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 Chapter 10 ● Advanced Methods of Forecasting
Exercises 10.7, 10.9, 10.10, and 10.11 Solutions

Authors’ note (Sept. 2012): The solutions to 10.7, 10.9 and 10.11 are at best incomplete!
10.7 Using the data set Gasprices_full.xlsx,
a. Test whether Crude, CPI, and Unemployment are stationary variables.
b. Develop a regression model for Unleaded, using the methods of Chapter 9.
c. Develop a three-variable VAR model that includes the price of Unleaded. In so doing, include only
those variables you expect to have an economic impact on the unleaded price. Use a maximum of two
lags.
d. Examine whether there is evidence for including lags longer than two in your model.
e. Evaluate the forecasting performance of your chosen model.
f. Develop a model in differences (for any of the nonstationary variables). Is this model a "better" model
than the model developed in levels in parts (b) and (c)? Explain. Does the forecasting performance of
the model improve on that of any of the earlier models?

The analysis we carry out are all much, much easier in proper econometric software. In the text we have
used either EViews7 or PCGive.`
10.9 Durkin, Ord, and Walker (2010) examined the growth of credit markets in the United States since 1946.
The data file Credit.xlsx contains annual values for real mortgage credit (RMC), real consumer credit
(RCC), and real disposable personal income (RDPI) for the period 1946-2006. All the observations are
measured in billions of dol lars, after adjustment by the Consumer Price Index (CPI). Develop a VAR
model for these data for the period 1946-2003, and then forecast the last three years, 2004-2006. Examine
the relative advantages of a logarithmic transform and the use of differences.
10.10 Using the data set Gasprices_1.xlsx, but setting aside the data for 2006 through 2010, develop an
unrestricted VAR model, an ECM, and a model in stationary variables. Use appropriate error statistics to
examine the residuals and test their respective forecasting performances.
a. Do the residuals of the various models suggest any inadequacies in the model?
b. If you now consider the more recent data, from 2006 to 2010, does your chosen model show any
instability in its performance?
c. If you also bring into consideration the performance of the models over the years 2009-2010, which
model would you use for forecasting for the period 2011-2012? Explain your reasons.

WE use PcGive. Our focus is on explaining unleaded prices and our first model has included Unleaded,
CRUDE, CPI and Unemployment, with 3 lags. We will also take logs based on the analysis we carried out
in chapter 10. Use of PDI does not help the modelling although since it affects CPI it might prove of overall
benefits (some of the other factors might – perhaps we should extend the data base to include World Trade).
The forecasts for the last 5 years and the residuals are shown below.
A model with Unemployment and PDI was considered. From 2008 unemployment was persistently higher as
was PDI. The model was clearly inadequate.
Some programs including PCGive carry out automatic model selection. Here we summarize the results for
Log(Unleaded). Automatic model selection with insignificant lags excluded gives the following equation
for LogUnleaded

Graphs of the residuals and the forecasts compared to the actual are provided as shown:
Ord/Fildes Principles of Business Forecasting 1e Chapter 10 Exercises 10.7, 10.9, 10.10, 10.11 Solutions 2

© Cengage Learning 2013

All the variables show 2008-9 to generate large negative residuals caused by the major recession.

Coefficient Std.Error t-value t-prob

LUnleaded_1 1.29990 0.1515 8.58 0.0000
LUnleaded_2 -0.889233 0.1619 -5.49 0.0000
LUnleaded_3 0.213719 0.09172 2.33 0.0216
LCrude_1 0.216071 0.04265 5.07 0.0000
LCPI_1 -9.19292 3.045 -3.02 0.0032
LCPI_2 8.83651 2.959 2.99 0.0035
LPDI_1 0.242545 0.2014 1.20 0.2310
Constant U -0.913144 0.8210 -1.11 0.2685

sigma = 0.0423565 RSS = 0.1955538353

The in-sample residual tests suggest some discrepancies as shown below:

1-step (ex post) forecast analysis 2006-01-15 - 2010-12-15
Parameter constancy forecast tests:
using Omega Chi^2(240)= 484.69 [0.0000]** F(240,109)= 2.0196 [0.0000]**
using V[e] Chi^2(240)= 367.04 [0.0000]** F(240,109)= 1.5293 [0.0062]**
using V[E] Chi^2(240)= 411.19 [0.0000]** F(240,109)= 1.7133 [0.0008]**

Single-equation diagnostics using reduced-form residuals:

LUleaded : AR 1-2 test: F(2,107) = 1.1161 [0.3313]
LUleaded : ARCH 1-1 test: F(1,115) = 0.10145 [0.7507]
LUleaded : Normality test: Chi^2(2) = 18.077 [0.0001]**
LUleaded : Hetero test: F(14,102) = 1.9298 [0.0314]*
LUleaded : Hetero-X test: F(35,81) = 1.1479 [0.3008]
LCrude : AR 1-2 test: F(2,107) = 0.97313 [0.3812]
LCrude : ARCH 1-1 test: F(1,115) = 0.17761 [0.6742]
LCrude : Normality test: Chi^2(2) = 2.8983 [0.2348]
LCrude : Hetero test: F(14,102) = 0.94443 [0.5149]
LCrude : Hetero-X test: F(35,81) = 0.89920 [0.6290]

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Ord/Fildes Principles of Business Forecasting 1e Chapter 10 Exercises 10.7, 10.9, 10.10, 10.11 Solutions 3

LCPI : AR 1-2 test: F(2,107) = 1.3463 [0.2646]

LCPI : ARCH 1-1 test: F(1,115) =0.0063127 [0.9368]
LCPI : Normality test: Chi^2(2) = 64.999 [0.0000]**
LCPI : Hetero test: F(14,102) = 1.8542 [0.0405]*
LCPI : Hetero-X test: F(35,81) = 1.2062 [0.2426]
LPDI : AR 1-2 test: F(2,107) = 4.0733 [0.0197]*
LPDI : ARCH 1-1 test: F(1,115) = 35.676 [0.0000]**
LPDI : Normality test: Chi^2(2) = 402.21 [0.0000]**
LPDI : Hetero test: F(14,102) = 3.1519 [0.0004]**
LPDI : Hetero-X test: F(35,81) = 2.9660 [0.0000]**

Vector AR 1-2 test: F(32,363) = 1.4495 [0.0583]

Vector Normality test: Chi^2(8) = 443.90 [0.0000]**
Vector ZHetero test: F(56,387) = 1.6613 [0.0033]**
Vector ZHetero-X test: F(140,313)= 1.4242 [0.0058]**
Vector RESET23 test: F(32,363) = 2.9373 [0.0000]**
As noted the stability tests show the problem.

However, we’ve fitted an unconstained model. Is that the appropriate strategy? Checking using the ADF
(Dickey-Fuller) test we can establish the variables are not stationary – and a visual check and consideration
as to what they measure also confirms that conclusion.
We now fit the model to the log differenced data.
URF equation for: DlnUnlead
Coefficient Std.Error t-value t-prob
DlnUnlead_1 0.555595 0.1356 4.10 0.0001
DlnUnlead_2 -0.442501 0.1021 -4.34 0.0000
DlnCrude_1 0.194860 0.06470 3.01 0.0032
DlnCrude_3 0.161456 0.06010 2.69 0.0083
DCPI_1 -8.36960 2.912 -2.87 0.0049
Constant U 0.0191948 0.006881 2.79 0.0062

sigma = 0.0435472 RSS = 0.2085990505

The constraint, despite making sense produces a marginally higher sigma. We should also check the accuracy of
the forecasts. We examine the 1-step ahead forecasts from the unconstrained model, the differenced model
noting that the errors are dominated by the 2008-9 errors so medians are used. We should consider
calculating rolling forecast for longer horizons, e.g. 12 months.
Differenced Levels
Model Model
Mean 0.056126 0.052908
Median 0.035411 0.039347
The differenced model appears to be more robust but there’s not much in it.
Error corrections models were considered but without success in identifying a set of meaningful restrictions.
Fitting a model to the full data set gives the following graphs.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Ord/Fildes Principles of Business Forecasting 1e Chapter 10 Exercises 10.7, 10.9, 10.10, 10.11 Solutions 4

© Cengage Learning 2013

As before there is some limited evidence of outliers in 2009. The equation for: LUleaded
Coefficient Std.Error t-value t-prob
LUleaded_1 1.21294 0.1339 9.06 0.0000
LUleaded_2 -0.713818 0.1424 -5.01 0.0000
LUleaded_3 0.0696510 0.07329 0.950 0.3433
LCrude_1 0.241842 0.04189 5.77 0.0000
LCPI_1 -3.94918 2.479 -1.59 0.1131
LCPI_2 3.28624 2.387 1.38 0.1704
LPDI_1 0.438498 0.1657 2.65 0.0089
Constant U -1.17888 0.5739 -2.05 0.0415

The coefficients are somewhat similar apart from CPI. Note that both model estimations suggest that CPI should
be included in differenced form. It is of course a non-stationary variable as the graph makes clear.
© Using the most recent data, we first need to add in some dummy variables for the unexpected large impact of
the recession.
10.11* Using the data set Exchange_rates.xlsx, covering data on the $US-Euro and $US-£Sterling exchange
rates from June 13, 1991, to June 13, 2011,
a. Test the stationarity of each series
i. with the subset with data from October 13, 1997, to June 13, 2002.
ii. with the full data set.
b. For each time series, develop an ARIMA model that produces one-step-ahead daily forecasts. Then do
the same for monthly average exchange rates.
c. Are the two series cointegrated? Consider both the full and the shorter data sets.
d. Is there any evidence of structural breaks in the full data series?

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Ord/Fildes Principles of Business Forecasting 1e Chapter 10 Exercises 10.7, 10.9, 10.10, 10.11 Solutions 5

e. Carry out a literature review of the comparative accuracy of alternative methods of exchange rate
forecasting. Do you find any evidence that any of the methods you have discovered have proved
successful beyond the random-walk naïve alternative?

We first graph the two series.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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 he often lays his hand lightly on
those who use him well.

Barnaby Rudge.

Second-hand cares, like second-hand clothes,

come easily off and on.

A Tale of Two Cities.

It’s much easier to talk

than to bear.

Madam Mantalini.
 Twenty-fourth Day.

here’s the good of putting

things off?
Strike while the iron’s hot.

Barnaby Rudge.

Money ... some people find their gratification

in storing it up,
and others in parting with it.

Martin Chuzzlewit.

Only the wisdom that holds the clue to

all hearts and all mysteries
can surely know to what extent a man can
impose upon himself.

Little Dorrit.

Every man came into this world for something.

Gabriel Varden.
 Twenty-fifth Day.

Perfect coolness and self-possession

... are indispensable
accomplishments of a great mind.

Pickwick Papers.

The hill has not lifted its face to Heaven yet,

that perseverance will not
gain the summit of at last.

Nicholas Nickleby.

If you can’t get to be uncommon

through going straight, you’ll never get to do it
through being crooked.
Great Expectations.
 Twenty-sixth Day.

heerful of spirit and guiltless

of affectation true practical
Christianity ever is.

The Uncommercial Traveller.

Live at least, in peace, and trust in God

to help.

Nicholas Nickleby.

Reflect upon your present blessings—

of which every man has many—not on your
past misfortunes,
of which all men have some.

Sketches by Boz.

All other swindlers upon earth are nothing

to the self-swindlers.

Great Expectations.
 Twenty-seventh Day.

here’s a moral in everything, if

we would
only avail ourselves of it.

Dombey and Son.

It is the highest part of the highest creed

to forgive before
memory sleeps, and ever to remember how the
good overcame the evil.

Haunted Man.

There is nothing, no, nothing innocent or

good that dies and is forgotten.

Old Curiosity Shop.

It does not follow that the more talkative a

person becomes
the more agreeable he is.

Dickens.
 Twenty-eighth Day.

Blustering assertion goes for proof half

over the world.

Little Dorrit.

From rough outsides serene and gentle influences

often proceed.

Dickens.

A generous nature is not prone to strong

aversions, and is slow
to admit them even dispassionately.

Little Dorrit.
 Twenty-ninth Day.

ork: don’t make fine playing

speeches about
bread, but earn it.

Ralph Nickleby.

If I do my duty, I do what I ought, and

do no more than all the rest.

Dombey and Son.

Do not strive and struggle to enrich

yourselves or to get the better of each other.

Martin Chuzzlewit.

People accustomed from infancy to lie on

down feathers,
have no idea how hard a paving-stone
is without trying it.

Hard Times.
 Thirtieth Day.

Memory, however sad, is the

best and purest
link between this world and a better.

Nicholas Nickleby.

It’s enough for a man to understand his

own business,
and not to interfere with other people’s.

Christmas Carol.

It’s a world full of hearts, and a serious world

with all its folly.

Battle of Life.
 Thirty-first Day.

ur judgments are so liable to be

influenced by many
considerations, which almost
without our knowing it, are unfair,
that it is necessary to keep a guard upon them.

Little Dorrit.

There are chords in the human heart—

strange varying strings—
which are only struck by accident.

Old Curiosity Shop.

It is well for a man to respect his own vocation,

whatever it is;
and to think himself bound to uphold it, and
to claim for it the respect it deserves.

Little Dorrit.
 Transcriber’s note
Minor punctuation errors have been changed
without notice. The following printer errors have
been changed.
CHANGED FROM TO
“always some thing “always something
Page 12:
to be” to be”
Page 19: “Go in an win” “Go in and win”
“An Uncommercial “The Uncommercial
Page 26:
Traveller.” Traveller.”
Page 31: “what ever it is” “whatever it is”
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