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I am fitting numerically an AR(1)/GARCH(1,1) process to index and stock log-returns, $r_t=\log(P_t/P_{t-1})$, where $P_t$ is the price at time $t$, and thus far am not clear on where the observed log returns would be used in an algorithm. Several author groups have described (some in part) the components of the AR(1)/GARCH(1,1) approach, for example:

E. Zivot: $$ r_t=\mu + \phi (r_{t-1} - \mu ) + \epsilon_t $$

Rachev et al: $$ \begin{split} r_t&=\mu+\phi r_{t-1}\\ \epsilon_t&=\sigma_t \delta_t \quad \quad (\delta_t \textrm{ is an innovation})\\ \sigma_t &= \sqrt{\alpha_0 + \alpha_1 \epsilon_{t-1}^2 + \beta_1 \sigma_{t-1}^2}\\ \end{split} $$

Brummelhuis & Kaufman: $$ \begin{split} X_t&=\mu_t+ \sigma_t \epsilon_t\\ \mu_t&=\lambda X_{t-1}\\ \sigma_t &= \sqrt{\alpha_0 + \alpha_1 (X_{t-1}-\mu_{t-1})^2 + \beta_1 \sigma_{t-1}^2}\\ \end{split} $$

Jalal & Rockinger: $$ \begin{split} \mu_t&=\phi X_{t-1}\\ \epsilon_t &=X_t - \mu_t\\ \sigma_t &= \sqrt{\alpha_0 + \alpha_1 \epsilon_{t-1}^2 + \beta_1 \sigma_{t-1}^2}\\ \end{split} $$

My approach:

$$ \begin{split} \mu_t&=\mu+\phi r_{t-1}\\ \epsilon_t&=r_t - \mu_t\\ \sigma_t &= \sqrt{\alpha_0 + \alpha_1 \epsilon_{t-1}^2 + \beta_1 \sigma_{t-1}^2}\\ \end{split} $$

Given the multiple descriptions above, my interpretation for an algorithm would be:

Algorithm for AR(1)/GARCH(1,1):

  1. Initialize $\mu=0$, $\sigma_1 = 1$, $\epsilon_1=0$, $\mu=\phi=\alpha_0=\alpha_1=\beta_1=U(0,1)* 0.01$
  2. For $t$ = 2 to $T$:
  3. $\quad \mu_t = \mu + \phi r_{t - 1}\quad \quad (\textrm{Log-returns lag-1 input here})$
  4. $\quad \epsilon_t = r_t - \mu_t \quad \quad (\textrm{Log-returns lag-0 input here})$
  5. $\quad \sigma_t= \sqrt{\alpha_0 + \alpha_1 \epsilon_{t-1}^ 2 + \beta_1 \sigma_{t - 1} ^ 2}$

  6. $\quad \hat{r}_t = \phi \mu_{t - 1} + \sigma_t \epsilon_t \quad \quad \textrm{OR}: \hat{r}_t = \mu + \phi \mu_{t - 1} + \sigma_t \epsilon_t \quad \quad ???$

  7. Next $t$
  8. Calculate residual, $e_t=r_t-\hat{r}_t$
  9. Determine $MSE=\frac{1}{T}\sum_t e_t^2$

The algorithm proposed above is essentially the recursive part to calculate the predicted log-returns $\hat{r}_t$ from the input observed returns $r_t$. Innovations or random quantiles from a probability distribution [such as N(0,1) or $t(\nu)$] would not be employed here since we are fitting a model, not simulating. During each iteration, the goodness-of-fit based on proposed parameters for the objective function would be based on $MSE=\frac{1}{T}\sum_t e_t$, which would be minimized via an optimization technique using non-linear regression, finite differencing, or MLE. Metaheuristics could be used as well where initialization of chromosome (particle) values for $(\mu,\phi,\alpha_0,\alpha_1,\beta_1)$ would occur at the first generation.

In terms of comparing results based R, MATLAB, SAS, etc. the parameterization would be:

mu=$\mu$

ar1=$\phi$

garch0=$\alpha_0$

garch1=$\alpha_1$

garch2=$\beta_1$

I am not sure whether the unconditional mean $\mu$ would be needed in line 6 of the algorithm, however. Please comment on correctness of the algorithm, and possibly suggest coding changes. Again, the goal is to algorithmically use numerical methods to solve for the parameters, not R, MATLAB, or SAS, etc.

SOLUTION: Let $r_t$ be the log-return at time $t$, and $\hat{r}_t$ be the predicted log-return from the regression model.

  1. Initialize $loglik=0$,$\epsilon_1=0$, $\sigma_1 = 0$, $\mu=U(0,1)*0.0001,\phi=U(0,1)*0.01$ $\alpha_0=U(0,1)*0.00002,\alpha_1=U(0,1)*0.01,\beta_1=0.9 + U(0,1)* 0.01$
  2. For $t$ = 2 to $T$:
  3. $ \quad \hat{r}_t = \mu + \phi r_{t - 1}$
  4. $ \quad \epsilon_t = r_t - \hat{r}_t$
  5. $ \quad \sigma^2_t = \alpha_0 + \alpha_1 \epsilon_{t-1} ^ 2 + \beta_1 \sigma_{t-1} ^ 2$
  6. Next $t$

At each iteration $b$, calculate the log-likelihood function below using the parameter values at that iteration: $LL_b = \sum_t^T \left\{ - \frac{1}{2} \log(\sigma^2_t) - \frac{1}{2}\epsilon_t^2 / \sigma^2_t \right\} $

Maximize the $LL$ over the $B$ iterations, that is, ensure it increases during iterations.

Parameter results:

$\mu=0.000745264$

$\phi=-0.110093524$

$\alpha_0=0.00000401$

$\alpha_1=0.117396192$

$\beta_1=0.849342676$

Below is a plot of the fitted SP500 index (Yahoo ^GSPC) volatility, $\sigma_t$, for dates 1/2/2001 to 10/31/2013. The subprime mortgage crisis in 2008 and debt ceiling in 2011 are very visible.

Fitted SP500 volatility, $\sigma_t$, from 2001 to 2013

In addition, below is a plot of the observed (input) log-returns, $r_t$, and predicted GARCH-filtered returns, $\hat{r}_t$, revealing that volatility clustering was removed. GARCH-filtered SP500 log-returns

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Nice post! Very useful. –  user847663 Dec 29 '13 at 16:35

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