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Conditional Correlation Models of Autoregressive Conditional Heteroskedasticity with Nonstationary GARCH Equations

  • Cristina Amado

    ()

    (University of Minho and NIPE)

  • Timo Teräsvirta

    ()

    (Aarhus University, School of Economics and Management and CREATES)

In this paper we investigate the effects of careful modelling the long-run dynamics of the volatil- ities of stock market returns on the conditional correlation structure. To this end we allow the individual unconditional variances in Conditional Correlation GARCH models to change smoothly over time by incorporating a nonstationary component in the variance equations. The modelling technique to determine the parametric structure of this time-varying component is based on a sequence of specification Lagrange multiplier-type tests derived in Amado and Teräsvirta (2011). The variance equations combine the long-run and the short-run dynamic behaviour of the volatilities. The structure of the conditional correlation matrix is assumed to be either time independent or to vary over time. We apply our model to pairs of seven daily stock returns belonging to the S&P 500 composite index and traded at the New York Stock Exchange. The results suggest that accounting for deterministic changes in the unconditional variances considerably improves the fit of the multivariate Conditional Correlation GARCH models to the data. The effect of careful specification of the variance equations on the estimated correlations is variable: in some cases rather small, in others more discernible. As a by-product, we generalize news impact surfaces to the situation in which both the GARCH equations and the conditional correlations contain a deterministic component that is a function of time.

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File URL: ftp://ftp.econ.au.dk/creates/rp/11/rp11_24.pdf
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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2011-24.

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Length: 38
Date of creation: 30 May 2011
Date of revision:
Handle: RePEc:aah:create:2011-24
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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  1. Van Bellegem, Sebastien & von Sachs, Rainer, 2004. "Forecasting economic time series with unconditional time-varying variance," International Journal of Forecasting, Elsevier, vol. 20(4), pages 611-627.
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