Time Series

“The Art of Forecasting”

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 Learning Objectives

• Describe what forecasting is

• Explain time series & its components
• Stationary and non stationary time series
• Vector autoregressions and optimal lag selection

2
 What Is Forecasting?

• Process of predicting a future event

• Underlying basis of
all business decisions
– Production
– Inventory
– Personnel
– Facilities

3
 Forecasting Approaches

Qualitative Methods Quantitative Methods

• Used when situation is
vague & little data exist
– New products
– New technology
• Involve intuition,
experience
• e.g., forecasting sales
on Internet
 Forecasting
Forecasting Approaches
Approaches

Qualitative Methods Quantitative Methods

• Used when situation is • Used when situation is
vague & little data exist ‘stable’ & historical data
– New products exist
– New technology – Existing products
• Involve intuition, – Current technology
experience • Involve mathematical
• e.g., forecasting sales techniques
on Internet • e.g., forecasting sales
of televisions
 What is a Time Series?

• Set of evenly spaced numerical data

– Obtained by observing response variable at regular time
periods
• Forecast based only on past values
– Assumes that factors influencing past, present, & future will
continue
• Example
– Year: 19951996199719981999
– Sales: 78.763.589.793.2 92.1

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 Time Series Data

• When working with time series data, it is vital that the data
is plotted so the researcher can view the data.

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Time Series Components
 Time Series Components

Trend
 Time Series Components

Trend Cyclical
 Time Series Components

Trend Cyclical

Seasonal
 Time Series Components

Trend Cyclical

Seasonal Irregular
 Trend Component

• Persistent, overall upward or downward

pattern
• Due to population, technology etc.
• Several years duration

Response

Mo., Qtr., Yr.

 Trend Component

• Overall Upward or Downward Movement

• Data Taken Over a Period of Years
d t rend
Sales Upwar

Time
 Cyclical Component

• Repeating up & down movements

• Due to interactions of factors influencing
economy
• Usually 2-10 years duration
Cycle
Response

Mo., Qtr., Yr.

 Cyclical Component

• Upward or Downward Swings

• May Vary in Length
• Usually Lasts 2 - 10 Years
Sales Cycle

Time
 Seasonal Component

• Regular pattern of up & down fluctuations

• Due to weather, customs etc.
• Occurs within one year

Summer
Response

Mo., Qtr.
 Seasonal Component

• Upward or Downward Swings

• Regular Patterns
• Observed Within One Year
Sales Winter

Time (Monthly or Quarterly)

 Irregular Component

• Unpredictable, unsystematic, ‘residual’

fluctuations
• Due to random variation or unforeseen events
– Union strike
– War
• Short duration &
nonrepeating

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 Random or Irregular Component

• Irregular, Nonsystematic, Random, ‘Residual’

Fluctuations

• Due to Random Variations of

– Nature

– Accidents

• Short Duration and Non-repeating

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 Introduction To Stationary And
Non-Stationary Processes

• Researchers often use financial time series data (such as

asset prices, exchange rates, GDP, inflation and other
macroeconomic indicators).

• But refining data is key to being able to apply it to your

analysis.

• Following discussion will show you how to isolate the data

points that are relevant to your research.

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 Cooking Raw Data

• Data points are often non-stationary or have means,

variances and covariances that change over time.

• Non-stationary behaviors can be trends, cycles, random

walks or combinations of the three.

• Non-stationary data, as a rule, are unpredictable and

cannot be modeled or forecasted.

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 Cooking Raw Data

• The results obtained by using non-stationary time series

may be spurious in that they may indicate a relationship
between two variables where one does not exist.

• In order to receive consistent, reliable results, the non-

stationary data needs to be transformed into stationary
data.

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 Cooking Raw Data

• In contrast to the non-stationary process that has a variable

variance and a mean that does not remain near, or returns
to a long-run mean over time, the stationary process reverts
around a constant long-term mean and has a constant
variance independent of time.

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Non-Stationary Behavior

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

• To use a variable into a time series model we must have to
convert it into stationary variable.
• First of all view graph of variable.
• To detect stationary or non stationary time series we’ll use
Correlogram (Q statistics).

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

30
 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

• Correlogram or Q statistics
H0: Variable is stationary (Stationary)
HA: Variable is not stationary (Non Stationary)

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

H0: Variable is stationary (Stationary)
HA: Variable is not stationary (Non Stationary)
• As p value is less than 5% for all lags so we can reject the
Null Hypothesis.
• So variable is not stationary we must convert it into
stationary in order to use it in time series model.
• Method: First difference method

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

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 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

38
 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

39
 Eviews: How to convert a
variable into stationary?

• File Name: how to convert variable into stationary

H0: Variable is stationary (Stationary)
HA: Variable is not stationary (Non Stationary)
• As p value is more than 5% for all lags so we cannot reject
the Null Hypothesis.
• So variable is stationary. We can use it in our time series
models.

40
 Types of Non-Stationary
Processes

• Now we should distinguish between the different types of

the non-stationary processes.

• Examples of non-stationary processes are random walk

with or without a drift (a slow steady change) and
deterministic trends (trends that are constant, positive or
negative.

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 Types of Non-Stationary
Processes

 Random Walk with Drift or Intercept only (Yt = α + Yt-1 + εt )

 Deterministic Trend or Trend and Intercept (Yt = α + βt + εt )

 Pure Random Walk or No Trend, No Intercept (Yt = Yt-1 + εt )

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 Random Walk with Drift
(Yt = α + Yt-1 + εt ) Intercept only

• If the random walk model predicts that the value at time

"t" will equal the last period's value plus a constant, or drift
(α), and a white noise term (εt), then the process is
random walk with a drift.

• It also does not revert to a long-run mean and has

variance dependent on time.

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 Deterministic Trend
(Yt = α + βt + εt ) Trend and Intercept

• Often a random walk with a drift is confused for a

deterministic trend.

• Both include a drift and a white noise component, but the

value at time "t" in the case of a random walk is regressed
on the last period's value (Yt-1), while in the case of a
deterministic trend it is regressed on a time trend (βt).

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 Pure Random Walk
(Yt = Yt-1 + εt ) No Trend, No Intercept

• Random walk predicts that the value at time "t" will be

equal to the last period value plus a stochastic (non-
systematic) component that is a white noise, which means
εt is independent and identically distributed with mean "0"
and variance "σ²".

• It is a non mean reverting process that can move away

from the mean either in a positive or negative direction.

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 Pure Random Walk
(Yt = Yt-1 + εt ) No Trend, No Intercept

• Another characteristic of a random walk is that the

variance evolves over time and goes to infinity as time
goes to infinity; therefore, a random walk cannot be
predicted.

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 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Types of non stationary behavior:

• Intercept only (Yt = α + Yt-1 + εt )

• Trend and Intercept (Yt = α + βt + εt )

• No Trend, No Intercept (Yt = Yt-1 + εt )

• Eviews Test: Unit Root Test (Augmented Dickey-Fuller

test)
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 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

48
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

49
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

50
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Unit Root Test (Augmented Dickey-Fuller test)

H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

51
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Intercept only (Yt = α + Yt-1 + εt )

52
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

53
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 6.89% so we cannot reject the null

hypothesis.
H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

54
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

55
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Trend and Intercept (Yt = α + βt + εt )

56
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

57
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 10.38% so we cannot reject the null

hypothesis.
H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

58
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

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 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• No Trend, No Intercept (Yt = Yt-1 + εt )

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 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

61
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 11.15% so we cannot reject the null

hypothesis.
H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

62
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• How to remove Unit root or non stationary behavior of

variable?

• Method: First Difference Method

63
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

64
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Intercept only (Yt = α + Yt-1 + εt )

65
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

66
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 0.22% so we can reject the null hypothesis.

H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

67
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

68
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• Trend and Intercept (Yt = α + βt + εt )

69
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

70
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 0.70% so we can reject the null hypothesis.

H0: Variable is not stationary (got a unit root)
HA: Variable is stationary

71
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

72
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

• No Trend, No Intercept (Yt = Yt-1 + εt )

73
 How to detect and remove non
stationary behavior (Unit Root test)

• File Name: Unit root test to detect non stationarity

74
 How to detect and remove non
stationary behavior (Unit Root test)
• File Name: Unit root test to detect non stationarity

• In order to conduct Augmented Dicky Fuller test the

coefficient of lagged value Y(-1) or Y lag must be
negative.

• As p-value is 0.02% so we can reject the null hypothesis.

H0: Variable is not stationary (got a unit root)
HA: Variable is stationary
• We can use D(Y) instead of Y in our model because Y
has a unit root problem (Not Stationary).
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OPTIMAL LAG SELECTION
IN VECTOR
AUTOREGRESSION (VAR)

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 Optimal Lag Selection in VAR

• If variables are not co-integrated---unrestricted VAR

• If variables are co-integrated---restricted VAR (vectror

error correction mechanism)

• How many lags we should include?

• There are many ways to choose optimal lag one of the

most commonly used is Akaike Information Criterion
(AIC).

• The lower the AIC value, better the model.

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• If we have two variables y and x, then VAR.

• Y = β11 Yt – 1 + β12 Xt – 1 + α13

• X = β21 Yt – 1 + β22 Xt – 1 + α23

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• So the AIC is 6.69

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• Y = β11 Yt – 1 + β12 Xt – 1 + α13

• X = β21 Yt – 1 + β22 Xt – 1 + α23

85
 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

87
 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• AIC = 6.43
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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• AIC = 6.19
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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• AIC = 6.38
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 Optimal Lag Selection in VAR

• File Name: Optimal Lag Selection

• AIC with one lag model = 6.69

• AIC with two lags model = 6.43

• AIC with three lags model = 6.19

• AIC with four lags model = 6.38

• So model with 3 lags is better as compare to other models.

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 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

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 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

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 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

98
 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

99
 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

100
 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

101
 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

102
 Optimal Lag Selection in VAR
(Alternative Method)

• File Name: optimal lag selection (with two

independent variables)

• If we are using AIC then we should use 7 lags in our

vector autoregressive or vector error correction models.
As AIC is minimum at 7th lag.

103
Cointegration

104
 Cointegration

• Cointegration Definition

• Cointegration is an econometric technique for testing the

correlation between non-stationary time series variables.

• If two or more series are themselves non-stationary, but a

linear combination of them is stationary, then the series
are said to be cointegrated.

• For instance, a stock index and the price of its associated

futures contract move through time, each roughly
following a random walk.
105
 Cointegration

• Cointegration Definition

• Testing the hypothesis that there is a statistically

significant connection between the future price and the
spot price could now be done by finding a cointegrating
vector.

• If such a vector has a low order of integration it can signify

an equilibrium relationship between the original series,
which are said to be cointegrated of an order below one.

106
 Cointegration

• Suppose you see two drunks (i.e., two random walks)

wandering around.

• The drunks don't know each other (they're independent),

so there's no meaningful relationship between their paths.

• But suppose instead you have a drunk walking with his

dog.

• This time there is a connection.

107
 Cointegration

• For example, if the dog wanders too far away from his
owner, he'll tend to move in his direction to avoid losing
him, so the two stay close together despite a tendency to
wander around on their own.

• We describe this relationship by saying that the drunk

and his dog form a cointegrating pair.

• Another example: A book and its movie adaptation:

while the book and the movie may differ in small details,
the overall plot will remain the same.
108
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• We want to check whether their exist a long run

association-ship (cointegration) between variables.

109
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

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 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

111
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• All variables should be at levels.

112
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• I believe that there is a trend in variables. So we’ll choose 3.

113
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• We’ll get two statistics:

i. Trace Statistics
ii. Max-Eigen Statistics

114
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

115
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• Trace Statistics:

116
 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• Max-Eigen Statistics

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 Johansen Cointegration Test

• File Name: Johansen Cointegration Test

• Conclusion:

• If variables are cointegrated then we cannot use VAR

(vector auto regression), we must use VECM (vector error
correction mechanism)

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