NumXLTipsandHintsVolatility201 1 SpiderFinancialCorp,2012

Volatility201
Thisisthethirdentryinourongoingseriesonvolatilitymodeling.Inanearlierissue,weintroducedthe
broadconceptofvolatilityinfinancialtimeseries,defineditsgeneralcharacteristics(e.g.clustering,
meanreversion)andidentifiedimportantvolatilitytermsinfinancialtimeseries.Weexploredholding
periods,volatilityscaling,theserialcorrelationassumption,multiperiodvolatility(i.e.termstructure)
anddiscussedafewnonparametricmethodstoestimatevolatilityusinghistoricaldata.
Inthisissue,welltakethepriordiscussionfurtheranddevelopanunderstandingofARCHvolatility
modeling.
Whyshouldyoucare?
Onceagain,theconceptsdiscussedherearepivotaltoasolidunderstandingoffinancialtimeseries
volatility.
Background
Letsconsiderthedependentassetslogreturn{ }
t
r timeseries.First,letsmodelthereturnasthesum
oftwocomponents:

t t t
r a = +
Where:
-
t
istheconditionalmean(nonstochastic)component
-
t
a istheinnovation,errortermorshock(stochastic)component
- E[ ] 0
t
a =
-
2
Var[ ] Var[ ]
t t t
r a o = =
- Cov[ , ] 0
t t k
a a
+
=
Tocomputethemultiperiodvolatility:

1
1 1 1 1
Var[ ] Var[ ] Var[ ] 2 Cov( , )
k k k k
t t k t i t i t i t j
i i i j i
r r r r r

+ + + + +
= = = = +
= = +


And

2
( , ) [( ) ( )] [ ] [ ] [ ]
t i t j t i t j t i t j t i t i
Cov r r E r r E r r E r E r
+ + + + + + + +
= = +
Where:

NumXLTipsandHintsVolatility201 2 SpiderFinancialCorp,2012

- istheunconditional(longrun)meanofthetimeseries

But,
[ ] [( )( )]
t i t j t i t i t j t j t i t j
E r r E a a
+ + + + + + + +
= + + =
Thus:

2
( , ) ( )
( , ) ( )( )
t i t j t i t j t i t j
t i t j t i t j
Cov r r
Cov r r


+ + + + + +
+ + + +
= + +
=

Insum,thecovarianceisafunctionoftheconditionalmeanandunconditionalmean.
Themultiperiodvolatility(termstructure)dependsnotonlyontheconditionalvolatilityofeachperiod,
butontheconditionalmeanaswell.
Assumption1:Letsassume
1 2
...
t t t t k
k

+ + +

= = = = =

'
t t
t t t
r a
r r a

= +
= =

And

2 2 2
Var[ ] [( - ) ]=E[ ]
t t t t
r E r a o = =
Note:Theassumptionisnotcontrarytowhatweseeinfinancialtimeseries,asthemajorityoftime
seriesdontpossesssignificantmeanoranyserialcorrelation;atthesametime,theyallexhibittime
varyingvolatility.
Next,letsassumetheinnovation,errortermorshocktermcanberepresentedasfollows:

t t t
a o c =
Where:
-
t
o istheconditionalvolatility(scalar)attimet
-
t
c istherandomvariablewithzeromean( [ ] 0
t
E c = )andunitvariance(
2
Var[ ] [ ] 1
t t
E c c = = )
-
t
c isseriallyuncorrelated,butstilldependent(higherorder).

NumXLTipsandHintsVolatility201 3 SpiderFinancialCorp,2012

Assumption2:letsassumetherandomvariable(
t
c )isidenticallydistributedovertime(notnecessarily
Gaussian).

Definition:Letsdefine
t
Z asthesquaredofthemeanadjustedassetsreturns:

2 2
( )
t t t
Z r a = =
And

2
[ ]
t t
E Z o =
Letsnowexaminethemethodsusedinearlierissuestoestimatevolatility:
Equalweightedmovingstandarddeviation:

2
2 2 2 1
1 1
( )
1 1
1 1 1
m
t i m m
i
t t i t i
i i
r
a Z
m m m

o

=

= =

= = =

Exponentialweightedmovingaverage(EWMA):

2 2 2 2
1
0 0
(1 ) (1 ) (1 )
i i
t t t t i t i
i i
a a Z o o

+
= =
= + = =


ProbabilityDistributionof
t
Z
Sofar,wehavenotassumedanyfunctionalformfortheprobabilitydistributionof
t
Z ,butheresafew
observationsaboutthecandidatedistributionfunction:
1. ( 0) 0 P Z < = (i.e. 0
t
Z > )
2. ( ) P Z isasymmetric
3. ( ) P Z ispositively(akaright)skewed
4. ( ) P Z isthedistributionofthesquaredinnovationsorshocks
Derivation
~ (.)
t
a q
Let (.) q betheprobabilitydensityfunctionwithzeromeanand
2
t
o variance.

NumXLTipsandHintsVolatility201 4 SpiderFinancialCorp,2012

( ) ( ) (1 ( ))
( ) ( )
( )
2
t t
P Z z H a z H a z
P z z
p z
z z
q q
s = s + s
c +
= =
c

Assume (.) q isasymmetricaldistribution.

( )
( )
z
p z
z
q
=
Case1:LetsusethestandardizedresidualsofaGaussiandistribution.
2
2
2 2
2
1
1
~ (0,1)
2
1
~ (.) (.)
2
t
t
t
Z
t t
t
e
Z e
Z
c
u
c
t
c q _
t

=
u =
= = =

ThedistributionofthesquaredvaluesofaGaussiandistributedrandomvariableisChisquarewithone
degreeoffreedom.

2 2 2 2 2
2 4 2 4 4
[ ] [ ]
[ ] [ ] 2 2
t t t
t t t t t
t t t t t
a
E a E
Var a Var
o c
o c o u o
o c o u o
=
= = =
= = =

Case2:Letsusethestandardizedresidualsofthestudentstdistribution.

1
2
2
2
1
2
2
2
1
( )
( 1)
2
( ) 1
( )
2
1
( )
( 1)
2
( ) 1
( )
2
t
t
t
t t
t
p
Z
p Z
Z
u
u
u
u c
c
u
u
ut
u
u
c
u
u
ut
+

+
I
| |
= +
|
\ .
I
+
I
| |
= = +
|
\ .
I

Alright,theequationisgettingabitcomplicatedhere,butthegeneralprinciplesareapplicabletohow
werelatedtheconditionalprobabilitydistributionofthesquaredtimeserieswiththeoriginal
conditionalprobabilitydistribution.

NumXLTipsandHintsVolatility201 5 SpiderFinancialCorp,2012

2
{ }
t
a Modeling
Sofar,wehaveexaminedthesquaredinnovationsproperties(i.e.atasingletimeinstance)atagiven
timeinstance(i.e.t),buthowdowedescribethe
2
{ }
t t
Z a = evolutionovertime?
SimilartoARMA/ARIMAmodeling,weexaminetheACF/PACFcorrelogramforthesquaredtimeseriesin
anattempttoidentifyadependencybetweenlaggedtimeseries,andproposeamodel.
Therearetwomaincategoriesofstatisticalvolatilitymodels:(1)
Deterministicformexactfunctiontogoverntheevolutionofvolatility(e.g.ARCH,GARCH,
EGARCH,etc.)

2 2
1
( | )
t t t
f F o o

=
Stochasticformuseofastochasticequation,i.e.allowingainnovation/shockterminthe
volatilityequation(e.g.stochasticvolatilitymodel)

2 2
1
( | )
t t t t
f F o o q

= +
Theconditionalvolatilityvaluesarecomputedindirectly,notdirectlyobserved,whichfurther
complicatestheprocess.
ARCHModel
ThefirstmodelthatprovidesasystematicframeworkforvolatilitymodelingisEnglesARCHmodel
(1982).Thisisagoodmodeltostartwithduetoitssimplicityandrelevancetoothermodels.

2 2 2 2
1 1
1
...
~ i.i.d~ (0,1)
t t t t
m
t o t m t m o i t i
i
t
r a
a a a
o c
o o o o o o
c

=
= =
= + + + = +
u


TheARCHmodelisanAR(p)for
2
{ }
t t
Z a = timesseries,butwithouttheerrortermsortheshocks.
Alternatively,wecanviewtheARCHmodelasaweightedmovingaverageofthesquaredtimeseries
(WMA)withaconstant.
Thecoefficientsvaluemustmeetsomeregulatoryrequirementtoensurethat(1)conditionalvariance
isalwayspositive,and(2)theunconditionalvarianceisfiniteandpositive.

NumXLTipsandHintsVolatility201 6 SpiderFinancialCorp,2012

2 2
1
m
t o i t i
i
a o o o

=
=

Volatilityclustering:theARCHmodelcapturesthevolatilityclusteringobservedinassetsreturns:alarge
pastsquaredshock
1
{ }
m
t i i
a
=
impliesalargeconditionalvariance(
2
t
o )forthemeancorrectedreturn
t
a .
Consequently,
t
a tendstobefollowedbyalargevalue(inabsoluteterms)duetothelargevariance,
andviceversaforsmallershocks.
ARCH(1)

2 2
1 1
2 2 2
1 1 1
2 2 2 2 2
2 1 1 1 1 1 1
2 2 3 2
3 1 1 1
2 2 3 1 2
1 1 1 1 1
2
1
( )
...
...
1
t o t
t o t o t
t o t o o t o o t
t o o o t
k k
t k o o o o o t
o
t k
k
a
E a
E a
o o o
o o o o o o
o o o o o o o o o o o o o
o o o o o o o o
o o o o o o o o o o o o
o
o
o

+
+ +
+

+
+

= +
( = + = +

( = + = + + = + +

= + + +
= + + + + + +
=

Thus,forapositiveconditionalvarianceandafiniteunconditionalvariance,then 0
o
o > and
1
0 1 o < < .
Modelparameters
Intheearlierissue(volatility101),wedidnotassumeanydistributionforthetimeseriesandthusused
therootmeansquareerrorasourutilityfunction,searchingforasetofparametersvaluesthat
minimizetheRMSE.
IntheARCHmodel,themeancorrectedreturns(
t
a )areinterdependent(e.g.clustering)andarenot
identicallydistributed,sohowdowegoaboutestimatinganefficientsetofvaluesforitsparameters?

~ (0,1)
~ i.i.d
t
t
t
t
a
N c
o
c
=

And

2
2
2
1 1 1
2
1
2 2
2
1 1 1 2 2
1 1
1
( , ,..., | , ,..., )
2
1 1
( , ,..., | , ,..., ) ln(2 ) ln(2 ) ln
2 2 2
t
t
a
T
T T o m
t m
t
T T
t t
T T o m t
t m t m
t t
LF a a a e
a a
LLF a a a
o
o o o
to
o o o t t o
o o

= +

= + = +
=
| |
= = + +
|
\ .
[

NumXLTipsandHintsVolatility201 7 SpiderFinancialCorp,2012

Foraninitialsetof
1
{ , ,..., }
o m
o o o ,werecursivelycomputetheconditionalvolatilityvaluesandrevise
thealphavaluesinanefforttomaximizetheoveralllikelihood.
ModelChecking
TheARCHmodeldoesnotassumei.i.dassumptionamongthemeancorrectedreturns{ }
t
a ,butthe
standardizedresiduals{ }
t
c arei.i.d.
~ (0,1)
~ i.i.d
t
t
t
t
a
N c
o
c
=

Inshort,weneedtoexaminethestandardizedresiduals{ }
t
c forindependence(e.g.thewhitenoise
testandarcheffecttest)andthenormalitydistributionassumption.
ModelExtension
Insomeapplications,itismoreappropriatetoassumethatstandardizedresiduals{ }
t
c followaheavy
taileddistributionsuchasthestudentstdistributionorthegeneralizederrordistribution(GED).
Thisextensionaffectsthecomputationoftheloglikelihoodfunction(LLF)(usingthealternative
probabilitydensityfunction),andtheinterpretationofconditionalvolatility.
Toillustrate,letstakethestudentstdistributionfor{ }
t
c
~ i.i.d ~ (0,1) t
u
c
Where:
(0,1) t
u
isthestandardizedstudentstdistribution(zeromeanandunitvariance)
u isthedegreesoffreedomofthestudentsdistribution( 2 u > )
Toyieldastandardizedtdistribution,withzeroskewandfiniteexcesskurtosis,:
1. 4 u >
2.
2
t
u
c
u

=
Thestandardizedtdistributionexhibitafattailwithexcesskurtosis= 6 / ( 4) u
Forecasting
Forthefirstpstepsoutofsample,theforecastformulaincludesamixofsquaredresiduals
2
{ }
t
a and
estimatedvariances
2
t
o

NumXLTipsandHintsVolatility201 8 SpiderFinancialCorp,2012

2 2 2 2
1 1 2 1
2 2 2 2 2 2 2
2 1 1 2 1 1 1 2 1
2 2 2 2 2 2
2 1 1 2 1 2 3 1 1 1 1 1 1
2 2
3 1 2 2
...
... ...
( 1) ( ) ( ) ...( )

t o t t p t p
t o t t p t p o t t p t p
t o t t p p t p p t p
t o t
a a a
a a a a a
a a a a
a
o o o o o
o o o o o o o o o o
o o o o o o o o o o o o o
o o o o
+
+ + + + +
+ +
+ +
= + + + +
= + + + + = + + + +
= + + + + + + + +
= + +
2 2 2 2 2 2
1 2 1 2 2 1 3 2
2 2 2 2 2
1 1 2 2 3 3 1
2 2 2 2 2
1 1 2 1 3 2 2
... ...
...
...
t p t p o t t t p t p
t p o t p t p t p p t
t p o t p t p t p p t
a a a a o o o o o o o o
o o o o o o o o o o
o o o o o o o o o o
+ + + + +
+ + + + +
+ + + + + +
+ + = + + + + +
= + + + + +
= + + + + +

Foralongerforecasthorizon,theestimatedconditionalvolatilitiesconvergetoalongtermvalue
determinedbythemodelparameters;forinstanceARCH(1)hasthefollowinglongrunvariance:

2
1
1
o
t k
k
o
o
o
+

ARCHEffect
AnARCHeffectisacharacteristicusedtodescribewhetheragiventimeseriesexhibitscorrelation
amongitssquareddatapointvalues.
TheoriginaltestconductedbyEngle(1982)isusingtheLaGrangemultiplier(LM)andordinaryleast
squaresregression.
Alternatively,wecanusetheLjungBoxtestonthesquared(meanadjusted)timeseries,compute
modifiedQ(m)andtestwhetherthedataexhibitsasignificantserialcorrelationornot.
Conclusion
Inthispaper,webuiltuponseveralbedrocklessonsfromearlierissuesandconstructedageneral
frameworkforvolatilitymodeling.Inthebeginning,welookedintocorrelatedreturnsandderiveda
relationshipbetweentermstructure(i.e.multiperiod)volatilityandconditionalmeans.
Next,assumingameanadjustedassetsreturnstimeseries,weproceedwithouranalysistovolatility.
Inpractice,themodelsdescribingvolatilityevolutionovertimearecategorizedintotwogroups:(1)
deterministicfunctionalformbasedmodels(e.g.ARCH,GARCH,etc.),and(2)stochasticmodelswhich
permitthevolatilitymodeltoincludeashock/innovationterm.
Finally,weexaminedindeptharatherimportantmodeltheARCHmodel(Engle1980);abuilding
blockmodeformanymodels(e.g.GARCH,EGARCH,etc.),whichwewillcoverinfutureissues.The
ARCHcanbethoughtofasaweightedmovingaverageofthesquaredtimeseries,buttheweightsare
relativelyconstrainedtoyieldapositivevarianceand(existent)finitelongrunvariance.Nevertheless,it
doesnotprovideaninsightintothevolatilityprocessandtreatspositiveandnegativeshock
indiscriminately,whichiscontrarytowhathasbeenobserved/documentedinfinancialtimeseries.