Time series Analysis and

Forecasting
 Introduction
• Forecasting is a very difficult task, both in the short run and in
the long run.
• Analysts search for patterns or relationships in historical data
and then make forecasts.
– There are two problems with this approach:
• It is not always easy to undercover historical patterns or
relationships.
– It is often difficult to separate the noise, or random behavior,
from the underlying patterns.
– Some forecasts may attribute importance to patterns that are in
fact random variations and are unlikely to repeat themselves.
• There are no guarantees that past patterns will continue in the
future.
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 Forecasting Methods: An Overview
• There are many forecasting methods available,
and there is little agreement as to the best
forecasting method.
• The methods can be divided into three groups:
1. Judgmental methods
2. Extrapolation (or time series) methods
3. Econometric (or causal) methods
• The first method is basically nonquantitative;
the last two are quantitative.
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 Extrapolation Models
• Extrapolation models are quantitative models that use past
data of a time series variable to forecast future values of the
variable.
• Many extrapolation models are available:
– Trend-based regression
– Autoregression
– Moving averages
– Exponential smoothing
• All of these methods look for patterns in the historical series
and then extrapolate these patterns into the future.
• Complex models are not always better than simpler models.
– Simpler models track only the most basic underlying patterns and can
be more flexible and accurate in forecasting
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 Econometric Models
• Econometric models, also called causal or regression-based
models, use regression to forecast a time series variable by
using other explanatory time series variables.
• Prediction from regression equation:

Causal regression models present mathematical challenges,

including:
– Determining the appropriate “lags” for the regression equation
– Deciding whether to include lags of the dependent variable as
explanatory variables
– Autocorrelation (correlation of a variable with itself) and cross-
correlation (correlation of a variable with a lagged version of
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 Combining Forecasts
• This method combines two or more forecasts to obtain
the final forecast.
• The reasoning is simple: The forecast errors from
different forecasting methods might cancel one another.
• Forecasts that are combined can be of the same general
type, or of different types.
• The number of forecasts to combine and the weights to
use in combining them have been the subject of several
research studies.

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Components of Time Series Data (slide 1 of 4)
• If observations increase or decrease regularly through time, the time
series has a trend.
– Linear trends occur when the observations increase by the same amount
from period to period.
– Exponential trends occur when observations increase at a tremendous rate.
– S-shaped trends occur when it takes a while for observations to start
increasing, but then a rapid increase occurs, before finally tapering off to a
fairly constant level.

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Components of Time Series Data (slide 2 of 4)
• If a time series has a seasonal component, it exhibits
seasonality—that is, the same seasonal pattern tends to
repeat itself every year.

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 Components of Time Series Data (slide 3 of 4)
• A time series has a cyclic component when business cycles affect
the variables in similar ways.
– The cyclic component is more difficult to predict than the
seasonal component, because seasonal variation is much more
regular.
– The length of the business cycle varies, sometimes substantially.
– The length of a seasonal cycle is generally one year, while the
length of a business cycle is generally longer than one year and
its actual length is difficult to predict.

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Components of Time Series Data (slide 4 of 4)
• Random variation (or noise) is the unpredictable component
that gives most time series graphs their irregular, zigzag
appearance.
– A time series can be determined only to a certain extent by its trend,
seasonal, and cyclic components; other factors determine the rest.
– These other factors combine to create a certain amount of
unpredictability in almost all time series.

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 Measures of Accuracy (slide 1 of 2)
• The forecast error is the difference between the actual value and the forecast. It
is denoted by E with appropriate subscripts.
• Forecasting software packages typically report several summary measures of
forecast errors:

– MAE (Mean Absolute Error):

– RMSE (Root Mean Square Error):

– MAPE (Mean Absolute Percentage Error):

• Another measure of forecast errors is the average of the errors.

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 Measures of Accuracy (slide 2 of 2)
• Some forecasting software packages choose the best
model from a given class by minimizing MAE, RMSE, or
MAPE.
– However, small values of these measures guarantee only that
the model tracks the historical observations well.
– There is still no guarantee that the model will forecast future
values accurately.
• Unlike residuals from the regression equation, forecast
errors are not guaranteed to always average to zero.
– If the average of the forecast errors is negative, this implies a
bias, or that the forecasts tend to be too high.
– If the average is positive, the forecasts tend to be too low.
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 Testing for Randomness (slide 1 of 2)
• All forecasting models have the general form shown in
the equation below:

– The fitted value is the part calculated from past data and
any other available information.
– The residual is the forecast error.
– The fitted value should include all components of the
original series that can possibly be forecast, and the leftover
residuals should be unpredictable noise.
• The simplest way to determine whether a time series of
residuals is random noise is to examine time series graphs
of residuals visually—although this is not always reliable.
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 Testing for Randomness (slide 2 of 2)
• Some common nonrandom patterns are shown below.

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 The Runs Test
• The runs test is a quantitative method of testing
for randomness. It is a formal test of the null
hypothesis of randomness.
– First, choose a base value, which could be the average
value of the series, the median value, or even some
other value.
– Then a run is defined as a consecutive series of
observations that remain on one side of this base level.
• If there are too many or too few runs in the series, the null
hypothesis of randomness can be rejected.

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 12-3b Autocorrelation
• Another way to check for randomness of a time series of
residuals is to examine the autocorrelations of the residuals
– a type of correlation used to measure whether values of a
time series are related to their own past values.
• In positive autocorrelation, large observations tend to
follow large observations, and small observations tend to
follow small observations.
– The autocorrelation of lag k is essentially the correlation
between the original series and the lag k version of the series.
• Lags are previous observations, removed by a certain
number of periods from the present time.

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