ECON2206IntroductoryEconometrics

Week 12 Tutorial Exercises

Readings
Read Chapter 11.111.3 thoroughly. Also read section 18.3.
Make sure that you know the meanings of the Key Terms at the chapter end.

Review Questions (these may or may not be discussed in tutorial classes)

What is a strictly stationary stochastic process (SP)? What is a covariance stationary SP?
In this course, what do we mean by weakly dependent (WD) time series?
What is a random walk? What are the main properties of the random walk? What are the
properties of the difference of the random walk?
What is a random walk with drift?
What are I(1) and I(0) time series? How do we decide whether a time series is I(1) or I(0)?
What is a spurious regression?

Problem Set
Q1. Wooldridge 11.1
Because of covariance stationarity:

0 = Var(xt) does not depend on t, so Var(xt+h) = 0 for any h 0.

By definition, Corr(xt, xt+h) = Cov(xt, xt+h)/[Var(xt)Var(xt+h)]1/2 = h/ 0.

Q2. Wooldridge 11.4
Assuming y0 = 0 is a special case of assuming y0 nonrandom, and so we can obtain the variances
from (11.21): Var(yt) = 2 t and Var(yt+h) = 2(t + h), h > 0.

Because E(yt) = 0 for all t (since E(y0) = 0), Cov(yt, yt+h) = E(yt yt+h) and, for h > 0,
E(yt yt+h) = E[(et + et1 + e1)(et+h + et+h1 + + e1)]
= E(et2) + E(et12) + + E(e12) = 2t,

where we have used the fact that {et} is a pairwise uncorrelated sequence. Therefore,
Corr(yt, yt+h) = Cov(yt, yt+h)/ [Var(yt)Var(yt+h)]1/2 = [t/(t+h)] 1/2.

Q3. Wooldridge 11.6

(i) The t statistic for H0: 1 = 1 is t = (1.104 1)/.039 2.67. Although we must rely on
asymptotic results, we might as well use df = 120 in Table G.2. So the 1% critical value against a
twosided alternative is about 2.62, and so we reject H0: 1 = 1 against H1: 1 1 at the 1% level.

It is hard to know whether the estimate is practically different from one without comparing
investment strategies based on the theory (1 = 1) and the estimate (1.104). But the estimate is
10% higher than the theoretical value.

(ii) The t statistic for the null in part (i) is now (1.053 1)/.039 1.36, so H0: 1 = 1 is no longer
rejected against a twosided alternative unless we are using more than a 10% significance level.
But the lagged spread is very significant (contrary to what the expectations hypothesis
predicts): t = .480/.109 4.40. Based on the estimated equation, when the lagged spread is
positive, the predicted holding yield on sixmonth Tbills is above the yield on threemonth T
bills (even if we impose 1 = 1), and so we should invest in sixmonth Tbills.

(iii) This suggests unit root behavior for {hy3t}, which generally invalidates the usual ttesting
procedure.

(iv) We would include three quarterly dummy variables, say Q2t, Q3t , and Q4t, and do an F test
for joint significance of these variables. (The F distribution would have 3 and 117 df.)


Q4. Wooldridge C11.3
(i) The estimated equation is

.226 . 049 . 0097

. 087 . 039 . 0070
n 689, R .0063

(ii) The null hypothesis is H0: 1 = 2 = 0.

Only if both parameters are zero does E(returnt|returnt1) not depend on returnt1.

The F statistic is 2.16 with pvalue .116. Therefore, we cannot reject H0 at the 10% level.

return 2
(iii) When we put returnt1 returnt2 in place of t 1 , the null can still be stated as in part

(ii): no past values of return, or any functions of them, should help us predict returnt. The R
squared is about .0052 and F=1.80 with pvalue .166. Here, we do not reject H0 at even the
15% level.

(iv) Predicting returnt based on past returns does not appear promising. Even though the F
statistic from part (ii) is almost significant at the 10% level, we have many observations. We
cannot even explain 1% of the variation in returnt.

In addition create a time series plot of return, the weekly percentage return on the New York
Stock Exchange composite index. What are the key features of the data? How does that help in
deciding whether the series is nonstationary? Does it seem to be covariance stationary?

10
5
100*(p - p(-1))/p(-1))
-5 -10
-15 0

0 200 400 600 800

t

Key features:
1. Considerable variability around what seems to be a mean of zero;
2. A couple of spikes of high volatility, especially the large negative return (associated with
the stock market crash of October 1987.)
3. Other than the spikes variability seems relatively constant over the period.

Think of comparing two different periods do they look very much the same? Yes. #1 and #3
are consistent with covariance stationarity. What we cant deduce from the graph is
dependence.

Might think of #2 as transitory random shocks to an otherwise stationary process.