Chapter 6

Univariate time series modeling and

forecasting

1
 I. Time Series: Introduction

Time Series: collection of observations made sequentially through time

Objectives of Time Series Analysis:
-Description: using summary statistics and/or graphical methods (Time Plot)
-Modeling: to find suitable statistical model to describe the Data-Generating-
Process.
-Univariate Model of a variable is based only on past values of that
variable
-Structural Model: based on present and past values of other variables
-Forecasting (Predicting): to estimate future values of the series.
-Control: good forecasts enable the analyst to take action so as to control a
given process (economic or industrial)
 Time Series and Forecasting

“Don’t never prophesy: if you prophesy right, nobody is going to remember and if
you prophesy wrong, nobody is going to let you forget”

Mark Twain

Applications of Time Series forecasting include:

- Economic Planning
- Sales forecasting
- Inventory control
- Production and Capacity Planning
- Budgeting
- Financial Risk Management
 II. Univariate Time Series Models: Notations and Concepts

• Where we attempt to predict returns using only information contained in their

past values.

• A Strictly Stationary Process

A strictly stationary process is one where
P{yt1  b1,..., ytn  bn}  P{yt1  m  b1,..., ytn  m  bn}
i.e. the probability measure for the sequence {yt} is the same as that for {yt+m}  m.

• A Weakly Stationary Process

If a series satisfies the next three equations, it is said to be weakly or covariance
stationary
1. E(yt) =  , t = 1,2,...,
2. E ( yt   )( yt   )   2  
3. E ( yt   )( yt   )   t  t  t1 , t2
1 2 2 1
 Univariate Time Series Models (cont’d)

• So if the process is covariance stationary, all the variances are the same and all
the covariances depend on the difference between t1 and t2. The moments
E ( yt  E ( yt ))( yt  s  E ( yt  s ))   s , s = 0,1,2, ...
are known as autocovariances.

• However, the value of the autocovariances depend on the units of measurement

of yt.
• It is thus more convenient to use the autocorrelations which are the
autocovariances normalised by dividing by the variance:
 s , s = 0,1,2, ...
 s
0
• If we plot s against s=0,1,2,... then we obtain the autocorrelation function
(ACF, acf) or correlogram.
 A White Noise Process (purely randomly process)

• A white noise process is one with (virtually) no discernible structure. A

definition of a white noise process is
E (ut )  
Var (ut )   2
 2 if s  0
s  
0 otherwise

Autocorrelation function will be zero apart from a single peak of 1 at s = 0.

• If ut is further normally distributed then s  approximately N(0,1/T)

where T = sample size and s denotes the autocorrelation at lag s

• We can use this to do significance tests for the autocorrelation coefficients

by constructing a confidence interval.
 Single Tests: s =0

• s  approximately N(0,1/T) where T = sample size and s denotes the
autocorrelation at lag s
• We can use this to do significance tests for the autocorrelation coefficients
by constructing a confidence interval.

• H0: true value of the autocorrelation coefficient at lag s is zero: s =0

1
• For example, a 95% confidence interval would be given by  .196 
T.

• If the sample autocorrelation coefficient, s , falls outside this region for
any value of s, then we reject the null hypothesis that the true value of the
autocorrelation coefficient at lag s is zero.
 Joint Hypothesis Tests: 1 =0, 2=0,…, m =0
(Data are independently distributed)

• We can also test the joint hypothesis that all m of the k autocorrelation
coefficients are simultaneously equal to zero using the Q-statistic developed
by Box and Pierce: m
Q  T   k2
k 1
where T = sample size, m = maximum lag length
• The Q-statistic is asymptotically distributed as a  m.
2

• However, the Box Pierce test has poor small sample properties, so a variant
has been developed, called the Ljung-Box statistic:
m
 k2
Q  T T  2

~  m2
k 1 T k
• This statistic is very useful as a portmanteau (general) test of linear
dependence in time series.
 An ACF Example

• Question:
Suppose that a researcher had estimated the first 5 autocorrelation coefficients
using a series of length 100 observations, and found them to be (from 1 to 5):
0.207, -0.013, 0.086, 0.005, -0.022.
a) Test each of the individual coefficient for significance
b) Use both the Box-Pierce and Ljung-Box tests to establish whether
they are jointly significant.

• Solution:
a) A coefficient would be significant if it lies outside (-0.196,+0.196) at the
5% level, so only the first autocorrelation coefficient is significant.
b) Q=5.09 and Q*=5.26
Compared with a tabulated 2(5)=11.07 at the 5% level, so the 5 coefficients
are jointly insignificant (low power of the joint test when 1 single
coefficient is significant).
 III. Moving Average Processes

• Let ut (t=1,2,3,...) be a white noise process with:

E(ut)=0 and Var (ut )   , then
2

yt =  + ut + 1ut-1 + 2ut-2 + ... + qut-q

is a qth order moving average model MA(q).

• Its properties are:

E(yt)=;
Var(yt) = 0 = (1+ 12   22 ... q2 )2
Covariances

( s   s 1 1   s  2 2  ...   q q  s ) 2 for s  1,2,..., q

s 
0 for s  q
MA(q) is stationary
 Example of an MA Problem

1. Consider the following MA(2) process:

where t is a zero mean white noise process with variance .

(i) Calculate the mean and variance of Xt
(ii) Derive the autocorrelation function for this process (i.e. express
the autocorrelations, 1, 2, ... as functions of the parameters 1 and
2).
(iii) If 1 = -0.5 and 2 = 0.25, sketch the ACF of Xt.
 Solution

(i) If E(ut)=0, then E(ut-i)=0  i.

So

E(Xt) = E(ut + 1ut-1+ 2ut-2)= E(ut)+ 1E(ut-1)+ 2E(ut-2)=0

Var(Xt) = E[Xt-E(Xt)][Xt-E(Xt)]
but E(Xt) = 0, so
Var(Xt) = E[(Xt)(Xt)]
= E[(ut + 1ut-1+ 2ut-2)(ut + 1ut-1+ 2ut-2)]
= E[ u t2   12 u t21   22 u t2 2 +cross-products]

But E[cross-products]=0 since Cov(ut,ut-s)=0 for s0.

 Solution (cont’d)

So Var(Xt) = 0= E [ ]
=
= (1   1   2 )
2 2 2

(ii) The ACF of Xt.

1 = E[Xt-E(Xt)][Xt-1-E(Xt-1)]
= E[Xt][Xt-1]
= E[(ut +1ut-1+ 2ut-2)(ut-1 + 1ut-2+ 2ut-3)]
= E[(  1u t 1   1 2 u t  2 )]
2 2

=  1  2   1 2  2
= ( 1   1 2 ) 2
 Solution (cont’d)

2 = E[Xt-E(Xt)][Xt-2-E(Xt-2)]
= E[Xt][Xt-2]
= E[(ut +1ut-1+2ut-2)(ut-2 +1ut-3+2ut-4)]
= E[(  2 u t2 2 )]
=  2
2

3 = E[Xt-E(Xt)][Xt-3-E(Xt-3)]
= E[Xt][Xt-3]
= E[(ut +1ut-1+2ut-2)(ut-3 +1ut-4+2ut-5)]
=0

So s = 0 for s > 2.
 Solution (cont’d)

We have the autocovariances, now calculate the autocorrelations:


0   0  1
0
1 ( 1   1 2 ) 2 ( 1   1 2 )
1   
 0 (1   12   22 ) 2 (1   12   22 )
2 ( 2 ) 2 2
2   
 0 (1   12   22 ) 2 (1   12   22 )

3   3  0
0

s   s  0s  2
0

(iii) For 1 = -0.5 and 2 = 0.25, substituting these into the formulae above
gives 1 = -0.476, 2 = 0.190.
 IV. Autoregressive Processes

• An autoregressive model of order p, an AR(p) can be expressed as

y t     1 y t 1   2 y t  2  ...   p y t  p  u t
where ut is a white noise process with zero mean.
• Or using the lag operator notation:
Lyt = yt-1 Liyt = yt-i
p
y t      i y t i  u t
i 1
p
• or y t      i Li y t  u t
i 1

or  ( L) y t    u t where  ( L)  1  (1 L  2 L2 ... p Lp ) .

 The Stationary Condition for an AR Model

• The condition for stationarity of a general AR(p) model is that the

roots of 1  1z   2 z ... p z  0 all lie outside the unit circle i.e. |z|>1
2 p

• A stationary AR(p) model is required for it to have an MA()

representation.

• Example 1 (Random walk): Is yt = yt-1 + ut stationary?

The characteristic root is 1, so it is a unit root process (so non-stationary)

• Example 2: Is yt = 2yt-1 - 2.75yt-2 + 0.75yt-3 +ut stationary?

 Wold’s Decomposition Theorem

• An AR(p) stationary series with no constant and no other terms can be

expressed as MA(∞)

• For the AR(p) model  ( L) y t  u t , ignoring the intercept, the Wold

decomposition is

y t   ( L)u t
where,

 ( L)  (1  1 L  2 L2 ... p Lp ) 1
 Characteristics of an Autoregressive Process

• The moments of an autoregressive process are as follows. The mean is given

by
E ( yt )  
1 1  2  ...   p

• The autocovariances and autocorrelation functions can be obtained by

solving what are known as the Yule-Walker equations:
1  1  12  ...   p 1 p
 2  11  2  ...   p  2 p
  
 p   p 11   p  22  ...   p
• If the AR model is stationary, the ACF will decay geometrically to zero.
 Example 5.4

Consider the following simple AR(1) model

yt    1 yt 1  ut
(i) Given that the series is stationary, calculate the (unconditional)
mean of yt

For the remainder of the question, set =0 for simplicity.

(ii) Calculate the (unconditional) variance of yt.

(iii) Derive the autocorrelation function for yt.

 V. The Partial Autocorrelation Function (denoted kk )

• Measures the correlation between an observation k periods ago and the

current observation, after controlling for observations at intermediate lags
(i.e. all lags < k).

• So kk measures the correlation between yt and yt-k after removing the effects
of yt-k+1 , yt-k+2 , …, yt-1 .

• At lag 1, the ACF = PACF: 11 = 1

• At lag 2, 22 = (2-12) / (1-12)

• For lags 3+, the formulae are more complex.

 The Partial Autocorrelation Function (denoted kk)
(cont’d)

• The PACF is useful for telling the difference between an AR process and
an ARMA process.

• In the case of an AR(p), there are direct connections between yt and yt-s only
for s p.

• So for an AR(p), the theoretical PACF will be zero after lag p.

• In the case of an MA(q), if it is invertible (roots of characteristic equations

(z)=0 lie outside the unit circle), it can be written as an AR(), so there are
direct connections between yt and all its previous values.

• For an MA(q), the theoretical PACF will be geometrically declining.

 VI. ARMA Processes

• By combining the AR(p) and MA(q) models, we can obtain an

ARMA(p,q) model:  ( L) y     ( L)u
t t

where  ( L)  1  1 L  2 L2 ... p Lp

and  ( L)  1  1L   2 L  ...   q L

2 q

or y t    1 y t 1   2 y t  2  ...   p y t  p   1u t 1   2 u t  2  ...   q u t  q  u t

with E (u t )  0; E (ut )   ; E (ut u s )  0, t  s

2 2
 The Invertibility Condition

• Similar to the stationarity condition, we typically require the MA(q) part of

the model to have roots of (z)=0 greater than one in absolute value.

• The mean of an ARMA series is given by


E ( yt ) 
1  1  2 ...p

• Remark: The ACF for an ARMA process will display combinations of

behaviour derived from the AR and MA parts
 Summary of the Behaviour of the ACF for
AR and MA Processes

An autoregressive process AR(p) has

• a geometrically decaying ACF
• number of non-zero points of PACF = AR order =p

A moving average process MA(q) has

• Number of non-zero points of ACF = MA order =q
• a geometrically decaying PACF

ARMA models have both ACF and PACF geometrically decaying to 0.

 VII. Building ARMA Models
- The Box Jenkins Approach

• Box and Jenkins (1970) were the first to approach the task of estimating
an ARMA model in a systematic manner. There are 3 steps to their
approach:

1. Identification
2. Estimation
3. Model diagnostic checking

Step 1: Identification

- Involves determining the order of the model.

- Use of graphical procedures (Time plot, ACF, PACF)
 Building ARMA Models
- The Box Jenkins Approach (cont’d)

Step 2: Estimation
- Estimation of the parameters
- Can be done using least squares or maximum likelihood depending
on the model.

Step 3: Model diagnostic checking

Box and Jenkins suggest 2 methods:

- overfitting (fitting a larger model than required to capture the
dynamics of the data, extra terms would be insignificant)
- residual diagnostics (checking the residuals for evidence of linear
dependence: ACF, PACF, Ljung-Box Test. If linear dependence is
present, the model is not appropriate). More common.
 Some More Recent Developments in
ARMA Modelling
• We want to form a parsimonious model: one with all features of data using
as few parameters as possible

• This gives motivation for using information criteria, which embody 2

factors:
- a term which is a function of the RSS (fitness of the model)
- some penalty for adding extra parameters (parsimonious model)

• The objective is to choose the parameters which minimise the

information criterion.
 Information Criteria for Model Selection

• The information criteria vary according to how stiff the penalty term is.
• The three most popular criteria are Akaike’s (1974) information criterion (AIC),
Schwarz’s (1978) Bayesian information criterion (SBIC), and the Hannan-
Quinn criterion (HQIC).
AIC  ln( 2 )  2 k / T
k
SBIC  ln(ˆ 2 )  ln T
T
2k
HQIC  ln(ˆ 2 )  ln(ln(T ))
T
where k = p + q + 1, T = sample size. So we min. IC s.t. p  p, q  q
SBIC embodies a stiffer penalty term than AIC.
• Which IC should be preferred if they suggest different model orders?
– SBIC is strongly consistent but inefficient.
– AIC is not consistent, but more efficient, and will typically pick “bigger”
models.
 ARIMA Models

• As distinct from ARMA models, the I stands for integrated.

• An integrated autoregressive process is one with a characteristic root

on the unit circle.

• Typically researchers difference the variable as necessary and then

build an ARMA model on those differenced variables.

• An ARMA(p,q) model in the variable differenced d times is

equivalent to an ARIMA(p,d,q) model on the original data.