ARCH and GARCH MODELS

David Leblang
University of Colorado

Leblang
ARCH

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I.

Motivation: Why ARCH/GARCH Models?

A.

What is ARCH/GARCH?

B.
C.
D.
E.

Generalizedmore general than ARCH

Autoregressivedepends on its past
Conditionalvariance depends on past info
Heteroscedasticitynon-constant variance.

F.

EconometricOLS assumes:
1)

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ARCH

No Serial Correlation: cov( t , t 1 ) = 0 -- tests

and corrections are standard in the
literature.

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2)

Homoscedastic Errors: t ~ NID ( , ) --errors

are normally and independently distributed.
Usual
for
papers
to
test
for
heteroscedasticity ( i) in the crosssectional context but unusual in the timeseries context ( t)

3) Consequences:
OLS
is
BLUE
and
consistent. HOWEVER, OLS is not efficient
(minimum variance) if we relax the class of
estimators to include nonlinear estimators.

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ARCH

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G.
H.

Empirical Regularities (S&P returns).

Volatility Clustering

100*[log(sp(t))-(log(sp(t-1)))]

4.65458

-6.00451
22dec1999

31mar2000

date

09jul2000

17oct2000

Volatility Clustering

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ARCH

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I. Fat/Heavy Tails (Kurtosis) [k=3]

Fraction

.113636

0
-6.00451

100*[log(sp(t))-(log(sp(t-1)))]

4.65458

Kurtosis

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ARCH

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J. TheoreticalVariance is of Interest
K. What causes volatility/variance of a series?
Finance literature (risk premium); economics
literature (target zones). Political science
political events/information influence variability
of asset prices (e.g., Leblang and Bernhard;
Freeman, Hays and Stix)
L. Are some events/periods/systems conducive
to more/less volatility than others?

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ARCH

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M. Textbook References
N. Enders, Applied Econometric
Series
O. Patterson, An Introduction to
Time Series

Applied

P. Franses and van Dijk, NonTime Series Models in Empirical

Linear
Finance

Q.

Software (others=PC-GIVE, RATS, TSP)

Software

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Time

Advantages

Disadvantages

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STATA
www.stata.com

EVIEWS
www.eviews.com

S+ GARCH
www.insightful.com

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ARCH

My favorite in
general
Lots of built in
models
Choice of algorithm
Easy to program

Only normal dist.

Few built-in
diagnostics

Lots of built in
models
Choice of algorithm
Lots of built in diag.
FAST!
Lots of built in
models
FIGARCH
MGARCH
t, ged, double exp
dist.

Only normal dist.

Difficult to program

Difficult to program
No choice of
algorithm
A bit clunky

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Terrific Graphics

II.

Preliminaries: Linear Time Series

R. Variable yt is observed for t=1,2,..,n
S. The error ( t) is a white noise series if
T. E [ t ] = 0
U. E [ 2t ] = E [ 2t | t 1 ] = 2 t .
The
error
is
unconditionally
and
conditionally
homoscedastic.
V. E [ t s ] = 0; s t .
Note: this says that the
t 1
information set
does not contain
information to forecast t .

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ARCH

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W. A time series for yt can be thought of as the

sum of a predictable and an unpredictable
component: yt = E[ yt | t 1 ] + t .
III.

Relax assumption of homoscedasticity

X. Allow conditional variance of t to vary over
time: E[ 2t | t 1 ] = ht
for some nonnegative
function.
Y. In general, this is expressed as: t = zt ht ,
where zt is independently and identically
distributed normally with mean zero and unit
variance (this can be relaxeduse student t
and ged distributions to allow for fatter tails).

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ARCH

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Z. This means that the distribution of t

conditional upon the history t 1 is normal with
mean zero and variance ht. It also means that
the unconditional variance of t is constant.
Using the law of iterated expectations:
2 E[ 2t ] = E[ E [ 2t | t 1 ]] = E [ht ] .
AA. We now need a model to specify how the
conditional variance of t evolves over time.

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IV. Autoregressive Conditional Heteroscedasticity

BB. Invented by Engle (1982) to explain the
volatility of inflation rates.
CC. Basic ARCH (1) model: conditional variance
of a shock at time t is a function of the squares
of past shocks: ht = + 1 2t 1 . (Recall, h is the
variance and is a shock, news, or
error).
DD. Since the conditional variance needs to be
nonnegative, the conditions > 0; 1 0 have to
be met.
If 1 = 0, then the conditional
variance is constant and t is conditionally
homoscedastic.
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V.

Generalized ARCH (GARCH)

EE. Because ARCH(p) models are difficult to
estimate, and because ( 2t 2 , 2t 3 ), ( 2t 3 , 2t 4 ), etc.
decay very slowly, Bollerslev (1986) developed
the GARCH model.
FF. GARCH (1,1):

ht = + 1 2t 1 + 1ht 1 .

GG. The variance (ht) is a function of an

intercept ( ), a shock from the prior period ( )
and the variance from last period ( ).

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ARCH

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HH. Higher
p

ht = + j
j =1

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ARCH

order
2
t j

GARCH

models:

h
k t k .
k =1

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VI. Linear GARCH Variations.

II. Integrated GARCH (Engle and Bollerslev
1986).
JJ. Phenomena is similar to integrated series in
regular (ARMA-type) time-series.
KK. Occurs when + =1. When this is the
case it means that there is a unit root in the
conditional variance; past shocks do not
dissipate but persist for very long periods of
time.
LL. Fractionally Integrated GARCH
Bollerslev and Mikkelsen (1996)).
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ARCH

(Baillie,

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MM. GARCH in Mean (Engle, Lilien and Robbins

(1987).
NN. Idea is that there is a direct relationship
between risk and return of an asset.
OO. In the mean equation, include some function
of the conditional varianceusually the
standard deviation.
PP. This allows the mean of a series to depend,
at least in part, on the conditional variance of
the series (more later)..

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VII. Non-Linear GARCH Variations (dozens in last 20

years). Linear GARCH models all allow prior
shocks to have a symmetric affect on ht. Nonlinear models allow for asymmetric shocks to
volatility. I will focus on the most common: the
Exponentional GARCH (1,1) (EGARCH) model
developed by Nelson (1991).
QQ. Conditional variance:

log(ht ) = + 1zt 1 + 1 (| zt 1 | E [| zt 1 |]) + 1 log(ht 1 ) , where

zt = t / ht and is the standardized residual. is

the asymmetric component.

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RR. News Impact Curvedifferential impact of

positive and negative shocks.

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Conditional Variance: GARCH

Conditional Variance: EGARCH

83.8448

.587194

.404425

Conditional Variance: GARCH

Conditional Variance: EGARCH

40.1751

-9.8

error (t-1)

9.8

News Impact Curve: dCPI w/ ARMA(1,1)

VIII. Testing for ARCH

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ARCH

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SS. ARCH Tests (Engle 1982).

TT. Regress Y on X and obtain some residuals
( t )
UU. Regress 2t on p lags
2t = 0 + 1 2t 1 + 2 2t 2 +..+ p 2t p

of

2t ;

that

is,

a.
Assess joint significance of 1 p .
If the coefficients are different from zero
then
the
null
of
conditional
homoscedasticity can be rejected.
b. T*R2 is Engles LM test statistic. Under
the null of homoscedasticity it is
asymptotically distributed 2 (q )
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ARCH

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VV. Graphical TestLjung-Box Q Statistic

WW. LB (Q) used to diagnose serial correlation
in the residuals
XX. LB(Q2) used to diagnose serial correlation in
the squared residualsheteroscedasticity

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IX. ExampleReturns on the S&P 500

. regress dlsp

/returns on the S & P 500 Index

Source |
SS
df
MS
-------------+-----------------------------Model |
0.00
0
.
Residual | 391.285893
219 1.78669358
-------------+-----------------------------Total | 391.285893
219 1.78669358

Number of obs
F( 0,
219)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

220
0.00
.
0.0000
0.0000
1.3367

-----------------------------------------------------------------------------dlsp |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------_cons |
.0096484
.0901184
0.11
0.915
-.167962
.1872588
-----------------------------------------------------------------------------. predict e if e(sample), resid / obtain residuals
. gen e2=e^2

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ARCH

/generate squared residuals

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. reg e2 l.e2 /regress squared residuals on a lag

Source |
SS
df
MS
-------------+-----------------------------Model |
72.087039
1
72.087039
Residual | 2684.92529
217 12.3729276
-------------+-----------------------------Total | 2757.01233
218 12.6468456

Number of obs
F( 1,
217)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

219
5.83
0.0166
0.0261
0.0217
3.5175

-----------------------------------------------------------------------------e2
|
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------e2
|
L1 |
.1616863
.0669855
2.41
0.017
.0296608
.2937118
_cons
|
1.49788
.2661034
5.63
0.000
.9734018
2.022358
-----------------------------------------------------------------------------. test l1.e2
( 1)

/test H0: homoscedastic residuals

L.e2 = 0.0
F(

1,
217) =
Prob > F =

5.83
0.0166

. display 219*.0261
5.7159
. display chiprob(1, 5.7159) /the value is the p-value to reject H0 of Homoscedasticity
.01681195

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Autocorrelation Function
. ac e2

/autocorrelation function of the squared residuals

Autocorrelations of e2

Bartlett's formula for MA(q) 95% confidence bands

1.00

1.00

0.75

0.75

0.50

0.50

0.25

0.25

0.00

0.00

-0.25

-0.25

-0.50

-0.50

-0.75

-0.75

-1.00

-1.00
0

10

20
Lag

30

40

Correlogram

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ARCH

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. corrgram e2 /correlegram gives the ac and pacs

-1
0
1 -1
0
1
LAG
AC
PAC
Q
Prob>Q [Autocorrelation] [Partial Autocor]
------------------------------------------------------------------------------1
0.1615
0.1617
5.8191 0.0159
||2
0.1511
0.1282
10.937 0.0042
||3
-0.0107 -0.0555
10.963 0.0119
|
|
4
0.0577
0.0505
11.715 0.0196
|
|
5
0.0724
0.0695
12.906 0.0243
|
|
6
0.1087
0.0765
15.603 0.0161
|
|
7
-0.0132 -0.0594
15.643 0.0286
|
|
8
0.0007 -0.0123
15.643 0.0478
|
|
9
-0.0317 -0.0189
15.876 0.0695
|
|
10
0.0070
0.0027
15.887 0.1029
|
|
. wntestq e2, lags(1)
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
5.8191
Prob > chi2(1)
=
0.0159

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ARCH

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Remedy: GARCH (1,1) Model

. arch dlsp, arch(1) garch(1) nolog
ARCH family regression
Sample:

4 to 223

Log likelihood = -366.1473

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
OPG
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0232815
.0826522
0.28
0.778
-.1387138
.1852768
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1652834
.045527
3.63
0.000
.0760521
.2545146
garch
|
L1 |
.7815966
.0783583
9.97
0.000
.6280172
.935176
_cons
|
.1121176
.0913255
1.23
0.220
-.066877
.2911122
------------------------------------------------------------------------------

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ARCH

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RESIDUAL TESTS
. predict e, resid
. predict v, variance
. gen s=sqrt(v)
. gen se=e/s
. gen se2=se^2
. wntestq se2
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
30.0623
Prob > chi2(40)
=
0.8735

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ARCH

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. corrgram se2
-1
0
1 -1
0
1
LAG
AC
PAC
Q
Prob>Q [Autocorrelation] [Partial Autocor]
------------------------------------------------------------------------------1
-0.0100 -0.0100
.02243 0.8810
|
|
2
0.0873
0.0875
1.7295 0.4212
|
|
3
-0.0914 -0.0911
3.6084 0.3070
|
|
4
0.0091
0.0009
3.6269 0.4588
|
|
5
-0.0114
0.0044
3.6562 0.5999
|
|
6
0.0214
0.0127
3.7612 0.7090
|
|
7
-0.0549 -0.0547
4.4529 0.7264
|
|
8
-0.0243 -0.0290
4.5894 0.8004
|
|
9
-0.0238 -0.0117
4.7205 0.8580
|
|
10
0.0067
0.0017
4.7311 0.9084
|
|

No Remaining ARCHBUT, what about normality??

Recall: Normal distribution has skewness of 0 and
kurtosis of 3 and we know that financial series tend
to be fat tailed.

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ARCH

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.graph se, norm bin(50)

Fraction

.1

0
-4.20146

se

2.73526

. sktest se
Skewness/Kurtosis tests for Normality
------- joint -----Variable | Pr(Skewness)
Pr(Kurtosis) adj chi2(2)
Prob>chi2
-------------+------------------------------------------------------se |
0.067
0.012
8.77
0.0125

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ARCH

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Solution: Use Robust Standard Errorsrobust to

departures from normality (Bollerslev & Wooldridge
1982)
. arch dlsp, arch(1) garch(1) nolog robust
ARCH family regression
Sample:

4 to 223

Log likelihood = -366.1473

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0232815
.0786518
0.30
0.767
-.1308732
.1774362
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1652834
.2083251
0.79
0.428
-.2430264
.5735931
garch
|
L1 |
.7815966
.3140995
2.49
0.013
.165973
1.39722
_cons
|
.1121176
.2578869
0.43
0.664
-.3933314
.6175666
------------------------------------------------------------------------------

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ARCH

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Inclusion of Exogenous Variables

. arch dlsp, arch(1) garch(1) nolog robust het(gore) bhhh
ARCH family regression -- multiplicative heteroskedasticity
Sample:

4 to 223

Log likelihood = -365.4092

Number of obs
Wald chi2(.)
Prob > chi2

=
=
=

220
.
.

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
.0135455
.080307
0.17
0.866
-.1438533
.1709443
-------------+---------------------------------------------------------------HET
|
gore
| -.1355259
.0615727
-2.20
0.028
-.2562061
-.0148457
_cons
|
5.006925
3.286556
1.52
0.128
-1.434607
11.44846
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1945511
.0973455
2.00
0.046
.0037575
.3853447
garch
|
L1 |
.6837859
.1219819
5.61
0.000
.4447057
.922866
------------------------------------------------------------------------------

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ARCH

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. wntestq se2
Portmanteau test for white noise
--------------------------------------Portmanteau (Q) statistic =
29.1930
Prob > chi2(40)
=
0.8965
. sktest se2
Skewness/Kurtosis tests for Normality
------- joint -----Variable | Pr(Skewness)
Pr(Kurtosis) adj chi2(2)
Prob>chi2
-------------+------------------------------------------------------se2 |
0.000
0.000
.
0.0000

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ARCH

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ARCH IN MEAN
. arch dlsp, arch(1) garch(1) nolog robust het(gore) archm archmexp(sqrt(X))
ARCH family regression -- multiplicative heteroskedasticity
Sample:

4 to 223

Log likelihood = -362.6718

Number of obs
Wald chi2(1)
Prob > chi2

=
=
=

220
4.84
0.0278

-----------------------------------------------------------------------------|
Semi-robust
dlsp
|
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------dlsp
|
_cons
|
-.80408
.3986817
-2.02
0.044
-1.585482
-.0226782
-------------+---------------------------------------------------------------ARCHM
|
sigma2ex
|
.7068768
.3213948
2.20
0.028
.0769545
1.336799
-------------+---------------------------------------------------------------HET
|
gore
| -.1067959
.016462
-6.49
0.000
-.1390609
-.0745308
_cons
|
3.790934
.9837613
3.85
0.000
1.862797
5.71907
-------------+---------------------------------------------------------------ARCH
|
arch
|
L1 |
.1835399
.0981365
1.87
0.061
-.0088041
.3758838
garch
|
L1 |
.6634369
.1133509
5.85
0.000
.4412733
.8856006
------------------------------------------------------------------------------

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ARCH

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