Time Series

Time Series
Econometrics:
Asst. Prof. Dr. Mete Feridun

Department of Banking and Finance
Faculty of Business and Economics
Eastern Mediterranean University
What is a time series?

A time series is any series of data that
varies over time. For example
Monthly Tourist Arrivals from Korea
Quarterly GDP of Laos
Hourly price of stocks and shares
Weekly quantity of beer sold in a pub
Because of widespread availability of
time series databases most empirical
studies use time series data.
Caveats in Using Time Series

Data in Applied Econometric
Modeling
Data Should be Stationary
Data Should be Stationary

Presence of Autocorrelation
Guard Against Spurious Regressions
Establish Cointegration
Reconcile SR with LR Behavior via ECM
Implications to Forecasting
Possibility of Volatility Clustering
What is a Stationary Time

Series?
A Stationary Series is a Variable with
constant Mean across time
A Stationary Series is a Variable with

constant Variance across time
These are Examples of

Non-Stationary Time Series
16000
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12000
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9000
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7000
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6000
5000
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4000
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6000
4000
2000
2000
0
92
94
96
98
00
02
04
3000
2000
2000
0
92
94
96
AUSTRALIA
98
00
02
04
1000
92
94
96
CANADA
24000
45000
20000
40000
98
00
02
04
94
96
98
00
02
04
00
02
04
00
02
04
GERMANY
50000
7000
6000
40000
35000
16000
92
CHINA
5000
30000
30000
4000
12000
25000
8000
3000
20000
20000
4000
15000
10000
92
94
96
98
00
02
04
2000
10000
1000
0
92
94
96
HONGKONG
98
00
02
04
0
92
94
96
JAPAN
00
02
04
92
94
96
KOREA
7000
30000
12000
6000
25000
10000
20000
8000
15000
6000
10000
4000
5000
2000
5000
98
98
MALAYSIA
60000
50000
40000
4000
3000
30000
2000
1000
0
0
92
94
96
98
00
SINGAPORE
02
04
20000
0
92
94
96
98
TAIWAN
00
02
04
10000
92
94
96
98
UK
00
02
04
92
94
96
98
USA
These are Examples of

Stationary Time Series
8000
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1000
-2000
-2000
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-4000
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-4000
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-6000
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0
-2000
92
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98
00
02
04
92
94
96
AUST
98
00
02
04
-6000
92
94
96
CAN
98
00
02
04
92
94
96
CHI
12000
12000
12000
8000
8000
8000
4000
4000
4000
-4000
-4000
-4000
-8000
-8000
-8000
98
00
02
04
00
02
04
00
02
04
GERM
2000
1000
0
-1000
-12000
-12000
92
94
96
98
00
02
04
-2000
-12000
92
94
96
HONG
98
00
02
04
-3000
92
94
96
JAP
3000
98
00
02
04
92
94
96
KOR
12000
98
MAL
5000
30000
4000
2000
8000
20000
3000
1000
2000
4000
10000
1000
0
-1000
-1000
-2000
-4000
-2000
-10000
-3000
-3000
-8000
92
94
96
98
SING
00
02
04
-4000
92
94
96
98
TWN
00
02
04
-20000
92
94
96
98
UKK
00
02
04
92
94
96
98
US
What is a Unit Root?

If a Non-Stationary Time
Series Yt has to be
differenced d times to make
it stationary, then Yt is said
to contain d Unit Roots. It is
customary to denote Yt ~ I(d)
which reads Yt is integrated
of order d
Establishment of Stationarity
Using Differencing of
Integrated Series
If Yt ~ I(1), then Zt = Yt Yt-1 is Stationary
If Yt ~ I(2), then Zt = Yt Yt-1 (Yt Yt-2 )is
Stationary
Unit Root Testing: Formal Tests

to Establish Stationarity of
Time
Series
Dickey-Fuller (DF) Test
Augmented Dickey
Fuller (ADF) Test

Phillips-Perron (PP) Unit
Root Test
Dickey-Pantula Unit
Root Test
GLS Transformed
Dickey-Fuller Test
ERS Point Optimal Test
KPSS Unit Root Test
Ng and Perron Test
What is a Spurious
Regression?
A Spurious or Nonsensical relationship

may result when one Non-stationary
time series is regressed against one
or more Non-stationary time series
The best way to guard against
Spurious Regressions is to check for
Cointegration of the variables used
in time series modeling
Symptoms of Likely Presence

of Spurious Regression
If the R2 of the regression is greater
than the Durbin-Watson Statistic
If the residual series of the regression

has a Unit Root
Cointegration
Is the existence of a long run
equilibrium relationship among time

series variables
Is a property of two or more variables
moving together through time, and
despite following their own individual
trends will not drift too far apart since
they are linked together in some sense
Two Cointegrated Time

Series
55
X
50
45
40
35
30
25
20
15
10
0
10
20
30
40
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Cointegration Analysis:
Formal Tests
Cointegrating Regression DurbinWatson (CRDW) Test
Augmented Engle-Granger (AEG) Test

Johansen Multivariate Cointegration
Tests or the Johansen Method
Error Correction Mechanism

(ECM)
Reconciles the Static LR Equilibrium
relationship of Cointegrated Time

Series with its Dynamic SR
disequilibrium
Based on the Granger Representation
Theorem which states that If
variables are cointegrated, the
relationship among them can be
expressed as ECM.
Forecasting: Main
Motivation
Judicious planning
requires reliable
forecasts of decision
variables
How can effective
forecasting be
undertaken in the light
of non-stationary nature
of most economic
variables?
Featured techniques:
Box-Jenkins Approach
and Vector Auto
regression (VAR)
Approaches to Economic
Forecasting
The Box-Jenkins Approach
One of most widely used methodologies for
the analysis of time-series data
Forecasts based on a statistical analysis of
the past data. Differs from conventional
regression methods in that the mutual
dependence of the observations is of primary
interest
Also known as the autoregressive integrated
moving average (ARIMA) model
Forecasting
Advantages
Derived from solid mathematical statistics foundations
ARIMA models are a family of models and the BJ approach is
a strategy of choosing the best model out of this family
It can be shown that an appropriate ARIMA model can
produce optimal univariate forecasts
Disadvantages
Requires large number of observations for model
identification
Hard to explain and interpret to unsophisticated users
Estimation and selection an art form
Forecasting
Differencing the series
to achieve stationarity
Identify model to be
tentatively entertained
Estimate the parameters

of the tentative model
No
Use the model for
forecasting and
control
Yes
Diagnostic checking. Is
the model adequate?
The Box-Jenkins Approach-Identification Tools
Forecasting
Correlogram graph showing the ACF and the PACF at
different lags.
Autocorrelation function (ACF)- ratio of sample
covariance (at lag k) to sample variance
Partial autocorrelation function (PACF) measures
correlation between (time series) observations that are k
time periods apart after controlling for correlations at
intermediate lags (i.e., lags less than k). In other words, it is
the correlation between Yt and Yt-k after removing the effects
of intermediate Ys.
The Box-Jenkins Approach-Identification
Forecasting
Theoretical Patterns of ACF and PACF
Type of
Model
Typical Pattern
of ACF
Typical
Pattern of
PACF
AR (p)
Decays
exponentially or
with damped sine
wave pattern or
both
Significant
spikes through
lags p
MA (q)
Significant spikes
through lags q
Exponential decay
Declines
exponentially
Exponential
decay
ARMA
(p,q)
The Box-Jenkins Approach-Diagnostic Checking
Checkin
Forecasting
How do we know that the model we estimated is a reasonable
fit to the data?
Check
residuals
Rule of thumb:
None of the ACF and the PACF are

individually statistically significant
Formal test:
Box-Pierce Q
Q N rk2
k 1
k
Ljung-Box LB LB n(n 2)
n k m
k 1
Some issues in the Box-Jenkins modeling
Forecasting
Judgmental decisions
on the choice of degree of order
on the choice of lags
Data mining
can be avoided if we confine to AR processes only
fit versus parsimony
Seasonality
observations, for example, in any month are often affected by
some seasonal tendencies peculiar to that month.
the differencing operation considered as main limitation for
a series that exhibit moving seasonal and moving trend.
Vector Autoregression (VAR)

Introduction
VAR resembles a SEM modeling we consider several

endogenous variables together. Each endogenous variables is
explained by its lagged values and the lagged values of all
other endogenous variables in the model.
In the SEM model, some variables are treated as endogenous and
some are exogenous (predetermined). In estimating SEM, we
have to make sure that the equation in the system are identified
this is achieved by assuming that some of the predetermined
variables are present only in some equation (which is very
subjective) and criticized by Christopher Sims.
If there is simultaneity among set of variables, they should all
be treated on equal footing, i.e., there should not be any a priori
distinction between endogenous and exogenous variables.

Its Uses
Forecasting
VAR forecasts extrapolate expected values of current and future
values of each of the variables using observed lagged values of
all variables, assuming no further shocks
Impulse Response Function (IRFs)

IRFs trace out the expected responses of current and future
values of each of the variables to a shock in one of the VAR
equations

Its Uses
Forecast Error Decomposition of Variance (FEDVs)

FEDVs provide the percentage of the variance of the error
made in forecasting a variable at a given horizon due to specific
shock. Thus, the FEDV is like a (partial) R2 for the forecast
error
Granger Causality Tests
Granger-causality requires that lagged values of variable A are
related to subsequent values in variable B, keeping constant the
lagged values of variable B and any other explanatory variables

Mathematical Definition
[Y]t = [A][Y]t-1 + + [A][Y]t-k + [e]t or
Yt1
Yt
Y3
t
...
p
Yt
A11
A
21
A31
...
Ap1
A12
A13
...
A22
A32
A23
A33
...
...
...
Ap 2
... ...
Ap 3 ...
Y
A1 p t 1
A2 p Yt 1
3
A3 p Yt 1 ...

... ...
App Yt p1
'
11
'
12
'
13
...
...
...
...
A' 21
A'31
...
A' 22
A'32
...
A' 23
A'33
...
A' p1
A' p 2
A' p 3 ...
Y
A t k e1t
A' 2 p Yt k e2t
3
A'3 p Yt k e3t
... ...
...

'
p
A pp Yt k e pt
'
1p
where:
p = the number of variables be considered in the system
k = the number of lags be considered in the system
[Y]t, [Y]t-1, [Y]t-k = the 1x p vector of variables
[A], and [A'] = the p x p matrices of coefficients to be estimated
[e]t = a 1 x p vector of innovations that may be contemporaneously
correlated but are uncorrelated with their own lagged values and
uncorrelated with all of the right-hand side variables.

Example
Consider a case in which the number of variables n is 2, the

number of lags p is 1 and the constant term is suppressed. For
concreteness, let the two variables be called money, mt and
output, yt .
The structural equation will be:
mt 1 yt 11mt 1 12 yt 1 mt
yt 2 yt 21mt 1 22 yt 1 yt

Example
Then, the reduced form is
11 1 21
12 1 22
1
1
mt
mt 1
yt 1
mt
yt
1 1 2
1 1 2
1 1 2
1 1 2
11mt 1 12 yt 1 1t
21 2 11
22 2 12
2
1
yt
mt 1
yt 1
mt
yt
1 1 2
1 1 2
1 1 2
1 1 2
21mt 1 22 yt 1 2t

Example
Among the statistics computed from VARs are:

Granger causality tests which have been interpreted as
testing, for example, the validity of the monetarist proposition
that autonomous variations in the money supply have been a
cause of output fluctuations.
Variance decomposition which have been interpreted as
indicating, for example, the fraction of the variance of output
that is due to monetary versus that due to real factors.
Impulse response functions which have been interpreted as
tracing, for example, how output responds to shocks to money
(is the return fast or slow?).

Granger Causality
In a regression analysis, we deal with the dependence of one

variable on other variables, but it does not necessarily imply
causation. In other words, the existence of a relationship
between variables does not prove causality or direction of
influence.
In our GDP and M example, the often asked question is whether
GDP M or M GDP. Since we have two variables, we are
dealing with bilateral causality.
Given the previous GDP and M VAR equations:
yt 2 mt 21mt 1 22 yt 1 yt

Granger Causality
We can distinguish four cases:
Unidirectional causality from M to GDP

Unidirectional causality from GDP to M
Feedback or bilateral causality
Independence
Assumptions:
Stationary variables for GDP and M
Number of lag terms
Error terms are uncorrelated if it is, appropriate
transformation is necessary
Granger Causality Estimation (t-test)

mt 11mt 1 12 yt 1 1t
yt 21mt 1 22 yt 1 2 t
A variable, say mt is said to fail to Granger cause another variable,

say yt, relative to an information set consisting of past ms and ys
if: E[ yt | yt-1, mt-1, yt-2, mt-2, ] = E [yt | yt-1, yt-2, ].
mt does not Granger cause yt relative to an information set
consisting of past ms and ys iff 21 = 0.
yt does not Granger cause mt relative to an information set
consisting of past ms and ys iff 12 = 0.
In a bivariate case, as in our example, a t-test can be used to test
the null hypothesis that one variable does not Granger cause
another variable. In higher order systems, an F-test is used.
Granger Causality Estimation (F-test)
1. Regress current GDP on all lagged GDP terms but do not

include the lagged M variable (restricted regression). From this,
obtain the restricted residual sum of squares, RSSR.
2. Run the regression including the lagged M terms (unrestricted
regression). Also get the residual sum of squares, RSSUR.
3. The null hypothesis is Ho: i = 0, that is, the lagged M terms do
not belong in the regression.
( RSS R RSSUR ) / m
F
RSSUR /( n k )
5. If the computed F > critical F value at a chosen level of
significance, we reject the null, in which case the lagged m
belong in the regression. This is another way of saying that m
causes y.

Variance Decomposition
Our aim here is to decompose the variance of each element of

[Yt] into components due to each of the elements of the error
term and to do so for various horizon. We wish to see how
much of the variance of each element of [Yt] is due to the first
error term, the second error term and so on.
Again, in our example:
The conditional variance of, say mt+j, can be broken down into
a fraction due to monetary shock, mt and a fraction due to the
output shock, yt .

Impulse Response Functions
Here, our aim is to trace out the dynamic response of each
element of the [Yt] to a shock to each of the elements of the
error term. Since there are n elements of the [Yt], there are n2
responses in all.
From our GDP and money supply example:
We have four impulse response functions:
mt j / mt
mt j / yt
yt j / mt
yt j / yt

Pros and Cons
Advantages
The method is simple; one does not have to worry about
determining which variables are endogenous and which
ones exogenous. All variables in VAR are endogenous
Estimation is simple; the usual OLS method can be applied
to each equation separately
The forecasts obtained by this method are in many cases
better than those obtained from the more complex
simultaneous-equation models.

Pros and Cons
Some Problems with VAR modeling

A VAR model is a-theoretic because it uses less prior
information. Recall that in simultaneous equation models
exclusion or inclusion of certain variables plays a crucial role
in the identification of the model.
Because of its emphasis on forecasting, VAR models are
less suited for policy analysis.
Suppose you have a three-variable VAR model and you decide
to include eight lags of each variable in each equation. You will
have 24 lagged parameters in each equation plus the constant
term, for a total of 25 parameters. Unless the sample size is
large, estimating that many parameters will consume a lot of
degree of freedom with all the problems associated with that.

Pros and Cons
Strictly speaking, in an m-variable VAR model, all the m

variables should be (joint) stationary. If they are not stationary,
we have to transform (e.g., by first-differencing) the data
appropriately. If some of the variables are non-stationary, and
the model contains a mix of I(0) and I(1), then the transforming
of data will not be easy.
Since the individual coefficients in the estimated VAR models
are often difficult to interpret, the practitioners of this technique
often estimate the so-called impulse response function. The
impulse response function traces out the response of the
dependent variable in the VAR system to shocks in the error
terms, and traces out the impact of such shocks for several
periods in the future.

Time Series

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Time Series

Asst. Prof. Dr. Mete Feridun

What is a time series?

Caveats in Using Time Series

Data Should be Stationary

What is a Stationary Time

A Stationary Series is a Variable with

These are Examples of

These are Examples of

What is a Unit Root?

Unit Root Testing: Formal Tests

Fuller (ADF) Test

A Spurious or Nonsensical relationship

Symptoms of Likely Presence

If the residual series of the regression

equilibrium relationship among time

Two Cointegrated Time

Augmented Engle-Granger (AEG) Test

Error Correction Mechanism

relationship of Cointegrated Time

Estimate the parameters

None of the ACF and the PACF are

Vector Autoregression (VAR)

VAR resembles a SEM modeling we consider several

Vector Autoregression (VAR)

Impulse Response Function (IRFs)

Vector Autoregression (VAR)

Forecast Error Decomposition of Variance (FEDVs)

Vector Autoregression (VAR)

[Y]t = [A][Y]t-1 + + [A][Y]t-k + [e]t or

Vector Autoregression (VAR)

Consider a case in which the number of variables n is 2, the

Vector Autoregression (VAR)

Then, the reduced form is

Vector Autoregression (VAR)

Among the statistics computed from VARs are:

Vector Autoregression (VAR)

In a regression analysis, we deal with the dependence of one

Vector Autoregression (VAR)

We can distinguish four cases:

Unidirectional causality from M to GDP

Vector Autoregression (VAR)

Granger Causality Estimation (t-test)

A variable, say mt is said to fail to Granger cause another variable,

Vector Autoregression (VAR)

Granger Causality Estimation (F-test)

1. Regress current GDP on all lagged GDP terms but do not

Vector Autoregression (VAR)

Our aim here is to decompose the variance of each element of

Vector Autoregression (VAR)

Vector Autoregression (VAR)

Vector Autoregression (VAR)

Some Problems with VAR modeling

Vector Autoregression (VAR)

Strictly speaking, in an m-variable VAR model, all the m

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