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FM Unit 4

Unit IV focuses on Time Series Analysis, covering key concepts such as stationarity tests, co-integration, and Error Correction Models (ECM). The Engle-Granger two-step procedure and the Johansen-Juselius Multivariate Test are outlined for testing co-integration between variables. Practical exercises involve checking co-integration between personal consumption expenditure and disposable income, as well as disposable income and GDP, utilizing ECM for short-term and long-term relationships.

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11 views31 pages

FM Unit 4

Unit IV focuses on Time Series Analysis, covering key concepts such as stationarity tests, co-integration, and Error Correction Models (ECM). The Engle-Granger two-step procedure and the Johansen-Juselius Multivariate Test are outlined for testing co-integration between variables. Practical exercises involve checking co-integration between personal consumption expenditure and disposable income, as well as disposable income and GDP, utilizing ECM for short-term and long-term relationships.

Uploaded by

MaNish RaThore
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Unit IV

Financial modeling

Instructor:
Dr. Renu Ghosh
Assistant Professor
DMS, NSUT
Syllabus
Unit IV: Time Series Analysis
Stationarity test, Short Run and Long Run Relationships, Co
integration: Co-integration and common trends, Tests of co
integration: Engle-Granger Two Step Procedure, the Johansen-
Juselius Multivariate Test, Error Correction Models: Estimation
and interpretation off an Error Correction Model, Forecasting
Using an Error Correction Model.

2
Engle-Granger two-step procedure for testing co-
integration between two variables
Step1: Open the individual time series (Dependent- Y and independent
variable- X) and check for stationarity of time series (Y and X series) at
level and first difference. If both the time series are stationary at the
first difference, run the regression of dependent (Y) and independent
variable (X) and save the residual of the run regression.
Step 2: In step 2, now check the stationarity of the residuals saved. If
the residual saved from the above regression are stationary at level, the
X and Y variables are long-term cointegrated.
Conclusion: If the two-time series are co-integrated, this means there
is long-term equilibrium or relationship exist between the two.
Johansen-Juselius Multivariate Test

Online Resource:
https://www.youtube.com/watch?v=E4fjzpq63cc
Error Correction Mechanism/Model (ECM)
We previous seen in Engle-Granger two step procedure that when two time
series are cointegrated, there may exist long-term relationship/equilibrium
between them. But in the short-term there may be disequilibrium because of
the structural changes or shocks in the time series. The residuals/error term
obtained in the Engle-Granger two-step procedure is treated as the
“equilibrium error” in ECM models, to integrate the short-term relationship
between the series with their long-term relationship. For this the relationship
between X and Y can be expressed as ECM by running following equation
where the lagged error term (equilibrium error) is included in the model:
d(Y)= c+d(X)+residual(-1)
Note: if the coefficient of equilibrium error term is negative and significant, it
means the discrepancy between long-term and short term (Y) is getting
corrected each period. The coefficient of equilibrium error is known as “speed
of adjustment”.
ECM methodology is given in detail in next slides
Practice with the data shared in google classroom

1. Check the Co-integration between personal consumption


expenditure (Y) and personal disposable income (X).
2. Check the Co-integration between personal disposable income
(Y) and Gross domestic product (X).
In the above two situation, if there is disequilibrium error, used
ECM to integrate short term (Y) with the long-term (Y).

Online Resource:
https://www.youtube.com/watch?v=1oasRhnt5AI&t=1025s
References:
1. Gujarati, D. N. (2021). Essentials of econometrics. Sage Publications.
2. Benninga, S. (1997). Financial Modeling (MIT Press). Bessis, J.(1998) Risk
Management in Banking John Wiley & Sons Ltd.
3. Winston, W. (2011). Microsoft Excel 2010 Data Analysis and Business Modeling:
Data Analysis and Business Modeling. Pearson Education.
4. Koutsoyiannis, A. (1977). Theory of econometrics an introductory. In Exposition
of Econometric Method.
5. Rees, M. (2018). Principles of financial modelling: model design and best
practices using Excel and VBA. John Wiley & Sons.
Note: latest version of the book shall be used.

31

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