ECON2209/5248 Notes & Tutorial Exercises, School of Economics, UNSW

Tutorial 8 (Week 9, 1 to 3 May 2012) Notes and Homework before Week 9 Read Chapter 8 and 9, including Concepts for Review. Additional reading: Questions 8 on page 165. Estimation of ARMA For the AR(p) model yt = 1 yt1 + + p ytp + c + t , the coecients [1 , . . . , p , c] may be estimated by the OLS of yt on [yt1 , . . . , ytp , 1] and 2 = SSR/(T p 1). For MA(q) or ARMA(p, q), either non-linear least squares (NLS) or maximum likelihood method is required. And numerical minimization techniques are needed. As an example, we consider the ARMA(1,1) yt = 1 yt1 + t + 1 t1 + c. Here t may be regarded as the 1-step ahead forecast error t (1 , 1 , c) = yt 1 yt1 1 t1 c, which depends on the parameters (1 , 1 , c). A popular method to estimate the parameters is to minimize the sum of squared forecast errors, ie, (1 , 1 , c) = arg min {
1 ,1 ,c T

t (1 , 1 , c)2 }
t=1

and 2 = SSR/(T 3). Here SSR =

T 2 t=1 t (1 , 1 , c)

is the minimized

objective function. We note that t (1 , 1 , c) is non-linear in the parameters (1 , 1 , c) and the OLS does not apply. We also note that y0 and 0 are required to evaluate the objective function but unobservable. One way to get around is to use the means y0 = c/(1 1 ) and 0 = 0. Another is to estimate both y0 and 0 as additional parameters. Forecasts Based on Conditional Expectation Suppose we are interested in forecasting the value of a variable based on the time-T information set T that contains the past values of yt and t . Let yT +h|T or ET (yT +h ) denote the forecast of yT +h based on T . To determine the usefulness of the forecast, we specify a loss function and from a class of loss functions, the quadratic loss function produces convenient results. A quadratic loss function implies the selection of the forecast yT +h|T so as to minimise: E yT +h yT +h|T
2

ECON2209/5248 Notes & Tutorial Exercises, School of Economics, UNSW

which is the mean squared error associated with the forecast that we denote: M SE yT +h|T = E yT +h yT +h|T
2

The forecast with the smallest mean squared errors the expectation of yT +1 conditional on T : yT +h|T = E (yT +h |T ) = ET (yT +h ) Forecasts Based on a Linear Projection We restrict the forecasts by requiring that the forecast yT +h|T to be a linear function of the information set T : yT +h|T = T Our task is to nd a value for such that the forecast error yT +h|T T is uncorrelated with T : E yT +h|T T T = 0

If the above holds then T is the linear projection of yT +h on T which we can denote P (yT +h |T ). In most cases a constant is included, and we can use the expectation operator to denote the linear projection as: ET (yT +h ) = P (yT +h |1, T ) Computing a Forecast The computation of a forecast yT +h|T can be done recursively using the estimated ARMA model. This involves rst computing the one step ahead foecast, using this to compute two periods ahead, and continuing until the h step ahead foreecat is obtained. As an example, we consider the ARMA(2,2): yt = 1 yt1 + 2 yt2 + t + 1 t1 + 2 t2 + c The one-step ahead forecast will be: ET (yT +1 ) = c + 1 yT + 2 yT 1 + E(T +1 ) + 1 T + 2 T 1 The two-step ahead forecast will be: ET (yT +2 ) = c + 1 ET (yT +1 ) + 2 yT + E(T +2 ) + 1 E(T +1 ) + 2 T The h-step ahead forecast will be: ET (yT +h ) = c+1 ET (yT +(h1) )+2 ET (yT +(h2) )+E(T +h )+1 E(T +(h1) )+2 E(T +(h2) )

ECON2209/5248 Notes & Tutorial Exercises, School of Economics, UNSW

Problem Set for Week 9 Tutorial (Chs 8 and 9) 1. Consider the ARMA(1,1) process: yt = 0.8yt1 + t 0.6t1 t WN(0, 1),

(a) Show the process in its lag operator representation, in terms of yt . (b) Calculate E(yt ) and V ar(yt ). (c) Comment on the stationarity and invertibility of the process. (d) Calculate autocorrelations for = 1, 2. (e) Suppose T = yT = 1. Calculate point and interval forecasts for yT +h h=13 (f) Draw a graph of actual and forecast yt and the interval forecasts for the periods T-1 to T+3. 2. Consider the following ARMA processes and comment on their stationarity, invertibility and common roots. Here t WN(0, 2 ). (a) yt = 0.8yt1 + t + 0.9t1 . (b) yt = 0.9yt1 0.1yt2 + t . (c) yt = 0.9yt1 + 0.1yt2 + t t1 . (d) yt = 1.8yt1 0.81yt2 + t 0.4t1 + 0.04t2 . 3. Question 6 (a) on Page 165. (BankWire). For part (b), let the upper bounds be (, q ) = (2,2) and include a constant in the models. p 4. The le hstarts contains the monthly housing starts dats from 1946 to 1994. (a) Plot the data against time and comment on what you regards as its signicant features. (b) Use the Box-Jenkins methodology to select the correct model. (c) Re-estimate a sub-sample from 1946:01 to 1993:12 and produce forecasts for 1994:01 to 1994:11 (with 2 standard error bands). (d) Compare these forecasts to the actual data series and comment on their dierences. 5. Question 3 on page 185. (Forecasting an AR(1) process with known and unknown parameters)