Empirical Methods in Finance

Cointegration and error correction models

Author 3
Author 3
Martin Wersing
University of Aberdeen Business School
Edward Wright Building
Aberdeen AB24 3QY
www.abdn.ac.uk/business/
Introduction 2

Motivation
Economic theory often suggest that pairs of variables wander
randomly but do not drift too far apart
▶ differencing such I (1) variables removes long-run relationship

Cointegration tests and error correction models study

▶ long-run equilibrium
▶ as well as short-run deviations from equilibrium

The core reading is

▶ Brooks (2008, Ch. 7.1–7.7)
▶ Enders (2005, Ch. 6.1–6.4)
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Introduction 3

Regression of I (1) variables

In the fully specified regression model:

yt = βzt + εt (1)

there is a presumption that the disturbances εt are stationary white

noise
E[εt ] = 0 and Var[εt ] = σ 2

But what if yt and zt are integrated series?

▶ unlikely that εt ∼ I (0)

▶ spurious regression (invalid inference, inflated R 2 )

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Introduction 4

Combinations of non-stationary variables

Generally, if variables are integrated to different orders linear

combinations of them will be integrated to the higher of the two
orders.
In practice, many economic and financial series contain a unit root.
If yt and zt are I (1), then

▶ we would normally expect yt − βzt to be I (1)

▶ we would not expect that yt − βzt is I (0) unless there is some
relationship between those variables

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Introduction 5

40
0
-40 0 100 200 300 400 500

Time
15
5
-5
-15

0 100 200 300 400 500

Time

Figure 1: Linear combination of two random walks.

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Introduction 6

15
10
5
0 0 100 200 300 400 500

Time
2 4 6
-2
-6

0 100 200 300 400 500

Time

Figure 2: Linear combination of two cointegrated random walks.

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Introduction 7

Example 1: A drunk and his dog (Murray 1994)

Assume that, both, a drunk’s and a puppy’s behaviour can be
described by a random walk

xt = xt−1 + ε1,t (2)

yt = yt−1 + ε2,t (3)

But what if the puppy belongs to the drunk?

▶ The drunk thinks: I can’t let the puppy get too far off!
▶ The puppy thinks: I can’t let the master get too far off!
▶ The “gap process" is stationary.

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Introduction 8

Example 2: Money demand (Enders 2005, Ch. 6)

Consider the following standard money demand model:

mt = β0 + β1 pt + β2 yt + β3 rt + εt (4)

where:
mt long-run demand for money (= supply)
pt price level
yt real income
rt interest rate
βi (population) parameters
All rhs variables are nonstationary I (1) variables.
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Introduction 9

For the theory to make sense, deviations in the demand for money
(εt ) must be temporary ⇒ εt must be a stationary error term
Solving Eq. 5 for the error term yields

εt = mt − β0 − β1 pt − β2 yt − β3 rt (5)

→ linear combination of the integrated RHS variables must be

→ stationary!

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Introduction 10

Cointegration

If yt and zt are I (1), then there may be a vector β = [1, θ] such

that
εt = yt − θzt (6)

is stationary, εt ∼ I (0), and yt and zt are said to be cointegrated.

⇒ long-run equilibrium relationship between yt and zt such that
→ their “difference” will rarely drift far from zero and often
→ crosses zero
⇒ allows us to distinguish between the long-run relationship and
→ the short-run dynamics

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Introduction 11

Cointegrated series in economics and finance

▶ Permanent income hypothesis: cointegration between

consumption and income.
▶ Money demand: cointegration between money demand,
income, prices and interest rates.
▶ Fisher equation: cointegration between nominal interest rates
and inflation.
▶ Term structure of interest rates: cointegration between
nominal interest rates at different maturities.
▶ Commodities: cointegration between prices of close
substitutes.
▶ Market efficiency: cointegration between spot and future
prices of an asset
▶ Forward looking prices: stock prices and dividends
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Modelling cointegrated series 12

Approaches to modeling cointegrated series

1. Single equation models: Engle and Granger (1987)

▶ allow for one cointegration relationship between two or more
variables
▶ we discuss these models in this lecture
2. System methods using VARs: Johansen (1988) and Johansen
and Juselius (1990)
▶ allow for more than one cointegration relationship
▶ in a later lecture

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Modelling cointegrated series 13

Models with multiple I (1) variables

Consider the time-series vector

yt = [y1,t , . . . , yM,t ]′ ,

where each individual variable is I (1).

The long-run relationship between these variables is

y′ t β = 0 , (7)
where
β = [β1 , β2 , . . . , βM ]′ is the cointegrating vector

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Modelling cointegrated series 14

In the short-run, the system may deviate from its equilibrium

y ′ t β = εt (8)

but the equilibrium error εt must be stationary

Example 3: Bivariate system

In the case of M = 2, Eq. 8 becomes

β1 y1,t + β2 y2,t = εt , (9)

with the cointegrating vector β = [β1 , β2 ]′

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Modelling cointegrated series 15

Number of cointegrating vectors

In general, since there are M variables in the system, there could be

more than one co-integrating vector.

In a system of M variables, there can only be up to M − 1 linearly

independent cointegrating vectors.
Proof: see appendix.

The number of linearly independent cointegrating vectors that exist

in the system is called its cointegrating rank.

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Modelling cointegrated series 16

Estimating cointegrating vectors

The simplest way to estimate the cointegrating vector β is to pick
one of the I (1) variables and regress it on the others.

Let y′ = [y1,t , y−1,t ], y1,t being the selected regressor and y−1,t the
remaining M − 1 variables,
′
y1,t = α + y−1,t θ + εt (10)

where β = [1, θ1 , θ2 , . . . , θM ] and θ1 ≡ −β2 /β1 and so on.

Note: 1. OLS is (super-)consistent, standard inference is not valid

Note: 2. only one cointegrating vector is identified up to a
Note: 2. normalization
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Modelling cointegrated series 17

Error correction model

examines the short-run and long-run relationship jointly.
For any set of I (1) variables, error correction and cointegration are
equivalent representations.
Example 4: Stock prices and dividends
Stock prices reflect the present value of discounted future
dividends. Under the Gordon growth model

D̃t
Pt = (11)
R
where Pt is the price, D̃t is the expected dividend, and R is the
discount factor.
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Modelling cointegrated series 18

Taking the logarithm of Eq. 11 yields

pt = d˜t − r = d˜t∗ (12)

where pt is the log price and d˜t∗ is the log of the real expected
dividend ⇒ in the long-run stock, prices equal future discounted
rents.

How can we model the dynamics of the stock price?

A general dynamic model for the stock price is the autoregressive
distributed lag (ADL) model

pt = α0 + α1 d˜t∗ + α2 d˜t−1
∗
+ α3 pt−1 + εt (13)

where εt is a white-noise error term.

What about the long-run equilibrium condition?
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Modelling cointegrated series 19

If Eq. 12 holds, the long-run equilibrium is

p = α0 + α1 d˜∗ + α2 d˜∗ + α3 p
α0 (α1 + α2 ) ˜∗
p = + d (14)
1 − α3 1−α
| {z } | {z 3 }
≡0 ≡1
Define λ ≡ α1 + α2 = 1 − α3 and rewrite the ADL model as
pt = α0 + α1 d˜t∗ + (λ − α1 )d˜t−1
∗
+ (1 − λ)pt−1 + εt
pt ∗
= α0 + α1 d˜t∗ − α1 d˜t−1 ∗
+ λd˜t−1 − λpt−1 + pt−1 + εt
∗ ∗
∆pt = α0 + α1 ∆d˜t + λ(d˜t−1 − pt−1 ) +εt (15)
| {z }
error correction
Note: The error correction term is stationary, if and only if pt and
d˜t∗ are cointegrated. Only then Eq. 15 is a balanced regression
model. i. e. involves only stationary variables.
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Modelling cointegrated series 20

In general, the error correction model is given by

∆yt = α + α1 ∆zt + γ(yt−1 − θzt−1 ) + εt (16)

describes the variation in yt around its long-run trend in terms of

1. a constant α0 (other exogenous variables may be included)

2. the impact of a change in zt (more lags of ∆zt and ∆yt may
be included)
3. the equilibrium error (yt−1 − θzt−1 ) which contains the
(unknown) cointegrating vector.

Note: Eq. 11 could be estimated directly via NLS or in two steps.

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Modelling cointegrated series 21

How to estimate ECM

1. Obtain equilibrium errors
▶ make sure that all the individual variables are I (1).
▶ estimate the cointegrating regression using OLS.
yt = α + θzt + εt
▶ save the estimated residuals ε̂t of the cointegrating regression.
▶ test these residuals to ensure that they are I (0).

2. Fit error correction model

▶ use the step 1 residuals as one variable in an error correction
model.
▶ for two variables z and y which are both I (1) the model
becomes
∆yt = α0 + α1 ∆zt + λε̂t−1 + et
which can be estimated via OLS
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Testing for cointegration 22

Cointegration tests

Two broad approaches for testing for cointegration and modeling

cointegrated series have been developed:

1. The Engle and Granger (1987) method is based on assessing

whether single-equation estimates of the equilibrium errors
appear to be stationary.
2. The second approach, due to Johansen (1988), is based on the
Vector Autoregression (VAR) model.

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Testing for cointegration 23

Engle-Granger test for cointegration

Let yt denote the set of M variables that are believed to be

cointegrated:

▶ establish that the variables are indeed integrated of the same

order using the (augmented) Dickey-Fuller
▶ if the evidence suggests that the variables are integrated to
different orders or not at all, reconsider model specification
▶ test if (estimated) equilibrium error is stationary

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Testing for cointegration 24

Step 1: Estimate equilibrium errors

Each cointegrating vector produces the equilibrium relationship:

yi,t = α + y′ −i,t θ + εt (17)

Estimate the cointegrating vector by OLS

▶ ε̂t are consistent estimates of the equilibrium errors

▶ standard inference on the estimated coefficients is not valid
▶ equilibrium errors should be I (0) if system is cointegrated

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Testing for cointegration 25

Step 2: Test if errors are stationary

The natural approach would be to apply the familiar Dickey-Fuller

tests to OLS residuals.

The logic is sound, but

▶ ADF critical values ignore estimation error from the first stage

Appropriate critical values for the tests

▶ Engle and Granger (1987) and many more

▶ Stata®

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Summary 26

Summary
Take home points from this lecture:
▶ cointegration occurs when the residuals of the regression of
multiple I (1) variables are stationary
▶ error correction is used to incorporate long- and short-run
dynamics into a model of cointegrated variables
▶ Engle and Granger provide cointegration test and two step
procedure to estimate ECM
In a later lecture:
▶ multi-equation dynamic models
▶ Vector autoregression (VAR)
▶ Vector error correction (VECM)

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References 27

References
Brooks, C.: 2008, Introductory Econometrics for Finance, 2 edn,
Cambridge University Press, Cambridge, UK.
Enders, W.: 2005, Applied Econometric Time Series, 2 edn, Wiley, New
York, NY.
Engle, R. F. and Granger, C. W. J.: 1987, Co-integration and error
correction: Representation, estimation, and testing, Econometrica
55, 251–276.
Johansen, S.: 1988, Statistical analysis of cointegrated vectors, Journal
of Economic Dynamics and Control .
Johansen, S. and Juselius, K.: 1990, Maximum likelihood estimation and
inference on cointegration–with applications to the demand for money,
Oxford Bulletin of Economics and Statistics 52, 169–210.
Murray, M. P.: 1994, A drunk and her dog: An illustration of
cointegration and error correction, The American Statistician
48, 37–39.
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Appendix 28

Matrix Algebra: Some definitions

Definition: Linear dependent vector
A set of vectors is linearly dependent if any one of the vectors can
be written as a linear combination of the others.

Example 5: Independent and dependent vectors

Independent
z  }|  {  
−0.5 −0.4 −0.3
ui =  −0.2  uj =  −0.1  e=  −0.25 
−0.3 −0.2 −0.4
| {z }
Dependent

 
−0.5 −0.4
1
 
e =  −0.2 −0.1 
0.5
−0.3 −0.2

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Appendix 29

Definition: Basis for a vector space

A basis for a vector space of K dimensions is any set of K linearly
independent vectors in the ℜK space
A standard basis is the identity matrix which consists of all ones on
the diagonal and zero everywhere else.

Corollary
Any (K + 1)th vector in a vector space can be written as a linear
combination of the K basis vectors

Definition: Rank of a matrix

The (column) rank of a matrix is the dimension of the vector space
that is spanned by its columns, i.e. the number of linearly
independent column vectors.

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Appendix 30

Proof: Maximum Number of Cointegrating vectors

▶ Suppose that βi is a cointegrating vector and that there are M
linearly independent cointegrating vectors. Then yt′ βi = ut,i is
a stationary series.
▶ Any linear combination of a set of stationary series is
stationary, so it follows that every linear combination of the
cointegrating vectors is also a cointegrating vector.
▶ If there are M such (M × 1) linearly independent vectors, then
they form a basis for the M-dimensional space, so any (M × 1)
vector can be formed from these cointegrating vectors,
including the columns of an (M × M) identity matrix.

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Appendix 31

▶ Thus, the first column of an identity matrix would be a

cointegrating vector, or yt,1 is I (0). This result is a
contradiction, since we are allowing yt,1 to be I (1). It follows
that there can be at most M − 1 cointegrating vectors as M
vectors would be fully stationary.

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