Modelling and Forecasting the Volatility of Thin Emerging Stock Markets: the Case of Bulgaria

Abstract

Modern Portfolio Theory associates the stock market risk with the volatility of return. Volatility is measured by the variance of the returns’ distribution. However, the investment community does not accept this measure, since it weights equally deviations of the average returns, whereas most investors determine the risk on the basis of small or negative returns. In the last few years the measure Value at Risk (VaR) has been established and adopted widely by practitioners. The issue of modelling and forecasting thin emerging stock markets’ risk is still open. The subject of this present paper is the risk of the Bulgarian stock market. The aim of this research is to give the investment community a model for assessing and forecasting the Bulgarian stock market risk. The result of this research shows that the SOFIX index has basic characteristics that are observed in most of the emerging stock markets, namely: high risk, significant autocorrelation, non-normality and volatility clustering. Three models have been applied to assess and estimate the Bulgarian stock market risk: RiskMetrics, EWMA with t-distributed innovations and EWMA with GED distributed innovations. The results revealed that the EWMA with t-distributed innovations and the EWMA with GED distributed innovations evaluate the risk of the Bulgarian stock market adequately.