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Universität Potsdam

Time Series Analysis


Exercises

Hans Gerhard Strohe

Potsdam 2005

1
I Typical exercises and solutions

1 For theoretically modelling the economic development of national economy scenarios


the following 2 models for GDP increment are analysed:

a. Yt = Yt-1 + at

b. Yt = 1.097 Yt-1 - 0,97 Yt-2 + at ,

where Y - GDP increment

a - White noise with zero mean and constant variance σ2=100

t - Time (quarters starting with Q1, 1993)

Check by an algebraic criterion which one is stationary.

2
Answer:

a) The process can be written


φ(L)Yt = at with the lag polynom
φ(L) = 1-L and L being the lag or backshift operator LYt.= Yt-1
From this follows the characteristic equation
φ(z) = 1-z = 0
The root, i.e. the solution of it, is z=1. It is not higher than 1, i.e. it is not placed
outside the unit circle. The process is not stationary. It is a “unit root” process or
more specific a random walk.

b) The process can be written


φ(L)Yt = at with the lag polynom
φ(L) = 1 – 1,079L + 0,97 L2.
From this follows the characteristic equation
φ(z) = 1- 1,097z + 0,97 z2 = 0
The roots (complex numbers) of it
are z1 = 0,57 + 0,84 i
z2 = 0,57 - 0,84 i
with | z1/ 2 |= 0,57 2 + 0,84 2 = 1,015 > 1.
That means that both of the roots are outside the unit circle what is a sufficient
condition for the stationarity of the process.

3
2 The variable l (=labour) in the file employees.dat denotes the quantity of labour
force, i. e. the number of employees, in a big German company from January 1995
till December 2004.

i. Display the graph of the time series lt.

ii. What are the characteristics of a stationary time series? Is the time series lt likely
to be stationary? Check it first by the naked eye.

iii. Test the stationarity of lt by a suitable procedure. Determine the degree of


integration.

iv. Estimate the correlation and the partial correlation function of the process. Give
a description and an interpretation.

v. What type of basic model could fit the time series lt. Why?

vi. Estimate the parameters concerning the model assumed in question v .

vii. Estimate alternative models and compare them by suitable indicators.

viii. Forecast the time series for 2005.

4
ix. A particular analysis method of time series lt results in the following graph.

1.6

Bartlett
1.4

1.2

Tukey

1.0

0.8

Parzen

0.6
0 1 2 3 4

Circular frequency

Fig. 1: A special diagnostic function

What is the name of this particular analysis method? What can you derive from the curve.
What should be the typical shape of the function estimated for a process type assumed in
question v?

5
Answers:

i. The graph of the time series lt.

6000

5600

5200

4800

4400

4000
95 96 97 98 99 00 01 02 03 04

Fig. 2: Graph of the employees time series

ii. The main characteristics of a stationary time series are that the mean µ t and the variance
of the stochastic process generating this special time series are independent from time t,
µ t = µ = const
σ t2 = σ 2 = const,

and that the autocovariances γ t , t depend only on the time difference τ :


1 2

γ t , t = γ t - t = γ τ with τ = t 1 – t 2 (Lag)
1 2 1 2

A check of the graph by the naked eye gives no reason to assume the time series not to be
stationary. At the first glance there does not appear any trend or relevant development of the
variance.

6
iii. Test of stationarity by DF Test.

The following Dickey Fuller regression of ∆l on lt-1 produces a t-value – 3,63. Application of
an augmented Dickey-Fuller regression is not necessary because the augmented model would
have higher values of the Schwarz criterion (SIC, version on the base of the error variance).

Table 1:
Dickey-Fuller Test Equation
Dependent Variable: ∆lt
Method: Least Squares
Sample (adjusted): 1995M02 2004M12; observations: 119

Variable Coefficient Std. Error t-Statistic Prob.

lt-1 -0.200468 0.055277 -3.626566 0.0004


C 1096.460 301.8879 3.632011 0.0004

R-squared 0.101051 Mean dependent var 2.038202


Adjusted R-squared 0.093368 S.D. dependent var 92.83931
S.E. of regression 88.39903 Akaike info criterion(σ) 11.81826
Sum squared resid 914283.5 Schwarz criterion(σ) 11.86497

The critical value of the t-statistic for a model with intercept c is -2,89 on the 5 % level:

Table 2:
Null Hypothesis: l has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=12)

t-Statistic

Test critical values: 1% level -3.486064


5% level -2.885863

The t-value measured exceeds the critical value downwards. That means that the null hypothesis
of nonstationarity or a unit root can be rejected on the 5 % level. The time series is stationary at
least with a probability of 95 %. As lt is stationary its degree of integration is 0 ( I(0)).

7
iv. Sample correlation and partial correlation functions of the process.

The sample autocorrelation function (AC) for a short series can be calculated using the formulae
for the sample autocovariance (9.7)

T −τ
∑ ( xt − x )( xt +τ − x )
cτ = t =1
T − τ

and the sample autocorrelation (9.8)



rτ =
s x2
with x and sx being the average and the standard deviation of the time series, respectively.

The partial sample autocorrelation function (PAC) can be obtained by linear OLS regression of xt
on xt-1, xt-2,…, xt-τ corresponding to formula (9.9):

xt = φ 0 + φ1τ xt −1 + ... + φττ xt −τ

The partial correlation coefficient ρpart(τ) is the coefficient φττ of the highest order lagged variable
xt-τ.

By calculating the first 5 regressions this way we obtain the following highest order coefficients
for each of them, respectively:

ф11= 0,799532; ф22= -0,037588; ф33= 0,075722; ф44= 0,008910; ф55= 0,115970

We can compare these „manually“ calculated coefficient with the partial autocorrelation
functions displayed in the following table and figure together with the sample autocorrelation
function delivered as a whole in one step by eViews. The differences between the regression
results and the eViews output probably are caused by different estimation methods.

8
Table 3:

AC PAC τ AC PAC τ AC PAC


τ
1 0.794 0.794 9 0.039 -0.008 17 -0.157 -0.066
2 0.616 -0.042 10 0.014 0.049 18 -0.154 0.038
3 0.495 0.052 11 -0.004 -0.027 19 -0.125 0.042
4 0.390 -0.028 12 -0.050 -0.092 20 -0.096 0.038
5 0.348 0.118 13 -0.061 0.069 21 -0.098 -0.083
6 0.298 -0.038 14 -0.100 -0.082 22 -0.142 -0.127
7 0.205 -0.115 15 -0.139 -0.042 23 -0.150 0.046
8 0.109 -0.083 16 -0.137 0.013 24 -0.183 -0.134

Correlogram

1,2
1
0,8
0,6
AC
0,4
PAC
0,2
0
-0,2 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

-0,4

Fig. 3: Correlogram

The bold curve shows the sample autocorrelation function. The thin one displays the partial
autocorrelation, both depending on the lag τ. While the smooth autocorrelation continuously
decreases from 1 towards zero and below to a limit of about 0,1 the partial autocorrelation starts
as well at the value 1 and has the same value as the autocorrelation for τ=1 but then drops down
to zero and remains there oscillating between -0,1 and 0,1.

9
v. Possible type of basic model fitting the time series l.

The basic model could be a first order autoregressive process , because AC is exponentially
decreasing and PAC is dropping down after τ=1. The shape of the AC is typical for the
autocorrelation of an AR process with positive coefficients. The partial autocorrelation drops
down to and remains close to zero after the lag τ=1 what indicates an AR(1) process.

vi. Estimated parameters concerning the model assumed in answer v.

Table 4:
Dependent Variable: lt
Method: Least Squares
Sample 1995M02 2004M12, observations: 119

Variable Coefficient Std. Error t-Statistic Prob.

CONST 1096.460 301.8879 3.632011 0.0004


lt-1 0.799532 0.055277 14.46398 0.0000

R-squared 0.641332 Mean dependent var 5461.386


Adjusted R-squared 0.638266 S.D. dependent var 146.9782
S.E. of regression 88.39903 Akaike info criterion 11.81826
Sum squared resid 914283.5 Schwarz criterion 11.86497

Thus we get the empirical model:


lt = 1096.5+ 0.7995 lt-1 + at

Because the t-statistic of both exceeds the 5-% critical value 1,96, both coefficients are
significant on this level, at least. The prob. values behind indicate that the even are on the 1 %
level.

10
Another way of estimation is to take advantage of the special ARMA estimation procedure of
eViews. Here first the mean of the variable is estimated and then the AR(1) coefficient of an AR
model of the deviations from the mean:
Table 5:
Dependent Variable: l
Method: Least Squares
Sample: 1995M02 2004M12; observations: 119
Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

CONST 5469.515 40.52025 134.9823 0.0000


AR(1) 0.799532 0.055277 14.46398 0.0000

R-squared 0.641332 Mean dependent var 5461.386


Adjusted R-squared 0.638266 S.D. dependent var 146.9782
S.E. of regression 88.39906 Akaike info criterion(σ) 11.81826
Sum squared resid 914284.2 Schwarz criterion(σ) 11.86497

The equivalent model obtained this way can be written:

(lt - 5469,5) = 0,7995 ( lt-1 - 5469.5) + at

11
vii. As an alternative, an ARMA(2,1) model would fit the data. It can be found by trial and
error via several different models and the aim of obtaining significant coefficients and
compared by Schwarz criterion.

As the model contains an MA term ordinary least squares is not practicable for estimating the
coefficients. Therefore again the iterative nonlinear least squares procedure by eViews is used:

Table 6:
Dependent Variable: l
Method: Least Squares
Sample 1995M03 2004M12; observations: 118
Convergence achieved after 7 iterations
Backcast: 1994M12

Variable Coefficient Std. Error t-Statistic Prob.

CONST 5469.200 37.73310 144.9444 0.0000


AR(2) 0.600156 0.093632 6.409735 0.0000
MA(1) 0.856271 0.060133 14.23960 0.0000

R-squared 0.646928 Mean dependent var 5462.352


Adjusted R-squared 0.640787 S.D. dependent var 147.2253
S.E. of regression 88.23855 Akaike info criterion(σ) 11.82306
Sum squared resid 895394.8 Schwarz criterion(σ) 11.89350

Again here is to be considered that the “constant” is the mean and the coefficients belong to a
model of derivations from it.
Thus the ARMA(2,1) model is to be written:
(lt - 5469,2) = 0,6002 ( lt-2 - 5469.5) + 0,8563 at + at

In order to have the model in the explicit form, the mean is subtracted:
lt = 5469,2 + 0,6002 ( lt-2 - 5469.2) + 0,8563 at + at
= 5469,2 - 5469.2 × 0,6002 .+ 0,6002 lt-2 + 0,8563 at + at
and at last
lt = 2186,6 .+ 0,6002 lt-2 + 0,8563 at + at

This model does not show an improvement compared by Akaike and Schwarz criteria with the
AR(1) estimated earlier. It has slightly higher values. EViews provides these criteria on the base
of the error variance which is to be minimised (in contrast to those on likelihood base such as in
Microfit that are to be maximised).

12
viii. Forecast of the number of employees for 2005:

The somewhat uneasy shape of both models:

(lt - 5469,5) = 0,7995 ( lt-1 - 5469.5) + at


and
(lt - 5469,2) = 0,6002 ( lt-2 - 5469.5) + 0,8563 at + at

give us the advantage of easily forecasting the process in the long run because the stochastic
limes for time tending to infinity is given by what we called the means 5469,5 and 5469,2,
respectively:

plim (lt - 5469,5) = plim (0,7995 ( lt-1 - 5469.5) + at)


= plim (0,7995 ( lt-1 - 5469.5) + plim at
= 0 + 0.
That means plim lt = 5469,5 and we can take this constant as suitable forecast for the farther
future.
In the same way we obtain from the second model the forecast 5469,2 that does not differ very
much.
The following graph displays the forecast for the years 2004 and 2005. In 2004 we obtain an
irregular curve, because the one-month ahead forecast for every month can be calculated on the
base of the varying values of the previous month. But in 2005, there is a smooth exponential
curve because the forecasts can be calculated only on the base of the previous forecast instead of
the real data.

13
5800

5700

5600

5500

5400

5300

5200

5100

5000
2004M01 2004M07 2005M01 2005M07

Forecast of the number of employees

Fig. 4: Forecast

ix. Spectral analysis is the name of this method.

Basically, the main peaks of spectral density occur at the circular frequencies
ω1= 0,71 ω2 = 1,86.
These correspond to frequencies
f1 = 0,114 f2 = 0,295
and to periods of average length
p1 = 8,8 p2 = 3,4 month, respectively.
But these periodicities are not of any practical importance. They superimpose to the point of
being unrecognizable. They are not visible in the original time series and the correlogram. Taking
standard errors of the spectral estimates into consideration, peaks and troughs of the spectral
density curve does not significantly differ.

The typical shape of the spectral density function for an AR(1) process is similar to the
following

14
Estimates of spectral density of an AR(1) process
8

Bartlett

4
Tukey

Parzen

0
0 1 2 3 4

Circular frequency

Fig. 5: Estimates of spectral density of an AR(1) process

In case of an additional seasonal component the spectral density would show a peak over the
frequency f = 1/12 or the circular frequency ω = 2π/12 = 0,52.

15
3 The file dax_j95_a04.txt contains the daily closing data of the main German stock
price index DAX from January 1995 by August 2004, i.e. 2498 values.

i. Display the graph of the time series dax.

ii. Determine the order of integration of dax.

iii. Generate the series of the growth rate or rate of return r in the direct way and in
the logarithmic way. Display both graphs of r.

iv. Compare the r data. Characterize the general patterns of both graphs of r

v. Check whether or not r is stationary.

vi. Estimate the correlation function and the partial correlation function till a lag of
20. Characterize generally the extent of correlation in this series.

vii. Estimate an AR(8) model to r that contains only coefficients significant at least on
the five percent level

viii. Estimate an ARIMA(8,d,8) model to r that contains only coefficients significant at


least on the one percent level.

ix. Test the residuals of this model for autoregressive conditional heteroscedasticity
by a rough elementary procedure

x. Make visible conditional heteroscedasticity by estimating a 5-day moving variance


of the residuals

xi. Estimate an ARCH(1) model on the base of the ARIMA(8,d,8) model estimated in
viii. You can change the ARMA part in order to keep only coefficients significant
on the one percent level.

xii. Estimate a GARCH(1,1) model on the base of the simple model r=const.

16
Answers:

i. The graph of dax.

9000

8000

7000

6000

5000

4000

3000

2000

1000

0
500 1000 1500 2000

DAX

Fig. 6: The graph of the German share price index

This graph indicates a non-stationary process, perhaps a random walk. It is characterized by


changing stochastic trends and increasing variance.

17
ii. The order of integration of dax.

For testing whether or not dax is stationary first the original date are tested by the Dickey-Fuller
test of the levels. The following table shows the estimation of the coefficient of the Dickey-
Fuller Test regression of ∆daxt on daxt-1 :

Table 7:
Dickey-Fuller Test Equation
Dependent Variable: ∆daxt
Method: Least Squares
Sample (adjusted): 2 2498; observations: 2497

Variable Coefficient Std. Error t-Statistic Prob.

daxt-1 -0.001453 0.000919 -1.580936 0.1140


C 6.970114 4.213823 1.654107 0.0982

R-squared 0.001001 Mean dependent var 0.701418


Adjusted R-squared 0.000600 S.D. dependent var 71.28183
S.E. of regression 71.26043 Akaike info criterion(σ) 11.37136
Sum squared resid 12669731 Schwarz criterion(σ) 11.37602

The t-value of the slope coefficient is -1.580936. As the following table demonstrates it is not
less than the 5%-critical t-value for a model with a constant, i.e. -2.862497.

Table 8:
Null Hypothesis: DAX has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=26)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -1.580936 0.4922


Test critical values: 1% level -3.432775
5% level -2.862497

That means that dax is on the 5% level not stationary. The next step is to check the first
differences of dax in the same way.

18
The Dickey-Fuller test equation of the first differences is a regression of the second differences
∆2daxt on the lagged first differences ∆daxt-1 .

Table 9:
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(DAX,2) = ∆2daxt
Method: Least Squares
Sample: 3 2498; observations: 2496

Variable Coefficient Std. Error t-Statistic Prob.

D(DAX(-1))= ∆daxt-1 -0.996234 0.020026 -49.74669 0.0000


C 0.702902 1.427408 0.492432 0.6225

R-squared 0.498061 Mean dependent var -0.017540


Adjusted R-squared 0.497860 S.D. dependent var 100.6319
S.E. of regression 71.30959 Akaike info criterion(σ) 11.37274
Sum squared resid 12682133 Schwarz criterion(σ) 11.37741

The t-value -49.74669 obviously exceeds all thinkable critical values.


Thus the first differences are stationary and dax itself is first order integrated I(1).

iii. The growth rate or rate of return r can be generated as the ratio

( dax t − dax t − 1 )
rt =
dax t − 1

That is displayed in the following graph:

19
.08

.04

.00

-.04

-.08

-.12
500 1000 1500 2000

R _ R A T IO

Fig. 7: Graph of the growth rate of DAX

Another way of calculating the rate of return mostly used in financial market analysis is the
logarithmic way:
rt = ln dax t − ln dax t −1
The next figure shows the graph of this logarithmically generated rate of return r.
.08

.04

.00

-.04

-.08

-.12
500 1000 1500 2000

R _ LO G

Fig. 8: Graph of the logarithmic return rate of DAX

20
iv. Both curves are very similar to each other and can hardly be distinguished by the naked
eye. An enlarged display of the differences as shown in the next figure demonstrates that
the ratio always slightly exceeds the logarithmic approximation. In the following analysis
the latter will be used.

Differences between alternative series of dax return rate r

.005

.004

.003

.002

.001

.000
500 1000 1500 2000

D IF F _ R

Fig. 9: Graph of the differences between both ways of calculating return rates

Both graphs of r show certain common general patterns. These are significant clusters of high
variability or volatility separated by quieter periods. This changing behaviour of variance is
typical for ARCH or GARCH processes.

v. Stationarity test for r.

Particularly for later fitting an ARCH or GARCH model, the time series should be stationary.
The following Dickey Fuller Regression of ∆rt on rt-1 produces a negative t-value of -50.377
that lies below of all possible critical values: The return rate r proves stationary.

21
Table 10:
Dickey-Fuller Test Equation
Dependent Variable: ∆rt
Method: Least Squares
Sample (adjusted): 3 2498; observations: 2496

Variable Coefficient Std. Error t-Statistic Prob.

rt-1 -1.008850 0.020026 -50.37696 0.0000


C 0.000250 0.000320 0.780708 0.4350

R-squared 0.504356 Mean dependent var -3.68E-06


Adjusted R-squared 0.504157 S.D. dependent var 0.022675
S.E. of regression 0.015967 Akaike info criterion(σ) -5.435790
Sum squared resid 0.635829 Schwarz criterion(σ) -5.431125

vi. Sample correlation function and partial correlation functions of r

Correlogram

1,2

0,8

0,6 AC
0,4 PAC

0,2

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
-0,2

Fig. 10: Graph of sample correlation and partial correlation function

22
Table 11:

τ AC PAC τ AC PAC τ AC PAC


1 -0.009 -0.009 13 -0.017 -0.015 25 0.005 0.004
2 -0.005 -0.005 14 0.071 0.076 26 -0.048 -0.048
3 -0.032 -0.032 15 0.027 0.028 27 -0.046 -0.036
4 0.027 0.026 16 -0.024 -0.026 28 0.021 0.014
5 -0.041 -0.040 17 -0.038 -0.030 29 0.056 0.048
6 -0.042 -0.043 18 0.001 -0.001 30 0.025 0.033
7 -0.006 -0.006 19 -0.048 -0.048 31 0.020 0.030
8 0.042 0.038 20 0.023 0.029 32 0.010 0.001
9 -0.005 -0.005 21 0.025 0.031 33 -0.001 -0.001
10 -0.007 -0.007 22 0.005 -0.008 34 -0.014 -0.006
11 0.012 0.011 23 -0.002 -0.004 35 -0.021 -0.022
12 0.014 0.010 24 0.033 0.033 36 0.019 0.017

Let us try a general characterisation of the extent of correlation in this series:


The sample correlation and partial correlation function do not differ very much. The graphs of
both of them coincide. There is not any significant correlation value. This could be the functions
of a white noise. Anyway, because of the little peaks at 5, 6 and 8 it could be sensible try to fit
an AR(8) model.

vii. Example: AR(8) model coefficients significant on the five percent level.

Several trials with AR coefficient up to the order 8 finally resulted in three significant
coefficients and a missing constant. The criterion for rejecting other variants was non-
significance of coefficients.

Table 12:
Dependent Variable: r
Method: Least Squares
Sample (adjusted): 10 2498; observations: 2489

Variable Coefficient Std. Error t-Statistic Prob.

rt-5 -0.039842 0.020023 -1.989799 0.0467


rt-6 -0.041799 0.020013 -2.088571 0.0368
rt-8 0.039960 0.020028 1.995155 0.0461

Mean dependent var 0.000244 S.D. dependent var 0.015982


S.E. of regression 0.015951 Akaike info criterion -5.437444
Sum squared resid 0.632487 Schwarz criterion -5.430429

23
Thus we obtain by OLS regression the AR(8) model

rt = -0.039842 rt-5 - 0.041799 rt-6 + 0.039960 rt-8 + et ,

where et is the error term of the process estimated.

We get exactly the same results, if we consider this AR model as a special case of an ARMA
model estimated by iterative nonlinear least squares

Table 13:
Dependent Variable: r
Method: Least Squares
Sample (adjusted): 10 2498; observations: 2489
Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

AR(5) -0.039842 0.020023 -1.989799 0.0467


AR(6) -0.041799 0.020013 -2.088571 0.0368
AR(8) 0.039960 0.020028 1.995155 0.0461

Mean dependent var 0.000244 S.D. dependent var 0.015982


S.E. of regression 0.015951 Akaike info criterion(σ) -5.437444
Sum squared resid 0.632487 Schwarz criterion(σ) -5.430429

viii. Example: ARIMA(8,d,8) model for r that contains only coefficients significant at least on
the one percent level.

Now we try to improve the model by including a moving average term. In this case we must use
the iterative nonlinear least squares method. Now the aim is to obtain coefficients, significant on
the 1% level. Again after a series of trials with varying ARMA(8,8) models we got finally the
following results by omitting non significant coefficients:

24
Table 14:
Dependent Variable: r
Method: Least Squares
Sample (adjusted): 10 2498; observations: 2489
Convergence achieved after 15 iterations

Variable Coefficient Std. Error t-Statistic Prob.

AR(3) -0.339258 0.025338 -13.38956 0.0000


AR(8) -0.613633 0.025849 -23.73905 0.0000
MA(3) 0.296335 0.027198 10.89544 0.0000
MA(6) -0.075689 0.013945 -5.427549 0.0000
MA(8) 0.654681 0.020088 32.59034 0.0000

Mean dependent var 0.000244 S.D. dependent var 0.015982


S.E. of regression 0.015874 Akaike info criterion(σ) -5.446226
Sum squared resid 0.625950 Schwarz criterion(σ) -5.434536

The model resulting from this estimation is the following:

rt = - 0.339 rt-3 - 0.614 rt-8 + et + 0.296 et-3 - 0.076 et-6 + 0.655 et-8

where et is the error term of the estimated ARMA process.

Now the goodness of fit of both models should be compared. Besides considering the
significance level of the coefficients in both models a powerful mean of comparison are the
Akaike and Schwarz criteria, which are to be minimised.
Here both criteria are very close to each other. But the slightly smaller (negative!) values of
both criteria in the second case give a certain preference to the ARMA model.
Because we know from v. that r is stationary, that means integrated of order 0, this model is an
ARIMA(1,0,1) for r at the same time.

25
ix. Rough and preliminary test of the residuals for autoregressive conditional
heteroscedasticity by OLS regression

A rough check for first order autoregressive conditional heteroscedasticity (ARCH(1)) is the
estimation of a regression of the squared residuals et2 on et-12 :

Table 15:
Dependent Variable: et2
Method: Least Squares
Sample (adjusted): 11 2498; observations: 2488

Variable Coefficient Std. Error t-Statistic Prob.

C 0.000208 1.18E-05 17.59238 0.0000


et-12 0.175073 0.019746 8.866325 0.0000

R-squared 0.030652 Mean dependent var 0.000252


Adjusted R-squared 0.030263 S.D. dependent var 0.000543
S.E. of regression 0.000535 Akaike info criterion (σ) -12.22961
Sum squared resid 0.000710 Schwarz criterion (σ) -12.22493

For testing this dependence we cannot simply use the usual t-test because the t-values estimated
do not meet an exact student distribution. Anyway, because here the t-values immensely exceed
the 5-percent and 1-percent critical values, we can with great practical confidence assume, that
there exist a highly significant relationship between et2 and et-12 i.e. high conditional
heteroscedasticity.

x. Visualisation of conditional heteroscedasticity by moving 5-day residual variance

The existence of conditional heteroscedasticity can be visualised by smoothing the series of


squared residuals that means by moving averages of the et2 or moving variances.

26
.004

.003

.002

.001

.000
500 1000 1500 2000

5 -d a y m o v in g re s id u a l v a ria n c e

Fig. 11:

At the figure, you can see typical clusters of higher variance, i.e. volatility, changing with
intervals of lower variance. The similarity of neighbouring variances is one more indicator for
conditional heteroscedasticity: On the base of knowing the variance at time t (i. e. conditionally)
you can forecast the variance at time t+1.

xi. ARCH(1) model on the base of the AR(8) model

Because of the latter analytical results it would be worthwhile to estimate an ARCH(1) model.
Then the conditional variance of the error et is

ht2 = var(et | et −1 ) = E(et2 | et −1 ) = λ0 + λ1et2−1 ,


where practically ht2 is estimated by et2

In the software used this is a special case of the more general GARCH model. An ARCH(1)
there corresponds to a GARCH(0,1) model. We assume here the time series to follow an AR(8)
process as estimated earlier without ARCH:

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Table 16:
Dependent Variable: r
Method: ML – ARCH
Sample (adjusted): 10 2498; observations: 2489
Included after adjustments
GARCH = C(4) + C(5)*RESID(-1)^2

Coefficient Std. Error z-Statistic Prob.

AR(5) -0.045702 0.013304 -3.435162 0.0006


AR(6) -0.046538 0.014090 -3.303005 0.0010
AR(8) 0.044716 0.013812 3.237367 0.0012

Variance Equation

C 0.000194 4.67E-06 41.55146 0.0000


RESID(-1)^2 0.243443 0.026156 9.307385 0.0000

R-squared 0.004705 Mean dependent var 0.000244


Adjusted R-squared 0.003102 S.D. dependent var 0.015982
S.E. of regression 0.015958 Akaike info criterion(σ) -5.493524
Sum squared resid 0.632539 Schwarz criterion(σ) -5.481833

The coefficients differ from the earlier estimated ones because here they are estimated
simultaneously with the ARCH term. The newly estimated model is:

rt = -0.0457 rt-5 - 0.0465 rt-5 + 0.0447 rt-8 + et ,


with the error process et2 = 0.000194 + 0.2434 et-12 + at

where at should be a pure random series. The AR representation of the error process gives
the opportunity to forecast the volatility.

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xii. GARCH(1,1) model on the base of the simple model r=const.

Here you should model the return rate as a real GARCH process.

The generalized autoregressive conditional heteroscedasticity model (GARCH (p,q)) describes a


process where the conditional error variance on all information Ωt-1 available at time t
ht2 = var (u t Ωt −1 )
is assumed to obey an ARMA(p,q) model:
ht2 = α 0 + α 1ht2−1 + ... + α p ht2− p + β 1ut2−1 + β 2 ut2−2 + ... + β q ut2−q

with u t being the error process .

Table 17:
Dependent Variable: r
Method: ML - ARCH (Marquardt) - Normal distribution
Sample (adjusted): 10 2498; observations: 2489
Convergence achieved after 12 iterations
GARCH = C(5) + C(6)*RESID(-1)^2 + C(7)*GARCH(-1)

Coefficient Std. Error z-Statistic Prob.

C 0.000710 0.000246 2.882234 0.0039


rt-5 -0.029571 0.020063 -1.473904 0.1405
rt-5 -0.036495 0.020360 -1.792478 0.0731
rt-8 0.012575 0.020570 0.611309 0.5410

Variance Equation

C 2.01E-06 4.03E-07 4.980196 0.0000


RESID(-1)^2 0.082160 0.009593 8.564982 0.0000
GARCH(-1) 0.911339 0.009476 96.17172 0.0000

R-squared 0.003340 Mean dependent var 0.000244


Adjusted R-squared 0.000930 S.D. dependent var 0.015982
S.E. of regression 0.015975 Akaike info criterion(σ) -5.752055
Sum squared resid 0.633406 Schwarz criterion (σ) -5.735688

While in the original AR(8) model the constant could be omitted here the constant is the only
significant term in the regression part of the model. Therefore all lagged r terms can be omitted
now:

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Table 18:
Dependent Variable: r
Method: ML – ARCH
Sample (adjusted): 2 2498; observations: 2497
Convergence achieved after 12 iterations
GARCH = C(2) + C(3)*RESID(-1)^2 + C(4)*GARCH(-1)

Coefficient Std. Error z-Statistic Prob.

C 0.000662 0.000240 2.753134 0.0059

Variance Equation

C 2.08E-06 4.06E-07 5.116231 0.0000


RESID(-1)^2 0.083192 0.009602 8.664398 0.0000
GARCH(-1) 0.910103 0.009445 96.35969 0.0000

R-squared -0.000681 Mean dependent var 0.000245


Adjusted R-squared -0.001886 S.D. dependent var 0.015961
S.E. of regression 0.015977 Akaike info criterion(σ) -5.756824
Sum squared resid 0.636337 Schwarz criterion(σ) -5.747496

The model proves very simple: DAX return equals the constant 0,00066 (i.e. 0,06 % per day on
an average) with sort of an ARMA(1,1) conditional variance that describes the development of
volatility or risk:

ht2 = 2,08 · !0-06 + 0,9101 ht-12 + 0.08319 et-12 + at

2
with ht being the conditional variance of rt on base of the information by time t, and et being
the deviation of r from its mean in this model.
In the meaning of Akaike and Schwarz criteria, the model fits better than all considered before:
The values of these criteria are the lower ones despite the model is extremely simple. The model
shows that conditional variance as a measure of volatility and investment risk is highly
determined by the variance of the last day, i.e. rather by the more theoretical conditional variance
ht-12 than by the directly measurable deviation et-1.

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