Palumbo, D.
Testing and Modelling Time Series with Time Varying Tails
CWPE2111
Abstract: The occurrence of extreme observations in a time series depends on the heaviness of the tails of its distribution. The paper proposes a dynamic conditional score model (DCS) for modelling dynamic shape parameters that govern the tail index. The model is based on the Generalised t family of conditional distributions. The framework is extended to allow also for the presence of asymmetric tails and therefore the possibility of specifying different dynamics for the left and right tail indices. The Paper examines through simulations both the convergence properties of the model and the implications of the link functions used. In addition the paper introduces and studies the size and power properties of a new Lagrange Multiplier (LM) test based on fitted scores to detect the presence of dynamics in the tail index parameter. The paper also shows that the novel LM test is more effective than existing testing methodologies. The model is fitted to Equity Indices and Credit Default Swaps returns. It is found that the tail index for equities has dynamics driven mainly by either the upper or lower tail depending if leverage is taken or not into account. In the case of Credit Default Swaps the test identifieses very persistent dynamics for both the tails. Finally the implications of dynamic tail indices for the estimated conditional distribution are assessed in terms of conditional distribution forecasting showing that the novel model predicts more accurately expected shortfalls and value-at-risk than existing models.
Keywords: Heavy Tailed Distributions, Extreme Events, Score-Driven Models, Tail Index, Lagrange Multiplier Test, Financial Markets
JEL Codes: C12 C18 C51 C52 C46 C58 G12
Author links: Dario Palumbo
PDF: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2111.pdf 
Open Access Link: https://doi.org/10.17863/CAM.65414
