Why does the GARCH(1,1) model fail to provide sensible longer- horizon volatility forecasts?

Catalin Starica, Stefano Herzel and Tomas Nord
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Tomas Nord: Chalmers University of Technology

Econometrics from University Library of Munich, Germany

Abstract: The paper investigates from an empirical perspective aspects related to the occurrence of the IGARCH effect and to its impact on volatility forecasting. It reports the results of a detailed analysis of twelve samples of returns on financial indexes from major economies (Australia, Austria, Belgium, France, Germany, Japan, Sweden, UK, and US). The study is conducted in a novel, non-stationary modeling framework proposed in Starica and Granger (2005). The analysis shows that samples characterized by more pronounced changes in the unconditional variance display stronger IGARCH effect and pronounced differences between estimated GARCH(1,1) unconditional variance and the sample variance. Moreover, we document particularly poor longer-horizon forecasting performance of the GARCH(1,1) model for samples characterized by strong discrepancy between the two measures of unconditional variance. The periods of poor forecasting behavior can be as long as four years. The forecasting behavior is evaluated through a direct comparison with a naive non-stationary approach and is based on mean square errors (MSE) as well as on an option replicating exercise.

Keywords: stock returns; volatility forecasting; GARCH(1; 1); IGARCH effect; hedging; non-stationary; longer horizon forecasting (search for similar items in EconPapers)
JEL-codes: C14 C32 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2005-08-02
New Economics Papers: this item is included in nep-cfn, nep-ecm, nep-ets and nep-for
Note: Type of Document - pdf; pages: 35
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Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpem:0508003

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