Homogeneity

Inthisissue,thethirdtutorialinourdatapreparationseries,wewilltouchonthethirdmostimportant assumptionintimeseriesanalysis:Homogeneity,ortheassumptionthatatimeseriessampleisdrawn fromastable/homogeneousprocess. Wellstartbydefiningthehomogeneousstochasticprocessandstatingtheminimumstationary requirementsforourtimeseriesanalysis.Thenwedemonstratehowtoexaminethesampledata,draw afewobservations,andhighlightsomeunderlyingintuitionsbehindthem.

Background
Instatistics,homogeneityisusedtodescribethestatisticalpropertiesofaparticulardataset.In essence,itstatesthatstatisticalpropertiesofanypartofanoveralldatasetarethesameasanyother part. Whatdowemeanbystatisticalproperties?Astrictwayoflookingathomogeneitywouldinvolve examiningthechangestothewholeofthemarginaldistribution,buttimeseriesanalysisonlydemands thatweconsiderthelocationstabilityovertime(versustrend)andthestabilityoflocalfluctuationover time.

What does this mean?

Intimeseriesanalysis,weareconcernedwiththestabilityoftheunderlyingstochasticprocessover time.Dowehavestructuralchanges?Ifchangesexistbutgoundetected,wefindourselvesinoneof severaldifficultsituations: 1. Theproposedmodelofferslittleexplanationforthedatavariationovertime 2. Themodelsparametervaluesvarysignificantlywhenwerecalibrateusingeitherasubsetof thesample,orbyincorporatingnewobservations 3. Inextremecases,theselectionofthebestmodeltypeororder(s)canbeinfluencedbythe selectionofsampledata

Why do we care?
Theobjectiveoftimeseriesanalysisandmodelingisusuallytheconstructionofoutofsampleforecasts. Howcanwegeneratetheseforecastsusingamodelwithtimevaryingparameters?Howmuch confidencecanweputinthoseforecasts?Aretheforecastrobust?Letsfindout.

Why does it happen?

Thereareseveralcausesforheterogeneity(oppositeofhomogeneity)inatimeseries: (1) Theunderlyingmodelsstatisticalpropertiesareevolvingovertime.Inthiscase,tryingtofita modelwithfixedparametervalueswouldnotbeoptimal,despiteourbestefforts.Weneedto DataPreparationHomogeneity 1 SpiderFinancialCorp,2012

examineadvancedmodelingtechniquestocapturethedynamicsofthestatisticalpropertiesof theprocess.This,unfortunately,isoutsidethescopeofthispaper. (2) Theunderlyingprocessisnotstationary(e.g.possessestrendovertime). (3) Theunderlyingprocessisheteroskedasticwherevolatilityexhibitsclusteringandmean reversion. (4) Theunderlyingprocesshadundergonefewbutmajorstructuralchangesduetoexogenous events,suchasthepassingandenforcementofnewrelevantlawsoramajordevelopmentin theprocessitself. Example I: OzonelevelindowntownLosAngelescase(refertotheHowdoesitfitissue)

Throughoutthesampletimebetween1955and1972,thereweretwomajordevelopments: (1) Rule#76forgasolinemixandcombustionenginedesign (2) OpeningofafreewaytodiverttrafficfromdowntownLA Obviously,thoseexogenouseventsaffectthenumberofcarsindowntownLA,andconsequently theamountofOzoneemittedinthearea.Onecanarguethattheprocessafterthoseevents(1972) isnotthesameastheprocessin1960. Example II: USConsumerPriceIndexanditsderivative,theinflationrate: TheinflationrateintheUSreflectstheeffectivenessofgovernmentpublicpolicies,sothroughout thesamplehorizonbetween1913and2009,itisnosurprisethatthedatacharacteristicsbeforeand afterWorldWarIIarefundamentallydifferent.Alsoconsiderthatinthe1970s,thesuddenrisein inflationevidentinourdatareflectsafundamentalchange(orfailure)inpublicpolicy.

DataPreparationHomogeneity

SpiderFinancialCorp,2012

Mostimportantly,theinflationrateunderlyingtheprocessafterthe1970sisverydifferentthanin prioryears,foranumberofreasons:(1)fundamentalchangesinpublicpoliciesand(2)amandate fortheFederalReservetofighttheinflationrateandunemploymentin1977.

Insum,onemayarguethatthepost1977processisverydifferentfromthepre1977process. Conclusion Theinvestigatormustbringrichpriorknowledgeandstronghypothesesabouttheunderlyingprocess structureanditsdriverstohisinterpretationofadataset.Theliabilityofpowerfulanalyticalmethodsis

DataPreparationHomogeneity

SpiderFinancialCorp,2012

thepotentialforarichdiversityofalternativesolutionsthatcanhaveverydifferentpropertieswhen extrapolatedfromthesituationfromwhichthedatawasoriginallysampled.

Checking For Homogeneity

Theinitialstagesintheanalysisofatimeseriesmayinvolveplottingvaluesagainsttimetoexaminethe homogeneityoftheseriesinvariousways:namely,stabilityacrosstime(asopposedtoatrend)and stabilityoflocalfluctuationsovertime. Inastatisticalsense,atestforhomogeneityisequivalenttoatestofastatisticaldistribution.Inplain English,wewishtodetectachangeintheunderlyingdistribution.Forthat,wecanexaminethe distributionmoments:mean,variance,skew,andkurtosisforchanges. Fortimeseriesanalysis,wewilllookintothe1sttwomoments:meanandvariance,andexamineany shiftovertime.Herearefewteststoaidus: StandardNormalHomogeneityTest(SNHT): Q:Dowehaveashiftinthemeanorvariance?

H o : r ~ N (0,1) H1 : Thereisashift

Where r arethestandardizedratios(anobservationsvaluecomparedtotheaverage). PettittsTestdetectingashiftinvarianceNonparametrictest(i.e.noassumptionaboutthe distributionofdata). Q:Dowehaveashiftinthevariance?When? ThePettitt'stestisanadaptationoftherankbasedMannWhitneytest,whichallowsyouto identifythetimeatwhichtheshiftoccurs. TestsfordetectingashiftinthemeanNonparametrictest(i.e.noassumptionaboutthe distributionofdata). Q:Dowehaveashiftinthemean?When? Where o

H o : t c H 1 : k c

H o isthenullhypothesis,whichstatesthat xt followsoneormoredistributionsthat
havethesamemean.

DataPreparationHomogeneity

SpiderFinancialCorp,2012

H1 isthealternativehypothesis,whichstatesthatthereexistsatimekfromwhichthe

variableschangemean. BartlesTest(rankedversionofVonNeumannratiotest)forrandomness Q:Isthesampledatarandom?Dowehavepatterns? o o NullHypothesis( H o ):timeseriesishomogeneous. Alternativehypothesis( H1 ):timeseriesisnothomogeneous.

Hold on, doesnt homogeneity sound a look like stationarity?

Stationarityandhomogeneityarecloselyrelated;stationaritylooksintothestabilityofthejoint distribution FX ( xt1 , xt2 ,..., xtN ) ,whilehomogeneityexaminesthestabilityofthewholemarginal distributionovertime. Anonstationarytimeseriesisnonhomogeneous,buttheoppositemaynotalwaysbetrue.

My time series is not homogeneous over time; what can I do?

Ifahomogeneousassumptionfailstohold,weneedtotakeacloserlookandunderstandthetime series: (1) Isthetimeseriesstationary?Ifso,transformthedatatobringittostationarity. (2) Identifyandunderstandthedriversoftheunderlyingprocess: a. Dowehaveexogenousdrivers/factors(e.g.laws,events,etc.)thatcouldaffectthe valuesoftheobservations? b. Hastheunderlyingprocesschangedpermanentlyovertime? c. Doweexpecttheexogenousfactortochangeagaininthefuture? d. Whendidtheprocessmeanorvariancechange? IntheUSCPIexample,thechangemadein1977bycongresstomandatetheFederalReservetoadopt publicpolicytocontrolinflationisamajorturningpoint,andweareinclinedtoconcludethatprocess underwentapermanentchangeasaresultofthatdevelopment.Inthiscase,Iwoulddisregardall observationbeforethattime. IntheOzonelevelindowntownLAexample,theopeningofafreewaydivertingtrafficfromdowntown isastructuralchangeintheunderlyingprocess.Thesamecanbesaidaboutthelawsforgasolinemix andenginedesign.Again,Iwoulddisregarddatabeforethechangestookeffect,andonlyconcern myselfwithobservationsthatoccuraftertheseevents.

DataPreparationHomogeneity

SpiderFinancialCorp,2012