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ECON2209

Slides 08

BF-08

Lecture Plan

Big picture:

yt = mt + st + xt ,

st + p = st ,

s

k =1

t +k

= 0,

E( xt ) = 0

Forecasting general linear processes

Forecasting ARMA processes with the chain rule

Long run forecasts

BF-08

Optimal forecast

As parameters can be estimated, we assume that

parameters in ARMA models are known for now.

At T, we wish to forecast the SP (or cycle) at T+h.

Information set T = {yT, yT-1, }. When models

are well-defined, T = {yT, yT-1, ; T, T-1, }.

Forecast for yT+h based on T: yT+h|T .

Expected quadratic loss (MSFE):

MSFE( yT + h|T ) = E[( yT + h yT + h|T ) 2 | T ].

BF-08

Optimal forecast

Optimal forecast under MSFE is the conditional

mean of yT+h, yT+h|T = E(yT+h|T), which

minimises MSFE.

eg. ARMA(1,1) optimal forecast and forecast error

Actual: yT +1 = c + 1 yT + T +1 + 1 T ,

Forecast: yT +1|T = E ( yT +1 | T ) = c + 1 yT + 1T ,

eT+1|T = yT+1 yT+1|T

F. Error: eT +1|T = T +1 ;

BF-08

Optimal forecast

eg. ARMA(1,1) forecast (continued)

yT + 2 = c + 1 yT +1 + T + 2 + 1 T +1 ,

yT + 2|T = E ( yT + 2 | T ) = c + 1 E ( yT +1 | T ) = c + 1 yT +1|T ,

eT + 2|T = T + 2 + 1 T +1 + 1eT +1|T .

yT+2|T

yT+3|T

yT +3 = c + 1 yT + 2 + T +3 + 1 T + 2 ,

yT +3|T = c + 1 yT + 2|T ,

eT +3|T = T +3 + 1 T + 2 + 1eT + 2|T .

BF-08

Optimal forecast

Linear forecast: a linear combination of the

elements in T. A linear forecast may be different

from E(yT+h|T).

Best linear forecast (aka. linear projection):

yT + h|T = 0 + 1 yT + 2 yT 1 +

with s being chosen to minimise MSFE.

If the true model (dgp) is ARMA, the linear

projection coincides with E(yT+h|T).

In general, the linear projection may be used as an

approximation to E(yT+h|T).

BF-08

General linear process (cf. Wold representation)

yt = bi t i ,

i =0

b0 = 1,

t ~ WN(0, 2 ).

Linear projection is

yT+h|T = bhT + bh+1T-1 +

yT + h = T + h + b1 T + h 1 + + bh 1 T +1

+ bh T + bh +1 T 1 + .

forecast : yT + h|T

BF-08

eT+h|T

yT+h

yT+h|T

T

7

Forecast error

eT + h|T = T + h + b1 T + h 1 + + bh 1 T +1 ,

MA(h 1)

E (eT + h|T ) = 0,

unbiased

95% Interval forecast when t ~ iid N(0, 2)

Chebyshevs theorem:

[ yT+h|T 1.96h , yT+h|T + 1.96h ]

Conditional density when t ~ iid N(0, 2)

yT+h | T ~ N(yT+h|T , h2)

BF-08

Use ARMA to produce a linear projection.

When dgp is ARMA, the linear projection is optimal;

In general, the linear projection approximates

E(yT+h|T) .

samples, uncertainty in estimates may be ignored.

ARMA: future Y = terms in T + terms outside T.

Use a chain rule to separate the terms in T and the

terms outside T.

BF-08

eg. ARMA(1,1) chain rule

yT +1

inside T

= c + 1 yT + 1 T + T +1 ,

yT +1|T = c + 1 yT + 1 T ,

eT +1|T = T +1 ;

yT + 2 = c + 1 ( yT +1|T + eT +1|T ) + T + 2 + 1 T +1 ,

= c + 1 yT +1|T + T + 2 + 1 T +1 + 1eT +1|T

inside T

yT + 2|T = c + 1 yT +1|T ,

eT + 2|T = T + 2 + 1 T +1 + 1eT +1|T .

BF-08

10

eg. ARMA(1,1) chain rule (continued)

yT +1 = c + 1 yT + T +1 + 1T = yT +1|T + eT +1|T ,

yT +1|T = c + 1 yT + 1T ,

eT +1|T = T +1 ;

12 = 2

yT + 2 = c + 1 ( yT +1|T + eT +1|T ) + T + 2 + 1T +1 ,

yT + 2|T = c + 1 yT +1|T ,

eT + 2|T = 1eT +1|T + T + 2 + 1T +1 ;

22 = 12 12 + (1 + 12 ) 2

yT +3 = c + 1 ( yT + 2|T + eT + 2|T ) + T +3 + 1T + 2 ,

yT +3|T = c + 1 yT + 2|T ,

eT +3|T = 1eT + 2|T + T +3 + 1T + 2 ;

BF-08

32 = 12 22 + (1 + 12 ) 2

11

115

110

105

100

95

90

85

80

1965

1970

1975

1980

1985

1990

AR(0-4)

Search within

ARMA(4,4,)

AIC: MA(0-4)

AR(0-4)

AIC: ARMA(3,1)

SIC: ARMA(2,0)

BF-08

SIC: MA(0-4)

12

AIC: ARMA(3,1)

120

25

Series: Residuals

Sample 1962Q1 1993Q4

Observations 128

110

20

100

8

6

90

15

4

80

10

7.38e-05

0.041454

6.754276

-3.629406

1.412262

0.547303

6.518596

Jarque-Bera

Probability

72.41962

0.000000

-2

-4

1965

1970

1975

1980

1985

1990

0

-4

Residual

BF-08

Mean

Median

Maximum

Minimum

Std. Dev.

Skewness

Kurtosis

Actual

-2

Fitted

13

Forecasts: ARMA(3,1)

the long horizon point forecast is

approximately the unconditional

mean of y. Its forecast error

variance is approximately the

unconditional variance of y.

Forecast 94M1-06M4: ARMA(3,1) Model

116

108

112

104

108

100

104

96

100

92

96

92

88

88

84

84

80

80

1990

1991

1992

1993

1994

Y

YF

BF-08

YF_UP

YF_LO

14

EViews

'caemp.prg

wfcreate(wf=null) q 1961:1 2010:4

smpl 1961:1 1994:4

read caemp.dat y

'Plots

smpl 1961:1 1993:4

y.line

y.correl(16)

'Selecting models within ARMA(4,4)

smpl 1962:1 1993:4

matrix(5,5) aic

matrix(5,5) sic

ls y c

sic(1,1)=@schwarz

aic(1,1)=@aic

ls y c ma(1)

sic(1,2)=@schwarz

aic(1,2)=@aic

ls y c ma(1) ma(2)

sic(1,3)=@schwarz

aic(1,3)=@aic

ls y c ma(1) ma(2) ma(3)

sic(1,4)=@schwarz

aic(1,4)=@aic

ls y c ma(1) ma(2) ma(3) ma(4)

sic(1,5)=@schwarz

aic(1,5)=@aic

BF-08

for model selection, so that

models within ARMA(4,4) use

the same sample size.

'Checking residuals

eq1.correl(10)

eq1.hist

for !k=1 to 4

ls y c y(-1 to -!k)

sic(!k+1,1)=@schwarz

aic(!k+1,1)=@aic

ls y c y(-1 to -!k) ma(1)

sic(!k+1,2)=@schwarz

aic(!k+1,2)=@aic

ls y c y(-1 to -!k) ma(1) ma(2)

sic(!k+1,3)=@schwarz

aic(!k+1,3)=@aic

ls y c y(-1 to -!k) ma(1) ma(2) ma(3)

sic(!k+1,4)=@schwarz

aic(!k+1,4)=@aic

ls y c y(-1 to -!k) ma(1) ma(2) ma(3) ma(4)

sic(!k+1,5)=@schwarz

aic(!k+1,5)=@aic

next

aic.bar

sic.bar

'Preferred models

equation eq1.ls y c ar(1) ar(2) ar(3) ma(1)

equation eq2.ls y c ar(1) ar(2)

'Forecast exercise

smpl 1962:1 1993:4

eq1.makeresids res

genr yf=y-res

smpl 1994:1 2006:4

eq1.forecast yhat se

genr yf=yhat

genr yf_up=yhat+1.96*se

genr yf_lo=yhat-1.96*se

smpl 1990:1 1994:4

group fig1 y yf yf_up yf_lo

freeze(Figure1) fig1.line

Figure1.draw(shade, bottom) 1994:1 1994:4

show Figure1

smpl 1990:1 2006:4

group fig2 y yf yf_up yf_lo

freeze(Figure2) fig2.line

Figure2.draw(shade, bottom) 1994:1 2006:4

show Figure2

stop

15

Summary

Under MSFE, what is the optimal forecast?

What is a linear forecast?

What is the linear projection?

How do we find the point forecast and forecast

error from a general linear process?

Do you know how to use the chain rule to produce

point forecasts and forecast error variances for

ARMA(1,1)?

How do you make long horizon forecasts for a

stationary time series?

BF-08

16

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