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Research Methods in Finance

Abdul Qadeer Khan (PhD Scholar & Research Associate)
D-Block 2
nd
Floor, Room # 218
Mohammad Ali Jinnah University, Islamabad
Office: 051-4486701 Ext: 212
Cell: 0333-6487274
dr.aqkhan@live.com; abdul.qadeer@jinnah.edu.pk


Section 1, 2 & 3
Lecture # 9
July 23-27, 2012

In this lecture we will discuss Autoregressive Conditional Heteroscedasticity Models in detail that
includes:
i. ARCH
ii. GARCH
iii. TARCH / GJR GARCH
iv. GARCH-M
v. EGARCH
vi. IGARCH
vii. QGARCH
viii. NARCH
ix. PARCH
ARCH-Auto Regressive Conditional Heteroscedasticity:
ARCH was introduced in the initial papers of Engle to model inflation rates. In linear regression analysis,
a standard assumption is that the variance of all squared error terms is the same. This assumption is
called Homoskedasticity (constant variance). However, many time series data shows Heteroscedasticity,
where the variances of the error term are not equal and in which the error terms may be expected to be
larger for some observations or periods of the data than for others. The issue is then how to construct
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models that accommodate Heteroscedasticity so that valid coefficient estimates and models are
obtained for the variance of the error term. For this purpose, ARCH (Auto Regressive Conditional
Heteroscedasticity) models are designed.
ARCH is applied when both autocorrelation and heteroskedasticity econometrics problems exists
alongwith. So, first step is to check autocorrelation and Heteroscedasticity. The process for applying
ARCH family in Eviews is following:
Autoregressive Conditional Heteroscedasticity:
Equations for ARCH (1) are:
R
t
=
o
+
1
R
t-1

This is mean equation, and shows return is a function of lag return. Here R
t
shows the todays return and
R
t-1
shows the previous day return.

t
= r
o
+ r
1
U
t-1
2
This is variance equation for ARCH (1) process. This is also called forecast of error variance. Where sigma
t square is todays volatility and U
t-1
2
is previous price behavior. The relation of todays volatility with
previous day error term. More concisely, past price behavior influences todays volatility.
Equations for ARCH (2) are:
R
t
=
o
+
1
R
t-1
+
2
R
t-2

t
= r
o
+ r
1
U
t-1
2
+ r
2
U
t-2
2

Equations for ARCH (3) are:
R
t
=
o
+
1
R
t-1
+
2
R
t-2
+
3
R
t-3

t
= r
o
+ r
1
U
t-1
2
+ r
2
U
t-2
2
+ r
3
U
t-3
2

Pre-Requisites for ARCH:
Autoregressive/autocorrelation and Heteroscedasticity must exit. For the purpose of testing these
issues, we downloaded daily data of S&P 500 (use its proxy GSPS) from yahoo finance w.e.f. January
1990 to June 2012 and take return as shown in picture below. Formula is:
R
t
= P
t
/ P
t-1
Whereas:
R
t
is return of time series data
P
t
is current day observation
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P
t-1
is the observation at one lag (means last day observation)

Test Autoregressive/autocorrelation and Conditional Heteroskedasticity
i. Take return and export data of return to Eviews
ii. Regress: r c r(-1)
iii. Go to view----Residual Diagnostics and Choose Heteroscedasticity Test and click on ARCH
iv. Choosing ARCH, both issues will be tested simultaneously, if the Prob. Chi-Square (1) is less
than .05 then it means both issues exist and ARCH Models can be applied. In this case, both
issues exit as shown in results given below:

Heteroskedasticity Test: ARCH


F-statistic 222.1636 Prob. F(1,5667) 0.0000
Obs*R-squared 213.8582 Prob. Chi-Square(1) 0.0000



ARCH (1):
i. Go to Quick---Estimate Equation. Choose ARCH from the below options and Regress: r c r(-1)
ii. Keep 1 for ARCH and zero for GARCH and TARCH [Note: Here ARCH (1) means we are
working on one lag as major literature is on one lag. We can put multiple lags according to
our model and data frequency and we will select lag where AIC will be minimum]
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Results and Interpretation:


Variable Coefficient Std. Error z-Statistic Prob.


C 0.000367 0.000128 2.871015 0.0041
R(-1) -0.162816 0.005136 -31.70227 0.0000


Variance Equation


C 9.45E-05 1.49E-06 63.22154 0.0000
RESID(-1)^2 0.366353 0.016451 22.26948 0.0000


First equation is the result of mean equation for ARCH (1) process and second is the variance equation
of ARCH (1). In mean equation there is significant value of R (-1) which shows that todays return is
predicted by past return. And Coefficient of R (-1) is negative that shows todays return will be 16.2%
less as compare to previous day return.
Second equation is the variance equation for ARCH (1) process which shows significant value of RESID (-
1)^2 that shows that past price behavior explains the todays volatility. And coefficient of residual is
positive that shows todays volatility will be greater and vice versa.
Generalized Autoregressive Conditional Heteroscedasticity:

Equations for GARCH are given below:
R
t
=
o
+
1
R
t-1

t
= r
o
+ r
1
U
t-1
2
+ r
2

t-1

Steps:
i. Quick---Estimate Equation and choose ARCH from below option that will shown on that
small window.
ii. Put ARCH (1), GARCH (1)

Results and Interpretation:


Variable Coefficient Std. Error z-Statistic Prob.


C 0.000511 0.000112 4.565710 0.0000
R(-1) -0.013093 0.015093 -0.867461 0.3857


Variance Equation


C 9.93E-07 1.26E-07 7.900720 0.0000
RESID(-1)^2 0.074957 0.004534 16.53240 0.0000
GARCH(-1) 0.918028 0.005025 182.6983 0.0000


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As the P-value of GARCH (-1) is significant which shows that todays volatility is influenced by previous
day volatility. The coefficient of GARCH (-1) is positive that shows that 91.8% last day volatility transfer
in next day.
TGARCH / GJR GARCH (Glosten-Jagannathan-Runkle GARCH):
Equation for TGARCH and GJR GARCH are given below:
R
t
=
o
+
1
R
t-1

t
= r
o
+ r
1
U
t-1
2
+ r2
t-2
+ r3 D* U
t-1
2

Last element of variance equation measures the good or bad news effect. If AR > E(R) -----------Good
News and error term will be positive. If AR < E(R) -----------Bad News and error term will be negative. In
simple words, to be positive of error term is Good news and to be negative of error term is bad news. In
equation form: U
t-1

< 0 -------As error term is less than zero it shows that there is bad news. U
t-1

> 0 --------
As error term is greater than zero it shows that there is good news.
Results and Interpretation:
If P-Value is significant then there exists asymmetric behavior; that means there is different effect of
good or bad news on market. If P-Value is insignificant then there exists symmetric behavior; that means
there is same effect of good or bad news on market. If coefficient is positive then bad news have greater
sensitivity than good news in the market. If coefficient is negative then good news have greater
sensitivity than bad news in the market.
Putting Dummy in Variance Repressors and Mean Equation:
In Variance Regressor and Interpretation:

Variable Coefficient Std. Error z-Statistic Prob.


C 0.000844 0.000217 3.892275 0.0001
R(-1) 0.081945 0.018240 4.492666 0.0000


Variance Equation


C 1.51E-05 9.39E-07 16.10990 0.0000
RESID(-1)^2 0.101356 0.009583 10.57626 0.0000
RESID(-1)^2*(RESID(-1)<0) 0.120614 0.015299 7.883813 0.0000
GARCH(-1) 0.793143 0.007176 110.5344 0.0000
Z -7.83E-06 8.14E-07 -9.614549 0.0000


As P-value of Z Dummy is significant that shows there is asymmetric behavior in the regime of zardari
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and previous regimes. The co-efficient of Z dummy is negative that shows current regime is less volatile
as compare to other regimes.
In Mean Equation and Interpretation:



Variable Coefficient Std. Error z-Statistic Prob.


C 0.001149 0.000254 4.527871 0.0000
R(-1) 0.076371 0.018205 4.195120 0.0000
Z -0.000710 0.000457 -1.552404 0.1206


Variance Equation


C 1.04E-05 5.91E-07 17.57575 0.0000
RESID(-1)^2 0.112532 0.009411 11.95739 0.0000
RESID(-1)^2*(RESID(-1)<0) 0.100373 0.014327 7.005685 0.0000
GARCH(-1) 0.802545 0.006790 118.2036 0.0000


As P-value of Z Dummy is insignificant that shows there is symmetric (same) behavior in the regime of
zardari and previous regimes.
GARCH-M (GARCH-in-Mean)
R
t
=
o
+
1
R
t-1
+
2

t
= r
o
+ r
1
U
t-1
2
+ r
2

t-1

Steps:
i. Regress: r c r(-1)
ii. Put ARCH 1 and GARCH 1
iii. Select Standard Deviation or variance
Results and Interpretation with Standard Deviation:



Variable Coefficient Std. Error z-Statistic Prob.


@SQRT(GARCH) 0.014570 0.052021 0.280075 0.7794
C 0.000895 0.000648 1.382526 0.1668
R(-1) 0.063260 0.018298 3.457171 0.0005


Variance Equation


C 9.06E-06 5.36E-07 16.89513 0.0000
RESID(-1)^2 0.164561 0.008424 19.53586 0.0000
GARCH(-1) 0.809472 0.006888 117.5192 0.0000


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As the P-value of GARCH-M [@SQRT (GARCH)] is insignificant that shows there is no effect on todays
return of todays volatility. And if P-value of GARCH-M [@SQRT (GARCH)] is significant that shows
todays return affected (positive/negative) by todays volatility.
Results and Interpretation with Variance:
As the P-value of GARCH-M [GARCH] is insignificant that shows there is no effect on todays return of
todays volatility. And if P-value of GARCH-M [GARCH] is significant that shows todays return affected
(positive/negative) by todays volatility.



Variable Coefficient Std. Error z-Statistic Prob.


GARCH -0.056488 1.487118 -0.037985 0.9697
C 0.001081 0.000301 3.591097 0.0003
R(-1) 0.062955 0.018278 3.444273 0.0006


Variance Equation


C 9.06E-06 5.35E-07 16.92364 0.0000
RESID(-1)^2 0.164396 0.008438 19.48356 0.0000
GARCH(-1) 0.809615 0.006909 117.1871 0.0000



E-GARCH (Exponential GARCH):
R
t
=
o
+
1
R
t-1
---------------- Mean Equation
Ln
t
= r
o
+ r
1
|u
t-1
/
t-1
| + r
2
U
t-1
/
t-1
+ r
3
ln
t-1
-------------Variance Equation
Whereas:
r
1
|u
t-1
/
t-1
| measure the size effect
r
2
U
t-1
/
t-1
measure sign effect
Steps:
i. Go to QuickEstimate Equation and choose ARCH Method Options
ii. Then regress: r c r(-1) and choose EGARCH from the Model Options as shown in below
picture
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Results and Interpretation:
As shown in below results, C (3) is intercept (r
o
) of variance equation and its P-Value is significant which
shows there are many other factors/variables which effect todays market volatility and should be the
part of equation to turn in into insignificant so that intercept become constant. Here, missing
variables/omitted/measurement error effect etc comes in intercept thats why intercept is significant.
C(4) is coefficient of size effect (r
1
|u
t-1
/
t-1
|); as P-value of C(4) is significant its coefficient is positive
which shows size effect in the market that large size news lead to high volatility as compare to small size
news. C (5) is sign effect [r2 U
t-1
/
t-1
]; as P-Value of C (5) is significant and negative which shows that bad
news effect is greater than good news. If coefficient of C (5) becomes positive then good news effect
dominates. C(6) tells us about the persistence of last day volatility; as P-Value is significant and positive
which shows that last day volatility persist and contributed 93.04% into next day volatility.


Variable Coefficient Std. Error z-Statistic Prob.


C 0.001120 0.000125 8.928903 0.0000
R(-1) 0.064574 0.017211 3.751965 0.0002


Variance Equation


C(3) -0.819359 0.032078 -25.54301 0.0000
C(4) 0.306836 0.012532 24.48450 0.0000
C(5) -0.067714 0.008570 -7.901120 0.0000
C(6) 0.930499 0.003383 275.0561 0.0000


ass




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IGARCH:
QGARCH (Quadratic GARCH):
In QGARCH we add error term in variance Regressor.
Steps:
i. Regress: r c r(-1)
ii. Choose ARCH (1); GARCH (1)
iii. Add U
t-1
in variance Regressor.
Results and Interpretation:
As the P-Value of U
t-1
is significant which shows that GARCH effect exist but not linear, its quadratic
because U
t-1
is significant.



Variable Coefficient Std. Error z-Statistic Prob.


C 0.001471 0.000205 7.184155 0.0000
R(-1) 0.062776 0.017666 3.553580 0.0004


Variance Equation


C -0.000717 4.35E-05 -16.48481 0.0000
RESID(-1)^2 0.159904 0.007952 20.10876 0.0000
GARCH(-1) 0.815800 0.005151 158.3832 0.0000
UT-1 -0.000725 4.35E-05 -16.68127 0.0000



NGARCH (Non-Linear GARCH):
PARCH:

Please convey immediately if you found typing or conceptual errors. Thanks for your cooperation.


Knowledge is power. Information is power. The secreting or hoarding of knowledge or information may be an act
of tyranny camouflaged as humility. (Robin Morgan)

Note: Please convey, if you found any mistake. Comments for improvement will be highly appreciated. Thanks
Abdul Qadeer Khan