Example of cointegrated series:

Time series of consumption

and income
1
Cointegration and Error
Correction Models Continued
2
The Error Correction Mechanism
Consider a simple bi-variate case where y
t
and x
1t

are cointegrated
y
t
= B
1
x
1t
+ e
t

e
t
= y
t
B
1
x
1t
in LR equilibrium e
t
= 0
If, in the long run, the system is to return to
equilibrium then in the short run at least one of the
variables must respond to the magnitude of the
short run disequilibrium.
i.e. if in the short run y
t
B
1
x
1t
> 0, for example y
t
would fall
and/or x
1t
would rise and long run equilibrium will be
attained when y
t
= B
1
x
1t
This adjustment back towards equilibrium is a
response to the short run error e
t
and is called error
correction.
3
The Error Correction Mechanism
The Error Correction Mechanism (ECM) may be represented (in its
simplest form) as follows

y
t
=
y
(y
t-1
B
1
x
1t-1
) + v
yt
Note: the part in brackets is the deviation from equilibrium, (i.e. e
t
)
x
1t
=
x
(y
t-1
B
1
x
1t-1
) + v
x1t

v
yt
and v
x1t
are white noise error terms

y
t
and x
1t
change in response to deviations from equilibrium (e
t
)


y
and
x
are speed of adjustment parameters. The larger their value
the greater is the response in y
t
and x
t
to deviations in equilibrium

4
Speed of adjustment parameters
If
y
and
x
are = 0, then the model is not one of either
error correction or cointegration. [since there is no
response leading towards an equilibrium!]

[Note: If
y
or
x
are >1 then we will observe over-
adjustment ]

For any set of I(1) variables error correction and
cointegration are equivalent representations. This is
referred to as the Granger Representation Theory

5
The Error Correction Mechanism
The ECM can be extended to
y
t
= -
y
(y
t-1
B
1
x
1t-1
) +
11
y
t-1
+
12
y
t-2
+ + v
yt

x
1t
=
x
(y
t-1
B
1
x
1t-1
) +
21
x
t-1
+
22
x
t-2
+ + v
x1t

As and are also stationary this
extension does not alter the results from earlier
We could also add in lagged values of x in the first
equation and y in the second.

=

A
p
i
i t i
y
1
1
o

=

A
p
i
i t i
x
1
1 2
o
6
Granger Representation Theorem
According to Granger, if there is evidence of
cointegration between two or more variables, then a
valid error correction model should also exist
between the two variables.
The error correction model is then a representation
of the short-run dynamic relationship between X and
Y, in which the error correction term incorporates the
long-run information about X and Y into our model.
This implies that the error correction term will be
significant, if cointegration exists.
7
Testing for Cointegration
The Engle-Granger Approach
This is essentially a bi-variate approach and is
based on the Augmented Dickey-Fuller test for
stationarity.
If we have two non-stationary variables containing a
unit root (i.e. I(1) variables), then we describe them
as being cointegrated if the error term is stationary
(i.e. I(0)).
We test for the stationarity of the error term using
the ADF test in the same way as the individual
variables.
8
Engle-Granger
A Two-Step Method
The method involves firstly estimating the
cointegrating relationship and test for
cointegration.
The second stage involves forming the error
correction model, where the error correction
term is the residual from the cointegrating
relationship, lagged once.
9
Testing for Cointegration
The Engle and Granger Approach
First Stage:
Test all the variables to determine if they are I(0), I(1) or I(2) using the ADF:
test.

If all the variables are I(1), then carry out the test for cointegration
by estimating the following regression:

y
t
= B
0
+ B
1
x
t
+ e
t


and testing the residuals for stationarity using the ADF without a time trend
or drift.
Note: you cannot use the usual ADF critical values. Use critical values for the
Engle-Granger Cointegration test.

If there is evidence of stationarity in the estimated error terms then conclude
that there is evidence of cointegration

Note: This is the first stage completed, now we move onto the second, forming the
ECM)
10
Testing for Cointegration
The Engle and Granger Approach
Second Stage:
3) If there is evidence of cointegration, use the residual to form the
error correction term in the corresponding ECM
[i.e. use the residual in place of (y
t-1
B
1
x
1t-1
)]
4) Add in a number of lags of both explanatory and dependent
variables to the ECM

y
t
=
y
(y
t-1
B
1
x
1t-1
) +
11
y
t-1
+ +
21
x
t-1
+ + v
yt


5) Omit those lags that are insignificant to form a parsimonious
model
6) Use the ECM to analyse the long run and short run effects of the
variables as well as to see the adjustment coefficient. Diagnostic
checks to check for the adequacy of the model should be applied
(as usual!)
11
Problems with the EG Testing Approach
1. The ADF test often indicates acceptance of the null hypothesis (no
cointegration), when in fact cointegration is present [Recall:
ADF tends to over-accept the presence of a unit root so here we
are more likely to say residuals are non-stationary than we should
be!]
2. When there are more than two variables there may be more than
one cointegrating relationship. The EG approach does not give the
number of cointegrating vectors
3. The two step procedure increases the likelihood of error
4. When estimating the long run relationship the test for cointegration
is sensitive to the decision as to which variable to included as the
dependent variable
5. There may be simultaneous equation bias which is not accounted
for in the first stage!

The Johansen approach is a popular test for cointegration which
allows for more than one cointegrating relationship to exist among
the variables and it is based on VAR so takes account of possible
simultaneous equation bias!
12
An alternative approach:
The Johansen Procedure
13
The Johansen Procedure
We can think of the Johansen procedure as a
multivariate version of the Dickey Fuller test.
Recall: for DF we had: Y
t
= Y
t-1
+ u
t
For stationarity we required || <1
We tested this by rewriting the model as:
Y
t
= (-1)Y
t-1
+ u
t
Then tested whether (-1) =0
We could also include an intercept, a trend
and lagged values of Y
t
(ADF)

14
The Johansen Procedure
For the Johansen procedure we are dealing with more
than one variable and are testing whether some
combination of them is stationary;
X
t
= X
t-1
+ u
t

Where:
X
t
is a (nx1) matrix (n is the number of variables)
is a (nxn) matrix This captures the influence of past
values of all of the Xs on each of the Xs
(Similar to in the univariate case on previous slide)

As with the DF test we take first differences:
X
t
= ( -I)X
t-1
+ u
t
(Here I is the identity Matrix)


15
The Johansen Procedure
Now we can write ( -I) as so our model
becomes:
X
t
= X
t-1
+ u
t
X
t
and u
t
are both stationary so for the equality
to hold, then x
t-1
must be stationary








16
The Johansen Procedure
There are three possibilities for x
t-1
to be
stationary:
1. The xs are all stationary
=> We should not be looking for cointegration!
2. The xs are not stationary but some
combination of them is
=> They are cointegrated
3. (1) and (2) are not the case but is 0
=> There is no cointegration

We thus test for cointegration by examining

17
The Johansen Procedure
An outline
The rows of are co-integrating vectors.

If there is no cointegration then all of the rows
of the matrix should be 0.

The number of linearly independent rows (known as
the rank) of the matrix gives the number of
combinations of the variables in X
t
which are stationary
i.e. the number of cointegrating vectors (= equilibrium
relationships).

18
Aside: Linear independence

Linearly independent => one row is not a linear function
of another:
Example:

If Row 1: [1 2 4] & Row 2: [2 4 8]
=>Row 2 = 2*Row 1 => linearly dependent!
But a row like [ 3 7 2] would be linearly independent of both!

It turns out that the number of linearly independent rows
in a matrix = the number of characteristic roots of the
characteristic equation (i.e. eigenvalues)
These can be found by solving |A-I| where A is the
matrix of interest.




19
(
(
(

2 7 3
8 4 2
4 2 1
Using 2 variables:
Suppose we were looking for cointegration
between x and y. We could write the
differenced equations as:

Re-writing as matrices:

Using our earlier notation of X
t
= X
t-1
+ u
t
So here X
t-1
would be and =

We would then test = to see how many rows were
linearly independent.

xt t x t x t
yt t y t y t
x y x
x y y
c | o
c | o
+ + = A
+ + = A


1 1
1 1
(

+
(

=
(

A
A

xt
yt
t
t
x x
y y
t
t
x
y
x
y
c
c
| o
| o
1
1
(

1
1
t
t
x
y
(

x x
y y
| o
| o
(

x x
y y
| o
| o
The Johansen Procedure
The test:
The Johansen approach tests for the rank of the
matrix.
It the rank of = n, then the variables are stationary
All rows are linearly independent => (can think of this as saying
any combination of the variables is stationary) => original
variable must be stationary
If the rank of = 1, then there is only 1 cointegrating vector
If rank of is up to (n-1), then there are n-1 cointegrating
vectors
If the rank of = 0 then there is no co-integration
Note: only a matrix of zeros has rank 0!!!

21
The Johansen Procedure
An outline

The rank of is the number of significant
characteristic roots [see Appendix 6.1 in Enders]

The Johansen Procedure tests for cointegration by
testing for the number of estimated characteristic
roots (also called eigenvalues) that are different to
zero

There are two tests to do so:
the
trace
and the
max

22
The Johansen Procedure: An outline

max
-T ln(1-
^
r+1
)
Where
^
i
= estimated characteristic root
H
0
: the number of cointegrating vectors = r
H
a
: the number of cointegrating vectors = r+1

trace

-T

Where
^
i
= estimated characteristic root
H
0
: the number of cointegrating vectors = r
H
a
: the number of cointegrating vectors r+1
T is the number of usable observations in both cases
Note the different alternative hypothesis (H
a
)
Both statistics along with their critical values are given by
statistical packages

+ =

n
r i
i
1
)

1 ln(
23

trace
and
max

In both cases we compare the test statistic
for
trace
and
max
to the critical value.
If the test statistic is higher we reject the null
hypothesis that there are r cointegrating
vectors.
For
max
: we fail to reject that there are r+1
For
trace
:

we fail to reject that there are r+1

24
Extension of simple models
We often extend the model to include an intercept and
lags
In general the ECM representation for n variables
where vector X
t
= (X
1t
, X
2t
, , X
nt
) can be written using
matrix notation as:
X
t
= C
0
+ x
t-1
+ (
1
x
t-1
+
2
x
t-2
+ +
p
x
t-p
) + e
t

Where
C
0
= a vector of intercept terms (nx1)
x
t-1
= Error correction term (nxn)(nx1)=(nx1)

i
x
t-i
= lagged values of dependents (nxn)(nx1)
e
t
= stationary error terms (nx1)
Since all other terms are stationary then x
t-1
must be
stationary as in the simpler model earlier.
25
Some Applications
26
Cointegration in Finance
Examples of possible Cointegrating Relationships in
finance:
spot and futures prices
ratio of relative prices and an exchange rate
equity prices and dividends

Market forces arising from no arbitrage conditions should
ensure an equilibrium relationship.

No cointegration implies that series could wander apart
without bound in the long run.

27
Engle Granger Procedure
example
28
Futures & Spot Data
Applying the EG Approach
Brooks and Garrett (2001) Can we Explain the dynamics
of the UK FTSE100 Stock and Stock Index Futures
Markets? Applied Financial Econometrics, 12(1), 25-31
Summary in Brooks 2002. Introductory Econometrics for
Finance. Pg 395. A useful text for examples of what we
do in class.
They analyse 13,035 10-minutely observations on the
FTSE 100 stock index and stock index futures prices for
all trading days in the period June 1996 1997.

29
Methodology
The fair futures price is given by the cost of carry model


where F
t
*
is the fair futures price, S
t
is the spot price, r is a continuously
compounded risk-free rate of interest, d is the continuously
compounded yield in terms of dividends derived from the stock index
until the futures contract matures, and (T-t) is the time to maturity of
the futures contract.
Taking logarithms of both sides of equation above gives


This suggests an equilibrium relationship! => should be cointegrated.
First, test f
t
and s
t
for nonstationarity.
t
*
t
(r-d)(T-t)
F = S e
t) - d)(T - (r
s
f
t
t
+ =
*
30
Dickey-Fuller Tests on Log-Prices and Returns for
High Frequency FTSE Data
Futures Spot
Dickey-Fuller Statistics
for Log-Price Data
-0.1329 -0.7335
Dickey Fuller Statistics
for Returns Data
-84.9968 -114.1803
(Dickey-Fuller critical values are usually not far from
3) => accept levels have unit roots and reject for
returns!
31
Cointegration Test Regression and Test on Residuals
Conclusion: log F
t
and log S
t
are not stationary, but Alog F
t
and Alog S
t

are stationary.
But a model containing only first differences has no long run
relationship.
Solution is to see if there exists a cointegrating relationship between f
t

and s
t
which would mean that we can validly include levels terms in
this framework.

Potential cointegrating regression:


where z
t
is a disturbance term.
Estimate the regression, collect the residuals, , and test whether they
are stationary.
z
t
t t t
z f s + + =
1 0

32
Estimated Equation and Test for Cointegration for
High Frequency FTSE Data
Cointegrating Regression
Coefficient

1
Estimated Value
0.1345
0.9834
DF Test on residuals
t
z
Test Statistic
-14.7303
t t t
z f s + + =
1 0

S=0.1345 + 0.9834f
t
+ z
t
33
Conclusions from Unit Root and Cointegration
Tests
Conclusion: are stationary and therefore we have a
cointegrating relationship between log F
t
and log S
t
.

Final stage in Engle-Granger 2-step method is to use the
first stage residuals, as the equilibrium correction term
in the general equation.

The overall model is



z
t
z
t
t t t t t
v F S z S + A + A + + = A
1 1 1 1 1 0
ln ln ln o | o |
34
Estimated Error Correction Model for
High Frequency FTSE Data





Look at the signs and significances of the coefficients:
is positive and highly significant
is positive and highly significant
is negative and highly significant
Coefficient Estimated Value t-ratio

|
0
9.6713E-06 1.6083

o
-8.3388E-01 -5.1298

|
1
0.1799 19.2886

o
1
0.1312 20.4946
1
o
1

o
35
Johansen Procedure example
36
Purchasing Power Parity (PPP)
PPP states that the equilibrium exchange rate between 2
countries is equal to the ratio of relative prices [i.e.
e
t
=q
t
(p
t
/p
t
*
)]
In logs: e
t
- p
t
+ p
t
* = q
t
A necessary and sufficient condition for PPP is that the
log of the exchange rate between countries A and B, and
the logs of the price levels in countries A and B be
cointegrated with cointegrating vector
[ 1 1 1] .
Chen (1995) uses monthly data for April 1973-December
1990 to test the PPP hypothesis using the Johansen
approach.

37
Cointegration Tests of PPP with European Data

Tests for
cointegration between
r = 0
r s 1 r s 2 o
1
o
2

FRF DEM 34.63* 17.10 6.26 1.33 -2.50
FRF ITL 52.69* 15.81 5.43 2.65 -2.52
FRF NLG 68.10* 16.37 6.42 0.58 -0.80
FRF BEF 52.54* 26.09* 3.63 0.78 -1.15
DEM ITL 42.59* 20.76* 4.79 5.80 -2.25
DEM NLG 50.25* 17.79 3.28 0.12 -0.25
DEM BEF 69.13* 27.13* 4.52 0.87 -0.52
ITL NLG 37.51* 14.22 5.05 0.55 -0.71
ITL BEF 69.24* 32.16* 7.15 0.73 -1.28
NLG BEF 64.52* 21.97* 3.88 1.69 -2.17
Critical values 31.52 17.95 8.18 - -
Notes: FRF- French franc; DEM German Mark; NLG Dutch guilder; ITL Italian lira; BEF
Belgian franc. Source: Chen (1995). Reprinted with the permission of Taylor and Francis Ltd.
(www.tandf.co.uk).
=> reject null hypothesis there are r cointegrating
vectors.
=> There is cointegration
38
Note: The Brooks book has a good few
example explained well (starting about
P355)
A good introduction to co-integration by
Johansen himself (more detailed than is
needed for this course but worth looking at if
you continue to work with time-series!):
http://www.math.ku.dk/~sjo/papers/OverviewPrepr
int.pdf

39