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(a) Many series in finance and economics in their levels (or log-levels) forms are non-stationary and exhibit stochastic trends. They have a tendency not to revert to a mean level, but they wander for !rolonged !eriods in one direction or the other. "xam!les would be most #inds of asset or goods !rices, $%&, unem!loyment, money su!!ly, etc. 'uch variables can usually be made stationary by transforming them into their differences or by constructing !ercentage changes of them. (b) (on-stationarity can be an im!ortant determinant of the !ro!erties of a series. )lso, if two series are non-stationary, we may ex!erience the !roblem of s!urious regression. This occurs when we regress one non-stationary variable on a com!letely unrelated non-stationary variable, but yield a reasonably high value of R*, a!!arently indicating that the model fits well. Most im!ortantly therefore, we are not able to !erform any hy!othesis tests in models which ina!!ro!riately use non-stationary data since the test statistics will no longer follow the distributions which we assumed they would (e.g. a t or F), so any inferences we ma#e are li#ely to be invalid. (c) ) wea#ly stationary !rocess was defined in +ha!ter ,, and has the following characteristics1. "(yt) . *. E ( yt )( yt ) = 2 < /. E ( yt1 )( yt 2 ) = t 2 t1 t1 , t* That is, a stationary !rocess has a constant mean, a constant variance, and a constant covariance structure. ) strictly stationary !rocess could be defined by an e0uation such as

Fx t1 , x t 2 ,..., x tT ( x1 ,..., x T ) = Fx t1 +k , x t 2 +k ,..., x tT +k ( x1 ,..., xT )

for any t1 , t* , ..., tT Z, any k Z and T . 1, *, ...., and where F denotes the 1oint distribution function of the set of random variables. 2t should be evident from the definitions of wea# and strict stationarity that the latter is a stronger definition and is a s!ecial case of the former. 2n the former case, only the first two moments of the distribution has to be constant (i.e. the mean and variances (and covariances)), whilst in the latter case, all moments of the distribution (i.e. the whole of the !robability distribution) has to be constant. 3oth wea#ly stationary and strictly stationary !rocesses will cross their mean value fre0uently and will not wander a long way from that mean value. )n exam!le of a deterministic trend !rocess was given in 4igure 5.,. 'uch a !rocess will have random variations about a linear (usually u!ward) trend. )n ex!ression for a deterministic trend !rocess yt could be

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yt = + t + ut where t . 1, *,6, is the trend and ut is a 7ero mean white noise disturbance term. This is called deterministic non-stationarity because the source of the non-stationarity is a deterministic straight line !rocess. ) variable containing a stochastic trend will also not cross its mean value fre0uently and will wander a long way from its mean value. ) stochastically non-stationary !rocess could be a unit root or ex!losive autoregressive !rocess such as yt = yt-1 + ut where 1. *. (a)The null hy!othesis is of a unit root against a one sided stationary alternative, i.e. we have 89 - yt 2(1) 81 - yt 2(9) which is also e0uivalent to 89 - . 9 81 - : 9

/ SE ( ) which e0uals -9.9* ; 9./1 . -9.9< (b) The test statistic is given by 'ince this is not more negative than the a!!ro!riate critical value, we do not re1ect the null hy!othesis.

(c) =e therefore conclude that there is at least one unit root in the series (there could be 1, *, / or more). =hat we would do now is to regress *yt on yt-1 and test if there is a further unit root. The null and alternative hy!otheses would now be 89 - yt 2(1) i.e. yt 2(*) 81 - yt 2(9) i.e. yt 2(1) 2f we re1ected the null hy!othesis, we would therefore conclude that the first differences are stationary, and hence the original series was 2(1). 2f we did not re1ect at this stage, we would conclude that yt must be at least 2(*), and we would have to test again until we re1ected. (d) =e cannot com!are the test statistic with that from a t-distribution since we have non-stationarity under the null hy!othesis and hence the test statistic will no longer follow a t-distribution. /. >sing the same regression as above, but on a different set of data, the researcher now obtains the estimate .-9.,* with standard error . 9.1<. 2/7 Introductory Econometrics for Finance Chris roo!s 2""#

(a) The test statistic is calculated as above. The value of the test statistic . -9.,* ;9.1< . -/.*,. =e therefore re1ect the null hy!othesis since the test statistic is smaller (more negative) than the critical value. (b) =e conclude that the series is stationary since we re1ect the unit root null hy!othesis. =e need do no further tests since we have already re1ected. (c) The researcher is correct. ?ne !ossible source of non-whiteness is when the errors are autocorrelated. This will occur if there is autocorrelation in the original de!endent variable in the regression ( yt). 2n !ractice, we can easily get around this by augmenting the test with lags of the de!endent variable to soa# u! the autocorrelation. The a!!ro!riate number of lags can be determined using the information criteria. @. (a) 2f two or more series are cointegrated, in intuitive terms this im!lies that they have a long run e0uilibrium relationshi! that they may deviate from in the short run, but which will always be returned to in the long run. 2n the context of s!ot and futures !rices, the fact that these are essentially !rices of the same asset but with different delivery and !ayment dates, means that financial theory would suggest that they should be cointegrated. 2f they were not cointegrated, this would im!ly that the series did not contain a common stochastic trend and that they could therefore wander a!art without bound even in the long run. 2f the s!ot and futures !rices for a given asset did se!arate from one another, mar#et forces would wor# to bring them bac# to follow their long run relationshi! given by the cost of carry formula. The "ngle-$ranger a!!roach to cointegration involves first ensuring that the variables are individually unit root !rocesses (note that the test is often conducted on the logs of the s!ot and of the futures !rices rather than on the !rice series themselves). Then a regression would be conducted of one of the series on the other (i.e. regressing s!ot on futures !rices or futures on s!ot !rices) would be conducted and the residuals from that regression collected. These residuals would then be sub1ected to a %ic#ey-4uller or augmented %ic#ey-4uller test. 2f the null hy!othesis of a unit root in the %4 test regression residuals is not re1ected, it would be concluded that a stationary combination of the non-stationary variables has not been found and thus that there is no cointegration. ?n the other hand, if the null is re1ected, it would be concluded that a stationary combination of the non-stationary variables has been found and thus that the variables are cointegrated. 4orming an error correction model ("+M) following the "ngle-$ranger a!!roach is a *-stage !rocess. The first stage is (assuming that the original series are non-stationary) to determine whether the variables are cointegrated. 2f they are not, obviously there would be no sense in forming an "+M, and the a!!ro!riate res!onse would be to form a model in first differences only. 2f the variables are cointegrated, the second stage of the !rocess involves forming the error correction model which, in the context of s!ot and futures !rices, could be of the form given in e0uation (5.,5) on !age /@,.

$/7

(b) There are many other exam!les that one could draw from financial or economic theory of situations where cointegration would be ex!ected to be !resent and where its absence could im!ly a !ermanent dise0uilibrium. 2t is usually the !resence of mar#et forces and investors continually loo#ing for arbitrage o!!ortunities that would lead us to ex!ect cointegration to exist. $ood illustrations include e0uity !rices and dividends, or !rice levels in a set of countries and the exchange rates between them. The latter is embodied in the !urchasing !ower !arity (&&&) theory, which suggests that a re!resentative bas#et of goods and services should, when converted into a common currency, cost the same wherever in the world it is !urchased. 2n the context of &&&, one may ex!ect cointegration since again, its absence would im!ly that relative !rices and the exchange rate could wander a!art without bound in the long run. This would im!ly that the general !rice of goods and services in one country could get !ermanently out of line with those, when converted into a common currency, of other countries. This would not be ex!ected to ha!!en since !eo!le would s!ot a !rofitable o!!ortunity to buy the goods in one country where they were chea!er and to sell them in the country where they were more ex!ensive until the !rices were forced bac# into line. There is some evidence against &&&, however, and one ex!lanation is that transactions costs including trans!ortation costs, currency conversion costs, differential tax rates and restrictions on im!orts, sto! full ad1ustment from ta#ing !lace. 'ervices are also much less !ortable than goods and everybody #nows that everything costs twice as much in the >A as anywhere else in the world. ,. (a) The Bohansen test is com!uted in the following way. 'u!!ose we have p variables that we thin# might be cointegrated. 4irst, ensure that all the variables are of the same order of non-stationary, and in fact are 2(1), since it is very unli#ely that variables will be of a higher order of integration. 'tac# the variables that are to be tested for cointegration into a p-dimensional vector, called, say, yt. Then construct a p1 vector of first differences, yt, and form and estimate the following C)D yt . yt-k E 1 yt-1 E * yt-* E ... E k-1 yt-(k-1) E ut Then test the ran# of the matrix . 2f is of 7ero ran# (i.e. all the eigenvalues are not significantly different from 7ero), there is no cointegration, otherwise, the ran# will give the number of cointegrating vectors. (Fou could also go into a bit more detail on how the eigenvalues are used to obtain the ran#.) (%) De!eating the table given in the 0uestion, but adding the null and alternative hy!otheses in each case, and letting r denote the number of cointegrating vectors-

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max

/I.G<* *G.1@I 1<./9@ I.I<1 1.GG@

+ritical

+onsidering each row in the table in turn, and loo#ing at the first one first, the test statistic is greater than the critical value, so we re1ect the null hy!othesis that there are no cointegrating vectors. The same is true of the second row (that is, we re1ect the null hy!othesis of one cointegrating vector in favour of the alternative that there are two). Joo#ing now at the third row, we cannot re1ect (at the ,H level) the null hy!othesis that there are two cointegrating vectors, and this is our conclusion. There are two inde!endent linear combinations of the variables that will be stationary. (c) BohansenKs method allows the testing of hy!otheses by considering them effectively as restrictions on the cointegrating vector. The first thing to note is that all linear combinations of the cointegrating vectors are also cointegrating vectors. Therefore, if there are many cointegrating vectors in the unrestricted case and if the restrictions are relatively sim!le, it may be !ossible to satisfy the restrictions without causing the eigenvalues of the estimated coefficient matrix to change at all. 8owever, as the restrictions become more com!lex, renormalisation will no longer be sufficient to satisfy them, so that im!osing them will cause the eigenvalues of the restricted coefficient matrix to be different to those of the unrestricted coefficient matrix. 2f the restriction(s) im!lied by the hy!othesis is (are) nearly already !resent in the data, then the eigenvectors will not change significantly when the restriction is im!osed. 2f, on the other hand, the restriction on the data is severe, then the eigenvalues will change significantly com!ared with the case when no restrictions were im!osed. The test statistic for testing the validity of these restrictions is given by

T

i =r +1

'(n(1 ) (n(1 ))

* i i

*(p-r)

where

* i are the characteristic roots (eigenvalues) of the restricted model

r is the number of non-7ero (eigenvalues) characteristic roots in the unrestricted model p is the number of variables in the system.

+/7

2f the restrictions are su!!orted by the data, the eigenvalues will not change much when the restrictions are im!osed and so the test statistic will be small. (d) There are many a!!lications that could be considered, and tests for &&&, for cointegration between international bond mar#ets, and tests of the ex!ectations hy!othesis were !resented in 'ections 5.G, 5.19, and 5.11 res!ectively. These are not re!eated here. (e) 3oth Bohansen statistics can be thought of as being based on an examination of the eigenvalues of the long run coefficient or matrix. 2n both cases, the g eigenvalues (for a system containing g variables) are !laced ascending order- 1 * ... g. The maximal eigenvalue (i.e. the max) statistic is based on an examination of each eigenvalue se!arately, while the trace statistic is based on a 1oint examination of the g-r largest eigenvalues. 2f the test statistic is greater than the critical value from BohansenKs tables, re1ect the null hy!othesis that there are r cointegrating vectors in favour of the alternative that there are rE1 (for max) or more than r (for trace). The testing is conducted in a se0uence and under the null, r . 9, 1, ..., g-1 so that the hy!otheses for trace and max are as follows (ull hy!othesis for both tests alternative 8 98 98 98 9r.9 r.1 r.* ... r . p-1 Trace alternative 81- 9 : r g 81- 1 : r g 81- * : r g ... 81- r . g 81- r . 1 81- r . * 81- r . / ... 81- r . g Max

Thus the trace test starts by examining all eigenvalues together to test 8 9- r . 9, and if this is not re1ected, this is the end and the conclusion would be that there is no cointegration. 2f this hy!othesis is not re1ected, the largest eigenvalue would be dro!!ed and a 1oint test conducted using all of the eigenvalues exce!t the largest to test 8 9- r . 1. 2f this hy!othesis is not re1ected, the conclusion would be that there is one cointegrating vector, while if this is re1ected, the second largest eigenvalue would be dro!!ed and the test statistic recom!uted using the remaining g-* eigenvalues and so on. The testing se0uence would sto! when the null hy!othesis is not re1ected. The maximal eigenvalue test follows exactly the same testing se0uence with the same null hy!othesis as for the trace test, but the max test only considers one eigenvalue at a time. The null hy!othesis that r . 9 is tested using the largest eigenvalue. 2f this null is re1ected, the null that r . 1 is examined using the second largest eigenvalue and so on.

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<. (a) The o!eration of the Bohansen test has been described in the boo#, and also in 0uestion ,, !art (a) above. 2f the ran# of the matrix is 7ero, this im!lies that there is no cointegration or no common stochastic trends between the series. ) finding that the ran# of is one or two would im!ly that there were one or two linearly inde!endent cointegrating vectors or combinations of the series that would be stationary res!ectively. ) finding that the ran# of is / would im!ly that the matrix is of full ran#. 'ince the maximum number of cointegrating vectors is g-1, where g is the number of variables in the system, this does not im!ly that there / cointegrating vectors. 2n fact, the im!lication of a ran# of / would be that the original series were stationary, and !rovided that unit root tests had been conducted on each series, this would have effectively been ruled out. (b) The first test of 8 9- r . 9 is conducted using the first row of the table. +learly, the test statistic is greater than the critical value so the null hy!othesis is re1ected. +onsidering the second row, the same is true, so that the null of r . 1 is also re1ected. +onsidering now 8 9- r . *, the test statistic is smaller than the critical value so that the null is not re1ected. 'o we conclude that there are * cointegrating vectors, or in other words * linearly inde!endent combinations of the non-stationary variables that are stationary. 5. The fundamental difference between the "ngle-$ranger and the Bohansen a!!roaches is that the former is a single-e0uation methodology whereas Bohansen is a systems techni0ue involving the estimation of more than one e0uation. The two a!!roaches have been described in detail in +ha!ter 5 and in the answers to the 0uestions above, and will therefore not be covered again. The main (arguably only) advantage of the "ngle-$ranger a!!roach is its sim!licity and its intuitive inter!retability. 8owever, it has a number of disadvantages that have been described in detail in +ha!ter 5, including its inability to detect more than one cointegrating relationshi! and the im!ossibility of validly testing hy!otheses about the cointegrating vector.

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