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Causes of autocorrelation Diagnosing autocorrelation Modeling autocorrelation
Autocorrelation
When the data used in regression model measure the same thing at different points in time, such as the price of Xerox stock, XRXt, it is not unusual for adjacent observations to be correlated with each other [APS_XRX.WF1] Corr(XRXt, XRXt-1) > 0, means that when the stock price in period t-1 is above the sample average, it is likely that the stock price in period t will also be above the sample average A graph of positively autocorrelated data shows smooth cycles, infrequently crossing the average
Autocorrelation: Why?
Autocorrelation happens for many reasons Information changes slowly through time, so the factors influencing a variable are likely to be similar in adjacent periods
Note: autocorrelations for returns are much smaller and returns vary randomly around the mean
AR(1) model for log of Xerox stock price by using the lagged dependent variable, log(XRXP(-1)), as the independent variable
Note that the AR(1) coefficient is close to 1
AR(1) model for log of Xerox stock price by using the AR(1) specification for the errors
Note the only difference is the constant, which equals the sample mean of XRXP in this case and [sample mean (1 - .971) ] when the lagged dependent variable is used
Model looks great??? R2 = 96% Coefficient of time = 0.0036 .36% inflation per month, about 4.3% per year But, lots of serial correlation in the residuals Durbin-Watson should be close to 2.0, not 0.0
Autocorrelations of Inflation
Autocorrelations are much smaller, but still decay very slowly Note that differencing the time trend model
[LCPINSAt = a + b1 TIMEt + et ] INFLNSAt = a + b1 TIMEt + et - a - b1 TIMEt-1 - et-1 = b1 + et - et-1
since TIMEt - TIMEt-1 = 1 Therefore, the constant in the first differences equation (the average inflation rate) is the same as the slope coefficient in the time trend model for the log of the CPI
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AR coefficient, 0.46, is pretty big (t-stat=8.57) Note R2 is much smaller than for time trend model it is in fact the square of the autoregressive coefficient, .462 This is NOT a problem, since the dependent variable is different logs of CPI for trend model and differences here The SE of regression is comparable, and smaller here (0.003402)
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MA coefficients are all small and positive and seem to be decaying slowly This suggests that maybe we need both an AR and an MA part to the model => try ARMA(1,1) for inflation
This is the best yet AR coefficient is close to one, so we will also try differencing the inflation rate and then estimating an MA(1) model
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This simple model is virtually the same as the ARMA(1,1) model earlier, because we are constraining the AR coefficient to equal 1 (and it was .96)
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Links
Xerox Stock Price dataset:
http://schwert.simon.rochester.edu/A425/A425_xrx.wf1
CPI dataset:
http://schwert.simon.rochester.edu/A425/A425_cpi.wf1
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