Abstract:

In this study we attempt to explain the volatility in the Indian stock market using the
Generalized Autoregressive Conditional Heteroscedasticity class of models. The data taken on
S&P CNX Nifty ranges from 1st April 2000 to 31st March, 2014. We use the daily returns to

model volatility. We find the returns series to be stationary and exhibiting features such as
heavy tails, volatility clustering and heteroscedasticity. We find that among symmetric
models GARCH(1,1) model is the best fit, and the TGARCH(1,1) model fits best among the
asymmetric models. TGARCH(1,1) is a better fit than the GARCH(1,1) model, and explains
the leverage effect. The results exhibit high persistence in volatility, indicating more
predictable returns and inefficiency. Using the GARCH-M, EGARCH-M and TGARCH-M
models it is found that the Indian stock market offers no risk premium.

Introduction:
Modelling volatility in the prices or returns from an asset has been a very active area of
research. It is important because volatility is considered as a very significant element for the
evaluation of assets, investment decision making, measurement of risk and monetary policy
making. Volatility has acquired a central role in derivative pricing and hedging, risk
management, and optimal portfolio selection. Analysis of stock market for the evaluation of
the risk has assumed greater significance in India after liberalisation.
Volatility is an integral part of the financial markets, with the bull and bear phases. Too much
volatility however creates an atmosphere of uncertainty, with investors in turn demanding a
higher risk premium for insurance against the increased uncertainty. A greater risk premium
results in a higher cost of capital, which then leads to less private physical investment.
Moderate returns, high liquidity and a low level of volatility are taken to be symptoms of a
developed market. Bekaert and Wu (2000)1 find that there are at least four distinguishing
features of emerging market returns: higher sample average returns, low correlations with
developed market returns, more predictable returns, and higher volatility. These differences
may have important implications for decision making by investors and policy makers and
relying on developed financial market findings may hamper the process.
Also, the quicker stock prices are in accurately reflecting new information as it becomes
available, the more efficient the stock market is in allocating resources. Thus modelling
volatility will improve the usefulness of stock prices as a signal about the intrinsic value of
securities, thereby making it easier for firms to raise fund in the market, and also for portfolio
management.
Indian stock markets have gone through a period of turmoil in recent years. As Goudarzi and
Ramanarayan (2010)2 point out, the turmoil in the international financial markets of advanced
economies that started around mid-2007 had exacerbated substantially since August 2008.
Top-11 Indian stock market crashes include Apr 1992, May 2004, May 2006, April 2007,
July 2007, Aug 2007, Oct 2007, Nov 2007, Dec 2007, Aug 2007and particularly, Jan 2008.
With the volatility in portfolio flows having been large during 2007 and 2008, the impact of
global financial turmoil has been felt particularly in the Indian equity market. The BSE
Sensex increased significantly from a level of 13072 as at end-March 2007 to its peak of
1

Bekaert Geert and Wu Guojun; (2000); "Asymmetric Volatility and Risk in Equity Markets"
Goudarzi Hojatallah and C.S. Ramanarayan; (2010); Modelling and Estimation of Volatility in the
Indian Stock Market
2

20873 on January 8, 2008 in the presence of heavy portfolio flows responding to the high
growth performance of the Indian corporate sector. With portfolio flows reversing in 2008,
partly because of the international market turmoil, the Sensex fell from its closing peak of
20873 on January 8, 2008, to less than 10000 by October 17, 2008, in line with similar large
declines in other major stock markets.
Motivation:
Given that Indian stock markets have experienced substantial volatility in the wake of the
2008 financial crisis, it makes sense to attempt to model the volatility in the returns so as to
gain clearer insights. This will help in making more accurate forecasts about the future which
will help in investment decisions. We make use of several models to make inferences about
the nature of Indian stock markets.
Literature Review:
We focus on some of the studies on modelling volatility in emerging economy stock markets.
Kalu O. (2010)3 investigates the behaviour of stock return volatility of the Nigerian Stock
Exchange using GARCH (1,1) and the GJR-GARCH(1,1) models assuming the Generalized
Error Distribution (GED). He provides evidence of volatility clustering, leptokurtosis and
leverage effects in the returns series from January 1985 to December 2008, and also shows
that volatility is persistent.
Elsheikh and Zakaria (2011)4 uses various GARCH models to estimate volatility in the daily
returns of the principal stock exchange of Sudan namely, Khartoum Stock Exchange (KSE),
over the period from January 2006 to November 2010. They find a high degree of persistence
in the conditional volatility of stock returns and also provide evidence on the existence of risk
premium for the KSE index return series.
Mittal and Goyal (2012)5 find that Indian stock market returns series exhibit
heteroscedasticity, volatility clustering & has fat tails. They observe GARCH (1, 1) model to
be most appropriate model to capture the symmetric effects. Among the asymmetric models,
Power GARCH (1, 1) model is found to be the best as per AIC and LL criterion. The ARCH
in Mean model reported that Indian markets do not offer risk premium.

Kalu O. Emenike; (2010); Modelling Stock Returns Volatility In Nigeria Using GARCH Models
Elsheikh Ahmed M. and Zakaria Suliman; (2011); Modelling Stock Market Volatility using GARCH
Models Evidence from Sudan
5
Mittal Anil K. and Goyal Niti; (2012); Modeling the Volatility of Indian Stock Market
4

Theory:
The literature observes that any satisfactory model for daily returns must be consistent with
some of the stylized or empirical facts that are of particular importance:
1. Leptokurtosis: Heavy tails as compared to normal distribution.
2. Large changes tend to be followed by large changes and small changes tend to be
followed by small changes, which lead to volatility clustering.
3. The autocorrelations of both the absolute and squared returns are positive for many
lags and they indicate substantially more linear dependence than the autocorrelation
of returns.
4. There is leverage effect which implies that most measures of volatility of an asset are
negatively correlated with the returns of that asset.
Researchers widely believe that financial econometrics evolved into a separate subject of
study after the publication of the seminal article on modelling conditional heteroscedasticity
in time series data, popularly called the ARCH model, by Robert Engle. There have been a
lot of subsequent improvements in this class of models and they are used to explain the
changing variance in some series. The following models have been used in this paper:
GARCH (p, q):

The GARCH specification, firstly proposed by Bollerslev, formulates the serial dependence
of volatility and incorporates the past observations into the future volatility. GARCH is a
more general class of process than ARCH, which allows a much more flexible lag structure.
The GARCH (p,q) process is given by:

EGARCH:
Nelson recommended an alternative to GARCH model, an exponential ARCH model, also
called an EGARCH model. This takes into account the sign and not only the magnitude of
lagged quantities. It allows the conditional variance to respond asymmetrically to rises and
falls in stock prices and thus can explain the leverage effect. The EGARCH specification for
is:

with

GJR-GARCH or TGARCH:
Another GARCH model that captures the asymmetry effect is the Glosten, Jagannathan,
Runkle GARCH model or the threshold GARCH (TGARCH) model. A GJR-GARCH(1,1)
is defined as follows:

if
if
In this specification,

should be negative for the leverage effect.

ARCH-M Models:
Economic theory holds that investors should be rewarded for taking risks. The ARCH-M
(ARCH in mean) model provides an explicit link between the risk (conditional volatility) and
the best forecast of a time series. Engle, Lilien and Robins (1987)6, in their paper which
introduced the model, showed that there were significant ARCH-M effects for a series of
excess returns on 6 month treasury bills compared to the return on two consecutive 3 month
treasury bills. In this model we get the risk premium necessary to induce a risk-averse agent
to hold the longer term asset. The standard deviation is introduced as a term in the mean
equation. If it is an AR(1) process, then the mean equation specification is:

Thus we can have GARCH-M, EGARCH-M and TGARCH-M models by changing the mean
equation as above.
Data:
We have used daily closing prices of the S&P CNX Nifty as proxy to the Indian stock market.
The data ranges from 1st April 2000 to 31st March, 2014. The data has been collected from the
official website of NSE of India (www.nseindia.com) and has been analysed using Eviews
software. There are 3497 observations with a high of 6704.2 on 31st March 2014 and a low of
854.2 on 21st September 2001.
6

Engle, R. F., Lilien, D. M. and Robins, R. P.; (1987); Estimating time varying risk premia in the term
structure: The ARCH-M model

Methodology and Results:

1. First we examine the closing prices data. It is shown in the following graph:
8000
7000
6000
5000
4000
3000
2000
1000
0
03-Apr-00 03-Apr-01 03-Apr-02 03-Apr-03 03-Apr-04 03-Apr-05 03-Apr-06 03-Apr-07 03-Apr-08 03-Apr-09 03-Apr-10 03-Apr-11 03-Apr-12 03-Apr-13

Closing Prices

We perform the Augmented Dickey Fuller test. The results are shown in the following table:
Null Hypothesis: has a unit root

Augmented Dickey-Fuller test statistic

Test critical values:
1% level
5% level
10% level

t-Statistic

Prob.*

-0.500546
-3.432034
-2.862169
-2.567149

0.8887

Thus we cannot reject the null hypothesis and we find that this closing prices series has a unit
root and is not stationary.
2. We turn our focus to the series of continuously compounded daily returns. We transform
the closing prices data to daily returns using the following formula:

where the

prices take logarithmic values. The daily returns series is shown by the following graph:
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08

returns

Thus volatility clustering can be observed from the graph. Large return values are followed
by large values and small values by small values.

3. Next we perform the Augmented Dickey Fuller test to check the stationarity of the returns
series. The following table gives the results:
Null Hypothesis: has a unit root

Augmented Dickey-Fuller test statistic

Test critical values:
1% level
5% level
10% level

t-Statistic

Prob.*

-54.52659
-3.432034
-2.862169
-2.567149

0.0001

Therefore we reject the null hypothesis and thus the returns series is stationary.
4. Next we look at the descriptive statistics of the returns series:
1,400

Series: RT
Sample 4/04/2000 3/31/2014
Observations 3496

1,200
1,000

Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis

800
600
400
200
0
-0.06

Jarque-Bera
Probability
-0.04

-0.02

0.00

0.02

0.04

0.000183
0.000470
0.070939
-0.056692
0.006908
-0.280720
11.02841
9434.926
0.000000

0.06

The series has a mean of around 0.02% and a standard deviation of around 0.7%, indicating a
large variability in returns. The series is negatively skewed. The kurtosis is 11.03 > 3, which
means that the returns series is heavy tailed and does not follow a normal distribution, which
is further confirmed by the Jarque-Bera statistic.
Next we move on to modelling the returns series using the changing variance models.
5. First we have to model the mean equation. We will use Box-Jenkins approach of model
building to fit an appropriate time series model to analyse the data. We will select the model
on the basis of information criteria. We find the ARMA(1,1) model to be the best fit with the
lowest Akaike Information Criterion (AIC). This is also in accordance with our literature
review. Now if this model fits the data, the correlation between its residuals must be
insignificant. To check we look at the correlogram of the residuals of this model upto 13 lags,
as given by the Table 1 in the Appendix. We find that they are not significant. We also look
at the correlogram of the squared residuals upto 20 lags (Table 2 in Appendix) and find that
they are all highly significant. This clearly indicates correlation between the squared

residuals, and strongly suggests the presence of ARCH effects. We also perform the ARCH
LM test and find that there exists correlation between squared residuals.
6. We use GARCH (1, 1) model to capture the conditional variance of the series since it gives
the minimum AIC among the competing models and it is the most popular among the class of
GARCH models according to our literature review. The method of estimation is maximum
likelihood. The following table gives the results of the variance equation:
Variable

Coeff.

C
RESID(-1)^2
GARCH(-1)

1.08E-06
0.127231
0.851185

Std. Error

z-Statistic

1.32E-07
0.008628
0.009478

8.180679
14.74674
89.80635

Prob.
0.0000
0.0000
0.0000

All the coefficients of the variance equation are highly significant. We estimate the
persistence in volatility by adding the coefficients
. It is very close to 1. Thus there is high persistence in volatility which
means that a shock in the present will have a lost lasting effect on the future returns and will
die out slowly.
We also look at the correlogram of the residuals of this GARCH model up to 20 lags, which
is included as Table 3 in the Appendix. We find that the correlations between the residuals
are now insignificant. This suggests that the GARCH(1,1) model is effective in modelling the
heteroscedasticity present in the returns series.
We have seen in the stylised facts that there is existence of leverage effect in many financial
series, where positive and negative shocks have different effects. However the GARCH does
not take into account this effect. So to capture such asymmetries we turn to the EGARCH and
TGARCH models.
7. Next we use the EGARCH(1,1) model to capture the conditional variance. The following
table gives the results of the variance equation:
Variable

Coeff.

Std. Error

z-Statistic

Prob.

C(4)
C(5)
C(6)
C(7)

-0.591250
0.239649
-0.103114
0.960555

0.045186
0.014177
0.008972
0.003772

-13.08474
16.90412
-11.49338
254.6438

0.0000
0.0000
0.0000
0.0000

We see that once again all the coefficients are highly significant. The asymmetric factor is
significantly negative: C(6)

, an indication that leverage effect is present. Thus

positive and negative shocks have different effects on the economy since people react
differently to them.

8. Next we use the TGARCH(1,1) model to check for asymmetries. Here the coefficient
value has to be positive for leverage effect to be present. The following table gives the
results:
Variable

Coeff.

C
RESID(-1)^2
RESID(-1)^2*(RESID(1)<0)
GARCH(-1)

Std. Error

z-Statistic

Prob.

1.28E-06
0.049189

1.34E-07
0.008240

9.524646
5.969181

0.0000
0.0000

0.142333
0.850434

0.014331
0.009866

9.931783
86.19854

0.0000
0.0000

All the coefficients in the variance equation are highly significant. The asymmetric factor is
significant and is positive (

suggestive of the presence of leverage effect. The

sum of the coefficients

, indicates high

persistence in volatility.
Thus we see that TGARCH and EGARCH models successfully indicate the presence of
leverage effects, and thus improve upon the GARCH model.
9. Next we compare the above three models on the basis of Akaike Information Criterion
(AIC) and Log Likelihood. The following table gives the results:
GARCH(1,1)

EGARCH(1,1)

TGARCH(1,1)

AIC

-7.438873

-7.455589

-7.456234*

LL

13005.43

13035.64

13036.77*

The results indicate that TGARCH (1, 1) model is the best in modelling the conditional
variance of the Indian stock market according to the Akaike Information Criterion and the
Log Likelihood Method. AIC is least for this model and Log Likelihood value is the highest.
10. Now we attempt to see if in the Indian stock market greater risk allows for greater return.
Thus we use the GARCH-M, EGARCH-M and TGARCH-M models to check if there indeed
is a positive risk-return tradeoff. The variance equations remain the same. The following
table gives the coefficient of the standard deviation term which is included in the mean
equation:
Coefficient

Std. Error

z-Statistic

Prob.

GARCH-M

0.047156

0.056761

0.830777

0.4061

EGARCH-M

0.016620

0.050218

0.330958

0.7407

TGARCH-M

0.016239

0.056479

0.287526

0.7737

Thus we see that none of the coefficients are significant, indicating that in Indian stock
markets the investors are not really rewarded for taking higher risks. Once again the
TGARCH-M model has the lowest AIC value as compared to the other two models,
indicating that it is the best fit to model the returns series.
Implications and Conclusion:
Thus we see that the continuously compounded returns series, obtained using CNX Nifty
data, is stationary and exhibits features such as heavy tails, volatility clustering and
heteroscedasticity. We use the Box Jenkins approach to fit an ARMA(1,1) to model the mean
equation.
We find that a GARCH(1,1) model is the best fit among the symmetric models. The results
exhibit high persistence in volatility. Thus there is indication of long memory in the stock
market, implying inefficiency since the information is not reflected in stock prices quickly.
The returns are thus more predictable. As said before, the quicker stock prices are in
accurately reflecting new information as it becomes available, the more efficient the stock
market is in allocating resources. Therefore the Indian stock market exhibits inefficiency.
We find that the TGARCH(1,1) model is the best fit among asymmetric models, and gives
better results than the GARCH(1,1) model. The leverage effect can be observed in the Indian
stock market by using the TGARCH and EGARCH models.
Finally we check whether in the Indian market there exists the risk premium necessary to
induce a risk-averse agent to hold the longer term asset, which involves higher uncertainty.
To examine this effect we use the GARCH-M, EGARCH-M and TGARCH-M models. It is
found that the Indian stock market offers no risk premium, and thus investors are not
rewarded with greater returns for undertaking higher risks. TGARCH-M model again is the
best fit.
Thus in this study we have modelled the volatility in stock market returns to see which model
explains it best. We have also drawn certain inferences about the market from the results.

References:

Bekaert Geert and Wu Guojun; (2000); "Asymmetric Volatility and Risk in Equity
Markets"; Review of Financial Studies, Society for Financial Studies, Vol. 13(1),
pages 1-42.

Elsheikh Ahmed M. and Zakaria Suliman; (2011); Modelling Stock Market

Volatility using GARCH Models Evidence from Sudan; International Journal of
Business and Social Science, Vol. 2 No. 23 [Special Issue December 2011].

Engle, R. F., Lilien, D. M. and Robins, R. P.; (1987); Estimating time varying risk
premia in the term structure: The ARCH-M model; Econometrica 55, pages 391-407.

Goudarzi Hojatallah and C.S. Ramanarayan; (2010); Modelling and Estimation of

Volatility in the Indian Stock Market; International Journal of Business and
Management, Vol. 5 No. 2, pages 85-98.

Kalu O. Emenike; (2010); Modelling Stock Returns Volatility In Nigeria Using

GARCH Models; MPRA Paper No. 22723.

Mittal Anil K. and Goyal Niti; (2012); Modeling the Volatility of Indian Stock
Market; International Journal of Research in IT & Management, Vol. 2, Issue 1
(January 2012).

Appendix:
Table1: Correlogram of Residuals of ARMA(1,1)
Autocorrelation
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Partial Correlation
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1
2
3
4
5
6
7
8
9
10
11
12
13

AC

PAC

-0.005
-0.018
-0.016
0.014
-0.007
-0.042
0.010
0.037
0.018
0.020
-0.020
-0.011
0.017

-0.005
-0.018
-0.016
0.013
-0.007
-0.042
0.010
0.035
0.018
0.022
-0.019
-0.013
0.018

Q-Stat
0.0721
1.2460
2.1606
2.8290
2.9797
9.1520
9.5013
14.268
15.429
16.771
18.142
18.593
19.643

Prob

0.142
0.243
0.395
0.057
0.091
0.027
0.031
0.033
0.034
0.046
0.050

Table 2: Correlogram of Squared Residuals of ARMA(1,1)

Autocorrelation
|**
|*
|*
|*
|*
|*
|*
|*
|*
|*
|*
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|*
|*
|*
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|*

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Partial Correlation
|**
|*
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|*
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|*
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|*
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

AC

PAC

0.222
0.177
0.113
0.176
0.134
0.096
0.136
0.075
0.131
0.140
0.123
0.070
0.097
0.092
0.096
0.081
0.064
0.084
0.052
0.079

0.222
0.134
0.053
0.130
0.062
0.019
0.081
-0.004
0.072
0.078
0.035
-0.009
0.034
0.015
0.028
0.014
-0.004
0.027
-0.013
0.019

Q-Stat
171.69
281.17
326.13
434.28
497.58
529.71
594.08
613.81
673.97
742.38
795.35
812.68
845.54
874.99
907.50
930.78
945.36
970.32
979.86
1001.9

Prob

0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Table 3: Correlogram of Residuals of GARCH(1,1)

Autocorrelation
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Partial Correlation
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

AC

PAC

0.022
0.002
0.022
0.032
-0.006
-0.020
0.019
-0.000
0.026
0.012
-0.015
0.001
0.014
0.040
-0.011
-0.005
0.036
0.003
-0.022
-0.045

0.022
0.001
0.022
0.031
-0.007
-0.020
0.018
-0.002
0.027
0.012
-0.017
0.000
0.013
0.039
-0.011
-0.006
0.033
-0.000
-0.021
-0.044

Q-Stat
1.7426
1.7528
3.3824
7.0042
7.1108
8.4688
9.6754
9.6755
12.068
12.591
13.396
13.398
14.120
19.729
20.161
20.252
24.740
24.777
26.456
33.724

Prob

0.066
0.030
0.068
0.076
0.085
0.139
0.098
0.127
0.145
0.202
0.226
0.072
0.091
0.122
0.054
0.074
0.067
0.014