Modelling time-varying higher moments with maximum entropy density

Since the introduction of the Autoregressive Conditional Heteroscedasticity (ARCH) model of Engle [R. Engle, Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation, Econometrica 50 (1982) 987–1007], the literature of modelling the conditional second moment has become increasingly popular in the last two decades. Many extensions and alternate models of the original ARCH have been proposed in the literature aiming to capture the dynamics of volatility more accurately. Interestingly, the Quasi Maximum Likelihood Estimator (QMLE) with normal density is typically used to estimate the parameters in these models. As such, the higher moments of the underlying distribution are assumed to be the same as those of the normal distribution. However, various studies reveal that the higher moments, such as skewness and kurtosis of the distribution of financial returns are not likely to be the same as the normal distribution, and in some cases, they are not even constant over time. These have significant implications in risk management, especially in the calculation of Value-at-Risk (VaR) which focuses on the negative quantile of the return distribution. Failed to accurately capture the shape of the negative quantile would produce inaccurate measure of risk, and subsequently lead to misleading decision in risk management. This paper proposes a solution to model the distribution of financial returns more accurately by introducing a general framework to model the distribution of financial returns using maximum entropy density (MED). The main advantage of MED is that it provides a general framework to estimate the distribution function directly based on a given set of data, and it provides a convenient framework to model higher order moments up to any arbitrary finite order k. However this flexibility comes with a high cost in computational time as k increases, therefore this paper proposes an alternative model that would reduce computation time substantially. Moreover, the sensitivity of the parameters in the MED with respect to the dynamic changes of moments is derived analytically. This result is important as it relates the dynamic structure of the moments to the parameters in the MED. The usefulness of this approach will be demonstrated using 5min intra-daily returns of the Euro/USD exchange rate.