Arima Modelling and Diagnostic Test

A brief introduction to the concepts and applications of Arima

models

What is Arima?
Arima stands for AutoRegressive Integrated Moving Average, a class of models that can capture the
dynamics of a time series. Arima models are specified by three parameters: p, d, and q, which
represent the order of the autoregressive, differencing, and moving average components,
respectively. Arima models can be used to forecast future values of a time series, as well as to
analyze the patterns and relationships in the data.

How to fit an Arima model?

The process of fitting an Arima model involves the following steps:

• Identify the appropriate values of p, d, and q by examining the autocorrelation and partial
autocorrelation functions of the time series.
• Estimate the parameters of the model using a method such as maximum likelihood or least
squares.
• Check the adequacy of the model by performing diagnostic tests on the residuals, such as
the Ljung-Box test, the Jarque-Bera test, and the Durbin-Watson test.
• Use the model to make predictions and evaluate the accuracy of the forecasts.

What are the diagnostic tests for Arima models?

The diagnostic tests for Arima models are used to assess the validity of the model assumptions
and the quality of the fit. Some of the common diagnostic tests are:

• The Ljung-Box test, which tests the null hypothesis that the residuals are uncorrelated up to
a certain lag. A low p-value indicates that the residuals exhibit significant autocorrelation,
which suggests that the model is misspecified or underfitted. For example, the following
table shows the results of the Ljung-Box test for the Arima(0,1,1) model fitted to the
monthly U.S. unemployment rate. The p-values are all above 0.05, which indicates that the
residuals are not autocorrelated.

Lag Test Statistic p-value

1 0.13 0.72
2 0.38 0.83
3 0.59 0.90
4 0.83 0.93
5 1.09 0.95
 6 1.34 0.97
7 1.62 0.98
8 1.88 0.98
9 2.15 0.98
10 2.41 0.99
11 2.67 0.99
12 2.93 0.99
• The Jarque-Bera test, which tests the null hypothesis that the residuals are normally
distributed. A low p-value indicates that the residuals deviate from normality, which may
affect the inference and prediction of the model. For example, the following table shows
the results of the Jarque-Bera test for the Arima(1,0,0) model fitted to the quarterly U.S. real
GDP growth rate. The p-value is 0.00, which indicates that the residuals are not normally
distributed.

Test Statistic p-value

119.66 0.00
• The Durbin-Watson test, which tests the null hypothesis that the residuals have no first-
order autocorrelation. A value close to 2 indicates that the residuals are independent, while
a value close to 0 or 4 indicates positive or negative autocorrelation, respectively. A
significant autocorrelation in the residuals may indicate that the model is overfitted or that
the data is non-stationary. For example, the following table shows the results of the Durbin-
Watson test for the Arima(2,1,2) model fitted to the daily closing price of the S&P 500 index.
The value is 1.98, which indicates that the residuals are not autocorrelated.

Test Statistic
1.98

What are some examples of Arima models?

Some examples of Arima models applied to real-world data are:

• Arima(0,1,1) model for the monthly U.S. unemployment rate from 1948 to 2020. This model
captures the trend and seasonality of the data, and produces accurate forecasts for the
future values.
• Arima(1,0,0) model for the quarterly U.S. real GDP growth rate from 1947 to 2020. This
model captures the persistence and volatility of the data, and provides a simple way to
measure the business cycle.
• Arima(2,1,2) model for the daily closing price of the S&P 500 index from 1950 to 2020. This
model captures the non-stationarity and heteroskedasticity of the data, and allows for
testing the efficiency and predictability of the stock market.