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Franz Eigner
UK Econometric Forecasting
Prof. Kunst, SS09
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Contents
1 Introduction in multivariate forecasting 3
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1 Introduction in multivariate forecasting
Multivariate data are given, when observations are taken on two or more time
series for the same time periods, describing e.g. measures of economic activity
like GDP or the inflation index. Multivariate modelling can then be assessed,
examining the structure, that is the interrelationship among the series in order
to obtain more accurate forecasts of the series of interest. Especially for eco-
nomic series mutual interactions between economic variables is often present,
e.g. the dependency between wages and prices. Therefore one may believe that
the neglection of the relationship between economic variables, which is done
in univariate forecasting, is not adequate for forecasting economic series. As a
consequence, multivariate forecasting, aiming at understanding the underlying
structure of a given system, seems to be very appealing.
The main focus of this paper lies in the description of multivariate forecasting
procedures. In order not to lose one’s head due to the large number of forecasting
procedures, a brief overview is given in advance in Figure 1.
feedback?
model-free: models: no yes
smoothing ARIMA,
filtering GARCH
open loop system closed loop system
(single equation) (multiple equation)
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AR. The VAR model became popular by Sims (1980), who advocated them
as an alternative to simultaneous equations models, which do not focus on the
dynamic structure of the variables. One advantage of VAR may be that they
treat all variables as endogenous, whereas in econometric modeling one gener-
ally needs to classify variables as exogenous, predetermined and endogenous.
However this classification is not always known and theoretical considerations
to find the correct one may be wrong. There is a broad variety of VAR mod-
els, integrating moving average terms (VARMA), structural features (SVAR) or
bayesian methods (BVAR). Cointegration can be implemented in form of the
vector error correction model (VEC).
Before modelling multivariate time-series data, a careful examination of the
data set should be assessed in advance. One important tool is the CCF (cross
correlation function), which is a generalization of the ACF to the multivariate
case. One can use it for identification of the model, which means finding the
optimal lag and for identification of the leading series by looking at the maximum
cross-correlation. However especially in case of time dependence within the
component series and of feedback between the series, final statements from the
empirical CCV are difficult to make.
yt = Φ1 yt−1 + . . . + Φp yt−p + ut
with Φi as (KxK) coefficient matrices for i = 1, . . . , p and ui is a K dimensional
white noise process. This means it holds: E(ut ) = 0, E(ut út ) = Σu , E(ut us ) =
0 for t 6= s
The VAR(p) process is stable, when it generates stationary time series, implying
that the equation returns to an equilibrium after a shock. This can be checked
by the characteristic matrix polynomial.
Yt = ΦYt−1 + vt
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Φ1 Φ2 ... Φp−1 Φp
ui
yt I 0 ... 0 0
..
0
where Yt =
,Φ =
0 I ... 0 0 , vt =
..
. .. .. .. .. ..
.
yt−p+1 . . . . .
0
0 0 ... I 0
It holds: If the moduli of the eigenvalues are less than one, the VAR process is
stable.
yt = Φ1 yt−1 + ut
φ11 φ12
where uTt = (uit , u2t ) and Φ1 =
φ21 φ22
uTt is bivariate white noise, which means that innovations have zero means and
are uncorrelated through time, within and between series. However, u1t and
u2t may be correlated at the same time point. Notice that the all equations
have the same regressors. Therefore the VAR(1) as well as the VAR(p) model
are just a seemingly unrelated regression (SUR) models with lagged variables
as common regressors.”
!11
Y1,t-1 Y1,t ...
!2
! 12 1
Y2,t ...
Y2,t-1
!22
VAR models provide the possibility for analyzing the relation between the
variables involved. These relations or dependences between and within time
series are expressed in the coefficient matrix Φ and are shown in Figure 2. One
calls a variable y1t causal for a variable y2t , if the information in y1t is helpful
for improving the forecasts of y2t . Obviously, y1t is not causal for y2t when
the coefficient variable φ21 equals zero. Then granger causality goes only in one
direction, that is from y2t to y1t , which would lead to an open-loop system, with
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yit following an AR(1) process. Because Granger-noncausality is characterized
by such zero restrictions on the levels VAR representation, standard F-tests can
be applied for causality analysis. It is obvious that unidirectional causality ex-
ists, if the coefficient matrix Φi can be reordered as an lower (upper) triangular.
If this is not the case, there is mutually dependency between the variables and
the VAR model should be more adequate than transfer models.
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While Granger causality falls short of quantifying the impact of the impulse
variable on the response variable over time, the impulse response analysis can
be used. For meaningful results it is important to isolate the actual shocks of
interest, which requires imposing some structure on the VAR.
These orthogonal shock matrices can then further be used for the forecast er-
ror variance decomposition (FEVD), which answers the question: what portion
of the variance of the forecast error in predicting yi,t+1 is due to the structural
shock?
yt = Φ1 yt−1 + ut
the best one-step-ahead forecast is given by
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3.3 Conditional forecast
Forecasts from VAR models are quite flexible because they can be made con-
ditional on the potential future paths of specified variables in the model. “For
example, when forecasting multivariate macroeconomic variables using quar-
terly data from a VAR model, it may happen that some of the future values
of certain variables in the VAR model are known, because data on these vari-
ables are released earlier than data on the other variables. By incorporating
the knowledge of the future path of certain variables, in principle it should be
possible to obtain more reliable forecasts of the other variables in the system.
Another use of con- ditional forecasting is the generation of forecasts conditional
on different “policy” scenarios. These scenario-based conditional forecasts allow
one to answer the question: if something happens to some variables in the sys-
tem in the future, how will it affect forecasts of other variables in the future?”
(Zivot/Wang, 2002).
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4 VAR models and Cointegration
The following chapter describes the analysis of nonstationary multivariate time
series using VAR models that incorporate cointegration relationships.
yt = Φ1 yt−1 + Φ2 yt−2 + ut
Φ(1) = (I − Φ1 − Φ2 ) = Π
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• 0 ... no cointegration (→ difference VAR)
• 1 ... one cointegrating vector (→ VECM)
which is the so-called VECM form, where Γ1 = −Φ2 is the transition matrix
and Π = αβ́ holds
• α as the »loading matrix« (speed of adjustment)
The VECM form tells us: changes in yt can be explained by their own history,
lagged changes of the other variables, and the error from the long-run equilib-
rium in the previous period. All variables in the VECM are stationary, also
yt−1 , which is made stationary by Π. The long term equation is implemented
in Πyt−1 , whereas short-run coefficients are described in Γ1 . To summarize,
“the long-run or cointegration relations are often associated with specific eco-
nomic relations which are of particular interest, whereas the short-run dynamics
describe the adjustment to the long-run relations when disturbances have oc-
curred.” (Lütkepohl, 2007).
Estimation of such a VECM needs a specific procedure called reduced rank
estimation and forecasts can then be estimated following the MMSE (naive
forecasting) method in VAR. One may forecast the changes in the variables,
∆Y, or the levels of the variables Y.
VAR can be used for stationary time series forecasting, e.g. interest rates, some
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exchange rates and some asset returns. One could also analyse many economic
variables on the basis of its growth rate.
VEC can always be used when one is able to verify long-term equilibirium con-
ditions in theoretical economics. Such cointegration relationships can be found
in economics and finance.
Economics:
• Money demand models imply cointegration between money, income, prices
and interest rates.
• Growth theory models imply cointegration between income, consumption
and investment, with productivity being the common trend.
• Purchasing power parity implies cointegration between the nominal ex-
change rate and foreign and domestic prices.
• The Fisher equation implies cointegration between nominal interest rates
and inflation.
Finance:
• Cointegration at a high frequency is motivated by arbitrage arguments.
The Law of One Price implies that identical assets must sell for the same
price to avoid arbitrage opportunities. This implies cointegration between
the prices of the same asset trading on different markets, for example.
• Cointegration at a low frequency is motivated by economic equilibrium
theories linking assets prices or expected returns to fundamentals. For
example, the present value model of stock prices states that a stock’s price
is an expected discounted present value of its expected future dividends
or earnings. This links the behavior of stock prices at low frequencies to
the behavior of dividends or earnings.
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References
Lesage, J.P. (1990) A comparison of the forecasting ability of the ECM and
VAR models, Review of Economics and Statistics, 72, 664-71.
Zivot E., Wang J. (2002) Modeling Financial Time Series with S-PLUS.
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