Chap 19

Statistics for
Business and Economics

6th Edition
Chapter 19
Time-Series Analysis and Forecasting

Chapter Goals
After completing this chapter, you should be able to:

▪ Compute and interpret index numbers
▪ Weighted and unweighted price index
▪ Weighted quantity index
▪ Test for randomness in a time series
▪ Identify the trend, seasonality, cyclical, and irregular
components in a time series
▪ Use smoothing-based forecasting models, including
moving average and exponential smoothing
▪ Apply autoregressive models and autoregressive
Statisticsintegrated
for Business and average models
moving
Economics, 6e © 2007 Pearson
Education, Inc. 2
Index Numbers
▪ Index numbers allow relative comparisons

over time
▪ Index numbers are reported relative to a Base
Period Index
▪ Base period index = 100 by definition

▪ Used for an individual item or measurement
Statistics for Business and

Education, Inc. 3
Single Item Price Index
Consider observations over time on the price of a single

item
▪ To form a price index, one time period is chosen as a
base, and the price for every period is expressed as a
percentage of the base period price
▪ Let p0 denote the price in the base period
▪ Let p1 be the price in a second period
▪ The price index for this second period is

Education, Inc. 4
Index Numbers: Example
▪ Airplane ticket prices from 1995 to 2003:
Index
Year Price (base year
= 2000)
1995 272 85.0
1996 288 90.0
1997 295 92.2
1998 311 97.2
Base Year:
1999 322 100.6
2000 320 100.0
2001 348 108.8
2002 366 114.4
Statistics
2003 for384
Business120.0
and
Education, Inc. 5
Index Numbers: Interpretation
▪ Prices in 1996 were 90%

of base year prices

of base year prices (by
definition, since 2000 is the
base year)

of base year prices
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Aggregate Price Indexes
▪ An aggregate index is used to measure the rate
of change from a base period for a group of items
Aggregate
Price Indexes
Unweighted Weighted
aggregate aggregate
price index price indexes
Laspeyres Index
Education, Inc. 7
Unweighted
Aggregate Price Index
▪ Unweighted aggregate price index for period
t for a group of K items:
i = item
t = time period
K = total number of items
= sum of the prices for the group of items at time t
= sum of the prices for the group of items in time period 0

Education, Inc. 8
Unweighted Aggregate Price
Index: Example
Automobile Expenses:
Monthly Amounts ($):
Index
Year Lease payment Fuel Repair Total (2001=100)
2001 260 5X45 40 345 100.0
2002 280 60 40 380 110.1
2003 305 10X55 45 405 117.4
2004 310 50 50 410 118.8
Statistics for Business▪ and

Unweighted total expenses were 18.8%
higher in 2004 than in 2001
Education, Inc. 9
Weighted
Aggregate Price Indexes
▪ A weighted index weights the individual prices by
some measure of the quantity sold
▪ If the weights are based on base period quantities the
index is called a Laspeyres price index
▪ The Laspeyres price index for period t is the total cost of
purchasing the quantities traded in the base period at prices in
period t , expressed as a percentage of the total cost of
purchasing these same quantities in the base period
▪ The Laspeyres quantity index for period t is the total cost of the
quantities traded in period t , based on the base period prices,
expressed as a percentage of the total cost of the base period
Statisticsquantities
for Business and
Education, Inc. 10
Laspeyres Price Index
▪ Laspeyres price index for time period t:
= quantity of item i purchased in period 0
= price of item i in time period 0

Statistics for Business= and
price of item i in period t
Education, Inc. 11
Laspeyres Quantity Index
▪ Laspeyres quantity index for time period t:
= price of item i in period 0
= quantity of item i in time period 0

= quantity of item i in period t
12
The Runs Test for Randomness
▪ The runs test is used to determine whether a

pattern in time series data is random
▪ A run is a sequence of one or more
occurrences above or below the median
▪ Denote observations above the median with “+”
signs and observations below the median with
“-” signs
13
(continued
)
▪ Consider n time series observations
▪ Let R denote the number of runs in the
sequence
▪ The null hypothesis is that the series is random
▪ Appendix Table 14 gives the smallest
significance level for which the null hypothesis
can be rejected (against the alternative of
positive association between adjacent
Statisticsobservations) as a function of R and n
for Business and
Education, Inc. 14
(continued
)
▪ If the alternative is a two-sided hypothesis on
nonrandomness,
▪ the significance level must be doubled if it is
less than 0.5
▪ if the significance level, α, read from the table
is greater than 0.5, the appropriate
significance level for the test against the two-
sided alternative is 2(1 - α)
Education, Inc. 15
Counting Runs
Sales
Median
Time
--+--++++-----++++
Runs: 1 2 3 4 5
6
Economics, 6e © n 2007
= 18 Pearson
and there are R = 6 runs
Education, Inc. 16
Runs Test Example
n = 18 and there are R = 6 runs
▪ Use Appendix Table 14

▪ n = 18 and R = 6
▪ the null hypothesis can be rejected (against the
alternative of positive association between adjacent
observations) at the 0.044 level of significance
▪ Therefore we reject that this time series is random
using α = 0.05
Education, Inc. 17
Runs Test: Large Samples
▪ Given n > 20 observations
▪ Let R be the number of sequences above or below the
median
Consider the null hypothesis H0: The series is random
▪ If the alternative hypothesis is positive association

between adjacent observations, the decision rule is:

Education, Inc. 18
Runs Test: Large Samples
(continued
)
Consider the null hypothesis H0: The series is random
▪ If the alternative is a two-sided hypothesis of

nonrandomness, the decision rule is:

Education, Inc. 19
Example: Large Sample
Runs Test
▪ A filling process over- or under-fills packages,
compared to the median
OOO U OO U O UU OO UU OOOO UU O UU
OOO UUU OOOO UU OO UUU O U OO UUUUU
OOO U O UU OOO U OOOO UUU O UU OOO U
OO UU O U OO UUU O UU OOOO UUU OOO
n = 100 (53 overfilled, 47 underfilled)

R = 45 runs
Education, Inc. 20
Runs Test
(continued
)
▪ A filling process over- or under-fills packages,
compared to the median
▪ n = 100 , R = 45

Education, Inc. 21
Runs Test
(continued
H0: Fill amounts are random )
H1: Fill amounts are not random

Test using α = 0.05
Rejection Region Rejection Region

α/2 = 0.025 α/2 = 0.025
Since z = -1.206 is not less than -z.025 = -1.96,

we do not reject H0
22
Time-Series Data
▪ Numerical data ordered over time

▪ The time intervals can be annually, quarterly,
daily, hourly, etc.
▪ The sequence of the observations is important
▪ Example:
Year: 2001 2002 2003 2004
2005
Sales: 75.3 74.2 78.5 79.7
80.2
Education, Inc. 23
Time-Series Plot
A time-series plot is a two-dimensional
plot of time series data
▪ the vertical axis

measures the variable
of interest
▪ the horizontal axis

corresponds to the
time periods
Education, Inc. 24
Time-Series Components
Time Series
Trend Seasonality Cyclical Irregular

Component Component Component Component

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Trend Component
▪ Long-run increase or decrease over time

(overall upward or downward movement)
▪ Data taken over a long period of time
t re n d
Sales U pw a r d
Time
26
Trend Component
(continued
)
▪ Trend can be upward or downward
▪ Trend can be linear or non-linear
Sales Sales
Time Time
Downward linear trend Upward nonlinear trend
27
Seasonal Component
▪ Short-term regular wave-like patterns

▪ Observed within 1 year
▪ Often monthly or quarterly
Sales
Summe
Winte r
Summe r
Winte r Spring Fall
r
Spring Fall
Time (Quarterly)
Education, Inc. 28
Cyclical Component
▪ Long-term wave-like patterns

▪ Regularly occur but may vary in length
▪ Often measured peak to peak or trough to
trough
1 Cycle
Sales

Economics, 6e © 2007 Pearson Year
Education, Inc. 29
Irregular Component
▪ Unpredictable, random, “residual” fluctuations

▪ Due to random variations of
▪ Nature
▪ Accidents or unusual events
▪ “Noise” in the time series

Education, Inc. 30
Time-Series Component Analysis
▪ Used primarily for forecasting
▪ Observed value in time series is the sum or product of
components
▪ Additive Model
▪ Multiplicative model (linear in log form)
where Tt = Trend value at period t

St = Seasonality value for period t
Ct = Cyclical value at time t
It = Irregular (random) value for period t
31
Smoothing the Time Series
▪ Calculate moving averages to get an overall

impression of the pattern of movement over
time
▪ This smooths out the irregular component
Moving Average: averages of a

designated
number of consecutive
time series values
32
(2m+1)-Point Moving Average
▪ A series of arithmetic means over time

▪ Result depends upon choice of m (the
number of data values in each average)
▪ Examples:
▪ For a 5 year moving average, m = 2
▪ For a 7 year moving average, m = 3
▪ Etc.
▪ Replace each xt with
33
Moving Averages
▪ Example: Five-year moving average
▪ First average:
▪ Second average:
▪ for
Statistics etc.
Business and
Education, Inc. 34
Example: Annual Data
Year Sales
1 23
2 40
3 25 …
4 27
5 32
6 48
7 33
8 37 …
9 37
10 50
11 40
Statistics
etc…
foretc…
Business
and
Education, Inc. 35
Calculating Moving Averages
▪ Let m = 2 5-Year
Average Moving
Year Sales Year Average
1 23 3 29.4
2 40 4 34.4
3 25 5 33.0
4 27 6 35.4
5 32 7 37.4
6 48 8 41.0
7 33 9 39.4
8 37 etc… … …
9 37
Statistics
10 for ▪ and
50 Business Each moving average is for a
Economics,
11 406e © 2007consecutive
Pearson block of (2m+1) years
Education, Inc. 36
Annual vs. Moving Average
▪ The 5-year
moving average
smoothes the
data and shows
the underlying
trend

Education, Inc. 37
Centered Moving Averages
(continued)
▪ Let the time series have period s, where s is even
number
▪ i.e., s = 4 for quarterly data and s = 12 for monthly data
▪ To obtain a centered s-point moving average series
Xt*:
▪ Form the s-point moving averages
▪ Form the centered s-point moving averages

Education, Inc. 38
Centered Moving Averages
▪ Used when an even number of values is used in the moving
average
▪ Average periods of 2.5 or 3.5 don’t match the original
periods, so we average two consecutive moving averages to
get centered moving averages
4-Quarter Centered
Average Moving Centered Moving
Period Average Period Average
2.5 28.75 3 29.88
3.5 31.00 4 32.00
4.5 33.00 5 34.00
5.5 35.00 etc… 6 36.25
6.5 37.50 7 38.13
7.5 38.75 8 39.00
Statistics for Business
8.5
and
39.25 9 40.13
Economics, 6e9.5 © 200741.00
Pearson
Education, Inc. 39
Calculating the
Ratio-to-Moving Average
▪ Now estimate the seasonal impact

▪ Divide the actual sales value by the centered
moving average for that period

Education, Inc. 40
Calculating a Seasonal Index
Centered Ratio-to-
Moving Moving
Quarter Sales Average Average
1 23
2 40
3 25 29.88 83.7
4 27 32.00 84.4
5 32 34.00 94.1
6 48 36.25 132.4
7 33 38.13 86.5
8 37 39.00 94.9
9 37 40.13 92.2
10 50 etc… etc…
Statistics
11
for Business
40
and
… …
Economics,
… 6e
… © 2007… Pearson …
Education, Inc. 41
Calculating Seasonal Indexes
(continued)
Centered Ratio-to-
Moving Moving
Quarter Sales Average Average
1 23
Fall 2 40 1. Find the median
3 25 29.88 83.7 of all of the
4 27 32.00 84.4
same-season
5 32 34.00 94.1
6 48 36.25 132.4
values
Fall 2. Adjust so that
7 33 38.13 86.5
8 37 39.00 94.9 the average over
9 37 40.13 92.2 all seasons is
10 50 etc… etc…
Statistics
Fall for Business and 100
11 40 … …
Economics,
… 6e
… © 2007… Pearson …
Education, Inc. 42
Interpreting Seasonal Indexes
▪ Suppose we get these
seasonal indexes:
Season
Seasonal ▪ Interpretation:
Index
Spring sales average 82.5% of the
Spring 0.825 annual average sales
Summer 1.310 Summer sales are 31.0% higher

than the annual average sales
Fall 0.920 etc…
Winter 0.945
Economics, 6e © Σ =2007
4.000Pearson
-- four seasons, so must sum to 4
Education, Inc. 43
Exponential Smoothing
▪ A weighted moving average

▪ Weights decline exponentially
▪ Most recent observation weighted most
▪ Used for smoothing and short term

forecasting (often one or two periods into
the future)

Education, Inc. 44
Exponential Smoothing
(continued)
▪ The weight (smoothing coefficient) is α

▪ Subjectively chosen
▪ Range from 0 to 1
▪ Smaller α gives more smoothing, larger α
gives less smoothing
▪ The weight is:
▪ Close to 0 for smoothing out unwanted cyclical
and irregular components
▪ Close to 1 for forecasting
Education, Inc. 45
Exponential Smoothing Model
▪ Exponential smoothing model
where:
= exponentially smoothed value for period t
= exponentially smoothed value already
computed for period i - 1
Statistics for Business and value in period t
xt = observed
Economics, 6e © α2007 Pearson
= weight (smoothing coefficient), 0 < α < 1
Education, Inc. 46
Exponential Smoothing Example
▪ Suppose we use weight α = .2
Time Forecast
Sales Exponentially Smoothed
Period from prior
(Yi) Value for this period (Ei)
(i) period (Ei-1)
= x1
1 23 -- 23 since no
2 40 23 (.2)(40)+(.8)(23)=26.4 prior
3 25 26.4 (.2)(25)+(.8)(26.4)=26.12 information
4 27 26.12 (.2)(27)+(.8)(26.12)=26.296 exists
5 32 26.296 (.2)(32)+(.8)(26.296)=27.437
6 48 27.437 (.2)(48)+(.8)(27.437)=31.549
7 33 31.549 (.2)(48)+(.8)(31.549)=31.840
8 37 31.840 (.2)(33)+(.8)(31.840)=32.872
9
Statistics 37
for Business32.872
and (.2)(37)+(.8)(32.872)=33.697
10 50 33.697 (.2)(50)+(.8)(33.697)=36.958
Economics,
etc.
6e ©
etc.
2007 Pearson
etc. etc.
Education, Inc. 47
Sales vs. Smoothed Sales
▪ Fluctuations
have been
smoothed
▪ NOTE: the
smoothed value in
this case is
generally a little low,
since the trend is
upward sloping and
the weighting factor
is only .2
Education, Inc. 48
Forecasting Time Period (t + 1)
▪ The smoothed value in the current period (t)

is used as the forecast value for next period
(t + 1)
▪ At time n, we obtain the forecasts of future

values, Xn+h of the series

Education, Inc. 49
Exponential Smoothing in Excel
▪ Use tools / data analysis /

exponential smoothing
▪ The “damping factor” is (1 - α)

Education, Inc. 50
Forecasting with the Holt-Winters
Method: Nonseasonal Series
▪ To perform the Holt-Winters method of forecasting:
▪ Obtain estimates of level and trend Tt as
▪ Where α and β are smoothing constants whose

values are fixed between 0 and 1
▪ Standing at time n , we obtain the forecasts of future
values, Xn+h of the series by
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Method: Seasonal Series
▪ Assume a seasonal time series of period s

▪ The Holt-Winters method of forecasting uses a
set of recursive estimates from historical series
▪ These estimates utilize a level factor, α, a trend
factor, β, and a multiplicative seasonal factor,
γ

Education, Inc. 52
(continued)
▪ The recursive estimates are based on the following
equations
Where
Statistics for Business and is the smoothed level of the series, Tt is the s
Economics, 6e © 2007 of the series, and Ft is the smoothed seasonal adjustme
Pearson
Education, Inc. 53
(continued)
▪ After the initial procedures generate the level,

trend, and seasonal factors from a historical
series we can use the results to forecast future
values h time periods ahead from the last
observation Xn in the historical series
▪ The forecast equation is

where the seasonal factor, Ft, is the one generated
Economics, 6e © 2007 Pearson the most recent seasonal time period
Education, Inc. 54
Autoregressive Models
▪ Used for forecasting

▪ Takes advantage of autocorrelation
▪ 1st order - correlation between consecutive values
▪ 2nd order - correlation between values 2 periods
apart
▪ pth order autoregressive model:
Statistics for Business and Random

Economics, 6e © 2007 Pearson Error
Education, Inc. 55
(continued)
▪ Let Xt (t = 1, 2, . . ., n) be a time series

▪ A model to represent that series is the autoregressive
model of order p:
▪ where
▪ γ, φ1 φ2, . . .,φp are fixed parameters
▪ εt are random variables that have
▪ mean 0
Statistics for▪ Business
constant variance
and
Economics,▪6eand©are uncorrelated
2007 Pearson with one another
Education, Inc. 56
(continued)
▪ The parameters of the autoregressive model are

estimated through a least squares algorithm, as the
values of γ, φ1 φ2, . . .,φp for which the sum of
squares
is a minimum

Education, Inc. 57
Forecasting from Estimated
▪ Consider time series observations x1, x2, . . . , xt
▪ Suppose that an autoregressive model of order p has been fitted to
these data:
▪ Standing at time n, we obtain forecasts of future values of the

series from
▪ Where for j > 0, is the forecast of Xt+j standing at time n and

for j ≤ 0 , is simply the observed value of Xt+j
Education, Inc. 58
Autoregressive Model:
Example
The Office Concept Corp. has acquired a number of office
units (in thousands of square feet) over the last eight years.
Develop the second order autoregressive model.
Year Units
1999 4
2000 3
2001 2
2002 3
2003 2
2004 2
2005 4
2006 6
Education, Inc. 59
Autoregressive Model:
Example Solution
▪ Develop the 2nd order Year xt xt-1 xt-2
table 99 4 -- --
00 3 4 --
▪ Use Excel to estimate 01 2 3 4
a regression model 02 3 2 3
03 2 3 2
Excel Output 04 2 2 3
05 4 2 2
06 6 4 2

Education, Inc. 60
Autoregressive Model
Example: Forecasting
Use the second-order equation to forecast

number of units for 2007:

Education, Inc. 61
Autoregressive Modeling Steps
▪ Choose p
▪ Form a series of “lagged predictor” variables
xt-1 , xt-2 , … ,xt-p
▪ Run a regression model using all p
variables
▪ Test model for significance
▪ Use model for forecasting
Education, Inc. 62
Chapter Summary
▪ Discussed weighted and unweighted index numbers

▪ Used the runs test to test for randomness in time series
data
▪ Addressed components of the time-series model
▪ Addressed time series forecasting of seasonal data
using a seasonal index
▪ Performed smoothing of data series
▪ Moving averages
▪ Exponential smoothing
▪ Addressed autoregressive models for forecasting
Education, Inc. 63

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Chap 19

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Statistics for

Business and Economics

Time-Series Analysis and Forecasting

After completing this chapter, you should be able to:

▪ Index numbers allow relative comparisons

▪ Base period index = 100 by definition

Statistics for Business and

Consider observations over time on the price of a single

Statistics for Business and

▪ Prices in 1996 were 90%

▪ Prices in 2000 were 100%

▪ Prices in 2003 were 120%

= sum of the prices for the group of items at time t

= sum of the prices for the group of items in time period 0

Statistics for Business▪ and

= quantity of item i purchased in period 0

= price of item i in time period 0

▪ Laspeyres quantity index for time period t:

= price of item i in period 0

= quantity of item i in time period 0

▪ The runs test is used to determine whether a

n = 18 and there are R = 6 runs

▪ Use Appendix Table 14

Consider the null hypothesis H0: The series is random

▪ If the alternative hypothesis is positive association

Statistics for Business and

▪ If the alternative is a two-sided hypothesis of

Statistics for Business and

n = 100 (53 overfilled, 47 underfilled)

Statistics for Business and

H1: Fill amounts are not random

Rejection Region Rejection Region

Since z = -1.206 is not less than -z.025 = -1.96,

▪ Numerical data ordered over time

▪ the vertical axis

▪ the horizontal axis

Trend Seasonality Cyclical Irregular

Statistics for Business and

▪ Long-run increase or decrease over time

▪ Short-term regular wave-like patterns

▪ Long-term wave-like patterns

Statistics for Business and

▪ Unpredictable, random, “residual” fluctuations

Statistics for Business and

▪ Multiplicative model (linear in log form)

where Tt = Trend value at period t

▪ Calculate moving averages to get an overall

Moving Average: averages of a

▪ A series of arithmetic means over time

Statistics for Business and

▪ Form the centered s-point moving averages

Statistics for Business and

▪ Now estimate the seasonal impact

Statistics for Business and

Summer 1.310 Summer sales are 31.0% higher

▪ A weighted moving average

▪ Used for smoothing and short term

Statistics for Business and

▪ The weight (smoothing coefficient) is α

▪ The smoothed value in the current period (t)

▪ At time n, we obtain the forecasts of future

Statistics for Business and