Econ2209 Week 5

Business Forecasting
ECON2209
Slides 05
Lecturer: Minxian Yang
BF-05
my, School of Economics, UNSW
Ch.7 Characterising Cycles
Lecture Plan
Big picture:
yt = mt + st + xt ,
st + p = st ,
s
k =1
t +k
= 0,
E( xt ) = 0
Stochastic processes
Strictly stationarity and covariance stationarity
Autocorrelation (ACF) and partial ACF
White noise and its ACF sampling distribution
Wolds theorem
Conditional expectations
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Characterising Cycles (Ch.7)

Notation change:
We use yt for the cycle component in this chapter.
Assume that yt is observable.
Cycle, stochastic process, time series
Cycle yt is described as a stochastic process (SP).

SP is a random variable dependent on time index.
yt is a random variable for each fixed t.
yt is a sample path (or time series, or realization) for
each fixed outcome.
Observed time series is a realisation (sample-path)

of the underlying SP.
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A random variable
for fixed t (eg. t= 30).
-2
SamplePathsofaStochasticProcessyt
10
20
30
40
50
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Discrete-time SP: { yt } = {..., y1 , y0 , y1 , y2 , y3 ,...}.
eg. monthly inflation rate of 2025
Continuous-time SP: { yt : a < t < b}.

eg. US/AUS exchange rate on Friday
We only cover discrete-time SP.
Main issues
Understand the characteristics of SP via a time
series, which is a realisation of SP.
In particular, find out SPs dependence structure.
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Expectation operations E
Many characteristics of SP are given by the expected
values.
Here are some useful rules of mathematical expectations.
Let X and Y be random variables and a be a constant.
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Strictly stationary process

The distribution of yt generally depends on t.
When it does not, yt is said to be strictly
stationary.
Precisely, a SP is strictly stationary if its joint
distribution at any set of points in time is invariant
to any time-shift, ie, the joint distribution at t+s is
the same as that at t for any s.
No matter at which point in time you observe a
stationary SP, the joint distribution is the same.
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Suppose yt is strictly stationary. Then
Its distributions at t = 1, 2, ... are the same;
So are its joint distributions at t = (2,6), (3,7), (4,8), ...;
So are its joint distributions at t = (1,3,5), (2,4,6), (3,5,7), ...;
...
SomeRealisationsofaStationaryProcessy
1
0
-1
-3
-2
Yt
Also, its mean and

variance (if exist)
are independent of t.
10
Time
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Stationary processes are statistically tractable and
rich enough for many applications. But they differ
from random samples.
A random sample from a population consists of many
independent realisations.
We learn the population/distribution via a large sample
(LLN and CLT).
A time series sample consists of one sample path, ie,
one realisation.
Only when the underlying SP is stationary (and ergodic), we
may learn the properties of SP via a long time series.
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eg. US 10-year treasury bond
yield (monthly):
stationary?
Unlikely, because its behaviour
differs markedly in sub-periods.
10-year T-bond Yield

16
14
12
10
8
6
4
2
65
eg. Department stores turnover

1982.04 1999.10,
cyclical component:
Stationary?
Likely.
75
80
85
90
95
00
05
Cycle
.12
.08
.04
.00
-.04
-.08
-.12
82
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70
84
86
88
90
92
94
96
98
10
Auto-covariance
Covariance of x and y:
Cov( x, y ) = E[( x x )( y y )],
x = E( x),
y = E( y ).
Auto-covariance of yt and yt-:

(t , ) = Cov( yt , yt ) = E[( yt Eyt )( yt Eyt )],
= 0, 1, 2, 3, ... .
When = 0, (t,0) is simply the variance of yt.

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11
Covariance stationary processes

When the mean and autocovariance of yt exist and
are independent of t,
E( yt ) = ,
Cov( yt , yt ) = ( ), = 0, 1, 2, 3, ... ,
{yt} is said to be covariance stationary.

For a covariance stationary process,
(0) = Var( yt ) = 2 ,
( ) = ( ), = 1, 2, 3, ... .
Strict stationarity and existence of variance

imply covariance stationarity.
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12
Sample autocovariance
1 T
= yt ,
T t =1
1 T
( ) = ( yt )( yt ), = 0, 1, 2, 3, ... ,
T t = +1
eg. Department stores turnover, 1982.04 2005.04,

cyclical component
Autocovariance/Var (variance=0.0014)
Cyclical Component of Retail Turnover: 1982:04 - 2005:04
.2
.15
.10
.1
.05
.0
.00
-.1
-.05
-.10
-.2
-.15
-.3
-.20
-.4
-.25
82
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84
86
88
90
92
94
96
98
00
02
04
10 11 12
13
Autocorrelation function (ACF)

For a stationary process, the autocovariance
depends only on displacement (not time index t).
The ACF is defined as
( ) =
Cov( yt , yt )
( )
=
,
Var ( yt )Var ( yt ) (0)
= 0,1,2,3,....
free of measurement unit;

-1 () 1;
(-) = () .
Sample ACF:
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( )
( ) =
,
(0)
= 0,1,2,3,....
14
Patterns of ACF
Exponential decay with/out cut-off (stationary series)
Close to 1 with very slow decay (non-stationary, unit root)
Seasonal peaks (presence of seasonality)
ACF: exponential decline with cut-off
ACF: exponential decline with oscillation

0.8
1.0
0.4
0.5
0.0
0.0
-0.4
-0.5
-0.8
-1.2
-1.0
1
10
11
12
10
11
12
ACF: seasonal effects
ACF: very slow decline

1.0
1.00
0.8
0.6
0.95
0.4
0.2
0.90
0.0
-0.2
-0.4
0.85
1
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10
11
12
10
12
14
16
18
20
22
24
15
Partial autocorrelation function (PACF)

Chain effect: (2) is non-zero because
either yt is directly related to yt-2;
or yt is related to yt-1 that is in turn related to yt-2;
or both.
PACF p(2) measures the direct relation between

yt and yt-2, after controlling for the effects of yt-1.
In general, PACF p() measures the direct relation
between yt and yt-, after controlling for the effects
of yt-1,..., yt-+1.
t-, t-+1,...
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, t-1, t
16
Sample PACF
Computation of p ( )
p (0) = 1;
For each = 1,2,3,..., run OLS of yt on [1, yt 1 ,..., yt ] and
p ( ) = estimated coefficient on yt .
eg.
p (1) is the estimated 11 in the regression
yt = 10 + 11 yt-1 + error.
yt = 20 + 21 yt-1 + 22 yt-2 + error.
yt = 30 + 31 yt-1 + 32 yt-2 + 33 yt-3 + error.
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17
Theoretical PACF
Theoretical PACF can be described as the limit of
sample PACF as sample size increases to infinity.
Or, p() is defined as a function of autocovariances
[(0), (1), , ()],
p ( ) = ,
1 (0)
(1)
2
( 1)
( 2)
=

(
1
)
(
2
)
(
0
)

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(1)
( 0)
(1)
(2)
.
(
)
18
Example & EViews
8
7
e.g. Department stores turnover,

1982.04 2005.04,
cyclical component from X12
Find the correlogram of y
y.correl(12)
6
5
4
Y_SF
Y_SA
Y_TC
Y_IR
2
1
0
-1
82 84 86 88 90 92 94 96 98 00 02 04

.15
.10
.05
.00
-.05
-.10
-.15
-.20
-.25
82
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84
86
88
90
92
94
96
98
00
02
04
19
White noise (WN) process

WN is a building block of time series models.
WN, {t}, is a serially-uncorrelated SP with zero
mean and constant finite variance.
t ~ WN(0, 2 ) : E( t ) = 0, Var( t ) = 2 , Cov( t , t ) = 0, for 0.
If t is iid (0,2), it is also a WN (called iid WN)

process. But WN is not necessarily iid.
ACF and PACF of a WN process
1, if = 0
( ) =
;
0, if 0
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1, if = 0
p ( ) =
.
0, if 0
20
Sampling properties of the ACF of WN

Let {1, 2,, T} be the sample path of an iid WN process.
The sample ACF
1
=
T
( ) =
t =1
( )
,
(0)
1
( ) =
T
t = +1
)( t ),
= 0, 1, 2, 3, ... ,
has the sampling distribution

T ( ) approx. ~ N (0,1),
T 2 ( ) approx. ~ 2 (1).
for large T. This is also true for PACF.

Useful to check if residuals from a model are serially
correlated.
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21
Test for autocorrelation

Null hypothesis H0: time series {et} is WN.
Reject H0 if | T ( ) | is too large.
Approximate 95% confidence band (Bartlett)
[0 2 / T , 0 + 2 / T ].
ACF is inside the band with probability 0.95 under H0.
Ljung-Box test
1
2 ( ),
=1 T
QLB = T (T + 2)
approx. ~ 2 (m),
where m should be less than T .

Reject H0 if QLB is too large.
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22
Test for autocorrelation

eg. Department stores turnover, 1982.04 2005.04,
P(2(1) > 31.946) = 0.000
cyclical component, 2/ T 0.12
No AC is rejected.
.15
.10
.05
.00
-.05
-.10
-.15
-.20
-.25
82
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84
86
88
90
92
94
96
98
00
02
04
23
Wolds representation theorem

A zero-mean covariance-stationary process {yt}
can be represented as the linear process,
yt = bi t i ,
i =0
where
2
b
i < ,
i =0
t ~ WN(0, 2 ),
b0 = 1.
If E(yt) = 0, the theorem applies to (yt - ).

t may be interpreted as 1-step forecast error of the
best linear predictor based on {yt-1, yt-2 , }.
Impulse response:
IR (i ) = bi =
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yt
,
( t i / )
i = 0,1,2,...
24
Conditional moments
Unconditional moments E(yt), Var(yt), Cov(yt, yt+)
do not take into account observed information.
Information set t-1 = {yt-1, yt-2, yt-3, } holds
observations up to t 1.
The conditional moments on given t-1
E(yt|t-1), Var(yt|t-1), Cov(yt, yt+|t-1)
are most relevant in forecasting.
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25
Conditioning on information set

Unemployment
1200
1000
800
'000
eg.
Predict
at Feb/82
Predict
at Feb/88
Predict
at Feb/94
600
400
200
0
Feb-98
Feb-96
Feb-94
Feb-92
Feb-90
Feb-88
Feb-86
Feb-84
Feb-82
Feb-80
Feb-78
Different info set lead to different forecasts.

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26
Conditional moments
eg. Conditional mean and variance of AR(1)
t-1 = {yt-1, yt-2, yt-3, },
yt = a + byt-1 + t,
t = , 2, 1, 0, 1, 2, 3, ,
t ~ iid WN(0, 2) , indepedent of t-1,
(a, b, 2) being constant parameters.
E ( yt | t 1 ) = E (a + byt 1 + t | t 1 )
= E (a + byt 1 | t 1 ) + E ( t | t 1 )
by Rule 2
= a + byt 1 + E ( t ) = a + byt 1.
var( yt | t 1 ) = E [ yt E ( yt | t 1 )]2 t 1
= E (t2 | t 1 ) = E (t2 ) = 2 .
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by Rule 3,4
)
by Rule 4
27
Summary
What is a stochastic process (SP)?
Which component of a time series is treated as a SP?
What is a strictly stationary SP? A covariance
stationary SP? What are the differences/similarities?
What is the autocorrelation function (ACF) of a SP?
And partial ACF (PACF)?
How do you compute sample ACF and PACF?
What is a white noise (WN) process? Is it stationary?
What are its ACF and PACF?
What does Wolds representation theorem tell you?
How do you find conditional expectations?
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28

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Econ2209 Week 5

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Business Forecasting

Lecturer: Minxian Yang

my, School of Economics, UNSW

Ch.7 Characterising Cycles

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Characterising Cycles (Ch.7)

Cycle, stochastic process, time series

Cycle yt is described as a stochastic process (SP).

Observed time series is a realisation (sample-path)

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Cycle, stochastic process, time series

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Cycle, stochastic process, time series

Continuous-time SP: { yt : a < t < b}.

We only cover discrete-time SP.

my, School of Economics, UNSW

Ch.7 Characterising Cycles

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Strictly stationary process

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Strictly stationary process

Also, its mean and

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Strictly stationary process

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Strictly stationary process

10-year T-bond Yield

eg. Department stores turnover

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Auto-covariance of yt and yt-:

When = 0, (t,0) is simply the variance of yt.

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Covariance stationary processes

{yt} is said to be covariance stationary.

Strict stationarity and existence of variance

my, School of Economics, UNSW

Ch.7 Characterising Cycles

eg. Department stores turnover, 1982.04 2005.04,

Cyclical Component of Retail Turnover: 1982:04 - 2005:04

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Autocorrelation function (ACF)

free of measurement unit;

my, School of Economics, UNSW

Ch.7 Characterising Cycles

ACF: exponential decline with oscillation

ACF: seasonal effects

ACF: very slow decline

my, School of Economics, UNSW

Ch.7 Characterising Cycles

Partial autocorrelation function (PACF)

PACF p(2) measures the direct relation between

my, School of Economics, UNSW

Ch.7 Characterising Cycles

my, School of Economics, UNSW