Applied Financial Econometrics Goh Kim Leng ESGC6328: TOPIC 3 = Data Stationarity, Vector Autoregression (VAR), Cointegration References: Brooks, Chris. (2002). “Introductory Econometrics to Finance”, Cambridge University Press — Chapter 6 and 7. Chong, C.S. and Goh K.L. (2005). “Inter-temporal Linkages of Economic Activity, Stock Prices and Monetary Policy in Malaysia”, Asia-Pacific Journal of Economics & Business, 9(1), 48-61 Ad jonal References: Gujarati, D. (2003). Basic Econometrics, 4" Edition. McGraw-Hill. (Chapter 21). Enders, W. (1995). Applied Econometric Time Series. John Wiley. (Chapter 6). Mansor, Ibrahim. (1996). “Random Walk or Stationarity with Structural-Break in Malaysian Stock Prices: An Empirical Note”, Capital Markets Review, 4(2), 71-81. Perron, P. (1989). “The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis,” Econometrica, 57, 1361-1401.Applied Financial Econometrics Goh Kim Leng, 3.1 Data Stationarity Time series data can be thought of as being generated by a stochastic or random process. They can be stationary or non-stationary. A stochastic process is stationary if: (i) _ Its means is constant over time (ii)_Its variance is constant over time (iii) The value of covariance between two time periods depends only on the distance between the two time periods but not on the actual time at which the covariance is computed. (weakly stationary stochastic process) Let Y, be a stochastic time series with Mean: E ( Xe) > M&M - vance: War (Ye)= © CYe-m) = ce” ; Covariance: ve = € [ee Yee] | : : - MA wl Ed a ie! hme («) (a) +G) not Stabonary (©) Stato nary meApplied Financial Econometrics Goh Kim Leng Let u, be a white noise process where E(w)=0 , Elue)= O E (Usue)=0 set u; is stationary. A random walk process (without drift) is: Yee Yee + Uy Yer Yes + Ue t Ug = ey + Una + Uy + Ue (eZ Uj a Ssuming 4.20 Fs Ely) =0 : —. Jor (4) = LHP) = €(Z Way) « Z ELL )=te Variance is not constant. Y, is not stationary. Tests of Stationarity 1, Autocorrelation Function (ACF) ' 5 Qvariane at lag k : uk ACF Ce Variance =~ Be sles (ks I A Sample AGE: A Be inci:Applied Financial Econometrics Goh Kim Leng where Nee 2C 4-9) Sern ~J n-Kk ts eee n For ao white noise precss, _* Nlo var +) n> eo Corre logram js a plot of k versus é et ie 1 . ACE tapers slowly indi cating non- statonarty BF gpPI SMES P— Tut Yo: Pit Paes = Pm = 0 Hai at least one vedrichion is not true Lyng - Bex Statistic Lee nner) z (BE /n-t) ~v iG. undey > ao N—v0oApplied Financial Eeonometries Gob Kim Leng, 2, Unit Root Tests (a) Dickey-Fuller Test Consider a process Ye = pYuit uy or Y,-Yu=pYur- Yurt AY, =(9- DY + AY, = 8Y.1 + uy 1f8=0, p= 1. Y; follows a random walk (non-stationary). ‘We estimate (1) with OLS NA AY, =8Yi1 and test. Hp:8=0 against Hy: 8<0 Test statistic is: Lae 1=8/se.(8) + resembles a t-statistic, but does not follow a t-distribution under Ho because the variance of the process is not constant. The empirical distribution of t was tabulated by Dickey and Fuller and further developed by a few other researchers including MacKinnon. This test is known as the DF test for presence of unit root. If Hy is rejected, Y, does not contain a unit root, and is stationary. The process is said to be integrated of order zero, or, 1(0).Applied Financial Econometrics Gob Kim Leng. If Hp is not rejected, Y, contains at least one unit root and is non-stationary. Proceed to test for Hy: 8=0 against H,: 8 <0 for the equation: By, -8avatu where a*%e= B% - A%-1 If Hp is rejected, AY, ~ 1(0) or Y; ~ I(1), where I(z) indicates integration order of z. Y; is said to be a difference-stationary process. If Hy is not rejected, this process is repeated with the next higher order of differencing, until a rejection is found. Often the process contains a drift, or, a drift with deterministic time trend: AY, = p+ 8¥ui + yy AY, = pt Btt 8Y.1+ ue The DF test can be applied in the same manner as above. If u, is autocorrelated, then the augmented DF test (ADF test) is applied, based on the following: AY, =8 Yet E AY tu AY, = p+ 8Yu+ = 0, AY,4+ uy AY, = pt Bt+ 8Yi.+ z crv. eeu ‘The ADF test can be applied in the same manner as above, i-e., Test Hy: 5 =0 against Hy: 8<0 using A A 1=8/s.0.(5) The lag length m is determined such that u; is not autocorrelated.Applied Financial Econometrics Goh Kim Leng Altematively, m is determined by choosing the value that minimizes the Akaike Information Criterion (AIC) AIC =n 0? + 2k ot, the Bayesian Schwarz Criterion (BIC) AIC=n 2%? +kinn where (2 = residuals, k = number of parameters including intercept. Because the penalty function for BIC is higher, as, kinn>n BIC tends to choose models that are more parsimonious. (b) Phil ips-Perron (PP) Test The DF test assumes uncorrelated errors with constant variance. The PP test allows for mildly correlated and heteroscedastic errors. The test is based on any of the following regressions: AY, =8 Y,1+ uy AY, =p + 8Y.i + uy AY, = p+ Bt+ 8Yut uy Non-parametric correction on the t statistic is made to test: Hy: 3=0 against Hy: 8<0 The PP test depends on the lag order of estimated ACF for the residuals to be included in the correction. The asymptotic distribution of the PP test statistic is the same as that of the ADF statistic.Applied Financial Econometries Goh Kim Leng (©) Kwiatkowski, Phillips, Schmidt and Shin (KPSS) Test The KPSS test is based on one of these equations: Yi = H+ p¥ea + ue Y, = p+ Bt+ pYurt uy The hypotheses to be tested are: Hp: Y; is trend stationary (stationary around a deterministic trend) Hy: Y; is not trend stationary The model with a time trend can be written as: t Y, =p pt+ o> usiter ai where eis a stationary process and u,~ i,i.d.(0,1). The hypotheses are: Hy:=0 against Hy: #0 (Note that the sum of all past errors represents a random walk). The test statistic is based that for a LM-type test. (d) Unit Root Test with a Structural Break The standard ADF test does not allow for the existence of a structural break in the time series. We consider the unit root test with a structural break in the series proposed by Perron (1989) whereby the breakpoint is treated as exogenous. He employed an adjusted ADF-type unit root test strategy to conduct the test with a break in trend occurring at the Great Crash of 1929 and oil-price shock in 1973. We consider possible changes in both the intercept and slope in the trend function and the regression equation to test for a unit root is as below:Applied Financial Evonometries Goh Kim Leng Ay = H+ B+ ODU, + ODT, + 111+ EA +6, ai where DU,=1ift> Tp, 0 otherwise, DT, =tift> Tp, 0 otherwise. The asymptotic distribution of the t-statistic for testing Hy: y= 0 is given by Perron (1989). To find the percentage points from the distribution, the value of break fraction is defined to be To/n. = Refer to the notes on PPP application for the critical values. Helpful Eviews commands: genr time = @trend(1971Q1) ——~ starts at t=0 at 1971 QL If break is at observation 21, gent DU=(time>21) Example for application of unit root tests: Refer to Part 1 of the application for testing PPP. Spurious Regression Why do we need to establish the stationarity properties of the series? One main reason is to avoid spurious regression, where the significance of a statistical relationship is artificially induced. Consider Y¥, = ay +a, x%+u, Eq. (A) where u, follows a white noise process.Applied Financial Econometrics Goh Kim Leng If Y, ~I(1) and x, ~1(1), then the above regression (Eq. (A)) is said to be spurious. F-statistic and t-statistic for the estimated model will be highly significant, R? tends to 1, and DW statistic tends to be low. Say, Y=Yutuy and x =X FU Assuming Yo = x0 =0, t ‘ YZ uy and =F ay = #1 From Eq. (A), 4 Uyj- Go = Gy 2% Usd uy = Yy =o ~ a X This means var(u,) increases as t increases, ie, the variance is heteroscedastic and could be explosive. The classical assumption is violated and the t- and F-tests are no longer valid statistically. However, if Y; and x; are cointegrated (see Section 3.3), then var(u,) is stable and the classical assumptions are met. In this case, the regression will not be spurious. 10