This paper reflects the view of the authors and not necessarily the view of CERAM Sophia Antipolis

or any of its lecturers.

Copyrights 2005 by the authors. All rights reserved

Contact:
Bernhard Lamark lamark@gmail.com
Philipp Jan Siegert siegert@pp-services.de
Jon Walle jon.walle@gmail.com

www.globalfinance.org
Volatility Modeling – From ARMA to ARCH

TABLE OF CONTENTS

I. HETEROSKEDASTICITY IN ECONOMETRICS 3

1. ASSUMPTIONS FOR ORDINARY LEAST SQUARES (OLS) REGRESSION ANALYSIS 3

2. HETEROSKEDASTICITY 4
A. CROSS SECTIONAL DATA 4
B. TIME SERIES 5
3. USING HETEROSKEDASTICITY IN VOLATILITY FORECASTING 6

II. ADVANCED VOLATILITY MODELLING TECHNIQUES 7

1. AUTOREGRESSIVE MODELS 7
2. THE ARCH MODEL 8
3. THE GARCH MODEL 10
4. ARCH-M 11

III. EMPIRICAL VOLATILITY MODELLING 11

1. HOW TO MEASURE DAILY VOLATILITY 11

2. DEVELOPMENT OF 30 DAYS VOLATILITY 13
3. MODELLING GENERAL ELECTRIC SHARES WITH GARCH 14
4. FORECASTING VOLATILITY WITH THE GARCH MODEL 15

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Volatility Modeling – From ARMA to ARCH

I. Heteroskedasticity in Econometrics

1. Assumptions for Ordinary Least Squares (OLS)

Regression Analysis
OLS regression analysis is the great workhorse of economists and statisticians and
forms a central tool in financial modelling. The well proved technique relies on a set of
four basic underlying assumptions to produce linear models that are the Best Unbiased
Linear Estimate (BLUE). Furthermore, it is necessary to add a fifth assumption of
homoskedasticity to obtain results that are also statistically consistent.
First, it is assumed that there are linear parameters, meaning that there is a linear
relationship between the dependent and the explanatory variables. Mathematically this
relationship is expressed as a function of the form: Y = β 0 + β1 X + ε where 0 is the
intercept, 1 the slope of the function and where represents an error term containing all
the factors affecting Y other than the specified independent variable(s).
Second, it is intuitively a necessity that the sample to be analysed must consist of a
random sample of the relevant population to yield an unbiased result. Mathematically
(xi, yi): i = 1, 2...n.
Third, a zero conditional mean is assumed. This means that the linear model will be the
single line that minimises the value of the sum of all error terms forming an average of
the positive and negative errors. In other words this means that the average error term of
the function should always be 0 as the negative and positive errors cancel each other
out. This can be refined into the assumption that the average value of does not depend
on the value of X as for any value of X the average value of will be equal to the
average value of in the entire population, which is 0. Mathematically it can be
expressed as: E (ε | x) = E(ε ) = 0
Fourth, it is assumed a sample variation in the independent variables X. This means that
two independent variables cannot be equal to the same constant. This is however not an
assumption that is likely to fail in an interesting statistical analysis as a completely
homogenous population is not the typical target for statistical analysis. The assumption
is defined as: xi, i = 1, 2...n. These assumptions assure an unbiased result where the
sample n is equal to the population n.

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Volatility Modeling – From ARMA to ARCH

Finally, we assume homoskedasticity to obtain a consistent result. This assumption

states that the value of the variance of error term conditional on the explanatory
variable X is constant. In other words, the pattern of distribution of error terms at any
given value of X will show the same distribution with a mean around the sample nX.

This is expressed as: Var(ε | x) = σ 2 .

2. Heteroskedasticity
The effect of a violation of this assumption is that we still have a BLUE model,
however it is no longer consistent and as a result the regression output in terms of test
statistics can no longer be reliable. This is due to the fact that the variance which is in
the heart of these statistics is no longer constant and will hence be misleading.

a. Cross sectional data

In normal cross sectional data the distribution of the error term should graphically
show a constant distribution in relation to the function Y = β 0 + β1 X + ε . This is
demonstrated in Figure 1 where we hypothetically evaluate the relationship between
disposable income and consumption and where we arrive at a consistent result where
consumption is a dependent variable explained as a constant percentage of the
explanatory variable disposable income.

In figure 2, a violation of assumption five – homoskedasticity – is graphically

demonstrated as the more realistic scenario where those with higher disposable income

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Volatility Modeling – From ARMA to ARCH

have the freedom to choose level of consumption according to preference while those
with a lower income are forced to consume more or less everything. The consequence is
that the error term and hence the variance will vary depending on the explanatory
variable X.

b. Time series
Heteroskedasticity in time series will take a graphically different appearance as the issue
here is that the variance, or the volatility, will vary according to time. Engle (1982) and
others with him have looked at the properties of the volatility of financial markets and
there is wide recognition of the presence of heteroskedasticity in the distribution of
returns. Mandelbrot (2002) describes this phenomenon as a clustering of volatility
where a period of high volatility is likely to be followed by another period of high
volatility and opposite. By using Microsoft Excel to generate a graphical output of the
volatility of a homoskedastic and a heteroskedastic time series process we obtained the
results depicted in Figures 3 and 4 respectively. Intuitively, the properties of the
heteroskedastic output resemble the sometimes calm and sometimes turbulent
volatilities observed in financial markets.

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Volatility Modeling – From ARMA to ARCH

Figure 3: Homoskedastic Time Series - Volatility

25%

20%

15%

10%

5%

0%

Figure 4: Heteroskedastic Time Series - Volatility

25%

20%

15%

10%

5%

0%

3. Using Heteroskedasticity in Volatility Forecasting

Research has found out that a relationship between volatility from one period to the next
one exists. The presence of this heteroskedastic relationship may be used when
modelling and forecasting future volatility of financial markets. The range and
complexity of methods applied to this problem is vast.

Historical volatility
Simply using all past information on past price movements does in fact utilise the
heteroskedastic properties of financial markets to some extent. By using the formula

1 N
σ= ( Rt − R) 2 (1)
N − 1 t =1

the assumption that all past prices have an equal relevance in the shaping of the
volatility of the future is applied. Intuitively this assumption is too crude as more recent
volatility is likely to have more relevance than that of several years ago and should

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Volatility Modeling – From ARMA to ARCH

hence be given a relatively higher weight in the calculation. A simple way to counter
this problem is done by only using the last 30 days to calculate the historical volatility
and this model is actually widely used by actors in the financial markets. The model
weighs volatility older than 30 days as 0 and puts equal weight on the volatility of the
last 30 days.
This model is however still crude and more sophisticated models are frequently used
moving into the area covered by models such as the Exponential Weighted Volatility
models.

II. Advanced Volatility Modelling Techniques

1. Autoregressive Models
To fully comprehend the GARCH model introduced by Bollerslev (1986) there should
be a clear understanding of the underlying assumptions and models from which
GARCH is derived. In its simplest form, an autoregressive model is a model in which
you use the statistical properties of the past behaviour of a variable y t to predict its

behaviour in the future. In other words, we can predict the value of the variable y t +1 by

looking at the sum of the weighted values that y t took in previous periods plus an error

term given by ε t . An autoregressive model with p lags, AR( p ), is given by

p
yt = µ + φ i y t −i + ε t (2)
i =1

where µ is the mean, φ is the weight and y t −i is the value y had t − i periods ago. We
may even want to forecast volatility based upon only the immediately previous value
of y t . Such a model is often referred to as an AR(1) or a first-order one process.

A simple linear combination of white noise processes that makes a variable y t

dependent on the current and previous values of a white noise disturbance term can be
given as

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Volatility Modeling – From ARMA to ARCH

q
yt= µ + θε t −i + ε t (3)
i =1

where µ is the mean, θ is the weight and ε t −i and ε t are the previous weighted
average values of a white noise disturbance term and the current disturbance term
respectively. This is referred to a moving average model or MA( q ). By combining
equations 2 and 4 we get a model or a tool for predicting future values of a variable y t

which is referred to as an autoregressive moving average model, or ARMA( p, q ). This

model states that the current value of some series y t depends linearly on its own
previous values (AR) plus a combination of current and previous values of a white noise
error term (MA). The ARMA( p, q ) model is given by

y t = φ1 y t −1 + ... + φ p y t − p + ε t − θ1ε t −1 − ... − θ q ε t − q (4)

2. The ARCH Model

Prior to the ARCH model introduced by Engle (1982), the most common way to
forecast volatility was to determine the standard deviation using a fixed number of the
most recent observations. As we know that the variance is not constant, i.e.
homoskedastic, but rather a heteroskedastic process, it is unattractive to apply equal
weights considering we know recent events are more relevant. Moreover, it is not
beneficial to assume zero weights for observations prior to the fixed timeframe. The
ARCH model overcomes these assumptions by letting the weights be parameters to be
estimated thereby determining the most appropriate weights to forecast the variance.

An ARCH(1) model, where the conditional variance depends only on one lagged square
error, is given by

σ t2 = α 0 + α 1ε t2−1 (5)

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Volatility Modeling – From ARMA to ARCH

We can capture more of the dependence in the conditional variance by increasing the
number of lags, p , giving us an ARCH( p ) model

σ t 2 = α 0 + α 1ε t2−1 + α 2ε t2− 2 ....α p ε t2− p (6)

We can illustrate the effect on the conditional variance when putting more emphasis on
the squared error term as shown in Figure 5.

Figure 5: Simulated Time Series with

different degrees of autoregression

Source: Gourieroux and Jasiak (2002)

As the image indicates, when we give little or no weight on the error term, the series is
completely random, or not autoregressive. As we approach one, however, we clearly see
how the time series becomes autoregressive where a period of large movements is often
followed by another period of movements with similar sizes. The bottom chart where 1

is set 0.8 can be considered as representing an actual stock return series most closely.

ARCH Shortcomings
Even though the ARCH model was useful at the time, it has its shortcomings. For
instance, we do not know how many lags, p , we should apply for the best results and
the potential number of lags required to capture all of the dependence in the conditional
variance could be very large thus making the model not very parsimonious or frugal.

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Volatility Modeling – From ARMA to ARCH

Intuitively, the more parameters we have in the model, the more likely it will be that
one of them will have a negative estimated value.

3. The GARCH Model

Unlike the ARCH model, the Generalized Autoregressive Centralized Heteroskedastic
model (GARCH), introduced by Bollerslev (1986) only has three parameters that allows
for an infinite number of squared errors to influence the current conditional variance.
This makes it much more parsimonious than the ARCH model which is why it is widely
employed in practice. Like the ARCH model, the conditional variance determined
through GARCH is a weighted average of past squared residuals. However, the weights
decline gradually but they never reach zero. Essentially, the GARCH model allows the
conditional variance to be dependent upon previous own lags.

In effect we can forecast the next period’s variance, examples of which will be shown
below (see also Engle, 2001), through the
Weighted average of the long run average variance (mean),
The variance predicted for this period (GARCH) and,
Information about volatility during the previous period which is the most recent
squared residual (ARCH).

The GARCH(1,1) model is given by

σ t2 = α 0 + α1ε t2−1 + βσ t2−1 (7)

where α 0 is the mean, ε t2−1 is the ARCH term and σ t2−1 is the GARCH term.

GARCH Shortcomings
The model only considers the magnitude of the returns, but not the direction. Investors
act differently depending on whether a share moves up or down which is why volatility
is not symmetric in relation to directional movements. Market declines forecast higher
volatility than comparable market increases. This is referred to as the leverage effect

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Volatility Modeling – From ARMA to ARCH

(see for example Gourieroux and Jasiak, 2002). Both ARCH and GARCH fail to
capture this fact and as such may not produce accurate forecasts. Recent models
building on ARCH and GARCH such as the Threshold ARCH (TARCH) model have
tried to overcome this problem.

4. ARCH-M
Most models used in finance suppose that investors should be rewarded for taking
additional risk by obtaining a higher return. The ARCH-M model is often used in
financial applications where the expected return on an asset is related to the expected
asset risk which itself is time-variant. The estimated coefficient on the expected risk is a
measure of the risk-return trade-off.

ARCH-M is given by

y t = α 1 + α 2 λt + α 3σ t2 + ε t (8)

If the Lambda is positive and significant, then increased risk, given by an increase in the
conditional variance, leads to a rise in the mean return. In other words, we may look at
Lambda as a risk premium.

III. Empirical Volatility Modelling

1. How to measure daily volatility

For the purpose of empirically modelling volatility we decided to choose a relatively
stable company as an example because we were expecting that this would lead to more
accurate forecasts. After looking at some charts, we decided to model the volatility of
General Electric (Ticker: GE) for the period 1990 to 2005. As we relied on publicly
available time series sources, we chose Yahoo Finance as a data source to obtain daily
prices. Yahoo Finance reports five different prices for each trading day: Open, High,
Low, Close, and Adjusted Close. Based on these prices we were faced with three
different choices on how to generate a daily volatility time series:

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Volatility Modeling – From ARMA to ARCH

• First, we could have taken the daily unadjusted close prices and computed the
day-to-day changes, either as logarithmic returns or as percentage returns. While
the choice for logarithmic or percentage returns is of minor importance for the
discussion here, the problem that the unadjusted close prices did not adjust for
stock splits and dividend payments was more severe. On the day of a 2:1
dividend split, the time series showed a percentage return change of more than
100% so that we quickly concluded that unadjusted close prices are
inappropriate for our needs
• Second, to circumvent the dividend and stock split issues we could have taken
the adjusted close prices as calculated by Yahoo Finance. In fact, we first used
this approach but later recognised that the created daily returns showed too
many large movements as can be seen in Figure 6. Two problems with Yahoo
Finance'
s adjusted close prices could be identified. First, Yahoo Finance takes
dividend payments into account at the day the dividend is paid, which results in
large positive returns for dividend payment dates. Second, as we went back in
time to 1990 the adjusted prices became very small, about $ 0.50. Since Yahoo
Finance only reports two decimals after the comma for each adjusted price, the
daily changes calculated were not very accurate.
• Third, the difference between the highest price of one day and the lowest price
of one day, expressed in percentage terms, can be used as a measure of
volatility. For the purpose of our project we believe that this method is most
appropriate because the issues described in the two previously discussed
methods can be circumvented. Consequently all our models and forecasts are
based on daily High-Low differences.

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Volatility Modeling – From ARMA to ARCH

Figure 6: GE daily price changes 1990 - 2005 based

on adjusted close prices of Yahoo Finance
0.15

0.10

0.05

0.00

-0.05

-0.10

-0.15
500 1000 1500 2000 2500 3000 3500

RETURN

Source: Yahoo Finance, adjusted close prices

2. Development of 30 Days Volatility

One assumption of earlier time series models such as autoregressive (AR) models or
autoregressive moving average (ARMA) models is that volatility is a constant term. To
assess to what extent in reality volatility is not constant and rather changing over time,
we computed the thirty day annual volatility of the General Electric time series
according to the following formula:

1 N
σ= (Ct − C ) 2 × 252 (9)
N − 1 t =1

where σ is the thirty day annual volatility, N is the number of days which was set to N =
30, Ct is the daily volatility, measured as High-Low price change and expressed in
percentage terms, and C is the daily mean volatility over the past thirty days.
Figures 7 and 8 show the movement of the 30 days volatility once for the period 1990 to
2005 and once for the period 2004 to 2005. Both figures reveal a strong up and down
movement of the volatility and it can be concluded that any model that assumes a
constant volatility for the shares of General Electric will necessarily be based on a
wrong assumption. One further interesting observation is that the 30 days volatility

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Volatility Modeling – From ARMA to ARCH

often forms plateaus where one day with a large movement has a persistent effect over
some time.

Figure 7: GE 30 Days Volatility 1990 - 2005

60%

50%

40%

30%

20%

10%

0%
90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05
19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20
Source: Yahoo Finance, Own Calculations

Figure 8: GE 30 Days Volatility 2004 - 2005

14%

12%

10%

8%

6%

4%

2%

0%
01/2004 04/2004 07/2004 10/2004 01/2005

Source: Yahoo Finance, Own Calculations

3. Modelling General Electric Shares with GARCH

Based on the previous discussion we modelled the volatility of General Electric'
s shares
as a GARCH process that takes changing volatility into account. We chose a relatively

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Volatility Modeling – From ARMA to ARCH

simple GARCH(1,1) process. All calculations were done with the computer program
EViews.
The process is divided into two steps. First, we estimate a model with an ARCH term
and a GARCH term based on the past data available. After fitting the model and
estimating the parameters we produce two forecasts. The first one forecasts the
volatility for 2005 based on our data set from 1990 to 2004. We compare this forecast to
actual volatility and implied volatility to assess how accurate the GARCH forecast was.
The second forecast is based on the whole data set available, i.e. 1990 to March 2005
and forecasts the volatility one month in advance for April 2005.
Figure 9 that shows a simplified output of the GARCH model reveals the following
findings. First, all estimated parameters are highly significant as can be seen in the last
column (Prob). Second, the ARCH(1) and GARCH(1) coefficients are very close to one
when added together. This means that the time series has a strong autoregressive
component and that the GARCH model might be appropriate.

Figure 9: EViews GARCH Model Output (simplified)

GE
Sample(adjusted): 2 3828
01/01/1990 - 07/03/2005

Coefficient Std. Error z-Statistic Prob.

C 0.017643 0.000162 108.7502 0.0000
Variance Equation
C 1.24E-06 2.33E-07 5.344111 0.0000
ARCH(1) 0.089516 0.004214 21.24374 0.0000
GARCH(1) 0.907963 0.003604 251.9385 0.0000

4. Forecasting Volatility with the GARCH Model

Based on our estimated model we now forecast volatility for two different forecast
horizons as described previously.
Figure 10 shows the dynamic volatility forecast for 2005 based on the data set 1990 to
2004. The starting point (3785) represents Jan 1st 2005 and the last point (3828)

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Volatility Modeling – From ARMA to ARCH

represents March 7th 2005. Clearly, volatility is expected to increase over the forecast
horizon from approximately 14.5 per cent to over 17 per cent.

Figure 10: EViews Dynamic Volatility Forecast 2005

0.18

0.17

0.16

0.15

0.14
3785 3790 3795 3800 3805 3810 3815 3820 3825

VOL

Figure 11 shows that volatility for March 7th is predicted to be 17.74 per cent.
Compared to other predictions such as exponentially weighted volatility, the figure is
rather high. When the GARCH forecast is compared to implied volatility that is derived
from options the estimate is still too high, although to a smaller extent when compared
to exponentially weighted volatility. However, the actual volatility for March 7th that
was available as of the writing of this report was only 11.53 per cent and much lower
than any predictions. This can be explained with historically very low volatility levels in
2005. The GARCH model that took the volatility for 1990 to 2004 into account
overestimated the true volatility because the higher past volatility was still taken into
account in the autoregressive process.
To see how the GARCH model would perform if the low volatility levels in 2005 were
taken into account we produced a second forecast for April 2005 based on the data
available up to March 7th 2005. From Figure 12 it can be seen that the GARCH model
took lower volatility levels into account and that the predicted volatility of 14.92 per
cent is closer to the actual volatility of 15.46 per cent. Clearly, the GARCH model was
able to capture the low volatility levels in 2005 and although the forecast is still

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Volatility Modeling – From ARMA to ARCH

approximately half a percentage point wrong the GARCH model produced a more
accurate forecast for April 2005 than the exponentially weighted model.

Figure 11: Volatility Estimated for March 7th

Predicted Volatility (GARCH) 17.74%

Predicted Volatility (Exp. Weighted) 12.94%
Implied Volatility (ivolatility.com) 15.39%

Actual Volatility (30d) 11.52%

Figure 12: Volatility Estimated for April 7th

Predicted Volatility (GARCH) 14.92%

Predicted Volatility (Exp. Weighted) 14.19%

Actual Volatility (30d) 15.46%

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Volatility Modeling – From ARMA to ARCH

References

Bollerslev, Tim (1986) Generalized autoregressive conditional heteroskedasticity,

Journal of Econometrics, 31, pp. 307-328.

Engle, Robert F. (1982), Autoregressive Conditional Heteroskedasticity with Estimates

of the Variance of United Kingdom Inflation, Econometrica 50:4, pp. 987–1007.

Engle, Robert F. (2001), GARCH 101: The Use of ARCH/GARCH Models in Applied
Econometrics, Journal of Economic Perspectives, 15, pp. 157-168.

Gourieroux, Christian, and Joann Jasiak (2002), Financial Econometrics: Problems,

Models, and Methods, pp. 137-138, Princeton University Press

Mandelbrot, Benoit (2002), The (Mis)behavior of Markets, Basic Books

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