FORECASTING

A probabilistic estimate

A description of a future value or condition

In general, effective forecasts vital for achieving the
strategic and operational goals of all organisations (public
or private, profit or non-profit, product or service).

In particular
eliminating waste, such as inventory shortages,
excesses
missed due dates
plant shut downs
lost sales
lost customers
in the long run, missed strategic opportunities.
FINANCIAL & STRATEGIC IMPORTANCE
Improved strategic information
Improved marketing information
Improved financial information
Improved operations information
Improved customer service
Improved allocation of scarce resources
Improved manufacturing and operating efficiency
Improved productivity
Improved stability in planning
Reduced finished goods inventory
Elimination of waste
More flexibility to respond to customer preferences
Increased profitability
Increased return on investment.
INDEPENDENT-VS-DEPENDENT DEMANDS
Only independent demands need to be forecast and the
many dependent demands can then be computed.

E.g. An auto firm needs to forecast demand for its final
assembly called its system unit. It is the independent
demand. Its spares & components or the dependent
demands can be computed (i.e. wheels, tyres, axels,
gear boxes, engines, carburetors, batteries, wind shield,
electrical fittings, upholstery etc.).

Similarly for bicycles or micro computers, hospitals,
educational institutions, wholesalers, retailers etc.
THE FORECASTING HIERARCHY
Type of Demand Examples of Forecasts
Macroeconomy : Forecasts of income, productivity,
employment, interest rates,
technology.
Industry Demand : General demand for products of an
industry e.g. automobiles.
Company demand : The companys market share.
Product-line demand : Small cars, mid-sized cars, luxury
cars.
Company-wide demand : National demand for each of the
products.
Demand for each location : Demand for luxury cars in
Mumbai, Delhi, Chennai etc.
ANALOGY WITH FISHING
In fishing, as in forecasting, one casts a line forward.
The cast is called forward cast. A backcast in fly-
fishing is the toss of a line backward overhead.

Analogous to modeling past demands in forecasting.

Past patterns are modeled (backcast) to throw those
patterns forward to the future.

Often, therefore a good backcast determines a good
forecast.
FORECASTING METHODS : AN OVERVIEW
TIME SERIES MODELS:
Trend fitting
Moving averages
Exponential smoothing
Fourier series
ARIMA

CAUSAL MODELS:
Multiple regression
Econometric
Cyclical
Multivariate ARIMA
Vector autoregression
I-O Models

QUALITATIVE TECHNOLOGICAL:
Expert opinion
Sales force composite
Delphi
Historical Analogy
S-growth curves

OTHER QUALITATIVE:
Market research
Expert systems
Artificial Neural Networks
Genetic Algorithms
THE FORECASTING PROCESS
Problem definition:
plans, objectives and decisions
boundaries of a system

Information search:
define the system
define possible cause and effects

Hypothesis/Theory/Model formulation:
refine causal model
graphical exploration
postulate direction of causality
consider appropriate methods

Experimental Design:
select in-sample fitting data
select out-of-sample validation data

THE FORECASTING PROCESS (Contd.)
Experimental Execution:
fit several in-sample models
forecast out-of-sample models

Results Analysis:
examine the validity of assumptions
examine whether results support theory
examine whether experts agree
perform out-of-sample validity tests

Ongoing Maintenance & Verification:
(Ensure that the model is still valid and effective)
incorporate real-time judgment
implement model/system
monitor model/system.

TIME SERIES ANALYSIS & FORECASTING

COMPONENTS :
TREND (INCOME, CONSUMPTION, EXPORTS,
IMPORTS, PRICE INDEX, STOCK PRICES ETC.)
SEASONALITY (SALES, TRAVEL & TOURS,
FESTIVALS/HOLIDAYS AFFECT CERTAIN
PHENOMENA & PURCHASE PATTERNS)
CYCLICAL (ASSOCIATED WITH BUSINESS CYCLE
FLUCTUATIONS)*
RANDOM (IRREGULAR)


* GENERAL MERCHANDISE SALES DIP DURING
RECESSIONS AND REMAIN SLUGGISH FOR
SEVERAL MONTHS AFTER THE UPTURN HAS
STARTED.

LINEAR TREND :
y = o + |t
CONSTANT RATE OF GROWTH (MOST MACRO
SERIES)
NON-LINEAR TRENDS
GROWING BUT AT A SLOWER RATE (POPULATION,
DURABLE CONSUMER GOODS ETC.)
DECLINING BUT AT A SLOWER RATE (SPIRALLIG
OIL PRICES OF THE 1973-80 PERIOD CAUSING A BIG
DECLINE IN THE ENERGY INTENSITY PER UNIT OF
GDP. INITIALLY BUT LATER DECLINING MORE
SLOWLY.
SATURATION CURVE:
PERCENTAGE OF MARKET PENETRATION
STARTING FROM ZERO, SLOWLY RISING, THEN
ACCELERATION, AND LATER LEVELLING OFF
NEAR THE STATURATION POINT.


SOME FORECASTING KEYS :

NAVE MODEL:


NAVE TREND MODEL:


NAVE RATE OF CHANGE MODEL:


NAVE SEASONAL MODEL FOR QUARTERLY DATA :


NAVE TREND & SEASONAL MODEL FOR QUARTERLY
DATA:




t t
y y =
+1

) (

1 1 +
+ =
t t t t
y y y y
1
1

+
=
t
t
t t
y
y
y y
3 1

+
=
t t
y y
4
) ( .... ) (

4 3 1
3 1

+
+ +
=
t t t t
t t
y y y y
y y


SIMPLE AVERAGE



UPDATED SIMPLE AVERAGE NEW PERIOD:




MOVING AVERAGE FOR K TIME PERIODS:

=
+
=
t
i
i t
y
t
y
1
1
1

1 1
2
+
+
=
+ +
+
t
y y t
y
t t
t
k
y y y y
y
k t t t t
t
) .... (

1 2 1
1
+
+
+ + + +
=


DOUBLE MOVING AVERAGE:




AND WHERE






SIMPLE EXPONENTIAL SMOOTHING:



k
M M M M
M
k t t t t
t
) .... (
1 2 1 +
+ + + +
=
'
| o
t t p t
y + =
+

t t t
M M
'
= 2 o
) (
1
2
t t t
M M
k
'

= |
t t t
y y y

) 1 (

1
o o + =
+
Time series or univariate models are used for short-term forecasting as they
are the most cost effective.

They typically relate a dependent variable to its past values or internal
patterns and to random errors that may be serially correlated.

May sales + June sales 1200 + 1000
Eg. July sales forecast = ---------------------------- = ---------------- = 1100
2 2

They are in general, not based on any underlying economic behaviour
(unlike econometric models)

Earlier, popular in engineering & physical sciences but since a couple of
decades or so, it is so in Economics as well for the purpose of short-term
forecasting.

It is often modeled as Y
t
= T
t
+ S
t
+ U
t
or Y
t
= T
t
S
t
U
t

Where Y is the dependent variable
T is the trend component
S is the seasonal component
and U is the random error term

A simple linear time trend is T
t
= o + |
t

If Y
t
has been growing exponentially, then it should be
converted first into logarithms.

S, the seasonal component is the one that occurs regularly as
a seasonal phenomenon such as the month or a quarter,
week, day, hour, public holidays and so on. Here, seasonal
dummies can be used to estimate seasonal patterns.
Structure of Time Series Models
Auto regressive Models

Y
t
=
1
Y
t-1
+
2
Y
t-2
+ .. +
p
Y
t-p
+ U
t

U
t
is well behaved error term with zero mean and constant
variance.

Y
t
is the t
th
observation on the dependent variable after
subtracting its mean.

Moving Average Models (Moving Average Models of order q)
Y
t
= e
1
+ |
1
e
t-1
+ |
2
e
t-2
+ |
q
e
t-q


ARMA Models
Y
t
=
1
Y
t-1
+
2
Y
t-2
+ .. +
+ e
1
+ |
1
e
t-1
+ |
2
e
t-2
+ |
q
e
t-q



ARIMA MODEL: It combines two different specifications (processes) into
one equation.

The first being the autoregressive process (AR) and the second being
moving average (MA).

ARIMA (p, d, q) :


d t t
q t q t t
Y Y Y


=
e + e + e + e +
*
2 2 1 1 1
Where
..... | | |
* *
2 2
*
1 1
*
....
p t p t t t
y y y o y

+ + + = u u u |
The two processes are integrated when the series is non-stationary (consistent
series say like GDP, interest rate, energy consumption, population etc.) That
is how `d the differencing term appears. If the series is stationary, there is
no integration and ARIMA becomes ARMA because d = 0.
Smoothing a Time Series
Reducing short term volatality of the series or fluctuations around a trend
entails smoothing.

Moving Average


( )
terms. successive m
averaging by obtained series new the is Y
series; original the is Where
.....
1
t
1 1
t
m t t t t
X
X X X
m
Y
+
+ + + =
Exponential Smoothing

Here, the new series is obtained as a weighted average of present and past
values of the series with geometrically declining weights.
| |
| |
1
3
2
2 1 1 - t
.... 2
2
1
) 1 (
... ) 1 ( ) 1 ( Y
OR
1. 0 Where
) 1 ( ) 1 (

+ =
+ + + =
< <
+ + =
t t t
t t t
t t t t
Y X Y
X X X
X X X Y

If is close to 1, then X
t
is given heavy weight & the resulting series
will also be unsmooth. The smaller the value of , smoother Y
t
will
be. In exponential smoothing, only one observation is lost whereas
in moving average, (m-1) observations are lost.

Exponential smoothing is also useful when adjusting forecasts to
allow for prediction errors made in the recent past !
EVALUATING FORECAST ACCURACY
In general, it is the standard error of the equation that is used to measure
the accuracy of any given equation.

However, when we move beyond the sample period, the relevant
measure is the Root Mean Square Error or RMS Forecast Error

Symbolically, RMSE =



Where Y
tf
are forecast values of Y and Y
ta
are actual values.

Comparable results are also obtained by a somewhat similar measure
called Absolute Average Error (AAE) which is the actual error
ignoring the sign.
( )

N
Y Y
ta tf
2
An equation generating forecasts with continuing bias may
still be useful if we can adjust for that bias:

e.g., if all recent residuals have been 5 or 10% above (or
below) the actual figures, that 5 or 10% factor can be
incorporated in the forecast.

Or it may be that the parameters need to be re-estimated;
or it is also likely that there has been a structural shift in
recent years (periods) that is noticeable in the residuals.

But has not occurred for a long enough time to warrant the
inclusion of an additional variable.

IMPLICATIONS:

If the predicted values are below the actual values,
the firms may lose some sales.


Alternatively, if predicted values are higher than
the actuals, the firms may run the risk of going
bankrupt.

Again, in financial markets, forecasting the
direction in which a particular market will move is
as important as forecasting the magnitude of that
move!

IMPLICATIONS (Contd.)

Surely, in all these cases, smaller forecast errors are
preferred to larger ones; and attention should be focussed
on the sources of the errors:


Errors that occur from the random nature of the
forecasting process
Errors due to the shift in the data generation function
as a subset this includes influences (exogenous) that
have not previously occurred.
Errors that occur because the actual values of the
independent variables are not known at the time of
forecast.

Hence, estimates and forecasts are not
always robust and often cannot be
precisely quantified. A lot of trial &
error, combining with qualitative
forecasts, judgments, collaborative/
consensus forecasts, scenario analysis
etc. become relevant.
GRANGER CAUSALITY
Often, one is tempted to infer on causation while
interpreting regression results. A good fit/significance of
the coefts. need not necessarily mean causation. One needs
to go deeper and look at the Granger causation.

Direction of casuality F-Value Decision Criterion

Y X 3 Do not reject
the Ho
X Y 0.7 Reject Ho

Great caution has to be exercised, as the Granger test is
sensitive to the lags involved in the model.
NON-PARAMETRIC METHODS OF
LONG-TERM FORECASTING
Oftentimes, especially when a new product or service is
being introduced, or new technology is being unveiled,
companies/corporate planners have no prior data to go by.
Also in situations where a firm plans to go for expansion,
it notices how other firms have fared, but has no data of
its own.

Further, when unprecedented events take place like the
first oil crisis, the fall of the Soviet Union/Berlin wall,
deregulation, stringent environmental regulations on
polluting vehicles/plants/technologies/products/processes
change the way business is done.
Although guess work plays a major role in such
contexts of forecasting, the challenge is to come
up with superior guesses. This is done by taking
recourse to:

Survey Methods
Analogy & Precursor Methods
Scenario Analysis
Delphi Analysis
A BRIEF RECAP & GENERAL CHECKLIST

Estimating regression equations for time series with
strong trends often gives rise to

Multi Collinearity and
Autocorrelation
Even when based on economic theory whether they are:

Demand Functions
Supply Functions
Production Functions
Stock Prices.

Although a number of different factors may be
responsible, more often than not it is the strong common
trend which is responsible.
CHECKLIST:

No cook book recipe for econometric forecasting equations.

However, if different forms of the regression equation
routinely result in R
2
greater than 0.99 it indicates
that one is only measuring a common trend and is should be
removed.

If the Durbin-Watson (DW) statistic is smaller than R
2

we should use percentage changes or first-
differences of logarithms rather than the absolute values.

If monthly or quarterly data are involved in similar
conditions try annual percentage changes i.e., say a
particular month or quarter over the same month or quarter a
year ago.

SOME USEFUL TIPS:

RETAIN THE INTERCEPT (CONSTANT) TERM EVEN
WHEN IT MAY APPEAR OTHERWISE THEORETICALLY
.
AVOID INTERPRETING THE ESTIMATES OF THE
INTERCEPT TERM.
THE UNDERLYING ECONOMIC THEORY SHOULD
GUIDE THE CHOICE OF THE FUNCTIONAL FORM IN
GENERAL. HOWEVER, A FUNCTION WHICH IS LINEAR
IN THE VARIABLES MAY BE RESORTED TO UNLESS
OTHERWISE INDICATED BY A PARTICULAR
HYPOTHESIS.
SOME USEFUL TIPS: (contd..)

MULTICOLLINEARITY IS HIGH WHEN R
-2
IS HIGH
WITH INSIGNIFICANT t-VALUES AND/OR WHEN
SIMPLE CORRELATION COEFTS. BETWEEN THE
EXPLANATORY VARIABLES IS HIGH. IT CAN BE A
THEORETICAL PHENOMENON AND ALSO BE A
SAMPLE PHENOMENON.


ONE WAY IS TO IGNORE THE PROBLEM
ESPECIALLY IF THE t-VALUE ARE NOT REDUCED
TO INSIGNIFICANCE.
ANOTHER WAY IS TO DROP SOME
MULTICOLLINEAR (OR REDUNDANT) VARIABLES.
WE MAY ALSO INCREASE THE SAMPLE SIZE.
TRANSFORM THE MULTICOLLINEAR VARIABLES.
AUTOCORRELATION IS GENERALLY PRESENT
(+VE) IN ECONOMIC/BUSINESS SITUATIONS.

DURBIN-WATSON d-STATISTIC OF VALUE O
SUGGESTS EXTREME +VE AUTOCORRELATION
AND 4 INDICATES EXTREME VE
AUTOCORRELATION. A d-VALUE OF 2 SUGGESTS
NO SUCH CORRELATION. THE SAFE RANGE IS
BETWEEN 1.8 TO 2.2.
HERE, ONE SHOULD CHECK FOR POSSIBLE
SPECIFICATION ERRORS.


HETEROSCEDASTICITY IS OFTEN SEEN IN CROSS-
SECTIONAL DATA.
SPECIFICATION ERROR SUCH AS AN OMITTED
VARIABLE MAY HAVE CAUSED IT OR IT MAY EVEN
BE A FUNCTION OF THE ERROR TERM OF THE
CORRECTLY SPECIFIED REGRESSION EQUATION.
HERE, ONE MAY CHECK FOR THE OMMITTED
VARIABLE.
ALSO, HAVE A RELOOK AT THE UNDERLYING
THEORY AND REFORMULATE THE VARIABLES,
CONVERT THEM TO PER CAPITA BASIS, ADJUSTING
THEM TO SIZE DIFFERENCES ETC.


LAG STRUCTURE OF DISTRIBUTED LAGS

IN CROSS SECTION DATA, LAGS ARE NOT
CONSIDERED IN GENERAL.
IN TIME-SERIES DATA, LAGGED VALUES DO PLAY A
ROLE.
WHETHER MACROECONOMIC RELATIONS LIKE
WAGES, INTEREST RATES, PRICES, CONSUMPTION,
INVESTMENT AND EXPORTS.
OR
MICROECONOMIC RELATIONS LIKE CHANCES IN
NEW ORDERS, SHIPMENTS AND INVENTORIES
DEPEND ON THE PAST AS WELL AS CURRENT
HAPPENINGS.
THEORETICALLY, THERE IS NOTHING TO TELL US
WHETHER MOST OF THE REACTION WILL TAKE
PLACE IN THE FIRST TIME PERIOD OR IT WILL
SPREAD OVER SEVERAL PERIODS.