Time Series Analysis and

Forecasting
Session 6

1
Session Plan
Testing for stationarity
Graphical
Autocorrelation Function
Unit Root tests
Stationarity Tests

2
Plotting the time series
Symptoms of non-stationarity
Change in levels- constant mean?
Increasing/ decreasing magnitudes of fluctuations over
time- constant variance?
Intermittent bursts of very high or very low fluctuations-
constant variance?
Covariance of lag k constant?- not easy to ‘see’
Graphical view may mislead us…
If in doubt- should we assume stationarity or non-
stationarity? What should be our null hypothesis?
3
Autocorrelation Function (ACF) or
Correlogram
Population Sample
ˆk
k ˆ k 
k  ˆ0
0 nk

ρk is unitless and [-1 , 1]  (Y  Y )(Y

t t k Y )
ˆk  t 1
(n  k )
The graph of ρk for varying values of k
is the population correlogram. For white - noise,

Each type of stochastic process has a ˆ k is approx N (0, 1 n )

characteristic correlogram or m

‘signature’. Q  stat  n ˆ k2 is approx  m2

k 1

The null hypothesis is white-noise.

m
ˆ k2
LB  stat  n(n  2) is also  m2
k 1 (n  k )
If Q-stat or LB-stat is significant,
reject null hypothesis.
4
Unit root process-an illustration
Consider this series: Yt=ρYt-1+ut, -1<=ρ<=1
If ρ=1, this is a random walk with no drift, a non-stationary
process. It is said to have a ‘unit root’
If │ρ│<1, this process can be shown to be stationary (why?)
If we use the ‘Lag operator’ LYt=Yt-1, L2Yt=Yt-2 etc,
We can rewrite the above as
Yt=ρLYt+ut
(1-ρL)Yt=ut
If ρ=1, (1-L)Yt=ut
(1-L) is a polynomial which has unit root in L=1

5
Unit Root Tests
Consider •Why not simply run an OLS regression of ΔYt
Yt  Yt 1  ut ,  1    1 against Yt-1 and test whether δ =0?
•If yes, conclude Yt is non-stationary
Yt  (   1)Yt 1  ut •If δ<0, conclude Yt is stationary.
 Yt 1  ut •What if δ>0?????
•While the thinking is in the correct direction,
  (   1) the rub is that ordinary t-tests are not applicable.
There are three versions of what are called Dickey-Fuller Test depending on the
assumed stochastic process (our good old friends!):
Random Walks :
Without Drift : Yt  Yt 1  ut
With Drift but no deterministic trend : Yt  1  Yt 1  ut
With drift and determinsistic trend : Yt  1   2t  Yt 1  ut
In each case, H0: δ=0, i.e., Yt is non-stationary
Cut-off values are dependent on which version (no guidance !)we are
6
testing for
Augmented Dickey-Fuller (ADF) Test
• DF test assumes that the error terms ut are serially uncorrelated.

• If we have reasons to believe otherwise, we use ADF by estimating and testing an

‘augmented’ regression equation:
m
Yt  1   2t  Yt 1   Yt i   t
i 1

• Again, we test for δ=o, using the same cut-off values as for DF test.

• The number of lags m to be used on the RHS is till the error terms become
white-noise.
• Philips-Peron (PP) is a non-parametric test equivalent to ADF, which does not
use lagged dependent values on the RHS
There are also F-tests of joint hypotheses for the DF regression equations to test
whether all βs are simultaneously =0. (Out of scope for this course)
7
Criticism of Dickey-Fuller and
Phillips-Perron-type tests
Main criticism is that the power of the tests is low if the
process is stationary but with a root close to the non-
stationary boundary.
e.g. the tests are poor at deciding if
ρ=1 or ρ=0.95,
especially with small sample sizes.
If the true data generating process (DGP) is
Yt = 0.95Yt-1 + ut
then the null hypothesis of a unit root should be rejected.
One way to get around this is to use a stationarity test as
well.

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KPSS Test with stationarity as null
Stationarity tests have
H0: Yt is stationary
Vs
H1: Yt is non-stationary
By default, the data will be assumed to be stationary.
One such stationarity test is the KPSS test (Kwaitowski, Phillips,
Schmidt and Shin).
Two versions: Consider Yt=β1+β2t+ut
 Trend stationary: H0: β2=0
 Level stationary: H0: β1 is a constant (does not have random walk element)
 We can compare the results of these tests with the ADF/PP procedure
to see if we obtain the same conclusion.
04/20/2024 9
Unit root tests Vs KPSS
A Comparison
ADF / PP KPSS
H0: Yt  I(1) H0: Yt  I(0)
H1: Yt  I(0) H1: Yt  I(1)
Guilty until proved innocent Vs Innocent until proved
guilty approaches to justice
Four possible outcomes
a. Reject H0 and Do not reject H0
b. Do not reject H0 and Reject H0
c. Reject H0 and Reject H0
d. Do not reject H0 and Do not reject H0
04/20/2024 10
Transforming Non-stationary Series
If the series is difference stationary:

Yt=β1+Yt-1+ut What if
ΔYt= Yt-Yt-1=β1+ut is stationary

If the series is trend stationary:

Yt  1   2t  Yt 1  ut ?
Yt=β1+β2t+ut
Yˆt  ˆ1  ˆ2t  uˆt
Estimate
Then, uˆt  Yˆt  ˆ1  ˆ2t

ut-hat is stationary…

What if the trend is quadratic? 11