Conditional Correlation Models of Autoregressive Conditional Heteroscedasticity With Nonstationary GARCH Equations

Cristina Amado () and Timo Teräsvirta

Journal of Business & Economic Statistics, 2014, vol. 32, issue 1, 69-87

Abstract: In this article, we investigate the effects of careful modeling the long-run dynamics of the volatilities of stock market returns on the conditional correlation structure. To this end, we allow the individual unconditional variances in conditional correlation generalized autoregressive conditional heteroscedasticity (CC-GARCH) models to change smoothly over time by incorporating a nonstationary component in the variance equations such as the spline-GARCH model and the time-varying (TV)-GARCH model. The variance equations combine the long-run and the short-run dynamic behavior 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 improves the fit of the multivariate CC-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. We also show empirically that the CC-GARCH models with time-varying unconditional variances using the TV-GARCH model outperform the other models under study in terms of out-of-sample forecasting performance. In addition, we find that portfolio volatility-timing strategies based on time-varying unconditional variances often outperform the unmodeled long-run variances strategy out-of-sample. 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.

Date: 2014
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Citations: View citations in EconPapers (22)

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Related works:
Working Paper: Conditional Correlation Models of Autoregressive Conditional Heteroskedasticity with Nonstationary GARCH Equations (2011)
Working Paper: Conditional Correlation Models of Autoregressive Conditional Heteroskedasticity with Nonstationary GARCH Equations (2011)
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DOI: 10.1080/07350015.2013.847376

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