Vectorautoregressive- VAR Models

and Cointegration Analysis

Time Series Analysis
Dr. Sevtap Kestel

VECTOR TIME SERIES

VECTOR TIME SERIES

Vectorautoregression

Vector autoregression (VAR) is an econometric model used to capture the evolution

and the interdependencies between multiple time series, generalizing the univariate
AR Models. All the variables in a VAR are treated symmetrically by including for each
variable an equation explaining its evolution based on its own lags and the lags of all
the other variables in the model.
A VAR model describes the evolution of a set of k variables measured over the same
sampleperiod (t T) as a linear function of only their past evolution.
The variables are collected in a k x 1 vector yt, which has as the ith element yi,t , the
time t observation of variable yi.
For example, if the ith variable is GDP, then yi,t is the value of GDP at t.
A (reduced) p-th order VAR, VAR(p), is

yt c A1 yt 1 A2 yt 2 ... Ap yt p t
where c is a k x 1 vector of constants (intercept)
Ai is a k x k matrix (for every i = 1, ..., p) and
t is a k x 1 vector of error terms satisfying the conditions.
Properties:

E[ t ] 0 every error term has mean zero

E[ t t ] the contemporaneous covariance matrix of errors
E[ t tk ] 0
Order of integration of the variables
Note that all the variables used have to be of the same order of integration.
We have the following cases:
All the variables are I(0) (stationary):
one is in the standard case, ie. a VAR in level

All the variables are I(d) (non-stationary) with d>1:

The variables are conintegrated: the error correction term has to be included in the
VAR.
The model becomes a Vector error correction model (VECM) which can be seen as a
restricted VAR.
The variables are not cointegrated:
the variables have first to be differenced d times and one has a VAR in difference

Example: VAR(1)
Suppose {y1t}tT denote real GDP growth, {y2t} tT denote inflation

y1t c1 A11
y c A
2t 2 21

A12 y1,t 1 1t

A22 y2,t 1 2t

y1t c1 A11 y1,t 1 A12 y2,t 1 1t

y2t c2 A21 y1,t 1 A22 y2,t 1 2 t
One equation for each variable in the model.
The current (time t) observation of each variable depends on its own lags
as well as on the lags of each other variable in the VAR.

VAR(1) PROCESS
Example:
1.1 0.3
Yt
Yt 1 Z t

0.6 0.2
1.1 0.3
I

0
.
6
0
.
2

det I 1.1 0.2 0.60.3

2 1.3 0.4 0
1 0.8, 2 0.5

The process is stationary.

8

Structural VAR (SVAR) with p lags

B0 yt c0 B1 yt 1 B2 yt 2 ... B p yt p et
where c0 is a k x 1 vector of constants, Bi is a k x k matrix, i = 0, ..., p, and
et is a k x 1 vector of error terms.
The main diagonal terms of the B0 matrix (the coefficients on the ith
variable in the ith equation) are scaled to 1.
The error terms et (structural shocks) satisfy the conditions and
particularity that all the elements off the main diagonal of the covariance
matrix E(etet') = are zero. That is, the structural shocks are
uncorrelated.

IMPULSE RESPONSE FUNCTION

The key tool to trace short run effects with an SVAR is
the impulse response function.
yt c A1 yt 1 A2 yt 2 ... Ap yt p t

can be expressed as MA()

yt c t 1 t 1 2 t 2 ... ( B) t

yt l
l
'
t
the row i , column j element of

identifies the consequences of a one-unit increase in the jth variables innovation at

date t (tj) for the value of the ith variable at time t+l, holding all other innovations
at all dates constant. A plot of the row i, column j element of as a function of lag l is
called the non-orthogonalized impulse response function.

GRANGER CAUSALITY
In time series analysis, sometimes, we would
like to know whether changes in a variable will
have an impact on changes other variables.
To find out this phenomena more accurately,
we need to learn more about Granger
Causality Test.

12

GRANGER CAUSALITY
In principle, the concept is as follows:
If X causes Y, then, changes of X happened
first then followed by changes of Y.

13

GRANGER CAUSALITY
If X causes Y, there are two conditions to be
satisfied:
1. X can help in predicting Y. Regression of X on Y
has a big R2
2. Y can not help in predicting X.

14

COINTEGRATION

Cointegration
In many time series, integrated processes are
considered together and they form equilibrium
relationships.
Short-term and long-term interest rates
Income and consumption

These leads to the concept of cointegration.

The idea behind the cointegration is that
although multivariate time series is integrated,
certain linear transformations of the time
series may be stationary.
16

SPURIOUS REGRESSION
If we regress a y series with unit root on
regressors who also have unit roots the usual t
tests on regression coefficients show statistically
significant regressions, even if in reality it is not
so.
The Spurious Regression Problem can appear
with I(0) series
In a Spurious Regression the errors would be
correlated and the standard t-statistic will be
wrongly calculated because the variance of the
errors is not consistently estimated. In the I(0)
case the solution is:

t t - distributi on , where (long - run varian ce of )1/2

17

SPURIOUS REGRESSION
Typical symptom: High R2, t-values, F-value, but low DW
1. Egyptian infant mortality rate (Y), 1971-1990, annual data,
on Gross aggregate income of American farmers (I) and
Total Honduran money supply (M)
Y ^ = 179.9 - .2952 I - .0439 M, R2 = .918, DW = .4752, F = 95.17
(16.63) (-2.32) (-4.26) Corr = .8858, -.9113, -.9445
2. US Export Index (Y), 1960-1990, annual data, on Australian
males life expectancy (X)
Y ^ = -2943. + 45.7974 X, R2 = .916, DW = .3599, F = 315.2
(-16.70) (17.76)
Corr = .9570
18

Cointegration
If two or more series are themselves non-stationary, but a linear combination
of them is stationary, then the series are said to be cointegrated.

Example:
A stock market index and the price of its associated follow a random walk by time. Testing
the hypothesis that there is a statistically significant connection between the futures price
and the spot price could now be done by testing for a cointegrating vector.
The usual procedure for testing hypotheses concerning the relationship between nonstationary variables was to run Ordinary Least Squares (OLS) regressions on data
which had initially been differenced.
Although this method is correct in large samples, cointegration provides more
powerful tools when the data sets are of limited length, as most economic time-series
are.
The two main methods for testing for cointegration are:
The Engle-Granger three-step method.
The Johansen procedure.

Granger Causality
According to Granger, causality can be further subdivided into long-run and short-run causality.
This requires the use of error correction models or
VECMs, depending on the approach for determining
causality.
Long-run causality is determined by the error
correction term, whereby if it is significant, then it
indicates evidence of long run causality from the
explanatory variable to the dependent variable.
Short-run causality is determined as before, with a test
on the joint significance of the lagged explanatory
variables, using an F-test or Wald test.
20

Granger Causality
Before the ECM can be formed, there first has to
be evidence of cointegration, given that
cointegration implies a significant error
correction term, cointegration can be viewed as
an indirect test of long-run causality.
It is possible to have evidence of long-run
causality, but not short-run causality and vice
versa.
In multivariate causality tests, the testing of longrun causality between two variables is more
problematic, as it is impossible to tell which
explanatory variable is causing the causality
through the error correction term.
21

Engle-Granger Approach
Estimation of parameters can be done by OLS estimation of
linear regression equation:

Yt 0 1Y2t .. MYMt t
Dickey-Fuller t test is applied to the OLS residuals

Rejecting the null hypothesis of non-stationarity concludes cointegration

relationship does exist.

Three-step approach
Determine the I(d) for every variable
Dickey Fuller, Perron tests H0: series is non-stationary
Estimate the cointegration relation by OLS regression
Test the residuals for stationarity
y1t 0 1 y2 t t t y1t 0 1 y2 t
y y
t

1t

2t

H0: series are not cointegrated

ADF Test does not give correct critical values because of the OLS
residuals

we use MacKinnon Table to determine the critical values

Multicointegration extends the cointegration technique beyond

two variables, and occasionally to variables integrated at
different orders.

Error Correction Model

Granger Representation Theorem
Determination of the dynamic relationship between
cointegrated variables in terms of their stationary error
terms.For bivariate case: Two integrated I(1) variables

y1t

and

y 2t

yielding one cointegrated combination

p 1

y1t 1 t 1 (a11 i y1t i a12 i y2 t i ) 1t

i 1

I (0)

p 1

y2 t 2 t 1 ( a21i y1t i a22 i y2 t i ) 1t

i 1

Estimate parameters by OLS.

Regression with only stationary variables on both sides.

Multivariate Cointegration Analysis - Johansen Test

VAR(1) having M I(1) variables can be expressed as:
Yt Yt 1 t

where: Y, and are (Mx1) vectors and is a (MxM) matrix

Johannsen Test
The approach of Johansen is based on the maximum likelihood
estimation of the matrix ( - I) under the assumption of normal
distributed error variables. Following the estimation the
hypotheses
H0: r = 0, H0: r = 1, , H0:r = M-1
are tested using likelihood ratio (LR) tests.

The Johansen Trace and Maximal

Eigenvalue Tests
To test whether the variables are cointegrated
or not, one of the well-known tests is the
Johansen trace test. The Johansen test is used
to test for the existence of cointegration and is
based on the estimation of the ECM by the
maximum likelihood, under various
assumptions about the trend or intercepting
parameters, and the number k of
cointegrating vectors, and then conducting
likelihood ratio tests.
26

Example: Exchange rate, interest rates, S&P 500(GLOBAL) index, ISE index

Series: GLOBAL EXCHANGE_RATE INTEREST_RATE ISE

Trace Test
Lags interval (in first differences): 1 to 4

Hypothesized

Trace

0.05

No. of CE(s)

Eigenvalue

Statistic

Critical Value

Prob.**

None *

0.065285

156.7717

47.85613

0.0000

At most 1 *

0.017048

38.96042

29.79707

0.0034

At most 2

0.005118

8.955273

15.49471

0.3695

At most 3

1.20E-06

0.002096

3.841466

0.9599

Trace test indicates 2 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized

Max-Eigen

0.05

No. of CE(s)

Eigenvalue

Statistic

Critical Value

Prob.**

None *

0.065285

117.8113

27.58434

0.0000

At most 1 *

0.017048

30.00514

21.13162

0.0022

At most 2

0.005118

8.953177

14.26460

0.2901

At most 3

1.20E-06

0.002096

3.841466

0.9599

Max-eigenvalue test indicates 2 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

1 Cointegrating Equation(s):

Log likelihood

-46009.85

Normalized cointegrating coefficients (standard error in parentheses)

GLOBAL

EXCHANGE_R
ATE

INTEREST_RAT
E

ISE

1.000000

-0.000120

-16.55210

-0.026394

(0.00014)

(1.44457)

(0.00218)

Log likelihood

-45994.85

2 Cointegrating Equation(s):

Normalized cointegrating coefficients (standard error in parentheses)

GLOBAL

EXCHANGE_R
ATE

INTEREST_RAT
E

ISE

1.000000

0.000000

-15.66567

-0.024910

(1.30729)

(0.00194)

7382.376

12.36210

(1649.84)

(2.44689)

0.000000

1.000000

Therefore, we can conclude that in

the long term these three variables
are cointegrated and there are 2
cointegration equations

Pairwise Granger Causality Tests

Date: 07/20/08 Time: 10:40

Granger Causality Test:

In order to compare
pairwise variables
Granger Causality Tests is
used

Sample: 1/02/2001 12/31/2007

Lags: 5
Null Hypothesis:

INTEREST_RATE does not Granger

Cause EXCHANGE_RATE

Obs

F-Statistic

Probability

174
5

28.3482

1.1E-27

32.1459

2.0E-31

58.2545

3.6E-56

2.31559

0.04151

21.4690

6.7E-21

1.16105

0.32611

12.2991

9.7E-12

0.10286

0.99158

2.98831

0.01084

1.48645

0.19105

20.7727

3.3E-20

1.91422

0.08894

EXCHANGE_RATE does not Granger Cause

INTEREST_RATE
ISE does not Granger Cause EXCHANGE_RATE

174
5

EXCHANGE_RATE does not Granger Cause ISE

GLOBAL does not Granger Cause
EXCHANGE_RATE

174
5

EXCHANGE_RATE does not Granger Cause GLOBAL

ISE does not Granger Cause INTEREST_RATE

174
5

INTEREST_RATE does not Granger Cause ISE

GLOBAL does not Granger Cause INTEREST_RATE

174
5

INTEREST_RATE does not Granger Cause GLOBAL

GLOBAL does not Granger Cause ISE
ISE does not Granger Cause GLOBAL

174
5

ARDL APPROACH TO
COINTEGRATION

AUTOREGRESSIVE DISTRIBUTED LAGS (ARDL)

APPROACH

In regression analysis if model includes both

current and lagged values for independent
variables it is called distributed lags model and
if model also includes lagged values of
dependent variable it is called as
autoregressive model (Gujarati, 2004).

AUTOREGRESSIVE DISTRIBUTED LAGS (ARDL)

APPROACH

Autoregressive distributed lags method allows us

to express cointegrated behavior of variables
which have different order of integration.
ARDL procedure is irrespective whether variables
used in model are I(0), I(1) or mutually
cointegrated (Peseran et al., 2001).

ARDL MODEL REPRESENTATION

BOUNDS TESTING PROCEDURE

Cointegration test for ARDL method is applied

through bound testing procedure
In this test there are two set of asymptotic values
which assume that all variables are I(1) in one set
and I(0) in another. These two sets provide critical
value bounds for cointegration for both I(1) and
I(0) data sets.

BOUNDS TESTING PROCEDURE

For applying ARDL procedure 3 steps are required as:

Applying bounds testing procedure for detecting
cointegration ranks between variables
Estimating long run relationship coefficients with respect
to cointegration relations estimated in first step and
Estimating short run dynamic coefficients through vector
error correction modeling.

BOUNDS TESTING PROCEDURE

DECISION RULE FOR THE TEST

Test on the null hypothesis through an F-statistics and the critical
values calculated by Peseran et al. (2001)
It is assumed that lower bound critical values could be used for I(0)
variables and upper bound critical values are used for I(1) variables.
if computed F-statistics is less than lower bound critical values the null
hypothesis is rejected that there is no long run relationship between
variables
if computed F-statistics is greater than the upper bound value, it could be
claimed that variables used in the model are cointegrated.
if computed F-statistic falls between the lower and upper bound values,
then the test results are inconclusive

EXAMPLE OF BOUNDS TESTING PROCEDURE

Cointegration hypothesis

F-statistics

F(CON|GDP,IND,LOS,PRICE,URB)

3.1012**

F(GDP|CON,IND,LOS,PRICE,URB)

6.3478*

F(IND|CON,GDP,LOS,PRC,URB)

7.2093*

F(LOS|CON,GDP,IND,PRICE,URB)

1.8595

F(PRC|CON,GDP,IND,LOS,URB)

5.5008*

F(URB|CON,GDP,IND,LOS,PRC)

0.88845

significance at 1%, ** at 2.5% levels with respect to Pesaran and Pesaran (1997)
critical values.
*

Bounds Test results indicates that there are four cointegated relations when
dependent variables are selected as annual electricity consumption, GDP,
industry value added and mean adjusted annual average electricity prices

EXAMPLE OF BOUNDS TESTING PROCEDURE

VECTOR ERROR CORRECTION MODELS

After implementing Bounds-Testing procedure to determine cointegrating
relationships, short and long run coefficients and related Error Correction
Models (ECM) have been estimated within ARDL method whose orders
are selected with respect to Schwarz Information Criterion (SIC).
In other words, vector error correction could be described as a restricted
vector autoregression, used for cointegrated nonstationary variables.
VECM is useful for determining short term dynamics between variables by
restricting long run behavior of variables. It restricts long run relationships
through their cointegrating relations and error correction term represents
the deviation from long run equilibrium.

VECTOR ERROR CORRECTION MODELS

EXAMPLE FOR ESTIMATING COEFFICIENTS

The long run coefficient estimates and ECM. Dependent variable CONS, ARDL(3,2,2,3,3,3)
(a) Estimated Long Run Coefficients
Regressor
Coefficients
Standard Error
T-Ratio (Prob*1%,**5%)
GDP
0.0020823
0.1058E-3
19.6864*
IND
-0.50248
0.052200
-9.6260*
LOS
1.9291
0.059938
32.1848*
PRC
-0.17769
3.6958
-0.048078*
URB
1977.1
104.0641
18.9993*
Constant
-627.1865
37.8846
-16.5551
(a) Error Correction Representation for the ARDL Model
CON(-1)
1.1063
0.23387
4.7303*
CON(-2)
0.63176
0.18166
3.4777*
GDP
0.0027787
0.4203E-3
6.6117*
GDP(-1)
-0.0017604
0.4911E-3
-3.5848*
IND
-0.74040
0.14494
-5.1084*
IND(-1)
0.42188
0.13797
3.0579*
LOS
2.7343
0.44020
6.2116*
LOS(-1)
-0.035601
0.46645
-0.076323(.940)
LOS(-2)
-2.0454
0.49798
-4.1074*
PRC
-21.6140
6.7027
-3.2247*
PRC(-1)
-14.7163
6.7179
-2.1906**
PRC(-2)
-19.7450
8.4128
-2.3470**
URB
2992.8
1910.6
1.5664(.132)
URB(-1)
141.2130
2060.3
0.068541(.946)
URB(-2)
-5826.9
1823.4
-3.1957*
INTERCEPT
-1286.2
192.2404
-6.6905*
ECM(-1)
-2.0507
0.30552
-6.7122*

EXAMPLE FOR ESTIMATING COEFFICIENTS

REFERENCES

Pesaran, M.H., Shin, Y., Smith, R.J.,2001. Bounds testing approaches to the analysis of
level relationships. Journal of Applied Econometrics. 16, 289-326.
Pesaran M.H., and Pesaran B.,1997. Working with Microfit 4.0: interactive econometric
analysis. Oxford University Press.
Hamilton J.D.A., 1994. The time series analysis. New Jersey, Princeton University Press.
Engle, R.F., Granger, C.W.J, 1987. Co-integration and error correction: Representation,
estimation and testing. Econometrica. 55, 251-276.
World Bank Statistics Service (data resource). Available at: http://data.worldbank.org/
(Accessed: 4.29.2013).
TEIAS Electricity Statistics (data resource). Available at:
http://www.teias.gov.tr/istatistikler.aspx (Accessed: 4.29.2013).