LS 01: Introduction to time series analysis 1) Theoretical basics (considerations) Eviews: Method Least Squares - Linear Regression

2) Statistical analysis (time series plot, correlogram,

Use of time series analysis in economics:
Empirical basis for economic theories / economic
studies (GDP forecast, seasonally adjusted AL ratio,
business cycle analysis / estimation of parameters for
models of financial math (returns, correlations) /
forecast for prices or returns (stocks, foreign
exchange, returns) / application in risk Mgt. /
Estimation of interest structures
What is a time series analysis?
Ad hoc definition of a time series: Time series are
ordered sequences of observations (values of
economic time series are very likely to be
interdependent) / Descriptive modeling: Modeling of
time series with components (trend, cycle, season) /
Stochastic modeling: Modeling the dependency
structure of time series by stoch , Processes / forecast
of future values from the observations of a time series
3 components:
Trend: Long-term development / business cycle:
Cyclical variation / season: Seasonal fluctuations +
residual component (random fluctuation): One-off and
random influences, the timing and strength of which
are difficult or impossible to estimate (weather, strikes,
FX, machine failures etc.)
Simple stochastic model - random walk with drift
Yt = δ + Yt-1 + ut / ∆Y = Yt - Yt-1 = δ + ut
Values of Y at time t depend on the values at time t-1.
There is also a constant δ.
There is also a random fluctuation ut.
The differences ∆Y fluctuate randomly around the
value δ (expected value of Yt).
Repeated insertion into the model equation delivers
tests)
3) Modeling: choosing a model and reviewing it
4) Forecast: quality of the forecast (confidence
interval)
LS 02: Descriptive modeling of time series
Components of economic time series (trend,
business cycle and season) Business cycle & trend
("smooth component"). Trend can also be exponential,
logarithmic, negative.
Additive model: Yt = Ft + St + Et (all additive)
Trend with seasonal fluctuations and constant
amplitude. Periodic deviations are independent of the
trend value. Ft = 207'143.30 + 1133.867 * t
Multiplicative model: Yt = Ft * St * Et (all Eview's solution with logarithmization of the linear
multiplicative) trend. Then reverse solution again with exponential
Trend with seasonal fluctuations with proportionally function (see before).
increasing amplitude. Periodic deviations from the
trend are proportional to the size of the trend. Rashes Example of polynomial growth
grow with trend. A multiplicative model can be Fitting a polynomial regression for the smooth
converted into an additive model by logarithmization component. Additional modeling of seasonal
(logYt = logFt + logSt + logEt). fluctuations with dummy variables for each month:
Yt = β0 + β1 * t + β2 * t2 + β3 * t3 + Σαi + Etαi =
dummy variables for the months / i (1, ..., 11)

The ut are independent and identically distributed

random variables with expected value 0 and variance
σ2.
A variable with these properties is called white noise.

The illustration shows why the process is called a
random walk with drift. The process consists of two
components:
◦ Deterministic growth path (drift): Y0 + δ⋅t
◦ Accumulated disturbance variables (random walk):
Σui
Goals of the time series analysis: Description of
time series
Goal: To make internal relationships visible
Descriptive methods: Graphics of the time series
("time series plot") / decomposition of the time series
into components / lagged scatter plot (LS03) /
correlogram (LS03)
Time series plot: Provides information about trends,
seasonal effects, variability and "outliers". Usual
representation: X: time and Y: measured variable
Properties of time series plot
Methods for estimating a trend
Regression model or filtering (method of moving
average)
Time series plot provides an indication of a possible
regression model
Seasonality Estimation Methods (In Course)
Modeling with dummy variables
Seasonality mostly known from problem / data (e.g. Q
data)
Determination of linear trend and exponent. Ft = 317.9641 + 0.081953 * t + 0.000106 * t2 - 5.77E-
Growth 08 * t3 + Σαit
Linear growth (approximately constant absolute
Warning: auto-correlated residuals (Durbin-
increases)
Ft = β0 + β1 * t + Et Watson)
Durbin-Watson stat. = 0.231636 (residuals highly
Exponential growth (roughly constant relative growth)
Ft = β0 * β1t + Et correlated)
-> As close as possible to 2
Linearization of exponential growth -> linear trend
log Ft = log β0 + t * log β1 + log Et
Trend determination through filtering / smoothing
Filtering a time series (moving average)
Example: Ln (4.6) = 1.526 => e1.526 = 4.6

Misinterpretations depending on: choice of scales
(transformed? Units?) / Choice of section (zero point?
Start? End?)
Time series plot is a unique realization of a random
process: The next realization can reject hypotheses /
Only under certain conditions (LS03) can one-off
realizations be considered representative. Conclusion:
Time series plots are important analytical tools, but
should be used with caution.
Modeling of time series - goal: understanding &
defining model relationships
(Given a time series y1, y2, y3, ...)
Methods: Descriptive modeling (classic, "older" time
series analysis) / Stochastic modeling: specification of
a stochastic process (Yt) t = 1,2,3, ...
Process: Theoretical considerations, analysis of
empirical data to uncover the laws, definition of the
model type, estimation of the model parameters,
testing of the model quality
Forecast with time series - goal: forecast of
unknown values with associated forecast intervals
The basis is an estimated and validated model
Procedure of an analysis
Regression models:
The regressor variable is the variable t of the observed
points in time.
Parameters can be determined using conventional
OLS estimators.
Determination of linear growth with regression
model in EViews:
The remaining time series "Residual" only contains
seasonality and remaining term.
A trend can be estimated by filtering the time series.
Prerequisite: Seasonal fluctuation has been adjusted
or does not exist. For filtering, a new time series is
generated with an additive, linear filter:
The "ai" are called weights. The smoothed series is
identified as a trend. The deviations from the
stochastic residual term. Disadvantage: Trend is not
described by the functional equation.
Linear filtering: simple moving average
If the additive, linear filter applies ...
p = q (symmetry) and sum of the "ai" = 1
(standardization)
Sum of "ai" = sum of all weights
Same weights: ai = 1 / (2p + 1) = 1 / (2q + 1)
... it is simply the same
average
The number of weights is odd n = 2p + 1 = 2q + 1
The number of weights "n" means length or Order of
the filter
At the edges p = q moving average values cannot be
calculated
Example: Real rate return with moving average:
3 different filters: p = 1 => n = 3 / p = 5 => n = 11 / p =
11 => n = 23
n = "length", depending on p / the larger, the smoother
General moving average
The position of the weights can be asymmetrical. In
addition, the weights can be different from one
another, with the standardization remaining. (p not
equal to q = asymmetry and "sum ai" = 1)
Warning: simple moving averages are distorted by
seasonal fluctuations. In order to eliminate seasonal
fluctuations, the moving averages must match the
cycle length. E.g. quarters = 4-element sliding.
average
Moving average for quarterly data is even order ->
average cannot be assigned to a point in time.
Sliding. Avg. with straight order / centered filtering
Use an odd number of time series values for the
calculation. The two outer time series values are
weighted with the factor ½. The weights at the edge
center the window at the observed point in time t.
Example with quarterly data:
Simple exponential filtering
α means smoothing parameter
Rule of thumb: α often between 0.1 and 0.3
Depending on the choice of α, past observations are
weighted differently. The smaller α, the less strongly
"more recent" points in time are weighted (but still the
strongest). The larger α, the less strongly "less
current" points in time are weighted (the most obvious
at all times).
Example: Exponential filtering of a real rate of
return with eviews and α = 0.2
Eviews: "Smoothing method": Trend and seasonality
can be included in exponential smoothing.
Holt-Winters method. At the beginning, you don't
know whether it's additive or multiplicative. Test both
and select where “Root Mean Squared Error (RMSE)”
is lower.
If δ ≠ 0 -> increases expected value> 0: E (Yt) = δ * t
(= drift)
Drift -> mean increases with time
Simulation example in Excel:
LS 03 Introduction to stochastic modeling
Static vs. Dynamic models - example demand
radio.
Requested quantity Q of a product depending on price
P and income Y.
Static model: Current price and current income
determine demand:
Qt = β1 + β2Pt + β3Yt + ut
Dynamic model: Current price and income from the
previous period determine demand:
Qt = β1 + β2Pt + β3Yt-1 + ut
Dynamic, autoregressive model: Current price and Time series as a stochastic model - definition
demand from the previous period determine demand:
Qt = β1 + β2Pt + β3Qt-1 + ut Time series = sequence of n observations yt.
Observations are the realization of the random
Feature, Transparent. static - arguments for variables Y1, Y2, ... Yn. The sequence as a section of
dynamic models the underlying stochastic process (infinite). Measuring
times can be discrete or continuous (with us: discrete).
Independent variables in static have an immediate The measured values can be discrete or continuous
effect. Adjustment of the dependent variable to the
(with us: continuous). Example of continuous time
independent one is completed within the current period series in discrete time (daily maximum of share
(process always seems to be in balance). Static prices).
models are often unsuitable because: 1) Activities are
determined by the past 2) Actors in economic
Comparison of random samples
processes react with a delay.
Cross-sectional data: Independence of the
Important properties of dynamic models observations is required. Then there are parameter
estimates according to BLUE.
Lag structure: Independents are delayed ("lagged").
Shows delayed effect of the regressors on the
Time series: random variables Yi are dependent.
dependent variable. Usually stochastic models Parameter estimation can be distorted (only one
dynamic models. observation at a time). So that the time series values
can be used for parameter estimation, the time series
Stochastic processes - definition must be stationary.
Stochastic process = infinite, temporally arranged
Description of time series with moments (3), if
sequence of random variables: (Yt, t = -∞, ...., + ∞). stationary:
(Simplified mostly started at time t = 0). The process
(Yt, t = 0,1,2,3 ...) is also called the data-generating 1) Expected value = mean of the time series: μt = E
process of the time series y0, y1, y2, ... (Yt)
2) Spread of the time series: σt2 = Var (Yt) = Cov (Yt,
Process in discrete time: data is collected at equally Yt)
spaced times / process in continuous time: continuous 3) Correlation of delayed values:
Error term as a stochastic process
Error term = Description of uncertainty in time series.
Reasons: 1) modeling of effects of unobserved /
unobservable variables, 2) measurement errors, 3)
random process
-> Often used as white noise
White noise - the simplest stochastic process
-> Casual for stationarity: mean values and variances
Strong white noise: Error term independently and constant over time
identically distributed (expected value = 0 "mean value
horizontal" and variance = σ2ε "constant") / Warning: OLS regression with EViews:
There is also "normally distributed" white noise,
special case! Distribution not identical (Gaussian curve
instead of horizontal).
Weak, white noise (relevant for us)
Available if εt = serial uncorrelated. May have
dependencies in third or higher moments and may not
be completely independent.
Special stochastic process - random walk with
drift
Yt = δ + Yt-1 + ut (δ as constant and ut white noise)
Problem: Everything OK except Durbin Watson (0.56)
Determination of expected value and variance (with indicates a problem. Reason: trend. If time series are
constant = 0 and Y0 = 0); Substitution by repeated not stationary -> usual test procedures provide
insertion; Yt = ut + ut-1 + ... + u1 (Yt is omitted), acc. distorted estimators; leads to false regression.
Calculation rule for E and Var.
Stationarity important prerequisite for analysis; if not
stationary -> make stationary! (Remove trend).
Weak and steady process
Weakly stationary (also covariance-stationary) if:
- μt = E (Yt) (strict, i.e. for all t, independent of time)
The expected value is constant
- Autocovariance depends only on k (the distance).
- It follows: variance is constant
- Weakly stationary if your first and second moments
do not depend on time. (E.g. black stat. = Black white
noise)
Types of instationarities:
Trends (not mean stat.), Heteroscedasticity (not
variance-stationary), or both, long periodicities
(business cycles)
How can stationary time series be recognized?
Consideration of the time series plots (danger of
deception) / autocorrelations and partial
autocorrelation function of the time series / tests for
stationarity (LS05) / window technology (different "cut
out windows" variabilities significant?)
Lagged scatter plot (e.g. logarithmic lynx data)
Is linear dependence on Yt and Yt-1 recognizable?
Y axis: normal data / shift X axis by time unit
In a year with few lynxes, it has little in the following
year
Autocorrelation function (AC function)
Measurement of dependence on Yt and Yt-k (Eviews
provides value).
Thumb rules for the AC function of a stationary
process:
Mind. N = 30 data points / only lags with k <n / 4
(purists) or Trust k <n / 2 (pragmatist) / Only lags k <10
* log10 (n). Equal distances and no gaps! (Holidays
are a problem).
Partial autocorrelation function (PAC)
Measures linear relationship between Yt and Yt-k after
eliminating the effects of the intermediate variables Yt-
1 to Yt-k + 1.
Coefficient okk measures partial effect after elimination
of the information contained in the other delayed
variables.
Correlogram pattern for white noise:
Goal: Within band -> randomly different from zero
(95%).
Q-Stat & Prob (H0 = p1 =… = pk = 0 white noise)
Prob> 0.05 -> assume H0 (example: lag 8 to lag 12;
white noise (not significantly different)).
Patterns for periodicity and non-stationary time
series:
---> Prob everywhere 0.000 (no white noise)
Attention: The same correlograms can differ from one
another. Time series come!
AR (p) process – definition
Autoregressive process -> variable is regressed on
itself. Model for the dependence of Yt on the past.
AR (1) process: Yt = α + φYt-1 + ut (φ = Beta at
regression number)
AR (p) process: Yt = α + φ1Yt-1 + φ2Yt-2 + ... + φpYt-
p + ut
Error term is white noise
A negative sign at φ leads to stronger swings.
φ = 1 -> no longer stationary (up to 1 limit, stationary
<1)
MA (∞) representation and moments AR (1)
processes
By recursive insertion, the AR (1) representation
results in the MA (∞) representation: Yt = α + φYt-1 +
ut ..... (algebraic conversion)
(Sum of error terms)
-> decaying influence of past disturbance terms ut-i
(Prerequisite for stationarity)
Moments (both constant)
Autocorrelations of an AR (1) process
Can be expressed by model parameters:
(for positive φ all theoretical autocorrelations are> 0)
For the n-1 possible empirical autocorrelations (finally)
the following sum applies (without proof):
Although all theoretical auto-correlations are positive,
some estimates will be negative. Be careful when
interpreting correlograms.
Lag operator and characteristic polynomial AR (p)
A lag operator is often used to simplify the notation of
an AR (p) process. The lag operator L shifts the index
of a variable by 1 in the past. LYt = Yt-1
Multiple use of L corresponds to multiple shift: LsYt =
Yt-s (specific case identity I: L0 = I -> L0Yt = Yt)
AR (p) model in the notation with lag operator:
Yt = α + φ1Yt-1 + φ2Yt-2 + ... + φpYt-p + ut
Yt = α + φ1LYt + φ2L2Yt + ... + φpLpYt + ut
Yt = α + (φ1L + φ2L2 + ... + φpLp) Yt + ut
(1- φ1L - φ2L2 - ... - φpLp) Yt = α + ut
Characteristic polynomial:
Φ (L) = (1 - φ1L - φ2L2 - ... - φpLp)
Φ (L) Yt = α + ut
MA (q) process - definition (moving average)
Yt is the weighted sum of the error terms
MA (1) process: Yt = α + ut + θut-1
MA (q) process:
Yt = α + ut + θ1ut-1 + θ2ut-2 + ... + θqut-q
The error term is white noise
Example MA (1) process / properties
Time series are shifted upwards on average.
Negative sign at θ -> Stronger debauchery
Time series are also stationary for θ = +/- 1.
AR (∞) representation (inversion) and moments of
an MA (1) process By recursive insertion, the MA (1)
representation results in the AR (∞) representation:
Yt = α + ut + θt-1 .... --->
The AR (∞) representation shows the decaying
influence of the past Yt .:
Moments: E (Yt) = α and Var (Yt) = σ2 (1 + θ2)  Var.
finally stay
Autocorrelation of an MA (1) process:
Autocovariances and correlations can be expressed
through the model parameters:
γ0 = Var (Yt) = σ2 (1 + θ2)
γ1 = Cov (Yt - Yt-1) = σ2θ
γk = Cov (Yt - Yt-k) = 0
(for k> 1 all theoretical autocovariances are 0.)
From this follows for the autocorrelations:
For k> 1, all autocorrelations are 0.
Lag operator and characteristic polynomial MA (q)
A lag operator is often used to simplify the notation of
an MA (q) process.
MA (q) model in the notation with lag operator:
Yt = α + θ1ut-1 + θ 2ut-2 + ... + θqut-q
Yt = α + ut + θ 1Lut + θ 2L2ut + ... + θqLqut
Yt = α + (1 + θ 1L + θ2L2 + ... + θqLq) ut
Characteristic polynomial:
Θ (L) = (1 - θ1L - θ2L2 - ... - θqLq)
Yt = α + Θ (L) ut
ARMA (p, q) process
Union of AR (p) and MA (q)
MA (q) process for the error term of AR (p)
ARMA (p, q) process:
Yt = α + φ1Yt-1 + φ2Yt-2 + ... + φpYt-p + θ1ut-1 + θ
2ut-2 + ... + θqut-q
-> Error term (ut) is white noise.
Notation with characteristic polynomial:
Φ (L) Yt = α + Θ (L) ut
Practice LS03
Calculation rules: expected value:
E (a + b * X + c * Y) = a + b * E (X) + c * E (Y)
With E (X) = μx and E (Y) = μy
Calculation rules: variance
Var (X) = (E ((X - E (X)) 2)
Var (X) = E (X2) - (E (X)) 2 (shift set for variances)
Var (X) = E (X2) if E (X) = 0
Var (X) greater than or equal to 0
Var (X +/- Y) = Var (X) + Var (Y) (X and Y are
uncorrelated)
Var (X +/- Y) = Var (X) + Var (Y) +/- 2 * Cov (X, Y) (X &
Y correlated)
Var (a * X +/- b * Y) = a2 * Var (X) + b2 * Var (Y) +/- 2 *
a * b * Cov (X, Y)
Calculation rules: covariance
Cov (X, Y) = E ((X - E (X)) * (Y - E (Y))
Cov (X, Y) = 0 (X & Y uncorrelated)
Cov (X, X) = Var (X)
Cov (a * b * X, c + d * Y) = b * d * Cov (X, Y)
Cov (X + Y, Z) = Cov (X, Z) + Cov (Y, Z)
Calculation of expected value, variance and
autocorrelation
Given: Random Walk with Drift
Calculation of expected value Yt = δ + Yt-1 + ut (with
Y0 = 0)
Y1 = δ + Y0 + u1 -> Y2 = δ + Y1 + u2
Y2 = δ + (δ + Y0 + u1) + u2 ---> .... ---> Yt = t * δ + ut +
ut-1 ... + u1
E (Yt) = E (t * δ + ut + ut-1 ... + u1)
E (Y t) = E (t * δ) + E (ut) + E (ut-1) + ... + E (u1) = t * δ
+ 0 + ... + 0 = t * δ
Calculating variance
Var (Yt) = Var (t * δ + ut + ut-1 ... + u1) = Var (t * δ) + t
* Var (u ...)
= 0 + t * 2u = Var (Yt) = t * 2u
Calc. Autok .: Cov (Yt, Yt-k) = E ((Yt - E (Yt)) (Yt-k - E
(Yt-k)) ---> =
E ((t * δ + ut + ut-1 ... + u1 - t * δ) ((tk) * δ + ut-k + ut-k-
1 ... + u1 - (tk) * δ) )
Cov (Yt, Yt-k) = E ((ut + ut-1 ... + u1) (ut-k + ut-k-1 ... +
u1))
Because of Cov (ut, ut-k) = 2u for k = 0 and 0 for k 
0 Correction of standard errors (flu agent) e.g. Prais-
Cov (Yt, Yt-k) = (t-k) * 2u
Interpretation of Lagged Scatterplot
Between times t and t + s, LOGLYNX and
LOGLYNX_1 move in the same direction, they fall.
Therefore there is a positive correlation between the
two variables. LOGLYNX_5 is increasing between the
same times. Therefore there is a negative correlation
between LOGLYNX and LOGLYNX_5.
LS04: Regression between time series / ARMA
models
Regression model for time series
The time series Yt is influenced by q further time
series Xt (1), Xt (2), ... Xt (q). Regression model:
Yt = β0 + β1Xt (1) + β2Xt (2) + ... + βqXt (q) + Et
Autocorrelated residuals
In contrast to models without a time series character,
time series models often (almost always) have
autocorrelated residuals. Reasons: positional structure
of the variables not correctly specified / variable not
taken into account / successive values of the missing
variables correlated? Then the residuals in the model
that does not take this variable into account are
correlated.
Impact of autocorrelated residuals: Ordinary OLS
estimators remain true to expectations, but they do not
have minimal variance, there are more precise
estimators / The standard error of the coefficients βi
are estimated distorted / This means that t-tests and
confidence intervals are inaccurate (t dependent on
standard deviation, and this is distorted ).
Detection of auto correlations
Graphical residual analysis (scatter plot) / analysis of
AC or PAC / Durbin Watson (Lag 1) / Breusch-Godfrey
(Lag p) / Box-Pierce Ljung Box (Lag p) - also known as
Portmanteau tests
Activities:
1) Adding additional explanatory variables (content)
2) Consideration of the situation structure of the
explanatory V. (content)
3) Generalized Least Square Estimator (GLS) ->
Winsten estimator
4) Modeling and incorporating the correlated errors as
an AR (p) model (flu agent) e.g. Cochrane-Orcutt
method
Only use GLS if 1) & 2) is fulfilled
Example with forced autocorrelations:
Coefficient β is well estimated. Stay true to
expectations.
Standard error is distorted.
Estimation without / taking into account the
correlated errors (Cochrane-Orcutt)
Coefficient = comparable, estimators are true to
expectations
Standard errors = clearly different, taking into account
the correlated errors (Cochrane-Orcutt) provides
smaller "s.e." (approx. 1/2)
Tests for auto-correlation of the error terms
Durbin-Watson test: values of 2 indicate that the error
terms are uncorrelated. Problem: Durbin-Watson only
tests the first autocorrelation. If error terms follow AR
(p) process with p> 1, the test fails.
Application of Durbin-Watson test using an
example:
Durbin Watson without correction: 3.3
Durbin Watson with correction (Cochrane Orcutt):
approx. 2
Bruche-Godfrey test
More general than the Durbin-Watson test. The value
of "p" must be determined before the test
(correlogram, you have to know beforehand -> play
around a bit).
Starting point for example: Et = φ1 * Et-1 + ... + φp *
Et-p + ut
(AR (p) process of error terms <-> autocorrelation)
Null hypothesis: H0: φi = 0, i = 1, ... p
Alternative hypothesis HA: φi ≠ 0 for at least one i
Here: reject P = 2 ... H0 because test significant. 1st
order AC.
Cochrane-Orcutt method for auto-correlated error
terms (special case AR (1) model for the error)
Model for the errors: Et = φ1 * Et-1 + ut (autocorre 1st
order)
Regression model of a time series, for example: Yt =
β0 + β1Xt (1) + β2Xt (2) + Et / forming the difference:
Use Y * t = Yt - φYt-1 / model for Yt and Yt-1
= β0 + β1Xt (1) + β2Xt (2) + Et - φ (β0 + β1Xt (1) +
β2Xt (2) + Et)
= β0 (1- φ) + β1 (Xt (1) - φXt-1 (1)) + β2 (Xt (2) -
φXt-1 (2)) + Et - φEt-1
Where: Et - φEt-1 = ut
= β * 0 + β1Xt * (1) + β2Xt * (2) + ut (new model;
auto correction gone, only white noise)
The following applies: β * 0 = β0 (1- φ) & X t * (1) = Xt
(1) - φXt-1 (1) & X t * (2) = Xt (2) - φXt-1 (2 )
The transformed model is free from autocorrelation
and meets the requirements of the general regression
model. Disadvantage: In order to calculate it, φ must
be known (estimated in EViews).
Example: Breusch-Godfrey test with p = 4
---> Residuals are autocorrelated (2nd order) with lag
2
Correction with flu: Cochrane-Orcutt model with lag 2
Properties of ARMA processes
Every stationary AR (p) process can be done with MA
(∞) -P. write
Any invertible MA (q) -P. can be called AR (∞) -P. write
Every stationary process can be approximated with an
ARMA process (!)

ARMA (p, q) processes are usually not clear. The

same process can be represented with different
combinations of p and q. Basically:

- Modeling with small p & q (0 - 4) simplify analysis

- AR representations are more suitable for the

estimation of parameters, since the OLS assumptions
are fulfilled
AR; φ1 = 0.3 und MA; θ1 = 0.8 (1. Bild
- MA representation is more suitable for the calculation ACF, 2. Bild PACF)
of variances and covariances.

Examples of Eview's estimates:

Time series is not stationary due to trend. Durbin

Watson too high. Estimation of the parameters with
errors. Model is not OK. (Trend)

Time series is stationary. OK model. Estimate

parameter OK. (without trend)

Properties of the ACF function of AR (p)

AR; φ1 = -0.8 und MA; θ1 = 0.3 (1. Bild
ACF, 2. Bild PACF)
Properties of the ACF function of AR (p)
LS05 - Trends and Unit Root Test / ARIMA Models
Deterministic vs. Stochastic trend
Fundamental differences:

Deterministic trend: Regressor "time" determines the

Properties of the PACF function of AR (p) time increase. Uncertainty in the system is described
by stationary interference. (Yt = α + β * t + εt)

Stochastic trend:

Shocks εt have persistent (persistent) effects. The

accumulated shocks (sum of εt) lead to the trend.
(Ascent with drift).

Deterministic trend (D):

Yt = f (t) + ut ut ̴ i.i.d.
f (t): function of time t
Frequently linear trend:

Yt = β0 + β1 * t + ut β0 and β1 determine growth path

Properties of the AC function of MA (q)
Moments of a linear trend:
E (Yt) = E (β0 + β1 * t + ut) = β0 + β1 * t
Var (Yt) = Var (β0 + β1 * t + ut) = σu2

Time series with a linear trend is non-stationary (non-

constant mean). It is variance-stationary, but not trend-
stationary.

Stochastic trend random walk with drift (C) AR (1)

Yt = δ + Yt-1 + ut ut ̴ i.i.d.

Representation as an MA (∞) process

Yt = δ + Yt-1 + ∑ui
Y0, δ determine growth path (drift)

moments:
Properties of the PACF function of MA (q)
E (Yt) = Y0 + δ * t
Properties of the PACF function of MA (q)
Var (Yt) = t * σu2
Non-canceling, damped, exponential or sine function.
Random walk with drift is not stationary (not constant
Root of the characteristic polynomial real =
mean, not constant variance)) not variance / trend
exponential function. Root of the characteristic
stationary
polynomial complex = sine function.
Stochastic trend Random Walk (B)
Theoretical ACF and PACF different ARMA (1,1)
processes
Yt = Yt-1 + ut
AR; φ1 = 0.8 and MA; θ1 = 0.3 (1st picture ACF, 2nd
Representation as an MA (∞) process
picture PACF)
Yt = Yt-1 + ∑ui

moments:

E (Yt) = Y0 (trend-stationary, i.e. constant on average)

Var (Yt) = t * σu2
Random Walk is not stationary (variance is not
constant)
Borderline case AR (1) process (A)
Yt = α + φYt-1 + ut
Representation as an MA (∞) process
moments:
<- if φ goes to 1 it becomes unstable
AR (1) process is stationary if φ applies
Comparison: A: AR (1), B: Random Walk, C:
Random Walk with Drift, D: Linear trend
Other features of a random walk (RW)
Autocorrelation: For fixed k, Yt and Yt-k are correlated
the more, the larger t is. For increasing k, ρk
converges to zero.
As t increases, convergence slows down.
A random walk has a long memory.
RW drift long in one direction without returning to the
mean of the time series -> trend
Y axis: autocorrelation / X axis: t = time
K: Distance between two time series elements
The bigger "k" the "worse" they know each other
Autocorrelation increases with increasing time ->
converges to 1 for all distances
Comparison of AR (1) process - MA (∞)
representation:
RW: constant weight:
Yt = δ + Yt-1 + ∑ui
AR (1): Decreasing weight:
Elimination of a trend - type of stationarity
Goal: A non-stationary time series with trend can be
transformed into a stationary time series by eliminating
the trend.
2 options: subtraction of a deterministic trend or
differentiation: formation of differences. Ex. 1. Diff: Yt -
Yt-1
A non-stationary time series means:
Trend stationary, if you remove the deterministic
trend ... (e.g. linear trend Yt = β0 + β1 * t + ut)
Differential stationary, if by means of differentiation ...
(Example: Random Walk Yt = δ + Yt-1 + ut)
... can be transformed into a stationary model.
Example of a trend-based time series: traffic
counting
EViews: Method Least Squares
Linear trend: Ft = β0 + β1 * t + ut -> Ft = 207'143.3 +
1133.867 * t
LS06: Time series with stochastic volatility
The remaining time series (“residual”) only contains
seasonality and residual term. The time series Introduction - Simple model for equity returns
"Residual" is still used. For example, to model
seasonality. Return on a share - Discrete return on a share
(“return”)
Example differential time series: Random Walk
with Drift
The new time series is white noise. Original time St = Current share price
series is stationary. (white noise is stationary)
For statistical analysis it is assumed that rt is normally
Example differential time series: GDP growth distributed. This leads to two problems:
Original time series = difference stationary 1) A normally distributed random variable takes values
between minus infinity and plus infinity, but rt is
New time series = growth rate (log return) compared to capped with -1 to plus infinity (-1 if St = 0 and St-1 ≠ 0)
previous quarter's Eviews: gdp_log = log (gdp) - log
(gdp (-4)) // Yt = (1-L4) log (BIPt) = log (BIPt) -log 2) Multi-period returns are not normally distributed,
(BIPt- 4) New time series is stationary. even if single-period returns are normally distributed
(follows from the probability calculation).
Integrated time series
-> Problems can be almost solved with steady returns,
A stochastic process Yt means integrated from the since these are viewed as more normally distributed.
order d if it has to be differentiated d times so that it
becomes stationary. Continuous (“log return”) versus discrete returns
Name: Yt ~ I (d) ("Process is integrated with order" d ")
Yt ~ I (1): Unit root process (integrated 1st order),
stationary after a single difference formation: Example:
RW with drift: Yt = δ + Yt-1 + ut
∆ Yt = Yt- Yt-1 = δ + ut  stationary
Yt ~ I (0): process is already stationary.
Example AR (1): Yt = α + φYt-1 + ut with φ
it is already stationary
The formation of the difference is described for
simplification with the difference operator ∆: The
difference operator ∆ forms the difference: ∆1 = ∆ Yt =
Yt- Yt-1 -> Multiple use of ∆ corresponds to multiple
difference formation. Example of second difference:
∆2 Yt = ∆ (∆Yt) = ∆ (Yt - Yt-1) = ∆Yt - ∆Yt-1 = ... = Yt
-2Yt-1 + Yt-2
Continuous return on a share (“log return”) normal is
Relationship with lag operator L: ∆3Yt = (1-L) dYt normally distributed:
* HAC: Heteroscedasticity and Autocorrelation
Consistent
For small price changes, the differences between
Unit root test helps in deciding which model choice is discrete and steady returns are small. If the discrete
correct. return lies in the interval (-0.10; +0.10), this leads to a
relative deviation between continuous and discrete
The consequences of Spurious Regression are more return of a maximum of approx. +/- 5%.
dramatic than modeling differences in a trend-based
process. Note: The analysis of differences describes Stochastic model for steady returns
(short-term) changes. The information about the
behavior of the process in equilibrium is not taken into Prerequisite: share price follows random walk or
account: Outlook: cointegration makes it possible to random walk with drift. Consequences for the
avoid this disadvantage modeling of steady returns:
ARIMA model -> Constant return is a constant μ with an error term.
Extension of the ARMA (p, q) model: ARIMA (p, d, q) -> Error term is white noise.
process is a process whose dth difference follows an
Model for constant return on a share:
ARMA (p, q).
ln (St / St-1) = rt = μ + εt
Implementation in eviews in two ways (e.g. ARIMA
(2,1,1)
μ = 0 -> random wak
Eviews: Form the first difference of the original time
series.
μ = const. -> Random walk with drift
Or Eviews: Introduce dependent variables directly into
the model as a difference. (D (y, 1))
εt white noise with E (εt) = 0 and Var (εt) = 2
Test for stationarity: unit root test
3 Stylized Facts of Financial Time Series - 1. Vola
Cluster
Is a time series stationary? If the zero of the
characteristic polynomial "Φ (z) = 1 - φz = 0 <-> φ = 1 /
Vola is subject to fluctuations. Time accumulations of
z" has the value 1, the process is not stationary. The
course swings. Example: UBS share (2003 - 2010)
solution to the zero of a polynomial is commonly
referred to as "root". If a zero has the value 1, its name 3 Stylized Facts of Financial Time Series - 2.
is "Unit Root". Leverage Effect
Negative relationship between yield and change in
volatility. Reason: Falling share prices lead to a higher
level of corporate leverage, which leads to increased
uncertainty and thus to higher volatility.
Real time series show asymmetrical reactions;
Negative messages influence vola more than positive
ones:
Simulated AR (1) process Yt = 0.3 + 0.6 Yt-1 + εt
Error term white noise:
εt i.i.d. with E (εt) = 0 and Var (εt) = 2 = 1/3 = 0.33
Absolutely. Expected value: Eu (Yt) = α / (1- φ) = 0.3 /
(1-0.6) = 0.75

Distance from 1-year GD in DJ since 1900 in percent Unconditional variance: Varu (Yt) = 2 / (1- φ2) =
0.33 / (1-0.62) = 0.52
3 Stylized Facts from Financial Time Series - 3.
Leptokurtosis

Leptokurtosis - narrow curvature and broad flanks ("fat

tails")

Small and large returns are overrepresented.

Example of UBS share (2003 to 2010):

Kurtosis 23.7, min -10.7, max 10.1

Comparison with white noise

Kurtosis -0.033, Min -3.3, Max 3.4

Conclusion for UBS example:

Accumulation of small returns around zero (Kurtosis

23.7 vs. -0.033 with white noise).

More extreme swings (min -10.7, max. 10.1 vs. -3.3,

3.4 with white noise

Conclusion stylized facts:

1. & 2. Can be solved. 3. Problem was not solved (just

determine)

Consequences on the choice of model

The model must be able to represent stochastic vola

(= variance)

-> Model with separate stochastic process for variance

ARCH model for time-discrete time series (ARCH =

autoregressive conditional heteroscedasticity)

Further developments:

GARCH: Generalized ARCH: extension to ARCH (∞)

process

EGARCH: Exponential GARCH for leverage effect

TGARCH: Thereshold GARCH: asymmetrical effect

(alphabet soup)

Conditional and unconditional variance - ARCH model

ARCH models distinguish explicitly conditioned &

unconditional var .:

Example AR (1) process:

Yt = α + φYt-1 + εt (εt i.i.d. with E (εt) = 0 and Var (εt) =

2)

Unconditional variance: Variance of the process “in the

long run” receives all the information: Var (Yt) = 2 /
1-φ2

Conditional variance: Variance in the information

available at time t, if Yt, Yt-1, ... Y1 realized .:

Var (Yt pt) = Var (εt) = 2

pt = common distribution of Yt, Yt-1, .... Y1

In the AR (1) process, the conditional variance

depends on the disturbance εt at time t (not constant,
coincidence).

In general, the conditional variance is a random

variable. With ARCH models, the conditional variance
is modeled as a function of time.

Example of conditional and unconditional variance: