FINANCIAL ECONOMETRICS

TIME SERIES ANALYSIS

Time Series Analysis 1

1.1 TIME SERIES

A time series is a sequential set of data points, measured typically over successive times with
equal periodicity
• Reserve banks record interest rates and exchange rates each day
• The government statistics department will compute the country’s gross domestic product on a yearly basis
• Newspapers publish yesterday’s noon temperatures for capital cities from around the world

Time Series Analysis 2

1.2 Why Time Series Analysis?

• Time series analysis comprises methods for analyzing time series data in order to extract
meaningful statistics and other characteristics of the data

• It is used when we only have one variable, eg. Stock Price, measured at equal intervals of
time
Approved
• Furthermore, it is also possible that the factors that determine a particular variable are not
identifiable, in which case we can use time series analysis
Not
Approved

Logistic Regression 3
2.1 COMPONENTS OF TIME SERIES

In general, a time series is affected by four components:

Trend Seasonal

Cyclical Irregular

Time Series Analysis 4

2.2 TREND

Trend Seasonal

Cyclical Irregular
Trend is the general tendency of a time series to increase,
decrease or stagnate over a long period of time

Time Series Analysis 5

2.3 SEASONAL VARIATION

Trend Seasonal

Cyclical Irregular
Seasonal Variation explains fluctuations within a year
during the season, usually caused by climate and weather
conditions, customs, traditional habits, etc.

Time Series Analysis 6

2.4 CYCLICAL VARIATION

Trend Seasonal

Cyclical Irregular
Cyclical Variation describes the medium-term changes
caused by circumstances, which repeat in cycles. The
duration of a cycle extends over longer period of time.

Time Series Analysis 7

2.5 IRREGULAR VARIATIONS

Irregular or random variations in a time series are caused

by unpredictable influences, which are not regular and also
Trend Seasonal do not repeat in a particular pattern.

These variations are caused by incidences such as war,

strike, earthquake, flood, revolution, etc.

Cyclical Irregular There is no defined statistical technique for measuring

random fluctuations in a time series.

Time Series Analysis 8

2.6 TIME SERIES MODELS

Multiplicative Additive
Models Models

Time Series Analysis 9

3.1 STATIONARITY
• A stationary time series is one whose statistical properties such as mean, variance, autocorrelation,
etc. are all constant over time

• There are two types of stationarity, i.e. strictly stationary and weakly stationary:

Strictly Stationary Weakly Stationary

• The time series {Xt ,t ∈ Z} is said to be strictly • The time series {Xt ,t ∈ Z} is said to be weakly
stationary if the joint distribution of (Xt1 , Xt2 , . . . , stationary if:
Xtk ) is the same as that of (Xt1+h, Xt2+h, . . . , Xtk+h) 1. E(Xt) = μ
• In other words, strict stationarity means that the 2. Var(Xt)=E(Xt −μ)2 =σ 2
joint distribution only depends on the “difference” 3. Cov(Xt, Xt+k) = f(k) and ≠ f(t)
h, not the time (t1,t2, . . . ,tk )
• However in most applications this stationary
condition is too strong
Time Series Analysis 10
3.2 STATIONARITY IN MEAN
E(Xt) = μ

Xt Xt

t t

Xt , Yt Xt , Yt

t t

Time Series Analysis 11

3.3 STATIONARITY IN VARIANCE
Var(Xt)=E(Xt −μ)2 =σ 2

Xt Xt

t t

Xt , Yt Xt , Yt

t t

Time Series Analysis 12

3.4 STATIONARITY IN COVARIANCE
Cov(Xt, Xt+k) = f(k) and ≠ f(t)

Xt Xt

t t

Xt , Yt Xt , Yt

t t

Time Series Analysis 13

3.5 WHY STATIONARY?

• Forecasting is difficult as time series is non-deterministic in nature, i.e. we cannot predict with
certainty what will occur in the future

• But the problem could be a little bit easier if the time series is stationary, you simply predict its
statistical properties will be the same in the future as they have been in the past

• Most statistical forecasting methods are based on the assumption that the time series can be
rendered approximately stationary after mathematical transformations

Time Series Analysis 14

3.6 AUTOCORRELATION FUNCTION AND CORRELOGRAM

• Autocorrelation function (ACF) at lag k, denoted by ρk , is defined as

𝛾𝑘 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑎𝑡 𝐿𝑎𝑔 𝑘
𝑝𝑘 = =
𝛾0 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒

• If we plot ρk against k, the graph we obtain is known as the population correlogram

• However in reality, we only have access to the sample. Hence, a plot of ρˆk against k is known as the
sample correlogram

Time Series Analysis 15

3.6 AUTOCORRELATION FUNCTION AND CORRELOGRAM

Time Series Analysis 16

3.6 AUTOCORRELATION FUNCTION AND CORRELOGRAM
The Choice of Lag Length
• This is basically an empirical question. A rule of thumb is to compute ACF up to one-third to one-quarter
the length of the time series

Statistical Significance
• The statistical significance of any ρˆk can be judged by its standard error
• If a time series is purely random, that is, it exhibits white noise, the sample autocorrelation coefficients
ρˆk are approximately
ρˆk ∼ N(0, 1/n)
• In large samples the sample autocorrelation coefficients are normally distributed with zero mean and
variance equal to one over the sample size
ρˆk ± SE ; SE = (1/n)0.5
• If the preceding interval includes the value of zero, we do not reject the hypothesis that the true ρk is zero,
but if this interval does not include 0, we reject the hypothesis that the true ρk is zero

Time Series Analysis 17

3.7 UNIT ROOT TEST
• We know that if ρ = 1, that is, in the case of
the unit root, the equation becomes a random
Yt = β1 + ρYt−1 + wt
walk model without drift, which we know is a
Subtracting Yt−1 From Both Sides nonstationary stochastic process
Yt - Yt−1 = β1 +(ρ-1)*Yt−1 + wt
Δ Yt = β1 +(ρ-1)*Yt−1 + wt • Therefore, we can regress Yt on its (one-
period) lagged value Yt−1 and find out if the

Now, let (ρ-1) = δ estimated ρ is statistically equal to 1

Δ Yt = β1 + δYt−1 + wt
• However, we cannot estimate it by OLS and
test the hypothesis that ρ = 1 by the usual t-
Null hypothesis that δ = 0 test because that test is severely biased in the
Alternative hypothesis being that δ < 0 case of a unit root

If δ = 0, then ρ = 1, that is we have a unit root,

• Hence, we make some manipulations as
meaning the time series under consideration is
nonstationary shown on the left

Time Series Analysis 18

3.7 UNIT ROOT TEST
• We know that if ρ = 1, that is, in the case of
the unit root, the equation becomes a random
Yt = β1 + ρYt−1 + wt
walk model without drift, which we know is a
nonstationary stochastic process
Subtracting Yt−1 From Both Sides
Yt - Yt−1 = β1 +(ρ-1)*Yt−1 + wt • Therefore, we can regress Yt on its (one-
Δ Yt = β1 +(ρ-1)*Yt−1 + wt period) lagged value Yt−1 and find out if the

Now, let (ρ-1) = δ estimated ρ is statistically equal to 1

Δ Yt = β1 + δYt−1 + wt
• However, we cannot estimate it by OLS and
test the hypothesis that ρ = 1 by the usual t-
Null hypothesis that δ = 0 test because that test is severely biased in the
Alternative hypothesis being that δ < 0 case of a unit root

If δ = 0, then ρ = 1, that is we have a unit root,

• Hence, we make some manipulations as
meaning the time series under consideration is
nonstationary shown on the left

Time Series Analysis 19

3.8 AUGMENTED DICKEY FULLER TEST

Yt = β1 + ρYt−1 + wt
Subtracting Yt−1 From Both Sides
Yt - Yt−1 = β1 +(ρ-1)*Yt−1 + wt
Δ Yt = β1 +(ρ-1)*Yt−1 + wt

Now, let (ρ-1) = δ and take lagged values

ℎ
Hence we have, Δ Yt = β1 +δ*Yt−1 + 𝑖=1 β𝑖 ∗ Δyt−i + wt

Time Series Analysis 20

3.8 AUGMENTED DICKEY FULLER TEST
How to decide value of i?

ℎ
Δ Yt = β1 +δ*Yt−1 + 𝑖=1 β𝑖 ∗ Δyt−i + wt

t-Distribution (When Null Hypothesis is True) No serial correlation in error term

• Hence, we can test if these terms are significant using

• Keep adding delta terms (i.e. increasing i) till
t-test. Since we are testing all, we can use F-test
there is no serial correlation in error term
• We will continue adding delta terms (i.e. increasing i)
• If there is serial correlation then it means
till they are significant
• If we add delta terms and they are not significant, we
OR there is a more complicated process, and
hence there is need of more lags
should not add them

Continue With ADT by testing the below hypothesis

H0: δ = 0 (Which implies, ρ=1)
H1: δ < 0 (Which implies, ρ<1)

Time Series Analysis 21

3.8 AUGMENTED DICKEY FULLER TEST
Continue With ADT by testing the below hypothesis
H0: δ = 0 (Which implies, ρ=1)
H1: δ < 0 (Which implies, ρ<1)

Calculate T-statistic and compare with critical value of DF Critical Value from DF Distribution

Time Series Analysis 22

3.8 AUGMENTED DICKEY FULLER TEST
Continue With ADT by testing the below hypothesis
H0: δ = 0 (Which implies, ρ=1)
H1: δ < 0 (Which implies, ρ<1)

Calculate T-statistic and compare with critical value of DF Critical Value from DF Distribution

Show On R using JJ Dataset

Time Series Analysis 23

4. WHITE NOISE
• A time series {wt : t = 1,2,...,n} is discrete white
noise (DWN) if the variables w1, w2, . . . , wn are
independent and identically distributed with a
mean of zero
• This implies that the variables all have the same
variance σ2 and Cor(wi,wj) = 0 for all i ≠ j
• If, in addition, the variables also follow a normal
distribution (i.e., wt ∼ N(0,σ2)) the series is called
Gaussian White Noise
Yt = Signal + Noise • A time-series which is white noise, cannot be
predicted
Yt = Yt^ + Noise • A white noise series usually arises as a residual
Noise (Wt)= Yt^ - Yt series after fitting an appropriate time series
model
Time Series Analysis 24
5.1 RANDOM WALKS (WITHOUT DRIFT)
• Let {xt} be a time series. Then {xt} is a Random Walk (Without) if:

xt = xt-1 + wt

• Where {wt} is a white noise series. Substituting xt -1 = xt -2+wt−1 in

above equation and then substituting for xt-2, followed by xt−3
and so on (a process known as ‘back substitution’) gives:

xt = x0 + wt + wt-1 + wt-2 +...

• In practice, the series above will not be infinite but will start at
some time t = 1. Hence, Important Properties:
1. E(xt) = 0
xt = x0 + w1 + w2 +...+ wt
2. Var (xt) = t*σ2
• An interesting feature of the Random Walks is the persistence of
random shocks Hence Random Walks (Without Drift) is Non-Stationary

Time Series Analysis 25

5.2 RANDOM WALKS (WITH DRIFT)

• Let {xt} be a time series. Then {xt} is a Random Walk if

xt = α + xt-1 + wt

• Where {wt} is a white noise series. Substituting xt -1 = α + xt -2+

wt−1 in above equation and then substituting for xt-2, followed
by xt−3 and so gives:

We get: xt = αt + x0 + wt + wt-1 + wt-2 +...

1. E(xt) = αt
2. Var (xt) = t*σ2

Hence Random Walks (Without Drift) is Non-Stationary

Time Series Analysis 26

6. UNIT ROOT

• Let us write RWM as:

Yt = ρYt-1 + wt ; −1 ≤ ρ ≤ 1

• If ρ = 1, the above equation becomes a RWM (without drift). If ρ is in fact 1, we face what is known
as the unit root problem, that is, a situation of non-stationarity

• If, however, |ρ| < 1, then it can be shown that the time series Yt is stationary in the sense we have
defined it

Time Series Analysis 27

7.1 TREND STATIONARY AND DIFFERENCE STATIONARY

• The distinction between stationary and nonstationary stochastic processes (or time series) has a
crucial bearing on whether the trend (the slow long-run evolution of the time series under
consideration) is deterministic or stochastic

• If the trend in a time series is a deterministic function of time, such as time, time-squared etc., we
call it a deterministic trend, whereas if it is not predictable, we call it a stochastic trend

Yt = β1 + β2t + β3Yt−1 + wt

Yt = Yt−1 + wt Yt = β1 + Yt−1 + wt Yt = β1 + β2t + wt Yt = β1 + β2t +Yt−1 + wt

Time Series Analysis 28

7.2 TREND STATIONARY AND DIFFERENCE STATIONARY
Yt = Yt−1 + wt

Pure Random Walk

Yt = Yt−1 + wt
Subtracting Yt−1 From Both Sides
Yt - Yt−1 = wt
Δ Yt = wt

Hence, Yt is DSP as Wt ~iid(0, σ2)

Time Series Analysis 29

7.3 TREND STATIONARY AND DIFFERENCE STATIONARY
Yt = β1 +Yt−1 + wt

Random Walk With Drift

Yt = β1 +Yt−1 + wt
Subtracting Yt−1 From Both Sides
Yt - Yt−1 = β1 + wt
Δ Yt = β1 + wt

Hence, Yt is DSP as Wt ~iid(0, σ2) and Covariance between constant and variable is 0

Time Series Analysis 30

7.4 TREND STATIONARY AND DIFFERENCE STATIONARY
Yt = β1 + β2t + wt

Deterministic

β1 β2 t β1 β2 t β1 + β2(t-1) + wt-1
β2 t β2(t-1) + wt-1
β1 β2 t β2(t-t+1) wt-1
β1 β2 t β2 wt-1
Now, Yt−1 = β1 + β2(t-1) + wt-1

β1 β2 t β1 + β2(t-1) + wt-1

called a TSP

Time Series Analysis 31

7.5 TREND STATIONARY AND DIFFERENCE STATIONARY
Yt = β1 + β2t + Yt−1 + wt

Random Walk with Drift and Deterministic

Yt = β1 + β2t + Yt−1 + wt
Subtracting Yt−1 From Both Sides
Yt - Yt−1 = β1 + β2t + Yt−1 - Yt−1 + wt
Δ Yt = β1 + β2t + wt

Hence Yt is not stationary

Time Series Analysis 32

8.1 INTEGRATED STOCHASTIC PROCESSES
• The random walk model is but a specific case of a more general class of stochastic processes known
as integrated processes

• Recall that the RWM without drift is nonstationary, but its first difference is stationary

• Therefore, we call the RWM without drift integrated of order 1, denoted as I(1)

• Similarly, if a time series has to be differenced twice (i.e., take the first difference of the first
differences) to make it stationary, we call such a time series integrated of order 2

• A time series Yt integrated of order d is denoted as Yt ∼ I(d)

• Most economic time series are generally I(1); that is, they generally become stationary only after
taking their first differences
Time Series Analysis 33
8.2 INTEGRATED STOCHASTIC PROCESSES (PROPERTIES)

1. A linear combination or sum of stationary and nonstationary time series is nonstationary

If Xt ∼I(0) and Yt ∼I(1), then Zt = (Xt +Yt)= I(1)

2. A linear combination of an I(d) series is also I(d)

If Xt ∼I(d), then Zt = (a+bXt) = I(d), where a and b are constants

3. A linear combination of an I(d1) series and I(d2) series will be stationary in larger of (d1,d2)

If Xt ∼ I(d1) and Yt ∼ I(d2), then Zt = (aXt+bYt) ∼ I(d2), where d1 < d2

4. A linear combination of two I(d1) series will be (generally) stationary in larger d1

If Xt ∼I(d) and Yt ∼ I(d), then Zt = (aXt+bYt) ∼ I(d∗); d∗ is generally equal to d

Time Series Analysis 34

9. SPURIOUS REGRESSION

• Consider two RWM as given below:

1. xt = xt-1 + wt
2. Xt’ = xt’-1 + wt’
• Suppose we regress Xt on Xt’ Since Xt and Xt are uncorrelated I(1) processes, the R2 from the
regression should tend to zero; that is, there should not be any relationship between the two
variables

Time Series Analysis 35

10.1 TRANSFORMATION
Difference Stationary
• DSP is stationary after
differencing
• Stock prices are usually
DSP
• To make such a time series
stationary, we subtract 1
lagged value from the
original value
Transformations Trend Stationary
• Transformations are used • TSP is stationary around the
to stabilize the non- trend line
constant variance of a • To make such a time series
series. stationary is to regress it on
• Common transformation time and the residuals from
methods include: this regression will then be
• Power stationary
• Square root,
• Log
Time Series Analysis 36
10.1 TRANSFORMATION

• It should be pointed out that if a time series is DSP but we treat it as TSP, this is called
under-differencing

• On the other hand, if a time series is TSP but we treat it as DSP, this is called
over-differencing

• The consequences of these types of specification errors can be serious, depending on

how one handles the serial correlation properties of the resulting error terms

Time Series Analysis 37

11. Exponential Smoothing Method
Forecasts produced using exponential smoothing methods are weighted averages of past
observations, with the weights decaying exponentially as the observations get older. In other words,
the more recent the observation the higher the associated weight.

If smoothing parameter 𝛼 creates a series St

𝑆𝑡 = 𝛼𝑋𝑡 + 1 − 𝛼 𝑆𝑡−𝑖
for all t.
This is an adaptive form of exponential smoother, implying
𝑇−1

𝑆𝑡 = 𝛼 1−𝛼 𝐾 𝑋𝑇 − 𝐾 + 1 − 𝛼 𝑇𝑆
0
𝑘=0

• Geometrically declining weights

• Choice of 𝛼 depicts rate of adjustment of St
Time Series Analysis 38
Time Series Analysis 39
 Single Double Triple
Univariate data Controls decay of Adds support for
without a trend or the influences in seasonality to the
seasonality trend univariate time
series
Single parameter 𝜶 Alpha: Smoothing Alpha: Smoothing
factor for the level. factor for the level.
Beta: Smoothing Beta: Smoothing
factor for the trend. factor for the trend.
Gamma:
Smoothing factor
for the seasonality
Useful to dampen
the trend over time
Time Series Analysis 40
11.2 Single Equation Regression Models
Most common of all ordinary least squares method used to estimate linear regressions.
For non linear relationships, models like Logit, Probit etc. come under this.
Example: the demand function for automobiles

Simultaneous Equation Regression Models

The dependent variables are functions of other dependent variables, rather than just
independent variables and are jointly determined with the dependent variable, which
in economics usually is the consequence of some underlying equilibrium mechanism.

ARIMA
Time Series Analysis 41
12. Autoregressive Model (AR)
Let Yt represent WPI at time t. If we model Yt as

𝑌𝑡 − 𝛿 = 𝛽1 𝑌𝑡 − 𝛿 + 𝑢𝑡 Mean of Y
−1

First-Order 𝑂𝑅

Autoregressive Error term with

𝑌𝑡 = 𝛽0 + 𝛽1 𝑌𝑡 + 𝑢𝑡 zero mean and
−1 constant variance,
i.e. White Noise

AR(1), stochastic process: In other words, this model says that the forecast value of Y at
time t is simply some proportion ( = 𝛽 1) of its value at time (t − 1) plus a random shock
or disturbance at time t; again the Y values are expressed around their mean values.

Time Series Analysis 42

12.2 Autoregressive Model (AR)
Second-Order (𝑌𝑡 − 𝛿) = 𝛽1(𝑌𝑡 − 1 𝛿) + 𝛽2(𝑌𝑡 − 2 𝛿) + 𝑢𝑡
− −
Autoregressive

AR(2), process. The value of Y at time t depends on its value in the previous two time
periods, the Y values being expressed around their mean value δ.

(𝑌𝑡 − 𝛿) = 𝛽1(𝑌𝑡 − 1 −
𝛿) + 𝛽2(𝑌𝑡 − 2 −
𝛿) +··· +𝛽𝑝(𝑌𝑡 − 𝑝 − 𝛿) + 𝑢𝑡

pth -Order Autoregressive

• “Data speak for themselves”: only the current and previous Y values are involved; there are
no other regressors
• Reduced form model that we encountered in our discussion of the simultaneous-equation
models
Time Series Analysis 43
13. Moving Average Model
𝑌𝑡 = µ + 𝛽0 𝑢𝑡 + 𝛽1𝑢𝑡 − 1
First-Order
Moving Average Constant White Noise
Stochastic Error
Terms

MA(1) process: Each forecast made here is adjusted for the errors made in previous
period.
Second-Order
𝑌𝑡 = µ + 𝛽0 𝑢𝑡 + 𝛽1𝑢𝑡 − 1 + 𝛽2𝑢𝑡 − 2
Moving Average

qth-Order 𝑌𝑡 = µ + 𝛽0 𝑢𝑡 + 𝛽1𝑢𝑡 − 1 + 𝛽2𝑢𝑡 − 2 + ⋯ + 𝛽𝑞𝑢𝑡 − 𝑞

Moving Average

A moving average process is simply a linear combination of white noise error terms.
Time Series Analysis 44
14. Autoregressive Moving Average (ARMA)
ARMA (1,1) 𝑌𝑡 = 𝜃 + 𝛼1𝑌𝑡 − 1 𝛽1𝑢𝑡 − 1 + 𝑢𝑡
+

Constant Autoregressive Moving Average

Term Terms

𝑌𝑡 = 𝜃 + 𝛽1 𝑌𝑡 1 + 𝛽2 𝑌𝑡 2 +··· +𝛽𝑝 𝑌𝑡 𝑝 + 𝛽0 𝑢𝑡 + 𝛽1 𝑢𝑡 1 +
𝛽2 𝑢𝑡 +⋯
−2
+ 𝛽𝑞 𝑢−𝑡 𝑞 + 𝑢𝑡 − − −
−

ARMA (p,q)
In general, in an ARMA( p, q) process, there will be p autoregressive and q moving average
terms.
Time Series Analysis 45
Assumption in AR, MA, ARMA: Weak Stationarity
However, in cases of nonstationary time series,
15. ARIMA
A time series stationary to begin with: 𝑌𝑡 ~ 𝐼(0)

Differenced once to make it stationary: 𝑌𝑡 ~ 𝐼(1) Integrated of Order 1

𝑧𝑡 = 𝑌𝑡 − 𝑌𝑡 − 1

Differenced twice to make it stationary: 𝑌𝑡 ~ 𝐼 2 Integrated of Order 2

𝑤𝑡 = 𝑧𝑡 − 𝑧𝑡 − 1

ARIMA(p,d,q) Process
Results in a Normal
Integrated
stationary process as for
of Order d
series ARMA(p,q)

Time Series Analysis 46

16. Box Jenkins Methodology
Identification of
appropriate p, d, q

Box Jenkins
Estimation of
Methodology
parameters
assumes
stationarity
Diagnostic checking

Forecasting

Time Series Analysis 47

16.2 Step I: Identification: AFC, PACF

Time Series Analysis 48

16.2.2 Step I: Identification
The chief tools employed: autocorrelation function (ACF), the partial autocorrelation function
(PACF), and the resulting correlograms.

For ARIMA (p,d,q)

Lags Component Identified using
p Autoregression Partial
Autocorrelation
d Integration Dickey Fuller Test
q Moving Average Autocorrelation

Time Series Analysis 49

16.3 Step II: Estimation of Parameters

Typically attempted using the handy statistical softwares, a regression model (ARIMA) is run on
the calculated lags for each component.
Consider a first-order autoregressive moving-average process. Then arima estimates all the
parameters in the model
𝑦𝑡 = 𝑥𝑡𝛽 + µ𝑡 (structural equation)
µ𝑡 = 𝜌µ𝑡 − 1 + 𝜃𝜖𝑡 − 1 + 𝜖𝑡 (disturbance, ARMA(1, 1))

Step III: Diagnostic Checking

The estimated model is checked for a reasonable fit on data by obtaining ACF and PACF of the
residuals.

Time Series Analysis 50

16.4 Step IV: Forecasting

Our regressand is no longer Yt but rather the dth order integration of Yt

On using the model obtained in ARMA, we get values of change in dependent variable.

Undo-ing the first difference transformation : Integration of the model.

Time Series Analysis 51

17. Volatility Over Time
Volatility clustering refers to the observation, that "large changes tend to be followed by large
changes, of either sign, and small changes tend to be followed by small changes.“

Time Series Analysis 52

17.2 Volatility Over Time
“Extreme movements do not appear out of nowhere”

Volatility depends on:

• Period observed
• Selected time resolution

• ARCH fits regression models in which the volatility of a series varies through time.
• ARCH models estimate future volatility as a function of prior volatility.
• ARCH fits models of autoregressive conditional heteroskedasticity (ARCH) by using
conditional maximum likelihood.

Time Series Analysis 53

17.3 Measuring Volatility
Highly volatile series:
Level Form: Random Walks
First Difference: Generally Stationary
In case of drastic volatility,
First Difference: Exhibit Wide Swings
Hence, there lies an interest is modeling volatility.

Model Employed: Autoregressive Conditional Heteroscedasticity (ARCH)

Durbin–Watson d: Very often a significant d value is an indication of the model specification
errors. However, in a time series regression, if a significant d value is obtained, we should test
for the ARCH.
On finding the ARCH effect: Generalized Least Squares: i.e. Applying OLS to transformed data.

Time Series Analysis 54

17.4 Measuring Volatility: Statistically
𝑌𝑡 = 𝑊𝑕𝑜𝑙𝑒𝑠𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥
𝑌 ∗ 𝑡 = log(𝑌𝑡)
𝑑𝑌 ∗ 𝑡 = 𝑌 ∗ 𝑡 − 𝑌 ∗ 𝑡 − 1 = 𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑕𝑒 𝑊𝑃𝐼
𝑑𝑌 ∗ 𝑡 = 𝑚𝑒𝑎𝑛 𝑜𝑓𝑑𝑌 ∗ 𝑡
𝑋𝑡 = 𝑑𝑌 ∗ 𝑡 − 𝑑𝑌 ∗ 𝑡 = 𝑀𝑒𝑎𝑛 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒𝑥𝑐𝑕𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
𝑋2𝑡 = 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦
Assuming that volatility in the current period is related to its value in the previous period plus a
white noise error term, using ARIMA (1,0,0):
𝑋2𝑡 = 𝛽0 + 𝛽1𝑋2𝑡 − 1 + 𝑢𝑡
Using ARIMA(p,0,0)
𝑋2𝑡 = 𝛽0 + 𝛽1𝑋2𝑡 − 1 +
𝛽2𝑋2𝑡 − 2 + ⋯ + 𝛽𝑝𝑋2𝑡 − 𝑝 + 𝑢𝑡

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17.5 ARCH
Let us consider the k-variable linear regression model

and assume that conditional on the information available at time (t − 1), the disturbance term is
distributed as

that is, ut is normally distributed with zero mean and

The error variance may depend not only on one lagged term of the squared error term but also
on several lagged squared terms as follows:

Time Series Analysis 56

17.6 ARCH
If there is no autocorrelation in the error variance:

𝐻0 = 𝛼1 = 𝛼2 = ⋯ = 𝛼𝑝

𝑣𝑎𝑟(𝑢𝑡) = 𝛼0, → No ARCH effect

Tested using OLS variances as following:

𝑢2𝑡 = 𝛼 0 + 𝛼 1𝑢2 𝑡 − 1 +
𝛼 2𝑢 2
𝑡−2 +··· +
𝛼 𝑝 𝑢 2
𝑡−𝑝

by the usual F test, or alternatively, by computing nR2, where R2 is the coefficient of

determination from the auxiliary regression

Time Series Analysis 57

17.7 GARCH
Generalized Autoregressive Conditional Heteroscedasticity Model

GARCH(1, 1) model:
𝜎2𝑡 = 𝛼0 + 𝛼1𝑢2 𝑡 − 1 + 𝛼2𝜎2 𝑡 − 1
Implying the conditional variance of u at time t depends not only on the squared error term in
the previous time period but also on its conditional variance in the previous time period.

GARCH(p, q) Model: p lagged terms of the squared error term and q terms of the lagged
conditional variances.

Time Series Analysis 58