Note on Co-integration Test Research Methodology, 2012-14 Gargi Sanati

The Hypothesis: Four variables Case

Trace test Null Hypothesis H0 a, b, c and d r=0 Alternative Statistics[Prob] Max test Null Hypothesis Alternative Statistics[Prob]

r>0

70.11 [0.000]**

r=0

r=1

32.50 [0.008]**

r<=1 r<=2 r<=3

r>1 r>2 r=4

37.61 [0.005]** 14.72 [0.064] 0.73 [0.393]

r=1 r=2 r=3

r=2 r=3 r=4

22.89 [0.006]* 13.99 [0.053] 0.73 [0.393]

Lets say there are four different markets represented by the variables a, b, c and d. We would like to do forecasting on the movement of the prices of these markets. [Please see the details on the calculation of trace and max eigen value statistics in the PPT. Kindly ignore the slide on the hypothesis given in PPT as there is a small mistake. For Hypothesis Test refer the above table] Interpretation of statistics Null r=0 and Alternative Hypothesis r>0 ----- if we are rejecting the null hypothesis we are concluding that the series are integrated. More conveniently, we may say that there is one co-integrating vector (although the alternative hypothesis for trace test is >0, the alternative for Max Eigen value statistics =1. Most of the times trace and max eigen value statistics provide us the same result.) Null r<=1 and alternative Hypothesis is r>1 ---- if we are rejecting the null hypothesis we are concluding there are more than one cointegrating vector (or in simple term co-integrating relationship). More conveniently, we may say that there is two co-integrating vector (as it is required to conclude in the close form and also this closed form is satisfied by the max statistic with the = sign) Null r<=2 and alternative Hypothesis is r>2 ---- if we are rejecting the null hypothesis we are concluding there are more than two cointegrating vector (or in simple term co-integrating relationship). More conveniently, we may say that there is three co-integrating vector (as it is required to conclude in the close form and also this closed form is satisfied by the max statistic with the = sign) Null r<=3 and alternative Hypothesis is r=4 ---- if we are rejecting the null hypothesis we are concluding there are four cointegrating vectors (or in simple term co-integrating relationship). But this is a stationary condition and might arise because of the model misspecification. In the above example we are concluding that there are more than one cointegrating vector (or two cointegrating vector, supported by the max eigen value test) and the result is significant at the one percent significance level.

Note : Remember as forecasting is expected with more accuracy, it is always good to forecast at the 1% level of significance, that means keeping the probability of error minimum. Example: Two variables Say, if it is two variable case and we are trying to understand if there is any co-integrating relationship in the series then we have only the following conditions
Trace test Null Hypothesis H0 a, b r=0 r<=1 Alternative r>0 r=2 Statistics[Prob] 70.11 [0.000]** 37.61 [0.005]** Max test Null Hypothesis r=0 r=1 Alternative r=1 r=2 Statistics[Prob] 32.50 [0.008]** 22.89 [0.006]**

This example signifies model misspecification as we know that rejecting null hypothesis, r<=1 leads to a stationary condition where number variables = number of cointegrating vectors (or relationship). Note: The number of cointegrating relationship has to be < number of variables for non-stationary series. Interpretion of result according to Eviews 3.1
Date: 03/14/13 Time: 17:26 Sample: 1997:01 2007:07 Included observations: 122 Series: BSES EXCH YIELD10 Lags interval: 1 to 4 Eigenvalue 0.178836 0.066333 0.003819 Likelihood Ratio 32.87832 8.840339 0.466814 5 Percent Critical Value 29.68 15.41 3.76 1 Percent Critical Value 35.65 20.04 6.65 Hypothesized No. of CE(s) None * At most 1 At most 2

*(**) denotes rejection of the hypothesis at 5%(1%) significance level L.R. test indicates 1 cointegrating equation(s) at 5% significance level Other than seeing the star we may see if the likelihood ratio test is greater than or less than the critical value at 5% and 1% If the value of Likelihood ratio test is greater than the critical value we reject the null hypothesis. Here, in the above example, at 5% level, the value of likelihood ratio test > critical value, we reject the null of no co-integration. At 1% level the likelihood ratio test < critical value, so we cant reject the null of no co-integration at 1% level.