Why do we need
GARCH models
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
Course overview
GARCH: Generalized AutoRegressive Conditional Heteroskedasticity
Chapter 1: GARCH Model Fundamentals
Chapter 2: GARCH Model Con guration
Chapter 3: Model Performance Evaluation
Chapter 4: GARCH in Action
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What is volatility
Describe the dispersion of nancial asset returns over time
Often computed as the standard deviation or variance of price returns
The higher the volatility, the riskier a nancial asset
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How to compute volatility
Step 1: Calculate returns as percentage of price changes
P1 − P0
return =
P0
Step 2: Calculate the sample mean return
∑ni=1 returni
mean =
n
Step 3: Calculate the sample standard deviation
√
2
∑n
(returni − mean)
volatility = i=1
= √variance
n−1
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Compute volatility in Python
Use pandas pct_change() method:
return_data = price_data.pct_change()
Use pandas std() method:
volatility = return_data.std()
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Volatility conversion
Convert to monthly volatility from daily:
(assume 21 trading days in a month)
σmonthly = √21 ∗ σd
Convert to annual volatility from daily:
(assume 252 trading days in a year)
σannual = √252 ∗ σd
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The challenge of volatility modeling
Heteroskedasticity:
In ancient Greek: "different" (hetero) + "dispersion" (skedasis)
A time series demonstrates varying volatility systematically over time
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Detect heteroskedasticity
Homoskedasticity vs Heteroskedasticity
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Volatility clustering
VIX historical prices:
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Let's practice!
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What are ARCH and
GARCH
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
First came the ARCH
Auto Regressive Conditional Heteroskedasticity
Developed by Robert F. Engle (Nobel prize laureate 2003)
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Then came the GARCH
"Generalized" ARCH
Developed by Tim Bollerslev (Robert F. Engle's student)
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Related statistical terms
White noise (z): Uncorrelated random variables with a zero mean and a nite variance
Residual = predicted value - observed value
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Model notations
Expected return: Expected volatility:
μt = Expected[rt ∣I(t − 1)] σ 2 = Expected[(rt − μt )2 ∣I(t − 1)]
Residual (prediction error): Volatility is related to the residuals:
rt = μt + ϵt ϵt = σt ∗ ζ(W hiteNoise)
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Model equations: ARCH
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Model equations: GARCH
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Model intuition
Autoregressive: predict future behavior based on past behavior
Volatility as a weighted average of past information
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GARCH(1,1) parameter constraints
To make the GARCH(1,1) process realistic, it requires:
All parameters are non-negative, so the variance cannot be negative.
ω, α, β >= 0
Model estimations are "mean-reverting" to the long-run variance.
α+β < 1
long-run variance:
ω/(1 − α − β)
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GARCH(1,1) parameter dynamics
The larger the α, the bigger the immediate impact of the shock
The larger the β , the longer the duration of the impact
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Let's practice!
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How to implement
GARCH models in
Python
GA RCH MODELS IN P YTH ON
Chelsea Yang
Data Science Instructor
Python "arch" package
from arch import arch_model
1 Kevin Sheppard. (2019, March 28). bashtage/arch: Release 4.8.1 (Version 4.8.1). Zenodo.
http://doi.org/10.5281/zenodo.2613877
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Work ow
Develop a GARCH model in three steps:
1. Specify the model
2. Fit the model
3. Make a forecast
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Model speci cation
Model assumptions:
Distribution: "normal" (default), "t" , "skewt"
Mean model: "constant" (default), "zero" , "AR"
Volatility model: "GARCH" (default), "ARCH" , "EGARCH"
basic_gm = arch_model(sp_data['Return'], p = 1, q = 1,
mean = 'constant', vol = 'GARCH', dist = 'normal')
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Model tting
Display model tting output after every n iterations:
gm_result = gm_model.fit(update_freq = 4)
Turn off the display:
gm_result = gm_model.fit(disp = 'off')
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Fitted results: parameters
Estimated by "maximum likelihood method"
print(gm_result.params)
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Fitted results: summary
print(gm_result.summary())
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Fitted results: plots
gm_result.plot()
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Model forecasting
# Make 5-period ahead forecast
gm_forecast = gm_result.forecast(horizon = 5)
# Print out the last row of variance forecast
print(gm_forecast.variance[-1:])
h.1 in row "2019-10-10": 1-step ahead forecast made using data up to and including that date
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Let's practice!
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