QuantitativeNotes

Reading9
Itmaygowithoutsaying,butXistheindependentvariable,Yisthedependentvariable.
Significancetestsallowtoassesswhetherapparentrelationshipsbetweenrandomvariablesaretheresultsof
chance.
Alternativehypothesisiswhatyouretestingfor.
Degreesoffreedom(df)increases,criticalvalue(tc)decreases.
#ofdf=thenumberofobservations(n)numberofparametersestimated.df=nparameters.
Inaregressionwithoneindependentvariable,therearetwoestimatedparameters,theintercept
andtheslopecoefficient.
Totaldfisn1.
Regressiondf=numberofindependentvariables.
Residualdf=differencebetweentotaldfandregressiondf.
dfequalsthenumberofobservationsminusthenumbersofparametersbeingestimated.
Inaregressionwithoneindependentvariable,therearetwoestimatedparameters,theinterceptandthe
coefficientontheindependentvariable.
tstatistics>criticaltvalue=resultissignificant.Thetestisshowingsomeinfluencefromtheindependent
variableonthedependentvariable.
tstat>tc=rejectnull
tstat<tc=failuretorejectnull
Useabsolutevalues!Iftstatisgreaterthantc,oriftstatislessthantc,thenrejectnull.
using=inyourhypothesis?Thenuseatwotailedtest.Using>,<, ,or ?Useaonetailedtest.
Afalsenullhypothesisismorelikelytoberejectedasweincreasesamplesize,ceterisparibus.
Useiforcrosssectional,tfortimeseries.
Linearregressionchoosesestimatessothatthesumofthesquaredverticaldistancesareminimized.
Youcanfindtheintercept,slope,andcorrelationonyourcalculator!
Putinyourdata
Press2ndSTAT
Scrolldownuntilyouseea.Thisisyouryintercept.
Scrolldownonemoretob.Thisisyourslope.
Scrolldownonemoretor.Thisisyoursamplecorrelation.
SxandSyaresamplestandarddeviations.
andarethesamplemeans.
Ifyoureonlyworkingwithonevariable,makesuretoswitchtheSTATmodeto1VAR.Youdothisby
pressing2ndSTAT,then2ndSET.
Samplevariance=
Samplecorrelationcoefficient:r=
Wecantesttoseeifpopulationcorrelationissignificant.H0: =0,orHa: 0.
Teststatistict=
Spuriouscorrelationmayreferto1)correlationbetweentwovariablesthatreflectsthechance

relationshipsinaparticulardataset,2)correlationinducedbyacalculationthatmixeseachoftwo
variableswitha3rd,and3)correlationbetweentwovariablearisingnotfromadirectrelationship
betweenthembutfromtheirrelationtoa3rdvariable.
Correlationwillhavethesamesignasyourslopecoefficient.
OnanANOVAtable,multipleRiscorrelation.
Assumptionsofthelinearregressionmodel
1)Therelationshipbetweenthedependentvariable(Y)andtheindependentvariable(X)islinearinthe
parametersb0andb1.Thismeansthatb0andb1areraisedtothefirstpoweronly.
2)Theindependentvariable(X)isnotrandom.
3)Theexpectedvalueoftheerrortermis0:.
4)Thevarianceoftheerrortermisthesameforallobservations(AKAhomoskedastic).
5)Theerrortermisuncorrelatedacrossobservations.
6)Theerrortermisnormallydistributed.
;thistermmeans(dependentvariablepredictedvalueofdependentvariable)
1

Sumofsquarederrors(SSE)=thesumofthesquareddifferencebetweentheactualobservationandestimated
observation.AKAresidualsumofsquares.Theunexplainedvariation.=theestimateddependentvariable.
SSE=
DeletingobservationsfromasamplewillincreasetheSEEanddecreaseR2.
SmallerStandardErrorsoftheEstimate(SEE)resultinmoreaccuratepredictions.
SEE=1/2
SEE=(unexplainedvariation/n2)0.5
SEE=(SSE/n2)0.5
SEEisthestandarddeviationoftheregressionresiduals.
Alsocalledresidualstandarderror.
R2=coefficientofdetermination=howmuchofthetotalvariationisexplainedbytheregression
explainedvar/totalvar
Withonly1independentvariable,correlationis(R2)0.5
R2iscorrelationcoefficientsquared.
Aconfidenceintervalisanintervalofvaluesthatwebelieveincludesthetrueparameter,b1,withagivendegreeof
confidence.
Thehigherthedegreeofconfidence,thewidertheinterval.
Thelargerthesamplesize,thesmallerthestandarderror,andthesmallertheinterval.
Forexample,yousaywith95%confidence,thatthemeanageofCamarodriversis24to28.Inotherwords,
basedoffyoursample,youare95%confidentthatthetruemeanageofthepopulationofCamarodriversis
between24and28.
Ifthehypothesizednullvalueisnotintheconfidenceinterval,youcanrejectthenull.(pg.290)

Higherlevelsofconfidenceresultinhighertc,whichleadstowiderconfidenceintervals,anddecreasedlikelihood
ofrejectingthenullhypothesis.
A0.05levelofsignificancemeansthatthereis5%chanceofrejectingnullwhenitistrue(typeIerror).Decreasing
levelofsignificanceto0.01decreasestheprobabilityoftypeIerror,butincreasestheprobabilityoftypeIIerror
failingtorejectthenullwhenitisfalse.
Thepvalueisthesmallestlevelofsignificanceatwhichthenullhypothesiscanberejected.Itsanumberbetween
0and1.
Forexample,ifthepvalueis0.005,wecanrejectthehypothesisthatthetrueparameterisequalto0atthe
0.5%significancelevel(99.5%).
Asmallpvalue(typically 0.05)indicatesstrongevidenceagainstthenullhypothesis,soyourejectthe
nullhypothesis.
pvalue<significancelevel=rejectnull
AlsocalledtheSignificanceF
Fstatistictestswhetheralltheslopecoefficientsinalinearregressionareequalto0.
TestofthenullHo:b1=0,versusthealternativeHa:b10.
Itmeasureshowwelltheregressionequationexplainsthevariationinthedependentvariable.
F=
Regressionsumofsquares(RSS)isthesquareddifferencebetweentheestimatedvariableandthemeanof
theactualvariables.ItisthetotalamountofvariationinYthatisexplainedintheregressionequation.
RSS=
AverageRSS(RSE)=RSS/#ofslopeparametersestimated.Alsocalledmeanregressionsumof
squares.
Remember,RSSistheexplainedvariationfromtheregression.
Sumofsquarederrors(SSE)andtheresidualsumofsquaresarethesamething.Itisthesumofthesquared
differencebetweentheactualvariableandtheestimate.
AverageSSE(MSE)=SSE/ntotalnumberofparameters(whichincludestheslope).Alsocalled
meansquarederror(MSE).
Remember,MSEistheunexplainedvariationfromtheregression.
YoucancalculateStandardErroroftheEstimate(SEE)fromaverageSSE:SEE=(MSE)0.5
FisdenotedF#slopeparameters,n#parameters
Iftheregressionmodeldoesagoodjobofexplainingvariationinthedependentvariable,thenthisratio
shouldbehigh.
2

Ithinkthehigherthetstatistic,thelowerthepvalue.ButImnot100%sure.
Totalsumofsquares(TSS)=totalvariation;RSS+SSE.
Predictionintervals
Step1:maketheprediction
Step2:computethevarianceofthepredictionerror
;s2=squaredSEE,n=numberofobservations,X=valueofindependentvariableusedtopredict
thedependentvariable,=estimatedmean,=varianceoftheindependentvariable
Step3:computethepredictioninterval,
Dontforgettotakethesquarerootofthevarianceofthepredictionerror!
Pg.306#9b,#10aandb.
Pg.308#12isreallygood.

Reading10
Aregressionequationhaskslopecoefficientsandk+1regressioncoefficients.The+1istheintercept.
Theslopecoefficientsinamultipleregressionareknownaspartialregressioncoefficientsorpartialslope
coefficientsandneedtobeinterpretedwithcare.
Forexample,iftheslopecoefficientwere0.75onX1withasecondindependentvariable,wewouldfind
generallyfindthattheestimatedcoefficientonX1isnot0.75unlessthesecondindependentvariablewere
uncorrelatedwithX1.Veryverytricky.
Toreiterate,apartialregressioncoefficientmeasuretheexpectedchangeinthedependentvariablefora
oneunitincreaseinaindependentvariable,holdingalltheotherindependentvariablesconstant.
Evenifnoexactlinearrelationshipexistsbetweentwoormoreindependentvariables,linearregressionmaystill
encounterproblemsiftwoormoreoftheindependentvariablesarehighlycorrelated.Thisisknownas
multicollinearity.
Ifnoneoftheindependentvariablesinaregressionmodelhelpsexplainthedependentvariable,theslope
coefficientsshouldallequal0.
Fstatisticfortestingthenullhypothesisthatallslopecoefficientsare0hasavalueof0whentheindependent
variablesdonotexplainthedependentvariableatall.
F=
TogettheFteststat,thedfisnotatedF{k,n(k+1)}.Forexample,ifyouhadtwoslopecoefficientsandn=
66,thentheF{2,63}.df1=2anddf2=63.
Inmultiplelinearregression,R2canautomaticallyincreasewhenanothervariableisaddedtotheregression.Tofix
this,someanalystsprefertouseadjustedR2,or

AdjustedR2canbenegativewhilenormalR2isalwaysnonnegative.
AdjustedR2isalwayssmallerthanR2.
AdjustedR2adjustsforthelossofdegreesoffreedomwhenadditionalindependentvariablesareaddedto
theregression.
ItdoesNOTcorrectforserialcorrelationorheteroskedasticity.
Regardingdummyvariables,whenwewanttodistinguishbetweenncategories,weneedn1dummyvariables.
Forexample,todistinguishbetweenthefourquartersoftheyear,wewouldneed3dummyvariables.
Heteroskedasticityisaviolationofthefollowingassumption:thevarianceoftheerrortermisthesameforall
observations.Inotherwords,thevarianceoferrorsdiffersacrossobservations.Theerrorsdiffer,buttheyarenot
related.
Homoskedasticgraph:nosystematicrelationshipbetweenthevalueoftheindependentvariableandthe
regressionresiduals(theverticaldistancebetweenaplottedpointandthefittedregressionline).
Heteroskedasticgraph:theresasystematicrelationshipgenerallytheregressionresidualsgrowmuch
largerasthesizeoftheindependentvariableincreases.
Whenerrorsareheteroskedastic,theFtestandttestarebothunreliable.
Inheteroskedasticfinancialdata,themostlikelyresultisthattheestimatedstandarderrorsare
underestimatedandthetstatisticsareinflated.
Unconditionalheteroskedasticityoccurswhenheteroskedasticityoftheerrorisnotcorrelatedwiththe
independentvariableinthemultipleregression.Assumption4isviolated,butitcreatesnomajorproblems
forstatisticalinference.
3

Conditionalheteroskedasticityheteroskedasticityintheerrorvariancethatiscorrelatedwiththe
valuesoftheindependentvariablesintheregression.Thistypeofheteroskedasticitycausesthemajorityof
problems.
Resultsinconsistentparameterestimatesbutbiasedstandarderrors,tstatistics,andFstatistics
BreuschPagantestswhetherthemodelisheteroskedastic.
Hoisthatthereisnoconditionalheteroskedasticity.
Haisthatthereisconditionalheteroskedasticity.
TheteststatisticistheR2inthesquaredresidualsregressionmultipliedbyn.nR2
CriticalvalueisX2distribution,withdfofhowevermanyindependentvariablesthereare.
nR2>X2=rejectnullofnoconditionalheteroskedasticity.#10onpg.385.
SerialCorrelationwhenyourregressionerrorsarecorrelatedacrosstime.Forexample,theregressionerrors
foryesterdaysandtodaysS&P500returnsarecorrelated.Mosttypicallyarisesintimeseriesregressions.
Canhappenwhenoneofthetheindependentvariablesisavalueofthedependentvariablefromaprevious
period.
Positiveserialcorrelation:apositiveerrorforoneobservationincreasesthechanceofapositiveerror
foranotherobservation.
ThismaycausetheFstatistictobeinflatedbecausethemeansquarederror(MSE)willtendto
underestimatethepopulationvarianceerror.
tstatisticsmaybeinflated,suggestingsignificancewhenthereisnone.
UseDurbinWatson(DW)statistictotestforserialcorrelation.
DWshouldbecloseto2,iferrorsarehomoskedasticandnotseriallycorrelated.
Ifthesampleislarge,DW 2(1r),rbeingthesamplecorrelationbetweentheregression
residualsfromoneperiodandthosefromthepreviousperiod.
DWcanrangefrom0(serialcorrelationof+1),to4(serialcorrelationof1).
DW<dl=rejectnullofnopositiveserialcorrelation
DWbetweendlanddu=testisinconclusive
DW>du=failuretorejectnullofnopositiveserialcorrelation
IfDW>4dlthenthereissignificantnegativecorrelation.TopictestReyes#4.
Positiveserialcorrelationwillbiasthestandarderrortermsdownward.
TheDurbinWatsonstatisticcantbeusedforaregressionthathasalaggedvalueofthedependent
variableasoneoftheexplanatory(independent)variables.Totestforserialcorrelationinthistype
ofmodel,wemustexaminetheautocorrelations.
Tofixpositiveserialcorrelation(andheteroskedasticity),userobuststandarderrors.
Multicollinearity:whentwoormoreindependentvariablesarehighly(butnotperfectly)correlated.Forexample,
S&P500returnsarecorrelatedtotheFTSE100returns.
GenerallyoccurswhenthereisahighR2,asignificantFstatistic,eventhoughthetstatisticsofthe
estimatedslopecoefficientsarenotsignificant(lowtstatistics).
Also,youcanlookatthecorrelationbetweentheindependentvariables,BUTonlyifthereexactly
twoindependentvariables.Iftherearemorevariables,youcantlookatthepairwisecorrelation.If
thepairwisecorrelationishigh,multicollinearityispresent.TopictestGarfield#6.
Tocorrectformulticollinearity,excludeoneormoreoftheregressionvariables.
Acommoncauseofmisspecificationinregressionmodelsistheuseofthewrongformofthedatainaregression,
whenatransformedversionofthedataisappropriate(suchasthenaturallog).Anothercommonmistakeisnot
usingcommonsizefinancialstatements.Thethirdwayofmodelmisspecificationispoolingdatafromdifferent
samplesthatshouldnotbepooled.Thegraphwilllookliketwodistinctlyseparateclustersofdata.
Modelspecificationreferstothesetofvariablesincludedintheregressionandtheregressionequations
functionalform
Principlesofmodelspecification
Themodelshouldbegroundedincogenteconomicreasoning
Becarefultoavoiddatamining,whichiswhentheinvestigatoressentiallydevelopsa
modelthatmaximallyexploitsthecharacteristicsofaspecificdataset.
Thefunctionalformchosenforthevariablesintheregressionshouldbeappropriategiventhe
natureofthevariables.
Themodelshouldbeparsimonious
Thismeansthatthemodelshouldaccomplishalotwithalittle.
Themodelshouldbeexaminedforviolationsofregressionassumptionsbeforebeingaccepted.
4

Themodelshouldbetestedandbefoundusefuloutofsamplebeforebeingaccepted.
Inmodelsthatusetimeseriesdata,itsparticularlyeasytoviolateassumption3,thattheerrortermhasmean0.
Thiscanbecausedbyincludinglaggeddependentvariablesasindependentvariables.
Mostcommonsourceofmisspecificationisusingtimeserieslinearregressionswithvariablesthatare
nonstationary.Thismeansthatthemeanandvariancearenotconstantthroughtime.
Predictionsinamultipleregressionmodelaresubjecttobothparameterestimateuncertaintyandregression
modeluncertainty.
Qualitativedependentvariablesaredummyvariablesusedasdependentvariablesinsteadofasindependent
variables.
Logitmodelsestimatetheprobabilityofadiscreteoutcomegiventhevaluesoftheindependentvariablesusedto
explainthatoutcome.
Probitmodelsarebasedonthenormaldistribution,andestimatetheprobabilitythatY=1(aconditionis
fulfilled)giventhevalueoftheindependentvariableX.
Acorrelatedomittedvariablewillresultinbiasedandinconsistentparameterestimatesandinconsistentstandard
errors.
#1722onpg.392.

Reading11
Timeseries:quarterlysalesofacompanyoverthelast5years.
Autoregressivemodel:amodelinwhichtheindependentvariableislaggedvalueofthedependentvalue.
Probablythemostfrequentlyusedmodelinfinancialforecasting.
Intimeseries,b1iscalledthetrendcoefficient.
Iftheresidualerrorsfromalineartrendmodelarepersistent(thusviolatingtheassumptionthattheregression
errorsarenotcorrelatedacrosstime,orrandom),wethenemployanalternativemodelsatisfyingtheconditionsof
linearregression,suchastheloglinearmodel.
ln(yt)=b0+b1t+ t
Thepredictedtrendvalueofytinaloglineartrendmodelis
Usealoglineartrendmodelwhenthetimeseriesgrowsataconstantrate.Usealineartrendmodelwhen
thetimeseriesgrowsbyaconstantamount.
Ifatrendispersistentlyaboveorbelowthevalueofthetimeseries,theresidualsareseriallycorrelated.
Whenthetrendlineisbelowthedata,thosearepositiveresiduals.Whenthetrendlineisabovethedata,thoseare
negativeresiduals.
Autoregressivemodel(AR):xt=b0+b1xt1+ t
Atimeseriesregressedonitsownpastvalues,inwhichtheindependentvariableisalaggedvalueofthe
dependentvariable.
Tousethismodel,wemustassumethatthetimeseriesiscovariancestationary.Thismeansthatits
properties,suchasmeanandvariance,donotchangeovertime.Forthetimeseriestobecovariance
stationary,threeprincipalsmustmet:
Theexpectedvalueofthetimeseriesmustbeconstantandfiniteinallperiods.
Thevarianceofthetimeseriesmustbeconstantandfiniteinallperiods.
Thecovarianceofthetimeserieswithitselfforafixednumberofperiodsinthepastorfuturemust
beconstantandfiniteinallperiods.
Stationaryinthepastdoesntguaranteestationaryinthefuture.
Whenseenonagraph,theplotoftheserieswillfluctuatearoundaconstantmeanifitscovariance
stationary.
Formosttimeseriesmodels(especiallyautoregressivemodels),theDurbinWatsontestcantbeused.
Theautocorrelationsofatimeseriesarethecorrelationsofthatserieswithitsownpastvalues.This
messesupyourmodel.
Iftheerrorautocorrelationsdifferfrom0,themodelisnotspecifiedcorrectly.
H0:errorautocorrelationsequals0.
Ha:errorautocorrelationsdifferfrom0.
Teststatistic:,withbeingthestandarderroroftheautocorrelations.Thetcisthenormaltcusedto
testagainstboandb1.
Tofixserialcorrelationinthismodel,estimateamodelwithmorelagsofthedependentvariableas
independentvariables.Examplebelow:
Originalmodel:inflationt=b0+b1inflationt1+ t
5

 Fixedmodel:inflationt=b0+b1inflationt1+b2inflationt2+ t
Meanrevertinglevel:xt=
Thetimeserieswilldecreaseifthecurrentvalueisabovethemeanrevertinglevel,andincreaseif
belowthemeanrevertinglevel.
Ifatimeseriesiscovariancestationary,thenitwillbemeanreverting.
Astationarytimeseriesmayneedmanyperiodstoreturntoitsequilibrium,meanrevertinglevel.
Chainruleofforecasting:aprocessinwhichthenextperiodsvalueaspredictedbytheforecastingequationis
substitutedintotherighthandsideoftheequationtogiveapredictedvaluetwoperiodsahead.
Multiperiodforecastsaremoreuncertainthansingleperiodforecastsbecauseeachforecastperiodhas
uncertainty.
Themodelwiththesmallerforecasterrorvarianceandlowerstandarderrorwillbethemoreaccurate
model.
Insampleforecasterrors:residualsfromwithinthefittedtimeseriesmodel.
Outofsampleforecasterrors:residualsfrompredicteddataoutsideofthetimeseries.The
futureisalwaysoutofsample.
Theforecastingmodelwiththesmallestrootmeansquarederror(RMSE)isthemost
accurate.RMSEisthesquarerootoftheaveragesquarederror.
Step1:takethedifferenceb/tactualvalueandforecastvalue
Step2:squaretheerror
Step3:sumthesquarederrors
Step4:dividebythenumberofforecasts
Step5:takethesquarerootoftheaverage
Youshouldnotcombinedata,forexample,fromaperiodwhenexchangerateswerefixeddatawithfroma
periodwhenexchangerateswerefloating.
Arandomwalkisatimeseriesinwhichthevalueoftheseriesinoneperiodisthevalueoftheseriesinthe
previousperiodplusanunpredictablerandomerror.xt=xt1+ t
Thismeansthatthebestforecastofthenextperiodsvariableisthecurrentperiodsvariable.

thasconstantvarianceandisuncorrelatedwiththeerrorterminthepreviousperiods.Theexpected
valueof tis0.Arandomwalkisnotcovariancestationary.Allrandomwalkshaveunitroot(discussedbelow).
Inrandomwalks,b0=0,andb1=1.(arandomwalkwithoutdrift)TopictestDeMolay#1.
Astgrowslarge,thevarianceofxtgrowswithoutanupperbounds:itapproachesinfinity.
Wecannotuseastandardregressionanalysisonatimeseriesthatisarandomwalk.
Wemustdifferencethetimeseriestousearandomwalkregressionmodel.
Thisisdonebycreatinganewtimeseriesthatinwhicheachperiodisequaltothedifference
betweenxtandxt1.Suchasyt=xtxt1= t.Alsowrittenas xt=xtxt1= t.
Whenthemodelisdifferenced,b0=0andb1=0.Residualautocorrelationsalsoarent
significantlydifferentfromzero.
Afirstdifferencedrandomwalkhasameanrevertinglevelof0.Itisalsocovariancestationary.
Youcantusetstatisticstotestwhetheradataseriesisarandomwalk,becausethestandarderrorsinan
ARmodelareinvalid.
HowshouldIinterpretR2inarandomwalk?
AccordingtoTBone,theR2isuselessinarandomwalk.
Arandomwalkwithdriftshouldincreaseordecreasebyaconstantamountineachperiod.b00
Inatypicalstationarytimeseries,theautocorrelationsatalllagsarestatisticallyindistinguishablefrom0,
ortheautocorrelationsdropoffrapidlyto0asthenumberoflagsbecomeslarge.Theautocorrelationsof
nonstationarytimeseriesDONOTdothis.
IfanAR(1)timeseriesiscovariancestationary,theabsolutevalueofthelagcoefficientb1mustbe
lessthan1.Wecouldntrelyonthestatisticalresultsiftheabsolutevalueofb1isgreaterorequalto
1.
Ifthelagisequalto1,thetimeserieshasaunitroot,anditisarandomwalkandisnot
covariancestationary.Allrandomwalks,withorwithoutdrift,haveunitroots.
Aseriesthattrendsupwardordownwardovertimeoftenhasaunitrootandisthusnot
covariancestationary.
Totestforregressionunitroot,useaDickeyFullertest:
Equation:xtxt1=b0+g1xt1+ t
Whereg1=(b11)
6

Ho:g1=0thetimeserieshasunitrootandisnonstationary.
Ha:g1<0thetimeseriesdoesnthaveunitrootandiscovariancestationary.
IfthereisunitrootintheAR(1)model,theng1willbe0inaregressionwherethe
dependentvariableisthefirstdifferenceofthetimeseriesandtheindependent
variableisthefirstlagofthetimeseries.
Tofixamodelthathasunitroot,istomodelthefirstdifferencedseriesasan
autoregressivetimeseries.
Iftheunitroottstatisgreaterthanthecriticalvalue(orlessthanthenegativecriticalvalue),the
modeldoesNOThaveunitroot.TopictestReyes#6.
YoumusttestBOTHthedependentvariableseriesandtheindependentvariableseriesforunit
root.TopictestDeMolay#5.
Movingaveragetimeseriesmodelsallowyoutoremoveshorttermfluctuationsbysmoothingoutthetime
series.
Onemethodistousethenperiodmovingaverage:
[xt+xt1+...+xt(n1)]/n
Mainweaknessofamovingaverageisthatitlagslargemovementsinthedata.
Abetterequationtouseisthefollowing:xt= t+ t1where istheparameteroftheMA(1)model.
Thismodelplacesdifferentweightsonthetwoitemsinthemovingaverage,1 tonand on t1
InanMA(1)model,allautocorrelationsexceptforthefirstonewillbeequalto0.
Lastly,qthordermovingaveragemodel,denotedMA(q),hasvaryingweightsonthelaggedterms
xt= t+ t1+...+ q tq
InanMA(q)model,allautocorrelationsexceptforthefirstqwillbeequalto0.
Theautocorrelationsofmostautoregressivetimeseriesstartlargeanddeclinegradually,whereasthe
autocorrelationsofanMA(q)timeseriessuddenlydropto0afterthefirstqautocorrelations.
Weareunlikelytoknowbeforehand,whetheratimeseriesisautoregressiveormovingaverage.
Toadjustforseasonality,includeaseasonallagintheautoregressivemodel.Examplebelow:
Quarterlyseasonaltimeseries:xt=b0+b1xt1+ t
Tofix,youwouldadjustthemodel:xt=b0+b1xt1+b2xt4+ t
Ifyouadjustthemodel,youshouldseeanimprovementinR2.
Autoregressivemovingaveragemodels(ARMA)canbeveryunstable,dependingonthedatasampleusedad
theparticularARAMmodelestimated.
Heteroskedasticityisthedependenceoftheerrortermvarianceontheindependentvariable.
ThismakestheregressioncoefficientsinAR,MA,andARMAmodelsinvalid.
Wecantestforthisbyusinganautoregressiveconditionalheteroskedasticity(ARCH)model.
ARCH(1): t~N(0,a0+a1)
Ifa1=0,thevarianceoftheerrorineveryperiodisjusta0.
Ifa1>0,thenthevarianceoftheerrorinoneperioddependsonhowlargethesquared
errorwasinthepreviousperiod.
AnalystscantestforfirstorderARCHinatimeseriesmodelbyregressingthesquared
residualonthesquaredresidualfromthepreviousperiod.Ifthecoefficientonthesquared
residualisstatisticallysignificant,thetimeserieshasARCH(1)errors.TopictestDeMolay
#3.
Tofixthis,youmustusegeneralizedleastsquaresorothermethods.TopictestDeMolay
#4.
Ifbothtimeserieshaveunitroot,thentheymaybecointegrated,whichmeansthatalong
termrelationshipexistsbetweenthemsuchthattheydonotdivergefromeachother
withoutboundinthelongrun.
Ifthetimeseriesiscointegratedandbothhaveunitroot,youcanstillusethemodel.Theyarecovariance
stationary.Thismodelisgoodforlongtermtrends,butmaynotbethebestforshorttermtrends.
Iftheybothhaveunitrootbutarenotcointegrated,youcannotusethatmodel.
Seepage460.
Rereadsection12onpage462!

Reading12
Scenarioanalysisanddecisiontreesaregenerallybuiltarounddiscreteoutcomesinriskyeventswhereas
simulationsarebettersuitedforcontinuousrisks.
7

Scenarioanalysis,decisiontrees,andsimulationsuseexpectedratherthanriskadjustedcashflowsandthe
discountratethatisusedshouldbeariskadjusteddiscountrate.Theriskfreeratecannotbeusedtodiscount
expectedcashflows.
Scenarioanalysisdoesntrequiretheestimationoftheunderlyingstatisticaldistributions.
Inanormaldistribution,meanandmedianarethesame.
Evenwhenthedatafitsastatisticaldistributioninonetimeperiod,nonstationaritymaycausetheparameterof
thedistributiontochangeinsubsequentperiods.TopictestYang.
Discrete/Continuous

Correlated/Independent

Sequential/Concurrent

RiskApproach

Discrete

Independent

Sequential

Decisiontree

Discrete

Correlated

Concurrent

Scenarioanalysis

Continuous

Either

Either

Simulations

Readthissectionagain.

Images