Guided tour on ARIMA estimation and forecasting

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ARIMA stands for AutoRegressive Integrated Moving Average. The ARIMA modeling
and forecasting approach is also known as the Box-Jenkins approach.
ARMA(p,q) processes
I will discuss the "I" in ARIMA later. For the time being is suffices to note that an
ARIMA(p,0,q) process is the same as an ARMA(p,q) process.
As is well known (if not to you, stop here and don't use module ARIMA!), the general
form of an ARMA(p,q) process y(t) is:
y(t) = o
1
y(t-1) + .... + o
p
y(t-p) + + e(t) - |
1
e(t-1) - .... - |
q
e(t-q)
where the e(t)'s are independently distributed with zero expectation and variance o
2
,
and is a constant. Thus, the p in "ARMA(p,q)" is the maximum lag of the AR part, and
q is the maximum lag of the MA part.
This model can be written more compactly in terms of lag polynomials and lag
operators. Define the lag operator L as:
L.y(t) = y(t-1)
L
2
y(t) = y(t-2)
.............
L
p
y(t) = y(t-p)
.............
etcetera. Then we can write:
y(t) - o
1
y(t-1) - .... - o
p
y(t-p) = y(t) - o
1
L.y(t) - .... - o
p
L
p
y(t) = a
p
(L)y(t)
say, where
a
p
(L) = 1 - o
1
L - .... - o
p
L
p

and similarly
e(t) - |
1
e(t-1) - .... - |
q
e(t-q) = e(t) - |
1
L.e(t) - .... - |
q
L
q
e(t) = b
q
(L)e(t)
say, where
b
q
(L) = 1 - |
1
L - .... - |
q
L
q

Thus, the ARMA(p,q) model involved can now be written as:
a
p
(L)y(t) = + b
q
(L)e(t)
If the roots of a
p
(L) are all outside the (complex) unit circle, i.e., if
a
p
(z) = 0 |z| > 1,
then [a
p
(L)]
-1
exists and is an infinite order lag polynomial with exponentially vanishing
coefficients:
[a
p
(L)]
-1
= 1+
j > 1

j
L
j
,
where |
j
| < c
j
for some constant c and a e (0,1). If so, we can write the ARMA
model as a stationary MA() process:
y(t) = /a
p
(1) + [a
p
(L)]
-1
b
q
(L)e(t)
Similarly, if the roots of b
q
(L) are all outside the (complex) unit circle then we can write
the ARMA model as an AR() process:
[b
q
(L)]
-1
a
p
(L)y(t) = /b
q
(1) + e(t)
where [b
q
(L)]
-1
a
p
(L) can be written as:
[b
q
(L)]
-1
a
p
(L) = 1 -
j > 1

j
L
j
,
so that
y(t) =
j > 1

j
y(t-j) + o + e(t),
with o = /b
q
(1). Thus
E
t-1
[y(t)] =
j > 1

j
y(t-j) + o,
which is the best one-step-ahead forecast of y(t).
I(d) processes
A time series process is called I(d) if we need to apply at least d times the first
difference operator
A = 1 - L
to make the process stationary. Now a time series process x(t) is an ARIMA(p,d,q)
process if
y(t) = A
d
x(t) = (1 - L)
d
x(t),
where y(t) is a stationary ARMA(p,q) process.
ARIMA estimation and forecasting in practice
Model and data
The time series y(t) I shall use has been artifically generated, as follows:
(1 - 0.7L)(1 - L)y(t) = (1 - 0.7L)Ay(t) = (1 + 0.5L)(1 - 0.25L
4
)e(t),
where e(t) is i.i.d. standard normally distributed. This is an ARIMA(1,1,5) process:
Ay(t) = 0.7Ay(t-1) + e(t) + 0.5e(t-1) - 0.25e(t-4) - 0.125e(t-5).
The data involved is available as CSV file ARIMADATA.CSV, with y(t) = "ARIMA test
data". The data should be interpreted as quarterly time series, starting from quarter
1950.1. Note that this data file has been created under US number setting. Hence, if
your Windows uses a comma as decimal delimiter you have to convert it to your local
number setting. See the guided tour on importing Excel files in CSV format.
Note that the MA lag polynomial b
5
(L) = (1 + 0.5L)(1 - 0.25L
4
) is specified as the product
of a non-seasonal lag polynomial b
ns,1
(L) = 1 + 0.5L and a seasonal lag polynomial
c
s,1
(L
4
), where c
s,1
(L) = 1 - 0.25L . In general a seasonal lag polynomial is a polynonial in
L
s
, where s is the number of observations per year (the number of seasons). For
example, for monthly data s =12, and for weekly data s = 52.
ARIMA estimation and forecasting in EasyReg
Import the data file ARIMADATA.CSV in EasyReg, and declare it quarterly time series,
with first year 1950 and first quarter 1.
Next, open "Menu > Single equation models > ARIMA estimation and forecasting". Then
the following window appears.

Click "Continue":

In order to conduct out of sample forecasting, either append the data with missing
values (via "Menu > Input > Prepare time series for forecasting"), or select a subset of
observations. I will choose the latter. Thus, click "Yes":

Choose the subsample 1950.1 through 1997.1. Then the ARIMA model will be fitten to
this subsample, and the observations after 1997.1 will be used to compare forecasts
and realizations.
Click "Bounds OK", and then "Confirm" and "Continue" (in the next window). Then the
following window appears:

You now have to tell EasyReg what the order of integration ("d") is. Usually you do not
know this in advance. If so, test the unit root hypothesis, via "Menu > Data analysis >
Unit root tests (root 1)". If you don't know what a unit root is, please read my lecture
notes on unit roots. If after reading these lecture notes you still don't understand what a
unit root is and how to test for it, click "Don't know".
In our case d = 1, as indicated. Thus click "1 times OK":

Although in our case the process Ay(t) has zero expectation so that there is no need for
an intercept, in practice this is rare. Therefore, in first instance include an intercept in
your model, and test afterwards whether the parameter involved is zero. Thus, click
"Continue":

Now you have to specify the ARMA process for u(t) = Ay(t) - E[Ay(t)]. The coefficients
a(1,i) are the non-zero coefficients of the non-seasonal AR lag polynomial, and the
coefficients c(1,i) are the non-zero coefficients of the seasonal AR lag polynomial.
Similarly, the coefficients a(2,i) are the non-zero coefficients of the non-seasonal MA
lag polynomial, and the coefficients c(2,i) are the non-zero coefficients of the seasonal
MA lag polynomial. If your data consist of annual time series the option of specifying
seasonal lag polynomials is not available.
In our case (1 - 0.7L)u(t) = (1 + 0.5L)(1 - 0.25L
4
)e(t), hence
- a(1,1) = 0.7
- a(2,1) = -0.5
- c(2,1) = 0.25
Thus you have to click a(1,1), a(2,1) and c(2,1). Of course, in practice you don't know
this in advance. To determine the lags involved, read first my lecture notes on
forecasting , and then use the option "ARIMA model section via information criteria".
This module also comes with a guided tour.
For more advanced time series analysis, see for example:
- James D. Hamilton: Time Series Analysis, Princeton University Press, 1994.
Now click "Specification OK":

The only action required is to click "Continue":

The model parameters will be estimated by minimizing
t
e(t)
2
, using the simplex
method of Nelder and Mead. Click first "Simplex method: How it works, and stopping
rules".

I recommend to use in first instance the default stopping rules. After completing the first
iteration round you may wish to decrease the value of "r". Thus click "Stoppings rules
OK". Then the previous window reappears. Click "Start SIMPLEX iteration":

In the current version of module ARIMA the simplex method is restarted until the
parameters do not change anymore. As a double check, check "Auto restart" and restart
the simplex iteration. Then click "Simplex method: How it works, and stopping rules"
again, and decrease the value of "r":

Click "Stopping rules OK":

Check "Auto restart" and click "Restart SIMPLEX iteration", and then click "Done with
SIMPLEX iteration":

Click "Continue":

This window is similar to the "What to do next" window when you run an OLS
regression. See the guided tour on OLS estimation. It contains the estimation results,
and an options menu.
Click the "Options" button:

Test parameter restrictions
Recall that the true values of the parameters are:
- b(1) = 0
- a(1,1) = 0.7
- a(2,1) = -0.5
- c(2,1) = 0.25
In order to see whether the estimates are significantly different from the true values, test
the null hypothesis involved using the "Test parameter restrictions" option. The
procedure is the same as for OLS (see the guided tour on OLS estimation), and
therefore I will not demonstrate it again how to conduct this test, but only show the
results:

The test result is as expected: The parameter estimates are not significantly different
from the true values, at any reasonable significance level.
Plot the fit

This window does not need explanation.
One-step ahead forecasts
Recall that the best one-step ahead forecast of Ay(t) takes the form
E
t-1
[Ay(t)] =
j > 1

j
Ay(t-j) + o,
where the parameters
j
and o can be derived from the parameters of the ARMA model
for Ay(t). See my Lecture notes on forecasting. Therefore, the best one-step ahead
forecast of y(t) itself takes the form
E
t-1
[y(t)] = y(t-1) + E
t-1
[Ay(t)].
Thus both forecast schemes use all the data up to time t-1. The option "One-step ahead
forecasts" generates these forecasts:

Click "Continue":

This picture displays E
t-1
[Ay(t)] on the vertical axis and its realisation Ay(t) on the
horizontal axis, for t = 1997.2 to 1999.4. The closer the points (Ay(t), E
t-1
[Ay(t)]) are to
the (45 degrees) line, the better the forecasts.
Click "Continue":

The top panel displays the plots of Ay(t) (solid line) and its forecasts E
t-1
[Ay(t)] (dotted
red line) for t = 1997.2 to 1999.4. The bottom panel plots the forecast errors Ay(t) - E
t-
1
[Ay(t)], together with the one- and two-times standard error bands.
Click "Continue":

This picture displays E
t-1
[y(t)] on the vertical axis and its realisation y(t) on the horizontal
axis, for t = 1997.2 to 1999.4. The closer the points (y(t), E
t-1
[y(t)]) are to the (45
degrees) line, the better the forecasts.
Click "Continue":

The top panel displays the plots of y(t) (solid line) and its forecasts E
t-1
[y(t)] (dotted red
line) for t = 1997.2 to 1999.4. The bottom panel plots the forecast errors y(t) - E
t-1
[y(t)].
Click "Continue". Then you will return to the "What to do next?" window.
Recursive forecasts
In recursive forecasting, the unknown Ay(t+h-j)'s in the one-step ahead forecast scheme
E
t+h
[Ay(t+h)] =
j > 1

j
Ay(t+h-j) + o
are replaced recursively by forecasts, which then yields the best h-step ahead forecast:
E
t
[Ay(t+h)] =
j > 0

h,j
Ay(t-j) + o
h

See my Lecture notes on forecasting. Thus, these forecasts only use the information up
to time t = 1997.1. The corresponding recursive level forecast of y(t+h) is then
E
t
[y(t+h)] = y(t) + E
t
[Ay(t+1)] + ... + E
t
[Ay(t+h)]





The results in the above windows indicate that recursive h step ahead forecasting only
yields reasonable forecasts for modest values of h. This corresponds to the fact that
E
t
[Ay(t+h)] E[Ay(t)] as h .
This is what you see happening in the last window.
Plot one-step ahead forecast coefficients
Recall that the best one-step ahead forecast of Ay(t+1) takes the form
E
t
[Ay(t+1)] =
j > 0

j+1
Ay(t-j) + o.
In the next window the coefficients a(j) =
j+1
are plotted, and their values displayed.

Kernel estimate of the error density

This picture compares the nonparametric kernel estimator of the density of e(t) with the
corresponding normal density. Note that nonparametric kernel density estimation lacks
"parametric backbone" and therefore needs much more data than parametric density
estimation. The effective sample size in this case is too small to do reliable
nonparametric estimation.
Comparison with the OLS module
An ARMA model can also be estimated via the linear regression (OLS) module, using
the option "Re-estimate the model with ARMA errors". See the guided tour on OLS
estimation. This option produces the same parameter estimates as the ARIMA module.
However, if you estimate an AR model directly via the linear regression (OLS) module,
without using the option "Re-estimate the model with ARMA errors", the estimation
results for the intercept, and eventually time trend and seasonal dummy parameters, will
differ from the corresponding results obtained via the ARIMA module under review. The
reason is the following. The ARIMA module estimates an AR(p) model with intercept in
the form
y
t
= + u
t
,
u
t
= o
1
u
t-1
+ .... + o
p
u
t-p
+ e
t
,
where = E[y
t
] and e
t
is white noise, whereas the linear regression module estimates
this model in the form
y
t
= o
0
+ o
1
y
t-1
+ .... + o
p
y
t-p
+ e
t
.
The intercept o
0
will be different from , because taking expectations in the latter case
yields = o
0
+ o
1
+ .... + o
p
, hence:
= (1 - o
1
- .... - o
p
)
-1
o
0
.
This is the end of the guided tour on ARIMA estimation and forecasting