Department of Statistics, University of Pune

ST E20/AS EL 4 : Financial Econometrics - Assignment - Cointegration

1. (a) When can dierent integrated (non-stationary) time series be validly regressed on
each other?
(b) What is the relationship between cointegration and error correction models (ECM)?
(c) Consider a vector autoregressive process of order 2 ( VAR(2) ). Derive the corre-
sponding ECM and obtain the cointegration vectors.
2. In the following table, the details of two test results are given corresponding to a system
with 5 variables using Johansens maximum likelihood procedure.
Cointegration Trace 5% critical Max. Eigen 5% critical
Relations (r) test value value test value
1 15.4 8.08 11.1 8.1
2 24.1 17.8 17.3 14.6
3 29.1 31.2 19.2 21.3
4 33.4 48.4 24.1 27.3
5 37.3 67.9 26.7 33.2
(a) Interpret the two tests.
(b) What is the cointegrating rank of the system? How many restrictions are required
for exact identication?
(c) If we assume r = 2 (2 cointegrating vectors) amongst 4 variables, write out general
vector error correction model.
3. (a) Consider the equations
X
t1
=
1
2
(X
t1,1
X
t1,2
) +Z
t1
X
t2
=
1
4
(X
t1,1
X
t1,2
) +Z
t2
where {Z
t1
} and {Z
t1
} are two independent sequences of iid random variables. Ex-
amine the stationarity of X
t1
, X
t2
and X
t1
X
t2
.
(b) State Grangers representation theorem and illustrate the result with a VAR(2) pro-
cess.
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(c) Consider an AR(1) process
X
t
= X
t1
+Z
t
, || < 1, Z
t
WN(0,
2
).
Is {X
t
} an I(0) process? What about Y
t
= X
t
X
t1
? Justify all your claims.
4. Consider the monthly U.S. 1-year and 3-year Treasury constant maturity rates. The data
may be obtained from Federal Reserve Bank of St. Louis. Use the interest rates directly
by dening x
t
= (x
1t
, x
2t
)

.
(a) Identify the VAR model for the bivariate interest rate series. Write down the tted
model.
(b) Are the two interest rates cointegrated? Carry out a test for cointegration.
(c) If the series are cointegrated, build an ECM for the series. Write down the tted
model.
(d) Compare the forecasts from VAR and ECM models.
5. Consider the data on spot index and the futures price of Nikkei Stock Average 225 (NSA).
(dh.dat.tex)
(a) Get time series plots of these two series and compare them.
(b) Carry out VAR modeling.
(c) Are they cointegrated? Carry out a test of cointegration.
(d) Obtain the ECM representation.
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