LONDON METROPOLITAN UNIVERSITY BUSINESS

SCHOOL

RESEARCH METHODS

AN EXAMPLE OF VOLATILITY ANALYSIS

by

John Coshall

AN EXAMPLE OF VOLATILITY ANALYSIS

Page
1 Introduction

2 Derivation of the mean equation

3 Computation of logarithms and the mean equation in EViews

4 The variance equation in EViews

10

5 Forecasting from volatility models

16

AN EXAMPLE OF VOLATILITY ANALYSIS

1 Introduction

On

the

university

file

server,

you

will

find

the

SPSS

data

file

TOURISMEARNINGS(VOL).SAV. The file contains UK monthly earnings from

international tourism (000s, current prices, SPSS variable name EARNINGS) from
January 1980 to March 2006.

The purpose of this exercise is to fit a volatility model

to the data from January 1980 to February 2005 inclusive, which is called the
historical period. We hold back data from March 2005 to March 2006 to see how
good the volatility model has been in generating forecasts. The latter period of time is
called the holdback period. There are two research questions:

1) Is the concept of volatility relevant to these data and

2) Does volatility modelling offer an improvement on competing forecasting

methods?

The raw data are plotted below:

2000

Earnings

1500

1000

500

0
JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN
1980 1981 1983 1985 1986 1988 1990 1991 1993 1995 1996 1998 2000 2001 2003 2005

Date

Seasonality, an upward trend and increasing variation are clearly evident. There
seems to be a drop in earnings associated with events leading up to the Gulf War of
1991 and with the events of September 11th 2001.

Natural logarithms have to be taken before any differencing is considered. This is

achieved in SPSS via:

Transform
Compute variable

in SPSS, by which means a variable called LOGEARN is created.

In the data file, each reading has been labelled from 1st to 315th via a variable called
CASENUM. In order to select the period before March 2005 as the historical period,
we need to access the Select Cases dialogue box by means of:

Data
Select cases

and the dialogue box below appears:

We need to select cases for which CASENUM is less than or equal to 302. Choose
the option If condition is satisfied from the previous dialogue box and click the IF
button:

Type in or paste the condition as shown above. When returning to the original data
file, you will notice that readings not selected for model building i.e. the holdback
period are crossed out in the left had margin.

2 Derivation of the mean equation

EViews is used to fit volatility models and the package permits the mean equation to
be either a regression model or an ARIMA model. Here we shall use the latter.
Having computed LOGEARN, we clearly need to take seasonal differences of this
variable in SPSS via:

Transform
Create Time Series

and selecting seasonal differences of order 1. This new variable was given the name
SEASDIFF. A plot of the first order, seasonally differenced data suggested that SD =
1 is adequate.

This leaves the trend to be dealt with. Using the above method to take ordinary first
differences of SEASDIFF, suggested that D = 1 is adequate. The plot below is the
EARNINGS after taking logarithms, 1st order seasonal differencing and 1st order
ordinary differencing:

Value DIFF(seasdiff,1)

0.20

0.00

-0.20

-0.40
JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN SEP MAY JAN
1980 1981 1983 1985 1986 1988 1990 1991 1993 1995 1996 1998 2000 2001 2003 2005

Date. Format: "MMM YYYY"

It only remains to use the autocorrelation function (ACF) and the partial
autocorrelation function (PACF) to establish a final ARIMA model.

The usual

considerations led to an AR(1), AR(2), MA(12) model with no intercept, to act as the
mean equation.

3 Computation of logarithms and the mean equation in EViews

It is necessary to define the historical period as 1980M1 to 2005M2 in EViews before
defining the mean and variance equations that are necessary for volatility analysis,
since the default in EViews is that all readings should be used. In EViews, click:

Quick
Sample

to generate the dialogue box below. EViews uses the notation @all to represent that
all the readings should be used. I have replaced this by the first and last dates of the
historical period:

Next we have to compute the natural logarithm of the variable EARNINGS, which is
achieved via:

Quick
Generate Series

and in EViews, the LOG operator represents logarithms to the base of e:

If the user wishes to run the AR(1), AR(2), MA(12) model as the mean equation,
click:

Quick
Estimate equation

and complete the dialogue box as shown overleaf:

EViews uses the d or difference operator, which has the form d(variable name, order
of ordinary differences, order of seasonal differences) and the order typed in for the
seasonal differences here is the number of months i.e. 12. Clicking the OK button
will give the ARIMA parameter values and their statistical significance. This is not
overly important here, since we wish to add a variance equation to the above mean
equation in order to produce a volatility model.

4 The variance equation in EViews

In order to run various volatility models, it is first necessary to type in the mean
equation via:

Quick
Estimate equation

10

which generates the dialogue box at the top of the previous page. However, we do not
require Least Squares as the Model, so click the downward pointing arrow and
choose the ARCH class of volatility models. This gives rise to the following dialogue
box:

The mean equation appears at the top of this dialogue box. Note that the default
model in EViews is the GARCH(1,1) scheme which occurs often in financial
analyses. Click the Options tab at the top of this dialogue box and choose the settings
overleaf:

11

There are two algorithms available and if a solution does not converge via one of
them, try the other. The maximum number of iterations used by either algorithm is
500, but may be increased.

Returning to the GARCH dialogue box on the previous page, you can change the
numbers of ARCH and GARCH terms in your model. I would suggest looking at all
combinations of ARCH = 0, 1, 2 with GARCH = 0, 1, 2 (ignoring the ARCH = 0,
GARCH = 0 combination). Most models reported in the literature fall within these
parameter values. When the Threshold order is set to zero, the volatility model is
symmetric i.e. the impact of good news equals the impact of bad news. If the user
requires an asymmetric model, change the Threshold order to have value 1.

12

If you click the downward pointing arrow associated with the Model box, you will
find the EGARCH and PARCH models become available. Again try the combinations
of ARCH terms = 0, 1, 2 and GARCH terms = 0, 1, 2. When the Asymmetric order
is set to 1, the user is generating an asymmetric EGARCH or PARCH model; when
the Asymmetric order is set to zero, the model is symmetric.

Clearly, more than one of the ARCH, GARCH, EGARCH and PARCH models may
have significant parameters and also obey any restrictions placed on the model e.g.
non-negativity in the cases of the (G)ARCH models. If two or more significant
models are generated, then the optimal model is that with the minimum Schwarz
Bayesian Criterion (SBC) or with the maximum Log Likelihood criterion (LL),
with the latter seemingly being the preferred reporting method in the literature.

All combinations of symmetric and asymmetric volatility models were run. The
symmetric EGARCH(0,1) model was applied via the dialogue box shown overleaf:

13

14

The results below apply to the symmetric EGARCH(0,1) model (SBC = -2.186, LL =
327.89). This was marginally superior to a symmetric GARCH(0,1) model (SBC =
-2.185, LL = 327.84).

The coefficients of the mean equation are all significant. By default, EViews always
enters a constant term [C(4) in the above dialogue box]. It does not matter that this
term is not significantly different from zero. We conclude that UK earnings from
international tourism can be volatile. Further, the impact of a bad news shock to
tourism earnings has the same impact as a good news shock of the same magnitude.
Consequently, the inclusion of the volatility concept should improve forecasts.

15

5 Forecasting from volatility models

Click the forecast button in the above dialogue box, firstly to generate forecasts for
the historical period. There is the option of forecasting LOGEARN or the differenced
values for this variable. Note that the default EViews name for the forecasts is
LOGEARNF.

Static forecasts have been chosen as opposed to dynamic forecasts. Static forecasts
use the previously observed values of the Y variable when generating forecasts. This
is fine for the historical period, because previous values of Y are known. Dynamic
forecasts use the previously forecasted values of Y in order to generate further
forecasts. This would apply to the holdback period, since in reality, future values of Y
are unobserved.

16

The results below were obtained:

The top graph is of LOGEARN and LOGEARNF and suggests an excellent fit. The
values of the RMSE, MAE and MAPE confirm this. The bottom graph is a plot of the
conditional variance over time for the historical period. Volatility peaked around
1984 and thereafter remained at a relatively constant level.

Of course, we are interested in forecasting the EARNINGS variable into the holdback
period 2005M3 to 2006M3. Run through the forecasting procedure again, but this
time selecting the time period as 2005M3 to 2006M3 and choose dynamic forecasts.
The forecasts are generated, but we must convert the logarithms back to earnings data
via:

17

Quick
Generate Series

and using EARNINGF to represent forecasted earnings from tourism, then

EARNINGF = EXP(LOGEARNF) as shown below:

Open just EARNINGS and ERARNINGF in one EViews sheet and plot them over the
holdback time period as shown on the next page. You use the option:

Quick
Plot

to achieve this. The variable names are entered for you and the dates pertaining to the
holdback period have to be set. The question is whether other models e.g. exponential
smoothing can beat the adequacy measures such as MAPE over the holdback period.

18

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