AFIN270 Stochastic Methods in Applied Finance

Time Series Models

- autoregressive (AR) model

- moving average (MA) model
- autoregressive moving average (ARMA) model
- autoregressive integrated moving average (ARIMA) model
- autoregressive conditional heteroscedasticity (ARCH) model
- generalised autoregressive conditional heteroscedasticity
(GARCH) model

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 AFIN270 Stochastic Methods in Applied Finance

Time Series General Concept

- a sequence of observations over time, e.g. share prices,

foreign exchange rates, interest rates
- observations at different points of time may be dependent on
one another
- stock price tomorrow partly depends on stock price today, and
potentially yesterday, the day before
- a time series model is designed to allow for such dependency
across time

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 AFIN270 Stochastic Methods in Applied Finance

Time Series General Concept (Cont)

- building a time series model allows us to explain the past and

make forecasts on future values
- recap: in contrast, regression models allow for dependency
between two or more variables
- notation: let X be a random variable observed at time t
t

- t runs from 0 onwards in discrete time steps

- e.g. we have X X , X ,... 0, 1 2

- let x be the actual observation at time t

t

Autoregressive or AR(1) Model

- X t 0 1 X t 1 Z t

- 0
and are parameters
1

- Z
s are independent error terms with mean 0 and variance
t 2

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 AFIN270 Stochastic Methods in Applied Finance

- 1 1
ensures weak stationarity, i.e. (1) X t is constant over
time, (2) Var X t is constant over time, (3) Cov X s , X t depends on lag
ts
only but not on s or t itself

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 AFIN270 Stochastic Methods in Applied Finance

AR(1) Model
0
X t
- 1 1
2
- Var X t
1 12
1k 2
- Cov X t k , X t
autocovariance at lag k is given by 1 12

- autocovariance approaches 0 as k increases

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 AFIN270 Stochastic Methods in Applied Finance

AR(p) Model

- X t 0 1 X t 1 2 X t 2 ... p X t p Z t p 1, 2, 3,...

- are parameters
0 , 1 , 2 , ... , p

- Z
s are independent error terms with mean 0 and variance
t 2

- each root of y y y ... 0 smaller than one in absolute

p
1
p 1
2
p2
p

value ensures weak stationarity

0
X t
- 1 1 2 ... p

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 AFIN270 Stochastic Methods in Applied Finance

AR(p) Model Fitting

- use partial autocorrelation function (PACF) to determine p
- fit these models one by one:
X t 1, 0 1,1 X t 1 Z t

X t 2, 0 2,1 X t 1 2, 2 X t 2 Z t

X t 3, 0 3,1 X t 1 3, 2 X t 2 3,3 X t 3 Z t

- examine 1,1 n,
2, 2 n,
3, 3 n , ...
and find cutoff from significance to
insignificance to decide p
AR(p) Model Checking
0 1 2
- examine , ,
SE 0 SE 1 SE 2
, ...
and check for any insignificant
ones, the parameters of which may be removed
- rt xt 0 1 xt 1 2 xt 2 ... p xt p

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 AFIN270 Stochastic Methods in Applied Finance

- multiply residuals autocorrelation at each lag (i.e. sample

correlation between rt k
and rt
at lag k) by n
and check for any
significant ones, i.e. model misspecification
- check for any significant changes in variability
AR(p) Model Forecasting

- suppose observations are made to time h

- 1-step ahead forecast x x x ... x
h 1 0 1 h 2 h 1 p h 1 p

- 2-step ahead forecast x x x ... x

h2 0 1 h 1 2 h p h 2 p

- 3-step ahead forecast x x x ... x

h 3 0 1 h 2 2 h 1 p h 3 p

- m-step ahead forecast approaches estimate of X t as m goes

to infinity

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 AFIN270 Stochastic Methods in Applied Finance

AR(p) Model Example

- consider Macquarie Group monthly returns from 2011 to 2015

- time series autocorrelation at lag 1 = 0.29
time series autocorrelation at lag 2 = 0.21
time series autocorrelation at lag 3 = 0.08
time series autocorrelation at lag 4 = 0.05
time series autocorrelation at lag 5 = 0.10
- 1,1 n 2.16 2, 2 n 1.07 3,3 n 0.08

4, 4 n 0.04 5, 5 n 0.89

AR(p) Model Example

- AR(1) model
0 1
1.88 2.23
SE 0 SE 1

residuals autocorrelation (statistic) at lag 1 = -0.05 (-0.40)

residuals autocorrelation (statistic) at lag 2 = 0.12 (0.89)
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 AFIN270 Stochastic Methods in Applied Finance

residuals autocorrelation (statistic) at lag 3 = 0.01 (0.07)

residuals autocorrelation (statistic) at lag 4 = -0.05 (-0.36)
residuals autocorrelation (statistic) at lag 5 = 0.10 (0.80)

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 AFIN270 Stochastic Methods in Applied Finance

AR(p) Model Example

- AR(1) model
rolling 12-month sample standard deviations of residuals
ranging from 3.57% to 7.34%

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 AFIN270 Stochastic Methods in Applied Finance

AR(p) Model Example

MA(1) Model
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 AFIN270 Stochastic Methods in Applied Finance

- X t Z t Z t 1

-
and are parameters
- Z
s are independent error terms with mean 0 and variance
t 2

- it is always weakly stationary

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 AFIN270 Stochastic Methods in Applied Finance

MA(1) Model

- X t

-
Var X t 1 2 2

- Cov X t 1 , X t 2

- Cov X t k , X t 0 for k 1

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model

- X t Z t 1 Z t 1 2 Z t 2 ... q Z t q q 1, 2, 3,...

- are parameters
, 1 , 2 , ... , q

- Z t
s are independent error terms with mean 0 and variance 2

- it is always weakly stationary

- X t

-
Var X t 1 12 22 ... q2 2

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Fitting

- use time series autocorrelations at different lags (i.e. sample
correlation between x and x at lag k) to determine q
t k t

- multiply time series autocorrelation at each lag by and find n

cutoff from significance to insignificance to decide q

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Checking

1 2
- examine ,
,

SE SE 1 SE 2
, ... and check for any insignificant ones,
the parameters of which may be removed
- obtain residuals r from mathematical software
t

- multiply residuals autocorrelation at each lag (i.e. sample

correlation between rt k
and rt
at lag k) by n
and check for any
significant ones, i.e. model misspecification
- check for any significant changes in variability
MA(q) Model Forecasting

- suppose observations are made to time h

- 1-step ahead forecast x r r ......... r
h 1 1 h 2 h 1 q h 1 q

- 2-step ahead forecast x r r ...... r

h 2 2 h 3 h 1 q h 2 q

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 AFIN270 Stochastic Methods in Applied Finance

- 3-step ahead forecast x r r ... r

h3 3 h 4 h 1 q h 3 q

- m-step ahead forecast becomes for m q

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Example

- consider Macquarie Group monthly returns from 2011 to 2015

- time series autocorrelation (statistic) at lag 1 = 0.29 (2.20)
time series autocorrelation (statistic) at lag 2 = 0.21 (1.60)
time series autocorrelation (statistic) at lag 3 = 0.08 (0.61)
time series autocorrelation (statistic) at lag 4 = 0.05 (0.35)
time series autocorrelation (statistic) at lag 5 = 0.10 (0.78)

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Example

- MA(1) model
1
2.49 1.72
SE
SE 1

residuals autocorrelation (statistic) at lag 1 = 0.04 (0.29)

residuals autocorrelation (statistic) at lag 2 = 0.20 (1.50)
residuals autocorrelation (statistic) at lag 3 = 0.04 (0.29)
residuals autocorrelation (statistic) at lag 4 = 0.01 (0.07)
residuals autocorrelation (statistic) at lag 5 = 0.14 (1.08)

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Example

- MA(1) model
rolling 12-month sample standard deviations of residuals
ranging from 3.57% to 7.47%

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 AFIN270 Stochastic Methods in Applied Finance

MA(q) Model Example

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 AFIN270 Stochastic Methods in Applied Finance

ARMA(p, q) Model

- X t 0 1 X t 1 2 X t 2 ... p X t p Z t 1 Z t 1 2 Z t 2 ... q Z t q

p 0, 1, 2, 3,... q 0, 1, 2, 3,...

- are parameters
0 , 1 , 2 , ... , p , 1 , 2 , ... , q

- Z
s are independent error terms with mean 0 and variance
t
2

- it combines the features of AR and MA models and is flexible

- it may lead to a smaller number of parameters involved

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 AFIN270 Stochastic Methods in Applied Finance

ARIMA(p, d, q) Model

- ARIMA(p, 1, q) is non-stationary but its first differences (i.e.

) follow weakly stationary ARMA(p, q)
X t X t X t 1

- ARIMA(p, 2, q) is non-stationary but its second differences

(i.e. 2 X t X t X t 1 ) (not first differences) follow weakly stationary
ARMA(p, q)
- ARIMA(p, 3, q) is non-stationary but its third differences (i.e.
3 X t 2 X t 2 X t 1 ) (not first and second differences) follow weakly
stationary ARMA(p, q)
ARCH(m) Model

- Zt ht t

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 AFIN270 Stochastic Methods in Applied Finance

- ht 0 1 Z t21 2 Z t2 2 ... m Z t2 m

- are parameters
0 , 1 , 2 , ... , m

-
s are independent random variables with mean 0 and
t

variance 1
- it allows for heteroscedasticity, i.e. changing variability

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 AFIN270 Stochastic Methods in Applied Finance

GARCH(m, s) Model

- Zt ht t

- ht 0 1 Z t21 2 Z t2 2 ... m Z t2 m 1 ht 1 2 ht 2 ... s ht s

- are parameters
0 , 1 , 2 , ... , m , 1 , 2 , ... , s

-
s are independent random variables with mean 0 and
t

variance 1
- it allows for heteroscedasticity

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 AFIN270 Stochastic Methods in Applied Finance

Question 1

There is a time series of 500 observations on the daily returns of a share. The
PACF figures of the data and the results of fitting an AR(2) model are given
below. Discuss whether the fitted model is a suitable choice for the data an
your recommendation of an alternative better model (if any).
Lag 1 2 3 4 5
PACF 0.25 0.35 0.36 -0.04 0.03 (observations)

Parameter 0 1 2
Estimate 0.002 0.1 0.15
Standard Error 0.002 0.2 0.05 (AR(2) model parameters)

Lag 1 2 3 4 5
Autocorrelation -0.2 0.3 0.2 0.04 0.01 (AR(2) model residuals)

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 AFIN270 Stochastic Methods in Applied Finance

Question 2

There is a time series of 100 observations on the monthly returns of a share.

The autocorrelation figures of the data and the results of fitting a MA(2) model
are given below. Discuss whether the fitted model is a suitable choice for the
data.
Lag 1 2 3 4 5
Autocorrelation 0.25 0.13 0.15 0.10 0.08 (observations)

Parameter 1 2
Estimate 0.005 0.2 0.05
Standard Error 0.004 0.1 0.05 (MA(2) model parameters)

Lag 1 2 3 4 5
Autocorrelation 0.10 -0.05 0.08 0.06 -0.10 (MA(2) model residuals)
Excel Question 1

Download the historical daily prices of Commonwealth Bank of Australia (CBA)

for the period 1 October 2015 to 31 December 2015 from Yahoo Finance. Use

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 AFIN270 Stochastic Methods in Applied Finance

an Excel spreadsheet to analyse the daily returns, and fit an AR(p) model to
the returns. Comment on the results and check the fitted model. Also project
the returns to 15 January 2016 and plot the returns over time.

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 AFIN270 Stochastic Methods in Applied Finance

Excel Question 2

Based on the information and results in Excel Question 1, discuss whether a

MA(2) model is also suitable for the data considered. The parameter estimates
and residuals are provided. Also project the returns to 15 January 2016 and
plot the returns over time.

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