EFIM0005 - QUANTITATIVE METHODS FOR FINANCE

AND INVESTMENT
Time Series Analysis (Summary)
1. First of all, we need to check whether the time series variables we are
dealing with are stationary or nonstationary.
2. We can do this using DF, ADF test. There is Phillips Peron (PP) test
as well, which is more useful in case of heteroscedastic models.
3. In order to decide whether to include a time trend in the DF, ADF,
PP test or not, we need to plot the data as a time series line graph. If
there is clear upward/downward trend in the data, we need to include
trend in our DF, ADF test statistics.
4. Remember the specification, when we test for non-stationarity for yt , we
use the regression of ∆yt on the lag of yt and some other autoregressive
explanatory variables. This is because we use the transformed equation.
It is easy to confuse, and read this as testing stationarity of ∆yt , which
is incorrect. If we want to test for stationarity of ∆yt , the regression
that we run for DF, ADF test is ∆2 yt on the lag of ∆yt (and some
autoregressive terms for ADF test).
5. We need to make sure that we are comparing the t-statistic with the
DF critical values (with trend, without trend, they are different).
6. If we find that the variables we are interested in are stationary (we reject
the null of non-stationary), we can use ARMA in case of single variable
estimation, and/or VAR if we are dealing with multiple stationary series
to explore causal effects. The standard procedure for selecting the lag
order will follow.
7. In case of single variable analysis, where our variable of interest is
nonstationary, we can use arima, where the middle order specifies the
integrated order of the series. With this specification, software like
stata will make the variable stationary and do ARMA regression on
the stationary variable.
8. If we find that all our variables of interest are non-stationary for more
than one variable analysis, we need to follow cointegration analysis.

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 9. In case of non-stationary variables, we need to take first difference, then
test for non-stationarity of the first differenced series using DF/ADF
test. If the first differenced series is stationary, we say our variables
if interest are I(1). If the first differenced series is non-stationary, we
need to repeat the testing for the second difference, and so on, until
we reach a stationary series. This helps us to determine the order of
integration of our variables of interest (the level variable, e.g., yt ).

10. If our sets of variables are all I(1), we run the regression yt = b0 +
b1 xt + b2 zt + ut . Then we estimate the error term from the regression
ût and check whether ût is stationary or not using DF/ADF test.

11. If ût is stationary, we say our regression using I(1) variables is valid,
it shows the cointegrating relationship/ long run/ equilibrium relation-
ship (It is not a spurious regression as in the wet weather, inflation
example).

12. The above process is called Engle-Granger first step.

13. Since our variables of interest were all I(1), we can have valid relation-
ships estimated using their first differences (as the first differences are
I(0), or stationary).

14. The regression in terms of the first differenced series is called the short
run regression.

15. We add the first lag of ût in the set of independent variables in the short
run regression. This is called the error correction term. The estimated
coefficient associated with this shows the speed of adjustment towards
the equilibrium/long run relationship.

16. We check the coefficient of the lagged error term whether it is negative,
statistically significant and less than one in absolute value. If these
are satisfied, cointegration is confirmed, as any short run deviation is
corrected to lead us towards the valid long run relationship.

17. The short run model with stationary variables (the first differences
of the I(1) variables) needs to be fit following the ARMA lag order
selection process. Since it is stationary variables that we consider here,
we try to fit including more lags of the dependent and independent

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 variables. We can follow general to specific methodology as well to
choose which lags we should include, which we should not, in our ECM
(short run) model.

18. The Engle-Granger procedure is valid for testing single cointerating

relationship. However, if there are multiple variables, like p, m and y,
there can be maximum 3-1=2 independent cointegrating relationships.

19. The general case is called VECM, vector error correction model, which
is similar to VAR, but now we are dealing with non-stationary vari-
ables. In case of VECM, first we need to check for the number of
cointegrating relationships using Johansen test. Then we set appropri-
ate lag orders for VECM (same as VAR), impose some restrictions to
identify our cointegrating relationships, and estimate the long run and
short run ECM models simultaneously. Similar to VAR, we can show
impulse response function (irf) and variance decomposition to analyze
our multi-variable results. All these relating VECM are out of the scope
of this course.