Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the term "Autoregressive" refer to in ARCH?

1. Predicting future values based on random processes

2. Predicting values based on past values

3. Predicting values based on external factors

4. Predicting values based on current conditions

The correct answer is: Predicting values based on past values

The term "Autoregressive" in ARCH (Autoregressive Conditional Heteroskedasticity) models indeed refers to predicting future values based on past values. Autoregressive models operate on the principle that past observations in a time series can be used to estimate future points. This assumption forms the core of many time series forecasting techniques, where the model essentially captures the relationship between the current value and its previous values. In the context of ARCH models, this autoregressive component specifically relates to the way volatility (or the variance of the error term) is modeled as a function of past squared observations. By utilizing the historical data, ARCH models enhance the understanding of how volatility changes over time, providing a systematic approach to modeling the time-varying nature of volatility in financial series. Focusing on the other choices: predicting future values based on random processes does not accurately describe the essence of autoregressive models, as they rely heavily on deterministic patterns observed in past data. Similarly, predictions based on external factors or current conditions do not align with the autoregressive feature, as these would imply a model using variables not strictly based on the series’ past values. Autoregressive specifically emphasizes the chronological pattern of past observations influencing future outcomes, which is central to understanding