Int. j. econ. manag. soc. sci., Vol(3), No (11), November, 2014. pp.

703-707

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International Journal of Economy, Management and Social Sciences

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ISSN:
2306-7276

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Modeling Volatility of Gold Futures Market in Iran by Switching

GARCH Models
Hasti Chitsazan *
Department of Business, Faculty of Entrepreneurship, University of Tehran, Iran.

Masoud Keimasi
Department of MBA, Faculty of Management, University of Tehran, Iran.
*Corresponding author: chitsazan@ut.ac.ir

Keywords

Abstract

Markov Switching
GARCH
Switching GARCH
Gold Futures Market

This paper analyzes volatility states of the gold futures in Iran. we apply a two-regime Markov-switching
GARCH model which enables us to estimate complex functional GARCH specifications within each regime.
We analyze the volatility structure of the daily returns sampled from the gold futures market between 26
March 2009 and 27 May 2013. We find that the gold futures market is relatively not stable and different
states will switch very often. This is consistent with our expectation of the futures market. The gold futures
market is like the stock market that volatility states changes frequently.

1.

Introduction

The volatility of financial markets has been the object of numerous developments and applications over the past two decades, both theoretically
and empirically. Because high volatility is very common in financial data, the family of ARCH and GARCH (Engle, 1982 and Bollerslev, 1986)
models are developed and widely applied to modeling the variance of financial variables [10,6]. These types of models allow the conditional
variance of a series to depend on the past realizations of the error process and simultaneously model the time-dependent mean and variance.
However, time series behavior is always complex and sometimes structural breaks occur. Lamoureux and Lastrapes (1990) argue that the near
integrated behavior of the conditional variances might be due to the presence of structural break, which are not accounted for by standard ARCH
models [19]. In the gold futures market, some events such as market crashes and changes in government policy always have obvious effects.
Thus, returns exhibit sudden jumps that are due not only to structural break in the real economy, but also to change in the operators expectations
about the futures [22]. Therefore, the parameters of a typical time series do not remain constant over time. There is a wide range of evidence that
the distribution of asset returns depends on an unobserved state (or regime) of the market (see, e.g., Turner, Startz, and Nelson, 1989; Hamilton
and Susmel, 1994; Ramchand and Susmel, 1998; PerezQuiros and Timmermann, 2001; Ang and Bekaert, 2002, 2004; and Guidolin and
Timmermann, 2005, 2006) [29, 17, 25, 24, 2, 3, 12, 13].
Following the work of Hamilton (1989) on switching regimes, several models based on the idea of regime changes have been proposed [16].
Hamilton and Susmel (1994) propose a new ARCH model, the Switch ARCH (SWARCH) model that is time-variant and allows for conditional
volatility process to switch stochastically among a finite number of regimes [17]. In addition, Bloomfield and Hales (2002) suggest regimeshifting model seems to be a reasonable framework in which to interpret some market anomalies [5]. This SWARCH model can incorporate the
possibility of volatility regime switch in the conditional variance in explaining volatility persistence.
The main purpose of this paper is to study volatility properties in the Iran gold futures prices. We examine whether volatility of gold futures
returns changed over time. We also analyze whether there are different states of volatility in the return series. We applied the SWARCH model
because this model can help us to analyze different states of volatility and estimate probability of changes in these states. The paper is structured
as follows. The next section reviews literature. Section 3 describes the applied methodologies. Estimation results are reported and discussed in
Section 4, and the last section draws some conclusions.

2.

Literature Review

Since the seminal papers of Engle (1982) and Bollerslev (1986) GARCH (generalized autoregressive conditional heteroskedasticity) models
have become a standard tool in modeling the conditional variances of the returns from financial time series data [10, 6]. Volatility clustering is
constantly seen in financial time series, which means that large fluctuations can often follow other previously large fluctuations, fat tails and
asymmetry, thereby indicating higher order moments. These models usually indicate a high persistence of the conditional variance. Diebold
(1986) and Lamoureux and Lastrapes (1990), among others, argue that the nearly integrated behavior of the conditional variance may originate
from structural changes in the variance process which are not accounted for by standard GARCH models [8, 19]. Furthermore, Mikosch and
Starica (2004) show that estimating a GARCH model on a sample displaying structural changes in the unconditional variance does indeed create
an integrated GARCH effect [23]. These findings clearly indicate a potential source of misspecification, to the extent that the form of the
conditional variance is relatively inflexible and held fixed throughout the entire sample period. Hence the estimates of a GARCH model may
suffer from a substantial upward bias in the persistence parameter. Therefore, models in which the parameters are allowed to change over time
may be more appropriate for modeling volatility.
Hamilton (1989) proposes a regime-switching model, which allows the conditional mean in the traditional model to change for certain structural
changes that we cannot observe [16]. The regime-switching process is a Markov chain of first order. Markov-switching models, as introduced by

Hasti Chitsazan *, Masoud Keimasi

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International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

Hamilton (1989), are very useful for capturing regimedependent return distributions. Even the most simple version of such an Markov
switching model, where the time variability of the parameters is governed solely by the unobserved regime variable, can generate rather flexible
return distributions, including skewness, excess kurtosis, volatility clustering, and regimedependent correlation structures. However, for returns
sampled at a daily or weekly frequency, it has been observed that the volatility dynamics are not adequately captured by the switching between
constant regimespecific variances and covariances [11, 28, 22], i.e., a considerable part of the conditional heteroskedasticity is linked to within
regime ARCHtype dynamics rather than to the discrete regime process. This has motivated the introduction of the Markovswitching ARCH
model in Cai (1994) and Hamilton and Susmel (1994), which was generalized to Markovswitching GARCH by Gray (1996), Dueker (1997)
and Klaassen (2002) [7, 17, 11, 9, 18]. A discussion of these models is provided in Haas, Mittnik, and Paolella (2004). These authors also
propose a new Markovswitching GARCH process and argue that their version can be viewed as the most natural specification of a multi
regime GARCH model [14]. Their model has been further investigated in Liu (2006, 2007), Abramson and Cohen (2007), Ardia (2007), and
Haas (2008) [20, 21, 1, 4, 15].
Schwert (1989) consider a model in which returns can have a high or low variance, and switches between these states are determined by a two
state Markov process [26]. Gray (1996) presents a tractable Markov-switching GARCH model and a modification of his model is suggested by
Klaassen (2002) [11, 18].
Researchers often identify a low and a high volatility regime, where the correlations between assets tend to be higher in the adverse state of the
market. These findings have important implications for asset allocation and risk management purposes. In addition, if the next periods regime is
not known with certainty, investors will want to hedge against the possible occurrence of the high volatility regime.
Schaller and Norden (1997) used Markov Switching model to find very strong evidence of regime switch in stock market returns from 1929 to
1989 [27]. Marcucci (2005) used a regime switching GARCH model to forecast volatility in S&P 500 which is characterized by several regime
switches [22].
Today, Markov-switching (or regime-switching) GARCH models, which are designed to capture discrete shifts in the volatility process of time
series data, are in widespread use in various fields of financial economics. We use markov-switching GARCH models as a very useful tool to
analyze volatility of gold futures market. GARCH models usually show high volatility persistence. To take into account the excessive
persistence usually found in GARCH models, SWGARCH models are analyzed, where the parameters are allowed to switch between low and
high volatility regimes. The aim of applying markov-switching is the possibility for some or all the parameters of the model to switch across
different regimes, which is governed by a state variable. In this study we use the SWGARCH model, which considers the structural changes in
the conditional variance and the shape parameters.

3.

Methodology

3.1 The Data

The data set used in this study is the daily prices of gold futures from 2009/03/26 to 2013/05/27. Daily observations are converted into
continuously compounded returns: R = 100 ln

3.2 The Switching GARCH Model

We employed the ARCH-type model to model the volatility of gold futures returns changing over time, and use the SWARCH model to see
whether there is regime-shifting in the variance. Many economic time-series do not have constant mean and volatility. Engle (1982) shows that it
is possible to simultaneously model the time-dependent mean and variance [10]. It is the widely known ARCH (Autoregressive Conditional
Heteroskedastic) model. It allows the conditional variance of a series to depend on the past realizations of the error process. Bollerslev (1986)
extended Engles original work by developing the GARCH (Generalized Autoregressive Conditional Heteroscedasticity) model that allows for
both autoregressive and moving average components in the heteroskedastic variance [6]. While the ARCH and GARCH models has been widely
applied to modeling variance of financial series, Lamoureux and Lastrapes (1990) show that these models may not be appropriate if structural
changes are existed in data [19]. Hamilton and Susmel (1994) propose a regime switching ARCH model (SWARCH model) allows for the
conditional volatility process to switch stochastically among a finite number of regimes, as follows [17]:
=
=

=
= { }, = 1,2

where St is a Markov chain with k-dimension state space, i.e. St denotes an unobserved random variable that can take values 1, 2, K, and
are scale parameters that capture the size of volatility in different regimes.
We also combine the GARCH approach with the Markov-switching model, as follows:
, =

= |

= ,

,
= ,.,

i {1,2,....., k}
,

,. =

= |

= =

These Equations are known as the two-state, two-order Markov-switching GARCH models, denoted as SWARCH (2, 2).
We proposed that the volatility of returns can be large and small, hence we use SWARCH(2,q) model in empirical test of this research, i.e. K=2.
The 2-state regime switching is assumed to follow a Markov process.

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Modeling Volatility of Gold Futures Market in Iran by Switching GARCH Models

International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

4.

Research Results

4.1 testing for Staitionarity and ARCH effect

Table 1 presents a summary of the descriptive statistics for gold futures returns time series. To avoid the problem of spurious regression, we use
Augmented Dickey-Fuller (ADF) test to assess whether the time series has unit root. Table 2 reports the outcome of tests for stationarity.
Augmented Dickey-Fuller (Said and Dickey, 1984) test confirm that returns variables are I(0). We also use Durbin-Watson (DW) test to be sure
that there is no serial autocorrelation in the residuals (DW=1.998).
Table 1. Descriptive Statistics

Statistics
No. of Observations
Mean
Std. Dev.
Skewness
Kurtosis
Jarque-Bera

Values
1092
0.001
0.022
0.444
12.679
7350.916

Signif Level (Sk=0) 0.000

Signif Level (Ku=0) 0.000
Signif Level (JB=0) 0.000

Table 2. Result of Augmented Dickey-Fuller Test

Variable

ADF

P-Value*

Result

-26.182

0.000

Staitionarity

*MacKinnon (1996) one-sided p-values.

Ho: has a unit root.

Before we use the ARCH and GARCH models, it is necessary to test whether there are ARCH effects existing in data. Table 3 presents the
result of ARCH effect test.
Table 3. Result of ARCH effect test

104.569

P-Value

Result

0.000

ARCH effects

* Ho: There are no ARCH effects.

To observe the volatility of market returns, Figure 1 plots the daily time series of gold futures market returns for the sample period.

RT

0.20
0.15
0.10

Return

0.05
-0.00
-0.05
-0.10
-0.15
-0.20
100

200

300

400

500

600

700

800

900

1000

Time
Figure 1. Return of Gold Futures Market

4.2 Switching GARCH Estimation

To see whether the conditional volatilities of gold futures market switch stochastically, we use a SWGARCH(2,1) model to estimate the
variance of the gold futures markets. The results of SWARCH model estimations are shown in Table 4.

Hasti Chitsazan *, Masoud Keimasi

706

International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

Table 4. Result of SWGARCH test

MAXIMIZE - Estimation by BFGS
Convergence in 36 Iterations. Final criterion was 0.0000037 <= 0.0000100
Usable Observations 1088
Function Value 3102.1201

Coeff.
-0.0004
0.1279
-0.2147
0.4979
0.7857
0.0000
0.0000

S.E.
0.0002
0.0277
0.1271
0.1056
0.0973
0.0000
0.0000

= 0.58
= 0.42

Transition Prob.

t-Stat
-2.2888
4.6122
-1.6893
4.7158
8.0785
3.5317
4.7230

Signif.
0.0221
0.0000
0.0912
0.0000
0.0000
0.0004
0.0000

= 0.77
= 0.23

Notes: The SWGARCH model is given by:

= +
+
=

=
= { }, = 1,2
, = +
,

= |

= ,

i {1,2,....., k}

= ,.,

,. =

= |

= =

We find from Table 4 that the gold futures market is relatively not stable and different states will switch very often. This is consistent with our
expectation of the futures market. The gold futures market is like the stock market that volatility states changes frequently.
The transition probabilities suggest transitions between states are more easily when some events occur. We can further estimate the average
duration of every state by

and have 2.38 and 1.30 days for state 1 and 2 respectively. These estimations suggest the states of gold futures

market change more easily, which means the market is relatively efficient.

5.

Conclusion

This paper tried to analyze the gold futures volatility when changes of volatility state are allowed in the gold futures market. We survey data on
the gold futures markets obtained from the Iran mercantile exchange. Our findings indicate that the volatility of gold futures market changes
over time. We further test whether there are different states of volatility by using the SWGARCH model. We use the SWGARCH model to
estimate volatility states and establish a two-regime Markov-switching GARCH model which enables us to estimate complex functional
GARCH specifications within each regime.
The estimations suggest the gold futures market is not stable and different states will switch very often. According to transition probabilities
transitions between states are more easily when some events occur. We also estimate the average duration of every state and have 2.38 and 1.30
days for state 1 and 2 respectively. These estimations suggest the states of gold futures market change more easily, which means the market is
relatively efficient.

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