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GARCH Models in Python 3

This document discusses various techniques for validating GARCH models in Python, including significance testing of model parameters, checking assumptions like autocorrelation of residuals, and evaluating goodness of fit. It covers calculating p-values and t-statistics to determine significance of parameters, using ACF plots and Ljung-Box tests to check the autocorrelation assumption, and evaluating models via log-likelihood, AIC, BIC and backtesting metrics like MAE and MSE. The goal is to select the most parsimonious GARCH model that fits the data well and makes valid predictions.

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vis
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182 views

GARCH Models in Python 3

This document discusses various techniques for validating GARCH models in Python, including significance testing of model parameters, checking assumptions like autocorrelation of residuals, and evaluating goodness of fit. It covers calculating p-values and t-statistics to determine significance of parameters, using ACF plots and Ljung-Box tests to check the autocorrelation assumption, and evaluating models via log-likelihood, AIC, BIC and backtesting metrics like MAE and MSE. The goal is to select the most parsimonious GARCH model that fits the data well and makes valid predictions.

Uploaded by

vis
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Signi cance testing

of model parameters
GA RCH MODELS IN P YTH ON

Chelsea Yang
Data Science Instructor
Do I need this parameter?
Is it relevant

KISS: keep it simple stupid

Always prefer a parsimonious model

GARCH MODELS IN PYTHON


Hypothesis test
Null hypothesis (H0): a claim to be veri ed

H0: parameter value = 0

If H0 cannot be rejected, leave out the parameter

GARCH MODELS IN PYTHON


Statistical signi cance
Quantify having the observed results by chance

Common threshold: 5%

GARCH MODELS IN PYTHON


P-value
The odds of the observed results could have happened by chance

The lower the p-value, the more ridiculous the null hypothesis looks

Reject the null hypothesis if p-value < signi cance level

GARCH MODELS IN PYTHON


P-value example
print(gm_result.summary()) print(gm_result.pvalues)

GARCH MODELS IN PYTHON


T-statistic
T-statistic = estimated parameter / standard error

The absolute value of the t-statistic is a distance measure

If |t-statistic| > 2: keep the parameter in the GARCH model

GARCH MODELS IN PYTHON


T-statistic example
print(gm_result.summary()) print(gm_result.tvalues)

# Manual calculation
t = gm_result.std_err/gm_result.tvalues

GARCH MODELS IN PYTHON


Let's practice!
GA RCH MODELS IN P YTH ON
Validation of GARCH
model assumptions
GA RCH MODELS IN P YTH ON

Chelsea Yang
Data Science Instructor
Visual check

GARCH MODELS IN PYTHON


Autocorrelation
Describe the correlation of a variable with itself given a time lag

Existence of autocorrelation in the standardized residuals indicates the model may not be sound

To detect autocorrelation:

ACF plot

Ljung-Box

GARCH MODELS IN PYTHON


ACF plot
ACF: AutoCorrelation Function

ACF Plot: visual representation of the autocorrelation by lags

Red area in the plot indicates the con dence level (alpha = 5%)

GARCH MODELS IN PYTHON


ACF plot in Python
from statsmodels.graphics.tsaplots import plot_acf

plot_acf(my_data, alpha = 0.05)

GARCH MODELS IN PYTHON


Ljung-Box test
Test whether any of a group of autocorrelations of a time series are different from zero

H0: the data is independently distributed

P-value < 5%: the model is not sound

GARCH MODELS IN PYTHON


Ljung-Box test Python
# Import the Python module
from statsmodels.stats.diagnostic import acorr_ljungbox

# Perform the Ljung-Box test


lb_test = acorr_ljungbox(std_resid , lags = 10)

# Check p-values
print('P-values are: ', lb_test[1])

GARCH MODELS IN PYTHON


Let's practice!
GA RCH MODELS IN P YTH ON
Goodness of t
measures
GA RCH MODELS IN P YTH ON

Chelsea Yang
Data Science Instructor
Goodness of t
Can model do a good job explaining the data?

1. Maximum likelihood

2. Information criteria

GARCH MODELS IN PYTHON


Maximum likelihood
Maximize the probability of getting the data observed under the assumed model

Prefer models with larger likelihood values

GARCH MODELS IN PYTHON


Log-likelihood in Python
Typically used in log form: log-likelihood

print(gm_result.loglikelihood)

GARCH MODELS IN PYTHON


Over tting
Fit in-sample data well, but perform poorly on out-out-sample predictions

Usually due to the model is overly complex

GARCH MODELS IN PYTHON


Information criteria
Measure the trade-off between goodness of t and model complexity

Likelihood + penalty for model complexity

AIC: Akaike's Information Criterion

BIC: Bayesian Information Criterion

_Prefer models with the lower information criterion score _

GARCH MODELS IN PYTHON


AIC vs. BIC
Generally they agree with each other

BIC penalizes model complexity more severely

GARCH MODELS IN PYTHON


AIC/BIC in Python

print(gm_result.aic)
print(gm_result.bic)

GARCH MODELS IN PYTHON


Let's practice!
GA RCH MODELS IN P YTH ON
GARCH model
backtesting
GA RCH MODELS IN P YTH ON

Chelsea Yang
Data Science Instructor
Backtesting
An approach to evaluate model forecasting capability

Compare the model predictions with the actual historical data

GARCH MODELS IN PYTHON


In-sample vs. out-of-sample
In-sample: model tting

Out-of-sample: backtesting

GARCH MODELS IN PYTHON


MAE
Mean Absolute Error

GARCH MODELS IN PYTHON


MSE
Mean Squared Error

GARCH MODELS IN PYTHON


Calculate MAE, MSE in Python
from sklearn.metrics import mean_absolute_error, mean_squared_error

# Call function to calculate MAE


mae = mean_absolute_error(observation, forecast)

# Call function to calculate MSE


mse = mean_squared_error(observation, forecast)

GARCH MODELS IN PYTHON


Let's practice!
GA RCH MODELS IN P YTH ON

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