Econ 424/Amath 540 Time Series Concepts

Eric Zivot

July 11, 2011

Time Series Processes Stochastic (Random) Process {. . . , Y1, Y2, . . . , Yt, Yt+1, . . .} = {Yt} t= sequence of random variables indexed by time Observed time series of length T {Y1 = y1, Y2 = y2, . . . , YT = yT } = {yt}T t=1

Stationary Processes

Intuition: {Yt} is stationary if all aspects of its behavior are unchanged by shifts in time A stochastic process {Yt} t=1 is strictly stationary if, for any given nite integer r and for any set of subscripts t1, t2, . . . , tr the joint distribution of (Yt, Yt1 , Yt2 , . . . , Ytr ) depends only on t1 t, t2 t, . . . , tr t but not on t.

Remarks

1. For example, the distribution of (Y1, Y5) is the same as the distribution of (Y12, Y16).

2. For a strictly stationary process, Yt has the same mean, variance (moments) for all t.

3. Any function/transformation g () of a strictly stationary process, {g (Yt)} is also strictly stationary. E.g., if {Yt} is strictly then {Yt2} is strictly stationary.

Covariance (Weakly) Stationary Processes {Yt} : E [Yt] = for all t var(Yt) = 2 for all t cov(Yt, Ytj ) = j depends on j and not on t Note cov(Yt, Ytj ) = j is called the j-lag autocovariance

Autocorrelations cov(Yt, Ytj ) j corr(Yt, Ytj ) = j = q = 2 var(Yt)var(Ytj )

Note: By stationarity var(Yt) = var(Ytj ) = 2.

Autocorrelation Function (ACF): Plot of j against j

Example: Gaussian White Noise Process Yt iid N (0, 2) or Yt GW N (0, 2) E [Yt] = 0, var(Yt) = 2 Yt independent of Ys for t 6= s cov(Yt, Yts) = 0 for t 6= s Note: iid = independent and identically distributed. Here, {Yt} represents random draws from the same N (0, 2) distribution

Example: Independent White Noise Process Yt iid (0, 2) or Yt IW N (0, 2) E [Yt] = 0, var(Yt) = 2 Yt independent of Ys for t 6= s

Here, {Yt} represents random draws from the same distribution. However, we dont specify exactly what the distribution is - only that it has mean zero and variance 2.

Example: Weak White Noise Process E [Yt] = 0, var(Yt) = 2 cov(Yt, Ys) = 0 for t 6= s Here, {Yt} represents an uncorrelated stochastic process with mean zero and variance 2. Recall, the uncorrelated assumption does not imply independence. Hence, Yt and Ys can exhibit non-linear dependence. Yt W N (0, 2)

Nonstationary Processes Example: Deterministically trending process

2) Yt = 0 + 1t + t, t W N (0,

E [Yt] = 0 + 1t depends on t

Note: A simple detrending transformation yield a stationary process: Xt = Yt 0 1t = t

Example: Random Walk

2), Y is xed Yt = Yt1 + t, t W N (0, 0

= Y0 +

j =1

t X

2 t depends on t j var(Yt) =

Note: A simple detrending transformation yield a stationary process: Yt = Yt Yt1 = t

Moving Average (MA) Processes MA(1) Model Yt = + t + t1, < <

2) t iid N (0,

Properties E [Yt] = + E [t] + E [t1] =+0+0=

var(Yt) = 2 = E [(Yt )2]

2 2 = E [2 t ] + 2E [tt1] + E [t1]

= E [(t + t1)2]

2 + 0 + 2 2 = 2(1 + 2) = cov(Yt, Yt1) = 1 = E [(t + t1)(t1 + t2)] 2 + E [2 t1] + E [t1t2] 2 + 0 = 2 = 0 + 0 +

= E [tt1] + E [tt2]

Furthermore, cov(Yt, Yt2) = 2 = E [(t + t1)(t2 + t3)] + E [t1t2] + 2E [t1t3] =0+0+0+0=0 Similar calculation show that cov(Yt, Ytj ) = j = 0 for j > 1 = E [tt2] + E [tt3]

Autocorrelations
2 1 1 = 2 = 2 = (1 + 2) (1 + 2) j j = 2 = 0 for j > 1

Note: 1 = 0 if = 0 1 > 0 if > 0 1 < 0 if < 0 Result: MA(1) is covariance stationary for any value of

Example: MA(1) model for overlapping returns Let rt denote the 1month cc return and assume that
2) rt iid N (r , r

Consider creating a monthly time series of 2month cc returns using rt(2) = rt + rt1 These 2month returns observed monthly overlap by 1 month rt1(2) = rt1 + rt2 rt2(2) = rt2 + rt3 . . Claim: The stochastic process {rt(2)} follows a MA(1) process rt(2) = rt + rt1

Autoregressive (AR) Processes AR(1) Model (mean-adjusted form) Yt = (Yt1 ) + t, 1 < < 1
2) t iid N (0,

Result: AR(1) model is covariance stationary provided 1 < < 1

Properties E [Yt] =
2/(1 2) var(Yt) = 2 = cov(Yt, Yt1) = 1 = 2

corr(Yt, Yt1) = 1 = 1/ 2 = cov(Yt, Ytj ) = j = 2j

corr(Yt, Ytj ) = j = j / 2 = j

Note: Since || < 1

lim j = j = 0

AR(1) Model (regression model form) Yt = (Yt1 ) + t = c + Yt1 + t

Yt = + Yt1 + t

where c = (1 ) = Remarks: c 1

Regression model form is convenient for estimation by linear regression

The AR(1) model and Economic and Financial Time Series The AR(1) model is a good description for the following time series

Interest rates Growth rate of macroeconomic variables Real GDP, industrial production Money, velocity Real wages, unemployment