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Correlogram

ARMA models example

Advanced Econometrics

Marco Sunder

Nov 04 2010

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Music

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Music

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We often assume that our time series have constant first and second

moments (covariance stationarity).

Trends in the data have to be dealt with.

(Linear) time trends are easy to spot, but what about stochastic trends

(unit roots)?

Simplest possible process with a unit root: random walk

yt = 1 yt1 + t

is white noise

yt = y0 + 1 + 2 + ... + t

Shocks long ago do not lose their effect on todays yt (persistence)

Difficult to distinguish this from AR(1) with 1 = 0.95 in small samples!

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The Augmented Dickey-Fuller test (ADF) starts from an AR(p)

model plus a linear time trend (as an alternative trend specification.

E.g.: AR(2) model

yt = + t + 1 yt1 + 2 yt2 + t

A unit root would imply 1 + 2 = 1.

Rewriting the equation yields

yt yt1 = + t + (1 + 2 1)yt1 2 yt1 + 2 yt2 + t

yt

= + t +

Marco Sunder

yt1

2 yt1

Advanced Econometrics

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Test can easily be extended to larger p, just include p 1 augmenting

lags:

p1

X

yt = + t + yt1 +

j ytj + t

j=1

Estimate the equation by OLS and choose p 1 such that the residuals

are not correlated anymore.

Null hypothesis of a single unit root: = 0 (H1 : < 0)

Caution: this test requires special critical t-values!

Critical values of ADF test statistic in large samples

Deterministic regressors

10%

5%

1%

Intercept only

2.57

2.86

3.43

Intercept and time trend

3.12

3.41

3.96

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4.5

lnsp500

5.5

6.5

1980m1

1985m1

1990m1

1995m1

time

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Autocovariances of y :

k = E[(yt )(ytk )] , k = 0, 1, 2, ...

0 denotes the variance of a process

The autocorrelation function (ACF) is the sequence of correlation

coefficients k = j /0

Empirical counterpart:

1 PT

)(yt y )

t=k+1 (ytk y

T

k =

P

T

1

)2

t=1 (yt y

T

The partial autocorrelation function (PACF) gives the strength of

the association between the time series and its k th lag after controlling

for lags 1 through k 1.

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ACF and PACF may help you in determining what kind of ARMA(p,q)

process may have generated a time series.

Pure AR processes tend to have many spikes in the ACF and few ones

in the PACF

The opposite is the case for pure MA processes

White noise has no autocorrelation at all (except lag zero)

If the ACF remains close to 1 for many lags, chances are the time series

is not stationary

Is there any (significant) autocorrelation?

Ljung-Box test statistic:

Q = T (T + 2)

m

X

k=1

1

2

T k k

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hprescott lnsp500, stub(hp) smooth(14400)

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ac hp_lnsp500_1, ylab(-1(0.5)1) lags(52)

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pac hp_lnsp500_1, ylab(-1(0.5)1) lags(52)

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ARMA models

Estimated ARMA(2,0) process:

yt = 0.001 + 1.213yt1 0.365yt2 + t

T = 189,

AIC = 777.3,

BIC = 764.3

yt = 0.001 + 1.176yt1 0.332yt2 + t + 0.043 t1

T = 189,

AIC = 775.3,

BIC = 759.1

Akaike information criterion: AIC = 2 ln L + 2(# parameters)

Schwarz Bayesian information criterion:

BIC = 2 ln L + (# parameters) ln T

Less is better! BIC tends to favor more parsimonious specifications.

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Autocovariances of a stationary process1 can be cast into the frequency

domain (Fourier transform).

The resulting spectral density function f (spectrum) helps us identify

cyclical features of the process: are there frequency bands that

contribute heavily to the overall variance?

Spectral density of a covariance-stationary process

X

X

f () =

k exp{i2k} = 0 + 2

k cos(2k)

k=

k=1

imaginary number 1

1

k=

|k | <

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If you have a time series rather than a theoretical process, you could

use the Fourier transform formula and replace k by its estimate k .

The result is called periodogram:

f() = 0 + 2

T

1

X

j cos(2k)

k=1

density as its variance does not approach zero with T . Longer

time horizons imply that more covariances can be estimated.

Covariances are not all based on the same subsample.

Alternative 1: smoothing the periodogram

Alternative 2: obtain spectrum from theoretical covariances implied by

ARMA model

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pergram hp_lnsp500_1

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ARMA processes imply certain autocorrelation structures

These can be used to construct the spectral density of the process

Spectrum of an ARMA(p,q) process

P

| 1 qh=1 h exp{i2h} |2

P

f () =

| 1 pj=1 j exp{i2j} |2

imaginary number 1

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arima hp_lnsp500_1, arima(8,0,0)

do armaspec

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