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Erdin

ECO 310

1.

A stochastic process (a collection of random variables ordered in time, e.g. GDP(t)) is said to

be (weakly)

stationary

if its mean and variance are constant over time, i.e. time invariant (along

with its autocovariance). Such a time series will tend to return to its mean (mean reversion) and

uctuations around this mean will have a broadly constant amplitude. Alternatively, a stationary

process will not drift too far away from its mean value because of the nite variance.

By contrast, a

nonstationary

or both.

with

Cov(ut , uts ) = 0

Example 1.

A Random Walk Model (RWM) is a nonstationary process. There are two types: a)

a)

Yt = Yt1 + ut

where value of Y at time t is equal to its previous value and a random shock.

process without a drift such that there is no scope for protable speculation in the stock market:

the change in the stock price from one period to the next is essentially random and unpredictable.

Y1 = Y0 + u1 , Y2 = Y1 + u2 , Y3 = Y2 + u3 and replacing, Y3 = Y0 + u1 + u2 + u3

P

such that Yt = Y0 +

ut Therefore, E(Yt ) = Y0 since errors have zero expectation. Similarly,

2

V ar(Yt ) = t i.e. it is dependent on time, not time invariant. Hence, RWM without a drift is a

We can write:

nonstationary

process: Although its mean is constant over time, its variance increases over time. In

this model, shocks persist as the current value is equal to the initial value plus a series of random

shocks over time. A RW has a innite memory!

P

P

and replacing, Y3 = + + + Y0 + u1 + u2 + u3 such that Yt =

+ Y0 + ut Therefore,

E(Yt ) = t + Y0 since errors have zero expectation. Similarly, V ar(Yt ) = t 2 Hence, RWM with a

b)

nonstationary

nonstationary

drift is a

again a

process: Both its mean and its variance increase over time such that it is

process.

= 1.

If in fact,

= 1,

case of nonstationarity (RW models are nonstationary as they contain a unit root!). If

the series

Yt

|| > 1

|| < 1,

then

2.

ECO310, Econometrics

Prof. Erdin

and

t2 ,

we call it a

deterministic trend (predictable). If it is not predictable, we have a stochastic trend. Consider the

following model:

Yt = + 1 t + 2 Yt1 + ut

where

ut

and

2 = 1.

iid.

Yt = Yt1 + ut .

because E(4Yt ) =

V ar(4Yt ) = V ar(ut ) = 2 . Both are time-invariant. Hence, a random

If we dierence, we get

E(ut ) = 0

and

walk without

and

2 = 1

E(4Yt ) = E( + ut ) = and V ar(4Yt ) = V ar(ut ) = 2 . Both are

we dierence, we get

again time-invariant. Hence, a

random walk with a drift is also dierence-stationary (DS). Also note that in this case,

upward or downward depending on the sign of the drift

Yt

is trending

Deterministic Trend: 6= 0, 1 6= 0,

the mean of the series, E(Yt ) = E( + 1 t) = + 1 t , which is time-varying but its variance,

V ar(Yt ) = V ar( + 1 t + ut ) = 2 which is time-invariant. Still, the series with a deterministic trend

is non-stationary! Once we know the values of and 1 (we can estimate them by regressing the

series on t), we can also estimate the mean value and forecast it perfectly. Hence, we can subtract

and

the mean from the series (detrending) and create detrended series which are stationary.

Yt = + 1 t + Yt1 + ut

and

4Yt = + 1 t + ut

2 = 1.

We get

is still time-varying

and hence, the mean of the dierenced series is nonstationary! Detrending is still necessary on the

dierenced series to make it stationary.

3.

are white noise.

= Yt1 + ut

instance, in Yt = + Xt + t where

and

is white noise error, we can obtain a spurious regression: We will get a highly signicant slope

R2 value

2

value for the R as well as highly signicant

to conclude that the variable X has a signicant impact on Y whereas a priori there should be none.

In fact, this regression is meaningless!

R2 > d

where

is durbin-watson statistic, is a good rule of thumb for suspecting that the estimated regression is

spurious.

ECO310, Econometrics

regression but if the original series are random walks such that Yt = Yt1 +ut and Xt = Xt1 +t , then

Yt = ut and Xt = t and regressing one on the other should generate a R2 which is practically

close to zero (intuition: a random shock regressed over another should show no correlation) and d

Also it must be noted that the dierenced series,

Yt

Prof. Erdin

and

is close to 2 (i.e. no serial correlation). This is yet another way to verify that the original series are

random walks.

Although quite dramatic, this is a strong reminder that one should be cautious in running regressions with such nonstationary series.

4.

There are several tests of stationarity, we will focus on a test which became popular over the past

years: This is the unit root tests (Dickey-Fuller tests).

The starting point is the following autoregressive process:

Yt = Yt1 + ut .

When

= 1,

we

have a unit root and a random walk without a drift. In principle, we can run this regression and

see if

=1

to check for a nonstationary random walk (unit root) process but we can not estimate

a model regressing the series on its lagged value to see if the estimated rho is equal to 1 because

in the presence of a unit root, the t-statistics for the

manipulate this equation and express it somewhat dierently subtracting the lagged value from both

sides.

Let us call ( 1) = , then Yt = Yt1 + ut

and test

against HA :

In practice, we can estimate this model (in Stata, reg d.Y l.Y, noconstant) and obtain

the hypothesis:

H0 : = 0

if = 0, then from ( 1) = we

can conclude that

=1

series is nonstationary) and we can not reject the null! Also, note that the alternative hypothesis

sets

< 0

< 1

(we reject the null and conclude there is no unit root and

>1

The problem is that we can not rely on the usual t-test on the signicance of

!!!

The alternative

is to use the Dickey-Fuller test statistic with its own critical values for each of the following three

specications.

4.1.

errors (residuals) are serially uncorrelated. In principle, 3 specications can be tried, depending on

whether the series show a trend or not.

b) Yt = + Yt1 + ut A random walk (with drift, no time trend)

a)

ECO310, Econometrics

Prof. Erdin

Note that for each case, H0 : = 0 (i.e. there is a unit root, and the series

has a stochastic trend) against HA : < 0 (i.e. there is no unit root and the

c)

it

is nonstationary or

series is stationary,

Short method:

regress.

The results report a MacKinnon p-value. If this p-value<, then reject the

null in each case. If not, then do not reject the null and conclude there is a unit root!

Alternatively,

Long Method:

Yt1

or its coecient,

and reject

the null if and only if the | t-statistic| > |df critical|. Note that you should take the absolute value of

both values when comparing and furthermore, you should use dierent dickey-fuller critical values

(df critical) for each 3 specications (trial and error! no specication is correct among the three a

priori, some graphical sense of the series may help).

DF critical values: b) at 1%, (-3.43), at 5% (-2.86) and at 10% (-2.57), c) at 1%, (-3.96), at 5%

(-3.41) and at 10% (-3.12)

These critical values also apply for the augmented DF test with lagged terms and Stata under

dfuller also report critical values.

4.2.

der the assumption that the errors (residuals) may be serially correlated.

augmenting the preceding 3 equations by adding the lagged values of the dependent variable,

Yt

to the specications to eliminate the serial correlation. Formally, the test is based on the following

equation.

Yt = a0 + Yt1 + a1 t +

m

X

i Yti + t

i=1

where

The number

of lagged dierenced terms is often determined empirically, the idea being to include enough terms

so that the the error term is indeed serially uncorrelated (so that we can obtain unbiased estimates

of the

Yt1 ).

for instance, based on minimizing the Akaike Information Criterion (AIC) (after the regression:

estat aic

reg

If we have quarterly data, we can set

m=4

To estimate this regression in Stata, issue the command:

Example 2.

ECO310, Econometrics

Prof. Erdin

Consider the class exercise on r6 (6 month T-bill rate) vs r3 (3 month T-bill rate)

with the UnitRootTest_USinterestrates.smcl le under Stata Output folder. In line 28, a df test is

conducted with one lag, no trend but a drift (case b, augmented). The t-statistic for lagged term

is -2.25 (or z(t)=-2.25) . Applying the long test, we obtain the result: Do not reject the null since

|-2.25| < |-2.86| at 5% signicance. Hence, we can not reject the unit root in r3 series! Note that

the Mackinnon p-value= 0.1887 > 0.05=alpha, conrming the previous result.

5.

6.

contain a unit root.

integrated of order 1

Yt

and

Xt

both are

two series contain a common stochastic trend that their regression will not necessarily be spurious.

In this case, despite the trend, they will move together over time such that they will be cointegrated.

Economically speaking, two series will be cointegrated if they have a long term, or equilibrium

relationship between them.

movement over time, indicating that that there is a stable long term equilibrium between them. For

instance, the quantity theory of money implies that a long term stable relationship exists between the

money growth and ination i.e. these series might be cointegrated (even when they are individually

random walks).

From nance theory, we expect the 6-month T-bill rate and the 3-

month T-bill rate to be cointegrated. Otherwise, one can exploit the discrepancy between these two

rates and make a prot (which should not persist in the long run equilibrium). Before we specify

a cointegration regression between these two variables to check for the presence of cointegration,

we test whether these series are stationary, trend stationary or dierence stationary (with the same

order of integration, for instance, I(1) process).

Regressing

t = 0.1354 + 1.0259r3t

r3t , we get the following equation: r6

r6t

on

r6t

and

with a

R2 = 0.9932

(line 45)

Since both

r3t

are nonstationary (see the unit root tests in the same smcl le), there is

a possibility for a spurious regression. Note also that in line 36 and 37, rst dierencing eliminates

the unit roots in both

r6t

and

r3t

so they are integrated order 1, I(1) processes. So, we can run the

When we obtain the residuals from this regression,

u

t

u

t

series do not drift too much apart from each other: the residual which is a linear combination of

these two series is stationary and hence, there is cointegration between the two variables!

ECO310, Econometrics

there is no cointegration between

there is cointegration between

r6t

r6t

and

r3t

and

r3t ).

) and

Prof. Erdin

H0 : u

t has a unit root and nonstationary

HA : u

t has no unit root and stationary

(i.e.

(i.e.

Note that in the smcl le on USinterest rates, several dierent unit root tests on

u

t

have been

tried and in each case, we nd that the Mackinnon p-value < alpha such that we reject the null of

no cointegration in favor of cointegration between these two rates. Indeed, there exists a longrun

equilibrium between the two series.

Important note:

cointegration exists based on a unit root test of its residuals. As an example, suppose you run the

above cointegration regression, save the residuals under uhat and conduct a unit root test on uhat

to check for cointegration.

is no cointegration. In this case, also try to rerun the regression with a time variable, again save

uhat2 and perform the cointegration test on uhat2. In this case, there is a possibility that uhat2

will this time be stationary, suggesting cointegration between the interest rates. This result implies

that uhat2 is stationary (no unit root) around a deterministic trend, still implying cointegration.

7.

According to Granger, cointegration check is necessary to avoid spurious regressions. When two

random walk (nonstationary, unit root) variables (integrated of order 1, I(1)) are cointegrated, then

an error correction model can be formulated to study their shortrun dynamics.

Example 3.

Assume that nance theory describes the longrun relationship between a 6 month and

r6 = + r3

where

bill over the 3 month bill. Let us formulate a regression model for this theory:

r6t = + r3t + ut

where

the theory.

and

reg

r6 r3

We expect

and

= 1

in line with

series are random walks with unit roots as we established before through dickey-fuller tests, unless

of course they are cointegrated. We have also tested for cointegration between these variables and

conrmed that there exists a longterm stable equilibrium relationship between these series, i.e. there

exists cointegration. This implies that the above regression is a meaningful cointegration regression

describing their longrun comovement.

Once we establish cointegration, we can also study the short-run dynamics in an error-correction

model. This enriches our understanding of how the series adjust to longrun equilibrium when and

if they deviate in the shortrun from this stable pattern of longrun behavior.

error-correction model under the simplifying assumption that

Here is a simple

u

t1 =

r6t1

r3t1 .

ECO310, Econometrics

Prof. Erdin

sradjt = u

t1

a) reg r6 r3, b) predict uhat, residuals ad c) gen sradj=l.uhat) and add this term to the equation in

dierences which forms our error correction model.

Note that the coecient of the sradj variable,

expected be of

negative

sign!

Intuition:

Assume that

at some time

t1

such

that there is a short-run disequilibrium in this market. As is well-known, this will drive the price

of

r6

t,

correcting partially the disequilibrium (it may take some time for the long-run equilibrium to be

bonds up and hence should reduce, at least to some extent, the yield,

r6t

restored with equality in the above model), hence, one should expect that when the

there should be a negative change in

r6t

i.e.,

4r6t < 0

Let us estimate the above model by running the Stata comamnd: reg d.r6 d.r3 sradj. Check the

sign of the estimated

in this regression and conrm that it is negative. Its value indicates what

proportion of disequilibrium is corrected each time period, i.e. it should be less than 1!

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