Question:

σ²_t = β₀ + β₁σ² _{t - 1} + λ₁ε²_{t -1}

(a) Interpret parameter 1 and 1 in model (1) and derive the long-term unconditional variance.

(b) What diagnostic test should be done before applying model (1)?

(c) A researcher finds that model (1) can only account for volatility clustering but not for leverage effects. Distinguish between these two terms and explain how you would adjust model (1) to cater for leverage effects?

(d) How GARCH modelling is related to hedging?