Banco Central de Reserva del Per

63 Curso de Extensin Universitaria

2016

Econometra

Cointegration 2

Gabriel Rodrguez
Ponticia Universidad Catlica del Per

Gabriel Rodrguez, 2016

1. Introduction
Economic theory often implies equilibrium relationships between the
levels of time series variables that are best described as being I(1).
The statistical concept of cointegration is required to make sense of
regression models and VAR models with I(1) data.
2. Spurious Regression
If some or all of the variables in a regression are I(1) then the usual statistical results may or may not hold. One case in which the usual statistical results do not hold is spurious regression: when all the regressors
are I(1) and not cointegrated. That is, there is no linear combination
of the variables that is I(0).
Example: consider two independent and not cointegrated I(1) processes
y1t and y2t :
yit = yit
it

it

i:i:d: N (0; 1) i = 1; 2:

Statistical implications of spurious regression: Let Yt = (y1t ; :::; ynt )0

denote an (n 1) vector of I(1) time series that are not cointegrated.
Write Yt = (y1t ; Y2t0 )0 and consider regressing of y1t on Y2t
0
y1t = b2 Y2t + u
bt :

Since y1t is not cointegrated with Y2t , then (i) true value of
(ii) the above is a spurious regression and u
bt

I(1).

The following results are due to Phillips (1986):

is zero;

 b2 does not converge in probability to zero. Instead, it converges

in distribution to a non-normal random variable not necessarily

centered at zero.

The usual t-statistics for testing

is zero diverges to

1 as

T ! 1: Hence, using the usual asymptotic normal inference and

a large enough sample imply that Yt will appear to be cointegrated.

The usual R2 converges to unity as T ! 1. The model appears

to t well even though it is misspecied.
3. Denition of Cointegration
Let Yt = (y1t ; :::; ynt )0 denote an (n 1) vector of I(1) time series. Yt is
cointegrated if there exists an (n 1) vector = ( 1 ; ::: n )0 such that
0

Yt =

1 y1t

+ ::: +

n ynt

I(0):

The linear combination 0 Yt is frequently motivated by economic theory

and referred to as a long-run equilibrium relationship. I(1) time series
with a long-run equilibrium relationship cannot drift too far apart from
the equilibrium because economic forces will act to restore the equilibrium relationship.
Normalization: the cointegration vector

is not unique since for any

scalar c
c 0 Yt =

Yt

I(0):

Hence, some normalization assumption is required to uniquely identify

. A typical normalization is
y1t

2 y2t

:::

n ynt

= (1;

I(0) or y1t =

2 ; :::;
2 y2t

n)

+ :::: +

, so that
n ynt

Yt =

+ ut where

ut I(0). In long-run equilibrium, ut = 0 and the long-run equilibrium

relationship is y1t = 2 y2t + :::: + n ynt .

Multiple cointegrating relationships. If the (n

1) vector Yt is coin-

tegrated there may be 0 < r < n linearly independent cointegrating

vectors. For example, let n = 3 and assume there are r = 2 cointegrating vectors 1 = ( 11 ; 12 ;
and 02 Yt are I(0) and the 3
B0 =

0
1
0
2

0
13 )

and 2 = (
2 matrix
=

21 ;

11

12

13

21

22

23

22 ;

0
23 ) .

Then

0
1 Yt

forms a basis for the space of cointegrating vectors.

4. Examples of Cointegration in Economics and Finance
The permanent income model implies cointegration between consumption and income, with consumption being the common trend.
Money demand models imply cointegration between money, income,
prices and interest rates.
Growth theory models imply cointegration between consumption and
investment. Productivity is the common trend.
Purchasing power parity implies cointegration between nominal exchange rate and foreign and domestic prices.
Covered interest rate parity implies cointegration between forward and
spot exchange rates.
The Fisher equation implies cointegration between nominal interest
rates and ination.
The expectation hypothesis of the term structure implies cointegration
between nominal interest rates at dierent maturities.
The Law of One Price implies that identical assets must sell for the
same price to avoid arbitrage opportunities. It implies cointegration
between the prices of the same asset trading on dierent markets.
3

Cointegration between spot and future prices, spot and forward prices,
bid and ask prices.
5. Cointegration and Common Trends
If the (n

1) vector time series Yt is cointegrated with 0 < r < n coin-

tegrating vectors then there are n

r common I(1) stochastic trends.

Example: Let Yt = (y1t ; y2t )0

I(1) and t = ( 1t ; 2t ; 3t )0
I(0).
0
Assume that Yt is cointegrated with cointegrating vector = (1;
2) .
This cointegration relationship may be represented as
y1t =

t
X

1s

1s

2t

3t ;

s=1

y2t =

t
X
s=1

P
the common stochastic trend is ts=1 1s . Notice that the cointegration
relationship annihilates the common stochastic trend:
0

Yt = y1t
=

2 y2t
t
X

1s

3t

s=1

3t

t
X
(

1s

I(0):

2 2t

Example 1. A bivariate system with

= (1; 1)0 . It is given by

y1t = y2t + ut
y2t = y2t

+ vt

ut = 0:75ut
t

vt

2t )

s=1

i:i:d: N (0; 0:25)

i:i:d: N (0; 0:25):
4

Example 2. A trivariate cointegrated system with 1 cointegrating vector

= (1;

1;

0
2) :

y1t =

1 y2t

2 y3t

y2t = y2t

+ vt ;

y3t = y3t

+ wt ;

+ ut ;

where ut ; vt and wt are I(0).

Example 3. A trivariate cointegrated system with 2 cointegrating vectors. A triangular representation for this system with cointegrating
vector

= (1; 0;

0
13 )

and

= (0; 1;

y1t =

13 y3t

+ ut ;

y2t =

23 y3t

+ vt ;

y3t = y3t

23 )

is

+ wt ;

where ut ; vt and wt are I(0).

6. Cointegration and Error Correction Models
Consider a bivariate I(1) vector Yt = (y1t ; y2t )0 and assume that Yt
0
0
is cointegrated with cointegrating vector = (1;
Yt =
2 ) so that
y1t
I(0). Engle and Granger (1987) showed that cointegration
2 y2t

implies the existence of an error correction model of the form

y1t = c1 +

1 (y1t 1

2 y2t 1 )

11 (L)

y1t +

12 (L)

y2t +

1t ;

y2t = c2 +

2 (y1t 1

2 y2t 1 )

21 (L)

y1t +

22 (L)

y2t +

2t :

Example. Let yt denote the log of real income and ct denote the log of
consumption and assume that Yt = (yt ; ct )0 is I(1). The permanent income hypothesis implies that income and consumption are cointegrated
5

with

= (1; 1)0 :
ct =

+ yt + ut

= E[ct
ut

yt ]
I(0):

Assume that the ECM has the form

yt =

y (ct 1

yt

)+

yt ;

ct =

c (ct 1

yt

)+

ct :

The rst equation relates the growth rate of income to the lagged disequilibrium error, and the second equation relates the growth rate of
consumption to the lagged disequilibrium as well. The reactions of
yt and ct to the disequilibrium error are captured by the adjustment
coe cients y and c .
7. The Cointegrated VAR
Consider the levels V AR(p) for the (n
Yt = Dt +

1 Yt 1

1) vector Yt

+ ::: + pYt

for t = 1; 2; :::; T and where Dt are deterministic components.

The V AR(p) is stable is
det(In

1z

:::

pz

)=0

has all roots outside the complex unit circle.

If there are roots on the unit circle then some or all of the variables in
Yt are I(1) and they may also be cointegrated.
6

If Yt is cointegrated then the VAR representation is not the most suitable representation for analysis because the cointegrating relations are
not explicitly apparent.
The cointegrating relations become apparent if the levels VAR is transformed to the vector error correction model (VECM)
Yt = Dt + Yt
where

1 +:::+

In and

Yt

+ :::: +
Pp

j=k+1

p 1
j,

Yt

p+1

for k = 1; 2; :::; p 1.

In the VECM, the term Yt 1 is the only which includes potential I(1)
variables and for Yt to be I(0) it must be the case that Yt 1 is also
I(0). Therefore,

Yt

must contain the cointegrating relations if they

exist.
Two cases to be considered.
Rank( )=0. It implies that

= 0 and therefore that Yt

I(1)

and not cointegrated. The VECM reduces to a V AR(p

1) in

rst dierences:
Yt = Dt +

Yt

+ ::: +

p 1

Yt

p+1

0 < rank( ) = r < n. It implies that Yt is I(1) with r linearly

independent cointegrating vectors and n r common stochastic
trends (unit roots). In this case
(n

, where

and

are

r) matrices with rank( )=rank( )= r.

The rows of 0 form a basis for the r cointegrating vectors and the
elements of distribute the impact of the cointerating vectors to the
evolution of

Yt . The VECM becomes

Yt = Dt +
where

Yt

Yt

I(0) since

1
0

Yt

+ ::: +

p 1

Yt

p+1

+ t;

is a matrix of cointegrating vectors.

7

The factorization

is not unique since for any r

r nonsingular

matrix H we have
0

1 0

= HH

The factorization

= ( H)( H

10 0

) =a

only identies the space spanned by the

cointegrating relations. To obtain unique values of

and

requires

further restrictions on the model.

Example 1. A bivariate cointegrated V AR(1) model. Consider the
bivariate V AR(1) model for Yt = (y1t ; y2t )0
Yt =

1 Yt 1

+ t:

The VECM is
Yt =

Yt

+ t;

I2 :

Assuming Yt is cointegrated there exists a 2

1 vector

=(

1;

0
2)

such that
0

Yt =

Using the normalization

becomes

Yt = y1t

1 y1t

= 1 and

2 y2t

I(0):
, the cointegrating relation

y2t

This normalization suggests the stochastic long-run equilibrium relation

y1t = y2t + ut :
Since Yt is cointegrated with one cointegrating vector, rank( ) = 1, so
that
=

The elements in the vector

are interpreted as speed of adjustment

coe cients. The cointegrated VECM for

0

Yt =

Yt

Yt may be rewritten as

+ t:

Writing the VECM equation by equation gives

y1t =

1 (y1t 1

y2t 1 ) +

1t ;

y2t =

2 (y1t 1

y2t 1 ) +

2t :

8. Johansens Methodology for Modeling Cointegration

Specify and estimate a V AR(p) model for Yt .
Construct likelihood ratio tests for the rank of

to determine the

number of cointegrating vectors.

If necessary, impose normalization and identifying restrictions on the
cointegrating vectors.
Given the normalized cointegrating vectors estimate the resulting cointegrated VECM by maximum likelihood (ML).
8.1 Likelihood Ratio Tests for the Number of Cointegrating Vectors
To test the rank of matrix ; Johansen (1988, 1995) developed maximum
likelihood cointegration testing methods using the reduced rank regression
technique based on canonical correlations. The procedure consists of obtaining an n

1 vector of residuals r0t and r1t from auxiliary regressions (re-

gressions of Yt and Yt 1 on a constant and the lagged Yt 1 ... Yt p+1 ).

These residuals are used to obtain the (n n) residual product matrices:
Sij = (1=T )

T
X
t=1

0
rit rjt
;

(1)

for i; j = 0; 1: The next step is to solve the following eigenvalue problem

j S11

S10 S001 S01 j = 0

(2)

which gives the eigenvalues b1 > ::: > bn and the corresponding eigenvectors
b through b , which are also the cointegrating vectors. A test for the rank
n

of matrix

can now be performed by testing how many eigenvalues

equals

to unity.

The unrestricted cointegrated VECM is denoted by H(r). The I(1)

model H(r) can be formulated as the condition that the rank of

is

less than or equal to r. This creates a nested set of model

H(0)

:::

H(r)

:::

H(n)

where H(0) is a non-cointegrated VAR and H(n) is a stationary V AR(p).

Since the rank of the long-run impact matrix

gives the number of

cointegrating relationships in Yt , Johansen formulates likelihood ratio

(LR) statistics for the number of cointegrating relationships as LR statistics for determining the rank of Yt .
These LR tests are based on the estimated eigenvalues b1 > b2 > ::: >
bn of the matrix . These eigenvalues also happen to be equal to
the squared canonical correlations between Yt and Yt 1 corrected for

lagged

Yt and Dt and so lie between 0 and 1. Recall, the rank of

is equal to the number of non-zero eigenvalues of

The Trace Statistic

H0 (r0 ) : r = r0
H1 (r0 ) : r > r0
The trace statistic is given by
LRtrace (r0 ) =

n
X

i=r0 +1

10

ln(1

bi )

If rank ( ) = r0 then br0 +1 ; :::; bn should all be close to zero and

LRtrace (r0 ) should be small since ln(1 bi ) 0 for i > r0 .
If rank( ) > r0 then some of br0 +1 ; :::; bn will not be zero (but less
than 1) and LRtrace (r0 ) should be large since ln(1 bi ) << 0 for some
i > r0 .

The asymptotic null distribution of LRtrace (r0 ) is not chi-square but

instead is a multivariate version of the Dickey-Fuller unit root distribution which depends on the dimension n

r0 and the specication of

the deterministic components. Critical values for this distribution are

tabulated in Osterwald-Lenum (1992) for n r0 = 1; 2; :::; 10.
Sequential procedure for determining the number of cointegrating vectors
First test H0 (r0 = 0) against H1 (r0 > 0). If this is not rejected
then it is concluded that there are no cointegrating vectors among
the n variables in Yt .
If H0 (r0 = 0) is rejected then it is concluded that there is at least
one cointegrating vector and proceed to test H0 (r0 = 1) against
H1 (r0 > 1). If this null is not rejected then it is concluded that
there is only one cointegrating vector.
If the H0 (r0 = 1) is rejected then it is concluded that there is at
least two cointegrating vectors.
The sequential procedure is continued until the null is not rejected.
The Maximum Eigenvalue Statistic
H0 (r0 ) : r = r0
H1 (r0 ) : r = r0 + 1

11

The LR statistic is given by

LRmax (r0 ) =

T ln(1

br

0 +1

):

The asymptotic null distribution is not chi-squared but instead is a

complicated function of Brownian motion, which depends on the dimension n

r0 and the specication of the deterministic components.

Critical values are tabulated in Osterwald-Lenum (1992) for n

1; 2; :::; 10.

r0 =

8.2 Specication of the deterministic terms

The deterministic terms are restricted to the form
Dt =

1t

If the deterministic terms are unrestricted then the time series in Yt

may exhibit quadratic trends and there may be a linear trend in the
cointegrating relationships. Restricted versions of the trend parameters
0

and

limit the trending nature of the series in Yt . The trend

behaviour of Yt can be classied into ve cases:

Model H2 (r) :

= 0 (no constant)
0

Yt =

Yt

Yt

+ ::: +

p 1

Yt

p+1

In this case all series in Yt are I(1) without drift and the cointegrating
relations 0 Yt have mean zero.
Model H1 (r) :

Yt = ( 0 Yt

0
0)

(restricted constant)

Yt

+ ::: +

p 1

Yt

p+1

In this case the series in Yt are I(1) without drift and the cointegrating
relations

Yt have non-zero means

12

0.

Model H1 (r) :

Yt =

(unrestricted constant)

0
0

Yt

Yt

+ ::: +

Yt

p 1

In this case the series in Yt are I(1) with drift vector

tegrating relations 0 Yt may have a non-zero mean.
Model H (r) :
Yt =

+ ( 0 Yt

+
1

1t

tegrating relations
Model H(r) :

Yt =

1 t)

Yt

+ ::: +

1t

Yt have a linear term

+

1t
0

Yt

and the coin-

(restricted trend)
p 1

In this case the series in Yt are I(1) with drift vector

0

p+1

Yt
0

p+1

and the coin-

1 t.

(unrestricted constant and trend)

1

Yt

+ ::: +

Yt

p 1

p+1

In this case the series in Yt are I(1) with a linear trend (quadratic trend
in levels) and the cointegrating relations

Yt have a linear trend.

8.3. Maximum Likelihood Estimation of the Cointegrated VECM

If it is found that rank( ) = r, 0 < r < n, then the cointegrated
VECM
Yt = Dt +

Yt

Yt

+ ::: +

p 1

Yt

p+1

becomes a reduced rank multivariate regression. Johansen derived the

maximum likelihood estimation of the parameters under the reduced
rank restriction rank( ) = r. He shows that:
b

= (b
v1 ; :::; vbr ), where vbi are the eigenvectors associated with the
eigenvalues bi .
mle

13

The MLEs of the remaining parameters are obtained by least squares

estimation of
Yt = Dt +

Yt

Yt

+ ::: +

p 1

Yt

p+1

8.4. Testing linear restrictions on

The Johansen MLE procedure only produces an estimate of the basis
for the space of cointegrating vectors. It is often of interest to test if
some hypothesized cointegrating vector lies in the space spanned by
the estimated basis:
H0 :
where
0

0
0

is a (r

0
0

is a s

r matrix of hypothesized cointegrating vectors, and

s)

n matrix of remaining unspecied cointegrating vec-

tors. Result: Johansen showed that a likelihood ratio statistic can be

computed, which is asymptotically distributed as a
degrees of freedom.

with s(n

r)

9. Cointegration and the Beveridge-Nelson (BN) Decomposisition

The Granger Representation Theorem (GRT) provides an explicit link
between the VECM form of a cointegrated VAR and the Wold or moving average representation.
The GRT also provides insight into the Beveridge-Nelson decomposition of a cointegrated time series
Let yt be cointegrated with r cointegrating vectors captured in the r n
matrix

so that

yt is I(0). Assume
yt =
(L) =

+ (L)ut
1
X
k=0

= In :
14

yt has the Wold representation

kL

Using the fact

(L) =

L) e (L), the BN decomposition of

(1) + (1

yt is given by

yt = y0 + t + (1)

t
X
k=1

ut = e (L)ut :
0

Multiplying both sides by

0

yt =

t+

(1)

1
X

ut +
0

yt is I(0) we must have that

and has rank n

covariance of

(y0 + u
et

(1) = 0 and

r. The singularity of
yt which is

u
e0

to give

k=1

Since

ut + u
et

u
e0 ):

(1) is singular

(1) implies that the long-run

(1) (1) is singular and has rank n

r.

Now assume that yt has the VECM representation

(L) yt = c + yt

r matrices

and

+ ut

=
where the n

both have rank r. The GRT gives an

explicit mapping from the BN decomposition to the parameters of the

VECM. Dene the n (n r) full rank matrices ? and ? such that

= 0,

rank( ;
(

0
?

?)

(1)

0
?( ?

?)

(1)

=0

= n, rank( ;
1
?)

?)

=n

exists where (1) = In

1

0
?

0
?

(1)

?)

Pp

1
i=1

1 0

= In

Theorem GRT. If det[A(z)] = 0 implies that jzj > 1 or z = 1 and

rank( ) = r < n, then there exist n
15

r matrices

and

of rank r

such that
I(0) is that

=
0
?

. A necessary and su cient condition for

(1)

yt to be

has full rank. Then the BN decomposition of yt

has the representation

yt = t + (1)

t
X
k=1

where

(1) =

0
?( ?

(1)

?)

0
?.

ut + y 0 + u
et

u
e0

yt is a cointegrated process with

0

cointegrating vectors given by the rows of

The main part of the GRT is the explicit representation of

0
?( ?

(1) =

(1)

?)

(1)

0
?:

Notice that
0

(1) =
(1)

0
?( ?

0
?( ?

(1)

(1)

?)

?)

0
?

0
?

=0
=0

The common trends in yt are extracted using

T St =

(1)

t
X

ut

k=1

?(

0
1
? ( ? (1) ? ) .
P
combinations 0? tk=1 ut :

where

0
?

0
?
t
X

(1)

?)

0
?

t
X

ut

k=1

ut

k=1

Hence the common trends are the linear

9.1. The GRT in a Cointegrated Bivariate VAR(1) Model

16

To illustrate the GRT, consider the simple cointegrated bivariate VECM

0

yt =

yt

+ ut

where = ( 0:1; 0:1)0 and = (1; 1)0 . Here there is one cointegrating
vector and one common trend. It may be deduced that
(1) = I2 ;
= (1; 1)0 ;

0
?

= (1; 1)0 ;

(1)

= 2:

The common trend is then given by

T St =

0
?

t
X

Pt
u1t
Pk=1
t
k=1 u2t

ut = (1; 1)

k=1

t
X

u1t +

t
X

u2t

k=1

k=1

and the loadings on the common trend are

=
Now assume that

0
?( ?

(1)

?)

1=2
1=2

= ( 0:1; 0:0)0 so that y2t is weakly and strongly

exogenous. The VECM has the simplied form

0:1 0 yt

y1t =

+ u1t

y2t = u2t
Therefore
(1) = I2 ;
?

0
?

(1)

17

= (0; 1)0 ;
= (1; 1)0 ;
= 1:

Then the common trend is

T St =

0
?

t
X

ut = (0; 1)

k=1

Pt
u1t
Pk=1
t
k=1 u2t

t
X
k=1

The loadings on the common trend are

=

0
?( ?

(1)

18

?)

1
1

u2t = y2t :