2017

IMPROVING EFFICIENCY OF EXISTING TIME SERIES

MODELS WITH DISCRETE WAVELET TRANSFORM

Guide: Syed Atif Umar

Authors:

Akash Raj & Sachin Kumar

5/2/2017
Abstract
Banking & financial institutions rely on the
analysis of time series for forecasting economic
indices, elaborating financial market models, and
registering international trade operations. Banks
specifically use time series for CCAR, Stress
Testing, Loss Given Default forecasting.
This contribution provides a review of the most
recent Wavelet applications in the field of time
series and proposes new wavelet analysis methods
in the field of Banking. Wavelets remain unknown in
the field of Banking even though it clearly
overcomes the well-known limits of the classical
Fourier/Time Series Analysis.
In any Time Series Model, if the time dependent
series undergoes a “Wavelet Transformation”, the
efficiency of the model improves significantly
because the transformation decomposes the time
series variables based on their frequency. The
original time series is decomposed through a
process consisting of a number of successive
filtering steps giving Approximation (Low frequency
terms) and Details (High frequency terms). The
individual time series resulting from the
decomposition taken together provides a detailed
view of the underlying process.
Published studies of comparison between
conventional and wavelet models suggest that
wavelet models have a strong generalization ability
and provide more accurate results.
In Banks, Wavelet transformations can be applied to
improve the efficiency of existing time series models
in Risk & Finance management, like CCAR & Loss
Given Default forecasting. It can also be applied to
forecast key performance indicators like sales,
balances & payment rates.
**************************************
Improving Efficiency of Time Series Models with Discrete Wavelet Transform
Introduction
Time Series
Every day large volumes of data are collected
in the form of time series. Time series are
collections of events or observations,
predominantly numeric in nature, sequentially
recorded on a regular or irregular time basis.
Time series are becoming increasingly
important in nearly every organization and
industry, including banking, finance,
telecommunication, and transportation.
Banking institutions, for instance, rely on the
analysis of time series for forecasting economic
indices, elaborating financial market models,
and registering international trade operations.
More and more time series are being used in
this type of investigation and becoming a
valuable resource in today’s organizations.
Nowadays, almost all managerial decisions are
based on forecasts. Every decision becomes
operational at some point in the future, so it
should be based on forecasts of future
conditions.
Forecasts are needed throughout an
organization -- and they should certainly not
be produced by an isolated group. Neither is
forecasting ever "finished". Forecasts are
needed continually, and as time moves on, the
impact of the forecasts on actual performance is
measured; original forecasts are updated; and
decisions are modified, and so on. [17]
1
Due to the indispensable importance of time
series forecasting in numerous practical fields
such as business, economics, finance, science
and engineering, etc. proper care should be
taken to fit an adequate model to the underlying
time series. It is obvious that a successful time
series forecasting depends on an appropriate
model fitting. A lot of efforts have been done
by researchers over many years for the
development of efficient models to improve the
forecasting accuracy. As a result, various
important time series forecasting models have
been evolved in literature.
Time Series Application in Banking &
Financial Institutions
Comprehensive Capital Analysis and Review
(CCAR)
The Comprehensive Capital Analysis and
Review (CCAR) is an annual exercise by the
Federal Reserve to assess whether the largest
bank holding companies operating in the United
States have sufficient capital to continue
operations throughout times of economic and
financial stress and that they have robust,
forward-looking capital-planning processes that
account for their unique risks.
Improving Efficiency of Time Series Models with Discrete Wavelet Transform
The Federal Reserve may object to a BHC’s
capital plan on quantitative or qualitative
grounds. If the Federal Reserve objects to a
BHC’s capital plan, the BHC may not make any
capital distribution unless the Federal Reserve
indicates in writing that it does not object to the
distribution. [12]
Pre-Provision Net Revenue (PPNR)
Modelling
In past cycles of the Federal Reserve’s
Comprehensive Capital Analysis and Review
(CCAR), banks pushed to improve their
modeling for credit losses as a key input for
capital management. More recently the Fed is
pressuring banks to advance their modeling for
pre-provision net revenue (PPNR). Both in
public pronouncements and in private
memoranda to many CCAR banks, the Fed is
expecting progress in two areas:
First, PPNR models are now expected to reach
a level of rigor and consistency in statistical
approach commensurate with previous
advances in loss modeling. Second, banks are
being asked to ensure that their advancements
in PPNR modeling bring capital management
closer to business forecasting and decision-
making. [13]
2

EL = Probability of Default x Exposure at
Default x Loss Given Default
Each of these components is modeled
separately and requires Time Series forecasting.
Balances, early payoff, prepayment,
amortization, involuntary payoff are important
but not technically risk weight parameters.
These are needed for 9 quarters of calculations.
[18]
Why Model Risk Matters?
The Key Benefits for Banks
Model risk arises through errors in the
individual components, through the way they
are put together or in the way they are used.
Thus, data input errors can result in errors in
model outputs. Errors in model specification,
either due to inappropriate conceptual design,
methodology or inaccurate implementation, can
also result in inaccurate model outputs. Finally,
even if data quality is both reliable and
sufficient, and the algorithms are accurate and
properly implemented, model risk can still arise
through misuse of model outputs.
By itself, however, the function of model risk
management might have stayed relatively
obscure in the arcane intersection of risk
management and quantitative finance. What
shot it to prominence in the United States was
Improving Efficiency of Time Series Models with Discrete Wavelet Transform
the Dodd-Frank Act Stress Testing (DFAST)
requirements for stressing bank regulatory
capital under regulatory scenarios for all banks
with assets of $10 billion or more, and the
Comprehensive Capital Analysis and Reporting
(CCAR) requirements for stress testing
scenarios for banks with assets greater than $50
billion. CCAR banks are required to conduct
stress tests using both the Fed-mandated
scenarios as well as idiosyncratic scenarios
designed to measure bank-specific risks.
Ironically, neither DFAST nor CCAR originally
required banks to use models in performing
stress tests. However, since a capital
management framework needs to include credit,
market, operational and liquidity risks under
various scenarios, each stress test must be
sufficiently tailored to capture an organization’s
unique exposures, activities and risks. In
practice, banks used models for estimating their
regulatory capital under these scenarios. They
then aggregated the risks using a calculator or
macro-model to estimate a final capital number.
The below graphic illustrates some of the
critical components of an effective capital
management framework—a framework which
for most banks includes heavy reliance on
models for stress testing their various risks.
3

Inevitably, as banks rely on models to estimate
capital for DFAST and CCAR, regulators
placed increasing emphasis on the governance
(including validation) around the use of models.
In addition, many banks who failed DFAST and
CCAR in the past several years failed in the
areas of governance or model risk management.
Clearly, there are lessons to be learned here.
And the lessons are costly. [11]

Why should Management and the
Board Care?
Simply stated, when models are not properly
built, used or validated, banks lose money.
Here are a few examples that most people will
recognize:
In Banks, time series models are mainly
utilized by Risk Management team for
Comprehensive Capital Analysis and Review
(CCAR) models & Loss Given Default
Forecasting Models

High-Profile Financial Losses Due to CCAR Model Failures [11]

Improving Efficiency of Time Series Models with Discrete Wavelet Transform 4

Wavelet Analysis
Wavelet Analysis Industry wide
Applications
Wavelet transform is now an old story for
signal and image processing specialists. It is
indeed more than thirty years ago, in 1982, that
a French engineer working on seismological
data for an oil company, Jean Morlet, proposed
the concept of wavelet analysis to reach
automatically the best trade-off between time
and frequency resolution. As any discovery in
science, wavelets resulted from numerous
contributions, they are based on concepts that
already existed before Morlet’s idea and,
clearly, it was in the mood of the signal
processing community in the 1980’s. [14]
From beginning, wavelets have found industry
wide applications in Signal Processing, Image
Processing, Bio-Informatics & Time Series
Analysis etc. In this paper we focus on the
Wavelet Transformation applications in Time
Series Modeling.
Wavelet Analysis – Discrete Wavelet
Transform
The Wavelet analysis is similar to Fourier
analysis. In Fourier analysis, signal is broken
into sinusoids of unlimited duration, whereas,
in wavelet analysis, wavelets are used instead
of the sinusoids. Wavelets have waveforms of
limited duration with a mean value of zero. In
wavelet analysis, the wavelet is shifted forward
in steps along full signal. At each step,
correlation of wavelet to the signal is measured.
When the full series is covered, a set of wavelet
coefficients is generated having same
Improving Efficiency of Time Series Models with Discrete Wavelet Transform
consistency in time as that of original signal.
The process is repeated. Thus, sets of wavelet
coefficients at different scales are generated.
Wavelet analysis is multi resolution analysis in
time and frequency domain. The wavelet
transform applies a bank of filters, with varying
frequency and widths, to the data. Wavelet
transforms provide sound mathematical
principles for designing and space filters, and
for making trade-offs between these objectives,
while retaining the original relationships in the
time series. These principles define a set of
filters obtained by rescaling a given function
several times, using what is often called a
mother wavelet, which is compressed or
expanding in the time domain to produce
wavelets.
First, original time series can be decomposed
into a certain number of sub-time series
{W1,W2,…,WP,CP} by wavelet transform
algorithm. W1,W2,…,WP are detail time series,
and CP is background time series. These play
different role in the original time series and the
behavior of each sub-time series is distinct. So
the contribution to original time series varies
from each other.
DWT (Discrete Wavelet Transform) operates
as set of two functions or filters i.e. high pass
and low pass filter. The original time series is
decomposed through a process consisting of a
number of successive filtering steps giving
a) Approximation (Low frequency terms)
b) Details (High frequency terms)
The individual time series resulting from the
decomposition taken together can provide a
detailed picture of the underlying process.
5
The main advantage of using the wavelet
method is its robustness since it does not
include any potentially erroneous assumptions
or parametric testing procedures. Another
advantage of the wavelet method is that wavelet
variance decomposition allows one to study
different investing behavior in different time
scales independently. A good illustration on
wavelet analysis can be found in the books of
Debnath (2010) and Rao (2004) [Ref 9, 10].
The base “Time Series Wave” undergoes first
level of decomposition via high & low pass
filters to produce D1 & A1. The A1 wave
seems to be a more smoothened curve than the
base time series. Similarly, A1 further
undergoes second & third level of
decomposition to produce D2 & D3. The
remaining background time series left is A3
which is a very smooth trend compared to the
base series.

How Wavelet Transformations can be
used in models?
An example of the wavelet decomposition can
be viewed from the Figure 1.
In the model, instead of using the base “Time
Series Wave”, we use the wavelets D1, D2 &
D3 along with the remaining background time
series A3 which left after decomposition.

Figure 1: Flow Chart for Decomposition of Time Series Wave

Improving Efficiency of Time Series Models with Discrete Wavelet Transform 6

Proven Research said to perform better, several research papers
state that the Wavelet Transformations based
regression models have out-performed the ANN
models in performance and accuracy.

Below are a couple of studies highlighting the

improvement in model performance due to
DWT transformation.

Case Study-1 : Hydrology

An abstract from a research paper of Springer,

one of the best international journals, clearly
The proposed technique has been tested
states the effectiveness of Wavelet Regression
positive in the field of signal processing,
model over Neural Network model. [Ref 1]
hydrology, geology, electronics, electrical
powers and even a few financial models.
Cited Abstract: Wavelet Regression Model as
an Alternative to Neural Networks for River
Wavelet Analysis however remains unknown
Stage Forecasting
in the field of Banking even though it clearly
overcomes the well-known limits of the
River stage forecasting is an important issue in
classical Fourier / Time Series analysis.
water resources management and real-time
prediction of extreme floods. The present study
In any Time Series Model, if the time
investigates the performance of the wavelet
dependent series undergoes a “Wavelet
regression (WR) technique in Daily River stage
Transformation”, improves the efficiency of
forecasting. The WR model was improved
the model significantly, because the
combining two methods, discrete wavelet
transformation decomposes the time series
transform and a linear regression model. Two
variable based on their frequency.
different WR models were developed using the
stage sub-time series, and these were compared
Many researchers have done a significant
with each other. The data from two stations on
amount of work in wavelet transformation
the Schuylkill River in Philadelphia were used.
application in models. We have cited a few
The root mean square errors (RMSE), mean
examples / published research as evidence
absolute errors (MAE) and correlation
supporting the claim. A few others are also
coefficient (R) statistics were used for
mentioned in the reference [Ref 1,2,5,7].
evaluating the accuracy of the WR models. The
accuracy of the WR models was then compared
Artificial Neural Networks are said to perform
with those of the artificial neural networks
empirically better than traditional multiple
(ANN) models. Based on a comparison of these
linear regression and auto regression models
results, the WR models were found to perform
due to its learning algorithms. While ANNs are
better than the ANN models. For the upstream
Improving Efficiency of Time Series Models with Discrete Wavelet Transform 7
and downstream stations, it was found that the wavelet transform is the central element of this
WR models with upstream readings of with paper. The proposed forecasting model uses the
RMSE = 0.070, MAE = 0.027, R = 0.937 and Discrete Wavelet Transform to decompose the
with downstream readings of RMSE = 0.048, financial time series data. The obtained
MAE = 0.024, R = 0.969 in the validation stage approximation and detail coefficients after
performed better in forecasting daily river decomposition of the original time series data
stages than the best accurate ANN models with are used as input variables of back propagation
upstream readings of RMSE = 0.168, MAE = neural network to forecast future stock prices.
0.052, R = 0.802 and with downstream Approximation coefficients can characterize the
readings of RMSE = 0.115, MAE = 0.051, R = coarse structure of the data and detail
0.807, respectively. coefficients capture ruptures, discontinuities
and singularities in the original data, to
The results from the paper, a comparison of recognize the long-term trends in the original
ANN & WR models is shown in below Table data.
Findings: The proposed model was applied to
Model Station R RMSE MAE
five datasets. For all of the datasets, accuracy
Wavelet Upstream 0.937 0.070 0.027
Regression measures showed that the presented model
Model Downstream 0.969 0.048 0.024
outperforms a conventional model. It also
Neural Upstream 0.802 0.168 0.052
Network
proved that the hybrid forecasting technique
Model Downstream 0.807 0.115 0.051 has achieved better results compared with the
approach which is not using the wavelet
Case Study-2 : Stock Market Price transform.

An abstract from another research paper from The results from the paper, a comparison of
“Indian Journal of Science and Technology”, BPNN & BPNN with DWT models are shown
states that Wavelet Transformations improve in below Table
performance & reduces error of base
Artificial Neural Network model
significantly. [Ref 15]

Cited Abstract: Prediction of Stock Market

Price using Hybrid of Wavelet Transform and
Artificial Neural Network

Accurate prediction of stock market is highly

challenging. This paper presents a forecasting
model based on Discrete Wavelet Transform
(DWT) and Artificial Neural Network (ANN)
for predicting financial time series.
Methods/Statistical analysis: The idea of
forecasting stock market prices with discrete
Improving Efficiency of Time Series Models with Discrete Wavelet Transform 8
A few other research studies stating the
improvement in model performance of Auto
Regression, ARIMA & Neural Network
Models:
Few Other Research Studies
Stochastic simulation model for non-stationary
time series using an autoregressive wavelet
1.
decomposition: Applications to rainfall and
temperature [2]
Day-Ahead Electricity Price Forecasting Using
2. the Wavelet Transform and ARIMA Models
[5]
Wavelet Network Model and Its Application to
3.
the Prediction of Hydrology [7]
Financial Time Series Forecasting Using
4.
Improved Wavelet Neural Network [16]
Scope in Banking
In Banks, there are many existing time series
models especially with Risk & Finance to
forecast sales, balances, revenues, loss given
defaults (LGDs) etc. We can leverage the
proposed technique to improve the performance
of the existing time series models in terms of
efficiency and error reduction.
One of the major applications of the time series
model can be found in CCAR. CCAR annual
stress test of capital adequacy of big US banks
is an area where time series modelling is widely
used to understand the impact of
macroeconomic changes on bank’s balance
sheet.
As the wavelet transformation of variables
yields better results, the CCAR prediction of
risk variables can be used to improve the
efficiency of prediction.
Improving Efficiency of Time Series Models with Discrete Wavelet Transform
Following table lists the Opportunity Areas in
Banks where Wavelet Transformations can be
used along with Time Series Models.
Risk Finance / Decision
Management Management
Product based sales/balance
CCAR
forecast
Sales and Balance Specific products / Number of
Forecasting Accounts forecast
Campaign Month over Month
Loss Given Defaults
sales
Macro-Economic
Payment Rate Forecast
Indicators
**************************************
Conclusion
Forecasting in Banks through mathematical
time series models like Auto Regression,
ARMA, ARIMA, etc. is very difficult as they
depend upon too many variables and their
interrelationships. Therefore, in recent past,
many data-driven models have been developed
for the purpose.
In the present paper, the efficiency of wavelet
technique- one of the data-driven techniques, is
proposed in modeling and forecasting Assets &
Liabilities.
On the basis of other mathematical researches it
is established that the Wavelet based models
(i.e. ensemble Discrete Wavelet Transformed
variables into base time series) may provide a
superior alternative for developing input–output
simulations and forecasting. A performance
comparison of Wavelet models suggested its
superiority over any base time series model.
9
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Alternative to Neural Networks for River Stage
Forecasting. Water Resource Manage (2011)
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[2] Kwon HH, Lall U, Khalil AF (2007) Stochastic
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[12] Comprehensive Capital Analysis and Review
2016: Assessment Framework and Results
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FRISBIE AND Jonathan WEST
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content/uploads/2014/11/NR_vol5no3_CCAR_v
f.pdf
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nd_multiresolution_based_signal-
image_processing_a_review
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Sivanandam, (2016) Prediction of Stock Market
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Artificial Neural Network, Indian Journal of
Science and Technology, Vol 9(8), DOI:
10.17485/ijst/2016/v9i8/87905, February 2016,
ISSN (Online) : 0974-5645
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[7] Journal of Computational Intelligence in France

1997:1-17
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Improving Efficiency of Time Series Models with Discrete Wavelet Transform 10