Stock Index Volatility

Modelling and Forecasting Stock
Index Volatility

a comparison between GARCH models and the
Stochastic Volatility model
Supervisor:
Professor Moisa Altar
Table of Contents
Competing volatility models
Data description
Model estimates and forecasting
performances
Concluding remarks
The Stylized Facts
The distribution of financial time series has heavier
tails than the normal distribution
Highly correlated values for the squared returns
Changes in the returns tend to cluster

Why model and forecast volatility?
investment
security valuation
risk management
policy issues
Competing Volatility Models
ARCH/GARCH class of models
Engle (1982)
Bollerslev (1986)
Nelson (1991)
Glosten, Jaganathan, and Runkle (1993)
Stochastic Volatility (Variance) model
Taylor (1986)

The GARCH model

=

=

+ + = -
= -
p
1 j
j t j
q
1 i
2
i t i 0 t
t t t
h r h : . eq iance var
h r : . eq mean
| o o
c
Parameter constraints:
ensuring variance to be positive

stationarity condition:
> >
> >
>
1 j 0
, 1 i 0
, 0
i
i
0
|
o
o

= =
< +
p
j
j
q
i
i
1 1
1 | o
Error distribution
1. Normal

The density function:

Implied kurtosis:
k=3
The log-likelihood function:

( )
|
|
.
|
\
|
=
t
t
t
t
h
h
f
2
2
1
exp
2
1 c
t
c
( ) ( )
=
(
+ + =
T
t
t
t
t Normal
h
h L
1
2
ln 2 ln
2
1 c
t
2. Student-t
Bollerslev (1987)


Implied kurtosis:


( )
( ) | |
( ) ( ) ( ) | |
( )
( ) 2 ,
2
s
var ;
s 1 2
s 2 1
f
t
t
2 1
t
2
t
2 1
2 1
t
t
>
=
+ I
+ I
=
+
v
v
v
c
v c v tv
v
c
v
( )
4 ,
4
2 3
>
= v
v
v
k
( ) | | ( ) ( )
( )
= (
(
|
|
.
|
\
|
+ + +
)
`
|
.
|
\
|
I
(
|
.
|
\
|
+
I =
T
t
t
t
t Student
T L
1
2
2
2
2
1 ln 1 ln
2
1
2 ln
2
1
2
ln
2
1
ln
v o
c
v o v t
v v
3. Generalized Error Distribution (GED)
Nelson (1991)


Implied kurtosis:


( )
|
.
|
\
|
I
|
.
|
\
|
I
=
|
.
|
\
|
I
(
(
|
.
|
\
|

=
+
v
v
c
v
c
v
v
v
v
3
2
1
;
1
2
2
1
exp
f
2
1
t
t
2
3 5 1
k
|
.
|
\
|
I
|
.
|
\
|
I
|
.
|
\
|
I =
v v v
( )
= (
(
|
.
|
\
|
I
|
.
|
\
|
+

|
.
|
\
|
=
T
t
t
GED
L
1
1
ln 2 ln
1
2
1
ln
v v
v
v
v
The SV model
( )
2
v t t 1 t t
t t
t t t t
0, N ~ v , v h h : . eq volatility
) h
2
1
exp(
) 1 , 0 ( N ~ , r : . eq mean
o o
o
c c o
+ + = -
=
= -
Parameter constraints:
stationarity condition:
Linearized form:
1 | | < o
+ + =
+ + = + = =
t t t
t t t t t t
v h h
h h r y
1
2 2
27 . 1 ) ln( ) ln(
o
c
( ) ( )
2
, 0
2
t
= =
t t
Var E
Forecast Evaluation Measures
Root Mean Square Error (RMSE)

Mean Absolute Error (MAE)

Theil-U Statistics

LINEX loss function
=
=
I
i
i i
I
RMSE
1
2 2 2
) (
1
o o
=
=
I
i
i i
I
MAE
1
2 2
1
o o
=

=
=
I
i
i i
I
i
i i
U Theil
1
2 2 2
1
1
2 2 2
) (
) (
o o
o o
=
+ =
I
i
i i i i
a a
I
LINEX
1
2 2 2 2
1 ) ( )) ( exp(
1
o o o o
Data Description
data series: BET-C stock index

time length:
April 17, 1998 - April 21, 2003

1255 daily returns

Pt daily closing value of BET-C

Software: Eviews, Ox

Descriptive statistics for BET-C return series
Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Prob.
0.000102 -0.0000519 0.1038602 -0.0975698 0.0153105 0.106634 9.423705 2160.141 0.000
( ) ( )
1 t t t
P ln P ln r

=
400
500
600
700
800
900
1000
1100
1200
1300
250 500 750 1000 1250
BETC
Daily closing prices of BET-C index
Tested Hypotheses
1. Normality

Histogram of the BET-C returns BET-C return quantile plotted
against the Normal quantile
0
100
200
300
400
500
-10 -5 0 5 10
Series: R100
Sample 2 1257
Observations 1256
Mean 0.010406
Median -0.004572
Maximum 10.38602
Minimum -9.756982
Std. Dev. 1.531051
Skewness 0.106367
Kurtosis 9.430919
Jarque-Bera 2166.704
Probability 0.000000
-4
-3
-2
-1
0
1
2
3
4
-.10 -.05 .00 .05 .10 .15
R
N
o
r
m
a
l

Q
u
a
n
t
i
l
e
2.Homoscedasticity
-.12
-.08
-.04
.00
.04
.08
.12
250 500 750 1000 1250
RETURN
.000
.002
.004
.006
.008
.010
.012
250 500 750 1000 1250
SQUARED_RETURN
BET-C return series
BET-C squared return series
3. Stationarity
Unit root tests for BET-C return series

ADF Test Statistic -13.53269 1% Critical Value* -3.4384
5% Critical Value -2.8643
*MacKinnon critical values for rejection of hypothesis of a unit root.
PP Test Statistic -28.07887 1% Critical Value* -3.4384
*MacKinnon critical values for rejection of hypothesis of a unit root.
4. Serial independence
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
1 4 7 10 13 16 19 22 25 28 31 34
AC
PAC
Autocorrelation coefficients for returns (lags 1 to 36)
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
1 5 9
1
3
1
7
2
1
2
5
2
9
3
3
AC
PA
C
Autocorrelation coefficients for squared returns (lags 1 to 36)
Model estimates and forecasting
performances
Constant Y(-1) R-squared
Mean equation with intercept -0.000355 0.276034 0.076278
t-statistic
(probability that the coefficient equals 0)
-0.768264
(0.4425)
9.087175
(0.000)
-
Mean equation without intercept - 0.276769 0.075733
t-statistic
(probability that the coefficient equals 0)
- 9.117758
(0.000)
-
Mean equation specification
GARCH models
Methodology:

- two sets: 1004 observations for model estimation
252 observations for out-of-sample forecast evaluation
Lag
number
Correlogram of
residuals
Correlogram of
squared residuals
Q-stat Prob Q-stat Prob
1 0.0085 0.927 103.60 0.000
5 3.3598 0.645 162.76 0.000
10 5.7904 0.833 165.21 0.000
15 8.0496 0.922 167.21 0.000
0
40
80
120
160
200
-0.05 0.00 0.05
Series: Residuals
Sample 3 1004
Observations 1002
Mean -0.000355
Median -0.000463
Maximum 0.093143
Minimum -0.077582
Std. Dev. 0.014613
Skewness -0.022081
Kurtosis 8.209193
Jarque-Bera 1132.997
Probability 0.000000
ARCH Test:
F-statistic 114.8229 Probability 0.000000
Obs*R-squared 103.1921 Probability 0.000000
Residual tests
White Heteroskedasticity Test:
ARCH-LM test and White Heteroscedasticity Test
Autocorrelation tests
Normality test
GARCH (1,1) Normal Distribution QML parameter estimates
Coefficient Std.Error t-value Probability
AR (1) 0.302055 0.045561 6.630 0.0000
Constant (V) 0.0000472947 0.141153 3.351 0.0008
ARCH(Alpha1) 0.320832 0.065118 4.927 0.0000
GARCH(Beta1) 0.483147 0.102838 4.698 0.0000
GARCH (1,1) Student-T Distribution QML parameter estimates
AR(1) 0.280817 0.037364 7.516 0.0000
Constant(V) 0.0000527251 0.144746 3.643 0.0003
ARCH(Alpha1) 0.350230 0.067874 5.160 0.0000
GARCH(Beta1) 0.439533 0.091994 4.778 0.0000
Student(DF) 4.512539 0.656110 6.878 0.0000
Diagnostic test based on the news impact curve (EGARCH vs. GARCH)
Test Prob
Sign Bias t-Test 0.41479 0.67830
Negative Size Bias t-Test 0.66864 0.50373
Positive Size Bias t-Test 0.02906 0.97682
Joint Test for the Three Effects 0.47585 0.92416
Test Prob
SV QML parameter estimates
Coefficient Std. Error z-Statistic Probability
C(1) -1.269102 0.450023 -2.820081 0.0048
C(2) 0.858869 0.050340 17.06149 0.0000
C(3) -1.486221 0.456019 -3.259119 0.0011
GARCH (1,1) GED Distribution QML parameter estimates
AR(1) 0.285181 0.057321 4.975 0.0000
Constant(V) 0.0000496321 0.130000 3.818 0.0001
ARCH(Alpha1) 0.333678 0.062854 5.309 0.0000
GARCH(Beta1) 0.450807 0.091152 4.946 0.0000
Student(DF) 1.172517 0.081401 14.40 0.0000
Test Prob
SV model
To estimate the SV model, the return series was first filtered in order
to eliminate the first order autocorrelation of the returns
In-sample model evaluation
a) Residual tests
Autocorrelation of the residuals
Lag GARCH(1,1) Nomal GARCH(1,1) Student-T GARCH(1,1) GED SV
Q-stat. p-value Q-stat. p-value Q-stat. p-value Q-stat. p-value
1 1.131 0.287 2.289 0.130 2.014 0.156 0.506 0.477
5 3.286 0.511 4.755 0.313 4.408 0354 2.802 0.591
10 5.654 0.774 7.046 0.632 6.720 0.667 6.237 0.716
15 8.679 0.851 10.144 0.752 9.796 0.777 7.571 0.910
Lag GARCH(1,1) Nomal GARCH(1,1) Student-T GARCH(1,1) GED SV
Q-stat. p-value Q-stat. p-value Q-stat. p-value Q-stat. p-value
1 0.127 1 0.204 1 0.186 1 0.589 0.443
5 3.198 0.362 3.606 0.307 3.499 0.321 2.681 0.613
10 6.033 0.644 6.235 0.621 6.180 0.627 6.539 0.685
15 6.782 0.913 6.936 0.905 6.895 0.907 8.824 0.842
Autocorrelation of the squared residuals
Kurtosis explanation
Unexplained
kurtosis
GARCH (1,1) Normal 4.28
GARCH (1,1) Student-t -7.21
GARCH (1,1) GED 2.56
SV -2.05
b) In-sample forecast evaluation
RMSE MAE THEI L-U
1
GARCH 11 Normal 0.0000196062 0.000257336 0.646352
GARCH 11 T 0.0000195026 0.000256516 0.639539
GARCH 11 GED 0.0000194814 0.000253146 0.638149
SV 0.0000186253 0.000231101 0.583293
LI NEX a=-20 a=-10 a=10 a=20
GARCH 11 Normal 7,70895E-09 1,92751E-09 1,92806E-09 7,71335E-09
GARCH 11 T 7,62777E-09 1,9072E-09 1,90773E-09 7,63198E-09
GARCH 11 GED 7,61114E-09 1,90305E-09 1,90359E-09 7,61545E-09
SV 6,95655E-09 1,73942E-09 1,73999E-09 6,96113E-09
1
Benchmark model - Random Walk
Out-of-sample Forecast Evaluation
Forecast methodology
- rolling sample window: 1004 observations
- at each step, the n-step ahead forecast is stored
- n=1, 5, 10
Benchmark: realized volatility = squared returns

.000
.002
.004
.006
.008
.010
.012
1050 1100 1150 1200 1250
RR
Forecast output
0
0,0005
0,001
0,0015
0,002
0,0025
0,003
0,0035
0,004
0,0045
0,005
1
1
9
3
7
5
5
7
3
9
1
1
0
9
1
2
7
1
4
5
1
6
3
1
8
1
1
9
9
2
1
7
2
3
5
2
5
3
1day
5days
10 days
0
0,001
0,002
0,003
0,004
0,005
0,006
1
1
9
3
7
5
5
7
3
9
1
1
0
9
1
2
7
1
4
5
1
6
3
1
8
1
1
9
9
2
1
7
2
3
5
2
5
3
1day
5days
10 days
0
0,0005
0,001
0,0015
0,002
0,0025
0,003
0,0035
0,004
0,0045
0,005
1
2
0
3
9
5
8
7
7
9
6
1
1
5
1
3
4
1
5
3
1
7
2
1
9
1
2
1
0
2
2
9
2
4
8
1day
5days
10 days
0
0,0001
0,0002
0,0003
0,0004
0,0005
0,0006
0,0007
0,0008
1
1
9
3
7
5
5
7
3
9
1
1
0
9
1
2
7
1
4
5
1
6
3
1
8
1
1
9
9
2
1
7
2
3
5
2
5
3
1 day
5 days
10 days
a) GARCH (1,1) Normal c) GARCH (1,1) GED
b) GARCH (1,1) Student-t d) SV
Evaluation Measures
1-step ahead forecast evaluation
RMSE MAE THEI L-U
1

GARCH 11 Normal 0,000035300 0,00022591 0,583721
GARCH 11 T 0,000035111 0,000204242 0,580597
GARCH 11 GED 0,000035760 0,000203486 0,591337
SV 0,000048823 0,000253071 0,807336
LI NEX a=-20 a=-10 a=10 a=20
GARCH 11 T 6,23593E-09 1,55923E-09 1,55971E-09 6,2398E-09
GARCH 11 GED 6,46868E-09 1,61743E-09 1,61795E-09 6,47286E-09
SV 1,2055E-08 3,01454E-09 3,01612E-09 1,20676E-08
1

RMSE MAE THEI L-U
1

GARCH 11 Normal 0.0000512767 0.0003042315 0.847915
GARCH 11 T 0.0000512001 0.0003077174 0.846648
GARCH 11 GED 0.0000511668 0.0002983467 0.846097
SV 0.0000511653 0.0002851430 0.846073
1
LI NEX a=-20 a=-10 a=10 a=20
GARCH 11 Normal 1.3297E-08 3.325E-09 3.3268E-09 1.33108E-08
GARCH 11 T 1.3257E-08 3.315E-09 3.3169E-09 1.32711E-08
GARCH 11 GED 1.3241E-08 3.311E-09 3.3126E-09 1.32539E-08
SV 1.3239E-08 3.310E-09 3.3125E-09 1.32534E-08

RMSE MAE THEI L-U
1

GARCH 11 Normal 0.0000513675 0.0003060239 0.849416
GARCH 11 T 0.0000513716 0.0003107481 0.849484
GARCH 11 GED 0.0000513779 0.000300542 0.849588
SV 0.0000514735 0.0002870131 0.851169
LI NEX a=-20 a=-10 a=10 a=20
GARCH 11 T 1,33467E-08 3,33753E-09 3,33925E-09 1,33604E-08
GARCH 11 GED 1,33499E-08 3,33834E-09 3,34007E-09 1,33637E-08
SV 1,33996E-08 3,35077E-09 3,35251E-09 1,34135E-08
1
Comparison between the statistical features
of the two sample periods

I n-sample Out-of-sample
Number of observations 1004 252
Mean -0.000468 0.002371
Median -0.000378 0.001137
Maximum 0.093332 0.103860
Minimum -0.097570 -0.065731
Standard Deviation 0.015209 0.015531
Skewness -0.116772 0.925148
Kurtosis 8.666434 11.94869
J arque-Bera 1344.146 880.2563
Probability 0 0
Concluding remarks
In-sample analysis:
a) residual tests: all models may be appropriate;
b) evaluation measures: SV model is the best performer;

Out-of-sample analysis:
- for a 1-day forecast horizon GARCH models outperform SV;
- for the 5-day and 10-day forecast horizon, model
performances seem to converge;
- the best model changes with forecast horizon and with
forecast evaluation measure;
- there is no clear winner;

Concluding remarks
Sample construction problems;

Further research:
- allowing for switching regimes;
- allowing for leptokurtotic distributions in the SV
- a better proxy for realized volatility;

Bibliography
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Appendix GARCH mean equation
Dependent Variable: Y
Method: Least Squares
Date: 06/23/03 Time: 00:45
Sample(adjusted): 3 1004
Included observations: 1002 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
C -0.000355 0.000462 -0.768264 0.4425
Y(-1) 0.276034 0.030376 9.087175 0.0000
R-squared 0.076278 Mean dependent var -0.000487
Adjusted R-squared 0.075354 S.D. dependent var 0.015204
S.E. of regression 0.014620 Akaike info criterion -5.610880
Sum squared resid 0.213740 Schwarz criterion -5.601080
Log likelihood 2813.051 F-statistic 82.57675
Durbin-Watson stat 2.002722 Prob(F-statistic) 0.000000
1. The AR(1) model with intercept
2.The AR(1) model without intercept

Dependent Variable: Y
Date: 06/23/03 Time: 00:46
Y(-1) 0.276769 0.030355 9.117758 0.0000
R-squared 0.075733 Mean dependent var -0.000487
Log likelihood 2812.755 Durbin-Watson stat 2.003016
Appendix Residual Tests
Date: 06/23/03 Time: 00:48
Sample: 3 1004
Included observations: 1002
Autocorrelation Partial Correlation AC PAC Q-Stat Prob
.| | .| | 1 -0.003 -0.003 0.0085 0.927
.| | .| | 2 -0.011 -0.011 0.1228 0.940
.| | .| | 3 0.041 0.041 1.8102 0.613
.| | .| | 4 0.004 0.004 1.8256 0.768
.| | .| | 5 0.039 0.040 3.3598 0.645
.| | .| | 6 0.030 0.028 4.2395 0.644
.| | .| | 7 0.013 0.014 4.4124 0.731
.| | .| | 8 0.027 0.025 5.1482 0.742
.| | .| | 9 -0.025 -0.027 5.7834 0.761
.| | .| | 10 -0.003 -0.005 5.7904 0.833
.| | .| | 11 0.034 0.029 6.9812 0.801
.| | .| | 12 0.008 0.008 7.0442 0.855
.| | .| | 13 0.030 0.029 7.9561 0.846
.| | .| | 14 -0.007 -0.009 8.0088 0.889
.| | .| | 15 0.006 0.007 8.0496 0.922
.| | .| | 16 -0.049 -0.055 10.543 0.837
.| | .| | 17 0.021 0.020 10.994 0.857
.| | .| | 18 -0.002 -0.008 10.998 0.894
.| | .| | 19 0.007 0.009 11.051 0.922
.| | .| | 20 0.023 0.023 11.599 0.929
Correlogram of Residuals
Date: 06/23/03 Time: 00:49
Sample: 3 1004
Autocorrelation Partial Correlation AC PAC Q-Stat Prob
.|** | .|** | 1 0.321 0.321 103.60 0.000
.|* | .|* | 2 0.194 0.101 141.44 0.000
.|* | .| | 3 0.125 0.041 157.05 0.000
.|* | .| | 4 0.075 0.010 162.73 0.000
.| | .| | 5 0.005 -0.043 162.76 0.000
.| | .| | 6 0.008 0.005 162.82 0.000
.| | .| | 7 0.042 0.045 164.59 0.000
.| | .| | 8 0.024 0.003 165.18 0.000
.| | .| | 9 0.005 -0.012 165.21 0.000
.| | .| | 10 -0.027 -0.040 165.97 0.000
.| | .| | 11 -0.004 0.012 165.98 0.000
.| | .| | 12 -0.009 0.000 166.06 0.000
.| | .| | 13 -0.028 -0.022 166.84 0.000
.| | .| | 14 -0.011 0.005 166.96 0.000
.| | .| | 15 -0.016 -0.012 167.21 0.000
.| | .| | 16 0.007 0.020 167.26 0.000
.| | .| | 17 -0.019 -0.020 167.61 0.000
.| | .| | 18 -0.004 0.005 167.62 0.000
.| | .| | 19 0.000 0.003 167.62 0.000
.| | .| | 20 -0.017 -0.019 167.91 0.000
Correlogram of Squared Residuals
ARCH Test:
Test Equation:
Dependent Variable: RESID^2
Date: 06/23/03 Time: 00:52
C 0.000145 1.83E-05 7.903650 0.0000
RESID^2(-1) 0.321081 0.029964 10.71555 0.0000
R-squared 0.103089 Mean dependent var 0.000213
ARCH-LM test
White Heteroskedasticity Test:
Test Equation:
Dependent Variable: RESID^2
Date: 06/23/03 Time: 00:53
Sample: 3 1004
C 0.000144 1.82E-05 7.933013 0.0000
Y(-1) -0.000222 0.001125 -0.197479 0.8435
Y(-1)^2 0.299471 0.026700 11.21598 0.0000
R-squared 0.112508 Mean dependent var 0.000213
White Heteroskedasticity Test

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