Vector Autoregression Analysis

ARIMA(p, d, q) models are useful for univariate time series

analysis
When we have several time series, we need to take into account
the interdependence between them which creates endogeneity
Endogeneity is present when some of the independent
variables in a regression are correlated to the error term
cov( X t , ut ) 0
Endogeneity causes serious misspecification biases
What causes endogeneity?
Omitted Variables

Measurement Errors

Simultaneity While we consider one variable as exogenous, in reality

this variable might be influenced simultaneously by the depended
variable
VECTOR AUTOREGRESSION (VAR)
Vector autoregressive models (VARs) are used to deal with forecasting two
or more time series and structural analysis.
In VAR we have one equation for each variable and each equation contains
only the lagged values of that variable and the lagged values of all other
variables in the system.
As in the case of the univariate time series, in VAR we also require the time series
to be stationary.
If each variable in the VAR is already stationary, each equation in it can be
estimated by OLS.
If each variable is not stationary, we can estimate VAR only in the first-differences
of the series.
If individual variables in VAR are nonstationary, but are cointegrated, we can
estimate VAR by taking into account the error correction term, which is obtained
from the cointegrating regression.
This leads to vector error correction model (VECM).
 Vector Autoregression Analysis
p p
yt c1 1,i yt i 1, j xt j u1,t
i 1 j 1
p p
xt c2 2,i yt i 2, j xt j u2,t
i 1 j 1

One drawback of VAR(p) models is over parameterization.

Observe that in the above example we have to estimate more
no coefficients
On the other hand, VAR(p) models provide us important
features
Testing Causality
Impulse Response Analysis ( not in syllabus)
Variance Decomposition
 NATURE OF CAUSALITY

VAR modes can also be used to shed light on causality among variables.
The basic idea behind VAR causality testing is that the past can cause
the present and the future, but not the other way around.
Granger causality: In establishing causality, we must make sure that the
underlying variables are stationary. If they are not, we have to
difference the variables and run the causality test on the differenced
variables.
However, if the variables are nonstationary, but are integrated, we need
to use the error correction term to account for causality, if any.
 Vector Autoregression Analysis
Granger Causality Testing
We aim to decide whether x causes y, by examining how much
of the current y can be explained by past values of y lagged
values of x and to see whether adding lagged values of x can
improve the explanation
The y is said to be Granger-caused by x, if x helps in the
prediction of y, or equivalently if the coefficients on the lagged
xs are statistically jointly significant (using the F statistic)
Null Hypothesis: y does not Granger cause x H 0 : 2,1 2,2 ... 2, p 0
Null Hypothesis: x does not Granger cause y H 0 : 1,1 1,2 ... 1, p 0
It is possible to have one-way causation: only x Granger causes y
or only y Granger causes x, but also two-way causation is
frequently the case; x Granger causes y and y Granger causes x