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Taj Basie 1W Simttanons-Eqvaton T 22 Tne See The ea covonetics Fourth Moda tose Freatiog Cop, 2 56 PARTFOUR: SIMULTANEOUSEQUATION MODELS 22.10 MEASURING VOLATILITY IN FINANCIAL TIME SERIES: THE ARCH AND GARCH MODELS. As noted in the introduction to this chapter, financial time series, such as stock prices, exchange rates, inflation rates, etc. often exhibit the phenome- non of volatility clustering, that is, periods in which their prices show wide swings for an extended time period followed by periods in which there is, relative calm. As Philip Franses notes: Since such [financial time series] data reflect the result of trading among buyers and sellers at, for example, stock markets, various sources of news and other ex- ‘ogenous economic events may have an impact on the time series pattern of asset prices. Given that news can lead to various interpretations, and also given that specific economic events like an oil criss ean last for some time, we often observe that large positive and large negative observations in financial time series tend to appear in clusters. Knowledge of volatility is of crucial importance in many areas. For ex- ample, considerable macroeconometric work has been done in studying the variability of inflation over time. For some decision makers, inflation in it- self may not be bad, but its variability is bad because it makes financial planning difficult. The same is true of importers, exporters, and traders in foreign exchange markets, for variability in the exchange rates means huge losses or profits. Investors in the stock market are obviously interested in the volatility of stock prices, for high volatility could mean huge losses or gains and hence greater uncertainty. In volatile markets itis difficult for companies to raise capital in the capital markets. ‘How do we model financial time series that may experience such volatil- ity? For example, how do we model times series of stock prices, exchange rates, inflation, etc.? A characteristic of most of these financial time series is, that in their level form they are random walks; that is, they are nonstation- ary. On the other hand, in the first difference form, they are generally sta- tionary, as we saw in the case of GDP series in the previous chapter even though GDP is not strictly a financial time series. Therefore, instead of modeling the levels of financial time series, why not model their first differences? But these first differences often exhibit wide swings, or volatility, suggesting that the variance of financial time series, varies over time. How can we model such “varying variance”? This is where the so-called autoregressive conditional heteroscedasticity (ARCH) model originally developed by Engle comes in handy:”! AAs the name suggests, heteroscedasticity, or unequal variance, may have an autoregressive structure in that heteroscedasticity observed over differ- "Philip Hans Franses, Time Series Models for Business and Economie Forecasting, Cam. jon” Eeoviometrica, vol 50-no 1, 1982, pp. 987-1007. See also A. Bera and M. Higgins, “ARCH Models: Properties, Estimation and Testing," Journal of Economic Sur {, vol. 7, 1993, pp. 305-368 1W Simttanons-Eqvaton T 22 Tne See ran Models Ezocometics: Forecasting Capes, abs CHAPTER TWENTY-TWO: TIME SERIES ECONOMETRICS: FORECASTING 857 ent periods may be autocorrelated. To see what all this means, let us con- sider a concrete example. USSU. EXCHANGE RATE: AN EXAMPLE Figure 22.6 gives logs of the monthly ULSULK. exchange rate (dollars per pound) forthe period 1973 10 1995, fora total of 276 monthly observations. As you can see tom tis figure, there are considerable ups and downs in the exchange rate Over the sample pariod. TO ‘20 this more vividly, n Figure 22.7 we pot tha changesin the logs of he exchange rate; note that changes in the log ofa variable denote relative changes, which, # muipled by 100, ‘ve percentage changes. As you can obsene, the relative changes in the U.SJULK. ex {change rate show periods of wide swings for some time period and periods of rather moder: ale swings in other ime periods, thus exempliying the phenomenon of volatility clustering Now the practical question is How do we statically measure volaity? Let us lustate this with our exchange rate example. Let Y/=USJUK. exchange rate Jog ot ¥5 veo viy mean of d¥;" ay — aye ative change inthe exchange rate ‘Thus, % is the mean-adjusted relative change in the exchange rate. Now we can use X? as ‘a measure of vlailiy, Being a squared quantity ite value willbe high in periods when there fare big changes in the pices of nancial assets and ts value ill be comparatively small ‘when there are modest changes inthe prices of fiancal assets“? Lo os 06 os Logexchange rate (Oe Te 80 2 SF Se 9D BOF Year FIGURE 22.6 Log of USJULK. exchange rate, 1973-1995 (monthy) (Continued) —BYou might wonder why we do not use the vatiance of X; = Y°X?/t asa measure of volt ity. This s because we want to take into account changing volatifiy of asset prices oxer time. If ‘weuse the Variance of%, twill only bea single value fora given data se Taj Basie 1W Simttanons-Eqvaton T 22 Tne See ran covonetics Fourth Moda tose Freatiog Cop, 2 58 PARTFOUR: SIMULTANEOUS EQUATION MODELS US/UK. EXCHANGE RATE: AN EXAMPLE. (Continued) 012 0s. os Change in log exchange rate Ta 76788082 S486 SR 9092 OH Year FIGURE 22.7 Changein the log of US/UK. exchange rate, Accepting XP as a measur of volatilty, how do we know iit changes overtime? Sup- se we consider the folowing AR(), or ARIMA (1,0), model MP ft XE + (e201) ‘This made! postulates that voltty inthe current perid is related tot value in the previous perio plus @ write noise error term. I postive, i suggests that volatility was high in the previous period, it will continue tobe high inthe curent peri, indicating volatity clus- tering, Ip is zero, then there is no volatility clustering, The statistical significance of he os timated fe can be judged by the usual tes “There is nothing to prevent us from considering an ARYp) model of volatity such that XP = ot AXE, + feXE a t+ BpME pt (22102) ‘This made! suggests that volatity in the eutent period is relate to voltity inthe past ppe- Fiods, the value of p being an empirical question. Tis empirical question can be resolved by ‘one or more ofthe model selection cilia that we discussed in Chapter 19 (e.g. the Akaike information measure). We can test the significance of ay individual .coeticent bythe ftest and the colectve signiticance of two or more coefficients by the usual F test, Model (22.10.1) is an example of an ARCH(1) model and (2.10.2) is called an ARCH(P) model, where p repeesents the number of autoregressive frm inthe model ojo proceeding further, let usilustrate the ARCH model withthe U.SJ/ULK. exchange rate data. The resus of the ARCH(1) model were as flows. Xx? = 0.0008 + 0.1604x?, 20. (6.7831) (2.8355) fe e % o2s7 d= 1.9972 here X? is as defined before. (Contiued) 1W Simttanons-Eqvaton T 22 Tne See Gr Models Ezocometics: Forecasting Capes, abs CHAPTER TWENTY-TWO: TIME SERIES ECONOMETRICS: FORECASTING 859 USJUK. EXCHANGE RATE: AN EXAMPLE (Continued) ‘Since the coeticiont of the lagged term is hight significant (p value of about 0.005), i ‘seems volatility clustering is present in the present instance. We tried higher-order ARCH ‘models, but only the ART) model turned out tobe signtcant. How would we test forthe ARCH effect ina regression model in general thats based on time series data? To be more specific, let us consider the kvarable near regression mod % bb Baar + Baer + (2210.4) land assume that conatonalon the information available a ime (! — 1) the disturbance term ‘edistrouted as + Nf, (ae +ave)] e105) that is, is normally istibuted with zero mean and (2210.8) ‘hati, the variance of u follows an ARCH(1) process. ‘The normaly of u isnot new tous. Whats new is thatthe variance of wat time tis pendent on the squared disturbance at ime (t~ 1), thus giving the appearance of serial cor- relation Of cours, the ertor variance may depend not only on one lagged term of the ‘squared eror term but also on several lagged squared terms as fllows: var(u) =o? enue tale gt + apt p (22.10.27) If there is no autocoraltion in the eror variance, we have Hosa = 2 (2210.8) In which case var(u1) =a, and we do not have the ARCH affect, ‘Since we do not directly observe o?, Engle has shown that running the following regres: ‘son can easily est he preceding nul hypothesis: @ ‘where @, as usual, denote the OLS variance obtained trom the cxginal regression model (22.104), ‘One can test the ull hypothesis Hy by the usual F test, or allernaivaly, by computing nF®, where Ais the coetcient of determination trom the auxiliary regression (22.10.). I ccan be shown that io tdi 5 +020 a. + 0p 5 (2210.8) DFR x8 (22.10.10) ‘hati, in large samples nf? folows the chi-square distribution with df equal tothe number ‘of autoregressive terms in the auxliary regression, Before we proceed to ilustrate, make sure that you do not confuse autocorrelation ofthe ‘errr term as discussed in Chaptar 12 and the ARCH modal. In the ARCH model itis the (conditona) variance of us that depends on the (squared) previous enor terms, thus giving the impression of autocorrelation Sy technical note; Remember that for our classical linear model the variance of , was assumed to be g?, which in the present context becomes unconditional variance. qq ~ 1, the Stability condition, we can write @* = ay -+ar0*: that is,¢* = n/(1 ~ ai). This shows that the Unconditional variance of u does not depend on , but does depend on the ARCH parameter af Taj Basie 1W Simttanons-Eqvaton T 22 Tne See ran covonetics Fourth Moda tose Freatiog Cop, 2 860 PART FOUR: SIMULTANEOUSEQUATION MODELS NEW YORK STOCK EXCHANGE PRICE CHANGES ‘AS a futher illustration ofthe ARCH effec, Figure 228 presents monthly percentage change in the NYSE (New York Stock Exchange) Indox or the porod 1952-1995. *I is evident from this graph thatthe percent price changes inthe NYSE Index exhibit considerable volt Notice especially the wide swing around the 1987 crash in stock prices. To capture the volatity in the stock tum seen in the gure, et us considera vary simple model a (22.10.11) where ¥; = percent change in the NYSE stock index and uy = random error tom. [Notice that besides the intereep, there is no ether explanatory variable in the model From the data, we obtained the following OLS regression: ¥= 0.00886 t (aae95) (22.10.12) = 19215 What does this intercapt denote? Itis simply the average percent rate of return on the NYSE index, othe mean value of ¥ (can you very this?). Thus over the sample period the aver- ‘age monthly tum on the NYSE index was about 0.0069 percent. 02 oa & 00 B- 02 “03 ws 90a 888 Year icuRE 22.8 ony pace change the NYSE Pc Index, 1952-108, (continue) SA paph and fs egression ress presented blow are hse on the data collet by Gary Koop, Anualtsis of Econonic Data, John Wiley & Sons, New York, 2000 (data from the data disk) The monthly percentage change inthe stock price index can be regarded asa rate of re turn on the index. Taj Basie 1W Simttanons-Eqvaton T 22 Tne See The ea Models Ezocometics: Forecasting Capes, abs CHAPTER TWENTY-TWO: TIME SERIES ECONOMETRICS: FORECASTING 861 NEW YORK STOCK EXCHANGE PRICE CHANGES (Continued) Now we obtain the residuals from the preceding regression and estimate the ARCH(1) ‘model, which gave the folowing results: of = 000145 + 0.116702 , 1 (8029) (2.6994) 22:10:13) Fe=001% = a=20121 ‘where 0s the estimated resiual rom regression (22.10.12) ‘Since the lagged squared disturbance term is statistically signicant (p value of about 0.007), it seems the error variances are correlated; that, thee isan ARCH effect. We ted higher-order ARCH models but only ARCH(1) was stasticaly significant What To Do if ARCH Is Present Recall that we have discussed several methods of correcting for het- eroscedasticity, which basically involved applying OLS to transformed data. Remember that OLS applied to transformed data is generalized least squares (GLS). If the ARCH effect is found, we will have to use GLS. We will not pursue the technical details, for they are beyond the scope of this book. Fortunately, software packages such as Eviews, Shazam, Microfit, and Pe-Give have now user-friendly routines to estimate such models. ‘AWord on the Durbin-Watson d and the ARCH Effect We have reminded the reader several times that a significant d statistic may not always mean that there is significant autocorrelation in the data at hand. Very often a significant d value is an indication of the model specifi- cation errors that we discussed in Chapter 13. Now we have an additional specification error, that due to the ARCH effect. Therefore, in a time series regression, if a significant d value is obtained, we should test for the ARCH effect before accepting the d statistic at its face value. An example is given in exercise 22.23. ANote on the GARCH Model Since its “discovery” in 1982, ARCH modeling has become a growth indus- try, with all kinds of variations on the original model. One that has become Davidson and James G. MacKinnon, Estimation and Inference in Econo Economer: Consult Riss ‘metres, Oxford University Press, New York, 1998, Sec. 16.4 and William H. Gr re Analysis, th ed, Prentice Hall, Englewood Clills,N.1, 2000, Sec. 18.5. Taj Basie 1W Simttanons-Eqvaton T 22 Tne See The ea covonetics Fourth Moda tose Freatiog Cop, 2 862 PART FOUR: SIMULTANEOUS-EQUATION MODELS popular is the generalized autoregressive conditional heteroscedasticity (GARCH) model, originally proposed by Bollerslev:® The simplest GARCH, model is the GARCH(I, 1) model, which can be written as: bt Wey + bof (22.10.14) which says that the conditional variance of u at time t depends not only on the squared error term in the previous time period [as in ARCH(1)] but also on its conditional variance in the previous time period. This model can be generalized to a GARCH(p, q) model in which there are p lagged terms of the squared error term and q terms of the lagged conditional variances. We will not pursue the technical details of these models, as they are in- volved, except to point out that a GARCH(1, 1) model is equivalent to an ARCH(2) model and a GARCH(p, g) model is equivalent to an ARCH(p +4) model? For our U.S/U.K. exchange rate and NYSE stock return examples, we have already stated that an ARCH(2) model was not significant, suggesting that perhaps a GARCH(1, 1) model is not appropriate in these cases. 22.11 CONCLUDING EXAMPLES We conclude this chapter by considering a few additional examples that il- lustrate some of the points we have made in this chapter. THE RELATIONSHIP BETWEEN THE HELP-WANTED INDEX (+t) AND ‘THE UNEMPLOYMENT RATE (UN) FROM JANUARY 1969 TO JANUARY 2000 To study causality between HI and UN, two indicators of labor market conditions in the United States, Marc A. Giammatteo considered the following regression model HW, = 00+ UN + SAW, 2a.) To save space wo wil not present the actual regression results, but the main conclusion that ‘emerges from this study is that there f bilateral causalty between the two labor market ind alors and this conclusion di not change when the lag length was varied. The data on HW and UN are given inthe data disk Autoregressive Conditional Heteroscedasticity,” Joumal of 1986, pp. 307-326 For details, see Davidson and MacKinnon, op. cit, pp. 558-560. ‘Mare A. Giamnmattco (West Point, Class of 2000}, "The Relationship between Wanted Index and the Unemployment Rate,” unpublished term paper (Notations l conform to our notation.) 1W Simttanons-Eqvaton T 22 Tne See ran Models Ezocometics: Forecasting Capes, abs CHAPTER TWENTY-TWO: TIME SERIES ECONOMETRICS: FORECASTING 863 ARIMA MODELING OF THE YEN/DOLLAR EXCHANGE RATE: ‘JANUARY 1971 TO DECEMBER 1998 “The yen/dolar exchange rate (WS) is a key exchange rate. From the logarithms of the ‘monthly ¥,# was found that inthe level form this exchange rata showed the typical pattem ‘of anonstationary ime series. But examining the fist diferences, it was found that hay were stationary; the graph here pretty much resembles Figure 228. Uni root analysis confirmed that the fist ciferances ofthe lags of WS were stationary. ‘Alter examining the correlogram of the log fist diferences, we estimated the following [ARIMA(I, 0,2) model Y= 0.0096 + 0.9678%,.,+ -0.5866u.4— 0.4057u, f=(-4.3638) (675439) (114361) (79532) @zat.g) P= 0.1us4 d= 1.9009, where ¥ = frst ferences ofthe logs of W'S and vis a white noise error torm, “To save space, we have provided the data underlying the preceding analysis in the data isk Using these data the reader is urged to try other models and compare ther forecasting performances. ARCH MODEL OF THE U.S. INFLATION RATE: JANUARY 1947 TO JANUARY 2001 ‘To see i the ARCH elect is present inthe U.S. inflation rato as measured by the CPI, we ‘obtained CP data trom January 1947 to January 2001. The pot ofthe logarithms ofthe CPI ‘showed thatthe time series was nonstationary. But the plt ofthe fist ifferences ofthe logs ofthe CPI, as shown in Figure 22.9, show considerable volaity eventhough the fst ter fences are stationary 0.020 oo1s 010 0.00: First difference 3035 a0 65707580 BS 909500 FIGURE 22.9 First iferences ofthe logs of CPL (Continued) Tam thankful to Gresory M. Ogborn and Mare C. Osborn (West Point, Class of 2001) for collecting and analyzing the daa Taj Basie 1W Simttanons-Eqvaton T 22 Tne See The ea covonetics Fourth Moda tose Freatiog Cop, 2 864 PART FOUR: SIMULTANEOUSEQUATION MODELS ARCH MODEL OF THE U.S. INFLATION RATE: ... (Continued) Following the procedure outined in regressions (22.10.12) and (22.10.19), we fist re lgressed the logged frst siferences of CPI on a constant and obtained residuals from this {equaton. Squaring these residuals, we obtained the folowing ARCH(3) model: @ = 0.000082 + 0.330907 , + 0.133807, + 0.092007 5 =(6:1899) (8.7270) (@5620) (25987) (2314) o2tsa d= 20304 [AS you can see, there is quilo a bt of persistence in the volatiy, as volatility inthe current ‘month depends on volatility inthe preceding 3 months. The reader is advised to obtain CPL ata trom government sources and try to see if another model does a beter jb, preferably @ GARCH model. 22.12 SUMMARY AND CONCLUSIONS 1. BoxJenkins and VAR approaches to economic forecasting are alter- natives to traditional single- and simultaneous-equation models. 2. To forecast the values of a time series, the basic Box-Jenkins is as follows: strategy a, First examine the series for stationarity. This step can be done by computing the autocorrelation function (ACF) and the partial autocorrela- tion function (PACF) or by a formal unit root analysis. The correlograms associated with ACF and PACF are often good visual diagnostic tools. b. IF the time series is not stationary, difference it one or more times to achieve stationarity. c. The ACF and PACF of the stationary time series are then computed to find out if the series is purely autoregressive or purely of the moving average type or a mixture of the two. From broad guidelines given in Table 22.1 one can then determine the values of p and q in the ARMA process to be fitted. At this stage the chosen ARMA(p, q) model is tentative . The tentative model is then estimated. €. The residuals from this tentative model are examined to find out if they are white noise. If they are, the tentative model is probably a good. approximation to the underlying stochastic process. If they are not, the process is started all over again. Therefore, the Box-Jenkins method is, iterative. £. The model finally selected can be used for forecasting. 3. The VAR approach to forecasting considers several time series at a time. The distinguishing features of VAR are as follows: a. Itisa truly simultaneous system in that all variables are regarded as endogenous.

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