12.

Nonlinearities in Financial Markets

Nonlinear Structure in Univariate Time Series
A typical time-series model relates an ob-
served time series x
t
to an underlying se-
quence of shocks
t
. In linear time-series the
shocks are assumed to be uncorrelated but
not necessarily IID. Assuming further that
E[
t
] =

(a nite constant) and Var[

t
] =
2

(a nite constant), then by the Wold Repre-

sentation Theorem any covariance station-
ary

series x
t
can be written as an innite-
order linear combination of
t
s.
In nonlinear time-series analysis the underly-
ing the shocks are assumed to be IID, but
the function relating x
t
and the shocks may
be nonlinear.

x
t
is covariance stationary if
E[x
t
] = for all t
Var[x
t
] =
0
for all t
Cov[x
t
; x
t+k
] =
k
for all t
119
In practice a general representation is
x
t
= g(
t1
;
t2
; : : :) +
t
h(
t1
;
t2
; : : :);
where E[
t
] = 0, Var[
t
] = 1, E
t1
[x
t
] =
g(
t1
;
t2
; : : :) is an (unknown) conditional
mean function and Var
t1
[x
t
] = h
2
(
t1
;
t2
; : : :)
is an (unknown) conditional standard devia-
tion function (h
2
() = h()
2
is the variance).
A simple nonlinear moving average model is
x
t
=
t
+
2
t1
:
Here g(
t1
; : : :) =
2
t1
and h(
t1
; : : :) = 1.
ARCH(1) model is of the form
x
t
=
t
q

2
t1
;
with g() = 0 and h() =
q

2
t1
.
120
The family of nonlinear models is impossi-
ble to account exhaustively. Most generally
utilized groups of nonlinear models are
Polynomial models
Piecewise-linear models
Markov-switching models
Deterministic nonlinear dynamical systems
(chaos theory)
We briey consider only the last item later in
this section. Before that we consider mod-
eling volatility with the popular ARCH ap-
proach.
121
Models of Changing Volatility
Let
t+1
be an innovation, i.e., E
t
[
t+1
] = 0.
For the moment we assume that the con-
ditional distribution, where we condition on
time t information, is

t+1
N(0;
2
t
);
where
2
t
= Var
t
[
t+1
]. Then we can always
write

t+1
=
t

t+1
;
122
were
t
NID(0; 1).
The unconditional variance is

2
= Var[
t+1
] = E[
2
t+1
] = E
h
E
t
[
2
t+1
]
i
= E[
2
t
]:
Variability in
2
t
aects higher moments of
the unconditional distribution. Implying that
the unconditional distribution has fatter tails
than a normal distribution.
This can be easily seen from the kurtosis
K(y) =
E[y E[y]]
4

E[y E[y]]
2

2
=
E[y E[y]]
4

4
y
;
where
y
=
q
Var[y]].
Then
K(
t+1
) =
E[
4
t
]E[
4
t+1
]
(
E[
2
t
]
)
2
=
3E[
4
t
]
(
E[
2
t
]
)
2

E[
2
t
]

2
(
E[
2
t
]
)
2
= 3:
123
ARCH Models
A basic observation about asset returns is
that large returns (of either sign) tend to
be followed by more large returns (of either
sign). That is, volatility of asset returns tend
to be serially correlated.
Example. Weekly HEX index December 28,
1990 to October 2, 1997.
0
1
0
0
2
0
0
3
0
0
6
.
5 7
7
.
5 8
T
i
m
e
l
a
g
W
e
e
k
l
y

L
o
g

H
e
x

I
n
d
e
x

[
2
8
.
1
0
.
9
0
-
-
2
.
1
0
.
9
7
]
W
e
e
k
l
y

H
e
x

R
e
t
u
r
n
s

(
l
o
g

d
i
f
f
e
r
e
n
c
e
s
)
-
1
0 0
1
0
0
1
0
0
2
0
0
3
0
0
0
5
1
0
-
.
5 0
.
5 1
C
o
r
r
e
l
o
g
r
a
m
T
i
m
e
-
1
0
-
5
0
5
1
0
.
0
5
.
1
R
e
t
u
r
n

d
i
s
t
r
i
b
u
t
i
o
n

w
i
t
h

n
o
r
m
a
l

d
e
n
s
i
t
y

c
u
r
v
e
124
Below are autocorrelations of weekly HEX re-
turns
Correlations of Series RFIN
Autocorrelations
1: 0.1738826 0.0887430 0.0761602
4: 0.0348751 0.0742724 -0.0455276
7: -0.0498641 -0.0270176 -0.0465262
10: -0.0052010 0.0685803 0.0363898
Ljung-Box Q-Statistics
Q(1) = 10.7337 Significance Level 0.00105200
Q(2) = 13.5375 Significance Level 0.00114911
Q(3) = 15.6085 Significance Level 0.00136401
Q(4) = 16.0440 Significance Level 0.00296066
Q(5) = 18.0250 Significance Level 0.00291528
Removing the serial dependence by ltering
the series with an AR(4) model, the residuals
are no more autocorrelated (actually AR(1)
would do the same thing).
Autocorrelations
1: 0.0002920 -0.0044309 0.0097342 . . .
Ljung-Box Q-Statistics
Q(1) = 2.9919e-005 Significance Level 0.99563576
Q(2) = 6.9411e-003 Significance Level 0.99653545
Q(3) = 0.0404 Significance Level 0.99786679
125
The same is seen from the graph below.
HEX return AR(4) residuals.
0
5
1
0
-
.
5 0
.
5 1
C
o
r
r
e
l
o
g
r
a
m
-
4
-
2
0
2
4
.
1
.
2
.
3
.
4
.
5
N
(
0
,
1
)
However, as the following plot and the auto-
correlations below show, the squared residu-
als are still autocorrelated.
126
Squared residuals
5
0
1
0
0
1
5
0
2
0
0
2
5
0
3
0
0
3
5
0
0
2
.
5 5
S
q
u
a
r
e
d

H
e
x

W
e
e
k
l
y

R
e
t
u
r
n

R
e
s
i
d
u
a
l
s

f
r
o
m

A
R
(
4
)
-
.
5 0
.
5 1
C
o
r
r
e
l
o
g
r
a
m
Correlations of Series RFRES2
Autocorrelations
1: 0.21929783 0.09208184 0.12010501
3: 0.09278874 0.11316812 0.08287282
7: 0.06507752 0.20459567 0.09322907
10: 0.16660506 0.23576720 0.00058920
Ljung-Box Q-Statistics
Q(1) = 16.8805. Significance Level 0.00003981
Q(2) = 19.8654. Significance Level 0.00004856
Q(3) = 24.9581. Significance Level 0.00001576
Q(4) = 28.0066. Significance Level 0.00001243
This indicates that the volatility is serially
correlated.
127
Engle (1982). ARCH(q)

2
t
= ! +(L)
2
t
;
where (L) is a polynomial of order q in the
lag operator L. The coecients of (L)
must be positive and ! must be positive.
An extension to ARCH is GARCH(p; q) due
to Bollerslev (1986).

2
t
= ! +(L)
2
t1
+(L)
2
t
;
where (L) is a polynomial of order p in the
lag operator. The most commonly used model
in the GARCH class is GARCH(1; 1)

2
t
= ! +
2
t1
+
2
t
= ! +( +)
2
t1
+(
2
t

2
t1
)
= ! +( +)
2
t1
+
2
t1
(
2
t
1)
Interpretation!
128
Alternatively we can write

2
t+1
= !+(+)
2
t
+(
t+1

2
t
)(
2
t

2
t1
);
an ARMA(1; 1) in squared variables where
the shocks
t+1

2
t
are heteroscedastic.
Persistence and Stationarity
When + < 1 then the unconditional vari-
ance is

2
= E[
2
t
] =
!
1
:
and j periods ahead predicted variance
E
t
[
2
t+j
] = (+)
j

2
t

!
1
!
+
!
1
:
129
When + = 1 then the j period prediction
is
E
t
[
2
t+j
] =
2
t
+j!:
So today's volatility aects forecasts of volatil-
ity into the innite future (unit root case).
The model is called IGARCH(1; 1) (Integrated
GARCH) due to Nelson (1990).
In a special case, when ! = 0, E
t
[
2
t+1
] =
2
t
,
so
2
t
is a martingale.
Extensions of GARCH
log ARCH
log(
2
t
) =
0
+
1
log(
2
t1
)+: : :+
q
log(
2
tq
)
Nonlinear ARCH (NARCH) (Higgins and Bera
1992)

2
t
=
h

0
(
2
)

+
2
(
2
t1
)

+: : : +
q
(
2
tq
)

i1

130
Exponential GARCH (EGARCH) (Nelson 1991)
log(
2
t
) =
0
+
q
X
i=1

i
g(
t1
)+
p
X
i=1

i
log(
2
ti
);
where
g(
t
) =
t
+[j
t
j E(j
t
j)]
and

t
=
t

t1
with
t
WN(0; 1). EGARCH responds asym-
metrically to positive and negative errors.
Asymmetric Power ARCH (A-PARCH) (Ding,
Granger and Engle 1993, JEF)

t
=
0
+
p
X
i=1

i
(j
ti
j
i

ti
)

+
q
X
j=1

tj
;
where
t
=
q

2
t
with the restrictions
0
> 0,
> 0,
i
0, 1 <
i
< 1, and
j
> 0.
Note. Most of the earlier models are just spe-
cial cases of A-PARCH. For example GARCH
is obtained by setting = 2 and
i
= 0.
131
Useful references for various types of ARCH-
models and their properties are found for ex-
ample from
Bera and Higgins. Journal of Econometrics
Surveys, 1993, 305{362.
Hentchel, L. (1995). All in one family: Nest-
ing symmetric and asymmetric GARCH mod-
els. Journal of Financial Economics, 39, 71{
104.
Nijman and Palm. GARCH Modelling of Volatil-
ity: An Introduction to Theory and Applica-
tions, Ch. 5 in Advanced Lectures in Quan-
titative Economics, 1993, Aart J. de Zeeuw
(editor).
Multivariate GARCH:
Kroner, K.F. and V.K. Ng (1998). Modeling
asymmetric comovements of asset returns.
The Review of Financial Studies, 11, 817{
844.
132
Conditional Nonnormality
So far we have assumed that the conditional
distribution (of returns) is normal, which im-
plies that the standardized variables

t+1
=

t+1

t
should be N(0; 1) distributed.
However, empirical studies have shown that
this is rarely supported. The standardized
residuals tend to remain still too fat tailed.
An alternative to normal distribution is the
t-distribution with k degrees of freedom
g(
t+1
) =

1
2
(k +1)

(
1
2
k)
p
k 2
0
@
1 +

2
t+1
k 2
1
A

1
2
(k+1)
;
133
where () is the Gamma function.
Using either the traditional normal or t-distribution,
estimation can be executed e.g. by SAS AU-
TOREG procedure, or RATS or some other
(advanced) econometric statistical package.
Consider as an example modeling the inno-
vations of weekly HEX returns. Use Glosten
et al. specication.
******************************
Normally distributed residuals
******************************
Estimation by BHHH
Iterations Taken 27
Usable Observations 349 Degrees of Freedom 343
Function Value -1103.63600205
Variable Coeff Std Error T-Stat Signif
*************************************************************
1. PH0 0.2797962886 0.0797533637 3.50827 0.00045103
2. PH1 0.1887899874 0.0281339071 6.71041 0.00000000
3. OM 0.4658294470 0.1827394751 2.54915 0.01079873
4. AL 0.0721917918 0.0259448874 2.78251 0.00539410
5. BE 0.8655281488 0.0365631950 23.67211 0.00000000
6. GA 0.0260153294 0.0231839782 1.12213 0.26180915
Log-likelihood -872.52755
AIC 878.52755
BIC 907.65798
134
***********************************
t-distribution
***********************************
Estimation by BHHH
Iterations Taken 21
Usable Observations 349 Degrees of Freedom 342
Function Value -1345.21316999
Variable Coeff Std Error T-Stat Signif
*************************************************************
1. PH0 0.2694599936 0.0805043296 3.34715 0.00081647
2. PH1 0.1881101341 0.0278632263 6.75120 0.00000000
3. OM 0.4699610142 0.1941738337 2.42031 0.01550725
4. AL 0.0740980429 0.0269020498 2.75436 0.00588063
5. BE 0.8663223819 0.0379900265 22.80394 0.00000000
6. GA 0.0190796278 0.0271234387 0.70344 0.48178351
7. 1/DF 0.0224820141 0.0230540368 0.97519 0.32946714
DF 44.48000
Log-likelihood -872.36195
AIC 879.36195
BIC 913.34745
Noting that t-distribution approaches the nor-
mal distribution as df ! 1 or equivalently
1=df !0, we observe that the estimate of df
is
^
df = 44:48 and 1=
^
df = 0:0225 with p-value
0:329. This indicates that the normal dis-
tribution ts empitrically equally well as the
t-ditrtibution to the data, and hence should
preferred here.
Below are also results when the AR(1)-model
for the return series is estimated by OLS.
135
Dependent Variable RFIN - Estimation by Least Squares
Usable Observations 351 Degrees of Freedom 349
Total Observations 352 Skipped/Missing 1
Centered R**2 0.030574 R Bar **2 0.027796
Uncentered R**2 0.045457 T x R**2 15.955
Mean of Dependent Variable 0.3885904951
Std Error of Dependent Variable 3.1165135719
Standard Error of Estimate 3.0728946250
Sum of Squared Residuals 3295.4958003
Regression F(1,349) 11.0068
Significance Level of F 0.00100336
Durbin-Watson Statistic 2.015949
Q(36-0) 36.349547
Significance Level of Q 0.45237282
Variable Coeff Std Error T-Stat Signif
**************************************************************
1. PH0 0.3247985634 0.1651421891 1.96678 0.05000038
2. PH1 0.1751273931 0.0527864835 3.31766 0.00100336
The estimates of
0
and
1
do not change
much but their standard erros dier quite
radically.
136