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Excel Models

Using GARCH to Forecast Volatility

๐ŸŽฏ GARCH is not just a descriptive model โ€” its purpose is to forecast the volatility of future returns on invested capital.

In previous posts, we:

Now we answer the key question:

How do we use the model once we are confident it works properly?

๐Ÿ”ง Forecasting Mechanism

The original model is defined as:ฯƒt+12=ฯ‰+ฮฑut2+ฮฒฯƒt2sigma_{t+1}^2 = omega + alpha u_t^2 + beta sigma_t^2

However, when forecasting, future shocks are unknown.
Therefore, we replace them with their expected values, which gives:

E[ฯƒt+k2]=VL+(ฮฑ+ฮฒ)k(ฯƒt2โˆ’VL)E[sigma_{t+k}^2] = V_L + (alpha+beta)^k(sigma_t^2 – V_L)

This means that volatility evolves according to a simple logic:

๐Ÿ‘‰ its current level gradually moves toward a long-term level โ€” a kind of gravitational equilibrium

Where:VL=ฯ‰1โˆ’ฮฑโˆ’ฮฒV_L = frac{omega}{1 – alpha – beta}

๐Ÿ“ˆ What This Looks Like in Excel

  • We start from the current variance (ฯƒโ‚œยฒ)
  • We forecast forward (t = 1โ€ฆ30)
  • We convert variance into volatility

The result:

๐Ÿ‘‰ a smooth curve that converges toward equilibrium

๐Ÿ” What Determines the Shape of the Curve

Two key factors:

  • Persistence (ฮฑ + ฮฒ)
    High โ†’ slow adjustment
    Low โ†’ fast adjustment
  • Mean Reversion
    Volatility does not remain at extreme levels โ€” it gradually returns to equilibrium

๐Ÿ“Ž Excel: Volatility Forecast โ€“ GARCH

Adapted from:

Options, Futures & Other Derivatives, John C. Hull