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Reading Material - Module-3 - Introduction To Time Series Analysis

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Reading Material - Module-3 - Introduction To Time Series Analysis

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sitaramr54
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Financial Analytics

FINANCIAL ANALYTICS
Curated by Kiran Kumar K V

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

Content Structure

1. Introduction to Financial Analytics


1.1. Different Applications of Financial Analytics
1.2. Overview of sources of Financial Data
1.3. Overview of Bonds, Stocks, Securities Data Cleansing
2. Statistical aspects of Financial Time Series Data
2.1. Plots of Financial Data (Visualizations)
2.2. Sample Mean, Standard Deviation, and Variance
2.3. Sample Skewness and Kurtosis
2.4. Sample Covariance and Correlation
2.5. Financial Returns
2.6. Capital Asset Pricing Model
2.7. Understanding distributions of Financial Data
3. Introduction to Time Series Analysis
3.1. Examining Time Series
3.2. Stationary Time Series
3.3. Auto-Regressive Moving Average Processes
3.4. Power Transformations
3.5. Auto-Regressive Integrated Moving Average Processes
3.6. Generalized Auto-Regressive Conditional
Heteroskedasticity
4. Portfolio Optimization and Analytics
4.1. Optimal Portfolio of Two Risky Assets
4.2. Data Mining with Portfolio Optimization
4.3. Constraints, Penalization, and the Lasso
4.4. Extending to Higher Dimensions
4.5. Constructing an efficient portfolio
4.6. Portfolio performance evaluation
5. Introduction to special topics
5.1. Credit Default using classification algorithms
5.2. Introduction to Monte Carlo simulation
5.3. Sentiment Analysis in Finance
5.4. Bootstrapping and cross validation
5.5. Prediction using fundamentals
5.6. Simulating Trading Strategies

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

Module-3: Introduction to Time Series Analysis

1. Examining Time Series


Time series data refers to a collection of observations or measurements recorded over
successive time intervals. In simpler terms, it's data that is gathered or measured sequentially
over time. Each data point in a time series is associated with a specific time stamp or period,
which could be regular (e.g., daily, monthly, yearly) or irregular (e.g., timestamps based on
events).
Time series data can be found in various fields and domains, including finance, economics,
meteorology, signal processing, engineering, social sciences, and more. Some common
examples of time series data include:
 Stock prices - Daily closing prices of a company's stock over a period of time.
 Temperature recordings - Hourly temperature measurements at a weather station
over several days.
 Economic indicators - Quarterly GDP growth rates over several years.
 Sales data - Monthly sales figures of a product over multiple years.
 Sensor readings - Time-stamped measurements from sensors monitoring
environmental conditions, machinery performance, or industrial processes.
Analyzing time series data involves understanding patterns, trends, seasonality, and
irregularities within the data to extract useful insights and make predictions about future
behavior. Techniques such as time series decomposition, autocorrelation analysis, and
forecasting models like ARIMA (Auto-Regressive Integrated Moving Average) and
exponential smoothing are commonly used in time series analysis to uncover underlying
patterns and make predictions.
Time series data is a rich source of information that captures the dynamics and behavior of a
phenomenon over time. Whether it's financial markets, weather patterns, or economic
indicators, analyzing time series data is essential for understanding past trends, predicting
future behavior, and making informed decisions. The examination of time series data typically
involves a multi-faceted approach aimed at uncovering underlying patterns, trends,
seasonality, and irregularities.
Visual Inspection
Visual examination is often the first step in analyzing time series data. It provides an intuitive
understanding of the data and can reveal important features. Various graphical techniques
can be employed for visual inspection -
 Line plots - These plots display the data points against time, allowing analysts to observe
trends and fluctuations.
 Scatter plots - Useful for identifying relationships between variables over time,
particularly in multivariate time series data.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

 Histograms - Histograms depict the distribution of values in the time series, providing
insights into the data's central tendency and dispersion.
 Autocorrelation plots - Autocorrelation measures the correlation between a time series
and a lagged version of itself. Autocorrelation plots help identify patterns such as
seasonality and cyclical behavior.
Identifying Patterns and Trends
Patterns and trends in time series data can provide valuable insights into the underlying
processes driving the data. Common patterns include:
 Trend - The long-term movement or directionality of the data. Trends can be increasing,
decreasing, or stable over time.
 Seasonality - Regular, periodic fluctuations in the data that occur at fixed intervals, such
as daily, weekly, or yearly patterns.
 Cyclical behavior - Non-periodic fluctuations in the data that occur over longer time
frames, often associated with economic cycles or other recurring phenomena.
 Irregularities - Random fluctuations or noise in the data that are not explained by trends,
seasonality, or cyclical patterns.

2. Stationary Time Series


Stationarity is a fundamental concept in time series analysis that describes the behavior of a
series over time. A stationary time series is one where the statistical properties, such as mean,
variance, and autocovariance, remain constant over time. This means that the series exhibits
a consistent behavior and does not display any systematic changes or trends.
Characteristics of Stationary Time Series
 Constant Mean - A stationary time series has a mean that remains constant over time.
This implies that, on average, the data points in the series do not show any upward or
downward trend.
 Constant Variance - The variance of a stationary time series is also constant across
different time periods. There are no systematic changes in the dispersion or variability of
the data points.
 Constant Autocovariance - Autocovariance measures the linear dependency between
observations at different time lags. In a stationary time series, the autocovariance structure
remains consistent over time, indicating that the relationship between past and future
observations does not change.
Non-Stationary Time Series
In contrast to stationary time series, non-stationary time series exhibit varying statistical
properties over time. Common characteristics of non-stationary time series include:
 Trends - Non-stationary series may display long-term trends, where the mean of the series
changes systematically over time. Trends can be increasing, decreasing, or periodic in
nature.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

 Seasonality - Seasonal effects refer to regular, repeating patterns in the data that occur
at fixed intervals, such as daily, weekly, or yearly cycles. Non-stationary series may exhibit
seasonality, leading to variations in mean and variance across different time periods.
 Other Time-Dependent Structures - Non-stationary series may also display other time-
dependent structures, such as cyclical behavior or irregular fluctuations.
Transformations to Achieve Stationarity
When dealing with non-stationary time series data, transformations can be applied to make
the series stationary. One common transformation technique is differencing, which involves
computing the difference between consecutive observations. By removing trends and
seasonality through differencing, the resulting series may exhibit stationarity.
 First-order differencing - Computes the difference between each observation and its
immediate predecessor.
 Higher-order differencing - In cases of higher-order trends or seasonality, multiple
difference operations may be necessary to achieve stationarity.
Importance of Stationarity
Stationarity is important in time series analysis for several reasons:
 Many statistical techniques and models assume stationarity to produce accurate results.
For example, classic time series models like ARMA (Auto-Regressive Moving Average)
require stationary data.
 Stationarity simplifies the analysis by providing a stable framework for interpreting the
data and making predictions.
 Stationarity allows for meaningful comparisons between different time periods and
facilitates the identification of underlying patterns and relationships within the data.

3. Auto-Regressive Moving Average Processes (ARMA)


ARMA models are essential tools in time series analysis for modeling stationary data with
both autoregressive (AR) and moving average (MA) components. These models provide a
flexible framework for capturing the complex dynamics and dependencies present in time
series data.
Autoregressive (AR) Process
The autoregressive component of an ARMA model captures the relationship between an
observation at time t and a number of lagged observations. In an AR(p) process, the current
value of the time series is modeled as a linear combination of its p most recent observations,
along with an error term:

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

Moving Average (MA) Process


The moving average component of an ARMA model captures the relationship between an
observation at time t and a linear combination of past error terms (residuals) from a moving
average model. In an MA(q) process, the current value of the time series is modeled as a linear
combination of its q most recent error terms:

ARMA Model
Combining the autoregressive and moving average components, an ARMA(p, q) model can
be expressed as the sum of an AR(p) process and an MA(q) process:

Model Selection and Estimation


Selecting appropriate values for the AR and MA orders (p and q) is crucial in ARMA modeling.
This selection process often involves analyzing autocorrelation and partial autocorrelation
plots to identify the orders that best capture the underlying patterns in the data. Once the
orders are determined, model parameters (coefficients) are estimated using methods such as
maximum likelihood estimation (MLE) or least squares estimation.
Forecasting and Prediction
Once an ARMA model is fitted to the data, it can be used for forecasting future values of the
time series. Forecasts are typically generated by recursively applying the estimated model to
predict one-step ahead values. Confidence intervals for the forecasts can also be calculated
to assess the uncertainty associated with the predictions.

4. Power Transformations
Power transformations are a valuable technique used in time series analysis to stabilize the
variance of a series, especially when the variance is not constant across different levels of the
mean. By transforming the data using a power function, power transformations can help
address issues such as heteroscedasticity and non-normality, making the data more amenable
to analysis and modeling.
Motivation for Power Transformations
In many time series datasets, the variability of the observations may change as the mean of
the series changes. This phenomenon, known as heteroscedasticity, violates the assumption
of constant variance required by many statistical techniques. Additionally, non-normality in
the data distribution can affect the validity of statistical tests and inference procedures. Power

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

transformations offer a solution by modifying the data distribution to achieve constant


variance and approximate normality.
Box-Cox Transformation
The Box-Cox transformation is a widely used method for power transformations in time series
analysis. It involves raising the original data to a power parameter λ, which can be estimated
from the data. The transformed data follows the formula:

Estimating λ
The choice of the power parameter λ is crucial in the Box-Cox transformation and can
significantly impact the effectiveness of the transformation. Common methods for estimating
λ include maximum likelihood estimation (MLE), which seeks to maximize the likelihood
function of the transformed data, and graphical techniques such as the profile likelihood plot
or the Box-Cox plot.
Interpretation and Application
 λ > 1: Indicates a positive transformation, where the data is raised to a power greater than
1. This compresses lower values and stretches higher values, often used to stabilize
variance in data with right-skewed distributions.
 λ = 1: Represents a natural logarithm transformation, useful for stabilizing variance and
approximating normality in data with exponential growth patterns.
 0 < λ < 1: Indicates a fractional transformation, commonly used to stabilize variance in
data with left-skewed distributions.
Considerations and Limitations
 The Box-Cox transformation assumes that the data values are strictly positive. For data
containing zero or negative values, alternative transformations may be necessary.
 The choice of λ should be guided by both statistical considerations and domain
knowledge, as overly aggressive transformations can distort the interpretation of the data.
 The effectiveness of the transformation should be assessed through diagnostic checks,
such as examining residual plots or conducting statistical tests for normality and
homoscedasticity.

5. Auto-Regressive Integrated Moving Average Processes (ARIMA)


ARIMA (Auto-Regressive Integrated Moving Average) models are powerful tools in time series
analysis for modeling and forecasting non-stationary data. They extend the capabilities of
ARMA models by incorporating differencing to handle non-stationarity, making them suitable
for a wide range of time series datasets exhibiting trends or other time-dependent structures.
Components of ARIMA

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

ARIMA models consist of three main components:


 Auto-Regressive (AR) component - This component captures the linear relationship
between an observation and a specified number of lagged observations. The order of the
AR component, denoted by p, indicates the number of lagged observations included in
the model.
 Integrated (I) component - The integrated component refers to differencing applied to
the original time series data to achieve stationarity. The degree of differencing, denoted
by d, represents the number of times differencing is performed to make the series
stationary.
 Moving Average (MA) component - The MA component models the dependency
between an observation and a linear combination of past error terms (residuals). The order
of the MA component, denoted by q, indicates the number of past error terms included
in the model.
Stationarity and Differencing
The 'I' in ARIMA signifies the integrated component, highlighting the role of differencing in
achieving stationarity. Differencing involves computing the difference between consecutive
observations to remove trends and other time-dependent structures from the data. By
iteratively differencing the series until it becomes stationary, ARIMA models can effectively
handle non-stationary data.
Model Specification
Specifying an ARIMA model involves determining appropriate values for the three
parameters: p, d, and q. This selection process often involves visual inspection of the data,
autocorrelation and partial autocorrelation analysis, and diagnostic tests for stationarity.
 The autoregressive order (p) captures the number of lagged observations included in the
model.
 The degree of differencing (d) indicates the number of times differencing is applied to
achieve stationarity.
 The moving average order (q) represents the number of past error terms included in the
model.
Model Estimation and Forecasting
Once the ARIMA model parameters are determined, the model can be estimated using
methods such as maximum likelihood estimation (MLE) or least squares estimation. Once
fitted, the ARIMA model can be used for forecasting future values of the time series.
Forecasting involves recursively applying the estimated model to predict future observations,
incorporating the autoregressive, differencing, and moving average components.
Limitations and Considerations
 ARIMA models assume linear relationships between variables and may not capture non-
linear dependencies present in the data.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

 Careful selection of model parameters is essential, as overly complex models may lead to
overfitting, while overly simple models may fail to capture important patterns in the data.
 Interpretation of ARIMA model results should be done cautiously, considering the
assumptions and limitations of the model.
Python Project
Let’s create a python project that generates an ARIMA model for a security:

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

The output & the interpretations are discussed below:

The Durbin-Watson Test Statistic value of 3.0786708200908914, which falls between the range
of 0 to 4, indicates the degree of autocorrelation present in the differenced data.
The Durbin-Watson test statistic ranges between 0 and 4, with a value close to 2 indicating
no autocorrelation. Values significantly below 2 indicate positive autocorrelation (i.e.,
consecutive observations are correlated), while values significantly above 2 indicate negative
autocorrelation (i.e., consecutive observations are negatively correlated).
In this case, the test statistic is close to 2, which suggests that there is little to no
autocorrelation present in the differenced data. A value of 3.0786708200908914 indicates a
mild positive autocorrelation, but it's close enough to 2 that it's often considered acceptable.
Therefore, the differenced data is likely adequately stationary for further analysis.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

For the ACF (Autocorrelation Function) plot of the Price Data, the correlation lines at all lag
levels being close to 1 indicate a strong positive autocorrelation, suggesting that each
observation in the time series is highly correlated with its neighboring observations. However,
the slowly decaying nature of these correlations indicates that while there is a strong
correlation between adjacent observations, this correlation diminishes as the time lag
increases. This implies that while recent prices heavily influence each other, the influence
gradually diminishes as we move further back in time.
Regarding the PACF (Partial Autocorrelation Function) plot of the Price Data, the high values
of lag-0 and lag-1, both close to 1, suggest strong partial autocorrelation at these lags. This
indicates that each observation in the time series is significantly influenced by its immediate
predecessor and the one just before it. Additionally, all other partial autocorrelations being
close to 0 and falling within the significance range (represented by the shaded blue area)
indicate that once we account for the influence of these immediate predecessors, the
influence of other observations becomes minimal and not statistically significant. This
suggests that the current observation is predominantly influenced by its recent past, with
diminishing influence from observations further back in time.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

The line plot of the stock returns illustrates a consistent level of volatility throughout the
analyzed period, characterized by fluctuations in returns around the mean. However, there
appears to be a notable increase in volatility during the initial period, marked by a spike in
the amplitude of fluctuations. This spike indicates a period of heightened variability in returns,
suggesting that significant market events or factors may have influenced stock performance
during that time.
In terms of stationarity, the visualization suggests that the data may not be entirely stationary.
Stationarity in a time series context typically refers to the statistical properties of the data
remaining constant over time, such as constant mean and variance. While the overall pattern
of returns shows relatively steady volatility, the spike in volatility during the initial period
suggests a departure from stationarity. Stationarity assumptions are crucial for many time
series analysis techniques, such as ARIMA modeling, as violations of stationarity can lead to
unreliable model results. Therefore, further investigation and potentially applying
transformations or differencing techniques may be necessary to achieve stationarity in the
data before proceeding with analysis.

The results of the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin


(KPSS) tests provide insights into the stationarity of the data.
The ADF test statistic is highly negative, indicating a strong rejection of the null hypothesis.
In the ADF test, the null hypothesis assumes the presence of a unit root, implying non-
stationarity in the data. The large negative ADF statistic, coupled with a very small p-value
(1.8709338021395687e-22), suggests that we can reject the null hypothesis of non-
stationarity. This indicates that the data is likely stationary.
The KPSS test statistic is relatively low, and the associated p-value is above the typical
significance level of 0.05. In the KPSS test, the null hypothesis assumes stationarity in the data,
while the alternative hypothesis suggests non-stationarity. With a test statistic of
0.029057279397134206 and a p-value of 0.1, we fail to reject the null hypothesis of
stationarity. This further supports the evidence from the ADF test, indicating that the data is
likely stationary.
Overall, the results from both tests suggest that the data is stationary. However, it's worth
noting that the ADF test is more commonly used for testing stationarity in finance and time
series analysis. Therefore, the strong rejection of the null hypothesis in the ADF test carries
more weight in this context.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

The output represents the results of a stepwise search to find the best ARIMA model order
that minimizes the Akaike Information Criterion (AIC), a measure used for model selection.
Each line in the output corresponds to a different ARIMA model that was evaluated during
the search.
Here's an interpretation of the output:
 ARIMA(p,d,q)(P,D,Q)[m] - This notation represents the parameters of the ARIMA model,
where 'p' denotes the number of autoregressive (AR) terms, 'd' denotes the degree of
differencing, 'q' denotes the number of moving average (MA) terms, 'P', 'D', and 'Q' denote
seasonal AR, differencing, and MA terms, respectively, and 'm' denotes the seasonal
period.
 AIC - The Akaike Information Criterion is a measure of the relative quality of a statistical
model for a given set of data. Lower AIC values indicate better-fitting models.
 Time - The time taken to fit the respective ARIMA model.
 Best model - The ARIMA model with the lowest AIC value, which indicates the best-fitting
model according to the stepwise search.
 Best ARIMA Model Order - This indicates the order of the best-fitting ARIMA model, in this
case, (4, 0, 5), suggesting that the model includes four AR terms, no differencing, and five
MA terms.
 Total fit time - The total time taken for the entire stepwise search process.
In this output, the best-fitting ARIMA model order is (4, 0, 5), meaning it includes four AR
terms, no differencing, and five MA terms. This model achieved the lowest AIC value among
all the tested models, indicating its superiority in capturing the underlying patterns in the
data. However, it's essential to further evaluate the model's performance using diagnostic
checks to ensure its adequacy for forecasting purposes.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

The provided output represents the results of fitting a SARIMAX (Seasonal AutoRegressive
Integrated Moving Average with eXogenous regressors) model to the data.
Here's an interpretation of the key components of the output:
 Dep. Variable - This indicates the dependent variable used in the model, which in this case
is "Adj Close" representing adjusted closing prices of the stock.
 No. Observations - The number of observations used in the model, which is 989.
 Model - Specifies the type of model used. In this case, it's an ARIMA(4, 0, 5) model,
indicating four autoregressive (AR) terms, no differencing (d = 0), and five moving average
(MA) terms.
 Log Likelihood - The log-likelihood value, which is a measure of how well the model fits
the data. Higher values indicate better fit.
 AIC (Akaike Information Criterion) - A measure of the relative quality of a statistical model
for a given set of data. Lower AIC values indicate better-fitting models. In this case, the
AIC value is -5808.515.
 BIC (Bayesian Information Criterion) - Similar to AIC, BIC is used for model selection. It
penalizes model complexity more strongly than AIC. Lower BIC values indicate better-
fitting models. Here, the BIC value is -5754.651.
 Sample - Specifies the range of observations used in the model. In this case, it ranges from
0 to 989.
 Covariance Type - Specifies the type of covariance estimator used in the model. In this
case, it's "opg" (Opeck-Gleser), which is one of the available options for estimating the
covariance matrix.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

The provided output represents the coefficient estimates, standard errors, z-values, p-values,
and the confidence intervals for each coefficient in the SARIMAX model.
 const - Represents the intercept term in the model. In this case, the coefficient is 1.505e-
06 with a standard error of 5.46e-05. The z-value is 0.028, and the p-value is 0.978,
indicating that the intercept term is not statistically significant at conventional levels of
significance (e.g., α = 0.05).
 ar.L1, ar.L2, ar.L3, ar.L4 - These are the autoregressive (AR) terms in the model. They
represent the coefficients of the lagged values of the dependent variable. The coefficients
represent the strength and direction of the relationship between the variable and its
lagged values. All of these coefficients have p-values less than 0.05, indicating that they
are statistically significant.
 ma.L1, ma.L2, ma.L3, ma.L4, ma.L5 - These are the moving average (MA) terms in the
model. They represent the coefficients of the lagged forecast errors. Similar to the AR
terms, these coefficients indicate the strength and direction of the relationship between
the forecast errors and their lagged values. Notably, ma.L2 has a p-value greater than 0.05,
suggesting that it is not statistically significant.
 sigma2 - Represents the variance of the residuals (error term) in the model. It is estimated
to be 0.0002 with a high level of statistical significance.

The provided output includes diagnostic test results for the SARIMAX model, including the
Ljung-Box test, Jarque-Bera test, and tests for heteroskedasticity.
 Ljung-Box (L1) (Q) - The Ljung-Box test is a statistical test that checks whether any group
of autocorrelations of a time series is different from zero. The "L1" in parentheses indicates
the lag at which the test is performed. In this case, the test statistic is 0.24, and the p-value
(Prob(Q)) is 0.63. Since the p-value is greater than the significance level (commonly 0.05),
we fail to reject the null hypothesis of no autocorrelation in the residuals at lag 1.
 Jarque-Bera (JB) - The Jarque-Bera test is a goodness-of-fit test that checks whether the
data follows a normal distribution. The test statistic is 5303.06, and the p-value (Prob(JB))
is reported as 0.00. A low p-value suggests that the residuals are not normally distributed.
 Heteroskedasticity (H) - Heteroskedasticity refers to the situation where the variability of a
variable is unequal across its range. The test for heteroskedasticity reports a test statistic
of 0.16 and a p-value (Prob(H)) of 0.00. A low p-value suggests that there is evidence of
heteroskedasticity in the residuals.
 Skew and Kurtosis - Skewness measures the asymmetry of the distribution of the residuals,
and kurtosis measures the "tailedness" or thickness of the tails of the distribution. In this
case, skew is reported as 0.07, indicating a slight skewness, and kurtosis is reported as
14.34, indicating heavy-tailedness.

Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk


Financial Analytics

Overall, these diagnostic tests provide valuable information about the adequacy of the
SARIMAX model. While the Ljung-Box test suggests no significant autocorrelation at lag 1,
the Jarque-Bera test indicates potential non-normality in the residuals, and the test for
heteroskedasticity suggests unequal variability. These findings may warrant further
investigation or model refinement.
Predicted values

6. Generalized Auto-Regressive Conditional Heteroskedasticity (GARCH)


Generalized Auto-Regressive Conditional Heteroskedasticity (GARCH) models are a class of
time series models widely used in finance and economics to model the volatility of financial
asset returns. They are particularly effective in capturing volatility clustering, where periods
of high volatility tend to cluster together, a common phenomenon observed in financial
markets.
Volatility Clustering
Volatility clustering refers to the tendency of financial asset returns to exhibit periods of high
volatility followed by periods of low volatility. This clustering phenomenon violates the
assumption of constant variance (homoskedasticity) commonly assumed in traditional time
series models. GARCH models provide a framework for modeling time-varying volatility by
incorporating past information on volatility.
Components of GARCH Models
GARCH models extend the Auto-Regressive Moving Average (ARMA) framework by modeling
the conditional variance of a time series as a function of past variance and past squared errors
(residuals). The key components of a GARCH(p, q) model include:
 Auto-Regressive (AR) terms - Captures the dependence of current volatility on past
volatility.
 Moving Average (MA) terms - Captures the dependence of current volatility on past
squared errors.
 Conditional Mean Equation - Represents the relationship between the conditional mean
of the series and its predictors (e.g., lagged returns).

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Financial Analytics

 Conditional Variance Equation - Models the conditional variance of the series as a


function of past variance and past squared errors.
Model Specification
The parameters of a GARCH model include:
 p: The order of the AR terms, indicating the number of lagged conditional variances
included in the model.
 q: The order of the MA terms, indicating the number of lagged squared errors included in
the model.
 α coefficients: Represent the weights assigned to past squared errors in the conditional
variance equation.
 β coefficients: Represent the weights assigned to past conditional variances in the
conditional variance equation.
Model selection typically involves analyzing autocorrelation and partial autocorrelation plots
of squared residuals and conducting diagnostic tests for autocorrelation and
heteroskedasticity.
Applications
GARCH models find widespread applications in finance and economics, including:
 Risk management - Assessing and managing financial risk by modeling and forecasting
volatility.
 Option pricing - Pricing financial derivatives that are sensitive to changes in volatility,
such as options.
 Portfolio optimization - Constructing optimal portfolios that balance risk and return by
accounting for volatility dynamics.
 Forecasting - Predicting future volatility to guide investment decisions and trading
strategies.
Limitations and Considerations
 GARCH models assume linear relationships and may not capture all aspects of volatility
dynamics.
 Model estimation can be computationally intensive, particularly for large datasets or
complex models.
 Careful model selection and validation are essential to ensure the reliability and
robustness of GARCH model results.

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Author Contact: 99644-02318 | [email protected] | linkedin.com/in/kirankvk

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