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The European Journal of Finance

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Forecasting stock market volatility: Further international evidence

Ercan Balaban , Asli Bayar & Robert W. Faff
a b c a b c

Management School and Economics, The University of Edinburgh, UK Department of Management, ankaya University, Ankara, Turkey

Department of Accounting and Finance, Monash University, Victoria, Australia Version of record first published: 17 Feb 2007.

To cite this article: Ercan Balaban , Asli Bayar & Robert W. Faff (2006): Forecasting stock market volatility: Further international evidence, The European Journal of Finance, 12:2, 171-188 To link to this article: http://dx.doi.org/10.1080/13518470500146082

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The European Journal of Finance Vol. 12, No. 2, 171188, February 2006

Forecasting Stock Market Volatility: Further International Evidence

ERCAN BALABAN , ASLI BAYAR & ROBERT W. FAFF
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Management

School and Economics, The University of Edinburgh, UK, Department of Management, ankaya University, Ankara, Turkey, Department of Accounting and Finance, Monash University, Victoria, Australia

ABSTRACT This paper evaluates the out-of-sample forecasting accuracy of eleven models for monthly volatility in fteen stock markets. Volatility is dened as within-month standard deviation of continuously compounded daily returns on the stock market index of each country for the ten-year period 1988 to 1997. The rst half of the sample is retained for the estimation of parameters while the second half is for the forecast period. The following models are employed: a random walk model, a historical mean model, moving average models, weighted moving average models, exponentially weighted moving average models, an exponential smoothing model, a regression model, an ARCH model, a GARCH model, a GJR-GARCH model, and an EGARCH model. First, standard (symmetric) loss functions are used to evaluate the performance of the competing models: mean absolute error, root mean squared error, and mean absolute percentage error. According to all of these standard loss functions, the exponential smoothing model provides superior forecasts of volatility. On the other hand, ARCH-based models generally prove to be the worst forecasting models. Asymmetric loss functions are employed to penalize under-/over-prediction. When under-predictions are penalized more heavily, ARCH-type models provide the best forecasts while the random walk is worst. However, when over-predictions of volatility are penalized more heavily, the exponential smoothing model performs best while the ARCH-type models are now universally found to be inferior forecasters. KEY WORDS: Stock market volatility, forecasting, forecast evaluation

1.

Introduction

In a recent review article, Poon and Granger (2003) present a persuasive case for why the forecasting of volatility is a critical activity in nancial markets it has a very wide sphere of inuence including investment, security valuation, risk management, and monetary policy making(p. 478). Specically, they emphasize the importance of volatility forecasting in: (a) pricing of options, underlined by the massive growth in the trading of derivative securities in recent times; (b) nancial risk management in the global banking sector, stimulated by the Basle Accords; and (c) US monetary policy, especially in the wake of major world events such as September 11. This begs the obvious question(s): how can we effectively forecast volatility and is it possible to clearly identify a preferred technique? Various methods by which such forecasts can be achieved have been developed in the literature and applied in practice. Such techniques range from the extremely simplistic models that use nave assumptions through to the relatively complex

Correspondence Address: Robert W. Faff, Department of Accounting and Finance, Monash University, Victoria, 3800, Australia. Email: robert.faff@buseco.monash.edu.au 1351-847X Print/1466-4364 Online/06/02017118 2006 Taylor & Francis DOI: 10.1080/13518470500146082

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conditional heteroscedastic models of the GARCH family (see Bollerslev et al., 1992; Bera and Higgins, 1993; and Bollerslev et al., 1994 for general reviews of this literature). However, despite the appeal of complexity and despite their popularity, it is by no means agreed that complex models such as GARCH provide superior forecasts of return volatility. Dimson and Marsh (1990) is a notable example in which simple models have prevailed although it should be pointed out that ARCH models were not included in their analysis. Specically, Dimson and Marsh apply ve different types of forecasting model to a set of UK equity data, namely, (a) a random walk model; (b) a long-term mean model; (c) a moving average model; (d) an exponential smoothing model; and (e) regression models. They recommend the nal two of these models and, in so doing, sound an early warning in this literature that the best forecasting models may well be the simple ones. Other papers in this literature however spell out a mixed set of ndings on this issue. For example, Akgiray (1989) found in favour of a GARCH (1,1) model (over more traditional counterparts) when applied to monthly US data. Brailsford and Faff (1996) investigate the out-of-sample predictive ability of several models of monthly stock market volatility in Australia. In the measurement of the performance of the models, in addition to symmetric loss functions, they use asymmetric loss functions to penalize under-/over-prediction. They conclude that the ARCH class of models and a simple regression model provide superior forecast of volatility. However, the various model rankings are shown to be sensitive to the error statistics used to assess the accuracy of the forecasts. In contrast, Tse (1991) and Tse and Tung (1992) investigated Japanese and Singaporean data and found that an exponentially weighted moving average (EWMA) model produced better volatility forecasts than ARCH models.1 In the nance literature, generally the existing evidence concerning the relative quality of volatility forecasts is related to an individual countrys stock market:Australia (Brailsford and Faff, 1996; Walsh and Tsou, 1998), Germany (Bluhm and Yu, 2000), Japan (Tse, 1991), New Zealand (Yu, 2002), Netherlands, Germany, Spain and Italy (Franses and Ghijsels, 1999), Singapore (Tse and Tung, 1992), Sweden (Frennberg and Hannsson, 1996), Switzerland (Adjaoute et al., 1998), Turkey (Balaban, 1999), UK (Dimson and Marsh, 1990; Loudon et al., 2000; McMillan et al., 2000), USA (Akgiray, 1989; Pagan and Schwert, 1990; Hamilton and Lin, 1996; Brooks, 1998).2 Notably, in any one of these papers the range of forecasting models is often restricted to a relatively narrow set of models. The current paper seeks to extend and supplement this existing evidence by, in a single unifying framework, analysing a wide range of volatility forecasting approaches across broad cross-section of countries that reect both developed and emerging markets. Specically, in the context of volatility forecasting we consider more countries than ever before evaluated in a single paper namely, fteen countries comprising Belgium; Canada; Denmark; Finland; Germany; Hong Kong; Italy; Japan; Malaysia; Netherlands; Philippines; Singapore; Thailand; the UK and the USA. Moreover, a considerable range of forecasting models is used a random walk model, a historical mean model, moving average models, weighted moving average models, exponentially weighted moving average models, an exponential smoothing model, a regression model, an ARCH model, a GARCH model, a GJR-GARCH model, and an EGARCH model. Furthermore, following Brailsford and Faff (1996), we compare the forecasting techniques based on both symmetric (the mean error, the mean absolute error, the root mean squared error and the mean absolute percentage error) and asymmetric error statistics. As established by Brailsford and Faff (1996), the consideration of asymmetric error statistics is of considerable practical interest for short and long positions in asset markets, and is especially motivated in the context of option pricing and risk management.3 Specically, it can be argued that option buyers versus sellers will

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Forecasting Stock Market Volatility

173

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not place equal importance on over and under predictions of volatility. For example, consider the case of call options under-predictions (over-predictions) of volatility will induce a downward (an upward) biased estimate of the call option price. The resulting under-estimate (over-estimate) of price is of major concern to the option seller (buyer) since they stand to lose money on any transaction based on these inferior volatility forecasts. Under-/over-prediction of volatility has also signicant implications for market risk management models such as value-at-risk (VaR). An overestimated VaR will only cause the rm to tie up capital in an unprotable form whereas an underestimate could lead either to pressure from the regulator or even bankruptcy.4 From a general standpoint, we choose to conduct this experiment in a multi-country context for two main reasons. First, a major motivation for this choice (as opposed to examining yet another US or other single country sample) is to accommodate the general argument of Leamer (1983) and extended by Lo and MacKinlay (1990) regarding the concern about data snooping in nance research. Specically, it is argued that investigating alternative data samples (either across time or across markets) is a credible out-of-sample robustness check. We have the added advantage of conducting such multi-country analysis in a single unied framework that will eliminate the vagaries of alternate research designs impacting on the comparability of results across markets. The second motivation for our multi-country focus is that it permits us to choose countries that involve a representative set of both developed and emerging markets. It is well known and widely accepted that emerging markets display risk (and return) characteristics that somewhat contrast that observed in developed market settings (see for example; Harvey, 1995; and Bekaert and Harvey, 1997). Accordingly, the inclusion of Malaysia, the Philippines and Thailand provide the emerging market focus, thereby enabling us to explore whether developed and emerging markets exhibit similar or different forecasting ability. The main results of our study can be summarized as follows. First, based on the conventional symmetric loss functions, we nd that the exponential smoothing model provides superior forecasts of volatility. Second, the ARCH-based models generally prove to be the worst forecasting models in the context of these symmetric measures. Third, when under-predictions are penalized more heavily ARCH-type models provide the best forecasts while the random walk is worst. Finally, when over-predictions of volatility are penalized more heavily, the exponential smoothing model performs best while the ARCH-type models are now universally found to be inferior forecasters. The remainder of this paper is organized as follows: in the second section, the data and methodology are described, in the third section the empirical results are presented, and nally in the fourth section the paper is concluded.

2.

Empirical Methodology

2.1 Data and Sample Description We employ daily observations of stock market indices of fteen countries covering the period December 1987 to December 1997. The data are sourced from Datastream. The investigated countries (indices) are Belgium (Brussels All Shares Price Index); Canada (Toronto SE 300 Composite Price Index); Denmark (Copenhagen SE General Price Index); Finland (Hex General Price Index); Germany (Faz General Price Index); Hong Kong (Hang Seng Price Index); Italy (Milan Comit General Price Index); Japan (Nikkei 500 Price Index); Malaysia (Kuala Lumpur Composite); the Netherlands (CBSAll Share General Price Index); the Philippines (the Philippines

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SE Composite Price Index); Singapore (Singapore All Share Price Index); Thailand (Bangkok S.E.T. Price Index); the UK (FTSE All Share Index) and the US (NYSE Composite Index). Our analysis involves monthly volatility forecasts. Continuously compounded daily returns are calculated as follows: Rm,t = ln(Im,t /Im,t 1 ) (1)

where Im,t and Rm,t denote the value of stock market index and continuously compounded return on trading day t in month m, respectively. We dene monthly realised volatility as the within-month standard deviation of continuously compounded daily returns as follows:

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a,m =

1 (n 1)
n

0.5

(Rm,t m )
t =1

(2)

m = (1/n)
t =1

Rm,t

(3)

The number of trading days in a month is n. In the dataset for each country, there are 120 monthly volatility observations. Of these observations, the rst 60 (from December 1987 to November 1992) are used for estimation, while the second 60 observations (from December 1992 to December 1997) are used for forecasting purposes. 2.2 Forecasting Techniques There exist a wide range of potentially useful models for forecasting volatility. It is clearly impossible to employ all models in a single paper and challenging to convincingly justify the choice of a narrow set purely on objective grounds (see for example; West and Chou, 1995). No doubt while our choice is inuenced by personal taste and practical implementation issues, it also importantly reects our assessment of the models most widely used by practitioners. Generally we employ time series models, but there will inevitably be versions of these models omitted that others would have liked included.5 With this background, the competing models employed are displayed in Table 1.

3.

Forecast Evaluation and Empirical Results

3.1 Symmetric Error Statistics Four commonly used loss functions or error statistics: the mean error (ME), the mean absolute error (MAE), the root mean squared error (RMSE), and the mean absolute percentage error (MAPE) are employed to measure the performance of the forecasting models. 1 ME = 60 MAE = 1 60
120

(f,m a,m )
61 120

(4)

|f,m a,m |
61

(5)

Table 1. Volatility forecasting models Model Equationa f,m (RW ) = a,m1 m1 1 f,m (HM) = a,j (m 1) f,m (MA()) = 1
j =1 m1

Parameter restrictions/Comments (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) 2
0.5

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Random walk (RW) Historical mean (HM) Moving average (MA ) Weighted moving average (WMA )b Exponential smoothing (ES) Exponentially weighted moving average (EWMA ) Regression (REG) ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH (1, 1)

= 3, 6, 12, 24, 36, 48, 60 = 3, 6, 12, 24, 36, 48, 60 The optimal value of [0, 1] is assessed using error statistics, incrementing by 0.01 from 0.c = 3, 6, 12, 24, 36, 48, 60. Optimal values of , are obtained similar to described above.d One-step ahead forecasts using rolling prior 60 obs. In all of the ARCH-type models we update the monthly volatility using daily returns (average 1,250 daily observations). Then n-day ahead (on the average 22 days) dynamic forecasts are made to construct the withinmonth standard deviations for each month, which make the ARCH type models comparable with the other models. This process will make it more challenging for the ARCH-type models.e

a,j
j =m m1

f,m (WMA()) =
j =m

j a,j

f,m (ES) = f,m1 (ES) + (1 )a,m1 f,m (EWMA ) = f,m1 (EWMA ) +(1 )f,m (MA ) f,m (REG) = c + b a,m1 ht = 0 + 1 t21 ht = 0 + 1 t21 + 1 ht 1 ht = 0 + 1 t21 + 2 t21 Dt 1 + 1 ht 1 ln(ht ) = 0 + + ln(ht 1 ) t 1 ht 1 + | t 1 | ht 1

Forecasting Stock Market Volatility

(16)

a In each case, monthly volatility is forecast for the latter 60 months in our sample, i.e. m = 61, . . . , 120. b The weight of each observation, , is chosen to decline by 10%, giving the highest (lowest) weight to the newest (oldest) information. j c Note that if = 0, the ES model collapses to a RW model. The initial forecasts in the ES and EWMA models are MA3 forecasts. d Note that if = 0, the EWMA model collapses to a MA model. eAll ARCH-type

models full the standard requirements for nonnegativity of conditional variance and parameter restrictions.

175

176

E. Balaban et al. RMSE = 1 60 1 60

120 0.5

(f,m a,m )
61

(17)

120

MAPE =

61

f,m a,m a,m

(18)

where f,m and a,m denote the volatility forecast and the realized volatility in month m, respectively. First, it should be recognized that the mean error (ME) metric suffers from the fact that large errors of positive and negative sign may offset each other and, hence, may lead to an unreliable ranking device across the various forecasting models. Accordingly, we provide only a brief discussion of the mean error measures across the various volatility forecasting models and markets. Perhaps, the most useful guide that the ME provides is the degree of average under- or overprediction of volatility. On this score we generally found that across all countries, the ARCH-type models tend to over-predict volatility, while the non-ARCH-type models under-predict volatility. Moreover, the degree of over-prediction of the former is considerably more pronounced than the under-prediction of the latter. Table 2 provides results of actual and relative forecast error statistics for each model according to the MAE error metric. The relative forecast error is obtained by taking the ratio of the actual error statistic of a given model divided by the actual error statistic of the worst-performing model for that country. The table also shows the ranking of forecasting models, for each country, from 1 (best forecast) to 11 (worst forecast). We can identify a number of key features from Table 2. First (and most notably), the exponential smoothing method clearly produces the most accurate volatility forecasts for 13 out of the 15 countries, ES is ranked number one. Moreover, for the two cases (Finland and Malaysia) in which ES is not ranked rst it ranks fourth but on both occasions only marginally behind the most preferred models. For example according to MAE, we nd that in the case of Finland the relative difference in forecasting performance between ES and the top-ranked model (MA-3) is about 3%. Second according to the MAE criterion, the worst model is the standard ARCH model which ranks last for nine countries. Interestingly however, the random walk model also does quite poorly. Third, Hong Kong produces the largest relative difference between the best model (ES) and the worst-ranked model (ARCH) a difference of 53%. In contrast, based on the MAE the narrowest relative gap between the best and worst models is found for Canada and Malaysia a difference of only 22% between ES (GJR-GARCH) and RW (ARCH). Fourth, in terms of MAE, the moving average group of models provide the second best volatility forecast behind ES. For the RMSE metric, in unreported results, ndings mostly reinforce the results gained from the MAE analysis.6 As was the case above with MAE the exponential smoothing approach dominates gaining a number one ranking for 12 out of the 15 countries. Also, based on RMSE there is a consistently poor showing of the ARCH model it ranks last seven times and second-last on a further three occasions. Indeed, the non-ARCH based models again are generally superior to the ARCH based models. In further unreported results, the outcome of the MAPE metric reveals that the major patterns identied for MAE and RMSE are predominantly intact and so only brief further comment will be made. Once again it is found that the ES model is clearly most favoured it provides superior forecasts in all but one instance (Finland). Based on the MAPE the REG model is superior in forecasting volatility for Finland. Furthermore, MA models continue to perform quite well while ARCH-based models remain as the poorest volatility forecasters.7

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Table 2. Mean absolute error (MAE) of forecasting monthly volatility

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Belgium

Canada

Denmark

Finland

Germany

Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 0.1420 0.1718 0.1369 0.1361 0.1369 0.1295 0.1386 0.2098 0.1860 0.1805 0.1924 0.677 0.819 0.653 0.649 0.653 0.617 0.661 1.000 0.887 0.860 0.917 6 7 3(4) 2 3(4) 1 5 11 9 8 10 0.1827 0.1596 0.1555 0.1547 0.1478 0.1425 0.1496 0.1564 0.1548 0.1519 0.1532 1.000 0.874 0.851 0.847 0.809 0.780 0.819 0.856 0.847 0.831 0.839 Italy 11 10 8 6 2 1 3 9 7 4 5 0.1776 0.1757 0.1514 0.1515 0.1514 0.1478 0.1605 0.1879 0.2120 0.2108 0.1934 0.838 0.829 0.714 0.715 0.714 0.697 0.757 0.886 1.000 0.994 0.912 Japan 7 6 2(3) 4 2(3) 1 5 8 11 10 9 0.3998 0.3359 0.2968 0.2995 0.3086 0.3086 0.3079 0.3189 0.3124 0.3213 0.3097 1.000 0.840 0.742 0.749 0.772 0.772 0.770 0.798 0.781 0.804 0.775 Malaysia 11 10 1 2 4(5) 4(5) 3 8 7 9 6 0.2556 0.3171 0.2311 0.2296 0.2207 0.2099 0.2726 0.3420 0.3615 0.3554 0.3145 0.707 0.877 0.639 0.635 0.611 0.581 0.754 0.946 1.000 0.983 0.870 5 8 4 3 2 1 6 9 11 10 7

Hong Kong

Netherlands

Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 0.4784 0.5382 0.4563 0.4534 0.4545 0.4366 0.4521 0.9332 0.5142 0.5034 0.4571 0.513 0.577 0.489 0.486 0.487 0.468 0.484 1.000 0.551 0.539 0.490 7 10 5 3 4 1 2 11 9 8 6 0.3290 0.2727 0.2627 0.2626 0.2502 0.2474 0.2612 0.2818 0.2817 0.2833 0.2661 1.000 0.829 0.798 0.798 0.760 0.752 0.794 0.857 0.856 0.861 0.809 11 7 5 4 2 1 3 9 8 10 6 0.2573 0.3241 0.2859 0.2816 0.2859 0.2543 0.2571 0.4730 0.3618 0.3275 0.2975 0.544 0.685 0.604 0.595 0.604 0.538 0.544 1.000 0.765 0.692 0.629 3 8 5(6) 4 5(6) 1 2 11 10 9 7 0.4391 0.4749 0.3866 0.3847 0.3866 0.3852 0.4340 0.4844 0.3843 0.3779 0.3917 0.906 0.980 0.798 0.794 0.798 0.795 0.896 1.000 0.793 0.780 0.809 9 10 5(6) 3 5(6) 4 8 11 2 1 7 0.2118 0.2474 0.1854 0.1836 0.1784 0.1714 0.1908 0.2414 0.2052 0.2131 0.2053 0.856 1.000 0.749 0.742 0.721 0.693 0.771 0.976 0.829 0.861 0.830 8 11 4 3 2 1 5 10 6 9 7

Forecasting Stock Market Volatility 177

(continued )

178 E. Balaban et al.

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Table 2. Continued Philippines Singapore Thailand UK USA

Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank Actual Relative Rank RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 0.4026 0.5122 0.3494 0.3467 0.3494 0.3371 0.4125 0.5577 0.4329 0.4523 0.4237 0.722 0.918 0.627 0.622 0.627 0.604 0.740 1.000 0.776 0.811 0.760 5 10 3(4) 2 3(4) 1 6 11 8 9 7 0.2454 0.2524 0.2267 0.2247 0.2267 0.2157 0.2375 0.3119 0.2705 0.2717 0.2670 0.787 0.809 0.727 0.720 0.727 0.692 0.761 1.000 0.867 0.871 0.856 6 7 3(4) 2 3(4) 1 5 11 9 10 8 0.4218 0.4687 0.3881 0.3869 0.3858 0.3755 0.3773 0.5697 0.4370 0.4280 0.4379 0.740 0.823 0.681 0.679 0.677 0.659 0.662 1.000 0.767 0.751 0.769 6 10 5 4 3 1 2 11 8 7 9 0.1135 0.1790 0.1179 0.1163 0.1162 0.1068 0.1455 0.1990 0.1730 0.1603 0.1487 0.570 0.899 0.592 0.584 0.584 0.537 0.731 1.000 0.869 0.806 0.747 4 10 5 3 2 1 6 11 9 8 7 0.1604 0.2278 0.1552 0.1534 0.1543 0.1393 0.1709 0.2433 0.1960 0.2184 0.1988 0.659 0.936 0.638 0.630 0.634 0.573 0.702 1.000 0.806 0.898 0.817 5 10 4 2 3 1 6 11 7 9 8

The mean absolute error, (MAE), actual gures must be multiplied by 102 . Actual is the calculated error statistic. Relative is the ratio between the actual error statistic of a model and that of the worst performing model. The best performing model has a rank 1.

Forecasting Stock Market Volatility 3.2 Asymmetric Error Statistics

179

The conventional error statistics used in the previous subsection, ME, MAE, RMSE, and MAPE, are symmetric; i.e. they give an equal weight to under- and over-predictions of volatility of similar magnitude. However, many investors do not give equal importance to under- and over-prediction of volatility, for example, in the pricing of options, while under-prediction of volatility is undesirable for a seller, over-prediction is undesirable for a buyer. Following Brailsford and Faff (1996), to penalize under-/over-predictions more heavily, the following mean mixed error statistics, MME, are constructed:8 1 60 1 60
O U

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MME(U ) =

|f,m a,m | +
t =1 U t =1 O

|f,m a,m |

(19)

MME(O) =

|f,m a,m | +
t =1 t =1

|f,m a,m |

(20)

where O is the number of over-predictions, and U is the number of under-predictions. MME (U ) and MME (O) penalize the under-predictions and over-predictions more heavily, respectively. In Table 3 we report the results of the eleven volatility forecasting methods across the fteen countries when assessed by the MME(U) and the MME(O) error metrics. The key features of this analysis in the context of MME(U) which penalizes under-prediction more heavily can be summarized as follows. First, given that we have already established that the ARCH-based models are more heavily prone to (average) over-prediction, it is no surprise that these models do particularly well according to MME(U). Indeed, in stark contrast to the previous analysis (based on the symmetric measures) ARCH-based models are ranked number 1 in twelve countries. Second, it is interesting to note that of these models the EGARCH variation fairs best by providing the supreme volatility forecast for ve of the fteen countries. Third, we nd that the difference between the forecasting ability of the ARCH-based models is typically quite small. For example, in the case of Hong Kong there is just 6.4% difference between the relative MME(U) measures of all four ARCH-based models. Fourth, we observe that the previously preferred ES method, according to MAE, mostly achieves middle rankings. Clearly, the smaller over-prediction tendency of ES (relative to the ARCH-based models) drives this result. Fifth, similar to the now poor showing of the ES, the MA models also rate quite badly often ranked at 7 or worse according to MME(U). Sixth, according to the MME(U) metric, the worst performing model at forecasting monthly volatility is the random walk model it achieves the worst ranking in seven of the fteen countries. This is not surprising when it is recognized that RW typically produces the highest incidence of under-estimation of monthly volatility. Turning now to the MME(O) results reported in Table 3, we tend to see a return to the same sort of pattern discussed earlier with regard to the symmetric error measures. Specically, the key features of this analysis (which penalizes over-prediction more heavily) can be summarized as follows. First, similar to all the symmetric measures, ES dominates it achieved supreme ranking for eight out of the 15 countries and a second ranking on another two occasions. Second, again (this time based on MME(O)) we see a relatively small gap between the accuracy of the non-ARCH based methods. Third, the non-ARCH based models again are consistently superior to the ARCH based models.

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Table 3. Mean mixed error (MME) statistics from forecasting monthly volatility
Belgium MME(U) Actual Relative RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 1.8239 1.3590 1.7819 1.7810 1.7819 1.7676 1.4224 1.4231 1.2880 1.3531 1.2672 1.000 0.745 0.977 0.976 0.977 0.969 0.780 0.780 0.706 0.742 0.695 Rank 11 4 9(10) 8 9(10) 7 5 6 2 3 1 MME(O) Canada

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation 1.7146 2.6474 1.7293 1.7315 1.7293 1.6392 2.0960 3.1107 3.0303 2.8719 3.1122 0.551 0.851 0.556 0.556 0.556 0.527 0.673 0.999 0.974 0.923 1.000 2 7 3(4) 5 3(4) 1 6 10 9 8 11 0.500 0.317 0.467 0.467 0.467 0.467 0.383 0.717 0.734 0.717 0.734 0.500 0.680 0.533 0.533 0.533 0.533 0.617 0.283 0.266 0.283 0.266 2.0160 1.7387 1.6450 1.6645 1.6234 1.6692 1.7930 1.7922 1.6975 1.7201 1.7753 1.000 0.862 0.816 0.826 0.805 0.828 0.889 0.889 0.842 0.853 0.881 11 7 2 3 1 4 10 9 5 6 8 1.9569 1.9953 2.0053 1.9951 1.8918 1.7509 1.8155 1.8827 1.9226 1.8937 1.8930 0.976 0.995 1.000 0.995 0.943 0.873 0.905 0.939 0.959 0.944 0.944 Finland 8 10 11 9 4 1 2 3 7 6 5 0.517 0.383 0.367 0.400 0.333 0.433 0.450 0.583 0.567 0.567 0.550 0.483 0.617 0.633 0.600 0.667 0.567 0.550 0.417 0.433 0.433 0.450

Denmark MME(U) Actual Relative RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 1.7814 1.4910 1.7865 1.7715 1.7865 1.6633 1.4044 1.2825 1.1925 1.1310 1.0490 0.997 0.835 1.000 0.992 1.000 0.931 0.786 0.718 0.668 0.633 0.587 Rank 9 6 10(11) 8 10(11) 7 5 4 3 2 1 MME(O)

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation 2.0905 2.5418 1.8807 1.8874 1.8807 1.9065 2.4229 2.9346 3.1113 3.1354 3.0692 0.667 0.811 0.600 0.602 0.600 0.608 0.773 0.936 0.992 1.000 0.979 5 7 1(2) 3 1(2) 4 6 8 10 11 9 0.467 0.367 0.500 0.500 0.500 0.450 0.367 0.717 0.700 0.717 0.734 0.533 0.633 0.500 0.500 0.500 0.550 0.633 0.283 0.300 0.283 0.266 3.0987 4.1430 2.6057 2.6216 2.2049 2.2049 3.1841 2.6767 2.2612 2.1361 2.0751 0.748 1.000 0.629 0.633 0.532 0.532 0.769 0.646 0.546 0.516 0.501 9 11 6 7 3(4) 3(4) 10 8 5 2 1 3.1082 1.3014 2.5952 2.6245 3.1922 3.1922 2.1471 2.7941 3.0638 3.3710 3.2514 0.922 0.386 0.770 0.779 0.947 0.947 0.637 0.829 0.909 1.000 0.965 7 1 3 4 8(9) 8(9) 2 5 6 11 10 0.517 0.683 0.533 0.533 0.400 0.400 0.533 0.567 0.600 0.633 0.600 0.483 0.317 0.467 0.467 0.600 0.600 0.467 0.433 0.400 0.367 0.400

Germany MME(U) MME(O)

Hong Kong

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank Actual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation

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RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH

2.4129 1.6339 2.2181 2.2101 2.2819 2.2344 1.5408 1.5870 1.3077 1.4074 1.4748

1.000 0.677 0.919 0.916 0.946 0.926 0.639 0.658 0.542 0.583 0.611

11 6 8 7 10 9 4 5 1 2 3

2.3466 4.0257 2.3840 2.3689 2.2304 2.0977 3.5973 4.2072 4.7271 4.4821 4.0719

0.496 0.852 0.504 0.501 0.472 0.444 0.761 0.890 1.000 0.948 0.861 Italy

3 7 5 4 2 1 6 9 11 10 8

0.517 0.267 0.417 0.417 0.467 0.467 0.283 0.767 0.800 0.783 0.750

0.483 0.733 0.583 0.583 0.533 0.533 0.717 0.233 0.200 0.217 0.250

3.250 3.570 3.174 3.191 3.164 3.001 3.206 2.915 2.688 2.707 2.713

0.910 1.000 0.889 0.894 0.886 0.841 0.898 0.817 0.753 0.758 0.760

10 11 7 8 6 5 9 4 1 2 3

3.1315 3.4678 3.1800 3.1613 3.1695 3.1633 3.1973 6.6425 4.0484 3.9225 3.7850

0.471 0.522 0.479 0.476 0.477 0.476 0.481 1.000 0.609 0.591 0.570 Japan

1 7 5 2 4 3 6 11 10 9 8

0.500 0.417 0.467 0.483 0.483 0.450 0.417 0.750 0.650 0.650 0.650

0.500 0.583 0.533 0.517 0.517 0.550 0.583 0.250 0.350 0.350 0.350

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank Actual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GJRGARCH(1, 1) EGARCH 2.7336 3.1402 2.2841 2.2831 2.2026 2.1142 2.7567 2.3810 2.3801 2.3459 2.0618 0.871 1.000 0.727 0.727 0.701 0.673 0.878 0.758 0.758 0.747 0.657 9 11 5 4 3 2 10 8 7 6 1 2.8764 1.8894 2.6255 2.6084 2.5382 2.6124 2.1989 2.7984 2.6347 2.6635 2.8298 1.000 0.657 0.913 0.907 0.882 0.908 0.764 0.973 0.916 0.926 0.984 11 1 6 4 3 5 2 9 7 8 10 0.500 0.617 0.450 0.467 0.467 0.433 0.517 0.550 0.500 0.550 0.583 0.500 0.383 0.550 0.533 0.533 0.567 0.483 0.450 0.500 0.450 0.417 2.4734 1.9291 2.5364 2.5372 2.5364 2.4685 2.0316 1.2401 1.4687 1.6083 1.7132 0.975 0.760 0.999 1.000 0.999 0.973 0.801 0.489 0.579 0.634 0.675 8 5 9(10) 11 9(10) 7 6 1 2 3 4 2.3647 3.7118 2.5756 2.5344 2.5756 2.3251 2.9029 5.7738 4.5315 4.0092 3.7359 0.410 0.643 0.446 0.439 0.446 0.403 0.503 1.000 0.785 0.694 0.647 2 7 4(5) 3 4(5) 1 6 11 10 9 8 0.467 0.317 0.467 0.483 0.467 0.483 0.383 0.867 0.767 0.717 0.717 0.533 0.683 0.533 0.517 0.533 0.517 0.617 0.133 0.233 0.283 0.283 (continued )

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Table 3. Continued
Malaysia MME(U) MME(O) Netherlands

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank Actual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GRJGARCH(1, 1) EGARCH 3.1778 3.3340 3.0356 3.0038 3.0356 2.9669 3.2130 2.5657 2.7225 2.7414 2.7585 0.953 1.000 0.910 0.901 0.910 0.890 0.964 0.770 0.817 0.822 0.827 9 11 7(8) 6 7(8) 5 10 1 2 3 4 3.1115 3.2046 2.7469 2.7754 2.7469 2.8355 3.0404 4.0917 3.3425 3.2753 3.3603 0.760 0.783 0.671 0.678 0.671 0.693 0.743 1.000 0.817 0.800 0.821 6 7 1(2) 3 1(2) 4 5 11 9 8 10 0.450 0.467 0.500 0.483 0.500 0.467 0.467 0.667 0.617 0.600 0.600 0.550 0.533 0.500 0.517 0.500 0.533 0.533 0.333 0.383 0.400 0.400 2.2855 2.0189 2.2359 2.1995 2.3351 2.1960 1.9682 2.1816 1.8266 1.9849 1.8069 0.979 0.865 0.958 0.942 1.000 0.940 0.843 0.934 0.782 0.850 0.774 10 5 9 8 11 7 3 6 2 4 1 2.1665 2.6375 1.8378 1.8514 1.6608 1.7056 2.1423 2.3459 2.4547 2.2977 2.4305 0.821 1.000 0.697 0.702 0.630 0.647 0.812 0.889 0.931 0.871 0.922 6 11 3 4 1 2 5 8 10 7 9 0.500 0.333 0.517 0.500 0.550 0.500 0.467 0.600 0.600 0.567 0.600 0.500 0.667 0.483 0.500 0.450 0.500 0.533 0.400 0.400 0.433 0.400

Philippines MME(U) MME(O)

Singapore

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank Actual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GRJGARCH(1, 1) EGARCH 3.1985 2.0710 3.0325 3.0441 3.0325 2.8762 2.1268 1.9493 2.1669 2.1274 2.0975 1.000 0.647 0.948 0.952 0.948 0.899 0.665 0.609 0.677 0.665 0.656 11 2 8(9) 10 8(9) 7 4 1 6 5 3 3.0967 5.2125 2.6569 2.6280 2.6569 2.6546 4.3861 5.7084 4.4727 4.6318 4.4460 0.542 0.913 0.465 0.460 0.465 0.465 0.768 1.000 0.784 0.811 0.779 5 10 3(4) 1 3(4) 2 6 11 8 9 7 0.500 0.283 0.533 0.567 0.533 0.517 0.300 0.767 0.683 0.683 0.700 0.500 0.717 0.467 0.433 0.467 0.483 0.700 0.233 0.317 0.317 0.300 2.3663 1.6810 2.2029 2.1829 2.2029 2.1584 1.7074 1.4862 1.4659 1.4573 1.7183 1.000 0.710 0.931 0.922 0.931 0.912 0.722 0.628 0.619 0.616 0.726 11 4 9(10) 8 9(10) 7 5 3 2 1 6 2.3192 3.0127 2.2389 2.2387 2.2389 2.1191 2.8521 3.9188 3.5067 3.4995 3.2306 0.592 0.769 0.571 0.571 0.571 0.541 0.728 1.000 0.895 0.893 0.824 5 7 3(4) 2 3(4) 1 6 11 10 9 8 0.500 0.283 0.433 0.433 0.433 0.483 0.300 0.767 0.717 0.717 0.667 0.500 0.717 0.567 0.567 0.567 0.517 0.700 0.233 0.283 0.283 0.333

Thailand MME(U) MME(O)

UK

% % MME(U) MME(O) % % UnderOverUnderOverActual Relative Rank Actual Relative Rank estimation estimation Actual Relative Rank Actual Relative Rank estimation estimation

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RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GRJGARCH(1, 1) TARCH EGARCH

3.0649 2.9870 2.9941 3.0096 2.9824 3.0289 2.5726 2.4625 2.3341 2.2250 2.3122

1.000 0.975 0.977 0.982 0.973 0.988 0.839 0.803 0.762 0.726 0.754

11 7 8 9 6 10 5 4 3 1 2

3.1456 3.7965 3.0188 3.0138 3.0000 2.9650 3.3052 5.2030 4.3094 4.3345 4.3747

0.605 0.730 0.580 0.579 0.577 0.570 0.635 1.000 0.828 0.833 0.841 USA

5 7 4 3 2 1 6 11 8 9 10

0.450 0.417 0.467 0.483 0.467 0.483 0.383 0.733 0.683 0.700 0.700

0.550 0.583 0.533 0.517 0.533 0.517 0.617 0.266 0.317 0.300 0.300

1.6947 0.8624 1.6212 1.6115 1.5459 1.6525 0.9541 0.9068 1.0012 0.8843 0.9893

1.000 0.509 0.957 0.951 0.912 0.975 0.563 0.535 0.591 0.522 0.584

11 1 9 8 7 10 4 3 6 2 5

1.4682 3.2718 1.6449 1.6275 1.6425 1.4493 2.8041 3.5110 3.1228 3.0486 2.7669

0.418 0.932 0.468 0.464 0.468 0.413 0.799 1.000 0.889 0.868 0.788

2 10 5 3 4 1 7 11 9 8 6

0.550 0.200 0.483 0.500 0.433 0.533 0.233 0.783 0.767 0.783 0.733

0.450 0.800 0.517 0.500 0.567 0.467 0.767 0.217 0.233 0.217 0.267

% % UnderOverActual Relative Rank Actual Relative Rank estimation estimation RW HM MA-3 WMA-3 EWMA-3 ES REG ARCH(1) GARCH(1, 1) GRJGARCH(1, 1) EGARCH 1.8228 1.3985 1.9712 1.9450 1.9913 1.8497 1.3991 1.8229 1.6125 1.7373 1.7101 0.915 0.702 0.990 0.977 1.000 0.929 0.703 0.915 0.810 0.872 0.859 6 1 10 9 11 8 2 7 3 5 4 1.8596 3.2614 1.8001 1.8043 1.7688 1.6407 2.6199 3.0547 2.6069 2.7464 2.5757 0.570 1.000 0.552 0.553 0.542 0.503 0.803 0.937 0.799 0.842 0.790 5 11 3 4 2 1 8 10 7 9 6 0.433 0.283 0.500 0.483 0.483 0.467 0.333 0.667 0.633 0.617 0.600 0.567 0.717 0.500 0.517 0.517 0.533 0.667 0.333 0.367 0.383 0.400

MME(U)

MME(O)

Forecasting Stock Market Volatility 183

MME(U) and MME(O) are the mean mixed error statistics that penalise the under-predictions and over-predictions more heavily, respectively. Actual is the calculated error statistics. MME(U) and MME(O) actual gures must be multiplied by 102 . Relative is the ratio between the actual error statistic of a model and that of the worst-performing model. The best performing model has a rank 1.

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3.3 Discussion Here we briey discuss three dimensions of our analysis: (1) symmetric error metric results; (2) asymmetric error metric results; and (3) developed versus emerging market comparisons. Our initial set of ndings relate to the outcome of the analysis when employing the standard symmetric error metrics to assess volatility forecasting performance. First, we consistently found that the Exponential Smoothing approach dominates in providing superior forecasts of monthly volatility. Generally in comparison with the existing literature, these results have cases of similarity and others of divergence. This nding largely conrms that of Dimson and Marsh (1990) for the UK FT All shares index (though it should be noted that they did not include ARCH-type models in their analysis). Other studies that similarly suggest a degree of superiority for the Exponential Smoothing (ES) model include Figlewski and Green (1999) for the S&P 500; McMillan, Speight and Gwilym (2000) where ES, MA and RW tended to perform well for low frequency UK data that included the crash; and Ferreira (1999) for the French interbank one-month mid rate. However, the superiority of the ES model contrasts that of Brailsford and Faff (1996) who found that for an Australian market index this model performed rather poorly. The second general aspect of note to our initial ndings (based on symmetric errors) is that non-ARCH based models are found to be superior to the ARCH based models, consistent with the ndings of Tse (1991) Japan; Tse and Tung (1992) Singapore; and McMillan, Speight and Gwilym (2000) UK. However, Poon and Granger (2003) report that of those studies they surveyed that involve historical volatility models and ARCH-type models, a slight majority (56%) found the historical models to generally outperform their ARCH counterparts. A third and nal nding of note in our initial analysis was that within the sub-group of ARCH-type models there is a tendency for more complex models to be superior. The ranking within ARCH-type models (in terms of their complexity) tends to be rather mixed throughout the literature and thus no clear point of comparison can be drawn. Our second set of ndings relate to the outcome of our analysis when employing the nonstandard asymmetric error metrics to assess volatility forecasting performance. Interestingly, our results change when the asymmetric loss functions, that penalize under-/over-prediction, are employed. Specically, when under-predictions are penalized more heavily, ARCH-type models provide the best forecasts while the random walk is worst. However, when over-predictions of volatility are penalized more heavily the exponential smoothing model performs best while the ARCH-type models are now universally found to be inferior forecasters. The observation that the rankings are dramatically affected by which asymmetric metric is used reinforces the ndings of Brailsford and Faff (1996). Moreover, the current paper conrms the Brailsford and Faff (1996) nding of GARCH(1, 1) tending to be preferred when under-predictions are penalized more heavily. However, with regard to the case when over-predictions are penalized more heavily, while the current paper shows ES to rank very highly, Brailsford and Faff (1996) nd it ranks worst. Our third point of discussion involves assessing whether any clear trends or patterns are evident in a comparison of forecasting volatility across developed versus emerging markets. In our sample, there are three countries commonly classied as emerging: Malaysia, Philippines and Thailand. In general terms no strong patterns are observed these emerging markets do not display clear common features that contrast their developed counterparts. It does seem however that Malaysia is a little different. In terms of the MAE symmetric error analysis Malaysia is one of the few countries which does not favour the Exponential Smoothing forecasts the GJR-GARCH model is superior. However, it should be noted in this case that (a) the ES model while ranked 4th,

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provides an MAE extremely close to GJR and (b) the only other country which does not favour ES is Finland which cannot be viewed as emerging. With regard to the asymmetric analysis again Malaysia shows up as being a little different to the others but only in the MME(O) case where it again avoids choosing ES as its superior model. What then are the major implications of these results? Based on our ndings assessed using standard symmetric error measures, it seems that in many market situations, in different market contexts (including both developed and emerging markets) the Exponential Smoothing model is preferred. Thus, in situations in which the direction of forecast error is equally important (e.g. portfolio selection), our study suggests that in the absence of other information leading to an alternative preference, the use of the Exponential Smoothing model is recommended. However, our results with regard to asymmetric error measures suggest that ARCH-type models (ES model) are preferred for those cases in which under-predictions (over-predictions) are penalized more heavily. These results are of greatest relevance to situations applications like VaR analysis wherein a dramatic underestimate could have dire consequences for investors. Based on our results they would be best served by using ARCH-type volatility forecasts as these models do best when under-predictions of volatility are penalized most.

4.

Conclusions

Volatility forecasting is a widely researched area in the nance literature. The performance of forecasting models of varying complexity has been investigated according to a range of measures and generally mixed results have been recorded. On the one hand some argue that relatively simple forecasting techniques are superior, while others suggest that the relative complexity of ARCH-type models is worthwhile. In this paper we seek to extend and supplement this existing evidence by, in a single unifying framework, analysing a wide range of volatility forecasting approaches across fteen countries. Specically, our analysis encompasses the ten-year period 1988 to 1997 for the market returns of Belgium; Canada; Denmark; Finland; Germany; Hong Kong; Italy; Japan; Malaysia; Netherlands; Philippines; Singapore; Thailand; the UK; and the USA. In our analysis, a considerable range of forecasting models are used a random walk model, a historical mean model, moving average models, weighted moving average models, exponentially weighted moving average models, an exponential smoothing model, a regression model, an ARCH model, a GARCH model, a GJR-GARCH model, and an EGARCH model. Furthermore, we compare the forecasting techniques based on both symmetric (mean error, the mean absolute error, the root mean squared error and the mean absolute percentage error) and asymmetric error statistics. The key features of our results can be summarized into two parts. First, in the context of standard symmetric error metrics the exponential smoothing approach dominates. Thus, in situations in which the direction of forecast error is equally important (e.g. portfolio selection), our study suggests that in the absence of other information leading to an alternative preference, the use of the exponential smoothing model is recommended. Second, in the context of asymmetric error metrics, when under(over)-predictions are penalized more heavily, ARCH-type (exponential smoothing) models provide the best forecasts. These results are of greatest relevance to option pricing, and market risk management applications. For example, in value-at-risk settings, underestimation of risk can be disastrous. Based on our results, VaR users would be best served by using ARCH-type volatility forecasts as these models do best when under-predictions of volatility are

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penalized most. Finally, no major discernible patterns could be isolated regarding forecasting volatility in emerging versus developed markets. Acknowledgements For helpful comments, we thank Chris Adcock, the editor; three anonymous referees; the participants at the 13th Annual Meeting of the European Financial Management Association held in Helsinki, Finland in June 2003; the 11th Conference on the Theories and Practices of Security and Financial Markets held in Taiwan in December 2002; and seminar participants at the Bank of England in February 2003 and at the University of Stirling in November 2003. The usual disclaimers apply.

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Notes
1

2 3

4 5

6 7

Evidence with respect to foreign exchange markets includes Taylor (1987), Lee (1991), West and Cho (1995),Andersen and Bollerslev (1998), Brooks and Burke (1998), Andersen et al. (1999), McKenzie (1999), Andersen et al. (2002), Klaassen (2002), Vilasuso (2002), Balaban (2004) for example, West and Cho (1995) cannot show superiority of any forecasting models. The interested reader is referred to Poon and Granger (2003) for an excellent review of 93 papers that have looked at forecasting volatility in nancial markets. Interestingly Poon and Granger (2003, p. 490) state that given . . . most investors would treat gains and losses differently, use of such [asymmetric] functions may be advisable, but their use is not common in the literature. Variation from the conventional loss functions is not new, however for example, see Pagan and Schwert (1990). We thank an anonymous referee for suggesting this VaR example. One type of model that we exclude is the regime-switching variety. While a regime-switching model is a good one for in-sample modelling, it is not readily amenable to an out-of-sample volatility forecasting exercise. Our desire to have a practical focus underlying our work helps rule this model out of consideration. While these results and the MAPE results discussed shortly are not reported in the interests of brevity, details are available from the authors upon request. As stated earlier, the ARCH models are updated monthly using daily data and n-day ahead forecasts are constructed. This process will make it more challenging for them to compete, thereby representing a potential explanation of their poor predictive performance. We thank an anonymous referee for bringing this issue to our attention. Since the absolute values of all forecast errors are less than one, taking their square root increases the penalty for under/over-prediction.

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