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ADF test

Correlogram
ARMA models example

Advanced Econometrics
Marco Sunder

Nov 04 2010

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Advanced Econometrics

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ADF test
Correlogram
ARMA models example

Contents

ADF test

Correlogram

ARMA models example

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ADF test
Correlogram
ARMA models example

Music

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ADF test
Correlogram
ARMA models example

Music

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ADF test
Correlogram
ARMA models example

ADF test
We often assume that our time series have constant first and second
moments (covariance stationarity).
Trends in the data have to be dealt with.
(Linear) time trends are easy to spot, but what about stochastic trends
(unit roots)?
Simplest possible process with a unit root: random walk
yt = 1 yt1 + t
is white noise
yt = y0 + 1 + 2 + ... + t
Shocks long ago do not lose their effect on todays yt (persistence)
Difficult to distinguish this from AR(1) with 1 = 0.95 in small samples!
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ADF test
Correlogram
ARMA models example

ADF test

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ADF test
Correlogram
ARMA models example

ADF test
The Augmented Dickey-Fuller test (ADF) starts from an AR(p)
model plus a linear time trend (as an alternative trend specification.
E.g.: AR(2) model
yt = + t + 1 yt1 + 2 yt2 + t
A unit root would imply 1 + 2 = 1.
Rewriting the equation yields
yt yt1 = + t + (1 + 2 1)yt1 2 yt1 + 2 yt2 + t
yt

= + t +

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yt1

2 yt1

Advanced Econometrics

+ t

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ADF test
Correlogram
ARMA models example

ADF test
Test can easily be extended to larger p, just include p 1 augmenting
lags:
p1
X
yt = + t + yt1 +
j ytj + t
j=1

Estimate the equation by OLS and choose p 1 such that the residuals
are not correlated anymore.
Null hypothesis of a single unit root: = 0 (H1 : < 0)
Caution: this test requires special critical t-values!
Critical values of ADF test statistic in large samples
Deterministic regressors
10%
5%
1%
Intercept only
2.57
2.86
3.43
Intercept and time trend
3.12
3.41
3.96
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ADF test
Correlogram
ARMA models example

4.5

lnsp500
5.5

6.5

ADF test: Example

1980m1

1985m1

1990m1

1995m1

time

Figure: Logarithm of S&P 500 index


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ADF test
Correlogram
ARMA models example

ADF test: Example

Figure: Testing for a unit root in the levels

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ADF test
Correlogram
ARMA models example

ADF test: Example

Figure: Testing for a unit root in the first differences

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ADF test
Correlogram
ARMA models example

Correlogram
Autocovariances of y :
k = E[(yt )(ytk )] , k = 0, 1, 2, ...
0 denotes the variance of a process
The autocorrelation function (ACF) is the sequence of correlation
coefficients k = j /0
Empirical counterpart:
1 PT
)(yt y )
t=k+1 (ytk y
T
k =
P
T
1
)2
t=1 (yt y
T
The partial autocorrelation function (PACF) gives the strength of
the association between the time series and its k th lag after controlling
for lags 1 through k 1.
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Correlogram
ARMA models example

Correlogram
ACF and PACF may help you in determining what kind of ARMA(p,q)
process may have generated a time series.
Pure AR processes tend to have many spikes in the ACF and few ones
in the PACF
The opposite is the case for pure MA processes
White noise has no autocorrelation at all (except lag zero)
If the ACF remains close to 1 for many lags, chances are the time series
is not stationary
Is there any (significant) autocorrelation?
Ljung-Box test statistic:
Q = T (T + 2)

m
X
k=1

1
2
T k k

For white noise: Q 2m


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ADF test
Correlogram
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Correlogram
hprescott lnsp500, stub(hp) smooth(14400)

Figure: Time series of lnsp500 deviations from HP trend


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Correlogram
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Correlogram
ac hp_lnsp500_1, ylab(-1(0.5)1) lags(52)

Figure: Autocorrelation function of HP deviations


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Correlogram
pac hp_lnsp500_1, ylab(-1(0.5)1) lags(52)

Figure: Partial autocorrelation function of HP deviations


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ADF test
Correlogram
ARMA models example

Correlogram

Figure: Correlogram in STATA


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ADF test
Correlogram
ARMA models example

ARMA models

Figure: ARMA(2,0) model for lnsp500 deviations from HP trend


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ADF test
Correlogram
ARMA models example

ARMA models

Figure: ARMA(2,1) model for lnsp500 deviations from HP trend


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ADF test
Correlogram
ARMA models example

ARMA models
Estimated ARMA(2,0) process:
yt = 0.001 + 1.213yt1 0.365yt2 + t
T = 189,

AIC = 777.3,

BIC = 764.3

Estimated ARMA(2,1) process:


yt = 0.001 + 1.176yt1 0.332yt2 + t + 0.043 t1
T = 189,

AIC = 775.3,

BIC = 759.1

How could one select a preferred specification?


Akaike information criterion: AIC = 2 ln L + 2(# parameters)
Schwarz Bayesian information criterion:
BIC = 2 ln L + (# parameters) ln T
Less is better! BIC tends to favor more parsimonious specifications.
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ADF test
Correlogram
ARMA models example

Frequency domain analysis


Autocovariances of a stationary process1 can be cast into the frequency
domain (Fourier transform).
The resulting spectral density function f (spectrum) helps us identify
cyclical features of the process: are there frequency bands that
contribute heavily to the overall variance?
Spectral density of a covariance-stationary process

X
X
f () =
k exp{i2k} = 0 + 2
k cos(2k)
k=

k=1

frequency [0, 0.5]


imaginary number 1

Notice: White noise process has k = 0 k > 0 flat spectrum


1

with the property

k=

|k | <
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Correlogram
ARMA models example

Frequency domain analysis: periodogram


If you have a time series rather than a theoretical process, you could
use the Fourier transform formula and replace k by its estimate k .
The result is called periodogram:
f() = 0 + 2

T
1
X

j cos(2k)

k=1

Problem: Periodogram is not a consistent estimator of the spectral


density as its variance does not approach zero with T . Longer
time horizons imply that more covariances can be estimated.
Covariances are not all based on the same subsample.
Alternative 1: smoothing the periodogram
Alternative 2: obtain spectrum from theoretical covariances implied by
ARMA model
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ADF test
Correlogram
ARMA models example

Frequency domain analysis: periodogram


pergram hp_lnsp500_1

Figure: Periodogram for HP-filtered lnsp500

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ADF test
Correlogram
ARMA models example

ARMA models: spectral analysis


ARMA processes imply certain autocorrelation structures
These can be used to construct the spectral density of the process
Spectrum of an ARMA(p,q) process
P
| 1 qh=1 h exp{i2h} |2
P
f () =
| 1 pj=1 j exp{i2j} |2

frequency [0, 0.5]


imaginary number 1

Set q = 1, 1 = 0 if you have a pure AR model


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ADF test
Correlogram
ARMA models example

ARMA models: spectral analysis


arima hp_lnsp500_1, arima(8,0,0)
do armaspec

Figure: Spectrum for AR(8) model estimated for HP-filtered lnsp500


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