Vector autoregression (VAR)

May 22

Vector autoregression (VAR)

Vector autoregression (VAR)

Suppose we are observing two stocks and their respective returns are $x_{t},y_{t}.$ To take into account their interdependence, we consider a vector autoregression

(1) $\left\{\begin{array}{c}x_{t}=a_{1}x_{t-1}+b_{1}y_{t-1}+u_{t} \\ y_{t}=a_{2}x_{t-1}+b_{2}y_{t-1}+v_{t}\end{array}\right.$

Try to repeat for this system the analysis from Section 3.5 (Application to an AR(1) process) of the Guide by A. Patton and you will see that the difficulties are insurmountable. However, matrix algebra allows one to overcome them, with proper adjustment.

Problem

A) Write this system in a vector format

(2) $Y_{t}=\Phi Y_{t-1}+U_{t}.$

What should be $Y_{t},\Phi ,U_{t}$ in this representation?

B) Assume that the error $U_{t}$ in (1) satisfies

(3) $E_{t-1}U_{t}=0,\ EU_{t}U_{t}^{T}=\Sigma ,~EU_{t}U_{s}^{T}=0$ for $t\neq s$ with some symmetric matrix $\Sigma =\left(\begin{array}{cc}\sigma _{11} & \sigma _{12} \\ \sigma _{12} & \sigma _{22}\end{array}\right) .$

What does this assumption mean in terms of the components of $U_{t}$ from (2)? What is $\Sigma$ if the errors in (1) satisfy

(4) $E_{t-1}u_{t}=E_{t-1}v_{t}=0,~Eu_{t}^{2}=Ev_{t}^{2}=\sigma ^{2},$ $Eu_{s}u_{t}=Ev_{s}v_{t}=0$ for $t\neq s,$ $Eu_{s}v_{t}=0$ for all $s,t?$

C) Suppose (1) is stationary. The stationarity condition is expressed in terms of eigenvalues of $\Phi$ but we don't need it. However, we need its implication:

(5) $\det \left( I-\Phi \right) \neq 0$ .

Find $\mu =EY_{t}.$

D) Find $Cov(Y_{t-1},U_{t}).$

E) Find $\gamma _{0}\equiv V\left( Y_{t}\right) .$

F) Find $\gamma _{1}=Cov(Y_{t},Y_{t-1}).$

G) Find $\gamma _{2}.$

Solution

A) It takes some practice to see that with the notation

$Y_{t}=\left(\begin{array}{c}x_{t} \\y_{t}\end{array}\right) ,$ $\Phi =\left(\begin{array}{cc}a_{1} & b_{1} \\a_{2} & b_{2}\end{array}\right) ,$ $U_{t}=\left(\begin{array}{c}u_{t} \\v_{t}\end{array}\right)$

the system (1) becomes (2).

B) The equations in (3) look like this:

$E_{t-1}U_{t}=\left(\begin{array}{c}E_{t-1}u_{t} \\ E_{t-1}v_{t}\end{array}\right) =0,$

$EU_{t}U_{t}^{T}=\left(\begin{array}{cc}Eu_{t}^{2} & Eu_{t}v_{t} \\ Eu_{t}v_{t} & Ev_{t}^{2}\end{array}\right) =\left(\begin{array}{cc}\sigma _{11} & \sigma _{12} \\ \sigma _{12} & \sigma _{22}\end{array}\right) ,$

$EU_{t}U_{s}^{T}=\left(\begin{array}{cc}Eu_{t}u_{s} & Eu_{t}v_{s} \\Ev_{t}u_{s} & Ev_{t}v_{s}\end{array}\right) =0.$

Equalities of matrices are understood element-wise, so we get a series of scalar equations $E_{t-1}u_{t}=0,...,Ev_{t}v_{s}=0$ for $t\neq s.$

Conversely, the scalar equations from (4) give

$E_{t-1}U_{t}=0,\ EU_{t}U_{t}^{T}=\left(\begin{array}{cc}\sigma ^{2} & 0 \\0 & \sigma ^{2}\end{array}\right) ,~EU_{t}U_{s}^{T}=0$ for $t\neq s$ .

C) (2) implies $EY_{t}=\Phi EY_{t-1}+EU_{t}=\Phi EY_{t-1}$ or by stationarity $\mu =\Phi \mu$ or $\left( I-\Phi \right) \mu =0.$ Hence (5) implies $\mu =0.$

D) From (2) we see that $Y_{t-1}$ depends only on $I_{t}$ (information set at time $t$ ). Therefore by the LIE

$Cov(Y_{t-1},U_{t})=E\left( Y_{t-1}-EY_{t-1}\right) U_{t}^{T}=E\left[ \left(Y_{t-1}-EY_{t-1}\right) E_{t-1}U_{t}^{T}\right] =0,$

$Cov\left( U_{t},Y_{t-1}\right) =\left[ Cov(Y_{t-1},U_{t})\right] ^{T}=0.$

E) Using the previous post

$\gamma _{0}\equiv V\left( \Phi Y_{t-1}+U_{t}\right) =\Phi V\left(Y_{t-1}\right) \Phi ^{T}+Cov\left( U_{t},Y_{t-1}\right) \Phi ^{T}+\Phi Cov(Y_{t-1},U_{t})+V\left( U_{t}\right)$

$=\Phi \gamma _{0}\Phi ^{T}+\Sigma$

(by stationarity and (3)). Thus, $\gamma _{0}-\Phi \gamma _{0}\Phi^{T}=\Sigma$ and $\gamma _{0}=\sum_{s=0}^{\infty }\Phi ^{s}\Sigma\left( \Phi^{T}\right) ^{s}$ (see previous post).