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Preface

In preparing the manuscript for the third edition of Forecasting: methods and applications,
one of our primary goals has been to make the book as complete and thorough as possible
in order that it might best meet its intended objectives. The same set of principles has
guided us in preparing this instructors manual. Our intent has been not only to provide
solutions to the exercises but to go beyond and suggest several other types of teaching
materials and suggestions to help those who teach forecasting. We hope that you will find
that this manual delivers on those objectives.
The instructors manual is in four parts. To avoid confusion with the chapters in the
textbook, we will refer to these as Parts A through D. When the word Chapter is used, it
refers to that chapter in the text itself.
Part A is aimed at providing different course outlines for a number of different settings
in which the text has been used. These range from short executive seminars to subsegments
of a required college course to full-length courses at the graduate level on the subject of
forecasting.
In Part B, we have provided some teaching suggestions as to how we would teach a
course based on the book.
When teaching, we always use a range of additional teaching materials as complements
to the text. In Part C, we discuss the use of case studies and provide suggestions for
projects and exam questions. There use will depend on the overall structure, teaching
style and design selected for the course.
Part D provides solutions to the end-of-chapter exercises. We have provided solutions
that can be used in teaching the course rather than just for grading student work. We hope
the graphs, tables and descriptions will be useful in preparing overhead transparencies or
handouts for students.
We have long found it useful to teach forecasting using a computer package for the
computational aspects of the subject. We have chosen in this edition not to emphasize
a particular package but to comment on the facilities available in a range of packages
(see Appendix I of the text). It is important to have a package that the students can

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iv Preface

learn relatively quickly and which provides as many of the statistical facilities as possible.
This will depend on the students background and the type of course being taught. In
preparing the solutions, we have mainly used Minitab version 11 and SAS version 6.12.
Be aware that other packages may give slightly different numerical results due to different
algorithms being used.
We would like to express special thanks to a number of instructors who have helped us
with this manual and given us their feedback from use of the second edition of Forecasting:
methods and applications. At Stanford University, the book has been used by Professor
Fred Shepardson and Professor Peter Reiss. Teaching materials were also provided by
two of our colleagues at the University of Virginia, Professor Jim Freeland and Professor
Bob Landel and by Dr Gary Grunwald who provided some ideas for the exercises while
teaching at the University of Melbourne.

Spyros Makridakis
Fontainebleau, France

Steven Wheelwright
Boston, Massachusetts

Rob Hyndman
Melbourne, Australia

November 1997
Contents

v
A/Planning a forecasting course

Since the late 1940s organizational forecasting has been directly affected by numerous de-
velopments in estimation and prediction. Today organizations of all sizes find it essential to
make forecasts in order to reduce the uncertainty of their environment and take advantage
of opportunities. We have been involved in the forecasting area for more than 25 years,
and this book is the culmination of our efforts and experiences at teaching forecasting to
both full-time students and practicing managers with forecasting responsibility.
This book grew out of our perception that a book was needed that would cover a
full range of forecasting methods, be accurate and complete in describing the essential
characteristics and steps for applying those methods in practice, and yet not get bogged
down in theoretical questions underlying the development of individual techniques. The
purpose of the book is to fill a gap in the literature by presenting in terms that are easily
understandable (but that accurately and rigorously describe the techniques) a wide range
of forecasting methods useful to students and practitioners of management, economics,
engineering, and other disciplines requiring effective forecasting.
The material included in the book has been particularly effective in a wide range of
teaching activities. These have included seminars for middle management, seminars for
practicing forecasters, and classes taught to both graduates and undergraduates in busi-
ness and in more specialized topic areas such as courses for statisticians, economists, and
management scientists.
Four objectives guided the structuring and development of the major sections of this
book. It is useful to understand these objectives before describing the way in which various
materials might be combined to develop an effective course or program on forecasting
and planning. Part A of this manual reviews these objectives and describes how the
materials in the text can be used to teach forecasting effectively. Alternative course
outlines that indicate how various parts of the book might be used for different audiences
and in programs of different length are also suggested. Parts B and C of this manual
provide additional information on the use of supplementary material and the teaching of
individual sessions in a forecasting course.
The various uses of the book can probably best be seen by considering specific course

1
2 Part A. Planning a forecasting course

outlines built around the text. Several such outlines are discussed and presented in Section
A/3.

A/1 Objectives

The major objectives we pursued in structuring and developing the four parts in this book
included the following:

1. Presenting essential aspects of a wide range of forecasting methods with sufficient


detail and clarity that they could be applied easily.

2. Presenting alternative forecasting methods in such a form that a minimum of tech-


nical background would be required to understand each technique, yet including
enough of the essential concepts and their theoretical basis that students could gain
a thorough understanding of each technique if desired.

3. Providing information concerning the operating and performance characteristics as-


sociated with each of the major forecasting methodologies so that criteria for select-
ing the most appropriate methods can be developed and applied.

4. Examining the important factors and issues in the application of forecasting and
planning and the effective use of forecasting resources in an ongoing organization.

It should be emphasized that while the body of each chapter is geared to the reader
with only a basic background in algebra, the aim has still been to present a complete
description of each technique and those factors that are relevant in deciding where and
how to use it.

A/2 Course materials

In addition to having a class study individual chapters, an instructor has four other major
sources of material to use as building blocks in developing a forecasting course.

Exercises As indicated in the preceding section, many of the chapters in this book deal
with specific techniques for forecasting. At the end of these methodology-oriented
chapters are exercises that we have found particularly helpful in teaching forecast-
ing. The purpose of these exercises is to give students the opportunity to test their
A/3 Sample course outlines 3

knowledge of the basic mechanics of individual methodologies and their understand-


ing of the strengths and limitations of those approaches. Complete solutions for
these exercises are provided in Part D of this manual. All data sets used in the
exercises are available from the books web page at

www.maths.monash.edu.au/hyndman/forecasting/

Case studies Case studies on forecasting situations can take a variety of forms including
basic exercises with a few paragraphs describing the situation surrounding that exer-
cise, providing organizational descriptions of a forecasting system, and even outlining
the management perspective of a decision maker who must use forecasts prepared
in accordance with a given methodology. Part C outlines procedures for using such
cases and suggests how those cases might be used to supplement the exercises at
the end of each chapter. Part C concludes with several additional exercises, project
suggestions and examination questions that might be useful in a forecasting course.

Computer programs A number of computer programs that implement many of the


quantitative techniques described in the text are available and their facilities are
summarized in Appendix I of the book. We have found that it is essential to use a
computer package when teaching Forecasting to enable students to apply the tech-
niques themselves without unnecessarily detailed calculations. In addition, use of
such a package has proved a particularly appropriate means of making students
aware of the strengths and weakness of individual techniques on the basis of their
applicability and results in a range of situations.

Additional readings At the end of each chapter is a set of references that we have found
relevant to topics raised in the chapter. These references provide more depth on the
most important issues and suggest follow-up material for students with a special
interest in a given topic.

A/3 Sample course outlines

We have used the materials included in Forecasting: Methods and Applications, third
edition, for a variety of purposes. These have varied in terms of (1) number of class
sessions in the course, (2) the audience at which the course is directed, and (3) the mix of
lecture and case sessions.
In each course, we find it useful to use real case studies. These are most successful
when the subject matter is of relevance to those attending the course. For longer courses
designed for users, it is important to include computer laboratory sessions giving those
4 Part A. Planning a forecasting course

attending real experience in forecasting real data. Often the concepts that are covered in
lectures are only understood after a person has carried out the procedure and seen the
results on a computer.
Here we provide six course outlines that vary along these three dimensions. Chapter
references are given for background reading. In longer courses, we would cover all (or
almost all) of the material in each chapter. In shorter courses, we given only a brief
introduction to the material listed.

Course A: 5-session (one-day) course for potential users of forecasting

Course A: for potential users of forecasting


Session 1: Introduction (Chapter 1)
Evaluating the performance of a forecasting system, identifying issues in organiza-
tional forecasting, and providing an overview of forecasting methodology.

Session 2: Time series approaches to forecasting (Sections 4/2 4/3)


Exponential smoothing methods and ARIMA models.

Session 3: Regression approaches to forecasting (Sections 5/1 5/3; 6/1 6/5)


Correlation analysis, simple regression, and multiple regression.

Session 4: Evaluating alternative forecasting methods (Section 2/4, Chapter 11)


Introduction of a basic framework.

Session 5: Managing the organizations forecasting function (Chapter 12)


Auditing the status of forecasting, identifying key problems, designing, and imple-
menting effective action plans.

The first outline is for a one-day course that would serve as a primer for potential users
of forecasting in a business organization. Given the audience, the teaching approach is a
combination of lectures and case discussions that can draw into the class the experience
of individual participants.
It is assumed that those attending such a course have some basic mathematical abilities;
if they also have some forecasting experience, it is assumed that it is in a fairly limited area
or that it involves a fairly narrow set of methodologies. As outlined below, selected sections
of half a dozen chapters in this book can be used to illustrate various methodologies and
the ways in which forecasting management issues can be tackled. The references to the
textbook are given in italics.
A/3 Sample course outlines 5

Course B: 12-session (two-day) course for practicing forecasters

In the second course outline, 12 sessions spread over two days are used to introduce
those with forecasting responsibility in a company to various methodologies and to an
interactive forecasting computer package. This program has been used with companies
who have have assigned forecasting responsibility to several people acting as business
managers for various product lines or as product/market managers for various segments
of the companys business.
The text chapters indicated serve as further reference on specific topics. The basic
information on those topics would be covered during lecture class sessions and would be
applied during the sessions that use the computer. Cases are used as the source of data
and as illustrations of various management issues.

Course C: 11-session (two-day) course for managers who will use forecasting

This is also a two-day program (11 sessions) aimed at managers who make use of forecasting
rather than at forecasters. These may be managers who must do their own forecasting or
managers who interface with a forecasting group, such as at a public utility or in a large
consumer products firm. Again, this program assumes that an interactive forecasting
package is available, and output from the package is used to illustrate methodologies.
However, the participants do not actually use the package during the course.
Much of the class time is spent describing the way in which alternative forecasting
techniques can tackle representative management problems. The objectives of such a
course would be to help managers identify situations in which a quantitative forecasting
approach would be appropriate and how to describe and define such situations so that
such a technique could be applied.

Course D: 9-session (three-day) course for potential users of forecasting

This course gives a nine-session program that could be provided as an elective in a regular
college or university curriculum or it might be compressed into a three-day program for
managers or practicing forecasters. It would go into more depth on the topics covered in the
outlines for one- or two-day courses and take a management orientation by concentrating
on case applications and their discussion in the classroom. As indicated, this course outline
includes specific time for group work after individual preparation of the cases.
6 Part A. Planning a forecasting course

Course B: for practicing forecasters


Session 1: Introduction and defining the forecasting problem (Chapters 1 and 2)
Major issues in forecasting, the concept of a forecasting strategy, a framework for
classifying forecasting methodologies, and measuring forecasting error.

Session 2: Exponential smoothing methods of forecasting (Chapter 4)


Single exponential smoothing, Holts method, and Holt-Winters seasonal method.

Session 3: Using an interactive forecasting package


A laboratory session introducing a forecasting package. Inputting data, plotting data,
using exponential smoothing methods for tackling a given case study.

Session 4: Time series analysis (Chapter 7)


Autoregressive and moving average models for time series analysis, autocorrelation
analysis, and model selection.

Session 5: Data preparation for forecasting


Determining what to forecast, deciding how to forecast, and securing the required
data. Use examples from past experience.

Session 6: Optional laboratory session


Application of smoothing methods and time series analysis to given case studies.

Session 7: Simple regression (Chapter 5)


Correlation analysis, simple linear regression, and statistical tests of significance.

Session 8: Multiple regression (Chapter 6)


Basics of time series multiple regression, causal factors in multiple regression, statis-
tical characteristics of this method.

Session 9: Laboratory session


Applying simple and multiple regression to given case studies.

Session 10: Selection of a forecasting methodology (Section 2/4 and Chapter 11)
Techniques for analyzing the characteristics of a given data set, criteria for select-
ing a forecasting methodology, and comparing the results obtained from alternative
techniques

Session 11: Systematic improvement of forecasting (Chapters 12)


Designing a forecasting strategy, measuring performance, and considering organiza-
tional aspects of the forecasting function
A/3 Sample course outlines 7

Course C: for managers who will use forecasting


Session 1: Overview of forecasting for management (Chapter 1)
A management perspective on forecasting, introduction to forecasting methodologies,
accuracy as a performance criterion, additional criteria for selecting a forecasting
method.

Session 2: Seasonal indices and decomposition (Chapter 3/1, 3/2 and 3/4)
Classical decomposition, computation of seasonal indices, deseasonalizing a data se-
ries.

Session 3: Exponential smoothing (Chapter 4)


Basic smoothing models, performance on trend and seasonal patterns.

Session 4: Interactive forecasting package


Philosophy and characteristics, overview of program structure and components, data
creation and handling, inputs and outputs to the program, sample runs, limitations,
and applications.

Session 5: Autocorrelation analysis (Section 2/3/3 and Section 7/1)


Time dependence, correlation error analysis. Apply to errors from exponential
smoothing method.

Session 6: Time series analysis (Sections 7/2 7/8)


Concepts and theory, performance, and practice.

Session 7: Simple regression (Chapter 5)


Linear time trend analysis, least squares estimation, performance, and practice.

Session 8: Multiple regression (Chapter 6)


Causal relationships, illustrative examples, performance, and practice.

Session 9: Management use of forecasting (Chapters 10 and 12)


Computer programs, business cycles, and judgmental inputs.

Session 10: Implementing quantitative forecasting techniques (Chapters 12)


Selecting the right data, specifying the forecasting project, determining support re-
quirements, using available methodologies.
8 Part A. Planning a forecasting course

Course D: for potential users of forecasting


Session 1: Introduction and overview

Session 2: Role of forecasting in decision making, planning, and control


(Chapter 1)

Session 3: Time series decomposition (Chapter 3)


Classical decomposition, computation of seasonal indices, deseasonalizing a data se-
ries. Value of decomposition for forecasting.

Session 4: Exponential smoothing (Chapter 4)


Group work on exercises for smoothing time series. Discussion of time series smoothing
and evaluation of accuracy

Session 5: Time series analysis (Chapter 7)


Introduction to autoregressive and moving average models for time series analysis,
autocorrelation analysis, and model selection. Some exercises on model selection and
autocorrelation analysis of errors. Interpretation of forecasts and prediction intervals.

Session 6: Simple regression (Chapter 5)


Correlation, least squares estimation, simple linear regression, statistical tests of sig-
nificance, forecasts.

Session 7: Multiple regression (Chapter 6)


Seasonal dummy variables, other explanatory variables, variable selection, estimation,
forecasts, collinearity.

Session 8: Regression analysis in practice (Chapter 6)


Group discussion of a case study. Identification of appropriate variables, variable
selection, interpretation of computer output, use of model for forecasting, forecasting
explanatory variables.

Session 9: The forecasting function in the firm (Chapter 10 and 12)


A/3 Sample course outlines 9

Course E: segment of production course on short-range forecasting


Session 1: Introduction to short-range forecasting (Chapters 1, 2, and 12)

Session 2: Analysis of time series data (Chapters 3 and 7)


Plots, seasonality, autocorrelation.

Session 3: Exponential smoothing (Chapter 4)


Simple models, calculation of forecasts, autocorrelation of errors.

Session 4: ARIMA models (Chapter 7)


Overview of models, model selection, interpretation of forecasts, and prediction inter-
vals.

Course E: 4-session segment of production course on short-range forecasting

This short course on forecasting is actually a four session segment of an MBA elective
course on production and operations management that focuses on short-range forecasting
as an input to production planning and control. Students are expected to use an interac-
tive forecasting package in applying selected methods to a variety of production planning
situations.

Course F: 18-session course for MBA elective on forecasting for management

This course is designed as a full-quarter elective course for MBA students who may accept
job assignments with forecasting responsibility immediately upon graduation. Thus, stu-
dents electing this course would tend to have a fairly good background in mathematics and
would be particularly interested in the knowledge needed to apply individual techniques.
The majority of the class sessions would involve lectures dealing with various topics related
to quantitative forecasting techniques and their application. However, at the end of each
of several major sections of the course, one or more cases would be used to show the prac-
tical application of the concepts being discussed and some of the difficulties encountered
in their implementation. A forecasting competition would be conducted during the course
so students could forecast a variable, obtain results, and then prepare further forecasts.
We have also used class visitors at the end of a long course of this type. These would
be practicing forecasters from business or industry who would provide a fresh perspective
on the practice of forecasting and would also discuss non-statistical problems they have
encountered in forecasting.
10 Part A. Planning a forecasting course

Course F: for MBA elective on forecasting for management


Session 1: Introduction to forecasting - Why forecast? (Chapter 1)
Summarizing data and relationships: a review of some useful concepts Explanatory
methods of forecasting. Forecasting and causality

Session 2: Summarizing data and relationships (Chapters 2 and 3)


A review of some simple quantitative concepts, time series, moving average smoothing.

Session 3: Decomposition (Chapter 3)


Trend analysis and seasonality, detrending, classical decomposition, overview of other
decomposition methods.

Session 4: Exponential smoothing methods (Chapter 4)


Simple exponential smoothing, Holts method, Holt-Winters method.

Session 5: Regression (Chapter 5)


Regression analysis, correlation, least squares estimation, tests of significance.

Session 6: Multiple regression (Chapter 6)


Multiple regression models, significance tests, variable selection,

Session 7: Multiple regression (Chapter 6)


More on estimating regressions, diagnostics, transformations, prediction with regres-
sion models.

Session 8: Multiple regression (Chapter 6)


Lagged variables, spurious regressions.

Session 9: Multiple regression (Chapter 6)


Econometrics and economic models.

Session 10: Time series analysis (Chapter 7)


tests for autocorrelation, analysis of errors from forecasting methods, autoregressive
models.

Session 11: Time series analysis (Chapter 7)


ARMA and ARIMA models

Session 12: Time series analysis (Chapter 7)


Box-Jenkins procedures, estimation, tests
A/3 Sample course outlines 11

Session 13: Time series analysis (Chapter 7)


Examples and applications.

Session 14: Advanced forecasting methods (Chapter 8)


Overview of some more advanced methods.

Session 15: Long-term forecasting (Chapter 9)


Cycle analysis and indexes, cycles and the forecast problem, index construction, lead-
ing indicators.

Session 16: Judgmental forecasting (Chapter 10)


Subjective methods, estimation, tests, model selection criteria, estimation, and diag-
nostics, choosing a method to fit the problem.

Session 17: Comparing forecasts (Chapter 11)


Measures of accuracy. How do we compare forecasts? Canonical procedures, rules of
thumb.

Session 18: Conclusion


Review and award presentation for the competition

A major project is also a worthwhile adjunct to such a course. One option would be
to give students a case and ask them to prepare the complete analysis and forecasts in
both written and oral form for the management of that company. Such a project allows
students not only to test their knowledge of various techniques but also to handle the
problems of deciding what to forecast and how, and determining what data would be
most appropriate.
A final variation of this forecasting project that we have used with some success is to
identify a forecasting situation in an existing company and to have the manager in that
situation come to class so that the students, acting as forecasters, can define the task and
determine what information is needed. Students can work on the project in teams and
make their final presentations to the manager involved. This type of project is perhaps
the best possible test of students knowledge of the subject area and their ability to handle
the practical aspects of forecasting in an organization. The final presentation could serve
as the final exam for the students.
Many other course outlines based on the material in this book are possible, of course.
Here we wish to introduce the range of such outlines and suggest how they might be
adapted to use the complementary materials described in Parts B and C of this manual.
B/Teaching suggestions

Chapter 1: The forecasting perspective

The fate of a course is often decided early. So motivating the subject is critical. This
chapter needs help to make it a live opening for the course, and here are some suggestions.

1. Spend time making the three points on page 5 meaningful.

(a) Scheduling existing resources


(b) Acquiring additional resources
(c) Determining what future resources are needed

If possible, invite a couple of business practitioners into the first class to make the
reality of these matters clear.

2. Consider Figure 1-1 and study it from the point of view of the group responsible for
making the sales forecast for a company. Sales forecasting is one of the most routine
and most fundamental business tasks. It directly impinges on budget policy at all
levels of the firm. Make the point that there are two directions to look:

where does it come from? where does it go?


 Sales Forecast -

3. Following the previous point, try to establish (i) the context within which a fore-
cast is made, and (ii) the environment in which a forecast is received. There is
more to forecasting than learning a mathematical method, getting data, running a
computer program, and reporting on extrapolated future values. Sales of a product
group take place within the context of sales of competing products (both internal
to the company and externally). Sales depend on market demand. Market demand

12
Chapter 1: The forecasting perspective 13

depends on market conditions. And so on. It is a dynamic interlocking system out


there. When the sales forecast has been made it is passed on in the hierarchy, to
be examined, modified by expert judgment, repackaged, and passed on again. Fore-
casting is not a passive activity. The physical environment within which forecasts
are created is dynamic, and the organizational consumer of forecasts shares these
dynamics and adds its own human relations.
4. Table 1-1 offers opportunities for class participation. What forecasting scenarios
are hot topics right nowin the local environment (what will acid rain do to our
forests)? in the nation (will the national deficit ever decrease)? in any firm that you
know about (will our ski businesses survive in the uncertain weather)? And so on.
5. Sections 1/2 and 1/3 begin to introduce the jargon of the field of forecasting, and it
is important to establish some of the most commonly used terms. For example, a lot
will be said about time series methods and explanatory methods. Distinctions are
also made between quantitative methods and qualitative methods. And you can no
doubt think up other dichotomous categories. The purpose of these categorizations
is to aid in communication.
For example, with the two mentioned above, we can identify four cells:
time series causal
quantitative non-quantitative
time series causal
non-quantitative quantitative
As more and more dichotomous categories are invented we can generate many, many
possible (methodology) cellsbut some of them will not be possible. It might be
enough to try to think of examples for the four cells given above.
6. Be careful with the distinction between explanatory models and time series models.
There is some semantic confusion with this choice of words, because explanatory
models can deal with time series data. So the context has to help out. When we
say time series models or time series methods we usually mean to talk about one set
of (time-dependent) data and we will try to develop a model (an equation) which can
be though of as the generating process of these data. We specifically will not look
at its relationship with other variables. When we causal models we are specifically
looking for other variables (which may be time series) which offer explanations (or
linkages) to the main variable (which may also be a time series).
7. It is important to see forecasting as a process involving several steps as outlined in
Section 1/3. Many people focus on just Step 4: choosing and fitting models. To
emphasize the basic steps in a forecasting task, it is helpful to take a particular
example and lead a class discussion on what is involved in each of the five steps.
14 Part B. Teaching suggestions

Chapter 2: Basic forecasting tools

Chapter 2 introduces some of the basic quantitative tools that will be used extensively
later. Therefore it is important the material covered here is well understood.

1. The two examples in section 2/1 will help to fix the distinction between explanatory
and time series methods.

2. The patterns discussed in Section 2/2/1 are important for later reference. In the
many time series to be dealt with in the book, it will become second nature to ask
(i) is there a trend? (ii) is there an annual pattern (seasonality)? (iii) is there a
longer (than one year) cycle?
It is important to emphasize that when we talk about business cycles we mean
something different from seasonality which refers to the annual pattern. Cycles
are almost always longer than seasonal patterns.

3. The plots in Section 2/2, particularly the time plot and the scatterplot, will be
used extensively in subsequent chapters. These also help students understand the
difference between explanatory and time series methods.

4. In dealing with the familiar descriptive statistics in Section 2/3, the following aspects
could be stressed.

(a) Cross-sectional versus time series data: Some students find it difficult to switch
their thinking from elementary descriptive statistics of cross-sectional data (e.g.,
the weights of 100 mice) to time series data which may have trend, seasonality
and longer term business cycles (e.g., housing starts). The mean of housing
starts does not convey much information because of the trend, seasonality and
cycle. Similarly, the variance of housing starts is hard to interpret. So in
section 2/3, as each descriptive statistic is defined, it is useful to ask: is there
any difference in meaning when we talk about cross-sectional data or time series
data?
(b) Absolute values: The sum of the deviations from the mean for any data set
always equals zero. The sum of the absolute deviations from the mean does
better. But it is an awkward statistic to deal with. (For those with a little
calculus background, ask them to differentiate the MAD equation (2.3) with
respect to the mean, and the point will be established.) It is easier to deal with
the mean of the squared values. (Again, ask those with calculus background to
differentiate the MS equation (2.4)).
Chapter 2: Basic forecasting tools 15

(c) Mean square versus variance: There is a tendency for current statistics texts
to define variance using (n 1) in the denominator without explanation. Then
there is the inevitable question, Why (n1) and not n? When we write down
formulas for computing summary numbers (statistics) the formulas dont know
anything about assumptions, so from their point of view it makes no difference.
Only when a statistical model has been defined (using random variables with
their accompanying probability distributions) does it make any sense to talk
about unbiased or biased estimates, and then a meaning can be given to
the issue. To avoid some of the problems in this connection, we have chosen to
talk about the mean square as the simple average of squares, and the variance
will use (n 1) in the denominator. This is a matter of convenience. Since
this issue is tied up with d.f. (degrees of freedom), it is useful to make a point
that d.f. are defined as (number of independent data points) minus (number of
parameters estimated). For example, if there are n = 20 students in the class
and each has a score on a test, then how many numbers must you sing out to a
stranger before they know all the scores? Twenty. So there are 20 d.f. for the
raw data. Now compute the mean. Find the deviation from the mean for all
20 students. How many of these deviations must be sung out before a stranger
can know them all? Nineteen. After hearing 19 of them, the last one must be
such that they sum to zero. One d.f. was lost in computing the mean.
(d) Bivariate statistics: Covariance and correlation are important concepts to un-
derstand. Note that variance is a special case of covariance (if you convert Y
to X). Understanding correlation is important in regression (Chapters 5 and
6) and in autocorrelation (Chapter 7).
(e) Autocorrelation: To give students a feel for the meaning of autocorrelation,
show some plots of a time series plotted against itself, lagged one period, then
lagged two periods, etc. The physical act of making one or two of these scat-
terplots is worth the time it takes.
Another worthwhile activity is to do Exercise 2.4 in class with students guessing
which plots align with which ACFs. Discussion is usually easy to stimulate with
students justifying their answers.
(f) Accuracy measurements: Dwell on the interpretation of these summary num-
bers, so that the distinctions between absolute statistical measures and relative
measures are clearly understood. For example, in dealing with MSE versus
MAPE, you could consider the X and F data in Table 2-9.
(i) What happens to the values of MSE and MAPE if the data were all mul-
tiplied by 2?
(ii) Similarly consider what happens to the values of MSE and MAPE if 100
was subtracted from all numbers.
16 Part B. Teaching suggestions

In case (i) the MSE is going to be 4 times larger but the MAPE wont change.
In case (ii) the MSE wont change but the MAPE is considerably changed.
What happens if 119 is subtracted from all data?
(g) Theils U statistic: This is worth understanding. It becomes easy to use in
practice because when U < 1 the forecasting method is better than the nave
one (using last periods observation as the forecast for the next period). When
U > 1 it is worse then the nave method. Unfortunately, not many computer
forecasting programs calculate Theils U .
(h) ACF of forecast error: It is good practice to look at the ACF of the errors ob-
tained from any forecasting method. (See Section 7/1) It is worth emphasizing
this throughout Chapters 48 whenever a forecast is calculated.

5. Throughout the book, we emphasize the calculation of forecast intervals wherever


possible because it provides a sense of how dependable a forecast is. Section 2/5
allows some simple forecast intervals to be computed using only the MSE. This
helps students understand the MSE better and introduces the basic concept of a
forecast interval.

6. The reason for giving a special section (2/6) to least squares is simply because it is
almost all-pervasive in the model building world. It has been found to be extremely
valuable in statistics (e.g., in the fitting of regression models to data).

7. Many forecasting tasks can be simplified by transforming or adjusting the data in


some way. It is helpful to ask students how they would transform or adjust a few
given data sets. This can lead to some interesting discussion and emphasizes the
need to understand the data before doing any forecasting.

Chapter 3: Time series decomposition

Decomposition methods are among the oldest of all the forecasting procedures. They are
easy to understand, at least in principle, because most people dealing with time series
data assume the presence of trend, the influence of a business cycle, seasonality (if were
dealing with monthly or quarterly data, for instance), and the ever-present noise (the error
term, the disturbance term, or the random shock). The following points should be noted
in teaching this chapter.

1. The components implied by decomposition are invariably described as trend, cycle,


seasonality and noise (or other words to describe this uncontrollable part). when
we speak of trend it seems easy to understand, but in fact it is not all that clear. it
Chapter 4: Exponential smoothing methods 17

is often inextricably mixed up with the so-called cycle (which itself is not a math-
ematical cyclesuch as a sine wavebut rather a irregularly shaped up and down
movement associated with general business conditions) and the only way trend can
be separated from cycle is by arbitrary definition of trend. Because of this complex-
ity many decomposition methods (e.g., the Census II method) identify trend/cycle
as one component. Seasonality is less ambiguous and it refers to systematic patterns
that occur within the calendar year.
Suggestion: Have students come up with a written definition of these four compo-
nents.

2. The ratio-to-moving averages method is easy to compute (see Table 3-6) and it is
good to see plots of the original data, the moving average and the ratio-to-moving
average. When the ratio-to-moving average values are portrayed as in Table 3-6 they
can be visualized in a seasonal plot (Section 2/2/2) which allows for the stability
of the seasonal pattern to be assessed. Students should be clear on the meaning of
each of the columns in Table 3-6.

3. The Wall Street Journal, Business Week, Fortune and other business magazines all
make repeated reference to seasonally adjusted time series and it is important that
all students know exactly what this means. The ratio-moving averages are in fact
seasonal indices plus the random noise component. By averaging these seasonal
indices for each month (or quarter as the case may be), the random component is
reduced, and the resulting seasonal index is a measure of the impact of the season.
By dividing the original data by this seasonal index we are left with seasonally
adjusted datawhich has in it, trend and cycle and noise. That is, the influence of
the season has been removed. The Census II method talks about preliminary and
final seasonal adjustment factors (same as seasonal indices), and preliminary
and final seasonally adjusted series.

4. If software is available for one or more of these decomposition methods, it is interest-


ing for students to compare the results. In particular, investigate what the methods
produce when the series contains some unusual behavior such as a level shift or
some outliers. The classical decomposition method is not designed to cope with
such behaviors, but the Census II and STL methods both contain some robustness
facilities.

Chapter 4: Exponential smoothing methods

Exponential smoothing methods can be useful as an introduction to some of the ideas of


time series forecasting, particularly the concept of forecasts being weighted averages of
18 Part B. Teaching suggestions

time-lagged observations. They are also useful forecasting methods in their own right.

1. These are time series methods as opposed to explanatory methods.

2. In dealing with time-dependent data the concept of a moving average is valuable


because it is dynamic. It moves with time.

3. Whereas moving averages involve equal weights over a set of observations, the simple
exponential smoothing (SES) method is fundamentally different in that it implies
unequal (exponentially decaying) weights.
Aside: You can engage the students in a discussion on how to weight past data in
making a forecast. Should the latest data count more than earlier data? When is
this true? (E.g., when older data was based on a different manufacturing process.)
When might it not be true? (E.g., when current data occurs during a strike.)

4. In order to appreciate the fact that all methodologies have built-in limitations, it is
useful to do what engineers typically do, namely, test the methods on some standard
types of input series. This can be demonstrated by constructing a simple series of 20
observations containing a level shift part way through the series. Then apply both
a moving average and SES to the data to see how each method accommodates the
step. This can be a most enlightening experience for students and a valuable base
for latter work. Similar test series might contain a single outlier, or a trend.

5. Following the previous point, you can ask if SES and moving averages keep pace with
trend. And then discuss seasonality as a complicating factor. Can moving averages
and SES take care of seasonal indices?

6. Discuss Pegels two-way classification with the students to emphasize the difference
between linear and multiplicative trend and seasonality. The flexibility of Pegels
classification has yet to be fully appreciated, and it is worth discussing some of the
cells other than those corresponding to SES (A-1), Holts method (B-1) and Holt-
Winters method (B-2 and B-3). For example, consider cell C-3 which will often
outperform Holt-Winters method.

7. A very important point to establish for exponential smoothing methods is the fact
that an initialization process (for getting a method going) has to be defined. Since
the initialization procedure has an influence on all subsequent smoothed values it
has to be handled with care. Therefore, in deciding how well an SES model fits, for
example, it is wise to define a test period which excludes that early part of the
series which is still settling down during the initializing phase. Contrast this with
regression models where we can define errors of fit for all data points at once. For
this reason, we have given explicit statements about each strategy and some general
Chapter 5: Simple regression 19

comments on alternative initialization strategies in Section 4/5/1. Note that these


are not the only ways of going about it. Students may be able to come up with there
own suggestions.

8. We have designed this chapter to be complete in the sense that the equations are
all given and fully worked examples are provided. Table 4-11 is something that you
might work toward. It gives in one place a comparison of how all the methods do on
one set of seasonal data. If your students have come to the course with their own
data sets they should be encouraged to work toward a table similar to this.

9. Also note that it is appropriate to discuss the extensive forecasting experiments


described in Chapter 11.

10. A good exercise in discussing ARRSES would be to ask students to generate a time
series using a slowly changing value, and then do an ARRSES analysis to see if
the method comes close to what was simulated.

Chapter 5: Simple regression

Many students will have already have had a first course in statistics and will have done
some simple regressionmostly in the context of cross-sectional data. Chapters 5 and 6
of this text should accomplish the following:

(a) Consolidate understanding of simple and multiple regression for cross-


sectional data.
(b) Discuss the importance and limitations of the correlation coefficient.
(c) Discuss the use of regression in a forecasting (time series) context.
(d) Deal with the practical application of simple regression, multiple regres-
sion and econometric models.

The following suggestions will assist in teaching this material.

1. Discuss the data setup for simple regression, multiple regression and econometric
models. Mention that in econometric modelling the dependent and independent
variables become mixed upin the sense that Y variables appear on the right hand
side of econometric equations as well as on the left hand side.

2. Review the details of simple regression of Y on X, make sure everyone knows the fun-
damental statistics (mean, variance, covariance, correlation, regression coefficients),
20 Part B. Teaching suggestions

and then deal with the definition and role of the overall F test, the t-tests for indi-
vidual coefficients and the sampling fluctuation of the coefficients.
3. The correlation coefficient is a very widely used statistic and therefore should be un-
derstood well. Mention that it is a measure of linear association, that it is therefore
unaffected by any linear transformation, that its sampling fluctuation is large for
small sample sizes (so beware of those regressions based on 10 observations!), and
that it can be severely affected by skewness (or outliers).
4. Emphasize the difference between regression for cross-sectional data and for time
series data. Cross-sectional regression can be useful in a forecasting context (e.g., the
automobile data in chapter 2) but time-indexed data and time series regression pose
special problems. The error terms in cross-sectional regression are usually assumed
independent, but in time series regression this independence is often suspect, and
in some cases (e.g., in dynamic regression models) the errors are carefully defined
not to be independent. The autocorrelation coefficient is simple to define and to
compute, but its sampling distribution is more difficult to handle than the sampling
distribution of the correlation coefficient.
5. Many textbooks talk about regression as a forecasting tool but very few actually do
forecasting with regression. For example, if we regress Y t on Xt1 ,
Yt = 3 + 5Xt1 + (error),
and we want to forecast Yt+1 , then the equation allows us to do that:
Yt+1 = 3 + 5Xt .
We already know Xt , and so can obtain Yt+1 . However, if we regress Yt on Xt :
Yt = 3 + 5Xt + (error),
then in order to forecast Yt+1 we will need to know Xt+1 , and we do not know this.
So we will have to forecast Xt+1 before we can forecast Yt+1 .
6. Discuss the meaning of equations (5.3) and (5.4) for slope and intercept. The slope
is actually (covariance of X and Y ) divided by (variance of X) and the intercept is
the mean of Y minus the slope times the mean of X.
7. There are no assumptions involved in calculating a correlation coefficient. Equation
(5.10) for r is merely a formula. When it comes to regressing Y on X and some
statistical regression model is defined, then the correlation between X and Y , when
squared, has another useful interpretation. It is the proportion of variance explained
by the linear relationship between X and Y . What this means is that, knowing the
X values we will be able to recover a certain proportion of the variance of Y , and
this proportion is r 2 .
Chapter 6: Multiple regression 21

8. The r value is a measure of linear association so point out the message in Figure 5-7
when a strong nonlinear association cannot be picked up by r. Note also that for
small samples the correlation coefficient is notoriously unstable (a phrase Kendall
and Stuart use in the Advanced Theory of Statistics, Vol. 1). Finally, emphasise how
skewness can have a profound effect on r. The King Kong example (see Figure 5-8)
is a useful illustration of this effect and the answers to exercise 5.6 present further
evidence.

9. It is a good idea to contrast equations (5.13) and (5.14) and ask the question: Where
are the random variables in each equation? In (5.13) there is only one random
variable. In (5.14) there are three random variablesa, b and e. The values of
a and b are estimates for the unknown parameters, and in (5.13). This is why
we can define a standard error for the slope and a standard error for the intercept
standard errors which are needed to define t tests for the slope and intercept.

10. Emphasise that the F statistic involves a numerator degree of freedom and a de-
nominator degree of freedom, and make sure that students know how to read the
F tables (Appendix III, Table C). A pragmatic point is that the F test should be
done first when appraising a regression analysis, and afterward the individual t tests
can be examined. In the case of simple regression there is no difference, because the
t test is a special case of the F test, but in multiple regression (chapter 6) this is
important.

11. In simple regression there is an intimate connection between the slope and the in-
tercept. Since the least squares regression line always goes through the mean of X
and the mean of Y , it stands to reason that if the slope is changed the intercept is
changed and vice versa. If the mean of X and Y are both positive then an increase
in the slope will cause a decrease in the intercept, and vice versa.
Equations (5.17) and (5.18) should be studied. Note in (5.17) that the second term
under the square root sign will be small if the denominator (representing the spread
of the Xs) is large relative to the numerator (which is the mean of X). In (5.18)
the standard error of the slope depends on how spread out the Xs are. If they are
well spread out, the standard error is small.

Chapter 6: Multiple regression

1. As for many other chapters, it will be helpful here to have a readily available regres-
sion package for students to work on, so that they can check various things in the
chapter and can run their own data through various regression models.
22 Part B. Teaching suggestions

2. If at all possible, students should run their own data through the various analyses
for maximum understanding. We sometimes adapt the exercises at the end of the
chapter to use the data sets of interests to our students.

3. In multiple regression for cross-sectional data it is important to point out that the
significance of individual coefficients is contingent upon the other regressors present
in the regression. We emphasise this and say: the coefficient for X 3 is significant
in the presence of the other regressors.

4. In real world regression problems a considerable amount of time is spent selecting


independent variables and coming up with a reasonable model specification. To
illustrate this we have used a mutual savings bank data set and have done a detailed
analysis of most of the stages that led to a model which was actually used by a large
metropolitan bank. The example is sometimes a little complicated, but we feel it is
worth the effort to get into it in detail.

5. In the notes on chapter 5 we pointed out that regression is often spoken of as a


forecasting methodology, but seldom actually used explicitly in a forecasting context.
In this chapter we carry the bank study through to its conclusion by forecasting
with a final regression model. We explore the difficulties of having to forecast the
independent variables before we can forecast the dependent variable.

6. As in chapter 5, it is worthwhile to understand the cross-sectional regression model


thoroughly, and then consider where the time series regression applications violate
certain assumptions. Since this text is not addressed to formal statisticians, it is
enough to discuss the implications of correlated errors, improper specification (e.g.,
linear when it might be curvilinear, or two regressors when it should be four regres-
sors), multicollinearity, etc., and refer interested students to texts such as Draper
and Smith (1981) for more details.

7. Table 6-1 and Table 6-2: Take time to get to know these data sets because they will
be used a lot during the chapter. Have students graph the data sets and keep them
handy for class discussion.

8. The Durbin-Watson statistic is described in equation (6.9) and Table 6-7. Students
dont have too much difficulty learning how this statistic is computed. However,
learning to use the D-W tables (Appendix III, Table F) is not so straightforward.
Please spend time going through a couple of examples in using the tables.

9. Selecting variables for inclusion in regression is a meaty subject and we give only an
introduction to the major ideas. In the context of the bank example we go through
some of the procedures without explaining all the details (for example, we talk about
Chapter 7: The Box-Jenkins methodology for ARIMA models 23

using principal components to get a short list of variables). However, any serious
multiple regression analysis will need to consider variable selection carefully.
10. Section 6/4 (Multicollinearity) gives some information that is not often given about
multicollinearity. We hear too often that multicollinearity is present when the
highest correlation among any pair of regressors is only .7, say. And we hear too
often that multicollinearity is not a problem when there are no large correlations
(i.e., not larger than say 0.5). Both of these statements are incorrect. Table 6-12
shows quite clearly that even when the correlations among regressors never get bigger
than 0.333 we can have perfect multicollinearity.
11. Standard error formula (6.13) is a multivariate equivalents of (5.19). It is a little
harder to interpret because it is written in matrix notation, but it should be part of
a regression package so that confidence intervals can be determined.
12. Table 6-14 should be studied very carefully to ensure students understand how these
forecasts are obtained. It takes a little while to get the time intervals straight, but
its a real issue.
13. In discussing econometric models (Section 6/6) we have only given an introduction to
how econometric models are related to the multiple regression models which are the
subject of this chapter. Our aims are to give students an appreciation for econometric
models, their breadth and depth, and the need for specialized skills to develop and
use them effectively.
The topic of econometric modelling is itself an extensive field and we have not chosen
to cover it in this book. An instructor may choose to include other materials on
econometric methods (such as Johnston, 1984; Judge et al., 1988; or Pindyck and
Rubenfeld, 1991) to complement the materials in this chapter. A useful introductory
perspective is provided by Aykac and Borges Econometric methods for managerial
applications in the Handbook of Forecasting, Makridakis and Wheelwright (editors),
(New York: Wiley and Sons, 1982).

Chapter 7: The Box-Jenkins methodology for ARIMA models

1. We have chosen to present this material in a different order from that found in most
other textbooks. Students always find this material a little difficult at first, and we
have found the order given in the textbook the most successful approach in leading
students through ARIMA modeling.
2. Section 7/1 allows students to firmly grasp the idea of white noise and the use of
the ACF and PACF before considering ARIMA models. The white noise tests can
24 Part B. Teaching suggestions

be applied to the residuals from regression models or exponential smoothing models.


Introducing residual analysis in the context of these earlier forecasting methods
emphasises that these ideas are not only applicable to ARIMA models, but to any
forecasting methodology. It also allows students to become familiar with some of
the tools used in ARIMA modelling before having to learn about ARIMA models
themselves.
3. Next we introduce the ideas of stationarity and differencing in Section 7/2. We find
it better to introduce these ideas before ARMA models (rather than after as is often
done) because it allows ARMA models to be applied to a much wider range of time
series from the start. A common approach is to consider only stationary series at
first and non-stationary series later, but this gives students the initial impression
that ARMA models are not very widely applicable. We find that the approach given
in the book leads students to be more positive about these very useful models.
4. You can anticipate that we will be wanting to use the backward shift operator nota-
tion later (particularly in chapter 8) and should make a decision whether to introduce
it at this time or not. Students do not seem to find this difficult to digest.
5. Students usually find autoregressive models relatively easy to understand as an ex-
tension of multiple regression. This is the way we normally introduce them. Next
consider the connection between exponential smoothing and AR processes. An ex-
ponential smoothing process also involves weighted past values and so is a special
case of an AR process.
6. Moving average models are usually more difficult to understand at first. Some in-
structors try to connect them with previous forecasting methods such as exponential
smoothing. We have not found that students find this particularly helpful. Instead
we just say they are like a multiple regression, but with past errors as the explana-
tory variables. Get the point across that linear functions of past values of the error
series are called MA processes, and linear functions of past values of the observations
are called AR processes.
7. Note the potential confusion between moving average models, moving average
smoothing and moving average forecasting. Students find this unfortunate dupli-
cation of terminology difficult and it needs to be explained very carefully.
8. If you have the facilities it is recommended that you have students generate time
series using some of the simpler models so that they really know what is implied.
Students will learn more about the models if they have to generate data using a
spreadsheet package, than if they use a package with built-in data generation facil-
ities. Generating data with known properties and then studying the shape of the
theoretical ACF and PACF gives a valuable insight into the BJ models.
Chapter 7: The Box-Jenkins methodology for ARIMA models 25

Make a point about learning in one direction and analyzing real data in the opposite
direction. In schematic form, this is:

(a) generate data with known properties


(b) study the theoretical ACF and PACF
(c) store the simulated data and then analyze it.
See if the empirical ACF and PACF match the
properties that we started with.

In real world data, it is the other way around:

(a) analyze the observed data


(b) study the empirical ACF and PACF
(c) try to identify a theoretical underlying model
that could have given rise to the observed data

9. Note that the constant term c in these models is not the same as the mean of the
time series if there is an AR component. For example, if the mean of Y t is , then

Yt = (Yt1 ) + et

so that c = (1 ). In general, the constant term will be

c = (1 1 2 p ).

For an MA model, the constant is equal to the mean of the series.

10. It will become increasingly important for students to be able to write out the equation
for any ARIMA model, so practice at this time is important.

11. The ACF and PACF are used repeatedly later Sections of this chapter, so they
should be learned thoroughly. Give students some sample ACFs and PACFs and
have them guess the type of series they come from.

12. Before proceeding to Section 7/5, it would be wise to have students very comfortable
with the ideas of stationarity, ACFs, PACFs, ARIMA models and how they are all
related. They should be able to write the equations for simple ARIMA models.

13. In trying to generate time series that are from an ARIMA(p, d, q) process, students
will need to be aware of the restrictions on the values that the AR and MA coefficients
can take on.
26 Part B. Teaching suggestions

14. Students should not be fooled into believing that it will be easy identifying ARIMA
models for real data series. As soon as the model becomes a mixed modeleven
the very simplest ARIMA(1, 0, 1)the shape of the ACF and PACF can become
confusing. It is good to lean the properties of the elementary models, and it is good
to remember that they will seldom make themselves known unequivocally in real
data series.

15. Estimation (Section 7/4) is often taught in two parts: preliminary estimation and
final estimation (using some iterative process such as Marquardts algorithm). Com-
putationally, this is the way it must be done, but from the point of view of a forecaster
using a computer package, the computational details are not relevant. Therefore, we
have focussed on the results which are obtained from a computer package as these
are of most relevance to practising forecasters.

16. The use of the AIC in Section 7/6 is not common in introductory forecasting books,
but we have found it extremely useful in practice and many computer packages are
not giving it as part of the standard output.

17. The conversion of an ARIMA equation into a form suitable for forecasting (Section
7/8/1) takes a little bit of algebraic multiplication and rearrangement of terms.
However, since all forecasting packages will provide forecasts from an ARIMA model
automatically, students will probably never need to do the calculation themselves.
The purpose of including the details in this section is to show how the equations give
forecasts, something which may not be immediately obvious to students, particularly
when there is an MA component.

18. The material in Section 7/8/3 is very poorly understood, even by some experienced
forecasters. The effect of differencing on the forecasts is worth understanding. Too
often differencing is carried out without thought for its implications later on.

19. Students learn most from working through an analysis of a time series from start
to finish. Exercises 7.8 and 7.9 are useful for this purpose. See also Section C/2/7
which can be used as a student project in longer forecasting courses as it enables
each student to choose a different set of data to analyze.

Chapter 8: Advanced forecasting models

1. There is a lot of material in this chapter, and the instructor may wish to select
only a few topics to cover. In a shorter course, we suggest omitting Section 8/5
(Multivariate autoregressive models) and Section 8/6 (State space models). Please
note that Sections 8/1, 8/2 and 8/3 are sequential. Therefore it is important to
Chapter 8: Advanced forecasting models 27

cover Section 8/1 (Regression with ARIMA errors) well before going on to Sections
8/2 (Dynamic regression models) and 8/3 (Intervention analysis).

2. The approach we have adopted for Sections 8/1 and 8/2 is very different from that
found in most books. We have followed the Pankratz approach (and terminology)
to modelling rather than the more traditional Box-Jenkins approach. We have
taught using both approaches many times and have found students find the Pankratz
approach very much easier to follow and use. In our own consulting work, we have
also found it a much simpler methodology when fitting dynamic regression (transfer
function) models.

3. It is essential when considering Sections 8/2 and 8/3 that students are comfortable
with the backshift operator notation.

4. Unfortunately, there are not many software packages which allow the range of models
covered in this chapter to be fitted. We have taught the material to a range of
students using click-and-point interface available in the SAS Forecasting system. It
provides particularly good facilities for dynamic regression and intervention models.
We have had most success in teaching this material through case studies with the
students spending most of the class time doing the analysis on PCs.

5. After studying Sections 8/1 and 8/2, have the students find examples in the real
world where one input variable influences another variable dynamically over future
time. One of our students came up with three series that seemed to go round robin:
monthly gas prices, domestic autos produced and autos sold.

6. For intervention analysis, a good class project is to ask students to read an article
involving the application of intervention analysis, then prepare their own report or
oral presentation on what was done. We have done this with the Ledolter and Chan
(1996) article with good results.

7. For Sections 8/4 through 8/7, we only provide a brief introduction to the ideas in-
volved, plus some applications. Our aim here is to provide students with enough
information to know when these models might be applicable and in what circum-
stances they might be useful. If students wish to use these models, they will need
to learn much more about them than is described in our book.

8. An interesting activity is to have students hunt for illustrations in the literature


which make use of one or more of the methods covered in this chapter. Each student
can give a brief presentation based on one application and lead a discussion on
whether the model was appropriate to the problem.
28 Part B. Teaching suggestions

Chapter 9: Forecasting the long term

1. The first thing which it is important to bring across to the students is long-term
mega-trends. A good way for doing so is to present Figure 9-1 and ask if the data
presents a trend (most students will say No), then Figure 9-2 asking the same
question. At this point several students would say that 14 years is enough to establish
a long-term trend. One can then show Figure 9-3, which indicates that the 14 years
of Figure 9-2, shown as a shaded region of Figure 9-3, are merely a small part of
Figure 9-3. Finally, one can show Figure 9-4 and discuss why mega-trends can only
be established by going back to the beginning of the Industrial Revolution (that is
around 1800). Another figure which can be used to help illustrate this starting date
as well as the persistence of mega-trends is Figure 9-6 which shows wheat prices in
constant and goes back to the middle of the 13th century.

2. Once long-term mega-trends have been identified they can be extrapolated unless we
believe that they will change due to some other revolution similar to the industrial
one. If that is the case then we have to make our predictions not by extrapolation
but by using analogies or by making various scenarios about the implications of large
changes like those of the forthcoming Information Revolution.

3. When forecasting for the long term, deviations around the long-term mega-trends are
of critical importance as cycles can last for many years or even decades. Moreover,
since cycles are mostly random walks we have to go beyond pure quantitative models
to predict them. This is a point worth making and can be illustrated by generating
random numbers, cumulating their effects, and showing the result on a graph. Such
graphs show that predicting turning points is impossible quantitatively since they
present random walks.

4. Chapter 9 has a lot of figures that usually generate a great deal of interest from
students. The way to present them is by discussing the implications if they are
extrapolated in the long run, ending up with the question of what will happen when
our buying power increases (at a double rate since real prices drop exponentially and
real income increases exponentially) and we get a situation of over-abundance, while
at the same time huge inequalities between rich and poor nations, and rich and poor
citizens in single nations.

5. The discussion about such implications, as well as those that would come up by
talking about various analogies and scenarios between the Industrial and forthcoming
Information Revolution, generate great interest and strong opinions which provide
the basis for a lively debate.
Chapter 10: Judgmental forecasting and adjustments 29

Chapter 10: Judgmental forecasting and adjustments

1. One way of introducing the topic of judgmental forecasting is to give Figure 10-4 to
the class and then ask them to make forecasts after consulting the figure. Tell one
third of the people that the product shown in the figure is mature, the second third
that it is old, and the final third that it is new. The results of their forecasts can
be summarised and presented. They usually are similar to those shown in Figure
10-5 which indicates how pre-conceived ideas are being used and how they can bias
the forecasting process (after all it can be indicated that the great majority of new
products fail after a couple of years).

2. Large errors in judgmental forecasts can also be illustrated by comparing the per-
formance of professional investment managers to those of randomly selected stocks.
The consistent under-performance of expert managers is remarkable and can be used
as the basis to discuss what is wrong as well as illustrating how one can improve
investment returns without having to pay any fees to professional experts by simply
selecting bond, stocks and other investments randomly. In addition one can discuss
why people prefer experts to manage their investments (obviously, they feel more
secure by doing so, or alternatively they think that they reduce their uncertainty)
while clearly such a choice results in smaller returns and extra fees.

3. Another interesting topic in Chapter 10 is the use of decision rules instead of intuitive,
global judgment when the judgmental inputs can be quantified. Again there is
a lot of material for interesting discussion starting with the finding that decision
models in the form of multiple regression equations can predict more accurately
the performance (their average GPA) of candidates for universities than admissions
officers. This and similar types of decision rules can therefore be discussed as ways
of improving future oriented decision-making.

4. The last part of this chapter deals with ways of debiasing decision making so that
the advantages of both quantitative models and judgment can be exploited while
avoiding their disadvantages.

5. The following is a list of judgmental exercises (there are two versions: one to be
given to half the class and the second to the other half). These exercises provide
an excellent way to show the students their biases as their answers from the two
versions vary considerably.
30 Part B. Teaching suggestions

Judgmental exercises

1. What is the percentage of countries in the UN that are African? To make your
estimate, I would suggest that you start with a value of 65% (this percentage was
found in the computer by generating a random number between 0 and 100). First
decide whether this value is too high or too lowthen move upward or downward
from that value to what you feel is the true value.
Your final estimate as to the true percentage of African nations in the UN is
.

2. A psychological test was administered to a group of 100 people. The group consisted
of 30 engineers and 70 lawyers. The following descriptions were obtained for Peter
Jones:

Peter Jones is of high intelligence and exhibits a strong drive for compe-
tence. He has a need for order and clarity and for neat and tidy systems in
which every detail finds its appropriate place. His writing is enlivened by
somewhat corny puns and by flashes of imagination. He seems to have lit-
tle feel and little sympathy for other people and does not enjoy interacting
with others. Self-centred, he nonetheless has a deep moral sense.

If you had to place a bet on whether a participant in the test named Peter Jones
was an engineer or a lawyer, what would you say?
Peter Jones is an engineer .
Peter Jones is a lawyer .
Please put a cross on the appropriate line.

3. You are the chief executive officer of a company faced with a difficult choice. Because
of worsening economic conditions, 12,000 people will need to be fired to reduce the
payroll costs and avoid serious financial problems. Two alternative programs to
combat the firings have been proposed to you. The estimates of the consequences of
the programs are as follows:

If program A is adopted, 4,000 jobs will be saved.


If program B is adopted, there is a two-thirds probability that no jobs will
be saved and a one-third probability that 12,000 jobs will be saved.

Which of the two research and development projects would you select?

A  B 
Please tick the appropriate box.
Chapter 10: Judgmental forecasting and adjustments 31

4. The figure below shows the sales of Electrack, a video game produced by Jeu-
tronics, a medium sized French toy company. Provide optimistic, most likely and
pessimistic forecasts for the year 2001.

Figure 1: Actual sales of Electrack

250000
200000
150000
Year Sales
1993 4,433
100000
1994 60,298
1995 67,884
50000

1996 89,512
0

1993 1995 1997 1999 2001

Your Forecasts of Electrack Sales in 2001:

Pessimistic .
Most Likely .
Optimistic .

5. You are in a store about to buy a new watch which will cost 350FF. As you wait for
the sales clerk, a friend comes by and tells you that an identical watch is available in
another store two blocks away for 200FF. You know that the service and reliability
of the other store are just as good as this one. Will you travel two blocks to save
150FF?

6. FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY


COMBINED WITH THE EXPERIENCE OF YEARS
Please indicate the number of Fs which appear in the above sentence. .
How confident are you of your above answer? Indicate your confidence on a scale of
0 to 100 with 0 indicating no confidence and 100 indicating full confidence. .
How many times did you read the sentence FINISHED . . . OF YEARS? .
32 Part B. Teaching suggestions

Judgmental exercises

1. What is the percentage of countries in the UN that are African? To make your
estimate, I would suggest that you start with a value of 10% (this percentage was
found in the computer by generating a random number between 0 and 100). First
decide whether this value is too high or too lowthen move upward or downward
from that value to what you feel is the true value.
Your final estimate as to the true percentage of African nations in the UN is
.

2. A psychological test was administered to a group of 100 people. The group consisted
of 30 engineers and 70 lawyers. If you had to place a bet on whether a participant
in the test named Peter Jones was an engineer or a lawyer, what would you say?

Peter Jones is an engineer .


Peter Jones is a lawyer .

Please put a cross on the appropriate line.

3. You are the chief executive officer of a company faced with a difficult choice. Because
of worsening economic conditions, 12,000 people will need to be fired to reduce the
payroll costs and avoid serious financial problems. Two alternative programs to
combat the firings have been proposed to you. The estimates of the consequences of
the programs are as follows:

If program A is adopted, 8,000 people will be fired.


If program B is adopted, there is a one-third probablity that no nobody will
be fired and a two-thirds probability that 12,000 people will be fired.

Which of the two research and development projects would you select?

A  B 
Please tick the appropriate box.

4. The figure below shows the sales of Electrack, a video game produced by Jeutron-
ics, a medium sized French toy company. Figure 2 shows the most likely predictions
from a widely-used computerized mathematical model for new products. After hav-
ing looked at Figures 1 and 2, provide an optimistic, most likely and pessimistic
forecast for the year 2001.
Chapter 10: Judgmental forecasting and adjustments 33

Year Sales
1993 4,433
1994 60,298
1995 67,884
1996 89,512

Figure 1: Actual sales of Electrack Figure 2: Actual and predicted sales of Electrack
250000

150000
200000

100000
150000


100000

50000

50000

1993 1995 1997 1999 2001 1993 1995 1997 1999 2001

Your Forecasts of Electrack Sales in 2001:


Pessimistic .
Most Likely .
Optimistic .

5. You are in a store about to buy a new video camera that costs 4000FF. As you
wait for the sales clerk, a friend comes by and tells you that an identical camera is
available in another store two blocks away for 3850FF. You know that the service
and reliability of the other store are just as good as this one. Will you travel two
blocks to save 150FF?

6. FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY


COMBINED WITH THE EXPERIENCE OF YEARS
(Please do not read the above sentence again)
Please indicate the number of Fs which appear in the above sentence. .
How confident are you of your above answer? Indicate your confidence on a scale of
0 to 100 with 0 indicating no confidence and 100 indicating full confidence. .
34 Part B. Teaching suggestions

Chapter 11: The use of forecasting methods in practice

1. The material of Chapter 11 relates to that of Chapter 10. The major question which
arises at the beginning of the chapter is the choice between judgmental and statistical
forecasting methods. As the quote by Sanders and Manrodt explains

Like past investigations (surveys) we found that judgmental methods are the
dominant forecasting procedure used in practice.

This means that there is a great deal of potential improvement as managers now
realize the potential for higher forecasting accuracy (and therefore reduced costs)
and they are continuously pushed, at the same time, to operate more efficiently and
effectively in order to reduce their operational cost. Thus the time is right to per-
suade them of the considerable benefits they can obtain by using the knowledge and
experience we have accumulated which clearly indicates the benefits from statistical
forecasting and how it can be best integrated (this is also the major topic for the
next chapter) with judgmental predictions.

2. The findings in Section 11/2 are very useful and relevant in putting forecasting
on a practical grounding. In this section, the major empirical evidence is being
summarized and various tables and figures are available for backing up the findings.
The major question then for forecasting users is to select the most appropriate
method for their specific situation. This topic is discussed in Section 11/3. It is
worthwhile for the instructor to present each one of these factors and discuss them
in class. Obviously a critical factor is the last one (the number and frequency
of forecasts). Such factor signifies the necessity for simple methods that can be
completely automated when the number of forecasts required is very large and they
are needed frequently.

3. In the absence of clear factors, when guidelines are not obvious or in case of doubt
as to what method to select, the best alternative is to combine three or four simple
methods and use their average as a way of predicting the future. As is well known,
through many empirical studies, such a simple average of the combined forecasting
methods is both more accurate than the individual methods being combined while
at the same time variance of the forecasting errors of combining is smaller than that
of the individual methods involved. Combining can, therefore, be presented as a
practical alternative which improves forecasting accuracy and reduces the chances
of errors (in particular large ones).
Chapter 12: Implementing forecasting: its uses, advantages, and limitations 35

Chapter 12: Implementing forecasting: its uses, advantages, and


limitations

1. In Chapter 12 it is important to emphasize what can and cannot be predicted or


in other words present and discuss the limits of predictability. This can be done in
terms of short-, medium- and long-term predictions as the horizon of our forecasts
presents different challenges and problems as far as predictability is concerned. Crit-
ical in such a discussion is the medium-term which must predict the ups and downs
of business cycles. Such predictions are extremely difficult and present a major chal-
lenge for businesses when they attempt to make budget estimates. The same is true
for the longer run (18 months to 5 years) when predictions for the five years Business
Plan are made and when longer term cyclical deviations around the long term trend
must be dealt with. The topic of predictability, or the lack of it, can be related to
the introductory chapters of the book and to our experience from the forecasting
practice (including the findings from the surveys among forecasting users presented
in the previous chapter).

2. The second topic of Chapter 12 deals with the organisational aspects of forecasting
and the need to deal with the various forecasting problems that are encountered in
organisations which are using forecasting methods and the possible solutions to such
problems. There is enough information in the corresponding part of Chapter 12 to
describe these problems and discuss suggestions for solving them satisfactorily.

3. The third section of Chapter 12 (Extrapolative predictions versus creative insights)


discusses the role and value of forecasting beyond its operational applications. As the
title implies, its greatest value is when the forecasts are creative in nature, which
by definition means that they cannot be based on simply extrapolating historical
information. On the contrary it may be necessary to go against conventional wisdom
in order to come up with creative insights about future changes or what the future
might hold.

4. In the last part of this chapter the instructor can discuss and possibly develop
his/her own ideas about how forecasting is going to evolve in the future. Central
to such a conception will have to be the creation of a learning process which will
result in organisational learning (rather than the experience of each individual person
concerning forecasting resting with such person and disappearing when he or she
changes jobs or company). Creating learning about forecasting is more practical
and cost efficient these days through the use of groupware (or intranets) which
allow the people in organisations working on forecasting not only to exchange ideas,
information and inside knowledge, but also to record the forecasting process they
have been using as well as their successes and failures so that they can be reviewed in
36 Part B. Teaching suggestions

the future by themselves or others in ways that can enhance learning. In other words
ways must be developed which can help organisations to improve their forecasting
process by knowing and avoiding past mistakes while using practices that they have
been found to be successful in the past.
C/Additional materials for teaching
forecasting

This chapter suggests additional materials that might be used to complement the contents
of Forecasting: Methods and Applications, 3rd ed., in a teaching situation.
Since cases can be a valuable addition to a forecasting course and yet often represent
a very different style of teaching from straight lectures and problem sets, Section C/1
outlines ways in which cases can be effectively integrated into the teaching of forecasting.
Section C/2 provides some suggestions for special project assignments. These provide a
context for forecasting but are shorter than field-based cases. Lastly, Section C/3 consists
of exam questions.

C/1 Using cases in teaching forecasting

Many different types of cases can be used to meet very different purposes in teaching.
Briefly, these can be grouped into three categories. The first would be case exercises in
which the case is simply an expanded problem (that is, what was traditionally described
as a story problem) providing data and their context for the students to use in applying
a specific tool or technique being covered in a forecasting course. The second type would
be the management process case in which the case describes the forecasting process in
an organization and allows students to consider the process itself as opposed to specific
techniques applied to specific data sets. The final category would be a mix of these two
but generally oriented toward applying a technique to specific data and then looking at the
management decision-making implications of the resulting forecasts. This third category
is closely tied to the implementation of what the forecaster recommends to management.
A case course is taught using a problem-centered, participant-involved method of in-
struction. For most class sessions in such a course, a case is assigned to be read and
prepared for discussion and analysis in the classroom. Each case describes a specific man-
agement problem and seeks to describe selected aspects of an everyday situation that
either the forecasting specialist or the management user of forecasting might encounter.

37
38 Part C. Additional materials for teaching forecasting

C/1/1 The nature of a case

In spite of the realism that an instructor seeks to build into all cases, they cannot be
completely true-to-life management situations for the following reasons.

1. The information comes to the student in a neatly presented form. By contrast,


managers and forecasters must gather facts in ongoing situations from memos, con-
versations, statistical reports, and the public press in a much less organized fashion.

2. A case is designed to fit a particular unit of class time and to focus on a certain
category of problem, such as a forecasting technique, forecasting system, or the
management use of a given forecast. Consequently, it may omit elements of the real
situationpeople or organizational issues for examplein order to focus attention
on what the instructor would like the class to see.

3. A case is a snapshot taken at a given point in time. In reality, business problems


form a continuum requiring some action today, further consideration and action
tomorrow, and so on. It is very seldom that a manager can wrap up his or her
problems, put them away and go on to the next case as is done in a course.

4. While students studying cases are required to make decisions, they do not have the
responsibility for implementing those decisions and do not have to bear the burden
of ineffective implementation. This can be a particularly important shortcoming
when training forecasting specialists, who will have to interface with managers, who
in turn must make decisions based on their forecasts.

C/1/2 The educational purposes of cases

Cases can help forecasters and managers sharpen their analytical skills by exposing them
to facts and figures which must be evaluated and used to produce both quantitative and
qualitative evidence to support recommendations and decisions. In case discussions stu-
dents are typically challenged by instructors and peers to defend their arguments and
analyses. This can have the cumulative effect on the students of helping to develop a
problem-solving methodology and heightened ability to think, reason, and apply specific
techniques in a rigorous fashion.
Case studies cut across a range of organizational situations and provide exposure to
a far greater number of situations than would be likely on a single job involving normal
day-to-day routine. Thus, cases permit building knowledge across a range of subjects and
situations by dealing selectively and intensively with problems in each field. Students
come to recognize that the problems they face as a manager or forecaster are not unique
C/1 Using cases in teaching forecasting 39

to one organization or even a system of organizations. This helps them to develop a more
professional sense of their tasks and the way in which they can be handled most effectively.
Cases and the related class discussions can provide the focal point around which the
students past experience, expertise, observations, and rules of thumb can be brought
together in a framework for effectively tackling new situations. What each class member
brings to identifying the central problems in a case, analyzing them and proposing solutions
to them, is as important as the content of the case itself. The lessons of experience
can be tested as students present and defend their analyses against those of participants
with different experiences and attitudes. This is one place where common problems,
interdependencies, differences of perception, and organizational needs can be highlighted
and resolved in a systematic fashion.
An important benefit of using cases is that they help students learn how to ask the
right questions. It has often been said that 90% of the task of a good manager is to ask
useful questions. Answers can be relatively easy to find once the appropriate questions are
asked. Even when assignment questions are used with individual cases, students should
be pressed to ask themselves, What are the real problems that the individual forecaster
or manager must resolve in this situation?
One final benefit that an instructor often seeks to achieve through the use of cases is
to transfer to the students the excitement and challenge that can come from pursuing
management and forecasting careers. In the cases they prepare, students often see some
problems they are glad they do not have to face in real life, and others that they recognize
from first-hand experience. They should come to recognize that being a manager or
working as a forecaster for a manager can be a great challenge intellectually, politically,
and socially.

C/1/3 How students should prepare a case

There is no single form of case preparation that works best for everyone. However, some
general guidelines can be offered that might well be adapted to the way each individual
student does his or her work. These guidelines would include the following.

1. Go through the case almost as fast as you can turn the pages, asking what the case
is about and what types of information are being provided for analysis.

2. Read the case very carefully, underlining key facts and perhaps writing those and
key issues in the margin. The students should try to put themselves in the position
of the manager or forecaster in the case and develop a sense of involvement in that
persons problem.
40 Part C. Additional materials for teaching forecasting

3. After a thorough reading of the case its often useful to prepare a list of the key prob-
lems. The case can then be gone through once more, picking up those considerations
and data that are relevant for resolving each of those problem areas.

4. Perform the analysis that will enable the student to conclude what recommendations
are most consistent with the situation and the facts provided.

5. Develop a set of recommendations that can be supported by case data and the
students analysis, and indicate how those recommendations should be implemented
in this situation.

These five steps can best be applied by the student working individually. The next step
which can aid in case preparation is to have students meet in discussion groups to present
their arguments to others as well as to listen to the arguments of their peers. This testing
of the students analysis and recommendations is an important preparatory step for class
discussion. The purpose of the group discussion is not to develop a consensus or a group
plan of action, but rather to help each member refine, adjust, and amplify their own
thinking. It is not necessary or even desirable that the discussion group members agree.
In class the instructor will usually let the class direct the discussion toward those topics
where most of the individuals have concentrated their attention. However, the faculty
member is also likely to prod the class to explore fully those avenues that are most relevant
based on the faulty members experience and based on the purposes for which the case was
included in that course. Often the faculty member will summarize the discussion and draw
out the useful lessons and observations toward the end of the class discussion. However,
this might also be done by asking a student to provide that type of summary. It should be
emphasized that learning through the case method results from rigorous discussion and
controversy. Each member of the class and the instructor must assume responsibility for
preparing a case and for contributing ideas to the class discussion.

C/1/4 Use of cases in course design

Just as there are many types of cases, there are many purposes for which they may be
used in course design. Perhaps the simplest is to select exercise cases that can be used
to present data for the students to use with various forecasting techniques. Many of the
cases that will be suggested later in this chapter are of this type and, thus, can be used
simply as exercises or work problems for students.
A second way in which cases are often used by instructors who do not teach largely by
the case method is as a way to get at implementation and management decision-making
issues. In such a use of cases, an instructor might choose to cover a topic such as regression
C/1 Using cases in teaching forecasting 41

analysis using a more traditional lecture method with exercises and problems and then
conclude that section of the course with one or two classes built around management
process-oriented cases. These can be viewed as a way for students not only to apply the
techniques related to regression that they have learned but to look at the implications
of those applications for managers and to consider how they might be effectively sold
to management and implemented. If this were to be the only use of cases the instructor
might simply choose to end each of four or five major sections of the course with one or
two cases, resulting in a course that is approximately 80% exercises and lecture/problems,
and 20% case applications.
A third way in which cases often have been used effectively in teaching forecasting and
planning is to teach the basic techniques and their applications using exercises and prob-
lems and then at the every end of the course to have a major section on implementation.
In that section, cases requiring the use of different techniques and illustrating the range
of management issues related to implementation could be addressed. If this approach is
followed a class of thirty sessions might have only the last four or five built around case
studies of the management process and implementation type.
Still a fourth approach to utilizing cases in this subject area would be to build the entire
course around cases. While this is certainly feasible given the amount of material readily
available, this can often be a most challenging task if the students are not used to case
courses from other parts of their curriculum. The authors experience would suggest that
it is best to use one of the foregoing forms of case use initially, before building an entire
course around cases.
When students are not particularly well versed in the case method, it has often been
found effective to assign study groups to meet in preparation for the classes in which cases
will be used and then to have two or three individuals briefly (5 minutes each) present
their recommendations and analysis at the start of class in order to get the discussion
going. That provides a complete set of thoughts and ideas on the case situation that the
rest of the class discussion can build on. It also ensures that students are well prepared for
that class since they know they might be called on to make such a starting presentation

C/1/5 Obtaining cases

Prepared cases with teaching notes are available from Harvard Business School Publishing,
60 Harvard Way, Box 230-5A, Boston, MA 02163. They can also be obtained through the
internet at
www.hbsp.harvard.edu
These can be reprinted by the instructor and used to complement the exercises in the text
itself.
42 Part C. Additional materials for teaching forecasting

C/2 Assignments

C/2/1 The Phrygian thread factory

(Prepared by Professor Fred Shepardson, Stanford University. Used by permission.)


The Phrygian Thread Factory was founded in 1947 by Ikos Matzakis shortly after
emigrating from Greece. The enterprise had begun on a small scale, supplying thread for
the local garment industry. In these days, Matzakis would buy cotton fiber from relatives
in Greece, import it to the United States, and dye it and spin it produce a rather wide
range of end products.
Since those humble beginnings Phrygian had grown to become a not inconsequential
thread supplier for the Northeastern United States. In addition to supplying the garment
industry and various distributors and retailers of sewing threads, Phrygian was now sup-
plying large industrial users. Major customers included the auto industry (for upholstery
and seat belts) and the telecommunications industry (for wrapping and insulating cables)
Similarly, Phrygian no longer restricted itself to cotton thread. The bulk of its output
was now nylon, although significant amounts of rayon, cotton, and silk were produced
as well. Phrygians product line was virtually unlimited, for it was standard operating
procedure to do custom dye jobs to match customer color specifications. However, color
notwithstanding, there still remained nearly a hundred distinct items in the product line.
One of Phrygians most important products was NC-216. This was a bonded nylon
thread customarily used by the auto industry in sewing seams in upholstery. To make it
Phrygian began with raw nylon fiber of weight 210 denier. Two strands were spun together
with a right-hand twist to form a thread. Then three threads were twisted together, again
with a right-hand twist, to form the final thread. Once this was ready, it was loosely
wound into large spools and sent to the dyehouse.
The dyehouse staff would dye the thread into batches of up to ninety pounds. From the
dye vats, the thread would go directly to large walk-in ovens to accelerate drying. After
2448 hours in the ovens the thread was moved to large drying rooms to finish drying.
After one to five days in the drying room, the thread was ready to be sent upstairs for
bonding.
In the bonding room the thread was passed slowly through a hot liquid plastic solution
and then through heaters and on to winders. Once this process was completed, random
samples were taken and tested, primarily for breaking strength. The thread was finally
sent down to the spooling room to be put on customer-specified spools (usually one pound
spools). Once finished, the completed order was sent down to shipping to be packaged
and shipped
C/2 Assignments 43

Other products followed the same general flow, although some required additional proce-
dures (such as skeining before dying) and others required fewer (for example, no bonding).
In the office suite life was characterized by a constant effort to track down and expedite
orders. Orders were phoned in by salesmen in the field. In the case of custom color
requirements, color samples followed by mail. For most orders, salesmen, wanted to know
a projected delivery date. The production manager, Roy, and his assistant, Fred would
characteristically supply delivery dates off the top of their heads. In this process they
relied on their intelligence guided by experience. For all products they were aware of the
normal production time. They also knew that these lead times were quite flexible. With
constant monitoring, a product could be shipped in a much shorter time than its expected
processing time. However, with no monitoring a product often took much longer than the
normal lead time.
For very important orders, Roy and Fred would promise an early date and then ride
the department managers closely to make sure the date was met.
Other aspects of production control were done in the same sort of ad hoc manner.
Workforce levels, overtime, and extra shifts were decided on pretty much a day-to-day
basis. Bernie, the new plant manager, had decided things had to change. This decision
had been made in response to the latest catastrophe. Phrygian had just received a large
rush order from Non-Specific Motors for three thousand pounds of NC-216, a thousand
pounds in each of three colors. Bernie was at first jubilant when he heard of it. But his
jubilation was short-lived when he learned that there was not enough 210 denier nylon to
meet such a large order. There was already additional nylon backordered but it was not
scheduled to arrive in time to be of use for the Non-Specific order.
While Roy and Fred scrambled orders, robbing Peter to pay Paul, and combed the coun-
tryside for additional supplies of 210 nylon, Bernie sat in his office and plotted strategy.
Bernie decided the first requirement was a good forecasting system so they would not be
caught off guard like this again. By going over orders for the last three years, he noticed
that each year Non-Specific had placed a large rush order for NC-216 at about this same
time. He felt sure such information could be used in planning operations. He decided to
call Roy and Fred in and have them set up a forecasting system.
The next day Bernie made his pitch. Look, you guys, things have been going pretty
well. Phrygians profits are up, even our market share is up. But now were getting bigger
and I think weve just about hit our breaking point. Last year you hired Fred, Roy. That
took some of the load off you, but already its getting ahead of you again. We are getting
more customer complaints about orders being shipped late. And now weve gotten caught
short on 210 for the Non-Specific order.
Look, Bernie, were getting burdened on this I know. But its the first time this has
44 Part C. Additional materials for teaching forecasting

1972 1973 1974 1975 1976 1977 1988 1979 1980


January 1340 3690 4110 4500 2600 5330 5140 6820
February 1500 3520 3870 4290 5830 5290 4900 6540
March 1570 3330 3550 4010 5400 4960 4400 6030
April 1360 3120 3420 3830 4210 4730 4090 5770
May 1350 2880 3250 3570 3900 4370 4600 c 5510
June 1400 2670 2910 3250 3640 4020 4540 5000
July 1610 2790 3080 3520 4010 4020b 4930 5430
August 2280 3540 3890 4280 4830 4830 5920 6520
September 2730 3920 4310 4830 5270 4880 6480 7180
October 260 3210 4310 4860 5310 5960 5540 7170
November 550 3350 4200 4660 5180 5830 5430 7080
December 930 3620 4070 4520 5030 5510 5210 6930

a As a matter of policy, no special discounts or sales campaigns have been


held for NC-216.
b Phrygian dropped NC-336, from their regular product line, retaining it
as an option at a price premium.
c Phrygian introduced NC-236, identical to NC-216, except with a right
hand spin and a left-hand twist.
Monthly order for NC in poundsa

happened. Give us a break.


Roy, I know its the first time and Im not really blaming you. But I want to make
sure it doesnt happen a second time. I want you two to develop a forecasting system so
youll have a better idea of what to expect.
You mean some sort of automated technique for the new computer you got?
Thats right, Fred. Since sales orders are now being entered into a data file for the
billing system anyway, there must be some way of accessing that information and using
it.
After the meeting Roy and Fred sat in Roys office kicking around ideas. Look, Roy,
heres the orders for NC-216 since late 1972. Thats when we introduced NC-216, to meet
the demand caused by federally mandated seat belts (see Table 3-1). Suppose we just use
this one item for discussion purposes. Now what do you propose to do?
Well, Fred, Im not sure. In the past I always used to talk with the salesmen periodi-
cally to get a feel for what they thought was coming. Then Id use that with my intuition
C/2 Assignments 45

1979 1980 1981


January 5983 6796
February 6767 7481
March 6355 6910
April 6380 6305
May 5326 6116
June 4960 5698
July 5565 6105
August 6646 7350
September 7018 7980
October 7353 8006
November 7009 7736
December 6795 7578

For January 1981 through September 1981, inflation factor was calcu-
lated using data from October 1980.
Freds forecasts for October 1979 through September 1981

to make decisions on ordering raw materials, setting up vacation and maintenance sched-
ules.
Well, your intuition didnt intuit the big Non-Specific order.
Actually, Id thought of it. Thats why we have had that big order already in on 210.
Its just I though we wouldnt need it for almost another month.
Hey, Roy, maybe we could just use last years figure for a months demand, plus an
inflation factor to get a forecast for the same month this year.
That might make sense, Fred. But look here with the NC-216. Notice in January of
1977 the low figure. Thats probably because of our wildcat strike that entire month. If
wed used that figure to predict January 1978 we would have really been caught short.
Well, perhaps this forecasting system should have a manual component as well. A
place for our intuition to pick up on facts like that.
Were busy enough already, Fred. With almost a hundred products, not considering
color differences, wed be buried under the reams of data and the damned computer output.
Of course we should be able to take advantage of the fact that most of our products fall
into one of three or four demand patterns.
Hows this then, Roy? Suppose we are trying to forecast January 1981. We need
46 Part C. Additional materials for teaching forecasting

the forecast about three months in advance; that means the first week of October, 1980.
Suppose we take the average January demand for the five years preceding and inflate it by
a certain percentage. Since we will know October 1980s real demand by then, we will let
the inflation percentage be the percentage difference between October 1980s real demand
and the five preceding years average of October demands. Following that procedure, we
should be able to develop forecasts for even the next twelve months. (See Table 3-2.)
That sounds really good, Fred. But lets test it by going back in the data and fore-
casting our last twelve months demand. Then we can compare it with reality (see Table
3-2). In any case, just to protect ourselves, I think we should hire a consultant and see
what ideas he has.
Sounds good to me. Boy, this could cut Phrygian Threads Gordian Knot.

Assignment

You are to act as a consultant to Phrygian Thread. Prepare a careful analysis of the
demand pattern for NC-216. Then present a forecasting system for Fred and Roy to
consider for their product line. Evaluate your model on whatever criteria you feel to be
appropriate. Make explicit any assumptions you make.
C/2 Assignments 47

C/2/2 Nike stock price predictions

(Prepared by Professor Peter Reiss, Stanford University. Used by permission.)


M.A. Verage is a retired stockbroker who on occasion still tries her hand at picking
stocks. Last summer she invested her entire lifes savings in Nike, a company that sells
not only running shoes, but also a wide range of athletic apparel. Having made a bundle
on her original investment, M.A. is now concerned that the athletic fad will fade. (She
privately fears that this is already happening.) She is also concerned that the current
speculative bubble of optimism on Wall Street will burst, and this too will send Nike stock
prices plummeting.
Her dilemma is this: since last August, the value of her stock has ranged from one and
a half to two times what she paid for it. If she sells now, she can realize a sure return on
her original investment. On the other hand, Nikes stock price has historically been quite
strongeven in recessionsand it may return to its 1983 high of $24.00. Not wanting to
make a foolish decision either way, she decides to call in an expert who can predict what
will happen to the price of Nike stock over the next 15 trading days.
For a rather modest fee, you have a suddenly become an expert on stock price behavior.
Having not had a course in finance and not having access to any information about Nikes
prospects in the athletic apparel market, you must resort to forecasting Nikes stock price
using only information on past stock prices.

Assignment

1. In a four-page (or less) document, you or your group must present your forecast of
how Nikes stock price will behave. If you present more than one set of forecasts,
you must state which one is your most preferred (and why).

2. You may assume that she has taken this subject and is familiar with the material
covered in the text.

3. You should spend at least three-quarters of your discussion describing the data
(e.g., plots, transformations, statistics . . .) and why you have elected to use your
forecasting techniques. Running every possible method on the data would be terribly
time consuming and burdensome. Please limit your efforts by first looking at the
data and then deciding what to do. You will be graded not so much on how you
do at forecasting the price and the sophistication of your techniques, as you will
on the thoughtfulness and clarity of your discussion. Remember, the idea here is
not so much to give you a once-and-for all grade, as it is for the experiment with
techniques used in class. If you get to the point where you are disgusted with moving
48 Part C. Additional materials for teaching forecasting

averages, exponential smoothing, etc, you have probably tried too many techniques
and written too much.

4. Your paper is limited to four double-spaced pages of text. You can attach as many
plots or copies of output as you want.

5. The data on Nikes stock price are below. Please use only these data. The data are
arrayed by date and price. February data are given first, followed by March.

Date Price Date Price Date Price Date Price Date Price
01 19.875 02 19.375 03 19.500 04 20.125 07 20.000
09 20.125 10 20.250 11 21.500 14 22.750 15 23.000
16 22.625 17 23.125 18 23.125 21 23.125 22 22.625
23 22.625 24 19.125 25 17.000 28 17.875 01 17.625
02 17.125 03 16.625 04 16.125 07 16.000 08 15.625
09 16.000 10 16.375 11 16.250 14 16.125 15 16.125
16 16.125 17 16.000 18 15.625 21 15.875 22 16.000
23 16.250 24 15.875
C/2 Assignments 49

C/2/3 Final Paper Option

(Prepared by Professor Peter Reiss, Stanford University. Used by permission.)

Paper requirements

All papers must be typed, double-spaced and have neat corrections. Your paper can be
anywhere from seven to sixteen pages in length. I suggest you aim for seven to ten pages,
but if you require more pages to make your arguments clear, you may use it. Footnotes,
references and exhibits are not counted in the above page limits.
In writing your papers, remember that, although content is paramount, style and clear
prose are also important. Any sources that contribute significant or little known facts
must be referenced with footnotes. You are also not permitted to turn in any paper
submitted for another course (or any modified course paper). All data sources must be
clearly detailed.

Topics

You pretty much have freedom to choose your own topic as long as it is related to a
forecasting problem. This forecasting problem can be an event change study, a time series
study, or a characteristics-based study. You must use real data. This data can be gathered
from public or private sources. You must reserve 5 to 10 per cent of your data for out of
sample predictions. You may not use this data when fitting your model. Once you have
settled on perhaps several models, you are then to forecast the out of sample data, as
well as periods (or phenomena) beyond your data. You are then to write up your results,
evaluating how you did in forecasting your reserved data and how you expect to do with
your future forecasts. You must not alter your models once you have simulated them over
the reserved data. I will not penalize you for bad out of sample predictions as long as you
intelligently evaluate why they occurred and you indicate how you might have gone about
fixing your model once these new data were revealed (you can actually revise your model
if you find it a compelling exercisebut you must report your initial models and results
first).
As far as content, you should in the beginning of the paper lay out the issue or topic
you are discussing. This should include a statement of the forecasting problem or topic,
any analytical or numerical frameworks you wish to use, and a brief statement of the
forecasting methods you have chosen to explore. You then should present your analysis
and facts back to your analysis . Finally, you should give a brief summary of your models,
50 Part C. Additional materials for teaching forecasting

and their out of sample predictions, and an evaluation of the reliability of your model.
Suggestions for actions based on your forecasts should also be made at this point.
Sample topics might include:

1. A model that predicts the sales of a companys product line.

2. A model of movements in macroeconomic variables.

3. A model of a firms choice of strategies (e.g., capacity utilization, price, output,


quality, advertising, etc.).

4. A model of seasonality, cycles and trend in macroeconomic or company data.

5. Inventory modeling and production scheduling problems.

6. Judgmental forecasting
C/2 Assignments 51

C/2/4 Demand for blood tests

(Prepared by Professor Fred Shepardson, Stanford University. Adapted with permission.)


This assignment is based on the article Box-Jenkins vs multiple regression: some
adventures in forecasting the demand for blood tests by Everette S. Gardner, Interfaces,
Vol. 9, August 1979.
This paper is a report on consulting activities performed for the Clinical Coagulation
Laboratory at the North Carolina Memorial Hospital. You are to put yourself in the
position of the Laboratory Director. Consider the papers as the consultants final report
to you on their study of the problem of forecasting the Laboratorys demand for blood
tests. While you are responsible for this project, your boss has taken a keen interest
in it as well and she is eager to have the Laboratory start using an analytically based
forecasting method. She has also received a copy of the consultants report and you can
assume she has read it. She is now awaiting your report on the project and how you will
proceed. Your presentation should include a brief analysis of the consultants work and
your own recommendation for implementing the proposed forecasting procedure. What is
your presentation?
52 Part C. Additional materials for teaching forecasting

C/2/5 Winning Wines

As the operations manager for Winning Wines, Sandra McDougal has become quite con-
cerned about managing her product release. The firm produces a large range of wines
primarily for local consumption. Lately Winning Wines has found a valuable new ex-
port market in South East Asia. Currently, of the 39 distinct products Winning Wines
produces, 12 are for this new market.
Ms McDougal is worried about managing the release of her products gradually so that
customer demand is satisfied without affecting the price by oversupply. Consequently she
has decided to introduce a formal forecasting procedure at Winning Wines. In order to
begin her analysis of the demand pattern for the companys products, Ms McDougal has
selected a product for which the company has a detailed historya popular sparkling
white wine.
From marketing she has obtained extensive monthly sales data for this wine. Graphs
of the data with ACF and PACF plots are attached. What forecasting techniques should
Ms McDougal be considering at this point? Defend your choice. What advice can you
give to help her in developing a forecasting system for demand for Winning Wines entire
product line?
C/2 Assignments 53

Sparkling wine sales

o
o
600

o
o o
500

o o
400

o
liters

o
o

o o
o
300

o o
o
o

o o o
o
200

o o
o o o o o o
o o
o o o o o o o o
o o o o o o o o
o o o o o o o
o o o o
o o o o
o
o o
o
100

1 2 3 4 5 6
0.8

0.6
0.4
0.4

PACF
ACF

0.2
0.0

0.0
-0.2
-0.4

0 10 20 30 0 10 20 30

Sparkling wine sales (liters) for Winning Wines.


54 Part C. Additional materials for teaching forecasting

C/2/6 Decomposition and exponential smoothing assignment

Select one time series of real data. The series can be selected from among those available
in the Time Series Data Library (www.maths.monash.edu.au/~hyndman/tseries/) or can be
published data or data you have collected. The data series must be seasonal and comprise
at least 30 observations.

1. Make a time plot of your data and describe the main features of the series.

2. Transform your series if necessary. Explain which transformation was used and why.
If no transformation was used, explain why not.

3. Decompose the transformed series using an additive model. Produce a decomposition


plot and a seasonal sub-series plot for the decomposition.

4. Forecast the next two years of your series using HoltWinters additive method. Give
the parameters of the method and report the MSE, MAPE and MAD of the one-step
forecasts from your method. If you transformed the series, give the forecasts on the
original scale.

5. Find a prediction interval for the next observation using the MSE. Check the as-
sumption of normality.

6. Add your forecasts and prediction interval to the graph of the data.

7. Explain why the MSE cannot be used to obtain prediction intervals for longer-term
forecasts.
C/2 Assignments 55

C/2/7 ARIMA Assignment

Select one time series of real data. The series can be selected from among those available
in the Time Series Data Library (www.maths.monash.edu.au/~hyndman/tseries/) or can be
published data or data you have collected. The data series must comprise at least 30
observations.
You should produce forecasts of the series using an ARIMA model. Write a brief report
(about 4 pages) of your analysis including

transformations

model selection

estimation

diagnostics

forecasts and prediction intervals

Explain carefully what you have done and why you have done it. You should also compare
your results with those obtained using an exponential smoothing method. Which method
do you think gives the better forecasts?
You should write as if your report is to a client who is interested in forecasts of your
data. You may assume that your client is familiar with the material covered in the text.
You will be graded not so much on the sophistication of your techniques, as you will on
the thoughtfulness and clarity of your discussion and the communication of your results.
You will also be required to give a presentation of your analysis in class.
56 Part C. Additional materials for teaching forecasting

C/3 Exams

C/3/1 Sample exam questions for a time series and forecasting subject

Question 1 The graphs in Figure 1 concern the production of sulphuric acid in Australia
between March 1956 and March 1992.

1.1 Describe the series in a few sentences. Does transforming or differencing seem
appropriate?
1.2 Given that Australian economic policy was radically different between 1972
and 1975 due to the Whitlam Labor Government and that there was a severe
recession in 19911992, explain in a couple of sentences some of the unusual
features of the time series plot. What other information might be helpful in
modelling this series?
1.3 Your client has asked you to provide forecasts of this series for the next two
years. She has no specific idea of the expected behavior of the forecasts and
does not require forecast intervals. Consider each of the methods listed below.
Say, in a few words each, if and why you think each of the methods listed might
be appropriate or not for this situation. If you find more than one method
that might be appropriate, discuss in about two sentences the relative merits
of the appropriate methods. Assume methods a)e) will be applied to the
data as given, without any preceding actions taken.
a) Single exponential forecasting
b) Holts method
c) HoltWinters method
d) AR(1) with 1 < < 1
e) ARIMA(0,1,1) with 1 < < 1 with a constant
f) ARIMA(0, 1, 4) applied to the data differenced at lag 4.
C/3 Exams 57

Quarterly production of sulphuric acid in Australia


o
o
o

600 o
o
o o
o
o
o
o o
o o o
o o oo
o o
o o
500

o o o o
o o o
o
o o o o
o o o o
o o o o
o o
o o o o
o
o o
o o o o o
o o o o
oo o o o o o o
o o
o o
o o o
o o o o
400

o
o o
o
o o
o o o
o o o
o o o
o o o
o o
o o o o
o
o o
o o
300

o o
o o
o o
o
o o o
o
o o o
o o o o
o o o o
o o o o
o
o o
o o
200

o
o
oo

1960 1970 1980 1990

Time
1.0

0.8
0.8

0.6
0.4
0.6

Partial ACF
ACF

0.2
0.4

0.0
0.2

-0.2
0.0

-0.4
-0.2

0 5 10 15 20 5 10 15 20
Lag Lag

Figure 1: Graphs relating to production of sulphuric acid in Australia.


58 Part C. Additional materials for teaching forecasting

300
200
100
0

1500 1600 1700 1800

Year
1.0

0.8
0.8

0.6
0.6

Partial ACF
0.4
ACF
0.4

0.2
0.2

0.0
0.0

-0.2

0 5 10 15 20 25 5 10 15 20 25
Lag Lag

Figure 2: Graphs relating to the Beveridge wheat price index.


C/3 Exams 59

Question 2 The graphs in Figure 2 concern the Beveridge wheat price index from 1500
1869.

2.1 Describe the series in a few sentences. Explain why taking logarithms of the
series is appropriate. Does differencing also seem appropriate? Explain why
or why not.
2.2 Suppose you wish to forecast the series for the next 10 years. Consider each of
the methods listed below. Say, in a few words each, if and why you think each
of the methods listed might be appropriate or not for this situation. If you
find more than one method that might be appropriate, discuss in about two
sentences the relative merits of the appropriate methods. Assume methods
(a)(f) will be applied to the logged data without any other actions taken.
(a) Single exponential forecasting
(b) Holts method
(c) HoltWinters method
(d) AR(1) with 1 < < 1
(e) ARIMA(p,1,q) with no constant
(f) ARIMA(p,1,q) with a constant
(g) ARMA(p,q) applied to the logged data differenced at lag 12.

Question 3 The graph in Figure 3 is of the number of housing starts in the US each
month for nine years.

3.1 Consider forecasting the time series using the various methods listed in the
previous question. Say, in a few words each, if and why you think each of the
methods might be appropriate or not for the client in this situation. If you
find more than one method that might be appropriate, discuss in about two
sentences the relative merits of the appropriate methods. Assume methods
(a)(f) will be applied to the data as given without any preceding actions
taken.
3.2 Describe what the ACF would probably look like for this series and describe
any actions you would take before trying to fit a stationary ARMA model.
3.3 Discuss in about 45 sentences (but without giving any equations) what ac-
tions you would take after you have obtained the parameter estimates from
your ARMA model but before you produce any forecasts.
60 Part C. Additional materials for teaching forecasting

200
thousands

150
100
50

1966 1967 1968 1969 1970 1971 1972 1973 1974 1975

Figure 3: U.S. monthly housing starts, January 1966December 1974.

Question 4 The graphs in Figure 4 concern the total building and construction activity
in Australia each quarter. The units represent the value of work done in millions of
dollars at 1984/1985 prices. Data are available from July 1976 to September 1994.
However, the graphs are based on a restricted set of data. The first quarter on the
graph is JulySeptember 1976; the last quarter on the graph is JulySeptember
1991. Let Yt denote the raw series shown in the time plot and let X t denote the
series after differencing at lags 1 and 4. The ACF and PACF graphs are for the X t
series.

4.1 Describe the series in a few sentences. Does transforming seem appropriate?
If so, what transformation would you try? What features of the series suggest
differencing is appropriate?
4.2 You are developing a forecasting model for the Housing Industry Association
and you wish to test the model by forecasting the data from December 1991 to
September 1994. Consider each of the methods listed below. Comment, in a
few words each, on whether the methods listed might be appropriate for these
data. If more than one method might be appropriate, discuss in about two
sentences the relative merits of the appropriate methods. Assume methods
a)e) will be applied to the data, Yt , without any preceding actions taken.
C/3 Exams 61

Building and construction activity in Australia


o
o
o
5000
o

o
4500

o o
o
o
o
o

o
4000

o o o o

o
o o o
o o
o
o o o o
o
3500

o
o o
o
o o
o o o
o o
o o o o
o o
3000

o o
o o o o
o
o o
o
o o

o
2500

1976 1978 1980 1982 1984 1986 1988 1990 1992

ACF and PACF for differenced data


1.0

0.2
0.8
0.6

0.0
Partial ACF
0.4
ACF
0.2

-0.2
0.0
-0.2

-0.4
-0.4

0 5 10 15 20 5 10 15 20
Lag Lag

Figure 4: Graphs relating to quarterly totals of building and construction activity in Australia,
First quarter: JulSep 1976; last quarter: JulSep 1991.
62 Part C. Additional materials for teaching forecasting

a) Single exponential forecasting


b) Holts method
c) HoltWinters method
d) AR(1) with 1 < < 1
e) ARIMA(0, 4, 1)
f) AR(8) applied to Xt
g) ARIMA(1,0,0) applied to Xt
4.3 Explain why it is better when evaluating forecast performance to fit the model
using the data up to September 1991 rather than using the complete data set
up to September 1994.
C/3 Exams 63

C/3/2 Two hour exam for a time series and forecasting subject

All questions of this exam involve the series plotted below.

Monthly retail turnover recreational goods (Tasmania)


25
20
15
10
5

1982 1984 1986 1988 1990 1992 1994 1996

Figure 1: Time plot of monthly retail turnover ($ million) of recreational goods in Tasmania
between April 1982 and March 1996.

The last 15 months of data are given below:


Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1995 13.7 14.7 14.8 13.0 14.0 13.4 13.6 14.9 13.5 14.7 15.7 21.9
1996 16.9 16.3 14.7

Question 1

1.1 Describe the series plotted above in a few sentences. Comment on trend,
seasonality, cycles and changes in variance and discuss the causes for these.
1.2 Explain why it is easier to analyze the logarithms of the data rather than the
raw data.
1.3 Your client has asked you to provide forecasts of this series for the next two
years. Consider each of the methods listed below. Assume the methods will
be applied to the logged data. Say, in a few words each, if and why you think
each of the methods listed might be appropriate or not for this situation. If
64 Part C. Additional materials for teaching forecasting

you find more than one method that might be appropriate, discuss in about
two sentences the relative merits of the appropriate methods.
a) Single exponential forecasting
b) Holts method
c) HoltWinters method
d) AR(1) with 1 < < 1
e) ARIMA(0,1,1) with 1 < < 1 and with the mean removed after differ-
encing at lag 1
f) ARMA(p,q) model fitted to the series after differencing at lag 12.
g) Seasonal means method.

Question 2 Figure 2 shows the results of a STL decomposition applied to the logarithm
of the data shown in Figure 1. The seasonal component is assumed to be constant
from year to year. Figure 3 shows the seasonal pattern.

2.1 Say which quantities are plotted in each graph of Figures 2 and 3.
2.2 Explain how seasonally adjusted data can be obtained using the quantities
plotted in Figure 2.
2.3 If you were using a classical decomposition, what sort of moving average
smoother would be appropriate for estimating the trend of the series? Ex-
press the smoother as a weighted moving average smoother and explain how
the weights ensure there is no seasonal contamination of the trend estimate.
2.4 Explain why there is a problem with computing a moving average smoother
near the ends of the series. Explain why a loess smoother does not have this
problem.
2.5 What sort of decomposition would have been necessary if we had used the
raw data instead of the logged data?
C/3 Exams 65

3.0
2.5
2.0
1.5

2.8
2.4
2.0
1.6
0.3
0.1
-0.1

0.10
0.0
-0.10

1982 1984 1986 1988 1990 1992 1994 1996

time

Figure 2: STL decomposition of the logarithm of the data shown in Figure 1.


66 Part C. Additional materials for teaching forecasting

Seasonal pattern
0.3
0.2
0.1
0.0
-0.1

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Figure 3: Seasonal pattern (or indices) based on the STL decomposition in Figure 2.
3.0

Forecasts
2.5
2.0
1.5

1982 1984 1986 1988 1990 1992 1994 1996 1998

Figure 4: Forecasts of the logarithms of the data shown in Figure 1, computed using Holt-
Winters method with parameters a = 0.47, b = 0.41 and c = 0.0.
C/3 Exams 67

Question 3 Holt-Winters method was used to forecast the logged data. The forecasts
are shown in Figure 4. The MSE for the one-step forecasts is 0.0045. The first few
forecasts are:

Apr 96 May 96 Jun 96 Jul 96 Aug 96


2.69 2.74 2.70 2.74 2.79

3.1 Give the forecasts for AprilAugust 1996 on the original scale.
3.2 Compute a 95% prediction interval for the first forecast (on the original scale).
3.3 The smoothing parameters (, and ) were chosen to minimize the one-step
MSE. Using the Holt-Winters equations, explain what = 0 implies about
the data. Discuss how this feature of the data is also seen in the seasonal
decomposition in Figure 2.

Question 4 Let the series plotted in Figure 1 be denoted by {X t }, let Yt = log(Xt ) and
let Wt = Yt Yt12 . Then the following model was fitted:

Wt = 0.52Wt1 + 0.38Wt2 + Zt

where {Zt } is white noise with variance 0.0063.

4.1 What sort of ARIMA model is Wt (i.e. what are p, d and q)?
4.2 Is the model for Wt stationary?
4.3 Write down the model for Yt . Is the model for Yt stationary?
4.4 Compute the forecasts for Xt for April 1996 and May 1996.
4.5 Compare the forecast performance of this model with the method used in
Question 3, referring to the one-step MSE for both models.
4.6 The Ljung-Box statistic for h = 24 is 50.3. Complete the Ljung-Box test and
comment on the adequacy of the model.

End of Exam
68 Part C. Additional materials for teaching forecasting

C/3/3 Final Exam: Elective MBA Course

(Prepared by Professor Peter Reiss, Stanford University. Adapted by permission.)

Part I: True or False (Worth 100 points. Suggested time allotment: 1 hour)
The following statements are either always true or they are false. Answer each
statement True or False and give a one or two sentence justification that supports
your conclusion. You will receive zero for an incorrect answer, one for the right
answer, and 1 to 3 more points for your justification.

1. A forecast error cost function based upon absolute deviations (MAD) penalizes
you more for large errors than does mean squared error (MSE).
2. The larger R2 , the better the model.
3. The smaller the standard error of a multiple regression model, the more accurate
are the predictions of the future.
4. The first four randomness tests we discussed in class will (with an extremely
high probability) perform equally well in detecting any trend or seasonality in
a time series.
5. Given that we now know how to use Box-Jenkins procedures, there is absolutely
no reason to ever use a simple moving average of past values of the time series.
6. The mean of a time series (that has any variance) can never be an optimal
forecasting rule.
t = (Xt1 + Xt2 )/2) is always sta-
7. A single moving average (for example, X
tionary.
8. Single moving averages as a smoothing and forecasting tool work well on data
that have a strong linear trend.
9. Single Exponential Smoothing (SES) puts most of its averaging weight on values
that are mid-way between the start and end of the observations being averaged.
10. Holts method is always better than single exponential smoothing because it
removes more trend.
11. In SES, if the value of that minimizes MSE is equal to one, this implies X t
t = Xt1 .
is best represented as a moving average of length one (i.e. X
12. If you definitely have seasonality, trend and randomness in your time series
data, Winters method should be used before any other smoothing method.
13. In trying to pick the best exponential smoothing method, it is always best to
compare MSE. The method with the smallest MSE is always preferred.
C/3 Exams 69

14. If a variable appears to be insignificant in a regression, it should be dropped.


15. A high F statistic for your regression indicates that you have a good forecasting
model.
16. A multiplicative decomposition method will usually be preferred to an additive
decomposition method when the variability of the data increases through time.
17. The adjusted R2 is a much better measure of goodness-of-fit and forecasting
accuracy because it penalizes you for data mining.
18. If the residuals from a regression show evidence of first-order serial correlation,
then we can obtain better forecasts of the dependent variable by incorporating
that serial dependence in our forecasting rule.
19. The F sub-block test in regression analysis is not useful if the linear regression
slope coefficients change through time.
20. Econometric system models are always better forecasting tools than linear re-
gression models because simultaneous equations models use more information
about the process generating the data.
21. Correlation always implies causality.
22. Autocorrelation coefficients are not very useful for detecting the presence of an
autoregressive process in time series data.
23. Differencing techniques can always make a time series stationary. Besides, we
can never over-difference a time series.
24. Box-Jenkins forecasting methods do not work well in the presence of quadratic
time trends in the data.
25. If there are patterns in your out-of-sample forecast errors, but your within-
sample forecast errors appear random, it was just by chance that you obtained
this nonrandomness out of sample.
3
Part II: Thought Questions (Worth 70 points. Suggested time allotment: 4 hour.)
Please answer only one of the following questions. Long answers are not required,
so please pay attention to your time. The situations described are hypothetical and
the names have been changed to protect the offenders.

1. Recently you received a forecasting report that used a multiple regression model
to construct the forecasts. The author of the report chose his model because
of the several hundred tried, it had by far the highest R-squared, adjusted
R-squared and F statistic. It also had the lowest sum of squared residuals and
a Durbin-Watson of 1.40 for n = 100 and k = 5. The author also claims that
on a reserved sample of the data the model has very little bias and the MSE
is only slightly worse than within sample. Given only this information,
70 Part C. Additional materials for teaching forecasting

(a) Comment on the authors judgment in choosing his forecasting model.


(b) Suggest a number of diagnostics or additional steps you would like to see
the author take.
2. Recently the Bank of the GSB issued its forecasts of macroeconomic aggregate
variables (e.g. GNP, the money supply, interest rates, etc.) for 1998. In their
report they say that they have a ten equation model of the U.S. economy.
Discuss:
(a) What types of data (or models) they would have to have in order to predict
the 1998 values.
(b) What sorts of questions you as a consumer of these forecasts would ask in
order to be more confident that their forecast of a 20 percent inflation rate
was reasonable.

Part III: Forecasting analysis (Worth 130 points. Suggested time allotment: 1 14
hours).

(a) Look at the following retail sales data (see the attached pages) and write a
short description of the data.
(b) A colleague has proposed that
Box-Jenkins, time trend and seasonal regression, and decomposition
appear to work best as forecasting tools.
Looking at the attached output that contains data and diagnostics on each of
these best methods, evaluate the above statement. Comment on the strengths
and weakness of the three approaches.
C/3 Exams 71

Quarterly Retail turnover

o o
1700

o
o
o
o

o
1600

o
o
1500

o o
o o
o
o o

o o o
o o o
1400

o
o o o o

o
o
o o o
o o
1300

o o
o o

1 2 3 4 5 6 7 8 9 10
0.6
0.6

PACF
ACF

0.2

0.2
-0.2

-0.2

2 4 6 8 10 12 14 2 4 6 8 10 12 14

Graphs of the retail turnover data.


72 Part C. Additional materials for teaching forecasting

1700
Data

1500
1300

1500
Trend-cycle

1400
150
Seasonal

50
-50 0

20
10
Remainder

0
-20
2 4 6 8 10

time

Decomposition plot of the retail turnover data.

Part of computer output for Seasonal decomposition:


Seasonal indices
-51.80256 -51.52647 189.64777 -86.31869
C/3 Exams 73

Part of computer output for Regression:


Regression Coefficients:

Value Std. Error t value Pr(>|t|)


(Intercept) 1271.2339 9.1093 139.5535 0.0000
t 5.0954 0.2961 17.2103 0.0000
Q1 36.8263 9.5463 3.8577 0.0005
Q2 35.6839 9.5417 3.7398 0.0007
Q3 275.2755 9.5463 28.8360 0.0000

Residual standard error: 20.77 on 34 degrees of freedom


Multiple R-Squared: 0.9771
F statistic: 363.2 on 4 and 34 degrees of freedom, the p-value is 0

Part of computer output for ARIMA modelling:


Period(s) of Differencing = 1,4.
Number of observations = 34
NOTE: The first 5 observations were eliminated by differencing.

Approx.
Parameter Estimate Std Error T Ratio Lag
MA1,1 0.74282 0.20763 3.58 4

Variance Estimate = 37259.2677


Std Error Estimate = 193.026599
AIC = 458.540303
SBC = 460.066663
Number of Residuals= 34

To Chi Autocorrelations
Lag Square DF Prob
6 2.05 5 0.842 -0.007 -0.005 -0.164 0.106 -0.083 -0.074
12 5.92 11 0.878 -0.100 0.055 0.191 -0.161 -0.004 -0.054
18 13.49 17 0.703 -0.118 -0.067 0.112 0.233 0.165 0.015
24 20.71 23 0.599 -0.118 -0.031 0.091 -0.225 0.019 -0.014

Model for variable TURNOVER


No mean term in this model.
Period(s) of Differencing = 1,4.

Moving Average Factors


Factor 1: 1 - 0.74282 B**(4)
74 Part C. Additional materials for teaching forecasting

Residuals from regression

o
40

o
o
o o o
o o

20
o
o
o o
o
o o
o o
o o

0 o
o o

o o
o o
o o o
o
o o
-20 o
o
o
o
o
o

-40 o

1 2 3 4 5 6 7 8 9 10

0.6 0.6

0.4 0.4

0.2
PACF

0.2
ACF

0.0
0.0

-0.2
-0.2

-0.4

2 4 6 8 10 12 14 2 4 6 8 10 12 14

Regression residuals for the retail turnover data.


C/3 Exams 75

Residuals from ARIMA model

o
40
o
o

o o
o
o
20 o
o
o
o o
o o
o
o
o
0 o
o
o o
o
o
o
o o
o o
o
o o
-20 o

-40

1 2 3 4 5 6 7 8 9 10

0.2 0.2
PACF
ACF

0.0 0.0

-0.2 -0.2

2 4 6 8 10 12 14 2 4 6 8 10 12 14

ARIMA residuals for the retail turnover data.


D/Solutions to exercises

Chapter 1: The forecasting perspective

1.1 Look for pragmatic applications in the real world. Note that there are no fixed
answers in this problem.

(a) Dow theory: There is an element of belief that past patterns will continue
into the future. So first, look for the patterns (support and resistance levels)
and then project them ahead for the market and individual stocks. This is a
quantitative time series method.
(b) Random walk theory: This is quantitative, and involves a time series rather
than an explanatory approach. However, the forecasts are very simple because
of the lack of any meaningful information. The best prediction of tomorrows
closing price is todays closing price. In other words, if we look at first differences
of closing prices (i.e., todays closing price minus yesterdays closing price) there
will be no pattern to discover.
(c) Prices and earnings: Here instead of dealing with only one time series (i.e., the
stock price series) we look at the relation between stock price and earnings per
share to see if there is a relationshipmaybe with a lag, maybe not. There-
fore this is an explanatory approach to forecasting and would typically involve
regression analysis.

1.2 Step 1: Problem definition This would involve understanding the nature of the indi-
vidual product lines to be forecast. For example, are they high-demand prod-
ucts or specialty biscuits produced for individual clients? It is also important
to learn who requires the forecasts and how they will be used. Are the forecasts
to be used in scheduling production, or in inventory management, or for bud-
getary planning? Will the forecasts be studied by senior management, or by
the production manager, or someone else? Have there been stock shortages so
that demand has gone unsatisfied in the recent past? If so, would it be better
to try to forecast demand rather than sales so that we can try to prevent this

76
Chapter 1: The forecasting perspective 77

happening again in the future? The forecaster will also need to learn whether
the company requires one-off forecasts or whether the company is planning on
introducing a new forecasting system. If the latter, are they intending it to
be managed by their own employees and, if so, what software facilities do they
have available and what forecasting expertise do they have in-house?
Step 2: Gathering information It will be necessary to collect historical data on each
of the product lines we wish to forecast. The company may be interested in
forecasting each of the product lines for individual selling points. If so, it is
important to check that there are sufficient data to allow reasonable forecasts
to be obtained. For each variable the company wishes to forecast, at least a
few years of data will be needed.
There may be other variables which impact the biscuit sales, such as economic
fluctuations, advertising campaigns, introduction of new product lines by a
competitor, advertising campaigns of competitors, production difficulties. This
information is best obtained by key personnel within the company. It will be
necessary to conduct a range of discussions with relevant people to try to build
an understanding of the market forces.
If there are any relevant explanatory variables, these will need to be collected.
Step 3: Preliminary (exploratory) analysis Each series of interest should be graphed
and its features studied. Try to identify consistent patterns such as trend
and seasonality. Check for outliers. Can they be explained? Do any of the
explanatory variables appear to be strongly related to biscuit sales?
Step 4: Choosing and fitting models A range of models will be fitted. These models
will be chosen on the basis of the analysis in Step 3.
Step 5: Using and evaluating a forecasting model Forecasts of each product line will
be made using the best forecasting model identified in Step 4. These forecasts
will be compared with expert in-house opinion and monitored over the period
for which forecasts have been made.
There will be work to be done in explaining how the forecasting models work
to company personnel. There may even be substantial resistance to the in-
troduction of a mathematical approach to forecasting. Some people may feel
threatened. A period of education will probably be necessary.
A review of the forecasting models should be planned.
78 Part D. Solutions to exercises

Chapter 2: Basic forecasting tools

2.1 (a) One simple answer: choose the mean temperature in June 1994 as the forecast
for June 1995. That is, 17.2 C.
(b) The time plot below shows clear seasonality with average temperature higher
in summer.

20
18
16
Celsius

14
12
10
8
6

1994 1994 1994 1994 1994 1994 1995 1995 1995


Jan Feb May Jul Sep Nov Jan Mar May

Month

Exercise 2.1(b): Time plot of average monthly temperature in Paris (January 1994May
1995).

2.2 (a) Rapidly increasing trend, little or no seasonality.


(b) Seasonal pattern of period 24 (low when asleep); occasional peaks due to stren-
uous activity.
(c) Seasonal pattern of period 7 with peaks at weekends; possibly also peaks during
holiday periods such as Easter or Christmas.
(d) Strong seasonality with a weekly pattern (low on weekends) and a yearly pat-
tern. Peaks in either summer (air-conditioning) or winter (heating) or both
depending on climate. Probably increasing trend with variation increasing with
trend.

2.3 (a) Smooth series with several large jumps or direction changes; very large range
of values; logs help stabilize variance.
(b) Downward trend (or early level shift); cycles of about 15 days; outlier at day
8; no transformation necessary.
(c) Cycles of about 910 years; large range and little variation at low points indi-
cating transformation will help; logs help stabilize variance.
Chapter 2: Basic forecasting tools 79

(d) No clear trend; seasonality of period 12; high in July; no transformation neces-
sary.
(e) Initial trend; level shift end of 1982; seasonal period 4 (high in Q2 and Q3, low
in Q1); no transformation necessary.

2.4 1-B, 2-A, 3-D, 4-C. The easiest approach to this question is to first identify D.
Because it has a peak at lag 12, the time series must have a pattern of period 12.
Therefore it is likely to be monthly. The slow decay in plot D shows the series has
trend. The only series with both trend and seasonality of period 12 is Series 3. Next
consider plot C which has a peak at lag 10. Obviously this cannot reflect a seasonal
pattern since the only series remaining which is seasonal is series 2 and that has
period 12. Series 4 is strongly cyclic with period approximately 10 and series 1 has
no seasonal or strong cyclic patterns. Therefore C must correspond to series 4. Plot
A shows a peak at lag 12 indicating seasonality of period 12. Therefore, it must
correspond with series 2. That leaves plot B aligned with series 1.

2.5 (a)
X Y
Mean 52.99 43.70
Median 52.60 44.42
MAD 3.11 2.47
MSE 15.94 8.02
St.dev. 4.14 2.94
(b) Mean and median give a measure of center; MAD, MSE and St.dev. are mea-
sures of spread.
(c) r = 0.660. See plot on next page.
(d) It is inappropriate to compute autocorrelations since there is no time component
to these data. The data are from 14 different runners. (Autocorrelation would
be appropriate if they were data from the same runner at 14 different times.)

2.6 (a) See plot on following page.


(b) and (c)
Notation: Error 1 = (actual demand) (method 1 forecast)
Error 2 = (actual demand) (method 2 forecast)
80 Part D. Solutions to exercises

48
Y: maximal aerobic capacity

46
44
42
40

48 50 52 54 56 58 60

X: running times

Exercise 2.5(c): Plot of running times versus maximal aerobic capacity.


240
220
200
Demand

180

Actual
160

Forecast Method 1
Forecast Method 2
140

5 10 15 20

Month

Exercise 2.6(a): Time plots of data and forecasts.


Chapter 2: Basic forecasting tools 81

Period Actual Method 1 Error 1 Method 2 Error 2


1 139 157 18 170 31
2 137 145 8 162 25
3 174 140 34 157 17
4 142 162 20 173 31
5 141 149 8 164 23
6 162 144 18 158 4
7 180 156 24 166 14
8 164 172 8 179 15
9 171 167 4 177 6
10 206 169 37 180 26
11 193 193 0 199 6
12 207 193 14 202 5
13 218 202 16 211 7
14 229 213 16 221 8
15 225 223 2 232 7
16 204 224 20 235 31
17 227 211 16 225 2
18 223 221 2 232 9
19 242 222 20 233 9
20 239 235 4 243 4

Analysis of errors ME 6.25 4.80


(periods 120) MAE 14.45 14.29
MSE 307.25 294.00
MPE 2.55 3.61
MAPE 7.87 8.24
Theils U 0.94 0.85

On MAE and MSE, Method 2 is better than Method 1. On MAPE, Method 1


is better than Method 2. Note that this is different from the conclusion drawn
in Section 4/2/3 where these two methods are compared. The difference is that
we have used a different time period over which to compare the results. Holts
method (Method 2) performs quite poorly at the start of the series. In Chapter
4, this period is excluded from the analysis of errors.

2.7 (a) Changes: 0.25, 0.26, 0.13, . . . , 0.09, 0.77. There are 78 observations in
the DOWJONES.DAT file. Therefore there are 77 changes.
(b) Average change: 0.1336. So the next 20 changes are each forecast to be 0.1336.
(c) The last value of the series is 121.23. So the next 20 are forecast to be:
79 = 121.23 + 0.1336 = 121.36
X
80 = 121.36 + 0.1336 = 121.50
X
81 = 121.50 + 0.1336 = 121.63
X etc.
82 Part D. Solutions to exercises

79+h = 121.23 + h(0.1336).


In general, X
(d) See the plot below.
120
Dow Jones index

115
110

0 20 40 60 80 100

day

Exercise 2.7(d): Plot of Dow Jones index (DOWJONES.DAT)

1 Pn n+h =
(e) The average change is c = n1 t=2 (Xt Xt1 ) and the forecasts are X
Xn + hc. Therefore,
n
n+h = Xn + h 1 X
X (Xt Xt1 )
n 1 t=2
h
= Xn + (Xn X1 ).
n1
This is a straight line with slope equal to (X n X1 )/(n 1). When h = 0,
n+h = Xn and when h = (n 1), X
X n+h = X1 . Therefore, the line is drawn
between the first and last observations.

2.8 (a) See the plot on the next page. The variation when the production is low is
much less than the variation in the series when the production is high. This
indicates a transformation is required.
(b) See the plot on the next page.
(c) See the table on page 84.
Chapter 2: Basic forecasting tools 83


10 12

Forecast
Vehicles (thousands)

8
6
4
2
0

1950 1960 1970 1980 1990


Logarithms of vehicles

8
6
4

1950 1960 1970 1980 1990

Exercise 2.8 (a) and (b): Time plots of Japanese automobile production and the logarithms
of Japanese automobile production.
84 Part D. Solutions to exercises

Year Data Log Forecast Error Error2 |Error/Log|


1947 11 2.40
1948 20 3.00 2.40 0.598 0.357 0.1996
1949 29 3.37 3.00 0.372 0.138 0.1103
1950 32 3.47 3.37 0.098 0.010 0.0284
1951 38 3.64 3.47 0.172 0.030 0.0472
1952 39 3.66 3.64 0.026 0.001 0.0071
1953 50 3.91 3.66 0.249 0.062 0.0635
1954 70 4.25 3.91 0.337 0.113 0.0792
1955 69 4.23 4.25 0.014 0.000 0.0034
1956 111 4.71 4.23 0.475 0.226 0.1009
1957 182 5.20 4.71 0.495 0.245 0.0950
1958 188 5.24 5.20 0.032 0.001 0.0062
1959 263 5.57 5.24 0.336 0.113 0.0602
1960 482 6.18 5.57 0.606 0.367 0.0981
1961 814 6.70 6.18 0.524 0.275 0.0782
1962 991 6.90 6.70 0.197 0.039 0.0285
1963 1284 7.16 6.90 0.259 0.067 0.0362
1964 1702 7.44 7.16 0.282 0.079 0.0379
1965 1876 7.54 7.44 0.097 0.009 0.0129
1966 2286 7.73 7.54 0.198 0.039 0.0256
1967 3146 8.05 7.73 0.319 0.102 0.0396
1968 4086 8.32 8.05 0.261 0.068 0.0314
1969 4675 8.45 8.32 0.135 0.018 0.0159
1970 5289 8.57 8.45 0.123 0.015 0.0144
1971 5811 8.67 8.57 0.094 0.009 0.0109
1972 6294 8.75 8.67 0.080 0.006 0.0091
1973 7083 8.87 8.75 0.118 0.014 0.0133
1974 6552 8.79 8.87 0.078 0.006 0.0089
1975 6942 8.85 8.79 0.058 0.003 0.0065
1976 7842 8.97 8.85 0.122 0.015 0.0136
1977 8514 9.05 8.97 0.082 0.007 0.0091
1978 9269 9.13 9.05 0.085 0.007 0.0093
1979 9636 9.17 9.13 0.039 0.002 0.0042
1980 11043 9.31 9.17 0.136 0.019 0.0146
1981 11180 9.32 9.31 0.012 0.000 0.0013
1982 10732 9.28 9.32 0.041 0.002 0.0044
1983 11112 9.32 9.28 0.035 0.001 0.0037
1984 11465 9.35 9.32 0.031 0.001 0.0033
1985 12271 9.41 9.35 0.068 0.005 0.0072
1986 12260 9.41 9.41 0.001 0.000 0.0001
1987 12249 9.41 9.41 0.001 0.000 0.0001
1988 12700 9.45 9.41 0.036 0.001 0.0038
1989 13026 9.47 9.45 0.025 0.001 0.0027
1990 9.47

Exercise 2.8 (c) and (d).


Chapter 2: Basic forecasting tools 85

(d) MSE=0.059 (average of column headed Error 2 )


MAPE=3.21% (average of values in last column multiplied by 100).
(e) See graph. Forecast is e9.47 = 13026.
(f ) There are a large number of possible methods. One method, which is discussed
in Chapter 5, is to consider only data after 1970 and use a straight line fitted
through the original data (i.e. without taking logarithms).
(g) The data for 1974 is lower than would be expected. If this information could be
included in the forecasts, the MSE and MAPE would both be smaller because
the forecast error in 1974 would be smaller.
86 Part D. Solutions to exercises

Chapter 3: Time series decomposition

3.1
Y 3-MA 5-MA 7-MA 3 3-MA 5 5-MA
42 55.50 70.33 81.50 62.92 81.14
69 70.33 81.50 91.60 73.50 88.71
100 94.67 91.60 99.83 93.56 96.65
115 115.67 111.40 107.57 113.22 111.10
132 129.33 128.40 126.00 129.11 125.92
141 142.33 142.60 141.86 142.33 141.60
154 155.33 155.60 156.71 155.33 156.80
171 168.33 170.00 172.86 169.56 172.32
180 185.00 187.40 189.29 185.78 189.80
204 204.00 206.00 210.71 205.11 210.96
228 226.33 230.00 236.86 228.56 236.72
247 255.33 261.40 268.29 257.78 262.54
291 291.67 298.80 283.00 295.56 289.27
337 339.67 316.50 298.80 331.78 304.09
391 364.00 339.67 316.50 351.83 318.32
400

3-MA
3x3 MA
5-MA
5x5 MA
7-MA
300
200
100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Exercise 3.1: Smoothers fitted to the shipments data.


Chapter 3: Time series decomposition 87

The graph on the previous page shows the five smoothers. Because moving average
smoothers are flat at the ends, the best smoother in this case is the one with the
smallest number of terms, namely the 3-MA.

3.2 1
Tt = 1
3 5 (Yt3 + Yt2 + Yt1 + Yt + Yt+1 )
+ 15 (Yt2 + Yt1 + Yt + Yt+1 + Yt+2 )

+ 15 (Yt1 + Yt + Yt+1 + Yt+2 + Yt+3 )
1 2 1 1 1 2 1
= 15 Yt3 + 15 Yt2 + 5 Yt1 + 5 Yt + 5 Yt+1 + 15 Yt+2 + 15 Yt+3 .

3.3 (a) The 4 MA is designed to eliminate seasonal variation because each quarter
receives equal weight. The 2 MA is designed to center the estimated trend at
the data points. The combination 2 4 MA also gives equal weight to each
quarter.
(b) Tt = 1 Yt2 + 1 Yt1 + 1 Yt + 1 Yt+1 + 1 Yt+2 .
8 4 4 4 8

3.4 (a) Use 24 MA to get trend. If the end-points are ignored, we obtain the following
results.
Data: Trend:
Y1 Y2 Y3 Y4 Y1 Y2 Y3 Y4
Q1 99 120 139 160 Q1 110.250 129.250 150.125
Q2 88 108 127 148 Q2 114.875 134.500 154.750
Q3 93 111 131 150 Q3 100.375 119.635 138.875
Q4 111 130 152 170 Q4 105.500 124.375 145.125

Data trend:
Y1 Y2 Y3 Y4 Ave
Q1 9.750 9.750 9.875 9.792
Q2 6.875 7.500 6.500 7.042
Q3 7.375 8.625 8.875 8.292
Q4 5.500 5.625 6.875 6.000
(b) Hence, the seasonal indices are:
S1 = 9.8, S2 = 7.0, S3 = 8.3 and S4 = 6.0.
The seasonal component consists of replications of these indices.
(c) End points ignored. Other approaches are possible.

3.5 (a) See the top plot on the next page. There is clear trend which appears close to
linear, and strong seasonality with a peak in AugustOctober and a trough in
JanuaryMarch.
(b) Calculations are given at the bottom of the next page. The decomposition plot
is shown at the top of the next page.
88 Part D. Solutions to exercises

1600
1200
Plastic sales
data

800
trend-cycle

1200
1000
110
seasonal

70 80 90

104
remainder

100
96
2 3 4 5

Year J F M A M J J A S O N D
Data
1 742 697 776 898 1030 1107 1165 1216 1208 1131 971 783
2 741 700 774 932 1099 1223 1290 1349 1341 1296 1066 901
3 896 793 885 1055 1204 1326 1303 1436 1473 1453 1170 1023
4 951 861 938 1109 1274 1422 1486 1555 1604 1600 1403 1209
5 1030 1032 1126 1285 1468 1637 1611 1608 1528 1420 1119 1013
212 MA Trend
1 977.0 977.0 977.1 978.4 982.7 990.4
2 1000.5 1011.2 1022.3 1034.7 1045.5 1054.4 1065.8 1076.1 1084.6 1094.4 1103.9 1112.5
3 1117.4 1121.5 1130.7 1142.7 1153.6 1163.0 1170.4 1175.5 1180.5 1185.0 1190.2 1197.1
4 1208.7 1221.3 1231.7 1243.3 1259.1 1276.6 1287.6 1298.0 1313.0 1328.2 1343.6 1360.6
5 1374.8 1382.2 1381.2 1370.6 1351.2 1331.2
Ratios
1 119.2 124.5 123.6 115.6 98.8 79.1
2 74.1 69.2 75.7 90.1 105.1 116.0 121.0 125.4 123.6 118.4 96.6 81.0
3 80.2 70.7 78.3 92.3 104.4 114.0 111.3 122.2 124.8 122.6 98.3 85.5
4 78.7 70.5 76.2 89.2 101.2 111.4 115.4 119.8 122.2 120.5 104.4 88.9
5 74.9 74.7 81.5 93.8 108.6 123.0
Seasonal indices
Ave 77.0 71.3 77.9 91.3 104.8 116.1 116.8 122.9 123.6 119.3 99.5 83.6

Exercise 3.5(a) and (b): Multiplicative classical decomposition of plastic sales data.
Chapter 3: Time series decomposition 89

(c) The trend does appear almost linear except for a slight drop at the end. The
seasonal pattern is as expected. Note that it does not make much difference
whether these data are analyzed using a multiplicative decomposition or an
additive decomposition.
3.6 Period Trend Seasonal Forecast
t Tt St Yt = Tt St /100
61 1433.96 76.96 1103.6
62 1442.81 71.27 1028.3
63 1451.66 77.91 1131.0
64 1460.51 91.34 1334.0
65 1469.36 104.83 1540.3
66 1478.21 116.09 1716.1
67 1487.06 116.76 1736.3
68 1495.91 122.94 1839.1
69 1504.76 123.55 1859.1
70 1513.61 119.28 1805.4
71 1522.46 99.53 1515.3
72 1531.31 83.59 1280.0

3.7 (a) See the top of the figure on the previous page.
(b) The calculations are given below.
Year Q1 Q2 Q3 Q4
Data
1 362 385 432 341
2 382 409 498 387
3 473 513 582 474
4 544 582 681 557
5 628 707 773 592
6 627 725 854 661
42 MA
1 382.5 388.0
2 399.3 413.3 430.4 454.8
3 478.3 499.6 519.4 536.9
4 557.9 580.6 601.5 627.6
5 654.8 670.6 674.9 677.0
6 689.4 708.1
Ratios
1 112.9 87.9
2 95.7 99.0 115.7 85.1
3 98.9 102.7 112.1 88.3
4 97.5 100.2 113.2 88.7
5 95.9 105.4 114.5 87.4
6 91.0 102.4
Seasonal indices
Ave 95.8 101.9 113.7 87.5
90 Part D. Solutions to exercises

600
data

400

700
trend-cycle

600
500
400
seasonal

105
90 95
remainder

100
98
96
2 3 4 5 6

Exercise 3.7: Decomposition plot for exports from French company.

(c) Multiplicative decomposition seems appropriate here because the variance is


increasing with the level of the series. The most interesting feature of the
decomposition is that the trend has levelled off in the last year or so. Any
forecast method should take this change in the trend into account.

3.8 (a) The top plot shows the original data followed by trend-cycle, seasonal and
irregular components. The bottom plot shows the seasonal sub-series.
(b) The trend-cycle is almost linear and the small seasonal component is very small
compared to the trend-cycle. The seasonal pattern is difficult to see in time
plot of original data. Values are high in March, September and December and
low in January and August. For the last six years, the December peak and
March peak have been almost constant. Before that, the December peak was
growing and the March peak was dropping. There are several possible outliers
in 1991.
Chapter 3: Time series decomposition 91

(c) The recession is seen by several negative outliers in the irregular component.
This is also apparent in the data time plot. Note: the recession could be made
part of the trend-cycle component by reducing the span of the loess smoother.

3.9 (a) and (b) Calculations are given below. Note that the seasonal indices are
computed by averaging the de-trended values within each half-year.
Data 22 MA Detrended Seasonal Seasonal
Trend Data Component Adjusted Data
1.09 0.017 1.073
1.07 1.0825 -0.0125 -0.014 1.084
1.10 1.0825 0.0175 0.017 1.083
1.06 1.0750 -0.0150 -0.014 1.074
1.08 1.0625 0.0175 0.017 1.063
1.03 1.0450 -0.0150 -0.014 1.044
1.04 1.0300 0.0100 0.017 1.023
1.01 1.0225 -0.0125 -0.014 1.024
1.03 1.0075 0.0225 0.017 1.013
0.96 -0.014 0.974
(c) With more data, we could take moving averages of the detrended values for
each half-year rather than a simple average. This would result in a seasonal
component which changed over time.
92 Part D. Solutions to exercises

Chapter 4: Exponential smoothing methods

4.1
Period Data MA(3) SES( = 0.7)
t Yt
Yt Et Yt Et
1974 1 1 5.4
2 2 5.3 5.40 -0.10
3 3 5.3 5.33 -0.03
4 4 5.6 5.33 0.27 5.31 0.29
1975 1 5 6.9 5.40 1.50 5.51 1.39
2 6 7.2 5.93 1.27 6.48 0.72
3 7 7.2 6.57 0.63 6.99 0.21
4 8 7.10 7.14
Accuracy statistics from period 4 through 7
ME 0.92 0.65
MAE 0.92 0.65
MAPE 13.22 9.56
MSE 1.08 0.64
Theils U 1.40 1.14

Theils U statistic suggests that the nave (or last value) method is better than
either of these. If SES is used with an optimal value of chosen, then = 1 is
selected. This is equivalent to the nave method. Note different packages may give
slightly different results for SES depending on how they initialize the method. Some
packages will also allow > 1.

4.2 (a) Forecasts for May 1992


Method MA(3) MA(5) MA(7) MA(9) MA(11)
Forecast 24.0 48.6 55.6 51.7 53.1
MSE 1484.3 1031.2 757.5 860.8 1313.8
(b) Forecasts for May 1992
Method = 0.1 = 0.3 = 0.5 = 0.7 = 0.9
Forecast 45.5 41.9 33.1 29.1 28.7
MSE 1421.35 1211.80 1193.98 1225.40 1298.49
(c) Of these forecasting methods, the best MA(k) method has k = 7 and the best
SES method has = 0.5. However, it should be noted that the MSE values for
the MA methods are taken over different periods. For example, the MSE for the
MA(7) method is computed only over 9 observations because it is not possible
to compute an MA(7) forecast for the first seven observations. So the MSE
Chapter 4: Exponential smoothing methods 93

values are not strictly comparable for the MA forecasts. It would be better to
use a holdout sample but there are too few data.
4.3 Optimizing for SES over the period 3 through 10:

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
MAPE 65.60 53.46 44.43 37.60 32.32 28.16 24.82 22.08 19.80 17.86
MSE 79.34 47.24 29.95 20.10 14.17 10.41 7.91 6.17 4.92 4.00

The optimal value is = 1.


With Holts method, any combination of and will give MAPE=0. This is so
because the differences between successive values of (4.13) are always going to be
zero with this errorless series. Using = 1 for SES and = 0.5 and = 0.5 for
Holts method gives the following results.

Data SES Holts


Yt
Yt Et
Yt Et
2
4 2 2 4 0
6 4 2 6 0
8 6 2 8 0
10 8 2 10 0
12 10 2 12 0
14 12 2 14 0
16 14 2 16 0
18 16 2 18 0
20 18 2 20 0

(a) Clearly Holts method is better as it allows for the trend in the data.
(b) For SES, = 1. Because of the trend, the forecasts will always lag behind the
actual values so that the forecast errors will always be at least 2. Choosing
= 1 makes the forecast errors as small as possible for SES.
(c) See above.

4.4 (a) (b) and (c) See the table on the following page.
(d) Theres not much to choose between these methods. They are both bad! Look
at Theils U values for instance. The last value method over the same period
(1328) gives MSE=6.0, MAPE=2.05 and Theils U=1.0.
94 Part D. Solutions to exercises

Period Data Forecast Errors Forecast Errors


t Yt MA(12) Et MA(6) Et
1 108
2 108
3 110
4 106
5 108
6 108
7 105 108.00 -3.00
8 100 107.50 -7.50
9 97 106.17 -9.17
10 95 104.00 -9.00
11 95 102.17 -7.17
12 92 100.00 -8.00
13 95 102.67 -7.67 97.33 -2.33
14 95 101.58 -6.58 95.67 -0.67
15 98 100.50 -2.50 94.83 3.17
16 97 99.50 -2.50 95.00 2.00
17 101 98.75 2.25 95.33 5.67
18 104 98.17 5.83 96.33 7.67
19 101 97.83 3.17 98.33 2.67
20 99 97.50 1.50 99.33 -0.33
21 95 97.42 -2.42 100.00 -5.00
22 95 97.25 -2.25 99.50 -4.50
23 96 97.25 -1.25 99.17 -3.17
24 96 97.33 -1.33 98.33 -2.33
25 97 97.67 -0.67 97.00 0.00
26 98 97.83 0.17 96.33 1.67
27 94 98.08 -4.08 96.17 -2.17
28 92 97.75 -5.75 96.00 -4.00
29 97.33 95.50
Accuracy criteria: periods 1328
ME -1.51 -0.10
MAE 3.12 2.96
MSE 14.40 12.64
MAPE 3.23 3.03
Theils U 1.58 1.45

Calculations for Exercise 4.4


Chapter 4: Exponential smoothing methods 95

4.5 (a) (b) and (c)


Paperbacks Hardcovers
SES Holt SES Holt
Smoothing parameters = 0.213 = 0.335 = 0.347 = 0.437
= 0.453 = 0.157
Forecast Day 31 210.15 224.24 240.38 250.73
Forecast Day 32 210.15 231.79 240.38 254.63
Forecast Day 33 210.15 239.33 240.38 258.53
Forecast Day 34 210.15 246.88 240.38 262.43
MAE 29.6 33.9 27.3 28.6
MSE 1252.2 1701.7 1060.6 1273.0
MAPE 17.1 18.4 13.5 14.3
Theils U 0.68 0.92 0.81 0.92
For both series, SES forecasting is performing better than Holts method.
(d) SES forecasts are flat and Holts forecasts show a linear trend. Both series
show an upward linear trend and we would expect the forecasts to reflect that
trend. Perhaps an out-of-sample analysis would give a better indication of the
merits of the two methods.
(e) The autocorrelation functions of the forecast errors in each case are plotted on
the next page. In each case, there is no noticeable pattern. Only a few spikes
are just outside the critical bounds which is expected.

4.6 Here is a complete run for one set of values ( = 0.1 and 1 = 0.1). Note that in this
program we have chosen to make the first three values of be equal to the starting
value. This is not crucial, but it does make a difference.

t Yt Ft Et At Mt t
1 200.0 200.00 0.00 0.00 0.00 0.100
2 135.0 200.00 -65.00 -6.50 6.50 0.100
3 195.0 193.50 1.50 -5.70 6.00 0.100
4 197.5 193.65 3.85 -4.74 5.79 0.950
5 310.0 197.31 112.69 7.00 16.48 0.820
6 175.0 289.74 -114.74 -5.18 26.30 0.425
7 155.0 241.00 -86.00 -13.26 32.27 0.197
8 130.0 224.08 -94.08 -21.34 38.45 0.411
9 220.0 185.43 34.57 -15.75 38.06 0.555
10 277.5 204.62 72.88 -6.89 41.55 0.414
11 235.0 234.77 0.23 -6.17 37.41 0.166
12 234.81 0.165
96 Part D. Solutions to exercises

0.4 SES paperbacks Holt paperbacks

0.4
0.2

0.2
ACF

ACF
0.0

0.0
-0.2

-0.2
-0.4

-0.4
2 4 6 8 10 12 14 2 4 6 8 10 12 14

Lag Lag

SES hardbacks Holt hardbacks


0.4

0.4
0.2

0.2
ACF

ACF
0.0

0.0
-0.2

-0.2
-0.4

-0.4

2 4 6 8 10 12 14 2 4 6 8 10 12 14

Lag Lag

Exercise 4.5 (e): Autocorrelation functions of forecast errors.

For other combinations of values for and starting values for , here is what the
final value is:

= 0.1 = 0.3 = 0.5 = 0.7


= 0.1 0.165 0.327 0.732 0.143
= 0.2 0.058 0.454 0.783 0.133
= 0.3 0.140 0.618 0.797 0.133

The time series is not very long and therefore the results are somewhat fickle. In
any event, it is clear that the value and the starting values for have a profound
effect on the final value of .

4.7 Holt-Winters method is best because the data are seasonal. The variation increases
with the level, so we use Holt-Winters multiplicative method. The optimal smooth-
ing parameters (giving smallest MSE) are a = 0.479, b = 0.00 and c = 1.00. These
give the following forecasts (read left to right):
Chapter 4: Exponential smoothing methods 97

309.1 312.1 315.2 318.3 321.3 324.4


327.5 330.5 333.6 336.7 339.7 342.8
345.9 348.9 352.0 355.0 358.1 361.2
364.2 367.3 370.4 373.4 376.5 379.6

4.8 First choose any values for the three parameters. Here we have used = = = 0.1.
Different values will choose different initial values. Our program uses the method
described in the textbook and gave the following results:

ME MAE MSE MAPE r1 Theils U


-240.5 240.5 62469.9 37.5 0.70 2.6

Now compare with the optimal values: = 0.917, = 0.234 and = 0.000. Using
the same initialization, we obtain the results in Table 4-11, namely

ME MAE MSE MAPE r1 Theils U


-9.46 24.00 824.75 3.75 0.17 0.29
98 Part D. Solutions to exercises

Chapter 5: Simple regression

5.1 (a) 0.7, almost 1, 0.2


(b) False. The correlation is negative. So below-average values of one are associated
with above-average values of the other variable.
(c) Wages have been increasing over time due to inflation. At the same time,
population has been increasing and consequently, new houses need to be built.
So, because they are both increasing with time, they are positively correlated.
(d) There are many factors affecting unemployment and it is simplistic to draw a
causal connection with inflation on the basis of correlation. As in the previous
question, both vary with time and the correlation could be induced by their
time trends. Or they could both be related to some third variable such as
business confidence or government spending.
(e) The older people in the survey had much less opportunity for education than the
younger people. This negative correlation is caused by the increase in education
levels over time.

5.2 (a) X = 5, Y = 25, P(Xi X)


2 = 20, P(Xi X)(Y
i Y ) = 78. So b = 78/20 = 3.9
and a = 25 3.9(5) = 5.5. Hence, the regression line is Y = 5.5 + 3.9X.
P P p
(b) (Yi Y )2 = 304.20, (Yi Yi )2 = 25.80, e = 25.80/(5 2) = 2.933. So

304.20/(2 1)
F = = 35.4.
25.80/(5 2)

This has (21) = 1 df for the numerator and (52) = 3 df for the denominator.
From Table C in Appendix III, the P -value is slightly smaller than 0.010. (Using
a computer, it is 0.0095.) Standard errors:
q
s.e.(a) = (2.93) 15 + 25 20 = 3.53
q
1
s.e.(b) = (2.93) 20 = 0.656.

On 3 df, t = 3.18 for a 95% confidence interval. Hence 95% intervals are

: 5.500 3.18(3.53) = [5.7, 16.7]


: 3.900 3.18(0.656) = [1.8, 6.0]
Chapter 5: Simple regression 99

Output from Minitab for Exercise 5.2:


Regression Analysis

The regression equation is


Y = 5.50 + 3.90X

Predictor Coef StDev T P


Constant 5.500 3.531 1.56 0.217
X 3.9000 0.6557 5.95 0.010

S = 2.933 R-Sq = 92.2% R-Sq(adj) = 89.6%

Analysis of Variance

Source DF SS MS F P
Regression 1 304.20 304.20 35.37 0.010
Error 3 25.80 8.60
Total 4 330.00

(c) R2 = 0.922, rXY = rY Y = 0.960.


(d) The line through the middle of the graph is the line of best fit. The 95%
prediction interval shown is the interval which would contain the Y value with
probability 0.95 if the X value was 17. The 80% prediction interval shown is
the interval which would contain the Y value with probability 0.80 if the X
value was 26. The dotted line at the boundary of the light shaded region gives
the ends of all the 95% prediction intervals. The dotted line at the boundary
of the dark shaded region gives the ends of all the 80% prediction intervals.

5.3 (a) See the plot on the next page and the Minitab output on page 101. The straight
line is Y = 0.46 + 0.22X.
(b) See the plot on the next page. The residuals may show a slight curvature (
shaped). However, the curvature is not strong and the fitted model appears
reasonable.
(c) R2 = 90.2%. Therefore, 90.2% of the variation in melanoma rates is explained
by the linear regression.
(d) From the Minitab output:
Prediction: 9.286. Prediction interval: (6.749, 11.823)
100 Part D. Solutions to exercises

10
8
melanoma

6
4
2

10 20 30 40

ozone

Exercise 5.3(a): Scatterplot of melanoma rate against ozone depletion.


1.5
1.0
Residuals

0.5
0.0
-0.5
-1.0

10 20 30 40

ozone

Exercise 5.3(b): Scatterplot of residuals from the linear regression.


Chapter 5: Simple regression 101

Output using Minitab for Exercise 5.3:

MTB > Regress Melanoma 1 Ozone;


SUBC> predict 40.

The regression equation is


Melanoma = 0.460 + 0.221 Ozone

Predictor Coef StDev T P


Constant 0.4598 0.6258 0.73 0.481
Ozone 0.22065 0.02426 9.09 0.000

S = 0.9947 R-Sq = 90.2% R-Sq(adj) = 89.1%

Analysis of Variance

Source DF SS MS F P
Regression 1 81.822 81.822 82.70 0.000
Error 9 8.905 0.989
Total 10 90.727

Fit StDev Fit 95.0% CI 95.0% PI


9.286 0.517 ( 8.116, 10.456) ( 6.749, 11.823)

Note that it is the prediction interval (PI) we want here. Minitab also gives
the confidence interval (CI) for the line at this point, something we have not
covered in the book.
(e) This analysis has assumed that the susceptibility to melanoma among people
living in the various locations is constant. This is unlikely to be true due to
the diversity of racial mix and climate over the locations. Apart from ozone
depletion, melanoma will be affected by skin type, climate, culture (e.g. is
sun-baking encouraged?), diet, etc.

5.4 (a) See plot on the next page and computer output on page 103.
(b) Coefficients: a = 4.184, b = 0.9431. Only b is significant, showing the relation-
ship is significant. (We could refit the model without the intercept term.)
(c) If X = 80, Y = 4.184 + 0.9431(80) = 79.63. Standard error of forecast is 1.88
(from computer output).
102 Part D. Solutions to exercises

90
80
70
Production rating

60
50
40
30

20 40 60 80

Manual dexterity

Exercise 5.4(a): Scatterplot of production rating against manual dexterity test scores.
100



80
Production rating


60






40



20

20 40 60 80 100

Manual dexterity

Exercise 5.4(e): 95% prediction intervals for production rating.


Chapter 5: Simple regression 103

Output using Minitab for Exercise 5.4

MTB > Regress Y 1 X;


SUBC> Predict newX.

The regression equation is


Y = 4.18 + 0.943 X

Predictor Coef StDev T P


Constant 4.184 3.476 1.20 0.244
X 0.94306 0.05961 15.82 0.000

S = 5.126 R-Sq = 93.3% R-Sq(adj) = 92.9%

Analysis of Variance

Source DF SS MS F P
Regression 1 6576.8 6576.8 250.29 0.000
Error 18 473.0 26.3
Total 19 7049.8

Fit StDev Fit 95.0% CI 95.0% PI


23.05 2.38 ( 18.04, 28.05) ( 11.17, 34.92)
41.91 1.46 ( 38.85, 44.97) ( 30.71, 53.10)
60.77 1.18 ( 58.28, 63.26) ( 49.71, 71.82)
79.63 1.88 ( 75.68, 83.58) ( 68.16, 91.10)

(d) For confidence and prediction intervals, use Table B with 18 df. 95% CI for
is 0.94306 2.10(0.05961) = [0.82, 1.07].
(e) See output. Again it is the prediction interval (PI) we want here, not the
confidence interval (CI). The prediction intervals are shown in the plot on the
previous page.

5.5 (a) See the plot on the following page. The straight line regression model is Y =
20.20.145X where Y = electricity consumption and X = temperature. There
is a negative relationship because heating is used for lower temperatures, but
there is no need to use heating for the higher temperatures. The temperatures
are not sufficiently high to warrant the use of air conditioning. Hence, the
electricity consumption is higher when the temperature is lower.
104 Part D. Solutions to exercises

19
Electricity consumption (Mwh)

18
17
16

10 15 20 25 30

Temperature

Exercise 5.5(a): Electricity consumption (Mwh) plotted against temperature (degrees Cel-
sius).

Possible outlier
2
1
Residuals

0
-1

10 15 20 25 30

Temperature

Exercise 5.5(c): Residual plot for the straight line regression of electricity consumption
against temperature.
Chapter 5: Simple regression 105

(b) r = 0.791
(c) See the plot on the previous page. Apart from the possible outlier, the model
appears to be adequate. There are no highly influential observations.
(d) If X = 10, Y = 20.2 0.145(10) = 18.75. If X = 35, Y = 20.2 0.145(35) =
15.12. The first of these predictions seems reasonable. The second is unlikely.
Note that X = 35 is outside the range of the data making prediction danger-
ous. For temperatures above about 20 C, it is unlikely electricity consumption
would continue to fall because no heating would be used. Instead, at high
temperatures (such as X = 35 C), electricity consumption is likely to increase
again due to the use of air-conditioning.

5.6 (a) When H = 130 and W = 45, r = 0.553.


(b) When H = 40 and W = 150, r = 0.001.
(c) The following table shows the influence of outliers at various positions.
H W r
129 0 -0.393
128 22 0.032
122 44 0.527
112 64 0.773
99 83 0.846
83 99 0.810
65 112 0.627
44 122 0.151
22 128 -0.365
0 129 -0.624
The point about all this is that an outlier (and skewness in general) can seriously
affect the correlation coefficient. It is a good idea to look at the scatterplot
before computing any correlation.

5.7 (a) See the plot on the next page. The winning time has been decreasing with year.
There is an outlier in 1896.
(b) The fitted line is Y = 1960.0768X where X denotes the year of the Olympics.
Therefore the winning time has been decreasing an average 0.0768 seconds per
year.
(c) The residuals are plotted on the next page. The residuals show random scatter
about 0 with only one usual point (the outlier in 1896). But note that the
last five residuals are positive. This suggests that the straight line is levelling
outthe winning time is decreasing at a slower rate now than it was earlier.
106 Part D. Solutions to exercises

54
52
50
winning.time

48
46
44

1900 1920 1940 1960 1980 2000

year

Exercise 5.7(a): Scatterplot of winning times against year.


3
2
fit$resid

1
0
-1

1900 1920 1940 1960 1980 2000

year

Exercise 5.7(c): Residual plot for linear regression model of winning times.
Chapter 5: Simple regression 107

(d) The predicted winning time in the 2000 Olympics is

Y = 196 0.0768(2000) = 42.50 seconds.

This would smash the world record. But given the previous five results (with
positive residuals), it would seem more likely that the actual winning time
would be higher. A prediction interval is

42.50 2.0796(1.1762) = 42.50 2.45 = [40.05, 44.95].

5.8 (a) There is strong seasonality with peaks in November and December and a trough
in January. The surfing festival shows as a smaller peak in March from 1988.
The variation in the series is increasing with the level and there is a strong
positive trend due to sales growth.
(b) Logarithms are necessary to stabilize the variance so it does not increase with
the level of the series.
(c) See the plot on the next page and the computer output on page 109. The fitted
line is Y = 526.57 + 0.2706X where X is the year and Y is the logged annual
sales.
(d)
X = 1994 : Y = 526.57 + 0.2706(1994) = 12.98
X = 1995 : Y = 526.57 + 0.2706(1995) = 13.25
X = 1996 : Y = 526.57 + 0.2706(1996) = 13.52

Prediction intervals (from computer output):

X = 1994 : [12.57, 13.40]


X = 1995 : [12.80, 13.71]
X = 1996 : [13.03, 14.02]

(e) We transform the forecasts and intervals with the exponential function:

Total annual sales for 1994 exp(12.98) = $434, 443


Total annual sales for 1995 exp(13.25) = $569, 439
Total annual sales for 1996 exp(13.52) = $746, 383

Prediction intervals:

X = 1994 : [e12.57 , e13.40 ] = [286673, 658385]


X = 1995 : [e12.80 , e13.71 ] = [361994, 895764]
X = 1996 : [e13.03 , e14.02 ] = [455060, 1224208]
108 Part D. Solutions to exercises

80000
60000
Sales

40000
20000
0

1988 1990 1992 1994

Exercise 5.8(a): Time plot of sales figures.


12.5
Log Total annual sales

12.0
11.5

1987 1988 1989 1990 1991 1992 1993

Exercise 5.8(c): Regression line fitted to the logged sales data.


Chapter 5: Simple regression 109

Output using Minitab for Exercise 5.8:


MTB > regress Log Sales 1 Year;
SUBC> predict new years;

The regression equation is


Log Sales = - 527 + 0.271 Year

Predictor Coef StDev T P


Constant -526.57 46.44 -11.34 0.000
Year 0.27059 0.02334 11.60 0.000

S = 0.1235 R-Sq = 96.4% R-Sq(adj) = 95.7%

Analysis of Variance

Source DF SS MS F P
Regression 1 2.0501 2.0501 134.45 0.000
Error 5 0.0762 0.0152
Total 6 2.1263

Fit StDev Fit 95.0% CI 95.0% PI


12.9818 0.1044 ( 12.7135, 13.2502) ( 12.5661, 13.3975)
13.2524 0.1257 ( 12.9293, 13.5755) ( 12.7994, 13.7054) X
13.5230 0.1476 ( 13.1435, 13.9025) ( 13.0282, 14.0178) X
X denotes a row with X values away from the center

These prediction intervals are very wide because we are only using annual totals
in making these predictions. A more accurate method would be to fit a model
to the monthly data allowing for the seasonal patterns. This is discussed in
Chapter 7.
(f ) One way would be to calculate the proportion of sales for each month compared
to the total sales for that year. Averaging these proportions will give a rough
guide as to how to split the annual totals into 12 monthly totals.
110 Part D. Solutions to exercises

14
12
Percentage mortality

10
8
6
4

0 20 40 60 80 100

Percentage Type A Birds

Exercise 5.9(a): Scatterplot of percentage mortality against percentage of Type A birds.

5.9 (a) The plot is shown above. The fitted line is

Y = 4.38 + 0.0154X

where X = percentage of type A birds and Y = percentage mortality.


(b) From the computer output:
Predictor Coef StDev T P
Constant 4.3817 0.6848 6.40 0.000
% Type A 0.015432 0.007672 2.01 0.046

So the t-test is significant (since P < 0.05). A 95% confidence interval for the
slope is

0.01543 1.976(0.007672) = 0.01543 0.01516 = [0.003, 0.031].

This suggests that the Type A birds have a higher mortality than the Type B
birds, the opposite to what the farmers claim.
(c) For a farmer using all Type A birds, X = 100. So Y = 4.38 + 0.0154(100) =
5.92%. For a farmer using all Type B birds, X = 0. So Y = 4.38%. Prediction
intervals for these are [2.363, 9.487] and [0.587, 8.177] respectively.
(d) R2 = 2.6. So only 2.6% of the variation in mortality is due to bird type.
Chapter 5: Simple regression 111

140
Model 1
Model 2

120
100
consumption

80
60
40

40 60 80 100

price

Exercise 5.10(b): Scatterplot of gas consumption against price.

(e) This information suggests that heat may be a lurking variable. If Type A birds
are being used more in summer and the mortality is higher in summer, than the
increased mortality of Type A birds may be due to the summer rather than the
bird type. A proper randomized experiment would need to be done to properly
assess whether bird type is having an effect here.
5.10 (a) Cross sectional data. There is no time component.
(b) See the plot above.
(c) When the price is higher, the consumption may be lower due to the pressure of
increased cost. Therefore, we would expect b 1 < b2 < 0.
(d) Model 1: First take logarithms of Y i , then use simple linear regression to obtain
a = 5.10, b = 0.0153, e2 = 0.0735.
Model 2: Split data into two groups. Fit each group separately using simple
linear regression to obtain
a1 = 221, b1 = 2.91 and a2 = 84.8, b2 = 0.447.
Using the equation given in the question, we obtain
e2 = 2913.7/16 = 182.06.
The fitted lines are shown on the graph above.
112 Part D. Solutions to exercises

(e) Model 1: R2 = rY2 Y = 0.721.


1
Model 2: R2 = rY2 Y = 0.859. The second model is better with higher R 2 value.
2
The residual plots are given on the following page. Again, the second model is
much better showing random scatter about zero. The first model show pattern
in the residuals.
(f ) The graph on page 114 shows a local linear regression through the data. The
fitted curve resembles the fitted lines for model 2. This suggests that model 2
is a reasonable model for the data. However, our approach has also meant the
two lines do not join at X = 60. A better model would force them to join. This
means the parameters must be restricted which makes the estimation much
harder.
(g) and (h) Using model 2, forecasts are obtained by

220.9 2.906X when X 60
Y =
84.8 0.447X when X > 60.

and standard errors are obtained from (5.19):


r
1 (X 63)2
s.e.(Y ) = 182.06 1 + + .
20 10672.11

The 95% PI are obtained using Y t (s.e.) where t = 2.12 (from Table B with
16 df). Hence, we obtain the following values.
X Y s.e. [ 95% PI ]
40 104.67 14.15 [74.7 , 134.7]
60 46.55 13.83 [17.2 , 75.9]
80 49.03 14.00 [19.3 , 78.7]
100 40.09 14.65 [ 9.0 , 71.1]
120 31.15 15.70 [ -2.1 , 64.4]
For example, at a price of 80c, the gas consumption will lie between 19.3 and
78.7 for 95% of towns.
Chapter 5: Simple regression 113

40
20
Residuals model 1

0
-20

40 60 80 100

Price
20
10
Residuals model 2

0
-10
-20

40 60 80 100

Price

Exercise 5.10(e): Residual plots for the two models.


114 Part D. Solutions to exercises

140
120
100
Consumption

80
60
40

40 60 80 100

Price

Exercise 5.10(f ): Local linear regression through the gas consumption data. The fitted line
suggests that model 2 is more appropriate.
140
120
100
Consumption

80
60
40
20
0

40 60 80 100 120

Price

Exercise 5.10(h): 95% prediction intervals for gas consumption.


Chapter 6: Multiple regression 115

Chapter 6: Multiple regression

6.1 (a) df for numerator = k and for denominator = n k 1 where n = number of


observations and k = number of explanatory variables. Here, k = 16 so that
n 16 1 = 30. Hence, n = 30 + 16 + 1 = 47.
(b)
2 = 1 (1 R2 ) n1 = 1 (1 0.943) 47 1
R nk1 = 0.913.
48 16 1
(c) F = 31.04 on (17,30) df. From Table C in Appendix III, the P -value is much
smaller than 0.01. So the regression is highly significant.
(d) The coefficients should be compared with a t 30 distribution. From Table B in
Appendix III, any value greater than 2.04 in absolute value will be significant
at the 5% level. So the constant and variables 4, 8, 12, 13, 14, 15 and 17 are
significant in the presence of other explanatory variables. Note that the signif-
icance level of 5% is arbitrary. There is no reason why some other significance
level (e.g. 2%) could not be used.
(e) The next stage would be to reduce the number of variables in the model by
removing some of the least significant variables and re-fitting the model.

6.2 (a) The fitted model is C = 273.935.68P +0.034P 2 . For this model, R2 = 0.8315.
[Recall: in exercise 5.6, model 1 had R 2 = 0.721 and model 2 had R2 = 0.859.]
So the R 2 values for each model are:

Model 1 2 = 1 (1 0.721) n1 = 1 (1 0.721) 46 = 0.715.


R nk1 45
= 1 (1 0.859)
2 n1 46
Model 2 R nk1 = 1 (1 0.859) 43 = 0.849.

Model 3 2 = 1 (1 0.832) n1 = 1 (1 0.832) 46 = 0.824.


R nk1 44
These values show that model 2 is the best model, followed by model 3. The t
values for the coefficients are:
Model 1 : t = 10.22 : t = 5.47
Model 2 1 : t = 10.33 1 : t = 6.61 2 : t = 4.11 2 : t = 1.99
Model 3 0 : t = 8.83 1 : t = 5.62 2 : t = 4.57
Of these, only 2 from model 2 is not significantly different from zero. This
suggests that a better model would be to allow the second part of model 2 to
be a constant rather than a linear function.
(b) From the computer output the following 95% prediction intervals are obtained.
116 Part D. Solutions to exercises

Output using Minitab for Exercise 6.2:


MTB > regress C 2 P Psq;
SUBC> predict newP newPsq.

The regression equation is


C = 274 - 5.68 P + 0.0339 Psq

Predictor Coef StDev T P


Constant 273.93 31.03 8.83 0.000
P -5.676 1.009 -5.62 0.000
Psq 0.033904 0.007412 4.57 0.000

S = 14.37 R-Sq = 83.2% R-Sq(adj) = 81.2%

Analysis of Variance
Source DF SS MS F P
Regression 2 17327.0 8663.5 41.95 0.000
Error 17 3511.0 206.5
Total 19 20838.0

Source DF Seq SS
P 1 13005.7
Psq 1 4321.3

Fit StDev Fit 95.0% CI 95.0% PI


173.97 14.29 ( 143.82, 204.13) ( 131.21, 216.74) XX
101.14 4.77 ( 91.08, 111.21) ( 69.19, 133.10)
55.43 4.91 ( 45.07, 65.80) ( 23.38, 87.48)
36.85 4.95 ( 26.40, 47.29) ( 4.77, 68.92)
45.38 7.14 ( 30.31, 60.46) ( 11.52, 79.25)
81.04 18.49 ( 42.02, 120.06) ( 31.62, 130.46) XX
X denotes a row with X values away from the center
XX denotes a row with very extreme X values
Chapter 6: Multiple regression 117

200
150
consumption

100
50
0

20 40 60 80 100 120

price

Exercise 6.2: Quadratic regression of gas consumption against price. 95% prediction inter-
vals shown.

P C [ 95% PI ]
20 173.97 [ 131.21 , 216.74 ]
40 101.14 [ 69.19 , 133.10 ]
60 55.43 [ 23.38 , 87.48 ]
80 36.85 [ 4.77 , 68.92 ]
100 45.38 [ 11.52 , 79.25 ]
120 81.04 [ 31.62 , 130.46 ]
It is clear from the plot that it is dangerous predicting outside the observed
price range. In this case, the predictions at P = 20 and P = 120 are almost cer-
tainly wrong. Predicting outside the range of the explanatory variable is always
dangerous, but much more so when a quadratic (or higher-order polynomial) is
used.
(c) rP P 2 = 0.990. If we were to use P , P 2 and P 3 , the correlations among these
explanatory variables would be very high and we would have a serious multi-
collinearity problem on our hands. The coefficients estimates would be unstable
(i.e. have large standard errors). Multicollinearity will often be a problem with
polynomial regression.
118 Part D. Solutions to exercises

6.3 (a) From Table 6-15, we obtain the following values


Period Actual Forecast
54 4.646 1.863
55 1.060 1.221
56 -0.758 0.114
57 4.702 2.779
58 1.878 1.959
59 6.620 5.789
Analysis of errors: periods 54 through 59.
ME MAE MSE MPE MAPE ACF1 Theils U
0.74 1.11 2.15 34.82 41.32 -0.35 0.34
Strictly speaking, we should not compute relative measures when the data cross
the zero line (i.e., when there are positive and negative values) because relative
measures will blow up if divided by zero.
(b) and (c) Optimizing the coefficients for Holts method will give better forecasts.
Another approach is to use a simple MA forecast. An MA(2) forecast actually
works better than Holts method for both series. Other approaches are also
possible.
Calculate accuracy statistics for your forecasts and compare them with the
forecasts in Table 6-14.

6.4 (a) The fitted equation is

Y = 73.40 + 1.52X1 + 0.38X2 0.27X3 .

95% confidence intervals for the parameters are calculated using a t 6 distribu-
tion. So the multiplier is 2.45:

73.40 2.45(14.687) = [37.46, 109.3]


1.52 2.45(0.1295) = [1.20, 1.84]
0.38 2.45(0.1941) = [0.09, 0.85]
0.27 2.45(0.1841) = [0.72, 0.18]

(b) F = 123.3 on (3,6) df. P = 0.000. This means that the probability of results
like this, if the three explanatory variables were not relevant, is very small.
(c) The residual plots on page 120 show the model is satisfactory. There is no
pattern in any of the residual plots.
(d) R2 = 0.984. Therefore 98.4% of the variation in Y is explained by the regression
relationship.
Chapter 6: Multiple regression 119

Output using Minitab for Exercise 6.4:

MTB > Regress Y 3 X1 X2 X3;


SUBC> Predict 10 40 30;
SUBC> Confidence 90.

The regression equation is


Y = 73.4 + 1.52 X1 + 0.381 X2 - 0.268 X3

Predictor Coef StDev T P


Constant 73.40 14.69 5.00 0.002
X1 1.5162 0.1295 11.71 0.000
X2 0.3815 0.1941 1.97 0.097
X3 -0.2685 0.1841 -1.46 0.195

S = 2.326 R-Sq = 98.4% R-Sq(adj) = 97.6%

Analysis of Variance
Source DF SS MS F P
Regression 3 2001.54 667.18 123.32 0.000
Error 6 32.46 5.41
Total 9 2034.00

Source DF Seq SS
X1 1 1118.36
X2 1 871.67
X3 1 11.51

Fit StDev Fit 90.0% CI 90.0% PI


95.762 1.632 ( 92.590, 98.934) ( 90.239, 101.285)
120 Part D. Solutions to exercises

4
3

3
2

2
residuals

residuals
1

1
0

0
-1

-1
-2

-2
5 10 15 20 30 40 50 60 70

X1 X2
4
3
2
residuals

1
0
-1
-2

10 20 30 40 50 60

X3

Exercise 6.4(c): Residual plots for the cement data.

(e) The signs of the coefficients indicate the direction of the effect of each variable.
X1 increases heat and has the greatest effect (the largest coefficient). The other
variables are not significant, so they may not have any effect. If they do, the
coefficients suggest that X2 might increase heat and X3 might decrease heat.
(f ) For X1 = 10, X2 = 40 and X3 = 30, Y = 73.40+1.52(10)+0.38(40)0.27(30) =
95.76. 90% Prediction interval: [90.24,101.29]

6.5 The data for this exercise were taken from McGee and Carleton (1970) Piecewise re-
gression, Journal of the American Statistical Association, 65, 11091124. It might
be worthwhile to get this paper to compare what conventional regression can ac-
complish when there are special features in the data. In this case, the relationship
Chapter 6: Multiple regression 121

between the Boston dollar volume and the NYSE-AME dollar volume underwent a
series of changes over the time period of interest. In this paper, the solution was as
follows:

from Jan 67 through Oct 67 Y = 8.748 + 0.0061X


from Nov 67 through Jul 68 Y = 20.905 + 0.0114X
from Aug 68 through Nov 68 Y = 79.043 + 0.0205X
from Dec 68 through Nov 69 Y = 11.075 + 0.0067X

Notice the slope coefficients in these four equations. They are small (because
Bostons dollar volume is small relative to the big board volumes) but they get
increasingly stronger (from6 1 to 114 to 205) in successive periods of commission
splitting. Then in Dec 68, the SEC said no more commission splitting and it
hurt the Boston dollar volume. The slope went back to 67, which is almost where it
started.

(a) The fitted equation is Y = 66.2 + 0.014X. The following output was obtained
from a computer package.

Value Std. Error t value Pr(>|t|)


(Intercept) -66.2193 39.6809 -1.6688 0.1046
X 0.0138 0.0029 4.7856 0.0000
F statistic: 22.9 on 1 and 33 degrees of freedom
the p-value is 0.00003465
R-sq = 0.4097 Rbar-sq = 0.3918 D-W = 0.694

Clearly, the regression is significant, although the intercept is not significant.


(b) Output from computer package:

Value Std. Error t value Pr(>|t|)


(Intercept) -67.2116 40.2550 -1.6696 0.1047
X 0.0135 0.0030 4.5025 0.0001
time 0.2737 0.6518 0.4199 0.6773
F statistic: 11.25 on 2 and 32 degrees of freedom
the p-value is 0.0001992
R-sq = 0.4129 Rbar-sq = 0.3762 D-W = 0.6814

Here, the regression is significant, but time is not significant. In fact, comparing
these two models shows that adding time to the regression equation is actually
worse than not adding it. See the R 2 values. And for both analyses, the D-W
122 Part D. Solutions to exercises

250
200
Y

150
100
50

10000 12000 14000 16000 18000

Exercise 6.5(c): Connected scatterplot for the Boston and American stock exchanges.

statistic shows that there is a lot of pattern left in the residuals. A piecewise
regression approach does far better with this data set.
(c) See the plot above.

6.6 (a) and (b) Here are the seasonality indices based on the regression equations
(6.10) and (6.12). They represent the intercept term in the regression for each
of the 12 first differences.
Using (6.10) Using (6.12)
Mar-Feb -2.6 -6.2
Apr-Mar -6.7 -10.6
May-Apr -3.5 -7.4
Jun-May -5.3 -9.2
Jul-Jun -3.6 -7.4
Aug-Jul -5.2 -9.2
Sep-Aug -5.9 -9.7
Oct-Sep -6.9 -10.7
Nov-Oct -4.1 -7.9
Dec-Nov -4.7 -8.5
Jan-Dec -0.8 -4.6
Feb-Jan -2.2 -6.2
These two sets of seasonal indices are not quite the same. In the first equa-
Chapter 6: Multiple regression 123

tion (6.10), all eleven dummy variables for seasonality were allowed to be in
the regression. In the second equation (6.12), the best subsets regression pro-
cedure did not allow the first seasonal dummy into the final equation. The
absolute values are not so important because, in the presence of different sets
of explanatory variables, we expect the intercept terms to be different.
(c) The seasonal indices should be the same regardless of which month is used as
a base.

6.7 (a) Yt = 78.7 + 0.534xt + et


(b) DW = 0.57. dL = 1.04 at 1% level. Therefore there is significant positive
autocorrelation.
124 Part D. Solutions to exercises

Chapter 7: The Box-Jenkins methodology for ARIMA models

7.1 (a) In general, the approximate standard error of the sample autocorrelations is

1/ n. So the larger the value of n, the smaller the standard error. Therefore,
the ACF has more variation for small values of n than for large values of n. All
three series show the autocorrelations mostly falling with the 95% bands. The
few that lie just outside the bands are not of concern since we would expect
about 5% of spikes to cross the bands. There is no reason to think these series
are anything but white noise.

(b) The lines shown are 95% critical values. These are calculated as 1.96/ n. So
they are closer to zero when n is larger. The autocorrelations vary randomly,
but they mostly stay within the bounds.

7.2 The time plot shows the series as a non-stationary level. It wanders up and down
over time in a similar way to a random walk. The ACF decays very slowly which
also indicates non-stationarity in the level. Finally, the PACF has a very large value
at lag 1, indicating the data should be differenced.

7.3 The five models are

AR(1) Yt = 0.6Yt1 + et .
MA(1) Yt = et + 0.6et1 .
ARMA(1,1) Yt = 0.6Yt1 + et + 0.6et1 .
AR(2) Yt = 0.8Yt1 + 0.3Yt2 + et .
MA(2) Yt = et + 0.8et1 0.3et2 .

In each case, we assume Yt = 0 and et = 0 for t 0. The generated data are shown
on the following two pages. There is a lot of similarity in the shapes of the series
because they are based on exactly the same errors.

7.4 (a) The ACF is slow to die out and the time plot shows the series wandering in a
non-stationary way. So we take first differences. The ACF of the first differences
show one significant spike at lag 1 indicating an MA(1) is appropriate. So the
model for the raw data is ARIMA(0,1,1).
(b) There is not consistent trend in the raw data and the differenced data have
mean close to zero. Therefore, there is no need to include a constant term.
(c) (1 B)Yt = (1 1 B)et .
(d) See the output on page 127. There may be slight differences with different
software packages and even different versions of the same package. The Ljung-
Box statistics are not significant and the ACF and PACF of residuals show no
significant differences from white noise.
Chapter 7: The Box-Jenkins methodology for ARIMA models 125

t AR(1) MA(1) ARMA(1,1) AR(2) MA(2)


1 0.010 0.010 0.010 0.010 0.010
2 1.386 1.386 1.392 1.372 1.388
3 1.362 1.358 2.193 -0.565 1.631
4 2.397 1.898 3.214 2.443 1.590
5 2.758 2.268 4.196 -0.804 2.425
6 2.695 1.832 4.350 2.416 1.622
7 1.947 0.954 3.564 -1.844 0.766
8 0.968 -0.002 2.136 2.000 -0.248
9 2.481 1.780 3.062 -0.253 1.641
10 2.209 1.860 3.697 1.523 2.300
11 1.055 0.162 2.380 -1.564 -0.264
12 -0.797 -1.592 -0.164 0.278 -1.862
13 -1.628 -2.008 -2.106 -1.842 -2.213
14 -1.047 -0.760 -2.024 1.487 -0.561
15 1.062 1.648 0.434 -0.052 1.979
16 0.917 1.294 1.554 0.768 1.653
17 0.560 0.178 1.111 -0.620 -0.273
18 1.276 0.946 1.612 1.666 0.864
19 -1.334 -1.536 -0.569 -3.619 -1.351
20 -0.711 -1.170 -1.511 3.485 -1.872
21 0.484 0.964 0.057 -2.964 1.612
22 2.050 2.306 2.340 5.176 2.461
23 2.070 1.896 3.300 -4.190 1.975
24 0.112 -0.626 1.354 3.775 -0.986
25 0.987 0.242 1.054 -3.357 -0.236
26 2.262 2.222 2.855 5.488 2.745
27 0.327 -0.028 1.685 -6.428 0.030
28 -1.514 -2.328 -1.317 5.079 -3.035
29 0.272 0.154 -0.636 -4.811 0.121
30 -0.427 0.118 -0.264 4.783 0.867

Generated data for Exercise 7.3


126 Part D. Solutions to exercises

AR(1) MA(1)

2
2

1
1

0
0

-1
-1

-2
0 10 20 30 0 10 20 30

ARMA(1,1) AR(2)
4

4
3

2
2

0
1

-2
0

-4
-1

-6
-2

0 10 20 30 0 10 20 30

MA(2)
2
1
0
-1
-2
-3

0 10 20 30

Exercise 7.3: Simulated ARMA series.


Chapter 7: The Box-Jenkins methodology for ARIMA models 127

Output using Minitab for Exercise 7.4:


MTB > ARIMA 0 1 1 Strikes;
SUBC> NoConstant;
SUBC> Forecast 3.

Final Estimates of Parameters


Type Coef StDev T
MA 1 0.3174 0.1886 1.68

Differencing: 1 regular difference


Number of observations: Original series 30, after differencing 29
Residuals: SS = 9256634 (backforecasts excluded)
MS = 330594 DF = 28

Modified Box-Pierce (Ljung-Box) Chi-Square statistic


Lag 12 24
Chi-Square 8.1(DF=11) 34.1(DF=23)

Forecasts from period 30


95 Percent Limits
Period Forecast Lower Upper
31 4164.87 3037.70 5292.04
32 4164.87 2800.11 5529.63
33 4164.87 2598.14 5731.60

(e) The last observation is yt = 3885; the last residual in series is e t = 881.87
(obtained from the computer package). Now
Yt = Yt1 + et 0.3174et1 .
So Y31 = Y30 + e31 0.3174
e30
= 3885 + 0 0.3174(881.87) = 4164.9
Y32 = Y31 + 0 0.3174(0) = 4164.9

Y33 = Y32 + 0 0.3174(0) = 4164.9

(f ) See the graph on the following page.


7.5 (a) The monthly data show strong seasonality and the seasonal pattern is reason-
ably stable. There is no trend in the data (this is a mature product).
(b) The pattern in the ACF plot shows the dominance of the seasonality. The
autocorrelations at lags 6, 18 and 30 are negative (because we are correlating
128 Part D. Solutions to exercises

Number of strikes in USA


6000
5000
4000
3000

1950 1960 1970 1980

Exercise 7.4(f ): Predicted number of strikes in USA. 95% prediction intervals shown.

the high periods with the low periods) and at lags 12, 14 and 36 they are
positive (because we are correlating high periods with high periods).
(c) The pattern in the PACF plot is not particularly revealing. However, there
is little need to try to interpret this plot when the analysis clearly shows the
dominance of the seasonality. The best approach would be to difference the
series to reduce the effect of the seasonality and then see what is left over.
(d) These graphs suggest a seasonal MA(1) because of the spike at lag 12 in the
ACF and the decreasing spikes at lags 12 and 24 in the PACF. Overall, the
suggested model is ARIMA(0,1,0)(0,1,1) 12 .
(e) Using the backshift operator: (1 B)(1 B 12 )Yt = (1 B 12 )et . Rewriting
gives
Yt Yt12 Yt1 + Yt13 = et et12 .

7.6 (a) ARIMA(3,1,0).


(b) For the differenced data, the PACF has a significant spikes at lags 1, 2 and
3 and a spike at lag 17 which is marginally significant. The spike at lag 17
is probably due to chance. Therefore an AR(3) is an appropriate model for
the differenced data. Consequently, an ARIMA(3,1,0) model is suitable for the
original data.
Chapter 7: The Box-Jenkins methodology for ARIMA models 129

(c) Now

(Yt Yt1 ) = 0.42(Yt1 Yt2 ) 0.20(Yt2 Yt3 ) 0.30(Yt3 Yt4 ) + et .

Therefore Yt = 1.42Yt1 0.62Yt2 0.10Yt3 + 0.30Yt4 + et and

Y1940 = 1.42(1797) 0.62(1791) 0.10(1627) + 0.30(1665) = 1778.1


Y1941 = 1.42(1778.1) 0.62(1797) 0.10(1791) + 0.30(1627) = 1719.8
Y1942 = 1.42(1719.8) 0.62(1778.1) 0.10(1797) + 0.30(1791) = 1697.3

7.7 (a) ARIMA(4,0,0).


(b) The model was chosen because the last significant spike in the PACF was at
lag 4. Note that the spikes at lags 2 and 3 were not significant. This makes
no difference. It is the last significant spike which determines the order of the
model.
(c) The model is

Yt = 146.1 + 0.891Yt1 0.257Yt2 + 0.392Yt3 0.333Yt4 + et .

So

Y1969 = 146.1 + 0.891(545) 0.257(552) + 0.392(534) 0.333(512) = 528.7


Y1970 = 146.1 + 0.891(528.7) 0.257(545) + 0.392(552) 0.333(534) = 515.7
Y1971 = 146.1 + 0.891(515.7) 0.257(528.7) + 0.392(545) 0.333(552) = 499.5

7.8 (a) The centered 12-MA smooth is shown in the plot on the next page. The trend
is generally linear and increasing with a flat period between 1990 and 1993.
(b) The variation does not change much with the level, so transforming will not
make much difference.
(c) The data are not stationary. There is a trend and seasonality in the data.
Differencing at lag 12 gives the data shown in the plot on page 131. These
appear stationary although it is possible another difference at lag 1 is needed.
(d) From the plots on page 131 it is clear there is a seasonal MA component of order
1. In addition there is a significant spike at lag 1 in both the ACF and PACF.
Hence plausible models are ARIMA(1,0,0)(0,1,1) 12 and ARIMA(0,0,1)(0,1,1)12 .
Comparing the two models we have the following results
ARIMA(1,0,0)(0,1,1)12 AIC=900.2
ARIMA(0,0,1)(0,1,1)12 AIC=926.9
130 Part D. Solutions to exercises

US electricity generation
300
280
260
240
220
200

1985 1987 1989 1991 1993 1995 1997

Year

Exercise 7.8(a): Total net generation of electricity in USA.

Hence the better model is the first one. Note that different packages will give
different values for the AIC depending on how it is calculated. Therefore the
same package should be used for all calculations.
(e) The residuals from the ARIMA(1,0,0)(0,1,1) 12 are shown in the plots on page
132. Because there are significant spikes in the ACF and PACF, the model is
not adequately describing the series. These plots suggest we need to add an
MA(1) term to the model. So we fit the revised model ARIMA(1,0,1)(0,1,1) 12 .
This time, the residual plots (not shown here) look like white noise. The AIC
is 876.7. Part of the computer output for fitting the revised model is shown
below.
Approx.
Parameter Estimate Std Error T Ratio Lag
MA1,1 0.74427 0.05887 12.64 1
MA2,1 0.77650 0.09047 8.58 12
AR1,1 0.99566 0.0070613 141.00 1
So the fitted model is

(1 0.996B)(1 B 12 )Yt = (1 0.744B)(1 0.777B 12 )et .


Chapter 7: The Box-Jenkins methodology for ARIMA models 131

Electricity data differenced at lag 12


30

o
o
o o
20

o
o o o
o o oo o
o o
o
o o o o o
oo o
o o
10

o o o
o
o
o o oo oo o o
o
o o
o o oo o o o
o o o o
o o o o o o o
o o o o o o
o o o o
o o o oo o o
oo o o o o o oo o o
o o o o
o
0

o o o o o o
o o
o o o
o o o o
o o o oo
o o o
o o
o
o
o
-10

o
o
o
o
o o
-20

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
0.2

0.2
PACF
ACF

0.0

0.0
-0.2

-0.2

0 10 20 30 40 0 10 20 30 40

Exercise 7.8(c): Seasonally differenced electricity generation.


132 Part D. Solutions to exercises

Residuals from ARIMA(1,0,0)(0,1,1) model


3

o
o
o
o
o
2

o o
o o o o
o
o o o o
o o
o
o o o
o
1

o o o o
o o o
o o o o oo
oo o o o o o o o
o o o o o o o o
o o o o o o
o o o o o o o o
o o o o o o
o o o
o ooo
0

o
oo o oo o o o o o
o o o o o o
o oo
o o o o o o
o o o o
o
o o
o
o o o
-1

o
o
o
o o
o
o o
o
-2

o
-3

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
0.2

0.1
0.1

0.0
PACF
ACF

-0.1
-0.1
-0.3

-0.3

0 10 20 30 40 0 10 20 30 40

Exercise 7.8(e): Residuals from ARIMA(1,0,0)(0,1,1)12 model fitted to the electricity data.
Chapter 7: The Box-Jenkins methodology for ARIMA models 133

Output using SAS for Exercise 7.8:


Approx.
Parameter Estimate Std Error T Ratio Lag
MA1,1 0.86486 0.06044 14.31 1
MA2,1 0.80875 0.09544 8.47 12
AR1,1 0.27744 0.10751 2.58 1

Variance Estimate = 41.8498466


Std Error Estimate = 6.46914574
AIC = 864.616345
SBC = 873.195782
Number of Residuals= 129

To Chi Autocorrelations of Residuals


Lag Square DF Prob
6 1.60 3 0.659 0.028 -0.036 -0.020 -0.010 -0.014 0.095
12 7.67 9 0.568 0.004 -0.082 0.073 0.128 -0.095 0.072
18 15.32 15 0.429 0.126 0.016 -0.091 0.125 -0.105 -0.020
24 18.67 21 0.607 0.065 -0.048 0.051 0.005 0.069 -0.085

Note that the first term on the left is almost the same as differencing (1 B).
This suggests that we probably should have taking a first difference as well as a
seasonal difference. We repeated the above analysis and arrived at the following
model: ARIMA(1,1,1)(0,1,1)12 which has AIC=864.6.
The computer output for the final model is shown above. The figures under
the heading Chi Square concern the Ljung-Box test. Clearly the model passes
the test (see Table E in Appendix III).
(f ) Forecasts for the next 24 months are given on the following page.
134 Part D. Solutions to exercises

Month Obs Forecast Std Error Lower 95% Upper 95%


Nov 96 143 240.1614 6.4691 227.4821 252.8407
Dec 96 144 262.5516 6.9981 248.8356 276.2677
Jan 97 145 270.2423 7.1820 256.1659 284.3187
Feb 97 146 244.0064 7.3027 229.6934 258.3194
Mar 97 147 249.8899 7.4074 235.3718 264.4081
Apr 97 148 232.7683 7.5069 218.0550 247.4816
May 97 149 249.3720 7.6042 234.4680 264.2759
Jun 97 150 270.7257 7.6999 255.6341 285.8173
Jul 97 151 295.5439 7.7944 280.2671 310.8207
Aug 97 152 295.6598 7.8878 280.2000 311.1196
Sep 97 153 257.1358 7.9800 241.4952 272.7764
Oct 97 154 246.4526 8.0712 230.6332 262.2719
Nov 97 155 245.0224 8.4340 228.4920 261.5528
Dec 97 156 267.1930 8.6077 250.3222 284.0638
Jan 98 157 274.8228 8.7406 257.6914 291.9541
Feb 98 158 248.5699 8.8622 231.2003 265.9395
Mar 98 159 254.4488 8.9796 236.8491 272.0484
Apr 98 160 237.3258 9.0948 219.5004 255.1513
May 98 161 253.9291 9.2083 235.8811 271.9772
Jun 98 162 275.2828 9.3205 257.0150 293.5506
Jul 98 163 300.1009 9.4313 281.6160 318.5858
Aug 98 164 300.2168 9.5407 281.5173 318.9163
Sep 98 165 261.6929 9.6490 242.7812 280.6045
Oct 98 166 251.0096 9.7560 231.8881 270.1311

7.9 (a) See the plot on the following page. Note that there is strong seasonality and
a pronounced trend-cycle. One way to study the consistency of the seasonal
pattern is to compute the seasonal sub-series and see how stable each month
is. The results are given below.
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1955: 94.7 94.0 96.5 101.3 102.4 103.7 104.5 104.3 104.1 101.2 98.3 95.4
1956: 94.1 93.5 96.8 103.1 104.1 102.8 103.7 103.6 103.6 101.7 98.6 96.8
1957: 95.9 96.8 99.0 97.7 99.5 101.1 102.0 103.3 105.1 103.2 99.8 96.7
1958: 95.0 94.8 96.1 100.4 101.7 102.1 103.6 104.9 104.4 101.1 96.7 95.3
1959: 93.9 94.5 96.4 100.9 102.1 103.3 104.7 106.0 104.4 100.9 98.7 96.1
1960: 95.7 95.7 95.1 98.9 100.8 102.5 104.6 106.0 104.0 100.1 98.0 96.7
1961: 95.2 94.8 96.5 101.3 101.7 103.7 105.2 105.3 104.3 101.2 97.7 96.5
1962: 93.5 93.7 95.6 100.7 102.3 102.5 104.4 106.4 103.5 101.0 97.6 96.9
1963: 94.6 93.4 95.5 99.1 100.8 104.1 106.1 107.4 104.1 100.7 97.9 97.4
1964: 93.6 93.2 94.6 98.6 100.2 103.5 106.6 107.5 103.6 101.7 97.9 96.9
1965: 95.6 92.7 94.0 96.7 99.4 103.7 108.2 108.0 104.7 100.5 98.4 99.6
1966: 97.0 93.7 95.2 97.0 98.4 104.1 105.9 107.2 104.2 99.7 97.1 96.8
1967: 93.9 93.6 94.1 99.0 102.5 105.7 109.2 109.9 104.9 99.8 98.3 93.8
1968: 91.2 91.7 94.5 99.0 101.9 103.1 105.7 106.0 103.5 100.2 100.7 99.1
1969: 96.0 94.3 94.1 96.8 100.7 104.5 106.3 107.2 103.7 102.5 100.2 99.4
1970: 95.8 93.0 92.0 96.0 100.2 103.7 106.0 105.8 102.7 98.9 97.1 96.5

These detrended data are relatively consistent from year to year with only minor
Chapter 7: The Box-Jenkins methodology for ARIMA models 135

Employment in motion picture industry


240

o
o oo
o
o o
o o
o o oo

o o
o
220

o o
o o
oo o o
o oo
o o
o oo o o
o oo o o
o o o
o
oo o o
o o o
o oo o o o
o o o
o o o
oo o o o
200

o oo o o oo
o o
o o o o o o
o o
o o o o
o oo o o o
oo o o
o o o
o o o o o oo
o o o
o o oo o o o o
o o o o o
o o o
o o o o o
o o o
o oo oo o o o o oo
o o
180

o o o o o o o o
o
o
o o o o oo
o o o o
o o o o oo
o o
o o oo o
o o
oo o
o o
o
o oo

1955 1957 1959 1961 1963 1965 1967 1969 1971


1.0
0.8

0.5
PACF
ACF
0.4

0.0
0.0

-0.5

0 10 20 30 40 0 10 20 30 40

Exercise 7.9(a): Employment in the motion picture industry


136 Part D. Solutions to exercises

110
105
ratios

100
95

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Exercise 7.9(a): Sub-series of detrended data

variations occurring here and there. For example, December 1967 and January
and February 1968 were noticeably lower than surrounding years.
Another way to look at seasonal patterns is via autocorrelation functions. Note
that for the raw data, the ACF shows strong seasonality over several seasonal
lags. This is further evidence of the consistency of the seasonal pattern. The
plot on the previous page shows the detrended data. Again, the seasonal pat-
tern is very consistent although the amplitude of the pattern each year varies.
Unusual results in early 1968 and early 1970 are seen.
(b) For the first 96 months, we identified an ARIMA(0,1,0)(0,1,1) 12 . For the second
96 months, we identified an ARIMA(0,1,0)(1,1,0) 12 : In practice, there is little
difference between these models. This means that once the trend has been
eliminated (by differencing), the seasonal patterns are very similar.
(c) Using the above ARIMA(0,1,0)(0,1,1) 12 model, we obtained the following fore-
casts.
Chapter 7: The Box-Jenkins methodology for ARIMA models 137

Detrended employment in motion picture industry


110

o
o
oo
o o
o o
o o
o
o o o o o o
o o o
105

o o oo o
oo o o o o
o o o o
o o o o o o o
o ooo o o o o o o o o
oo o o
o o
o o
o o oo o o
o o o
o o o o o
o o o o o
o o o o
o o o o o o
100

o o
o o o o o
o o o o
o o o
o o o o o o
o o
o o o o
o o
o o o
o o o o
o o o o o o o
o oo o o o o o o
o o o o
o o
o oo o o
o o o
o o
95

o o o
oo o
o o o o o o oo
o o o o oo
o o
o oo o o o
o
o
o
o
o
o

1955 1957 1959 1961 1963 1965 1967 1969 1971


0.5
0.5

PACF
ACF
0.0

0.0
-0.5

-0.5

0 10 20 30 40 0 10 20 30 40

Exercise 7.9(a): Seasonal differences of employment in the motion picture industry


138 Part D. Solutions to exercises

Month Actual Forecast Upper (95%) Lower (95%) Error


Jan 1963 167.2 167.3286 172.4228 162.2345 -0.1286
Feb 1963 165.0 166.7030 171.7902 161.6159 -1.7030
Mar 1963 168.8 167.7141 172.8012 162.6269 1.0859
Apr 1963 175.0 176.5972 181.6844 171.5100 -1.5972
May 1963 177.9 176.9498 182.0369 171.8626 0.9502
Jun 1963 183.7 179.2212 184.3084 174.1340 4.4788
Jul 1963 187.2 186.1708 191.2579 181.0836 1.0292
Aug 1963 189.3 188.7598 193.8470 183.6727 0.5402
Sep 1963 183.4 186.1678 191.2550 181.0806 -2.7678
Oct 1963 177.3 177.2392 182.3264 172.1520 0.0608
Nov 1963 172.3 170.7711 175.8583 165.6839 1.5289
Dec 1963 171.4 168.8708 173.9580 163.7837 2.5292
Jan 1964 164.9 167.5935 172.6807 162.5063 -2.6935
Feb 1964 164.4 163.9412 169.0247 158.8577 0.4588
Mar 1964 166.9 167.4086 172.4920 162.3251 -0.5086
Apr 1964 174.2 174.2641 179.3475 169.1806 -0.0641
May 1964 177.5 176.4075 181.4909 171.3240 1.0925
Jun 1964 183.6 180.0358 185.1193 174.9523 3.5642
Jul 1964 189.5 186.3499 191.4333 181.2664 3.1501
Aug 1964 191.6 191.2063 196.2898 186.1228 0.3937
Sep 1964 185.1 187.7172 192.8007 182.6338 -2.6172
Oct 1964 181.9 178.9557 184.0392 173.8722 2.9443
Nov 1964 175.4 175.7857 180.8692 170.7022 -0.3857
Dec 1964 174.2 172.6567 177.7402 167.5732 1.5433

(d) For the second half of the data we used the ARIMA(0,1,0)(1,1,0) 12 to obtain
the forecasts at the top of the following page. The actual 19711972 figures
are also shown. The source is Employment and Earnings, US 19091978,
published by the Department of Labor, 1979.
A good exercise would be to take these forecasts and check the MAPE for 1971
and 1972 separately. The MAPE for the first forecast year should be smaller
than the MAPE for the second year.
(e) If the objective is to forecast the next 12 months then the latest data is obviously
the most relevant but to get seasonal indices we have to go back several years
and to anticipate what the next move the large cycle is going to be, we really
need to look at as much data as possible. So a good strategy would be
i. study the trend-cycle by looking at the 12-month moving average;
ii. remove the trend-cycle and study the consistency of the seasonality;
iii. decide how much of the data series to retain for the ARIMA modeling;
iv. forecast the next 12 months and use some judgment as to how to modify
the ARIMA forecasts on the basis of anticipated trend-cycle movements.
Chapter 7: The Box-Jenkins methodology for ARIMA models 139

Month Actual Forecast Upper (95%) Lower (95%) Error


Jan 1971 194.5 196.0141 201.4418 190.5864 -1.5141
Feb 1971 187.9 191.2939 198.9698 183.6180 -3.3939
Mar 1971 187.7 189.9446 199.3456 180.5436 -2.2446
Apr 1971 198.3 197.3595 208.2149 186.5042 0.9405
May 1971 202.7 205.7424 217.8790 193.6057 -3.0424
Jun 1971 204.2 213.1446 226.4396 199.8495 -8.9446
Jul 1971 211.7 217.8789 232.2392 203.5186 -6.1789
Aug 1971 213.4 218.8543 234.2061 203.5025 -5.4543
Sep 1971 212.0 213.2939 229.5769 197.0109 -1.2939
Oct 1971 203.4 208.3371 225.5009 191.1733 -4.9371
Nov 1971 199.5 204.7595 222.7611 186.7580 -5.2595
Dec 1971 199.3 203.4670 222.2690 184.6650 -4.1670
Jan 1972 191.3 196.2469 217.0365 175.4573 -4.9469
Feb 1972 192.1 191.0587 213.6617 168.4557 1.0413
Mar 1972 193.3 189.3618 213.6432 165.0804 3.9382
Apr 1972 203.4 196.9907 222.8417 171.1396 6.4093
May 1972 205.5 205.3066 232.6373 177.9760 0.1934
Jun 1972 218.2 212.5618 241.2960 183.8276 5.6382
Jul 1972 220.3 217.4298 247.5022 187.3575 2.8702
Aug 1972 219.9 218.2314 249.5848 186.8780 1.6686
Sep 1972 211.9 213.0587 245.6428 180.4746 -1.1587
Oct 1972 204.5 207.6473 241.4174 173.8773 -3.1473
Nov 1972 198.5 204.3907 239.3064 169.4750 -5.8907
Dec 1972 200.5 203.2051 239.2300 167.1802 -2.7051

Forecasts for Exercise 7.9(d)

7.10 (a) There is strong seasonality as can be seen from the time plot and the seasonal
peaks in the ACF.
(b) The trend in the series is small compared to the seasonal variation. However,
there is a period of downward trend in the first four years, followed by an
upward trend for four years. At the end the trend seems to have levelled off.
(c) The one large spike in the PACF of Figure 7-34 suggests the series needs dif-
ferencing at lag 1. This is also apparent from the slow decay in the ACF and
the non-stationary mean in the time plot.
(d) You would need to difference again at lag 1 and plot the ACF and PACF of the
new series (differenced at lags 12 and 1). It is not possible to identify a model
from Figures 7-33 and 7-34.
140 Part D. Solutions to exercises

Chapter 8: Advanced forecasting models

8.1 (a) The fitted model in Exercise 6.7 (using OLS) was

Yt = 78.7 + 0.534xt + Nt .

The computer output below shows the results for fitting the straight line re-
gression with AR(1) errors. Hence the new model is

Yt = 79.3 + 0.508xt + Nt where Nt = 0.72Nt1 + et .

In this case, the error model makes very little difference to the parameters.

Output from SAS for Exercise 8.1:

Approx.
Parameter Estimate Std Error T Ratio Lag Variable Shift
MU 79.27236 0.76093 104.18 0 SALES 0
AR1,1 0.72469 0.14647 4.95 1 SALES 0
NUM1 0.50801 0.02318 21.91 0 ADVERT 0

Constant Estimate = 21.8242442


Variance Estimate = 1.11639088
Std Error Estimate = 1.056594
AIC = 74.2915405
SBC = 77.825702
Number of Residuals= 24

Autocorrelation Check of Residuals


To Chi Autocorrelations
Lag Square DF Prob
6 3.46 5 0.630 0.027 0.099 -0.037 0.111 -0.060 -0.274
12 9.31 11 0.593 0.055 0.126 0.229 -0.227 0.060 -0.095
18 16.39 17 0.497 -0.117 -0.238 -0.080 0.054 -0.108 0.101

(b) The ACF and PACF of the errors is plotted on the following page. An AR(1)
model for the errors is appropriate since there is a single significant spike at
lag 1 in the PACF and geometric decay in the ACF. This is confirmed by the
Ljung-Box test in the computer output above. The Q values are given under
the column Chi Square. None are significant showing the residuals from the
full model are white noise.
Chapter 8: Advanced forecasting models 141

Errors from regression model

o
2

o
o
o
1

o
o
o

o
0

o o
o
o
o
-1

o o o
o

o o
-2

o
-3

10 20
0.4

0.4
PACF
ACF

0.0

0.0
-0.4

-0.4

2 4 6 8 10 12 2 4 6 8 10 12

Exercise 8.1: Errors from regression model with AR(1) error term.
142 Part D. Solutions to exercises

Output from SAS for Exercise 8.2(a):

Approx.
Parameter Estimate Std Error T Ratio Lag Variable Shift
MU 9.56328 0.40537 23.59 0 HURON 0
AR1,1 0.78346 0.06559 11.94 1 HURON 0
NUM1 -0.02038 0.01066 -1.91 0 YEAR 0

Constant Estimate = 2.07087134

Variance Estimate = 0.51219788


Std Error Estimate = 0.71568001
AIC = 216.450147
SBC = 224.205049
Number of Residuals= 98

Autocorrelation Check of Residuals


To Chi Autocorrelations
Lag Square DF Prob
6 8.35 5 0.138 0.222 -0.100 -0.133 -0.056 -0.007 -0.042
12 15.01 11 0.182 -0.051 0.009 0.175 0.017 -0.121 -0.107
18 16.36 17 0.499 -0.053 0.014 0.019 0.058 0.006 -0.067
24 25.47 23 0.326 -0.071 -0.166 -0.043 0.051 0.160 0.092

8.2 (a) To reduce numerical error, we subtracted 1900 from the year to create an ex-
planatory variable. Hence the year ranged from -25 (1875) to 72 (1972). The
computer output above shows the fitted model to be
Yt = 9.56 0.02xt + Nt where Nt = 0.78Nt1 + et
where xt is the year 1900.
(b) The errors are shown in the plot on the following page. This demonstrates
that a better model would have an AR(2) error term since the PACF has two
significant spikes at lags 1 and 2. The spike at lag 10 is probably due to chance.
The ACF shows geometric decay which is possible with an AR(2) model. So
the full regression model is
Yt = 0 + 1 xt + N t where Nt = 1 Nt1 + 2 Nt2 + et .
Fitting this model gives the output shown on page 144. So the fitted model is
Yt = 9.53 0.02xt + Nt where Nt = Nt1 0.29Nt2 + et .
Chapter 8: Advanced forecasting models 143

Errors from regression model

o
2

o
o o o
o
o o o
oo o
o
o o o
1

o o oo o
o o o
o
o oo
o o
oo o
o
o ooo o
o o o
o o
o o o
0

o o o
o o
o o o o
o
o o o
o o
oo oo o
oo o o
o o
o
-1

o o
o o o oo
o o o
o o o
o o

o
oo oo
-2

oo o

1880 1900 1920 1940 1960


0.8

0.8
0.6
0.6

0.4
0.4

PACF
ACF

0.2
0.2
0.0

-0.2
-0.2

5 10 15 5 10 15

Exercise 8.2(b): Errors from regression model with AR(1) error term.
144 Part D. Solutions to exercises

Output from SAS for Exercise 8.2(b):

Approx.
Parameter Estimate Std Error T Ratio Lag Variable Shift
MU 9.53078 0.30653 31.09 0 HURON 0
AR1,1 1.00479 0.09839 10.21 1 HURON 0
AR1,2 -0.29128 0.10030 -2.90 2 HURON 0
NUM1 -0.02157 0.0082537 -2.61 0 YEAR 0

Constant Estimate = 2.73048107

Variance Estimate = 0.4760492


Std Error Estimate = 0.68996319
AIC = 210.396534
SBC = 220.736404
Number of Residuals= 98

Autocorrelation Check of Residuals


To Chi Autocorrelations
Lag Square DF Prob
6 0.60 4 0.964 0.018 -0.028 -0.003 0.040 0.054 -0.007
12 5.35 10 0.867 -0.032 -0.037 0.167 -0.007 -0.098 -0.055
18 6.21 16 0.986 -0.036 0.005 -0.025 0.035 -0.006 -0.063
24 10.49 22 0.981 -0.003 -0.141 -0.007 0.006 0.116 0.008

8.3 (a) ARIMA(0,1,1)(2,1,0)12 . This model would have been chosen by first identifying
that differences at lags 12 and 1 are necessary to make the data stationary. Then
looking at the ACF and PACF of the differenced data would have shown two
significant spikes in the PACF at lags 12 and 24. There would have also been
a significant spike in the ACF at lag 1 and geometric decay in the early lags of
the PACF.
(b) Since both parameter estimates are positive (and significantly different from
zero), we can conclude that electricity consumption increases with both heating
degrees and cooling degrees. Because b 2 is larger, we know that there is a greater
increase in electricity usage for each heating degree than for each cooling degree.
(c) To use this model for forecasting, we would first need forecasts of both X 1,t
and X2,t into the future. These could be obtained by taking averages of these
variables over the equivalent months of the previous few decades. Then the
model can be used to forecast electricity demand over the next 12 months by
Chapter 8: Advanced forecasting models 145

forecasting the Nt series using the method discussed in chapter 7 and plugging
the forecasts of X1,t , X2,t and Nt into the formula for Yt .
(d) If the model was fitted using a standard regression package (thus modeling N t
as white noise), then the seasonality and autocorrelation in the data would have
been ignored. This would result in less efficient parameter estimates and invalid
estimates of their standard errors. In particular, tests for significance would be
incorrect, as would prediction intervals. Also, when producing forecasts of Y t ,
the forecasts of Nt would be all be zero. Hence, the model would not adequately
allow for the seasonality or autocorrelation in the data.

8.4 (a) b = 3, r = 1, s = 2.
(b) ARIMA(2,0,0)
(c) 0 = 0.53, 1 = 0.37, 2 = 0.51, 1 = 0.57, 2 = 0, 1 = 2 = 0, 1 = 1.53,
2 = 0.63.
(d) 27 seconds.

8.5 See the graphs on the following page.

8.6 (a) The three series are shown on page 147. For Set 1, four X t values are needed
(since v1 , v2 , v3 and v4 are all non-zero). Therefore 27 Yt values can be produced.
Similarly 26 Yt values for Set 2 and 24 Yt values for Set 3 can be calculated.
(b) The first model is
2.0B
Yt = Xt + N t .
1 0.7B
The simplest way to generate data for this transfer function is to rewrite it as
follows

(1 0.7B)Yt = (1 0.7B)B(2 1.4B)Xt + (1 0.7B)Nt

so that Yt = 0.7Yt1 + 2.0Xt1 1.4Xt2 + Nt 0.7Nt1 .


Thus Yt values can only be generated for times t = 3, 4, . . . since we need at
least two previous Xt values. However, for t = 3, we also need Y 2 . To start the
process going, we have assumed here that Y 2 = 0. Other values could also have
been used. The effect of this initialization is negligible after a few time periods.
The second model is easier to generate as we can write it

Yt = 1.2Xt + 2.0Xt1 0.8Xt2 + Nt .


146 Part D. Solutions to exercises

(a) (b)
2.0

3.0
1.5

2.5
1.0

2.0
weight

weight
0.5

1.5
0.0

1.0
0.5
-1.0

0.0

0 2 4 6 8 10 0 2 4 6 8 10

lag lag

(c) (d)
0.8

1.0
0.6

0.8
0.4

0.6
weight

weight
0.2

0.4
0.0

0.2
-0.2
-0.4

0 2 4 6 8 10 0 2 4 6 8 10

lag lag

Exercise 8.5: Impulse response weights for the four different transfer functions.
Chapter 8: Advanced forecasting models 147

Set 1 Set 2 Set 3 Set 4 Set 5


t Nt Xt Yt Yt Yt
1 -0.8003 50
2 0.8357 90 0.0
3 1.4631 50 110.9 201.5
4 0.7332 30 58.7 51.3 64.7
5 0.3260 80 52.3 58.3 25.7 116.3
6 -0.7442 80 61.3 51.3 135.0 231.3
7 0.7362 30 65.7 62.7 74.7 143.8 132.7
8 1.1931 70 59.2 66.2 88.2 49.3 81.2
9 -1.4681 60 55.5 56.5 87.5 130.2 186.5
10 -0.5285 10 49.5 56.5 79.5 113.7 75.5
11 0.4314 40 37.4 50.4 83.4 16.4 20.4
12 -1.6341 20 27.4 35.4 72.4 75.5 94.4
13 0.8198 40 29.8 29.8 54.8 38.8 56.8
14 0.4183 20 30.4 29.4 47.4 79.0 88.4
15 -0.4065 10 23.6 29.6 41.6 38.6 19.6
16 -0.0615 30 19.9 23.9 40.9 19.3 39.9
17 0.1432 60 29.1 20.1 36.1 59.7 124.1
18 -1.0747 70 46.9 27.9 27.9 118.6 178.9
19 -0.5355 40 56.5 47.5 38.5 139.2 139.5
20 -0.1454 70 56.9 56.9 59.9 79.7 107.9
21 0.2088 10 49.2 57.2 74.2 140.1 120.2
22 -0.6854 30 34.3 48.3 76.3 19.2 -0.7
23 0.1182 30 28.1 35.1 73.1 60.1 88.1
24 0.6971 40 30.7 28.7 54.7 60.7 84.7
25 0.3698 30 34.4 30.4 43.4 80.3 92.4
26 -0.0802 100 46.9 33.9 43.9 59.9 147.9
27 -0.9202 60 64.1 46.1 44.1 199.1 247.1
28 1.1483 90 76.1 66.1 61.1 121.1 149.1
29 -0.1663 60 75.8 74.8 84.8 179.8 203.8
30 -0.5461 100 76.5 75.5 97.5 119.4 167.5

Generated data for Exercise 8.6


148 Part D. Solutions to exercises

8.7 (a) The average cost of a nights accommodation is C/R.


(b) There are a number of ways this could be done. The simplest is to define the
monthly CPI to be the same as that of the quarter. For example, January,
February and March of 1980 would each have a CPI of 45.2; April, May and
June 1980 would each have a CPI of 46.6; and so on. Other methods might
involve fitting a smooth curve through the quarterly figures and using the curve
to predict the CPI at other points along the time axis.
(c) See figure below.

Consumer price index (Melbourne)


100
80

Average rate per room per night ($)


60
40

1980 1982 1984 1986 1988 1990 1992 1994 1996

Exercise 8.7(c): Time plots of average room rate and CPI.

(d) Our preliminary model is

Yt = a + (0 + 1 B + + 6 B 6 )Xt + Nt

where Yt denotes the average room rate, Xt denotes the CPI and Nt is an AR(1)
process. The estimated errors from this model are shown in the figure on the
previous page. They are clearly non-stationary and have some seasonality.
So we difference both Yt and Xt and refit the model with Nt specified as an
ARIMA(1,0,0)(1,0,0)12 . The parameter estimates are shown below (as given
by SAS).
Chapter 8: Advanced forecasting models 149

Residuals from dynamic regression with AR(1) errors

o o o
o o o
o o o
o o o
o o o
o o o o
oo
o
0.05

o o oo o
o o
o o o
o oo o o o
o o
o o
oo o
o o o
o o
o o o o
o o o o
o o o
o o
o o oo o
o o o
o o
o oo o o o
0.0

o o o
o o o o o
o oo o o o
oo
o o o o o o
oo o o o o
o o o o o
o o o o o o
o o o o
o o o oo oo oo
o o o
o o o o o o o o o
o o o
o o o o
o o o o
-0.05

o o o
o o
o o o
o o
o o o o
o o o o
o o
o
o o
o o

1980 1982 1984 1986 1988 1990 1992 1994 1996


0.6
0.6

0.4
0.4

PACF
ACF

0.2
0.2

0.0
0.0

-0.4

5 10 15 20 5 10 15 20

Exercise 8.7(d): Errors from regression model with AR(1) error term.
150 Part D. Solutions to exercises

Parameter Estimate s.e. P -value


a 0.20200 0.2848 0.4791
0 0.20730 0.2602 0.4267
1 -0.41687 0.2634 0.1154
2 0.23165 0.2655 0.3842
3 0.32048 0.2716 0.2396
4 -0.72093 0.2665 0.0075
5 0.74707 0.2633 0.0051
6 -0.36272 0.2656 0.1739
Thus the intercept and first four coefficients are not significant and can be
omitted. Hence we select b = 4. We shall retain the last three coefficients for
the moment. Since they show no clear pattern, we select r = 0 and s = 3 giving
the model
Yt = (0 + 1 B + 2 B 2 )B 4 Xt + Nt .
Looking at the ACF and PACF of the error series (not shown) and trying a
number of alternative models led us to the model ARIMA(2,1,0)(2,0,0) 12 for
Nt . That is

(1 1 B 2 B 2 )(1 1 B 12 2 B 24 )(1 B)Nt = et .

The parameter values (all significant) were


Parameter 0 1 2 1 2 1 2
Estimate 0.52 0.61 -0.47 -0.49 -0.33 0.37 0.41
The model suggests that there is a lag of four months between changes in the
CPI and changes in the price of travel accommodation. The seasonality inherent
in the model may be due to seasonal price variation or due to the way CPI was
estimated from quarterly data.
(e) Forecasts of CPI were obtained using Holts method. These are only needed
from November 1995 because of the time lag of 4 months. Actual data beyond
June 1995 are given in the second column for comparison.
Chapter 8: Advanced forecasting models 151

Month Predicted Actual


Yt Yt Xt4 Xt5 Xt6
Jul 1995 90.4 94.0 115.0 115.0 115.0
Aug 1995 91.8 96.7 116.2 115.0 115.0
Sep 1995 92.0 94.8 116.2 116.2 115.0
Oct 1995 91.6 89.6 116.2 116.2 116.2
Nov 1995 93.4 95.8 116.9 116.2 116.2
Dec 1995 90.3 91.5 117.3 116.9 116.2
Jan 1996 90.4 92.0 117.7 117.3 116.9
Feb 1996 92.6 95.5 118.1 117.7 117.3
Mar 1996 94.7 100.6 118.5 118.1 117.7
Apr 1996 90.7 94.1 118.9 118.5 118.1
May 1996 91.5 97.2 119.3 118.9 118.5
Jun 1996 93.0 102.9 119.8 119.3 118.9
80
Perpetual speed score

60
40

0 20 40 60 80 100 120

Day

Exercise 8.8: Time plot of daily perceptual speed scores for a schizophrenic patient. The
drug intervention is shown at day 61.

8.8 (a) See the figure above.


(b) The step intervention model with an ARIMA(0,1,1) error was used:

Yt = Xt + Nt where (1 B)Nt = et1 + et


152 Part D. Solutions to exercises

where Yt denotes the perceptual speed score and X t denotes the step dummy
variable. The estimated coefficients were
Parameter
Estimate -22.1 0.76
(c) The drug has lowered the perceptual speed score by about 22.
(d) The new model is

Yt = Xt + N t where (1 B)Nt = et1 + et
1 B
(An ARIMA(0,1,1) error was found to be the best model again.) Here the
estimated coefficients were
Parameter
Estimate -13.21 0.54 0.76
The following accuracy measures show that the delayed effect model fits the
data better.
Model Step Delayed step
MAPE 15.1 15.0
MSE 92.5 91.1
AIC 542.8 538.4
The forecasts for the two models are very similar. This is because the effect of
the step in the delayed step model is almost complete at the end of the series,
60 days after the drug intervention.
(e) The best ARIMA model we found was an ARIMA(0,1,1) with = 0.69. This
gave MAPE=15.4, MSE=100.8 and AIC=550.9.
This model gives a flat forecast function (since we did not include a constant
term). The forecast values are 33.9. Because the step effect is almost complete
in the delayed step model, it also gives a virtually flat forecast function with
forecast values of 34.1. Hence there is virtually no difference. If forecasts had
been made earlier (for example, at day 80), there would have been a difference
because the step effect would still be in progress and so the delayed step model
would have showed a continuing decline in perceptual speed. The real advantage
of the intervention model over the ARIMA model is that the intervention model
provides a way of measuring and evaluating the effect of an intervention.
(f ) If the drug varied from day to day and the reaction times depended on dose,
then a better model would be a dynamic regression model with the the quantity
of drug as an explanatory variable.
Chapter 8: Advanced forecasting models 153

8.9 (a)      
Yt Yt1 Yt1 Yt2 Yt2 Yt3
= 1 + 2
Xt Xt1 Xt1 Xt2 Xt2 Xt3
 
Yt12 Yt13
+ + 12 + Zt.
Xt12 Xt13

(b)
Yt = Yt1 0.38(Yt1 Yt2 ) + 0.15(Xt1 Xt2 )
0.37(Yt2 Yt3 ) + 0.13(Xt2 Xt3 ) +
= 0.62Yt1 + 0.01Yt2 + 0.15Xt1 0.02Xt2 +

(c)
Multivariate model assumes feedback. That is, X t depends on past values
of Yt . But regression does not allow this.
Regression model does not assume Xt is random.
Regression model allows Yt to depend on Xt as well as past values
Xt1 , Xt2 , . . .. Multivariate AR only allows dependence on past values
of {Xt }.
For these data, it is unlikely room rates will substantially affect Y t although
it is possible. Small values in lower left of coefficient matrices suggest that
Xt is not affecting Yt . Yt should depend on Xt . So regression is probably
better.
8.10 (a) An AR(3) model can be written using the same procedure as the AR(2) model
described in Section 8/5/1. Thus we define X 1,t = Yt , X2,t = Yt1 and X3,t =
Yt2 . Then write

1 2 3 at
X t = 1 0 0 X t1 + 0
0 1 0 0

and Yt = [1 0 0]X t .
This is now in state space form with

1 2 3 1 0 0 at
F = 1 0 0 ,G = 0 1 0 , H = [1 0 0], et = 0 and zt = 0.
0 1 0 0 0 1 0

(b) An MA(1) can be written as Yt = at1 + at where at is white noise. We can


write this in state space form by letting F = 0, G = , e t = at1 , zt = at and
H = 1. Thus
Yt = X t + a t and Xt = at1 .
154 Part D. Solutions to exercises

(c) Holts method is defined in Chapter 4 as

Lt = Yt + (1 )(Lt1 + bt1 ),
bt = (Lt Lt1 ) + (1 )bt1 ,

with the one-step forecast as Ft+1 = Lt + bt . Hence the one-step error is


et = Yt Lt1 bt1 . The first row can be written

Lt = (Yt Lt1 bt1 ) + Lt1 + bt1


= et + Lt1 + bt1

and the second row can be written

bt = (Lt Lt1 ) + (1 )bt1


= bt1 + (Lt Lt1 bt1 )
= bt1 + et

using the first equation.


Now let Xt,1 = Lt and Xt,2 = bt . Then the state space form of the model is
   
1 1
Xt = X t1 + et
0 1

Yt = [1 1] X t1 + et .

(d) The state space form might be preferable because


it allows missing values to be handled easily;
it is easy to generalize to allow the parameters to change over time;
the Kalman recursion equations can be used to calculate the forecasts and
likelihood.
Chapter 9: Forecasting the long term 155

Chapter 9: Forecasting the long term

9.1 There is little doubt that the trends in computer power and memory show a very
clear exponential growth while that of price is declining exponentially. It is therefore
a question of time until computers that cost only a few hundred dollars will exist
that can perform an incredible array of tasks which until now have been the sole
prerogative of humans, for example playing chess (a high-power judgmental and
creative process). It is therefore up to our imaginations to come up with future
scenarios when such computers will be used as extensively as electrical appliances
are used today. The trick is to free our thinking process so that we can come up with
scenarios that are not constrained by our perception of the present when computers
are being used mostly to make calculations.

9.2 As the cost of computers (including all of the peripherals such as printers and scan-
ners) is being reduced drastically, and at the same time we will be getting soon to
devices that will perform a great number of functions now done by separate ma-
chines, it will become more practical and economical to work at home. Furthermore,
the size of these all-purpose machines is being continuously reduced. In the next
five to ten years we will be able to have everything that is provided to us now in
an office at home with two machines: one a powerful all-inclusive computer and the
other a printer-scanner-photocopier-fax machine. Moreover these two machines will
be connected to any network we wish via modems so that we can communicate and
get information from anywhere.

9.3 As it was also mentioned in Exercise 9.1, there is no doubt that the trend in computer
and equipment prices are declining exponentially at a fast rate. This would make it
possible for everyone to be able to afford them and be able to have an office not only
at home but at any other place he or she wishes, including ones car, a hotel room,
a summer vacation residence, or a sail boat.

9.4 Statements like those referred to in Exercise 9.4 abound and demonstrate the short-
sightedness of peoples ability to predict the future. As a matter of fact as late
as the beginning of our century people did not predict all four major inventions of
the Industrial Revolution (cars, telephones, electrical appliances and television) that
have dramatically changed our lives. Moreover, they did not predict the huge impact
of computers even as late as the beginning of the 1950s. This is why we must break
from our present mode of thinking and see things in a different, new light. This is
where scenarios and analogies can be extremely useful.
156 Part D. Solutions to exercises

Chapter 10: Judgmental forecasting and adjustments

10.1 Phillips problems have to do with the management bias of overoptimism, that is
believing that all changes will be successful and that they can overcome peoples
resistance to change. This is not true, but we tend to believe that most organisational
changes are successful because we hear and we read about the successful ones while
there is very little mention of those that fail. Introducing changes must be considered,
therefore, in an objective manner and our ability to succeed estimated correctly.

10.2 The quote by Glassman illustrates the extent to which professional, expert invest-
ment managers underperform the average of the market. Business Week, Fortune
and other business journals regularly publish summary statistics of the performance
of mutual funds and other professionally-managed funds, benchmarking them with
the Standard & Poor or other appropriate indexes. The instructor can therefore get
some more recent comparisons than those shown in Chapter 10 and show them in
class.

10.3 Assuming that the length of cycles varies considerably we have little way to say how
long it will take until the expansion started in May 1991 will be interrupted. Un-
fortunately the length (and depth) of cycles varies a great deal making it extremely
difficult to say how long an expansion will last. It will all depend on the specific
situation involved that will require judgmental inputs, structured in such a way as
to avoid biases and other problems.

10.4 There are twenty 8s that one will encounter when counting from 0100. When given
this exercise most people say nine or ten because they are not counting the eights
coming from 81 to 87, and 89 (they usually count the 8s in 88 often one time).
Chapter 11: The use of forecasting methods in practice 157

Chapter 11: The use of forecasting methods in practice

11.1 The results of Table 1 are very similar to those of the previous M-Competitions. As
a matter of fact the resemblance is phenomenal given the fact that the series used
and the time horizon they refer to are completely different.

11.2 In our view the combined method will do extremely well. More specifically its accu-
racy will be higher than the individual methods being combined while its variance
of forecasting error will be smaller than that of the methods involved.

11.3 It seems that proponents of new forecasting methods usually exaggerate their ben-
efits. This has been the case with methods under the banner of neural networks,
machine learning and expert systems. These methods did not do well in the M3-IJF
Competition. In addition only few experts participated in the competition using
such methods, even though more than a hundred were contacted (and invited to
participate) and more than fifty expressed an interest in the M3-IJF Competition,
indicating that they would possibly participate . In the final analysis it seems that
it is not so simple to run a great number of series by such methods resulting in not
too many participants from such methods.
158 Part D. Solutions to exercises

Chapter 12: Implementing forecasting: its uses, advantages, and


limitations

The exercises for Chapter 12 are general and can be answered by referring to the text
of Chapter 12 which covers each one of the topics. Each instructor can therefore form
his/her way of answering these exercises.