Slides-Chapter-8 - TSA

Time Series Analysis
Chapter 8 - Nonlinearity
Annika Camehl
Econometric Institute
Erasmus University Rotterdam
Chapter 8 - Nonlinearity
Key concepts in this chapter:
• Regime-switching
• Threshold models
• Smooth transition models
• Markov-Switching models
• Structural change
• Testing for threshold nonlinearity
• Estimation of threshold models
• Forecasting with nonlinear models
Time Series Analysis: Chapter 8 1

Nonlinearity
(Autoregressive) Time series models take the general form

yt = g(yt−1, yt−2, . . . , yt−p; θ) + εt, (1)
where g(·) is some parametric function, θ denotes a vector of

unknown parameters, and εt is a white noise “shock” (“news”).
So far, we only considered linear AR models, where

g(yt−1, yt−2, . . . , yt−p; θ) = α + φ1yt−1 + φ2yt−2 + · · · + φpyt−p,
possibly augmented with additional components for trend,
seasonality and outliers.
⇒ If we allow nonlinear specifications for g(yt−1, yt−2, . . . , yt−p; θ),

the number of possibilities is infinite.
For economic and financial time series, most successful nonlinear
time series models incorporate the idea of regime-switching.
Regime-switching
• What do we mean by regime-switching, and why might this be

relevant for economic and financial variables?
Intuitively: The “world” (“the economy”/“financial markets”) can

be in different states or regimes, with switches between different
regimes occurring on a regular basis.
Examples of regimes:
• business cycle regimes: expansions vs. recessions;

• “bull” vs. “bear” markets;
• periods of low vs. high volatility.
⇒ Economic and financial variables (may) behave differently in

different regimes.
US Unemployment
11
10
3
1960 1970 1980 1990 2000 2010
Monthly US unemployment rate

Regime-switching models
Regime-switching models allow the dynamic behaviour of

economic and financial variables to depend on the regime which
occurs at any given point in time.
• Suppose we want to describe/forecast a financial or economic

variable yt with xt = (1, yt−1, . . . , yt−p, x1t, . . . , xkt)0 where xjt,
j = 1, . . . , k are exogenous variables.
• All regime-switching models assume that within each regime, a

linear model can describe the relationship between yt and xt.
But, across regimes, the parameters in the linear model can be
different.

In case of 2 regimes:
yt = α1 + φ1,1yt−1 + . . . + φ1,pyt−p
+ β1,1x1,t + . . . + β1,k xk,t + εt if regime 1 occurs,
and
yt = α2 + φ2,1yt−1 + . . . + φ2,pyt−p
+ β2,1x1,t + . . . + β2,k xk,t + εt if regime 2 occurs.
Written more compactly:


φ0 x + ε if regime 1 occurs,
yt = 1 t t
(2)
φ0 xt + εt if regime 2 occurs,
2
where εt ∼ (0, σ 2).

• Model needs to be completed by specification of the way the

regime is determined at each point in time, or of the
“regime-switching” process.
All regime-switching models assume that regime-switching is

stochastic, that is, regimes that occur in the future are not
known with certainty.
Two main classes of models:
• Regimes can be characterized by an observable variable:

Threshold models and smooth transition models;
• Regimes are latent and cannot be characterized by an
observable variable: Markov-Switching model.

Threshold models
• The regimes can be characterized by the value of a certain

(observable) variable qt relative to a threshold c:

φ0 x + ε if qt ≤ c,
yt = 1 t t
(3)
φ0 xt + εt if qt > c,
2
• Note that the model can also be written as
yt = φ01xt(1 − I[qt > c]) + φ02xtI[qt > c] + εt, (4)

where I[A] = 1 if the event A occurs and I[A] = 0 otherwise.

Smooth transition models
• Crucial assumptions:
1. the regime that occurs at time t can be characterized by the
value of a certain (observable) variable qt, but
2. the “border” or threshold between the two regimes is not
“sharp” (as in the threshold model), but rather the transition
between two regimes is gradual or smooth:
The smooth transition model is given by
yt = φ01xt(1 − G(qt; γ, c)) + φ02xtG(qt; γ, c) + εt, (5)

where εt ∼ (0, σ 2) and G(qt; γ, c) is the logistic function
1
G(qt; γ, c) = , γ > 0. (6)
1 + exp(−γ[qt − c])

Logistic transition function
1.0
0.8
G(q(t);gamma,c)
0.6
0.4
gamma=1
0.2 gamma=2.5
gamma=5
gamma=25
0.0
-4 -3 -2 -1 0 1 2 3 4
q(t)
Examples of the logistic function G(qt; γ, c) as given in (6) for

various values of the smoothness parameter γ and threshold c = 0.

The smooth transition model
yt = φ01xt(1 − G(qt; γ, c)) + φ02xtG(qt; γ, c) + εt,

with the logistic function
1
G(qt; γ, c) = , γ > 0.
1 + exp(−γ[qt − c])
is such that:
• For very small values of qt, G(qt; γ, c) ≈ 0 and yt ≈ φ01xt + εt.

• For very large values of qt, G(qt; γ, c) ≈ 1 and yt ≈ φ02xt + εt.
• For intermediate values of qt, the parameters in the linear
model linking yt and xt are a linear combination of φ1 and φ2,
with the weights determined by the value of G(qt; γ, c).

The smooth transition model contains both threshold and linear

models as special cases:
1
G(qt; γ, c) = , γ > 0.
1 + exp(−γ[qt − c])
• As γ → ∞, G(qt; γ, c) → I[qt > c]: threshold model.

• As γ → 0, G(qt; γ, c) → 0.5 for all qt: linear model with
coefficients (φ1 + φ2)/2.

Threshold and smooth transition models
Threshold models and smooth transition models assume that

regime can be characterized by value of an observable variable qt.
This is convenient, because
• regimes which have occurred in past and present are known

with certainty,
• estimation of models and testing for regime-switching
behaviour is “not too difficult”.
Sometimes it might not be easy to obtain a “reliable”

regime-indicator qt.
Alternative: assume that qt does not exist, or, that regimes can
only be associated with an unobservable (stochastic) variable.

Markov-switching models
Alternative: assume that qt does not exist, or, that regimes can
not only be associated with an unobservable variable:

φ0 x + ε if St = 1,
yt = 1 t t
(7)
φ0 xt + εt if St = 2,
2
where St is unobserved.
• To complete the model, the properties of the process St need to

be specified (necessary for estimation, etc).
• Markov-Switching model: St is first-order Markov process

⇒ the current regime St only depends on the regime one period
ago, St−1.

Transition probabilities
Pr[St = 1|St−1 = 1] = p,
Pr[St = 2|St−1 = 1] = 1 − p,
Pr[St = 2|St−1 = 2] = q,
Pr[St = 1|St−1 = 2] = 1 − q.
⇒ 1 − p is equal to the probability that the Markov chain moves

from state 1 at time t − 1 to state 2 at time t or, put differently,
the probability that regime 1 at time t − 1 is followed by regime 2
at time t.

⇒ Important difference between threshold and Markov-Switching

models:
• In threshold models, the probability of a regime-switch varies

over time (depending on the properties of qt);
• In Markov-Switching models this probability is constant (and
determined by p and q).
⇒ But, p and q can be made time-varying by making them

functions of “duration” or of observable variables x1t, . . . , xkt.

Specification procedure for regime-switching models
“Specific-to-general”:
1. Specify a linear model (ARX) to describe yt in terms of
xt = (1, yt−1, . . . , yt−p, x1t, . . . , xkt)0)
2. (As part of model evaluation) Test linearity against threshold,
smooth transition and/or Markov-Switching alternatives.
3. If linearity is rejected, estimate parameters in the
regime-switching model;
4. Evaluate the model by applying misspecification tests
(parameter constancy, no remaining nonlinearity, ...) and other
diagnostic measures;
5. Modify the model if necessary;
6. Use the model for description or forecasting.

Specification procedure for regime-switching models
• Why specific-to-general? ⇒ Nonlinear models are more difficult

to work with than linear models (e.g. parameter estimation,
forecasting), hence only use nonlinear models if they are really
necessary!

Structural change
What do we mean by structural change?
⇒ Permanent change in statistical properties of time series

variables, such as its mean, variance or autocorrelations.
Why should we care about structural change?
⇒ Because time series analysis is based on the assumption of

stationarity: the constancy of means, variances and
autocorrelations...

Structural change in mean?
0
Feb
Mar
Feb
Mar
Jan
Jun
Jan
Jun
Jul
Jul
May
May
Aug
Sep
Nov
Dec
Aug
Sep
Nov
Dec
Apr
Apr
Oct
Oct
1999 2000 2001
Daily closing prices of AAPL stock

(31/12/1999 - 28/12/2001)

Structural change in trend?
4.8
4.4
4.0
3.6
3.2
2.8
2.4
1960 1965 1970 1975 1980 1985 1990 1995 2000
Quarterly industrial production Japan

Structural change in seasonality?
.6
.4
.2
.0
-.2
-.4
Q1
Q2
-.6 Q3
Q4
-.8
1985 1990 1995 2000 2005 2010 2015
Quarterly foreign tourist expenditures in the UK (growth rates).

Structural change in volatility?
15
10
-5
-10
1960 1970 1980 1990 2000 2010
Quarterly growth US real GDP

σ̂(59-83)=4.3; σ̂(84-07)=2.0; [σ̂(84-18)=2.3]

Modelling structural change
Structural change can take different forms, e.g. it could be

immediate, or take some time to take effect.
⇒ Here we focus on instantaneous change.
We can then consider many different types of structural change as

breaks in parameters in a regression model

φ0 x + ε t = 1, . . . , τ,
yt = 1 t t
(8)
φ0 xt + εt t = τ + 1, . . . , T,
2
where εt ∼ (0, σ 2). Parameters change at the breakdate τ .
For example, to describe a change in trend growth, take xt = (1, t).

Modelling structural change
Consider the regression model with a single structural change


φ0 x + ε t = 1, . . . , τ,
yt = 1 t t
(9)
φ0 xt + εt t = τ + 1, . . . , T,
2
(At least) two relevant questions:
1. How do we test whether a structural change really occurred?

2. How do we estimate the timing of structural change, that is,
the breakdate τ ?

Testing for structural change
If we assume the breakdate τ is known, or if we fix it a priori to a

certain date, testing for structural change is straightforward.
⇒ The null hypothesis of no structural change can then be tested

by means of the Chow test (Wald test) F (τ ),
σ̃ 2 − σ̂ 2(τ )
!
F (τ ) = T , (10)
σ̂ 2(τ )
where
1
PT
• σ̃ 2 is an estimate of the residual variance under H0 , that is σ̃ 2 = T
2
t=1 ε̃t
0
with ε̃t = yt − φ̃ xt .
• σ̂ 2 (τ ) an estimate of the residual variance under the alternative of a
structural break occurring at t = τ .
F (τ ) has asymptotic χ2-distribution with k degrees of freedom,

where k is the dimension of xt.
Possible drawbacks
• Result may be sensitive to the specified breakdate τ ;

• We may not have a clear idea of when a structural change has
occurred.
⇒ In general, we may want to treat the breakdate as unknown

when testing for the possible presence of a structural change.
Quandt (1960): take the maximum of the Chow statistics over all
possible breakdates, that is, the test statistic is
SupF = sup F (τ ).
τ
⇒ Problem: distribution of SupF under H0 is non-standard, and
remained unknown until the early 1990’s...
US Labor productivity
Empirical example (Hansen, 2001): Monthly observations on US

labor productivity in the manufacturing /durables sector, for the
period 1947.1-2001.4
Conventional wisdom: “US labor productivity experienced a

slowdown around 1973 and a speedup in the second half of the
1990s.”
Is this reflected in time series models for labor productivity growth?

Can structural change be detected by means of formal tests?
Consider tests for structural change in an AR(1) model for

monthly growth rate
yt = α + ρyt−1 + εt.

-7.6
-8.0
-8.4
-8.8
-9.2
-9.6
-10.0
50 55 60 65 70 75 80 85 90 95 00
Monthly (log) US labor productivity, 1947.1-2001.4

16
12
-4
-8
50 55 60 65 70 75 80 85 90 95 00
Annual growth US labor productivity, 1947.1-2001.4

24
20
16
12
0
50 55 60 65 70 75 80 85 90 95 00
Chow test sequence as a function of breakdate

The Quandt statistic is given by
SupF = sup F (τ ),
τ
where F (τ ) is a Wald (or LR or LM) statistic testing for a
structural break occurring at t = τ .
Each individual F (τ ) statistic has asymptotic χ2(k)-distribution.
Statistics F (τ1) and F (τ2) will be correlated, but exact form of

dependence is unclear.
⇒ This makes deriving the asymptotic distribution of SupF

complicated.

Alternative interpretation: Consider the problem of testing for a

single structural change, that is, the model under the alternative is

φ0 x + ε t = 1, . . . , τ,
yt = 1 t t
(11)
φ0 xt + εt t = τ + 1, . . . , T,
2
• The null hypothesis can be expressed as equality of the

parameters before and after the break, that is, H0 : φ1 = φ2.

Problem: “unidentified nuisance parameters under H0”
• Intuitively: the model under the alternative contains certain

parameters which are not restricted by the null hypothesis and are
not present in the model under the null.
Here, the unidentified parameter is the breakdate τ .
⇒ Consequence: (asymptotic) distribution of (LR, LM, Wald) test

statistics is non-standard.

Andrews (1993) derived the asymptotic distribution of
SupF = sup F (τ ),
λT ≤τ ≤(1−λ)T
where 0 < λ < 0.5 is called the trimming fraction.
⇒ In principle the supremum could be taken over all values of τ

such that k + 1 ≤ τ ≤ T − k. The idea of ‘trimming’ is that you
would like to get reliable/accurate parameter estimates both
before and after the break. Therefore, we impose a minimum
fraction λ of observations in both subsamples.
⇒ Distribution of SupF depends on the number of restrictions k

that are tested, as well as on the trimming fraction λ.

Estimating the timing of structural change
How do we estimate the parameters φ1, φ2 and τ in the structural

change model

φ0 x + ε t = 1, . . . , τ,
yt = 1 t t
(12)
φ0 xt + εt t = τ + 1, . . . , T,
2
and how do we obtain confidence intervals for the breakdate τ ?
⇒ We can apply least squares to minimize the residual variance
(τ̂ , φ̂1, φ̂2) = argmin σ 2(τ, φ1, φ2).
In practice, we do a ‘grid search’ over τ : we estimate φ1 and φ2

for all possible break-dates, compute σ 2(τ, φ1, φ2) and examine for
which breakdate this is minimized.

124.5
124.0
123.5
123.0
122.5
122.0
121.5
121.0
120.5
120.0
50 55 60 65 70 75 80 85 90 95 00
Residual variance as a function of breakdate

125
124
123
122
25 Residual variance 121

Chow test
20 120
15
10
0
50 55 60 65 70 75 80 85 90 95 00
Residual variance and Chow test as a function of breakdate

The structural change model


φ0 x + ε t = 1, . . . , τ,
yt = 1 t t
(13)
φ0 xt + εt t = τ + 1, . . . , T,
2
can also be written as
yt = φ01xtI[t ≤ τ ] + φ02xtI[t > τ ] + εt, (14)

where I[A] = 1 if the event A occurs and I[A] = 0 otherwise.
⇒ For fixed or known breakdate τ , the model is linear in the

remaining parameters φ1 and φ2.

Estimates φ̂(τ ) of φ = (φ01, φ02)0 are obtained by least squares

regression of yt on xt(τ ) = (x0tI[t ≤ τ ], x0tI[t > τ ])0, that is
 −1  
T T
0
X X
φ̂(τ ) =  xt(τ )xt(τ )   xt(τ )yt . (15)
t=1 t=1
Define the corresponding residuals ε̂t(τ ) = yt − φ̂(τ )0xt(τ ), which

2 1 PT
have variance σ̂ (τ ) = T t=1 ε̂t(τ )2.

An estimate of τ can be obtained by minimizing this residual

variance, that is
τ̂ = argmin σ̂ 2(τ ), (16)
λT ≤τ ≤(1−λ)T
where again we assume a ‘trimming fraction’ λ.

Threshold Models
• Consider the threshold model with two regimes:


yt = 1 t t
(17)
2
⇒ If qt = t, this is in fact a structural change model!!
Hence, for testing and estimation we can adopt the same methods
as used in the context of structural change.

Testing for nonlinearity
Consider the problem of testing the null hypothesis of linearity

against the alternative of a 2-regime threshold model,

yt = 1 t t
(18)
2
• The null hypothesis can be expressed as equality of the

conditional mean parameters in the two regimes, that is,
H0 : φ1 = φ2,
while the alternative hypothesis is
H1 : φ1 6= φ2.

Testing for nonlinearity
• This testing problem of course resembles the problem of testing

for structural change. The same complication of “unidentified
nuisance parameters under the null hypothesis” arises here if we
want to leave the threshold c unspecified.
⇒ Linearity can then be tested against a threshold model with

fixed c with a standard the “pointwise” Wald or F statistic F (c)
• If we want to leave c unspecified, we can use the SupF statistic.

Estimation of threshold models
Consider the 2-regime threshold model
yt = φ01xt(1 − I[qt > c]) + φ02xtI[qt > c] + εt.
⇒ For fixed or known threshold c, the model is linear in the

remaining parameters φ1 and φ2.
Estimates φ̂(c) of φ = (φ01, φ02)0 are obtained by least squares

regression of yt on xt(c) = (x0t(1 − I[qt > c]), x0tI[qt > c])0, that is
 −1  
T T
xt(c)xt(c)0
X X
φ̂(c) =   xt(c)yt . (19)
t=1 t=1
Define the corresponding residuals ε̂t(c) = yt − φ̂(c)0xt(c), which

2 1 PT
have variance σ̂ (c) = T t=1 ε̂t(c)2.
An estimate of c can be obtained by minimizing this residual

variance, that is
ĉ = argmin σ̂ 2(c), (20)
c∈C
where C denotes the set of all allowable threshold values.
For example, C may be defined such that each regime contains at

least a fraction λ of the observations, that is,
C = {c | q([λT ]) ≤ c ≤ q([(1−λ)T ])}. (21)

• Is this a feasible procedure, as the set C may contain a very large

number of possible threshold values?
Note: for given c, the estimates of φ1 (φ2 ) are based only on

those observations in the lower (upper) regime, i.e. those
observations for which qt ≤ c (qt > c).
As c is varied between two consecutive order statistics of qt, no

observations move from one regime to the other.
⇒ φ̂(c) does not change
⇒ the value of σ̂ 2(c) does not change
Hence, σ̂ 2(c) need only be computed for values of c equal to the

order statistics of qt.

-2
-4
-6
-8
-10
-6 -4 -2 0 2 4 6
Example of estimation of threshold model: varying the

threshold c between the two vertical lines does not change σ̂ 2(c).

Forecasting with regime-switching models
• Out-of-sample forecasting with regime-switching models is more

complicated than forecasting with linear models.
• Denote the point forecast of yT +h made at time T as ŷT +h|T

and the corresponding forecast error as eT +h|T , that is
eT +h|T = yT +h − ŷT +h|T . (22)
• If we want to minimize the mean squared prediction error

[MSPE]
MSPE(h) ≡ E[e2
T +h|T ] = E [(yT +h − ŷT +h|T ) 2 ]. (23)
the optimal forecast ŷT +h|T is the conditional expectation of
yT +h at time T ,
ŷT +h|T = E[yT +h|YT ], (24)
where YT denotes the information set at time T .
Example: AR(1) model

yt = φ1yt−1 + εt, (25)
with E[εt|Yt−1] = 0 and E[ε2 2
t |Yt−1 ] = σ .
• The 1-step ahead forecast at time T is given by

ŷT +1|T = E[yT +1|YT ]
= E[φ1yT + εT +1|YT ]
= φ1yT .
• In general, the h-step ahead forecast can be computed directly as

ŷT +h|T = φh
1 yT ,
or recursively as
ŷT +h|T = φ1ŷT +h−1|T .

Example: Threshold model


−2 + ε if yt−1 ≤ 0,
t
yt = (26)
 2 + εt if yt−1 > 0,
with E[εt|Yt−1] = 0 and E[ε2

t |Y t−1 ] = σ 2 , or
yt = −2I(yt−1 ≤ 0) + 2I(yt−1 > 0) + εt.
Suppose yT = −1, then the 1-step ahead forecast is equal to
ŷT +1|T = E[yT +1|YT ] = −2.

• For the 2-step ahead forecast, it follows that:

ŷT +2|T = E[yT +2|YT ]
= E[−2I(yT +1 ≤ 0) + 2I(yT +1 > 0)|YT ]
= −2P (yT +1 ≤ 0|YT ) + 2P (yT +1 > 0|YT )
= −2P (−2 + εT +1 ≤ 0) + 2P (−2 + εT +1 > 0)
= −2P (εT +1 ≤ 2) + 2P (εT +1 > 2),
because yT < 0 (such that yT +1 = −2 + εT +1), and
E[I(A)] = P (A).
• Computing the 3-step ahead forecast is even more complicated:

ŷT +3|T = E[yT +3|YT ]
= E[−2I(yT +2 ≤ 0) + 2I(yT +2 > 0)|YT ]
= −2P (yT +2 ≤ 0|YT ) + 2P (yT +2 > 0|YT ),
because P (yT +2 > 0|YT ) is difficult to compute.
Notice that:
ŷT +2|T = E[yT +2|YT ]

= E[−2I(yT +1 ≤ 0) + 2I(yT +1 > 0)|YT ]
6= −2I(E[yT +1|YT ] ≤ 0) + 2I(E[yT +1|YT ] > 0)
= −2I(ŷT +1|T ≤ 0) + 2I(ŷT +1|T > 0)
= −2
Hence, it appears that in this case, multiple step ahead forecasts
cannot be computed recursively...

• The reason the above computation fails is that the expected

value of a nonlinear function is not equal to the function evaluated
at the expected value of its argument, that is
E[g(x)] 6= g(E[x]).
⇒ Example: g(x) = x2 and x uniformly distributed on the interval

[0, 1]. Then E[x] = 0.5, so g(E[x]) = 0.25, but E[g(x)] = 1/3.
⇒ As a consequence, multiple step ahead forecasts can not be

computed recursively (as in the linear AR model).
In addition, analytic expressions for multiple step ahead forecasts

are not available...

• For the general nonlinear autoregressive model of order 1,
yt = g(yt−1; θ) + εt, (27)

the 2-step ahead forecast cannot be computed as
ŷT +2|T = E[yT +2|YT ] = E[g(yT +1; θ) + εT +2|YT ]

= E[g(yT +1; θ)|YT ]
6= g(E[yT +1|YT ]; θ) = g(ŷT +1|T ; θ).
• The relation between 1- and 2-step ahead forecasts is given by
ŷT +2|T = E[yT +2|YT ] = E[g(yT +1; θ) + εT +2|YT ]

= E[g(g(yT ; θ) + εT +1; θ)|YT ]
= E[g(ŷT +1|T + εT +1; θ)|YT ].

• There are several different ways to compute multiple step ahead

forecasts from nonlinear models - the easiest of which is using
simulation:
k
(mc) 1 X
ŷT +2|T = g(ŷT +1|T + εi; θ). (28)
k i=1
⇒ εi can be drawn either from an assumed distribution, e.g.

normal (“Monte Carlo”), or from the residuals of the estimated
model (“bootstrap”).
⇒ easy to compute!

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Time Series Analysis

Key concepts in this chapter:

Time Series Analysis: Chapter 8 1

(Autoregressive) Time series models take the general form

where g(·) is some parametric function, θ denotes a vector of

So far, we only considered linear AR models, where

⇒ If we allow nonlinear specifications for g(yt−1, yt−2, . . . , yt−p; θ),

• What do we mean by regime-switching, and why might this be

Intuitively: The “world” (“the economy”/“financial markets”) can

• business cycle regimes: expansions vs. recessions;

⇒ Economic and financial variables (may) behave differently in

Monthly US unemployment rate

Time Series Analysis: Chapter 8 4

Regime-switching models allow the dynamic behaviour of

• Suppose we want to describe/forecast a financial or economic

• All regime-switching models assume that within each regime, a

Time Series Analysis: Chapter 8 5

Written more compactly:

where εt ∼ (0, σ 2).

Time Series Analysis: Chapter 8 6

• Model needs to be completed by specification of the way the

All regime-switching models assume that regime-switching is

Two main classes of models:

• Regimes can be characterized by an observable variable:

Time Series Analysis: Chapter 8 7

• The regimes can be characterized by the value of a certain

where εt ∼ (0, σ 2).

• Note that the model can also be written as

yt = φ01xt(1 − I[qt > c]) + φ02xtI[qt > c] + εt, (4)

Time Series Analysis: Chapter 8 8

The smooth transition model is given by

yt = φ01xt(1 − G(qt; γ, c)) + φ02xtG(qt; γ, c) + εt, (5)

Time Series Analysis: Chapter 8 9

Examples of the logistic function G(qt; γ, c) as given in (6) for

Time Series Analysis: Chapter 8 10

The smooth transition model

yt = φ01xt(1 − G(qt; γ, c)) + φ02xtG(qt; γ, c) + εt,

• For very small values of qt, G(qt; γ, c) ≈ 0 and yt ≈ φ01xt + εt.

Time Series Analysis: Chapter 8 11

The smooth transition model contains both threshold and linear

• As γ → ∞, G(qt; γ, c) → I[qt > c]: threshold model.

Time Series Analysis: Chapter 8 12

Threshold models and smooth transition models assume that

• regimes which have occurred in past and present are known

Sometimes it might not be easy to obtain a “reliable”

Time Series Analysis: Chapter 8 13

• To complete the model, the properties of the process St need to

• Markov-Switching model: St is first-order Markov process

Time Series Analysis: Chapter 8 14

⇒ 1 − p is equal to the probability that the Markov chain moves

Time Series Analysis: Chapter 8 15

⇒ Important difference between threshold and Markov-Switching

• In threshold models, the probability of a regime-switch varies

⇒ But, p and q can be made time-varying by making them

Time Series Analysis: Chapter 8 16

Time Series Analysis: Chapter 8 17

• Why specific-to-general? ⇒ Nonlinear models are more difficult