ARCH Models

ARCH (autoregressive conditional heteroskedasticity) models recognize the presence of successive periods of relative volatility and stability. The error variance conditional on past information evolves over time as a function of past errors. The model !as introduced by "ngle #$%&'(. )ollerslev #$%&*( proposed the +ARCH (generalized ARCH) conditional variance specification that allo!s for a parsimonious parameterisation of the lag structure. Considerable interest has been in applications of ARCH,+ARCH models to high fre-uency financial time series. The HET command in .HA/A0 provides features for ma1imum likelihood estimation of models !ith ARCH or +ARCH errors. Examples The e1amples in this section use a data set of daily e1change rate changes for the 2eutschemark,)ritish pound. The data set is from )ollerslev and +hysels #$%%*( and has been adopted as a benchmark data set by 0cCullough and Renfro #$%%%( (also see the discussion in 0cCullough and 3inod #$%%%(). The model of interest is4 5t 6 $77 #ln(8t) - ln(8t-$)( 6 9 :
t

!here 8t is the bilateral 2eutschemark,)ritish pound rate. The topics are4

Testing for ARCH "stimation of a +ARCH($ $) model )enchmark comparisons of coefficients and standard errors

Testing for ARCH

The residuals from a preliminary ;<. estimation can be tested for ARCH behaviour. Testing approachesare as follo!s.

Tests for non-normality can be considered. If the normality assumption is used to describe the conditional error distribution then a property of ARCH is that the unconditional error distribution will be non-normal with high values for kurtosis. The autocorrelation structure of the residuals and the s uared residuals can be inspected. An indication of ARCH is that the residuals will be

uncorrelated but the s uared residuals will show autocorrelation. Test statistics are given by !"ung-#o$-%ierce portmanteau tests on the residuals and the s uared residuals.

A test based on the !agrange multiplier &!'( principle can be applied. Consider the null hypothesis of no ARCH errors versus the alternative hypothesis that the conditional error variance is given by an ARCH& ( process. The test approach proposed in )ngle *+,-./ is to regress the s uared residuals on a constant and lagged values of the s uared residuals. 0rom the results of this au$iliary regression1 a test statistic is calculated as2 &3- (4R. There is evidence to re"ect the null hypothesis if the test statistic e$ceeds the critical value from a chi-s uare distribution with degrees of freedom.

Example The .HA/A0 commands (filename4 ARCH1.SHA) belo! generate some statistics for the e1change rate data set.
Estimation of a GARCH(1,1) model

The HET command in .HA/A0 provides features for ma1imum likelihood estimation of models !ith ARCH or +ARCH errors. Conditional normality of the errors is assumed. The estimation re-uires the use of a numerical optimization algorithm. The algorithm !orks as follo!s.

5tarting values for the parameters of the mean e uation are obtained from an 6!5 regression. 0or an ARCH& ( or 7ARCH&p1 ( process the starting values for the parameters of the conditional variance e uation are obtained from a regression of the 6!5 s uared residuals on a constant and lags. 0or a 7ARCH process1 the starting values for the parameters on the lagged conditional variances are set to 8ero. 9ifferent starting values can be set with the START= option on the HETcommand. %re-sample estimates are re uired for the s uared errors and the conditional variances. 9iscussion of this initiali8ation is given in 'cCullough and Renfro *+,,,/. The PRESAMP option on the HETcommand sets the pre-sample values to the average of the s uared 6!5 residuals &or to the average of the s uared residuals evaluated at the starting

parameter values(. If the PRESAMP option is not specified then the presample values are introduced as an additional parameter. An estimated value is then obtained by ma$imi8ing the value of the log-likelihood function. The estimate is reported as the coefficient DELTA_ on the 5HA:A' estimation output.

An initial Hessian estimate is constructed from the outer product of the gradient. Analytic e$pressions for the derivatives are used &see )ngle *+,-./ and #ollerslev *+,-;/(. Armed with the various starting values1 the estimation can proceed. 5HA:A' uses a uasi-3ewton algorithm. A description of the uasi3ewton method is given in <udge1 7riffiths1 Hill1 !utkepohl and !ee *+,-=1 pp. ,=--,;>/. The updating steps use analytic e$pressions for the first derivatives. At model convergence1 an estimate of the variance-covariance matri$ of the parameter estimates is obtained from the inverse of the information matri$. The information matri$ is defined as the negative of the e$pectation of the matri$ of second-order derivatives. )$pressions for the information matri$ are given in )ngle *+,-./ and #ollerslev *+,-;/. Alternative estimates for the variance-covariance matri$ are presented in the section on benchmark comparisons of coefficients and standard errors. 8itfalls are4

The numerical optimi8ation algorithm does not guarantee convergence. The solution method does not guarantee that the coefficients of the conditional variance e uation will be non-negative and in the region re uired for stationarity.

The follo!ing !arning messages give a signal that the estimation has failed.
THE STARTING VALUES GIVE NEGATIVE VARIANCE OR OVERFLOWS RERUN WITH THE START= OPTION

The above message indicates that negative coefficients for the conditional variance e-uation !ere calculated as the default starting values.
...MAXIMUM NUMBER OF ITERATIONS

The default iteration limit is $77 iterations. The above message indicates that the estimation algorithm failed to reach a solution !ithin the iteration limit.
**** FAILURE TO COMPLETE A LINE SEARCH IN 20 FUNCTION EVALUATIONS. THIS IS PROBABLY BECAUSE THE FUNCTION HAS NO GLOBAL MAXIMUM

The above message indicates that the algorithm !as unsuccessful in finding a solution.
...MATRIX ERROR...MAGNITUDE BELOW MACHINE PRECISION IN ROW - . THIS IS USUALLY CAUSED BY SINGULAR MATRIX. ...ATTEMPTING INVERSION OF HESSIAN FOR COVARIANCE COVARIANCE MATRIX AND STD ERRORS ARE INCORRECT

The above message indicates that the variance=covariance matri1 of the parameter estimates could not be computed.
*** WARNING - STATIONARITY CONSTRAINTS NOT SATISFIED

The above message indicates that the coefficients of the conditional variance e-uation are not in the region re-uired for stationarity. Example The .HA/A0 commands (filename4 ARCH'..HA) belo! estimate a +ARCH($ $) model for the data set of daily e1change rate changes for the 2eutschemark,)ritish pound.