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# Universit`a di Pavia

## Introduction to Stochastic processes

Eduardo Rossi
Stochastic Process
Stochastic Process: A stochastic process is an ordered sequence of
random variables dened on a probability space (, F, P).
{Y
t
(), , t T }, such that for each t T , y
t
() is a random
variable on the sample space , and for each , y
t
() is a
realization of the stochastic process on the index set T (that is an
ordered set of values, each corresponds to a value of the index set).
Time Series: A time series is a set of observations {y
t
, t T
0
}, each
one recorded at a specied time t. The time series is a part of a
realization of a stochastic process, {Y
t
, t T } where T T
0
. An
innite series {y
t
}

t=
Eduardo Rossi c - Time series econometrics 2011 2
Mean, Variance and Autocovariance
The unconditional mean

t
= E[Y
t
] =
_
Y
t
f(Y
t
)dY
t
(1)
Autocovariance function: The joint distribution of
(Y
t
, Y
t1
, . . . , Y
th
)
is usually characterized by the autocovariance function:

t
(h) = Cov(Y
t
, Y
th
)
= E[(Y
t

t
)(Y
th

th
)]
=
_
. . .
_
(Y
t

t
)(Y
th

th
)f(Y
t
, . . . , Y
th
)dY
t
. . . dY
th
The autocorrelation function

t
(h) =

t
(h)
_

t
(0)
th
(0)
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Stationarity
Weak (Covariance) Stationarity: The process Y
t
is said to be weakly
stationary or covariance stationary if the second moments of the
process are time invariant:
E[Y
t
] = < t
E[(Y
t
)(Y
th
)] = (h) < t, h
Stationarity implies
t
(h) =
t
(h) = (h).
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Stationarity
Strict Stationarity The process is said to be strictly stationary if for
any values of h
1
, h
2
, . . . , h
n
the joint distribution of
(Y
t
, Y
t+h
1
, . . . , Y
t+h
n
) depends only on the intervals h
1
, h
2
, . . . , h
n
but
not on the date t itself:
f(Y
t
, Y
t+h
1
, . . . , Y
t+h
n
) = f(Y

, Y
+h
1
, . . . , Y
+h
n
) t, h (2)
Strict stationarity implies that all existing moments are time
invariant.
Gaussian Process The process Y
t
is said to be Gaussian if the joint
density of (Y
t
, Y
t+h
1
, . . . , Y
t+h
n
), f(Y
t
, Y
t+h
1
, . . . , Y
t+h
n
), is Gaussian
for any h
1
, h
2
, . . . , h
n
.
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Ergodicity
The statistical ergodicity theorem concerns what information can be
derived from an average over time about the common average at each
point of time.
Note that the WLLN does not apply as the observed time series
represents just one realization of the stochastic process.
Ergodic for the mean. Let {Y
t
(), , t T } be a weakly
stationary process, such that E[Y
t
()] = < and
E[(Y
t
() )
2
] =
2
< t. Let y
T
= T
1

T
t=1
Y
t
be the time
average. If y
T
converges in probability to as T , Y
t
is said to
be ergodic for the mean.
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Ergodicity
To be ergodic the memory of a stochastic process should fade in the
sense that the covariance between increasingly distant observations
converges to zero suciently rapidly.
For stationary process it can be shown that absolutely summable
autocovariances, i.e.

h=0
|(h)| < , are sucient to ensure
ergodicity.
Ergodic for the second moments
(h) = (T h)
1
T

t=h+1
(Y
t
)(Y
th
)
P
(h) (3)
Ergodicity focus on asymptotic independence, while stationarity on
the time-invariance of the process.
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Example
Consider the stochastic process {Y
t
} dened by
Y
t
=
_
_
_
u
0
t = 0 with u
0
N(0,
2
)
Y
t1
t > 0
(4)
Then {Y
t
} is strictly stationary but not ergodic.
Proof Obviously we have that Y
t
= u
0
for all t 0. Stationarity
follows from:
E[Y
t
] = E[u
0
] = 0
E[Y
2
t
] = E[u
2
0
] =
2
E[Y
t
Y
t1
] = E[u
2
0
] =
2
(5)
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Example
Thus we have = 0, (h) =
2
(h) = 1 are time invariant.
Ergodicity for the mean requires:
y
T
= T
1
T1

t=o
Y
t
= T
1
(Tu
0
)
y
T
= u
0
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Random walk
Y
t
= Y
t1
+u
t
where u
t
WN(0,
2
). By recursive substitution,
Y
t
= Y
t1
+u
t
Y
t
= Y
t2
+u
t1
+u
t
.
.
.
= Y
0
+u
t
+u
t1
+u
t2
+. . . + u
1
The mean is time-invariant:
= E[Y
t
] = E
_
Y
0
+
t

s=1
u
s
_
= Y
0
+
t

s=1
E[u
s
] = 0. (6)
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Random walk
But the second moments are diverging. The variance is given by:

t
(0) = E[Y
2
t
] = E
_
_
_
Y
0
+
t

s=1
u
s
_
2
_
_
= E
_
_
_
t

s=1
u
s
_
2
_
_
= E
_
t

s=1
t

k=1
u
s
u
k
_
= E
_
t

s=1
u
2
s
+
t

s=1
t

k=1
u
s
u
k
_
=
t

s=1
E[u
2
s
] +
t

s=1
t

k=1,k=s
E[u
s
u
k
] =
t

s=1

2
= t
2
.
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Random walk
The autocovariances are:

t
(h) = E[Y
t
Y
th
] = E
__
Y
0
+
t

s=1
u
s
__
Y
0
+
th

k=1
u
k
__
= E
_
t

s=1
u
s
_
th

k=1
u
k
__
=
th

k=1
E[u
2
k
]
=
th

k=1

2
= (t h)
2
h > 0. (7)
Finally, the autocorrelation function
t
(h) for h > 0 is given by:

2
t
(h) =

2
t
(h)

t
(0)
th
(0)
=
[(t h)
2
]
2
[t
2
][(t h)
2
]
= 1
h
t
h > 0 (8)
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White Noise Process
A white-noise process is a weakly stationary process which has zero
mean and is uncorrelated over time:
u
t
WN(0,
2
) (9)
Thus u
t
is WN process t T :
E[u
t
] = 0
E[u
2
t
] =
2
<
E[u
t
u
th
] = 0 h = 0, t h T (10)
If the assumption of a constant variance is relaxed to E[u
2
t
] < ,
sometimes u
t
is called a weak WN process.
If the white-noise process is normally distributed it is called a
Gaussian white-noise process:
u
t
NID(0,
2
). (11)
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White Noise Process
The assumption of normality implies strict stationarity and serial
independence (unpredictability). A generalization of the NID is the
IID process with constant, but unspecied higher moments.
A process u
t
with independent, identically distributed variates is
denoted IID:
u
t
IID(0,
2
) (12)
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Martingale
Martingale The stochastic process x
t
is said to be martingale with
respect to an information set (-eld), I
t1
, of data realized by time
t 1 if
E[|x
t
|] <
E[x
t
|I
t1
] = x
t1
a.s. (13)
Martingale Dierence Sequence The process u
t
= x
t
x
t1
with
E[|u
t
|] < and E[u
t
|I
t1
] = 0 for all t is called a martingale
dierence sequence, MDS.
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Martingale difference
Let {x
t
} be an m.d. sequence and let g
t1
= (x
t1
, x
t2
, . . .) be any
measurable, integrable function of the lagged values of the sequence.
Then x
t
g
t1
is a m.d., and
Cov[g
t1
, x
t
] = E[g
t1
x
t
] E[g
t1
]E[x
t
] = 0
This implies that, putting g
t1
= x
tj
j > 0
Cov[x
t
, x
tj
] = 0
M.d. property implies uncorrelatedness of the sequence.
White Noise processes may not be m.d. because the conditional
expectation of an uncorrelated process can be a nonlinear.
An example is the bilinear model (Granger and Newbold, 1986)
x
t
= x
t2

t1
+
t
,
t
i.i.d(0, 1)
The model is w.n. when 0 < <
1

2
.
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Martingale difference
The conditional expectations are the following nonlinear functions:
E[x
t
|I
t1
] =

i=1
()
i+1
x
ti
_
_
i+1

j=2
x
tj
_
_
Uncorrelated, zero mean processes:
White Noise Processes
1. IID processes
(a) Gaussian White Noise processes
Martingale Dierence Processes
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Innovation
Innovation An innovation {u
t
} against an information set I
t1
is a
process whose density f(u
t
|I
t1
) does not depend on I
t1
.
Mean Innovation {u
t
} is a mean innovation with respect to an
information set I
t1
if E[u
t
|I
t1
] = 0
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The Wold Decomposition
If the zero-mean process Y
t
is wide sense stationary (implying
E(Y
2
t
) < ) it has the representation
Y
t
=

j=0

tj
+v
t
where
0
= 1,

j=0

2
j
<

t
WN(0,
2
)
E(v
t

tj
) = 0, j
and there exist constants
0
,
1
,
2
, . . . , such that
V ar(

j=0

j
v
t
) = 0.
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The Wold Decomposition
The distribution of v
t
is singular, since
v
t
=

j=1
(
j
/
0
)v
tj
with probability 1, and hence is perfectly predictable one-step ahead.
(Deterministic process).
If v
t
= 0, Y
t
is called a purely non-deterministic process.
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Box-Jenkins approach to modelling time series
Approximate the innite lag polynomial with the ratio of two
nite-order polynomials (L) and (L):
(L) =

j=0

j
L
j

=
(L)
(L)
=
1 +
1
L +
2
L
2
+. . . +
q
L
q
1
1
L
2
L
2
. . .
p
L
p
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Box-Jenkins approach to modelling time series
Time Series Models
p q Model Type
p > 0 q = 0 (L)Y
t
=
t
AR(P)
p = 0 q > 0 Y
t
= (L)
t
MA(Q)
p > 0 q > 0 (L)Y
t
= (L)
t
ARMA(p,q)
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