Here is a complete cointegration example

Suppose that we take the nominal interest rate on a 20 year US

savings and loan credit instrument. Call this R20 = SL20rate
and now consider an alternative credit instrument say a
Seasoned AAA Moodys bond rate which we can call R30 =
AAArate. This is a very long run instrument, near to 30 years.
We believe that these two yields must be closely related over
time. If the SL20rate is greater than the AAArate, then people
will buy the S&L instrument. Its price will rise and its yield will
fall down, till it becomes nearly equal to the other rate. This is
called arbitrage.
Thus, in equilibrium
R20t o R30t t
1

Since we are dealing with time series, we must be careful about

the problem of stationarity. It may be well to consider a time
series plot of the two variables.

The two variables are clearly related. The shorter term rate is
significantly lower than the longer term rate. This is due to
liquidity and risk premiums. The two variables are not
stationary since the means are not constant. Both variable
appear to be I(1), although we should test for unit roots.
GRETL can do this for us.
First we open GRETL and choose the path
MODEL
TIME SERIES
COINTEGRATION TEST
ENGLE-GRANGER
As shown in the figure below

Clicking on ENGLE-GRANGER results in the following

window

The important items are marked in red. The adjustment in the

bond market should be quick and therefore we use only 1 lag. If
there is correlation in the unit root regression, we might try more
lags. If we choose R20 and R30, in that order, then the
cointegration regression above will be run. If we change the
order, we get a regression of R30 on R20. That is, the first
variable will be the left hand side variable in the cointegrating
regression. Note how that we run the unit root tests with a
constant.
Here is the output we get running R20 on R30.
Step 1: testing for a unit root in R20

BOX 1

Augmented Dickey-Fuller test, order 1, for R20

sample size 178
unit-root null hypothesis: a = 1
test with constant
estimated value of (a - 1): -0.0290819
test statistic: tau_c(1) = -1.68109
asymptotic p-value 0.441

Step 2: testing for a unit root in R30

BOX 2
Augmented Dickey-Fuller test, order 1, for R30
sample size 178
unit-root null hypothesis: a = 1
test with constant
estimated value of (a - 1): -0.0242551
test statistic: tau_c(1) = -1.53538
asymptotic p-value 0.5158

Step 3: cointegrating regression

BOX 3
Cointegrating regression OLS estimates using the 180 observations 1959:1-2003:4
Dependent variable: R20
VARIABLE

COEFFICIENT

STDERROR

T STAT P-VALUE

const

-0.390957

0.0971120

-4.026 0.00008 ***

R30

0.821951

0.0117602

69.893 <0.00001 ***

Unadjusted R-squared = 0.964843

Adjusted R-squared = 0.964645
Durbin-Watson statistic = 0.407987
First-order autocorrelation coeff. = 0.796322
Akaike information criterion (AIC) = 178.355
Schwarz Bayesian criterion (BIC) = 184.741
Hannan-Quinn criterion (HQC) = 180.944

Step 4: Dickey-Fuller test on residuals

BOX 4
lag order 1
sample size 178
unit-root null hypothesis: a = 1
estimated value of (a - 1): -0.193805
test statistic: tau_c(2) = -4.00502
asymptotic p-value 0.007024

There is evidence for a cointegrating relationship if:

(a) The unit-root hypothesis is not rejected for the individual variables.
(b) The unit-root hypothesis is rejected for the residuals (uhat) from the
cointegrating regression.

You should look closely at each box above.

Box 1: This is a unit root test for R20. The p-value is greater
than 0.05 and therefore we cannot reject Ho. This means R20 is
probably I(1).
Box 2: This is a unit test for R30. The p-value is greater than
0.05 and therefore we cannot reject Ho. This means that R30 is
probably I(1).

Box 3: This is the output from the cointegrating regression.

Box 4: This is a unit root test on the residuals from the

cointegrating regression. The p-value is less than 0.05 and
therefore we can reject Ho that the residuals are I(1). The
residuals t are therefore I(0) and are stationary. It follows that
R20 and R30 are cointegrated.
Since R20 and R30 are cointegrated, we can form an error
correction model and estimate it. The ECM for our
cointegration above can be written as
R20t o R30t

1
2 t 1 t

This time we run OLS on our ECM to get the following output

Running GRETL we get the following output

Note the t-statistics, the negative estimate on e1, the R2 statistic,

and the D-W. This is a very good ECM estimation.
The estimated constant is nearly zero and is insignificant. A
quick t-test on the d_R30 variable shows that we can reject Ho:
1 1