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Contemporaneous Aggregation of GARCH Models and Evaluation of the Aggregation Bias

  • Eric Jondeau

    (University of Lausanne and Swiss Finance Institute)

It is well known that the class of strong (Generalized) AutoRegressive Conditional Heteroskedasticity (or GARCH) processes is not closed under contemporaneous aggregation. This paper provides the dynamics followed by the aggregate process when the individual persistence parameters are drawn from the same (unknown) distribution. Assuming heterogeneity across individual parameters, the dynamics of the aggregate volatility involves additional lags that reflect the moments of the distribution of the individual persistence parameters. Then the paper describes a consistent estimator of the aggregate process, based on nonlinear least squares. A simulation study reveals that this aggregation-corrected estimator performs very well under realistic sets of parameters. Last, this approach is extended to a multi-sector context. This extension is used to evaluate the importance of the aggregation bias. Using size and book-to-market portfolios, I show that the investor is willing to pay one fifth of her expected return to switch from the standard GARCH (1,1) estimator to the aggregation-corrected estimator.

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File URL: http://ssrn.com/abstract=1105784
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Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 08-06.

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Length: 53 pages
Date of creation: Feb 2008
Date of revision:
Handle: RePEc:chf:rpseri:rp0806
Contact details of provider: Web page: http://www.SwissFinanceInstitute.ch

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