The ARCH model
Based on previous arguments, we know that the volatility or variance of stock returns is not constant. According to the ARCH model, we could use the error terms from the previous estimation to help us predict the next volatility or variance. This model was developed by Robert F. Engle, the winner of the 2003 Nobel Prize in Economics. The formula for an ARCH (q) model is presented as follows:
Here, is the variance at time t, is the ith coefficient, is the squared error term for the period of t-i, and q is the order of error terms. When q is 1, we have the simplest ARCH (1) process as follows: