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Dynamic Models for Volatility and Heavy Tails

The volatility of financial returns changes over time and, for the last thirty years,
Generalized Autoregressive Conditional Heteroscedasticity (GARCH) models have
provided the principal means of analyzing, modelling and monitoring such changes.
Taking into account that financial returns typically exhibit heavy tails – that is,
extreme values can occur from time to time – Andrew C. Harvey’s new book shows
how a small but radical change in the way GARCH models are formulated leads to a
resolution of many of the theoretical problems inherent in the statistical theory. The
approach can also be applied to other aspects of volatility, such as those arising from
data on the range of returns and the time between trades. Furthermore, the more
general class of Dynamic Conditional Score models extends to robust modelling of
outliers in the levels of time series and to the treatment of time-varying relationships.
As such, there are applications not only to financial data but also to macroeconomic
time series and to time series in other disciplines. The statistical theory draws
on basic principles of maximum likelihood estimation and, by doing so, leads to
an elegant and unified treatment of nonlinear time-series modelling. The practical
value of the proposed models is illustrated by fitting them to real data sets.

Andrew C. Harvey is Professor of Econometrics at the University of Cambridge and

a Fellow of Corpus Christi College. He is a Fellow of the Econometric Society and of
the British Academy. He has published more than 100 articles in journals and edited
volumes and is the author of three books, The Econometric Analysis of Time Series,
Time Series Models and Forecasting and Structural Time Series Models and the
Kalman Filter (Cambridge University Press, 1989). He is one of the developers of
the STAMP computer package.

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Christopher Sims, Editor, Advances in econometrics – Sixth World Congress (Volume II),
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Roger Guesnerie, A contribution to the pure theory of taxation, 9780521629560
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theory: The Nancy L. Schwartz Memorial Lectures, 1983–1997, 9780521632225,
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Dynamic Models for Volatility

and Heavy Tails

With Applications to Financial

and Economic Time Series

Andrew C. Harvey
University of Cambridge

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CAMBRIDGE UNIVERSITY PRESS

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Singapore, São Paulo, Delhi, Mexico City
Cambridge University Press
32 Avenue of the Americas, New York, NY 10013-2473, USA
www.cambridge.org
Information on this title: www.cambridge.org/9781107630024

© Andrew C. Harvey 2013

This publication is in copyright. Subject to statutory exception

and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without the written
permission of Cambridge University Press.

First published 2013

Printed in the United States of America

A catalog record for this publication is available from the British Library.

Library of Congress Cataloging in Publication Data

Harvey, A. C. (Andrew C.)
Dynamic models for volatility and heavy tails : with applications to financial and economic time
series / Andrew C. Harvey.
p. cm. – (Econometric society monographs)
Includes bibliographical references and index.
ISBN 978-1-107-03472-3 (hbk.) – ISBN 978-1-107-63002-4 (pbk.)
1. Econometrics. 2. Finance – Mathematical models. 3. Time-series analysis. I. Title.
HB139.H369 2013
330.01 5195–dc23 2012036508

ISBN 978-1-107-03472-3 Hardback

ISBN 978-1-107-63002-4 Paperback

Cambridge University Press has no responsibility for the persistence or accuracy of URLs for
external or third-party Internet Web sites referred to in this publication and does not guarantee
that any content on such Web sites is, or will remain, accurate or appropriate.

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Contents

Preface page xiii

Acronyms and Abbreviations xvii
1 Introduction 1
1.1 Unobserved Components and Filters 2
1.2 Independence, White Noise and Martingale Differences 5
1.2.1 The Law of Iterated Expectations and Optimal Predictions 5
1.2.2 Definitions and Properties 6
1.3 Volatility 7
1.3.1 Stochastic Volatility 8
1.3.2 Generalized Autoregressive Conditional
Heteroscedasticity 8
1.3.3 Exponential GARCH 9
1.3.4 Variance, Scale and Outliers 10
1.3.5 Location/Scale Models 10
1.4 Dynamic Conditional Score Models 11
1.5 Distributions and Quantiles 16
1.6 Plan of Book 17

2 Statistical Distributions and Asymptotic Theory 19

2.1 Distributions 19
2.1.1 Student’s t Distribution 20
2.1.2 General Error Distribution 22
2.1.3 Beta Distribution 22
2.1.4 Gamma Distribution 24
2.2 Maximum Likelihood 25
2.2.1 Student’s t Distribution 26
2.2.2 General Error Distribution 28
2.2.3 Gamma Distribution 29
2.2.4 Consistency and Asymptotic Normality* 29

vii
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2.3 Maximum Likelihood Estimation of Dynamic Conditional
Score Models 32
2.3.1 An Information Matrix Lemma 32
2.3.2 Information Matrix for the First-Order Model 34
2.3.3 Information Matrix with the δ Parameterization* 38
2.3.4 Asymptotic Distribution 39
2.3.5 Consistency and Asymptotic Normality* 40
2.3.6 Nonstationarity 45
2.3.7 Several Parameters 46
2.4 Higher Order Models* 48
2.5 Tests 52
2.5.1 Serial Correlation 52
2.5.2 Goodness of Fit of Distributions 54
2.5.3 Residuals 55
2.5.4 Model Fit 56
2.6 Explanatory Variables 56

3 Location 59
3.1 Dynamic Student’s t Location Model 60
3.2 Basic Properties 61
3.2.1 Generalization and Reduced Form 63
3.2.2 Moments of the Observations 63
3.2.3 Autocorrelation Function 64
3.3 Maximum Likelihood Estimation 65
3.3.1 Asymptotic Distribution of the Maximum
Likelihood Estimator 65
3.3.2 Monte Carlo Experiments 68
3.3.3 Application to U.S. GDP 69
3.4 Parameter Restrictions* 69
3.5 Higher Order Models and the State Space Form* 70
3.5.1 Linear Gaussian Models and the Kalman Filter 70
3.5.2 The DCS Model 72
3.5.3 QARMA Models 74
3.6 Trend and Seasonality 75
3.6.1 Local Level Model 75
3.6.2 Application to Weekly Hours of Employees
in U.S. Manufacturing 77
3.6.3 Local Linear Trend 77
3.6.4 Stochastic Seasonal 79
3.6.5 Application to Rail Travel 80
3.6.6 QARIMA and Seasonal QARIMA Models* 82

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