What is Cointegration?

Cointegration is a statistical method used to test the correlation between two or more non-
stationary time series in the long-run or for a specified time period. The method helps in
identifying long-run parameters or equilibrium for two or more sets of variables. It helps in
determining the scenarios wherein two or more stationary time series are cointegrated in such
a way that they cannot depart much from the equilibrium in the long-run.

Cointegration tests analyze non-stationary time series— processes that

have variances and means that vary over time. In other words, the method allows you to
estimate the long-run parameters or equilibrium in systems with unit root variables (Rao,
2007).

Two sets of variables are cointegrated if a linear combination of those variables has a lower
order of integration. For example, cointegration exists if a set of I(1) variables can be
modeled with linear combinations that are I(0). The order of integration here—I(1)— tells
you that a single set of differences can transform the non-stationary variables to stationarity.
Although looking at a graph can sometimes tell you if you have an I(1) process, you may
need to run a test such as the KPSS test or the Augmented Dickey-Fuller test to figure it out.

 The method is used to determine the sensitivity of two or more variables to the same set of
conditions or parameters in a period of time.

 Let us understand the method with the help of a graph. The prices of two commodities A and
B, are shown on the graph. We can infer that these are perfectly co integrated commodities in
terms of price as the difference between the prices of both the commodities has remained the
same for decades. Though this is a hypothetical example, it perfectly explains the
cointegration of two non-stationary time series.
 History

 Earlier Linear regression was being used as a statistical method to find the relation between
two or more time-series. Granger and Newbold, British economists, argued against the use
of linear regression as a technique for analyzing time series for a specified period of time.
As per them, using linear regression sometimes produce false correlation due to the impact of
other factors.

 In 1987, Granger and Engle published a paper on this topic where they established the
concept of the cointegration of non-stationary time series to find the correlations between
them. They established the fact that two or more non-stationary time series are cointegrated
in such a way that they can move much from equilibrium. The two economists were awarded
the Nobel memorial prize in economic sciences for their revolutionary work.

Examples of Cointegration

 Cointegration as correlation does not measure whether two or more time-series data or
variables move together in the long-run, while it measures whether the difference between
their means remains constant or not.

 So that means that two random variables completely different from each other can have one
common trend that combines them in the long-run. If this happens, variables are said to be
cointegrated.

 Now let’s take the example of Cointegration in pair trading. In pair trading, a trader
purchases two cointegrated stocks, Stock A at the long position and Stock B in the short
position. The Trader was unsure about the direction of price for both the stocks but was sure
that Stock A’s position would definitely be better than stock B.

 Now let us say that the prices of both the stocks go down, the trader will still make a profit as
long as stock A’s position is better than stock B if both the stocks were equally weighted at
the time of purchase.
#1 – Engle-Granger Two-Step Method

This method is based on testing the residuals created based on static regression for the
presence of unit roots, i.e., if two non-stationary time series are cointegrated, the result will
confirm the stationary characteristic of residuals. There are some limitations with this method
because if there are two or more non-stationary variables, the method will reflect two or more
cointegrated relationship and also, the method is a single equation model. Some of these
limitations have been addressed in recent times tests like Johansen’s and Philip-Ouliari’s test.

The Engle-Granger method first constructs residuals (errors) based on the static regression.

The residuals are tested for the presence of unit roots using ADF or a similar test. If the time
series is cointegrated, then the residuals will be practically stationary. A major issue with the
Engle-Granger method is that choice of the dependent variable may lead to different
conclusions (Armstrong, 2001), an issue corrected by more recent tests such as Phillips-
Ouliaris and Johansen’s.

H0: No cointegration exists

H1: Cointegration exists

#2 – Johansen Test

Johansen test is used for testing Cointegration between several time-series data at a time. This
test overcomes the limitation of an incorrect test result for more than two time series of the
Engle-Granger method. This test is subject to asymptotic properties; i.e., it takes a large
sample size because a small sample size would give incorrect or false results. There are two
further bifurcations of the Johansen Test, i.e., Trace test and Maximum Eigenvalue test.

The Johansen test is used to test cointegrating relationships between several non-stationary
time series data. Compared to the Engle-Granger test, the Johansen test allows for more than
one cointegrating relationship. However, it is subject to asymptotic properties (large sample
size) since a small sample size would produce unreliable results. Using the test to find
cointegration of several time series avoids the issues created when errors are carried forward
to the next step.

Johansen’s test comes in two main forms, i.e., Trace tests and Maximum Eigenvalue test.

 Trace tests

Trace tests evaluate the number of linear combinations in a time series data, i.e., K to be
equal to the value K0, and the hypothesis for the value K to be greater than K0. It is illustrated
as follows:

H0: K = K0

H0: K > K0                                       

When using the trace test to test for cointegration in a sample, we set K 0 to zero to test
whether the null hypothesis will be rejected. If it is rejected, we can deduce that there exists a
cointegration relationship in the sample. Therefore, the null hypothesis should be rejected to
confirm the existence of a cointegration relationship in the sample.

 Maximum Eigenvalue test

An Eigenvalue is defined as a non-zero vector which, when a linear transformation is applied

to it, changes by a scalar factor. The Maximum Eigenvalue test is similar to the Johansen’s
trace test. The key difference between the two is the null hypothesis.

H0: K = K0

H0: K = K0 + 1

In a scenario where K=K0 and the null hypothesis is rejected, it means that there is only one
possible outcome of the variable to produce a stationary process. However, in a scenario
where K0 = m-1 and the null hypothesis is rejected, it means that there are M possible linear
combinations. Such a scenario is impossible unless the variables in the time series are
stationary.

#3 – Philip-Ouliaris Test

The Philips-Ouliaris (1990) is a residual-based unit root test. It is an improvement over the
Engle-Ganger test; Prior to 1987, tests for cointegration worked on the assumption that
regression errors are independent with common variance—which is rarely true in real life
(Chaovalitwongse et. al, 2010).

H0: No cointegration exists

H1: Cointegration exists
The Philips-Ouliaris test takes supplementary variability into account (stemming from the
fact that residuals are estimates instead of the actual parameter values). The tests is also
invariant to normalization of the cointegration relationship (i.e. which variable is counted as
the dependent variable).

This test proves that when residual-based unit root test is applied on time series, the
cointegrated residuals give asymptotic distribution instead of Dickey-Fuller distribution. The
resulted asymptotic distributions are known as Philip-Ouliaris distributions.

Condition of Cointegration

The Cointegration test is based on the logic that more than two-time series variables have
some similar deterministic trends that can be combined over a period of time. This is the
utmost condition for all cointegration testing for non-stationary time series variables that they
should be integrated in the same order, or they should have a similar identifiable trend that
can define a correlation between them. So that they should not deviate much from the average
parameter in the short-run, and in the long run, they should be reverting to the trend.