Garch-in-mean :: Recursive Estimates
Finance theory suggests that an asset with a higher perceived risk would pay a higher return on average [Caution]. For example, let rt denote the ex post rate of return on some asset minus the return on a safe alternative asset. Suppose that rt is decomposed into a component anticipated by investors at date t-1 (denoted μt) and a component that was unanticipated (denoted ut):
garchblogThen the theory suggests that the mean return (μt) would be related to the variance of the return. The GARCH(1,1)-in-mean, or GARCH(1,1)-M, regression model is characterized by
garchblogg
for ε i.i.d. with zero mean and unit variance. The effect that higher perceived variability of ut has on the level of rt is captured by the parameter γ (see Hamilton's TSA Bible).
A realization (n = 500) of a Garch(1,1)-M process with κ = 0.005, γ = 2, ω = 0.0001, α = 0.1, β = 0.8, and ε ~ N(0,1) looks as follows:
examplegarchm
Unfortunately, I got a GARCH-in-mean effect (γ) of -34 instead of +2 after I estimated the process given above (n=500) with R (R uses the Ox package with "garchOxFit" command to estimate GARCH models. See here for "garchOxFit" installation instructions for Windows OS.) Estimating the GARCH(1