Garch 101

GARCH 101
Robert Engle
Robert Engle is Visiting Professor of Finance, Stern School of Business,

New York University, New York, New York, and Professor of Economics,
University of California at San Diego, La Jolla, California.
The great workhorse of applied econometrics is the least squares

model. The basic version of the model assumes that, the expected
value of all error terms, in absolute value, is the same at any given
point. Thus, the expected value of any given error term, squared, is
equal to the variance of all the error terms taken together. This
assumption is called homoskedasticity. Conversely, data in which the
expected value of the error terms is not equal, in which the error terms
may reasonably be expected to be larger for some points or ranges iof
the data than for others, is said to suffer from heteroskedasticity.
It has long been recognized that heteroskedasticity can pose
problems in ordinary least squares analysis. The standard warning is
that in the presence of heteroskedasticity, the regression coefficients
for an ordinary least squares regression are still unbiased, but the
standard errors and confidence intervals estimated by conventional
procedures will be too narrow, giving a false sense of precision.
However, the warnings about heteroskedasticity have usually been
applied only to cross sectional models, not to time series models. For
example, if one looked at the cross-section relationship between
income and consumption in household data, one might expect to find
that the consumption of low-income households is more closely tied to
income than that of high-income households, because poor households
are more likely to consume all of their income and to be liquidityconstrained. In a cross-section regression of household consumption
on income, the error terms seem likely to be systematically larger for
high-income than for low-income households, and the assumption of
homoskedasticity seems implausible. In contrast, if one looked at an
aggregate time series consumption function, comparing national
income to consumption, it seems more plausible to assume that the
variance of the error terms doesnt changed much over time.
A recent developments in estimation of standard errors,
known as robust standard errors, has also reduced the concern over
heteroskedasticity. If the sample size is large, then robust standard
errors give quite a good estimate of standard errors even with
heteroskedasticity. Even if the sample is small, the need for a
heteroskedasticity correction that doesnt affect the coefficients, but
only narrows the standard errors somewhat, can be debated.
However, sometimes the key issue is the variance of the error
terms itself. This question often arises in financial applications where
the dependent variable is the return on an asset or portfolio and the
variance of the return represents the risk level of those returns. These
are time series applications, but it is nonetheless likely that
heteroskedasticity is an issue. Even a cursory look at financial data
suggests that some time periods are riskier than others; that is, the
expected value of error terms at some times is greater than at others.
Moreover, these risky times are not scattered randomly across

quarterly or annual data. Instead, there is a degree of autocorrelation
in the riskiness of financial returns. ARCH and GARCH models, which
stand for autoregressive conditional heteroskedasticity and
generalized autoregressive conditional heterosjedasticity, have
become widespread tools for dealing with time series heteroskedastic
models such as ARCH and GARCH. The goal of such models is to
provide a volatility measure like a standard deviation -- that can be
used in financial decisions concerning risk analysis, portfolio selection
and derivative pricing.
ARCH/GARCH Models
Because this paper will focus on financial applications, we will use

financial notation. Let the dependent variable be labeled rt , which
could be the return on an asset or portfolio. The mean value m and the
variance h will be defined relative to a past information set. Then, the
return r in the present will be equal to the mean value of r (that is, the
expected value of r based on past information) plus the standard
deviation of r (that is, the square root of the variance) times the error
term for the present period.
The econometric challenge is to specify how the information is used to
forecast the mean and variance of the return, conditional on the past
information. While many specifications have been considered for the

mean return and have been used in efforts to forecast future returns,
rather simple specifications have proven surprisingly successful in
predicting conditional variances. The most widely used specification is
the GARCH (1,1) model introduced by Bollerslev (1986) as a
generalization of Engle(1982). The (1,1) in parentheses is a standard
notation in which the first number refers to how many autoregressive
lags appear in the equation, while the second number refers to how
many lags are included in the moving average component of a
variable. Thus, a GARCH (1,1) model for variance looks like this:
ht ht 1t21 ht 1 .
This model forecasts the variance of date t return as a weighted

average of a constant, yesterdays forecast, and yesterdays squared
error. Of course, if the mean is zero, then from the surprise is simply
rt21 .
Thus the GARCH models are conditionally heteroskedastic but have a

constant unconditional variance.
Possibly the most important aspect of the ARCH/GARCH model is the

recognition that volatility can be estimated based on historical data
5
and that a bad model can be detected directly using conventional

econometric techniques. A variety of statistical software packages like
Eview and others? are available for implementing GARCH and ARCH
approaches.
A Value at Risk Example
Applications of the ARCH/GARCH approach are widespread in

situations where volatility of returns is a central issue. Many banks and
other financial institutions use the idea of value at risk as a way to
measure the risks faced by their portfolios. The 1% value at risk is
defined as the number of dollars that one can be 99 percent certain
exceeds any losses for the next day. Lets use the GARCH (1,1) tools to
estimate the 1 percent value at risk of a $1,000,000 portfolio on March
23, 2000. This portfolio consists of 50 percent Nasdaq, 30 percent Dow
Jones, and 20 percent long bonds. This date is chosen to be just before
the big market slide at the end of March and April. It is a time of high
volatility and great anxiety.
First, we construct the hypothetical historical portfolio. (All
calculations in this example were done with the Eviews software
program.) Figure 1 shows the pattern of the Nasdaq, Dow Jones, and
long bonds. In Table 1, we present some illustrative statistics for each
of these three investments separately, and for the portfolio as a whole

in the final column.
Then we forecast the standard deviation of the portfolio and its 1

percent quantile. We carry out this calculation over several different
time frames: the entire 10 years of the sample up to March 23, 2000;
the year before March 23, 2000; and from January 1, 2000 to March 23,
2000.
Consider first the quantiles of the historical portfolio at these
three different time horizons. Over the full ten-year sample, the 1
percent quantile times $1,000,000 produces a value at risk of $22,477.
Over the last year the calculation produces a value at risk of #24, 653
somewhat higher, but not enormously so. However, if the first
quantile is calculated based on the data from January 1, 2000 to March
23, 2000, the value at risk is $35,159. Thus, the level of risk has
increased dramatically over the last quarter.
The basic GARCH(1,1) results are given in Table 2 below. Notice
that the coefficients sum up to a number slightly less than one. The
forecast standard deviation for the next day is 0.014605, which is
almost double the average standard deviation of .0083 presented in
the last column of Table 1. If the residuals were normally distributed,
then this would be multiplied by 2.326348 giving a VaR=$33,977. As it
turns out, the standardized residuals, which are the estimated values
of t , have a 1% quantile of 2.8437, which is well above the normal

quantile. The estimated 1% VaR is $39,996. Notice that this VaR has
risen to reflect the increased risk in 2000.
Extensions and Modifications of GARCH
The GARCH(1,1) is the simplest and most robust of the family of

volatility models. However, the model can be extended and modified
in many ways. We will briefly mention three modifications.
The GARCH (1,1) model can be generalized to a GARCH(p,q)
model; that is, a model with additional lag terms. Such higher order
models are often useful when a long span of data is used, like several
decades of daily data or a year of hourly data. With additional lags,
such models allow both fast and slow decay of information. A
particular specification of the GARCH(2,2) by Engle and Lee(1999),
sometimes called the component model, is a useful starting point to
this approach.
Another version of GARCH models takes an asymmetric view by
estimating positive and negative returns separately. Typically, higher
volatilities follow negative returns than positive returns of the same
magnitude. Two models which take this asymmetric approach are the
TARCH model threshhold ARCH -- attributed to Zakoian() and Glosten
Jaganathan and Runkle (1993), and the EGARCH model of Nelson(1991

It is also possible to incorporate exogenous variables into the
GARCH equation. Like what variables?
Software packages like Eviews offer a variety of tests to check
specifications of ARCH/GARCH models or to choose between models.
Conclusion
Volatility models have been applied in a wide variety of applications. In

most cases, volatility is itself an interesting aspect of the problem. In
some cases, volatility is an input used for purposes of measurement,
like in the example of estimating value at risk given earlier. In other
cases, volatility may be a causal variable, as in models expected
volatility is a determinant of expected returns.
0.10
0.05
0.00
-0.05
-0.10
3/27/90
2/25/92
1/25/94
12/26/95
11/25/97
10/26/99
11/25/97
10/26/99
11/25/97
10/26/99
NQ
0.10
0.05
0.00
-0.05
-0.10
3/27/90
2/25/92
1/25/94
12/26/95
DJ
0.10
0.05
0.00
-0.05
-0.10
3/27/90
2/25/92
1/25/94
12/26/95
RATE
Nasdaq,Dow Jones, and Bond Returns

Figure 1
10
Table 1
Portfolio Data
Sample: 3/23/1990 3/23/2000
Mean
Std. Dev.
Skewness
Kurtosis
NQ
DJ
RATE
PORT
0.0009
0.0115
-0.5310
7.4936
0.0005
0.0090
-0.3593
8.3288
0.0001
0.0073
-0.2031
4.9579
0.0007
0.0083
-0.4738
7.0026
11
Table 2
GARCH(1,1)
Dependent Variable: PORT
Sample(adjusted): 3/26/1990 3/23/2000
Convergence achieved after 16 iterations
Bollerslev-Wooldrige robust standard errors & covariance
Variance Equation
C
ARCH(1)
GARCH(1)
S.E. of regression
Sum squared resid
Log likelihood
0.0000
0.0772
0.9046
0.0083
0.1791
9028.2809
0.0000
0.0179
0.0196
Akaike info criterion
Schwarz criterion
Durbin-Watson stat
12
3.1210
4.3046
46.1474
0.0018
0.0000
0.0000
-6.9186
-6.9118
1.8413
References
Bollerslev, Tim, 1986, Generalized Autoregressive Conditional

Heteroskedasticity, Journal of Econometrics, 31, 307-327.
Bollerslev, Tim and Wooldridge, Jeffrey M., 1992, Quasi-Maximum

Likelihood Estimation and Inference in Dynamic Models with TimeVarying Covariances, Econometric Reviews, 11(2), 143-172.
Engle, Robert F., 1982, Autoregressive Conditional Heteroscedasticity

with Estimates of the Variance of United Kingdom Inflation,
Econometrica, 50(4), 987-1007.
Engle, Robert F., and Manganelli, Simone, 1999, CAViaR: Conditional

Autoregressive Value at Risk by Regression Quantiles, University of
California, San Diego, Department of Economics Working Paper 99-20.
Engle, Robert F., and Mezrich, Joseph, 1996, GARCH for Groups, RISK,
9(8), 36-40.
Engle, Robert F., and Ng, Victor, 1993, Measuring and Testing the
Impact of News on Volatility, Journal of Finance, 48, 1749-1778.
13
Glosten, Lawrence R., Jagannathan, Ravi and Runkle, David E., 1993,
On the Relation between the Expected Value and the Volatility of
the Nominal Excess Returns on Stocks, Journal of Finance, 48(5),
1779-1801.
Nelson, Daniel B., 1991, Conditional Heteroscedasticity in Asset
Returns: A New Approach, Econometrica, 59(2), 347-370.
14

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GARCH 101

Robert Engle is Visiting Professor of Finance, Stern School of Business,

The great workhorse of applied econometrics is the least squares

Moreover, these risky times are not scattered randomly across

Because this paper will focus on financial applications, we will use

information. While many specifications have been considered for the

This model forecasts the variance of date t return as a weighted

Thus the GARCH models are conditionally heteroskedastic but have a

Possibly the most important aspect of the ARCH/GARCH model is the

and that a bad model can be detected directly using conventional

A Value at Risk Example

Applications of the ARCH/GARCH approach are widespread in

of these three investments separately, and for the portfolio as a whole

Then we forecast the standard deviation of the portfolio and its 1

of t , have a 1% quantile of 2.8437, which is well above the normal

Extensions and Modifications of GARCH

The GARCH(1,1) is the simplest and most robust of the family of

Jaganathan and Runkle (1993), and the EGARCH model of Nelson(1991

Volatility models have been applied in a wide variety of applications. In

Nasdaq,Dow Jones, and Bond Returns

Bollerslev, Tim, 1986, Generalized Autoregressive Conditional

Bollerslev, Tim and Wooldridge, Jeffrey M., 1992, Quasi-Maximum

Engle, Robert F., 1982, Autoregressive Conditional Heteroscedasticity

Engle, Robert F., and Manganelli, Simone, 1999, CAViaR: Conditional

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