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5/18/2014 GARCH - Tutorial and Excel Spreadsheet

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13 GARCH Tutorial and Excel Spreadsheet
Posted by Samir Khan
3
This article gives a simple introduction to GARCH, its
fundamental principles, and offers an Excel
spreadsheet for GARCH(1,1).Scroll down to the
bottom if you just want to download the spreadsheet,
but I encourage you to read this guide so you
understand the principles behind GARCH.
Least squares is a fundamental concept in statistics,
and is widely used across many fields, including
engineering, science, econometrics, and finance.
Least squares determines how a dependent variable
changes in response to the variation of another variable (call the independent variable).
The difference between the actual and the predicted value is known as the residual. Fitting a
modeling involves minimizing the sum of the squares of the residuals.
The least squares approach assumes that the squared error has the same magnitude across the
entire data set. This assumption is known as homoskedasticity. But financial data (known as a time
series) has periods of high and low volatility, with periods of high volatility often clustering together.
This is known as heteroskecadicity.
In reference to modeling fitting, this means the residuals vary in magnitude. Volatility clustering
means the data is auto correlated. GARCH is a statistical tool that helps predict the residuals in k
data
ARCH means Autoregressive Conditional Heteroskedasiticy and is closely related to GARCH. The
simplest method to predict stock volatility is an n day standard deviation, and lets consider a rolling
year with 252 trading days. If we want to predict stock prices for the next day, the mean is usually a
safe starting point.
But the mean treats each day with the same weight. Giving the recent past more significance is more
logical, with perhaps an exponential weighted average being a better method to predict tomorrows
stock price.
However, this method does not capture any data older than a year, and the weighting is rather
arbitrary. The ARCH model, however, varies weights on each residual such that the best fit is
obtained. The GARCH (General Autoregressive Conditional Heteroscedasiticy) is similar, but gives
recent data more significance.
The GARCH(p,q) model has two characteristic parameters; p is the number of GARCH terms and q is
the number of ARCH terms. GARCH(1,1) is defined by the following equation.
h is variance, is the residual squared, t denotes time. , and are empirical parameters
determined by maximum likelihood estimation. The equation tells us that tomorrows variance is a
function of
todays squared residual,
todays variance,
the weighted average long-term variance
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5/18/2014 GARCH - Tutorial and Excel Spreadsheet
http://investexcel.net/garch-excel/ 2/4
February 9, 2012 at 7:22 pm
February 10, 2012 at 3:03 pm
March 3, 2012 at 6:05 pm
GARCH(1,1) captures only once square residual and one square variance.
This is not a magic wand, and financial analysts should be use the approach with a high degree of
caution. Given the appropriate circumstance, the predicted variance can greatly differ from the actual
variance. Techniques such as the Ljung box text are used to determine if any autocorrelation remains
in the residuals.
Several researchers have highlighted deficiencies in GARCH(1,1) models, including its failure to
predict the volatility in the S&P500 more accurately than other methods.
GARCH in Excel
This Excel spreadsheet models GARCH(1,1) on time series data. You can use your own data, but the
spreadsheet uses the GBP/CAD exchange rate between May 2007 and October 2011 (data obtained
using this Forex data downloader spreadsheet). The spreadsheet uses Excels Solver for the
maximum likelihood estimation, but full instructions are given on its use.
Download Excel Spreadsheet for GARCH(1,1) analysis
13 Responses to "GARCH Tutorial and Excel Spreadsheet"
elena
hello
I would really like to understand step by step how to build a model garch
I have much need for my thesis.
I understand that I take a data column
a column yields
and then??
please help me
Reply
ANTRIKSH
I am also working on the same.If you need any help I can try for it.
Reply
melisa
i will used the A-DCC GARCH model for my thesis. unfortunately, i have zero knowledge on the econometric and
time series analysis. i hope anybody can help me to understand the model.
Reply
5/18/2014 GARCH - Tutorial and Excel Spreadsheet
http://investexcel.net/garch-excel/ 3/4
March 19, 2012 at 3:37 pm
March 20, 2012 at 7:24 am
July 17, 2012 at 11:04 am
August 7, 2012 at 8:04 pm
September 23, 2012 at 7:44 pm
June 20, 2013 at 6:54 am
July 10, 2013 at 1:24 pm
Shane
How do you get the alpha, beta and omega values?
Reply
Samir
Not sure if I understand your question. You get the alpha,beta and omega values through model fitting
with Excels Solver (everythings already set up in the spreadsheet)
Reply
Bengt-Rune Holm
Hey I wondered why do you use difference (B14-B13) and not return LN(B14/B13) when estimating the volatility.
Can`t see you get the right implied volatility using difference. But when calculating the implied volatility I changed
B collum to use return so the data will be I(0). Get insanly high implied volatility using difference hence the data
will probably not be I(0) when using difference. could be that you forgot to divede with B13 when making the
sheet? ((B14-B13)/B13) which is almost the same as LN(B14/B13). Best regard Bengt-Rune
Reply
Latiole
I wondered the same thing. And why dont you use an AR or ARMA model to calculate the residuals ?
Thx
Reply
Jarryd Phillip
How can you model volatility using GARCH(1,1) if you have two variables?
Reply
Mikko
Thanks for the great example!
One question though. I have a problem that the solver does not solve the parameter values as it should. t gives
negative values sometimes and then the other functions just give a lot of errors.
Any suggestion how to avoid this problem?
You can answer to my email: mikko.harjuoja@gmail.com
Reply
Tom
Thanks for this great Excel sheet. It helps a lot in understanding how to apply a GARCH model!
Reply
lynn
5/18/2014 GARCH - Tutorial and Excel Spreadsheet
http://investexcel.net/garch-excel/ 4/4
March 4, 2014 at 4:12 pm
May 13, 2014 at 5:58 pm
May 13, 2014 at 1:40 pm
Submit Comment
Hello Samir,
Have read this with great interest.
Am I correct in saying that to solve the spreadsheet, i.e calculate h(t+1) and calculate the predicted variance for
the next time period, you would use from the spreadsheet cells:
B5+(B6*D1279)+(B7*B4) or .00008615
Thanks
Lynn
Reply
Shu
Hi Lynn,
Have you got an answer on your question? Is it alright to use cell B4 (h at time t) as your variance?
Thanks,
Shu
Reply
Shu
Hi Samir,
Your explanations on GARCH, VaR, etc using excel are very very helpful for someone with limited knowledge on
finance.
I have a question on calculation of log likelihood function. What is the interpretation of the calculation (i.e.
=LN((1/SQRT(2*3.1415927*F15))*EXP(-0.5*D15/F15)))? If you can guide me to a reference, I would appreciate
it.
Kind regards,
Shu
Reply
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