Lect 2 ARMA

Stationary models
MA, AR and ARMA

Matthieu Stigler
November 14, 2008
Version 1.1
This document is released under the Creative Commons Attribution-Noncommercial 2.5 India
license.
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Lectures list
1
Stationarity
ARMA models for stationary variables
Seasonality
Non-stationarity
Non-linearities
Multivariate models
Structural VAR models
Cointegration the Engle and Granger approach
Cointegration 2: The Johansen Methodology
10
Multivariate Nonlinearities in VAR models
11
Multivariate Nonlinearities in VECM models
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Outline
1
Last Lecture
AR(p) models
Autocorrelation of AR(1)
Stationarity Conditions
Estimation
MA models
ARMA(p,q)
The Box-Jenkins approach
Forecasting
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Recall: auto-covariance
Definition (autocovariance)
Cov(Xt , Xtk ) k (t) E [(Xt )(Xtk )]
Definition (Autocorrelation)
Corr(Xt , Xtk ) k (t)
Cov(Xt ,Xtk )
Var(Xt )
Proposition
Corr(Xt , Xt0 ) = Var(Xt )
Corr(Xt , Xtj ) = j depend on the lage: plot its values at each lag.
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Recall: stationarity
The stationarity is an essential property to define a time series process:
Definition
A process is said to be covariance-stationary, or weakly stationary, if
its first and second moments are time invariant.
E(Yt ) = E[Yt1 ] =
Var(Yt ) = 0 <
Cov(Yt , Ytk ) = k
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t
t
t, k
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Recall: The AR(1)

The AR(1): Yt = c + Yt1 + t
t iid(0, 2 )
with || < 1, it can be can be written as:
t1
X
c
i ti
+
Yt =
1
i=0
Its moments do not depend on the time: :

E(Xt ) =
c
1
Var(Xt ) =
2
12
j
2
12
= j
Cov(Xt , Xtj ) =
Corr(Xt , Xtj )
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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Autocorrelation function
A usefull plot to understand the dynamic of a process is the

autocorrelation function:
Plot the autocorrelation value for different lags.
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0.0
6
10 12 14
Lag k
Lag k
= 0.9
=1
10 12 14
0.4
0.0
0.0
0.4
0.8
0.8
0.4
0.4
0.0
0.8
= 0.5
0.8
=0
10 12 14
Lag k
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Lag k
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AR(1) with 1 < < 0
in the AR(1): Yt = c + Yt1 + t

with 1 < < 0
we have negative autocorrelation.
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t iid(0, 2 )
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phi=0.7
ar
3
2 1
ar
phi=0.2
40
60
80
100
40
60
80
Time
= 0.2
= 0.7
100
0.5
1.0
0.0
0.5
0.0
1.0
20
Time
1.0
20
1.0
10 12 14
Lag k
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Lag k
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Definition (AR(p))
yt = c + 1 yt1 + 2 yt2 + . . . + p ytp + t
Expectation?
Variance?
Auto-covariance?
Stationary conditions?
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Lag operator
Definition (Backshift /Lag operator)

LXt = Xt1
Proposition
See that: L2 Xt = Xt2
Proposition (Generalisation)
Lk Xt = Xtk
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Lag polynomial
We can thus rewrite:
Example (AR(2))
Xt = c + 1 Xt1 + 2 Xt2 + t
(1 1 L 2 L2 )Xt = c + t
Definition (lag polynomial)

We call lag polynomial: (L) = (1 1 L 2 L2 . . . p Lp )
So we write compactly:
Example (AR(2))
(L)Xt = c + t
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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Definition (Characteristic polynomial)

(1 1 z 2 z 2 . . . p z p )
Stability condition:
Proposition
The AR(p) process is stable if the roots of the lag polynomial lie outside
the unit circle.
Example (AR(1))
The AR(1): Xt = Xt1 + t
can be written as: (1 L)Xt = t
Solving it gives: 1 x = 0 x =
And finally: | 1 | > 1 || < 1
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Proof.
1
Write an AR(p) as AR(1)
Show conditions for the augmented AR(1)
Transpose the result to the AR(p)
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Proof.
The AR(p):
yt = 1 yt1 + 2 yt2 + . . . + p ytp + t
can be recast as the AR(1) model:
t = F t1 + t
yt
t
yt1
1 2 3 . . . p1 p
yt1 1 0 0 . . .
0
0 yt2 0
yt2 0 1 0 . . .
0
0
yt3 + 0
=
.. ..
..
..
..
.. .. ..
. .
.
. ...
.
. . .
0
ytp
0 0 0 ...
1
0
ytp+1
yt
= c + 1 yt1 + 2 yt2 + . . . + p ytp + t
y
= yt1
t1
...
y
tp+1 = ytp+1
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Proof.
Starting from the augmented AR(1) notation:
t = F t1 + t
Similarly as in the simple case, we can write the AR model recursively:
t = F t 0 + t + F t1 + F 2 t2 + . . . + F t1 1 + F t 0
Remember the eigenvalue decomposition: F
and the propriety that: F j = T j T 1
with
j
1 0 . . .
0 j . . .
2
j = .
..
..
. ...
0
= T T 1
0
0
..
.
. . . j3
So the AR(1) model is stable if |i | < 1 i

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Proof.
So the condition on F is that all from |F I | = 0 are < 1.
One can show that the eigenvalues of F are:
Proposition
p 1 p1 2 p2 . . . p1 p = 0
But the are the reciprocal of the values z that solve the characteristic
polynomial of the AR(p):
(1 1 z 2 z 2 . . . p z p ) = 0
So the roots of the polynomial should be > 1, or, with complex values,
outside the unit circle.
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Stationarity conditions
The conditions of roots outside the unit circle lead to:

AR(1): || < 1
AR(2):
I
I
I
1 + 2 < 1
1 2 < 1
|2 | < 1
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Example
Consider the AR(2) model:
Yt = 0.8Yt1 + 0.09Yt2 + t
Its AR(1) representation is:

yt
0.8 0.09 yt1
=
+ t
yt1
1
0
yt2
0
Hence
its eigenvalues
are taken from:

0.8 0.09

= 2 0.8 0.09 = 0
1
0
And the eigenvalues are smaller than one:
> Re(polyroot(c(-0.09, -0.8, 1)))
[1] -0.1
0.9
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Example
Yt = 0.8Yt1 + 0.09Yt2 + t
Its lag polynomial representation is: (1 0.8L 0.09L2 )Xt = t
Its characteristic polynomial is hence: (1 0.8x 0.09x 2 ) = 0
whose solutions lie outside the unit circle:
> Re(polyroot(c(1, -0.8, -0.09)))
[1]
1.111111 -10.000000
And it is the inverse of the previous solutions:

> all.equal(sort(1/Re(polyroot(c(1, -0.8, -0.09)))), Re(polyroot(c(-0.09,
+
-0.8, 1))))
[1] TRUE
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Unit root and integration order

Definition
A process is said to be integrated of order d if it becomes stationary after
being differenced d times.
Proposition
An AR(p) process with k unit roots (or eigenvalues) is integrated of order
k.
Example
Take the random walk: Xt = Xt1 + t
Its polynomial is (1-L), and the roots is 1 x = 0 x = 1
The eigenvalue of the trivial AR(1) is 1 = 0 = 1
So the random walk is integrated of order 1 (or difference stationary).
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Integrated process
Take an AR(p):
yt = 1 yt1 + 2 yt2 + . . . + p ytp + t
With the lag polynomial:
(L)Xt = t
If one of its p (not necessarily distinct) eigenvalues is equal to 1, it can be
rewritten:
(1 L)0 (L)Xt = t
Equivalently:
0 (L)Xt = t
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The AR(p) in detail
Moments of a stationary AR(p)

E(Xt ) =
c
11 2 ...p
Var(Xt ) = 1 1 + 2 2 + . . . + p p + 2
Cov(Xt , Xtj ) = 1 j1 + 2 j2 + . . . + p jp
Note
that j Cov(Xt , Xtj ) so we can rewrite both last equations as:
(
0 = 1 1 + 2 2 + . . . + p p + 2
j = 1 j1 + 2 j2 + . . . + p jp
They are known under the name of Yule-Walker equations.
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Yule-Walker equations
Dividing by 0 gives:
(
0 = 1 1 + 2 2 + . . . + p p + 2
j = 1 j1 + 2 j2 + . . . + p jp
Example (AR(1))
We saw that:
Var(Xt ) =
2
12
j
2
12
= j
Cov(Xt , Xtj ) =
Corr(Xt , Xtj )
And we have effectively: 1 = 0 = and 2 = 1 = 2

Utility:
Determination of autocorrelation function
Estimation
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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To estimate a AR(p) model from a sample of T we take t=T-p

Methods of moments: estimate sample moments (the i ), and find
parameters (the ) correspondly
Unconditional ML: assume yp , . . . , y1 N (0, 2 ). Need numerical
optimisation methods.
Conditional Maximum likelihood (=OLS): estimate
f (yT , tT 1 , . . . , yp+1 |yp , . . . , y1 ; ) and assume t N (0, 2 ) and
that yp , . . . , y1 are given
What if errors are not normally distributed? Quasi-maximum likelihood
estimator, is still consistent (in this case) but standard erros need to be
corrected.
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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Moving average models
Two significations!
regression model
Smoothing technique!
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MA(1)
Definition (MA(1))
Yt = c + t + t1
E(Yt ) = c
Var(Yt ) = (1 + 2 ) 2
(
2
Cov(Xt , Xtj ) =
0
(
Corr(Xt , Xtj ) =
if j = 1
if j > 1
(1+2 )
if j = 1
if j > 1
Proposition
A MA(1) is stationnary for every
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= 0.5
0 2 4 6 8
=2
20
40
60
80
100
20
40
60
Time
Time
= 0.5
= 2
80
100
80
100
1 2 3
20
40
60
80
100
20
Time
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60
Time
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0.0
6
10
Lag k
Lag k
= 0.5
= 3
10
10
0.5
0.0
1.0
1.0
0.0
0.5
1.0
1.0
0.4
0.4
0.0
0.8
=3
0.8
= 0.5
10
Lag k
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Lag k
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MA(q)
The MA(q) is given by:
Yt = c + t + 1 t1 + 2 t2 + . . . + 1 tq
E(Yt ) = c
Var(Yt ) = (1 + 12 + 22 + . . . + q2 ) 2
Cov(X
t , Xtj ) =
(
2
(j + j+1 1 + j+2 2 + . . . + q q1 )
0
(
if j = 1
(1+2 )
Corr(Xt , Xtj ) =
0
if j > 1
if j = 1
if j > 1
Proposition
A MA(q) is stationary for every sequence {1 , 2 , . . . , q }
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= c( 0.5,, 1.5)
0.5
1.0
2
10
10
= c( 0.6,, 0.3,, 0.5,, 0.5)
= c( 0.6,, 0.3,, 0.5,, 0.5,, 3,, 2,, 1)
0.5
0.0
1.0
0.0
0.5
1.0
Lag k
1.0
Lag k
1.0
0.0
0.4
0.0
0.8
1.0
= c(0.5,, 1.5)
10
Lag k
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Lag k
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The MA()
Take now the MA():
Yt = t + 1 t1 + 2 t2 + . . . + =
j tj
j=0
Definition (Absolute summability)

A sequence is absolute summable if
i=0 |i |
<0
Proposition
The MA() is stationary if the coefficients are absolute summable.
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Back to AR(p)
Recall:
Proposition
If the characteristic polynomial of a AR(p) has roots =1, it is not
stationary.
See that:
(1 1 yt1 2 yt2 . . . p ytp )yt =
(1 1 L)(1 2 L) . . . (1 p L)yt = t
It has a MA() representation if: 1 6= 1:
yt = (11 L)(112 L)...(1p L) t
Furthermore, if the i (the eigenvalues of the augmented AR(1)) are
smaller than 1, we can write it:
yt =
i t
i=0
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Estimation of a MA(1)
We do not observe neither t nor t1

But if we know 0 , we know 1 = Yt 0
So obtain
and minimize the conditional SSR:
Pthem recursively
2
S() = T
(y
)
t1
t=1 t
This recquires numerical optimization and works only if || < 1.
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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ARMA models
The ARMA model is a composite of AR and MA:
Definition (ARMA(p,q))
Xt = c+1 Xt1 +2 Xt2 +. . .+p Xtp +t1 +1 t1 +2 t2 +. . .+tq
It can be rewritten properly as:
(L)Yt = c + (L)t
Theorem
The ARMA(p,q) model is stationary provided the roots of the (L)
polynomial lie outside the unit circle.
So only the AR part is involved!
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Autocorrelation function of a ARMA(p,q)
Proposition
After q lags, the autocorrelation function follows the pattern of the AR
component.
Remember: this is then given by the Yule-Walker equations.
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phi(1)=0.5, theta(1)=0.5
0.5
1.0
0.0
0.4
0.0
0.8
1.0
phi(1)=0.5, theta(1)=0.5
10
Lag k
10
Lag k
1.0
0.5
0.0
1.0
0.0
1.0
0.5
1.0
phi(1)=0.5, theta(1:3)=c(0.5,0.9,0.3) phi(1)=0.5, theta(1:3)=c(0.5,0.9,0.3)
10
Lag k
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Lag k
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ARIMA(p,d,q)
Now we add a parameter d representing the order of integration (so the I

in ARIMA)
Definition (ARIMA(p,d,q))
ARIMA(p,d,q): (L)d Yt = (L)t
Example (Special cases)

White noise: ARIMA(0,0,0) Xt = t
Random walk : ARIMA(0,1,0): Xt = t Xt = Xt1 + t
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Estimation and inference
The MLE estimator has to be found numerically.

Provided the errors are normaly distributed, the estimator has the usual
asymptotical properties:
Consistent
Asymptotically efficients
Normally distributed
If we take into account that the variance had to be estimated, one can
rather use the T distribution in small samples.
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Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
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Transform data to achieve stationarity
Identify the model, i.e. the parameters of ARMA(p,d,q)
Estimation
Diagnostic analysis: test residuals
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Step 1
Transformations:
Log
Square root
Differenciation
(
Box-Cox transformation:
()
Yt
Yt 1
log(Y t)
for 6= 0
for = 0
Is log legitimate?
Process is: yt e t Then zt = log(yt ) = t and remove trend
Process is yt = yt1 + t Then (by log(1 + x)
= x)
log(yt ) =
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yt
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Step 2
Identification of p,q (d should now be 0 after convenient transformation)

Principle of parsimony: prefer small models Recall that
incoporating variables increases fit (R 2 ) but reduces the degrees of
freedom and hence precision of estimation and tests.
A AR(1) has a MA() representation
If the MA(q) and AR(p) polynomials have a common root, the
ARMA(p,q) is similar to ARMA(p-1,q-1).
Usual techniques recquire that the MA polynomial has roots outside
the unit circle (i.e. is invertible)
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Step 2: identification
How can we determine the parameters p,q?

Look at ACF and PACF with confidence interval
Use information criteria
I
I
Akaike Criterion (AIC)

Schwarz criterion (BIC)
Definition (IC)
AIC (p) = n log
2 + 2p
BIC (p) = n log
2 + p log n
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Step 3: estimation
Estimate the model...

R function: arima() argument: order=c(p,d,q)
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Step 4: diagnostic checks
Test if the residuals are white noise:

1
Autocorrelation
Heteroscedasticity
Normality
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80
60
40
20
CPI
100
120
140
CPI
1985
1990
1995
2000
2005
Time
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diff(CPI)
20
1
2 1
diff(CPI)
100
60
CPI
140
original
1995
2005
1985
1995
Time
Time
log(CPI)
diff(log(CPI))
2005
0.02
0.02
0.00
diff(log(CPI))
4.0
3.5
3.0
log(CPI)
4.5
5.0
1985
1985
1995
2005
1985
Time
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2005
Time
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detrend
20 60
CPI
120
linear trend
1985
1990
1995
2000
2005
1985
1990
Time
1995
2000
2005
2000
2005
2000
2005
Time
1985
1990
1995
2000
6
2
2
CPI
20 60
120
CPI smo$y
Smooth trend
2005
1985
1990
Time
1995
Time
10
5
0
detrend2
20 60
CPI
120
Quadratic trend
1985
1990
1995
Time
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2005
1985
1990
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1995
Time
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1
3
diff2
Diff2
1985
1990
1995
2000
2005
2000
2005
Time
0.00
0.03
diff2log
Diff2 of log
1985
1990
1995
Time
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0.3
0.1
Partial ACF
0.03 0.01
CPI2
0.01
0.1
Series CPI2
1985
1995
2005
0.5
Time
1.0
1.5
2.0
Lag
0.0
0.2
ACF
0.2
Series CPI2
0.5
1.0
1.5
2.0
Lag
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> library(forecast)
This is forecast 1.17

> fit <- auto.arima(CPI2, start.p = 1, start.q = 1)
> fit
Series: CPI2
ARIMA(2,0,1)(2,0,2)[12] with zero mean
Coefficients:
ar1
ar2
0.2953 -0.2658
s.e. 0.0630
0.0578
ma1
-0.9011
0.0304
sar1
0.6021
0.1067
sar2
0.3516
0.1051
sma1
-0.5400
0.1286
sma2
-0.2850
0.1212
sigma^2 estimated as 4.031e-05: log likelihood = 1146.75

AIC = -2277.46
AICc = -2276.99
BIC = -2247.44
> res <- residuals(fit)
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1985
1995
2005
0.00
0.10
Partial ACF
0.00
0.02
res
0.02
0.10
Series res
0.5
Time
1.0
1.5
2.0
Lag
0.05
0.15
ACF
0.05
Series res
0.5
1.0
1.5
2.0
Lag
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> Box.test(res)
Box-Pierce test
data: res
X-squared = 0.0736, df = 1, p-value = 0.7862
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0.01
0.02
Sample Quantiles
Normal QQ Plot
Theoretical Quantiles
40
0
Density
80
density.default(x = res)
0.02
0.01
0.00
0.01
0.02
N = 315 Bandwidth = 0.001481

Matthieu Stigler ()
Stationary models
November 14, 2008
62 / 65
Outline
1
Last Lecture
AR(p) models
Estimation
MA models
ARMA(p,q)
Forecasting
Matthieu Stigler ()
Stationary models
November 14, 2008
63 / 65
Notation (Forecast)
yt+j Et (yt+j ) = E(yt+j |yt , yt1 , . . . , t , t1 , . . .) is the conditional
expectation of yt+j given the information available at t.
Definition (J-step-ahead forecast error)

et (j) yt+j yt+j
Definition (Mean square prediction error)

MSPE
1
H
PH
2
i=1 ei
Matthieu Stigler ()
Stationary models
November 14, 2008
64 / 65
R implementation
To run this file you will need:

R Package forecast
R Package TSA
Data file AjaySeries2.csv put it in a folder called Datasets in the same
level than your.Rnw file
(Optional) File Sweave.sty which change output style: result is in
blue, R commands are smaller. Also in same folder as .Rnw file.
Matthieu Stigler ()
Stationary models
November 14, 2008
65 / 65

Lect 2 ARMA

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Lect 2 ARMA

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Stationary models

MA, AR and ARMA

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ARMA models for stationary variables

Structural VAR models

Cointegration the Engle and Granger approach

Cointegration 2: The Johansen Methodology

Multivariate Nonlinearities in VAR models

Multivariate Nonlinearities in VECM models

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The stationarity is an essential property to define a time series process:

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Recall: The AR(1)

Its moments do not depend on the time: :

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A usefull plot to understand the dynamic of a process is the

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AR(1) with 1 < < 0

in the AR(1): Yt = c + Yt1 + t

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Definition (Backshift /Lag operator)

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Definition (lag polynomial)

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Definition (Characteristic polynomial)

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Write an AR(p) as AR(1)

Show conditions for the augmented AR(1)

Transpose the result to the AR(p)

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So the AR(1) model is stable if |i | < 1 i

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The conditions of roots outside the unit circle lead to:

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And it is the inverse of the previous solutions:

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Unit root and integration order

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The AR(p) in detail

Moments of a stationary AR(p)

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And we have effectively: 1 = 0 = and 2 = 1 = 2

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To estimate a AR(p) model from a sample of T we take t=T-p

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Moving average models

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