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July, 2015

Econometrics so far

We have studied the regression equation

yi = α + βxi + i i = 1...n

We have been interested in

The effect of x on y; dy /dx = β

The predicted value of y, given x; E[yi |xi ] = α + βxi

The fit of the model, e.g. the R 2 statistic

Can we do the same with a pair of time series

yt = α + βxt + t

NO!

(Or rather, only under special circumstances, and such a regression is only

ever part of the answer!)

Two problems in time series (1)

maintain. The y and x are often simultaneously determined in a system,

’the economy’.

yt = αy + βy xt + yt

xt = αx + βx yt + xt

yt = a + bxt + et

= a + b(α + βx yt + xt ) + et

correlated with the regressor xt as this regressor actually contains yt , and

so contains yt

Two problems in time series (2)

a 7.9 (139)

b 2.9 (15.6)

R2 0.75 -

Two problems in time series (2)

a 7.9 (139)

b 2.9 (15.6)

R2 0.75 -

Now what do you think about the regression?

Two problems in time series (2)

a 7.9 (139)

b 2.9 (15.6)

R2 0.75 -

Now what do you think about the regression?

It is called the spurious regression problem.

It is easy to do crap regressions with time series data!

Overview

yt = α + βyt−1 + t or yt = α + βt−1 + t

dependent variable, or by previous errors.

Our primary interest will be prediction, E[yt |yt−1 ] = α + βyt−1 .

Overview

yt = α + βyt−1 + t or yt = α + βt−1 + t

dependent variable, or by previous errors.

Our primary interest will be prediction, E[yt |yt−1 ] = α + βyt−1 .

In Part II we will learn how to estimate dynamic relationships

yt = α0 + α1 yt−1 + β0 xt + β1 xt−1 + t

in a way that elimantes the two common problems with time series

regressions.

Time series data

Our sample data {yt }, {xt } refers to observations on the same unit in

sequential time periods, t = 1, . . . , T

Periods may be years, quarters, months, weeks or days, depending on

interst and data availability

finance finance finance

macro macro macro

growth growth

Time series data

Mean reverting (’stationary’)

Series with a trend (’trend stationary’) series

Series with permanent shocks (’Integrated series’)

Part II looks at testing for permanent shocks and dealing with Integrated

series

Mean reverting series

Trend stationary series

Integrated series

Know your data

The data file ‘macro vars.xls’ contains lots of U.S. data series

GDP is a good example

Take logs

Our regressions are linear regressions, so lets transform the data to make it

more linear

Logs

Look at your data. For data in levels, taking logs is often the first

step in applied work

Not if the data is already in % changes, or an interest rate!

Logarithms make percentage changes comparable by eye, which is

often more relevant.

Recall g = (xt − xt−1 )/xt−1 ⇒ 1 + g = xt /xt−1 , so then

ln(xt ) − ln(xt−1 ) = ln(1 + g ) ≈ ln(g ) for small g .

Difference

do is take differences.

What is the main difference compared to previous plots?

This now looks mean reverting. Later we will test formally whether a

series is mean reverting or integrated, but don’t forget it’s always

sensible to start by looking at your data.

∆yt = yt − yt−1 is the difference operator.

Know your data: prices

levels

log levels

difference of logs - inflation

the difference of inflation

Which would you be happy to consider mean reverting?

Part I: Modelling stationary time series

So far I have talked about mean reverting series, but we can be more

precise

We will model variables which are covariance stationary (stationary

for short)

The mean exists and does not depend on time, E[yt ] = µ for all t

(quick notation ∀t).

The variance exists and is independent of time, var(yt ) = σy2 .

The Autocovariance, cov(yt , yt−k ) = σk2 is indpendent of time, it

depends only on k and not on t

Modelling stationary time series: assumptions on errors

errors

A1: E[t ] = E[E[t |yt−1 ]] = 0

A2: E[t t−s ] = 0 ∀s > 0

There are also some technical assumptions

A3: E[2t ] = var(t ) = σ2

A4: yt and yt−j become independent as j gets large

A5: Very large outliers are unlikely

These assumptions apply to the true model, and we have to replicate them

in our statistical model.

Discussion of assumpions

available before period t begins. In the regression context, we require

that t is unpredictable given all our r.h.s. variables. We use

predetermined data yt−1 , yt−2 , t−1 , t−2 , ...

A2 In cross-sections, this is a second order assumption determining the

standard error of b.

In time series it is a first order assumption, determining the

consistency of b. See exercise.

A3 Allows us to make calculations about variances, including confidence

intervals around parameter estimates and forecasts. It is implied by

stationarity

Discussion of assumptions

estimators. It replaces i.i.d. assumption in cross-sectional data

A5 This says that our models are not suitable for certain types of very

wild randomness. You should worry about this if you do

high-frequency finance, but it’s generally not a problem with

macroeconomic data.

In applied work, spurious regressions and models with wrong/insufficient

dynamics tend to violate A2, so checking it is key. Also, check A2 if you

are evaluating someone else’s work!

Stationary time series: AR(1) model

yt = α + βyt−1 + t (1)

dependent variable.

Models the correlation between yt and its own past

Stationarity requires |β| < 1

Then the influence of past shocks dies away smoothly

Estimate the model by OLS

The AR(1) estimator

PT

t=2 (yt − ȳ )(yt−1 − ȳ )

b= PT 2

t=2 (yt−1 − ȳ )

cov(yt , yt−1 )

=

var (yt )

a = ȳ − b ȳ

a

⇒ ȳ =

1−b

The AR(1) estimator

T

X −1

var(b) = σ̂ 2 (yt−1 − ȳ )2

t=2

σ̂ 2

=

\t )

var(y

T

1 X

where σ̂ 2 = ˆ2t

T −1−k

t=2

Note we lose an extra DoF for every lag we include in the autoregression

Confidence testing as usual, given |b| < 1:

τ = (b − bH0 )/SE (b) ∼ tα/2,DoF

Expect low R 2 compared to cross sectional data.

Example

a

b

R2 -

Plot the residuals of the regression. Do you think they meet A1 - A3?

We will look at formal tests for these assumptions below.

General AR(p) model

One lag of yt may not be enough: an omitted variable bias

This shows up as E[t t−s ] 6= 0

We find a model with enough lags to ensure E[t t−s ] = 0∀s

ˆ + νt

H0 : b1 = b2 = · · · = bq = 0

HA : bi 6= 0 for some i

(RSSR − RSSU)/q

τ= ∼ χ2q

(RSSU)/DoF

= nR 2 ∼ χ2q

Alexander Karalis Isaac (Warwick) Time Series July, 2015 24 / 90

Model selection strategy

Model selection strategy

NO!: Don’t base your model selection algorithm on starting from

models that don’t make any statistical sense

Start big and eliminate insignificant regressors, to find the smallest

model for which A2 still holds

Often start with p = f + 1 where f =nobs/year.

Quarterly example

Begin with p=5

Re-esetimate excluding the insiginifcant longer lags

Check E[t t−s ] = 0, s = 1...4

Repeat untill model contains only significant terms

D. Hendry ’PcGets’ software automates this

Notes on examples

You do some examples: ∆GDPt , ∆Const , ∆Invt , ∆Inft :

The MA(q) process

the conditional correlation of the yt series.

This costs degress of freedom, making estimates and forecasts less

accurate

Is there a smaller model which could capture the dependency that AR

models struggle with?

The MA(q) process

the conditional correlation of the yt series.

This costs degress of freedom, making estimates and forecasts less

accurate

Is there a smaller model which could capture the dependency that AR

models struggle with?

This is the moving average process

The MA(1) process

Equation:

yt = α + βt−1 + t

Simple to analyse

Stationary for any β value

t }T

Harder to estimate - b determines {ˆ t }T

t=1 , but {ˆ t=1 is the

regressor which determines b!

Solution: take an MLE approach (as in Probit)

MLE in the MA(1)

1

f (yt |yt−1 ) = √ exp((yt − α − βt−1 )2 /(2σ2 ))

2πσ

X

l(α, β, σ2 ) = ln f (yt |yt−1 )

t

max l(.)w .r .t.α, β, σ2

0 = E[t ] = 0, though there are other approaches.

Inference follows standard maximum likelihood procedure

Information criteria

The MLE approach suggests another tool for tackling model selection

Minimise the expected information loss across potential models

BIC: −(2l(θ̂) − k ln(T )): choose model with lowest BIC

parsimonious model. Always check A2 holds!

Information criteria are also relevant for AR models, which can be

placed within MLE theory

Notes on examples

You do some MA(q) examples: ∆GDPt , ∆Const , ∆Invt , ∆Inft :

Model evaluation: forecast performance

If your job is forecasting, choose model with best forecasts!

I In sample forecasts:

Estimation period is 1 . . . T and look at e.g. 1-period ahead forecast

E[yt+1 |yt , θ̂T ]

This is similar to in-sample fit where we compare ŷt with yt , but now

we are doing it 1-period ahead.

I Out of sample forecasts:

Estimation period is 1 . . . N, and look at 1-period ahead forecasts

E[yt+1 |yt , θ̂N ] for t = N + 1, N + 2, N + 3 etc. up to final data point T .

This is a tougher test as none of the information in the forecast period

contributed to the parameter estimation.

A simple criterion Minimum Mean Square Error

N

1 X

MSE = (ŷi − yi )2

N

i=1

Alexander Karalis Isaac (Warwick) Time Series July, 2015 32 / 90

Empirical Example: In-sample forecast comparisons

Compare 1-step ahead forecasts from 4-lag and preferred AR, MA models

∆ GDP AR(4) MA(4)

AR( ) MA( )

∆ Cons AR(4) MA(4)

AR( ) MA( )

∆ Inv AR(4) MA(4)

AR( ) MA( )

∆ Inf AR(4) MA(4)

AR( ) MA( )

ARMA(p,q) models

Estimation is by maximum likelihood

Don’t do large ARMAs, in practice ARMA(2,1) is often a good

approximation for macroeconomic time series.

Forecasts from an ARMA(2,1)

MSE

Variable k=1 k=4 k=8

∆ GDP

∆ Cons

∆ Inv

∆ Inf

Estimate the model to 2005. From 2003q1, produce static 1-period ahead

forecasts up to 2005, then dynamic 4 and 8 period ahead forecasts also

from 2003q1

What happens to the MSE as the forecast horizon increases?

Out of sample forecast example

Now estimate the model to 2007 and repeat the process using dynamic

out of sample forecasting up to 2011

MSE

Variable k=1 k=4 k=8

∆ GDP

∆ Cons

∆ Inv

∆ Inf

This is the problem the BoE had (with a more sophisticated model) during

the crisis

The FED did less badly because its model updates the parameters, via the

Kalman filter, when it makes an error. Beyond the scope of this course!

More on forecast errors

We have used the MSFE to look at different models and the effect of

different time horizons

Out of sample forecasts errors are larger than in-sample, because the

forecast error is really composed of two parts

= σ2 + var[(a − α) + (b − β)yT ]

an estimate of the likely performance of the model in real time

Deeper into time sereis: preliminaries

What does the MS part actually measure?

Why is their combination sometimes more useful?

Think about the way the influence past shocks, t−s decays over time

To go deeper into time series we need to brush up our maths!

We will look at deriving the conditional and unconditional

expectations, variances and autocovariances for simple time-series

models.

Conditional Expectations

The conditional expectation E[yt+1 |yt ] follows from the conditional mean

eqation we write down in AR(1) or MA(1) model

= α + βE[yt |yt ] + E[t+1 |yt ]

= α + βyt

= α + βE[t |yt ]

= α + βt

Looking further ahead: iterative forecasts

AR(1)

= α + βE[yt+1 |yt ] + E[t+2 |yt ]

= α + β(α + βyt )

= α + βα + β 2 yt

k−1

X

E[yt+k |yt ] = β i α + β k yt

i=0

α

lim E[yt+k |yt ] =

k→∞ 1−β

MA(1)

E[yt+k |yt ] = α ∀k ≥ 2

Unconditional Expectations

guess at a value yt ? Our best guess is the unconditional mean implied

by the process

AR(1)

= α + βE[yt ]

α

E[yt ] =

1−β

MA(1)

=α

Uncertainty and variance AR(1)

Conditional variance

= var (t |yt ) = σ2

var(tt+2 |yt ) = var(α + βyt+1 + t+2 |yt )

= β 2 var(yt+1 |yt ) + var(t+2 |yt )

= (1 + β 2 )σ 2

k−1

X

var(yt+k |yt ) = (β 2 )i σ 2

i=0

⇒ lim var(yt+k |yt ) =

k→∞

Uncertainty and variance AR(1)

Unconditional variance

= β 2 var(yt ) + σ2

σ2

σy2 =

1 − β2

Compare this to the limit of the conditional variance

Uncertainty and Variance MA(1)

Conditional variance

= σ2

var(yt+k |yt ) = var(α + βt+k−1 + t+k |yt )

= (1 + β 2 )σ2 ∀k ≥ 2

Unconditional variance

= (1 + β 2 )σ 2

variance after 2 periods!

Forecast error variance

Assume t ∼ N(0, σ2 )

Then the 95% confidence intervals for E[yt+k |yt ] are

k−1

X

AR(1) = yt+k|t ± 1.96 (β 2 )i σ2

j=0

generated with estimates a, b, σ̂2 , ignoring the extra uncertainty

created by estimating parameters

Forecasts with confidence intervals

PIC

Deeper into time sereis: ACF

The Autocovariance function is the set of numbers

cov(yt , yt−k ) := σk2

The sample estimator

PT of the Autocovariance function is

2 1

σ̂k = T −k−1 t=k+1 ỹt ỹt−k where ỹt = yt − ȳ

The Autocovariance function is normalised by the variance of y to

give the Autocorrelation function ACF(k):

cov(yt , yt−k )

ρk =

var(yt )

ACF for various stationary models

PIC

ACF: discussion

The ACF shows us how long it takes for the influence of past shocks

to die away, by measuring the correlation between yt and its own past

values.

For stationary processes the ACF becomes statistically insignificant

after a finite number of periods.

Stationary processes have finite memory - the influence of a shock is

finite

PIC:growth ACF

Deeper into time series: PACF

past, but how many lags do we need?

If yt = α + β1 yt−1 + β2 yt−2 + t , then we know from regression

analysis that β2 is a measure of the conditional correlation between yt

and yt−2 after accounting for the correlation explained by yt−1

PACF (k) = 1/2

var(yt |yt−1 , ..., yt−k+1 ) var(yt−k |yt−1 , ..., yt−k+1 )

e.g. PACF (3) =

PACFs for stationary processes

PIC

Memory in AR(1)

Let yt = βyt−1 + t , i.e. put α = 0 ⇒ µ = 0

2

= βE[yt−1 ] = βσy2

⇒ corr (yt , yt−1 ) = β

= E[(β(βyt−2 + t−1 ) + t )yt−2 ]

= E[β 2 yt−1 + βt−1 yt−2 + t yt−2 ]

= βσy2

⇒ corr (yt , yt−2 ) = β 2

ACF for different AR(1) models

PIC

PACF AR models

| {z }

cond corr

cov(yt , yt−2 |yt−1 )

p

var(yt |yt−1 ) var(yt−2 |yt−1 )

So the PACF drops sharply to 0 after the final lagged term in the

AR(p) model

This is an alternative way to think about how many lags to include

PACF various AR models

PIC

What do you notice about ACF vs. PACF in AR models?

ACF MA(1)

= βσ2

⇒ corr (yt , yt−1 ) = β

=0

ACF (k) = 0 ∀k≥2

PACF of MA(1)

Assume β < 1, notice t = yt − βt−1

yt = β(yt−1 − βt−2 ) + t

= β(yt−1 − β(yt−2 − βt−3 )) + t

= βyt−1 − β 2 yt−2 + β 3 (yt−3 − βt−4 ) + t

X∞

yt = (−1)i+1 β i yt−i + t

j=1

Using the earlier result, the PACF will decay geometrically as β i declines

to zero

Box Jenkins model building method

times series regressions

ACF Decays smoohtly Chops off at q lags Decays smoothly

PACF Chops off at p lags Decays smoothly Decays smoothly

ARMA(p,q) model.

Then test down to small model using significance and information

criteria.

Always check A2 holds for your residuals

Emprical P/ACF

PIC

∆ ln GDP

PIC

Emprical P/ACF

PIC

∆Inf

PIC

Summary

I ACF (k) → 0 as k → ∞

I PACF (k) → 0 as k → ∞

I E[yt ] = µ ∀ t

I var(yt ) = σy2 ∀ t

I cov(yt , yt−k ) depends only on k and not t

ARMA(p,q) models make decent forcasts for these series

But in economics, they are only approximate models

dynamic economic variables?

PART II: Integrated processes

I A simple example shows our ideas of µ and σ 2 are not compatible with

permanent shocks

The first problem is to decide if a series is integrated

I Dickey Fuller tests

We then have a choice

I Difference the series to make it stationary

I Look for cointegration between two or more integrated series

Permanent shocks

y1 = y0 + 1 = 1

y2 = y1 + 2 = 1 + 2

...yt = 1 + 2 + · · · + t

Xt−1

var(yt ) = var( t−i )

j=0

2

= tσ

→∞ as t → ∞

Permanent shocks

Think about the random walk with drift yt = α + yt−1 + t

This is an AR(1) with β = 1

α

Thus E[yt ] = 1−β is undefined

The process has no unconditional mean

Conditional forecasts

Regressions with random walks

eachother

α

β

R2 -

This is typical of a spurious regression

High R 2 combined with positive serial correlation is always a sign of

spurious regression

Now regress ∆y on ∆x. Is there any relationship?

Testing for unit roots: Dickey-Fuller test

stationary series

To determine stationarity, we need to test β = 1 in the process

yt = α + βyt−1 + t

∆yt = α + (β − 1)yt−1 + t

= α + ρyt−1 + t

H0 : ρ̂ = 0 ⇒ there is a unit root

HA : ρ̂ < 0 ⇒ No unit root

ρ̂

tDF =

SE (ρ̂)

The test stat tDF follows the Dickey Fuller distribution, which gives much

more negative critical values than the standard normal

Dickey Fuller distribution

PIC

The DF distribution is sensitive to specification of the test

I Inclusion of an intercept

I Inclusion of a trend

I Number of lags

I Sample size

The Augmented Dickey Fuller test

residuals

If necessary add lagged differences of the dependent variable

yt = α + β1 yt−1 + β2 yt−2 + t

= α + β1 yt−1 + β2 yt−1 − β2 yt−1 + β2 yt−2 + t

= α + (β1 + β2 )yt−1 − β2 ∆yt−1 + t

∆yt = α + (β1 + β2 − 1)yt−1 − β2 ∆yt−1 + t

= α + ρyt−1 − β2 ∆yt−1 + t

Dealing with trends

g = γ/(1 − β)

yt = α + γt + βyt−1 + t

∆yt = α + (β − 1)(yt−1 − gt) + t

= α + ρ(yt−1 − gt) + t

⇒ ∆yt = α + t if ρ = 0 (2)

⇒ yt = α + γt + βyt−1 + t if ρ < 0 (3)

From (3) if process is not unit root, it is trend stationary with |β| < 1.

Dickey Fuller Tables

Notes on exercise

a series must be differenced in order to make the series yt stationary

Determine the order of integration of Output, Consupmtion,

Investment and Prices.

Do any series exhibit trend-stationary behaviour?

Cointegration: Random walks which Tango!

them stationary and modelling their (univariate) stationary behaviour.

There is an important case when we can work with two (or more)

Integrated series directly. This is when the series are cointegrated

I Economic behaviour creates long run - equilibrium - relationships

between series. E.g. output and consumption, investment and output,

house prices and earnings (?), stock prices and profits (?)

I The ratio of such series is a stationary series, even though the two

series are I(1)!

I Variables which cointegrate in this way adjust to dynamic shocks in

order to move back towards their equilibrium relationship

Output and Consumption

Plots of series

Cointegration: formal definition

If a linear combination of I(1) series is I(0) then the two series cointegrate

xt ∼ I (1) yt ∼ I (1)

yt − βxt ∼ I (0)

(working in logs) give the stationary ratio between the series

Economic theory often suggests theoretical values for β, so itis

interesting to see if these are true in the data

Common stochastic trends

Cointegration occurs when two series share a common stochastic trend,

say Xt . Let X0 = 0 and

Xt = Xt−1 + t

t

X

⇒ Xt = t

s=1

⇒ yt − βxt = βXt + ỹt − β(Xt + x̃t )

= ỹt − β x̃t ∼ I (0)

The common stochastic trend has been cancelled out. The pair (1, β) is

called the cointegrating vector as gives is the stationary linear combination

of y and x

Alexander Karalis Isaac (Warwick) Time Series July, 2015 75 / 90

Output and Consumption

Cointegration: long and short-run relationships

There must be dynamic adjustment in the short run in order to return

the variables towards equilibrium levels when shocks push them apart

Thus the long-run relationship makes predictions about short-run

adjustment dynamics

The levels of the series this period help us predict changes in the

series next period

We can represent both the long-run and the short-run behaviour of

cointegrated series through the error correction model

Error correction model

const and outputt

ct = βyt +

But look at the BGodfrey stat - XXX - the above model is not

dynamically well-specified; it does not meet A2.

A model with more general dynamics is

This allows for the response of ct to its own past, current and lagged

values of yt

Error correction model

Although (4) is a more general dynamic specification, it consists of

I (1) variables, yet the t series should be I (0).

With a bit of algebra we can rewrite the model entirely in terms of

I (0) variables

ct = β1 yt + β2 yt−1 + β3 ct−1 + t

= β1 yt − β1 yt−1 + β1 yt−1 + β2 yt−1 + β3 ct−1 + t

= β1 ∆yt + (β1 + β2 )yt−1 + β3 ct−1 + t

∆ct = β1 ∆yt + (β1 + β2 )yt−1 + (β3 − 1)ct−1 + t

β1 + β2

= β1 ∆yt + (β3 − 1) ct−1 − yt−1 +t

1 − β3

| {z }

E. C. term

∆yt , ∆ct are I (0), provided there is cointegration, so are the error

term and the equilibrium relationship in the large brackets

Error correction model

β1 +β2

Cointegration imposes the restrictions γ = (β3 − 1) and β = 1−β3

If there is a cointegrating relationship

I ct−1 − β̂yt−1 ∼ I (0), and ˆt ∼ I (0)

I α̂2 < 0

The α̂2 < 0 requirement ensures ct adjusts to being above its

long-run level in period t − 1 by reducing in period t

To estimate such a model, we need an estimate of ct−1 − β̂yt−1

Estimation of the ECM

Engle and Granger (1987) propose a two-step procedure for estimating (5)

First we need an estimate of the cointegrating vector. Regress:

ct = βyt + νt

⇒ ν̂t = ct − β̂yt

relationship

Second, we estimate, by OLS

model (4) from the parameters of the estimated ECM, α̂1 , α̂2 and

ν̂t−1

Testing for cointegration: EG procedure

The two-step estimation approach suggests a method for testing whether 2

series are actually cointegrated

Estimate the cointegrating relationship

ct = βyt + νt

p−1

X

∆ν̂t = ρν̂t + γi ∆ν̂t−i + ut

i=1

H0 : ρ = 0 ⇒ ut is I(1) and there is no conitegration

HA : ρ < 0 ⇒ ut is I(0) and there may be cointegration

Critical values are McKinnon’s < DF critical values

Testing for cointegration: EG procedure

...estimate the ECM

ct−1 > β̂yt−1 , in order to restor equilibrium

HA : α̂2 ≥ 0 ⇒ no significant error correction

α̂2

τ= ∼ t0.05,DoF

SE (α̂2 )

and the ECM can be used to estimate the dynamic model

If not, then work with differences, i.e. transform the two series to

make them stationary.

EG procedure: discussion

The Engle-Granger procedure works well with two variables, but there are

drawbacks

The initial regression is misspecified, ν̂t is usually serially correlated

This two-step step approach introduces more variance than a

dynamically well-specified 1-step procedure

Results, esp. with more than two variables are sensitive to which

variable is taken as the left hand side variable

With more than two variables, there may be more than one

cointegrating relationship, and EG will estimate a linear combination

of these relationships, which has no real interpretation

These problems can be overcome by the Johansen procedure which is a

vector-based approach to estimating cointegrating equations

Empirical examples

(ct , yt )

(hpt , wt )

(SPt , Dt )

Forecast comparisons

Estimate your preferred ARIMA on 1960-2000

Produce 1-step and 4-step ahead out of sample forecasts with each

model for 2001-2006

Compare the MSPE from each model

Summary: Work stream for applied time series

I Is the series trending over time?

I Is the trend exponential or linear?

I Is the series mean reverting?

I Would the series look mean reverting in most subsamples?

I Are there several variables that seem to exhibit the same random trend?

Take logs of exponentially increasing variables

Begin Dickey Fuller tests

I Decide about appropriate inclusion of trends and constants based on

visual inspection and inspection of DF regression results

I Include f + 1 lags in initial DF specification and remove insignificant

lags; check for serial correlation up to order f , ensure A2 is satisfied.

Using preferred specification of DF tests decide on order of

integration of the series

Summary: With the transformed stationary series

I Inspect ACF, PACF, decide on candidate AR, MA, ARMA specification

I Start with AR(f+1), MA(f+1) or ARMA (f/2,f/2)(?) specification and

test down by eliminating insignificant lags, minimizing AIC/BIC; ensure

A2 is satisfied in preferred model

Inspect forecast predictions v.s. actual outcomes

I Do the forecast error bounds include 95% of actual outcomes?

I Are the forecast errors close to uncorrelated?

Test robustness by performing out of sample forecast exercise

I You will need to reserve part of your sample so will lose some

information from the estimation

I But you might find a model that performs better in practice, or at

leatunderstand more about how your model is likely to perform as new

data comes in

Summary: Modelling cointegrating series

Plot the ratio of interest

Engle-Granger Procedure Step I

I Estimate the cointegrating relationship with appropriate constant/trend

inclusion

I Save the residuals

I Perform Dickey Fuller test on residuals

I No constant! McKinnon p-values

I H0 : no cointegration. If reject H0 go to...

Engle-Granger Procedure Step II

I Estimate ECM with appropriate lagged differences so that A2 holds

I Test αˆ2 < 0 by standard t-test

I H0 : no cointegration (α2 = 0). If reject H0 ...

ECM is correct model. Recover parameters of restricted ARDL model

with appropriate tranformations

Interpret cointegrating relationship

Make dynamic forecasts

Alexander Karalis Isaac (Warwick) Time Series July, 2015 89 / 90

The End!

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