Portfolio Risk Analysis using ARCH and GARCH Models in the Context of the Global Financial Crisis* Oana Mădălina PREDESCU Bucharest Academy of Economic Studies firstname.lastname@example.org Stelian STANCU Bucharest Academy of Economic Studies email@example.com Abstract. This paper examines both the benefits of choosing an internationally diversified portfolio and the evolution of the portfolio risk in the context of the current global financial crisis. The portfolio is comprised of three benchmark indexes from Romania, UK and USA. Study results show that on the background of a global economic climate eroded strongly by the effects of the current financial crisis, international diversification does not reduce risk. Moreover, using ARCH and GARCH models shows that the evolution of portfolio volatility is influenced by the effects of the current global financial crisis. Keywords: global financial crisis; diversification; volatility; ARCH model; GARCH model. JEL Code: G01. REL Code: 11B.
Ideas in this article were presented at the Symposium „The global crisis and reconstruction of economics?”, 5-6 November 2010, Faculty of Economics, Bucharest Academy of Economic Studies.
Oana Mădălina Predescu, Stelian Stancu
1. Introduction The sub-prime credit problem that started in the United States during 2007 affected the financial sector in other countries, especially Europe. Deterioration of this sector led to the collapse of national financial systems in different parts of the world, the result being a severe global financial crisis. The magnitude of the recent financial crisis is considered to have no precedent since the Great Depression, the International Monetary Fund (IMF) referring to this global recession as “The Great Recession”. A study developed by the IMF in 2009 stated that the recent financial crisis has “revealed important flaws in the current global architecture”. The IMF managing Director, Dominique Strauss-Kahn, has underlined, in May 2009, the necessity of a “new global framework” that can ensure a better coordination of national policies (Moshirian, 2010, pp. 5-6). Thus, any national policy must be strongly related with global policies in order to avoid another global financial crisis. However, not few have been those that questioned if a global financial system is desirable. In order to clarify this debate we must first understand the role of the financial system for the economy. The financial system represents the link between investors and private or public entities. Through this system the economy grows, the consumers also grow their capacity to consume, risks are shared and individuals confront with a smaller volatility on the market. All these correlations extend to the level of the global financial system, a system that works as a powerful and efficient mechanism when the economy is characterized by stability. Whereas the potential of the financial system certainly exists, words like moral hazard or adverse selection remind us that the economic theory has identified the reasons why financial markets do not always work perfectly, the failure of one or more markets generating losses for the other ones under the conditions of a global financial system. The recent financial crisis, as well as past episodes, teaches us very clearly that the capital flows guided by financial markets can represent something very different from an efficient and optimal allocation of savings towards the right investment projects. Increasing interconnections of financial institutions and markets lead to highly correlated financial risks, liquidity pressures and depletion of bank capital. Although the recent crisis originated in the United States, due to a highly integrated global economy, the financial markets around the world collapsed and the use of sophisticated financial instruments along with massive international capital flows...