Forecasting II

(forecasting with ARMA models)

There are two kind of forecasters: those who dont know and those who dont know they dont know
John Kenneth Galbraith (1993)

Gloria Gonzlez-Rivera
University of California, Riverside
and
Jess Gonzalo U. Carlos III de Madrid
Spring 2002

Copyright( MTS-2002GG): You are free to use and mod

Optimal forecast for ARMA models

For a general ARMA process

( L) Z t ( L)at
( L)
Zt
at ( L)at at 1at 1 2 at 2 .....
( L)
Objective: given information up to time n, Z n , Z n 1 ,......Z1
want to forecast l-step ahead Z (l )
n

at t n l

l 1

Z l n j an l j j an l j j an l j
j 0
j 0
j l
future a

Z n (l ) l *an *l 1an 1 *l 2an 2 ......

past a

What is * ?

Criterium: Minimize the mean square forecast error

(l )) 2
min
E
(
Z

Z
n l
n
*

E ( Z n l

l 1

Z n (l )) 2 2 a j a
j 0

(
j 0

l j

l j )

* 2

E ( Z n l Z n (l )) 2
2
*
a 2( l j l j )( 1) 0
*

j 0

l j l j

Z n (l ) l an l 1an 1 l 2 an 2 ........

Another interpretation of optimal forecast

Consider
l 1

j 0

j 0

Z l n j an l j l j an j

E ( Z n l | Z n , Z n 1.....) l j an j l an l 1an 1 l 2an 2 ....

j 0

Hence

Z n (l ) E ( Z n l | Z n , Z n 1.....)

Given a quadratic loss function, the optimal forecast is a

conditional expectation, where the conditioning set is past
information

Sources of forecast error

)
When the forecast is using n ( I n ,

e n (l) Z n l n (I n , )

{Z n l E[ Z n l | I n ]}

{E[ Z n l | I n ] n (I n , )}

{ h (I n , ) h (I n , )}

Properties of the forecast error

l 1

j 0

j 0

Z l n j an l j l j an j

Since Z n l Z n (l ) en (l )

l 1

forecast error en (l ) Z n l Z n (l ) j an l j MA(l-1)

j 0

1. The forecast Z n (l ) and the forecast error en (l ) are

uncorrelated
2. E ( en (l )) 0
Unbiased

3.

l 1

Var ( en (l )) j a
2

j 0

4.

en (l ) for l 1 are correlated

Properties of the forecast error (cont)

1-step ahead forecast errors, e n (1), e n 1 (1).....e n l (1) , are uncorrelated

en (1) Z n 1 Z n (1) an 1

In general, l-step ahead forecast errors (l>1) are correlated

en (l ) Z n l Z n (l ) an l 1an l 1 ...... l 1an 1

en j (l ) Z n j l Z n j (l ) an j l 1an j l 1 ...... l 1an j 1
cov(en (l ), en j (l ))

n-j

n l j

i n i n j

i n 1

n-j+l n+l

jl

Forecast of an AR(1) process

Z t Z t 1 at Z n (l ) ?
l 1

Z n 1 Z n an 1
E ( Z n 1 | n ) Z n

l2

Z n 2 Z n 1 an 2

E ( Z n2 | n ) 2 Z n
l

for any l Z n (l ) Z n
The forecast decays geometrically as l increases

Forecast of an AR(p) process

Z t 1Z t 1 2 Z t 2 ........ p Z t p at
Z n (l ) E ( Z n l | Z n , Z n 1 ,.....) ?
l 1 Z n 1 1Z n 2 Z n 1 ........ p Z n p 1 an 1
Z n (1) E ( Z n 1 | n ) 1Z n 2 Z n 1 ........ p Z n p 1
l 2 Z n 2 1Z n 1 2 Z n ........ p Z n p 2 an 2
Z n (2) E ( Z n 2 | n ) 1Z n (1) 2 Z n ........ p Z n p 2
for any l

Z n (l ) 1Z n (l 1) 2 Z n (l 2) ........ p Z n (l p )

You need to calculate the previous forecasts l-1,l-2,.

Forecast of a MA(1)

Z t at at 1
Z n (l ) E ( Z n l | I n ) ?
l 1

Z n 1 an 1 an
Z n (1) E ( Z n 1 ) an

l2
l 1

Z n 2 an 2 an 1

Z n 2 0
Z n (l ) 0

Zn
an
1 L

That is the mean of the process

Forecast of a MA(q)

Z t (1 1L 2 L ...... q L )at
2

( l l 1L l 2 L2 .... q Lql )an l q

Z n (l ) E ( Z n l | I n )
where

0
1
an
Z
q n
1 1L .... q L

lq

Forecast of an ARMA(1,1)

(1 L) Z t (1 L)at
Z n l Z n l 1 an l an l 1
1 L
where an
Zn
1 L
l 2 Z n ( 2) Z n (1) (Z n an )
l 2 Z n (l ) Z n (l 1) 2 Z n (l 2) .... l 1Z n (1)
l 1 Z n (1) Z n an

Forecast of an ARMA(p,q)

p ( L ) Z t q ( L ) at
Z n l 1Z n l 1 ..... p Z n l p an l 1an l 1 ..... qan l q
Z n (l ) 1Z n (l 1) .... p Z n (l p ) an (l ) 1an (l 1) .... qan (l q)
where

Z n ( j ) E ( Z n j | Z n , Z n 1.....)
Z n ( j ) Z n j
an ( j ) 0

j 1

j0
j 1

an ( j ) an j Z n j Z n j 1 (1)

j0

Example: ARMA(2,2)

Z t 1Z t 1 2 Z t 2 at 1at 1 2at 2
l 1 Z n 1 1Z n 2 Z n 1 an ! 1an 2an 1
Z n (1) E ( Z n 1 | I n ) 1Z n 2 Z n 1 1an 2an 1
where
Z n (0) Z n
Z n ( 1) Z n 1
2 ( L)
n
a
Zn
2 ( L )
n 1 Z n 1 Z n 2 (1)
a

Updating forecasts
Suppose you have information up to time n, such that

Z n (1), Z n ( 2),......Z n (l )

When new information comes, Z n 1

can we update the previous forecasts?

1.
2.

en (l ) Z n l Z n (l )
en 1 (l 1)
en 1 (l 1)

3.

l 11

j 0

l 1

j 0

l 1

j 0

an l j

an 1l 1 j

j 0

an l j

an l j l an en (l ) l an

Z n l Z n 1 (l 1) Z n l Z n (l ) l an
Z n (l ) Z n 1 (l 1) l an
Z n 1 (l ) Z n (l 1) l an 1

Problems
P1: For each of the following models:
(i) (1 - 1L) Z t a t
(ii) (1 1L 2 L2 ) Z t a t
(iii) (1 - 1L)(1 L) Z t a t
(a) Find the l-step ahead forecast of Zn+l
(b) Find the variance of the l-step ahead forecast error for l=1, 2,
and 3.
P2: Consider the IMA(1,1) model
(1 L) Z t (1 L)a t

(a) Write down the forecast equation that generates the forecasts
(b) Find the 95% forecast limits produced by this model
(c) Express the forecast as a weighted average of previous
observations

Problems (cont)
P3: With the help of the annihilation operator (defined in the
appendix) write down an expression for the forecast of an
AR(1) model, in terms of Z.
P4: Do P3 for an MA(1) model.

Appendix I: The Annihilation operator

We are looking for a compact lag operator expression to be used to
express the forecasts
( L)
L s 1L1 s ... s 1L1 s L0 s 1L1 s 2 L2 ...
Ls

The annihilation operator is

[

Then if

( L)
] s L0 s 1L1 s 2 L2 ..
Ls

Z t (L)a t , E[ Z t s | a t , a t 1 , ...] [

( L)
] a t
Ls

Appendix II: Forecasting based on lagged Zs

Let

( L) Z t a t
Z t ( ( L)) 1 a t ( L)a t

Then
(L)
1
E[ Z t s | Z t , Z t 1 , ...] [
]
Zt
(L)
Ls

Wiener-Kolmogorov
Prediction Formula