JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 337

DO P O W E R G A R C H MODELS REALLY IMPROVE

VALUE-AT-RISK FORECASTS?
By Thierry And*

Abstract
Traditional heteroskedastic models either rely on the specification of the conditional variance
as in Bollerslev (1986) or on a direct modeling of the conditional standard deviation as in Taylor
(1986). With its endogenous estimation of the optimal power transformation, the Power GARCH
(PGARCH) of Ding, Granger, and Engle (1993) represents a flexible alternative that also nests
the previous competing families. Building on a "dynamic" estimation and out-of-sample tests, the
current paper undertakes a comparison of the three models in a value-at-risk setting. Despite
existing fluctuations in the optimal power transformation obtained with the Ding, Granger, and
Engle model, our empirical investigations suggest that the parameter is rarely found different
from one or two. Although the volatility dynamics may switch from Taylor's to Bollerslev's
specification during the life of the future contract, the measures of accuracy and efficiency used to
assess the performance of VaR forecasts indicate that the additional flexibility brought by the
PGARCH model provides little, if any, improvement for risk management. (JEL C13, C52, G15)

Introduction

Central to a wide range of financial applications, volatility has attracted the attention of
researchers since the seminal studies of Mandelbrot (1963) and Fama (1965). The availability of
high-frequency data and the huge improvement in computational speed have undoubtedly fostered
empirical investigations in finance, giving birth over the years to a list of commonly
acknowledged "stylized facts" about the distribution and dynamics of asset returns. The most
puzzling observation is certainly that, although the volatility is time-varying, it does not evolve
without systematic patterns. Indeed, periods of high or low volatility tend to cluster, rendering the
volatility process highly predictable. Building on this assumption, Engle (1982) introduces the
autoregressive conditional heteroskedasticity (ARCH) models while Bollerslev (1986) extends
them to generalized ARCH (GARCH), where volatility becomes dependent on return shocks and
past volatilities.
Due to their ability to capture most of the stylized characteristics of financial assets, these
models have rapidly found countless fields of application in finance. [See Bollerslev, Chou, and
Kroner (1992) for an excellent survey.] As a result, several theoretical papers have extended and
refined the mean and variance equation to improve the general performance of GARCH models.
Two competing families have emerged from this abundant literature.
The first class follows Bollerslev (1986) in that shocks to the variance persist according to an
autoregressive moving average (ARMA) structure of the squared residuals of the process.
Noticing that the autocorrelation decay is slower for absolute than squared returns, Taylor (1986)
introduces the competing family. The goal of heteroskedastic models is to better capture the
persistence of past shocks on volatility. Since absolute returns exhibit a stronger long-term
dependency than squared returns, Taylor's class of GARCH models specifies a power of unity in
that it directly relates the conditional standard deviation of a series to lagged absolute residuals
and past standard deviations.

* ThierryAn6,Professor,Universityof Reims,57 his rue Taittinger,51096 Reims,France,ane@planete.net.

338 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 Fall 2005

Although theoretically quite different, both families are deeply rooted in the traditional
Gaussian framework, where expected squared returns can be related to the variance while
expected absolute returns can be directly related to the standard deviation. In theory, however, any
power term used in the second-moment equation would allow the resulting model to exhibit
volatility clustering. Since virtually all empirical studies highlight the abnormality of financial
series, the superiority of the square or absolute term is lost in practice, and other power
transformations may be more appropriate. Although the inclusion of any power term acts so as to
emphasise the periods of relative volatility by magnifying the outliers in the series, an arbitrary
value (as for instance one or two) may furnish suboptimal modeling and forecasting performance
relative to other power terms.
Ding, Granger, and Engle (1993) suggest a new class of GARCH models, known as the Power
GARCH, where the power transformation is endogenized rather than fixed arbitrarily. Among its
different advantages, the PGARCH structure is flexible enough to nest both the conditional
variance (Bollerslev) and the conditional standard deviation (Taylor) models as particular cases. It
thus provides an encompassing framework for model analysis and selection.
Using S&P 500 index returns for their empirical investigation, Ding, Granger, and Engle
(1993) obtain an optimal power transformation of 1.43. Statistical tests reveal that this value is
significantly different from one (Taylor) and two (Bollerslev). The superiority of the Power
GARCH model over the two traditional specifications is confirmed by the likelihood ratio test.
Since this seminal research, several interesting studies have analyzed the applicability of Power
GARCH to capture the stylized features of volatility for different underlying assets.
Tse and Tsui (1997) apply the PGARCH model to daily Malaysian--U.S. and Singapore--
exchange-rate data. In agreement with Ding, Granger, and Engle's (1993) findings on the leading
stock index, they show that the model adequately describes the exchange-rate data and that the
optimal power term is some value other than unity or two. The most extensive study on the role
played by the power transformation in heteroskedastic models has been carried out by Brooks,
Faff, McKenzie, and Mitchell (2000). Focusing on stock markets, they conclude to the general
applicability of the Power GARCH model using 10 national stock market indices as well as a
world index. They document a strong leverage effect in the national stock market data and show
that the inclusion of a power term proves to be a worthwhile addition to the model. Moreover, the
authors compare the optimal power transformations obtained for the different indices and test the
significativity of their departure from the classical values. The optimal power terms appear
remarkably similar for the 10 national indices: a pairwise test provides support for the null
hypothesis that the estimated power transformations are not significantly different from one
another. In addition, with very few exceptions, the coefficients are significantly different from two
but statistically indistinguishable from one, giving support for the Taylor family of GARCH
models. Since the PGARCH specification encompasses the Bollerslev and Taylor families, they
also use likelihood ratio tests to investigate the possible superiority of any specification. Despite
the strong support for the Taylor GARCH model obtained when testing the estimated coefficients
relative to the values one or two, the likelihood ratio test rejects both Taylor's and Bollerslev's
GARCH models in favour of the PGARCH specification for all indices.
On the other hand, applying the same methodology, McKenzie, Mitchell, Brooks, and Faff
(2001) fred that Taylor's model performs best when trying to capture the stylized features of
volatility in a range of commodity future prices traded on the London Metal Exchange. McKenzie
and Mitchell (2002), however, seem to suggest that most of the time, Bollerslev's model is
preferred when heavily traded bilateral exchange rates are investigated.
All these important empirical studies shed light on the general interest of a Power GARCH
model and discuss its applicability to various types of financial assets. However, several questions
about the usefulness of an endogenous estimation of the power term remain unanswered. The
superiority of the Power GARCH specification seriously entertained by the likelihood ratio test is
sometimes difficult to reconcile with the direct statistical tests often concluding that the estimated
 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 F a l l 2 0 0 5 339

power transformations are not statistically different from one (two). When the case arises, what do
we lose, for financial applications, if we use Taylor's (Bollerslev's) model instead of the more
complex specification introduced by Ding, Granger, and Engle?
Keeping in mind the practical implementation, the above-mentioned studies can be regarded as
"static" in the sense that they estimate all three models on several retum series over a fixed period
of time. The stability of parameters is always an important aspect to check when assessing the
comparative merits of competing models. This analysis takes on an additional dimension for the
parameter representing the optimal power transformation since it controls the switch between
different GARCH families. Is it the case that the obtained parameter value cannot be differentiated
from one during a particular period of time while the estimate for the same underlying asset
becomes statistically equal to two for another estimation period? If this is so, understanding when
and why a financial series switches from Taylor's to Bollerslev's specification (or the other way
around) would be of considerable interest for practitioners.
The purpose of the current paper is to provide a first attempt at answering the previous
questions by a rollover estimation of the competing models on two foreign-exchange future
contracts. Further, to provide an objective ranking of the different models, we also investigate
their relative interest for portfolio management purposes by comparing their ability to forecast
accurate values-at-risk. The models can thus be tested out-of-sample through a generally admitted
measure of accuracy and efficiency, namely the value-at-risk forecasts.
The remainder of the paper is organized as follows. The second section presents the Power
GARCH model introduced by Ding, Granger, and Engle (1993). The data and a preliminary
empirical investigation are introduced in the third section. The fourth section compares the models
in a risk management context, while the fifth section gives the concluding remarks.

The Power GARCH Model

The main scope of this paper is to investigate the impact of alternative variance equation
specifications on volatility and value-at-risk forecasts. Hence, without implying that the mean
equation has no interest, we follow a classical approach and simply assume a first-order
autoregressive process as in (1) where R t = 100 * In ( Pt / Pt-1 ) is the future return.

Rt =ao +al Rt-1 +~.t (1)

For high-frequency data, Nelson (1991, 1992) shows that the effect of misspecification of the
conditional mean does not particularly affect the conditional volatility. The error term e t in
equation (1) may be decomposed as (2) where e t ~ (0,1).

e t = cr t e t (2)

The standardized error term e t is usually assumed to be normally distributed. However, to

further enhance the robustness of the results with respect to non-normality, we use a Student-t
distribution where F (.) is the gamma function.

v+l
F(-~-) e2 ~+1
et~t(O,l,V)_F(2) ~(~/_.~_2 ) (l+v~_~t2) z (3)
340 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 Fall 2005

Studies on the predictability of asset returns also allow for nonlinear effects by explicitly
modeling time dependence in the second conditional moment where W ( . ) is some time-invariant
function.

},:,
P
},<,> (4)

In this paper, a first-order lag structure is adopted for both the ARCH and GARCH terms (i.e.,
p = q = 1 ) and the effort is made on the choice of the function ~ ( . ) itself.
Since the seminal work of Engle (1982), several models that capture the effects of past
disturbances on the conditional volatility have been formulated. Most of the popular additions to
the literature have tried to refine the mean and variance equations of two classical alternative
specifications. The first family relates the second moment to lagged squared residuals and past
variances as in Bollerslev's (1986) model, shown here in (5).

(5)

The second-class links directly the conditional standard deviation to lagged absolute residuals
and past standard deviations as in Taylor's model, shown in (6).

or, ---/~o +/~,1 e,_11+/32 cr,_x (6)

To account for the possibility that other power transformations may be optimal outside the
Gaussian framework, Ding, Granger, and Engle (1993) propose a more general class of models
known as the Asymmetric Power GARCH where the power term is endogenized:

= )~ + t~2 o',+-~ (7)

The parameter 7t introduces an asymmetric response to past shocks while 6 corresponds to

the optimal power transformation directly estimated on the data.
In this paper, we investigate the general relevance of the PGARCH dynamics to capture the
structure o f the volatility in foreign-exchange future returns. The existence of a leverage effect in
stock returns dates back to Black (1976) and justifies the introduction of the asymmetric parameter
71 in equation (7) for Ding, Granger, and Engle's initial study of the S&P 500 index. Our study,
however, focuses on foreign-exchange products. It is known that exchange rates do not exhibit
asymmetry in their distributions. Calibrating the Asymmetric Power GARCH model on exchange
rates, Tse and Tsui (1997) confirm that the parameter Yt is not statistically different from zero.
Since we obtain the same result on a preliminary estimation of the model with our exchange-rate
futures, we do not include the asymmetric term and replace equation (7) by the dynamics in (8).

-- a0 + a, Ic,_11+ + o,+_, (8)

Data and Preliminary Findings

The empirical study focuses on two future contracts on exchange rates traded against the U.S.
dollar on the Chicago Mercantile Exchange: the Australian dollar (AUD/USD) and the Japanese
 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 V o l u m e 29 9 N u m b e r 3 9 F a l l 2 0 0 5 341

yen (JPY/USD). Series of continuous prices were collected from Datastream for the period
January 1990 to July 2004.

Table 1: Descriptive Statistics for the Future Returns.

AUD/USD JPY/USD

Mean -0.0021 0.0074

Standard Deviation 0.6452 0.7526
Minimum -3.6441 -4.2073
Maximum 5.1699 8.2739
Skewness -0.1849* 0.7681 *
Kurtosis 6.2231 * 10.6747*
Jarque-Bera 1604.25" 9337.35*
p-value [<.001 ] [<.001 ]

Notes: Future contracts for the Australian dollar and the Japanese yen
against the U.S. dollar traded on the Chicago Mercantile Exchange were
collected from Datastreamfor the period January 1990 to July 2004. The
descriptive statistics for the logarithmic daily returns are summarizedin
Table 1. The Jarque-Bera statistic rejects normality for both series. We
use * to indicate significanceat the 5 percent level.

We display in Table 1 the usual descriptive statistics for the daily percentage returns of the two
series. As commonly observed with spot or future exchange rates, the percentage mean is close to
zero in both cases. Plots of the return series (not shown here) indicate that the return process of
each exchange-rate future is quite stable around its mean. Such empirical regularities further
justify that no extra care is brought to the definition o f the conditional mean equations in this
paper. Although both contracts present a significant leptokurtocity, the future on the Japanese yen
seems riskier with a higher standard deviation and a larger kurtosis. The Australian dollar and the
Japanese yen also display opposite skewness. Despite the existence of an asymmetry in the data,
the introduction of an asymmetric parameter in the PGARCH dynamics as in equation (7) does not
improve the goodness of fit. We thus carry out the estimations using the symmetric version of the
model as described in equation (8). Similarly, no asymmetric term is included in Taylor's or
Bollerslev's specification. Given the large excess kurtosis of both future contracts, they
unsurprisingly fail to pass the Jarque-Bera normality test.
We use the GAUSS CML module for our empirical analysis and start our investigation by the
estimation of the three models underlying our discussion over the entire sample period. The
standard errors are computed from the diagonal of the heteroskedastic-consistent covariance
matrix. [See White (1980).] Following a classical approach, we start by estimating the model with
constant parameters for the means and variances and then augment it by steps using simpler
versions to determine the best starting values. Robustness to the starting values has, of course,
been tested. Since the simplest versions are nested in the final models, such an approach can also
be used to assess the relevance of each additional parameter through a likelihood ratio test. To
save space, the intermediate results are not reported in this paper. However, the final model
corresponds to the best fit according to the likelihood ratio test. The parameter estimates for the
Bollerslev GARCH(1,1) model are reported in Table 2. Table 3 provides the estimation results for
the Taylor GARCH(1,1) model, while Table 4 is dedicated to the Power GARCH(1,1) model
introduced by Ding, Granger, and Engle.
342 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 F a l l 2 0 0 5

Table 2: P a r a m e t e r Estimates for Future Returns for Bollerslev GARCI-I(1,1) Model.

AUD/USD JPY/USD
Mean Parameters
Constant: a0 0.0179 (2.1691)* -0.0120 (-1.3246)
Lag Return of Order 1: al -0.0156 (-0.8576) -0.0414 (-2.1326)*
Variance Parameters
Constant: b0 0.0022 (2.3646)* 0.0101 (3.2270)*
ARCH Term: bl 0.0357 (5.4469)* 0.0405 (5.4519)*
GARCH Term: b2 0.9609 (135.1661)* 0.9423 (87.6721)*
Shape Parameters
Degrees of Freedom: n 5.3813 (11.5540)* 4.5936 (14.7516)*
Log-Likelihood -3294.73 -3771.76
Ljung-Box Statistics
LB (20) 24.33 [0.184] 16.91 [0.596]
LB 2 (20) 11.02 [0.923] 10.83 [0.754]
Implied Jarque-Bera Test
Skewness -0.1588 [0.048]* 0.1502 [0.054]
Kurtosis 2.9828 [0.644] 2.9920 [0.754]
Jarque-Bera 0.0495 [0.976] 0.0134 [0.993]

Notes: Table 2 presents the parameter estimates for the Bollerslev GARCH(1,1) model using a Student-t conditional
density. Both contracts show a high degree of volatility persistence with fll + f12 always above 0.98. The Ljung-Box
statistics indicate a correct specification. Similarly, the implied Jarque-Bera statistics reveal that normality cannot be
rejected for the standardized residuals. We use parentheses to indicate t statistics and brackets for p-values. * denotes
significance at the 5 percentconfidence level.

All three models provide similar results regarding the behaviour of the conditional means. The
parameter estimates a 0 and a 1 obtained for both futures are virtually identical with the three
variance specifications. Except the first-order lag a s for the Japanese yen, the mean parameters
are not statistically different from zero. The level o f the parameter v for the degrees of freedom of
the Student-t distributions used for the innovations is also coherent with the level o f kurtosis of
each future contract.
We now turn our attention to the parameters o f direct interest for the current study, namely
those defining the variance dynamics. First of all, it is worth noticing that, in both cases, the
obtained parameters are largely significant and of comparable size from one contract to the other.
Although the volatility persistence cannot be simply expressed by the sum o f the ARCH ( fll ) and
GARCH (f12) terms for all three models, their direct examination gives insights on the level of
persistence, which happens to be present in both contracts. We should thus expect the models to
perform quite well in forecasting volatility and value-at-risk.
The novelty of the PGARCH model is to endogenize the computation o f the optimal power
transformation S to capture the volatility clustering. The power term is 1.4742 for the Australian
dollar and 1.3590 for the Japanese yen. We first test whether the obtained values for 5 are
statistically different from one or two, namely the Taylor and Bollerslev specifications. Although
the value obtained for the Australian dollar is found to be different from our benchmarks, the
power term estimated for the Japanese yen is statistically different from two but not from one.
Hence, in view of these preliminary results, Ding, Granger, and Engle's model appears to be the
only suitable specification for the Australian dollar, while the Japanese yen could well be
described by Taylor's model.
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The absence of a "universal" specification, however, justifies the subsequent investigations of

this paper. In particular, we would like to understand whether the volatility switches over the time
from Taylor's to Bollerslev's specification, and if so, whether the use of a more flexible model
that allows for this free selection of the power transformation improves the forecasting
performances.
In order to investigate the possible superiority of one model, we run several goodness-of-fit
tests. First o f all, we compute the Ljung-Box statistics to investigate any remaining autocorrelation
in power transformations of the standardized residuals. Tables 2, 3, and 4 provide the results of the
Ljung-Box statistics for up to 20 lags, calculated for both the return and the squared return series.
This classical goodness-of-fit statistic indicates that the linear and nonlinear dependencies have
been removed. Overall, this traditional test would imply that all three models perform equally well
in describing the behavior of exchangerrate future returns.
In order to check this assertion, we present a more robust test we name "implied Jarque-Bera
normality test" in the last panel of Tables 2, 3, and 4. Let e 1 be the residuals of a general
econometric model as the one described in equation (1) or (2). Taking into account the existence
of conditional heteroskedasticity in the data, shown in equation (4), one obtains the standardized
residuals e t = e l l . To fully characterize the model, we have selected the conditional Student-t
distribution t(e;O,l,v) in equation (3). We then denote dt the probability integral
transformation of et defined as follows in (9).

dt = I_e't(u; O,l,v)du (9)

Table 3: Parameter Estimates for Taylor GARCH(I,1) Model Future Returns.

AUD/USD JPY/USD
Mean Parameters
Constant: ao 0.0193 (1.9076) -0.0136 (-1.6326)
Lag Return of Order 1: al -0.0144 (-1.7894) -0.0462 (-2.7576)*
Variance Parameters
Constant: b0 0.0081 (3.7938)* 0.0166 (3.3956)*
ARCH Term: bl 0.0512 (6.3142)* 0.0593 (5.8175)*
GARCH Term: bz 0.9497 (120.5770)* 0.9345 (76.1544)*
Shape Parameters:
Degrees o f Freedom: n 5.4062 (11.4395)* 4.6046 (14.7843)*
Log-Likelihood -3295.25 -3770.41
Ljung-Box Statistics
LB (20) 22.48 [0.261] 16.50 [0.624]
LB 2 (20) 23.81 [0.204] 17.44 [0.560]
Implied Jarque-Bera Test
Skewness -0.1587 [0.048]* 0.1437 [0.060]
Kurtosis 2.9905 [0.732] 3.0080 [0.753]
Jarque-Bera 0.0179 [0.991 ] 0.0132 [0.993 ]
Notes: Table 3 displays the parameter estimates for the Taylor GARCH(1,1) model relying on a Student-t conditional
density. The degree of volatilitypersistence is again very high. The Ljung-Boxand the implied Jarque-Berastatistics do
not revealthe presenceofmisspecifications.We use parenthesesto indicatet statisticsand brackets for p-values.
344 JOURNAL O F ECONOMICS AND F I N A N C E 9 Volume 29 9 Number 3 9 Fall 2005

Then, if the econometric model is well specified, the probability integral transformations d t of
the standardized residuals are identically and independently distributed with U(0,1). [See
Rosenblatt (1952).] To this point, if we assume that H ( . ) is a standard Gaussian cumulative
distribution function, the series of (10)will be Gaussian.

xt=n-l(dt), t = l , 2 ..... N (10)

Hence, testing the adequacy of the distribution and specification selected for the standardized
residuals et is tantamount to testing the normality of the transformed series of x t . The Jarque-
Bera test is thus applied to the transformed series, and results are presented in the last panel o f
Tables 2, 3, and 4. Regardless of the model used for the conditional variance, the two future
contracts exhibit no significant asymmetry, and the implied kurtoses are not statistically different
from three. Unsurprisingly, both series pass the implied Jarque-Bera normality test.
Eventually, since both Taylor's and Bollerslev's specifications are nested in the PGARCH
model, we use a likelihood ratio test to investigate whether the additional flexibility brought by the
Power GARCH model really provides an improvement in fit. We thus compare the Power
GARCH model in turn to Bollerslev's and Taylor's model. The obtained likelihood ratio test
statistics are, respectively, 5.52 and 6.56 for the Australian dollar contract and 5.56 and 2.86 for
the Japanese yen future. The Z2(1) critical value at the 5 percent confidence level is 3.84. Hence,
in the case of the Australian dollar, both specifications are rejected in favour of the Power
GARCH model. This is o f course consistent with our previous statistical test indicating that the
obtained power transformation, S = 1.4742, is statistically different from one and two. In the case
of the Japanese yen contract, however, the likelihood ratio test selects the Power GARCH model
over Bollerslev's specification, but the statistic indicates that a free power transformation does not
represent an improvement in fit compared to Taylor's model. Again, these results are perfectly
coherent with our previous findings. Since the power transformation, t~= 1.3590, is statistically
different from two, the use of the flexible Power GARCH model is preferred to Bollerslev's
GARCH. However, since this parameter cannot be statistically differentiated from one, the Power
GARCH does not bring anything relative to Taylor's model.
The two future contracts presented in this study are written on the same type of underlying
asset. Nevertheless, the preliminary estimation shows that no common model can be found to
describe the dynamics of their volatility. In addition, there is no obvious explanation for the
preference given to Ding, Granger, and Engle's model in the case of the Australian dollar and to
Taylor's GARCH for the Japanese yen. Moreover, the two values obtained for the power
transformations are close to one another and also close to the mid-zone: values of 6 around 1.5, at
equal distance to one and two. In this area, the preference can easily switch from one model to
another, and stability should thus be tested.
In order to better assess the differences between the three models under consideration, we thus
turn to a "dynamic" estimation of the parameters. To do so, one first needs to def'me an estimation
window. There is obviously no generally admitted method that guarantees a correct selection. Our
choice is guided by two opposite concerns. The use of a too-short estimation window could create
a very "erratic" dynamic whereby the parameters are excessively affected by outliers in the series,
while the selection of a too-long estimation window would smooth away all the dynamics in the
parameters. We try several specifications and notice that the sensitivity o f the resulting parameters
is weak for values between 1,200 and 1,700 (i.e., the parameter values are not significantly
affected). We thus retain an estimation window of 1,500 days. Using the first 1,500 observations,
the parameters of the three models are estimated. The estimation window is then moved forward
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 345

by one day, and the estimation is launched again. The procedure is repeated until the last day of
our initial database.
We start this empirical analysis with a somewhat surprising result. We plot in Figure 1 the time
evolution of the degrees-of-freedom parameter obtained from the iterative estimation of the three
models. Beyond the mere comparison of the different models, these graphs provide an interesting
analysis of the changes in the leptokurtocity of the future contracts over the sample period.
Surprisingly enough, we can observe a reduction in the fat-tailedness of the distribution of the
innovations over the years. The reduction of kurtosis is roughly 30 percent for both contracts
whatever the selected model for the variance.

Table 4: Parameter Estimates for Ding, Granger, and Engle's GARCH(1,1) Model
Future Returns.

AUD/USD JPY/USD
Mean Parameters
Constant: a0 0.0185 (2.2736)* -0.0129 (-1.3547)
Lag Return of Order 1: al -0.0155 (-0.7982) -0.0438 (-2.8018)*
Variance Parameters
Constant: b0 0.0041 (2.6473)* 0.0130 (3.1269)*
ARCH Term: bl 0.0454 (5.6893)* 0.0548 (5.2627)*
GARCH Term: b2 0.9563 0.9385 (83.2128)*
Power Transformation: d 1.4742 (9.2242)* 1.3590 (6.1656)*
Shape Parameters
Degrees of Freedom: n 5.4226 (11.5236)* 4.6177 (14.7806)*
Log-Likelihood -3291.97 -3768.98
Ljung-Box Statistics
LB (20) 23.31 [0.224] 16.87 [0.599]
LB 2 (20) 12.49 [0.864] 12.38 [0.869]
Implied Jarque-Bera Test
Skewness -0.1591 [0.047]* 0.1478 [0.056]
Kurtosis 2.9862 [0.680] 2.9991 [0.916]
Jarque-Bera 0.0332 [0.984] 0.0038 [0.998]

Note: Table 4 exhibits the parameterestimates for the Ding, Granger, and Engle GARCH(1,1)model relyingon a Student-t
conditional density. The optimalpower transformation is statisticallydifferent from 1 and 2 in the case of the Australian
dollar, while it cannot be differentiated from 1 for the Japanese yen. Overall, the Ljung-Boxand the implied Jarque-Bera
statistics indicate a correct specification. Parentheses and brackets are used to indicate, respectively, t statistics and p-
values. * denotes significanceat the 5% confidence level.

In order not to impose a suboptimal structure on the volatility process, the PGARCH model
relies on a direct estimation of the optimal power transformation parameter 8. Table 5 displays
the mean and standard deviation for the power transformation obtained by a rollover estimation on
a moving window of 1,500 days. The average power transformation is in the intermediate zone
(1.5) for both contracts, and the uncertainty on the value of this parameter as measured by the
standard deviation (Table 5) is very comparable for both futures. Figure 2 shows the empirical
distribution of the power Iransformation for the two exchange-rate futures. The densities are
obtained by the kernel method using a Gaussian kernel and Silverman's (1986) bandwidth.
346 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 2 9 9 N u m b e r 3 9 F a l l 2 0 0 5

F i g u r e 1: D e g r e e s o f F r e e d o m f o r t h e C o n d i t i o n a l S t u d e n t - t D i s t r i b u t i o n .

Degrees of Freedom v for the AUD/USD Future

7.5

6.5

5.5

4.5

Degrees of Freedom v for the AUD/USD Future

7.5

6.5

5.5

4,5

4 : ~' '

.......................

Notes: Using the parameters obtained from the iterative estimation of the three models, Figure 1 displays the time
evolution of the degrees of freedom v of the underlying onnditional Studont-t dis~butions. Beyond the mere comparison
of the different models, these graphs provide an interesting analysis of the changes in the leptokurtocity of the two future
contracts over the sample period.
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 347

F i g u r e 2. E m p i r i c a l D i s t r i b u t i o n of the P o w e r T r a n s f o r m a t i o n 6

Empirical Distribution for Power Transformation 8 of AUD/USD Future Returns

2.5

1.5

0.5

Empirical Distribution for Power Transformation 8 of JPY/USD Future Returns

2.5

1.5

0.5

Notes: Figure 2 shows the empirical distributionof the power transformation 6 for the two future contracts. The
densities are obtainedby the Kernel method using a Gaussiankernel and Silverman's(1986) bandwidth,
348 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005

Table 5. Rollover Values for the Power Transformation 8 .

AUD/USD JPY/USD

Descriptive Statistics f o r the Power Transformation d

Mean 1.5342 1.6368
Standard Deviation 0.1916 0.2135
d different from 1 49.84% 16.58%
d different from 2 28.95% 8.57%
d different from 1 & 2 4.72% 0.00%

Rollover Likelihood Ratio Tests

DGE versus Bollerslev 5.51% 2.55%
d equal to 2 23.44% 6.02%
DGE versus Taylor 33.30% 43.03%
d equal to 1 16.67% 0.46%

Notes: Table 5 displaysthe mean and standard deviation for the powertransformation 8
obtained by a rolloverestimation on a movingwindowof 1,500 values. For eachestimate
of the parameter 8, we test whether the obtained value is different from one (Taylor),
different from two (Bollerslev), or different for both values. Table 5 summarizes this
investigation by the percentage of parameter estimates that violate the 5 percent
confidenceinterval for the values 1 and 2.

The initial purpose of this study is to understand whether the variability of the parameter 8
that can be captured with the model introduced by Ding, Granger, and Engle represents an
improvement. To this end, we use the parameter estimates obtained with our iterative procedure
together with their standard deviations to compute, for each estimation of 8 , a 5 percent
confidence interval around the value two (Bollerslev's model) and the value one (Taylor's model).
Figures 3 and 4 show the results of this investigation by plotting the time evolution of the power
transformation 8 over the sample period together with 5 percent confidence intervals
corresponding, respectively, to the hypothesis 8 -- 2 (Bollerslev) and 8 = I (Taylor). Table 5 also
summarizes this information with the percentage of parameter estimates that violate the 5 percent
confidence interval. I f Bollerslev's model is rejected 49.84 percent of the time for the Australian
dollar, Taylor's specification also presents a high rejection rate (28.95 percent). However, only
4.72 percent of the power transformation estimates are statistically different from one and two.
Although the best specification often switches, our empirical findings suggest that it seldom takes
another form than those advocated by Taylor or Bollerslev. This is even truer for the Japanese yen,
where no violation o f the hypothesis 8 = 1 o r 8 = 2 can be observed. For this future contract,
however, Taylor and Bollerlsev models seem to provide a comparable goodness o f fit for most of
the estimates with no clear-cut preference.
 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 F a l l 2 0 0 5 349

Figure 3: Power Transformation 6 with Bollerslev 5 Percent Confidence.

AUDRJSD Future Power Transformation

with Bolle~lev 5 Percent Confidence Bounds
3.5

2.5

1.5

0.5

...... lower bound ...... upper b o u n d

JPY/USD Future Power Transformation

with Bollerslev 5 Pereeat Confidence Bounds
3.5

2.5

1.5

0.5

Notes: Figure 3 plots the evolution of the power transformation t5 over the sample period using the rollover estimates. For
each future, we also display on the same graph the 5 percent confidence interval corresponding to 6 = 2 , that is,
Bollerslev's specification.
350 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 2 9 9 N u m b e r 3 9 F a l l 2 0 0 5

Figure 4: Power Transformation t~ with Taylor 5 Percent Confidence Bounds.

AUD/USD Future Power Transformation 6

with Taylor 5 Percent Confidence Bounds
2.5

1.5

0.5

-0.5

?):

- - ~ .... lower bound ...... upper bound

JPY/USD Future Power Transformation 8

with Taylor 5 Percent Confidence Bounds

2.5

2 ', . . ,,gr, ';,

1.5

0.5.

Notes: Figure 4 uses the rollover estimates to present the evolution of the power transformation t$, together with the 5
percent confidenceintervalcorrespondingto Taylor's specification,namely t~= 1.
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 35]

Aside from the direct statistical comparison of the power transformation estimate ~ to its
benchmark values of one and two, the likelihood ratio test provides another goodness-of-fit test.
Running the rollover estimation for the three models, we keep track of the maximized log-
likelihood to iteratively carry out likelihood ratio tests. The last panel of Table 5 summarizes our
empirical investigation through different statistics. We first provide the percentage of time the
likelihood ratio test selects Ding, Granger, and Engle's model over either Bollerslev's or Taylor's
model. Surprisingly, we find that the Power GARCH is preferred to Bollerslev's model in only
5.51 percent of the cases for the Australian dollar and 2.55 percent for the Japanese yen. Let us
remind the readers that the power transformation 6 is found statistically different from two,
respectively, 28.95 percent and 8.57 percent of the time. There is clearly a contradiction in the
results of these two tests that is particularly strong for the Australian dollar. Either the likelihood
ratio test is too restrictive or the direct test on the parameters is too permissive. Compared to
Taylor's model, the Power GARCH is selected by the likelihood ratio test in 33.30 percent and
43.03 percent of the estimations, while the direct test on the power term indicates that the value is
different from one in 49.84 percent of the cases for the Australian dollar and in 16.58 percent of
the cases for the Japanese yen. Again, the two tests are not in strong agreement. Eventually, Table
5 provides the percentage of contradictory cases: the number of times 6 = 2, whereas Ding,
Granger, and Engle's model is selected relative to Bollerslev's GARCH (23.44 percent for the
Australian dollar and 6.02 percent for the Japanese yen) as well as the number o f times 6 = 1
whereas the Taylor model does not outperform the Power GARCH specification using the
likelihood ratio test (16.67 percent and 0.46 percent, respectively, for the two future contracts).
In summary, this first part of the empirical investigation seems to suggest that no model clearly
outperforms the other two. Rather, the volatility dynamic is at times captured by one specification
whereas, in another time period, it is better described by a competing model. The difference in fit
should be very subtle, however, since the battery of statistical tests at our disposal sometimes
gives contradicting results. Since no clear-cut ranking o f the different models can be obtained
from a purely statistical viewpoint, we will try to answer this important question from an
operational viewpoint. In other words, we would like to differentiate the models by their ability to
provide accurate volatility forecasts and more generally by comparing their efficiency in a risk-
management context.

Value-at-Risk Analysis
In order to compare the alternative volatility models from an operational viewpoint, we now
move to the computation of one-step-ahead value-at-risk measures. VaR modeling is indeed a
natural application of volatility models since VaR measures are directly related to the expected
volatility over the relevant time horizon. Since 1998, financial institutions have been required to
hold capital against their defined market-risk exposure. These capital requirements are based on
VaR estimates generated by the financial institutions' own risk-management models. Put simply,
the scope of VaR models is to provide, at a given percentage level r and for a portfolio of assets,
the most likely loss for the financial institution. For instance, the VaR on day t at the level or and
at a one-day time horizon, denoted V a R (cr is the one-day loss that will not be exceeded in
100 * a realizations out of 100, as in (11).

P ( Rt <VaRt/t_t(ot) ) = a . (11)

With the assumed Student-t distribution for the innovations, the value-at-risk forecast for day
t conditional on the information set Ft_ 1 can thus be expressed as (12) where ].lt/t_ 1 and ~t/t-i
352 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005

are the one-day-ahead mean and volatility forecasts and za.vt/t_l represents the left quantile at a

percent for the Student-t distribution with vt/t_ 1 degrees of freedom.

VaR,/,_l ( a ) = Pt/,-1 + z,~. v. , _ l crt/,_l (12)

For the following empirical investigation, all models are tested with a confidence level a = 5
percent. From the financial institution viewpoint, VaR models should provide sufficient
conservatism to meet the supervisors' requirements while at the same time minimizing the amount
o f capital that must be held. Therefore, the performance o f VaR models (and implicitly of
volatility models) will be assessed from two different perspectives: accuracy and efficiency. [See
Engle and Gizycki (1999)]. We will thus adopt different measures presented in the literature to
match this double requirement. The statistical adequacy will be tested based on Kupiec's (1995)
and Christoffersen's (1998) backtesting measures, while the efficiency o f the different models will
be compared via loss functions introduced by Lopez (1998).

LR Test For Unconditional Coverage: LRvc

The performance o f all models can first be assessed by computing the failure rate. By
definition, the failure rate f is the proportion of times the realized returns R t are below the
forecasted value at risk VaRt/t_ 1 (oc). If the VaR model is correctly specified, the failure rate
N
should be equal to the prespecified VaR level or. Let T = ~ I t be the number of days over a
t=l
period of length N that a portfolio loss is larger than the VaR estimates, where (13) is true.

it={~ifRt<VaRt/t-1 (t~)
(13)
if R t > VaRt/t_l(ot)

The failure rate, which is equal to the percentage of negative returns smaller than the one-step-
ahead VaR, can be expressed as f = T / N . Since the computation o f the failure rate defines a
sequence of yes/no observations, it is possible to test H 0 : f = o t against H 1 : f ~ t z by first
observing that the number of failures follows a binomial distribution T ~ B (N, t~ ). Consequently,
the appropriate likelihood ratio statistic, also called the Kupiec (1995) LR unconditional test,
equals (14).

T T
LRuc = 2 * In [ (1 - ~..)N-TN_( ~ ) r ] _ 2 * In [ (1 - a ) N - r (a) r ] (14)

Under the null hypothesis the LRuc statistic is asymptotically distributed as Z 2 (1). This test
can reject a model for both too-high and too-low failure rates.

L R Test f o r Conditional Coverage: LRcc

Like any other interval forecasts, VaR estimates can be evaluated conditionally or
unconditionally--that is, with or without reference to the information available at each point in
time. The LRuc test is an unconditional test since it simply counts the number of exceptions over
the entire period. However, since our VaR estimates are computed within a framework of
conditional volatility models where the emphasis is put on the variance dynamics, the conditional
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 353

accuracy of the different VaR forecasts is a fundamental issue. If volatilities are low in some
periods and high in other periods, the VaR forecasts should respond to this clustering effect.
Interval forecasts that ignore the variance dynamics may have a correct unconditional coverage
(and thus pass the LRvc test), but at any given time they may have incorrect conditional coverage.
The LRcc test adapted from Christoffersen (1998) is a test of correct conditional coverage. If
the VaR estimates VaR (r correctly incorporate the variance dynamics, the series of I t
tit-1
defined in equation (13) must exhibit both correct unconditional coverage and serial
independence. The LRcc test is a joint test of these two properties. The relevant statistic, which is
asymptotically Z2(2) distributed, is defined by (15) where nij is the number of observations
with value i followed by value j for i,j=O,1, while ]~ij =nij / Z n i j are the corresponding
J
probabilities.

LRcc = 2 * l n [ ( 1 - ~ r o l ) n~176
(7/701) n~ (1--7/711) nl~ (Tgll) n'' ] - 2 * l n [ ( 1 - a ) u - r (a) r ] (15)

The values i , j = l indicate that a violation o f the VaR level has occurred, while i , j = 0
denotes the opposite. The advantage of this test is that it can reject a VaR model that generates
either too many or too few clustered violations.

Binary and Quadratic Loss Functions: BLF and QLF

The previous two tests can only be regarded as a first step in the selection of a VaR model.
Indeed, all VaR models for which the null hypothesis cannot be rejected will be considered
adequate: the tests remain silent about the relative accuracy of competing models. The loss
function evaluation method suggested by Lopez (1998) answers this important issue by assigning,
to each VaR estimate, a numerical score that provides a measure of relative performance. The
general form of these loss functions is defined below in (16).

LF ~f(R,,VaRt/t_l(ct)) if R t <VaR.t_l(a)
(16)
t =lg(Rt,VaRt/t_l(Ot) ) if Rt >gagt/t_l(O 0

The numerical scores are constructed with a negative orientation: the functions f (x, y) and
g ( x , y ) are selected such that f ( x , y ) > g ( x , y )
for any given y . Hence, lower values of LFt are
preferred since exceptions are given higher scores than nonexceptions. Under very general
conditions, the best VaR estimate will thus generate the lowest numerical scores.
In this study, we use two different loss functions. The first one is merely the reflection of the
LRuc test and gives a penalty of one to each violation o f the VaR level. It is called the binary loss
function, shown in (17).

BLFt= {10 if Rt<VaRt/t-l(a) (17)

if Rt >VaRt/t_l(a)

However, the magnitude as well as the number of violations is a matter of regulatory concern.
In order to include this aspect, we follow Lopez (1998) and use the quadratic loss function, (18).
354 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 F a l l 2005

QLF [l+(Rt-VaRt/t-l(~ if R t <VaRt/t_i(a ) (18)

'=~0 if R, >_VaR,/,_~(a)

As before, a score of one is imposed when a violation occurs, but now an additional term based
on the magnitude of the exception is also introduced. In order to assess the performance of the
three different models, we use the rollover parameters obtained with the window of 1,500 days to
generate the series o f one-day-ahead volatility forecasts crtlt_ l . T h e VaR estimates V a R _ ~ ( a ) at
the 5 percent level are then computed. The different measures o f VaR accuracy and efficiency are
then calculated by comparing the forecasted V a R (a) with the observed returns Rt for all
t/t-1
days in the forecasting period.
The presentation of our results takes two forms. We first provide in Figure 5 a visual
comparison of the one-day-ahead volatility forecasts cyt/,_ 1 obtained with the different models.
Whatever the future contract, no deviation of significant magnitude can be observed for the three
trajectories. The differences in the volatility forecasts generated by the three models are thus very
subtle, and the whole battery of measures o f VaR accuracy and efficiency developed above will be
necessary to compare the models. Results o f these estimations for the three GARCH models and
the two exchange-rate futures are summarized in Table 6 both for long and short positions on the
future contracts.
First of all, let us note that the mean and standard deviation o f the VaR forecasts is necessarily
the same for long and short positions since we use a symmetric model in all respects (the
conditional Student-t distribution is symmetric, and the variance dynamic does not allow for
asymmetric past shocks). A comparison of the results obtained for the different tests of accuracy
and efficiency o f VaR measures for long and short position will thus also allow checking the
appropriateness o f this assumption of symmetry.
Not surprisingly, the three models pass the unconditional coverage test both for long and short
position with the two future contracts. The binary loss functions, expressed in percentage, are
never statistically different from 5 percent. In the whole sample period, the Australian dollar future
exhibits a slight negative skewness, while the Japanese yen contract presents a positive skewness
(Table 1). If these asymmetries were modeled, one would observe a higher violation rate for the
long position in the case of the Australian dollar and for the short position in the case o f the
Japanese yen. Whatever the underlying model, no such pattern is observable, confirming that no
particular attention should be brought to asymmetry in the modeling process. In addition, the three
models also manage to pass the conditional coverage test except for the fact that the VaR forecasts
do not present too many or too few clustered violations.
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9Fall 2005 355

Table 6: Testing the Models with Out-of-Sample Value-at-Risk Statistics.

AUD/USD JPY/USD
Long Short Long Short
Position Position Position Position

Bollerslev GARCH(1,1) Model

VaR M e a n -0.9371 0.9371 -1.1363 1.1363
LRuc statistic 0.03 0.47 0.17 0.03
LRcc statistic 2.56 3.13 0.18 1.47
Binary Loss Function 4.91% 4.68 % 5.19% 4.91%
Q u a d r a t i c Loss Function 7.14% 6.29% 6.67% 10.92%
Taylor GARCH(1,1) Model
VaR M e a n -0.9296 0.9296 -1.1477 1.1477
VaR S t a n d a r d D e v i a t i o n 0.1781 0.1781 0.2892 0.2892
LRuc statistic 0.01 0.62 0.15 0.04
LRcc statistic 1.63 2.96 0.92 1.06
Binary Loss Function 5.05% 4.64% 4.82% 5.10%
Q u a d r a t i c Loss Function 7.29% 6.28% 6.29% 10.95%
Ding, Granger and Engle GARCH(1,1) Model
VaR M e a n -0.9342 0.9342 -1.1356 1.1356
VaR S t a n d a r d D e v i a t i o n 0.1915 0.1915 0.3123 0.3123
LRuc statistic 0.01 0.34 0.04 0.01
LRcc statistic 2.16 3.06 0.08 1.12
Binary Loss Function 4.96% 4.73% 5.10% 5.05%
Quadratic Loss Function 7.17% 6.34% 6.59% 11.04%

Notes: Table 6 presents an out-of-sample comparison of the three autoregressive dynamics from a risk-management
perspective. Beyond the average value-at-risk and its standard deviation obtained for each model, several tests are
presented to assess the accuracyof the different one-day-aheadVaR forecasts.Violation of the confidence level is again
indicated by *.

The two backtesting measures LRuc and LRcc can only be used to test the adequacy of a
particular model. As stated before, they cannot directly be used to compare different VaR models.
Counting the number of violations, the binary loss function provides a first statistic in this sense.
This measure, however, does not incorporate the magnitude of violations. The quadratic loss
function includes this important aspect. Results of the estimation are also reported in Table 6. We
can observe that this measure is of very similar magnitude for the three models and does not
overwhelmingly reveal the superiority o f one model over the others.
356 J O U R N A L O F E C O N O M I C S A N D F I N A N C E 9 Volume 29 9 N u m b e r 3 9 Fall 2005

Figure 5: Time Evolution of the Volatility Forecasts for Future Contracts.

Volatility Foree~t~m for the AUD/~dSD Future

1.35

1.15

0.95

0.75

0.55

0.35

................... :~E::::::Boii~ieV:::c:u

Volatility Forecasts for the JPY/USD Future

2.45

1.95

1.45

0.95

0.45
~ ,~ ~ ~ ~ ~ ~ ~..@ ~.,~.~..~.~ ~ +d~

Notes. Figure 5 provides a comparison of the time evolution of the volatility forecasts obtained when using the three
different dynamics to capture the heteroskedasticity of the foreign-exchange futures.
 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 29 9 Number 3 9 Fall 2005 357

Conclusion

The Power GARCH model introduced by Ding, Granger, and Engle (1993) represents a
turning point in the ARCH literature. Indeed, unlike all previous extensions, the model frees itself
from the Gaussian framework that implicitly justifies the use of a squared term or a power of unity
in the volatility dynamics. This new model relies on an endogenous estimation of the optimal
power transformation. Since the Power GARCH nests the two traditional competing families,
namely Taylor's and Bollerslev's GARCH models, several interesting papers have investigated
whether and to what extent this more flexible model is statistically superior to its less sophisticated
counterparts. These empirical studies, however, are "static" in the sense that they restrict their
analysis to the estimation of the competing models on a given data series and a direct in-sample
statistical comparison. Moreover, they do not provide overwhelming evidence in favor of a
particular model.
The current study adds to the previous empirical findings along two directions. We first
provide a "dynamic" estimation and comparison of the three GARCH families to understand
whether the best model is asset-specific or whether the volatility dynamics of a particular asset
may switch from one specification to another over time. The second addition regards the way the
models are usually compared. Previous studies have provided a battery of goodness-of-fit tests.
They remained silent, however, on the out-of-sample performances of the different models. The
raison d'&re of all volatility models being the production of volatility forecasts, we investigate the
relative performances of the three models when computing volatility and VaR forecasts.
Our results show that the optimal power transformation obtained with Ding, Granger, and
Engle's model is never statistically different from one or two. Neither Bollerslev's nor Taylor's
GARCH model, however, enjoys a clear statistical superiority. Since the volatility dynamic seems
to switch from Taylor's to Bollerslev's specification (and the other way around), one should
expect a better forecasting performance, both at the volatility and value-at-risk level, for the only
model flexible enough to include these variations, namely the Power GARCH model. It is
disappointing that the results obtained with the different measures of accuracy and efficiency of
VaR estimates do not support our conjectures. In most of the cases, the differences between the
models are not statistically significant, and one cannot safely conclude which model performs
better. Given the additional complexity brought by the estimation of the Ding, Granger, and Engle
model, the poor (if any) out-of-sample improvements it provides do not justify its use for risk-
management purposes.

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