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Conditionally heteroskedastic factor models with skewness and leverage effects

  • Dovonon, Prosper

Conditional heteroskedasticity, skewness and leverage effects are well known features of financial returns. The literature on factor models has often made assumptions that preclude the three effects to occur simultaneously. In this paper I propose a conditionally heteroskedastic factor model that takes into account the presence of both the conditional skewness and leverage effects. This model is specified in terms of conditional moment restrictions and unconditional moment conditions are proposed allowing inference by the generalized method of moments (GMM). The model is also shown to be closed under temporal aggregation. An application to daily excess returns on sectorial indices from the U.K. stock market provides a strong evidence for dynamic conditional skewness and leverage with a sharp efficiency gain resulting from accounting for both effects. The estimated volatility persistence from the proposed model is lower than that estimated from models that rule out such effects. I also find that the longer the returns’ horizon, the fewer conditionally heteroskedastic factors may be required for suitable modeling and the less strong is the evidence for dynamic leverage. Some of these results are in line with the main findings of Harvey and Siddique (1999) and Jondeau and Rockinger (2003), namely that accounting for conditional skewness impacts the persistence in the conditional variance of the return process.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 40206.

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Date of creation: Dec 2008
Date of revision: Feb 2012
Handle: RePEc:pra:mprapa:40206
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  2. Javier Mencía & Enrique Sentana, 2012. "Distributional Tests in Multivariate Dynamic Models with Normal and Student-t Innovations," The Review of Economics and Statistics, MIT Press, vol. 94(1), pages 133-152, February.
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  8. Brandt, Michael W. & Diebold, Francis X., 2004. "A no-arbitrage approach to range-based estimation of return covariances and correlations," CFS Working Paper Series 2004/07, Center for Financial Studies (CFS).
  9. Sentana, Enrique & Fiorentini, Gabriele, 2001. "Identification, estimation and testing of conditionally heteroskedastic factor models," Journal of Econometrics, Elsevier, vol. 102(2), pages 143-164, June.
  10. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
  11. Enrique Sentana & Giorgio Calzolari & Gabriele Fiorentini, 2004. "Indirect Estimation Of Conditionally Heteroskedastic Factor Models," Working Papers wp2004_0409, CEMFI.
  12. Dovonon, Prosper, 2008. "Conditionally heteroskedastic factor models with skewness and leverage effects," MPRA Paper 40206, University Library of Munich, Germany, revised Feb 2012.
  13. Melino, Angelo & Turnbull, Stuart M., 1990. "Pricing foreign currency options with stochastic volatility," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 239-265.
  14. Singleton, Kenneth J., 2001. "Estimation of affine asset pricing models using the empirical characteristic function," Journal of Econometrics, Elsevier, vol. 102(1), pages 111-141, May.
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  22. Harvey, Campbell R. & Siddique, Akhtar, 1999. "Autoregressive Conditional Skewness," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(04), pages 465-487, December.
  23. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  24. Rubinstein, Mark E., 1973. "The Fundamental Theorem of Parameter-Preference Security Valuation," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(01), pages 61-69, January.
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  29. Harvey, Andrew & Ruiz, Esther & Sentana, Enrique, 1992. "Unobserved component time series models with Arch disturbances," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 129-157.
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