ECON 332

Business Forecasting Methods

Chapter 3
Prof. Kirti K. Katkar
3-2 Moving Averages and Exponential Smoothing
Models
3-3

Characteristics

• Periodic – daily, weekly, monthly etc. - forecasts of 100s of items

– Inventories of products
– Future prices of individual stocks
• Major assumption:
– Fluctuations in past represent random departures from some smooth
curve
– Once the underlying curve is identified, it can be extrapolated to
generate a series of forecasts
– Only past observations: history or time-series - is required to forecast
future occurrences
– All time series data to be forecast have some cycles or fluctuations that
are recurring in nature
• Weighted averages of past observations to smooth up-and down
movements – i.e. suppress statistical fluctuations
3-4

p-Period Moving Average Model

• If the original time series is a1, a2, ……., an ,,,
and MAp (t) – p-period Moving average time series,
where p < n
then MAp (t+p) = (a1+ a2+ …..+at+p-1)/ p
where t = 0,1,2,3,…….,(n-p+1)
And the moving average forecast is
Ft+1 = MAp(t)
• The first naïve model is a degenerate case of moving average
model i.e. it is a 1-period moving average
• Choice of moving average period p depends on the
understanding of the underlying phenomenon. If not, by
simulation or trial and error.
3-5
Example of Moving Average Model

•Actuals of quarterly exchange rate with Japan

•No discernable pattern per se
3-6
Yen Exchange Rate - 3 Quarter Moving
Average Forecast
3-7

Yen Exchange Rate - 5 Quarter Moving Average

Forecast
3-8

Exchange Rate with Japanese Yen

3-9

Exchange Rate with Japanese Yen (Contd.)

3-10
Exchange Rate with Japanese Yen (Contd.)
3-11

Other Uses of Moving Average Models

• Technical analysis of stocks*

– 200 day moving average for buy/ sell signals
• Buy if the stock price now is > 200 day moving average
• Sell if the stock price now is < 200 day moving average
– 25 day moving average for bullish/ bearish outlook
• If stock price now is > 25 day moving average, outlook is bullish
• If stock price now is < 25 day moving average, outlook is bearish

* Ref. “equis” – Technical Analysis fro A to Z

3-12

Simple Exponential Smoothing Model

• Forecast value at any time is a weighted average of past values
• Most recent actual is given highest weight
• Weights decrease geometrically as you go further into past
• Assumption is that most recent values contain the most
relevant information which influences future value
• If α is the smoothing constant, where 0 < α < 1
then the simple exponential model is
Ft+1 = αXt + (1-α)Ft
where
Ft is the forecast value for period t
Xt is the actual value for period t
• Also assumes that the series is stationary – no trend/
seasonality/ cycles
3-13

Exponential Smoothing Models Learn

from Past Errors
• Transforming the model, we see
Ft+1 = αXt + (1-α)Ft
= αXt + Ft -αFt
=Ft + α(Xt – Ft)
• Forecast for t+1 period is increased if the actual value for t
period is > forecasted value for period t
• Forecast for t+1 period is decreased if the actual value for t
period is < forecasted value for period t
3-14

How do Weights Decrease Geometrically?

• Forecast for period t+1 include all past actuals weighted per
the smoothing constant α
Ft+1 = αXt + (1-α)Ft
and Ft = αXt-1 + (1-α)Ft-1
so Ft+1 = αXt + (1-α)αXt-1 + (1-α)2Ftt-1
again Ft-1 = αXt-2 + (1-α)Ft-2
thus Ft+1 = αXt + (1-α)αXt-1 + (1-α)2αXt-2 + (1-α)3Ftt-2
• Most recent actual has the highest weight with weights on
subsequent actuals decrease geometrically
3-15

Illustration of Weights for α = 0.1

Time Period Weight Calculation Weight

1 1 x 0.1 0.1

2 0.9 x 0.1 0.09

3 0.9 x 0.9 x 0.1 0.081

4 0.9 x 0.9 x 0.9 x 0.1 0.073

. .
. .
. .
Total 1.0
3-16
Example of Simple Exponential Model
University of Michigan Consumer Sentiment Index

α = 0.6
3-17

U of M Index of Consumer Sentiment

3-18

U of M Index of Consumer Sentiment (Contd.)

3-19

Holt’s Exponential Smoothing Model

• Used when time series exhibits trend or seasonality
• Extends the exponential smoothing model by introducing another smoothing
constant for trend
• Holt’s two-parameter exponential smoothing model:
Ft+1 = αXt + (1-α)(Ft +Tt)
Tt+1 = β(Ft+1 - Ft) + (1-β)Tt
Ht+m = Ft+1 + m Tt+1
where Ft+1 = Smoothed value for period t+1
α = Smoothing constant for data, 0 < α < 1
Xt = Actual value for period t, now
Ft = Forecast value for period t
Tt+1 = Trend estimate for period t+1
Tt = Previously smoothed trend for period t
Ht+m = Holt’s forecast value for period t+1
β = Smoothing constant for trend, 0 < β < 1
m = number of periods ahead to be forecast,
where m= 1,2,…,m
3-20
Example of Holt’s Model

α = 0.64, β = 0.24
3-21

S & P 500 Returns

3-22

Winter’s Exponential Smoothing

• Extension of Holt’s model to include seasonality in addition to trend
• Winter’s four-equation model:
Ft = αXt/ St-p + (1-α) (Ft-1 + Tt-1)
St = βXt/ Ft + (1-β) St-p
Tt = γ(Ft – Ft-1) + (1-γ)Tt-1
Wt+m = (Ft + mTt) St+m-p
where,
Ft = Smoothed value for period t
α = Smoothing constant for data (0<α<1)
Xt = Actual value now, i.e. period t
Ft-1 = Average experience of series smoothed for period t-1
Tt-1 = Trend estimate for period t-1
St = Seasonality estimate for period t
β = Smoothing constant for seasonality estimate (0<β<1)
γ = Smoothing constant for trend estimate (0<γ<1)
m = Number of periods in the forecast lead period, m = 1,2,…..,m
p = Number of periods in a seasonal cycle
3-23
Illustration of Winter’s Model Forecast
3-24
Light Truck Production
3-25

Adaptive-Response-Rate Single
Exponential Smoothing Model (ADRES)
• ADRES is a variant of simple exponential smoothing model
• No need to choose smoothing constant α
• Low cost method to forecast 100s of items on a periodic basis
• α does not remain constant : it’s value adapts to data
• Time series is assumed to be stationary i.e. no trend or
seasonality just as in simple exponential smoothing model
3-26

ADRES Model

Ft+1 = αtXt + (1-αt)Ft

where,St
αt = At Adaptive value of α at period t

St = β
et + (1-β)S Smoothed error
t-1

At = β + (1-β)At-1 Absolute smoothed error

and et = Xt – Ft Error
3-27
Illustration of ADRES Model
3-28
Seasonal time Series can be forecasted using
single, Holt’s and ADRES Exponential Smoothing
Models
• Alternative to using Winter’s exponential smoothing models
• Pre-condition is to deseasonalize the original series and then to
reseasonalize the forecasts
• Three step process
– Calculate seasonal indices for the series
– Deseasonalize the original series by dividing each value by its
corresponding seasonal index
– Apply one of above forecasting methods to the deseasonalized
forecasting series to generate the desired forecast(s)
– Reseasonalize the forecast by multiplying each deseasonalized forecast
with its corresponding seasonal index
• Simpler and less expensive to use
3-29
Illustration of Using Holt’s Model Forecast
with De-seasonalized Data
3-30 Light Truck Production Forecast using Deseasonalizing
Approach
3-31

Deseasonalizing Data and Determining

Seasonal Indices
• Moving average(MA) removes short term fluctuations – both
seasonal and random
• For deseasonalizing the MAs should contain same # of periods
as the seasonality that is evident – 4 for quarterly seasonality,
12 for monthly seasonality
• For quarterly data
MAt = (Xt-2 + Xt-1 + Xt +Xt+1)/4
• For monthly data
MAt = (Xt-6 + Xt-5 + Xt-4 + ….. + Xt + Xt+1 + … + Xt+5)/12
• Centered moving average (CMA)
CMAt = (MAt + MAt+1)/2
• Seasonal factor (SF)
SFt = Xt/ CMAt
3-32 Illustration: Deseasonalizing Quarterly Data and
Determining Seasonal Indices
Year/ Time Index X MA CMA SF
Quarter
1Q1 1 10 Missing Missing Missing
1Q2 2 18 Missing Missing Missing
1Q3 3 20 15 15.25 1.31
1Q4 4 12 15.5 15.75 0.76
2Q1 5 12 16 Missing Missing
2Q2 6 20 Missing Missing Missing

MA3 = (10+18+20+12)/4 = 60/4 = 15 CMA3 = (15 +15.5)/2 = 30.5/2 = 15.25

MA4 = (18+20+12+12)/4 = 62/4 = 15.5 CMA4 = (15.5 + 16)/2 = 31.5/2 = 15.75
MA5 = (20+12+12+20)/4 = 64/4 = 16 SF3 = 20/15.25 = 1.31 and SF4 = 12/15.75 = 0.76
3-33
Seasonal Indices for Private Housing Starts