RegressionModels

Bivariate data(y,x)
Multivariate(y,x
1
,,x
k
)
Supposetheconditionalmeanofy isa
functionofx
Thentheregressionfunctionistheoptimal
forecastofy givenx
( )
t t t
x x y E + = |
Regression
Model
Estimation:LeastSquares
Example:InterestRates
Monthly
Rateson3monthand12monthTBills
t t t
e x y + + =
3monthand12monthTBill
LeastSquares,3monthon12month
Forecast
Aforecastofy
n+h
requiresx
n+h
Thisisnottypicallyfeasible
h n h n h n
e x y
+ + +
+ + =
h n n h n
x y
+ +
+ =
|

Regressor forecast
Supposewehaveaforecastforx
Then
Forexample,if
then
h n n h n
x y
+ +
+ =

|

( )
h t h t t
x x E

+ = |
n n h n
x x + =
+ |

12monthtbillonLaggedValue
Regressx
t
onx
t12
(12monthaheadforecast)
3monthon12month
Predictionusingregressionandfittedvalue
InterestRateForecast
Estimates
Current:x
2010M2
=0.35%
12
85 . 0 84 . 0

94 . 0 21 . 0

+ =
+ =
t t
t t
x x
x y
86 . 0 14 . 1 94 . 0 21 . 0

14 . 1 35 . 0 85 . 0 84 . 0

2 2011
= + =
= + =
t
M
y
x
Example
TheAR(1)forecaststhe12monthTbillnext
Februarytoriseto1.14%
Theregressionmodelforecaststhe3month
TbillnextFebruarytobe0.85%
Currently0.11%
DirectMethod(preferred)
Combine
Weobtain
( )
t t t
x x y E + = |
( )
h t h t t
x x E

+ = |
( ) ( )
( )
h t
h t
h t t h t t
x
x
x E y E

+ =
+ + =
+ =


| |
ForecastRegression
hstepahead
Forecast
t h t t
e x y + + =


n n h n
x y + =
+ |
3monthonLagged12month
n n h n
x y 79 . 61 .
|
+ =
+
89 . 0 35 . 0 79 . 61 .

|
= + =
+ n h n
y
AR(q)Regressors
SupposexisanAR(q)
Thenaonestepforecastingequationfory is
Andanhstepis
t q t q t t t
t t t
u x x x x
e x y
+ + + + + =
+ + =



L
2 2 1 1
t q t q t t t
e x x x y + + + + + =

L
2 2 1 1
t q h t q h t h t t
e x x x y + + + + + =
+ 1 1 2 1
L
TBillexample:AR(12)for12month
Regress3monthon12lagsof12month
Forecast
Predictedvaluefor2011M2=1.06
Predictedvalueusing3lags=0.91
DistributedLags
Thisclassofmodelsiscalleddistributedlags
Ifweinterpretthecoefficientsastheeffectof
x ony,wesometimessay

1
istheimmediateimpact

1
+ +
n
= B(1) isthelongrunimpact
t t
t q t q t t t
e x L B
e x x x y
+ + =
+ + + + + =

1
2 2 1 1
) (
L
Regressors andDynamics
WehaveseenARforecastingmodels
Andnowdistributedlagmodel
Addbothtogether!
or
t t t
e x L B y L A + + =
1
) ( ) (
t q t q t
p t p t t
e x x
y y y
+ + + +
+ + + =




L
L
1 1
1 1
hstep
Regressonlagsofyandx,hperiodsback
Estimatebyleastsquares
Forecastusingestimatedcoefficientsandfinal
values
t q h t q h t
p h t p h t t
e x x
y y y
+ + + +
+ + + =
+
+
1 1
1 1


L
L
3monthtbillforecast
Forecast
Predictedvaluefor2011M2=1.26
ModelSelection
Thedynamicdistributedlagmodelhasplags
ofy andqlagsofx,atotalof1+p+q
estimatedcoefficients
Models(pandq)canbeselectedby
calculatingandminimizingtheAIC
Ifthesampleis,say,251,theAICis
.dis ln(e(rss)/e(N))*251+e(rank)*2
( ) 1 2 ln + + +

= q p
T
SSR
N AIC
PredictiveCausality
Thevariablexaffectsaforecastforyif
laggedvaluesofxhavetruenonzero
coefficientsinthedynamicregressionofyon
laggedys andlaggedxs
Ifoneofthesarenonzero
t q t q t
p t p t t
e x x
y y y
+ + + +
+ + + =




L
L
1 1
1 1
PredictiveCausality
Inthiscase,wesaythatxcausesy
Itdoesnotmeancausalityinamechanicalsense
Onlythatxpredictively causesy
Truecausalitycouldactuallybethereverse
Ineconomics,predictivecausalityis
frequentlycalledGrangercausality
CliveGranger
UCSDeconometrician
19342009
Winnerof2003NobelPrize
Greatesttimeseries
econometricianofalltime
PhotofromMarch2007
Manyaccomplishments
Grangercausality
Spuriousregression
Cointegration
NonCausality
Hypothesis:
xdoesnotpredictively (Granger)causey
Test
Rejecthypothesisofnoncausalityifjointtestof
alllagsonxarezero
Ftestusingrobustroption
t q t q t
p t p t t
e x x
y y y
+ + + +
+ + + =




L
L
1 1
1 1
STATACommand
.reg t3L(1/12).t3L(1/12).t12,r
.testparm L(1/12).t12
T3onT12
LagsonT12
CausalityTest
Pvalueisnearzero
Rejecthypothesisofnoncausality
Inferthat12monthTBillhelpspredict3monthTbill
Longrateshelptopredictshortrates
Reverse:T12onT3
Doshortrateshelptoforecastlongrates?
RegressT12onlaggedvalues,andlagsofT3
T12onT3
LagsonT3
CausalityTest
Pvalueisnearlysignificant
Notclearifwerejecthypothesisofnoncausality
Unclearif3monthTBillhelpspredict12monthTbill
Ifshortrateshelptopredictlongrates
TermStructureTheory
Thisisnotsurprising,giventhetheoryofthe
termstructureofinterestrates
Helpfultoreviewinterestratetheory
Bonds
Abondwithfacevalue$1000isapromisetopay
$1000ataspecificdateinthefuture
Ifthatdateis3monthsfromtoday,itisa3month
bonds
Ifthatdateis12monthsfromtoday,itisa12month
bond
Rate:Ifa3month$1000bondsellsfor$980,the
interestpercentageforthe3monthperiodis
100*20/980=2.04%,or8.16%annualrate
TermStructure
Supposeaninvestorhasa2periodhorizon
Theycanpurchasea2periodbond
Orasequenceofoneperiodbonds
Competitiveequilibriumsetsthepricesofthe
bondssotheyhaveequalexpectedreturns.
Theaverageexpectedoneperiodreturnsequalthe
twoperiodreturn
Thetwoperiodreturnisanexpectationoffuture
shortrates
( )
2
|
1 t t t
t
Short E Short
Long
+
=
+
TermStructureRegression
Thisimplies
Thusapredictiveregressionforshortterminterest
ratesisafunctionoflaggedlongterminterestrates
Longterminterestrateshelpforecastshorttermrates
becauselongtermratesarethemselvesmarket
forecastoffutureshortrates
Highlongtermratesmeanthatinvestorsexpectshort
ratestoriseinthefuture
( )
t t t t
Short Long Short E =
+
2 |
1
Causality
Thetheoryofthetermstructurepredictsthat
longtermrateswillhelppredictshortterm
rates
Itdoesnotpredictthereverse
Thisisconsistentwithourhypothesistests
12monthTBillpredicted3monthTBill
Unclearif3monthpredicts12month.
SelectionofCausalVariables
Evenifwedontrejectnoncausalityofybyx,
westillmightwanttoincludexinforecast
regression
Testingisnotagoodselectionmethod
AICisabetterforselection
Example
Predictionof3monthrate
AR(12)only:AIC=1249
AR(12)plusT12(12lags):AIC=1313
FullmodelhassmallerAIC,soispreferredfor
forecasting
Thisisconsistentwithcausalitytest
Predictionof12monthrate
AR(12)only:AIC=1309
AR(12)plusT3(12lags):AIC=1333
FullmodelhassmallerAIC,soispreferredfor
forecasting
Eventhoughwecannotrejectnoncausality,AIC
recommendsusingtheshortratetoforecastthelongrate