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How to detect and correct Autocorrelation?

Submitted By- Bahirat Shraddha Dhananjay (14AR91R01)

Research Methodology
In statistics, the autocorrelation of a random process describes the correlation
between values of the process at different points in time, as a function of the
two times or of the time difference. Autocorrelation occurs in time-series
studies when the errors associated with a given time period carry over into
future time periods.

Detecting Autocorrelation:
There are two ways of detecting autocorrelation- First is the informal way
which is done through graphs and hence called the graphical method.
The second is through formal tests for autocorrelation, which are as

The Durbin Watson Test

Run Test
The Breusch-Godfrey Test
The Durbins h Test (for the presence of lagged dependent variables)

1. Run test
A run is defined as uninterrupted sequence of one symbol or attribute,
such as + or - . The length of the run is defined as the number of element
in it.
If, N: total number of observations
N1: number of + symbols (i.e. + residuals)
N2: number of symbols (i.e. residuals)
R: number of runs
2 N N (2 N N N )
2 N1 N 2
R2 1 2 2 1 2
E ( R)
( N ) ( N 1)
If the null hypothesis of randomness is sustainable, following the
properties of the normal distribution, we should expect that: Prob [E(R)
1.96 R R E(R) 1.96 R]. Hypothesis: do not reject the null hypothesis
of randomness with 95% confidence if R, the number of runs, lies in the
preceding confidence interval; reject otherwise.
2. Durbin and Watson Test

t n

t 2

ut 1 ) 2

t n

t 1


It is simply the ratio of the sum of squared differences in

successive residuals to the RSS. The number of observation is n-1 as one
observation is lost in taking successive differences.

Steps for testing autocorrelation through Durbin and Watson test:

Step 1: Estimate the model by OLS and obtain the residuals
Step 2: Calculate the DW statistic
Step 3: Construct the table with
the calculated DW statistic and the
dU, dL, 4-dU and 4-dL critical values.
Step 4: Conclude


Drawbacks of the Durbin and Watson

It may give inconclusive results.


It is not applicable when a lagged dependent variable is used.


It cant take into account higher order of autocorrelation.

3. The Breusch-Godfrey Test
It is a Lagrange Multiplier Test that resolves the drawbacks of the DW test.
Consider the model:
Where: ut=1ut-1+ 2ut-2+3ut-3 ++ put-p +et
Combining those two we get:
Yt=1+2X2t+3X3t+4X4t++kXkt +1ut-1+ 2ut-2+3ut-3 ++ put-p
Thus, the null and the alternative hypotheses are:

H0: 1= 2== p=0 no autocorrelation

Ha: at least one of the s is not zero, thus, autocorrelation

Steps for testing autocorrelation through Durbin and Watson test:

Step 1: Estimate the model and obtain the residuals
Step 2: Run the full LM model with the number of lags used being
determined by the assumed order of autocorrelation.
Step 3: Compute the LM statistic = (n-)R2 from the LM model and
compare it with the chi-square critical value.
Step 4: Conclude
4. The Durbins h Test (for the presence of lagged dependent variables)
When there are lagged dependent variables (i.e. Yt-1) then the DW test is
not applicable.

h 1

2 1 n 2

Durbin developed an alternative test statistic, named

the h-statistic, which is calculated by:

Where sigma of gamma hat square is the variance of the estimated

coefficient of the lagged dependent variable. This statistic is distributed
following the normal distribution.
Resolving Autocorrelation:
There are two different cases for resolving Autocorrectional
When the value of is known.
When the value of is not known.
Consider the model: Yt=1+2X2t+3X3t+4X4t++kXkt+ut .
Where ut=1ut-1+et

When the value of is known:

For the model of t-1:

Multiply both sides by to get
Yt-1= 1+ 2X2t-1+ 3X3t-1+ 4X4t-1 ++ kXkt-1+ ut-1
Subtract those two equations:
Yt-Yt-1= (1-)1+ 2(X2t-X2t-1)+ 3(X3t-X3t-1)+ + k(Xkt-Xkt-1)+(ut-ut-1)

Or Y*t= *1+ *2X*2t+ *3X*3t++ *kX*kt+et

Where now the problem of autocorrelation is resolved because et is no longer autocorrelated.

When the value of is not known:

The Cochrane-Orcutt iterative procedure:

Step 1: Estimate the regression and obtain residuals
Step 2: Estimate from regressing the residuals to its lagged terms.
Step 3: Transform the original variables as starred variables using the
obtained from step 2.
Step 4: Run the regression again with the transformed variables and
obtain residuals.
Step 5 and on: Continue repeating steps 2 to 4 for several rounds until
(stopping rule) the estimates of from two successive iterations differ by
no more than some preselected small value, such as 0.001.