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Volatility Models
4.1 Background
Example 4.1: Consider the following daily close-to-
close SP500 values [January 3, 2000 to Feb 2, 2010]
-
.
1
-
.
0
5
0
.
0
5
.
1
l
o
g
r
e
t
u
r
n
6
.
6
6
.
8
7
7
.
2
7
.
4
l
o
g
c
l
o
s
e
2000 2002 2004 2006 2008 2010
day
SP500 Daily Prices and Returns
u=tk+1
r
u
,
(2) s
t
=
_
252
k
t
u=tk+1
(r
u
m
t
)
2
,
t = k, . . . T
-
1
0
-
5
0
5
1
0
SP500 daily returns and 22-day rolling average
R
e
t
u
r
n
(
%
)
0
5
0
1
0
0
1
5
0
SP500 absolute returns and 22-day rolling volatility
Day
V
o
l
a
t
i
l
i
t
y
(
%
p
.
a
)
2000 2002 2004 2006 2008
sqrt(252) x abs ret
22 day volat
7
Because squared observations are the build-
ing blocks of the variance of the series, the
results suggest that the variation (volatility)
of the series is time dependent.
This leads to the so called ARCH-family of
models.
2
t
= Var(u
t
[T
t1
) = +
1
u
2
t1
+
2
u
2
t2
+ +
q
u
2
tq
.
9
Furthermore, it is assumed that > 0,
i
0
for all i and
1
+ +
q
< 1.
For short it is denoted u
t
ARCH(q).
This reminds essentially an AR(q) process for
the squared residuals, because dening
t
=
u
2
t
2
t
, we can write
(6)
u
2
t
= +
1
u
2
t1
+
2
u
2
t2
+ +
q
u
2
tq
+
t
.
Nevertheless, the error term
t
is time het-
eroscedastic, which implies that the conven-
tional estimation procedure used in AR-estimation
does not produce optimal results here.
10
Properties of ARCH-processes
Consider (for the sake of simplicity) ARCH(1)
process
(7)
2
t
= +u
2
t1
with > 0 and 0 < 1 and u
t
[u
t1
N(0,
2
t
).
(a) u
t
is white noise
(i) Constant mean (zero):
(8) E[u
t
] = E[E
t1
[u
t
]
. .
=0
] = E[0] = 0.
Note E
t1
[u
t
] = E[u
t
[T
t1
], the conditional
expectation given information up to time t
1.
n
i=0
i
_
=
1
.
(iii) Autocovariances: Exercise, show that
autocovariances are zero, i.e., E[u
t
u
t+k
] = 0
for all k ,= 0. (Hint: use the law of iterated expec-
tations.)
12
(b) The unconditional distribution of u
t
is
symmetric, but nonnormal:
(i) Skewness: Exercise, show that E[u
3
t
] = 0.
(ii) Kurtosis: Exercise, show that under the
assumption u
t
[u
t1
N(0,
2
t
), and that <
_
1/3, the kurtosis
(11) E[u
4
t
] = 3
2
(1 )
2
1
2
1 3
2
.
Hint: If X N(0,
2
) then E[(X)
4
] = 3(
2
)
2
= 3
4
.
13
Because (1
2
)/(13
2
) > 1 we have that
(12) E[u
4
t
] > 3
2
(1 )
2
= 3[Var(u
t
)]
2
,
we nd that the kurtosis of the unconditional
distribution exceed that what it would be, if
u
t
were normally distributed.
Thus the unconditional distribution of u
t
is
nonnormal and has fatter tails than a normal
distribution with variance equal to Var[u
t
] =
/(1 ).
14
(c) Standardized variables:
Write
(13) z
t
=
u
t
_
2
t
then z
t
NID(0, 1), i.e., normally and inde-
pendently distributed.
Thus we can always write
(14) u
t
= z
t
_
2
t
,
where z
t
independent standard normal ran-
dom variables (strict white noise).
This gives us a useful device to check after
tting an ARCH model the adequacy of the
specication: Check the autocorrelations of
the squared standardized series.
15
Estimation of ARCH models
Given the model
(15) y
t
= x
t
t
+u
t
with u
t
[T
t1
N(0,
2
t
), we have y
t
[x
t
, T
t1
N(x
t
t
,
2
t
), t = 1, . . . , T.
Then the log-likelihood function becomes
(16) () =
T
t=1
t
()
with
(17)
t
() =
1
2
log(2)
1
2
log
2
t
1
2
(y
t
x
t
t
)
2
/
2
t
,
where = (
t
, , )
t
.
|
|
In practice more fat tailed (and/or skewed) conditional distri-
butions are assumed.
16
Most popular conditional distributions:
Student t:
(18)
t
=
1
2
log
_
(2)(/2)
2
((+1)/2)
2
_
1
2
log
2
t
(+1)
2
log
_
1 +
(y
t
x
t
t
)
2
2
t
(2)
_
,
() the gamma function, > 2 the degrees of free-
dom.
Generalized error distribtuion (GED):
(19)
t
=
1
2
log
_
(1/r)
3
(3/r)(r/2)
2
_
1
2
log
2
t
_
(3/r)(y
t
x
t
t
)
2
2
t
(1/r)
_
r/2
,
r the tail parameter, r = 2 a normal distribution, r < 2
fat-tailed.
17
Skewed-Student:
(20)
t
=
1
2
log
_
(2)(/2)
2
(+1/)
2
4s
2
((+1)/2)
2
_
1
2
log
2
t
log
_
1 +
(m+s(y
t
x
t
t
))
2
2
t
(2)
2I
t
_
,
where
(21) I
t
=
_
1, if (y
t
x
t
t
) m/s
1, if (y
t
x
t
t
) < m/s
is the asymmetry parameter ( = 1, symmetric).
Also skewed normal and skewed ged are available in
some versions.
More details: www.garch.org
18
The maximum likelihood (ML) estimate
is
the value maximizing the likelihood function,
i.e.,
(22) (
) = max
().
The maximization is accomplished by numer-
ical methods.
19
Non-Gaussian series are estimated often by
quasi maximum likelihood (QML), i.e., as if
the error were conditionally normal.
Under fairly general conditions the QML es-
timator of
is consistent and asymptotically
normal:
(23)
T(
) N(0,
1
),
where
(24)
= E
_
t
()
t
_
,
and
(25) 7
= E
_
t
()
t
()
t
_
.
Remark 4.1: If the conditional ditribution is Gaussian,
= 7
.
20
Generalized ARCH models
In practice the ARCH needs fairly many lags.
Usually far less lags are needed by modifying
the model to
(26)
2
t
= +u
2
t1
+
2
t1
,
with > 0, > 0, 0, and + < 1.
The model is called the Generalized ARCH
(GARCH) model.
Usually the above GARCH(1,1) is adequate
in practice.
Econometric packages call (coecient of
u
2
t1
) the ARCH parameter and (coecient
of
2
t1
) the GARCH parameter.
21
Note again that dening
t
= u
2
t
2
t
, we can
write
(27) u
2
t
= +( +)u
2
t1
+
t
t1
a heteroscedastic ARMA(1,1) process.
Applying backward substitution, one easily
gets
(28)
2
t
=
1
+
j=1
j1
u
2
tj
an ARCH() process.
Thus the GARCH term captures all the his-
tory from t 2 backwards of the shocks u
t
.
22
Imposing additional lag terms, the model can
be extended to GARCH(r, q) model
(29)
2
t
= +
r
j=1
2
tj
+
q
i=1
u
2
ti
[c.f. ARMA(p, q)].
Nevertheless, as noted above, in practice
GARCH(1,1) is adequate.
23
Example 4.2: MA(1)-GARCH(1,1) model of SP500
returns estimated with conditional normal,
u
t
[T
t1
N(0,
2
t
), and GED, u
t
[T
t1
GED(0,
2
t
)
The model is
(30)
r
t
= +u
t
+u
t1
2
t
= +u
2
t1
+
2
t1
.
-
1
0
-
5
0
5
1
0
SP500 Returns
2000 2002 2004 2006 2008
24
Using R-program with package fGarch
(see http://cran.r-project.org/web/packages/fGarch/index.html)
> fGarch::garchFit(spr ~arma(0,1) + garch(1,1), data = spr,
cond.dist = "ged", trace = F)
Conditional Distribution: norm
Coefficient(s):
mu ma1 omega alpha1 beta1
0.027604 -0.077629 0.010057 0.076014 0.919177
Std. Errors:
based on Hessian
Error Analysis:
Estimate Std. Error t value Pr(>|t|)
mu 0.027604 0.016958 1.628 0.103569
ma1 -0.077629 0.022753 -3.412 0.000645 ***
omega 0.010057 0.002848 3.532 0.000413 ***
alpha1 0.076014 0.009613 7.907 2.66e-15 ***
beta1 0.919177 0.009830 93.505 < 2e-16 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Log Likelihood:
-3460.251 normalized: -1.490845
AIC: 2.985999 BIC: 2.998385 (computed from fit@llh)
25
> fGarch::garchFit(spr ~arma(0,1) + garch(1,1), data = spr,
cond.dist = "ged", trace = F)
Conditional Distribution: ged
Coefficient(s):
mu ma1 omega alpha1 beta1 shape
0.044617 -0.077417 0.007632 0.074422 0.923302 1.461375
Std. Errors:
based on Hessian
Error Analysis:
Estimate Std. Error t value Pr(>|t|)
mu 0.044617 0.016108 2.770 0.005608 **
ma1 -0.077417 0.021397 -3.618 0.000297 ***
omega 0.007632 0.003011 2.535 0.011252 *
alpha1 0.074422 0.011051 6.734 1.65e-11 ***
beta1 0.923302 0.010954 84.286 < 2e-16 ***
shape 1.461375 0.062208 23.492 < 2e-16 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Log Likelihood:
-3432.333 normalized: -1.478816
AIC: 2.962803 BIC: 2.977666 (computed from fit@llh)
Goodness of t (AIC, BIC) is marginally better for
GED. The shape parameter estimate is < 2 (statisti-
cally signicantly) indicated fat tails.
Otherwise the coecient estimates are about the same.
26
Residual Diagnostics:
Autocorrelations of squared standardized residuals:
Normal: GED:
Lag LB p-value LB p-value
1 4.306651 0.03796362 3.878418 0.04891062
2 4.823842 0.08964290 4.404404 0.11055943
3 4.843815 0.18359760 4.436248 0.21804779
5 6.009314 0.30531370 5.535524 0.35406622
10 16.268283 0.09220573 15.493970 0.11506346
JB = 232.8991, df = 2, p-value = 0.000
(dropping the outlier JB = 43.96)
-8
-6
-4
-2
0
2
4
SP500 Return residuals [MA(1)-GED-GARCH(1,1)]
2000 2002 2004 2006 2008
2
0
4
0
6
0
8
0
Conditional Volatility
Days
V
o
la
tility
[s
q
rt(2
5
2
*h
_
t)]
2000 2002 2004 2006 2008
27
The autocorrelations of the squared standardized resid-
uals pass (approximately) the white noise test.
Nevertheless, the normality of the standardized resid-
uals is strongly rejected.
Usually this aects mostly to stantard errors. Com-
mon practice is to use some sort of robust standard
errors (e.g. White)
28
The variance function can be extended by
including regressors (exogenous or predeter-
mined variables), x
t
, in it
(31)
2
t
= +u
2
t1
+
2
t1
+x
t
.
Note that if x
t
can assume negative values, it
may be desirable to introduce absolute values
[x
t
[ in place of x
t
in the conditional variance
function.
For example, with daily data a Monday dummy
could be introduced into the model to cap-
ture the non-trading over the weekends in the
volatility.
29
Example 4.3: Monday eect in SP500 returns and/or
volatility?
Pulse (additive) eect on mean and innovative
eect on volatility
(32)
y
t
=
0
+
m
M
t
+(y
t1
m
M
t1
) +u
t
2
t
= +M
t
+u
2
t1
+
2
t1
,
where M
t
= 1 if Monday, zero otherwise.
30
SAS: conditional t-distribution
proc autoreg data = tmp;
model sp500 = mon/ nlag = 1 garch = (p=1, q=1) dist = t;
hetero mon;
run;
...............
The AUTOREG Procedure
GARCH Estimates
SSE 4568.81922 Observations 2321
MSE 1.96847 Uncond Var 8.46322547
Log Likelihood -2110.3323 Total R-Square 0.0054
SBC 4274.91297 AIC 4234.6647
MAE 0.93300313 AICC 4234.71312
MAPE 140.612286 Normality Test 327.0029
Pr > ChiSq <.0001
Standard Approx
Variable DF Estimate Error t Value Pr > |t| Variable Label
Intercept 1 0.0332 0.0187 1.77 0.0765
mon 1 0.0110 0.0485 0.23 0.8202
AR1 1 0.0669 0.0230 2.91 0.0036
ARCH0 1 0.006221 0.002781 2.24 0.0253
ARCH1 1 0.0742 0.0105 7.04 <.0001
GARCH1 1 0.9251 0.0102 90.91 <.0001
TDFI 1 0.1059 0.0172 6.16 <.0001 Inverse of t DF
HET1 1 6.452E-23 1.002E-10 0.00 1.0000
Degrees of freedom estimate: 1/0.1059 9.4.
No empirical evidence of a Monday eect in returns
or volatility.
31
ARCH-M Model
The regression equation may be extended
by introducing the variance function into the
equation
(33) y
t
= x
t
t
+g(
2
t
) +u
t
,
where u
t
GARCH, and g is a suitable func-
tion (usually square root or logarithm).
This is called the ARCH in Mean (ARCH-M)
model [Engle, Lilien and Robbins (1987)
5
].
The ARCH-M model is often used in nance,
where the expected return on an asset is re-
lated to the expected asset risk.
The coecient reects the risk-return trade-
o.
5
Econometrica, 55, 391407.
32
Example 4.4: Does the daily mean return of SP500
depend on the volatility level?
Model AR(1)-GARCH(1, 1)-M with conditional t-distribution
(34)
y
t
=
0
+
1
y
t1
+
_
2
t
+u
t
2
t
= +u
2
t1
+
2
t1
,
where u
t
[T
t1
t
2
t
is the standardized shock.
Again, the impact is asymmetric if ,= 0,
and leverage is present if < 0.
38
Example 4.7: MA(1)-EGARCH(1,1)-M estimation re-
sults.
Dependent Variable: SP500
Method: ML - ARCH (Marquardt) - Generalized error distribution (GED)
Sample (adjusted): 1/04/2000 3/27/2009
Included observations: 2321 after adjustments
Convergence achieved after 25 iterations
MA Backcast: 1/03/2000
Presample variance: backcast (parameter = 0.7)
LOG(GARCH) = C(3) + C(4)*ABS(RESID(-1)/@SQRT(GARCH(-1))) + C(5)
*RESID(-1)/@SQRT(GARCH(-1)) + C(6)*LOG(GARCH(-1))
=============================================================
Variable Coefficient Std. Error z-Statistic Prob.
-------------------------------------------------------------
C 0.017476 0.016027 1.090422 0.2755
MA(1) -0.072900 0.021954 -3.320628 0.0009
=============================================================
Variance Equation
=============================================================
C(3) -0.066913 0.013105 -5.106018 0.0000
C(4) 0.081930 0.016677 4.912873 0.0000
C(5) -0.121991 0.012271 -9.941289 0.0000
C(6) 0.986926 0.002323 424.9402 0.0000
=============================================================
GED PARAM 1.562564 0.051706 30.22032 0.0000
=============================================================
R-squared 0.007607 Mean dependent var -0.024928
Adj R-sq 0.007179 S.D. dependent var 1.407094
S.E. of regr 1.402035 Akaike info criterion 2.929546
Sum sq resid 4558.461 Schwarz criterion 2.946887
Log lik -3392.738 Hannan-Quinn criter. 2.935865
F-statistic 2.962535 Durbin-Watson stat 2.040231
P(F-stat) 0.006964
=============================================================
Inverted MA Roots .07
=============================================================
Again statistically signicant leverage.
39
Power ARCH (PARCH)
Ding, Granger, and Engle (1993). A long
memory property of stock market returns and
a new model. Journal of Empirical Finance.
PARC(1,1)
(37)
t
= +
t1
+([u
t1
[ u
t1
)
,
where is the leverage parameter. Again
> 0 implies leverage.
40
Example 4.8: R: fGarch::garchFit MA(1)-APARCH(1,1)
results for SP500 returns.
R parametrization: MA(1), mu and theta
gfa <- fGarch::garchFit(sp500r~arma(0,1) + aparch(1,1),
data = sp500r, cond.dist = "ged", trace=F)
Mean and Variance Equation:
data ~ arma(0, 1) + aparch(1, 1)
[data = sp500r]
Conditional Distribution:
ged
Error Analysis:
Estimate Std. Error t value Pr(>|t|)
mu 0.014249 0.016825 0.847 0.397049
ma1 -0.076112 0.021454 -3.548 0.000389 ***
omega 0.013396 0.003474 3.856 0.000115 ***
alpha1 0.055441 0.008217 6.747 1.51e-11 ***
gamma1 1.000000 0.016309 61.316 < 2e-16 ***
beta1 0.935567 0.007620 122.775 < 2e-16 ***
delta 1.207412 0.203576 5.931 3.01e-09 ***
shape 1.579328 0.068530 23.046 < 2e-16 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Log Likelihood:
-3388.234 normalized: -1.459816
41
The leverage parameter (gamma1 ) estimates to unity.
2
t[k
=
(1
k1
)
1
+
k1
2
t+1
=
2
+
k1
(
2
t+1
2
),
where
(45)
2
= Var[u
t
] =
1
Recursive fromula:
(46)
2
t[k
=
_
_
_
2
t+1
for k = 1
+
2
t[k1
for k > 1
46
GARCH(1,1):
(47)
2
t+1
= +u
2
t
+
2
t
.
(48)
2
t[k
=
(1(+)
k1
)
1(+)
+( +)
k1
2
t+1
=
2
+( +)
k1
(
2
t+1
2
),
where
(49)
2
=
1
.
Recursive fromula:
(50)
2
t[k
=
_
_
_
2
t+1
for k = 1
+( +)
2
t[k1
for k > 1
47
IGARCH:
(51)
2
t+1
= +u
2
t
+(1 )
2
t
.
(52)
2
t[k
= (k 1) +
2
t+1
.
Recursive fromula:
(53)
2
t[k
=
_
_
_
2
t+1
for k = 1
+
2
t[k1
for k > 1
48
TGARCH:
(54)
2
t+1
= +u
2
t
+u
2
t
d
t
+
2
t
.
(55)
2
t[k
=
(1(+
1
2
+)
k1
)
1(+
1
2
+)
+( +
1
2
+)
k1
2
t+1
=
2
+( +
1
2
+)
k1
(
2
t+1
2
)
with
(56)
2
=
1
1
2
.
Recursive fromula:
(57)
2
t[k
=
_
_
_
2
t+1
for k = 1
+( +
1
2
+)
2
t[k1
for k > 1
49
EGARCH and APARCH prediction equations
are a bit more involved.
Recursive formulas are more appropriate in
these cases.
The volatility forecasts are applied for exam-
ple in Value At Risk computations.
50
Evaluation of predictions unfortunately not
that straightforward! (see, Andersen and Boller-
slev (1998) International Economic Review.)
51
4.4 Realized volatility
Under certain assumptions, volatility during
a period of time can be estimated more and
more precisely as the frequency of the returns
increases.
Daily (log) returns r
t
are sums of intraday re-
turns (e.g. returns calculated at 30 minutes
interval)
(58) r
t
=
m
h=1
r
t
(h)
where r
t
(h) = logP
t
(h) logP
t
(h 1) is the
days t intraday return in time interval [h 1, h],
h = 1, . . . , m, P
t
(h) is the price at time point
h within the day t, P
t
(0) is the opening price
and P
t
(m) is the closing price.
52
The realized variance for day t is dened as
(59)
2
t,m
=
m
h=1
r
2
t
(h)
and the realized volatility is
t,m
=
_
2
t,m
which
is typically presented in percentages per an-
num (i.e., scaled by the square root of the
number of trading days and presented in per-
centages).
Under certain conditions it can be shown that
t,m
t
as m , i.e., when the intraday
return interval 0.
For a resent survey on RV, see:
Andersen, T.G. and L. Benzoni (2009). Re-
alized volatility. In Handbook of Finan-
cial Time Series, T.G. Andersen, R.A.
Davis, J-P. Kreiss and T. Mikosh (eds),
Springer, New York, pp. 555575.
53
4.4 An Application in Risk Management
Several types of risk categories: Credit risk,
operational risk, and market risk
Value at Risk (VaR)
Value at Risk (VaR) can be utilized to quan-
tify market (risk due to general market de-
cline)
For a given probability p and time horizon h VaR in-
dicates the risk for a portfolio to loose the amount of
VaR or more.
or
VaR indicates the maximum loss with prob-
ability 1 p in time horizon h.
54
In probability terms VaR is simply the pth
quantile of the distribution.
Thus, given probability p and time horizon h,
for a long position VaR > 0 is the threshold
(quantile) loss dened by
(60) p = P[V
t
(h) VaR] = F
h
(VaR)
where V
t
is the value of the long position
(investment) at time point t,
(61) V
t
(h) = V
t+h
V
t
is the change in the value, and F
h
() is the
distribution function of V
t
(h).
55
For a short position
(62) p = P[V
t
(h) VaR] = 1 F
h
(VaR).
Important: VaR deals with the tail-probabilities.
F
h
a key problem.
56
In practice VaR is convenient to compute in
terms of (one period) returns.
r
t
=
V
t
V
t1
.
Thus, assuming that r
t
(
t
,
2
t
) and stan-
dardizing
(63) z
t
=
r
t
t
.
57
We can write generally:
Long position:
(64) VaR = V
t
(
t
z
p
+
t
)
Short position:
(65) VaR = V
t
_
t
z
1p
+
t
_
where V
t
is the amount of investment and
z
p
is the percentile of the distribution of the
standardized return z
t
dened in (63).
58
Remark 4.4.1: If standardized returns are t-distributed
with > 2 degrees of freedom then, e.g. for long
position:
(66) VaR = V
_
t
_
/(2 )
t
p
() +
t
_
,
where
t
is the scale parameter (estimated as a stan-
dard deviation) of the t-distribution and t
p
() is the
p-percentile obtained from p = P[t t
p
()].
59
Typically:
p is 0.01 or 0.05 5 or 1 percent VaR
h is set by a regulation committee, e.g. from
1 or 10 days
Daily observations
60
Example 4.4.1: Portfolio manager has 10Meur posi-
tion stocks with volatility 25% (p.a) and changes are
assumed normally distributed with zero mean.
One day 5% VaR?
Assuming 252 trading days then V
t
(1) N(0, 0.25
2
/252),
z
.05
= z
.95
= 1.645
VaR = 10 (0.25/
t+1
,
and h-day
(68) VaR(h) = Value z
1p
h
t+1
=
hVaR,
61
Remark 4.4.2: If the return distribution is non-symmetric
then of course z
p
,= z
1p
, implying that VaRs for long
and short positions must be evaluated separately.
62
RiskMetrics:
EWMA volatility
(69)
t
= 0,
2
t+1
=
2
t
+(1 )r
2
t
,
(0, 1), typically (0.90, 1).
That is IGARCH(1, 1) with = 0. This im-
plies
(70)
2
t[h
=
2
t+1
for all h 1.
63
Example 4.4.2: 10,000,000 position in USD (Euro-
area portfolio manager) EUR/USD (price of one USD
in euros, dollar depreciates)
0
.
7
0
.
8
0
.
9
1
.
0
1
.
1
1
.
2
E
U
R
/
U
S
D
-
4
-
2
0
2
C
h
a
n
g
e
(
%
)
(
l
o
g
)
Time
EUR-USD Daily Exchange Rates
1999 2001 2003 2005 2007 2009
64
EWMA volatility, = 0.94
> sigma2.t <- var(deur) # starting value
> for (t in 1:length(deur)) {
sigma2.t[t+1] <- 0.94*sigma2.t[t] + 0.06*deur[t]^2
}
-
4
-
2
0
2
C
h
a
n
g
e
(
%
)
(
l
o
g
)
5
1
0
1
5
2
0
2
5
V
o
l
a
t
[
p
.
a
%
]
Time
EUR-USD Daily Changes and Volatility
1999 2001 2003 2005 2007 2009
(p.a volatility
252sigma2.t)
65
h = 10 day p = 0.05 VaR:
> sqrt(sigma2.t[length(sigma2.t)]) # sigma(t+1) (%)
[1] 1.216485
Thus
t+1
= 1.216485% = 0.01216485
VaR:
> V <- 10 ## Million EUR
> VaR <- V*0.01*sqrt(sigma2.t[length(sigma2.t)])*qnorm(0.95)
> VaR
[1] 0.200094
VaR(10):
> VaR10 <- sqrt(10)*VaR; VaR10
[1] 0.632753
Thus, h = 10 days p = 0.05 VaR for the 10Meur po-
sition is 632 753 Eur
66
Remark 4.4.3: Returns are typically log returns,
r
t
= 100 log(P
t
/P
t1
).
Thus, more exactly
(71) VaR = V (exp(z
1p
t+1
) 1)
and
(72) VaR(h) = V
_
exp(z
1p
h
t+1
) 1
_
.
> V <- 10 ## million EUR
> VaR <- V*(exp(0.01*sqrt(sigma2.t[length(sigma2.t)])*qnorm(0.95))-1)
[1] 0.2021093
and
> VaR10 <- V*(exp(0.01*sqrt(10)*sqrt(sigma2.t)*qnorm(.95))-1);
VaR10
[1] 0.6532005
i.e., VaR(10) is 653 200 eur, about 20 teur bigger
than above.
67
Non-zero mean return:
If
(73)
r
t
= +u
t
, u
t
=
t
z
t
, ,= 0
2
t
=
2
t1
+(1 )u
2
t1
,
Note: The mean evolves at rate h and the
volatility at rate
h.
68
Equations in (64) and (65) give one period
VaRs.
h-period VaRs are obtained straightforwardly
Long (h-period):
(74) VaR(h) = V (
h
t+1
z
p
+h).
Short (h-period):
(75) VaR(h) = V (
h
t+1
z
1p
+h).
69
ARMA-GARCH(1,1) returns
(76)
(L)r
t
=
0
+(L)u
t+1
2
t+1
= +u
2
t
+
2
t
,
[
1
[ < 1.
Notations:
h-period log-return
(77) r
t
(h) = 100log
_
P
t
P
th
_
or
(78) r
t
(h) = r
t
+r
t1
+ +r
th+1
.
Note: r
t
= r
t
(1).
70
Denote a h-period predicted return from t as
(79)
t
[h] = E
t
[100log(P
t+h
/P
t
)] = E
t
[r
t+h
(h)]
or
(80)
t
[h] =
t[1
+
t[2
+ +
t[h
,
where
(81)
t[j
= E
t
_
r
t+j
_
are one period returns predicted j periods
ahead.
For an AR(1)-process r
t[j
= +
j
1
(r
t
) with
=
0
/(1
1
) the long run mean,
(82)
t
[h] = h +(r
t
)
1
1
h
1
1
1
.
71
MA-representation of an ARMA-process
(83) r
t
= +u
t
+
1
u
t1
+
2
u
t1
+ ,
where =
0
/(L), u
t
=
t
z
t
with
z
t
i.i.d(0, 1).
For an AR(1),
j
=
j
1
.
72
Prediction errors:
(84) e
t
[h] = r
t
(h)
t
(h) =
h
j=1
(r
t+j
t[j
).
From the MA-representation
(85) e
t[j
r
t+j
t[j
=
j1
k=0
k
u
t+jk
,
with
0
= 1 .
73
After collecting terms
(86) e
t
[h] =
h1
j=0
j
u
t+hj
,
where
(87)
j
=
j
k=0
k
with
0
=
0
= 1.
Using u
t+j
=
t+j
z
t+j
with z
t+j
i.i.d, and thus
independent of
t+j
,
(88)
2
t
[h] Var
t
[e
t
[h]] =
h1
j=0
2
j
2
t[(hj)
.
74
Example 4.4.3: MA(1)-GARCH(1,1)
(89)
r
t+1
= +u
t
+u
t+1
2
t+1
= +u
2
t
+
2
t
(90)
0
= 1,
j
= 1 +, j > 0.
(91)
t[j
= E
t
_
r
t+j
=
_
+u
t
, for j = 1
, for j > 1.
Then
(92)
t
[h] = h +u
t
and
(93)
2
t
[h] =
2
(1 +(h 1)(1 +)
2
)
+
_
[1(+)
h
](1+)
2
1(+)
_
(
2
t+1
2
),
where
2
= /(1 ) is the unconditional (long
run) variance.
75
Example 4.4.4: Consider the EUR/USD example.
GARCH(1,1) with conditional normal distribution yields:
> gf <- garchFit(deur~garch(1,1), data = deur, trace = F)
> summary(gf)
Title:
GARCH Modelling
Call:
garchFit(formula = deur ~ garch(1, 1), data = deur)
Mean and Variance Equation:
data ~ garch(1, 1)
[data = deur]
Conditional Distribution:
norm
Coefficient(s):
mu omega alpha1 beta1
-0.01745817 0.00055545 0.02718111 0.97254904
Std. Errors:
based on Hessian
Error Analysis:
Estimate Std. Error t value Pr(>|t|)
mu -0.0174582 0.0110655 -1.578 0.115
omega 0.0005555 0.0004541 1.223 0.221
alpha1 0.0271811 0.0037161 7.314 2.58e-13 ***
beta1 0.9725490 0.0037294 260.779 < 2e-16 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Log Likelihood:
-2363.183 normalized: -0.9159624
76
Description:
Tue Apr 14 10:23:07 2009 by user: sp
Standardised Residuals Tests:
Statistic p-Value
Jarque-Bera Test R Chi^2 57.70481 2.948752e-13
Shapiro-Wilk Test R W 0.9946075 4.230857e-08
Ljung-Box Test R Q(10) 15.03485 0.1307965
Ljung-Box Test R Q(15) 19.76627 0.1810835
Ljung-Box Test R Q(20) 22.66414 0.3055854
Ljung-Box Test R^2 Q(10) 13.51373 0.1963489
Ljung-Box Test R^2 Q(15) 16.70982 0.3365053
Ljung-Box Test R^2 Q(20) 29.01204 0.08752258
LM Arch Test R TR^2 14.72602 0.2567627
Information Criterion Statistics:
AIC BIC SIC HQIC
1.835026 1.844104 1.835021 1.838316
77
Estimate of is insignicant and
+
= 0.0271811 +0.9725490 = 0.9997302,
which, however, diers at 5% from 1 (Wald test,
EViews).
Empirically, however, EWMA.
GARCH(1,1)-VaR(10):
s.t.h <- function(gfit, h){
## VaR(h) return standard deviation, sigma2.t[h]
## gf: fGarch object with GARCH(1,1)
## h: VaR periods
## REMARK: rescale with 0.01 if input in percentages!
omega <- gfit@fit$coef["omega"]
alpha <- gfit@fit$coef["alpha1"]
beta <- gfit@fit$coef["beta1"]
T <- length(gfit@residuals)
s2 <- omega / (1 - alpha - beta)
s2.tp1 <- (omega + alpha*gfit@residuals[T]^2 + beta*gfit@h.t[T])
sth <- sqrt(s2*h + ((1- (alpha + beta)^h)/(1 - (alpha + beta)))*
(s2.tp1 - s2))
names(sth) <- NULL
return(sth)
}
V <- 10
gVaR10 <- V*(0.01*s.t.h(gf,10)*qnorm(.95)); gVaR10
[1] 0.6297266
I.e., 629,727 eur, which is about the same as in EWMA
(Example 4.4.3).
78
Other Approaches:
Empirical Estimation
Quantile Estimation
Extreme value theory [E.g. Longin (2000)
JBF]
etc.
79