Unit Roots and Cointegration

Asad Dossani

Fin 625: Quantitative Methods in Finance

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Stationarity and Unit Root Testing

A stationary series is one with a constant mean, constant variance,

and constant autocovariances for each lag. The stationarity of a
series can strongly influence its behavior and properties. Consider
the impact of a shock. A shock is defined as the value of the error
term during a particular time period. For a stationary series, the
impact of a shock will gradually die away. For a non-stationary
series, the persistence of shocks is infinite.

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Spurious Regression

The use of non stationary data can lead to spurious regressions.

Suppose two stationary variables are generated as independent ran-
dom series. When one of the variables is regressed on the other, the
t-statistic on the slope coefficient should not be significantly differ-
ent from zero, and the R 2 should be close to zero.

However, if two variables are trending over time, a regression of one

variable on the other could have a high R 2 , even if the two variables
are unrelated. This is called a spurious regression. If variables in a
regression model are not stationary, then standard assumptions for
asymptotic analysis (e.g t-ratio, F-statistic) are invalid.

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R 2 for 1000 Regressions with Non Stationary Variables

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T-ratio for 1000 Regressions with Non Stationary Variables

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Unit Roots

Consider a mean zero AR(1) model:

yt = φyt−1 + ut
What is the impact of a shock at time t on future values of the
series? In other words, suppose ut = 1, yt−1 = 0, and ut+h = 0 for
all h ≥ 1. What are the values of yt+1 , yt+2 , . . . , yt+h ?

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Unit Roots

The impact of a shock ut = 1 on future values of yt is as follows:

yt = φyt−1 + ut = 1
yt+1 = φyt + ut+1 = φ
yt+2 = φyt+1 + ut+2 = φ2
yt+3 = φyt+2 + ut+3 = φ3
.. ....
. ..
yt+h = φyt+h−1 + ut+h = φh

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Unit Roots

yt+h = φh

Recall than an AR(1) process is stationary if |φ| < 1. If |φ| < 1,

then yt+h = φh = 0 as h → ∞. This means that the impact of the
unit shock at time t gradually dies away over time, i.e. as h gets
large.

On the other hand, if φ = 1, then yt+h = φh = 1 as h → ∞. This

means that the impact of the unit shock at time t is permanent. yt
has a unit root, because the root of the characteristic equation is
equal to one.

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Unit Roots
Suppose yt has the following process:
yt = yt−1 + ut and ut ∼ WN(0, σ 2 ).
Show that yt has a unit root, i.e. show that one of the roots of the
characteristic equation is equal to one.

yt = yt−1 + ut
yt − yt−1 = ut
yt − Lyt = ut
(1 − L)yt = ut
0=1−z
z =1

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Random Walk

When φ = 1, yt is a random walk process. We define two types of

random walks: the first without drift, and the second with drift. A
random walk with drift will trend upwards (if µ > 0) or downwards
(if µ < 0) over time.

yt = yt−1 + ut (without drift)

yt = µ + yt−1 + ut (with drift)

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Trend Stationary

Another type of non-stationary process is called a trend stationary

process. In this situation, yt is stationary around a linear trend.

yt = α + βt + ut

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White Noise Process

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Random Walk With and Without Drift

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Trend Stationary Process

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AR(1) process for φ = 0, 0.8, 1

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Inducing Stationarity by Differencing

If yt is a random walk, then the first difference ∆yt = yt − yt−1 is

stationary.

yt = µ + yt−1 + ut
yt − yt−1 = µ + ut
∆yt = µ + ut

For example, suppose yt is the log price of a stock. Then ∆yt is the
stock return. Log prices are typically not stationary, while returns
are stationary. For this reason, we work with stock returns rather
than log prices in regressions.

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Testing for a Unit Root

We use the Dickey-Fuller test to test for a unit root. The objective
is to examine the null hypothesis φ = 1 in the following regression.

yt = φyt−1 + ut

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Dickey-Fuller Test

In practice, the following regressions are employed, with the null

hypothesis ψ = 0, and the alternative hypothesis ψ < 0. There are
three specifications: a model without drift, a model with drift, and
a model with drift and a linear trend.

∆yt = ψyt−1 + ut (without drift)

∆yt = µ + ψyt−1 + ut (with drift)
∆yt = µ + λt + ψyt−1 + ut (with drift and linear trend)

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Dickey-Fuller Test Statistic

The Dickey-Fuller test statistic is computed using the OLS estimate

ψ̂ and the corresponding standard error SE (ψ̂). The test statistic
does not follow a standard t-distribution under the null hypothesis
of non stationarity. It instead follows a non-standard distribution.

ψ̂
test statistic =
SE (ψ̂)

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Cointegration

A variable with a unit root is said to be integrated of order 1, denoted

I(1). A variable that is stationary is said to be integrated of order
0, denoted I(0). Suppose xt and yt are I(1). If a linear combination
of xt and yt is I(0), then xt and yt are cointegrated. xt and yt are
cointegrated if:

xt ∼ I(1)
yt ∼ I(1)
yt − γxt ∼ I(0)

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Cointegration

If two variables are cointegrated, there is a long run equilibrium

relationship between them. Examples include Treasury yields with
different maturities, and futures and spot prices on the same un-
derlying asset. Cointegrated variables move together over time. In
the short run, cointegrated variables may deviate from their long run
equilibrium relationship, but their association returns in the long run.

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Cointegration

A simple approach to handling I(1) variables is to run a regression

in first differences.

∆yt = β∆xt + ut

While this approach is statistically valid, the model has no long run
dynamics. It has nothing to say about whether x and y have an
equilibrium relationship.

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Error Correction Model

An error correction model incorporates lagged levels of the cointe-

grated variables into a regression using first differences.

∆yt = β1 ∆xt + β2 (yt−1 − γxt−1 ) + ut

If x and y are cointegrated, then (yt−1 − γxt−1 ) is stationary, i.e. is

I(0). Thus, the above regression is statistically valid.

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Error Correction Model

In the error correction model, β1 describes the short run relationship

between changes in x and changes in y . (yt−1 − γxt−1 ) is called the
error correction term. β2 describes the speed of adjustment back
to equilibrium. It is the proportion of last period’s equilibrium error
that is corrected for.

∆yt = β1 ∆xt + β2 (yt−1 − γxt−1 ) + ut

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Vector Error Correction Model

Suppose yt is a (g x 1) vector of cointegrated variables. That is,

β 0 y ∼ I(0) while each individual component of y is I(1). A vector
error correction model (VECM) with k lags is defined as follows:

∆yt = Πyt−1 + Γ1 ∆yt−1 + · · · + Γk ∆yt−k

Π = αβ 0

β is a matrix of cointegrating vectors and α are the speed of ad-

justment parameters.

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A Simple Vector Error Correction Model

Suppose that y1,t − βy2,t ∼ I(0). We can express the VECM as

follows, where α1 and α2 are the speed of adjustment parameters.

      
∆y1,t π11 π12 y1,t−1 u
= + 1,t
∆y2,t π21 π22 y2,t−1 u2,t
     
α1   y1,t−1 u
= 1 −β + 1,t
α2 y2,t−1 u2,t
∆yt = αβ 0 yt−1 + ut
∆y1,t = α1 (y1,t−1 − βy2,t−1 ) + u1,t
∆y2,t = α2 (y1,t−1 − βy2,t−1 ) + u2,t

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Cointegrated VAR as a VECM

Consider the bivariate VAR(1) process, where yt = (y1,t , y2,t )0 :

yt = Ayt−1 + ut
ut ∼ WN(0, Σu )
 
A= 0.8 0.2
0.2 0.8

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Cointegrated VAR as a VECM

Show that y1,t and y2,t are cointegrated.

      
y1,t 0.8 0.2 y1,t−1 u
= + 1,t
y2,t 0.2 0.8 y2,t−1 u2,t
y1,t = 0.8y1,t−1 + 0.2y2,t−1 + u1,t
y2,t = 0.2y1,t−1 + 0.8y2,t−1 + u2,t
y1,t − y2,t = 0.6(y1,t−1 − y2,t−1 ) + u1,t − u2,t

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Cointegrated VAR as a VECM
Write the model in error correction form. Compute the speed of
adjustment coefficient α and the cointegrating vector β, where the
β on y1,t is normalized to 1.
      
y1,t 0.8 0.2 y1,t−1 u
= + 1,t
y2,t 0.2 0.8 y2,t−1 u2,t
          
y1,t y1,t−1 0.8 0.2 y1,t−1 y1,t−1 u
− = − + 1,t
y2,t y2,t−1 0.2 0.8 y2,t−1 y2,t−1 u2,t
     !   
∆y1,t 0.8 0.2 1 0 y1,t−1 u
= − + 1,t
∆y2,t 0.2 0.8 0 1 y2,t−1 u2,t
    
−0.2 0.2 y1,t−1 u
= + 1,t
0.2 −0.2 y2,t−1 u2,t
     
−0.2   y1,t−1 u
= 1 −1 + 1,t
0.2 y2,t−1 u2,t

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Testing for Cointegration

The Johannsen trace test is used to test for cointegration using the
VECM model.

∆yt = Πyt−1 + Γ1 ∆yt−1 + · · · + Γk ∆yt−k

The test centers around the Π matrix. It is conducted by examining

the rank of Π via its eigenvalues.

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Testing for Cointegration

If the rank of Π = 0, then there is no long run relationship between

the components of y , and the variables are not cointegrated. For
1 ≤ rank(Π) < g , there are r cointegrating vectors, where r =
rank(Π).

∆yt = Πyt−1 + Γ1 ∆yt−1 + · · · + Γk ∆yt−k

Testing is conducted via a sequence under the null hypothesis: r =

0, 1, . . . , (g − 1). The alternative hypothesis is that there are more
than r cointegrating vectors. The lowest value of r for which the null
hypothesis is not rejected is the number of cointegrating vectors.

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