Proceedings of the 34th Hawaii International Conference on System Sciences - 2001

An Intelligent Clustering Forecasting System based on

Change-Point Detection and Artificial Neural Networks:
Application to Financial Economics

Kyong Joo Oh* and Ingoo Han*

*Graduate School of Management,
Korea Advanced Institute of Science and Technology

Abstract There have been many exciting developments in the

This article suggests a new clustering forecasting
system to integrate change-point detection and artificial
neural networks. The basic concept of proposed model is
to obtain intervals divided by change point, to identify
them as change-point groups, and to involve them in the
forecasting model. The proposed models consist of two
stages. The first stage, the clustering neural network
modeling stage, is to detect successive change points in
dataset and to forecast change-point group with
backpropagation neural networks (BPN). In this stage,
three change-point detection methods are applied and
compared: (1) the parametric method, (2) the
nonparametric approach, and (3) model-based approach.
The next stage is to forecast the final output with BPN.
Through the application to the financial economics, we
compare the proposed models with a neural network model
alone and, in addition, determine which of three change
point detection methods can perform better. This article is
then to examine the predictability of the integrated neural
network model based on change-point detection.
1. Introduction
The prediction of structural changes in financial and
economic time series is one of the most important
forecasting problems for economists. Neither factory is
built nor inventory acquired without any prediction that a
serious depression is not going to begin within the next
few months. Polices based on prediction of change points
in business cycles can produce stabilizing ones, while ill-
timed fiscal and monetary policies may result in some
unintended destabilizing ones. For instance, government
expenditures are likely to contribute more to excess
demand and inflationary pressures during a business
expansion than during a business contradiction. Therefore,
the detection and estimation of a structural or parametric
change point in forecasting is an important and difficult
problem.
theory of change-point detection. New promising
directions of research have emerged, and traditional trends
have flourished anew. Furthermore, there are a large
variety of change-point detection problems in time series
and dynamical systems. The literature on this topic is
rapidly growing mainly due to applications in engineering,
financial mathematics and econometrics. In these
applications, the problem is known under different
headings, such as quality control, failure detection and
shock detection. These change-point detections have
brought to various change-point models, which are
classified as likelihood ratio tests [6, 21, 12, 40, 41, 42, 17,
48, 49, 50], nonparametric approaches [4, 30, 31, 32, 33,
35, 36], and linear model approaches [38, 39, 1, 9, 43, 18,
19, 7, 15, 16]. Csorgo and Horvath [11] provide a concise
overview and rigorous mathematical treatment of methods
for change-point detections and use a number of datasets
to illustrate the effectiveness of the various techniques.
Most of the previous research for the change-point
detection has a focus on the finding of unknown change
points for the past, not the forecast for the future [47, 26,
51]. We suggest the neural network forecasting model
using structural change on the basis of the theoretic
background, and compare the neural network model alone
with the proposed models. In the proposed model, the
change-point detection becomes a basis of classification
that plays a core role of model building based on time
series segmentation.
The performance of the proposed model is evaluated in
the context of the integrated neural network model which
consists of two stages. The first stage obtains intervals
divided by change points, identifies them as change-
point groups, and forecasts the group output with
backpropagation neural networks (BPN). In this stage, the
various change-point detection methods will be applied
and compared: (1) parametric method, (2) nonparametric
approach, and (3) linear model approach. The second stage
forecasts the output with BPN. The study then examines
the predictability of the proposed models. To explore the

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 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001

predictability, we divided the sample data into the training chi-square distribution for large sample sizes [11].
data over one period and the testing data over the next
period. The predictability is examined using the metrics of 2.2. The Pettitt Test: A Nonparametric Approach
the root mean squared error (RMSE), the mean absolute Consider a sequence of random variables
error (MAE) and the mean absolute percentage error X1 , X 2 , , X T , then the sequence is said to have a
(MAPE) in the final stage.
change-point at if X t for t = 1, 2, , have a
In Section 2, we review the various change-point
detection methods. Section 3 describes the proposed model common distribution function F1 ( x ) and X t for
details. Section 4 reports the results of application to t = + 1, + 2, , T have a common distribution F2 ( x) ,
interest rates forecasting. Finally, the concluding remarks and F1 ( x ) F2 ( x) . We consider the problem of testing
are presented in Section 5.
the null hypothesis of no-change, H 0 : = T , against the
2. Change-Point Detection Methods alternative hypothesis of change, H A : 1 < T , using a
According to the classification by Csorgo and Horvath non-parametric statistic.
[11], three major change-point detection methods are used An appealing non-parametric test to detect a change
and compared: (1) the likelihood ratio test for a parametric would be to use a version of the Mann-Whitney two-
method based on likelihood approach, (2) the Pettitt test sample test. A Mann-Whitney type statistic has remarkably
for a nonparametric approach based on the Mann-Whitney stable distribution and provides a robust test of the change
type statistic, and (3) the Chow test for a linear model point resistant to outliers [37]. Let
approach which is involved with linear model. The Pettitt Dij = sgn( X i X j ) (2)
test and the Chow test are selected for nonparametric
approach and linear model approach respectively since
where sgn( x ) = 1 if x>0 , 0 if x = 0, 1 if
they are frequently reviewed on the text and offered by
statistical packages. x < 0 , then consider
t T

2.1. Likelihood Ratio Test (LRT): A Parametric U t ,T = D

i =1 j =t +1
ij (3)
Method
We assume that X1, X 2 , ... , X n are independent
The statistic U t ,T is equivalent to a Mann-Whitney
normal observations with parameters ( 1 , 2 ), ( 2 , 2 ),
statistic for testing that the two samples X 1 , , X t and
... , ( n , 2 ) . Under H 0 , 1 = 2 = = n and
X t +1 , , X T come from the same population. The
under the alternative hypothesis, there is an integer k
statistic U t ,T is then considered for values of t with
such that 1 = 2 = = k k +1 = = n . The
1 t < T . For the test of H 0 : no change against H A :
variance is an unknown. It is further assumed that the
variance as well as the mean may change at an unknown change, we propose the use of the statistic
time, then the maximally selected likelihood ratio test is K T = max U t ,T . (4)
1t <T
max1i n Lk such that
L k = 2 log k = {n log n2 k log k2 (n k ) log n2 k } (1) The limiting distribution of K T is approximated to

where n2 =
1
n

(X i X k )2 , {
2 exp 6k 2 /(T 2 + T 3 ) } for T .
n i =1
2.3. The Chow Test: A Linear Model Approach
1
k n
~
k2 =
( X i X k ) +
n i =1
2

i = k +1

( X i X n k ) 2 ,

Chow [7] suggested the test for structural breaks which
are for stationary variables and a single break. Consider
n the linear regression model with k variables as follows.
1 ~
n2 k =
nk (X
i = k +1
i X nk ) 2 ,
Y = 0 + 1 X 1 + 2 X 2 + + k X k + (5)
n k n
1 1 ~ 1
Xn =
n i =1
X i , X k =
k i =1
X i , X nk =
nk X
i = k +1
i where Y is the value of the response variable in the i th
observation; 0 , 1 , 2 , , k are parameters; X 1 ,
The distribution of max 1i n Lk is approximated to the X 2 , , X k are the values of the independent variables in

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 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001
the i th observation; is an identically independent
random error term with mean E ( ) = 0 and variance
Var ( ) = 2 under the normal distribution for sample
size n .
Now consider the two linear regressions for the two
subsets of the data modeled separately,
Y = 10 + 11 X 1 + 12 X 2 + + 1k X k + 1 (6)
Y = 20 + 21 X 1 + 22 X 2 + + 2 k X k + 2
where the number of observations from the first set is n1
and the number of observations from the second set is n 2 .
The Chow test statistic is used to test the null hypothesis,
H 0 : 10 = 20 , 11 = 21 , 12 = 22 , , 1k = 2 k
conditionally upon the same
Var ( 1 ) = Var ( 2 ).
The Chow test statistic is computed using three residual
sums of squares errors:
n 2 n1 2 n2 2
i
1i 2i k
Fchow =
i =1 i =1 i =1
n1 2 n2 2
+
1i
2i (n1 + n 2 2k )
i =1 i =1
where the mark ^ means the predicted value obtained
from the model. Under the null hypothesis, the Chow test
statistic has an F -distribution with k and (n1 +
n 2 2k ) degrees of freedom.
The above-mentioned tests detect a possible change
point in the time sequence dataset. Once the change point
is detected through the test, then the dataset is divided into
two intervals. The intervals before and after the change
point form homogeneous groups which take heterogeneous
characteristics from each other. This process becomes a
fundamental part of the binary segmentation method [45]
explained in Section 3.
3. Model Specification
In order to build the forecasting model based on the
structural change, we need to integrate change-point
detection methods and artificial neural networks (ANN).
The advantages of combining multiple techniques to yield
synergism for discovery and prediction have been widely
recognized [14, 22, 23]. The proposed model consists of
two stages: (1) the change-point-assisted clustering (CPC)
stage and (2) the final output forecasting (FOF) stage.
ANN is used as a classification tool in CPC and as a
forecasting tool in FOF.
The CPC stage
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In this stage, we make the change-point-assisted neural
network model for the intervals based on various change-
point detection methods.
Step 1: Perform the change-point detection
Let x it be t th time series data for i th input variable
where i = 1, , m , and let y t be t th time series data for
output variable where t = 1, , n . Multiple change points
(7)
are obtained under the binary segmentation method [45].
With H 0 as in Section 2, under the alternative hypothesis
we now assume that there are R changes in the
parameters, where R is a known integer. The alternative
can be formulated as
error variance H A( R ) : there are integers 1 < k1 < k 2 < < k R < n
such that 1 = = k1 k1 +1 = = k 2 k 2 +1 =
= k R k R +1 = = n for the parameter ' s.
We note that the test statistics under the null hypothesis
will remain consistent against H A(R ) as well, despite the
fact that they were derived under the assumption that
(8)
R = 1 . Without the loss of generality, we can deduce that
the tests mentioned in Section 2 are extended to the form
for no change against the R changes alternative
H A(R ) .
Vostrikova [45] suggested a binary segmentation
method as follows. First, use the change-point detection
test. If H 0 is rejected, the find k1 that is the time where
the maximum of Equation (1), (4) and (8) is reached. Next
divide the random sample into two subsamples
{ t 1 } { t 1 }
x : 1 t k and x : k < t n , where x should be
t
selected among all input variables such that it is highly
correlated with the desired output, and test both
subsamples for further changes. The number of change
points, R , should be determined under the view of field
experts. Thus, one continues this segmentation procedure
until the opinion of expert is satisfied.
This process plays a role of clustering which constructs
groups as well as maintains the time sequence. In this
point, Step 1 is distinguished from other clustering
methods such as the k-means nearest neighbor method and
the hierarchical clustering method that classify data
samples by the Euclidean distance between cases without
considering the time sequence. Therefore, this step may be
considered as the time-based clustering model.
Step 2: Train the groups with BPN
The proposed model is based on ANN, where the
neuron input path (i) has a signal on it ( xit ) and the
strength of the path is characterized by a weight ( wi ) .
The neuron is modeled as summing the path weight times
3
 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001

the input signal over all paths and adding the node bias together different responses over different intervals based
() . The output ( y t ) is usually a sigmoid shaped on BPN:
logistic function that is expressed as follows: f1 ( x1at , , x mt
a
; 1 ), D 1 = 1
1
y t = f ( xt ) = (9)
a a
f ( x , , x mt ; 2 ), D 2 = 2
m y t +1 = 2 1t (12)
1 + exp
wi x it +


f (, x a , , x a ; ), D

i =1 R +1 1t mt R R +1 = R + 1
for t = 1, 2, , n The variances of the estimated means are denoted by
Note that this S-shaped function reduces the effect of V pure and V prop , which indicate the variances produced
extreme input variables on the performance of the network. by the pure ANN alone and the proposed model
Let respectively. Then, the following establishes:
{ }
Dt = x it : k h 1 < x t k h = h, h = 1, , R + 1. 1
R +1 nh

where k 0 = 1 and k R +1 = n . Once ANN to xit and Dt V pure = ( y

n 1 h =1 i =1
hi y) 2
have been established, we consider predictors of the future R +1 R +1
nh 2 nh
evolution of Dt . A predictor is simply a rule for obtaining
an estimate of Dt +1 for the next observation. The

h =1
n
Sh + n (y
h =1
h y) 2 (13)

R +1
prediction D nh
t +1 of D t +1 can be obtained using some
extrapolation of the observations for input variables
= V prop + n (y
h =1
h y) 2

x1t , x 2t , , x mt subsequently to the ANN that have been nh nh

1 1
chosen, that is to say: where S h2 =
nh 1 (y hi yh ) 2 , yh =
nh y hi for
D t +1 = f ( x1t , x 2t , , x mt ) (10) i =1 i =1
R +1 R +1
1
Then x1t , x 2t , , x mt are adjusted to x1at , x 2at , , x mt
n n
a
h = 1, , R + 1 , y= h yh , n= h , and n h =
n
according to D t +1 . Learning occurs through the h =1 h =1

adjustment of the path weights and node biases. The most
common method used for the adjustment is BPN, which is
known to be a useful tool in many applications such as
classification, forecasting, and pattern recognition [34].
The significant intervals in Step 1 are grouped to detect
the regularities hidden in desired output. Such groups
represent a set of meaningful trends encompassing interest
rates. Since those trends help to find regularity among the
related output values more clearly, the neural network
model can have a better ability of generalization for the
unknown data. After Step 1 detect the appropriate groups
hidden in the time series data, BPN is applied to the input
data samples at time t with group outputs for t + 1 given
by Step 1. In this sense, the CPC stage is a neural network
model that is trained to find an appropriate group for each
given sample.
The FOF stage
When generating ANN predictions. Locally adjusted
nonlinear predictions are usually employed for each group
h:
y t +1 = f h ( x1at , x 2at , , x mt
a
) , h = 1, , R + 1 (11)
Consider a relationship between y t and xit in which the
function E ( y | x) = f ( x; ) is obtained by classifying
the number of sample for h th group.
Equality holds in (13) if terms in 1 n h are negligible and
hence also in 1 n . Thus,
V pure V prop . (14)
This is indeed a very useful point to reduce the
prediction error. In the model, the number of change-point
group is an important factor to improve the performance.
Inequality (14) is always guaranteed if time series
segmentation is optimally established. The error for
forecasting may be reduced by making the subsampling
units within groups homogeneous and the variation
between groups heterogeneous [10]. Thus, the number of
change-point group should be optimally determined. To do
this, we perform the heuristic experiment as we change the
number of group. Subsequently, we demonstrate that
inequality (14) holds for the prediction of chaotic financial
data in this article.
FOF is built by applying BPN to each group. FOF is a
mapping function between the input sample and the
corresponding desired output. Once FOF is built, then the
sample can be used to forecast the target value. This stage
is needed to evaluate and compare the predictability of the
proposed integrated models through various change-point
detection methods.

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 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001

4. Application to the U.S. Interest Rates
Financial analysts and econometricians have frequently
used piecewise-linear models which also include change-
point detection. They are known as models with structural
breaks in economic literature. In these models, the
parameters are assumed to shift typically once
during a given sample period and the goal is to estimate
the two sets of parameters as well as the change point or
structural break. However, this study has a focus on the
clustering group based on change-point detection while the
next learning is occurred in the FOF stage that forecasts
the final output. The models, labeled LRT_NN, PET_NN
and CHOW_NN, indicate that the LRT, the Pettitt test and
the Chow test are used respectively as a change-point
detection method. For validation, four learning models are
also compared.
16

forecast for the future, not on the finding of unknown 14

changes points for the past, with the assumption that the 12

multiple change points may have occurred. 10

In this study, the proposed model is applied to interest 8

rates forecasting which is one of the most closely watched 6

variables in the financial economy. In general, the 4

movement of interest rates has a series of change points

which occur because of the monetary policy of the
2

government [13, 44, 28, 8, 25, 3]. The case study is 0

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conducted for monthly yields on the Treasury bill rate of 1
years maturity in the U.S. Figure 1. Yield of US Treasury bills with a
The input variables used in this study are M2, consumer maturity of 1 year from Jan. 1960 to May 1999
price index, expected real inflation rates and industrial
production index. They are used in both the CPC stage and The change-point detection methods are applied to the
the FOF stage. The lists of variables used in this study are interest rate dataset in the training phase. It is known that
summarized in Table 1. By the previous study, input interest rates at time t are more important than
variables in Table 1 are those which were significant in fundamental economic variables in determining interest
interest rates forecasting [29]. To obtain stationary and rates at time t + 1 [24]. Thus, we apply LRT, the Pettitt
thereby facilitate forecast, the input data were transformed test, and the Chow test to interest rates at time t in the
by a logarithm and a difference operation. Moreover, the training phase. The heuristic experiment is performed as
resulting variables were standardized to eliminate the the number of group is changed. The number of group is
effects of units. varied until the minimum error rate is found for the
prediction values, which is based on MAPE. This metric is
Table 1. Description of Variables. chosen since it is commonly used [5] and is highly robust
Variable Description Attribute [2, 27]. The performance results are observed by the
Name change of the number of group. Table 2 indicates these
TBILL Treasury Bill with 1 years Output results. Four groups are selected as an optimal number of
maturity groups. Furthermore, the Pettitt test shows the best
M2 Money Stock Input
performance. The Pettitt test is recommended in the
CPI Consumer Price Index Input
forecast of chaotic time series since its error rates in Table
ERIR Expected Real Interest Rates Input
IPI Industrial Production Index Input
2 have more stable results than other tests. Nonparametric
statistical property of the Pettitt test is suitable match for a
neural network model that is a kind of nonparametric
The training phase included observations from January
method [46]. On the average, the Chow test has lower
1961 to August 1991 while the testing phase runs from
September 1991 to May 1999. The interest rate data are performance since it has strong constraints that the
observations are required to constitute the linear regression,
presented in Figure 1. Figure 1 shows that the movement
in addition that they are random samples with the normal
of interest rates is highly fluctuated during the last forty
distribution, which is also assumption of LRT. If the given
years.
dataset is not suitable for the regression model, it is natural
The study employed four neural network models. One
that the application of the Chow test may bring about low
model, labeled Pure_NN, include input variables at time
performance.
t to generate a forecast for t + 1 . The input variables are
To highlight the performance due to various models, the
also M2, CPI, ERIR and IPI. The second type has the two-
actual values of Treasury bill rates and their predicted
staged learning model mentioned in section 3. The first
values are shown in Figure 2 when the dataset is
learning is occurred in the CPC stage that forecasts the
segmented into four groups. The predicted values of the

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 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001

pure BPN model (i.e. Pure_NN) get apart from the actual dependence [20]. Table 4 shows t-values and p-values
values in some intervals. Numerical values for the when the prediction accuracies of the left-vertical methods
performance metrics by predictive model are given in are compared with those for the right-horizontal methods.
Table 3. Figure 3 presents histograms of RMSE, MAE and Mostly, the proposed models using change-point detection
MAPE of predictions for each learning model. According method perform significantly better than the pure BPN
to RMSE, MAE and MAPE, the outcomes indicate that model at a 1% or 5% significant level. This means that the
LRT_NN, PET_NN and CHOW_NN are superior to change-point-assisted clustering model takes a major role
Pure_NN. to improve the performance.

Table 2. Performance results according to the 0.35

change of the number of change based on MAPE

Number of
0.3

Group Chow Pettitt

LRT Average 0.25

to be occurred Test Test

Pure_N N
0.2
LR T_N N
Two Groups 5.443 3.765 3.820 4.342 PET_N N
0.15

C H O W _N N
Four Groups 4.392 3.811 3.746 3.983 0.1

0.05

Eight Groups 3.882 6.695 3.985 4.854

0
R M SE M AE M A PE

7.5 Figure 3. Histogram of RMSE, MAE and MAPE

7 resulting from forecasts of TBILL
6.5

6 Table 4. Pairwise t-tests for the differences in

5.5 Actual residuals for US interest rate prediction based on
5
Pure_N N
the absolute percentage error (APE)
with the significance level in parentheses.
LRT_N N
4.5
PET_N N
4 C H O W _N N
Model LRT_NN CHOW_NN Pure_NN
3.5 PET_NN 0.31 2.60 3.43
3
(0.756) (0.010) * (0.000) **
2.5
LRT_NN 2.58 3.58
(0.011) * (0.000) **
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Sep-98
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Dec-95

Dec-96

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Dec-98

CHOW_NN 2.55
Figure 2. Actual vs predicted values due to (0.012) *
various models for TBILL ** Significant at 1%; * Significant at 5%

Table 3. Performance results in the case In summary, the proposed models turn out to have a
of the U.S. Treasury bill rate forecasting based on high potential in interest rate forecasting. This is
RMSE, MAE and MAPE attributable to the fact that it categorizes the input data
Model RMSE MAE MAPE (%) samples into homogeneous group and extracts regularities
Pure_NN 0.3119 0.2506 5.969 from each homogeneous group. Therefore, the proposed
LRT_NN 0.2224 0.1738 3.811 models cope with the noise or irregularities more
PET_NN 0.2416 0.1745 3.746 efficiently than the pure BPN model. For the chaotic time
CHOW_NN 0.2557 0.1980 4.392 series data, furthermore, the Pettitt test is recommended
since it is free from assumptions and constraints.
When the dataset is segmented into four groups, we use
the pairwise t-test to examine whether there exist the
differences in the predicted values of models according to 5. Concluding Remarks
the absolute percentage error (APE). Since the forecasts The basic concept of proposed model is to obtain
are not statistically independent and not always normally significant intervals by change-point detection, to identify
distributed, we compare the forecasts APEs using the them as change-point groups, and to include them in the
pairwise t-test. Where sample sizes are reasonably large, final output forecasting. In order to validate its
this test is robust to the distribution of the data, to performance, we propose the integrated neural network
nonhomogeneity of variances, and to statistical model which consists of two stages. In the first stage, we

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 Proceedings of the 34th Hawaii International Conference on System Sciences - 2001
find a change-point to construct the homogeneous groups
and then make the change-point-assisted clustering model
to predict the group outputs. In the next stage, we apply
BPN to forecast the final output.
The proposed models perform significantly better than
the pure BPN model at a 1% or 5% significant level.
Experimental results show that the proposed neural
network models outperform the pure BPN model
significantly, which implies the high potential of involving
the change-point detection in the model. The proposed
models are demonstrated to be useful intelligent data
analysis methods based on the concept of change-point
detection. In the case study, finally, we have shown that the
proposed models improve the predictability of interest
rates significantly.
If further studies are to focus on optimizing the number
of change point in terms of the performance, the proposed
models have the promising possibilities to improve the
performance. In the final stage of the model, other
intelligent approaches can be used to forecast the final
output besides BPN. In addition, the proposed models may
be applied to other application fields. By the extension of
these points, future research is expected to provide more
improved models with superior performances.
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