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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

follows:

1.

2.

3.

4.

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)

1

( N ) ( N 1)

N

Then,

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

(u

t 2

ut 1 ) 2

t n

u

t 1

2

t

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

observation is lost in taking successive differences.

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

1.

test

It may give inconclusive results.

2.

3.

3. The Breusch-Godfrey Test

It is a Lagrange Multiplier Test that resolves the drawbacks of the DW test.

Consider the model:

Yt=1+2X2t+3X3t+4X4t++kXkt+ut.

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

+et

Thus, the null and the alternative hypotheses are:

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

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.

DW

n

h 1

2 1 n 2

the h-statistic, which is calculated by:

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

Yt-1=1+2X2t-1+3X3t-1+4X4t-1++kXkt-1+ut-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)

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

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.

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