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ABSTRACT To analyse the intertemporal interaction between stock and interest rates, we apply the GARCH framework to monthly U.S data and performed various diagnostic tests to assess their performance. We find that the symmetric GARCH models reveal a common inability to explain the asymmetry present in our sample observations. Although the EGARCH model satisfactorily incorporates some of these leverage effects, the application of the News Impact Curve suggests that these models tend to overfit the asymmetric feature of volatility. By including lagged interest rate (stock) returns into our model of stocks (interest rates), we find that stock movements respond negatively to interest rate returns while its volatility is positively affected by interest rate shocks. Interestingly enough, interest rate volatility also influences fluctuations in stock returns. The improvement of our univariate models by the inclusion of an exogenous variable suggests that our previous models were mis-specified.

2001 All rights reserved. No part of this document may be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission. Page 1

CONTENTS 1. Introduction........................................................................................................ 2. Models of Volatility........................................................................................... 3. Data .................................................................................................................. 3.1 Summary Statistics.............................................................................. 3.2 Tests for Stationarity........................................................................... 3.3 Mean Equations................................................................................... 3.4 Squared Returns................................................................................... 3.5 Tests for ARCH Effects...................................................................... 3.6 Asymmetry Tests................................................................................. 4. Estimates of Our Parametric Volatility Models................................................. 4.1 Models of Stock Volatility................................................................... 3 5 10 12 14 16 17 18 19 21 21

4.2 Models of Interest Rate Volatility........................................................ 25 4.3 Estimated News Impact Curve............................................................ 5. The Relationship Between Stocks and Interest Rates........................................ 5.1 Sensitivity of Interest Rate on Stock Volatility................................... 5.2 Effect of Stocks on Interest Rate Volatility......................................... 27 30 31 34

6. Summary and Conclusions................................................................................. 37 7. Extensions.......................................................................................................... 8. References.......................................................................................................... 38 39

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1. INTRODUCTION Modelling the conditional volatilities of asset returns, including the interaction between them, is fundamental for the pricing of financial securities, asset allocation and risk management strategies. While a vast amount of literature on volatility has emerged over the past decade, these studies have often been restricted by either examining the stock or bond market separately. This paper will extend previous investigations by modelling the volatility of stock and interest rate markets as well as examine their co-movements. Our objective will be to determine whether stock (interest rates) movements are sensitive to interest rate (stocks) shocks and evaluate the implications of such sensitivities. An analysis of volatility is fundamental in the application of asset pricing, portfolio selection, capital structure, and valuation theory. For example, more efficient estimators can be obtained through appropriate modelling of heteroscedasticity in the errors. In practice, it is especially relevant for risk management, program trading and dynamic hedging strategies. By modelling volatility, a risk manager is able to determine the likelihood that his portfolio will decline in the future. Alternatively, an option trader desiring to hedge his/her position may need to understand the volatility of the future life of a contract. Volatility is also applied implicitly in pricing equities and derivatives. For instance, in the CAPM and Black-Scholes option pricing formula, the key parameters are the beta and standard deviation of the underlying stock returns. The correlation between the stock and interest rate market is important for a variety of investment and risk management decisions. Portfolio managers often shift funds from stocks into bonds when they expect stock market volatility to increase. The effectiveness of this risk reduction strategy depends on the volatility linkages between the stock and bond markets. If the volatilities across these markets are highly correlated than bonds may not provide the safe haven managers are seeking. Furthermore, fund managers rely upon volatility estimates and market correlations in determining their asset allocation through estimates of efficient portfolios. The interaction between stock and interest rates is also important for valuing derivative securities and hedging strategies. For instance, a derivative dealer who operates in more than one market is vulnerable to the volatility exposure associated with cross market correlations and should incorporate this information into his risk measurement systems. Meanwhile, a trader should consider the correlation between stock and bond returns when taking a position in bonds to hedge his speculative position in stocks.

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Moreover, volatility linkages are also considered in setting regulatory policy. Banking regulators are required to understand the covariance between the two markets to appropriately assess capital adequacy. Similarly, market regulators should account for these linkages when evaluating the effects of proposed policy changes, such as the impact of margin requirements on trading activity. Spiro (1990) argues that the volatility of stock prices is mainly attributable to the volatility of interest rates. A rise in the stock market stimulates investment and increases the demand for credit and eventually leads to higher interest rates throughout the economy. Spiro concludes that although it is unfeasible to forecast every movement of the stock index through economic variables such as interest rates, it is possible to obtain a reasonably good forecast of changes in stock direction. Accurate modelling of this behaviour can be potentially rewarding but it is surprising that researchers have only recently begun to examine these temporal dependencies. Fischer (1981) proposed that the variance of inflation positively responds to the volatility of interest rates. If short-term interest rates embody expectations about inflation then it may be possible to apply them to predict future stock volatility. Other papers have documented a close relationship between the stock and interest rate market. For example, Breen, Glosten and Jagannathan (1989) found a negative relationship between short-term interest rates and stock index returns, while Schwert (1989) concluded that U.S stock and bond volatilities commonly move together. In general, volatility is expected to change over time and evidence of this comes from Kwan (1996). He finds that individual stocks and bonds can either be positively or negatively correlated, depending on the information disseminated over time. A more recent study by Fleming, Kirby and Ostdiek (1998) reveal that strong volatility linkages between the stock and bond markets are mainly due to common information that affects expectations in both markets and information spillover caused by cross-market hedging. Hence, for the above reasons, it is important for us to study the behaviour of volatility and their interactions over different markets.

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2. MODELS OF VOLATILITY The aim of any modelling process is to produce an adequate conditional characterisation of the data. Financial time series displays strong clustering of volatility. Mandelbrot (1963) and Fama (1965) both reported evidence that 'large changes tend to be followed by large changes of either sign, while small changes tend to be followed by small changes'. This behaviour has been confirmed by numerous other studies such as Chou (1988) and Bailie et al. (1996). Volatility clustering implies that shocks today will influence the expectation of volatility shocks into the future. It also suggests that the volatility is mean-reverting, i.e. there is a normal level to which volatility will return. Another common feature of financial time series is that they exhibit leptokurtosis. This means they contain higher peaks and thicker tails relative to the normal distribution. Note that leptokurtosis is an outcome of volatility clustering. The autoregressive conditional heteroscedasticity (ARCH) model was introduced by Engle (1982) to capture the volatility clustering as well as leptokurtosis inherent in many financial times series. It is unique in that it specifies the variance of the error term in a regressive equation as conditional on the squared of past errors. To understand the advantage of conditioning on past information, let us first consider a simple stationary AR(1) model without drift: = + where | | < 1 ( )= ( = = ( The unconditional variance is ( ) = ( = ( = = + + ) ( + + ~ (0, + ) + + ) + + ) +) )+ ) + ) = 0 )

The unconditional mean is

(1 + /(1

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We can calculate the mean and variance of

by conditioning on all available information up to

time t -1. The conditional mean and variance are respectively: ( | )= and ( | ) =

where represents the information set at time t These values provide better forecasts because the conditional mean is time-varying and the conditional variance is smaller than the unconditional variance eg. Let us now return to our ARCH model. The ARCH(p) model involves a joint estimation of a conditional mean and variance equation: < /(1 )

= =

+ +

~ (0, + +

(1.0) with coefficients and an error

The mean is expressed as a function of exogenous variables term AR(p)

. For example, we can represent the mean by an autoregressive AR(p) equation: = + ++ + is conditional on the information set and is

The distribution of the stochastic error term

assumed to follow a normal distribution with mean zero and variance

. The conditional

variance comprises a constant and past news on volatility reflected by the squared residuals from (t-p) to (t-1). We assume that the error terms are uncorrelated and the conditional variance is time-varying. This gives rise to the name heteroscedasticity. Note that in practice the residuals in many time series regressions are correlated. Due to difficulties in attaining precision by selecting the optimal lag p, we can replace many of the lagged values of by one or two lagged values of . This leads us to the generalised

autoregressive conditional heteroscedasticity (GARCH) model proposed by Bollerslev (1986). The GARCH(p,q) model has a conditional variance containing lagged variances as well as past squared error terms.

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, ,

are constant parameters.


This model allows a more parsimonious representation because it corresponds to an infinite order ARCH model. To ensure a positive conditional variance, we place non-negativity constraints on the coefficients whereby > 0 and , 0. Such restrictions are more easily satisfied for the

GARCH(p,q) since there are fewer parameters to be estimated. Note that changes in news, either positive or negative, leads to increases in the variance with more emphasis being place on the most recent innovations. Therefore, the model effectively captures the volatility-clustering phenomenon. Since GARCH models are a function of lagged squared errors and not their signs, they are severely limited by their inability to capture the asymmetric volatility frequently inherent in stock market data. The sign asymmetry of stocks suggests that there is a tendency for negative shocks to elicit a larger response than positive shocks of equal magnitude. Furthermore, large shocks have been found to produce a proportionately larger response when compared to smaller shocks. This has been known as size asymmetry. Asymmetry was first noted by Black (1976) and is commonly ascribed to the leverage effect. Black (1976), Christie (1982) and Nelson (1991) argued that an increase in stock volatility associated with 'bad news' lowers the stock price and increases the debt-equity ratio of a company. As a result, the financial leverage of the firm rises, increasing the risk of holding stock and reinforcing further volatility and price declines. On the other hand, an increase in stock price volatility associated with the arrival of 'good news' decreases the firm's corporate leverage and reduces the risk. Thus the increased price is effectively offset by the reduced corporate risk, producing a lower impact on volatility. Black (1976) noted that leverage alone does not fully explain this asymmetry in equity volatility. Several recent papers have proposed alternative explanations. One approach is that of French, Schwert and Stambaugh (1987) and Campbell and Hentschel (1992) with their volatility feedback hypothesis. Arrival of good news signals a positive change in market volatility. This direct positive effect is partially offset by an increase in risk premium causing only a minor impact. Alternatively, when bad news arrives, both the direct effect and risk premium effect
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move in the same direction so the impact of news is amplified. Another explanation was developed by Veronosi (1999), who attributed it to a following-the-herd-effect. Here, investors imitate one another in selling stocks when bad news arrives and this induces relatively higher volatility. Whatever the reasons, we acknowledge that volatility asymmetry exists and will now focus on the exciting part modelling. The presence of asymmetric responses can be parsimoniously accounted for by explicitly incorporating an indicator variable, d, into the conditional variance equation. This leads us to the Threshold (TARCH) model introduced independently by Zakoian (1994) or otherwise known as the GJR-GARCH model, named after Glosten, Jagannathan and Runkle (1993).

= =

+ +

+ +

+ +

or more generally, (1.2)

Where , ,

= 1

< 0,

= 0 otherwise

, are constant parameters

The TARCH(p,q) model implies that a positive innovation at time ( ( volatility at time t + 1 equal to < 0) has an impact equal to (

> 0) has an impact on

+ ) times the squared residual. The presence of leverage

times the residual squared, while a negative innovation

effects suggests that the coefficient is positive ie. negative innovations have a greater impact on volatility. Another historically successful asymmetric specification is the Exponential GARCH (EGARCH) proposed by Nelson (1991). Here, the parameters are created to be non-linear in a logarithmic transformation of the conditional variance:

log (


+ log (



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This model implies that the leverage effect is exponential rather than quadratic. Hence, it is not necessary to enforce non-negative constraints on the coefficients because the conditional variance is guaranteed to be positive. The presence of leverage effects can be tested by the hypothesis that > 0, and the impact is asymmetric if 0

Other models such as the GARCH-in-Mean (GARCH-M) have been developed by Engle, Lillien, and Robins (1987), to incorporate a direct relation between the conditional variance and mean equation. This accounts for the fact that risk-averse investors trade off higher risk for higher expected return. It is worth noting that other models like these exist even though they will not be applied in this study. The models explained above have been quite successful in characterising volatility. However, we must be aware of their limitations such as the assumption of normally distributed errors. Furthermore, although these models may appear correctly specified for one frequency of data, they could be incorrectly specified for data with different time scales.

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3. DATA The data comprised of 378 monthly observations from the period 01/1970 to 06/2000 on the Standard and Poor's (S&P) 500 Index and the Three Month Treasury Bill in the secondary market (TB3MS). Data were obtained from the Federal Reserve Bank of St Louis website under FRED - an economic time series database which provides historical U.S. economic and financial data1. All data was transformed to continuously compounded returns over the period (t -1) to t, and is calculated as = log( ) log( ), where represents the price for the S&P index or

the yield for the TB3MS. Figures 1.1 presents the monthly time series plots for our stock data. The S&P 500 index exhibits a general positive exponential trend until year 2000. It is clearly non-stationary. Figure 1.2 represents continuously compounded returns calculated by taking the difference of logarithms. Note that the mean return on the S&P500 index is slightly above zero, indicating a drift component in the time series. The peak in volatility observed in 1974 coincides with the dramatic rise in world oil prices associated with OPEC, while the downward spike in late 1987 corresponds to the October 1987 stock market crash. Apart from other lesser peaks, the fluctuations appear fairly evenly distributed.

Figure 1.3 displays the 3-Month Treasury-bill yield over time. Observe the interesting variation as rates fluctuated upwards until early 1980, and then oscillated back down. Figure 1.4 represents the continuously compounded return on the T-Bill. Note the sharp downward spike in rates in 1980. There is a high risk and return period around 1979-1983 with excess fluctuations and may be attributed to a period of monetary change in the Federal Reserve Bank discussed by Hamilton

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(1988). In contrast to Figure 1.2, the series appears to exhibit no drift component with the mean very close to zero.

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3.1 SUMMARY STATISTICS The tables below exhibit descriptive statistics for the S&P500 index and T-Bill respectively. The probability values are displayed in parenthesis. Jarque-Bera is a statistic to test whether the series is normally distributed. The test measures the difference in the data's skewness and kurtosis from those of the normal distribution. The formula is: = +
( )


where S represents the skewness, K is kurtosis and k represents the number of estimated coefficients used to create the series. A small probability value leads to a rejection of the null hypothesis of normal distribution. The Ljung-Box Q-statistic at lag k tests for the null hypothesis that there is no autocorrelation up to order k. A lag k of 12 months is applied here.

= ( + 2)


is the j-th autocorrelation and T is the number of observations.

Table 1.0 Descriptive Statistics for the S&P500 Index

Table 1.1 Descriptive Statistics for the Three-Month Treasury Bill

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As suspected, stocks have higher average returns than bonds with a positive mean significantly different from zero. A comparison of the variances reveals that interest rate returns are much more volatile over the same period. Both sets of data exhibit negative skewness such that large negative returns are more common than large positive ones. Note that the return on the T-Bill is much more negatively skewed. This can be attributable to the negative spikes over the period 1980-1983. Both stock and interest rate returns are strongly leptokurtic with a kurtosis significantly greater than 3. This indicates that both series have an excessive number of observations in the tails compared to the normal distribution (which has a kurtosis equal to 3). As expected, the JarqueBera test for normality reveals that both data sets are non-normal. Numerous studies including Mckenzie et al. (1999), and Brailsford and Faff (1993) have shown that stock data exhibits volatility persistence and serial correlation between consecutive returns. Hence it was surprising to see that our Q(12) statistic showed significant autocorrelation for interest rate returns but rejected the autocorrelation between stock returns.

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3.2 TESTS FOR STATIONARITY A series is stationary if both the mean and variance of a process is constant over time. Hamilton (1994) previously noted that financial time series data are typically non-stationary and contain a unit root. However our returns series will need to be stationary in order for our model assumptions to be applicable. We can establish whether a series is stationary by using two common root tests to our return series. The Augmented Dickey-Fuller (ADF) Test is based on the regression equation:


If the coefficient p is significantly different from zero, than the null hypothesis that Y is nonstationary is rejected. The test statistic is (OLS) Estimator of p and < . ( ) is its standard error. The criterion is to reject non-stationarity if = ( ) where is the Ordinary Least Squares

Second is the Phillips-Perron (PP) Test, which uses the equation: = + + + (1.7)

Similar to 1.6, this test takes the difference of the series and identifies the statistical significance correlation. The ADF includes lagged values of of . The primary difference between the ADF and PP tests is the way each test deals with serial while the PP test applies a Newey-West

Correction Procedure which is used to generate a consistent heteroscedasticity autocorrelation estimate. For more information, refer to Phillips and Perron (1988). The table below presents the test results for both returns. The 5% critical values are in parenthesis. The tests included a trend and a constant with lag of 4. Table 1.3 Unit Root Test for Stationarity

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Note that the calculated t-statistics are substantially less than the critical values for both stock and interest rates. Hence both tests clearly reject the null hypothesis of a unit root and indicate that our returns are stationary.

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3.3 MEAN EQUATIONS Optimal inference requires the correct specification of the conditional mean and variance equations. On the basis of the significance of the parameters using the t-statistic, we model the S&P500 index return by a simple mean equation with no autoregressive terms. By doing this, we illustrate that most of the movements in stock returns are primarily due to disturbances in the residual rather than by past period returns. The Q-statistics reveal that the mean equation has adequately modelled the serial correlation in the residuals. The Jarque-Bera statistic is highly significant, indicating that the distribution of the residuals are non-normal - a fact which is largely explained by strong leptokurtosis (kurtosis = 5.96). Interest rates present a much more interesting analysis. The mean equation shows that interest rates are affected by a negative trend and approximately 36% of last period's return. The constant in the equation is insignificant and confirms our previous observation that the trend is very close to zero. The Q-statistic of up to 4th lag indicates a marginal acceptance of no correlation while the Q(12)-statistic demonstrates that there is a significant amount of correlation in the residuals that are unaccounted for. We must note here that the Ljung-Box test loses power for higher order lags. In addition, the statistics indicate that the residual distribution is clearly non-normal with an extreme leptokurtosis (8.24) and negative skewness. Table 1.4 Mean Equation Model Summary

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3.4 SQUARED RETURNS Before estimating our ARCH model, it is first appropriate to establish whether ARCH effects are present in our data. Through visual inspection of the squared return in Figure 1.5 and Figure 1.6, we find presence of volatility clustering, that is, shocks of similar magnitude of either sign are followed by similar degree of shocks. For instance, large returns are clustered together around the period 1975 while small movements in returns are evident around 1995.

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3.5 TESTS FOR ARCH EFFECTS A formal ARCH test is the Lagrange Multiplier (LM) test for autoregressive conditional heteroscedasticity (ARCH) in the residual suggested by Engle (1982). This is a regression of squared residuals on a constant and lagged squared residuals up to order q:



is a white noise disturbance term. The null hypothesis is that there is no ARCH up to

lag q in the residuals. Table 1.5 presents the F-statistic for the joint significance of all lagged residuals. Table 1.5 Arch LM Test on the Mean Equations

The test reveals strong presence of up to the 12th order ARCH for our interest rate data. For stock returns there is reasonable evidence of 1st order ARCH but less evidence of 4th and 12th order ARCH. This suggests that our mean equation may have reasonably modelled the serial correlation within the residuals.

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3.6 ASYMMETRY TESTS As noted in 2.0, GARCH models are symmetric in their response to news. Aside from examining the skewness of the standardised residuals, we can conduct formal diagnostic tests developed by Engle and Ng (I993), which focus on assessing the asymmetry of volatility in response to past innovations. The test is based on dummy variables that identifies negative innovations and includes (a) a sign bias test; (b) a negative size bias test; and (c) a positive size bias test. The tests are based on the OLS regression: = + where + + + (1.9) ( ) is a dummy is

are the standardised residuals from the GARCH model and

variable that takes a value of one when a disturbance term.

is negative (positive) and zero otherwise. Here,

The sign bias test refers to the statistical significance of . If is found to be statistically nonbias tests relate to the significance of ( ) and if these are non-zero then large and small negative (positive) innovations impact differently on volatility. The standard symmetric GARCH models require , , and to be jointly equal to zero. This hypothesis can be tested based on the Lagrange Multiplier Principle and is performed as . ~ 1.9. The results of these diagnostic tests for our ARCH and GARCH models are presented in Table 1.6. Note the null hypothesis equals zero so that our series is symmetric. from the estimation of Equation zero then positive and negative shocks have different impacts on volatility. Similarly, the size

Table 1.6. Diagnostic Tests of Asymmetric Responses in Volatility

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According to our tests, size bias is strongly insignificant for both sets of data. This implies that shocks in the residuals of either sign have a symmetric impact on volatility. The test strongly rejects positive size bias for stock returns but has marginally accepted negative size bias at around the 10% critical level. The estimated coefficient of the variable that captures the negative shock for ARCH(1) is equal to -0.017563, which means that large negative innovations causes more volatility than can be explained by the above models. Existing literature like Glosten, Jagannathan and Runkle (1993), and Engle and Ng (1993) all claimed significant asymmetry effects in the stock indices, so it is quite surprising to see that leverage effects are only marginally present here. Strong size bias is evident for our Treasury-bill data with all size bias p-values (in parenthesis) close to zero. Given that ARCH(3) and GARCH(1,1) models incorporate a symmetric response to past innovations, it is not surprising that they both fail the positive and negative size bias test. For our interest rate data, we can interpret that large innovations, whether positive or negative, causes more volatility than small innovations. Note that the leverage explanation of Black (1976) cannot be the only valid argument for this effect since it is based on a debt-to-equity ratio which only holds true for stocks. The asymmetric feature of volatility is reinforced by the highly significant joint statistic, indicating a rejection of the joint hypothesis of the absence of sign and size biases. The Engle and Ng (1993) test demonstrates that we should be able to estimate asymmetric models for the data. We must note however that this test has low power and results should be interpreted indicatively rather than conclusively. The program Eviews applies the Berndt, Hall, Hall and Hausman (BHHH) algorithm of maximum likelihood estimation to calculate the parameters. For details, refer to Berndt, Hall, Hall and Hausman (1974). Given the inherent non-normality in the returns series, we will use Bollerslev and Wooldridges (1992) robust standard errors to perform inference on the model estimates. In a sense, our approach is "Quasi Maximum Likelihood".

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4.0 ESTIMATES OF PARAMETRIC VOLATILITY MODELS 4.1 MODELS OF STOCK VOLATILTY Various models were estimated with different lags and the four most appropriate for our S&P500 data were presented in Table 1.7. We restrict our estimations to a few lags since it is well known that parsimonious models typically outperform more complicated models {see Hansen (2001)}. Note that a double line separates the conditional mean and variance equations while the parameters used are analogous to the equations displayed in 2.0. To determine the adequacy of these models we initially check for positive and significant ARCH and GARCH coefficients in the variance. Clearly, the ARCH(1) and TARCH(1,1) models have failed this test with an insignificant value (p-value =0.2606) and a negative parameter (-0.0885) respectively.

The coefficients in our GARCH(1, I) model reveal that approximately 87% of the previous period's volatility and 5% of past residuals affect the current periods conditional variance. There is significant evidence of asymmetry in the estimates of our EGARCH(2,1). This, coupled with the previous evidence from 3.5, suggests that the GARCH(1,I) model is mis-specified. Another constraint is for the sum of the coefficients to be less than unity. This restriction allows the GARCH processes to be stationary so that shocks to the system are temporary rather than permanent. All four models passed this test. For the GARCH(1, 1) model, appears to be marginally insignificantly different from zero at

the 5% level. The ARCH term also presents problems for our asymmetric EGARCH(2,1) model (with a p-value of 0.1165). The insignificance of the ARCH term in modelling stock index returns has not been documented in history. This may be attributed to the fact that most of past literature has concentrated on modelling daily and weekly returns which seem to exhibit stronger ARCH effects. Despite this, the GARCH(1,1) and EGARCH(2,1) model appear to be the most feasible set of symmetric and asymmetric models respectively for our monthly data. This is consistent with evidence from Bollerslev, Chou and Kroner (1992) who indicate that the majority of U.S studies found the GARCH(1,1) specification to be preferred. Note that the log likelihood has moderately increased from the simple ARCH(1) model to the more sophisticated asymmetric EGARCH(2,1) model. Although this suggests that the parameters in the EGARCH(2,1) more closely resemble the data than the other models, a direct comparison on the basis of Likelihood values is not possible given the difference in functional forms.

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Two statistics often used for model selection are the Akaike Information Criterion (AIC) and Schwarz Bayesian Criterion (SBC). They are computed as follows: = 2 + 2 = 2 + (2.0)

where ML is the maximum likelihood value of the model, q is the number of independently estimated parameters, and n is the sample size. The model selection criterion is to choose the model with the lowest AIC and SBC value. By examining these statistics, we see that the EGARCH(2,1) model generated the lowest AIC (-3.4502) and SBC (-3.3772) values and thus is preferred. However, Pagan and Schwert (1990) argued that the use of the AIC and SBC may be inappropriate because these statistics are concerned with the first moment. Correct specification of the GARCH and EGARCH models implies that the moment condition satisfied. This naturally lends itself to the diagnostic regression: = + + (2.1) . In Table 1.7, = 0 and = 1 in the following ( )= be

The test is wald-type from the estimation of Equation 2.1 and is distributed as this test strongly accepts the joint hypothesis that higher preference for the EGARCH(2,1) specification. = 0 and

= 1 for all models with a

The Durbin Watson (DW) statistic tests for first order serial correlation within the residuals. There is no serial correlation when DW = 2, however there is evidence of positive serial correlation when 0 < DW < 2 and negative correlation when 2 < DW < 4. The DW statistic for all models is marginally below 2, suggesting that serially correlation is not evidently present in the residuals. Recall from 2.0 that our assumption inferred that the standardised residuals are distributed normally with zero mean and unit variance, ie =

~ (0,1). We can examine descriptive

statistics of the standardised residuals to assess the adequacy of this assumption. The results of this test favoured the EGARCH(2,1) model because it showed the least negative skewness and kurtosis. The mean and variance of all standardised residuals are close to zero and one respectively. Nevertheless, they are strongly non-normal (as shown by the Jarque-Bera test) with extreme negative skewness, and leptokurtosis (a minimum kurtosis = 4.306).

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A satisfactory model must be able to account for most of the serial correlation in the residuals. The Q-statistics and Q2-statistics clearly accept the hypothesis of no serial correlation at all levels of confidence. The ARCH tests strongly rejects the presence of further ARCH effects. Hence we can safely conclude that our models have adequately accounted for any serial correlation among the residuals. Note that when our mean equations were modelled in 3.3, the Q-statistics had already indicated no evidence of serial correlation. Therefore, the conditional variance may have played only a minor role in the improvement of our characterisation.

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Table 1.7. Estimated volatility models for the Return on the SP500 Index

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4.2 MODELS OF INTEREST RATE VOLATILITY Various models of different lags were fitted to the return on the 3-month Treasury Bill and those with the closest fit were presented in Table 1.8. First, note that all parameters in the conditional variance equations are significant apart from the coefficient in the TARCH(1,l) (with p-value =

0.2386) and EGARCH(1,l) (p-value= 0.1448) models. Although evidence of asymmetry was present in our data, these effects were rejected by the t-statistics. In time, further investigations led to an improved asymmetric model - the EGARCH(1,2). Here the coefficient is -0.157144,

indicating a leverage effect on the conditional variance of approximately 0.85(

) times.

The negative sign suggests that a larger volatility response is generated from a negative shock than a positive shock. Notice that this value is significant at the 10% critical level (p-value = 0.0821). Another alternative is the GARCH(1,l) with all parameters significant. It implies that this period's fluctuations are influenced by 73% of last period's volatility and 26% of last periods squared errors. The Log Likelihood and AIC statistics further reinforces the superiority of the EGARCH(1,2) model. Note that the Wald Test rejected our assumption of ( )= for all models but has

given preference to the EGARCH(1,2) specification. On the other hand, the SBC statistic suggests a conflicting opinion by indicating a lower SBC for the GARCH(1,1). Due to this, we will now need to examine the residuals to improve the closeness of fit with the models. Despite failing the normality tests with insignificant Jarque-Bera statistics, all models behaved reasonably well with the mean of the standardised residuals not significantly different from zero while the standard deviations were very close to unity. However, the skewness and excess kurtosis should have been smaller in absolute size. The preferred model for this test is the EGARCH(I,2) which has the smallest negative skewness (-0.008) and kurtosis (3.685). Furthermore, these models show a stronger conformity to our normality assumptions than the stock models in Table 1.7. The Q-statistics rejects the presence of serially correlation among the residuals and marginally rejects the 12th lag for most models which is a cause for concern. To eliminate this problem, perhaps we could include moving average terms. Engle's (1982) ARCH tests of the 4th and 12th order clearly show that most of the ARCH effects have been accounted for. We are unable to differentiate between the GARCH(I,I) and EGARCH(1,2) models from these tests because they

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contain approximately the same results. Nevertheless, on an overall basis, the EGARCH(1,2) is favoured because it accounts for the asymmetry within the volatility of the residuals. Table 1.8 Volatility models for the Return on 3 Month Treasury-Bill

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4.3 ESTIMATED NEWS IMPACT CURVE One can plot against on any volatility model to illustrate how the volatility reacts to the

difference between the realised and expected return. This plot allows a visual inspection to the extent to which models facilitate the asymmetry response to news. It also characterises the differences among the various specifications of volatility. This method was introduced by Pagan and Schwert (1990), and later named the News Impact Curve (NIC) by Engle and Ng (1993). Suppose that the information at and before time (t-1) is held constant. The NIC of the GARCH(l,l) model can be graphed as: = + where C is a constant and = + against = for simplicity.

For the EGARCH models, we will plot the variance The equations are as follows: EGARCH(2,1) : where EGARCH(1,2): = where = = + = + + | + |+ + | |+ | |+

Table 1.9 presents the news impact curves calculated for our selected four models. Figure 1.5 demonstrates that the GARCH(1,1) NIC is symmetric and centred at = 0. Comparing

Figure 1.5 and 1.7 we see that the GARCH(1,1) specification on the Treasury Bill has a much larger response to volatility (about five-fold) from changes in the previous residuals than the GARCH(1,1) specification for stocks. The news impact curves for the EGARCH models are also centred at steeper slope when = 0 but contain a

< 0. The EGARCH(2,1) NIC indicates that a negative shock will have

an impact on stock volatility roughly equal to 2.6 times the impact of a positive shock. This appears reasonably consistent with the leverage theory presented in 2.0. On the other hand, the NIC of the EGARCH(1,2) model seems extreme in that positive values of have only a

minute effect on the variance relative to negative innovations. This suggests that the EGARCH(1,2) model is heavy in the tails and may be an inadequate characterisation of interest
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rates. This fact was also described by Henry (1998) who stated that the EGARCH model can be overly sensitive to extremely large positive and negative shocks. Note that the NIC for the EGARCH is plotted in different units to the GARCH specification. However, by comparing them we can decipher that the GARCH(1,1) would underestimate large negative shocks and overestimate large positive shocks. Meanwhile, the EGARCH(1,2) model may reflect excessive fluctuations in volatility for large negative innovations. Table 1.9 Estimated News Impact curves

Further Asymmetric tests shown in Table 2.0 suggests that the EGARCH(2,1) specification has successfully modelled the asymmetry of stock volatility with tests adequately accepting the hypothesis that the coefficients are indifferent from zero. On the contrary, a substantial amount of size asymmetry remains with our EGARCH(1,2) model, indicating that large and small negative (positive) innovations continue to impact differently on volatility. We can account for this by observing Figure 1.8. Notice that large positive innovations have a minor influence on volatility compared with the excessive impact of large negative innovations. This extreme imbalance between positive and negative innovations on volatility may be impractical for our interest rate data. Nevertheless, our EGARCH(1,2) proved significant in modelling part of the asymmetry as shown by the increased p-values relative to Table 1.6.
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Table 2.0 Final Tests for Further Asymmetric Responses

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5.0 THE RELATIONSHIP BETWEEN STOCKS & INTEREST RATES In 1.0 numerous studies confirmed that strong correlations exists between stocks and interest rates. In this section we will attempt to statistically detect whether there is causality between our data, that is, whether one market causes the other to change. By combining the returns of our two series, we can visually interpret these findings. Figure 1.9 displays a moderate trend between stock and interest rates. Fluctuations from both the S&P500 and 3-month Treasury bill returns lie relatively in line with one another. Notice also that there are many extreme outliers, which may be the result of various macroeconomic shocks such as changes in monetary policy, recessions, speculative bubbles and oil price shocks. Figure 1.9 Volatility of T-Bill returns relative to S&P500 returns

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5.1 SENSITIVITY OF INTEREST RATES ON STOCK VOLATILITY To formally assess whether there is any effect of interest rates on stock volatility we place the lagged level of the 3-month Treasury-Bill return as an exogenous regressor within the conditional mean and variance of our final stock models. The T-Bill rate is correlated with the cost of borrowing to firms and thus may carry information that is relevant to the volatility of the S&P 500 index. Note that an absolute value of the T-bill regressor is applied in the conditional variance of the GARCH(1, 1) model to avoid a negative volatility. The results from Table 2.1 reveal the significance of the T-Bill regressor in the mean equation of both the GARCH(1,1) and EGARCH(2,1) with coefficients of -0.ll04 and -0.0717 respectively. This indicates that information driving individual stock and bond prices tend to be dominated by the information about the mean value of the underlying asset rather than by information about their variances. The value of the coefficients suggests that stock returns are negatively affected by interest rates from the previous period by around 10%. A possible reason for this is that as interest rates rise, consumer spending drops and retail sales begin to slow, leading to decreased corporate profits and a declining stock market. The effect of this decline is compounded by the fact that investors often borrow to finance their position. Higher interest rates reduce borrowing and makes interest-bearing investments more attractive, causing an exodus of money from the stockmarket and a decline in prices. This is also consistent with the study by Breen, Glosten and Jagannathan (1989) who demonstrated a negative relation between short-term interest rates and stock index returns. The impact of the T-bill rate on the volatility process of the S&P500 return is small, but quite significant. Although the t-statistic has rejected the variance coefficient in the EGARCH(2,1) specification (p-value = 0.1645), the positivity of this parameter in both models indicate that high interest rates are generally associated with high levels of equity return volatility. This result confirms a variety of studies such as Campbell (1987) and Glosten, Jagannathan, and Runkle (1993) who documented a positive relation between stock volatility and the level of short-term interest rates. Fleming et al. (1998) suggested an explanation whereby volatility linkages exist between these two markets due to information flow that affects expectations in both markets, such as news about inflation, which is often proxied by the short-term interest rate. The second source of volatility linkage comes from information spillover caused by cross-market hedging. When information alters expectations in one market, traders will adjust their holdings across all markets causing the higher volatility.

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Results from the Log Likelihood, Wald and AIC tests suggest an improvement in our characterisation relative to the models presented in Table 1.7. The DW test is closer to 2, while the AIC and SBC criterions are lower than previously revealed. Although the normality test once again failed, serial correlation in the residuals has been adequately accounted for. These results suggest that our previous models in Table 1.7 were mis-specified.

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Table 2.1 Effect of Interest rates on the SP500 Index

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5.2 EFFECT OF STOCKS ON INTEREST RATE VOLATILITY Various regressions were performed with the lagged return of the S&P 500 index applied to both the conditional mean and variance of the interest rate models. We find that stocks returns do not directly affect the T-Bill rate and therefore, is insignificant in the mean equation. Despite this, we discover that stocks have a minor influence on the volatility of our EGARCH models. Table 2.2 present the results. Firstly, observe that the coefficient for the absolute value of the S&P 500 index return in both the GARCH and TARCH models are insignificant with values close to zero. This finding is consistent with results from Scruggs and Glabadanidis (2001) who reported that bond market variance is relatively unresponsive to stock return shocks. On the other hand, our EGARCH representations indicate that stocks have a minor effect on interest rate volatility equal to a factor of approximately 7% (calculated as

). This is a relatively new discovery and may be

attributed to the fact that negative stock return shocks typically lead to higher demands for bonds and thus raises bond prices and volatility. Another explanation can be attributed to the effect of similar expectations in both markets from common information, indicated by Fleming et al. (1998). Although it appears that this result contradicts Scruggs and Glabadanidis (2001), we must understand that covariances between assets changes are higher (lower) at times of high (low) volatility (This fact was indicated by Goeij and Leuven (2001)). Given that our data type and time frame are different from Scruggs and Glabadanidis, we would expect to obtain varied results.

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Table 2.2 Effect of stock on interest rate volatility

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The EGARCH models have reasonably improved with the input of lagged stock returns into the variance specification. Notice that both coefficients, especially for the EGARCH(1,1), have

become increasingly significant relative to Table 1.8. This suggests that interest rates have a minor asymmetric effect on fluctuations in stocks which cannot be accounted for by single GARCH(1,1) specifications, and may be due to similar investor expectations from common information revealed in both markets. The suitability of these EGARCH models is reinforced by a higher Log Likelihood value and lower AIC criteria than previously stated. The only drawback comes from information revealed by statistics of the standardised residuals for our EGARCH(1,2) model. Although the mean and variance are reasonable close to zero and one respectively, the addition of the lagged stock parameter caused an increase in negative skewness (-0.028) and excess kurtosis (3.76) by a fraction. This resulted in stronger acceptance of non-normality. Note that our inference is robust to this departure from conditional normality, due to the "Quasi-Maximum Likelihood" correction to the variance-covariance matrix of the parameters. Nonetheless, the presence of serial correlation within the residuals is similar to Table 1.8, with Q-statistics remaining fairly stable, marginally accepting no correlation at the 5% level. This approach in assessing the significance of stock (interest rate) returns in the conditional mean and volatility of interest rates (stocks) is limited by the fact that it does not provide information on the magnitude of the correlation. Nor does it offer any information regarding whether the covariances exhibit asymmetric effects. More sophisticated modelling techniques have been recently proposed to capture these traits, and will be discussed in 7.0.

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6.0 SUMMARY AND CONCLUSIONS Historically, the majority of U.S studies, as outlined by Bollerslev, Chou and Kroner (1992) have favoured the GARCH(1,1) specification. While this model parsimoniously characterises both stock and interest rate data, it neglects to capture an important feature of volatility - the asymmetric responses to past innovations. Our application of the news impact curve reveal that the GARCH(1, 1) specification tends to underestimate (overestimate) the conditional variance for large negative (positive) shocks. We discover that the EGARCH specifications were able to adequately characterise a portion of this leverage effect, but similarly to Henry (1998), we also find that the EGARCH model is restricted in that it is overly sensitive to extreme negative shocks. Our investigation into the relation between stock and interest rates supports the result of Breen, Glosten and Jagannathan (1989). We find a negative relation between short-term interest rates and stock returns. In other words, rises in interest rates tend to be associated with reductions in stock returns, assuming all other variables are constant. This information is reflected in the determination of security prices as indicated by the Efficient Market Hypothesis. In addition, we find that interest rates shocks have a positive impact (to a lesser extent) on conditional stock volatility. Hence by examining the volatility of interest rates, it is possible to forecast future stock return volatility to a limited degree. As indicated in 1.0, these results have important implications for asset allocation and risk management strategies. Perhaps more interesting is our analysis on whether stock return shocks have an impact on interest rate volatility. Unlike Scruggs and Glabadanidis (2001), we find that movements in interest rates have an asymmetric response to stock return shocks. This is a relatively new result and can be attributed to the relation between volatility and common information flows by Ross (1989). Furthermore, the improvement of our univariate models by the inclusion of an exogenous variable suggests that our original models were mis-specified. In order for us to obtain reasonably accurate forecasts of volatility changes, we may need to account for intertemporal dependencies and causality across markets.

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7.0 EXTENSIONS Although ARCH models have been quite successful in capturing the volatility clustering and heteroscedasticity characteristic exhibited in financial time series data, they do not accurately describe the leptokurtosis element very well, as indicated in this paper with most of our models rejecting the normality assumption. We can extend the GARCH models by specifying conditionally t-distributed errors as done by Bollerslev (1987). The t-distributed series contains a larger proportion of outliers (fat-tails), and hence is able to characterise the data more effectively. Another extension is to allow for seasonal effects by incorporating dummy variables in our mean equation. This accounts for any predictable influences such as holidays and non-synchronous trading in the return series. Finally, the interactions between stock and interest rate volatility can be more thoroughly captured by Multivariate GARCH models. These models specify the error term as a column vector and describe the relationship between the variances by a conditional covariance matrix. In doing so, they are able to portray the way in which correlation varies, as well as whether asymmetric effects are present in covariances. For further details, refer to the recent study by Goeij and Leuven (2001).

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