Orthogonal GARCH and covariance matrix forecasting: The Nordic stock markets during the Asian financial crisis 1997-1998

Hans Byström

The European Journal of Finance, 2004, vol. 10, issue 1, 44-67

Abstract: In risk management, modelling large numbers of assets and their variances and covariances in a unified framework is often important. In such multivariate frameworks, it is difficult to incorporate GARCH models and thus a new member of the ARCH-family, Orthogonal GARCH, has been suggested as a remedy to inherent estimation problems in multivariate ARCH modelling. Orthogonal GARCH creates positive definite covariance matrices of any size but builds on assumptions that partly break down during stress scenarios. This article therefore assesses the stress performance of the model by looking at four Nordic stock indices and covariance matrix forecasts during the highly volatile years of 1997 and 1998. Overall, Orthogonal GARCH is found to perform significantly better than traditional historical variance and moving average methods. Out-of-sample evaluation measures include symmetric loss functions (RMSE), asymmetric loss functions, operational methods suggested by the Basle Committee on Banking Supervision, as well as a forecast evaluation methodology based on pricing of simulated 'rainbow options'.

Keywords: principal components; multivariate GARCH; covariance matrix; forecast evaluation (search for similar items in EconPapers)
Date: 2004
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Citations: View citations in EconPapers (5)

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DOI: 10.1080/1351847032000061379

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