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SYSTEM COINTEGRATION
ANALYSIS
Maximum Likelihood Method
Professor Dr. Abdul Qayyum
August 2, 2013 Time Series Analysis
2
Johansen (1988) Maximum Likelihood
Method
Assume that
the individual time series data are non-stationary.
the variables are cointegrated.
the dynamic model can be represented by the error
correction mechanism.
The relationship between the cointegration and the error
correction mechanism is proved in the Granger
representation theorem (Engle and Granger, 1987).
Johansen (1988) and Johansen and Juselius (1990),
the dynamic error correction function is thus approached
through the process of autoregressive distributed lag
(ADL).
August 2, 2013 Time Series Analysis
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Therefore following VAR formulation could be achieved.

t t
i t
k
i
i t
D
X
X c + u + + H =

=

1
t i k t k t k t t
D c + u + + X H + X A I + + X A I = X A
+ 1 1 1 1
....
X
t
is a vector of variables included in the model,

t
is constant term,
D
t
is a vector of dummy variables and
c is iid(0, A) disturbance term.
using A=1-L, where L is the lag operator, we can
deduce the error correction model
August 2, 2013 Time Series Analysis
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If the objective is to investigate the cointegrating
relationship among the variables then
the analysis of the matrix H is crucial.
It contains all the relevant information.
For example,
Rank (H) = p X
t
is a stationary process.
Rank (H) = 0 X
t
is AR(1) process. This implies that there is no
long-run information in the data.
Rank (H) = r, where 0 < r < p, there exists r cointegrating
relationships among the variables
[1]
.
The other p-r linear combinations of the variables act as
common stochastic trends.
the long-run matrix can be factorized as p r matrices of o
and of the form H =o .
In the presence of the cointegration relationship, the vector
has the property that 'X
t
is stationary, though X
t
itself is
nonstationary.
August 2, 2013 Time Series Analysis
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The vector o is the loading vector,
the elements of which weight each cointegrating
relationship in each of the p equations of the system.
The expected sing of the error correction parameter
is negative.
It gives the speed of adjustment towards the state of
equilibrium.
August 2, 2013 Time Series Analysis
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Choice of Deterministic Components
We may have non zero mean, deterministic trend as well as
stochastic trend in a series.
Cointegrating equation may have intercept and deterministic trends.
Johansen (1995) considered following five possibilities;
1. Series y have no deterministic trend and cointegrating equation
have no intercepts
2. Series y have no deterministic trends and the cointegrating
equations have intercepts,
3. Series y have linear trend but cointegrating equation have only
intercept,
4. Series y and cointegrating equation both have linear trend, and
5. Series y have quadratic trend and the cointegrating equation
have linear trends.
The choice of options depends on the assumption that long run
equilibrium do not have trends. Therefore final model is chosen
with help of theoretical interpretations as well as the statistical
criteria.
August 2, 2013 Time Series Analysis
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t t
p
i
i t i t
t c c + + H + X H + X A I = X A

=
1 1
1
1
) (
t t
p
i
i t i t
c + X H + X A I = X A

=
1
1
1
1: No Intercept and No Trend
2: Restricted Intercept and No trend
3: Unrestricted Intercept and No Trend
t t
p
i
i t i t
c c + + X H + X A I = X A

=
0 1
1
1
t t
p
i
i t i t
t c c c + + + X H + X A I = X A

=
1 0 1
1
1
August 2, 2013 Time Series Analysis
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4: Unrestricted Intercept and Restricted Trend
5: Unrestricted Intercept and Unrestricted Trend
t t
p
i
i t i t
t c c c + + + X H + X A I = X A

=
1 0 1
1
1
t t
p
i
i t i t
t c c + H + + X H + X A I = X A

=

) (
0 1
1
1
August 2, 2013 Time Series Analysis
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Estimation of Cointegrating and the
Loading Vectors
Choose AR of order p for the model
Obtain R
ot
by regressing AX
t
on the lagged AX
t
and
Obtain R
kt
by regressing X
t-k
on the lagged AX
t

Compute squares of the Canonical correlations
between R
ot
and

R
kt
, call them
1
2
> .. > n
2

The likelihood function is
L EXP R R R R
T
ot
t
T
kt ot kt
( , , ) [ ( ) ( )]
/
o | o | o | A O
A
= + ' ' + '

2
1
1
1
2
August 2, 2013 Time Series Analysis
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Johansen Method: Test of
Cointegration
The null hypothesis is that there exists r
cointegration vector(s).
The likelihood ratio (LR) test statistic for the
hypothesis that there are at most r cointegrating
vector is:


where i are the roots of the determinant equation
) 1 ( ln ) / ; ( ln 2
1
1 2
+ =
.
=
p
r i
i
T H H Q
August 2, 2013 Time Series Analysis
Trace Statistic
Null hypothesis H
0
(r): Rank (H) s r
Alternative hypothesis Ha

(r): Rank (H) = r
by the trace statistic.

August 2, 2013 11
) 1 ( ln ) / ; ln( 2
1
^
1 2

+ =
= =
n
r i
i
Treace T H H Q
Time Series Analysis
Maximal Eigenvalue Statistic
Null H
0
(r): Rank (H) = r
Alternative H
a
(r+1): Rank (H) = r+1
can be tested by looking at the maximal eigenvalue
statistic

August 2, 2013 12
) 1 ( ln ) 1 / ; ln 2
1
1
^

+ =
+ = = +
n
r i
r Max T r r Q
these statistics are asymptotically distributed as _2 with r(p-r) degrees
of freedom. Osterwald-Lenum (1992) - critical values
Time Series Analysis