Serial Correlation
and
Chapter 12 Heteroskedasticity
in Time Series
Regressions
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Serial Correl. and Heterosked. in
Time Series Regressions
● Properties of OLS with serially correlated errors
• OLS still unbiased and consistent if errors are serially correlated
• Correctness of R-squared also does not depend on serial correlation
• OLS standard errors and tests will be invalid if there is serial
correlation
• OLS will not be efficient anymore if there is serial correlation
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Serial correlation and the presence of lagged dependent
variables
• Is OLS inconsistent if there are ser. corr. and lagged dep. variables?
• No: Including enough lags so that TS.3‘ holds guarantees
consistency
• Including too few lags will cause an omitted variable problem and
serial correlation because some lagged dep. var. end up in the error
term
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Testing for serial correlation
● Testing for AR(1) serial correlation with strictly exog.
regressors
AR(1) model for serial correlation (with an i.i.d. series e t)
Replace true unobserved errors by estimated residuals
Test in
● Example: Static Phillips curve (see above)
Reject null hypothesis
of no serial correlation
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● The Durbin-Watson test under classical assumptions
• Under assumptions TS.1 – TS.6, the Durbin-Watson test is an exact
test (whereas the previous t-test is only valid asymptotically).
Unfortunately, the Durbin-Watson
vs. test works with a lower and an
upper bound for the critical value.
In the area between the bounds
Reject if , fail to reject if the test result is inconclusive.
● Example: Static Phillips curve (see above)
Reject null hypothesis of no serial correlation
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Testing for AR(1) serial correlation with general regressors
• The t-test for autocorrelation can be easily generalized to allow for
the possibility that the explanatory variables are not strictly
exogenous:
The test now allows for the possibility that
Test for
the strict exogeneity assumption is violated.
• The test may be carried out in a heteroskedasticity robust way
● General Breusch-Godfrey test for AR(q) serial correlation
Test
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certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Correcting for serial correlation with strictly exog. regressors
• Under the assumption of AR(1) errors, one can transform the model
so that it satisfies all GM-assumptions. For this model, OLS is BLUE.
Simple case of regression with only one explana-
tory variable. The general case works analogusly.
Lag and multiply by
The transformed error satis-
fies the GM-assumptions.
• Problem: The AR(1)-coefficient is not known and has to be
estimated
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Correcting for serial correlation (cont.)
• Replacing the unknown by leads to a FGLS-estimator
• There are two variants:
• Cochrane-Orcutt estimation omits the first observation
• Prais-Winsten estimation adds a transformed first observation
• In smaller samples, Prais-Winsten estimation should be more efficient
● Comparing OLS and FGLS with autocorrelation
• For consistency of FGLS more than TS.3‘ is needed (e.g. TS.3)
because the transformed regressors include variables from different
periods
• If OLS and FGLS differ dramatically this might indicate violation of
TS.3
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Serial correlation-robust inference after OLS
• In the presence of serial correlation, OLS standard errors overstate
statistical significance because there is less independent variation
• One can compute serial correlation-robust std. errors after OLS
• This is useful because FGLS requires strict exogeneity and assumes
a very specific form of serial correlation (AR(1) or, generally, AR(q))
• Serial correlation-robust standard errors:
The usual OLS standard errors
are normalized and then
“inflated” by a correction factor.
• Serial correlation-robust F- and t-tests are also available
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Serial Correl. and Heterosked. in
Time Series Regressions
● Correction factor for serial correlation (Newey-West formula)
This term is the product of the residuals and the residuals
of a regression of xtj on all other explanatory variables
The integer g controls how much serial correlation is allowed:
g = 1: The weight of higher order
autocorrelations is declining
g = 2:
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Discussion of serial correlation-robust standard errors
• The formulas are also robust to heteroskedasticity; they are
therefore called “heteroskedasticity and autocorrelation consistent”
(=HAC)
• For the integer g, values such as g=2 or g=3 are normally sufficient
(there are more involved rules of thumb for how to choose g)
• Serial correlation-robust standard errors are only valid
asymptotically; they may be severely biased if the sample size is not
large enough
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
• The bias is the higher the more autocorrelation there is; if the series
are highly correlated, it might be a good idea to difference them
first
• Serial correlation-robust errors should be used if there is serial corr.
and strict exogeneity fails (e.g. in the presence of lagged dep. var.)
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Heteroskedasticity in time series regressions
• Heteroskedasticity usually receives less attention than serial
correlation
• Heteroskedasticity-robust standard errors also work for time series
• Heteroskedasticity is automatically corrected for if one uses the
serial correlation-robust formulas for standard errors and test
statistics
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Testing for heteroskedasticity
• The usual heteroskedasticity tests assume absence of serial
correlation
• Before testing for heteroskedasticity one should therefore test for
serial correlation first, using a heteroskedasticity-robust test if
necessary
• After ser. corr. has been corrected for, test for heteroskedasticity
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Example: Serial correlation and homoskedasticity in the EMH
Test equation for the EMH
Test for serial correlation:
No evidence for serial
correlation
Test for heteroskedasticity:
Strong evidence for heteroskedasticity
Note: Volatility is higher
if returns are low
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Autoregressive Conditional Heteroskedasticity (ARCH)
Even if there is no heteroskedasticity in the usual sense (the error variance depends
on the explanatory variables), there may be heteroskedasticity in the sense that the
variance depends on how volatile the time series was in previous periods:
ARCH(1) model
● Consequences of ARCH in static and distributed lag models
• If there are no lagged dependent variables among the regressors,
i.e. in static or distributed lag models, OLS remains BLUE under
TS.1-TS.5
• Also, OLS is consistent etc. for this case under assumptions TS.1‘-
TS.5‘
• As explained, in this case, assumption TS.4 still holds under ARCH
© 2016 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
®
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Consequences of ARCH in dynamic models
• In dynamic models, i.e. models including lagged dependent
variables, the homoskedasticity assumption TS.4 will necessarily be
violated:
because
• This means the error variance indirectly depends on explanat.
variables
• In this case, heteroskedasticity-robust standard error and test
statistics should be computed, or a FGLS/WLS-procedure should be
applied
• Using a FGLS/WLS-procedure will also increase efficiency
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● Example: Testing for ARCH-effects in stock returns
Are there ARCH-effects in these errors?
Estimating equation for ARCH(1)
model
There are statistically significant ARCH-
effects:
If returns were particularly high or low
(squared returns were high) they tend to
be particularly high or low again, i.e. high
volatility is followed by high volatility.
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Serial Correl. and Heterosked. in
Time Series Regressions
● A FGLS procedure for serial correlation and heteroskedasticity
Given or estimated model for heteroskedasticity
Model for serial correlation
Estimate transformed model by Cochrane-Orcutt or Prais-Winsten
techniques (because of serial correlation in transformed error term)
© 2016 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
