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This document summarizes Auto-Regressive Conditional Heteroscedasticity (ARCH) models. ARCH models allow for time-varying volatility in time series data. The conditional variance is modeled as a function of past residuals. GARCH models extend ARCH models by including past conditional variances. Various GARCH specifications and extensions are discussed, including asymmetric GARCH models, multivariate GARCH models like the BEKK model, and applications in finance and econometrics.

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178 views8 pages

Arch

This document summarizes Auto-Regressive Conditional Heteroscedasticity (ARCH) models. ARCH models allow for time-varying volatility in time series data. The conditional variance is modeled as a function of past residuals. GARCH models extend ARCH models by including past conditional variances. Various GARCH specifications and extensions are discussed, including asymmetric GARCH models, multivariate GARCH models like the BEKK model, and applications in finance and econometrics.

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a ayesha
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ARCH

(Auto-Regressive Conditional Heteroscedasticity)


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

More efficient estimators can be obtained if heteroscedasticity


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

ARCH(p) model:

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

or

yt = a + bXt + t

t2 = + 2t-1 + t

> 0, >0

t is i.i.d.

GARCH(p,q) model:

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


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

Use of Univariate GARCH models in Finance

Step 1: Estimate the appropriate GARCH


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

Use of ARCH models in Econometrics


Step 1. ARCH tests

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

Step 2. Estimate a GARCH model (embedded in


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

Asymmetric GARCH (TARCH or GJR Model)


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

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


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

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

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


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

Shock spillover, Volatility spillover

Diagonal VECH Model: (describes the variance as a function


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

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


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

12,t 22,t

however, this assumption may be unrealistic.

BEKK Model: guarantees the positive definiteness


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

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