---------------------------------------------------
#                                                 #
#     Chapter 4: The ARCH Time Series Model       #
#                                                 #
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In the last chapter we simulated the model

S(t_k) = S(t_{k-1}) * [ 1 + vol(t_{k-1})*phi_k ]                    (1)

with

vol^2(t_{k-1}) = stddev_d^2(t_{k-1})
               = 1/d * [ret^2(t_{k-1})+...+ret^2(t_{k-d})]          (2)

and we saw, that the volatility in that model converged 
to zero, the simulated paths stayed constant after a 
while. Apparently  vol(t_{k-1}) = 0  and  S(t_k) = const 
is a solution of the equations (1,2) for arbitrary 
random numbers phi_k. On the other hand, we saw that the 
model

S(t_k) = S(t_{k-1}) * [ 1 + bsvol * phi_k ]                         (3)

with a constant Black-Scholes volatility bsvol does not 
have this problem, the simulated paths looked quite 
reasonable. However, the data analysis of chapter 2 
clearly revealed that volatility is not constant and 
a good model should take this into account. Therefore, 
as a compromise between the models (1,2) and (3), we 
make the Ansatz:

vol^2(t_{k-1}) = w0*bsvol^2 + w1*stddev_d(t_{k-1})^2                (4)

               = w0 * bsvol^2 + 
                 w1 * 1/d * [ret^2(t_{k-1})+...+ret^2(t_{k-d})]     

with some positive weights w0 and w1 with 

                     w0 + w1 = 1 .

The price dynamics (1) with vol-specification (4) is 
called the ARCH-model or more precisely the ARCH(d)-
model, since the history of the past d days is taken 
into account.

Before we simulate a couple of paths, let's make some 
remarks:


Remark 1) The letters A, R, C and H stand for 

AR = AutoRegressive, that means, future returns depend 
                     on past returns, and: 
CH = Conditional Heteroskedastic, that means, that the current, 
     instantaneous volatilities are time dependent. 

There are conditional or instantaneous variances or 
volatilities, 

vol^2(t_{k-1}) = E[ ret^2(t_k) | t_{k-1} ]        

-- the notation on the right meaning that until time 
t_{k-1} everything is known and the expectation is 
taken only over phi_k -- and unconditional variances 
or volatilities, 

volbar^2 = E[ ret^2(t_k) ]                        

where the expectation is taken over all phi_k,...,phi_1.  
Heteroskedastic simply means: not constant, but time 
dependent.


Remark 2) Instead of vol-specification (4) one could 
make the more general Ansatz 

vol^2(t_{k-1}) = alpha0 + 
  alpha1 * ret^2(t_{k-1}) + ... + alphad * ret^2(t_{k-d})           (5)

with some d+1 parameters alpha0,...,alphad. Typically 
the specification (5) can be found in the books as the 
definition of the ARCH(d)-model. However, if one really 
wants to fit the model to actual time series data, one 
would merely choose a parametrization (4), eventually 
not necessasarily with equally weighted returns, but 
with linearly or exponentially weighted returns. The 
GARCH-model discussed in chapter 7 is basically an 
ARCH(d)-model with exponentially weighted returns. 

In addition, the parameters w0 and bsvol in (4) have an 
immediate intuitive meaning: as we will see in later 
chapters when we estimate the parameters with the 
maximum likelihood method, bsvol is usually very close 
to the standard deviation of the realized returns 
calculated over the full length of the time series. 
Thus, we don't have to estimate this parameter 
actually, but can calculate it directly as sd(ret), 
the standard deviation of the return series. 


Remark 3) In 2003, Robert Engle from New York Uni-
versity (together with Clive Granger) was awarded 
the Nobel Prize in Economics "for methods of analy-
zing economic time series with time-varying vola-
tility (ARCH)".


Now let's start and simply take a look at some 
simulated paths. To this end, we modify our  
pathNaivArch-function from the last chapter:



#
# Start R-Session: 
# 

pathArchd = function( N , bsvol , w0 , d )
{
  S = rep(0,N)
  ret = rep(0,N)
  phi = rnorm(N)
  S0 = 100
  vol0 = bsvol            # we put startvol to bsvol
  vol = rep(vol0,N)       # ARCH-vol
  
  sumretd = 0

  # the first step, k=1, is special:
  S[1] = S0*(1+vol0*phi[1])
  ret[1] = (S[1]-S0)/S0
  vol[1] = sqrt( w0*bsvol^2 + (1-w0)*ret[1]^2 )
  sumretd = sumretd + ret[1]^2

  for(k in 2:N)
  {
    if(k<=d)
    {
      S[k] = S[k-1]*(1+vol[k-1]*phi[k])
      ret[k] = (S[k]-S[k-1])/S[k-1]
      sumretd = sumretd + ret[k]^2
      vol[k] = sqrt( w0*bsvol^2 + (1-w0)*sumretd/k )
    }
    else
    {
      S[k] = S[k-1]*(1+vol[k-1]*phi[k])
      ret[k] = (S[k]-S[k-1])/S[k-1]
      sumretd = sumretd + ret[k]^2
      sumretd = sumretd - ret[k-d]^2
      vol[k] = sqrt( w0*bsvol^2 + (1-w0)*abs(sumretd)/d )
    }
  }#next k
  
  par(mfrow=c(2,1))
  plot(S,type="l",ylim=c(0,250))
  plot(ret,type="l",ylim=c(-0.08,0.08))

  result = list(S,ret)
  names(result) = c("S","ret")
  return(result)
}


#
# let's check:
#
# this should be Black-Scholes:
res = pathArchd( N=2500 , bsvol=0.01 , w0=1 , d=15 )
# returns are uniformly distributed:




# this is with variable vol:
res = pathArchd( N=2500 , bsvol=0.01 , w0=0.5 , d=15 )    
# vol looks still quite uniform:




res = pathArchd( N=2500 , bsvol=0.01 , w0=0.1 , d=15 )    
# this shows vol clustering:




res = pathArchd( N=2500 , bsvol=0.01 , w0=0.1 , d=10 )    
# this shows vol clustering:




res = pathArchd( N=2500 , bsvol=0.01 , w0=0.1 , d=250 )    
# for large d, returns become more uniform:




res = pathArchd( N=2500 , bsvol=0.01 , w0=0.1 , d=5 )     
# this shows vol clustering:




res = pathArchd( N=2500 , bsvol=0.01 ,w0=0.1  , d=1 )




res = pathArchd( N=2500 , bsvol=0.01 ,w0=0.01 , d=1 )




res = pathArchd( N=2500 , bsvol=0.01 ,w0=0    , d=1 )       
# w0 > 0 necessary to stabilizes the model:




res = pathArchd( N=2500 , bsvol=0.01 ,w0=0    , d=15 )      
# w0 > 0 necessary to stabilizes the model:




# a realistic set of parameters:
res = pathArchd( N=2500 , bsvol=0.015 ,w0=0.15, d=15 )  





This looks not unreasonable. Now we can start to fit 
the model to actual time series data. This we will do 
in the next chapter with the maximum likelihood method.




Option Pricing
Time Series Models















Hochschule RheinMain,
Applied Mathematics:


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