Introductory Econometrics for Finance

Chris Brooks
Solutions to Review Questions - Chapter 8

1. (a) Many series in finance and economics in their levels (or log-levels) forms
are non-stationary and exhibit stochastic trends. They have a tendency not to
revert to a mean level, but they “wander” for prolonged periods in one
direction or the other. Examples would be most kinds of asset or goods prices,
GDP, unemployment, money supply, etc. Such variables can usually be made
stationary by transforming them into their differences or by constructing
percentage changes of them.

(b) Non-stationarity can be an important determinant of the properties of a

series. Also, if two series are non-stationary, we may experience the problem
of “spurious” regression. This occurs when we regress one non-stationary
variable on a completely unrelated non-stationary variable, but yield a
reasonably high value of R2, apparently indicating that the model fits well.

Most importantly therefore, we are not able to perform any hypothesis tests
in models which inappropriately use non-stationary data since the test
statistics will no longer follow the distributions which we assumed they would
(e.g. a t or F), so any inferences we make are likely to be invalid.

(c) A weakly stationary process was defined in Chapter 6, and has the
following characteristics:
1. E(yt) = 
2.
3.  t1 , t2
That is, a stationary process has a constant mean, a constant variance, and a
constant covariance structure. A strictly stationary process could be defined
by an equation such as

for any t1 , t2 , ..., tT  Z, any k Z and T = 1, 2, ...., and where F denotes the
joint distribution function of the set of random variables. It should be evident
from the definitions of weak and strict stationarity that the latter is a stronger
definition and is a special case of the former. In the former case, only the first
two moments of the distribution has to be constant (i.e. the mean and
variances (and covariances)), whilst in the latter case, all moments of the
distribution (i.e. the whole of the probability distribution) has to be constant.
Both weakly stationary and strictly stationary processes will cross their mean
value frequently and will not wander a long way from that mean value.

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An example of a deterministic trend process was given in Figure 8.5. Such a

process will have random variations about a linear (usually upward) trend. An
expression for a deterministic trend process yt could be
yt =  + t + ut
where t = 1, 2,…, is the trend and ut is a zero mean white noise disturbance
term. This is called deterministic non-stationarity because the source of the
non-stationarity is a deterministic straight line process.

A variable containing a stochastic trend will also not cross its mean value
frequently and will wander a long way from its mean value. A stochastically
non-stationary process could be a unit root or explosive autoregressive
process such as
yt = yt-1 + ut
where   1.

2. (a)The null hypothesis is of a unit root against a one sided stationary

alternative, i.e. we have
H0 : yt  I(1)
H1 : yt  I(0)
which is also equivalent to
H0 :  = 0
H1 :  < 0

(b) The test statistic is given by which equals -0.02 / 0.31 = -0.06
Since this is not more negative than the appropriate critical value, we do not
reject the null hypothesis.

(c) We therefore conclude that there is at least one unit root in the series
(there could be 1, 2, 3 or more). What we would do now is to regress 2yt on
yt-1 and test if there is a further unit root. The null and alternative
hypotheses would now be:

H0 : yt  I(1) i.e. yt  I(2)

H1 : yt  I(0) i.e. yt  I(1)

If we rejected the null hypothesis, we would therefore conclude that the first
differences are stationary, and hence the original series was I(1). If we did not
reject at this stage, we would conclude that yt must be at least I(2), and we
would have to test again until we rejected.

(d) We cannot compare the test statistic with that from a t-distribution since
we have non-stationarity under the null hypothesis and hence the test
statistic will no longer follow a t-distribution.

3. Using the same regression as above, but on a different set of data, the researcher
now obtains the estimate =-0.52 with standard error = 0.16.

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(a) The test statistic is calculated as above. The value of the test statistic = -
0.52 /0.16 = -3.25. We therefore reject the null hypothesis since the test
statistic is smaller (more negative) than the critical value.

(b) We conclude that the series is stationary since we reject the unit root null
hypothesis. We need do no further tests since we have already rejected.

(c) The researcher is correct. One possible source of non-whiteness is when

the errors are autocorrelated. This will occur if there is autocorrelation in the
original dependent variable in the regression (yt). In practice, we can easily
get around this by “augmenting” the test with lags of the dependent variable
to “soak up” the autocorrelation. The appropriate number of lags can be
determined using the information criteria.

4. (a) If two or more series are cointegrated, in intuitive terms this implies that
they have a long run equilibrium relationship that they may deviate from in
the short run, but which will always be returned to in the long run. In the
context of spot and futures prices, the fact that these are essentially prices of
the same asset but with different delivery and payment dates, means that
financial theory would suggest that they should be cointegrated. If they were
not cointegrated, this would imply that the series did not contain a common
stochastic trend and that they could therefore wander apart without bound
even in the long run. If the spot and futures prices for a given asset did
separate from one another, market forces would work to bring them back to
follow their long run relationship given by the cost of carry formula.

The Engle-Granger approach to cointegration involves first ensuring that the

variables are individually unit root processes (note that the test is often
conducted on the logs of the spot and of the futures prices rather than on the
price series themselves). Then a regression would be conducted of one of the
series on the other (i.e. regressing spot on futures prices or futures on spot
prices) would be conducted and the residuals from that regression collected.
These residuals would then be subjected to a Dickey-Fuller or augmented
Dickey-Fuller test. If the null hypothesis of a unit root in the DF test regression
residuals is not rejected, it would be concluded that a stationary combination
of the non-stationary variables has not been found and thus that there is no
cointegration. On the other hand, if the null is rejected, it would be concluded
that a stationary combination of the non-stationary variables has been found
and thus that the variables are cointegrated.

Forming an error correction model (ECM) following the Engle-Granger

approach is a 2-stage process. The first stage is (assuming that the original
series are non-stationary) to determine whether the variables are
cointegrated. If they are not, obviously there would be no sense in forming an
ECM, and the appropriate response would be to form a model in first
differences only. If the variables are cointegrated, the second stage of the

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process involves forming the error correction model which, in the context of
spot and futures prices, could be of the form given in equation (8.57).

(b) There are many other examples that one could draw from financial or
economic theory of situations where cointegration would be expected to be
present and where its absence could imply a permanent disequilibrium. It is
usually the presence of market forces and investors continually looking for
arbitrage opportunities that would lead us to expect cointegration to exist.
Good illustrations include equity prices and dividends, or price levels in a set
of countries and the exchange rates between them. The latter is embodied in
the purchasing power parity (PPP) theory, which suggests that a
representative basket of goods and services should, when converted into a
common currency, cost the same wherever in the world it is purchased. In the
context of PPP, one may expect cointegration since again, its absence would
imply that relative prices and the exchange rate could wander apart without
bound in the long run. This would imply that the general price of goods and
services in one country could get permanently out of line with those, when
converted into a common currency, of other countries. This would not be
expected to happen since people would spot a profitable opportunity to buy
the goods in one country where they were cheaper and to sell them in the
country where they were more expensive until the prices were forced back
into line. There is some evidence against PPP, however, and one explanation
is that transactions costs including transportation costs, currency conversion
costs, differential tax rates and restrictions on imports, stop full adjustment
from taking place. Services are also much less portable than goods and
everybody knows that everything costs twice as much in the UK as anywhere
else in the world.

5. (a) The Johansen test is computed in the following way. Suppose we have p
variables that we think might be cointegrated. First, ensure that all the
variables are of the same order of non-stationary, and in fact are I(1), since it
is very unlikely that variables will be of a higher order of integration. Stack the
variables that are to be tested for cointegration into a p-dimensional vector,
called, say, yt. Then construct a p1 vector of first differences, yt, and form
and estimate the following VAR
yt =  yt-k + 1 yt-1 + 2 yt-2 + ... + k-1 yt-(k-1) + ut

Then test the rank of the matrix . If  is of zero rank (i.e. all the
eigenvalues are not significantly different from zero), there is no
cointegration, otherwise, the rank will give the number of cointegrating
vectors. (You could also go into a bit more detail on how the eigenvalues are
used to obtain the rank.)

(b) Repeating the table given in the question, but adding the null and
alternative hypotheses in each case, and letting r denote the number of
cointegrating vectors:

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(c)
Null Alternative max 95% Critical value
Hypothesis Hypothesis
r=0 r=1 38.962 33.178
r=1 r=2 29.148 27.169
r=2 r=3 16.304 20.278
r=3 r=4 8.861 14.036
r=4 r=5 1.994 3.962

Considering each row in the table in turn, and looking at the first one first, the
test statistic is greater than the critical value, so we reject the null hypothesis
that there are no cointegrating vectors. The same is true of the second row
(that is, we reject the null hypothesis of one cointegrating vector in favour of
the alternative that there are two). Looking now at the third row, we cannot
reject (at the 5% level) the null hypothesis that there are two cointegrating
vectors, and this is our conclusion. There are two independent linear
combinations of the variables that will be stationary.

(c) Johansen’s method allows the testing of hypotheses by considering them

effectively as restrictions on the cointegrating vector. The first thing to note is
that all linear combinations of the cointegrating vectors are also cointegrating
vectors. Therefore, if there are many cointegrating vectors in the unrestricted
case and if the restrictions are relatively simple, it may be possible to satisfy
the restrictions without causing the eigenvalues of the estimated coefficient
matrix to change at all. However, as the restrictions become more complex,
“renormalisation” will no longer be sufficient to satisfy them, so that imposing
them will cause the eigenvalues of the restricted coefficient matrix to be
different to those of the unrestricted coefficient matrix. If the restriction(s)
implied by the hypothesis is (are) nearly already present in the data, then the
eigenvectors will not change significantly when the restriction is imposed. If,
on the other hand, the restriction on the data is severe, then the eigenvalues
will change significantly compared with the case when no restrictions were
imposed.

The test statistic for testing the validity of these restrictions is given by
p
T  [ln(1   )  ln(1   )]
i  r 1
*
i i  2(p-r)

where
i* are the characteristic roots (eigenvalues) of the restricted model
i are the characteristic roots (eigenvalues) of the unrestricted model
r is the number of non-zero (eigenvalues) characteristic roots in the
unrestricted model
p is the number of variables in the system.

If the restrictions are supported by the data, the eigenvalues will not change
much when the restrictions are imposed and so the test statistic will be small.

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(d) There are many applications that could be considered, and tests for PPP,
for cointegration between international bond markets, and tests of the
expectations hypothesis were presented in Sections 8.9, 8.10, and 8.11
respectively. These are not repeated here.

(e) Both Johansen statistics can be thought of as being based on an

examination of the eigenvalues of the long run coefficient or  matrix. In both
cases, the g eigenvalues (for a system containing g variables) are placed
ascending order: 1  2  ...  g. The maximal eigenvalue (i.e. the max)
statistic is based on an examination of each eigenvalue separately, while the
trace statistic is based on a joint examination of the g-r largest eigenvalues. If
the test statistic is greater than the critical value from Johansen’s tables,
reject the null hypothesis that there are r cointegrating vectors in favour of
the alternative that there are r+1 (for max) or more than r (for trace). The
testing is conducted in a sequence and under the null, r = 0, 1, ..., g-1 so that
the hypotheses for trace and max are as follows

Null hypothesis for both tests Trace alternative Max alternative

H0 : r=0 H1 : 0 < r  g H1 : r = 1
H0 : r=1 H1 : 1 < r  g H1 : r = 2
H0 : r=2 H1 : 2 < r  g H1 : r = 3
... ... ...
H0 : r = p-1 H1 : r = g H1 : r = g

Thus the trace test starts by examining all eigenvalues together to test H 0: r =
0, and if this is not rejected, this is the end and the conclusion would be that
there is no cointegration. If this hypothesis is not rejected, the largest
eigenvalue would be dropped and a joint test conducted using all of the
eigenvalues except the largest to test H 0: r = 1. If this hypothesis is not
rejected, the conclusion would be that there is one cointegrating vector, while
if this is rejected, the second largest eigenvalue would be dropped and the
test statistic recomputed using the remaining g-2 eigenvalues and so on. The
testing sequence would stop when the null hypothesis is not rejected.

The maximal eigenvalue test follows exactly the same testing sequence with
the same null hypothesis as for the trace test, but the max test only considers
one eigenvalue at a time. The null hypothesis that r = 0 is tested using the
largest eigenvalue. If this null is rejected, the null that r = 1 is examined using
the second largest eigenvalue and so on.

6. (a) The operation of the Johansen test has been described in the book, and
also in question 5, part (a) above. If the rank of the  matrix is zero, this
implies that there is no cointegration or no common stochastic trends
between the series. A finding that the rank of  is one or two would imply
that there were one or two linearly independent cointegrating vectors or

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combinations of the series that would be stationary respectively. A finding

that the rank of  is 3 would imply that the matrix is of full rank. Since the
maximum number of cointegrating vectors is g-1, where g is the number of
variables in the system, this does not imply that there 3 cointegrating vectors.
In fact, the implication of a rank of 3 would be that the original series were
stationary, and provided that unit root tests had been conducted on each
series, this would have effectively been ruled out.

(b) The first test of H0: r = 0 is conducted using the first row of the table.
Clearly, the test statistic is greater than the critical value so the null
hypothesis is rejected. Considering the second row, the same is true, so that
the null of r = 1 is also rejected. Considering now H0: r = 2, the test statistic is
smaller than the critical value so that the null is not rejected. So we conclude
that there are 2 cointegrating vectors, or in other words 2 linearly
independent combinations of the non-stationary variables that are stationary.

7. The fundamental difference between the Engle-Granger and the Johansen

approaches is that the former is a single-equation methodology whereas Johansen is
a systems technique involving the estimation of more than one equation. The two
approaches have been described in detail in Chapter 8 and in the answers to the
questions above, and will therefore not be covered again. The main (arguably only)
advantage of the Engle-Granger approach is its simplicity and its intuitive
interpretability. However, it has a number of disadvantages that have been described
in detail in Chapter 8, including its inability to detect more than one cointegrating
relationship and the impossibility of validly testing hypotheses about the
cointegrating vector.

9. (a) If there is a structural break that is not accounted for, either in the level or
rate of change of a series under investigation for a potential unit root, then
the tests will not work well. Standard Dickey-Fuller type tests are not only
oversized (so that they reject the null hypothesis when it is correct), they also
lack power (so that they do not reject the null hypothesis when it is wrong).

(b) Perron’s (1989) approach to dealing with structural breaks in series tested
for unit roots allows for various types of break in the series (a break in the
level of a series, in its slope, or both) but the methodology presumes that the
date of the break is known a priori and this assumption is reflected in the
critical values used with the test. However, in practice it is likely that not only
is the break date unknown in advance, but also researchers will use the same
dataset to search for the break date, thus making the critical values used
inappropriate. Slightly more recent approaches, such as those by Banerjee et
al. (1992) and Zivot and Andrews (1992) as well as Perron (1997) explicitly
incorporate choice of the break date into the testing procedure.

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