ARCH and GARCH Estimation

Dr. Chen, Jo-Hui

The types of serial correlation discussed so far refer only to the
error term u
t
. In AR(p) we postulated that u
t
depends linearly on
the p past errors u
t-1
, u
t-2
, ,u
t-p
. Another type of serial
correlation is often encountered in time series data, especially
when forecasts are generated. Some forecasters have observed
that the variance of prediction errors is not a constant but differs
from period to period. For instance, when the Federal Reserve
Board switched to controlling money growth rather than the
interest rate, as was done before, interest rates became quite
volatile (that is, they began to vary a great deal around the mean).
Forecast errors associated with interest rate predictions were thus
heteroscedastic.
A similar heteroscedasticity was observed when exchange
rate policy switched from fixed exchange rates to flexible
exchange rates. In the latter case, exchange rates
fluctuated a great deal, making their forecast variances
larger. In monetary theory and the theory of finance,
financial asset portfolios are functions of the expected
means and variances of the rates of returns. Increased
volatility of security prices or rates of return are often
indicators that the variances are not constant over time.
Engle (1982) introduced a new approach to modeling
heteroscedasticity in a time series context.

The structure of this topic

A. The ARCH Specification
B. Estimating ARCH models in EViews
C. Asymmetric ARCH Models
D. EViews Example
Autoregressive Conditional Heteroskedasticity (ARCH) models are
specifically designed to model and forecast conditional variances.
The variance of the dependent variable is modeled as a function of
past values of the dependent variable and independent, or
exogenous variables. In developing an ARCH model, you will have
to provide two distinct specificationsone for the conditional mean
and one for the conditional variance.
A. The ARCH Specification
1. The GARCH(1,1) Model
A. The ARCH Specification
= News about volatility from the previous period, measured as the
lag of the squared residual from the mean equation. (ARCH term)
= the conditional variance equation is a function of three terms
w = the mean.
where
2
t
o
2
1 t
c
2
1 t
o
= last periods forecast variance. (GARCH term)
variance conditioal The (2).......
equation Mean (1)......
2
1
2
1
2
'

+ + =
+ =
t t t
t t t
r x y
o | c o = o
c
1. The GARCH(1,1) Model
The (1,1) in GARCH(1,1) refers to the presence of a first-order
GARCH term and a first-order ARCH term. An ordinary ARCH
model is a special case of a GARCH specification in which there are
no lagged forecast variances in the conditional variance equation.

For example, if the asset return was unexpectedly large in either the
upward or the downward direction, then the trader will increase the
estimate of the variance for the next period. This model is consistent
with the volatility clustering often seen in financial returns data, where
large changes in returns are likely to be followed by further large
changes.
A. The ARCH Specification
2. The ARCH-M model
The xs in equation (1) represent exogenous or predetermined variables
that are included in the mean equation. If we introduce the conditional
variance into the mean equation, we get the ARCH-in-Mean (ARCH-M)
model:



The ARCH-M model is often used in financial applications where the
expected return on an asset is related to the expected asset risk. The
estimated coefficient on the expected risk is a measure of the risk-return
tradeoff.
A. The ARCH Specification
t t t t
r r x y c o + + =
~
2 '
3. The GARCH(p,q) model
Higher order GARCH models, denoted GARCH(p,q), can be estimated
by choosing either p or q greater than 1. The representation of the
GARCH(p,q) variance is



where p is the order of the GARCH terms and q is the order of the
ARCH term.

The error variance at time t is assumed to depend on previous squared
error terms. Also, the variance at time t is conditional on those in
previous periods and hence the term conditional heteroscedasticity.
The ARCH test is one the null hypothesis H
0
:
1
=
2
=..=
q
=0.
A. The ARCH Specification

=

=

+ + =
p
j
j t j
q
i
i t i t
1
2
1
2 2
o | c o = o
a) Quick/Estimate Equation/ARCH
b) Option:
Heteroskedasticity Consistent Covariances: You should use this option if you
suspect that the residuals are not conditionally normally distributed.
c) The Mean Equation:
You can enter the specification in list form by listing the dependent variable
followed by the regressors. You should add the C to your specification if you
wish to include a constant. If your specification includes an ARCH-M term,
you should click on the appropriate radio button in the upper right-hand side of
the dialog.
d) The variance Equation
Under the ARCH specification label, you should choose the number of
ARCH and GARCH terms.
In the edit box labeled Variance Regressors, you may optionally list
variables you wish to include in the variance specification. Note that
EViews will always include a constant as a variance regressor so that you do
not need to add C to the list.
B. Estimating ARCH models in EViews
Examples 1
GARCH(1,1)
To estimate a standard GARCH(1,1) model with no regressors in the mean and
variance equations.



(a) File/Open/workfile/c:\program file\EView4\example file\data\gerus
(b) Quick/Estimate Equation/ARCH
(c) R c
(d) Enter 1 for the number of ARCH terms, and 1 for the number of GARCH
terms, and select GARCH (symmetric) Select None for the ARCH-M
(e) Leave blank the Variance Regressors edit box.
B. Estimating ARCH models in EViews


2
1
2
1
2

+ + =
+ =
t t t
t t
c R
o | c o = o
c
Mean Eq.
Examples 2
To estimate the ARCH(4)-M model:




a) Quick/Estimate Equation/ARCH
b) NYS c DUM
c) Enter 4 for the ARCH term and 0 for the GARCH term, and select
GARCH (symmetric).
d) Select std. Dev. for the ARCH-M term
e) enter DUM in the Variance Regressors edit box.
B. Estimating ARCH models in EViews
t t t t t t
t t t t
DUM r
r DUM r r NYS
3
2
4 4
2
3 3
2
2 2
2
1 1
2
2 1 0
+ + + + + =
+ + + =

c o c o c o c o = o
c o
Click
Examples 3
To estimate ARCH(3) model:
Supposed that annual data for the U.S. for 1960-1995 on the Federal Reserve
discount rate (in percent), money supply (M2 in billions of dollars), and Federal
deficit (D) in billions of current dollars. The model relating discount rates (r) to
the money supply (M) and government budget deficits (D) lagged twice is as
follows:
B. Estimating ARCH models in EViews
2
3 3
2
2 2
2
1 1 0
2
2 5 1 4 2 3 1 2 1


+ + + =
+ + + + + =
t t t t
t t t t t t
u u u
u D D M M r
o o o o o
| | | | |
Examples 3
Steps:
The interest equation was first estimated, its estimated residuals squared, and the
auxiliary regression for the variance estimated. R
2
for this regression was 0.126,
but nR
2
=3.91 has p-value 0.27, which in not significant for x
2
test. Thus,
ARCH(3) is not supported. However, the ARCH(1) term was significant at the
level 0.09, so an ARCH(1) specification was tested next. The p-value for this
test was 0.048, which indicates significant at the 5 percent level. Because the
deficit term D
2
was insignificant, it was excluded from the model in order to
improve the precision of the other variables and to reduce any multicollinearity
that may be present. The final model is given below with p-values in
parentheses:
B. Estimating ARCH models in EViews
464 . R
0.01) ( 0.01) ( 0.01) ( 0.01) (
0347 . 0 0262 . 0 0283 . 0 38 . 3
2
1 2 1
=
< < < <
+ =
t t t t
D M M r
1. ARCH Estimation Output
The output from ARCH estimation is divided into two sections:
1) The upper part provides the standard output for the mean equation.
2) The lower part, labeled Variance Equation contains the coefficients, standard
errors, z-statistics and p-values for the coefficients of the variance equation.
The ARCH parameters correspond toand the GARCH parameters to.
3) Note that measures such as R
2
may not be meaningful if there are no regressors
in the mean equation. Here, for example, the R
2
is negative.
4) The sum of the ARCH and GARCH coefficient (+) is very close to one,
indicating that volatility shocks are quite persistent.
B. Estimating ARCH models in EViews
2. Working with ARCH Model
Once your model has been estimated, EViews provides a variety of views and
procedures for inference and diagnostic checking.

Views of ARCH Models
Views/actual, fitted, residual
/Conditional SD Graph
/Covariance Matrix
/Coefficient Tests
/Residual Tests/Correlogram-Q-statistics
/Correlogram Squared Residuals
/Histogram-Normality Test
/ARCH LM Test
B. Estimating ARCH models in EViews
2. Working with ARCH Model
The ARCH LM test statistic is computed from an auxiliary test
regression. To test the null hypothesis that there is no ARCH up to
order q in the residuals, we run the regression


where e is the residual. This is a regression of the squared residuals on
a constant and lagged squared residuals up to order q. EViews reports
two test statistics for this test regression. The F-statistic is an omitted
variable test for the joint significance of all lagged squared residuals.
The Obs*R-squared statistic is Engles LM test statistic, computed as
the number of observations times the R
2
from the test regression. The
exact finite sample distribution of the F-statistic under H
0
is not known
but the LM test statistic is asymptotically distributed x
2
(q) under quite
general conditions.
B. Estimating ARCH models in EViews
,
1
2
0
2
t
q
s
s t s t
v e e +
|
|
.
|

\
|
+ =

=

| |
(1)Mean equation:
By using ACF, PACF, and Q test, we can evaluate the form of mean equation
via ARMA procedure.
View/Residual Tests/Correlogram Q-statistics

This view can be used to test for remaining serial correlation in the mean
equation and to check the specification of the mean equation. If the mean
equation is correctly specified, all Q-statistics should not be significant.

(2) Variance equation:
We can also apply Ljung-Box Q
2
test:
and use ACF and PACF to decide the number of lag for GARCH (p, q ).

View/Residual Tests/Correlogram Squared Residuals

This view can be used to test for remaining ARCH in the variance equation
and to check the specification of the variance equation. If the variance
equation is correctly specified, all Q-statistics should not be significant.

3. Working with GARCH Model

=

+ =
q
i
i T
i
T T q Q
1
2
) (
) 2 ( ) (

Q-statistics
Q
2
-statistics
For Equities, it is often observed that downward movements in the
market are followed by higher volatilities than upward movements of
the same magnitude. EViews estimates two models that allow for
asymmetric shocks to volatility: TARCH and EGARCH.
C. Asymmetric ARCH Models
News
Volatility
1. The TARCH Model: Threshold ARCH
In this model, good news (
t
>0 ), and bad new (
t
<0 ), have differential
effects on the conditional variancegood news has an impact of ,
while bad news has an impact of + r. If r>0 we say that the leverage
effect exists. If r0, the news impact is asymmetric.
C. Asymmetric ARCH Models
2
1 1
2
1
2
1
2

+ + + =
t t t t t
d r o | c c o = o
where d
t
=1 if
t
<0 , and 0 otherwise.
1. The TARCH Model: Threshold ARCH
For higher order specifications of the TARCH model, EViews
estimates


1) Quick/Estimate Equation
2) ARCH specification.
3) R c
4) TARCH

If the leverage effect term (r), represented by (RESID<0)*ARCH(1) in
the output, is significantly positive but there appears to be no
asymmetric effect.
C. Asymmetric ARCH Models

=

=

+ + + =
p
j
j t j t t
q
i
i t i t
d r
1
2
1
2
1
1
2 2
o | c c o = o
2. The EGARCH Model
The specification for the conditional variance is



Note that the left-hand side is the log of the conditional variance. This
implies that the leverage effect is exponential, and that forecasts of the
conditional variance are guaranteed to be nonnegative. The presence
of leverage effects can be tested by the hypothesis that r0. The
impact is asymmetric if r 0.
C. Asymmetric ARCH Models
( ) ( )
1
1
1
1 2
1
2
log log

+ + + =
t
t
t
t
t t
r
o
c
o
c
o o | = o
2. The EGARCH Model
The higher order specifications of EGARCH model:




To estimate an EGARCH model, simply select the EGARCH radio button
under the ARCH specification settings.
The leverage effect term (r), denoted as RES/SQR[GARCH](1) in the
output, is negative and statistically different from zero, indicating the
existence of the leverage effect in future bonds returns R during the
sample period.
C. Asymmetric ARCH Models
( ) ( )

= =

|
|
.
|

\
|
+ + + =
p
j
q
i
i t
i t
i
i t
i t
i j t j t
r
1 1
2 2
log log
o
c
o
c
o o | = o
3. Plotting the Estimated News Impact Curve
Our goal is to plot the volatility
2
, against z =/the impact, where



a) Procs/Make GARCH Variance Series
C. Asymmetric ARCH Models
( ) ( )
1 1
2
1
2
log log

A

A A
+ + + =
t t t t
z r z o o | = o
Modeling the Volatility in the US Dollar/Deutschmark exchange rates
from 1971 to 1993.

1. The dependent variable is the daily nominal return,
where s is the spot rate. The return series clearly shows volatility
clustering, especially early in the sample.

2. GARCH(1,1)-MA(1) model



The mean equation includes the conditional variance and the errors
are MA(1). The MON series in the conditional variance equation is
a dummy variable for Monday, which is meant to capture the non-
trading period effect during the weekend.
D. EViews Example
|
|
.
|

\
|
=
1
log
t
t
t
s
s
r
t t t t
t t t t
MON r
R
+ + + =
+ + + =

2
1
2
1
2
1
2
1 0
|o oc = o
uc c o t t
3. Test
a) Open/workfile/Example/data/gerus
b) Quick/Estimate Equation/ARCH
c) ARCH specification: R c ma(1)
d) Variance Regressors: mon
e) 1 1
f) Select Variance for the ARCH-M
g) View/Residual Tests/ARCH LM Test/7
The top part of the output from testing up to an ARCH(7) is given by

D. EViews Example
F-statistic 0.1163 Probability 0.9970
Obs*R-squared 0.8836 Probability 0.9964
ARCH TEST:
Indicating that there does not appear to be any ARCH up to order 7.
3. Test
h) View/Residual Tests/Historgram-Normality test
The residuals are highly leptokurtic and the Jarque-Bera (JB) test
decisively rejects the normal distribution.
JB test is a test statistic for testing whether the series is normally
distributed. The test statistic measures the difference of the skewness
and kurtosis of the series with those from the normal distribution.

Jarque-Bera=

Where S is the skewness, K is the kurtosis, and k represents the number
of estimated coefficients used to create the series.
Under the null hypothesis of a normal distribution, the JB statistic is
distributed as x
2
with 2 degrees of freedom.
D. EViews Example
( )
|
|
.
|

\
|

+

4
3
6
2
2
K
S
k N
h) Procs/Make Residual Series/Standardized/View/Distribution
Graphs/Quantile-Quantile/normal distribution
If the residuals are normally distributed, the QQ-plots should lie
on a straight line. The plot shows that it is primarily a few large
outliers that are driving the departure from normality.