QUESTION NO. 1 WHAT IS DURBIN WATSON?

The Durbin Watson Test (DW) is the most common test for autocorrelation and is
based on the assumption that the structure is of first order. Since first order autocorrelation
is most likely to appear in time series data, the test is very important. The Durbin-Watson
test statistics for the first order autocorrelation is:

∑𝑛𝑡=2(𝑢𝑡 − 𝑢𝑡−1 )2
𝐷𝑊 =
∑𝑛𝑡=1(𝑢𝑡 )2

Where 𝑢 being the estimated residual from a sample regression model. The above equation
can be simplified as:

∑𝑛𝑡=2(𝑢𝑡2 + 𝑢𝑡−1
2
− 2𝑢𝑡 𝑢𝑡−1 )
𝐷𝑊 = 𝑛 = 2(1 − 𝑒̂ )
∑𝑡=1(𝑢𝑡 )2

Based on the above equation, we can draw this picture.

The Durban-Watson or DW statistic ranges between 0 and 4; where:

There is no-autocorrelation around DW = 2 (between du and 4-du)

Then there are two ‘indecision zones’ on both sides of ‘No-autocorrelation’ zone.

On both extreme ends, ‘positive autocorrelation’ and ‘negative autocorrelation’ zones exist.

QUESTION NO. 2 WHAT IS PRAIS WINSTEN (AR)

REGRESSION?

Prais–Winsten estimation is a procedure to take care of the serial correlation of type

AR (1) in a linear regression model. It was developed by Sigbert Prais and Christopher
Winsten in 1954, it is a modification of Cochrane–Orcutt estimation in the sense that it does
not lose the first observation, which leads to more efficiency as a result and makes it a
special case of feasible generalized least squares.
 Consider simple time series regression model,

𝑌𝑡 = 𝛼 + 𝛽𝑋𝑡 + 𝜀𝑡

In case of autocorrelation over time, 𝑢𝑡 = 𝜌𝑢𝑡−1 + 𝑢𝑡 , |𝜌| < 1 and 𝑢𝑡 is a white

nose. For this, Cochrane-Orcutt Procedure Transformation will be,

𝑌𝑡 − 𝜌𝑌𝑡−1 = 𝛼(1 − 𝜌) + 𝛽(𝑋𝑡 − 𝜌𝑋𝑡−1 ) + 𝑒𝑡

In this equation, we are using lag value of X, this will reduce our sample size. So a
new model Prais-Winsten was formed as:

𝑌𝑡 √(1 − 𝜌2 )+= 𝛼√(1 − 𝜌2 ) + 𝛽 (𝑋𝑡 √(1 − 𝜌2 )) + 𝜖𝑡 √(1 − 𝜌2 )

QUESTION NO. 10.13

10.13.a. Is there serial correlation in Model A? In Model B?

For Model A, the value of DW is: 0.8252

At n = 16, and K = 1, the value of Dl = 1.106 and Du = 1.371

1.106 1.371 2.69 2.89

Our value is bellow then 1.106, that proves that there is positive autocorrelation.

For Model A, the value of DW is: 1.8252

Positive Indecision Zone No Autocorrelation Indecisive Zone Negative

Dl Du 4-du 4-dl
 0.982 1.539 2.461 2.461
At n = 16, and K = 1, the value of Dl = 0.982 and Du = 1.539

Here the answer is in the region of no autocorrelation. So, model 2 has no autocorrelation.

10.13.b. If there is serial correlation in Model A but not in Model

B, what accounts for the serial correlation in the former?

Normally autocorrelation exists due to three main reasons:

o Omitted Variables
o Functional Misspecification
o Measurement Error

Model 1 has only one explanatory variable while model 2 has two explanatory variables.
Model 2 is showing no autocorrelation while model 1 shows it has autocorrelation. So we
can say that this was due to omitted variables.

10.13.b. What does this example tell us about the usefulness of

the d statistic in detecting autocorrelation?

This example illustrates that how we can use Durbin Watson to find out the existence of the
autocorrelation problem in the linear regression model. By using DW value, we are able to
find it that whether a model has autocorrelation or not.

QUESTION NO. 10.17

10.17.a. Estimate the OLS regression

10.17.b. Find out if there is first-order autocorrelation in the
data on the basis of the d statistic.

Positive Indecision Zone No Autocorrelation Indecisive Zone Negative

Dl Du 4-du 4-dl
1.316 1.469 2.531 2.684
Based on the above DW value, we can say that our data has positive autocorrelation.

10.17.c. If there is, use the d value to estimate the

autocorrelation parameter 𝝆.

𝐷𝑊 = 2(1 − 𝜌)
0.4284 = 2(1 − 𝜌)
𝜌 = 0.7857516
10.17.d.
QUESTION NO. 10.21

10.21.a. What do these results suggest about the nature of

autocorrelation in this example?
The DW Value at model 1 is lower then the Dl, so there is positive auto correlation in the
data.

In model 2, DW is 0.341, which is lower from the DL, so there is still positive
autocorrelation in the data.

In model 3, AR (1) is significant that indicate that there exist autocorrelation problem.

10.21.b. How would you interpret the time and lagged Y terms
in Model 3?

Yes, we will interpret these items as well. Time is considered important but AR term only
indicate problem that should be rectified.