developed, a huge number of extensions

and variants have been proposed. Three of the most important
examples are EGARCH, GJR, and GARCH-M models.

Problems with GARCH(p,q) Models:

- Non-negativity constraints may still be violated
- GARCH models cannot account for leverage effects

Possible solutions: the exponential GARCH (EGARCH) model or the

GJR model, which are asymmetric GARCH models.

Introductory Econometrics for Finance Chris Brooks 2008

The EGARCH Model

Suggested by Nelson (1991). The variance equation is given by

log( t ) log( t 1 )
2

u
t 1

u t 1

t 1

t 1

Advantages of the model

- Since we model the log(t2), then even if the parameters are negative, t2
will be positive.
- We can account for the leverage effect: if the relationship between
volatility and returns is negative, , will be negative.
Introductory Econometrics for Finance Chris Brooks 2008

The GJR Model

Due to Glosten, Jaganathan and Runkle

t2 = 0 + 1 ut21 +t-12+ut-12It-1
where It-1 = 1 if ut-1 < 0
= 0 otherwise

For a leverage effect, we would see > 0.

We require 1 + 0 and 1 0 for non-negativity.

Introductory Econometrics for Finance Chris Brooks 2008

An Example of the use of a GJR Model

Using monthly S&P 500 returns, December 1979- June 1998

Estimating a GJR model, we obtain the following results.

y t 0.172
(3.198)

t 1.243 0.015u t21 0.498 t 1 0.604u t21 I t 1

(16.372) (0.437) (14.999) (5.772)
2

Introductory Econometrics for Finance Chris Brooks 2008

News Impact Curves

The news impact curve plots the next period volatility (ht) that would arise from various
positive and negative values of ut-1, given an estimated model.
News Impact Curves for S&P 500 Returns using Coefficients from GARCH and GJR
Model Estimates:
0.14
GARCH
GJR

Value of Conditional Variance

0.12

0.1

0.08

0.06

0.04

0.02

0
-1

-0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1

0.1

0.2

Value of Lagged Shock

Introductory Econometrics for Finance Chris Brooks 2008

0.3

0.4

0.5

0.6

0.7

0.8

0.9

GARCH-in Mean

We expect a risk to be compensated by a higher return. So why not let

the return of a security be partly determined by its risk?

Engle, Lilien and Robins (1987) suggested the ARCH-M specification.

A GARCH-M model would be

yt = + t-1+ ut , ut N(0,t2)

t2 = 0 + 1 ut21 +t-12
can be interpreted as a sort of risk premium.

It is possible to combine all or some of these models together to get

more complex hybrid models - e.g. an ARMA-EGARCH(1,1)-M
model.

Introductory Econometrics for Finance Chris Brooks 2008

What Use Are GARCH-type Models?

GARCH can model the volatility clustering effect since the conditional
variance is autoregressive. Such models can be used to forecast volatility.

We could show that

Var (yt yt-1, yt-2, ...) = Var (ut ut-1, ut-2, ...)

So modelling t2 will give us models and forecasts for yt as well.

Variance forecasts are additive over time.

Introductory Econometrics for Finance Chris Brooks 2008

Forecasting Variances using GARCH Models

Producing conditional variance forecasts from GARCH models uses a

very similar approach to producing forecasts from ARMA models.
It is again an exercise in iterating with the conditional expectations
operator.
Consider the following GARCH(1,1) model:
y t u t , ut N(0,t2), t 2 0 1u t21 t 1 2
What is needed is to generate are forecasts of T+12 T, T+22 T, ...,
T+s2 T where T denotes all information available up to and
including observation T.
Adding one to each of the time subscripts of the above conditional
variance equation, and then two, and then three would yield the
following equations
T+12 = 0 + 1 +T2 , T+22 = 0 + 1 +T+12 , T+32 = 0 + 1 +T+22

Introductory Econometrics for Finance Chris Brooks 2008

Forecasting Variances
using GARCH Models (Contd)
Let 1f,T be the one step ahead forecast for 2 made at time T. This is
easy to calculate since, at time T, the values of all the terms on the
RHS are known.
1f,T 2 would be obtained by taking the conditional expectation of the
first equation at the bottom of slide 36:
2
1f,T = 0 + 1 uT2 +T2
2
Given, 1f,T 2 how is 2f,T , the 2-step ahead forecast for 2 made at time T,
calculated? Taking the conditional expectation of the second equation
at the bottom of slide 36:
2
2
f 2
2f,T = 0 + 1E( uT 1 T) + 1,T
2
2
where E( uT 1 T) is the expectation, made at time T, of uT 1, which is
the squared disturbance term.
2

Introductory Econometrics for Finance Chris Brooks 2008

Forecasting Variances
using GARCH Models (Contd)
We can write
E(uT+12 t) = T+12
But T+12 is not known at time T, so it is replaced with the forecast for it,
2
, so1f,Tthat
the 2-step ahead forecast is given by
2
2
f 2
=20f,T+ 1
+ 1f,T
1,T
2
f
2
f
1,T
=2,0T + (1+)
By similar arguments, the 3-step ahead forecast will be given by
2
3f,T = ET(0 + 1 + T+22)
2
= 0 + ( 1 + )
2f,T
2
= 0 + (1+)[ 0 + (1+)
] 1f,T
f 2
= 0 + 0( 1+ ) + ( 1+ ) 2
1,T
Any s-step ahead forecast (s 2) would be produced by

f
s ,T

s 1

0 ( 1 ) i 1 ( 1 ) s 1 h1f,T
i 1

Introductory Econometrics for Finance Chris Brooks 2008

What Use Are Volatility Forecasts?

1. Option pricing
C = f(S, X, 2, T, rf)
2. Conditional betas

i ,t

im,t
m2 ,t

3. Dynamic hedge ratios

The Hedge Ratio - the size of the futures position to the size of the underlying
exposure, i.e. the number of futures contracts to buy or sell per unit of the spot
good.

Introductory Econometrics for Finance Chris Brooks 2008

What Use Are Volatility Forecasts? (Contd)

What is the optimal value of the hedge ratio?
Assuming that the objective of hedging is to minimise the variance of the
hedged portfolio, the optimal hedge ratio will be given by

h p

s
F

where h = hedge ratio

p = correlation coefficient between change in spot price (S) and
change in futures price (F)
S = standard deviation of S
F = standard deviation of F
What if the standard deviations and correlation are changing over time?
s ,t
Use
h p
t

F ,t

Introductory Econometrics for Finance Chris Brooks 2008

Testing Non-linear Restrictions or

Testing Hypotheses about Non-linear Models

Usual t- and F-tests are still valid in non-linear models, but they are
not flexible enough.

There are three hypothesis testing procedures based on maximum

likelihood principles: Wald, Likelihood Ratio, Lagrange Multiplier.

Consider a single parameter, to be estimated, Denote the MLE as

~
and a restricted estimate as .

Introductory Econometrics for Finance Chris Brooks 2008

Likelihood Ratio Tests

Estimate under the null hypothesis and under the alternative.

Then compare the maximised values of the LLF.
So we estimate the unconstrained model and achieve a given maximised
value of the LLF, denoted Lu
Then estimate the model imposing the constraint(s) and get a new value of
the LLF denoted Lr.
Which will be bigger?
Lr Lu comparable to RRSS URSS
The LR test statistic is given by
LR = -2(Lr - Lu) 2(m)
where m = number of restrictions

Introductory Econometrics for Finance Chris Brooks 2008

Likelihood Ratio Tests (contd)

Example: We estimate a GARCH model and obtain a maximised LLF of
66.85. We are interested in testing whether = 0 in the following equation.
yt = + yt-1 + ut , ut N(0,
= 0 + 1 +t2

t2

)
ut21

t21

We estimate the model imposing the restriction and observe the maximised
LLF falls to 64.54. Can we accept the restriction?
LR = -2(64.54-66.85) = 4.62.
The test follows a 2(1) = 3.84 at 5%, so reject the null.
Denoting the maximised value of the LLF by unconstrained ML as L( )
and the constrained optimum as L(~ ) . Then we can illustrate the 3 testing
procedures in the following diagram:

Introductory Econometrics for Finance Chris Brooks 2008

Comparison of Testing Procedures under Maximum

Likelihood: Diagramatic Representation

L
A

~
L

B
~

Introductory Econometrics for Finance Chris Brooks 2008

Hypothesis Testing under Maximum Likelihood

The vertical distance forms the basis of the LR test.

The Wald test is based on a comparison of the horizontal distance.

The LM test compares the slopes of the curve at A and B.

We know at the unrestricted MLE, L(), the slope of the curve is zero.

~
L(

)?
But is it significantly steep at

This formulation of the test is usually easiest to estimate.

Introductory Econometrics for Finance Chris Brooks 2008

An Example of the Application of GARCH Models

- Day & Lewis (1992)
Purpose
To consider the out of sample forecasting performance of GARCH and EGARCH
Models for predicting stock index volatility.
Implied volatility is the markets expectation of the average level of volatility of
an option:
Which is better, GARCH or implied volatility?
Data
Weekly closing prices (Wednesday to Wednesday, and Friday to Friday) for the
S&P100 Index option and the underlying 11 March 83 - 31 Dec. 89
Implied volatility is calculated using a non-linear iterative procedure.

Introductory Econometrics for Finance Chris Brooks 2008

The Models
The Base Models
For the conditional mean
(1)
And for the variance

(2)

RMt R Ft 0 1 ht u t

ht 0 1u t21 1 ht 1

or

1/ 2
(3)
u
u t 1
2

t 1
ln(ht ) 0 1 ln(ht 1 ) 1 (

)
ht 1
h

t 1
where
RMt denotes the return on the market portfolio
RFt denotes the risk-free rate
ht denotes the conditional variance from the GARCH-type models while t2 denotes
the implied variance from option prices.

Introductory Econometrics for Finance Chris Brooks 2008

The Models (contd)

Add in a lagged value of the implied volatility parameter to equations (2) and (3).
(2) becomes
(4)

ht 0 1u t21 1 ht 1 t21

and (3) becomes

(5)
ln(ht ) 0 1 ln(ht 1 ) 1 (

u t 1

u
t 1

ht 1
We are interested in testing H0 : = 0 in (4) or (5).
Also, we want to test H0 : 1 = 0 and 1 = 0 in (4),
and H0 : 1 = 0 and 1 = 0 and = 0 and = 0 in (5).
ht 1

Introductory Econometrics for Finance Chris Brooks 2008

1/ 2

) ln( t21 )

The Models (contd)

If this second set of restrictions holds, then (4) & (5) collapse to
ht2 0 t21
(4)

and (3) becomes

ln(ht2 ) 0 ln( t21 )

(5)

We can test all of these restrictions using a likelihood ratio test.

Introductory Econometrics for Finance Chris Brooks 2008

In-sample Likelihood Ratio Test Results:

GARCH Versus Implied Volatility
RMt R Ft 0 1 ht u t

(8.78)

ht 0 1u t21 1 ht 1

(8.79)

ht 0 1u t21 1 ht 1 t21

(8.81)

ht2 0 t21
Equation for
0

Variance
specification
(8.79)
(8.81)
(8.81)

0.0072
(0.005)
0.0015
(0.028)
0.0056
(0.001)

(8.81)
Log-L
2

010-4

0.071
(0.01)
0.043
(0.02)
-0.184
(-0.001)

5.428
(1.65)
2.065
(2.98)
0.993
(1.50)

0.093
(0.84)
0.266
(1.17)
-

0.854
(8.17)
-0.068
(-0.59)
-

767.321

17.77

0.318
(3.00)
0.581
(2.94)

776.204

764.394

23.62

Notes: t-ratios in parentheses, Log-L denotes the maximised value of the log-likelihood function in
each case. 2 denotes the value of the test statistic, which follows a 2(1) in the case of (8.81) restricted
to (8.79), and a 2 (2) in the case of (8.81) restricted to (8.81). Source: Day and Lewis (1992).
Reprinted with the permission of Elsevier Science.

Introductory Econometrics for Finance Chris Brooks 2008

In-sample Likelihood Ratio Test Results:

EGARCH Versus Implied Volatility
RMt RFt 0 1 ht u t
ln(ht ) 0 1 ln(ht 1 ) 1 (
ln(ht ) 0 1 ln(ht 1 ) 1 (

ln(ht2 ) 0 ln( t21 )

Equation for
0
1
010-4

Variance
specification
(c)
(e)
(e)

-0.0026
(-0.03)
0.0035
(0.56)
0.0047
(0.71)

0.094
(0.25)
-0.076
(-0.24)
-0.139
(-0.43)

-3.62
(-2.90)
-2.28
(-1.82)
-2.76
(-2.30)

(8.78)

u t 1
ht 1
u t 1
ht 1

u
t 1

ht 1

u
t 1

ht 1

1/ 2

1/ 2

(8.80)

) ln( t21 ) (8.82)

(8.82)
Log-L

0.529
(3.26)
0.373
(1.48)
-

-0.273
(-4.13)
-0.282
(-4.34)
-

0.357
(3.17)
0.210
(1.89)
-

776.436

8.09

0.351
(1.82)
0.667
(4.01)

780.480

765.034

30.89

Notes: t-ratios in parentheses, Log-L denotes the maximised value of the log-likelihood function in
each case. 2 denotes the value of the test statistic, which follows a 2(1) in the case of (8.82) restricted
to (8.80), and a 2 (2) in the case of (8.82) restricted to (8.82). Source: Day and Lewis (1992).
Reprinted with the permission of Elsevier Science.

Introductory Econometrics for Finance Chris Brooks 2008

Conclusions for In-sample Model Comparisons &

Out-of-Sample Procedure

IV has extra incremental power for modelling stock volatility beyond

GARCH.

But the models do not represent a true test of the predictive ability of IV.

So the authors conduct an out of sample forecasting test.

There are 729 data points. They use the first 410 to estimate the models,
and then make a 1-step ahead forecast of the following weeks volatility.

Then they roll the sample forward one observation at a time,

constructing a new one step ahead forecast at each step.

Introductory Econometrics for Finance Chris Brooks 2008

Out-of-Sample Forecast Evaluation

They evaluate the forecasts in two ways:
The first is by regressing the realised volatility series on the forecasts plus a
constant:
t21 b0 b1 2ft t 1
(7)
2
2

where t 1 is the actual value of volatility, and ft is the value forecasted

for it during period t.

Perfectly accurate forecasts imply b0 = 0 and b1 = 1.
But what is the true value of volatility at time t ?
Day & Lewis use 2 measures
1. The square of the weekly return on the index, which they call SR.
2. The variance of the weeks daily returns multiplied by the number
of trading days in that week.

Introductory Econometrics for Finance Chris Brooks 2008

Out-of Sample Model Comparisons

t21 b0 b1 2ft t 1
Historic

Proxy for ex
post volatility
SR

Historic

WV

GARCH

SR

GARCH

WV

EGARCH

SR

EGARCH

WV

Implied Volatility

SR

Implied Volatility

WV

Forecasting Model

(8.83)
b0

b1

R2

0.0004
(5.60)
0.0005
(2.90)
0.0002
(1.02)
0.0002
(1.07)
0.0000
(0.05)
-0.0001
(-0.48)
0.0022
(2.22)
0.0005
(0.389)

0.129
(21.18)
0.154
(7.58)
0.671
(2.10)
1.074
(3.34)
1.075
(2.06)
1.529
(2.58)
0.357
(1.82)
0.718
(1.95)

0.094
0.024
0.039
0.018
0.022
0.008
0.037
0.026

Notes: Historic refers to the use of a simple historical average of the squared returns to forecast
volatility; t-ratios in parentheses; SR and WV refer to the square of the weekly return on the S&P 100,
and the variance of the weeks daily returns multiplied by the number of trading days in that week,
respectively. Source: Day and Lewis (1992). Reprinted with the permission of Elsevier Science.

Introductory Econometrics for Finance Chris Brooks 2008

Encompassing Test Results: Do the IV Forecasts

Encompass those of the GARCH Models?
2
t21 b0 b1 It2 b2 Gt2 b3 Et2 b4 Ht
t 1

(8.86)

b1
0.601
(1.03)

b2
0.298
(0.42)

b3
-

b4
-

R2
0.027

Implied vs. GARCH

b0
-0.00010
(-0.09)

Implied vs. GARCH

vs. Historical

0.00018
(1.15)

0.632
(1.02)

-0.243
(-0.28)

0.123
(7.01)

0.038

Implied vs. EGARCH

-0.00001
(-0.07)

0.695
(1.62)

0.176
(0.27)

0.026

Implied vs. EGARCH

vs. Historical

0.00026
(1.37)

0.590
(1.45)

-0.374
(-0.57)

0.118
(7.74)

0.038

GARCH vs. EGARCH

0.00005
(0.37)

1.070
(2.78)

-0.001
(-0.00)

0.018

Forecast comparison

Notes: t-ratios in parentheses; the ex post measure used in this table is the variance of the weeks daily
returns multiplied by the number of trading days in that week. Source: Day and Lewis (1992).
Reprinted with the permission of Elsevier Science.

Introductory Econometrics for Finance Chris Brooks 2008

Conclusions of Paper

Within sample results suggest that IV contains extra information not

contained in the GARCH / EGARCH specifications.

Out of sample results suggest that nothing can accurately predict

volatility!

Introductory Econometrics for Finance Chris Brooks 2008

Multivariate GARCH Models

Multivariate GARCH models are used to estimate and to forecast

covariances and correlations. The basic formulation is similar to that of the
GARCH model, but where the covariances as well as the variances are
permitted to be time-varying.
There are 3 main classes of multivariate GARCH formulation that are
widely used: VECH, diagonal VECH and BEKK.
VECH and Diagonal VECH
e.g. suppose that there are two variables used in the model. The conditional
covariance matrix is denoted Ht, and would be 2 2. Ht and VECH(Ht) are

h11t
Ht
h21t

h12 t

h22 t

h11t
VECH ( H t ) h22t
h12t

Introductory Econometrics for Finance Chris Brooks 2008

VECH and Diagonal VECH

In the case of the VECH, the conditional variances and covariances would each depend upon lagged values of
all of the variances and covariances and on lags of the squares of both error terms and their cross products.
In matrix form, it would be written
Writing out all of the elements gives the 3 equations as

VECH H t C A VECH t 1 t 1 B VECH H t 1

t t 1 ~ N 0, H t

Such a model would be hard2to estimate.

The diagonal VECH is much simpler and is specified, in the 2 variable
h11t c11 a11u1t a12 u 22t a13u1t u 2 t b11 h11t 1 b12 h22 t 1 b13 h12 t 1
case, as follows:

h22 t c21 a 21u12t a 22 u 22t a 23u1t u 2 t b21h11t 1 b22 h22 t 1 b23 h12 t 1
h12 t c31 a 31u12t a 32 u 22t a 33u1t u 2 t b31h11t 1 b32 h22 t 1 b33 h12 t 1

h11t 0 1u12t 1 2 h11t 1

2
The
Model
uses
h22BEKK

u
2 h22form
t
0
1 2t a
1Quadratic
t 1 for the parameter matrices to ensure a positive definite variance /
covariance matrix Ht.
h12t 0 1u1t 1u 2t 1 2 h12t 1

Introductory Econometrics for Finance Chris Brooks 2008

BEKK and Model Estimation for M-GARCH

Neither the VECH nor the diagonal VECH ensure a positive definite variancecovariance matrix.
An alternative approach is the BEKK model (Engle & Kroner, 1995).
In matrix form, the BEKK model is

H t W W AH t 1 A B t 1t 1B

Model estimation for all classes of multivariate GARCH model is again

performed using maximum likelihood with the following LLF:
TN
1 T

log 2 log H t t' H t1 t
2
2 t 1
where N is the number of variables in the system (assumed 2 above), is a
vector containing all of the parameters to be estimated, and T is the number of
observations.

Introductory Econometrics for Finance Chris Brooks 2008

An Example: Estimating a Time-Varying Hedge Ratio

for FTSE Stock Index Returns
(Brooks, Henry and Persand, 2002).

Data comprises 3580 daily observations on the FTSE 100 stock index and
stock index futures contract spanning the period 1 January 1985 - 9 April
1999.
Several competing models for determining the optimal hedge ratio are
constructed. Define the hedge ratio as .
No hedge (=0)
Nave hedge (=1)
Multivariate GARCH hedges:
Symmetric BEKK
Asymmetric BEKK
In both cases, estimating the OHR involves forming a 1-step ahead
h
forecast and computing OHRt 1 CF ,t 1 t
hF ,t 1

Introductory Econometrics for Finance Chris Brooks 2008

OHR Results
In Sample
Unhedged
=0

Nave Hedge
=1

Symmetric Time
Varying
Hedge

t
Return
Variance

0.0389
{2.3713}
0.8286

-0.0003
{-0.0351}
0.1718

hFC ,t
hF ,t

Asymmetric
Time Varying
Hedge

hFC ,t
h F ,t

0.0061
{0.9562}
0.1240

0.0060
{0.9580}
0.1211

Symmetric Time
Varying
Hedge

Asymmetric
Time Varying
Hedge

Out of Sample
Unhedged
=0

Nave Hedge
=1

t
Return
Variance

0.0819
{1.4958}
1.4972

-0.0004
{0.0216}
0.1696

Introductory Econometrics for Finance Chris Brooks 2008

hFC ,t
hF ,t

0.0120
{0.7761}
0.1186

hFC ,t
h F ,t

0.0140
{0.9083}
0.1188

Plot of the OHR from Multivariate GARCH

Time Varying Hedge Ratios

1.00

0.95

0.90

0.85

Conclusions
- OHR is time-varying and less
- M-GARCH OHR provides a
better hedge, both in-sample
- No role in calculating OHR for

than 1
and out-of-sample.
asymmetries

0.80

0.75

0.70

0.65
500

1000

1500

2000

2500

3000

Symmetric BEKK
Asymmetric BEKK

Introductory Econometrics for Finance Chris Brooks 2008