# Autoregressive conditional heteroskedasticity

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In econometrics, **autoregressive conditional heteroskedasticity** (ARCH) models are used to characterize and model observed time series. They are used whenever there is reason to believe that, at any point in a series, the error terms will have a characteristic size or variance. In particular ARCH models assume the variance of the current error term or innovation to be a function of the actual sizes of the previous time periods' error terms: often the variance is related to the squares of the previous innovations.

Such models are often called **ARCH** models (Engle, 1982),^{[1]} although a variety of other acronyms are applied to particular structures of model which have a similar basis. ARCH models are employed commonly in modeling financial time series that exhibit time-varying volatility clustering, i.e. periods of swings followed by periods of relative calm. ARCH-type models are sometimes considered to be part of the family of stochastic volatility models but strictly this is incorrect since at time *t* the volatility is completely pre-determined (deterministic) given previous values.^{[2]}

## Contents

## ARCH(*q*) model Specification

Suppose one wishes to model a time series using an ARCH process. Let denote the error terms (return residuals, with respect to a mean process), i.e. the series terms. These are split into a stochastic piece and a time-dependent standard deviation characterizing the typical size of the terms so that

The random variable is a strong white noise process. The series is modelled by

where and .

An ARCH(*q*) model can be estimated using ordinary least squares. A methodology to test for the lag length of ARCH errors using the Lagrange multiplier test was proposed by Engle (1982). This procedure is as follows:

- Estimate the best fitting autoregressive model AR(
*q*) . - Obtain the squares of the error and regress them on a constant and
*q*lagged values:- where
*q*is the length of ARCH lags.

- where
- The null hypothesis is that, in the absence of ARCH components, we have for all . The alternative hypothesis is that, in the presence of ARCH components, at least one of the estimated coefficients must be significant. In a sample of
*T*residuals under the null hypothesis of no ARCH errors, the test statistic*T'R²*follows distribution with*q*degrees of freedom, where is the number of equations in the model which fits the residuals vs the lags (i.e. ). If*T'R²*is greater than the Chi-square table value, we*reject*the null hypothesis and conclude there is an ARCH effect in the ARMA model. If*T'R²*is smaller than the Chi-square table value, we*do not reject*the null hypothesis.

## GARCH

If an autoregressive moving average model (ARMA model) is assumed for the error variance, the model is a **generalized autoregressive conditional heteroskedasticity** (**GARCH**), Bollerslev (1986)) model.

In that case, the GARCH (*p*, *q*) model (where *p* is the order of the GARCH terms and *q* is the order of the ARCH terms ), following the notation of original paper is given by

Generally, when testing for heteroskedasticity in econometric models, the best test is the White test. However, when dealing with time series data, this means to test for ARCH errors (as described above) and GARCH errors (below).

Exponentially weighted moving average (EWMA) is an alternative model in a separate class of exponential smoothing models. It can be an alternative to GARCH modelling as it has some attractive properties such as a greater weight upon more recent observations but also some drawbacks such as an arbitrary decay factor that introduce subjectivity into the estimation.

### GARCH(*p*, *q*) model specification

The lag length *p* of a GARCH(*p*, *q*) process is established in three steps:

- Estimate the best fitting AR(
*q*) model- .

- Compute and plot the autocorrelations of by
- The asymptotic, that is for large samples, standard deviation of is . Individual values that are larger than this indicate GARCH errors. To estimate the total number of lags, use the Ljung-Box test until the value of these are less than, say, 10% significant. The Ljung-Box Q-statistic follows distribution with
*n*degrees of freedom if the squared residuals are uncorrelated. It is recommended to consider up to T/4 values of*n*. The null hypothesis states that there are no ARCH or GARCH errors. Rejecting the null thus means that such errors exist in the conditional variance.

## NGARCH

Nonlinear GARCH (NGARCH) also known as Nonlinear Asymmetric GARCH(1,1) (NAGARCH) was introduced by Engle and Ng in 1993.

.

For stock returns, parameter is usually estimated to be positive; in this case, it reflects the leverage effect, signifying that negative returns increase future volatility by a larger amount than positive returns of the same magnitude.^{[3]}^{[4]}

This model shouldn't be confused with the NARCH model, together with the NGARCH extension, introduced by Higgins and Bera in 1992.^{[clarification needed]}

## IGARCH

Integrated Generalized Autoregressive Conditional Heteroskedasticity IGARCH is a restricted version of the GARCH model, where the persistent parameters sum up to one, and therefore there is a unit root in the GARCH process. The condition for this is

.

## EGARCH

The **exponential generalized autoregressive conditional heteroskedastic** (EGARCH) model by Nelson (1991) is another form of the GARCH model. Formally, an EGARCH(p,q):

where , is the conditional variance, , , , and are coefficients, and may be a standard normal variable or come from a generalized error distribution. The formulation for allows the sign and the magnitude of to have separate effects on the volatility. This is particularly useful in an asset pricing context.^{[5]}

Since may be negative there are no (fewer) restrictions on the parameters.

## GARCH-M

The GARCH-in-mean (GARCH-M) model adds a heteroskedasticity term into the mean equation. It has the specification:

The residual is defined as

## QGARCH

The Quadratic GARCH (QGARCH) model by Sentana (1995) is used to model asymmetric effects of positive and negative shocks.

In the example of a GARCH(1,1) model, the residual process is

where is i.i.d. and

## GJR-GARCH

Similar to QGARCH, The Glosten-Jagannathan-Runkle GARCH (GJR-GARCH) model by Glosten, Jagannathan and Runkle (1993) also models asymmetry in the ARCH process. The suggestion is to model where is i.i.d., and

where if , and if .

## TGARCH model

The Threshold GARCH (TGARCH) model by Zakoian (1994) is similar to GJR GARCH, and the specification is one on conditional standard deviation instead of conditional variance:

where if , and if . Likewise, if , and if .

## fGARCH

Hentschel's **fGARCH** model,^{[6]} also known as **Family GARCH**, is an omnibus model that nests a variety of other popular symmetric and asymmetric GARCH models including APARCH, GJR, AVGARCH, NGARCH, etc.

## COGARCH

In 2004, Claudia Klüppelberg, Alexander Lindner and Ross Maller proposed a continuous-time generalization of the discrete-time GARCH(1,1) process. The idea is to start with the GARCH(1,1) model equations

and then to replace the strong white noise process by the infinitesimal increments of a Lévy process , and the squared noise process by the increments , where

is the purely discontinuous part of the quadratic variation process of . The result is the following system of stochastic differential equations:

where the positive parameters , and are determined by , and . Now given some initial condition , the system above has a pathwise unique solution which is then called the continuous-time GARCH (**COGARCH**) model.^{[7]}

## References

- ↑
**Lua error in Module:Citation/CS1/Identifiers at line 47: attempt to index field 'wikibase' (a nil value).** - ↑ Brooks, Chris (2014).
*Introductory Econometrics for Finance*(3rd ed.). Cambridge: Cambridge University Press. p. 461. ISBN 9781107661455.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles> - ↑
**Lua error in Module:Citation/CS1/Identifiers at line 47: attempt to index field 'wikibase' (a nil value).** - ↑ Posedel, Petra (2006). "Analysis Of The Exchange Rate And Pricing Foreign Currency Options On The Croatian Market: The Ngarch Model As An Alternative To The Black Scholes Model" (PDF).
*Financial Theory and Practice*.**30**(4): 347–368.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles> - ↑
**Lua error in Module:Citation/CS1/Identifiers at line 47: attempt to index field 'wikibase' (a nil value).** - ↑
- ↑

## Further reading

- Bollerslev, Tim (2008). "Glossary to ARCH (GARCH)" (PDF).
*working paper*.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles> - Enders, W. (2004). "Modelling Volatility".
*Applied Econometrics Time Series*(Second ed.). John-Wiley & Sons. pp. 108–155. ISBN 0-471-45173-8.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles> *(the paper which sparked the general interest in ARCH models)*- Engle, Robert F. (1995).
*ARCH: selected readings*. Oxford University Press. ISBN 0-19-877432-X.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles> *(a short, readable introduction)*- Gujarati, D. N. (2003).
*Basic Econometrics*. pp. 856–862.<templatestyles src="Module:Citation/CS1/styles.css"></templatestyles>