Time-Series Econometrics

A Concise Course

Francis X. Diebold
University of Pennsylvania

Edition 2015
Version 2015.03.22
Time Series Econometrics
Time Series Econometrics
A Concise Course

Francis X. Diebold
Copyright c 2013 Onward, by Francis X. Diebold.
All rights reserved.
 To Marc Nerlove,
who taught me time series,

and to my wonderful Ph.D. students,

his “grandstudents”
 Brief Table of Contents

About the Author xvii

About the Cover xviii

Guide to e-Features xix

Acknowledgments xx

Preface xxiv

Chapter 1. Introduction 1

Chapter 2. The Wold Representation and its Approximation 5

Chapter 3. Nonparametric Estimation and Prediction 20

Chapter 4. Spectral Analysis 29

Chapter 5. Markovian Structure, Linear Gaussian State Space, and Optimal (Kalman) Filtering 52

Chapter 6. Frequentist Time-Series Likelihood Evaluation, Optimization, and Inference 84

Chapter 7. Simulation for Economic Theory, Econometric Theory, Estimation, Inference, and
Optimization 96

Chapter 8. Bayesian Time Series Posterior Analysis by Markov Chain Monte Carlo 119

Chapter 9. Non-Stationarity: Integration, Cointegration and Long Memory 129

Chapter 10. Volatility Dynamics 139

Chapter 11. Non-Linear Non-Gaussian State Space and Optimal Filtering 179

Appendices 185

Appendix A. A “Library” of Useful Books 186

Appendix B. Elements of Continuous-Time Processes 188

 x BRIEF TABLE OF CONTENTS

Appendix C. Seemingly Unrelated Regression 192

 Detailed Table of Contents

About the Author xvii

About the Cover xviii

Guide to e-Features xix

Acknowledgments xx

Preface xxiv

Chapter 1. Introduction 1
1.1 Economic Time Series and Their Analysis 1
1.2 A Practical Toolkit 1
1.2.1 Software (and a Tiny bit of Hardware) 1
1.2.2 Data 2
1.2.3 Markup 3
1.2.4 Version Control 3
1.3 Exercises, Problems and Complements 3
1.4 Notes 4

Chapter 2. The Wold Representation and its Approximation 5

2.1 The Environment 5
2.2 White Noise 6
2.3 The Wold Decomposition and the General Linear Process 7
2.4 Approximating the Wold Representation 9
2.4.1 The M A(q) Process 9
2.4.2 The AR(p) Process 9
2.4.3 The ARM A(p, q) Process 9
2.5 Wiener-Kolmogorov-Wold Extraction and Prediction 9
2.5.1 Extraction 9
2.5.2 Prediction 9
2.6 Multivariate 10
2.6.1 The Environment 10
2.6.2 The Multivariate General Linear Process 11
2.6.3 Vector Autoregressions 12
2.7 A Small Empirical Toolkit 13
2.7.1 Nonparametric: Sample Autocovariances 13
2.7.2 Parametric: ARM A Model Selection, Fitting and Diagnostics 14
2.8 Exercises, Problems and Complements 15
2.9 Notes 18

Chapter 3. Nonparametric Estimation and Prediction 20

 DETAILED TABLE OF CONTENTS xiii

3.1 Density Estimation 20

3.1.1 The Basic Problem 20
3.1.2 Kernel Density Estimation 20
3.1.3 Bias-Variance Tradeoffs 21
3.1.4 Optimal Bandwidth Choice 22
3.2 Multivariate 23
3.3 Functional Estimation 25
3.4 Local Nonparametric Regression 25
3.4.1 Kernel Regression 25
3.4.2 Nearest-Neighbor Regression 26
3.5 Global Nonparametric Regression 27
3.5.1 Series (Sieve, Projection, ...) 27
3.5.2 Neural Networks 27
3.6 Time Series Aspects 27
3.7 Exercises, Problems and Complements 28
3.8 Notes 28

Chapter 4. Spectral Analysis 29

4.1 The Many Uses of Spectral Analysis 29
4.2 The Spectrum and its Properties 29
4.3 Rational Spectra 32
4.4 Multivariate 33
4.5 Filter Analysis and Design 36
4.6 Estimating Spectra 40
4.6.1 Univariate 40
4.6.2 Multivariate 42
4.7 Exercises, Problems and Complements 42
4.8 Notes 51

Chapter 5. Markovian Structure, Linear Gaussian State Space, and Optimal (Kalman) Filtering 52
5.1 Markovian Structure 52
5.1.1 The Homogeneous Discrete-State Discrete-Time Markov Process 52
5.1.2 Multi-Step Transitions: Chapman-Kolmogorov 52
5.1.3 Lots of Definitions (and a Key Theorem) 53
5.1.4 A Simple Two-State Example 54
5.1.5 Constructing Markov Processes with Useful Steady-State Distributions 55
5.1.6 Variations and Extensions: Regime-Switching and More 56
5.1.7 Continuous-State Markov Processes 57
5.2 State Space Representations 58
5.2.1 The Basic Framework 58
5.2.2 ARMA Models 60
5.2.3 Linear Regression with Time-Varying Parameters and More 65
5.2.4 Dynamic Factor Models and Cointegration 67
5.2.5 Unobserved-Components Models 68
5.3 The Kalman Filter and Smoother 69
5.3.1 Statement(s) of the Kalman Filter 70
5.3.2 Derivation of the Kalman Filter 71
5.3.3 Calculating P0 74
5.3.4 Predicting yt 74
5.3.5 Steady State and the Innovations Representation 75
5.3.6 Kalman Smoothing 77
5.4 Exercises, Problems and Complements 77
5.5 Notes 83
 xiv DETAILED TABLE OF CONTENTS

Chapter 6. Frequentist Time-Series Likelihood Evaluation, Optimization, and Inference 84

6.1 Likelihood Evaluation: Prediction-Error Decomposition and the Kalman Filter 84
6.2 Gradient-Based Likelihood Maximization: Newton and Quasi-Newton Methods 85
6.2.1 The Generic Gradient-Based Algorithm 85
6.2.2 Newton Algorithm 86
6.2.3 Quasi-Newton Algirithms 87
6.2.4 “Line-Search” vs. “Trust Region” Methods: Levenberg-Marquardt 87
6.3 Gradient-Free Likelihood Maximization: EM 88
6.3.1 “Not-Quite-Right EM”
(But it Captures and Conveys the Intuition) 89
6.3.2 Precisely Right EM 89
6.4 Likelihood Inference 91
6.4.1 Under Correct Specification 91
6.4.2 Under Possible Mispecification 92
6.5 Exercises, Problems and Complements 94
6.6 Notes 95

Chapter 7. Simulation for Economic Theory, Econometric Theory, Estimation, Inference, and
Optimization 96
7.1 Generating U(0,1) Deviates 96
7.2 The Basics: c.d.f. Inversion, Box-Mueller, Simple Accept-Reject 98
7.2.1 Inverse c.d.f. 98
7.2.2 Box-Muller 99
7.2.3 Simple Accept-Reject 99
7.3 Simulating Exact and Approximate Realizations of Time Series Processes 101
7.4 more 101
7.5 Economic Theory by Simulation: “Calibration” 101
7.6 Econometric Theory by Simulation: Monte Carlo and Variance Reduction 101
7.6.1 Experimental Design 102
7.6.2 Simulation 103
7.6.3 Variance Reduction: Importance Sampling, Antithetics, Control Variates
and Common Random Numbers 104
7.6.4 Response Surfaces 109
7.7 Estimation by Simulation: GMM, SMM and Indirect Inference 110
7.7.1 GMM 110
7.7.2 Simulated Method of Moments (SMM) 110
7.7.3 Indirect Inference 111
7.8 Inference by Simulation: Bootstrap 112
7.8.1 i.i.d. Environments 112
7.8.2 Time-Series Environments 114
7.9 Optimization by Simulation 116
7.9.1 Local 116
7.9.2 Global 116
7.9.3 Is a Local Optimum Global? 117
7.10 Interval and Density Forecasting by Simulation 118
7.11 Exercises, Problems and Complements 118
7.12 Notes 118

Chapter 8. Bayesian Time Series Posterior Analysis by Markov Chain Monte Carlo 119
8.1 Bayesian Basics 119
8.2 Comparative Aspects of Bayesian and Frequentist Paradigms 119
8.3 Markov Chain Monte Carlo 121
8.3.1 Metropolis-Hastings Independence Chain 121
 DETAILED TABLE OF CONTENTS xv

8.3.2 Metropolis-Hastings Random Walk Chain 121

8.3.3 More 121
8.3.4 Gibbs and Metropolis-Within-Gibbs 122
8.4 Conjugate Bayesian Analysis of Linear Regression 123
8.5 Gibbs for Sampling Marginal Posteriors 124
8.6 General State Space: Carter-Kohn Multi-Move Gibbs 125
8.7 Exercises, Problems and Complements 128
8.8 Notes 128

Chapter 9. Non-Stationarity: Integration, Cointegration and Long Memory 129

9.1 Random Walks as the I(1) Building Block: The Beveridge-Nelson Decomposition 129
9.2 Stochastic vs. Deterministic Trend 130
9.3 Unit Root Distributions 131
9.4 Univariate and Multivariate Augmented Dickey-Fuller Representations 132
9.5 Spurious Regression 133
9.6 Cointegration, Error-Correction and Granger’s Representation Theorem 133
9.7 Fractional Integration and Long Memory 137
9.7.1 Characterizing Integration Status 137
9.8 Exercises, Problems and Complements 137
9.9 Notes 138

Chapter 10. Volatility Dynamics 139

10.1 Volatility and Financial Econometrics 139
10.2 GARCH 139
10.3 Stochastic Volatility 139
10.4 Observation-Driven vs. Parameter-Driven Processes 139
10.5 Exercises, Problems and Complements 178
10.6 Notes 178

Chapter 11. Non-Linear Non-Gaussian State Space and Optimal Filtering 179
11.1 Varieties of Non-Linear Non-Gaussian Models 179
11.2 Markov Chains to the Rescue (Again): The Particle Filter 179
11.3 Particle Filtering for Estimation: Doucet’s Theorem 179
11.4 Key Application I: Stochastic Volatility (Revisited) 179
11.5 Key Application II: Credit-Risk and the Default Option 179
11.6 Key Application III: Dynamic Stochastic General Equilibrium (DSGE) Macroe-
conomic Models 179
11.7 A Partial “Solution”: The Extended Kalman Filter 179

Appendices 185

Appendix A. A “Library” of Useful Books 186

Appendix B. Elements of Continuous-Time Processes 188

B.1 Diffusions 188
B.2 Jumps 191
B.3 Quadratic Variation, Bi-Power Variation, and More 191
B.4 Integrated and Realized Volatility 191
B.5 Realized Covariance Matrix Modeling in Big Data Multivariate Environments 191
B.6 Exercises, Problems and Complements 191
B.7 Notes 191
 xvi DETAILED TABLE OF CONTENTS

Appendix C. Seemingly Unrelated Regression 192

 About the Author

Francis X. Diebold is Paul F. and Warren S. Miller Professor of Economics, and Professor
of Finance and Statistics, at the University of Pennsylvania and its Wharton School, as well
as Faculty Research Associate at the National Bureau of Economic Research in Cambridge,
Mass., and past President of the Society for Financial Econometrics. He has published
widely in econometrics, forecasting, finance and macroeconomics, and he has served on the
editorial boards of numerous scholarly. He is an elected Fellow of the Econometric Society,
the American Statistical Association, and the International Institute of Forecasters, and
the recipient of Sloan, Guggenheim, and Humboldt fellowships. Diebold lectures actively,
worldwide, and has received several prizes for outstanding teaching. He has held visiting
appointments in Economics and Finance at Princeton University, Cambridge University,
the University of Chicago, the London School of Economics, Johns Hopkins University, and
New York University. His research and teaching are firmly rooted in applications; he has
served as an economist under Paul Volcker and Alan Greenspan at the Board of Governors
of the Federal Reserve System in Washington DC, an Executive Director at Morgan Stanley
Investment Management, Co-Director of the Wharton Financial Institutions Center, and
Chairman of the Federal Reserve System’s Model Validation Council. All his degrees are
from the University of Pennsylvania; he received his B.S. from the Wharton School in 1981
and his economics Ph.D. in in 1986. He is married with three children and lives in suburban
Philadelphia.
 About the Cover

The colorful graphic is by Peter Mills and was obtained from Wikimedia Commons. As
noted there, it represents “the basins of attraction of the Gaspard-Rice scattering system
projected onto a double impact parameter” (whatever that means). I used it mainly because
I like it, but also because it’s vaguely reminiscent of a trending time series.

For details see http://commons.wikimedia.org/wiki/File%3AGR_Basins2.tiff. The

complete attribution is: By Peter Mills (Own work) [CC-BY-SA-3.0 (http://creativecommons.
org/licenses/by-sa/3.0)], via Wikimedia Commons)
Guide to e-Features

• Hyperlinks to internal items (table of contents, index, footnotes, etc.) appear in red.
• Hyperlinks to bibliographic references appear in green.

• Hyperlinks to the web appear in cyan.

• Hyperlinks to external files (e.g., video) appear in blue.
• Many images are clickable to reach related material.

• Additional related materials may appear at http://www.ssc.upenn.edu/~fdiebold.

These may include book updates, presentation slides, datasets, and R code.
• Facebook group: Diebold Time Series Econometrics
• Related blog (No Hesitations): www.fxdiebold.blogspot.com
 Acknowledgments

All media (images, audio, video, ...) were either produced by me (computer graphics using
R, original audio/video, etc.) or obtained from the public domain repository at Wikimedia
Commons.
List of Figures

1.1 The R Homepage 2

1.2 Resources for Economists Web Page 3

3.1 Bandwidth Choice – from Silverman (1986) 22

4.1 Granger’s Typical Spectral Shape of an Economic Variable 33

4.2 Gain of Differencing Filter 1 − L 37
4.3 Gain of Kuznets’ Filter 1 38
4.4 Gain of Kuznets’ Filter 2 38
4.5 Composite Gain of Kuznets’ two Filters 39

7.1 Ripley’s “Horror” Plots of pairs of (Ui+1 , Ui ) for Various Congruential

Generators Modulo 2048 (from Ripley, 1987) 97
7.2 Transforming from U(0,1) to f (from Davidson and MacKinnon, 1993) 98
7.3 Naive Accept-Reject Method 100

10.1 Time Series of Daily NYSE Returns 140

10.2 Correlogram of Daily NYSE Returns. 141
10.3 Histogram and Statistics for Daily NYSE Returns. 141
10.4 Time Series of Daily Squared NYSE Returns. 142
10.5 Correlogram of Daily Squared NYSE Returns. 142
10.6 True Exceedance Probabilities of Nominal 1% HS-V aR When Volatility
is Persistent. We simulate returns from a realistically-calibrated dynamic volatility
model, after which we compute 1-day 1% HS-V aR using a rolling window of 500 ob-
servations. We plot the daily series of true conditional exceedance probabilities, which
we infer from the model. For visual reference we include a horizontal line at the desired
1% probability level. 145
10.7 GARCH(1,1) Estimation, Daily NYSE Returns. 151
10.8 Correlogram of Squared Standardized GARCH(1,1) Residuals, Daily NYSE
Returns. 152
10.9 Estimated Conditional Standard Deviation, Daily NYSE Returns. 152
10.10Conditional Standard Deviation, History and Forecast, Daily NYSE Re-
turns. 152
10.11AR(1) Returns with Threshold t-GARCH(1,1)-in Mean. 153
10.12S&P500 Daily Returns and Volatilities (Percent). The top panel shows daily
S&P500 returns, and the bottom panel shows daily S&P500 realized volatility. We
compute realized volatility as the square root of AvgRV , where AvgRV is the average
of five daily RVs each computed from 5-minute squared returns on a 1-minute grid of
S&P500 futures prices. 154
xxii LIST OF FIGURES

10.13S&P500: QQ Plots for Realized Volatility and Log Realized Volatility.

The top panel plots the quantiles of daily realized volatility against the corresponding
normal quantiles. The bottom panel plots the quantiles of the natural logarithm of daily
realized volatility against the corresponding normal quantiles. We compute realized
volatility as the square root of AvgRV , where AvgRV is the average of five daily RVs
each computed from 5-minute squared returns on a 1-minute grid of S&P500 futures
prices. 155
10.14S&P500: Sample Autocorrelations of Daily Realized Variance and Daily
Return. The top panel shows realized variance autocorrelations, and the bottom panel
shows return autocorrelations, for displacements from 1 through 250 days. Horizontal
lines denote 95% Bartlett bands. Realized variance is AvgRV , the average of five daily
RVs each computed from 5-minute squared returns on a 1-minute grid of S&P500
futures prices. 156
10.15Time-Varying International Equity Correlations. The figure shows the esti-
mated equicorrelations from a DECO model for the aggregate equity index returns for
16 different developed markets from 1973 through 2009. 160
10.16QQ Plot of S&P500 Returns. We show quantiles of daily S&P500 returns from
January 2, 1990 to December 31, 2010, against the corresponding quantiles from a
standard normal distribution. 162
10.17QQ Plot of S&P500 Returns Standardized by NGARCH Volatilities. We
show quantiles of daily S&P500 returns standardized by the dynamic volatility from a
NGARCH model against the corresponding quantiles of a standard normal distribution.
The sample period is January 2, 1990 through December 31, 2010. The units on each
axis are standard deviations. 163
10.18QQ Plot of S&P500 Returns Standardized by Realized Volatilities. We show
quantiles of daily S&P500 returns standardized by AvgRV against the corresponding
quantiles of a standard normal distribution. The sample period is January 2, 1990
through December 31, 2010. The units on each axis are standard deviations. 164
10.19Average Threshold Correlations for Sixteen Developed Equity Markets.
The solid line shows the average empirical threshold correlation for GARCH residuals
across sixteen developed equity markets. The dashed line shows the threshold correla-
tions implied by a multivariate standard normal distribution with constant correlation.
The line with square markers shows the threshold correlations from a DECO model
estimated on the GARCH residuals from the 16 equity markets. The figure is based on
weekly returns from 1973 to 2009. 167
10.20Simulated data, ρ = 0.5 174
10.21Simulated data, ρ = 0.9 174
10.22Simulated data 177
List of Tables

10.1 Stock Return Volatility During Recessions. Aggregate stock-return volatility

is quarterly realized standard deviation based on daily return data. Firm-level stock-
return volatility is the cross-sectional inter-quartile range of quarterly returns. 168
10.2 Real Growth Volatility During Recessions. Aggregate real-growth volatility is
quarterly conditional standard deviation. Firm-level real-growth volatility is the cross-
sectional inter-quartile range of quarterly real sales growth. 168
 Preface

Time Series Econometrics (TSE ) provides a modern and concise Ph.D.-level course in
econometric time series. It can be covered realistically in one semester; indeed I have used
the material successfully for many years with first-year Ph.D. students at the University of
Pennsylvania.
The elephant in the room is of course Hamilton’s Time Series Analysis, so let me address
it immediately. TSE complements it in three key ways. First, TSE offers a concise yet
precise overview – from the classic early framework of Wold, Wiener, and Kolmogorov,
straight through to cutting-edge Bayesian MCMC analysis of non-linear non-Gaussian state
space models with the particle filter – and Hamilton’s book can be used for more extensive
background reading for those topics that overlap.
Second and crucially, however, many of the topics do not overlap, as TSE treats a variety
of more recently-emphasized topics. It stresses Markovian structure throughout, from linear
state space, to MCMC, to optimization, to non-linear state space and particle filtering. Bayes
features prominently, as do simulation, continuous time, realized volatility, nonparametrics,
global optimization, and more.
Finally, TSE is in touch with modern computing environments. It uses R throughout,
which in this author’s opinion is the clear environment of choice for the foreseeable future.
Related, TSE is generally e-aware, with numerous hyperlinks to internal items, bibliographic
references, the internet (web pages, video, etc.), databases, etc.

Francis X. Diebold
Philadelphia

Sunday 22nd March, 2015

Time Series Econometrics
 Chapter One

Introduction

1.1 ECONOMIC TIME SERIES AND THEIR ANALYSIS

Any series of observations ordered along a single dimension, such as time, may be thought
of as a time series. The emphasis in time series analysis is the study of dependence among
the observations at different points in time.1
Many economic and financial variables, such as prices, sales, stocks, GDP and its com-
ponents, stock returns, interest rates and foreign exchange rates, are observed over time;
in addition to being interested in the interrelationships among such variables, we are also
concerned with relationships among the current and past values of one or more of them,
that is, relationships over time.
At its broadest level, time series analysis provides the language for of stochastic dy-
namics. Hence it’s the language of even pure dynamic economic theory, quite apart from
empirical analysis. It is, however, a great workhorse of empirical analysis, in “pre-theory”
mode (non-structurally “getting the facts straight” before theorizing, always a good idea),
in “post-theory” mode (structural estimation and inference), and in forecasting (whether
non-structural of structural).
Empirically, the analysis of economic time series is central to a wide range of applica-
tions, including business cycle measurement, financial risk management, policy analysis,
and forecasting. Special features of interest in economic time series include trends and non-
stationarity, seasonality, cycles and persistence, predictability (or lack thereof), structural
change, and nonlinearities such as volatility fluctuations and regime switching.

1.2 A PRACTICAL TOOLKIT

1.2.1 Software (and a Tiny bit of Hardware)

Let’s proceed from highest level to lowest level.

Eviews is a good high-level environment for economic time-seres analysis. It’s a modern
object-oriented environment with extensive time series, modeling and forecasting capabili-
ties. It implements almost all of the methods described in this book, and many more.

1 Indeed what distinguishes time series analysis from general multivariate analysis is precisely the temporal

order imposed on the observations.

 2 CHAPTER 1

Figure 1.1: The R Homepage

Eviews, however, can sometimes be something of a “black box.” Hence you’ll also want
to have available slightly lower-level (“mid-level”) environments in which you can quickly
program, evaluate and apply new tools and techniques. R is one very powerful and popular
such environment, with special strengths in modern statistical methods and graphical data
analysis.2 R is available for free as part of a massive and highly-successful open-source
project. RStudio provides a fine R working environment, and, like R, it’s free. A good R
tutorial, first given on Coursera and then moved to YouTube, is here. R-bloggers is a massive
blog with all sorts of information about all things R.
If you need real speed, such as for large simulations, you will likely need a low-level
environment like Fortran or C++. And in the limit (and on the hardware side), if you
need blazing-fast parallel computing for massive simulations etc., graphics cards (graphical
processing units, or GPU’s) provide stunning gains, as documented for example in Aldrich
et al. (2011). Actually the real limit is quantum computing, but we’re not there yet.
For a compendium of econometric and statistical software, see the software links site,
maintained by Marius Ooms at the Econometrics Journal.

1.2.2 Data

Here we mention just a few key “must-know” sites. Resources for Economists, maintained
by the American Economic Association, is a fine portal to almost anything of interest to
economists. It contains hundreds of links to data sources, journals, professional organiza-
tions, and so on. FRED (Federal Reserve Economic Data) is a tremendously convenient
source for economic data. The National Bureau of Economic Research site has data on U.S.
business cycles, and the Real-Time Data Research Center at the Federal Reserve Bank of

2 Python and Julia are other interesting mid-level environments.

 INTRODUCTION 3

Figure 1.2: Resources for Economists Web Page

Philadelphia has real-time vintage macroeconomic data. Quandl is an interesting newcomer

with striking breadth of coverage; it seems to have every time series in existence, and it has
a nice R interface.

1.2.3 Markup

Markup languages effectively provide typesetting or “word processing.” HTML is the most
well-known example. Research papers and books are typically written in LaTeX. MiCTeX
is a good and popular flavor of LaTeX, and TeXworks is a good editor designed for LaTeX.
knitr is an R package, but it’s worth mentioning separately, as it powerfully integrates R
and LaTeX./footnoteYou can access everything in RStudio.
Another markup language worth mentioning is Sphinx, which runs under Python. The
Stachurchski-Sargent e-book Quantitative Economics, which features Python prominently,
is written in Sphinx.

1.2.4 Version Control

Git and GitHub are useful for open/collaborative development and version control. For
my sorts of small-group projects I find that Dropbox or equivalent keeps me adequately
synchronized, but for serious large-scale development, use of git or equivalent appears crucial.

1.3 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Approaches and issues in economic time series analysis.

4 CHAPTER 1

Consider the following point/counterpoint items. In each case, which do you think
would be more useful for analysis of economic time series? Why?

• Continuous / discrete
• linear / nonlinear
• deterministic / stochastic
• univariate / multivariate
• time domain / frequency domain
• conditional mean / conditional variance
• trend / seasonal / cycle / noise
• ordered in time / ordered in space
• stock / flow
• stationary / nonstationary
• aggregate / disaggregate
• Gaussian / non-Gaussian

2. Nobel prizes for work involving time series analysis.

Go to the economics Nobel Prize web site. Read about Economics Nobel Prize win-
ners Frisch, Tinbergen, Kuznets, Tobin, Klein, Modigliani, Friedman, Lucas, Engle,
Granger, Prescott, Sargent, Sims, Fama, Shiller, and Hansen. Each made extensive
contributions to, or extensive use of, time series analysis. Other econometricians and
empirical economists winning the Prize include Leontief, Heckman, McFadden, Koop-
mans, Stone, Modigliani, and Haavelmo.

1.4 NOTES

• The study of time series of, for example, astronomical observations predates recorded
history. Early writers on economic subjects occasionally made explicit reference to
astronomy as the source of their ideas. For example, Cournot stressed that, as in as-
tronomy, it is necessary to recognize secular variation that is independent of periodic
variation. Similarly, Jevons made clear his approach to the study of short-term fluc-
tuations used the methods of astronomy and meteorology. During the 19th century
interest in, and analysis of, social and economic time series evolved into a new field of
study independent of developments in astronomy and meteorology. Time-series anal-
ysis then flourished. Nerlove et al. (1979) provides a brief history of the field’s early
development.

• For references old and new, see the “library” of useful books in Appendix A.
 Chapter Two

The Wold Representation and its Approximation

2.1 THE ENVIRONMENT

Time series Yt (doubly infinite)

Realization yt (again doubly infinite)

Sample path yt , t = 1, ..., T

Strict Stationarity

Joint cdfs for sets of observations

depend only on displacement, not time.

Weak Stationarity

(Second-order stationarity, wide sense stationarity,

covariance stationarity, ...)

Eyt = µ, ∀t

γ(t, τ ) = E(yt − Eyt ) (yt+τ − Eyt+τ ) = γ(τ ), ∀t

0 < γ(0) < ∞

Autocovariance Function

(a) symmetric
γ(τ ) = γ(−τ ), ∀τ

(b) nonnegative definite

a0 Σa ≥ 0, ∀a
where Toeplitz matrix Σ has ij -th element γ(i − j)

(c) bounded by the variance

γ(0) ≥ |γ(τ )|, ∀τ
6 CHAPTER 2

Autocovariance Generating Function

∞
X
g(z) = γ(τ ) z τ
τ =−∞

Autocorrelation Function

γ(τ )
ρ(τ ) =
γ(0)

2.2 WHITE NOISE

White noise: ηt ∼ W N (µ, σ 2 ) (serially uncorrelated)

Zero-mean white noise: ηt ∼ W N (0, σ 2 )

iid
Independent (strong) white noise: ηt ∼ (0, σ 2 )

iid
Gaussian white noise: ηt ∼ N (0, σ 2 )

Unconditional Moment Structure of Strong White Noise

E(ηt ) = 0

var(ηt ) = σ 2
Conditional Moment Structure of Strong White Noise

E(ηt |Ωt−1 ) = 0

var(ηt |Ωt−1 ) = E[(ηt − E(ηt |Ωt−1 ))2 |Ωt−1 ] = σ 2

where

Ωt−1 = ηt−1 , ηt−2 , ...

THE WOLD REPRESENTATION 7

Autocorrelation Structure of Strong White Noise

(
σ2 , τ = 0
γ(τ ) =
0, τ ≥ 1

(
1, τ = 0
ρ(τ ) =
0, τ ≥ 1

An Aside on Treatment of the Mean

In theoretical work we assume a zero mean, µ = 0.

This reduces notational clutter and is without loss of generality.

(Think of yt as having been centered around its mean, µ,

and note that yt − µ has zero mean by construction.)

(In empirical work we allow explicitly for a non-zero mean,

either by centering the data around the sample mean
or by including an intercept.)

2.3 THE WOLD DECOMPOSITION AND THE GENERAL LINEAR PRO-

CESS

Under regularity conditions,

every covariance-stationary process {yt } can be written as:
∞
X
yt = bi εt−i
i=0

where:

b0 = 1

∞
X
b2i < ∞
i=0

εt = [yt − P (yt |yt−1 , yt−2 , ...)] ∼ W N (0, σ 2 )

The General Linear Process

8 CHAPTER 2

∞
X
yt = B(L)εt = bi εt−i
i=0

εt ∼ W N (0, σ 2 )

b0 = 1

∞
X
b2i < ∞
i=0

Unconditional Moment Structure of the LRCSSP

∞ ∞ ∞
!
X X X
E(yt ) = E bi εt−i = bi Eεt−i = bi · 0 = 0
i=0 i=0 i=0

∞ ∞ ∞
!
X X X
var(yt ) = var bi εt−i = b2i var(εt−i ) = σ 2 b2i
i=0 i=0 i=0

Conditional Moment Structure

E(yt |Ωt−1 ) = E(εt |Ωt−1 ) + b1 E(εt−1 |Ωt−1 ) + b2 E(εt−2 |Ωt−1 ) + ...

(Ωt−1 = εt−1 , εt−2 , ...)

∞
X
= 0 + b1 εt−1 + b2 εt−2 + ... = bi εt−i
i=1

var(yt |Ωt−1 ) = E[(yt − E(yt |Ωt−1 ))2 |Ωt−1 ]

= E(ε2t |Ωt−1 ) = E(ε2t ) = σ 2

(These calculations assume strong WN innovations. Why?)

Autocovariance Structure
 THE WOLD REPRESENTATION 9

∞ ∞
" ! !#
X X
γ(τ ) = E bi εt−i bh εt−τ −h
i=−∞ h=−∞

∞
X
= σ2 bi bi−τ
i=−∞

(where bi ≡ 0 if i < 0)

g(z) = σ 2 B(z) B(z −1 )

2.4 APPROXIMATING THE WOLD REPRESENTATION

2.4.1 The M A(q) Process

(Obvious truncation)
Unconditional moment structure, conditional moment structure, autocovariance func-
tions, stationarity and invertibility conditions

2.4.2 The AR(p) Process

(Stochastic difference equation)

Unconditional moment structure, conditional moment structure, autocovariance func-
tions, stationarity and invertibility conditions

2.4.3 The ARM A(p, q) Process

Rational B(L), later rational spectrum, and links to state space.

Unconditional moment structure, conditional moment structure, autocovariance func-
tions, stationarity and invertibility conditions

2.5 WIENER-KOLMOGOROV-WOLD EXTRACTION AND PREDICTION

2.5.1 Extraction

2.5.2 Prediction

yt = εt + b1 εt−1 + ...

yT +h = εT +h + b1 εT +h−1 + ... + bh εT + bh+1 εT −1 + ...

Project on ΩT = {εT , εT −1 , ...} to get:

 10 CHAPTER 2

yT +h,T = bh εT + bh+1 εT −1 + ...

Note that the projection is on the infinite past

Prediction Error
h−1
X
eT +h,T = yT +h − yT +h,T = bi εT +h−i
i=0

(An M A(h − 1) process!)

E(eT +h,T ) = 0

h−1
X
var(eT +h,T ) = σ 2 b2i
i=0

Wold’s Chain Rule for Autoregressions

Consider an AR(1) process:

yt = φyt−1 + εt

History:
{yt }Tt=1

Immediately,
yT +1,T = φyT
yT +2,T = φyT +1,T = φ2 yT
..
.
yT +h,T = φyT +h−1,T = φh yT

Extension to AR(p) and AR(∞) is immediate.

2.6 MULTIVARIATE

2.6.1 The Environment

(y1t , y2t )0 is covariance stationary if:

E(y1t ) = µ1 ∀ t
E(y2t ) = µ2 ∀ t

!
y1t − µ1
Γy1 y2 (t, τ ) = E (y1,t−τ − µ1 , y2,t−τ − µ2 )
y2t − µ2
 THE WOLD REPRESENTATION 11

!
γ11 (τ ) γ12 (τ )
=
γ21 (τ ) γ22 (τ )
τ = 0, 1, 2, ...

Cross Covariances and the Generating Function

γ12 (τ ) 6= γ12 (−τ )

γ12 (τ ) = γ21 (−τ )

Γy1 y2 (τ ) = Γ0y1 y2 (−τ ), τ = 0, 1, 2, ...

∞
X
Gy1 y2 (z) = Γy1 y2 (τ ) z τ
τ =−∞

Cross Correlations

Ry1 y2 (τ ) = Dy−1
1 y2
Γy1 y2 (τ ) Dy−1
1 y2
, τ = 0, 1, , 2, ...

!
σ1 0
D =
0 σ2

2.6.2 The Multivariate General Linear Process

! ! !
y1t B11 (L) B12 (L) ε1t
=
y2t B21 (L) B22 (L) ε2t

yt = B(L)εt = (I + B1 L + B2 L2 + ...)εt
(
Σ if t = s
E(εt ε0s ) =
0 otherwise

∞
X
k Bi k2 < ∞
i=0
 12 CHAPTER 2

Autocovariance Structure

∞
X
0
Γy1 y2 (τ ) = Bi Σ Bi−τ
i=−∞

(where Bi ≡ 0 if i < 0)

Gy (z) = B(z) Σ B 0 (z −1 )

2.6.3 Vector Autoregressions

N -variable VAR of order p:

Φ(L) yt = εt
(N xN )(N x1)(N x1)

εt ∼ (0, Σ)
(N x1)(N xN )

– Simple estimation and analysis (OLS)

– Granger-Sims causality
– Getting the facts straight before theorizing; assessing the restrictions implies by
economic theory

Impulse Response Functions

How does a shock to yit (alone) dynamically affect yjt ?

Impulse responses are pieces of the MA(∞) representation:

yt = (I + Θ1 L + Θ2 L2 + ...) εt

εt ∼ (0, Σ)

Problem: Σ generally not diagonal

Cholesky Factor Identification

(I − Φ1 L − ... − Φp LP )yt = εt
 THE WOLD REPRESENTATION 13

(I − Φ1 L − ... − Φp LP )yt = P vt

where vt ∼ (0, I) and Σ = P P 0

Impulse Response Function:

yt = (I + Θ1 L + Θ2 L2 + ...) P vt

= (P + Θ1 P L + Θ2 P L2 + ...) vt

2.7 A SMALL EMPIRICAL TOOLKIT

2.7.1 Nonparametric: Sample Autocovariances

T −|τ |
1 X
γ̂(τ ) = xt xt+|τ | , τ = 0, ± 1, ..., ± (T − 1)
T t=1

T −|τ |
1 X
γ ∗ (τ ) = xt xt+|τ | , τ = 0, ± 1 , ..., ± (T − 1)
T − |τ | t=1

Perhaps surprisingly, γ̂(τ ) is better

Asymptotic Distribution of the Sample Autocorrelations

ρ = (ρ(0), ρ(1), ..., ρ(r))0

d
√
T (ρ̂ − ρ) → N (0, Σ)

Important special case (iid):

1
asyvar(ρ̂(τ )) = , ∀τ
T

asycov(ρ̂(τ ), ρ̂(τ + v)) = 0

“Bartlett standard errors”

 14 CHAPTER 2

2.7.2 Parametric: ARM A Model Selection, Fitting and Diagnostics

2.7.2.1 Fitting and Selection

Fitting: OLS, MLE, GMM.

Model Selection (Relative Model Performance)
What not to do...

PT 2
t=1 et
M SE =
T
PT 2
2 t=1 et
R = 1 − PT
t=1 (yt − ȳ)2

M SE
= 1 − 1
PT
T t=1 (yt − ȳ)2
Still bad:

PT 2
t=1 et
s2 =
T −k
PT !
2
 
2 T t=1 et
s =
T −k T

PT 2
2 t=1 et / T −k
R̄ = 1 − PT
t=1 (yt − ȳt )2 / T − 1

s2
= 1 − PT
t=1 (yt − ȳt )2 / T − 1
Good:

PT !
2
t=1 et
SIC = T ( T )
k

More generally,
−2lnL KlnT
SIC = +
T T

Consistency (oracle property)

 THE WOLD REPRESENTATION 15

2.7.2.2 Diagnostics

Box-Pierce and Related Results:

m
X
QBP = T ρ̂2 (τ ) ∼ χ2 (m)
τ =1

m  
X 1
QLB = T (T + 2) ρ̂2 (τ )
τ =1
T −τ

2.8 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Ergodicity.
We shall say (loosely speaking) that a time series is ergodic if consistent inference
regarding its stochastic structure can be made on the basis of one realization. While
ergodicity is a deep mathematical property of the distribution function characteriz-
ing the time series in question, its meaning for a stationary time series is essentially
independence of observations far enough apart in time.
Ergodicity refers to consistent moment estimability based only on a single realization,
as opposed to stationarity, which is concerned with the time−constancy of the prob-
ability structure of a stochastic process. It is therefore nonsensical to pose questions
regarding the ergodicity of nonstationary processes. We stress that ergodicity cannot
be “checked,” even with a (doubly) infinitely sample path. The intuition is simple:
regardless of whether or not a time−series is ergodic, sample moments converge to a
random variable. If the series is ergodic, that random variable is in fact a (degenerate)
constant. It is immediately clear, then, that even with an infinitely large sample one
cannot tell whether or not sample moments converge to a constant (fixed in repeated
realizations) or just one particular realization of a random variable (which will change
from realization to realization). To check ergodicity, one must have available an entire
ensemble, which is never the case in practice.
Due to the impossibility of empirically checking ergodicity in observed time series,
attention has focused on the study of specific parameterizations for which ergodic-
ity can be theoretically established. For example, the important LRCSSP, discussed
below, is always ergodic. More generally, we seek sufficient conditions under which
laws of large numbers (LLN) can be shown to hold. For a time series of independent,
identically distributed random variables, Kolmogorov’s LLN holds. For dependent,
identically (unconditionally) distributed time series, sufficient conditions for the LLN
are well known. Much recent research examines conditions sufficient for the LLN in
16 CHAPTER 2

more general situations, such as dependent time series with heterogeneous innovations.
The resulting theories of mixing, martingale difference, and near−epoch dependent se-
quences are discussed in White (1984), Gallant and White (198*), and White (199*),
among many others.

2. The autocovariance function of the MA(1) process, revisited.

In the text we wrote


 θσ 2 , τ = 1
γ(τ ) = E(yt yt−τ ) = E((εt + θεt−1 )(εt−τ + θεt−τ −1 )) =

0, otherwise.


Fill in the missing steps by evaluating explicitly the expectation

E((εt + θεt−1 )(εt−τ + θεt−τ −1 )).

3. Predicting AR processes.
Show the following.

(a) If yt is a covariance stationary AR(1) process, i.e., yt = αyt−1 + t with |α| < 1,
then yt+h,t = αh yt .
(b) If yt is AR(2),

yt = (α1 + α2 )yt−1 − α1 α2 yt−2 + t ,

with | α1 |, | α2 | < 1, then

yt+1,t = (α1 + α2 )yt − α1 α2 yt−1 .

(c) In general, the result for an AR(p) process is

yt+k,t = ψ1 yt+k−1,t + ... + ψp yt+k−p,t ,

where yt−j = yt−j , for j = 0, 1, ..., at time t. Thus for pure autoregressions, the
MMSE prediction is a linear combination of only the p most recently observed
values.

4. Predicting M A process.
If yt is M A(1),

yt = t − βt−1 ,

where |β < 1, then

∞
X
yt+1 = −β β j xt−j ,
j=0
THE WOLD REPRESENTATION 17

and yt+k = 0 for all k > 1.

For moving-average processes more generally, predictions for a future period greater
than the order of the process are zero and those for a period less distant cannot be
expressed in terms of a finite number of past observed values.

5. Predicting the ARM A(1, 1) process.

If yt is ARM A(1, 1),

yt − αyt−1 = t − βt−1 ,

with | α |, | β | < 1, then

∞
X
yt+k,t = αk−1 (α − β) β j yt−j .
j=0

6. Prediction-error dynamics.
Consider the general linear process with strong white noise innovations. Show that
both the conditional (with respect to the information set Ωt = {t , t−1 , ...}) and
unconditional moments of the Wiener-Kolmogorov h-step-ahead prediction error are
identical.

7. Truncating the Wiener-Kolmogorov predictor.

Consider the sample path, {yt }Tt=1 , where the data generating process is yt = B(L)t
and B(L) is of infinite order. How would you modify the Weiner-Kolmogorov linear
least squares prediction formula to generate an operational 3-step-ahead forecast?
(Hint: truncate.) Is your suggested predictor linear least squares? Least squares within
the class of linear predictors using only T past observations?

8. Empirical GDP dynamics.

(a) Obtain the usual quarterly expenditure-side U.S. GDPE from FRB St. Louis,
1960.1-present.
(b) Leaving out the 12 most recent quarters of data, perform a full correlogram
analysis for GDPE logarithmic growth.
(c) Again leaving out the 12 most recent quarters of data, specify, estimate and de-
fend appropriate AR(p) and ARM A(p, q) models for GDPE logarithmic growth.
(d) Using your preferred AR(p) and ARM A(p, q) models for GDPE logarithmic
growth, generate a 12-quarter-ahead linear least-squares path forecast for the
“hold-out” sample. How do your AR(p) and ARM A(p, q) forecasts compare to
the realized values? Which appears more accurate?
(e) Obtain ADNSS GDPplus logarithmic growth from FRB Philadelphia, read about
it, and repeat everything above.
 18 CHAPTER 2

(f) Contrast the results for GDPE logarithmic growth and GDPplus logarithmic
growth.

9. Time-domain analysis of housing starts and completions.

(a) Obtain monthly U.S. housing starts and completions data from FRED at FRB
St. Louis, seasonally-adjusted, 1960.1-present. Your two series should be of equal
length.
(b) Using only observations {1, ..., T −4}, perform a full correlogram analysis of starts
and completions. Discuss in detail.
(c) Using only observations {1, ..., T − 4}, specify and estimate appropriate univari-
ate ARM A(p, q) models for starts and completions, as well as an appropriate
V AR(p). Discuss in detail.
(d) Characterize the Granger-causal structure of your estimated V AR(p). Discuss in
detail.
(e) Characterize the impulse-response structure of your estimated V AR(p) using all
possible Cholesky orderings. Discuss in detail.
(f) Using your preferred ARM A(p, q) models and V AR(p) model, specified and es-
timated using only observations {1, ..., T − 4}, generate linear least-squares path
forecasts for the four quarters of “hold out data,” {T − 3, T − 2, T − 1, T }. How
do your forecasts compare to the realized values? Discuss in detail.

10. Factor structure.

Consider the bivariate linearly indeterministic process,
! ! !
y1t B11 (L) B12 (L) ε1t
= ,
y2t B21 (L) B22 (L) ε2t

under the usual assumptions. Suppose further that B11 (L) = B21 (L) = 0 and ε1t = ε2t = εt
(with variance σ 2 ). Discuss the nature of this system. Why might it be useful in eco-
nomics?

2.9 NOTES

Characterization of time series by means of autoregressive, moving average, or ARMA mod-

els was suggested, more or less simultaneously, by the Russian statistician and economist E.
Slutsky and the British statistician G.U. Yule. The Slutsky-Yule framework was modern-
ized, extended, and made part of an innovative and operational modeling and forecasting
paradigm in a more recent classic, a 1970 book by Box and Jenkins. In fact, ARMA and
related models are often called “Box-Jenkins models.”
 THE WOLD REPRESENTATION 19

By 1930 Slutzky and Yule had shown that rich dynamics could be obtained by tak-
ing weighted averages of random shocks. Wold’s celebrated 1937 decomposition established
the converse, decomposing covariance stationary series into weighted averages of random
shocks, and paved the way for subsequent path-breaking work by Wiener, Kolmogorov,
Kalman and others. The beautiful 1963 treatment by Wold’s student Whittle (1963), up-
dated and reprinted as Whittle (1983) with a masterful introduction by Tom Sargent, re-
mains widely-read. Much of macroeconomics is built on the Slutzky-Yule-Wold-Wiener-
Kolmogorov foundation. For a fascinating overview of parts of the history in its relation
to macroeconomics, see Davies and Mahon (2009), at http://www.minneapolisfed.org/
publications_papers/pub_display.cfm?id=4348.
 Chapter Three

Nonparametric Estimation and Prediction

3.1 DENSITY ESTIMATION

3.1.1 The Basic Problem

iid
{xi }N
i=1 ∼ f (x)

f smooth in [x0 − h, x0 + h]

Goal: Estimate f (x) at arbitrary point x = x0

By the mean-value theorem,

Z x0 +h
1 1
f (x0 ) ≈ f (u)du = P (x ∈ [x0 − h, x0 + h])
2h x0 −h 2h

#xi ∈[x0 −h, x0 +h]

Estimate P (x ∈ [x0 − h, x0 + h]) by N

1 #xi ∈ [x0 − h, x0 + h]
fˆh (x0 ) =
2h N

N  
1 X1 x0 − xi
= I ≤1
N h i=1 2 h

“Rosenblatt estimator”

Kernel density estimator with

kernel: K(u) = 21 I(|u| ≤ 1)

bandwidth: h

3.1.2 Kernel Density Estimation

Issues with uniform kernels:

 NONPARAMETRIC ESTIMATION AND PREDICTION 21

1. Why weight distant observations as heavily as nearby ones?

2. Why use a discontinuous kernel if we think that f is smooth?

Obvious solution: Choose smooth kernel

Standard conditions:

R
K(u)du = 1

K(u) = K(−u)
Common Kernel Choices
u2
Standard normal: K(u) = √1 e− 2
2π

Triangular K(u) = (1 − |u|)I(|u| ≤ 1)

Epinechnikov: K(u) = 34 (1 − u2 )I(|u| ≤ 1)

General Form of the Kernel Density Estimator

N  
1 X x0 − xi
fˆh (x0 ) = K
N h i=1 h

“Rosenblatt-Parzen estimator”

3.1.3 Bias-Variance Tradeoffs

3.1.3.1 Inescapable Bias-Variance Tradeoff (in Practice, Fixed N )

3.1.3.2 Escapable Bias-Variance Tradeoff (in Theory, N → ∞)

h2
E(fˆh (x0 )) ≈ f (x0 ) + 2 · Op (1)

(So h → 0 =⇒ bias → 0)

var (fˆh (x0 )) ≈ 1

Nh · Op (1)

(So N h → ∞ =⇒ var → 0)

Thus,
) p
h→0 ˆ
=⇒ fh (x0 ) → f (x0 )
Nh → ∞
 22 CHAPTER 3

Figure 3.1: Bandwidth Choice – from Silverman (1986)

3.1.3.3 Convergence Rate

d
√
N h(fˆh (x0 ) − f (x0 )) → D

Effects of K minor; effects of h major.

3.1.4 Optimal Bandwidth Choice

   2
M SE fˆh (x0 ) = E fˆh (x0 ) − f (xo )
 
M SE fˆh (x0 ) f (x) dx
R
IM SE =

Choose bandwidth to minimize IMSE:

h∗ = γ ∗ N −1/5
Corresponding Optimal Convergence Rate
Recall:

√   d
N h fˆh (x0 ) − f (x0 ) → D

h∗ ∝ N −1/5

Substituting yields the best obtainable rate:

 NONPARAMETRIC ESTIMATION AND PREDICTION 23

p   d
N 4/5 fˆh (x0 ) − f (x0 ) → D

“Stone optimal rate”

Silverman’s Rule
For the Gaussian case,

h∗ = 1.06σN −1/5

So use:

ĥ∗ = 1.06σ̂N −1/5

Better to err on the side of too little smoothing:

ĥ∗ = σ̂N −1/5

3.2 MULTIVARIATE

Earlier univariate kernel density estimator:

N  
1 X x0 − xi
fˆh (x0 ) = K
N h i=1 h

Can be written as:

N
1 X
fˆh (x0 ) = Kh (x0 − xi )
N i=1

where Kh (·) = h1 K( h· )

or Kh (·) = h−1 K(h−1 ·)

Multivariate Version (d-Dimensional)
Precisely follows equation (3.2):

N
1 X
fˆH (x0 ) = KH (x0 − xi ),
N i=1

where KH (·) = |H|−1 K(H −1 ·), and H (d × d) is psd.

 24 CHAPTER 3

Common choice: K(u) = N (0, I), H = hI

   
1 1 1 x0 − xi
=⇒ KH (·) = d K · = dK
h h h h

N  
1 X x0 − xi
=⇒ fˆh (x0 ) = K
N hd i=1 h

Bias-Variance Tradeoff, Convergence Rate, Optimal Bandwidth, Correpsonding Optimal

Convergence Rate

) p
h→0 ˆ
=⇒ fh (x0 ) → f (x0 )
N hd → ∞

√   d
N hd ˆ
fh (x0 ) − f (x0 ) → D

1
h∗ ∝ N − d+4

q
d
  d
N 1− d+4 fˆh (x0 ) − f (x0 ) → D

Stone-optimal rate drops with d

“Curse of dimensionality”
Silverman’s Rule

 1
 d+4
4 1
∗
ĥ = σ̂N − d+4
d+2

where

d
2 1X 2
σ̂ = σ̂
d i=1 i

(average sample variance)

 NONPARAMETRIC ESTIMATION AND PREDICTION 25

3.3 FUNCTIONAL ESTIMATION

Conditional Mean (Regression)

Z
f (y, x)
E(y|x) = M (x) = y dy
f (x)
Regression Slope

∂M (x) (M (x + h2 ) − M (x − h2 ))
β(x) = = lim
∂xj h→0 h

Regression Disturbance Density

f (u), u = y − M (x)

Conditional Variance
Z
f (y, x)
var(y|x) = V (x) = y2 dy − M (x)2
f (x)

Hazard Function

f (t)
λ(t) =
1 − F (t)

Curvature (Higher-Order Derivative Estimation)

∂ ∂2 lim β(x + h2 ) − β(x − h2 )

C(x) = β(x) = ( )M (x) =
∂ xj ∂ xj 2 h→0 h

The curse of dimensionality is much worse for curvature...

d-vector: r = (r1 , ..., rd ), |r| = Σdi=1 ri

|r|

Define M (r) (x) ≡ ∂ ∂ r1 x1 ,...,∂ rd xd M (x)

√ 2|r|+d
Then Nh [M̂ (r) (x0 ) − M (r) (x0 )] →d D

3.4 LOCAL NONPARAMETRIC REGRESSION

3.4.1 Kernel Regression

Z Z
f (x0 , y)
M (x0 ) = yf (y|x0 )dy = y dy
f (x0 )
 26 CHAPTER 3

Using multivariate kernel density estimates and manipulating gives the “Nadaraya-Watson”
estimator:

N
" #
x0 −xi


X K h
M̂h (x0 ) = PN x0 −xi

yi
i=1 i=1 K h

h → 0, N h → ∞ =⇒

d
√
N hd (M̂h (x0 ) − M (x0 )) → N (0, V )

3.4.2 Nearest-Neighbor Regression

3.4.2.1 Basic Nearest-Neighbor Regression

M̂k (x0 ) = k1
P
i∈n(x0 ) yi (Locally Constant, uniform weighting)

k P
k → ∞, N → 0 ⇒ M̂k (x0 ) M (x0 )
→
√ d
k (M̂k (x0 ) − M (x0 ))
D
→
Equivalent to Nadaraya-Watson kernel regression with:
1
K(u) = 2 I(|u| ≤ 1) (uniform)
and h = R(k) (distance from x0 to k th nearest neighbor)
⇒ Variable bandwidth!

3.4.2.2 Locally-Weighted Nearest-Neighbor Regression (Locally Polynomial, Non-Uniform

Weighting)

yt = g(xt ) + εt

Computation of ĝ(x∗ ) :

0 < ξ ≤ 1

kT = int(ξ · T )

Find KT nearest neighbors using norm:

1
λ(x∗ , x∗kT ) = [ΣP ∗
j=1 (xkT j − x∗j )2 ] 2
Neighborhood weight function:
 NONPARAMETRIC ESTIMATION AND PREDICTION 27

 
λ(xt , x∗ )
vt (xt , x∗ , x∗kT ) = C λ(x∗ , x∗
k )
T

(
(1 − u3 )3 f or u < 1
C(u) =
0 otherwise

3.5 GLOBAL NONPARAMETRIC REGRESSION

3.5.1 Series (Sieve, Projection, ...)

M (x0 ) = Σ∞
j=0 βj φj (x0 )
(the φj are orthogonal basis functions)
M̂J (x0 ) = ΣJj=0 β̂j φj (x0 )
J P
J → ∞, N → 0 ⇒ M̂ J (x0 ) M (x0 )
→

Stone-optimal convergence rate, for suitable choice of J .

3.5.2 Neural Networks

Run linear combinations of inputs through “squashing functions” i = 1, ..., R inputs, j =

1, ..., S neurons

hjt = Ψ(γjo + ΣR
i=1 γij xit ), j = 1, ..., S (N euron j)
e.g. Ψ(·) can be logistic (regression), 0-1 (classification)

Ot = Φ(β0 + ΣSj=1 βj hjt )

e.g. Φ(·) can be the identity function

Compactly: Ot = Φ(β0 + ΣSj=1 βj Ψ(γjo + ΣR

i=1 γij xit ) ≡ f (xt ; θ)

S
Universal Approximator: S → ∞, N → 0 ⇒ Ô(x0 ) →p O(x0 )

Same as other nonparametric methods.

3.6 TIME SERIES ASPECTS

1. Many results go through under mixing or Markov conditions.

2. Recursive kernel regression.

Use recursive kernel estimator:

fˆN (x0 ) = ( NN−1 )fN −1 (x0 ) + 1

N hd
K( x0 −x
h
N
)
28 CHAPTER 3

to get:

x −xN
(N −1)hd fˆN −1 (x0 )M̂N −1 (x0 ) + YN K( 0 )
M̂N (x0 ) = x −x
h
(N −1)hd fˆN −1 (x0 ) + K( 0 N )
h

3. Bandwidth selection via recursive prediction.

4. Nonparametric nonlinear autoregression.

yt = g(yt−1 , ..., yt−p ) + εt
R
E(yt+1 | yt , ..., yt−p+1 ) = yt+1 f (yt+1 | yt , ..., yt−p+1 ) dy
R f (yt+1 ,...,yt−p+1 )
= yt+1 f (yt ,...,yt−p+1 ) dy

Implementation: Kernel, Series, NN, LWR

5. Recurrent neural nets.

hjt = Ψ(γjo + ΣR S
i=1 γij xit + Σl=1 δjl hl, t−1 ), j = 1, ..., S

Ot = Φ(β0 + ΣSj=1 βj hjt )

Compactly: Ot = Φ(β0 + ΣSj=1 βj Ψ (γj0 + ΣR S

i=1 γij xi t + Σl=1 δjl hl, t−1 )

Back substitution:
Ot = g(xt , xt−1 , ..., x1 ; θ)

3.7 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Tightly parametric models are often best for time-series prediction.

Generality isn’t so great; restrictions often help!

2. Semiparametric and related approaches.

√
N consistent estimation. Adaptive estimation.

3.8 NOTES
 Chapter Four

Spectral Analysis

4.1 THE MANY USES OF SPECTRAL ANALYSIS

Spectral Analysis

• As with the acov function, “getting the facts straight”

• Trend and persistence (power near zero)

• Integration, co-integration and long memory

• Cycles (power at cyclical frequencies)

• Seasonality (power spikes at fundamental and harmonics)

• Filter analysis and design

• Maximum-likelihood estimation (including band spectral)

• Assessing agreement between models and data

• Robust (HAC) variance estimation

4.2 THE SPECTRUM AND ITS PROPERTIES

Recall the General Linear Process

∞
X
yt = B(L)εt = bi εt−i
i=0

Autocovariance generating function:

∞
X
g(z) = γ(τ ) z τ
τ =−∞

= σ 2 B(z)B(z −1 )

γ(τ ) and g(z) are a z-transform pair

30 CHAPTER 4

Spectrum
Evaluate g(z) on the unit circle, z = e−iω :

∞
X
g(e−iω ) = γ(τ ) e−iωτ , − π < ω < π
τ = −∞

= σ 2 B(eiω ) B(e−iω )

= σ 2 | B(eiω ) |2

Spectrum
Trigonometric form:

∞
X
g(ω) = γ(τ )e−iωτ
τ =−∞

∞
X
γ(τ ) eiωτ + e−iωτ


= γ(0) +
τ =1

∞
X
= γ(0) + 2 γ(τ ) cos(ωτ )
τ =1

Spectral Density Function

1
f (ω) = g(ω)
2π

∞
1 X
f (ω) = γ(τ )e−iωτ (−π < ω < π)
2π τ =−∞

∞
1 1X
= γ(0) + γ(τ ) cos(ωτ )
2π π τ =1

σ2
B eiω B e−iω



=
2π

σ2
| B eiω |2


=
2π
SPECTRAL ANALYSIS 31

Properties of Spectrum and Spectral Density

1. symmetric around ω = 0

2. real-valued

3. 2π-periodic

4. nonnegative

A Fourier Transform Pair

∞
X
g(ω) = γ(τ )e−iωτ
τ =−∞

Z π
1
γ(τ ) = g(ω)eiωτ dω
2π −π

A Variance Decomposition by Frequency

Z π
1
γ(τ ) = g(ω)eiωτ dω
2π −π

Z π
= f (ω)eiωτ dω
−π

Hence
Z π
γ(0) = f (ω)dω
−π

Robust Variance Estimation

PT
x̄ = T1 t=1 xt
PT PT
var(x̄) = T12 s=1 t=1 γ(t − s)
(“Add row sums”)
 
PT −1 |τ |
= T1 τ =−(T −1) 1 − T γ(τ )
(“Add diagonal sums,” using change of variable τ = t − s)
Hence:

 
T −1
√
 
X |τ |
T (x̄ − µ) ∼ 0, 1− γ(τ )
T
τ =−(T −1)

d
√
T (x̄ − µ) → N (0, gx (0))
 32 CHAPTER 4

4.3 RATIONAL SPECTRA

White Noise Spectral Density

yt = ε t

εt ∼ W N (0, σ 2 )

σ2
B eiω B e−iω



f (ω) =
2π

σ2
f (ω) =
2π
AR(1) Spectral Density

yt = φyt−1 + εt

εt ∼ W N (0, σ 2 )

σ2
f (ω) = B(eiω )B(e−iω )
2π

σ2 1
=
2π (1 − φeiω )(1 − φe−iω )

σ2 1
=
2π 1 − 2φ cos(ω) + φ2
How does shape depend on φ? Where are the peaks?
ARMA(1, 1) Spectral Density

(1 − φL)yt = (1 − θL)εt

σ 2 1 − 2θ cos(ω) + θ2
f (ω) =
2π 1 − 2φ cos(ω) + φ2
“Rational spectral density”
Internal peaks? What will it take?
 SPECTRAL ANALYSIS 33

Figure 4.1: Granger’s Typical Spectral Shape of an Economic Variable

4.4 MULTIVARIATE

Multivariate Frequency Domain

Covariance-generating function;
∞
X
Gyx (z) = Γyx (τ )z τ
τ =−∞

Spectral density function:

1
Fyx (ω) = Gyx (e−iω )
2π

∞
1 X
= Γyx (τ ) e−iωτ , − π < ω < π
2π τ =−∞

(Complex-valued)
Co-Spectrum and Quadrature Spectrum

Fyx (ω) = Cyx (ω) + iQyx (ω)

∞
1 X
Cyx (ω) = Γyx (τ ) cos(ωτ )
2π τ =−∞

∞
−1 X
Qyx (ω) = Γyx (τ ) sin(ωτ )
2π τ =−∞

Cross Spectrum
fyx (ω) = gayx (ω)exp(i phyx (ω)) (generic cross spectrum)
34 CHAPTER 4

1
2
gayx (ω) = [Cyx (ω) + Q2yx (ω)] 2 (gain)
 
Qyx (ω)
phyx (ω) = arctan Cyx (ω) (phase)
ph(ω)
(Phase shift in time units is ω )

|fyx (ω)|2
cohyx (ω) = (coherence)
fxx (ω)fyy (ω)
Squared correlation decomposed by frequency
Useful Spectral Results for Filter Design and Analysis

• (Effects of a linear filter)

If yt = B(L)xt , then:
2
– fyy (ω) = |B(e−iω )| fxx (ω)
– fyx (ω) = B(e−iω )fxx (ω).

B(e−iω ) is the filter’s frequency response function.

• (Effects of a series of linear filters (follows trivially))

If yt = A(L)B(L)xt , then
2 2
– fyy (ω) = |A(e−iω )| |B(e−iω )| fxx (ω)
– fyx (ω) = A(e−iω )B(e−iω )fxx (ω).

• (Spectrum of an independent sum)

PN
If y = i=1 xi , and the xi are independent, then
N
X
fy (ω) = fxi (ω).
i=1

Nuances... Note that

fyx (ω)
B(e−iω ) =
fxx (ω)

gayx (ω)ei phyx (ω)

=⇒ B(e−iω ) =
fxx (ω)
Phases of fyx (ω) and B(e−iω ) are the same.
Gains are closely related.
Example

yt = .5xt−1 + εt
 SPECTRAL ANALYSIS 35

εt ∼ W N (0, 1)

xt = .9xt−1 + ηt

ηt ∼ W N (0, 1)

Correlation Structure
Autocorrelation and cross-correlation functions are straightforward:

ρy (τ ) = .9|τ |

ρx (τ ) ∝ .9|τ |

ρyx (τ ) ∝ .9|τ −1|

(What is the qualitative shape of ρyx (τ )?)

Spectral Density of x

1
xt = ηt
1 − .9L

1 1 1
=⇒ fxx (ω) = −iω
2π 1 − .9e 1 − .9eiω

1 1
=
2π 1 − 2(.9) cos(ω) + (.9)2

1
=
11.37 − 11.30 cos(ω)
Shape?
Spectral Density of y

yt = 0.5Lxt + εt

1
=⇒ fyy (ω) =| 0.5e−iω |2 fxx (ω) +
2π

1
= 0.25fxx (ω) +
2π
 36 CHAPTER 4

0.25 1
= +
11.37 − 11.30 cos(ω) 2π
Shape?
Cross Spectrum
B(L) = .5L
B(e−iω ) = 0.5e−iω
fyx (ω) = B(e−iω )fxx (ω)
= 0.5e−iω fxx (ω)
= (0.5fxx (ω)) e−iω
0.5
gyx (ω) = 0.5fxx (ω) = 11.37−11.30 cos(ω)
P hyx (ω) = −ω
(In time units, P hyx (ω) = −1, so y leads x by -1)
Coherence
| fyx (ω) |2 2
.25fxx (ω) .25fxx (ω)
Cohyx (ω) = = =
fxx (ω)fyy (ω) fxx (ω)fyy (ω) fyy (ω)

1 1
.25 2π 1−2(.9) cos(ω)+.92
= 1 1 1
.25 2π 1−2(.9) cos(ω)+.92 + 2π

1
=
8.24 + 7.20 cos(ω)
Shape?

4.5 FILTER ANALYSIS AND DESIGN

Filter Analysis: A Trivial (but Important) High-Pass Filter

yt = xt − xt−1

=⇒ B(e−iω ) = 1 − e−iω

Hence the filter gain is:

B(e−iω ) = 1 − e−iω = 2(1 − cos(ω))

How would the gain look for B(L) = 1 + L?

Filter Analysis: Kuznets’ Infamous Filters
Low-frequency fluctuations in aggregate real output growth.
“Kuznets cycle” – 20-year period
SPECTRAL ANALYSIS 37

Figure 4.2: Gain of Differencing Filter 1 − L

Filter 1 (moving average):

2
1 X
yt = xt−j
5 j=−2

2
−iω 1 X −iωj sin(5ω/2)
=⇒ B1 (e )= e =
5 j=−2 5sin(ω/2)

Hence the filter gain is:

sin(5ω/2)
B1 (e−iω ) =
5sin(ω/2)
Kuznets’ Filters, Continued
Kuznets’ Filters, Continued
Filter 2 (fancy difference):

zt = yt+5 − yt−5

=⇒ B2 (e−iω ) = ei5ω − e−i5ω = 2sin(5ω)

Hence the filter gain is:

B2 (e−iω ) = |2sin(5ω)|

Kuznets’ Filters, Continued

Kuznets’ Filters, Continued
Composite gain:
38 CHAPTER 4

Figure 4.3: Gain of Kuznets’ Filter 1

Figure 4.4: Gain of Kuznets’ Filter 2

SPECTRAL ANALYSIS 39

Figure 4.5: Composite Gain of Kuznets’ two Filters

sin(5ω/2)
B1 (e−iω )B2 (e−iω ) = |2sin(5ω)|
5sin(ω/2)
Kuznets’ Filters, Continued
Filter Design: A Bandpass Filter
Canonical problem:
Find B(L) s.t.

(
fx (ω) on [a, b] ∪ [−b, −a]
fy (ω) =
0 otherwise,
where
∞
X
yt = B(L)xt = bj εt−j
j=−∞

Bandpass Filter, Continued

Recall
2
fy (ω) = |B(e−iω )| fx (ω).
Hence we need:
(
−iω 1 on [a, b], ∪[−b, −a], 0 < a < b < π
B(e )=
0 otherwise

By Fourier series expansion (“inverse Fourier transform”):

Z π
1
bj = B(e−iω )eiωj
2π −π
 
1 sin(jb) − sin(ja)
= , ∀j ∈ Z
π j
 40 CHAPTER 4

Bandpass Filter, Continued

Many interesting issues:

• What is the weighting pattern? Two-sided? Weights symmetric around 0?

• How “best” to make this filter feasible in practice? What does that mean? Simple
truncation?

• One sided version?

• Phase shift?

4.6 ESTIMATING SPECTRA

4.6.1 Univariate

Estimation of the Spectral Density Function

Periodogram ordinate at frequency ω:

T 2 r T
! r T
!
2 X −iωt 2 X −iωt 2 X iωt
I(ω) = yt e = yt e yt e
T t=1 T t=1 T t=1

−π ≤ ω ≤ π
2πj
Usually examine frequencies ωj = T , j = 0, 1, 2, ..., T2
Sample Spectral Density

T −1
1 X
fˆ(ω) = γ̂(τ )e−iωτ
2π
τ =−(T −1)

T 2
1 X −iωt
fˆ(ω) = yt e
2πT t=1

T
! T
!
1 X −iωt 1 X iωt
= √ yt e √ yt e
2πT t=1 2πT t=1

1
= I(ω)
4π
Properties of the Sample Spectral Density
2πj
(Throughout we use ωj , j = T , j = 0, 1, ..., T2 )

• Ordinates asymptotically unbiased

 SPECTRAL ANALYSIS 41

• Ordinates asymptotically uncorrelated

• But variance does not converge to 0

(degrees of freedom don’t accumulate)

• Hence inconsistent

For Gaussian series we have:

d
2fˆ(ωj )
→ χ22 ,
f (ωj )

where the χ22 random variables are

independent across frequencies
Consistent (Lag Window) Spectral Estimation

T −1 T −1
1 X 1 2 X
fˆ(ω) = γ̂(τ )e−iωτ = γ̂(0) + γ̂(τ ) cos(ωτ )
2π 2π 2π τ =1
τ =−(T −1)

T −1
1 X
f ∗ (ω) = λ(τ )γ̂(τ )e−iωτ
2π
τ =−(T −1)

Common lag windows with truncation lag MT :

λ(τ ) = 1, |τ | ≤ MT and 0 otherwise (rectangular, or boxcar)
|τ |
λ(τ ) = 1 − MT , τ ≤ MT and 0 otherwise
(triangular, or Bartlett, or Newey-West)
MT
Consistency: MT → ∞ and T →0
Truncation lag must increase “appropriately” with T
Other (Closely-Related) Routes to
Consistent Spectral Estimation
Fit parametric approximating models (e.g., autoregressive)
(“Model-based estimation”)
– Let order increase appropriately with sample size
Smooth the sample spectral density
(“spectral window estimation”)
– Let window width decrease appropriately with sample size
 42 CHAPTER 4

4.6.2 Multivariate

Spectral density matrix:

∞
1 X
Fyx (ω) = Γyx (τ )e−iωτ , −π < ω < π
2π τ =−∞

Consistent (lag window) estimator:

(T −1)
∗ 1 X
Fyx (ω) = λ(τ )Γ̂yx (τ ) e−iωτ , −π < ω < π
2π
τ =−(T −1)

Different lag windows may be used for different elements of Fyx (ω)
Or do model-based...

4.7 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Seasonality and Seasonal Adjustment

2. HAC Estimation

3. Applied spectrum estimation.

Pick an interesting and appropriate real time series. Compute and graph (when ap-
propriate) the sample mean, sample autocovariance, sample autocorrelation, sample
partial autocorrelation, and sample spectral density functions. Also compute and graph
the sample coherence and phase lead. Discuss in detail the methods you used. For the
sample spectra, try to discuss a variety of smoothing schemes. Try smoothing the
periodogram as well as smoothing the autocovariances, and also try autoregressive
spectral estimators.

4. Sample spectrum.
Generate samples of Gaussian white noise of sizes 32, 64, 128, 256, 512, 1024 and
2056, and for each compute and graph the sample spectral density function at the
usual frequencies. What do your graphs illustrate?

5. Lag windows and spectral windows.

Provide graphs of the rectangular, Bartlett, Tukey-Hamming and Parzen lag windows.
Derive and graph the corresponding spectral windows.

6. Bootstrapping sample autocorrelations.

Assuming normality, propose a “parametric bootstrap” method of assessing the finite-
sample distribution of the sample autocorrelations. How would you generalize this to
assess the sampling uncertainty associated with the entire autocorrelation function?
How might you dispense with the normality assumption?
SPECTRAL ANALYSIS 43

Solution: Assume normality, and then take draws from the process by using a noram
random number generator in conjunction with the Cholesky factorization of the data
covariance matrix. This procedure can be used to estimate the sampling distribution
of the autocorrelations, taken one at a time. One will surely want to downweight
the long-lag autocorrelations before doing the Cholesky factorization, and let this
downweighting adapt to sample size. Assessing sampling uncertainty for the entire
autocorrelation function (e.g., finding a 95% confidence “tunnel”) appears harder,
due to the correlation between sample autocorrelations, but can perhaps be done
numerically. It appears very difficult to dispense with the normality assumption.

7. Bootstrapping sample spectra.

Assuming normality, propose a “parametric bootstrap” method of assessing the finite-
sample distribution of a consistent estimator of the spectral density function at various
selected frequencies. How would you generalize this to assess the sampling uncertainty
associated with the entire spectral density function?
Solution: At each bootstrap replication of the autocovariance bootstrap discussed
above, Fourier transform to get the corresponding spectral density function.

8. Bootstrapping spectra without normality.

Drop the normality assumption, and propose a “parametric bootstrap” method of
assessing the finite-sample distribution of (1) a consistent estimator of the spectral
density function at various selected frequencies, and (2) the sample autocorrelations.
Solution: Make use of the asymptotic distribution of the periodogram ordinates.

9. Sample coherence.
If a sample coherence is completed directly from the sample spectral density matrix
(without smoothing), it will be 1, by definition. Thus, it is important that the sam-
ple spectrum and cross-spectrum be smoothed prior to construction of a coherence
estimator.
Solution:
2
|fyx (ω)|
coh(ω) =
fx (ω) fy (ω)
In unsmoothed sample spectral density analogs,
[Σyt e−iωt Σxt e+iωt ][Σyt e+iωt Σxt e−iωt ]
côh(ω) = [Σxt e−iωt Σxt e+iωt ][Σyt e−iωt Σyt e+iωt ]
≡ 1.

10. De-meaning.
Consider two forms of a covariance stationary time series: “raw” and de-meaned.
Contrast their sample spectral density functions at ordinates 2πj/T, j = 0, 1, ...,
44 CHAPTER 4

T/2. What do you conclude? Now contrast their sample spectral density functions at
ordinates that are not multiples of 2πj/T. Discuss.
Solution: Within the set 2πj/T, j = 0, 1, ..., T/2, only the sample spectral density at
frequency 0 is affected by de-meaning. However, de-meaning does affect the sample
spectral density function at all frequencies in [0, π] outside the set 2πj/T, j = 0, 1,
..., T/2. See Priestley (1980, p. 417). This result is important for the properties of
time- versus frequency-domain estimators of fractionally-integrated models. Note in
particular that
1 X iωj t 2
I(ωj ) ∝ | yt e |
T
so that
1 X 2
I(0) ∝ | yt | ∝ T ȳ 2 ,
T
which approaches infinity with sample size so long as the mean is nonzero. Thus it
makes little sense to use I(0) in estimation, regardless of whether the data have been
demeaned.

11. Schuster’s periodogram.

The periodogram ordinates can be written as
T T
2 X X
I(ωj ) = ([ yt cos ωj t]2 + [ yt sin ωj t]2 ).
T t=1 t=1

Interpret this result.

12. Applied estimation.

Pick an interesting and appropriate real time series. Compute and graph (when appro-
priate) the sample mean, sample autocovariance, sample autocorrelation, sample par-
tial autocorrelation, and sample spectral density functions. Also compute and graph
the sample coherence and phase lead. Discuss in detail the methods you used. For
the sample spectra, try and discuss a variety of smoothing schemes. If you can, try
smooting the periodogram as well as smoothing the autocovariances, and also try
autoregressive spectral estimators.

13. Periodogram and sample spectrum.

Prove that I(ω) = 4π fˆ(ω).

14. Estimating the variance of the sample mean.

Recall the dependence of the variance of the sample mean of a serially correlated time
series (for which the serial correlation is of unknown form) on the spectral density
of the series evaluated at ω = 0. Building upon this result, propose an estimator of
SPECTRAL ANALYSIS 45

the variance of the sample mean of such a time series. If you are very ambitious, you
might want to explore in a Monte Carlo experiment the sampling properties of your
estimator of the standard error vs. the standard estimator of the standard error, for
various population models (e.g., AR(1) for various values of ρ) and sample sizes. If
you are not feeling so ambitious, at least conjecture upon the outcome of such an
experiment.

15. Coherence.
a. Write out the formula for the coherence between two time series x and y.
b. What is the coherence between the filtered series, (1 - b1 L) xt and (1 - b2 L) yt ?
(Assume that b1 6= b2 .)
c. What happens if b1 = b2 ? Discuss.

16. Multivariate spectra.

Show that for the multivariate LRCSSP,

Fy (ω) = B(e−iω ) Σ B ∗ (e−iω )

where “*” denotes conjugate transpose.

17. Filter gains.

Compute, plot and discuss the squared gain functions associated with each of the fol-
lowing filters.
(a) B(L) = (1 - L)
(b) B(L) = (1 + L)
(c) B(L) = (1 - .5 L12)-1
(d) B(L) = (1 - .5 L12).

Solution:
(a) G2 = 1 - e-iω2 is monotonically increasing on [0, π]. This is an example of a “high
pass” filter.
(b) G2 = 1 + e-iω2 is monotonically decreasing on [0, π]. This is an example of a “low
pass” filter.
(c) G2 = (1 - .5 e-12iω)2 has peaks at the fundamental seasonal frequency and its
harmonics, as expected. Note that it corresponds to a seasonal autoregression.
(d) G2 = (1 - .5 e-12iω)2 has troughs at the fundamental seasonal frequency and its
harmonics, as expected, because it is the inverse of the seasonal filter in (c) above.
46 CHAPTER 4

Thus, the seasonal process associated with the filter in (c) above would be appropri-
ately “seasonally adjusted” by the present filter, which is its inverse.

18. Filtering
(a) Consider the linear filter B(L) = 1 + θ L. Suppose that yt = B(L) xt,
where xt ∼ WN(0, σ2). Compute fy(ω).

(b) Given that the spectral density of white noise is σ2/2π, discuss how the filtering
theorem may be used to determine the spectrum of any LRCSSP by viewing it as a
linear filter of white noise.

Solution:
(a) fy(ω) = 1 + θe-iω2 fx(ω)
= σ2/2π (1 + θe-iω)(1 + θeiω)
= σ2/2π (1 + θ2 + 2θ cos ω),
which is immediately recognized as the sdf of an MA(1) process.
(b) All of the LRCSSP’s that we have studied are obtained by applying linear filters
to white noise. Thus, the filtering theorem gives their sdf’s as
f(ω) = σ2/2π B(e-iω)2
= σ2/2π B(e-iω) B(eiω)
= σ2/2π B(z) B(z-1),
evaluated on |z| = 1, which matches our earlier result.

19. Zero spectra.

Suppose that a time series has a spectrum that is zero on an interval of positive mea-
sure. What do you infer?

Solution: The series must be deterministic, because one could design a filter such that
the filtered series has zero spectrum everywhere.

20. Period.
Period is 2π/ω and is expressed in time/cycle. 1/P, cycles/time. In engineering, time
is often measured in seconds, and 1/P is Hz.

21. Seasonal autoregression.

Consider the “seasonal” autoregression (1 - φ L12) yt = t.
(a) Would such a structure be characteristic of monthly seasonal data or quarterly
seasonal data?
SPECTRAL ANALYSIS 47

(b) Compute and plot the spectral density f(ω), for various values of φ. Does it have
any internal peaks on (0, π)? Discuss.
(c) The lowest-frequency internal peak occurs at the so-called fundamental seasonal
frequency. What is it? What is the corresponding period?
(d) The higher-frequency spectral peaks occur at the harmonics of the fundamental
seasonal frequency. What are they? What are the corresponding periods?
Solution:
(a) Monthly, because of the 12-period lag.
(b)
σ2
f (ω) = (1 + φ2 − 2φ cos(12ω))
2π
The sdf has peaks at ω = 0, π/6, 2π/6, ..., 5π/6, and π.
(c) The fundamental frequency is π/6, which corresponds to a period of 12 months.
(d) The harmonic frequencies are 2π/6, ..., 5π/6, and π, corresponding to periods of
6 months, 4 months, 3 months, 12/5 months and 2 months, respectively.

22. More seasonal autoregression.

Consider the “seasonal” autoregression
(1 - φ L4) yt = t.
(a) Would such a structure be characteristic of monthly seasonal data or quarterly
seasonal data?
(b) Compute and plot the spectral density f(ω), for various values of φ. Does it have
any internal peaks on (0, π)? Discuss.
(c) The lowest-frequency internal peak occurs at the so-called fundamental seasonal
frequency. What is it? What is the corresponding period?
48 CHAPTER 4

(d) The higher-frequency spectral peaks occur at the harmonics of the fundamental
seasonal frequency. What are they? What are the corresponding periods?
Solution: (a) Quarterly, because of the 4-period lag.
(b)
σ2
f (ω) = (1 + φ2 − 2φ cos(4ω))
2π
The sdf has peaks at ω = 0, π/2 and π.
(c) The fundamental frequency is π/2, which corresponds to a period of 4 quarters.
(d) The only harmonic is π, corresponding to a period of 2 quarters.

23. The long run.

Discuss and contrast the economic concept of “long run” and the statistical concept
of ”low frequency”. Give examples showing when, if ever, the two may be validly and
fruitfully equated. Also give examples showing when, if ever, it would be inappropriate
to equate the two concepts.
Solution:
A potential divergence of the concepts occurs when economists think of the “long run”
as “in steady state,” which implies the absence of dynamics.

24. Variance of the sample mean.

The variance of the sample mean of a serially correlated time series is proportional to
the spectral density function at frequency zero.
Solution:
SPECTRAL ANALYSIS 49

Let
T
1X
x̄ = xt .
T t=1

Then
1
PT PT
var(x̄) = T2 s=1 t=1 γ(t − s)
1
PT −1 |τ |
= T τ =−(T −1) (1 − T )γ(τ ),

where γ(τ ) is the autocovariance function of x. So for large T, we have

2πfx (0)
var(x̄) ≈ .
T
25. ARCH process spectrum.
Consider the ARCH(1) process xt , where

xt | xt−1 ∼ N (0, .2 + .8 x2t−1 )

a. Compute and graph its spectral density function.

b. Compute and graph the spectral density function of x2T . Discuss.

Solution:
a. By the law of iterated expectations, we have

E(xt ) = E[E(xt |xt−1 )] = E(0) = 0

γ(0) = E(x2t ) = E[E(x2t |xt−1 )] = E[E(0.2 + 0.8x2t−1 )] = 0.2 + 0.8γ(0)

0.2
γ(0) = = 1
1 − 0.8

γ(τ ) = E(xt xt−τ ) = E[E(xt xt−τ |xt−1 , xt−2 , · · · )] = E[xt−τ E(xt |xt−1 , xt−2 , · · · )] = E(xt−τ 0) = 0

for τ =1,2,. . ..
Therefore
∞
1 X 1 1
f (ω) = γ(τ )e−iωτ = γ(0) =
2π τ =−∞ 2π 2π

Because it is white noise, the spectrum will be flat.

b. Because the kurtosis of normal random variables is 3, we have

E(x4t ) = E[E(x4t |xt−1 , xt−2 · · · )] = E[3(0.2 + 0.8x2t−1 )2 ] = 3[0.04 + 0.32E(x2t−1 ) + 0.64E(x4t−1 )].

∴ γx2 (0) = E(x4t ) − (E(x2t ))2 = 3 − 1 = 2

50 CHAPTER 4

Because

x2t

follows an AR(1) process, it follows that

γx2 (τ ) = 0.8γx2 (τ − 1)

for τ =1,2,.... We can write the s.d.f . as

∞ ∞
1 X 1 X
f (ω) = γx2 (0) + 2 γx2 (τ ) cos(ωτ ) = (1 + 2 0.8τ cos(ωτ ))
2π τ =1
2π τ =1

which will look like an AR(1) process’ s.d.f .

26. Computing spectra.

Compute, graph and discuss the spectral density functions of
a. yt = .8yt−12 + t
b. yt = .8t−12 + t .
Solution:
a.
σ2 σ2
f (ω) = [(1 − 0.8e12iω )(1 − 0.8e−12iω )]−1 = (1 − 1.6cos12ω + 0.64)−1
2π 2π
b.

σ2 σ2
f (ω) = [(1 + 0.8e12iω )(1 + 0.8e−12iω )] = (1 + 1.6cos12ω + 0.64)
2π 2π
 SPECTRAL ANALYSIS 51

27. Regression in the frequency domain.

The asymptotic diagonalization theorem provides the key not only to approximate
(i.e., asymptotic) MLE of time-series models in the frequency domain, but also to
many other important techniques, such as Hannan efficient regression:

β̂GLS = (X 0 Σ−1 X)−1 X 0 Σ−1 Y

But asymptotically,

Σ = P 0 DP

so

Σ−1 = P 0 D−1 P

Thus asymptotically

β̂GLS = (X 0 P 0 D−1 P X)−1 X 0 P 0 D−1 P Y

which is just WLS on Fourier transformed data.

28. Band spectral regression

4.8 NOTES

Harmonic analysis is one of the earliest methods of analyzing time series thought to exhibit
some form of periodicity. In this type of analysis, the time series, or some simple trans-
formation of it, is assumed to be the result of the superposition of sine and cosine waves
of different frequencies. However, since summing a finite number of such strictly periodic
functions always results in a perfectly periodic series, which is seldom observed in practice,
one usually allows for an additive stochastic component, sometimes called “noise.” Thus, an
observer must confront the problem of searching for “hidden periodicities” in the data, that
is, the unknown frequencies and amplitudes of sinusoidal fluctuations hidden amidst noise.
An early method for this purpose is periodogram analysis, initially used to analyse sunspot
data, and later to analyse economic time series.
Spectral analysis is a modernized version of periodogram analysis modified to take account
of the stochastic nature of the entire time series, not just the noise component. If it is assumed
that economic time series are fully stochastic, it follows that the older periodogram technique
is inappropriate and that considerable difficulties in the interpretation of the periodograms
of economic series may be encountered.
These notes draw in part on Diebold, Kilian and Nerlove, New Palgrave, ***.
 Chapter Five

Markovian Structure, Linear Gaussian State Space, and Optimal

(Kalman) Filtering

5.1 MARKOVIAN STRUCTURE

5.1.1 The Homogeneous Discrete-State Discrete-Time Markov Process

{Xt }, t = 0, 1, 2, . . .

Possible values (”states”) of Xt : 1, 2, 3, . . .

First-order homogeneous Markov process:

P rob(Xt+1 = j|Xt = i, Xt−1 = it−1 , . . . , X0 = i0 )

= P rob(Xt+1 = j|Xt = i) = pij

1-step transition probabilities:

[time (t + 1)]

 
p11 p12 ···
[time t]  p21 p22 ···
 

 
 · · ··· 
 
P ≡  · · ···
 

·

P∞
pij ≥ 0, j=1 pij = 1

5.1.2 Multi-Step Transitions: Chapman-Kolmogorov

m-step transition probabilities:

(m)
pij = P rob(Xt+m = j | Xt = i)

 
(m)
Let P (m) ≡ pij .
 STATE SPACE AND THE KALMAN FILTER 53

Chapman-Kolmogorov theorem:

P (m+n) = P (m) P (n)

Corollary: P (m) = P m

5.1.3 Lots of Definitions (and a Key Theorem)

(n)
State j is accessible from state i if pij > 0, for some n.

Two states i and j communicate (or are in the same class) if each is accessible from the
other. We write i ↔ j.

A Markov process is irreducible if there exists only one class (i.e., all states communicate).

(n)
State i has period d if pii = 0 ∀n such that n/d 6∈ Z, and d is the greatest integer with
that property. (That is, a return to state i can only occur in multiples of d steps.) A state
with period 1 is called an aperiodic state.

A Markov process all of whose states are aperiodic is called an aperiodic Markov process.
Still more definitions....
The first-transition probability is the probability that, starting in i, the first transition to
j occurs after n transitions:
(n)
fij = P rob(Xn = j, Xk 6= j, k = 1, ..., (n − 1)|X0 = i)
P∞ (n)
Denote the eventual transition probability from i to j by fij (= n=1 fij ).

State j is recurrent if fjj = 1 and transient otherwise.

Denote the expected number of transitions needed to return to recurrent state j by

P∞ (n)
µjj (= n=1 nfjj ).

A recurrent state j is positive recurrent if µjj < ∞ null recurrent if µjj = ∞.

One final definition...
The row vector π is called the stationary distribution for P if:

πP = π.

The stationary distribution is also called the steady-state distribution.

Theorem: Consider an irreducible, aperiodic Markov process.

Then either:
 54 CHAPTER 5

(1) All states are transient or all states are null recurrent

(n)
pij → 0 as n → ∞ ∀i, j. No stationary distribution.

or

(2) All states are positive recurrent.

(n)
pij → πj as n → ∞ ∀i, j. {πj , j = 1, 2, 3, ...} is the unique stationary distribution.
π is any row of limn→∞ P n .

5.1.4 A Simple Two-State Example

Consider a Markov process with transition probability matrix:

!
0 1
P =
1 0
Call the states 1 and 2.

We will verify many of our claims, and we will calculate the steady-state distribution.

5.1.4.1 Valid Transition Probability Matrix

pij ≥ 0 ∀i, j
2
X 2
X
p1j = 1, p2j = 1
j=1 j=1

5.1.4.2 Chapman-Kolmogorov Theorem (for P (2) )

! ! !
0 1 0 1 1 0
P (2) = P · P = =
1 0 1 0 0 1

5.1.4.3 Communication and Reducibility

Clearly, 1 ↔ 2, so P is irreducible.
 STATE SPACE AND THE KALMAN FILTER 55

5.1.4.4 Periodicity

State 1: d(1) = 2
State 2: d(2) = 2

5.1.4.5 First and Eventual Transition Probabilities

(1) (n)
f12 = 1, f12 = 0 ∀ n > 1 ⇒ f12 = 1
(1) (n)
f21 = 1, f21 = 0 ∀ n > 1 ⇒ f21 = 1

5.1.4.6 Recurrence

Because f21 = f12 = 1, both states 1 and 2 are recurrent.

Moreover,
∞
(n)
X
µ11 = nf11 = 2 < ∞ (and similarly µ22 = 2 < ∞)
n=1

Hence states 1 and 2 are positive recurrent.

5.1.4.7 Stationary Probabilities

We will guess and verify.

Let π1 = .5, π2 = .5 and check πP = π:

!
0 1
(.5, .5) = (.5, .5).
1 0

Hence the stationary probabilities are 0.5 and 0.5.

Note that in this example we can not get the stationary probabilities by taking limn→∞ P n .
Why?

5.1.5 Constructing Markov Processes with Useful Steady-State Distributions

In section 5.1.4 we considered an example of the form, “for a given Markov process, character-
ize its properties.” Interestingly, many important tools arise from the reverse consideration,
“For a given set of properties, find a Markov process with those properties.”
 56 CHAPTER 5

5.1.5.1 Markov Chain Monte Carlo

(e.g., Gibbs sampling)

We want to sample from f (z) = f (z1 , z2 )
(0)
Initialize (j = 0) using z2
1 (0) (1) (1)
Gibbs iteration j = 1: Draw z(1) from f (z1 |z2 ), draw z2 from f (z2 |z1 )
Repeat j = 2, 3, ....

5.1.5.2 Global Optimization

(e.g., simulated annealing)

If θc ∈
/ N (θ(m) ) then P (θ(m+1) = θc |θ(m) ) = 0
If θc ∈ N (θ(m) ) then P (θ(m+1) = θc | θ(m) ) = exp (min[0, ∆/T (m)])

5.1.6 Variations and Extensions: Regime-Switching and More

5.1.6.1 Markovian Regime Switching

!
p11 1 − p11
P =
1 − p22 p22

st ∼ P

yt = cst + φst yt−1 + εt

εt ∼ iid N (0, σs2t )

“Markov switching,” or “hidden Markov,” model

Popular model for macroeconomic fundamentals

5.1.6.2 Heterogeneous Markov Processes

 
p11,t p12,t ···
 
p21,t p22,t ··· 
Pt = 
 ·
.
 · ··· 

· · ···

e.g., Regime switching with time-varying transition probabilities:

st ∼ Pt
 STATE SPACE AND THE KALMAN FILTER 57

yt = cst + φst yt−1 + εt

εt ∼ iid N (0, σs2t )

Business cycle duration dependence: pij,t = gij (t)

Credit migration over the cycle: pij,t = gij (cyclet )
General covariates: pij,t = gij (xt )

5.1.6.3 Semi-Markov Processes

We call semi-Markov a process with transitions governed by P , such that the state durations
(times between transitions) are themselves random variables. The process is not Markov,
because conditioning not only the current state but also time-to-date in state may be useful
for predicting the future, but there is an embedded Markov process.

Key result: The stationary distribution depends only on P and the expected state dura-
tions. Other aspects of the duration distribution are irrelevant.

Links to Diebold-Rudebush work on duration dependence: If welfare is affected only by

limiting probabilities, then the mean of the duration distribution is the only relevant aspect.
Other, aspects, such as spread, existence of duration dependence, etc. are irrelevant.

5.1.6.4 Time-Reversible Processes

Theorem: If {Xt } is a stationary Markov process with transition probabilities pij and sta-
tionary probabilities πi , then the reversed process is also Markov with transition probabilities
πj
p∗ij = pji .
πi

In general, p∗ij 6= pij . In the special situation p∗ij = pij (so that πi pij = πj pji ), we say that
the process is time-reversible.

5.1.7 Continuous-State Markov Processes

5.1.7.1 Linear Gaussian State Space Systems

αt = T αt−1 + Rηt

yt = Zαt + εt

ηt ∼ N, εt ∼ N
 58 CHAPTER 5

5.1.7.2 Non-Linear, Non-Gaussian State Space Systems

αt = Q(αt−1 , ηt )

yt = G(αt , εt )

ηt ∼ Dη , εt ∼ Dε

Still Markovian!

5.2 STATE SPACE REPRESENTATIONS

5.2.1 The Basic Framework

Transition Equation

αt = T αt−1 + R ηt
mx1 mxm mx1 mxg gx1

t = 1, 2, ..., T

Measurement Equation

yt = Z αt + Γ wt + εt
1x1 1xm mx1 1xL Lx1 1x1

(This is for univariate y. We’ll do multivariate shortly.)

t = 1, 2, ..., T

(Important) Details

!  
ηt
∼ WN 0, diag( Q , |{z}
h )
εt |{z}
g×g 1×1

E(α0 ηt 0 ) = 0mxg

E(α0 εt ) = 0mx1
STATE SPACE AND THE KALMAN FILTER 59

All Together Now

αt = T αt−1 + R ηt
mx1 mxm mx1 mxg gx1

yt = Z αt + Γ wt + εt
1x1 1xm mx1 1xL Lx1 1x1

!  
ηt
∼ WN 0, diag( Q , |{z}
h )
εt |{z}
g×g 1×1

E(α0 εt ) = 0mx1 E(α0 ηt 0 ) = 0mxg

State Space Representations Are Not Unique

Transform by the nonsingular matrix B.
The original system is:

αt = T αt−1 + R ηt
mx1 mxm mx1 mxg gx1

yt = Z αt + Γ wt + εt
1x1 1xm mx1 1xL Lx1 1x1

Rewrite the system in two steps

First, write it as:

αt = T B −1 B αt−1 + R ηt
mx1 mxm mxm mxm mx1 mxg gx1

yt = Z B −1 B αt + Γ wt + εt
1x1 1xm mxm mxm mx1 mxL Lx1 1x1

Second, premultiply the transition equation by B to yield:

 60 CHAPTER 5

(B αt ) = (B T B −1 ) (B αt−1 ) + (B R) ηt
mx1 mxm mx1 mxg gx1

yt = (Z B −1 ) (B αt ) + Γ wt + εt
1x1 1xm mx1 mxL Lx1 1x1

(Equivalent State Space Representation)

5.2.2 ARMA Models

State Space Representation of an AR(1)

yt = φ yt−1 + ηt

ηt ∼ W N (0, ση2 )

Already in state space form!

αt = φ αt−1 + ηt

yt = αt

(T = φ, R = 1, Z = 1, Γ = 0, Q = ση2 , h = 0)
MA(1)

yt = Θ(L)εt

εt ∼ W N (0, σ 2 )

where

Θ(L) = 1 + θ1 L

MA(1) in State Space Form

yt = ηt + θ ηt−1

ηt ∼ W N (0, ση2 )
STATE SPACE AND THE KALMAN FILTER 61

! ! ! !
α1t 0 1 α1,t−1 1
= + ηt
α2t 0 0 α2,t−1 θ

yt = (1, 0) αt = α1t

MA(1) in State Space Form

Why? Recursive substitution from the bottom up yields:

!
yt
αt =
θηt

MA(q)

yt = Θ(L)εt

εt ∼ W N (0, σ 2 )

where

Θ(L) = 1 + θ1 L + ... + θq Lq

MA(q) in State Space Form

yt = ηt + θ1 ηt−1 + ... + θq ηt−q

ηt ∼ W N N (0, ση2 )

       
α1t 0 α1,t−1 1
α2t 0 Iq  α2,t−1  θ1 
       
    

 .. 
 = 
 .. 


 ..  +  .  ηt
  . 
 .   .   .   . 
αq+1,t 0 00 αq+1,t−1 θq

yt = (1, 0, ..., 0) αt = α1t

MA(q) in State Space Form

Recursive substitution from the bottom up yields:
62 CHAPTER 5

   
θq ηt−q + . . . + θ1 ηt−1 + ηt yt

 .. 


 .. 

αt ≡ 
 . 
 =

 . 


 θq ηt−1 + θq−1 ηt 

 θ η
 q t−1 + θq−1 ηt


θq ηt θq ηt
AR(p)

Φ(L)yt = εt

εt ∼ W N (0, σ 2 )

where

Φ(L) = (1 − φ1 L − φ2 L2 − ... − φp Lp )

AR(p) in State Space Form

yt = φ1 yt−1 + ... + φp yt−p + ηt

ηt ∼ W N (0, ση2 )

       
α1t φ1 α1,t−1 1
       
 α2t   φ2 Ip−1   α2,t−1   0 
αt =  . =  +  .  ηt
       
 . ..
 ..  ..  .. 
  


 



 . 
  
αpt φp 00 αp,t−1 0

yt = (1, 0, ..., 0) αt = α1t

AR(p) in State Space Form

Recursive substitution from the bottom up yields:
   
α1t φ1 α1,t−1 + . . . + φp α1,t−p + ηt

 .. 


 .. 

αt =

 . 
 =

 . 

 α   φp−1 α1,t−1 + φp α1,t−2 
 p−1,t   
αpt φp α1,t−1
 
yt

 .. 

=

 . 


 φp−1 yt−1 + φp yt−2  
φp yt−1
ARMA(p,q)
 STATE SPACE AND THE KALMAN FILTER 63

Φ(L)yt = Θ(L)εt
εt ∼ W N (0, σ 2 )

where
Φ(L) = (1 − φ1 L − φ2 L2 − ... − φp Lp )

Θ(L) = 1 + θ1 L + ... + θq Lq

ARMA(p,q) in State Space Form

yt = φ1 yt−1 + ... + φp yt−p + ηt + θ1 ηt−1 + ... + θq ηt−q

ηt ∼ W N (0, ση2 )

Let m = max(p, q + 1) and write as ARMA(m, m − 1):

(φ1 , φ2 , ..., φm ) = (φ1 , ..., φp , 0, ..., 0)

(θ1 , θ2 , ..., θm−1 ) = (θ1 , ..., θq , 0, ..., 0)

ARMA(p,q) in State Space Form

   
φ1 1
   
 φ2 Im−1   θ1 
αt =  αt−1 +   ηt
   
 . ..
 ..   . 
   
φm 00 θm−1

yt = (1, 0, ..., 0) αt

ARMA(p,q) in State Space Form Recursive substitution from the bottom up yields:
   
α1t φ1 α1,t−1 + φp α1,t−p + ηt + θ1 ηt−1 + . . . + θq ηt−q
 .   . 
 .   . 

 . 
 =

 . 

   
 αm−1,t   φm−1 α1,t−1 + αm,t−1 + θm−2 ηt 
αmt φm α1,t−1 + θm−1 ηt
 
yt
 . 
 . 
=

 . 

 
 φm−1 yt−1 + φm yt−2 + θm−1 ηt−1 + θm−2 ηt 
φm yt−1 + θm−1 ηt

Multivariate State Space

(Same framework, N > 1 observables)

αt = T αt−1 + R ηt
mx1 mxm mx1 mxg gx1
64 CHAPTER 5

yt = Z αt + Γ Wt + εt
N x1 N xm mx1 N xL Lx1 N x1

!  
ηt
∼ WN H )
0, diag( Q , |{z}
εt |{z}
g×g N ×N

E(α0 ηt 0 ) = 0mxg E(α0 εt 0 ) = 0mxN

N -Variable V AR(p)

yt = Φ1 yt−1 + ... + Φp yt−p + ηt

N x1 N xN N x1

ηt ∼ W N (0, Σ)

State Space Representation

       
α1t Φ1 α1,t−1 IN
 α2t Φ2 IN (p−1)  α2,t−1 0N xN
       
     
= +  ηt
       
 .   .   .  . 
 .   .   .   . 
 .   .   .   . 
αpt Φp 00 αp,t−1 0N xN
N px1 N pxN p N px1 N P xN

yt = (IN , 0N , ..., 0N ) αt
N x1 N xN p N px1

Multivariate ARMA(p,q)

yt = Φ1 yt−1 + ... + Φp yt−p

N x1 N xN N xN

+ ηt + Θ1 ηt−1 + ... + Θq ηt−q

N xN N xN

ηt ∼ W N (0, Σ)
 STATE SPACE AND THE KALMAN FILTER 65

Multivariate ARMA(p,q)
   
Φ1 I
 Φ2 IN (m−1) Θ1
   
  
αt =  .
 .
 αt−1 + 
  ..  ηt

 .   . 
N mx1
Φm 0N xN (m−1) Θm−1

yt = (I, 0, ..., 0) αt = α1t

where m = max(p, q + 1)

5.2.3 Linear Regression with Time-Varying Parameters and More

Linear Regression Model, I

Transition: Irrelevant
Measurement:

yt = β 0 xt + ε t

(Just a measurement equation with exogenous variables)

(T = 0, R = 0, Z = 0, γ = β 0 , Wt = xt , H = σε2 )
Linear Regression Model, II
Transition:

αt = αt−1

Measurement:

yt = x0t αt + εt

(T = I, R = 0, Zt = x0t , γ = 0, H = σε2 )
Note the time-varying system matrix.
Linear Regression with ARMA(p,q) Disturbances

yt = βxt + ut

ut = φ1 ut−1 + ... + φp ut−p + ηt + φ1 ηt−1 + ... + θq ηt−q

   
φ1 1
 φ2 Im−1  θ1
   
 
αt =  .
 .
 αt−1 + 
  ..  ηt

 .   . 
φm 00 θm−1
 66 CHAPTER 5

yt = (1, 0, ..., 0)αt + βxt

where m = max(p, q + 1)

Linear Regression with Time-Varying Coefficients

Transition:

αt = φ αt−1 + ηt

Measurement:

yt = x0t αt + εt

(T = φ, R = I, Q = cov(ηt ), Zt = x0t , γ = 0, H = σε2 )

– Gradual evolution of tastes, technologies and institutions
– Lucas critique
– Stationary or non-stationary

5.2.3.1 Simultaneous Equations

N -Variable Dynamic SEM

+
Structure:

φ0 yt = φ1 yt−1 + ... + φp yt−p + P ηt

ηt ∼ W N (0, I)

Reduced form:

yt = φ−1 −1 −1
0 φ1 yt−1 + ... + φ0 φp yt−p + φ0 P ηt

Assume that the system is identified.

SEM State Space Representation

φ−1 φ−1
       
α1t 0 φ1 α1,t−1 0 P
 
  −1 η1t
 α2t   φ 0 φ2 I   α2,t−1 0
     
   . 
 . = .. .. + ..  .
 .
  
 .      
 . . . .

      
ηN t
αpt φ−1
0 φp 00 αp,t−1 0

yt = (IN , 0N , ..., 0N ) αt
N x1 N xN p N px1
 STATE SPACE AND THE KALMAN FILTER 67

5.2.4 Dynamic Factor Models and Cointegration

Dynamic Factor Model – Single AR(1) factor

(White noise idiosyncratic factors uncorrelated with each other
and uncorrelated with the factor at all leads and lags...)

    
  
y1t µ1 λ1 ε1t
 .   .   .   . 
 .  =  .  +  .  Ft +  .
 .   .  .   .

 
yN t µN λN εN t

Ft = φFt−1 + ηt

Already in state-space form!

Dynamic Factor Model – Single ARMA(p,q) Factor
       
y1t µ1 λ1 ε1t
 .   .   .   . 
 .  =  .  +  .  Ft +  .
 .   .   .   .


yN t µN λN εN t

Φ(L) Ft = Θ(L) ηt

Dynamic Factor Model – Single ARMA(p,q) Factor State vector for F is state vector for
system:

   
φ1 1
 φ2 Im−1  θ1
   
 
αt =  .
 .
 αt−1 + 
  ..  ηt

 .   . 
φm 00 θm−1

Dynamic Factor Model – Single ARMA(p,q) factor System measurement equation is then:

      
y1t µ1 λ1 ε1t
 . 
 .  =  ..  +  ..  (1, 0, ..., 0) αt +  ..
     
 .   .  .   .

 
yN t µN λN εN t

     
µ1 λ1 0 ... 0 ε1t
 .   .
 αt +  .. 
  
=  .   .
 .  +  .   . 
µN λN 0 ... 0 εN t

Cointegration (A Special Dynamic Factor Model)

 68 CHAPTER 5

! ! !
y1t λ1 ε1t
= αt +
y2t λ2 ε2t
αt = αt−1 + ηt
“Common trend” αt
y1t y2t ε1t ε2t
Note that λ1 − λ2 = λ1 − λ2
That is, I(1) − I(1) = I(0)
“CI(1,0)”

5.2.5 Unobserved-Components Models

– Separate components for separate features

– Signal extraction
– Trends and detrending
– Seasonality and seasonal adjustment
– Permanent-transitory decompositions
Cycle (“Signal”) + Noise Model

xt = φ xt−1 + ηt

yt = xt + εt

! ! !
εt σε2 0
∼ WN 0,
ηt 0 ση2

(αt = xt , T = φ, R = 1, Z = 1, γ = 0, Q = ση2 , H = σε2 )

Cycle + Seasonal + Noise

yt = ct + st + εt

ct = φ ct−1 + ηct

st = γ st−4 + ηst

Cycle + Seasonal + Noise

Transition equations for the cycle and seasonal:

αct = φ αc,t−1 + ηct

 STATE SPACE AND THE KALMAN FILTER 69

   
0 1
   
 0 I3 
 αs,t−1 +  0  ηst
 
αst = 
 0   0 
   
γ 00 0
Cycle + Seasonal + Noise Stacking transition equations gives the grand transition equa-
tion:

   
0 1 0 0 0 1 0
 0 0 10 0  0 0 
!   !   !
αst   αs,t−1   ηst
=  0 0 0 1 0  + 
 0 0 
αct   αc,t−1  ηct
 γ 0 0 0 0   0 0 
   

0 0 0 0 φ 0 1
Finally, the measurement equation is:
!
αst
yt = (1, 0, 0, 0, 1) + εt
αct

5.3 THE KALMAN FILTER AND SMOOTHER

State Space Representation

αt = T αt−1 + R ηt
mx1 mxm mx1 mxg gx1

yt = Z αt + γ Wt + εt
N x1 N xm mx1 N xL Lx1 N x1

!  
ηt
∼ WN 0, diag( Q , |{z}
H )
εt |{z}
g×g N ×N

E(α0 ηt0 ) = 0mxg

E(α0 ε0t ) = 0mxN

 70 CHAPTER 5

5.3.1 Statement(s) of the Kalman Filter

I. Initial state estimate and MSE

a0 = E(α0 )

P0 = E(α0 − a0 ) (α0 − a0 )0

Statement of the Kalman Filter

II. Prediction Recursions

at/t−1 = T at−1

Pt/t−1 = T Pt−1 T 0 + R Q R0

III. Updating Recursions

at = at/t−1 + Pt/t−1 Z 0 Ft−1 (yt − Zat/t−1 − γWt )

(where Ft = Z Pt/t−1 Z 0 + H)

Pt = Pt/t−1 − Pt/t−1 Z 0 Ft−1 Z Pt/t−1

t = 1, ..., T
State-Space in Density Form (Assuming Normality)

αt |αt−1 ∼ N (T αt−1 , RQR0 )

yt |αt ∼ N (Zαt , H)

Kalman Filter in Density Form (Assuming Normality)

Initialize at a0 , P0
State prediction:
αt |ỹt−1 ∼ N (at/t−1 , Pt/t−1 )
at/t−1 = T at−1
Pt/t−1 = T Pt−1 T 0 + RQR0
Data prediction:
yt |ỹt−1 ∼ N (Zat/t−1 , Ft )
Update:
αt |ỹt ∼ N (at , Pt )
 STATE SPACE AND THE KALMAN FILTER 71

at = at/t−1 + Kt (yt − Zat/t−1 )

Pt = Pt/t−1 − Kt ZPt/t−1
where ỹt = {y1 , ..., yt }

5.3.2 Derivation of the Kalman Filter

Useful Result 1: Conditional Expectation is MMSE Extraction Under Normality Suppose

that
!  
x
∼N µ, Σ
y
where x is unobserved and y is observed.
Then
Z Z
E(x|y) = argmin x̂(y) (x − x̂(y))2 f (x, y) dx dy

Useful Result 2: Properties of the Multivariate Normal

!   !
x Σxx Σxy
∼N µ, Σ µ = (µx , µy )0 Σ=
y Σyx Σyy

=⇒ x|y ∼ N µx|y , Σx|y

µx|y = µx + Σxy Σ−1

yy (y − µy )

Σx|y = Σxx − Σxy Σ−1

yy Σyx

Constructive Derivation of the Kalman Filter

Under Normality
Let Et (·) ≡ E(· |Ωt ), where Ωt ≡ {y1 , ..., yt }.
Time 0 “update”:

a0 = E0 (α0 ) = E (α0 )

P0 = var0 ( α0 ) = E [(α0 − a0 ) (α0 − a0 )0 ]

Derivation of the Kalman Filter, Continued...

Time 0 prediction

α1 = T α0 + Rη1
 72 CHAPTER 5

=⇒ a1/0 = E0 (α1 ) = T E0 (α0 ) + RE0 (η1 )

= T a0

Derivation of the Kalman Filter, Continued...

 
0
P1/0 = E0 (α1 − a1/0 ) (α1 − a1/0 )

 
(subst. a1/0 ) = E0 (α1 − T a0 ) (α1 − T a0 )0

 
(subst. α1 ) = E0 (T (α0 − a0 ) + Rη1 ) (T (α0 − a0 ) + Rη1 )0

= T P0 T 0 + RQR0

(using E(α0 ηt0 ) = 0 ∀t)

Derivation of the Kalman Filter, Continued...

Time 1 updating
We will derive the distribution of:
!
α1
Ω0
y1
and then convert to

α1 |(Ω0 ∪ y1 )

or

α1 |Ω1

Derivation of the Kalman Filter, Continued...

Means:

E0 (α1 ) = a1/0

E0 (y1 ) = Za1/0 + γW1

 STATE SPACE AND THE KALMAN FILTER 73

Derivation of the Kalman Filter, Continued...

Variance-Covariance Matrix:

 
var0 (α1 ) = E0 (α1 − a1/0 ) (α1 − a1/0 ) = P1/0

 
var0 (y1 ) = E0 (y1 − Za1/0 − γW1 ) (y1 − Za1/0 − γW1 )0

 
= E0 (Z(α1 − a1/0 ) + ε1 ) (Z(α1 − a1/0 ) + ε1 )0

= Z P1/0 Z 0 + H (using ε⊥η)

cov0 (α1 , y1 ) = E0 (α1 − a1/0 ) (Z (α1 − a1/0 ) + ε1 )0

= P1/0 Z 0 (using ε⊥η)

Derivation of the Kalman Filter, Continued...

Hence:

! ! !!
α1 a1/0 P1/0 P1/0 Z 0
Ω0 ∼ N ,
y1 Za1/0 + γW1 ZP1/0 ZP1/0 Z 0 + H

Now by Result 2, α1 | Ω0 ∪ y1 ∼ N (a1 , P1 )

a1 = a1/0 + P1/0 Z 0 F1−1 (y1 − Za1/0 − γW1 )

P1 = P1/0 − P1/0 Z 0 F1−1 Z P1/0

(F1 = Z P1/0 Z 0 + H)

Repeating yields the Kalman filter.

What Have We Done?
Under normality,
we proved that the Kalman filter delivers
MVU predictions and extractions.
Dropping normality,
one can also prove that the Kalman filter delivers
 74 CHAPTER 5

BLU predictions and extractions.

5.3.3 Calculating P0

Treatment of Initial Covariance Matrix: P0 = Γ(0) (Covariance stationary case: All eigen-
values of T inside |z| = 1)

αt = T αt−1 + Rηt

=⇒ Γα (0) = E(T αt−1 + Rηt )(T αt−1 + Rηt )0 = T Γα (0)T 0 + RQR0

=⇒ P0 = T P0 T 0 + RQR0

=⇒ vec(P0 ) = vec(T P0 T 0 ) + vec(RQR0 )

= (T ⊗ T )vec(P0 ) + vec(RQR0 )

=⇒ vec(P0 ) = (I − (T ⊗ T ))−1 vec(RQR0 )

5.3.4 Predicting yt

Point prediction:

yt/t−1 = Zat/t−1 + γWt

Prediction error:

vt = yt − (Zat/t−1 + γWt )

Density Prediction of yt

yt |Ωt−1 ∼ N (yt/t−1 , Ft )

or equivalently

vt | Ωt−1 ∼ N (0, Ft )

Et−1 vt = Et−1 [yt − (Zat/t−1 + γWt )]

= Et−1 [Z (αt − at/t−1 ) + εt ] = 0

 STATE SPACE AND THE KALMAN FILTER 75

Et−1 vt vt0 = Et−1 [Z (αt − at/t−1 ) + εt ] [Z (αt − at/t−1 ) + εt ]0

= ZPt/t−1 Z 0 + H ≡ Ft

Normality follows from linearity of all transformations.

5.3.4.1 Combining State Vector Prediction and Updating

(For notational convenience we now drop Wt )

(1) Prediction: at+1/t = T at
(2) Update: at = at/t−1 + Pt/t−1 Z 0 Ft−1 (yt − Zat/t−1 )
= at/t−1 + Kt vt
where

Kt = Pt/t−1 Z 0 Ft−1

Substituting (2) into (1):

at+1/t = T at/t−1 + T Kt vt

5.3.5 Steady State and the Innovations Representation

Recall the “Two-Shock” State Space Representation

αt = T αt−1 + Rηt

yt = Zαt + εt

E(ηt ηt0 ) = Q

E(εt ε0t ) = H

(Nothing new)

5.3.5.1 Combining Covariance Matrix Prediction and Updating

(1) Prediction: Pt+1/t = T Pt T 0 + RQR0

(2) Update: Pt = Pt/t−1 − Kt Z Pt/t−1
 76 CHAPTER 5

Substitute (2) into (1):

Pt+1/t = T Pt/t−1 T 0 − T Kt Z Pt/t−1 T 0 + RQR0

(Matrix Ricatti equation)

Why Care About Combining Prediction and Updating?
It leads us to the notion of steady state of the Kalman filter...
...which is the bridge from the Wold representation
to the state space representation

5.3.5.2 “One-Shock” (“Prediction Error”) Representation

We have seen that

at+1|t = T at|t−1 + T Kt vt (transition)

Moreover, it is tautologically true that

yt = Z at|t−1 + (yt − Zat|t−1 )

= Z at|t−1 + vt (measurement)
Note that one-shock state space representation
has time-varying system matrices:

• “R matrix” in transition equation is T Kt

• Covariance matrix of vt is Ft

5.3.5.3 “Innovations” (Steady-State) Representation

at+1|t = T at|t−1 + T K̄vt

yt = Z at|t−1 + vt

where

K̄ = P̄ Z 0 F̄ −1

E(vt vt0 ) = F̄ = Z P̄ Z 0 + H

P̄ solves the matrix Ricatti equation

– Effectively Wold-Wiener-Kolmogorov prediction and extraction
 STATE SPACE AND THE KALMAN FILTER 77

– Prediction yt+1/t is now the projection of yt+1 on infinite past, and one-step prediction
errors vt are now the Wold-Wiener-Kolmogorov innovations
Remarks on the Steady State

1. Steady state will be approached if:

• underlying two-shock system is time invariant

• all eigenvalues of T are less than one

• P1|0 is positive semidefinite

2. Because the recursions for Pt|t−1 and Kt don’t depend on the data, but only on P0 ,
we can calculate arbitrarily close approximations to P̄ and K̄ by letting the filter run

5.3.6 Kalman Smoothing

1. (Kalman) filter forward through the sample, t = 1, ..., T

2. Smooth backward, t = T, (T − 1), (T − 2), ..., 1

Initialize: aT,T = aT , PT,T = PT

Then:

at,T = at + Jt (at+1,T − at+1,t )

Pt,T = Pt + Jt (Pt+1,T − Pt+1,t )Jt0

where
−1
Jt = Pt T 0 Pt+1,t

5.4 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Markov process theory.

Prove the following for Markov processes.

(a) Communication is an equivalence relation; i.e., i ↔ i (reflexive), i ↔ j ⇐⇒ j ↔ i

(symmetric), and i ↔ j, j ↔ k =⇒ i ↔ k (transitive).
(b) Any two classes are either disjoint or identical.
(c) Periodicity is a class property.
(d) Let fij denote the probability of an eventual transition from i to j. Then fij =
P∞ n
n=1 fij .
78 CHAPTER 5

(e) The expected number of returns to a recurrent state is infinite, and the expected
number of returns to a transient state is finite. That is,

∞
X
n
State j is recurrent ⇐⇒ Pjj = ∞,
n=1
X∞
n
State j is transient ⇐⇒ Pjj < ∞.
n=1

(f) Recurrence is a class property. That is, if i is recurrent and i ↔ j, then j is

recurrent.
(g) The expected number of transitions into a transient state is finite. That is,
∞
X
j transient =⇒ Pijn < ∞, ∀ i.
n=1

(h) Positive and null recurrence are class properties.

(i) If the probability distribution of X0 (call it πj = P (X0 = j), j ≥ 1) is a stationary
distribution, then P (Xt = j) = πj , ∀t. Moreover, the process is stationary.
(j) A stationary Markov process is time-reversible iff each path from i to i has the
same probability as the reversed path, ∀i.

2. A Simple Markov Process.

Consider the Markov process:
!
.9 .1
P =
.3 .7

Verify and/or calculate:

(a) Validity of the transition probability matrix

(b) Chapman-Kolmogorov theorem
(c) Accessibility/communication
(d) Periodicity
(e) Transition times
(f) Recurrence/transience
(g) Stationarity
(h) Time reversibility

Solution:
STATE SPACE AND THE KALMAN FILTER 79

(a) See Ross*** or any other good text.

(b) Valid transition probability matrix:

Pij ≥ 0 ∀i, j
2
X 2
X
P1j = 1, P2j = 1
j=1 j=1

(c) Illustrating the Chapman-Kolmogorov Theorem:

! ! ! !
3 .9 .1 .9 .1 .9 .1 .804 .196
P = =
.3 .7 .3 .7 .3 .7 .588 .412

(d) Communication and reducibility:

1 ↔ 2, so the Markov process represented by P is irreducible.
(e) Periodicity:

State 1: d(1) = 1
State 2: d(2) = 1

Hence both states are aperiodic.

(f) First and eventual transition probabilities:
First:

(1)
f12 = .1
(2)
f12 = .9 ∗ .1 = .09
(3)
f12 = .92 ∗ .1 = .081
(4)
f12 = .93 ∗ .1 = .0729
···

(1)
f12 = .3
(2)
f21 = .7 ∗ .3 = .21
(3)
f21 = .72 ∗ .3 = .147
(4)
f21 = .73 ∗ .3 = .1029
···

Eventual:
∞
X (n) .1
f12 = f12 = =1
n=1
1 − .9
80 CHAPTER 5

∞
X (n) .3
f21 = f21 = =1
n=1
1 − .7

(g) Recurrence:
Because f12 = f21 = 1, both states 1 and 2 are recurrent. In addition,
P∞ (n)
µ11 = n f11 < ∞
Pn=1
∞ (n)
µ22 = n=1 n f22 < ∞

States 1 and 2 are therefore positive recurrent and (given their aperiodicity es-
tablished earlier) ergodic.
(h) Stationary distribution
We can iterate on the P matrix to see that:
!
.75 .25
lim P n =
n→∞ .75 .25
Hence π1 = 0.75 and π2 = 0.25.
Alternatively, in the two-state case, we can solve analytically for the stationary
probabilities as follows.

!
  P11 P12  
π1 π2 = π1 π2
P21 P22

π1 P11 + π2 P21 = π1 (1)

=⇒
π1 P12 + π2 P22 = π2 (2)

Using π2 = 1 − π1 , we get from (1) that

π1 P11 + (1 − π1 )P21 = π1

P21
π1 =
1 − P11 + P21
1 − P11
π2 =
1 − P11 + P21
Thus,
!
n 1 P21 1 − P11
lim P =
n→∞ (1 − P11 + P21 ) P21 1 − P11

(i) Time reversibility:

∗ π2
P12 = π1 P21 = .1
∗ π2
P21 = π1 P12 = .3
We have a time-reversible process.
STATE SPACE AND THE KALMAN FILTER 81

3. AR(p) in state-space form.

Find a state-space representation different from the one used in the text, in which the
state vector is (y1 , ..., yp )0 . This is precisely what one expects given the intuitive idea
of state: in an AR(p) all history relevant for future evolution is (y1 , ..., yp )0 .

4. ARMA(1,1) in state space form.

yt = φ yt−1 + ηt + θ ηt−1

ηt ∼ W N (0, ση2 )

! ! ! !
α1t φ 1 α1,t−1 1
= + ηt
α2t 0 0 α2,t−1 θ

yt = (1, 0) αt = α1t

Recursive substitution from the bottom up yields:

! !
φ yt−1 + θ ηt−1 + ηt yt
αt = =
θ ηt θηt

5. Rational spectra and state space forms.

Can all linear discrete-time systems be written in state-space form? In particular, what
is the relationship, if any, between rational spectra and existence of a state-space form?

6. Impulse-responses and variance decompositions.

If given a model in state space form, how would you calculate the impulse-responses
and variance decompositions?

7. Identification in UCM’s.
Discuss the identifying assumption that UC innovations are orthogonal at all leads and
lags. What convenient mathematical properties does it entail for the observed sum of
the unobserved components? In what ways is it restrictive?
Solution: Orthogonality of component innovations implies that the spectrum of the
observed time series is simply the sum of the component spectra. Moreover, the or-
thogonality facilitates identification. The assumption is rather restrictive, however, in
that it entails no interaction between cyclical and secular economic fluctuations.
82 CHAPTER 5

8. ARMA(1,1) “Reduced Form” of the Signal Plus Noise Model.

Consider the “structural” model:

xt = yt + ut

yt = αyt−1 + vt .

Show that the reduced form is ARM A(1, 1):

yt = αyt−1 + εt + βεt−1

and provide expressions for σε2 and β in terms of the underlying parameters α, σv2 and
σu2 .
Solution:
Box and Jenkins (1976) and Nerlove et al. (1979) show the ARMA result and give the
formula for β. That leaves σε2 . We will compute var(x) first from the UCM and then
from the ARMA(1,1) reduced form, and equate them.
From the UCM:

σv2
var(x) = + σu2
1 − α2
From the reduced form:

(1 + β 2 − 2αβ)
var(x) = σ2
1 − α2
Equating yields
σv2 + σu2 (1 − α2 )
σ2 =
1 + β 2 − 2αβ

9. Properties of optimal extractions.

In the case where the seasonal is modeled as independent of the nonseasonal and
the observed data is just the sum of the two, the following assertions are (perhaps
surprisingly) both true:
i) optimal extraction of the nonseasonal is identically equal to the observed data minus
optimal extraction of the seasonal (i.e., y ≡ ŷs + ŷn ≡ yn ), so it doesn’t matter whether
you estimate the nonseasonal by optimally extracting it directly or instead optimally
STATE SPACE AND THE KALMAN FILTER 83

extract the seasonal and substract–both methods yield the same answer;
ii) ŷs , the estimated seasonal, is less variable than ys , the true seasonal, and ŷn , the
estimated nonseasonal, is less variable than yn , the true nonseasonal. It is paradoxical
that, by (ii), both estimates are less variable than their true counterparts, yet, by (i),
they still add up to the same observed series as their true counterparts. The paradox is
explained by the fact that, unlike their true counterparts, the estimates ŷs and ŷn are
correlated (so the variance of their sum can be more than the sum of their variances).

5.5 NOTES
 Chapter Six

Frequentist Time-Series Likelihood Evaluation, Optimization,

and Inference

6.1 LIKELIHOOD EVALUATION: PREDICTION-ERROR DECOMPOSITION

AND THE KALMAN FILTER

Brute-Force Direct Evaluation:

yt ∼ N (µ, Σ(θ))

Example: AR(1)

(yt − µ) = φ(yt−1 − µ) + εt

σ2
Σij (φ) = φ|i−j|
1 − φ2

 
T /2 −1/2 1 0 −1
L(y; θ) = (2π) |Σ(θ)| exp − (y − µ) Σ (θ)(y − µ)
2

1 1
lnL(y; θ) = const − ln|Σ(θ)| − (y − µ)0 Σ−1 (θ) (y − µ)
2 2
T xT matrix Σ(θ) can be very hard to calculate (we need analytic formulas for the auto-
covariances) and invert (numerical instabilities and inaccuracies; slow even if possible)
Prediction-error decomposition and the Kalman filter:
Schweppe’s prediction-error likelihood decomposition is:

T
Y
L(y1 , . . . , yT ; θ) = Lt (yt |yt−1 , . . . , y1 ; θ)
t=1
or:
T
X
ln L(y1 , . . . , yT ; θ) = ln Lt (yt |yt−1 , . . . , y1 ; θ)
t=1
 MAXIMUM LIKELIHOOD 85

“Prediction-error decomposition”
In the univariate Gaussian case, the Schweppe decomposition is

T T
T 1X 1 X (yt − µt )2
ln L = − ln 2π − ln σt2 −
2 2 t=1 2 t=1 σt2

T T
T 1X 1 X vt2
=− ln 2π − ln Ft −
2 2 t=1 2 t=1 Ft

Kalman filter delivers vt and Ft !

No autocovariance calculation or matrix inversion!
In the N -variate Gaussian case, the Schweppe decomposition is
T T
NT 1X 1X
ln L = − ln 2π − ln |Σt | − (yt − µt )0 Σ−1
t (yt − µt )
2 2 t=1 2 t=1

T T
NT 1X 1 X 0 −1
=− ln 2π − ln |Ft | − v F vt
2 2 t=1 2 t=1 t t

Kalman filter again delivers vt and Ft .

Only the small matrix Ft (N × N ) need be inverted.

6.2 GRADIENT-BASED LIKELIHOOD MAXIMIZATION: NEWTON AND

QUASI-NEWTON METHODS

The key is to be able to evaluate lnL for a given parameter configuration

Then we can climb uphill to maximize lnL to get the MLE
Crude Search
Function lnL(θ) to be optimized w.r.t. θ,
θ ∈ Θ, a compact subset of Rk

• Deterministic search: Search k dimensions at r locations in each dimension.

• Randomized Search: Repeatedly sample from Θ, repeatedly evaluating lnL(θ)

– Absurdly slow (curse of dimensionality)

6.2.1 The Generic Gradient-Based Algorithm

So use the gradient for guidance.

“Gradient-Based” Iterative Algorithms (“Line-Search”)
Parameter vector at iteration m: θ(m) .
 86 CHAPTER 6

θ(m+1) = θ(m) + C (m) , where C (m) is the step.

Gradient algorithms: C (m) = −t(m) D(m) s(m)
t(m) is the step length, or step size (a positive number)
D(m) is a positive definite direction matrix
s(m) is the score (gradient) vector evaluated at θ(m)
General Algorithm

1. Specify θ(0)

2. Compute D(m) and s(m)

3. Determine step length t(m)

(Often, at each step, choose t(m) to optimize the objective function (“variable step
length”))

4. Compute θ(m+1)

5. If convergence criterion not met, go to 2.

Convergence
Convergence Criteria
k s(m) k “small”
k θ(m) − θ(m−1) k “small”
Convergence Rates
kθ (m+1) −θ̂k
p such that limm→∞ kθ (m) −θ̂k
p = O(1)
Method of Steepest Decent
Use D(m) = I, t(m) = 1, ∀ m.
Properties:

1. May converge to a critical point other than a minimum

(of course)

2. Requires only first derivative of the objective function

3. Very slow to converge (p = 1)

6.2.2 Newton Algorithm

Take D(m) as the inverse Hessian of lnL(θ) at θ(m)

 −1
∂ 2 lnL ∂ 2 lnL
|
∂θ12 θ (m)
. . . ∂θ1 ∂θk |θ (m)
 

 . 

D(m) = H −1(m) =  .
 

 

 . 

∂ 2 lnL ∂ 2 lnL
∂θk ∂θ1 |θ (m) . . . ∂θk 2 |θ (m)
 MAXIMUM LIKELIHOOD 87

Also take t(m) = 1

Then θ(m+1) = θ(m) − H −1(m) s(m)
Derivation From Second-Order Taylor Expansion
Initial guess: θ(0)
lnL(θ) ≈ lnL(θ(0) ) + s(0) (θ − θ(0) ) + 12 (θ − θ(0) )0 H (0) (θ − θ(0) )
F.O.C.:
s(0) + H (0) (θ∗ − θ(0) ) = 0
or
θ∗ = θ(0) − H −1(0) s(0)
Properties of Newton
lnL(θ) quadratic ⇒ full convergence in a single iteration
More generally, iterate to convergence:
θ(m+1) = θ(m) − H −1(m) s(m)
Faster than steepest descent (p = 2 vs. p = 1)
But there is a price:
Requires first and second derivatives of the objective function
Requires inverse Hessian at each iteration

6.2.3 Quasi-Newton Algirithms

e.g., Davidon-Fletcher-Powell (DFP):

D(0) = I
 
D(m) = D(m−1) + f D(m−1) , δ (m) , φ(m) , m = 1, 2, 3, ...

δ (m) = θ(m) − θ(m−1)

φ(m) = s(m) − s(m−1)

• Second derivatives aren’t needed, but first derivatives are

• Approximation to Hessian is built up during iteration

• If lnL(θ) is quadratic, then D(k) = H, where k = dim(Θ)

• Intermediate convergence speed (p ≈ 1.6)

6.2.4 “Line-Search” vs. “Trust Region” Methods: Levenberg-Marquardt

An interesting duality...
Line search: First determine direction, then step
Trust region: First determine step, then direction
– Approximate the function locally in a trust region
containing all admissible steps, and then determine direction
Classic example: Levenberg-Marquardt
 88 CHAPTER 6

Related R packages:
trust (trust region optimization)
minpack.lm (R interface to Levenberg-Marquardt in MINPACK)

6.3 GRADIENT-FREE LIKELIHOOD MAXIMIZATION: EM

Recall Kalman smoothing

1. Kalman filter the state forward through the sample, t = 1, ..., T
2. Kalman smooth the state backward, t = T, (T − 1), (T − 2), ..., 1
Initialize:

aT,T = aT

PT,T = PT

Smooth:

at,T = at + Jt (at+1,T − at+1,t )

Pt,T = Pt + Jt (Pt+1,T − Pt+1,t )Jt0

−1
where Jt = Pt T 0 Pt+1,t

Another Related Smoothing Piece, Needed for EM

3. Get smoothed predictive covariance matrices as well:

P(t,t−1),T = E[(αt − at,T )(αt−1 − at−1,T )0 ]

Initialize:

P(T,T −1),T = (I − KT Z)T PT −1

Then:
0 0
P(t−1,t−2),T = Pt−1 Jt−2 + Jt−1 (P(t,t−1),T − T Pt−1 )Jt−2

where Kt is the Kalman gain.

The EM “Data-Augmentation Algorithm” Think of {αt }Tt=1 as data that are unfortunately
missing in

αt = T αt−1 + ηt

yt = Zαt + εt
 MAXIMUM LIKELIHOOD 89

Incomplete Data Likelihood:

lnL(y; θ)

Complete Data Likelihood: (If only we had complete data!)

lnL y, {αt }Tt=0 ; θ

Expected Complete Data Likelihood:

lnL(m) (y; θ) ≈ Eα lnL y, {αt }Tt=0 ; θ




EM iteratively constructs and maximizes the expected complete-data likelihood, which

(amazingly) has same
maximizer as the (relevant) incomplete-data likelihood.
The EM (Expectation/Maximization) Algorithm
1. E Step:



Construct lnL(m) (y; θ) ≈ Eα lnL y, {αt }Tt=0 ; θ
2. M Step:



θ(m+1) = argmaxθ lnL(m) (y; θ }

3. If convergence criterion not met, go to 1

But how to do the E and M steps?

6.3.1 “Not-Quite-Right EM”

(But it Captures and Conveys the Intuition)

1. E Step:
Approximate a “complete data” situation by replacing
{αt }Tt=0 with at,T from the Kalman smoother
2. M Step:
Estimate parameters by running regressions:
at,T → at−1,T
yt → at,T
3. If convergence criterion not met, go to 1

6.3.2 Precisely Right EM

6.3.2.1 Complete Data Likelihood


The complete data are α0 , {αt , yt }Tt=1 .
 90 CHAPTER 6

Complete-Data Likelihood:
T
Y T
Y
fθ (y, α0 , {αt }Tt=1 ) = fa0 ,P0 (α0 ) fT,Q (αt |αt−1 ) fZ,H (yt |αt )
t=1 t=1

Gaussian Complete-Data Log-Likelihood:

1 1
ln L(y, {αt }T
t=1 ; θ) = const − ln |P0 | − (α0 − a0 )0 P0−1 (α0 − a0 )
2 2
T
T 1X
− ln |Q| − (αt − T αt−1 )0 Q−1 (αt − T αt−1 )
2 2 t=1
T
T 1X
− ln |H| − (yt − Zαt )0 H −1 (yt − Zαt )
2 2 t=1

6.3.2.2 E Step


Construct: lnL(m) (y; θ) ≈ Eα lnL y, {αt }Tt=0 ; θ

h i 1 1 h i
Eα ln L(y, {αt }T
t=0 ; θ) = const − ln |P0 | − Eα (α0 − a0 )0 P0−1 (α0 − a0 )
2 2
T
T 1X
Eα (αt − T αt−1 )0 Q−1 (αt − T αt−1 )
 
− ln |Q| −
2 2 t=1
T
T 1X
Eα (yt − Zαt )0 H −1 (yt − Zαt )
 
− ln |H| −
2 2 t=1

– Function of {at,T (θ(m) ), Pt,T (θ(m) ), and P(t,t−1),T (θ(m) )}Tt=1

– So the E step is really just running the three smoothers

6.3.2.3 M Step Formulas


Find: θ(m+1) = argmaxθ lnL(m) (y; θ)

T
! T !−1
X X
0 0 0
   
T̂ = Eα αt αt−1 Eα αt−1 αt−1
t=1 t=1

η̂t = (αt − T̂ αt−1 )

T
1X
Q̂ = Eα [η̂t η̂t0 ]
T t=1

T
! T
!−1
0
X X
0
Ẑ = yt Eα [αt ] Eα [αt αt0 ]
t=1 t=1

ˆt = (yt − Ẑαt )

 MAXIMUM LIKELIHOOD 91

T
1X
Ĥ = t ˆ0t ]
Eα [ˆ
T t=1

where:

Eα [αt ] = at|T

Eα [αt αt0 ] = at|T a0t|T + Pt|T

0
= at|T a0t−1|T + P(t,t−1)|T
 
Eα αt αt−1

Simply replacing αt with at,T won’t work because E [αt αt0 |ΩT ] 6= at,T a0t,T
Instead we have E [αt αt0 |ΩT ] = E [αt | ΩT ] E [αt |ΩT ]0 + V ar(αt |ΩT ) = at,T a0t,T + Pt,T

6.4 LIKELIHOOD INFERENCE

6.4.1 Under Correct Specification

T
X
ln L(θ) = ln Lt (θ)
t=1

• Always true in iid environments

• Also holds in time series, via prediction-error decomposition of ln L

Expected Fisher Information

Score at true parameter θ0 :
T T
∂ ln L(θ) X ∂ ln Lt (θ) X
s(θ0 ) = = = st (θ0 )
∂θ θ0 t=1
∂θ θ0 t=1

Expected Fisher Information at true parameter θ0 :

∂ 2 ln L(θ)
 
IEX,H (θ0 ) = −E
∂θ ∂θ0 θ0

T T
∂ 2 ln Lt (θ)
X   X
= − EH(θ0 ) = −E = −EHt (θ0 )
t=1
∂θ ∂θ0 t=1
θ0

More on Expected Information Matrices

PT
(1) We had already: IEX,H (θ0 ) = t=1 − E Ht (θ0 )
“Expected information based on the Hessian”
PT 0
(2) Can also form: IEX,s (θ0 ) = t=1 E st (θ0 ) st (θ0 )
“Expected information based on the score”
(In a moment we’ll see why this is of interest)
Distribution of the MLE Under Correct Specification
 92 CHAPTER 6

Under correct specification and regularity conditions,

d
√
T (θ̂M L − θ0 ) → N (0, VEX (θ0 )) (6.1)

where
 −1
IEX,H (θ0 )
VEX (θ0 ) = VEX,H (θ0 ) = plimT →∞
T

 −1
IEX,s (θ0 )
= VEX,s (θ0 ) = plimT →∞
T

θ̂M L consistent, asymptotically normal, asymptotically efficient (Cramer-Rao lower bound

met)
Observed Information Matrices
PT
(1) IOB,H (θ0 ) = t=1 − Ht (θ0 )
(“Observed information based on the Hessian”)
PT 0
(2) IOB,s (θ0 ) = t=1 st (θ0 ) st (θ0 )
(“Observed information based on the score”)
In a moment we’ll see why these are of interest.
Consistent Estimators of VEX (θ0 )

!−1 !−1
IEX,H (θ̂M L ) IEX,s (θ̂M L )
V̂EX,H (θ0 ) = V̂EX,s (θ0 ) =
T T

!−1 !−1
IOB,H (θ̂M L ) IOB,s (θ̂M L )
V̂OB,H (θ0 ) = V̂OB,s (θ0 ) =
T T

Under correct specification, plimT →∞ V̂EX,H (θ0 ) = plimT →∞ V̂EX,s (θ0 ) = VEX (θ0 )
plimT →∞ V̂OB,H (θ0 ) = plimT →∞ V̂OB,s (θ0 ) = VEX (θ0 )

6.4.2 Under Possible Mispecification

6.4.2.1 Distributional Misspecification

Under possible distributional misspecification (but still assuming correct conditional mean
and variance function specifications),

d
√ m
T (θ̂M L − θ0 ) → N (0, VEX (θ0 )) (6.2)
 MAXIMUM LIKELIHOOD 93

where:
m
VEX (θ0 ) = VEX,H (θ0 )−1 VEX,s (θ0 )VEX,H (θ0 )−1

“Quasi MLE” or “Pseudo-MLE”

Under correct specification: (6.2) collapses to standard result (6.1)
Under distributional misspecification:
θ̂M L consistent, asymptotically normal, asymptotically inefficient (CRLB not met), but we
can nevertheless do credible
(if not fully efficient) inference
m
Consistent estimators of VEX (θ0 ):

!−1 ! !−1
m IEX,H (θ̂M L ) IEX,s (θ̂M L ) IEX,H (θ̂M L )
V̂EX (θ0 ) =
T T T

!−1 ! !−1
m IOB,H (θ̂M L ) IOB,s (θ̂M L ) IOB,H (θ̂M L )
V̂OB (θ0 ) =
T T T

“Sandwich Estimator”

6.4.2.2 General Misspecification

Under possible general mispecification,

d
√ m
T (θ̂M L − θ∗ ) → N (0, VEX (θ∗ )) (6.3)

where:
m
VEX (θ∗ ) = VEX,H (θ∗ )−1 VEX,s (θ∗ )VEX,H (θ∗ )−1

Under correct specification: Collapses to standard result (6.1)

Under purely distributional specification: Collapses to result (6.2)
Under general misspecification:
θ̂M L consistent for KLIC-optimal pseudo-true value θ∗ ,
asymptotically normal, and we can do credible inference
m
Consistent estimators of VEX (θ∗ ):

!−1 ! !−1
m IEX,H (θ̂M L ) IEX,s (θ̂M L ) IEX,H (θ̂M L )
V̂EX (θ∗ ) =
T T T
94 CHAPTER 6

!−1 ! !−1
m IOB,H (θ̂M L ) IOB,s (θ̂M L ) IOB,H (θ̂M L )
V̂OB (θ∗ ) =
T T T

6.5 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Approximate (asymptotic) frequency domain Gaussian likelihood

Recall that for Gaussian series we have as T → ∞ :
d
2fˆ(ωj )
xj = → χ22
f (ωj ; θ)

where f (ωj ; θ) is the spectral density and the χ22 random variables are independent
across frequencies
2πj T
ωj = , j = 0, 1, ...,
T 2
⇒ MGF of any one of the xj ’s is
1
Mx (t) =
1 − 2t

Let
f (ωj ; θ) xj
yj = fˆ(ωj ) =
2

 
f (ωj ; θ) 1
⇒ My (t) = Mx t =
2 1 − f (ωj ; θ) t

This is the MGF of exponential rv with parameter 1/f (ωj ; θ).

ˆ
−f (ωj )
1
⇒ g(fˆ(ωj ); θ) = e f (ωj ;θ)
f (ωj ; θ)

Univariate asymptotic Gaussian log likelihood:

T /2 T /2
X X fˆ(ωj )
ln L(fˆ; θ) = − ln f (ωj ; θ) −
j=0 j=0
f (ωj ; θ)

Multivariate asymptotic Gaussian log likelihood:

MAXIMUM LIKELIHOOD 95

 
T /2 T /2
X X
ln L(fˆ; θ) = − ln |F (ωj ; θ)| − trace  F −1 (ωj ; θ) F̂ (ωj )
j=0 j=0

2. State space model fitting by exact Gaussian pseudo-MLE using a prediction-error

decomposition and the Kalman filter.
Read Aruoba et al. (2013), and fit the block-diagonal dynamic-factor model (3)-(4) by
exact Gaussian pseudo-MLE using a predecition-error decomposition and the Kalman
filter. Obtain both filtered and smoothed estimates of the series of states. Compare
them to each other, to the “raw” GDPE and GDPI series, and to the current vintage
of GDPplus from FRB Philadelphia.

3. Method of scoring
Slight variation on Newton:
Use E(H (m) )−1 rather than H −1(m)

(Expected rather than observed Hessian.)

4. Constrained optimization.

(a) Substitute the constraint directly and use Slutsky’s theorem.

– To keep a symmetric matrix nonnegative definite, write it as P P 0
– To keep a parameter in [0, 1], write it as p2 /(1 + p2 ).
(b) Barrier and penalty functions

6.6 NOTES
 Chapter Seven

Simulation for Economic Theory, Econometric Theory,

Estimation, Inference, and Optimization

7.1 GENERATING U(0,1) DEVIATES

Criteria for (Pseudo-) Random Number Generation

1. Statistically independent

2. Reproducible

3. Non-repeating

4. Quickly-generated

5. Minimal in memory requirements

The Canonical Problem: Uniform (0,1) Deviates

Congruential methods
a = b(mod m)
“a is congruent to b modulo m”
“(a − b) is an integer multiple of m”
Examples:
255 = 5(mod50)
255 = 5(mod10)
123 = 23(mod10)

Key recursion: xt = axt−1 (mod m)

To get xt , just divide axt−1 by m and keep the remainder
Multiplicative Congruential Method

xt = axt−1 (mod m), xt , a, m ∈ Z+

Example:
 SIMULATION 97

Figure 7.1: Ripley’s “Horror” Plots of pairs of (Ui+1 , Ui ) for Various Congruential Gener-
ators Modulo 2048 (from Ripley, 1987)

xt = 3xt−1 (mod 16), x0 = 1

x0 = 1, x1 = 3, x2 = 9, x3 = 11, x4 = 1, x5 = 3, ...

Perfectly periodic, with a period of 4.

Generalize:

xt (axt−1 + c)(mod m) (xt , a, c, m ∈ Z+ )

Remarks

xt
1. xt ∈ [0, m − 1], ∀t. So take x∗t = m, ∀t

2. Pseudo-random numbers are perfectly periodic.

3. The maximum period, m, can be attained using the mixed congruential generator if:

• c and m have no common divisor

• a = 1(mod p) ∀ prime factors p of m
• a = 1(mod 4) if m is a multiple of 4

4. m is usually determined by machine wordlength; e.g., 264

5. Given U (0, 1) , U (α, β) is immediate

 98 CHAPTER 7

Figure 7.2: Transforming from U(0,1) to f (from Davidson and MacKinnon, 1993)

7.2 THE BASICS: C.D.F. INVERSION, BOX-MUELLER, SIMPLE ACCEPT-

REJECT

7.2.1 Inverse c.d.f.

Inverse cdf Method (“Inversion Methods”)

Desired density: f (x)

1. Find the analytical c.d.f., F (x), corresponding to f (x)

2. Generate T U (0, 1) deviates {r1 ,...rT }

3. Calculate {F−1 (r1 ),..., F−1 (rT )}

Graphical Representation of Inverse cdf Method

Example: Inverse cdf Method for exp(β) Deviates
f (x) = βe−βx where β > 0, x ≥ 0
Rx
⇒ F (x) = 0 βe−βt dt
x
βe−βt
= −β = − e−βx + 1 = 1 − e−βx
o
ln(1 − F (x))
Hence e−βx = 1 − F (x) so x = −β
Then insert a U (0, 1) deviate for F (x)
Complications Analytic inverse cdf not always available (e.g., N (0, 1) distribution).

• Approach 1: Evaluate the cdf numerically

• Approach 2: Use a different method

e.g., CLT approximation:
P 
12
Take i=1 Ui (0, 1) − 6 for N (0, 1)
 SIMULATION 99

7.2.2 Box-Muller

An Efficient Gaussian Approach: Box-Muller

Let x1 and x2 be i.i.d. U (0, 1), and consider
√
y1 = −2 ln x1 cos(2πx2 )
√
y2 = −2 ln x1 sin(2πx2 )
Find the distribution of y1 and y2 . We know that

∂x1 ∂x1
∂y1 ∂y2
f (y1 , y2 ) = f (x1 , x2 ) ∂x2 ∂x2
∂y1 ∂y2

1 2 2
 
y2
Box-Muller (Continued) Here we have x1 = e− 2 (y1 +y2 ) and x2 = 1
2π arctan y1

∂x1 ∂x1   
1 2 1 2
Hence ∂y1
∂x2
∂y2
∂x2
= √ e−y1 /2 √ e−y2 /2
∂y1 ∂y2 2π 2π

Bivariate density is the product of two N (0, 1) densities, so we have generated two inde-
pendent N (0, 1) deviates.
Generating Deviates Derived from N(0,1)

χ21 = [N (0, 1)]2

Pd
χ2d = i=1 [Ni (0, 1)]2 , where the Ni (0, 1) are independent
N (µ, σ 2 ) = µ + σ N (0, 1)
p
td = N (0, 1)/ x2d /d, where N (0, 1) and χ2d are independent
Fd1 ,d2 = χ2d1 /d1 /χ2d2 /d2 where χ2d1 and χ2d2 are independent
Multivariate Normal
N (0, I) (N -dimensional) – Just stack N N (0, 1)’s
N (µ, Σ) (N -dimensional)
Let P P 0 = Σ (P is the Cholesky factor of Σ)
Let X ∼ N (0, I). Then P X ∼ N (0, Σ)
To sample from N (µ, Σ), take µ + P X

7.2.3 Simple Accept-Reject

Accept-Reject
(Naive but Revealing Example)
We want to sample x ∼ f (x)
Draw:

ν1 ∼ U (α, β)
 100 CHAPTER 7

Figure 7.3: Naive Accept-Reject Method

ν2 ∼ U (0, h)

If ν1 , ν2 lies under the density f (x), then take x = ν1

Otherwise reject and repeat
Graphical Representation of Naive Accept-Reject
Accept-Reject
General (Non-Naive) Case
We want to sample x ∼ f (x) but we only know how to sample x ∼ g(x).
f (x)
Let M satisfy g(x) ≤ M < ∞, ∀x. Then:

1. Draw x0 ∼ g(x)

f (x0 )
2. Take x = x0 w.p. g(x0 )M ; else go to 1.

(Allows for “blanket” functions g(·) more efficient than the uniform)
Note that accept-reject requires that we be able to evaluate f (x) and g(x) for any x.
Mixtures
On any draw i,

x ∼ fi (x), w.p. pi

where

0 ≤ pi ≤ 1, ∀ i

N
X
pi = 1
i=1
 SIMULATION 101

For example, all of the fi could be uniform, but with different location and scale.

7.3 SIMULATING EXACT AND APPROXIMATE REALIZATIONS OF TIME

SERIES PROCESSES

Simulating Time Series Processes

VAR(1) simulation is key (state transition dynamics).

1. Nonparametric: Exact realization via Cholesky factorization of desired covariance ma-

trix. One need only specify the autocovariances.

2. Parametric I: Exact realization via Cholesky factorization of covariance matrix corre-

sponding to desired parametric model

3. Parametric II: Approximate realization via arbitrary startup value with early realiza-
tion discarded

4. Parametric III: Exact realization via drawing startup values from unconditional den-
sity

7.4 MORE

Slice Sampling
Copulas and Sampling From a General Joint Density

7.5 ECONOMIC THEORY BY SIMULATION: “CALIBRATION”

7.6 ECONOMETRIC THEORY BY SIMULATION: MONTE CARLO AND

VARIANCE REDUCTION

Monte Carlo
Key: Solve deterministic problems by simulating stochastic analogs, with the analytical
unknowns reformulated as parameters to be estimated.
Many important discoveries made by Monte Carlo.
Also, numerous mistakes avoided by Monte Carlo!
The pieces:
(I) Experimental Design
(II) Simulation (including variance reduction techniques)
(III) Analysis: Response surfaces (which also reduce variance)
 102 CHAPTER 7

7.6.1 Experimental Design

(I) Experimental Design

• Data-Generating Process (DGP), M (θ)

• Objective
• e.g., MSE of an estimator:

E[(θ − θ̂)2 ] = g(θ, T )

• e.g., Power function of a test:

π = g(θ, T )

Experimental Design, Continued

• Selection of (θ, T ) Configurations to Explore

a. Do we need a “full design”? In general many values of θ and T need be explored.
But if, e.g., g(θ, T ) = g1 (θ) + g2 (T ), then only explore θ values for a single T , and T
values for a single θ (i.e., there are no interactions).
b. Is there parameter invariance (g(θ, T ) unchanging in θ)? e.g., If y = Xβ + ε,
2
β̂M LE −β σ̂M
ε ∼ N (0, σ 2 Ω(α)), then the exact finite-sample distributions of σ and LE
σ2
are invariant to true β, σ 2 . So vary only α, leaving β and σ alone (e.g., set to 0 and
1). Be careful not to implicitly assume invariance regarding unexplored aspects of the
design (e.g., structure of X variables above.)

Experimental Design, Continued

• Number of Monte Carlo Repetitions (N )

e.g., MC computation of test size
#rej ΣN
i=1 I(reji )
nominal size α0 , true size α, estimator α̂ = N = N

a  
α(1 − α)
N ormal approximation : α̂ ∼ N α,
N

" r #!
α(1 − α)
P α∈ α̂ ± 1.96 = .95
N

Suppose we want the 95% CI for α to be .01 in length.

 SIMULATION 103

Experimental Design, Continued

Strategy 1 (Use α = α0 ; not conservative enough if α > α0 ):

r
α0 (1 − α0 )
2 ∗ 1.96 = .01
N
If α0 = .05, N = 7299
1
Strategy 2 (Use α = 2 = argmaxα [α(1 − α)]; conservative):

s
1 1


2 2
2 ∗ 1.96 = .01 ⇒ N = 38416
N
Strategy 3 (Use α = α̂; the obvious strategy)

7.6.2 Simulation

(II) Simulation
Running example: Monte Carlo integration
R1
Definite integral: θ = 0 m(x)dx
Key insight:
R1
θ = 0 m(x)dx = E(m(x))
x ∼ U (0, 1)
Notation:
θ = E[m(x)]
σ 2 = var(m(x))
Direct Simulation:
Arbitrary Function, Uniform Density
Generate N U (0, 1) deviates xi , i = 1, ..., N
Form the N deviates mi = m(xi ), i = 1, ..., N

N
1 X
θ̂ = mi
N i=1

d
√
N (θ̂ − θ) → N (0, σ 2 )

Direct Simulation General Case:

Arbitrary Function, Arbitrary Density

Z
θ = E(m(x)) = m(x)f (x)dx
 104 CHAPTER 7

– Indefinite integral, arbitrary function m(·), arbitrary density f (x)

Draw xi ∼ f (·), and then form mi (xi ),
N
1 X
θ̂ = mi
N i=1

d
√
N (θ̂ − θ) → N (0, σ 2 )

Direct Simulation Leading Case

Mean Function, Arbitrary Density
(e.g., Posterior Mean)

Z
θ = E(x) = xf (x)dx

– Indefinite integral, x has arbitrary density f (x)

Draw xi ∼ f (·)
N
1 X
θ̂ = xi
N i=1

d
√
N (θ̂ − θ) → N (0, σ 2 )

7.6.3 Variance Reduction: Importance Sampling, Antithetics, Control Variates

and Common Random Numbers

Importance Sampling to Facilitate Sampling

Sampling from f (·) may be difficult. So change to:
Z
f (x)
θ= x g(x)dx
g(x)
where the “importance sampling density” g(·) is easy to sample
f (xi )
Draw xi ∼ g(·), and then form mi = g(xi ) xi , i = 1, ..., N
N N N
1 X 1 X f (xi ) X
θ̂∗ = mi = xi = wi xi
N i=1 N i=1 g(xi ) i=1

d
√
N (θ̂∗ − θ) → N (0, σ∗2 )
 SIMULATION 105

– Avg of f (x) draws replaced by weighted avg of g(x) draws

– Weight wi reflects relative heights of f (xi ) and g(xi )
Importance Sampling
Consider the classic problem of calculating the mean E(y) of r.v. y with marginal density:

Z
f (y) = f (y/x)f (x)dx.

The standard solution is to form:

N
1 X
E(y)
b = f (y|xi )
N i=1

where the xi are iid draws from f (x).

But f (x) might be hard to sample from! What to do?
Importance Sampling
Write
Z
f (x)
f (y) = f (y|x) g(x)dx,
I(x)
where the “importance sampler,” g(x), is easy to sample from.
Take
N f (xi ) N
I(xi )
X X
E(y)
b = PN f (xj ) f (y|xi ) = wi f (y|xi ).
i=1 j=1 g(xj ) i=1

So importance sampling replaces a simple average of f (y|xi ) based on initial draws from
f (x) with a weighted average of f (y|xi ) based on initial draws from g(x), where the weights
wi reflect the relative heights of f (xi ) and g(xi ).
Indirect Simulation
“Variance-Reduction Techniques”
(“Swindles”)
Importance Sampling to Achieve Variance Reduction
Again we use:
Z
f (x)
θ= x g(x)dx,
g(x)
and again we arrive at

d
√
N (θ̂∗ − θ) → N (0, σ∗2 )

If g(x) is chosen judiciously, σ∗2  σ 2

 106 CHAPTER 7

xf (x)
Key: Pick g(x) s.t. g(x) has small variance
Importance Sampling Example
Let x ∼ N (0, 1), and estimate the mean of I(x > 1.96):
Z
θ = E(I(x > 1.96)) = P (x > 1.96) = I(x > 1.96) φ(x) dx
| {z } |{z}
m(x) f (x)

N
X I(xi > 1.96)
θ̂ = (with variance σ 2 )
i=1
N

Use importance sampler:

g(x) = N (1.96, 1)
Z
I(x > 1.96) φ(x)
P (x > 1.96) = g(x) dx
g(x)

PN I(xi >1.96) φ(xi )

i=1 g(xi )
θ̂∗ = (with variance σ∗2 )
N

σ∗2
≈ 0.06
σ2
Antithetic Variates
We average negatively correlated unbiased estimators of θ (Unbiasedness maintained,
variance reduced)
The key: If x ∼ symmetric(µ, v), then xi ± µ are equally likely
e.g., if x ∼ U (0, 1), so too is (1 − x)
e.g., if x ∼ N (0, v), so too is −x
Consider for example the case of zero-mean symmetric f (x)
Z
θ = m(x)f (x)dx

N
1 X
Direct : θ̂ = mi , (θ̂ is based on xi , i = 1, ..., N )
N i=1

1 1
Antithetic : θ̂∗ = θ̂(x) + θ̂(−x)
2 2
(θ̂(x) is based on xi , i = 1, ..., N/2 , and
θ̂(−x) is based on −xi , i = 1, ..., N/2)
Antithetic Variates, Cont’d
 SIMULATION 107

More concisely,
N/2
2 X
θ̂∗ = ki (xi )
N i=1

where:
1 1
ki = m(xi ) + m(−xi )
2 2

d
√
N (θ̂∗ − θ) → N (0, σ∗2 )

1 1 1
σ∗2 = var (m(x)) + var (m(−x)) + cov (m(x), m(−x))
4 4 2 | {z }
<0 f or m monotone incr.

Often σ∗2  σ 2

Z Z Z
θ= m(x)f (x)dx = g(x)f (x)dx + [m(x) − g(x)]f (x)dx

Control function g(x) simple enough to integrate analytically and flexible enough to absorb
most of the variation in m(x).

We just find the mean of m(x)−g(x), where g(x) has known mean and is highly correlated
with m(x).
Control Variates

Z N
1 X
θ̂ = g(x)dx + [m(xi ) − g(xi )]
N i=1

d
√
N (θ̂ − θ) → N (0, σ∗2 )

If g(x) is chosen judiciously, σ∗2  σ 2 .

Related method (conditioning): Find the mean of E(z|w) rather than the mean of z. The
two are of course the same (the mean conditional mean is the unconditional mean), but
var(E[z|w]) ≤ var(z).
Control Variate Example

Z 1
f (x) = ex dx
0
 108 CHAPTER 7

Control variate: g(x) = 1 + 1.7x

Z 1 
1.7 2 1

⇒ g(x)dx = x+ x  = 1.85

0 2 
0

N
1 X xi
θ̂direct = e
N i=1

N
1 X xi
θ̂cv = 1.85 + [e − (1 + 1.7xi )]
N i=1

var(θ̂direct )
≈ 78
var(θ̂CV )
Common Random Numbers
We have discussed estimation of a single integral:
Z 1
f1 (x)dx
0

But interest often centers on difference (or ratio) of the two integrals:

Z 1 Z 1
f1 (x)dx − f2 (x)dx
0 0

The key: Evaluate each integral using the same random numbers.
Common Random Numbers in Estimator Comparisons
Two estimators θ̂, θ̃ ; true parameter θ0
Compare MSEs: E(θ̂ −θ0 )2 , E(θ̃ − θ0 )2 
Expected difference: E (θ̂ − θ0 )2 − (θ̃ − θ0 )2
Estimate:
N
1 X  2

(θ̂i − θ0 )2 − (θ̃i − θ0 )
N i=1

Variance of estimate:
1   1   2  
var (θ̂ − θ0 )2 + var (θ̃ − θ0 )2 − cov (θ̂ − θ0 )2 , (θ̃ − θ0 )2
N N N

Extensions...

• Sequential importance sampling: Builds up improved proposal densities across draws

 SIMULATION 109

7.6.4 Response Surfaces

(III) Response surfaces

1. Direct Response Surfaces

2. Indirect Responses Surfaces:

• Clear and informative graphical presentation

• Variance reduction
• Imposition of known asymptotic results
(e.g., power → 1 as T → ∞)
• Imposition of known features of functional form
(e.g. power ∈ [0,1])

Example: Assessing Finite-Sample Test Size

α = P (s > s∗ |T, H0 true) = g(T )

(α is empirical size, s is test statistic, s∗ is asymptotic c.v.)

rej
α̂ =
N
 
α(1 − α)
α̂ ∼ N α,
N
or

α̂ = α + ε = g(T ) + ε

 
g(T )(1 − g(T ))
ε∼N 0,
N
Note the heteroskedasticity: variance of ε changes with T .
Example: Assessing Finite-Sample Test Size
Enforce analytically known structure on α̂.
Common approach:

p
!
−i
− 12
X
α̂ = α0 + T c0 + ci T 2 +ε
i=1

α0 is nominal size, which obtains as T → ∞. Second term is the vanishing size distortion.
Response surface regression:
 110 CHAPTER 7

1 3
(α̂ − α0 ) → T − 2 , T −1 , T − 2 , ...

Disturbance will be approximately normal but heteroskedastic.

So use GLS or robust standard errors.

7.7 ESTIMATION BY SIMULATION: GMM, SMM AND INDIRECT INFER-

ENCE

7.7.1 GMM

k-dimensional economic model parameter θ

θ̂GM M = argminθ d(θ)0 Σd(θ)

where
 
m1 (θ) − m̂1
m2 (θ) − m̂2 
 
d(θ) = 
 .. 

 . 
mr (θ) − m̂r

The mi (θ) are model moments and the m̂i are data moments.
MM: k = r and the mi (θ) calculated analytically
GMM: k < r and the mi (θ) calculated analytically

• Inefficient relative to MLE, but useful when likelihood is not available

7.7.2 Simulated Method of Moments (SMM)

(k ≤ r and the mi (θ) calculated by simulation )

• Model moments for GMM may also be unavailable (i.e., analytically intractable)

• SMM: if you can simulate, you can consistently estimate

– Simulation ability is a good test of model understanding

– If you can’t figure out how to simulate pseudo-data from a given probabilistic
model, then you don’t understand the model (or the model is ill-posed)
– Assembling everything: If you understand a model you can simulate it, and if you
can simulate it you can estimate it consistently. Eureka!
– No need to work out what might be very complex likelihoods even if they are in
principle ”available.”
 SIMULATION 111

• MLE efficiency lost may be a small price for SMM tractability gained.

SMM Under Misspecification

All econometric models are misspecified.
GMM/SMM has special appeal from that perspective.

• Under correct specification any consistent estimator (e.g., MLE or GMM/SMM) takes
you to the right place asymptotically, and MLE has the extra benefit of efficiency.

• Under misspecification, consistency becomes an issue, quite apart from the secondary
issue of efficiency. Best DGP approximation for one purpose may be very different
from best for another.

• GMM/SMM is appealing in such situations, because it forces thought regarding which

moments M = {m1 (θ), ..., mr (θ)} to match, and then by construction it is consistent
for the M -optimal approximation.

SMM Under Misspecification, Continued

• In contrast, pseudo-MLE ties your hands. Gaussian pseudo-MLE, for example, is con-
sistent for the KLIC-optimal approximation (1-step-ahead mean-squared prediction
error).

• The bottom line: under misspecification MLE may not be consistent for what you
want, whereas by construction GMM is consistent for what you want (once you decide
what you want).

7.7.3 Indirect Inference

k-dimensional economic model parameter θ

δ > k-dimensional auxiliary model parameter β

θ̂IE = argminθ d(θ)0 Σd(θ)

where
 
β̂1 (θ) − β̂1
β̂2 (θ) − β̂2 
 
d(θ) = 
 .. 

 . 
β̂d (θ) − β̂d

β̂i (θ) are est. params. of aux. model fit to simulated model data
 112 CHAPTER 7

β̂i are est. params. of aux. model fit to real data

– Consistent for true θ if economic model correctly specified

– Consistent for pseudo-true θ otherwise
– We introduced “Wald form”; also LR and LM forms
Ruge-Murcia (2010)

7.8 INFERENCE BY SIMULATION: BOOTSTRAP

7.8.1 i.i.d. Environments

Simplest (iid) Case

iid
T
{xt }t=1 ∼ (µ, σ 2 )

100α percent confidence interval for µ:

σ(x) σ(x)
I = [x̄T − u(1+α)/2 √ , x̄T − u(1−α)/2 √ ]
T T

T
1X
x̄T = xt , σ 2 (x) = E(x − µ)2
T t=1

!
(x̄T − µ)
uα solves P ≤ uα =α
√σ
T

Exact interval, regardless of the underlying distribution.

Operational Version

σ̂(x) σ̂(x)
I = [x̄T − û(1+α)/2 √ , x̄T − û(1−α)/2 √ ]
T T

T
1 X
σ̂ 2 (x) = (xt − x̄T )2
T − 1 t=1

 

ûα solves P  (x̄T − µ) ≤ ûα  = α

σ̂(x)
√
T

Classic (Gaussian) example:

σ̂(x)
I = x̄T ± t(1−α)/2 √
T
SIMULATION 113

Bootstrap approach: No need to assume Gaussian data.

“Percentile Bootstrap”
(x̄T − µ)
Root : S =
√σ
T

!
(x̄T − µ)
Root c.d.f. : H(z) = P ≤z
√σ
T

(j) T
1. Draw {xt }t=1 with replacement from {xt }Tt=1
(j)
x̄T −x̄T
2. Compute σ̂(x)
√
T

(j)
x̄T −x̄T
3. Repeat many times and build up the sampling distribution of σ̂(x)
√
which is an
T
x̄T −µ
approximation to the distribution of √σ
T

“Russian doll principle”

Percentile Bootstrap, Continued
Bootstrap estimator of H(z):

 
(j)
Ĥ(z) = P  (x̄T − x̄T ) ≤ z
σ̂(x)
√
T

Translates into bootstrap 100α percent CI:

σ̂(x) σ̂(x)
Iˆ = [x̄T − û(1+α)/2 √ , x̄T − û(1−α)/2 √ ]
T T
!
(j)
(x̄T − x̄T )
where P σ̂(x)
≤ ûα = Ĥ(ûα ) = α
√
T

“Percentile-t” Bootstrap
(x̄T − µ)
S= σ̂(x)
√
T

 

H(z) = P  (x̄T − µ) ≤ z
σ̂(x)
√
T

 
(j)
Ĥ(z) = P  (x̄T − x̄T ) ≤ z
σ̂(x(j) )
√
T
 114 CHAPTER 7

σ̂(x) σ̂(x)
Iˆ = [x̄T − û(1+α)/2 √ , x̄T − û(1−α)/2 √ ]
T T
 
(j)
(x̄ T − x̄T)
P (j)
≤ ûα  = α
σ̂(x )
√
T

Percentile-t Bootstrap, Continued

Key Insight:
(j)
Percentile: x̄T changes across bootstrap replications
(j)
Percentile-t: both x̄T and σ̂(x(j) ) change across bootstrap replications
Effectively, the percentile method bootstraps the parameter, whereas the percentile-t boot-
straps the t statistic
Key Bootstrap Property: Consistent Inference
Real-world root:
d
S → D (as T → ∞)

Bootstrap-world root:

d
∗
S → D∗ (as T, N → ∞)

Bootstrap consistent (“valid,” “first-order valid”) if D = D∗ .

Holds under regularity conditions.
But Aren’t There Simpler ways to do Consistent Inference?
Of Course. BUT:

1. Bootstrap idea extends mechanically to much more complicated models

2. Bootstrap can deliver higher-order refinements

(e.g., percentile-t)

3. Monte Carlo indicates that bootstrap often does very well in finite samples (not un-
related to 2, but does not require 2)

4. Many variations and extensions of the basic bootstraps

7.8.2 Time-Series Environments

Stationary Time Series Case Before:

(x̄T −µ)
1. Use S = σ̂(x)
√
T

(j) T
2. Draw {xt }t=1 with replacement from {xt }Tt=1
 SIMULATION 115

Issues:

1. Inappropriate standardization of S for dynamic data. So replace σ̂(x) with 2πfx∗ (0),
where fx∗ (0) is a consistent estimator of the spectral density of x at frequency 0.
(j) T
2. Inappropriate to draw {xt }t=1 with replacement for dynamic data. What to do?

Non-Parametric Time Series Bootstrap

(Overlapping Block Sampling)
Overlapping blocks of size b in the sample path:

ξt = (xt , ..., xt+b−1 ), t = 1, ..., T − b + 1

−b+1
Draw k blocks (where T = kb) from {ξt }Tt=1 :
(j) (j)
ξ1 , ..., ξk
(j) (j) (j) (j)
Concatenate: (x1 , ..., xT ) = (ξ1 ...ξk )
Consistent if b → ∞ as T → ∞ with b/T → 0
AR(1) Parametric Time Series Bootstrap

xt = c + φxt−1 + εt , εt ∼ iid

1. Regress xt → (c, xt−1 ) to get ĉ and φ̂, and save residuals, {et }Tt=1
(j)
2. Draw {εt }Tt=1 with replacement from {et }Tt=1
(j)
3. Draw x0 from {xt }Tt=1
(j) (j) (j)
4. Generate xt = ĉ + φ̂xt−1 + εt , t = 1, ..., T
(j) (j)
5. Regress xt → (c, xt−1 ) to get ĉ(j) and φ̂(j) , associated t-statistics, etc.

6. Repeat j = 1, ..., R, and build up the distributions of interest

General State-Space Parametric Time Series Bootstrap

Recall the prediction-error state space representation:

at+1/t = T at/t−1 + T Kt vt

yt = Zat/t−1 + vt
1. Estimate system parameters θ. (We will soon see how to do this.)
2. At the estimated parameter values θ̂, run the Kalman filter to get the corresponding 1-step-ahead
−1/2
prediction errors v̂t ∼ (0, F̂t ) and standardize them to ût = Ω̂t v̂t ∼ (0, I), where Ω̂t Ω̂0t = F̂t .
 116 CHAPTER 7

(j) (j) (j)

3. Draw {ut }T T T T
t=1 with replacement from {ût }t=1 and convert to {vt }t=1 = {Ω̂t ut }t=1 .
(j) (j)
4. Using the prediction-error draw {vt }T T
t=1 , simulate the model, obtaining {yt }t=1 .

5. Estimate the model, obtaining θ̂(j) and related objects of interest.

6. Repeat j = 1, ..., R, simulating the distributions of interest.

Many Variations and Extensions...

• Stationary block bootstrap: Blocks of random (exponential) length
• Wild bootstrap: multiply bootstrap draws of shocks randomly by ±1 to enforce symmetry
• Subsampling

7.9 OPTIMIZATION BY SIMULATION

Markov chains yet again.

7.9.1 Local
Using MCMC for MLE (and Other Extremum Estimators)
Chernozukov and Hong show how to compute extremum estimators as mean of pseudo-posterior distri-
√
butions, which can be simulated by MCMC and estimated at the parametric rate 1/ N , in contrast to the
much slower nonparametric rates achievable (by any method) by the standard posterior mode extremum
estimator.

7.9.2 Global
Summary of Local Optimization:

1. initial guess θ(0)

2. while stopping criteria not met do
3. select θ(c) ∈ N (θ(m) ) (Classically: use gradient)
4. if ∆ ≡ lnL(θ(c) ) − lnL(θ(m) ) > 0 then θ(m+1) = θ(c)
5. end while

Simulated Annealing
(Illustrated Here for a Discrete Parameter Space)
Framework:

1. A set Θ, and a real-valued function lnL (satisfying regularity conditions) defined on Θ. Let Θ∗ ⊂ Θ
be the set of global maxima of lnL
2. ∀θ(m) ∈ Θ, a set N (θ(m) ) ⊂ Θ − θ(m) , the set of neighbors of θ(m)
3. A nonincreasing function, T (m) : N → (0, ∞) (“the cooling schedule”), where T (m) is the “temper-
ature” at iteration m
4. An initial guess, θ(0) ∈ Θ

Simulated Annealing Algorithm

1. initial guess θ(0)

2. while stopping criteria not met do
3. select θ(c) ∈ N (θ(m) )
 SIMULATION 117

4. if ∆ > 0 or exp (∆/T (m)) > U (0, 1) then θ(m+1) = θ(c)

5. end while
Note the extremes:

T = 0 implies no randomization (like classical gradient-based)

T = ∞ implies complete randomization (like random search)

A (Heterogeneous) Markov Chain

If θ(c) ∈
/ N (θ(m) ) then
P (θ(m+1) = θ(c) |θ(m) ) = 0
If θ(c) ∈ N (θ(m) ) then
P (θ(m+1) = θ(c) | θ(m) ) = exp (min[0, ∆/T (m)])
Convergence of a Global Optimizer
Definition. We say that the simulated annealing algorithm converges if
limm→∞ P [θ(m) ∈ Θ∗ ] = 1.
Definition: We say that θ(m) communicates with Θ∗ at depth d if there exists a path in Θ (with each
element of the path being a neighbor of the preceding element) that starts at θ(m) and ends at some element
of Θ∗ , such that the smallest value of lnL along the path is lnL(θ(m) ) − d.
Convergence of Simulated Annealing
Theorem: Let d∗ be the smallest number such that every θ(m) ∈ Θ communicates with Θ∗ at depth d∗ .
Then the simulated annealing algorithm converges if and only if, as m → ∞,
T (m) → 0
and
exp(−d∗ /T (m)) → ∞.
P

Problems: How to choose T , and moreover we don’t know d∗

Popular choice of cooling function: T (m) = ln 1m
Regarding speed of convergence, little is known

7.9.3 Is a Local Optimum Global?

1. Try many startup values (sounds trivial but very important)
2. At the end of it all, use extreme value theory to assess the likelihood that the local optimum is global
(“Veall’s Method”)

θ ∈ Θ ⊂ Rk
lnL(θ) is continuous
lnL(θ∗ ) is the unique finite global max of lnL(θ), θ ∈ Θ
H(θ∗ ) exists and is nonsingular
lnL(θ̂) is a local max
Develop statistical inference for θ∗
Draw {θi }N i=1 uniformly from Θ and form {lnL(θi )}i=1
N

lnL1 first order statistic, lnL2 second order statistic

P [lnL(θ∗ ) ∈ (lnL1 , lnLα )] = (1 − α), as N → ∞
where
lnLα = lnL1 + lnL1 −lnL −2
2
.
(1−α) k −1
118 CHAPTER 7

7.10 INTERVAL AND DENSITY FORECASTING BY SIMULATION

7.11 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Convex relaxation.
Our approaches to global optimization involved attacking a nasty objective function with methods
involving clever randomization. Alternatively, one can approximate the nasty objective with a friendly
(convex) objective, which hopefully has the same global optimum. This is called “convex relaxation,”
and when the two optima coincide we say that the relaxation is “tight.”

7.12 NOTES
 Chapter Eight

Bayesian Time Series Posterior Analysis by Markov Chain Monte

Carlo

8.1 BAYESIAN BASICS

8.2 COMPARATIVE ASPECTS OF BAYESIAN AND FREQUENTIST PARADIGMS

Overarching Paradigm (T → ∞)
√
T (θ̂ − θ) ∼ N (0, Σ)
Shared by classical and Bayesian, but interpretations differ.
Classical: θ̂ random, θ fixed
Bayesian: θ̂ fixed, θ random
Classical: Characterize the distribution of the random data (θ̂) conditional on fixed “’true” θ. Focus on
the likelihood max (θ̂M L ) and likelihood curvature in an -neighborhood of the max.
Bayesian: Characterize the distribution of the random θ conditional on fixed “true” data (θ̂). Examine
the entire likelihood.
Bayesian Computational Mechanics
Data y ≡ {y1 , . . . , yT }
Bayes’ Theorem:
f (y/θ)f (θ)
f (θ/y) =
f (y)
or
f (θ/y) = c f (y/θ)f (θ)
where c−1 = θ f (y/θ)f (θ)
R

f (θ/y) ∝ f (y/θ)f (θ)

p(θ/y) ∝ L(θ/y)g(θ)
posterior ∝ likelihood · prior
Classical Paradigm (T → ∞)
−1 !
√

d IEX,H (θ)
T (θ̂M L − θ) → N 0,
T
or more crudely

√
T (θ̂M L − θ) ∼ N (0, Σ)
(Enough said.)
Bayesian Paradigm (T → ∞)
(Note that as T → ∞, p(θ/y) ≈ L(θ/y),
so the likelihood below can be viewed as the posterior.)
 120 CHAPTER 8

Expand lnL(θ/y) around fixed θ̂M L :

lnL(θ/y) ≈ lnL(θ̂M L /y) + S(θ̂M L /y)0 (θ − θ̂M L )
−1/2(θ − θ̂M L )0 IOB,H (θ̂M L /y)(θ − θ̂M L )
But S(θ̂M L /y) ≡ 0, so:
lnL(θ/y) ≈ lnL(θ̂M L /y) − 1/2(θ − θ̂M L )0 IOB,H (θ̂M L /y)(θ − θ̂M L )
Neglecting the expansion remainder, we then have:
L(θ/y) ∝ exp(−1/2(θ − θ̂M L )0 IOB,H (θ̂M L /y)(θ − θ̂M L ))
or
−1
L(θ/y) ∝ N (θ̂M L , IOB,H (θ̂M L /y))
√
Or, a posteriori, T (θ − θ̂M L ) ∼ N (0, Σ)
Bayesian estimation and model comparison
Estimation:

Full posterior density

Highest posterior density intervals
Posterior mean, median, mode (depending on loss function)

Model comparison:
p(Mi |y) p(y|Mi ) p(Mi )
= •
p(Mj |y) p(y|Mj ) p(Mj )
| {z } | {z } | {z }
posterior odds Bayes f actor prior odds

The Bayes factor is a ratio of marginal likelihoods, or marginal data densities.

– For comparison, simply report the posterior odds
– For selection, invoke 0-1 loss which implies selection of the model with highest posterior probability.
– Hence select the model with highest marginal likelihood if prior odds are 1:1.
Understanding the Marginal Likelihood
As a penalized log likelihood:
As T → ∞, the marginal likelihood is approximately the maximized log likelihood minus KlnT /2. It’s
the SIC!
As a predictive likelihood:

T
Y
P (y) = P (y1 , ..., yT ) = P (yt |y1:t−1 )
t=1
T
X
=⇒ lnP (y) = lnP (yt |y1:t−1 )
t=1
T
X Z
= ln P (yt |θ, y1:t−1 )P (θ|y1:t−1 ) dθ
t=1
Bayesian model averaging:
Weight by posterior model probabilities:

P (yt+1 |y1:t ) = πit P (yt+1 |y1:t , Mi ) + πjt P (yt+1 |y1:t , Mj )

As T → ∞, the distinction between model averaging and selection vanishes, as one π goes to 0 and the
other goes to 1.
If one of the models is true, then both model selection and model averaging are consistent for the true
model. Otherwise they’re consistent for the X-optimal approximation to the truth. Does X = KLIC?
 BAYES 121

8.3 MARKOV CHAIN MONTE CARLO

Metropolis-Hastings
We want to draw S values of θ from p(θ). Initialize chain at θ(0) and burn it in.
1. Draw θ∗ from proposal density q(θ; θ(s−1) )
2. Calculate the acceptance probability α(θ(s−1) , θ∗ )
3. Set


 θ∗ w.p. α(θ(s−1) , θ∗ ) “accept”
s
θ =

θ(s−1) w.p. 1 − α(θ(s−1) , θ∗ ) “reject”


4. Repeat 1-3, s = 1, ..., S

The question, of course, is what to use for step 2.

8.3.1 Metropolis-Hastings Independence Chain

Fixed proposal density:

q(θ; θ(s−1) ) = q ∗ (θ)

Acceptance probability:
" #
p(θ = θ∗ ) q ∗ θ = θ(s−1)


(s−1) ∗
α(θ , θ ) = min , 1
p(θ = θ(s−1) ) q ∗ (θ = θ∗ )

8.3.2 Metropolis-Hastings Random Walk Chain

Random walk proposals:

θ∗ = θ(s−1) + ε
Acceptance probability reduces to:

p(θ = θ∗ )
 
α(θ(s−1) , θ∗ ) = min ,1
p(θ = θ(s−1) )

8.3.3 More
Burn-in, Sampling, and Dependence
“total simulation” = “burn-in” + “sampling”
Questions:
How to assess convergence to steady state?
In the Markov chain case, why not do something like the following. Whenever time t is a multiple of m,
use a distribution-free non-parametric (randomization) test for equality of distributions to test whether the
unknown distribution f1 of xt , ..., xt−(m/2) equals the unknown distribution f2 of xt−(m/2)+1 , ..., xt−m . If,
for example, we pick m = 20, 000, then whenever time t is a multiple of 20,000 we would test equality of the
distributions of xt , ..., xt−10000 and xt−10001 , ..., xt−20000 . We declare arrival at the steady state when the
null is not rejected. Or something like that.
Of course the Markov chain is serially correlated, but who cares, as we’re only trying to assess equality of
unconditional distributions. That is, randomizations of xt , ..., xt−(m/2) and of xt−(m/2)+1 , ..., xt−m destroy
the serial correlation, but so what?
How to handle dependence in the sampled chain?
Better to run one long chain or many shorter parallel chains?
 122 CHAPTER 8

A Useful Property of Accept-Reject Algorithms

(e.g., Metropolis)
Metropolis requires knowing the density of interest only up to a constant, because the acceptance prob-
ability is governed by the RATIO p(θ = θ∗ )/p(θ = θ(s−1) ). This will turn out to be important for Bayesian
analysis.
Metropolis-Hastings (Discrete)
For desired π, we want to find P such that πP = π. It is sufficient to find P such that πi Pij = πj Pji .
Suppose we’ve arrived at zi . Use symmetric, irreducible transition matrix Q = [Qij ] to generate proposals.
That is, draw proposal zj using probabilities in ith row of Q.
Move to zj w.p. αij , where: 
πj
 1, if πi ≥ 1


αij =
 πj otherwise


πi

Equivalently, move to zj w.p. αij , where:

 
πj
αij = min , 1
πi
Metropolis-Hastings, Continued...
This defines a Markov chain P with:


 αij Qij , for i 6= j
Pij =
 P
1− Pij , for i = j

j6=i

Iterate this chain to convergence and start sampling from π.

Blocking strategies: Yu and Meng (2010)
Note that I have set this up to list bibliography at end. It gives a compiling error, but you can skip
through it, and everything looks fine at the end.
Blocking MH algorithms: Ed Herbst Siddhartha Chib and Srikanth Ramamurthy. Tailored randomized
block mcmc methods with application to dsge models. Journal of Econometrics, 155(1):1938, 2010. Vasco
Curdia and Ricardo Reis. Correlated disturbances and u.s. business cycles. 2009. Nikolay Iskrev. Evaluating
the information matrix in linearized dsge models. Economics Letters, 99:607610, 2008. Robert Kohn, Paolo
Giordani, and Ingvar Strid. Adaptive hybrid metropolis-hastings samplers for dsge models. Working Paper,
2010. G. O. Roberts and S.K. Sahu. Updating schemes, correlation structure, blocking and parameterization
for the gibbs sampler. Journal of the Royal Statistical Society. Series B (Methodological), 59(2):291317, 1997.

8.3.4 Gibbs and Metropolis-Within-Gibbs

Bivariate Gibbs Sampling
We want to sample from f (z) = f (z1 , z2 )
Initialize (j = 0) using z20
Gibbs iteration j = 1:
a. Draw z11 from f (z1 |z20 )
b. Draw z21 from f (z2 |z11 )
Repeat j = 2, 3, ....
Theorem (Clifford-Hammersley): limj→∞ f (z j ) = f (z)
Useful if/when conditionals are known and easy to sample from, but joint and marginals are not. (This
happens a lot in Bayesian analysis.)
General Gibbs Sampling
We want to sample from f (z) = f (z1 , z2 , ..., zk )
Initialize (j = 0) using z20 , z30 , ..., zk0
 BAYES 123

Gibbs iteration j = 1:
a. Draw z11 from f (z1 |z20 , ..., zk0 )
b. Draw z21 from f (z2 |z11 , z30 , ..., zk0 )
c. Draw z31 from f (z3 |z11 , z21 , z40 , ..., zk0 )
...
k. Draw zk1 from f (zk |z11 , ..., zk−1
1 )
Repeat j = 2, 3, ....
Again, limj→∞ f (z j ) = f (z)
Metropolis Within Gibbs
Gibbs breaks a big draw into lots of little (conditional) steps. If you’re lucky, those little steps are simple.
If/when a Gibbs step is difficult, i.e., it’s not clear how to sample from the relevant conditional, it can be
done by Metropolis.
(”Metropolis within Gibbs”)
Metropolis is more general but also more tedious, so only use it when you must.
Composition
We may want (x1 , y1 ), ..., (xN , yN ) ∼ iid from f (x, y)
Or we may want y1 , ..., yN ∼ iid from f (y)
They may be hard to sample from directly.
But sometimes it’s easy to:
Draw x∗ ∼ f (x)
Draw y ∗ ∼ f (y|x∗ )
Then:
(x1 , y1 ), ..., (xN , yN ) ∼ iid f (x, y)
(y1 , ..., yN ) ∼ iid f (y)

8.4 CONJUGATE BAYESIAN ANALYSIS OF LINEAR REGRESSION

Bayes for Gaussian Regression with Conjugate Priors

y = Xβ + ε
ε ∼ iid N (0, σ 2 I)
Standard results:
β̂M L = (X 0 X)−1 X 0 y
2 e0 e
σ̂M L =
T
β̂M L ∼ N β, σ 2 (X 0 X)−1

2
T σ̂M L
∼ χ2T −K
σ2
Bayesian Inference for β/σ
Prior:
β/σ 2 ∼ N (β0 , Σ0 )
g(β/σ 2 ) ∝ exp(−1/2(β − β0 )0 Σ−1 0 (β − β0 ))
Likelihood:
−1 0
L(β/σ 2 , y) ∝ exp( 2σ 2 (y − Xβ) (y − Xβ))

Posterior:
p(β/σ 2 , y) ∝ exp(−1/2(β − β0 )0 Σ−1 1 0
0 (β − β0 ) − 2σ 2 (y − Xβ) (y − Xβ))
This is the kernel of a normal distribution (*Problem*):
β/σ 2 , y ∼ N (β1 , Σ1 )
where −1
β1 = Σ−1 0 +σ
−2 (X 0 X) (Σ−1
0 β0 + σ
−2 (X 0 X)β̂
ML)
 124 CHAPTER 8

Σ1 = (Σ−1
0 +σ
−2 (X 0 X))−1

Gamma and Inverse Gamma Refresher

  v  
iid 1 X v δ
zt ∼ N 0, , x= zt2 ⇒ x ∼ Γ x; ,
δ t=1
2 2

(Note δ = 1 ⇒ x ∼ χ2v , so χ2 is a special case of Γ)

   
v δ v −xδ
Γ x; , ∝ x 2 −1 exp
2 2 2
v
E(x) =
δ
2v
var(x) = 2
δ
x ∼ Γ−1 ( v2 , 2δ ) (”inverse gamma”) ⇔ 1
x
∼ Γ( v2 , 2δ )
Bayesian Inference for σ 2 /β
Prior:  
1
σ2
/β ∼ Γ v20 , δ20
    v0 −1  
2 δ0
g σ12 /β ∝ σ12 exp − 2σ 2

(Independent
 σ 2 /β for completeness.) 
 of β,
but write 
1 −T /2
L σ2 /β, y ∝ σ 2 exp − 2σ1 2 (y − Xβ)0 (y − Xβ)
(*Problem*: In contrast to L(β/σ 2 , y) earlier, we don’t absorb the (σ 2 )−T /2 term into the constant of
proportionality. Why?)
Hence (*Problem*):
    v1 −1  
exp −δ
2
p σ12 /β, y ∝ σ12 1
2σ 2
 
or σ12 /β, y ∼ Γ v21 , δ21
v1 = v0 + T
δ1 = δ0 + (y − Xβ)0 (y − Xβ)
Bayesian Pros Thus Far
1. Feels sensible to focus on p(θ/y). Classical relative frequency in repeated samples replaced with
subjective degree of belief conditional on the single sample actually obtained
2. Exact finite-sample full-density inference
Bayesian Cons Thus Far
1. From where does the prior come? How to elicit prior distributions?
2. How to do an “objective” analysis?
(e.g. what is an “uninformative” prior? Uniform?)
(Note, however, that priors can be desirable and helpful. See, for example, the cartoon at http:
//fxdiebold.blogspot.com/2014/04/more-from-xkcdcom.html)
3. We still don’t have the marginal posteriors that we really want: p(β, σ 2 /y), p(β/y).
– Problematic in any event!

8.5 GIBBS FOR SAMPLING MARGINAL POSTERIORS

Markov Chain Monte Carlo Solves the Problem! 0. Initialize: σ 2 = (σ 2 )(0)

Gibbs sampler at generic iteration j:
j1. Draw β (j) from p(β (j) /(σ 2 )(j−1) , 
y) (N(β1 , Σ1))
j2. Draw (σ 2 )(j) from p(σ 2 /β (j) , y) Γ−1 v21 , δ21
Iterate to convergence to steady state, and then estimate posterior moments of interest
 BAYES 125

8.6 GENERAL STATE SPACE: CARTER-KOHN MULTI-MOVE GIBBS

Bayesian Analysis of State-Space Models

αt = T αt−1 + Rηt
yt = Zαt + εt

! !
ηt iid Q 0
∼ N
εt 0 H
Let α̃T = (α01 , . . . , α0T )0 , θ = (T 0 , R0 , Z 0 , Q0 , H 0 )0
The key: Treat α̃T as a parameter, along with system matrices θ
Recall the State-Space Model in Density Form

αt |αt−1 ∼ N (T αt−1 , RQR0 )

yt |αt ∼ N (Zαt , H)
Recall the Kalman Filter in Density Form
Initialize at a0 , P0
State prediction:
αt |ỹt−1 ∼ N (at/t−1 , Pt/t−1 )
at/t−1 = T at−1
Pt/t−1 = T Pt−1 T 0 + RQR0
State update:
αt |ỹt ∼ N (at , Pt )
at = at/t−1 + Kt (yt − Zat/t−1 )
Pt = Pt/t−1 − Kt ZPt/t−1
Data prediction:
yt |ỹt−1 ∼ N (Zat/t−1 , Ft )
where ỹt = (y10 , ..., yt0 )0
Carter-Kohn Multi-move Gibbs Sampler
Let ỹT = (y10 , . . . , yT
0 )0

0. Initialize θ(0)
Gibbs sampler at generic iteration j:
(j)
j1. Draw from posterior α̃T /θ(j−1) , ỹT (“hard”)
(j) (j)
j2. Draw from posterior θ /α̃T , ỹT (“easy”)
Iterate to convergence, and then estimate posterior moments of interest
Just two Gibbs draws: (1) α̃T parameter, (2) θ parameter
(j)
Multimove Gibbs Sampler, Step 2 (θ(j) |α̃T , ỹT ) (“easy”)
(j) (j)
Conditional upon draws α̃T , sampling θ becomes a multivariate regression problem.
We have already seen how to do univariate regression. We can easily extend to multivariate regression.
The Gibbs sampler continues to work.
Multivariate Regression

Y = X B + E ,
|{z} |{z} |{z} |{z}
T ×n T ×k k×n T ×n

where E = [1 , 2 , ..., T ]0 , t = [1,t , ...n,t ]0

iid
t ∼ N (0, Σ)
 126 CHAPTER 8

Important differences compared to univariate regression:

a) B is a matrix rather than a vector.
b) Σ is matrix rather than a scalar.
Conjugate Priors for Multivariate Regression
B|Σ multivariate normal prior:

vec(B)|Σ ∼ N (B0 , Σ0 )
Inverse Wishart refresher (multivariate inverse gamma):

X ∼ W −1 (n, V) ↔ X −1 ∼ W (n, V)
where  
n−p−1 1
W (X; n, V) ∝ |X| 2 exp − tr(XV−1 )
2
Σ|B inverse Wishart prior:

n−p−1 1
p(Σ−1 |vec(B)) ∝ |Σ−1 | 2 exp(− tr(Σ−1 V−1 ))
2
Bayesian Inference for B|Σ
Prior:
 
1 
p(vec(B)|Σ) ∝ exp − tr vec(B − B0 )0 V0−1 vec(B − B0 )
2
Likelihood:

T
!
1X 0 0 −1 0
p(Y, X|B, Σ) ∝ exp − (Yt − B Xt ) Σ (Yt − B Xt )
2 t=1
 
1
∝ exp − tr Σ−1 (Y − XB)0 (Y − XB)


2
 
1 
∝ exp − tr vec(B − B̂)0 Σ−1 ⊗ X 0 X vec(B − B̂)


2
Posterior:

p(vec(B)|Σ, Y ) ∝
 
1 
tr vec(B − B̂)0 Σ−1 ⊗ X 0 X vec(B − B̂) + vec(B − B0 )0 V0−1 vec(B − B0 )


exp −
2
This is the kernel of a multivariate normal distribution:

vec(B)|Σ, Y ∼ N (B1 , V1 )
h i h i−1
vec(B1 ) = V1 (Σ−1 ⊗ X 0 X)vec(B̂) + V0−1 B0 , V1 = Σ−1 ⊗ X 0 X + V0−1
and B̂ = (X 0 X)−1 (X 0 Y )
Bayesian Inference for Σ|B
Prior:
n−p−1 1
p(Σ−1 |vec(B)) ∝ |Σ−1 | 2 exp(− tr(Σ−1 V−1 ))
2
Likelihood:  
T 1
p(Y, X|B, Σ) ∝ |Σ|− 2 exp − tr Σ−1 (Y − XB)0 (Y − XB)


2
Posterior:
 
T +n−p−1 1
p(Σ−1 |vec(B), Y ) ∝ |Σ−1 | exp − tr Σ−1 (Y − XB)0 (Y − XB) + V−1



2
2
 BAYES 127

This is the kernel of a Wishart distribution:

Σ−1 |vec(B), Y ∼ W (T + n, ((Y − XB)0 (Y − XB) + V−1 )−1 )

(j)
Multimove Gibbs Sampler, Step 1 (α̃T /θ(j−1) , ỹT ) (“hard”)
For notational simplicity we write p(α̃T /ỹT ), suppressing the dependence on θ.
p(α̃T /ỹT ) = p(αT /ỹT )p(α̃T −1 /αT , ỹT )
= p(αT /ỹT )p(αT −1 /αT , ỹT )p(α̃T −2 /αT −1 , αT , ỹT )
= ...
(T −1)
= p(αT /ỹT )Πt=1 p(αt /αt+1 , ỹt )
(*Problem*: Fill in the missing steps subsumed under “. . . ”)
So, to draw from p(α̃T /ỹT ), we need to be able to draw from p(αT /ỹT ) and p(αt /αt+1 , ỹt ), t = 1, . . . , (T −
1)
Multimove Gibbs sampler, Continued
The key is to work backward:
Draw from p(αT /ỹT ),
then from p(αT −1 /αT , ỹT −1 ),
then from p(αT −2 /αT −1 , ỹT −2 ),
etc.
Time T draw is easy:
p(αT /ỹT ) is N (aT,T , PT,T )
(where the Kalman filter delivers aT,T and PT,T )
Earlier-time draws are harder:
How to get p(αt /αt+1 , ỹt ), t = (T − 1), ..., 1?
Multimove Gibbs sampler, Continued
It can be shown that (*Problem*):
p(αt /αt+1 , ỹt ), t = (T − 1), ..., 1, is N (at/t,αt+1 , Pt/t,αt+1 )
where
at/t,αt+1 = E(αt /ỹt , αt+1 ) = E(αt |at , αt+1 )
= at + Pt T 0 (T Pt T 0 + Q)−1 (αt+1 − T at )
Pt/t,αt+1 = cov(αt /ỹt , αt+1 ) = cov(αt |at , αt+1 )
= Pt − Pt T 0 (T Pt T 0 + Q)−1 T Pt
*** Expanding S(θ̂M L ) around θ yields:
S(θ̂M L ) ≈ S(θ) + S 0 (θ)(θ̂M L − θ) = S(θ) + H(θ))(θ̂M L − θ).
Noting that S(θ̂M L ) ≡ 0 and taking expectations yields:
0 ≈ S(θ) − IEX,H (θ)(θ̂M L − θ)
or
−1
(θ̂M L − θ) ≈ IEX,H (θ).
a
Using S(θ) ∼ N (0, IEX,H (θ)) then implies:
a −1
(θ̂M L − θ) ∼ N (0, IEX,H (θ))
or
Case 3 β and σ 2
Joint prior g(β, σ12 ) = g(β/ σ12 )g( σ12 )
where β/ σ12 ∼ N (β0 , Σ0 ) and σ12 ∼ G( v20 , δ20 )
HW Show that the joint posterior,
p(β, σ12 /y) = g(β, σ12 )L(β, σ12 /y)
can be factored as p(β/ σ12 , y)p( σ21/y )
where β/ σ12 , y ∼ N (β1 , Σ1 )
and σ12 /y ∼ G( v21 , δ21 ),
and derive expressions for β1 , Σ1 , v1 , δ1
 128 CHAPTER 8

in terms of β0 , Σ0 , δ0 , x, and y.
Moreover, the key marginal posterior
P (β/y) = 0∞ p(β, σ12 /y)dσ 2 is multivariate t.
R

Implement the Bayesian methods via Gibbs sampling.

8.7 EXERCISES, PROBLEMS AND COMPLEMENTS

8.8 NOTES
 Chapter Nine

Non-Stationarity: Integration, Cointegration and Long Memory

9.1 RANDOM WALKS AS THE I(1) BUILDING BLOCK: THE BEVERIDGE-

NELSON DECOMPOSITION

Random Walks
Random walk:
yt = yt−1 + εt
εt ∼ W N (0, σ 2 )
Random walk with drift:
yt = δ + yt−1 + εt
εt ∼ W N (0, σ 2 )
Properties of the Random Walk

t
X
yt = y0 + εi
i=1
(shocks perfectly persistent)

E(yt ) = y0
var(yt ) = tσ 2
lim var(yt ) = ∞
t→∞
Properties of the Random Walk with Drift

t
X
yt = tδ + y0 + εi
i=1
(shocks again perfectly persistent)

E(yt ) = y0 + tδ
var(yt ) = tσ 2
lim var(yt ) = ∞
t→∞
The Random Walk as a Building Block
Generalization of random walk: ARIM A(p, 1, q)
Beveridge-Nelson decomposition:
yt ∼ ARIM A(p, 1, q) ⇒ yt = xt + zt
xt = random walk
zt = covariance stationary
– So shocks to ARIM A(p, 1, q) are persistent, but not perfectly so.
 130 CHAPTER 9

– This was univariate BN. We will later derive multivariate BN.

Forecasting a Random Walk with Drift

xt = b + xt−1 + εt
εt ∼ W N (0, σ 2 )
Optimal forecast:
xT +h,T = bh + xT
Forecast does not revert to trend
Forecasting a Linear Trend + Stationary AR(1)
xt = a + bt + yt

yt = φyt−1 + εt
εt ∼ W N (0, σ 2 )
Optimal forecast:
xT +h,T = a + b(T + h) + φh yT
Forecast reverts to trend

9.2 STOCHASTIC VS. DETERMINISTIC TREND

Some Language...
“Random walk with drift” vs. “stat. AR(1) around linear trend”
“unit root” vs. “stationary root”
“Difference stationary” vs. “trend stationary”
“Stochastic trend” vs. “deterministic trend”
“I(1)” vs. “I(0)”
Stochastic Trend vs. Deterministic Trend
 BAYES 131

9.3 UNIT ROOT DISTRIBUTIONS

Unit Root Distribution in the AR(1) Process

yt = yt−1 + εt

d
T (φ̂LS − 1) → DF

Superconsistent
Biased in finite samples (E φ̂ < φ ∀ φ ∈ (0, 1])
“Hurwicz bias” “Dickey-Fuller bias”
“Nelson-Kang spurious periodicity”
Bigger as T → 0 , as φ → 1 , and as intercept, trend included
Non-Gaussian (skewed left)
DF tabulated by Monte Carlo
Studentized Version

φ̂ − 1
τ̂ = r
s PT 1 2
t=2 yt−1

Not t in finite samples

Not N (0, 1) asymptotically
Again, tabulate by Monte Carlo
Nonzero Mean Under the Alternative

(yt − µ) = φ(yt−1 − µ) + εt
yt = α + φyt−1 + εt
where α = µ(1 − φ)
Random walk null vs. mean-reverting alternative
Studentized statistic τ̂µ
Deterministic Trend Under the Alternative

(yt − a − b t) = φ(yt−1 − a − b (t − 1)) + εt

yt = α + βt + φyt−1 + εt
where α = a(1 − φ) + bφ and β = b(1 − φ)
H0 : φ = 1 (unit root)
H1 : φ < 1 (stationary root)
“Random walk with drift” vs. “stat. AR(1) around linear trend”
“Difference stationary” vs. “trend stationary”
“Stochastic trend” vs. “deterministic trend”
“I(1)” vs. “I(0)”
Studentized statistic τ̂τ
Tabulating the Dickey-Fuller Distributions
1. Set T

2. Draw T N (0, 1) variates

3. Construct yt

4. Run three DF regressions (using common random numbers)

 132 CHAPTER 9

• τ̂ : yt = φyt−1 + et
• τ̂µ : yt = c + φyt−1 + et
• τ̂τ : yt = c + βt + φyt−1 + et

5. Repeat N times, yielding {τ̂ i , τ̂µi , τ̂τi }N

i=1

6. Sort and compute fractiles

7. Fit response surfaces

AR(p)

p
X
yt + φj yt−j = εt
j=1
p
X
yt = ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

where p ≥ 2, ρ1 = − pj=1 φj , and ρi = pj=i φj , i = 2, ..., p

P P

Studentized statistic τ̂
Allowing for Nonzero Mean Under the Alternative

p
X
(yt − µ) + φj (yt−j − µ) = εt
j=1
p
X
yt = α + ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

where α = µ(1 + pj=1 φj )

P

Studentized statistic τ̂µ

Allowing for Trend Under the Alternative

p
X
(yt − a − bt) + φj (yt−j − a − b(t − j)) = εt
j=1
p
X
yt = k1 + k2 t + ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2
p
X p
X
k1 = a(1 + φi ) − b iφi
i=1 i=1
p
X
k2 = b (1 + φi )
i=1
Pp
Under the null hypothesis, k1 = −b i=1 iφi and k2 = 0
Studentized statistic τ̂τ

9.4 UNIVARIATE AND MULTIVARIATE AUGMENTED DICKEY-FULLER

REPRESENTATIONS

General ARM A Representations

(“Augmented Dickey-Fuller” (ADF))
Use one of the representations:
 BAYES 133

k−1
X
yt = ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

k−1
X
yt = α + ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

k−1
X
yt = k1 + k2 t + ρ1 yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

Let k → ∞ with k/T → 0

“Trick Form” of ADF

k−1
X
(yt − yt−1 ) = (ρ1 − 1)yt−1 + ρj (yt−j+1 − yt−j ) + εt
j=2

• Unit root corresponds to (ρ1 − 1) = 0

• Use standard automatically-computed t-stat
(which of course does not have the t-distribution)

9.5 SPURIOUS REGRESSION

Multivariate Problem: Spurious Time-Series Regressions

Regress a persistent variable on an unrelated persistent variable:

yt = β x t + ε t

(Canonical case: y, x independent driftless random walks)

d
R2 → RV (not zero)

d
√t → RV (t diverges)
T

d
√β̂ → RV (β̂ diverges)
T

When are I(1) Levels Regressions Not Spurious?

Answer: When the variables are cointegrated.

9.6 COINTEGRATION, ERROR-CORRECTION AND GRANGER’S REP-

RESENTATION THEOREM

Cointegration
Consider an N -dimensional variable x:
x ∼ CI (d, b) if

1. xi ∼ I(d), i = 1, . . . , N

2. ∃ 1 or more linear combinations zt = α0 xt s.t. zt ∼ I(d − b), b > 0

Leading Case
 134 CHAPTER 9

x ∼ CI(1, 1) if
(1) xi ∼ I(1), i = 1, . . . , N
(2) ∃ 1 or more linear combinations
zt = α0 xt s.t. zt ∼ I(0)
Example

xt = xt−1 + vt , vt ∼ W N
yt = xt−1 + εt , εt ∼ W N, εt ⊥ vt−τ , ∀t, τ
⇒ (yt − xt ) = εt − vt = I(0)
Cointegration and “Attractor Sets”
xt is N -dimensional but does not wander randomly in RN
α0 xt is attracted to an (N − R)-dimensional subspace of RN
N : space dimension
R: number of cointegrating relationships
Attractor dimension = N − R
(“number of underlying unit roots”)
(“number of common trends”)
Example
3-dimensional V AR(p), all variables I(1)
R = 0 ⇔ no cointegration ⇔ x wanders throughout R3
R = 1 ⇔ 1 cointegrating vector ⇔ x attracted to a 2-Dim hyperplane in R3 given by α0 x = 0
R = 2 ⇔ 2 cointegrating vectors ⇔ x attracted to a 1-Dim hyperplane (line) in R3 given by intersection
of two 2-Dim hyperplanes, α01 x = 0 and α02 x = 0
R = 3 ⇔ 3 cointegrating vectors ⇔ x attracted to a 0-Dim hyperplane (point) in R3 given by the
intersection of three 2-Dim hyperplanes, α01 x = 0 , α02 x = 0 and α03 x = 0
(Covariance stationary around E(x))
Cointegration Motivation: Dynamic Factor Structure
Factor structure with I(1) factors
(N − R) I(1) factors driving N variables
e.g., single-factor model:
     
y1t 1 ε1t
 .   .   . 
 .  =  .  ft +  . 
 .   .   . 
yN t 1 εN t
ft = ft−1 + ηt
R = (N − 1) cointegrating combs: (y2t − y1t ), ..., (yN t − y1t )
(N − R) = N − (N − 1) = 1 common trend
Cointegration Motivation: Optimal Forecasting
I(1) variables always co-integrated with their optimal forecasts
Example:
xt = xt−1 + εt
xt+h|t = xt
⇒ xt+h − xt+h|t = h
P
i=1 εt+i

(finite MA, always covariance stationary)

Cointegration Motivation:
Long-Run Relation Augmented with Short-Run Dynamics
BAYES 135

Simple AR Case (ECM):

∆yt = α ∆yt−1 + β ∆xt−1 − γ(yt−1 − δxt−1 ) + ut

= α ∆yt−1 + β ∆xt−1 − γzt−1 + ut

General AR Case (VECM):

A(L) ∆xt = −γzt−1 + ut
where:
A(L) = I − A1 L − ... − Ap Lp
z t = α 0 xt
Multivariate ADF
Any V AR can be written as:

p−1
X
∆xt = − Πxt−1 + Bi ∆xt−i + ut
i=1
Integration/Cointegration Status

• Rank(Π) = 0
0 cointegrating vectors, N underlying unit roots
(all variables appropriately specified in differences)
• Rank(Π) = N
N cointegrating vectors, 0 unit roots
(all variables appropriately specified in levels)
• Rank(Π) = R (0 < R < N )
R cointegrating vectors, N − R unit roots
New and important intermediate case
(not possible in univariate)

Granger Representation Theorem

xt ∼ V ECM ⇔ xt ∼ CI(1, 1)
V ECM ⇐ Cointegration
We can always write
Pp−1
∆xt = i=1 Bi ∆xt−i − Π xt−1 + ut
But under cointegration, rank(Π) = R < N , so
Π γ α0
=
N ×N N ×R R×N
⇒ ∆xt = p−1 0
P
i=1 Bi ∆xt−i − γα xt−1 + ut
Pp−1
= i=1 Bi ∆xt−i − γzt−1 + ut
V ECM ⇒ Cointegration

p−1
X
∆xt = Bi ∆xt−i − γ α0 xt−1 + ut
i=1
Premultiply by α0 :

p−1
X
α0 ∆xt = α0 Bi ∆xt−i − α0 γ α0 xt−1 + α0 ut
|{z}
i=1
full rank
So equation balance requires that α0 x t−1 be stationary.
 136 CHAPTER 9

Stationary-Nonstationary Decomposition
 
α0
 
(R × N ) CI combs
 
M0
 
x  
= x = 
 
(N × N ) (N × 1)   
δ com. trends
 
 
(N − R) × N

(Rows of δ ⊥ to columns of γ)
Intuition Transforming the system by δ yields
p−1
X
δ ∆ xt = δ Bi ∆ xt−i − δ0 γ α0 xt−1 + δ µt
|{z}
i=1
0 by orthogonality

So δ isolates that part of the VECM

that is appropriately specified as a VAR in differences.
Note that if we start with M0 x, then the observed series is
(M0 )−1 M0 x, so nonstationarity is spread throughout the system.
Example

x1t = x1t−1 + u1t

x2t = x1t−1 + u2t

Levels form:
! ! ! ! !
1 0 1 0 x1t u1t
− L =
0 1 1 0 x2t u2t
Dickey-Fuller form:
! ! ! !
∆x1t 0 0 x1t−1 u1t
=− +
∆x2t −1 1 x2t−1 u2t
Example, Continued

!
0  
Π= −1 1 = γα0
1

! !
0 −1 1 α0
M = =
1 0 ⊥γ

! ! !
0 x1t u2t − u1t x2t − x1t
M = =
x2t x1t x1t
 BAYES 137

9.7 FRACTIONAL INTEGRATION AND LONG MEMORY

Long Memory and Fractional Integration

“Integer-integrated” ARIM A(p, d, q) I(d):

(1 − L)d Φ(L)yt = Θ(L)εt , d = 0, 1, ...

Covariance stationary: ARIM A(p, 0, q)

Random walk: ARIM A(0, 1, 0) “pure unit root process”
“Fractionally-integrated” ARF IM A(p, d, q) I(d):
1 1
(1 − L)d Φ(L)yt = Θ(L)εt , − <d<
2 2
Covariance stationary: − 12 < d < 1
2 (focus on 0 < d < 21 )
ARF IM A(0, d, 0): “pure fractionally-integrated process”

d(d − 1) 2 d(d − 1)(d − 2) 3

(1 − L)d = 1 − dL + L − L + ...
2! 3!
Long Memory and Fractional Integration, Continued Time domain, τ → ∞

• I(1) : ρ(τ ) ∝ const

• I(0) : ρ(τ ) ∝ rτ (0 < r < 1)

• I(d) : ρ(τ ) ∝ τ 2d−1 (0 < d < 1/2)

9.7.1 Characterizing Integration Status

Frequency domain, ω → 0

• I(1) : f (ω) ∝ ω −2

• I(0) : f (ω) ∝ const

• I(d) : f (ω) ∝ ω −2d (0 < d < 1/2)

Frequency-domain I(d) behavior implies that for low frequencies,

ln f ∗ (ω) = β0 + β1 lnω + εt
|{z}
−2d

∗
GPH estimator of d: Regress ln f (ω) → const, ln ω
So take dˆ = − 1 β̂1 . “GPH estimator”
2

9.8 EXERCISES, PROBLEMS AND COMPLEMENTS

1. Applied modeling.
138 CHAPTER 9

Obtain a series of U.S. industrial production, monthly, 1947.01-present, not seasonally

adjusted. Discard the last 20 observations. Now graph the series. Examine its trend
and seasonal patterns in detail. Does a linear trend (fit to logs) seem appropriate? Do
monthly seasonal dummies seem appropriate? To the log of the series, fit an ARMA
model with linear trend and monthly seasonal dummies. Be sure to try a variety of
the techniques we have covered (sample autocorrelation and partial autocorrelation
functions, Bartlett standard errors, Box-Pierce test, standard error of the regression,
adjusted R2 , etc.) in your attempt at selecting an adequate model. Once a model has
been selected and estimated, use it to forecast the last 20 observations, and compare
your forecast to the actual realized values. Contrast the results of the approach with
those of the Box-Jenkins seasonal ARIMA approach, which involves taking first and
seasonal differences as necessary to induce covariance stationarity, and then fitting a
multiplicative seasonal ARMA model.

2. Aggregation.
Granger (1980) shows that aggregation of a very large number of stationary ARMA
time series results, under regularity conditions (generalized in Robinson, 1991), in a
fractionally-integrated process. Thus, aggregation of short-memory processes results
in a long-memory process. Discuss this result in light of theorems on aggregation of
ARMA processes. In particular, recall that aggration of ARMA processes results in
new ARMA processes, generally of higher order than the components.

3. Over-differencing and UCM’s.

The stochastic trend:
Tt = Tt−1 + βt−1 + ηt
βt = βt−1 + ζt ,
has two unit roots. Discuss as regards “overdifferencing” in economic time series.

9.9 NOTES
 Chapter Ten

Volatility Dynamics

10.1 VOLATILITY AND FINANCIAL ECONOMETRICS

10.2 GARCH

10.3 STOCHASTIC VOLATILITY

10.4 OBSERVATION-DRIVEN VS. PARAMETER-DRIVEN PROCESSES

Prologue: Reading
Much of what follows draws heavily upon:

• Andersen, T.G., Bollerslev, T., Christoffersen, P.F. and Diebold, F.X. (2012), ”Finan-
cial Risk Measurement for Financial Risk Management,” in G. Constantinedes, M.
Harris and Rene Stulz (eds.), Handbook of the Economics of Finance, Elsevier.

• Andersen, T.G., Bollerslev, T. and Diebold, F.X. (2010), ”Parametric and Nonpara-
metric Volatility Measurement,” in L.P. Hansen and Y. Ait-Sahalia (eds.), Handbook
of Financial Econometrics. Amsterdam: North-Holland, 67-138.

• Andersen, T.G., Bollerslev, T., Christoffersen, P.F., and Diebold, F.X. (2006), ”Volatil-
ity and Correlation Forecasting,” in G. Elliott, C.W.J. Granger, and A. Timmermann
(eds.), Handbook of Economic Forecasting. Amsterdam: North-Holland, 778-878.

Prologue

• Throughout: Desirability of conditional risk measurement

• Aggregation level
– Portfolio-level (aggregated, univariate) Risk measurement
– Asset-level (disaggregated, multivariate): Risk management

• Frequency of data observations

– Low-frequency vs. high-frequency data
– Parametric vs. nonparametric volatility measurement
140 CHAPTER 10

Figure 10.1: Time Series of Daily NYSE Returns

• Object measured and modeled

– From conditional variances to conditional densities

• Dimensionality reduction in “big data” multivariate environments

– From ad hoc statistical restrictions to factor structure

What’s in the Data?

Returns
Key Fact 1: Returns are Approximately Serially Uncorrelated
Key Fact 2: Returns are not Gaussian
Key Fact 3: Returns are Conditionally Heteroskedastic I
Key Fact 3: Returns are Conditionally Heteroskedastic II

Why Care About Volatility Dynamics?

Everything Changes when Volatility is Dynamic

• Risk management

• Portfolio allocation

• Asset pricing

• Hedging

• Trading

Risk Management
VOLATILITY DYNAMICS 141

Figure 10.2: Correlogram of Daily NYSE Returns.

Figure 10.3: Histogram and Statistics for Daily NYSE Returns.

142 CHAPTER 10

Figure 10.4: Time Series of Daily Squared NYSE Returns.

Figure 10.5: Correlogram of Daily Squared NYSE Returns.

VOLATILITY DYNAMICS 143

Individual asset returns:

r ∼ (µ, Σ)

Portfolio returns:

rp = λ0 r ∼ (λ0 µ, λ0 Σλ)

If Σ varies, we need to track time-varying portfolio risk, λ0 Σt λ

Portfolio Allocation
Optimal portfolio shares w∗ solve:

minw w0 Σw

s.t. w0 µ = µp

Importantly, w∗ = f (Σ)
If Σ varies, we have wt∗ = f (Σt )
Asset Pricing I: Sharpe Ratios
Standard Sharpe:
E(rit − rf t )
σ
Conditional Sharpe:
E(rit − rf t )
σt
Asset Pricing II: CAPM Standard CAPM:

(rit − rf t ) = α + β(rmt − rf t )

cov((rit − rf t ), (rmt − rf t ))
β =
var(rmt − rf t )
Conditional CAPM:
covt ((rit − rf t ), (rmt − rf t ))
βt =
vart (rmt − rf t )
Asset Pricing III: Derivatives
Black-Scholes:

C = N (d1 )S − N (d2 )Ke−rτ

ln(S/K) + (r + σ 2 /2)τ
d1 = √
σ τ
ln(S/K) + (r − σ 2 /2)τ
d2 = √
σ τ
 144 CHAPTER 10

PC = BS(σ, ...)

(Standard Black-Scholes options pricing)

Completely different when σ varies!
Hedging

• Standard delta hedging

∆Ht = δ ∆St + ut

cov(∆Ht , ∆St )
δ =
var(∆St )

• Dynamic hedging

∆Ht = δt ∆St + ut

covt (∆Ht , ∆St )

δt =
vart (∆St )

Trading

• Standard case: no way to trade on fixed volatility

• Time-varying volatility I: Options straddles, strangles, etc. Take position according to

whether PC >< f (σt+h,t , . . .)
(indirect)

• Time-varying volatility II: Volatility swaps

Effectively futures contracts written on underlying
“realized volatility”
(direct)

Some Warm-Up
Unconditional Volatility Measures
Variance: σ 2 = E(rt − µ)2 (or standard deviation: σ)
Mean Absolute Deviation: M AD = E|rt − µ|
Interquartile Range: IQR = 75% − 25%
 VOLATILITY DYNAMICS 145

12

10

8
True Probability, %

0
0 100 200 300 400 500 600 700 800 900 1000
Day Number

Figure 10.6: True Exceedance Probabilities of Nominal 1% HS-V aR When Volatility is

Persistent. We simulate returns from a realistically-calibrated dynamic volatility model, after which we
compute 1-day 1% HS-V aR using a rolling window of 500 observations. We plot the daily series of true
conditional exceedance probabilities, which we infer from the model. For visual reference we include a
horizontal line at the desired 1% probability level.

p% Value at Risk (V aRp )): x s.t. P (rt < x) = p

Outlier probability: P |rt − µ| > 5σ (for example)
Tail index: γ s.t. P (rt > r) = k r−γ
Kurtosis: K = E(r − µ)4 /σ 4
Dangers of a Largely Unconditional Perspective (HS-V aR)
Dangers of an Unconditional Perspective, Take II
The unconditional HS-V aR perspective encourages incorrect rules of thumb, like scaling
√
by h to convert 1-day vol into h-day vol.
Conditional VaR
Conditional VaR (V aRTp +1|T ) solves:

p
Z −V aRT +1|T
p = PT (rT +1 ≤ −V aRTp +1|T ) = fT (rT +1 )drT +1
−∞

( fT (rT +1 ) is density of rT +1 conditional on time-T information)

But VaR of any Flavor has Issues

• V aR is silent regarding expected loss when V aR is exceeded

(fails to assess the entire distributional tail)

• V aR fails to capture beneficial effects of portfolio diversification

Conditionally expected shortfall:

Z p
ESTp+1|T = p −1
V aRTγ+1|T dγ
0

• ES assesses the entire distributional tail

• ES captures the beneficial effects of portfolio diversification

 146 CHAPTER 10

Exponential Smoothing and RiskMetrics

σt2 = λ σt−1
2 2
+ (1 − λ) rt−1

∞
X
σt2 = 2
ϕj rt−1−j
j=0

ϕj = (1 − λ) λj

(Many initializations possible: r12 , sample variance, etc.)

RM-VaRpT +1|T = σT +1 Φ−1

p

• Random walk for variance

• Random walk plus noise model for squared returns

• Volatility forecast at any horizon is current smoothed value

• But flat volatility term structure is not realistic

Rigorous Modeling I
Conditional Univariate Volatility Dynamics from “Daily”
Data
Conditional Return Distributions
f (rt ) vs. f (rt |Ωt−1 )
Key 1: E(rt |Ωt−1 )
Are returns conditional mean independent? Arguably yes.
Returns are (arguably) approximately serially uncorrelated, and (arguably) approximately
free of additional non-linear conditional mean dependence.
Conditional Return Distributions, Continued Key 2: var(rt |Ωt−1 ) = E((rt − µ)2 |Ωt−1 )
Are returns conditional variance independent? No way!
Squared returns serially correlated, often with very slow decay.
The Standard Model
(Linearly Indeterministic Process with iid Innovations)

∞
X
yt = bi εt−i
i=0
 VOLATILITY DYNAMICS 147

∞
X
ε ∼ iid (0, σε2 ) b2i < ∞ b0 = 1
i=0

Uncond. mean: E(yt ) = 0 (constant)

P∞ 2
Uncond. variance: E(yt − E(yt ))2 = σε2 i=0 bi (constant)
P∞
Cond. mean: E(yt | Ωt−1 ) = i=1 i t−i (varies)
b ε
2
Cond. variance: E([yt − E(yt | Ωt−1 )] | Ωt−1 ) = σε2 (constant)
The Standard Model, Continued
k-Step-Ahead Least Squares Forecasting

∞
X
E(yt+k | Ωt ) = bk+i εt−i
i=0

Associated prediction error:

k−1
X
yt+k − E(yt+k | Ωt ) = bi εt+k−i
i=0

Conditional prediction error variance:

k−1
X
2
E([yt+k − E(yt+k | Ωt )] | Ωt ) = σε2 b2i
i=0

Key: Depends only on k, not on Ωt

ARCH(1) Process

rt |Ωt−1 ∼ N (0, ht )

2
ht = ω + αrt−1

E(rt ) = 0

2 ω
E(rt − E(rt )) =
(1 − α)

E(rt |Ωt−1 ) = 0

2 2
E([rt − E(rt |Ωt−1 )] |Ωt−1 ) = ω + αrt−1

GARCH(1,1) Process
“Generalized ARCH”

rt | Ωt−1 ∼ N (0, ht )
148 CHAPTER 10

2
ht = ω + αrt−1 + βht−1

E(rt ) = 0

2 ω
E(rt − E(rt )) =
(1 − α − β)

E(rt |Ωt−1 ) = 0

2 2
E([rt − E(rt | Ωt−1 )] | Ωt−1 ) = ω + αrt−1 + βht−1

Conditionally-Gaussian GARCH-Based 1-Day VaR

GARCH-VaRTp +1|T ≡ σT +1|T Φ−1

p

– Consistent with fat tails of unconditional return distribution

– Can be extended to allow for fat-tailed conditional distribution
Unified Theoretical Framework

• Volatility dynamics (of course, by construction)

• Conditional symmetry translates into unconditional symmetry

• Volatility clustering produces unconditional leptokurtosis

Tractable Empirical Framework

L (θ; r1 , . . . , rT ) ≈ f (rT |ΩT −1 ; θ) f (rT −1 |ΩT −2 ; θ) . . . f (rp+1 |Ωp ; θ)

If the conditional densities are Gaussian,

1 rt2
 
1
f (rt |Ωt−1 ; θ) = √ ht (θ)−1/2 exp −
2π 2 ht (θ)

T T
T −p 1 X 1 X rt2
ln L (θ; rp+1 , . . . , rT ) ≈ − ln(2π) − ln ht (θ) −
2 2 t=p+1 2 t=p+1 ht (θ)

The Squared Return as a Noisy Volatility Proxy

Note that we can write:
rt2 = ht + νt
Thus rt2 is a noisy indicator of ht
Various approaches handle the noise in various ways.
 VOLATILITY DYNAMICS 149

GARCH(1,1) and Exponential Smoothing

Exponential smoothing recursion:

r̄t2 = γ rt2 + (1 − γ) r̄t−1

2

Back substitution yields:

X
r̄t2 = 2
wj rt−j

where wj = γ (1 − γ)j
But in GARCH(1,1) we have:
2
ht = ω + αrt−1 + βht−1

ω X
ht = + α β j−1 rt−j
2
1−β
Variance Targeting
Sample unconditional variance:
T
1X 2
σ̂ 2 = r
T t=1 t

Implied unconditional GARCH(1,1) variance:

ω
σ2 =
1−α−β
We can constrain σ 2 = σ̂ 2 by constraining:

ω = (1 − α − β)σ̂ 2

– Saves a degree of freedom and ensures reasonableness

ARMA Representation in Squares
rt2 has the ARMA(1,1) representation:

rt2 = ω + (α + β)rt−1
2
− βνt−1 + νt ,

where νt = rt2 − ht .
Variations on the GARCH Theme
Regression with GARCH Disturbances

yt = x0t β + εt

εt |Ωt−1 ∼ N (0, ht )
 150 CHAPTER 10

• Regression with GARCH Disturbances

• Incorporating Exogenous Variables
• Asymmetric Response and the Leverage Effect:
• Fat-Tailed Conditional Densities

• Time-Varying Risk Premia

Incorporating Exogenous Variables

2
ht = ω + α rt−1 + β ht−1 + γ 0 zt

γ is a parameter vector
z is a set of positive exogenous variables.
Asymmetric Response and the Leverage Effect I: TARCH
2
Standard GARCH: ht = ω + αrt−1 + βht−1
2 2
TARCH:( ht = ω + αrt−1 + γrt−1 Dt−1 + βht−1
1 if rt < 0
Dt =
0 otherwise
positive return (good news): α effect on volatility

negative return (bad news): α + γ effect on volatility

γ 6= 0: Asymetric news response

γ > 0: “Leverage effect”
Asymmetric Response II: E-GARCH

rt−1 rt−1
ln(ht ) = ω + α 1/2
+ γ 1/2
+ β ln(ht−1 )
ht−1 ht−1

• Log specification ensures that the conditional variance is positive.

• Volatility driven by both size and sign of shocks

• Leverage effect when γ < 0

Fat-Tailed Conditional Densities: t-GARCH

If r is conditionally Gaussian, then √rt ∼ N (0, 1)
ht
But often with high-frequency data, √rht ∼ f at tailed
t
So take:
1/2
rt = ht zt
VOLATILITY DYNAMICS 151

Figure 10.7: GARCH(1,1) Estimation, Daily NYSE Returns.

iid
td
zt ∼
std(td )

Time-Varying Risk Premia: GARCH-M

Standard GARCH regression model:

yt = x0t β + εt

εt |Ωt−1 ∼ N (0, ht )

GARCH-M model is a special case:

yt = x0t β + γht + εt

εt |Ωt−1 ∼ N (0, ht )

A GARCH(1,1) Example
A GARCH(1,1) Example
A GARCH(1,1) Example
A GARCH(1,1) Example
After Exploring Lots of Possible Extensions...

Rigorous Modeling II
Conditional Univariate Volatility Dynamics from High-
Frequency Data
 152 CHAPTER 10

Figure 10.8: Correlogram of Squared Standardized GARCH(1,1) Residuals, Daily NYSE

Returns.

Figure 10.9: Estimated Conditional Standard Deviation, Daily NYSE Returns.

Figure 10.10: Conditional Standard Deviation, History and Forecast, Daily NYSE Returns.
VOLATILITY DYNAMICS 153

Dependent Variable: R
Method: ML - ARCH (Marquardt) - Student's t distribution
Date: 04/10/12 Time: 13:48
Sample (adjusted): 2 3461
Included observations: 3460 after adjustments
Convergence achieved after 19 iterations
Presample variance: backcast (parameter = 0.7)
GARCH = C(4) + C(5)*RESID(-1)^2 + C(6)*RESID(-1)^2*(RESID(-1)<0)
+ C(7)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

@SQRT(GARCH) 0.083360 0.053138 1.568753 0.1167

C 1.28E-05 0.000372 0.034443 0.9725
R(-1) 0.073763 0.017611 4.188535 0.0000

Variance Equation

C 1.03E-06 2.23E-07 4.628790 0.0000

RESID(-1)^2 0.014945 0.009765 1.530473 0.1259
RESID(-1)^2*(RESID(-
1)<0) 0.094014 0.014945 6.290700 0.0000
GARCH(-1) 0.922745 0.009129 101.0741 0.0000

T-DIST. DOF 5.531579 0.478432 11.56188 0.0000

Figure 10.11: AR(1) Returns with Threshold t-GARCH(1,1)-in Mean.

 154 CHAPTER 10

Daily Annualized Realized Volatility (%)

150

100

50

0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Daily close−to−close Returns (%)

15

10

−5

−10

−15
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Figure 10.12: S&P500 Daily Returns and Volatilities (Percent). The top panel shows daily S&P500
returns, and the bottom panel shows daily S&P500 realized volatility. We compute realized volatility as the
square root of AvgRV , where AvgRV is the average of five daily RVs each computed from 5-minute squared
returns on a 1-minute grid of S&P500 futures prices.

Intraday Data and Realized Volatility

dp(t) = µ(t)dt + σ(t)dW (t)

N (∆)
X
2
RVt (∆) ≡ pt−1+j∆ − pt−1+(j−1)∆
j=1

Z t
RVt (∆) → IVt = σ 2 (τ ) dτ
t−1

Microstructure Noise
– State space signal extraction
– AvgRV
– Realized kernel
– Many others
RV is Persistent
RV is Reasonably Approximated as Log-Normal
RV is Long-Memory
Exact and Approximate Long Memory
Exact long memory:

(1 − L)d RVt = β0 + νt
 VOLATILITY DYNAMICS 155

Quantiles of Input Sample QQ plot of Daily RV−AVR

100

−100
−5 −4 −3 −2 −1 0 1 2 3 4 5
Standard Normal Quantiles
QQ plot of Daily Realized Volatility
Quantiles of Input Sample

10

−10
−5 −4 −3 −2 −1 0 1 2 3 4 5
Standard Normal Quantiles
QQ plot of Daily log RV−AVR
Quantiles of Input Sample

−5
−5 −4 −3 −2 −1 0 1 2 3 4 5
Standard Normal Quantiles

Figure 10.13: S&P500: QQ Plots for Realized Volatility and Log Realized Volatility. The top
panel plots the quantiles of daily realized volatility against the corresponding normal quantiles. The bottom
panel plots the quantiles of the natural logarithm of daily realized volatility against the corresponding normal
quantiles. We compute realized volatility as the square root of AvgRV , where AvgRV is the average of five
daily RVs each computed from 5-minute squared returns on a 1-minute grid of S&P500 futures prices.

“Corsi model” (HAR):

RVt = β0 + β1 RVt−1 + β2 RVt−5:t−1 + β3 RVt−21:t−1 + νt

Even better:

log RVt = β0 + β1 log RVt−1 + β2 log RVt−5:t−1 + β3 log RVt−21:t−1 + νt

– Ensures positivity and promotes normality

RV-VaR

RV − V aRTp+1|T = RV
d T +1|T Φ−1
p ,

GARCH-RV

σt2 = ω + β σt−1
2
+ γ RVt−1

• Fine for 1-step

• Multi-step requires “closing the system” with an RV equation

– “Realized GARCH”
– “HEAVY”

Separating Jumps

QVt = IVt + JVt

 156 CHAPTER 10

ACF of Daily RV−AVR

0.8

0.6
Autocorrelation

0.4

0.2

50 100 150 200 250

Lag Order

ACF of Daily Return

0.8

0.6
Autocorrelation

0.4

0.2

50 100 150 200 250

Lag Order

Figure 10.14: S&P500: Sample Autocorrelations of Daily Realized Variance and Daily Re-
turn. The top panel shows realized variance autocorrelations, and the bottom panel shows return autocor-
relations, for displacements from 1 through 250 days. Horizontal lines denote 95% Bartlett bands. Realized
variance is AvgRV , the average of five daily RVs each computed from 5-minute squared returns on a 1-minute
grid of S&P500 futures prices.

where
Jt
X
2
JVt = Jt,j
j=1

e.g., we might want to explore:

RVt = β0 + β1 IVt−1 + β2 IVt−5:t−1 + β3 IVt−21:t−1

+ α1 JVt−1 + α2 JVt−5:t−1 + α3 JVt−21:t−1 + νt
But How to Separate Jumps?

• Truncation:
N (∆)
X
T Vt (∆) = ∆p2t−1+j∆ I ( ∆pt−1+j∆ < T )
j=1

• Bi-Power Variation:
N (∆)−1
π N (∆) X
BP Vt (∆) = |∆pt−1+j∆ | |∆pt−1+(j+1)∆ |
2 N (∆) − 1 j=1

• Minimum:
  N (∆)−1
π N (∆) X  2
M inRVt (∆) = min |∆pt−1+j∆ |, |∆pt−1+(j+1)∆ |
π−2 N (∆) − 1 j=1

Rigorous Modeling III

Conditional Asset-Level (Multivariate) Volatility Dynam-
 VOLATILITY DYNAMICS 157

ics from “Daily” Data

Multivariate
Univariate volatility models useful for portfolio-level risk measurement (VaR, ES, etc.)
But what about risk management questions:

• Portfolio risk change under a certain scenario involving price movements of set of
assets or asset classes?

• Portfolio risk change if certain correlations increase suddenly

• Portfolio risk change if I double my holdings of Intel?

• How do optimal portfolio shares change if the covariance matrix moves in a certain
way?

Similarly, what about almost any other question in asset pricing, hedging, trading? Almost
all involve correlation.
Basic Framework and Issues I
N × 1 return vector Rt
N × N covariance matrix Ωt
N (N +1)
• 2 distinct elements

• Structure needed for pd or even psd

• Huge number of parameters even for moderate N

• And N may be not be moderate!

Basic Framework and Issues II

Univariate:

rt = σt zt

zt ∼ i.i.d.(0, 1)

Multivariate:
1/2
Rt = Ωt Zt

Zt ∼ i.i.d.(0, I)
1/2
where Ωt is a “square-root” (e.g., Cholesky factor) of Ωt
Ad Hoc Exponential Smoothing (RM)

0
Ωt = λ Ωt−1 + (1 − λ) Rt−1 Rt−1
 158 CHAPTER 10

• Assumes that the dynamics of all the variances and covariances are driven by a single
scalar parameter λ (identical smoothness)

• Guarantees that the smoothed covariance matrices are pd so long as Ω0 is pd

PT
• Common strategy is to set Ω0 equal to the sample covariance matrix 1
T t=1 Rt Rt0
(which is pd if T > N )

• But covariance matrix forecasts inherit the implausible scaling properties of the uni-
variate RM forecasts and will in general be suboptimal

Multivariate GARCH(1,1)

0
vech (Ωt ) = vech (C) + B vech (Ωt−1 ) + A vech (Rt−1 Rt−1 )

• vech operator converts the upper triangle of a symmetric matrix into a 12 N (N + 1) × 1

column vector

• A and B matrices are both of dimension 21 N (N + 1) × 12 N (N + 1)

• Even in this “parsimonious” GARCH(1,1) there are O(N 4 ) parameters

– More than 50 million parameters for N = 100!

Encouraging Parsimony: Diagonal GARCH(1,1)

Diagonal GARCH constrains A and B matrices to be diagonal.

0
vech (Ωt ) = vech (C) + (Iβ) vech (Ωt−1 ) + (Iα) vech (Rt−1 Rt−1 )

– Still O(N 2 ) parameters.

Encouraging Parsimony: Scalar GARCH(1,1)
Scalar GARCH constrains A and B matrices to be scalar:
0
vech (Ωt ) = vech (C) + (Iβ) vech (Ωt−1 ) + (Iα) vech (Rt−1 Rt−1 )

– Mirrors RM, but with the important difference that the Ωt forecasts now revert to
Ω = (1 − α − β)−1 C
– Fewer parameters than diagonal, but still O(N )2
(because of C)
Encouraging Parsimony: Covariance Targeting
Recall variance targeting:
T
1X 2 ω
σ̂ 2 = r , σ2 = =⇒ take ω = (1 − α − β)σ̂ 2
T t=1 t 1−α−β
 VOLATILITY DYNAMICS 159

Covariance targeting is the obvious multivariate generalization:

T
1 X
vech(C) = (I − A − B) vech ( Rt Rt0 )
T t=1

– Encourages both parsimony and reasonableness

Constant Conditional Correlation (CCC) Model
[Key is to recognize that correlation matrix
is the covariance matrix of standardized returns]
Two-step estimation:

• Estimate N appropriate univariate GARCH models

• Calculate standardized return vector, êt = Rt D̂t−1

1
PT 0
• Estimate correlation matrix Γ (assumed constant) as T t=1 êt êt

– Quite flexible as the N models can differ across returns

Dynamic Conditional Correlation (DCC) Model
Two-step estimation:

• Estimate N appropriate univariate GARCH models

• Calculate standardized return vector, êt = Rt D̂t−1

• Estimate correlation matrix Γt (assumed to have scalar GARCH(1,1)-style dynamics)

as following

vech(Γt ) = vech(C) + (Iβ)vech(Γt−1 ) + (Iα)vech(et−1 e0t−1 )

– “Correlation targeting” is helpful

DECO

• Time-varying correlations assumed identical across all pairs of assets, which implies:

Γt = (1 − ρt ) I + ρt J ,

where J is an N × N matrix of ones

• Analytical inverse facilitates estimation:

 
−1 1 ρt
Γt = I − J
(1 − ρt ) 1 + (N − 1)ρt

• Assume GARCH(1,1)-style conditional correlation structure:

ρt = ωρ + αρ ut + βρ ρt−1
 160 CHAPTER 10

DECO Correlation, 1973−2009

0.8

0.6

0.4

0.2

0
75 80 85 90 95 00 05 10

Figure 10.15: Time-Varying International Equity Correlations. The figure shows the estimated
equicorrelations from a DECO model for the aggregate equity index returns for 16 different developed
markets from 1973 through 2009.

• Updating rule is naturally given by the average conditional correlation of the stan-
dardized returns,
PN PN
2 i=1 j>i ei,t ej,t
ut = PN
N i=1 e2i,t

• Three parameters, ωρ , αρ and βρ , to be estimated.

DECO Example
Factor Structure

Rt = λFt + νt

where
1/2
Ft = ΩF t Zt

Zt ∼ i.i.d.(0, I)

νt ∼ i.i.d.(0, Ων )

=⇒ Ωt = λ ΩF t λ0 + Ωνt

One-Factor Case with Everything Orthogonal

Rt = λft + νt
 VOLATILITY DYNAMICS 161

where

ft = σf t zt

zt ∼ i.i.d.(0, 1)

νt ∼ i.i.d.(0, σν2 )

=⇒ Ωt = σf2 t λλ0 + Ων

2
σit = σf2 t λ2i + σνi
2

2
σijt = σf2 t λi λj

Rigorous Modeling IV
Conditional Asset-Level (Multivariate) Volatility Dynam-
ics from High-Frequency Data
Realized Covariance

dP (t) = M (t) dt + Ω(t)1/2 dW (t)

N (∆)
X
0
RCovt (∆) ≡ Rt−1+j∆,∆ Rt−1+j∆,∆
j=1

Z t
RCovt (∆) → ICovt = Ω (τ ) dτ
t−1

– p.d. so long as N (∆) > N ; else use regularization methods

Asynchronous Trading and the Epps Effect
– Epps effect biases covariance estimates downward
– Can overcome Epps by lowering sampling frequency to accommodate least-frequently-
traded asset, but that wastes data
– Opposite extreme: Calculate each pairwise realized covariance matrix using appropriate
sampling; then assemble and regularize
Regularization (Shrinkage)
 162 CHAPTER 10

15

10

5
Quantiles of Input Sample

−5

−10

−15
−15 −10 −5 0 5 10 15
Standard Normal Quantiles

Figure 10.16: QQ Plot of S&P500 Returns. We show quantiles of daily S&P500 returns from January
2, 1990 to December 31, 2010, against the corresponding quantiles from a standard normal distribution.

Ω̂St = κ RCovt (∆) + (1 − κ) Υt

– Υt is p.d. and 0 < κ < 1

– Υt = I (naive benchmark)
– Υt = Ω (unconditional covariance matrix)
– Υt = σf2 λλ0 + Ων (one-factor market model)
Multivariate GARCH-RV

vech (Ωt ) = vech (C) + B vech (Ωt−1 ) + A vech(Ω̂t−1 )

• Fine for 1-step

• Multi-step requires “closing the system” with an RV equation

– Noureldin et al. (2011), multivariate HEAVY

Rigorous Modeling V
Distributions
Modeling Entire Return Distributions:
Returns are not Unconditionally Gaussian
Modeling Entire Return Distributions:
Returns are Often not Conditionally Gaussian
Modeling Entire Return Distributions: Issues

• Gaussian QQ plots effectively show calibration of Gaussian VaR at different levels

• Gaussian unconditional VaR is terrible

• Gaussian conditional VaR is somewhat better but left tail remains bad
 VOLATILITY DYNAMICS 163

2
Quantiles of Input Sample

−1

−2

−3

−4

−5
−5 −4 −3 −2 −1 0 1 2 3 4 5
Standard Normal Quantiles

Figure 10.17: QQ Plot of S&P500 Returns Standardized by NGARCH Volatilities. We show

quantiles of daily S&P500 returns standardized by the dynamic volatility from a NGARCH model against
the corresponding quantiles of a standard normal distribution. The sample period is January 2, 1990 through
December 31, 2010. The units on each axis are standard deviations.

• Gaussian conditional expected shortfall, which integrates over the left tail, would be
terrible

• So we want more accurate assessment of things like V aRTp +1|T than those obtained
under Gaussian assumptions
–Doing so for all values of p ∈ [0, 1] requires estimating the entire conditional return
distribution
– More generally, best-practice risk measurement is about tracking the entire condi-
tional return distribution

Observation-Driven Density Forecasting

Using r = σ ε and GARCH
Assume:

rT +1 = σT +1/T εT +1

εT +1 ∼ iid(0, 1)

Multiply εT +1 draws by σT +1/T (fixed across draws, from a GARCH model) to build up
the conditional density of rT +1 .

• εT +1 simulated from standard normal

• εT +1 simulated from standard t

rT +1
• εT +1 simulated from kernel density fit to σT +1/T

• εT +1 simulated from any density that can be simulated

 164 CHAPTER 10

2
Quantiles of Input Sample

−1

−2

−3

−4

−5
−5 −4 −3 −2 −1 0 1 2 3 4 5
Standard Normal Quantiles

Figure 10.18: QQ Plot of S&P500 Returns Standardized by Realized Volatilities. We show

quantiles of daily S&P500 returns standardized by AvgRV against the corresponding quantiles of a standard
normal distribution. The sample period is January 2, 1990 through December 31, 2010. The units on each
axis are standard deviations.

Parameter-Driven Density Forecasting

Using r = σ ε and SV
Assume:

rT +1 = σT +1 εT +1

εT +1 ∼ iid(0, 1)

Multiply εT +1 draws by σT +1 draws (from a simulated SV model) to build up the condi-

tional density of rT +1 .
– Again, εT +1 simulated from any density deemed relevant
Modeling Entire Return Distributions:
Returns Standardized by RV are Approximately Gaussian
A Special Parameter-Driven Density Forecasting Approach
Using r = σ ε and RV
(Log-Normal / Normal Mixture)
Assume:

rT +1 = σT +1 εT +1

εT +1 ∼ iid(0, 1)

Multiply εT +1 draws from N (0, 1) by σT +1 draws (from a simulated RV model fit to log
realized standard deviation) to build up the conditional density of rT +1 .
 VOLATILITY DYNAMICS 165

Pitfalls of the “r = σ ε” Approach

In the conditionally Gaussian case we can write with no loss of generality:

rT +1 = σT +1/T εT +1

εT +1 ∼ iidN (0, 1)

But in the conditionally non-Gaussian case there is potential loss of generality in writing:

rT +1 = σT +1/T εT +1

εT +1 ∼ iid(0, 1),

because there may be time variation in conditional moments other than σT +1/T , and using
εT +1 ∼ iid(0, 1) assumes that away
Multivariate Return Distributions
– If reliable realized covariances are available, one could do a multivariate analog of the
earlier lognormal/normal mixture model. But the literature thus far has focused primarily
on conditional distributions for “daily” data.
Return version:
−1/2
Zt = Ω t Rt , Zt ∼ i.i.d., Et−1 (Zt ) = 0 V art−1 (Zt ) = I

Standardized return version (as in DCC):

et = Dt−1 Rt , Et−1 (et ) = 0, V art−1 (et ) = Γt

where Dt denotes the diagonal matrix of conditional standard deviations for each of the
assets, and Γt refers to the potentially time-varying conditional correlation matrix.
Leading Examples
Multivariate normal:

f (et ) = C (Γt ) exp − 12 e0t Γ−1

t et

Multivariate t:

−(d+N )/2
e0 Γ−1 et

f (et ) = C (d, Γt ) 1+ t t
(d − 2)
 166 CHAPTER 10

Multivariate asymmetric t:
  r    
C d, Γ˙t K d+N d + (et − µ̇)0 Γ̇−1
t (et − µ̇) ξ 0 Γ̇−1
t ξ exp (et − µ̇)0 Γ̇−1
t ξ
2
f (et ) = (d+N )
 −1
 (d+N ) r −
(et −µ̇)0 Γ̇t (et −µ̇) 2 2

1+ d d + (et − µ̇)0 Γ̇−1
t (et − µ̇) ξ 0 Γ̇−1
t ξ

– More flexible than symmetric t but requires estimation of N asymmetry parameters si-
multaneously with the other parameters, which is challenging in high dimensions.
Copula methods sometimes provide a simpler two-step approach.
Copula Methods
Sklar’s Theorem:

F (e) = G( F1 (e1 ), ..., FN (eN ) ) ≡ G( u1 , ..., uN ) ≡ G(u)

N
∂ N G(F1 (e1 ), ..., FN (eN )) Y
f (e) = = g (u) × fi (ei )
∂e1 ...∂eN i=1

T
X T X
X N
=⇒ log L = log g(ut ) + log fi (ei,t )
t=1 t=1 i=1

Standard Copulas
Normal:

 
−1 1 −1 ∗−1
g(ut ; Γ∗t ) = |Γ∗t | 2 0 −1
exp − Φ (ut ) (Γt − I)Φ (ut )
2
where Φ−1 (ut ) refers to the N × 1 vector of standard inverse univariate normals, and the
correlation matrix Γ∗t pertains to the N × 1 vector e∗t with typical element,

e∗i,t = Φ−1 (ui,t ) = Φ−1 (Fi (ei,t )).

– Often does not allow for sufficient dependence between tail events.
– t copula
– Asymmetric t copula
Asymmetric Tail Correlations
Multivariate Distribution Simulation (General Case)
Simulate using:

1/2
Rt = Ω̂t Zt

Zt ∼ i.i.d.(0, I)

– Zt may be drawn from parametrically-(Gaussian, t, ...) or nonparametrically-fitted

 VOLATILITY DYNAMICS 167

16 Developed Markets, 1973−2009

0.5

Empirical
Gaussian
0.4 DECO

0.3
Threshold Correlation

0.2

0.1

0
−1 −0.5 0 0.5 1
Standard Deviation

Figure 10.19: Average Threshold Correlations for Sixteen Developed Equity Markets. The
solid line shows the average empirical threshold correlation for GARCH residuals across sixteen developed
equity markets. The dashed line shows the threshold correlations implied by a multivariate standard normal
distribution with constant correlation. The line with square markers shows the threshold correlations from a
DECO model estimated on the GARCH residuals from the 16 equity markets. The figure is based on weekly
returns from 1973 to 2009.

distributions, or with replacement from the empirical distribution.

Multivariate Distribution Simulation (Factor Case)
Simulate using:

1/2
Ft = Ω̂F,t ZF,t

Rt = λ̂ Ft + νt

– ZF,t and νt may be drawn from parametrically- or nonparametrically-fitted distributions,

or with replacement from the empirical distribution.

Rigorous Modeling VI
Risk, Return and Macroeconomic Fundamentals
We Want to Understand the Financial / Real Connections
Statistical vs. “scientific” models
Returns ↔ Fundamentals
r↔f
Disconnect?
“excess volatility,” “disconnect,” “conundrum,” ...
µr , σr , σf , µf
Links are complex:
µr ↔ σr ↔ σf ↔ µf
Volatilities as intermediaries?
For Example...
 168 CHAPTER 10

Mean Recession Standard Sample

Volatility Increase Error Period
Aggregate Returns 43.5% 3.8% 63Q1-09Q3
Firm-Level Returns 28.6% 6.7% 69Q1-09Q2

Table 10.1: Stock Return Volatility During Recessions. Aggregate stock-return volatility is quar-
terly realized standard deviation based on daily return data. Firm-level stock-return volatility is the cross-
sectional inter-quartile range of quarterly returns.

Mean Recession Standard Sample

Volatility Increase Error Period
Aggregate Growth 37.5% 7.3% 62Q1-09Q2
Firm-Level Growth 23.1% 3.5% 67Q1-08Q3

Table 10.2: Real Growth Volatility During Recessions. Aggregate real-growth volatility is quarterly
conditional standard deviation. Firm-level real-growth volatility is the cross-sectional inter-quartile range of
quarterly real sales growth.

GARCH σr usually has no µf or σf :

2 2 2
σr,t = ω + αrt−1 + βσr,t−1 .

One might want to entertain something like:

2 2 2
σr,t = ω + αrt−1 + βσr,t−1 + δ1 µf,t−1 + δ2 σf,t−1 .

µf ↔ σr
Return Volatility is Higher in Recessions
Schwert’s (1989) “failure”: Very hard to link market risk to expected fundamentals (lever-
age, corporate profitability, etc.).
Actually a great success:
Key observation of robustly higher return volatility in recessions!
– Earlier: Officer (1973)
– Later: Hamilton and Lin (1996), Bloom et al. (2009)
Extends to business cycle effects in credit spreads via the Merton model
µf ↔ σr , Continued
Bloom et al. (2009) Results
µf ↔ σf
Fundamental Volatility is Higher in Recessions
More Bloom, Floetotto and Jaimovich (2009) Results
σf ↔ σr
Return Vol is Positively Related to Fundamental Vol
Follows immediately from relationships already documented
Moreover, direct explorations provide direct evidence:
– Engle et al. (2006) time series
VOLATILITY DYNAMICS 169

– Diebold and Yilmaz (2010) cross section

– Engle and Rangel (2008) panel
Can be extended to fundamental determinants of correlations (Engle and Rangle, 2011)
[Aside: Inflation and its Fundamental (U.S. Time Series)]

Weak inflation / money growth link

[Inflation and its Fundamental (Barro’s Cross Section)]
Strong inflation / money growth link
100

90

80

70
ΔP (% per year)

60

50

40

30

20

10

0
0 10 20 30 40 50 60 70 80 90 100

ΔM currency (% per year)

Back to σf ↔ σr : Cross-Section Evidence

 170 CHAPTER 10

Real Stock Return Volatility and Real PCE Growth Volatility, 1983-2002

Now Consider Relationships Involving the Equity Premium

?? µr ??
µr ↔ σr
“Risk-Return Tradeoffs” (or Lack Thereof)
Studied at least since Markowitz
ARCH-M characterization:

Rt = β0 + β1 Xt + β2 σt + εt

σt2 = ω + αrt−1
2 2
+ βσt−1

– But subtleties emerge...

µr ↔ µf
Odd Fama-French (1989):

rt+1 = β0 + β1 dpt + β2 termt + β3 deft + t+1

Less Odd Lettau-Ludvigson (2001):

rt+1 = β0 + β1 dpt + β2 termt + β3 deft + β4 cayt + t+1

Natural Campbell-Diebold (2009):

rt+1 = β0 + β1 dpt + β2 termt + β3 deft + β4 cayt + β5 gte + t+1
– Also Goetzman et al. (2009) parallel cross-sectional analysis
Expected Business Conditions are Crucially Important!
µr ↔ σf
Bansal and Yaron (2004)
(and many others recently)
 VOLATILITY DYNAMICS 171

(1) (2) (3) (4) (5) (6) (7)

gte -0.22 – – -0.21 -0.20 – -0.20
(0.08) – – (0.09) (0.09) – (0.10)

DPt – – 0.25 0.17 – 0.19 0.12

(0.10) (0.10) (0.12) (0.11)
DEFt – – -0.11 -0.01 – -0.10 0.00
(0.07) (0.09) (0.08) (0.09)
T ERMt – – 0.15 0.17 – 0.09 0.11
(0.07) (0.07) (0.09) (0.09)
CAYt – 0.24 – – 0.22 0.17 0.15
(0.07) (0.08) (0.11) (0.10)

So, Good News:

We’re Learning More and More About the Links
– We’ve Come a Long Way Since Markowitz:
µr ↔ σr
The Key Lesson
The business cycle is of central importance for both µr and σr
– Highlights the importance of high-frequency business cycle monitoring. We need to
interact high-frequency real activity with high-frequency financial market activity
e.g., Aruoba-Diebold-Scotti real-time framework at Federal Reserve Bank of Philadelphia
Conclusions

• Reliable risk measurement requires conditional models that allow for time-varying
volatility.

• Risk measurement may be done using univariate volatility models. Many important
recent developments.

• High-frequency return data contain a wealth of volatility information.

• Other tasks require multivariate models. Many important recent developments, espe-
cially for N large. Factor structure is often useful.

• The business cycle emerges as a key macroeconomic fundamental driving risk.

• New developments in high-frequency macro monitoring yield high-frequency real ac-

tivity data to match high-frequency financial market data.

****************************
Models for non-negative variables (from Minchul)
Introduction Motivation: Why do we need dynamic models for positive values?

• Volatility: Time-varying conditional variances

 172 CHAPTER 10

• Duration: Intertrade duration, Unemployment spell

• Count: Defaults of U.S. corporations

Autoregressive Gamma processes (ARG)

• Gourieroux and Jasiak (2006)

• Monfort, Pegoraro, Renne and Roussellet (2014)

Alternative model

• ACD (autoregressive conditional duration) by Engle and Russell (1998)

• Its extension through Dynamic conditional score models

– Harvey (2013)
– Creal, Koopman, and Lucas (2013)
Autoregressive Gamma Processes
Autoregressive Gamma Processes (ARG): Definition Definition: Yt follows the autoregressive gamma
process if

Yt conditional on Yt−1 follows the non-central gamma distribution with

• degree of freedom parameter: δ
• non-centrality parameter: βYt−1
• scale parameter: c

Very exotic ... but we can guess

• Gamma distribution –¿ Maybe it takes positive values
• Conditional dynamics through non-centrality parameter
ARG Processes: State space representation If Yt follows ARG, then

Measurement:
Yt Zt ∼ Gamma(δ + Zt , c)

Transition:
Zt Yt−1 ∼ P oisson(βYt−1 )
 BAYES 173

• Yt takes positive real number

• Zt takes positive integer
• Dynamics through Zt

Conditional moments Measurement:

Yt Zt ∼ Gamma(δ + Zt , c)

Transition:
Zt Yt−1 ∼ P oisson(βYt−1 )

Conditional moments:

E(Yt |Yt−1 ) = ρYt−1 + cδ

V (Yt |Yt−1 ) = 2ρcYt−1 + c2 δ
Corr(Yt , Yt−h ) = ρh

where ρ = βc > 0.

The process is stationary when ρ < 1.

Conditional over-dispersion The conditional over-dispersion exists if and only if

V (Yt |Yt−1 ) > E(Yt |Yt−1 )2

When δ < 1,
• The stationary ARG process features marginal over-dispersion.
• The process may feature either conditional under- or over-dispersion, depending on the value of Yt−1 .

Remark: ACD (autoregressive conditional duration) model assumes the path-indepednet over-dispersion.
Continuous time limit of ARG(1) The stationary ARG process is a discretized version of the CIR process.
p
dYt = a(b − Yt )dt + σ Yt dWt

where

a = − log ρ
cδ
b=
1−ρ
−2 log ρ
σ2 = c
1−ρ

• This process is non-negative almost surely.

– Originally model for interest rates.

– Also used for volatility dynamics.
 174 CHAPTER 10

Figure 10.20: Simulated data, ρ = 0.5

Figure 10.21: Simulated data, ρ = 0.9

Long memory Case 1) Let ρ = 1, then

• Yt is a stationary Markov process.

• An autocorrelation function with a hyperbolic rate of decay.

Case 2) Stochastic autoregressive coefficient. Let ρ ∼ π. Then

Corr(Yt , Yt−h |δ, c, π) = Eπ (ρh )

The autocorrelation function features hyperbolic decay when the distribution π assigns sufficiently large
probabilities to values close to one.
Figures 1

Application in the original paper

Measurement:
Yt Zt ∼ Gamma(δ + Zt , c)

Transition:
Zt Yt−1 ∼ P oisson(βYt−1 )

• Yt : Interquote durations of the Dayton Mining stock traded on the Toronto Stock Exchange in October
1998.
• Estimation based on QMLE

Extension Creal (2013) considers the following non-linear state space

 BAYES 175

Measurement

yt ∼ p(yt |ht , xt ; θ)

where xt is an exogenous regressor.

Transition

ht ∼ Gamma(δ + zt , c)
zt ∼ P oisson(ρht−1 )

• When yt = ht , the process becomes ARG.

• Various applications are fall into this form.

Example 1: Stochastic volatility models Measurement

p
yt = µ + xt β + ht et , et ∼ N (0, 1)

Transition

ht ∼ Gamma(δ + zt , c)
zt ∼ P oisson(ρht−1 )

Example 2: Stochastic duration and intensity models Measurement

yt ∼ Gamma (α, ht exp(xt β))

Transition

ht ∼ Gamma(δ + zt , c)
zt ∼ P oisson(ρht−1 )

Example 3: Stochastic count models Measurement

yt ∼ P oisson (ht exp(xt β))

Transition

ht ∼ Gamma(δ + zt , c)
zt ∼ P oisson(ρht−1 )

Recent extension: ARG-zero processes 1 Monfort, Pegoraro, Renne, Roussellet (2014) extend ARG process
to take account for zero-lower bound spells,

Recent extension: ARG-zero processes 2 Monfort, Pegoraro, Renne, Roussellet (2014) extend ARG process
to take account for zero-lower bound spells,
 176 CHAPTER 10

If Yt follows ARG, then

Yt Zt ∼ Gamma(δ + Zt , c)
Zt Yt−1 ∼ P oisson(βYt−1 )

If Yt follows ARG-zero, then

Yt Zt ∼ Gamma(Zt , c)
Zt Yt−1 ∼ P oisson(α + βYt−1 )

Two modifications
• δ = 0: As δ → 0, Gamma(δ, c) converges to dirac delta function.
• α is related with a probability of escaping from the zero lower bound.
Characterization Probability density for ARG-zero is
∞
X
p(Yt |Yt−1 ; α, β, c) = g(Yt , Yt−1 , α, β, c, z)1{Yt >0} + exp(−α − βYt−1 )1{Yt =0}
z=1

• Second term is consequence of δ → 0.

• If α = 0, Yt = 0 becomes an absorbing state.

Conditional moments
E[Yt |Yt−1 ] = αc + ρYt−1
and
V (Yt |Yt−1 ) = 2c2 α + 2cρYt−1
where ρ = βc.
Figure: ARG-zero

ACD and DCS

 BAYES 177

Figure 10.22: Simulated data

Autoregressive conditional duration model (ACD) Yt follows the autoregressive conditional duration
model if

yt = µt et , E[et ] = 1
µt = w + αµt−1 + βyt−1

• Because of its multiplicative form, it is classified as the multiplicative error model (MEM).
• Conditional moments

E[yt |y1:t−1 ] = µt
V (yt |y1:t−1 ) = k0 µ2t

• Conditional over-dispersion is path-independent

V (yt |y1:t−1 )
= k0
E[yt |y1:t−1 ]2

Recall that ARG process can have path-dependent over-dispersion.

Dynamic conditional score (DCS) model Dynamic conditional score model (or Generalized Autoregressive
Score model) is a general class of observation-driven model.

• Observation-driven model is a time-varying parameter model where time-varying parameter is a

function of histories of observable. For example, GARCH, ACD, ...
• DCS (GAS) model encompasses GARCH, ACD, and other observation-driven models.

The idea is very simple and pragmatic

• Give me a conditional likelihood and time-varying parameters, I will give you a law of motion for
time-varying parameters.

Convenient and general modelling strategy. I will describe it within the MEM class of model.
DCS Example: ACD 1 Recall

yt = µt et , E[et ] = 1
µt = w + αµt−1 + βyt−1
 178 CHAPTER 10

Instead, we apply DCS principle: “Give me conditional likelihood and time-varying parameters, then I
will give you a law motion”
yt = µt et , et ∼ Gamma(κ, 1/κ)
DCS Example: ACD 2
yt = µt et , et ∼ Gamma(κ, 1/κ)

Then DCS specifies a law of motion for µt as follows:

µt = w + αµt−1 + βst−1

where (w, α, β) are additional parameters and st is a scaled score,

−1
∂ log p(yt |µt , y1:t ; κ) ∂ log p(yt |µt , y1:t ; κ) 0

∂ log p(yt |µt , y1:t ; κ)
st = Et−1
∂µt ∂µt ∂µt

In this case, it happens to be

µt = w + αµt−1 + βyt−1

which is ACD.

However, a law of motion will be different with different choice of distribution – General-
ized Gamma, Log-Logistic, Burr, Pareto, and many other distributions

10.5 EXERCISES, PROBLEMS AND COMPLEMENTS

10.6 NOTES
 Chapter Eleven

Non-Linear Non-Gaussian State Space and Optimal Filtering

11.1 VARIETIES OF NON-LINEAR NON-GAUSSIAN MODELS

11.2 MARKOV CHAINS TO THE RESCUE (AGAIN): THE PARTICLE FIL-

TER

11.3 PARTICLE FILTERING FOR ESTIMATION: DOUCET’S THEOREM

11.4 KEY APPLICATION I: STOCHASTIC VOLATILITY (REVISITED)

11.5 KEY APPLICATION II: CREDIT-RISK AND THE DEFAULT OPTION

11.6 KEY APPLICATION III: DYNAMIC STOCHASTIC GENERAL EQUI-

LIBRIUM (DSGE) MACROECONOMIC MODELS

11.7 A PARTIAL “SOLUTION”: THE EXTENDED KALMAN FILTER

Familiar Linear / Gaussian State Space

αt = T αt−1 + Rηt

yt = Zαt + εt

ηt ∼ N (0, Q), εt ∼ N (0, H)

Linear / Non-Gaussian

αt = T αt−1 + Rηt

yt = Zαt + εt
180 CHAPTER 11

ηt ∼ Dη , εt ∼ Dε

Non-Linear / Gaussian

αt = Q(αt−1 , ηt )

yt = G(αt , εt )

ηt ∼ N (0, Q), εt ∼ N (0, H)

Non-Linear / Gaussian II
(Linear / Gaussian with time-varying system matrices)

αt = Tt αt−1 + Rt ηt

yt = Zt αt + εt

ηt ∼ N η , εt ∼ N ε

“Conditionally Gaussian”
White’s theorem
Non-Linear / Non-Gaussian

αt = Q(αt−1 , ηt )

yt = G(αt , εt )

ηt ∼ D η , εt ∼ Dε

(DSGE macroeconomic models are of this form)

Non-Linear / Non-Gaussian, Specialized

αt = Q(αt−1 ) + ηt

yt = G(αt ) + εt
 BAYES 181

ηt ∼ D η , εt ∼ Dε

Non-Linear / Non-Gaussian, Generalized

αt = Qt (αt−1 , ηt )

yt = Gt (αt , εt )

ηt ∼ Dtη , εt ∼ Dtε

Credit Risk Model (Nonlinear / Non-Gaussian)

Asset value of the firm Vt :

Vt = µVt−1 ηt0 , ηt0 ∼ lognormal

Firm issues liability D: Zero-coupon bond, matures at T , pays D

Equity value of the firm St :

St = max(Vt − D, 0)

From the call option structure of St , Black-Scholes gives:

St = BS(Vt )ε0t
ε0t ∼ lognormal
(ε0t captures BS misspecification, etc.)
Credit Risk Model (Nonlinear / Gaussian Form)
Taking logs makes it Gaussian, but it’s intrinsically non-linear:
ln Vt = ln µ + Vt−1 + ηt
ln St = ln BS(Vt ) + εt
ηt ∼ N, εt ∼ N
Regime Switching Model (Nonlinear / Gaussian)
! ! ! !
α1t φ 0 α1,t−1 η1t
= +
α2t 0 γ α2,t−1 η2t
!
α1t
yt = µ0 + δ I(α2t > 0) + (1, 0)
α2t

η1t ∼ N η1 η2t ∼ N η2 η1t ⊥η2t

Extensions to:
– Richer α1 dynamics (governing the observed y)
– Richer α2 dynamics (governing the latent regime)
– Richer ηt distribution (e.g., η2t asymmetric)
– More than two states
– Switching also on dynamic parameters, volatilities, etc.
 182 CHAPTER 11

– Multivariate
Stochastic Volatility Model (Nonlinear/Gaussian Form)

ht = ω + βht−1 + ηt (transition)
p
rt = eht εt (measurement)
ηt ∼ N (0, ση2 ), εt ∼ N (0, 1)
Stochastic Volatility Model (Linear/Non-Gaussian Form)

ht = ω + βht−1 + ηt (transition)
2ln|rt | = ht + 2ln|εt | (measurement)
or
ht = ω + βht−1 + ηt
yt = ht + ut
ηt ∼ N (0, ση2 ),
ut ∼ Du
– A “signal plus (non-Gaussian) noise”
components model for volatility
Realized and Integrated Volatility

IVt = φIVt−1 + ηt

RVt = IVt + εt
ε represents the fact that RV is based on less than an infinite sampling frequency.
Microstructure Noise Model
**Hasbrouck
(Non-linear / non-Gaussian)
A Distributional Statement of the Kalman Filter ****
Multivariate Stochastic Volatility with Factor Structure
***
Approaches to the General Filtering Problem Kitagawa (1987), numerical integration (linear / non-
Gaussian) More recently, Monte Carlo integration
Extended Kalman Filter (Non-Linear / Gaussian)

αt = Q(αt−1 , ηt )
yt = G(αt , εt )
ηt ∼ N, εt ∼ N
Take first-order Taylor expansions of:
Q around at−1
G around at,t−1
Use Kalman filter on the approximated system
Unscented Kalman Filter (Non-Linear / Gaussian)
Bayes Analysis of SSMs: Carlin-Polson-Stoffer 1992 JASA
“single-move” Gibbs sampler
(Many parts of the Gibbs iteration: the parameter vector, and then each observation of the state vector,
period-by-period)
Multi-move Gibbs sampler can handle non-Gaussian (via mixtures of normals), but not nonlinear.
Single-move can handle nonlinear and non-Gaussian.
 BAYES 183

Expanding S(θ̂M L ) around θ yields:

S(θ̂M L ) ≈ S(θ) + S 0 (θ)(θ̂M L − θ) = S(θ) + H(θ))(θ̂M L − θ).
Noting that S(θ̂M L ) ≡ 0 and taking expectations yields:
0 ≈ S(θ) − IEX,H (θ)(θ̂M L − θ)
or
−1
(θ̂M L − θ) ≈ IEX,H (θ).
a
Using S(θ) ∼ N (0, IEX,H (θ)) then implies:
a −1
(θ̂M L − θ) ∼ N (0, IEX,H (θ))
or
***
Case 3 β and σ 2
Joint prior g(β, σ12 ) = g(β/ σ12 )g( σ12 )
where β/ σ12 ∼ N (β0 , Σ0 ) and σ12 ∼ G( v20 , δ20 )
HW Show that the joint posterior,
p(β, σ12 /y) = g(β, σ12 )L(β, σ12 /y)
can be factored as p(β/ σ12 , y)p( σ21/y )
where β/ σ12 , y ∼ N (β1 , Σ1 )
and σ12 /y ∼ G( v21 , δ21 ),
and derive expressions for β1 , Σ1 , v1 , δ1
in terms of β0 , Σ0 , δ0 , x, and y.
Moreover, the key marginal posterior
P (β/y) = 0∞ p(β, σ12 /y)dσ 2 is multivariate t.
R

Implement the Bayesian methods via Gibbs sampling.

Linear Quadratic Business Cycle Model
Hansen and Sargent
Linear Gaussian state space system
Parameter-Driven vs. Observation-Driven Models
Parameter-driven: Time-varying parameters measurable w.r.t. latent variables
Observation-driven: Time-varying parameters measurable w.r.t. observable variables
Parameter-driven models are mathematically appealing but hard to estimate. Observation-driven models
are less mathematically appealing but easy to estimate. State-space models, in general, are parameter-driven.
Stochastic volatility models are parameter-driven, while ARCH models are observation-driven.
—–
Regime Switching
We have emphasized dynamic linear models, which are tremendously important in practice. They’re
called linear because yt is a simple linear function of past y’s or past ε ’s. In some forecasting situations,
however, good statistical characterization of dynamics may require some notion of regime switching, as
between “good” and “bad” states, which is a type of nonlinear model.
Models incorporating regime switching have a long tradition in business-cycle analysis, in which expansion
is the good state, and contraction (recession) is the bad state. This idea is also manifest in the great interest
in the popular press, for example, in identifying and forecasting turning points in economic activity. It is
only within a regime-switching framework that the concept of a turning point has intrinsic meaning; turning
points are naturally and immediately defined as the times separating expansions and contractions.
—————
Observable Regime Indicators
Threshold models are squarely in line with the regime-switching tradition. The following threshold model,
 184 CHAPTER 11

for example, has three regimes, two thresholds, and a d-period delay regulating the switches:
 (u) 

 c(u) + φ(u) yt−1 + εt , θ(u) < yt−d 

(m)
yt = c(m) + φ(m) yt−1 + εt , θ(l) < yt−d < θ(u) .
(l)
 
c(l) + φ(l) yt−1 + εt , θ(l) > yt−d .
 

The superscripts indicate “upper,” “middle,” and “lower” regimes, and the regime operative at any time t
depends on the observable past history of y – in particular, on the value of yt−d .
—————–
Latent Markovian Regimes
Although observable threshold models are of interest, models with latent states as opposed to observed
states may be more appropriate in many business, economic and financial contexts. In such a setup, time-
series dynamics are governed by a finite-dimensional parameter vector that switches (potentially each period)
depending upon which of two unobservable states is realized, with state transitions governed by a first-
order Markov process. To make matters concrete, let’s take a simple example. Let {st }T t=1 be the (latent)
sample path of two-state first-order autoregressive process, taking just the two values 0 or 1, with transition
probability matrix given by !
p00 1 − p00
M = .
1 − p11 p11
The ij-th element of M gives the probability of moving from state i (at time t − 1) to state j (at time t).
Note that there are only two free parameters, the staying probabilities, p00 and p11 . Let {yt }T t=1 be the
sample path of an observed time series that depends on {st }T
t=1 such that the density of y t conditional upon
{st } is !
1 −(yt − µst )2
f (yt |st ; θ) = √ exp .
2π σ 2σ 2
Thus, yt is Gaussian white noise with a potentially switching mean. The two means around which yt moves
are of particular interest and may, for example, correspond to episodes of differing growth rates (“booms”
and “recessions”, “bull” and “bear” markets, etc.).
Appendices

185
 Appendix A

A “Library” of Useful Books

Ait-Sahalia, Y. and Hansen, L.P. eds. (2010), Handbook of Financial Econometrics. Amsterdam: North-
Holland.

Ait-Sahalia, Y. and Jacod, J. (2014), High-Frequency Financial Econometrics, Princeton University Press.

Beran, J., Feng, Y., Ghosh, S. and Kulik, R. (2013), Long-Memory Processes: Probabilistic Properties and
Statistical Methods, Springer.

Box, G.E.P. and Jenkins, G.W. (1970), Time Series Analysis, Forecasting and Control, Prentice-Hall.

Davidson, R. and MacKinnon, J. (1993), Estimation and Inference in Econometrics, Oxford University Press.

Diebold, F.X. (1998), Elements of Forecasting, South-Western.

Douc, R., Moulines, E. and Stoffer, D.S. (2014), Nonlinear Time Series: Theory, Methods, and Applications
with R Examples, Chapman and Hall.

Durbin, J. and Koopman, S.J. (2001), Time Series Analysis by State Space Methods, Oxford University
Press.

Efron, B. and Tibshirani, R.J. (1993), An Introduction to the Bootstrap, Chapman and Hall.

Elliott, G., Granger, C.W.J. and Timmermann, A., eds. (2006), Handbook of Economic Forecasting, Volume
1, North-Holland.

Elliott, G., Granger, C.W.J. and Timmermann, A., eds. (2013), Handbook of Economic Forecasting, Volume
2, North-Holland.

Engle, R.F. and McFadden, D., eds. (1995), Handbook of Econometrics, Volume 4, North-Holland.

Geweke, J. (2010), Complete and Incomplete Econometric Models, Princeton University Press.

Geweke, J., Koop, G. and van Dijk, H., eds. (2011), The Oxford Handbook of Bayesian Econometrics, Oxford
University Press.

Granger, C.W.J. and Newbold, P. (1977), Forecasting Economic Time Series, Academic Press.

Granger, C.W.J. and Tersvirta, Y. (1996), Modeling Nonlinear Economic Relationships, Oxford University
Press.
 USEFUL BOOKS 187

Hall, P. (1992), The Bootstrap and Edgeworth Expansion, Springer Verlag.

Hammersley, J.M. and Handscomb, D.C. (1964), Monte Carlo Methods, Chapman and Hall.

Hansen, L.P. and Sargent, T.J. (2013), Recursive Models of Dynamic Linear Economies, Princeton University
Press.

Harvey, A.C. (1989), Forecasting, Structural Time Series Models and the Kalman Filter, Cambridge Uni-
versity Press.

Harvey, A.C. (1993.), Time Series Models, MIT Press.

Harvey, A.C. (2013), Dynamic Models for Volatility and Heavy Tails, Cambridge University Press.

Hastie, T., Tibshirani, R. and Friedman, J. (2001), The Elements of Statistical Learning: Data Mining,
Inference and Prediction, Springer-Verlag.

Herbst, E. and Schorfheide, F. (2015), Bayesian Estimation of DSGE Models, Manuscript.

Kim, C.-J. and Nelson, C.R. (1999), State-Space Models with Regime Switching, MIT Press.

Koop, G. (2004), Bayesian Econometrics, John Wiley.

Nerlove, M., Grether, D.M., Carvalho, J.L. (1979), Analysis of Economic Time Series: A Synthesis, Academic
Press.

Priestley, M. (1981), Spectral analysis and Time Series, Academic Press.

Silverman, B.W. (1986), Density Estimation for Statistics and Data Analysis, Chapman and Hall.

Whittle, P. (1963), Prediction and Regulation by Linear Least Squares Methods, University of Minnesota
Press.

Zellner, A. (1971), An Introduction to Bayesian Inference in Econometrics, John Wiley and Sons.
 Appendix B

Elements of Continuous-Time Processes

B.1 DIFFUSIONS

A key general reference is Karatzas and Shreve (1991).

Continuous-time white noise with finite variance is hard to define. (Why? See, for example, Priestley,
1980, pp. 156-158). Continuous-time analogs of random walks are easier to define, so they wind up playing
a more crucial role as building blocks for continuous-time processes.
A diffusion is a process with Markovian structure and a continuous (but non-differentiable) sample path.
Some important special cases:
• Standard Brownian motion

dx = dW,

where

Z t
W (t) = ε(u)du
0

(that is, it is an additive process). W(t) is the continuous-time analog of a discrete-time driftless Gaussian
random walk. Intuitively, the normality arises from central-limit considerations stemming from the
additive nature of the process. A key property of Brownian motion is its independent Gaussian increments,

iid
(W (t) − W (s)) N (0, t − s), ∀0 ≤ s ≤ t ≤ ∞
∼
Brownian motion is fundamental, because processes with richer dynamics are built up from it, via location
and scale shifts. “W” stands for “Wiener process.” Standard Brownian motion is the simplest example of
the slightly more general Wiener process.

• Wiener process. Standard Brownian motion shifted and scaled.

dx = α dt + σ dW.
Figure: Gaussian random walk with drift, optimal point and interval forecasts
Wiener process arises as the continuous limit of a discrete-time binomial tree. Discrete periods ∆t . Each
period the process moves up by ∆h w.p. p, and down by ∆h w.p. 1-p. If we take limits as ∆t → 0 and
adjust ∆h and p apropriately (as they depend on ∆t ), we obtain the Wiener process. Useful for simplified
derivatives pricing, as in Cox, Ross and Rubinstein (1979, JFE ).

• Wiener process subject to reflecting barriers

dx = α dt + σ dW.
 CONTINUOUS TIME 189

s.t. |x| < c

Figure: Gaussian random walk with drift subject to reflecting barriers.
Stationary distribution exists. Symmetry depends on whether drift exists, and if so, on the sign of the drift.
Process arises as the continuous limit of a discrete-time binomial tree subject to reflecting barriers.
Discrete periods ∆t . Each period the process moves up by ∆h w.p. p, and down by ∆h w.p. 1-p, except
that if it tries to move to c or -c, it is prohibited from doing so.

• Ito process

dx = α(x, t) dt + σ(x, t) dW
An important generalization of a Wiener process.

• Geometric Brownian motion

dx = α x dt + σ x dW.
Simple and important Ito process.
Figure: Exp of a logarithmic Gaussian random walk with drift, optimal point and interval forecasts

• Orstein-Uhlenbeck process

dx = (α + βx)dt + σdW.
Simple and important Ito process. Reverts to a mean of -α/β. Priestley (1980) shows how it arises as one
passes to continuous time when starting from a discrete-time AR(1) process.
Figure: Gaussian AR(1) with nonzero mean, optimal point and interval forecasts

• The square-root process of Cox, Ingersoll and Ross (1985, Econometrica):

√
dx = (α + βx)dt + σ xdW.
This is an important example of an Ito process – this time heteroskedastic, as the variance depends on the
level.

• Generalized CIR process (Chan et al., JOF 1992; Kroner et al.) 1

dr = (a + βr)dt + ψrγ dW
Discrete approximation:

4rt = a + βrt−1 + εt ⇒ rt = a + brt−1 + εt

εt | Ωt−1 ∼ N (0, ht )
2γ
ht = ψ 2 rt−1 ,
where
b ≡ (1 + β)
.
More precisely, let r1,t denote a ”1-aggregated” series at time t. Then

r1,t = a + br1,t−1 + ε1,t

2γ
ε1,t |Ωt−1 ∼ N (0, ψ 2 r1,t−1 ).

1 We change the notation from x to r, in keeping with the fact that the models are commonly used for

interest rates.
 190 APPENDIX B

Back substitution gives:

h−1
X h−1
X
r1,t = a bi + bh r1,t−h + bi ε1,t−i .
i=0 i=0
Thus the h-aggregated series follows:

h−1
X
rh,t = a bi + bh rh,t−1 + εh,t
i=0
h−1
!
X
εh,t |Ωt−1 ∼ N 0, b2i var(ε1,t−i ) ,
i=0
where
2γ
var(ε1,t−i ) = ψ 2 r1,t−i−1 .

Note that, although the ”discretization interval” must be set by the investigator, and is therefore
subject to discretion, from that point on the parameter estimates are (asymptotically) invariant to the
data recording interval.
• Diffusion limit of GARCH (Nelson, 1990; Drost-Werker, 1996)

drt = σt dWpt
√
dσt2 = θ(ω − σt2 ) + 2λθσt2 dWst
ω > 0, θ > 0, 0 < λ < 1, Wpt indepof Wst

Drost and Werker (1996) show that approximate discretizations are available, which follow weak-GARCH
processes and are therefore closed under temporal aggregation. They provide formulae for the
continuous-time coefficients in terms of the discrete weak-GARCH coefficients at any aggregation level.
Makes for a tidy framework bridging continuous and discrete time. See also Andersen and Bollerslev (1998).

• A Poisson Jump Diffusion

It can be shown that any additive process can be written as the sum of a Wiener process and a “jump”
process. “Jump diffusion.” In many aplications the jump part is absent. Here we consider the opposite
case, pure jump diffusion driven by Poisson jumps,

dx = α(x, t) dt + σ(x, t) dP

 0, w.p.1 − λdt

where dP =

u, w.p.λdt


and u, is a jumpsize, which can itself be a random variable.

This is an example of a non-standard Brownian motion, which is to say that the increments
are not Gaussian.
Ito’s Lemma
Let F(x, t) be a function of a diffusion, at least twice differentiable in x and once in t. Then:

2
h i
dF = ∂F ∂t
+ α(x, t) ∂F
∂x
+ 12 σ 2 (x, t) ∂∂xF2 dt + σ(x, t) ∂F
∂x
dW
Ito’s Lemma is central because we often need to characterize the diffusion followed by a
function of an underlying diffusion, as in derivatives pricing.
 CONTINUOUS TIME 191

As an example, suppose that x follows a geometric Brownian motion. Then a simple

application of Ito’s Lemma reveals that lnx follows the simple Wiener process:
dF = (α − 12 σ 2 ) dt + σ dW ,
where F = lnx.
Hence lnx is the continuous time limit of a logarithmic Gaussian random walk.

B.2 JUMPS

B.3 QUADRATIC VARIATION, BI-POWER VARIATION, AND MORE

B.4 INTEGRATED AND REALIZED VOLATILITY

B.5 REALIZED COVARIANCE MATRIX MODELING IN BIG DATA MUL-

TIVARIATE ENVIRONMENTS

B.6 EXERCISES, PROBLEMS AND COMPLEMENTS

1. A key problem in nonparametric estimation.

Estimate the drift function f (t) in:
1
dyt = f (t)dt + √ dW, t ∈ [0, 1]
N
consistently (N → ∞).

B.7 NOTES
 Appendix C

Seemingly Unrelated Regression

0 βi + ε
yit = Xit it
cov(εit , εjt ) = σij , Σ = [σij ]
i = 1, ..., N ; t = 1, ...T

Matrix form: y i = X i β i + εi , i = 1, ..., N

Stacked version:  
 1 X1
 β1
   1
y ε
X2 0 

 .   
 .   . 
 . =   ..  +  .. 
..
 
 .   
 0 . 
yN βN εN

X N

y = Xβ + ε
cov(ε) = Σ ⊗ I ≡ Ω
 −1
β̂SU R = X 0 Ω̂−1 X X 0 Ω̂−1 y
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