In developing an ARCH model, you will have to provide three distinct specifications-one

for the conditional mean equation, one for the conditional variance, and one for the
conditional error distribution. e begin by describing some basic specifications for these
terms. !he discussion of more complicated models is ta"en up in Additional ARCH
#odels.
!he $ARCH%&, &' #odel
e begin with the simplest $ARCH%&,&' specification(
%)*.&'
%)*.)'
in which the mean equation given in %)*.&' is written as a function of e+ogenous
variables with an error term. ,ince is the one-period ahead forecast variance based on
past information, it is called the conditional variance. !he conditional variance equation
specified in %)*.)' is a function of three terms(
A constant term( .
-ews about volatility from the previous period, measured as the lag of the squared
residual from the mean equation( %the ARCH term'.
.ast period/s forecast variance( %the $ARCH term'.
!he %&, &' in $ARCH%&, &' refers to the presence of a first-order autoregressive $ARCH
term %the first term in parentheses' and a first-order moving average ARCH term %the
second term in parentheses'. An ordinary ARCH model is a special case of a $ARCH
specification in which there are no lagged forecast variances in the conditional variance
equation-i.e., a $ARCH%0, &'.
!his specification is often interpreted in a financial conte+t, where an agent or trader
predicts this period/s variance by forming a weighted average of a long term average %the
constant', the forecasted variance from last period %the $ARCH term', and information
about volatility observed in the previous period %the ARCH term'. If the asset return was
une+pectedly large in either the upward or the downward direction, then the trader will
increase the estimate of the variance for the ne+t period. !his model is also consistent
with the volatility clustering often seen in financial returns data, where large changes in
returns are li"ely to be followed by further large changes.
!here are two equivalent representations of the variance equation that may aid you in
interpreting the model(
If we recursively substitute for the lagged variance on the right-hand side of
1quation %)*.)', we can e+press the conditional variance as a weighted average of all of
the lagged squared residuals(
%)*.*'.
e see that the $ARCH%&,&' variance specification is analogous to the sample variance,
but that it down-weights more distant lagged squared errors.
!he error in the squared returns is given by . ,ubstituting for the variances in the variance
equation and rearranging terms we can write our model in terms of the errors(
%)*.2'.
!hus, the squared errors follow a heteros"edastic AR#A%&,&' process. !he
autoregressive root which governs the persistence of volatility shoc"s is the sum of plus
. In many applied settings, this root is very close to unity so that shoc"s die out rather
slowly.
!he $ARCH%q, p' #odel
Higher order $ARCH models, denoted $ARCH%', can be estimated by choosing either
or greater than & where is the order of the autoregressive $ARCH terms and is the
order of the moving average ARCH terms.
!he representation of the $ARCH%' variance is(
%)*.3'
!he $ARCH-# #odel
!he in equation %)*.)' represent e+ogenous or predetermined variables that are included
in the mean equation. If we introduce the conditional variance or standard deviation into
the mean equation, we get the $ARCH-in-#ean %$ARCH-#' model %1ngle, .ilien and
Robins, &456'(
%)*.7'.
!he ARCH-# model is often used in financial applications where the e+pected return on
an asset is related to the e+pected asset ris". !he estimated coefficient on the e+pected
ris" is a measure of the ris"-return tradeoff.
!wo variants of this ARCH-# specification use the conditional standard deviation or the
log of the conditional variance in place of the variance in 1quation %)*.7'.
%)*.6'.
%)*.5'
Regressors in the 8ariance 1quation
1quation %)*.3' may be e+tended to allow for the inclusion of e+ogenous or
predetermined regressors, , in the variance equation(
%)*.4'.
-ote that the forecasted variances from this model are not guaranteed to be positive. 9ou
may wish to introduce regressors in a form where they are always positive to minimi:e
the possibility that a single, large negative value generates a negative forecasted value.
;istributional Assumptions
!o complete the basic ARCH specification, we require an assumption about the
conditional distribution of the error term . !here are three assumptions commonly
employed when wor"ing with ARCH models( normal %$aussian' distribution, ,tudent/s t-
distribution, and the $enerali:ed 1rror ;istribution %$1;'. $iven a distributional
assumption, ARCH models are typically estimated by the method of ma+imum
li"elihood.
<or e+ample, for the $ARCH%&, &' model with conditionally normal errors, the
contribution to the log-li"elihood for observation is(
%)*.&0',
where is specified in one of the forms above.
<or the ,tudent/s t-distribution, the log-li"elihood contributions are of the form(
%)*.&&'
where the degree of freedom controls the tail behavior. !he t-distribution approaches the
normal as .
<or the $1;, we have(
%)*.&)'
where the tail parameter . !he $1; is a normal distribution if , and fat-tailed if .
=y default, ARCH models in 18iews are estimated by the method of ma+imum
li"elihood under the assumption that the errors are conditionally normally distributed.
o estimate an ARCH or $ARCH model, open the equation specification dialog by
selecting >uic"?1stimate 1quation... or by selecting @bAect?-ew @bAect...?1quation....
,elect ARCH from the method combo bo+ at the bottom of the dialog.
!he dialog will change to show you the ARCH specification dialog. 9ou will need to
specify both the mean and the variance specifications, the error distribution and the
estimation sample.
!he #ean 1quation
In the dependent variable edit bo+, you should enter the specification of the mean
equation. 9ou can enter the specification in list form by listing the dependent variable
followed by the regressors. 9ou should add the C to your specification if you wish to
include a constant. If you have a more comple+ mean specification, you can enter your
mean equation using an e+plicit e+pression.
If your specification includes an ARCH-# term, you should select the appropriate item
of the combo bo+ in the upper right-hand side of the dialog.
!he 8ariance 1quation
9our ne+t step is to specify your variance equation.
Class of models
!o estimate one of the standard $ARCH models as described above, select the
$ARCH?!ARCH entry from the #odel combo bo+. !he other entries %1$ARCH,
BARCH, and Component ARCH%&, &'' correspond to more complicated variants of the
$ARCH specification. e discuss each of these models in Additional ARCH #odels.
Cnder the @ptions label, you should choose the number of ARCH and $ARCH terms.
!he default, which includes one ARCH and one $ARCH term is by far the most popular
specification.
If you wish to estimate an asymmetric model, you should enter the number of asymmetry
terms in the !hreshold order edit field. !he default settings estimate a symmetric model.
8ariance regressors
In the 8ariance Regressors edit bo+, you may optionally list variables you wish to
include in the variance specification. -ote that 18iews will always include a constant as
a variance regressor so that you do not need to add C to the list.
!he distinction between the permanent and transitory regressors is discussed in !he
Component $ARCH %C$ARCH' #odel.
!he 1rror ;istribution
!o specify the form of the conditional distribution for your errors, you should select an
entry from the combo bo+ labeled 1rror ;istribution. 9ou may choose between the
default -ormal %$aussian', the ,tudent/s t, the $enerali:ed 1rror %$1;', the ,tudent/s t
with fi+ed d.f., or the $1; with fi+ed parameter. In the latter two cases, you will be
prompted to enter a value for the fi+ed parameter. ,ee ;istributional Assumptions for
details on the supported distributions.
1stimation @ptions
18iews provides you with access to a number of optional estimation settings. ,imply
clic" on the @ptions tab and fill out the dialog as desired.
=ac"casting
=y default, both the innovations used in initiali:ing #A estimation and the initial
variance required for the $ARCH terms are computed using bac"casting methods.
;etails on the #A bac"casting procedure are provided in =ac"casting #A terms.
hen computing bac"cast initial variances for $ARCH, 18iews first uses the coefficient
values to compute the residuals of the mean equation, and then computes an e+ponential
smoothing estimator of the initial values,
%)*.&*',
where are the residuals from the mean equation, is the unconditional variance estimate(
%)*.&2'
and the smoothing parameter . Alternatively, you can choose to initiali:e the $ARCH
process using the unconditional variance(
%)*.&3'.
If you turn off bac"casting, 18iews will set the presample values of the residual to :ero
to initiali:e an #A, if present, and will set the presample values of the variance to the
unconditional variance using 1quation %)*.&3'.
@ur e+perience has been that $ARCH models initiali:ed using bac"cast e+ponential
smoothing often outperform models initiali:ed using the unconditional variance.
Heteros"edasticity Consistent Covariances
Clic" on the chec" bo+ labeled Heteros"edasticity Consistent Covariance to compute the
quasi-ma+imum li"elihood %>#.' covariances and standard errors using the methods
described by =ollerslev and ooldridge %&44)'. !his option is only available if you
choose the conditional normal as the error distribution.
9ou should use this option if you suspect that the residuals are not conditionally normally
distributed. hen the assumption of conditional normality does not hold, the ARCH
parameter estimates will still be consistent, provided the mean and variance functions are
correctly specified. !he estimates of the covariance matri+ will not be consistent unless
this option is specified, resulting in incorrect standard errors.
-ote that the parameter estimates will be unchanged if you select this optionD only the
estimated covariance matri+ will be altered.
;erivative #ethods
18iews currently uses numeric derivatives in estimating ARCH models. 9ou can control
the method used in computing these derivatives to favor speed %fewer function
evaluations' or to favor accuracy %more function evaluations'.
Iterative 1stimation Control
!he li"elihood functions of ARCH models are not always well-behaved so that
convergence may not be achieved with the default estimation settings. 9ou can use the
options dialog to select the iterative algorithm %#arquardt, =HHH?$auss--ewton',
change starting values, increase the ma+imum number of iterations, or adAust the
convergence criterion.
,tarting 8alues
As with other iterative procedures, starting coefficient values are required. 18iews will
supply its own starting values for ARCH procedures using @., regression for the mean
equation. Csing the @ptions dialog, you can also set starting values to various fractions of
the @., starting values, or you can specify the values yourself by choosing the Cser
,pecified option, and placing the desired coefficients in the default coefficient vector.
$ARCH%&,&' e+amples
!o estimate a standard $ARCH%&,&' model with no regressors in the mean and variance
equations(
%)*.&7'
you should enter the various parts of your specification(
<ill in the #ean 1quation ,pecification edit bo+ as
r c
1nter & for the number of ARCH terms, and & for the number of $ARCH terms, and
select $ARCH?!ARCH.
,elect -one for the ARCH-# term.
.eave blan" the 8ariance Regressors edit bo+.
!o estimate the ARCH%2'-# model(
%)*.&6'
you should fill out the dialog in the following fashion(
1nter the mean equation specification ER C ;C#E.
1nter E2E for the ARCH term and E0E for the $ARCH term, and select $ARCH
%symmetric'.
,elect ,td. ;ev. for the ARCH-# term.
1nter ;C# in the 8ariance Regressors edit bo+.
@nce you have filled in the 1quation ,pecification dialog, clic" @F to estimate the
model. ARCH models are estimated by the method of ma+imum li"elihood, under the
assumption that the errors are conditionally normally distributed. =ecause the variance
appears in a non-linear way in the li"elihood function, the li"elihood function must be
estimated using iterative algorithms. In the status line, you can watch the value of the
li"elihood as it changes with each iteration. hen estimates converge, the parameter
estimates and conventional regression statistics are presented in the ARCH obAect
window.
As an e+ample, we fit a $ARCH%&,&' model to the first difference of log daily ,GB 300
%;.@$%,BH'' using bac"cast values for the initial variances and =ollerslev-ooldridge
standard errors. !he output is presented below(
=y default, the estimation output header describes the estimation sample, and the
methods used for computing the coefficient standard errors, the initial variance terms, and
the variance equation.
!he main output from ARCH estimation is divided into two sections-the upper part
provides the standard output for the mean equation, while the lower part, labeled
E8ariance 1quationE, contains the coefficients, standard errors, :-statistics and p-values
for the coefficients of the variance equation.
!he ARCH parameters correspond to and the $ARCH parameters to in 1quation )*.).
!he bottom panel of the output presents the standard set of regression statistics using the
residuals from the mean equation. -ote that measures such as may not be meaningful if
there are no regressors in the mean equation. Here, for e+ample, the is negative.
In this e+ample, the sum of the ARCH and $ARCH coefficients %' is very close to one,
indicating that volatility shoc"s are quite persistent. !his result is often observed in high
frequency financial data.