Modelling the Variance:

ARCH−GARCH Models

CHAPTER CONTENTS
Introduction 310
The ARCH model 311
The GARCH model 321
Alternative specifications 323
Application: a GARCH model of UK GDP and the effect of
socio-political instability 338
Questions and exercises 342

LEARNING OBJECTIVES
After studying this chapter you should be able to:
1 Understand the concept of conditional variance.
2 Detect ‘calm’ and ‘wild’ periods in a stationary time series.
3 Understand the autoregressive conditional heteroskedasticity (ARCH) model.
4 Perform a test for ARCH effects.
5 Estimate an ARCH model.
6 Understand the GARCH model and the difference between the GARCH and ARCH
specifications.
7 Understand the distinctive features of the ARCH-M and GARCH-M models.
8 Understand the distinctive features of the TGARCH and EGARCH models.
9 Estimate all ARCH-type models using appropriate econometric software.

309
310 Time series econometrics

Introduction
Recent developments in financial econometrics have led to the use of models and tech-
niques that can model the attitude of investors not only towards expected returns but
also towards risk (or uncertainty). These require models that are capable of dealing
with the volatility (variance) of the series. Typical are the autoregressive conditional
heteroskedasticity (ARCH) family of models, which are presented and analysed in
this chapter.
Conventional econometric analysis views the variance of the disturbance terms
as being constant over time (the homoskedasticity assumption that was analysed in
Chapter 7). However, often financial and economic time series exhibit periods of
unusually high volatility followed by more tranquil periods of low volatility (‘wild’
and ‘calm’ periods, as some financial analysts like to call them).
Even from a quick look at financial data (see, for example, Figure 14.1, which
plots the daily returns of the FTSE-100 index from 1 January 1990 to 31 December
1999) we can see there are certain periods that have a higher volatility (and are there-
fore riskier) than others. This means that the expected value of the magnitude of the
disturbance terms may be greater at certain periods compared with others. In addition,
these riskier times seem to be concentrated and followed by periods of lower risk (lower
volatility) that again are concentrated. In other words, we observe that large changes
in stock returns seem to be followed by further large changes. This phenomenon is
what financial analysts call volatility clustering. In terms of the graph in Figure 14.1,
it is clear that there are subperiods of higher volatility; it is also clear that after 1997
the volatility of the series is much higher than it used to be.
Therefore, in such cases, it is clear that the assumption of homoskedasticity (or
constant variance) is very limiting, and in such instances it is preferable to examine
patterns that allow the variance to depend on its history. Or, to use more appropri-
ate terminology, it is preferable to examine not the unconditional variance (which
is the long-run forecast of the variance and can be still treated as constant) but the
conditional variance, based on our best model of the variable under consideration.

0.06

0.04

0.02

0.00

– 0.02

– 0.04

– 0.06
1/01/90 12/02/91 11/01/93 10/02/95 9/01/97 8/02/99
R_FTSE

Figure 14.1 Plot of the returns of FTSE-100, 1 January 1990 to 31 December 1999
 Modelling the variance: ARCH–GARCH models 311

To understand this better, consider an investor who is planning to buy an asset at

time t and sell it at time t + 1. For this investor, the forecast of the rate of return on
this asset alone will not be enough; they would be interested in knowing the vari-
ance of the return over the holding period. Therefore, the unconditional variance
is of no use either; the investor will want to examine the behaviour of the condi-
tional variance of the series to estimate the riskiness of the asset at a certain period
of time.
This chapter will focus on the modelling of the behaviour of conditional vari-
ance, or more appropriately, of conditional heteroskedasticity (from which comes
the CH part of the ARCH models). The next section presents the first model
that proposed the concept of ARCH, developed by Robert F. Engle in his sem-
inal paper ‘Autoregressive Conditional Heteroskedasticity with Estimates of the
Variance of United Kingdom Inflation’, published in Econometrica in 1982, and
which began a whole new era in applied econometrics with many ARCH varia-
tions, extensions and applications. We shall then present the generalized ARCH
(GARCH) model, followed by an alternative specification. Finally, illustrations of
ARCH/GARCH models are presented using examples from financial and economic
time series.

The ARCH model

Engle’s model suggests that the variance of the residuals at time t depends on the
squared error terms from past periods. Engle simply suggested that it is better to model
simultaneously the mean and the variance of a series when it is suspected that the
conditional variance is not constant.
Let’s examine this in a more detailed way. Consider the simple model:

Yt = a + β Xt + ut (14.1)

where Xt is a k × 1 vector of explanatory variables and β is a k × 1 vector of coefficients.

Normally, we assume that ut is independently distributed with a zero mean and a
constant variance σ 2 , or, in mathematical notation:

ut ∼ iid N(0, σ 2 ) (14.2)

Engle’s idea begins by allowing the variance of the residuals (σ 2 ) to depend on history,
or to have heteroskedasticity because the variance will change over time. One way to
allow for this is to have the variance depend on one lagged period of the squared error
terms as follows:

σt2 = γ0 + γ1 u2t−1 (14.3)

which is the basic ARCH(1) process.

312 Time series econometrics

The ARCH(1) model

Following on, the ARCH(1) model will simultaneously model the mean and the
variance of the series with the following specification:

Yt = a + β Xt + ut (14.4)
ut | t ∼ iid N(0, ht )

ht = γ0 + γ1 u2t−1 (14.5)

where t is the information set. Here Equation (14.4) is called the mean equation
and Equation (14.5) the variance equation. Note that we have changed the nota-
tion of the variance from σt2 to ht . This is to keep the same notation from now
on, throughout this chapter. (The reason it is better to use ht rather than σt2 will
become clear through the more mathematical explanation provided later in the
chapter.)
The ARCH(1) model says that when a big shock happens in period t − 1, it is
more likely that the value of ut (in absolute terms because of the squares) will
also be bigger. That is, when u2t−1 is large/small, the variance of the next inno-
vation ut is also large/small. The estimated coefficient of γ1 has to be positive for
positive variance.

The ARCH(q) model

In fact, the conditional variance can depend not just on one lagged realization but
on more than one, each case producing a different ARCH process. For example, the
ARCH(2) process will be:

ht = γ0 + γ1 u2t−1 + γ2 u2t−2 (14.6)

the ARCH(3) will be given by:

ht = γ0 + γ1 u2t−1 + γ2 u2t−2 + γ3 u2t−3 (14.7)

and in general the ARCH(q) process will be given by:

ht = γ0 + γ1 u2t−1 + γ2 u2t−2 + · · · + γq u2t−q

q
= γ0 + γj u2t−j (14.8)
j=1
 Modelling the variance: ARCH–GARCH models 313

Therefore, the ARCH(q) model will simultaneously examine the mean and the variance
of a series according to the following specification:

Y t = a + β X t + ut (14.9)
ut | t ∼ iid N(0, ht )
q
ht = γ0 + γj u2t−j (14.10)
j=1

Again, the estimated coefficients of the γ s have to be positive for positive variance.

Testing for ARCH effects

Before estimating ARCH(q) models it is important to check for the possible presence
of ARCH effects in order to know which models require the ARCH estimation method
instead of OLS. Testing for ARCH effects was examined extensively in Chapter 7, but a
short version of the test for qth order autoregressive heteroskedasticity is also provided
here. The test can be done along the lines of the Breusch–Pagan test, which entails
estimation of the mean equation:

Yt = a + β Xt + ut (14.11)

by OLS as usual (note that the mean equation can also have, as explanatory variables in
the Xt vector, autoregressive terms of the dependent variable), to obtain the residuals
ût , and then run an auxiliary regression of the squared residuals (û2t ) on the lagged
squared terms (û2t−1 , . . . , û2t−q ) and a constant as in:

û2t = γ0 + γ1 û2t−1 + · · · + γq û2t−q + wt (14.12)

and then compute R2 × T. Under the null hypothesis of homoskedasticity (0 = γ1 =

· · · = γq ) the resulting test statistic follows a χ 2 distribution with q degrees of freedom.
Rejection of the null suggests evidence of ARCH(q) effects.

Estimation of ARCH models by iteration

The presence of ARCH effects in a regression model does not invalidate completely
the use of OLS estimation: the coefficients will still be consistent estimates, but
they will not be fully efficient and the estimate of the covariance matrix of the
parameters will be biased, leading to invalid t-statistics. A fully efficient estima-
tor with a valid covariance matrix can, however, be calculated by setting up a
model that explicitly recognizes the presence of ARCH effects. This model can no
longer be estimated using a simple technique such as OLS, which has an analyti-
cal solution, but instead a non-linear maximization problem must be solved, which
requires an iterative computer algorithm to search for the solution. The method used
314 Time series econometrics

to estimate ARCH models is a special case of a general estimation strategy known as

the maximum-likelihood approach. A formal exposition of this approach is beyond the
scope of this book (see Cuthbertson et al., 1992), but an intuitive account of how this
is done is given here. Approaching the task, we assume we have the correct model and
know the distribution of the error process; we select a set of values for the parameters to
be estimated and can then in principle calculate the probability that the set of endoge-
nous variables we have noted in our data set would actually occur. We then select
a set of parameters for our model that maximize this probability. These parameters
are then called the maximum-likelihood parameters and they have the general prop-
erty of being consistent and efficient (under the full set of CLRM assumptions, OLS
is a maximum-likelihood estimator). Except in certain rare cases, finding the parame-
ters that maximize this likelihood function requires the computer to search over the
parameter space, and hence the computer will perform a number of steps (or iterations)
as it searches for the best set of parameters. Packages such as EViews or Stata include
routines that do this very efficiently, though if the problem becomes too complex the
program may sometimes fail to find a true maximum, and there are switches within the
software to help convergence by adjusting a range of options. The next section explains
step by step how to use EViews to estimate ARCH models and provides a range of
examples.

Estimating ARCH models in EViews

The file ARCH.wf1 contains daily data for the logarithmic returns FTSE-100 (named
r_ftse) and three more stocks of the UK stock market (named r_stock1, r_stock2 and
r_stock3). We first consider the behaviour of r_ftse alone, by checking whether the
series is characterized by ARCH effects. From the time plot of the series in Figure 14.1,
it can be seen clearly that there are periods of greater and lesser volatility in the sample,
so the possibility of ARCH effects is quite high.
The first step in the analysis is to estimate an AR(1) model (having this as the mean
equation for simplicity) for r_ftse using simple OLS. To do this, click Quick/Estimate
Equation, to open the Equation Specification window. In this window we need to
specify the equation to be estimated (by typing it in the white box of the Equation
Specification window). The equation for an AR(1) model will be:

r_ftse c r_ftse(−1)

Next click OK to obtain the results shown in Table 14.1.

These results are of no interest in themselves. What we want to know is whether
there are ARCH effects in the residuals of this model. To test for such effects we use
the Breusch–Pagan ARCH test. In EViews, from the equation results window click on
View/Residuals Tests/ARCH-LM Test. EViews asks for the number of lagged terms to
include, which is simply the q term in the ARCH(q) process. To test for an ARCH(1)
process, type 1, and for higher orders the value of q. Testing for ARCH(1) (by typing 1
and pressing OK), we get the results shown in Table 14.2.
The T ∗ R2 statistic (or Obs*R-squared, as EViews presents it) is 46.05 and has a
probability value of 0.000. This clearly suggests that we reject the null hypothesis of
 Modelling the variance: ARCH–GARCH models 315

Table 14.1 A simple AR(1) model for the FTSE-100

Dependent variable: R_FTSE
Method: least squares
Date: 12/26/03 Time: 15:16
Sample: 1/01/1990 12/31/1999
Included observations: 2610

Variable Coefficient Std. error t-statistic Prob.

C 0.000363 0.000184 1.975016 0.0484

R_FTSE(−1) 0.070612 0.019538 3.614090 0.0003

R -squared 0.004983 Mean dependent var. 0.000391

Adjusted R -squared 0.004602 S.D. dependent var. 0.009398
S.E. of regression 0.009376 Akaike info criterion −6.500477
Sum squared resid. 0.229287 Schwarz criterion −6.495981
Log likelihood 8485.123 F -statistic 13.06165
Durbin–Watson stat. 1.993272 Prob(F -statistic) 0.000307

Table 14.2 Testing for ARCH(1) effects in the FTSE-100

ARCH test :

F -statistic 46.84671 Probability 0.000000

Obs*R -squared 46.05506 Probability 0.000000

Test equation:
Dependent variable: RESID∧ 2
Method: least squares
Date: 12/26/03 Time: 15:27
Sample(adjusted): 1/02/1990 12/31/1999
Included observations: 2609 after adjusting endpoints

Variable Coefficient Std. error t-statistic Prob.

C 7.62E−05 3.76E−06 20.27023 0.0000

RESID∧ 2(−1) 0.132858 0.019411 6.844466 0.0000

R -squared 0.017652 Mean dependent var. 8.79E − 05

Adjusted R -squared 0.017276 S.D. dependent var. 0.000173
S.E. of regression 0.000171 Akaike info criterion −14.50709
Sum squared resid. 7.64E−05 Schwarz criterion −14.50260
Log likelihood 18926.50 F -statistic 46.84671
Durbin–Watson stat. 2.044481 Prob(F -statistic) 0.000000

homoskedasticity, and conclude that ARCH(1) effects are present. Testing for higher-
order ARCH effects (for example order 6) the results appear as shown in Table 14.3.
This time the T ∗ R2 statistic is even higher (205.24), suggesting a massive rejection
of the null hypothesis. Observe also that the lagged squared residuals are all highly
statistically significant. It is therefore clear for this equation specification that an ARCH
model will provide better results.
To estimate an ARCH model, click on Estimate in the equation results window to
go back to the Equation Specification window (or in a new workfile, by clicking on
Quick/Estimate Equation to open the Equation Specification window) and this time
change the estimation method by clicking on the down arrow in the method setting
316 Time series econometrics

Table 14.3 Testing for ARCH(6) effects in the FTSE-100

ARCH test:

F -statistic 37.03529 Probability 0.000000

Obs*R -squared 205.2486 Probability 0.000000

Test equation:
Dependent variable: RESID∧ 2
Method: least squares
Date: 12/26/03 Time: 15:31
Sample(adjusted): 1/09/1990 12/31/1999
Included observations: 2604 after adjusting endpoints

Variable Coefficient Std. error t-statistic Prob.

C 4.30E−05 4.46E−06 9.633006 0.0000

RESID∧ 2(−1) 0.066499 0.019551 3.401305 0.0007
RESID∧ 2(−2) 0.125443 0.019538 6.420328 0.0000
RESID∧ 2(−3) 0.097259 0.019657 4.947847 0.0000
RESID∧ 2(−4) 0.060954 0.019658 3.100789 0.0020
RESID∧ 2(−5) 0.074990 0.019539 3.837926 0.0001
RESID∧ 2(−6) 0.085838 0.019551 4.390579 0.0000

R -squared 0.078821 Mean dependent var. 8.79E− 05

Adjusted R -squared 0.076692 S.D. dependent var. 0.000173
S.E. of regression 0.000166 Akaike info criterion −14.56581
Sum squared resid. 7.16E−05 Schwarz criterion −14.55004
Log likelihood 18971.68 F -statistic 37.03529
Durbin–Watson stat. 2.012275 Prob(F -statistic) 0.000000

and choosing the ARCH-Autoregressive Conditional Heteroskedasticity option. In

this new window, the upper part is devoted to the mean equation specification and
the lower part to the ARCH specification, or the variance equation specification. In
this window some things will appear that are unfamiliar, but they will become clear
after the rest of this chapter has been worked through. To estimate a simple ARCH(1)
model, assuming that the mean equation, as before, follows an AR(1) process, type in
the mean equation specification:

r_ftse c rftse(−1)

making sure that the ARCH-M part selects None, which is the default EViews case. For
the ARCH specification choose GARCH/TARCH from the drop-down Model: menu,
which is again the default EViews case, and in the small boxes type 1 for the Order
ARCH and 0 for the GARCH. The Threshold Order should remain at zero (which is
the default setting). By clicking OK the results shown in Table 14.4 will appear.
Note that it took ten iterations to reach convergence in estimating this model. The
model can be written as:

Yt = 0.0004 + 0.0751Yt−1 + ut (14.13)

(2.25) (3.91)
ut | t ∼ iid N(0, ht )

ht = 0.000007 + 0.1613u2t−1 (14.14)

(35.97) (7.97)
 Modelling the variance: ARCH–GARCH models 317

Table 14.4 An ARCH(1) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 15:34
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 10 iterations

Coefficient Std. error z-statistic Prob.

C 0.000401 0.000178 2.257832 0.0240

R_FTSE(−1) 0.075192 0.019208 3.914538 0.0001

Variance equation

C 7.39E−05 2.11E−06 35.07178 0.0000

ARCH(1) 0.161312 0.020232 7.973288 0.0000

R -squared 0.004944 Mean dependent var. 0.000391

Adjusted R -squared 0.003799 S.D. dependent var. 0.009398
S.E. of regression 0.009380 Akaike info criterion −6.524781
Sum squared resid. 0.229296 Schwarz criterion −6.515789
Log likelihood 8518.839 F -statistic 4.316204
Durbin–Watson stat. 2.001990 Prob(F -statistic) 0.004815

with values of z-statistics in parentheses. Note that the estimate of γ1 is highly signifi-
cant and positive, which is consistent with the finding from the ARCH test above. The
estimates of a and β from the simple OLS model have changed slightly and become
more significant.
To estimate a higher-order ARCH model, such as the ARCH(6) examined above,
again click on Estimate and this time change the Order ARCH to 6 (by typing 6 in
the small box) leaving 0 for the GARCH. The results for this model are presented in
Table 14.5.
Again, all the γ s are statistically significant and positive, which is consistent
with the findings above. After estimating ARCH models in EViews you can view
the conditional standard deviation or the conditional variance series by clicking on
the estimation window View/Garch Graphs/Conditional SD Graph or View/Garch
Graphs/Conditional Variance Graph, respectively. The conditional standard devia-
tion graph for the ARCH(6) model is shown in Figure 14.2.
You can also obtain the variance series from EViews by clicking on Procs/Make
GARCH Variance Series. EViews automatically gives names such as GARCH01,
GARCH02 and so on for each of the series. We renamed our obtained variance series
as ARCH1 for the ARCH(1) series model and ARCH6 for the ARCH(6) model. A plot of
these two series together is presented in Figure 14.3.
From this graph we can see that the ARCH(6) model provides a conditional vari-
ance series that is much smoother than that obtained from the ARCH(1) model.
This will be discussed more fully later. To obtain the conditional standard deviation
series plotted above, take the square root of the conditional variance series with the
following command:

genr sd_arch1=arch1^(1/2) [for the series of the ARCH(1) model]

genr sd_arch6=arch6^(1/2) [for the series of the ARCH(6) model]
318 Time series econometrics

Table 14.5 An ARCH(6) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 15:34
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 12 iterations

Coefficient Std. error z-statistic Prob.

C 0.000399 0.000162 2.455417 0.0141

R_FTSE(−1) 0.069691 0.019756 3.527551 0.0004

Variance equation

C 3.52E−05 2.58E−06 13.64890 0.0000

ARCH(1) 0.080571 0.014874 5.416946 0.0000
ARCH(2) 0.131245 0.024882 5.274708 0.0000
ARCH(3) 0.107555 0.022741 4.729525 0.0000
ARCH(4) 0.081088 0.022652 3.579805 0.0003
ARCH(5) 0.089852 0.022991 3.908142 0.0001
ARCH(6) 0.123537 0.023890 5.171034 0.0000

R -squared 0.004968 Mean dependent var. 0.000391

Adjusted R -squared 0.001908 S.D. dependent var. 0.009398
S.E. of regression 0.009389 Akaike info criterion −6.610798
Sum squared resid. 0.229290 Schwarz criterion −6.590567
Log likelihood 8636.092 F -statistic 1.623292
Durbin–Watson stat. 1.991483 Prob(F -statistic) 0.112922

A plot of the conditional standard deviation series for both models is presented in
Figure 14.4.

A more mathematical approach

Consider the simple stationary model of the conditional mean of a series Yt :

Y t = a + β X t + ut (14.15)

It is usual to treat the variance of the error term var(ut ) = σ 2 as a constant, but the vari-
ance can be allowed to change over time. To explain this more fully, let us decompose
the ut term into a systematic component and a random component, as:

ut = zt ht (14.16)

where zt follows a standard normal distribution with zero mean and variance one, and
ht is a scaling factor.
In the basic ARCH(1) model we assume that:

ht = γ0 + γ1 u2t−1 (14.17)
 Modelling the variance: ARCH–GARCH models 319

0.025

0.020

0.015

0.010

0.005
1/01/90 11/01/93 9/01/97

Figure 14.2 Conditional standard deviation graph for an ARCH(6) model of the FTSE-100

0.0006

0.0005

0.0004

0.0003

0.0002

0.0001

0.0000
1/01/90 11/01/93 9/01/97

ARCH1 ARCH6

Figure 14.3 Plot of the conditional variance series

320 Time series econometrics

0.025

0.020

0.015

0.010

0.005
1/01/90 11/01/93 9/01/97

SD_ARCH1 SD_ARCH6

Figure 14.4 Plot of the conditional standard deviation series

The process for yt is now given by:

yt = a + β xt + zt γ0 + γ1 u2t−1 (14.18)

and from this expression it is easy to see that the mean of the residuals will be zero
(E(ut ) = 0), because E(zt ) = 0. Additionally, the unconditional (long-run) variance of
the residuals is given by:

γ0
var(ut ) = E z2t E(ht ) = (14.19)
1 − γ1

which means that we simply need to impose the constraints γ0 > 0 and 0 < γ1 < 1 to
obtain stationarity.
The intuition behind the ARCH(1) model is that the conditional (short-run) variance
(or volatility) of the series is a function of the immediate past values of the squared
error term. Therefore the effect of each new shock zt depends on the size of the shock
in one lagged period.
An easy way to extend the ARCH(1) process is to add additional, higher-order
lagged parameters as determinants of the variance of the residuals to change
Equation (14.17) to:

q
ht = γ0 + γj u2t−j (14.20)
j=1
 Modelling the variance: ARCH–GARCH models 321

which denotes an ARCH(q) process. ARCH(q) models are useful when the variability
of the series is expected to change more slowly than in the ARCH(1) model. However,
ARCH(q) models are quite often difficult to estimate, because they frequently yield
negative estimates of the γj s. To resolve this issue, Bollerslev (1986) developed the idea
of the GARCH model, which will be examined in the next section.

The GARCH model

One of the drawbacks of the ARCH specification, according to Engle (1995), was that
it looked more like a moving average specification than an autoregression. From this,
a new idea was born, which was to include the lagged conditional variance terms
as autoregressive terms. This idea was worked out by Tim Bollerslev, who in 1986
published a paper entitled ‘Generalised Autoregressive Conditional Heteroskedasticity’
in the Journal of Econometrics, introducing a new family of GARCH models.

The GARCH (p,q) model

The GARCH(p, q) model has the following form:

Y t = a + β Xt + ut (14.21)
ut | t ∼ iid N(0, ht )
p q
ht = γ0 + δi ht−i + γj u2t−j (14.22)
i=1 j=1

which says that the value of the variance scaling parameter ht now depends both on
past values of the shocks, which are captured by the lagged squared residual terms, and
on past values of itself, which are captured by lagged ht terms.
It should be clear by now that for p = 0 the model reduces to ARCH(q). The simplest
form of the GARCH(p, q) model is the GARCH(1,1) model, for which the variance
equation has the form:

ht = γ0 + δ1 ht−1 + γ1 u2t−1 (14.23)

This model specification usually performs very well and is easy to estimate because it
has only three unknown parameters: γ0 , γ1 and δ1 .

The GARCH(1,1) model as an infinite ARCH process

To show that the GARCH(1,1) model is a parsimonious alternative to an infi-
nite ARCH(q) process, consider Equation (14.23). Successive substitution into the
right-hand side of Equation (14.23) gives:

ht = γ0 + δht−1 + γ1 u2t−1

= γ0 + δ γ0 + δht−2 + γ1 u2t−2 + γ1 u2t−1

322 Time series econometrics

= γ0 + γ1 u2t−1 + δγ0 + δ 2 ht−2 + δγ1 u2t−2

= γ0 + γ1 u2t−1 + δγ0 + δ 2 γ0 + δht−3 + γ1 u2t−3 + δγ1 u2t−2

···
γ0
= + γ1 u2t−1 + δu2t−2 + δ 2 γ1 u2t−3 + · · ·
1−δ
∞
γ0
= + γ1 δ j−1 u2t−j (14.24)
1−δ
j=1

which shows that the GARCH(1,1) specification is equivalent to an infinite order ARCH
model with coefficients that decline geometrically. For this reason, it is essential to
estimate GARCH(1,1) models as alternatives to high-order ARCH models, because with
the GARCH(1,1) there are fewer parameters to estimate and therefore fewer degrees
of freedom are lost.

Estimating GARCH models in EViews

Consider again the r-ftse series from the ARCH.wf1 file. To estimate a GARCH model,
click on Quick/Estimate Equation to open the Equation Specification window, and
again change the estimation method by clicking on the down arrow in the method set-
ting and choosing the ARCH-Autoregressive Conditional Heteroskedasticity option.
In this new Equation Specification window, the upper part is for the mean equation
specification while the lower part is for the ARCH/GARCH specification or the variance
equation. To estimate a simple GARCH(1,1) model, assuming that the mean equa-
tion as before follows an AR(1) process, in the mean equation specification window,
we type:

r_ftse c rftse(−1)

making sure that within the ARCH-M part None is selected, which is the default in
EViews. For the ARCH/GARCH specification choose GARCH/TARCH from the drop-
down Model: menu, which is again the default EViews case, and in the small boxes
type 1 for the Order ARCH and 1 for the GARCH. It is obvious that for higher orders,
for example a GARCH(4,2) model, you would have to change the number in the small
boxes by typing 2 for the Order ARCH and 4 for the GARCH. After specifying the
number of ARCH and GARCH and clicking OK the required results appear. Table 14.6
presents the results for a GARCH(1,1) model.
Note that it took only five iterations to reach convergence in estimating this model.
The model can be written as:

Yt = 0.0004 + 0.0644Yt−1 + ût (14.25)

(2.57) (3.05)
ut | t ∼ iid N(0, ht )

ht = 0.0000002 + 0.893ht−1 + 0.084û2t−1 (14.26)

(4.049) (59.43) (7.29)
 Modelling the variance: ARCH–GARCH models 323

Table 14.6 A GARCH(1,1) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 18:52
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 5 iterations

Coefficient Std. error z-statistic Prob.

C 0.000409 0.000158 2.578591 0.0099

R_FTSE(−1) 0.064483 0.021097 3.056426 0.0022

Variance equation

C 2.07E − 06 5.10E−07 4.049552 0.0001

ARCH(1) 0.084220 0.011546 7.294102 0.0000
GARCH(1) 0.893243 0.015028 59.43780 0.0000

R -squared 0.004924 Mean dependent var. 0.000391

Adjusted R -squared 0.003396 S.D. dependent var. 0.009398
S.E. of regression 0.009382 Akaike info criterion −6.645358
Sum squared resid. 0.229300 Schwarz criterion −6.634118
Log likelihood 8677.192 F -statistic 3.222895
Durbin–Watson stat. 1.981507 Prob(F -statistic) 0.011956

with values of z-statistics in parentheses. Note that the estimate of δ is highly signifi-
cant and positive, as well as the coefficient of the γ1 term. Taking the variance series
for the GARCH(1,1) model (by clicking on Procs/Make GARCH Variance Series) it has
been renamed as GARCH11 and this series has been plotted together with the ARCH6
series to obtain the results shown in Figure 14.5.
From this we observe that the two series are quite similar (if not identical), because
the GARCH term captures a high order of ARCH terms as was proved earlier. Therefore,
again, it is better to estimate a GARCH instead of a high order ARCH model because of
its easier estimation and the least possible loss of degrees of freedom.
Changing the values in the boxes of the ARCH/GARCH specification to 6 in order
to estimate a GARCH(6,6) model, the results shown in Table 14.7 are obtained, where
the insignificance of all the parameters apart from the ARCH(1) term suggests that it is
not an appropriate model.
Similarly, estimating a GARCH(1,6) model gives the results shown in Table 14.8,
where now only the ARCH(1) and the GARCH(1) terms are significant; also some of
the ARCH lagged terms have a negative sign. Comparing all the models from both the
ARCH and the GARCH alternative specifications, we conclude that the GARCH(1,1) is
preferred, for the reasons discussed above.

Alternative specifications
There are many alternative specifications that could be analysed to model conditional
volatility, and some of the more important variants are presented briefly in this section.
(Berra and Higgins (1993) and Bollerslev et al. (1994) provide very good reviews of
these alternative specifications, while Engle (1995) collects some important papers in
the ARCH/GARCH literature.)
324 Time series econometrics

0.0006

0.0005

0.0004

0.0003

0.0002

0.0001

0.0000
1/01/90 11/01/93 9/01/97

ARCH6 GARCH1,1

Figure 14.5 Plots of the conditional variance series for ARCH(6) and GARCH(1,1)

The GARCH in mean, or GARCH-M, model

GARCH-M models allow the conditional mean to depend on its own conditional vari-
ance. Consider, for example, investors who are risk-averse and therefore require a
premium as compensation for holding a risky asset. That premium is clearly a posi-
tive function of the risk (that is the higher the risk, the higher the premium should
be). If the risk is captured by the volatility or by the conditional variance, then the
conditional variance may enter the conditional mean function of Yt .
Therefore, the GARCH-M(p,q) model has the following form:

Y t = a + β Xt + θ h t + ut (14.27)
ut | t ∼ iid N(0, ht )
p q
h t = γ0 + δi ht−i + γj u2t−j (14.28)
i=1 j=1

Another variant of the GARCH-M type model is to capture risk not through the
variance series but by using the standard deviation of the series having the following
specification for the mean and the variance equation:

Y t = a + β X t + θ h t + ut (14.29)
ut | t ∼ iid N(0, ht )
 Modelling the variance: ARCH–GARCH models 325

Table 14.7 A GARCH(6,6) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 19:05
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 18 iterations

Coefficient Std. error z-statistic Prob.

C 0.000433 0.000160 2.705934 0.0068

R_FTSE(−1) 0.065458 0.020774 3.150930 0.0016

Variance equation

C 1.70E−06 7.51E-06 0.227033 0.8204

ARCH(1) 0.038562 0.015717 2.453542 0.0141
ARCH(2) 0.070150 0.113938 0.615692 0.5381
ARCH(3) 0.022721 0.269736 0.084234 0.9329
ARCH(4) −0.017544 0.181646 −0.096585 0.9231
ARCH(5) 0.011091 0.077074 0.143905 0.8856
ARCH(6) −0.017064 0.063733 −0.267740 0.7889
GARCH(1) 0.367407 3.018202 0.121730 0.9031
GARCH(2) 0.116028 1.476857 0.078564 0.9374
GARCH(3) 0.036122 1.373348 0.026302 0.9790
GARCH(4) 0.228528 0.819494 0.278864 0.7803
GARCH(5) 0.217829 0.535338 0.406900 0.6841
GARCH(6) −0.092748 0.979198 −0.094719 0.9245

R -squared 0.004904 Mean dependent var. 0.000391

Adjusted R -squared −0.000465 S.D. dependent var. 0.009398
S.E. of regression 0.009400 Akaike info criterion −6.643400
Sum squared resid. 0.229305 Schwarz criterion −6.609681
Log likelihood 8684.637 F -statistic 0.913394
Durbin–Watson stat. 1.983309 Prob(F -statistic) 0.543473

p q
ht = γ0 + δi ht−i + γj u2t−j (14.30)
i=1 j=1

GARCH-M models can be linked with asset-pricing models such as the capital asset-
pricing models (CAPM) with many financial applications (for more, see Campbell et al.
1997; Hall et al. 1990).

Estimating GARCH-M models in EViews

To estimate a GARCH-M model in EViews, first click Quick/Estimate Equation to open
the Estimation Window, then change the estimation method by clicking on the down
arrow in the method setting and choosing the ARCH-Autoregressive Conditional
Heteroskedasticity option. In this new Equation Specification window, the upper
part is again for the mean equation specification while the lower part is for the
ARCH/GARCH specification or the variance equation. To estimate a GARCH-M(1,1)
model, assuming that the mean equation (as before) follows an AR(1) process, type in
the mean equation specification:
326 Time series econometrics

Table 14.8 A GARCH(1,6) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 19:34
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 19 iterations

Coefficient Std. error z-statistic Prob.

C 0.000439 0.000158 2.778912 0.0055

R_FTSE(−1) 0.064396 0.020724 3.107334 0.0019

Variance equation

C 9.12E−07 2.79E−07 3.266092 0.0011

ARCH(1) 0.040539 0.013234 3.063199 0.0022
ARCH(2) 0.048341 0.025188 1.919235 0.0550
ARCH(3) −0.027991 0.031262 −0.895354 0.3706
ARCH(4) −0.037356 0.028923 −1.291542 0.1965
ARCH(5) 0.016418 0.028394 0.578219 0.5631
ARCH(6) 0.015381 0.023587 0.652097 0.5143
GARCH(1) 0.934786 0.011269 82.95460 0.0000

R -squared 0.004883 Mean dependent var. 0.000391

Adjusted R -squared 0.001438 S.D. dependent var. 0.009398
S.E. of regression 0.009391 Akaike info criterion −6.646699
Sum squared resid. 0.229310 Schwarz criterion −6.624220
Log likelihood 8683.943 F -statistic 1.417557
Durbin–Watson stat. 1.981261 Prob(F -statistic) 0.174540

r_ftse c rftse(−1)

and this time click on either Std.Dev or the Var selections from the ARCH-M part for
versions of the mean Equations (14.29) and (14.27), respectively.
For the ARCH/GARCH specification choose GARCH/TARCH from the drop-down
Model: menu, which is again the default EViews case, and in the small boxes specify
by typing the number of the q lags (1, 2, . . . , q) for the Order ARCH and the number of
p lags (1, 2, . . . , p) for the GARCH. Table 14.9 presents the results for a GARCH-M(1,1)
model based on the specification that uses the variance series to capture risk in the
mean equation, as given by Equation (14.27).
Note that the variance term (GARCH) in the mean equation is slightly significant
but its inclusion substantially increases the significance of the GARCH term in the
variance equation. Re-estimate the above model but this time clicking on the Std.Dev
from the ARCH-M part to include the conditional standard deviation in the mean
equation. The results are presented in Table 14.10, where this time the conditional
 Modelling the variance: ARCH–GARCH models 327

Table 14.9 A GARCH-M(1,1) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML – ARCH
Date: 12/26/03 Time: 19:32
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 13 iterations

Coefficient Std. error z-statistic Prob.

GARCH 6.943460 4.069814 1.706088 0.0880

C −2.39E−05 0.000311 −0.076705 0.9389
R_FTSE(−1) 0.061006 0.020626 2.957754 0.0031

Variance equation

C 7.16E-07 2.22E−07 3.220052 0.0013

ARCH(1) 0.049419 0.006334 7.801997 0.0000
GARCH(1) 0.942851 0.007444 126.6613 0.0000

R -squared 0.004749 Mean dependent var. 0.000391

Adjusted R -squared 0.002838 S.D. dependent var. 0.009398
S.E. of regression 0.009385 Akaike info criterion −6.648319
Sum squared resid. 0.229341 Schwarz criterion −6.634831
Log likelihood 8682.056 F -statistic 2.485254
Durbin–Watson stat. 1.974219 Prob(F -statistic) 0.029654

Table 14.10 A GARCH-M(1,1) for the FTSE-100 (using standard deviation)

Dependent variable: R_FTSE
Method: ML – ARCH
Date: 12/26/03 Time: 19:36
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 13 iterations

Coefficient Std. error z-statistic Prob.

SQR(GARCH) 0.099871 0.080397 1.242226 0.2142

C −0.000363 0.000656 −0.553837 0.5797
R_FTSE(−1) 0.063682 0.020771 3.065923 0.0022

Variance equation

C 9.23E-07 2.72E−07 3.394830 0.0007

ARCH(1) 0.055739 0.007288 7.647675 0.0000
GARCH(1) 0.934191 0.008832 105.7719 0.0000

R -squared 0.005128 Mean dependent var. 0.000391

Adjusted R -squared 0.003218 S.D. dependent var. 0.009398
S.E. of regression 0.009383 Akaike info criterion −6.648295
Sum squared resid. 0.229253 Schwarz criterion −6.634807
Log likelihood 8682.025 F -statistic 2.684559
Durbin–Watson stat. 1.980133 Prob(F -statistic) 0.019937
328 Time series econometrics

standard deviation (or SQR(GARCH)) coefficient is not significant, suggesting that if

there is an effect of the risk on the mean return, this is captured better by the variance.

The threshold GARCH (TGARCH) model

A major restriction of the ARCH and GARCH specifications above is that they are sym-
metric. By this we mean that what matters is only the absolute value of the innovation
and not its sign (because the residual term is squared). Therefore, in ARCH/GARCH
models a large positive shock will have exactly the same effect in the volatility of the
series as a large negative shock of the same magnitude. However, for equities it has
been observed that negative shocks (or ‘bad news’) in the market have a larger impact
on volatility than do positive shocks (or ‘good news’) of the same magnitude.
The threshold GARCH model was introduced by the works of Zakoian (1990) and
Glosten et al. (1993). The main target of this model is to capture asymmetries in terms
of negative and positive shocks. To do this, we simply add into the variance equation
a multiplicative dummy variable to check whether there is a statistically significant
difference when shocks are negative.
The specification of the conditional variance equation (for a TGARCH(1,1)) is
given by:

ht = γ0 + γ u2t−1 + θ u2t−1 dt−1 + δht−1 (14.31)

where dt takes the value of 1 for ut < 0, and 0 otherwise. So ‘good news’ and ‘bad
news’ have different impacts. Good news has an impact of γ , while bad news has an
impact of γ + θ. If θ > 0 we conclude there is asymmetry, while if θ = 0 the news
impact is symmetric. TGARCH models can be extended to higher order specifications
by including more lagged terms, as follows:

q q
ht = γ0 + (γi + θi dt−i )u2t−i + δj ht−j (14.32)
i=1 j=1

Estimating TGARCH models in EViews

To estimate a TGARCH model in EViews, first click Quick/Estimate Equation to
open the Estimation Window. Then change the estimation method by clicking on
the down arrow in the method setting, to choose the ARCH-Autoregressive Condi-
tional Heteroskedasticity option. In this new Equation Specification window we
again have the upper part for the mean equation specification and the lower part for
the ARCH/GARCH specification or the variance equation. To estimate a TGARCH(p,q)
model, assuming that the mean equation follows an AR(1) process as before, type in
the mean equation specification:

r_ftse c rftse(−1)
 Modelling the variance: ARCH–GARCH models 329

Table 14.11 A TGARCH(1,1) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/27/03 Time: 15:04
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 11 iterations

Coefficient Std. error z-statistic Prob.

C 0.000317 0.000159 1.999794 0.0455

R_FTSE(−1) 0.059909 0.020585 2.910336 0.0036

Variance equation

C 7.06E − 07 1.90E - 07 3.724265 0.0002

ARCH(1) 0.015227 0.006862 2.218989 0.0265
(RESID<0)*ARCH(1) 0.053676 0.009651 5.561657 0.0000
GARCH(1) 0.950500 0.006841 138.9473 0.0000

R -squared 0.004841 Mean dependent var. 0.000391

Adjusted R -squared 0.002930 S.D. dependent var. 0.009398
S.E. of regression 0.009384 Akaike info criterion −6.656436
Sum squared resid. 0.229320 Schwarz criterion −6.642949
Log likelihood 8692.649 F -statistic 2.533435
Durbin–Watson stat. 1.972741 Prob(F -statistic) 0.026956

ensuring also that None was clicked in the ARCH-M part of the mean equation
specification.
For the ARCH/GARCH specification, choose GARCH/TARCH from the drop-down
Model: menu, and specify the number of q lags (1, 2, . . . , q) for the Order ARCH,
the number of p lags (1, 2, . . . , p) for the Order GARCH, and the Threshold Order
by changing the value in the box from 0 to 1 to have the TARCH model in action.
Table 14.11 presents the results for a TGARCH(1,1) model.
Note that because the coefficient of the (RESID < 0)∗ ARCH(1) term is positive and
statistically significant, indeed for the FTSE-100 there are asymmetries in the news.
Specifically, bad news has larger effects on the volatility of the series than good news.

The exponential GARCH (EGARCH) model

The exponential GARCH (EGARCH) model was first developed by Nelson (1991),
and the variance equation for this model is given by:

q q p
ut−j ut−j
log(ht ) = γ + ζj + ξj + δi log(ht−i ) (14.33)
j=1 ht−j j=1 ht−j i=1

where γ , the ζ s, ξ s and δs are parameters to be estimated. Note that the left-hand side
is the log of the variance series. This makes the leverage effect exponential rather than
quadratic, and therefore the estimates of the conditional variance are guaranteed to
be non-negative. The EGARCH model allows for the testing of asymmetries as well
330 Time series econometrics

as the TGARCH. To test for asymmetries, the parameters of importance are the ξ s. If
ξ1 = ξ2 = · · · = 0, then the model is symmetric. When ξj < 0, then positive shocks
(good news) generate less volatility than negative shocks (bad news).

Estimating EGARCH models in EViews

To estimate an EGARCH model in EViews, first click Quick/Estimate Equation to
open the Estimation Window. Then change the estimation method by clicking the
down arrow in the method setting to choose the ARCH-Autoregressive Conditional
Heteroskedasticity option. In this new Equation Specification window we again
have the upper part for the mean equation specification, while the lower part is for
the ARCH/GARCH specification or the variance equation. To estimate an EGARCH(p,q)
model, assuming that the mean equation follows an AR(1) process, as before type in
the mean equation specification:

r_ftse c rftse(−1)

again making sure that None is clicked in the ARCH-M part of the mean equation spec-
ification.
For the ARCH/GARCH specification now choose EGARCH from the drop-down
Model: menu, and in the small boxes specify the number of the q lags (1, 2, . . . , q)
for the Order ARCH and the number of p lags (1, 2, . . . , p) for the GARCH. Table 14.12
presents the results for an EGARCH(1,1) model.

Table 14.12 An EGARCH(1,1) model for the FTSE-100

Dependent variable: R_FTSE
Method: ML–ARCH
Date: 12/26/03 Time: 20:19
Sample: 1/01/1990 12/31/1999
Included observations: 2610
Convergence achieved after 17 iterations

Coefficient Std. error z-statistic Prob.

C 0.000306 0.000156 1.959191 0.0501

R_FTSE(−1) 0.055502 0.020192 2.748659 0.0060

Variance equation

C −0.154833 0.028461 −5.440077 0.0000

|RES|/SQR[GARCH](1) 0.086190 0.012964 6.648602 0.0000
RES/SQR[GARCH](1) −0.044276 0.007395 −5.987227 0.0000
EGARCH(1) 0.990779 0.002395 413.7002 0.0000

R -squared 0.004711 Mean dependent var. 0.000391

Adjusted R -squared 0.002800 S.D. dependent var. 0.009398
S.E. of regression 0.009385 Akaike info criterion −6.660033
Sum squared resid. 0.229350 Schwarz criterion −6.646545
Log likelihood 8697.343 F -statistic 2.465113
Durbin–Watson stat. 1.964273 Prob(F -statistic) 0.030857