VOLATILITY FORECASTING

Steven Poher
Ramzi Rached
Ricardo Uribe
Global Investment Management Dongting Zheng
AGENDA

• Objective
• Background Information
• Forecasting Models
• Data set
• Methodology
• Results
• Conclusion
OBJECTIVE

• Objective
• To establish a variance forecasting model

• Why?
• Important for risk managers (VaR)
• Used to price options
• Volatility + Return = investment
decision
BACKGROUND INFORMATION

• Realized / observed volatility is measured by

squared returns
• Volatility displays a positive correlation
with its own past

1 m 2
• Simple Model  t 1   R t 1
2

m  1

• PB : Equal weights on the past m

observations
FORECASTING MODELS

• More flexible model  Simple GARCH or

GARCH (1,1)
 2t 1    Rt 2    t 2

• Extended to Local and Global

Instruments
 2t 1     Rt 2   t 2  i 1 ( L ZiL   G ZiG )
n
i i

• Models to be tested for this project

1. GARCH (1,1)
2. GARCH (1,1) + Local
3. GARCH (1,1) + Global
4. GARCH (1,1) + Local + Global
DATA SET
• Source DataStream
• Period 3/27/1998 - 3/28/2008 (10 years)
• Granularity 1 day

Country Index
NIKKEI 225
CAC 40
DAX 30
FTSE 100
S&P 500
DATA SET

• Local Instruments
• Change in Exchange Rates
• EUR / USD / JPY / GBP
• Change in short-term interest rates
• T-Bill (US) / BTAN (FR)

• Global Instruments
• Change in Short-term Eurodollar rate
• Change in the Term Structure spread
METHODOLOGY

• Using EXCEL, test our 4 models for each of our 5 markets

• Use Maximum Likelihood Estimation (MLE) to estimate  /

 /  /  EXCEL Solver

• Test the models using a regression of Squared Returns vs.

Forecasted Variance

• Discuss the statistical significance of the regression /

Select the best model for a given country
METHODOLOGY - EXAMPLE
GR
Estimating GARCH(1,1) with Local and Global Instruments - German Market
GERMANY % Change in Ū/£ T erm Structure Squared Conditional
DAT E Return Likelihood
DAX 30 Exchange Rate Spread Returns Variance
Without Variance Targeting
Mar 27, 98 5,438.86  0.084361
Mar 30, 98 5,311.90 0.44% 0.24% -2.36% 0.000558 0.000238 2.080044  0.901481
Mar 31, 98 5,396.16 0.04% 0.24% 1.57% 0.000248 0.000265 2.731626  0.000002
Apr 01, 98 5,450.07 -0.03% 0.24% 0.99% 0.000099 0.000261 3.016659  0.095203
Apr 02, 98 5,475.79 -0.37% 0.24% 0.47% 0.000022 0.000246 3.191489  0.000242
Apr 03, 98 5,530.61 -0.45% 0.24% 1.00% 0.000099 0.000226 3.058406 MLE 7,532.98
Apr 06, 98 5,595.27 -0.18% 0.25% 1.16% 0.000135 0.000216 2.988255 R2 0.1556
Apr 07, 98 5,697.96 0.14% 0.25% 1.82% 0.000331 0.000208 2.525438 F Statistic 480.62
Apr 08, 98 5,649.06 -0.56% 0.25% -0.86% 0.000074 0.000218 3.126785
Apr 09, 98 5,721.73 0.02% 0.25% 1.28% 0.000163 0.000207 2.927757
Apr 10, 98 5,721.73 0.00% 0.25% 0.00% 0.000000 0.000202 3.334149
Apr 13, 98 5,704.71 0.00% 0.25% -0.30% 0.000009 0.000184 3.357209
Apr 14, 98 5,828.16 -0.11% 0.25% 2.14% 0.000458 0.000168 2.064456
Apr 15, 98 5,864.82 -0.18% 0.25% 0.63% 0.000039 0.000192 3.257141
Apr 16, 98 5,760.89 0.75% 0.25% -1.79% 0.000320 0.000179 2.501362
Apr 17, 98 5,701.19 -0.47% 0.25% -1.04% 0.000109 0.000195 3.074001
Apr 20, 98 5,905.46 -0.55% 0.22% 3.52% 0.001239 0.000189 0.087533
Apr 21, 98 5,886.94 -0.72% 0.22% -0.31% 0.000010 0.000279 3.154881
Apr 22, 98 5,851.94 0.07% 0.22% -0.60% 0.000036 0.000259 3.141278
Apr 23, 98 5,710.36 -0.17% 0.22% -2.45% 0.000600 0.000238 1.994152
Apr 24, 98 5,604.24 -0.05% 0.22% -1.88% 0.000352 0.000268 2.536585
Apr 27, 98 5,560.93 -0.08% 0.27% -0.78% 0.000060 0.000273 3.074337
Apr 28, 98 5,467.96 0.12% 0.27% -1.69% 0.000284 0.000253 2.660274
Apr 29, 98 5,570.09 0.16% 0.27% 1.85% 0.000342 0.000254 2.545737
Apr 30, 98 5,566.62 0.08% 0.27% -0.06% 0.000000 0.000259 3.208788
May 01, 98 5,614.38 -1.09% 0.27% 0.85% 0.000073 0.000236 3.102717
May 04, 98 5,834.77 0.00% 0.30% 3.85% 0.001483 0.000232 0.067145
May 05, 98 5,772.30 -0.64% 0.30% -1.08% 0.000116 0.000336 2.908149
May 06, 98 5,796.04 -0.23% 0.30% 0.41% 0.000017 0.000318 3.081275
RESULTS

Best models for each country

Country Model R2
GARCH + % Change in Term Structure 1.21 %
Spread (G)
GARCH + % Change in €/£ (L) 14.12 %

GARCH + % Change in €/£ (L) + % 15.56 %

Change in Term Structure Spread (G)
GARCH (1,1) + % Change in $/£ (L) + 14.23 %
% Change in ST Eurodollar (G)
GARCH 10.58 %
 RESULTS

• Best model for German Market

• R2 of 15.56%
• Final equation
• Simple GARCH +
• % Change in €/£ Exchange (L) +
• % Change in Term Structure Spread (G)
 2 t 1  0 .000002  0.084361 Rt 2  0.901481  t 2  0.095203 L
3  0.000242 Z G 1
RESULTS
DE MARKET - SIMPLE GARCH + Ū/£ + Term Structure Spread

0.0024
Realized Forecasts

0.0020

0.0016

0.0012

0.0008

0.0004

0.0000
Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep
98 98 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07
CONCLUSION

• No universal model
• Different countries = different models
• Good proxy for DE / Bad for JP

• GARCH could also be extended

• Leverage effects
• Day-of-week effects
• Jumps

• Economic intuition & reality check

QUESTIONS?

THANK YOU