Question
Suppose we are estimating a model for the return on a bond ( r_{t} ) of the form, ( r_{t}=gamma_{0}+gamma_{1} r_{t-1}+u_{t} ) where ( u_{1}
Suppose we are estimating a model for the return on a bond \( r_{t} \) of the form, \( r_{t}=\gamma_{0}+\gamma_{1} r_{t-1}+u_{t} \) where \( u_{1} \) is an error term (a) Explain the difference between the conditional variance and thic unconditional variance of \( r \). Which of the two is more relevant for financial decision making? (b) If we suspect that the variance of e changes systematically through tir, e what \( w \) ould be the consequences for standard OLS estimation. Outlin. the ARCH and GARCH models, which would allow us to deal with th's problem fully. (c) If you believed that the variance of \( e \) affects the return on the bond hou would adapt the GARCH model to allow for this. (d) If you were investigating a model such as the capital asset pricing mocel which used the covariance between the market return \( r_{m} \) and the bord return \( r \), how could the GARCH model be extended to allow for this case?
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