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ECO 310
1.
A stochastic process (a collection of random variables ordered in time, e.g. GDP(t)) is said to
be (weakly)
stationary
if its mean and variance are constant over time, i.e. time invariant (along
with its autocovariance). Such a time series will tend to return to its mean (mean reversion) and
uctuations around this mean will have a broadly constant amplitude. Alternatively, a stationary
process will not drift too far away from its mean value because of the nite variance.
By contrast, a
nonstationary
or both.
with
Cov(ut , uts ) = 0
Example 1.
A Random Walk Model (RWM) is a nonstationary process. There are two types: a)
Yt = Yt1 + ut
where value of Y at time t is equal to its previous value and a random shock.
process without a drift such that there is no scope for protable speculation in the stock market:
the change in the stock price from one period to the next is essentially random and unpredictable.
Y1 = Y0 + u1 , Y2 = Y1 + u2 , Y3 = Y2 + u3 and replacing, Y3 = Y0 + u1 + u2 + u3
P
such that Yt = Y0 +
ut Therefore, E(Yt ) = Y0 since errors have zero expectation. Similarly,
2
V ar(Yt ) = t i.e. it is dependent on time, not time invariant. Hence, RWM without a drift is a
We can write:
nonstationary
process: Although its mean is constant over time, its variance increases over time. In
this model, shocks persist as the current value is equal to the initial value plus a series of random
shocks over time. A RW has a innite memory!
nonstationary
nonstationary
drift is a
again a
process: Both its mean and its variance increase over time such that it is
process.
= 1.
If in fact,
= 1,
case of nonstationarity (RW models are nonstationary as they contain a unit root!). If
the series
Yt
|| > 1
|| < 1,
then
ECO310, Econometrics
Prof. Erdin
and
t2 ,
we call it a
deterministic trend (predictable). If it is not predictable, we have a stochastic trend. Consider the
following model:
Yt = + 1 t + 2 Yt1 + ut
where
ut
2 = 1.
iid.
Yt = Yt1 + ut .
because E(4Yt ) =
If we dierence, we get
E(ut ) = 0
and
walk without
and
2 = 1
random walk with a drift is also dierence-stationary (DS). Also note that in this case,
upward or downward depending on the sign of the drift
Yt
is trending
Deterministic Trend: 6= 0, 1 6= 0,
the mean from the series (detrending) and create detrended series which are stationary.
Yt = + 1 t + Yt1 + ut
and
4Yt = + 1 t + ut
2 = 1.
We get
is still time-varying
and hence, the mean of the dierenced series is nonstationary! Detrending is still necessary on the
dierenced series to make it stationary.
3.
= Yt1 + ut
and
is white noise error, we can obtain a spurious regression: We will get a highly signicant slope
R2 value
2
value for the R as well as highly signicant
to conclude that the variable X has a signicant impact on Y whereas a priori there should be none.
In fact, this regression is meaningless!
R2 > d
where
is durbin-watson statistic, is a good rule of thumb for suspecting that the estimated regression is
spurious.
ECO310, Econometrics
Yt
Prof. Erdin
and
is close to 2 (i.e. no serial correlation). This is yet another way to verify that the original series are
random walks.
Although quite dramatic, this is a strong reminder that one should be cautious in running regressions with such nonstationary series.
4.
There are several tests of stationarity, we will focus on a test which became popular over the past
years: This is the unit root tests (Dickey-Fuller tests).
The starting point is the following autoregressive process:
Yt = Yt1 + ut .
When
= 1,
we
have a unit root and a random walk without a drift. In principle, we can run this regression and
see if
=1
to check for a nonstationary random walk (unit root) process but we can not estimate
a model regressing the series on its lagged value to see if the estimated rho is equal to 1 because
in the presence of a unit root, the t-statistics for the
manipulate this equation and express it somewhat dierently subtracting the lagged value from both
sides.
In practice, we can estimate this model (in Stata, reg d.Y l.Y, noconstant) and obtain
the hypothesis:
H0 : = 0
=1
series is nonstationary) and we can not reject the null! Also, note that the alternative hypothesis
sets
< 0
< 1
(we reject the null and conclude there is no unit root and
>1
!!!
The alternative
is to use the Dickey-Fuller test statistic with its own critical values for each of the following three
specications.
4.1.
errors (residuals) are serially uncorrelated. In principle, 3 specications can be tried, depending on
whether the series show a trend or not.
ECO310, Econometrics
Prof. Erdin
it
is nonstationary or
series is stationary,
regress.
The results report a MacKinnon p-value. If this p-value<, then reject the
null in each case. If not, then do not reject the null and conclude there is a unit root!
Alternatively,
Long Method:
Yt1
or its coecient,
and reject
the null if and only if the | t-statistic| > |df critical|. Note that you should take the absolute value of
both values when comparing and furthermore, you should use dierent dickey-fuller critical values
(df critical) for each 3 specications (trial and error! no specication is correct among the three a
priori, some graphical sense of the series may help).
DF critical values: b) at 1%, (-3.43), at 5% (-2.86) and at 10% (-2.57), c) at 1%, (-3.96), at 5%
(-3.41) and at 10% (-3.12)
These critical values also apply for the augmented DF test with lagged terms and Stata under
dfuller also report critical values.
4.2.
der the assumption that the errors (residuals) may be serially correlated.
augmenting the preceding 3 equations by adding the lagged values of the dependent variable,
Yt
to the specications to eliminate the serial correlation. Formally, the test is based on the following
equation.
Yt = a0 + Yt1 + a1 t +
m
X
i Yti + t
i=1
where
The number
of lagged dierenced terms is often determined empirically, the idea being to include enough terms
so that the the error term is indeed serially uncorrelated (so that we can obtain unbiased estimates
of the
Yt1 ).
for instance, based on minimizing the Akaike Information Criterion (AIC) (after the regression:
estat aic
reg
m=4
Example 2.
ECO310, Econometrics
Prof. Erdin
Consider the class exercise on r6 (6 month T-bill rate) vs r3 (3 month T-bill rate)
with the UnitRootTest_USinterestrates.smcl le under Stata Output folder. In line 28, a df test is
conducted with one lag, no trend but a drift (case b, augmented). The t-statistic for lagged term
is -2.25 (or z(t)=-2.25) . Applying the long test, we obtain the result: Do not reject the null since
|-2.25| < |-2.86| at 5% signicance. Hence, we can not reject the unit root in r3 series! Note that
the Mackinnon p-value= 0.1887 > 0.05=alpha, conrming the previous result.
5.
6.
Yt
and
Xt
both are
two series contain a common stochastic trend that their regression will not necessarily be spurious.
In this case, despite the trend, they will move together over time such that they will be cointegrated.
Economically speaking, two series will be cointegrated if they have a long term, or equilibrium
relationship between them.
movement over time, indicating that that there is a stable long term equilibrium between them. For
instance, the quantity theory of money implies that a long term stable relationship exists between the
money growth and ination i.e. these series might be cointegrated (even when they are individually
random walks).
From nance theory, we expect the 6-month T-bill rate and the 3-
month T-bill rate to be cointegrated. Otherwise, one can exploit the discrepancy between these two
rates and make a prot (which should not persist in the long run equilibrium). Before we specify
a cointegration regression between these two variables to check for the presence of cointegration,
we test whether these series are stationary, trend stationary or dierence stationary (with the same
order of integration, for instance, I(1) process).
Regressing
t = 0.1354 + 1.0259r3t
r3t , we get the following equation: r6
r6t
on
r6t
and
with a
R2 = 0.9932
(line 45)
Since both
r3t
are nonstationary (see the unit root tests in the same smcl le), there is
a possibility for a spurious regression. Note also that in line 36 and 37, rst dierencing eliminates
the unit roots in both
r6t
and
r3t
so they are integrated order 1, I(1) processes. So, we can run the
u
t
u
t
series do not drift too much apart from each other: the residual which is a linear combination of
these two series is stationary and hence, there is cointegration between the two variables!
ECO310, Econometrics
r6t
r6t
and
r3t
and
r3t ).
) and
Prof. Erdin
H0 : u
t has a unit root and nonstationary
HA : u
t has no unit root and stationary
(i.e.
(i.e.
u
t
have been
tried and in each case, we nd that the Mackinnon p-value < alpha such that we reject the null of
no cointegration in favor of cointegration between these two rates. Indeed, there exists a longrun
equilibrium between the two series.
Important note:
cointegration exists based on a unit root test of its residuals. As an example, suppose you run the
above cointegration regression, save the residuals under uhat and conduct a unit root test on uhat
to check for cointegration.
is no cointegration. In this case, also try to rerun the regression with a time variable, again save
uhat2 and perform the cointegration test on uhat2. In this case, there is a possibility that uhat2
will this time be stationary, suggesting cointegration between the interest rates. This result implies
that uhat2 is stationary (no unit root) around a deterministic trend, still implying cointegration.
7.
According to Granger, cointegration check is necessary to avoid spurious regressions. When two
random walk (nonstationary, unit root) variables (integrated of order 1, I(1)) are cointegrated, then
an error correction model can be formulated to study their shortrun dynamics.
Example 3.
Assume that nance theory describes the longrun relationship between a 6 month and
r6 = + r3
where
bill over the 3 month bill. Let us formulate a regression model for this theory:
r6t = + r3t + ut
where
the theory.
and
reg
r6 r3
We expect
and
= 1
in line with
series are random walks with unit roots as we established before through dickey-fuller tests, unless
of course they are cointegrated. We have also tested for cointegration between these variables and
conrmed that there exists a longterm stable equilibrium relationship between these series, i.e. there
exists cointegration. This implies that the above regression is a meaningful cointegration regression
describing their longrun comovement.
Once we establish cointegration, we can also study the short-run dynamics in an error-correction
model. This enriches our understanding of how the series adjust to longrun equilibrium when and
if they deviate in the shortrun from this stable pattern of longrun behavior.
error-correction model under the simplifying assumption that
Here is a simple
u
t1 =
r6t1
r3t1 .
ECO310, Econometrics
Prof. Erdin
sradjt = u
t1
a) reg r6 r3, b) predict uhat, residuals ad c) gen sradj=l.uhat) and add this term to the equation in
dierences which forms our error correction model.
negative
sign!
Intuition:
Assume that
at some time
t1
such
that there is a short-run disequilibrium in this market. As is well-known, this will drive the price
of
r6
t,
correcting partially the disequilibrium (it may take some time for the long-run equilibrium to be
bonds up and hence should reduce, at least to some extent, the yield,
r6t
restored with equality in the above model), hence, one should expect that when the
there should be a negative change in
r6t
i.e.,
4r6t < 0
in this regression and conrm that it is negative. Its value indicates what
proportion of disequilibrium is corrected each time period, i.e. it should be less than 1!