The VARMAX Procedure

Cointegration

Subsections:

Common Trends
Test for the Common Trends

This section briefly introduces the concepts of cointegration (Johansen 1995a).

Definition 1.: (Engle and Granger 1987): If a series $y_ t$ with no deterministic components can be represented by a stationary and invertible ARMA process after differencing d times, the series is integrated of order d, that is, $y_ t \sim I(d)$ .
Definition 2.: (Engle and Granger 1987): If all elements of the vector $\mb{y} _ t$ are $I(d)$ and there exists a cointegrating vector $\bbeta \neq 0$ such that $\bbeta ’\mb{y} _ t \sim I(d-b)$ for any $b > 0$ , the vector process is said to be cointegrated $CI(d,b)$ .

A simple example of a cointegrated process is the following bivariate system:

$\begin{eqnarray*} y_{1t} & =& \gamma y_{2t} + \epsilon _{1t} \\ y_{2t} & =& y_{2,t-1} + \epsilon _{2t} \end{eqnarray*}$

with $\epsilon _{1t}$ and $\epsilon _{2t}$ being uncorrelated white noise processes. In the second equation, $y_{2t}$ is a random walk, $\Delta y_{2t} = \epsilon _{2t}$ , $\Delta \equiv 1-B$ . Differencing the first equation results in

$\Delta y_{1t} = \gamma \Delta y_{2t} +\Delta \epsilon _{1t} = \gamma \epsilon _{2t} +\epsilon _{1t}-\epsilon _{1,t-1}$

Thus, both $y_{1t}$ and $y_{2t}$ are $I(1)$ processes, but the linear combination $y_{1t} - \gamma y_{2t}$ is stationary. Hence $\mb{y} _ t =(y_{1t}, y_{2t})’$ is cointegrated with a cointegrating vector $\bbeta = (1, -\gamma )’$ .

In general, if the vector process $\mb{y} _ t$ has k components, then there can be more than one cointegrating vector $\bbeta ’$ . It is assumed that there are r linearly independent cointegrating vectors with $r<k$ , which make the $k\times r$ matrix $\bbeta$ . The rank of matrix $\bbeta$ is r, which is called the cointegration rank of $\mb{y} _ t$ .

Common Trends

This section briefly discusses the implication of cointegration for the moving-average representation. Let $\mb{y} _ t$ be cointegrated $CI(1,1)$ , then $\Delta \mb{y} _ t$ has the Wold representation:

$\begin{eqnarray*} \Delta \mb{y} _ t = \bdelta + \Psi (B)\bepsilon _ t \end{eqnarray*}$

where $\bepsilon _ t$ is $iid (0,\Sigma )$ , $\Psi (B)=\sum _{j=0}^{\infty } \Psi _ jB^ j$ with $\Psi _0=I_ k$ , and $\sum _{j=0}^{\infty }j|\Psi _ j| < \infty$ .

Assume that $\bepsilon _ t = 0$ if $t\leq 0$ and $\mb{y} _0$ is a nonrandom initial value. Then the difference equation implies that

$\begin{eqnarray*} \mb{y} _ t = \mb{y} _0 + \bdelta t + \Psi (1)\sum _{i=0}^{t}\bepsilon _ i + \Psi ^{*}(B)\bepsilon _ t \end{eqnarray*}$

where $\Psi ^{*}(B) = (1-B)^{-1}(\Psi (B)-\Psi (1))$ and $\Psi ^{*}(B)$ is absolutely summable.

Assume that the rank of $\Psi (1)$ is $m=k-r$ . When the process $\mb{y} _ t$ is cointegrated, there is a cointegrating $k\times r$ matrix $\bbeta$ such that $\bbeta ’ \mb{y} _ t$ is stationary.

Premultiplying $\mb{y} _ t$ by $\bbeta ’$ results in

$\bbeta ’ \mb{y} _ t = \bbeta ’\mb{y} _0 + \bbeta ’ \Psi ^{*}(B)\bepsilon _ t$

because $\bbeta ’\Psi (1)=0$ and $\bbeta ’\bdelta =0$ .

Stock and Watson (1988) showed that the cointegrated process $\mb{y} _ t$ has a common trends representation derived from the moving-average representation. Since the rank of $\Psi (1)$ is $m=k-r$ , there is a $k\times r$ matrix $H_1$ with rank r such that $\Psi (1)H_1=0$ . Let $H_2$ be a $k\times m$ matrix with rank m such that $H_2’H_1=0$ ; then $A=C(1)H_2$ has rank m. The $H=(H_1,H_2)$ has rank k. By construction of $\bH$ ,

$\begin{eqnarray*} \Psi (1)H = [0, A] = A S_ m \end{eqnarray*}$

where $S_ m=(0_{m\times r},I_ m)$ . Since $\bbeta ’\Psi (1)=0$ and $\bbeta ’\bdelta =0$ , $\bdelta$ lies in the column space of $\Psi (1)$ and can be written

$\begin{eqnarray*} \bdelta = \Psi (1)\tilde{\bdelta } \end{eqnarray*}$

where $\tilde{\bdelta }$ is a k-dimensional vector. The common trends representation is written as

$\begin{eqnarray*} \mb{y} _ t & = & \mb{y} _0 + \Psi (1)[\tilde{\bdelta } t + \sum _{i=0}^{t}\bepsilon _ i] + \Psi ^{*}(B)\bepsilon _ t \\ & = & \mb{y} _0 + \Psi (1)H[H^{-1}\tilde{\delta } t + H^{-1}\sum _{i=0}^{t}\bepsilon _ i] + \mb{a} _ t \\ & = & \mb{y} _0 + A\btau _ t + \mb{a} _ t \end{eqnarray*}$

and

$\btau _ t = \pi + \btau _{t-1} + \mb{v} _ t$

where $\mb{a} _ t = \Psi ^{*}(B)\bepsilon _ t$ , $\pi =S_ mH^{-1}\tilde{\bdelta }$ , $\btau _ t= S_ m[H^{-1}\tilde{\bdelta } t + H^{-1}\sum _{i=0}^{t}\bepsilon _ i]$ , and $\mb{v} _ t=S_ mH^{-1}\bepsilon _ t$ .

Stock and Watson showed that the common trends representation expresses $\mb{y} _ t$ as a linear combination of m random walks ( $\btau _ t$ ) with drift $\pi$ plus $I(0)$ components ( $\mb{a} _ t)$ .

Test for the Common Trends

Stock and Watson (1988) proposed statistics for common trends testing. The null hypothesis is that the k-dimensional time series $\mb{y} _{t}$ has m common stochastic trends, where $m\leq k$ and the alternative is that it has s common trends, where $s < m$ . The test procedure of m versus s common stochastic trends is performed based on the first-order serial correlation matrix of $\mb{y} _ t$ . Let $\bbeta _{\bot }$ be a $k\times m$ matrix orthogonal to the cointegrating matrix such that $\bbeta _{\bot }^{'}\bbeta = 0$ and $\bbeta _{\bot }^{}\bbeta _{\bot }^{'}=I_ m$ . Let $\mb{z} _{t}=\bbeta ’\mb{y} _ t$ and $\mb{w} _{t}=\bbeta _{\bot }^{'}\mb{y} _ t$ . Then

$\mb{w} _{t} = \bbeta _{\bot }’\mb{y} _0 + \bbeta _{\bot }’\bdelta t + \bbeta _{\bot }’ \Psi (1)\sum _{i=0}^{t}\bepsilon _ i + \bbeta _{\bot }’ \Psi ^{*}(B)\bepsilon _ t$

Combining the expression of $\mb{z} _ t$ and $\mb{w} _ t$ ,

$\begin{eqnarray*} \left[ \begin{array}{c} \mb{z} _ t \\ \mb{w} _ t \end{array} \right] & = & \left[ \begin{array}{c} \bbeta ’\mb{y} _0 \\ \bbeta _{\bot }^{'}\mb{y} _0 \end{array} \right] + \left[ \begin{array}{c} 0 \\ \bbeta _{\bot }^{'}\bdelta \end{array} \right] t + \left[ \begin{array}{c} 0 \\ \bbeta _{\bot }^{'}\Psi (1) \end{array} \right] \sum _{i=1}^ t\bepsilon _ i \\ & + & \left[ \begin{array}{c} \bbeta ’\Psi ^{*}(B) \\ \bbeta _{\bot }’\Psi ^{*}(B) \end{array} \right] \bepsilon _ t \end{eqnarray*}$

The Stock-Watson common trends test is performed based on the component $\mb{w} _ t$ by testing whether $\bbeta _{\bot }^{'}\Psi (1)$ has rank m against rank s.

The following statements perform the Stock-Watson test for common trends:

proc iml;
   sig = 100*i(2);
   phi = {-0.2 0.1, 0.5 0.2, 0.8 0.7, -0.4 0.6};
   call varmasim(y,phi) sigma=sig n=100 initial=0
                        seed=45876;
   cn = {'y1' 'y2'};
   create simul2 from y[colname=cn];
   append from y;
quit;

data simul2;
   set simul2;
   date = intnx( 'year', '01jan1900'd, _n_-1 );
   format date year4. ;
run;

proc varmax data=simul2;
   model y1 y2 / p=2 cointtest=(sw);
run;

In Figure 42.67, the first column is the null hypothesis that $\mb{y} _ t$ has $m\leq k$ common trends; the second column is the alternative hypothesis that $\mb{y} _ t$ has $s < m$ common trends; the third column contains the eigenvalues used for the test statistics; the fourth column contains the test statistics using AR(p) filtering of the data. The table shows the output of the case $p=2$ .

Figure 42.67: Common Trends Test (COINTTEST=(SW) Option)

The VARMAX Procedure

Common Trend Test
H0: Rank=m	H1: Rank=s	Eigenvalue	Filter	5% Critical Value	Lag
1	0	1.000906	0.09	-14.10	2
2	0	0.996763	-0.32	-8.80
	1	0.648908	-35.11	-23.00

The test statistic for testing for 2 versus 1 common trends is more negative (–35.1) than the critical value (–23.0). Therefore, the test rejects the null hypothesis, which means that the series has a single common trend.