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An Empirical Analysis of Nonstationarity in a Panel of Interest Rates with Factors

Author(s): Hyungsik Roger Moon and Benoit Perron


Source: Journal of Applied Econometrics, Vol. 22, No. 2, Heterogeneity and Cross Section
Dependence in Panel Data Models: Theory and Applications (Mar., 2007), pp. 383-400
Published by: Wiley
Stable URL: http://www.jstor.org/stable/25146521
Accessed: 09-05-2015 02:28 UTC
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JOURNAL OF APPLIED ECONOMETRICS


J. Appl

Econ.

22: 383-400

(2007)

Published online inWiley InterScience


DOI:

(www.interscience.wiley.com)

?WILEY

?':

*4&#

iTltetSCieTICe?

BTr^rTTTTSTrnTTTrrnTif

^?

10.1002/jae.931

AN EMPIRICALANALYSIS OF NONSTATIONARITY INA


PANEL OF INTERESTRATESWITH FACTORS
HYUNGSIK ROGER MOONa AND BENOIT PERRON**
a
b

Departement

Department
de sciences

Los Angeles,
CA, USA
University
of Economics,
of Southern California,
de Montreal,
Montreal,
CIREQ and CIRANO, Universite
Quebec,
economiques,

Canada

SUMMARY
This

studies

paper
risk. We
focus

nonstationarities

in a panel
of Canadian
model
the cross-sectional

and US

rates

interest

of different

maturities

and

as a linear dynamic
the panel
our data into common
and idiosyncratic
in turn.
and decompose
factor model,
that we analyze
components
some of the idiosyncratic
in our panel.
Our results
the presence
of a single nonstationary
factor
Since
suggest
we conclude
are cointegrated.
can
are stationary,
that these series
the dominant
factors
components
Finally,
on methods

which

dependence

within

be interpreted as level and slope factors as in the term structure literature. Copyright ? 2007 JohnWiley &
Sons,

Ltd.

Received 23 September 2004; Revised 4May 2006

1. INTRODUCTION
In earlier empirical studies, using standard methods, nominal interest rates of different maturities
are typically found to be nonstationary and cointegrated
(see, for example, Campbell and Shiller,
1987; Evans and Lewis, 1994). On the other hand, early results in the nonstationary panel literature
that suppose that the series in the panel are independent are more favorable to stationarity (see,
for example, Wu and Chen, 2001).
In this paper, we analyze a panel of 25 monthly Canadian and US interest rates of different
maturities and risk. First, we document significant cross-sectional
correlation among the series in
the panel. To model the correlation, we employ a dynamic factor model. Our analysis then focuses
on a decomposition
of the panel into common and idiosyncratic components
in order to answer
the following three questions: (i) Is the observed data stationary or not and, if it is nonstationary,
common components
or nonstationary
is it because of nonstationary
idiosyncratic components?
correlations and how
(ii) How many common factors are necessary to capture the cross-sectional
Do
the
estimated
factors
many of these common factors are nonstationary?
(iii)
represent some
observable variables of interest?
The first question will be answered by carrying out a series of panel unit root tests and stationarity
tests that have been developed
on the specification of the test, this will test
recently. Depending
are nonstationary or not. The first part of the
whether the idiosyncratic or common components
second question will be answered by using the panel information criteria proposed by Bai and Ng
(2002), while the second part of the question will be answered using a combination of tests and
*
Correspondence
Montreal,
Quebec,

Copyright

to: Benoit
Canada

2007

de sciences economiques,
Perron, Departement
H3C 3J7. E-mail: benoit.perron@umontreal.ca

John Wiley

CIREQ

and CIRANO,

Universite"

& Sons, Ltd.

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de Montreal,

384

H. R. MOON AND B. PERRON

a new

information criterion developed by Bai (2004). Finally, the third question will be answered
the
results in Bai (2004).
using
We find that interest rates are characterized by a single nonstationary factor and some stationary
in other words, they are cointegrated as in Campbell and Shiller (1987)
idiosyncratic components;
and Evans and Lewis (1994). Secondly, we find that the first two factors in our interest rate panel
have interpretations as level and slope factors as in the term structure literature.
The paper is organized as follows. Section 2 introduces our dataset and documents strong cross
for the analysis of
of the methodology
sectional correlation. Sections 3 provides an overview
factors and our related empirical results. In Section 4, we discuss our analysis of the idiosyncratic
components by focusing specifically on the application of panel unit root tests with factors. Finally,
Section 5 concludes.

2. DATA
section introduces our panel of interest rates briefly. Throughout, we suppose that we have
panel data zu of individual i that is observed at time t. Let n and T denote the size of the cross
section and time series dimensions,
respectively. We model our panel using the decomposition
common
and idiosyncratic components as in Bai and Ng (2004):
among deterministic,

This

Za = dit + cit + uit

(1)

and uit the idiosyncratic


is the deterministic
cu the common component,
component,
we
the
the
deterministic
In
of
data
that
view
of
consider,
component will be
component.
type
= a,-. We model the common
restricted to an individual-specific
component, ca, with
intercept, da
a linear factor structure. Our goal is to characterize the stationary properties of the common and

where

du

idiosyncratic components.
is nonstationary while the idiosyncratic one
Except for the case where the common component
it is sometimes more convenient
for characterizing
the
is stationary (hence zu is cointegrated),
as
an
and
Perron
form
in
Moon
to
in
of
model
zu
(1)
express
autoregressive
stationarity properties

(2004):
zu =
zl
where

are

yit

unobservable

error

terms

<*i+ zl

Pizl_i
a factor

with

yit

(2)
+ yit
structure:

Pi ft + eit (3)

random factors, pt are nonrandom factor loading


ft are K x 1 vectors of unobservable
eit are idiosyncratic shocks, and the number of factors K is unknown.
coefficients,
Because Bai and Ng (2004) work with the decomposition
(1) directly, this allows them to
consider testing separately the stationarity of the factors and the stationarity of the idiosyncractic
component. This has two advantages: first, the factors are considered as objects of interest that
can be analyzed; and second, cointegration among the panel units is allowed. We will follow this

where

strategy rather closely.


Copyright

2007

John Wiley

& Sons,

Ltd.

J.

Appl.

Econ.

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22:

383-400
(2007)
DOI:
10.1002/jae

AN EMPIRICALANALYSIS OF NONSTATIONARITY 385

Our panel consists of 14 monthly Canadian interest rates and 11 US rates. These vary by both
maturity and risk. The included Canadian rates are 1-, 3-, and 6-month T-bills, federal government
bonds with a maturity of 1, 2, 3, 4, 7, and 10 years, commercial paper with a maturity of 1month
and Scotia indices of yields on corporate bonds with mid-term
and long-term
and 3 months,
maturities. The US rates are Treasury securities with 3 months, 6 months, and 1, 2, 3, 5, 7, and
10 years to maturity,
1-month commercial
indices of yields on corporate
paper, and Moody's
bonds with AAA and BAA ratings. The panel spans the January 1985-April
2004 period for a
total of 232 observations
for each rate.
Table I presents estimates of the short-run correlation matrix for these data.1 We have divided
the data into Canadian and US rates. There are high correlations among yields with similar maturity
in a given country. In particular, the correlation among long rates is very high, as should be the
case if the expectations hypothesis were true. There is much lower correlation within a country
between short rates and long rates and across countries for the same maturity. For example, the
3-month Canadian T-bill has a correlation of 0.933 with the 6-month Canadian T-bill but of only
0.405 with the 3-month US Treasury. Thus, the data are supportive of a model with high degree
of correlation among cross-sectional
units such as our factor model.

3. ANALYSIS OF FACTORS
The first step in our analysis of the nonstationary properties of our panel is to analyze the behavior
of the common factors. This entails estimating the total number of common factors and determining
how many of these are nonstationary. We will also attempt to relate the estimated factors to
observable variables of interest. The first subsection discusses our methodology,
while the second
one

reports

our

results.

empirical

3.1. Methodology
Estimation of Number of Factors
One of our main goals is to determine the number of factors in the possibly nonstationary panel
model (l)-(3). To this end, we will employ information criteria as suggested by Bai and Ng (2002).
These information criteria will be applied to factors estimated by principal components either on
residuals (following
the Moon and Perron, 2004, approach) or on first differences
(following Bai
and Ng, 2004).
To estimate the true number of factors, K, Bai and Ng (2002) propose tominimize
the following
criterion functions:
PC(r)
IC(r)

o2e(r) + rGnT,

ln(o2e(r)) + rGnT (4)

r is the number

where

of factors included in the model,


o2e(r) is the variance of the estimated
a
and
is
function
that depends on the size of the panel.
Gnr
idiosyncratic components,
penalty
These criteria are similar in spirit to the common AIC and BIC criteria for time series. They
some measure
involve a trade-off between
of fit (as measured
by o2(r)) and a function Gnj
1
The

long-run

Copyright

correlation
2007

matrix

John Wiley

is similar

& Sons,

and is not reported.


Ltd.

J.

Appl

Econ.

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22: 383-400
(2007)
DOI:
10.1002/jae

n_o

1361

10 1-m3-m

Mid
1-m
Long

10 1m AAA

fcP
mth
mths
mths
yr
yrs
yrs
yrs
yrs
yrs
CP
BA
corp.
CP
corp.
mths
mths
yr
yrs
yrs
yrs
yrs
yrs
CP

?BAA
0.108
0.148
0.193
0.241
0.346
0.380
0.444
0.455
0.486
0.134
0.152
0.136
0.479
0.365
0.456
0.525
0.615
0.731
0.775
0.822
0.855
0.870
0.299
0.942
??
AAA
0.100
0.153
0.214
0.274
0.379
0.417
0.484
0.489
0.121
0.524
0.155
0.122
0.499
0.481
0.412
0.570
0.663
0.769
0.815
0.860
0.893
0.906
0.309

matrix.

First

of
monthly

Canadian

and

US

interest

rates

1985-2004
^
10.970
m
com.
paper
0.165
0.309
0.354
0.360
0.304
0.308
0.258
0.229
0.215
0.311
0.254
0.264
0.215
0.244
0.661
0.698
0.660
0.528
0.465
0.392
0.361
0.319
^
10
years
0.122
0.205
0.276
0.347
0.453
0.485
0.556
0.559
0.206
0.144
0.584
0.501
0.146
0.516
0.500
0.650
0.766
0.886
0.930
0.989
Ju
7years
0.137
0.228
0.304
0.377
0.484
0.511
0.574
0.590
0.226
0.158
0.160
0.499
0.527
0.543
0.694
0.811
0.926
0.963
0.989

differences

S5years
0.147
0.242
0.316
0.388
0.492
0.506
0.559
0.550
0.556
0.239
0.169
0.171
0.456
0.502
0.598
0.744
0.857
0.958
0.984
0.267
0.162
0.494
0.436
0.913
0.807
0.512
0.411
0.342
0.560
0.543
0.191
0.260
0.663
0.988
0.520
0.546
0.186
3years
2years
0.193
0.304
0.373
0.436
0.523
0.524
0.548
0.526
0.222
0.515
0.295
0.228
0.408
0.476
0.732
0.863
0.952
1year
0.248
0.359
0.414
0.459
0.500
0.501
0.461
0.473
0.504
0.279
0.347
0.289
0.365
0.856
0.429
0.953

Canadian
US
<l
rates

6months
0.278
0.372
0.404
0.426
0.431
0.434
0.420
0.365
0.380
0.306
0.362
0.315
0.294
0.361
0.937 -*
O
0.323
0.405
0.401
0.426
0.418
0.340
0.394
0.310
0.326
0.380
0.300
0.237
0.365
0.325
3months
g 0.333
0.759
0.670
0.513
0.322
0.954
0.948
0.900
0.953
0.514
0.860
0.292
Mid
corporate
Long
corporate
0.233
0.440
0.591
0.667
0.885
0.757
0.815
0.911
0.940
0.266
0.440
0.277
1-m
bank.
ace.
0.952
0.909
0.761
0.651
0.404
0.469
0.517
0.376
0.313
0.993
0.922
ffl
3-m

com.

paper

0.863

3
2

0.979

years
years

0.924

0.642
0.698
20.976
0.830
0.621
0.474
0.955
0.883
0.276
0.710
10
years
0.509
0.299
0.363
0.910
0.948
0.644
0.755
0.392
0.456
1-m
>com.
paper
0.848
7years
0.334
0.545
0.690
0.889
0.778
0.928
0.977
O
5years
0.359
0.575
0.716
0.802
0.924
0.961
g

0.567

0.414
0.862
0.783
0.910
0.834
1year
0.583
0.851
0.966
E
0.704
0.649
0.466

0.535

0.466

0.928

0.962

0.933
0.697
6months
a.

0.872
3
j*>Canadian
rates
months

?I

D_

o-

??
rates
US

fc
-

Ooo

8c3

s? So?8

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AN EMPIRICALANALYSIS OF NONSTATIONARITY 387

that acts as penalty for more complex models. The penalty function has to satisfy the conditions
(i) Gnj -> 0 and (ii) min{w, T}Gnj -> oo, as both n and T go to infinity. As we increase the
number of factors, the fit must improve (i.e., a% goes down), but the penalty term increases. The
the appropriate criterion.
estimated number of factors is the integer that minimizes
Bai and Ng (2002) and Moon and Perron (2004) demonstrate that estimation of the total number
either the PC or IC criterion is consistent in the sense that the probability
of factors by minimizing
that the estimated number of factors equals the true one approaches one as both n and T become
large.

Bai and Ng

suggest

forms of the penalty

three specific

GpcXnT

GPcxnT
Gpc,3,nT

^2
<?e (Kmzx)-?

n + T (-? nT \
m
nT
\n + TJ

=
^(Xmax)^^nT
=

(5)

T})\

-?.-??
(

\ min{n,T}

estimated
where a^(Kmax) is the variance of the idiosyncratic
component
and
number of factors leading to criteria PCi, PC2, and PC3 respectively,

GicxnT

Gicxm

triC,3,nT

= ??

n+ T\ (??- nT \
In
nT

minjn,

T)

the maximum

(6)

T}),

fln(rmn{n,T})\

I
-r";-7f\?

with

\n + T J

n+ T
= ?zrln(min{/i,
nT
=

criterion:

ln(min{/i,r}),

/ln(min{?,

^2
^C^max)

for the PC

function

leading to the ICi, IC2, and IC3 criteria, respectively. Note that, just as in BIC, the IC has the
advantage of not requiring the estimation of a scaling factor in the penalty function. We also
consider the modified BIC criterion (called BIC3):

BIC3(r) = a](r) + ra*(Kmax)H


+^~

r
ln(nT) (1)

because simulation evidence suggests that it performs better in selecting the number of factors
when min (n, T) is small (<20), as is often the case in empirical applications. Bai and Ng rejected
this criterion because it does not satisfy the required conditions for consistency when either n or
T dominates the other one exponentially,
but this appears to be a rather unusual case. For small
n and T of roughly the same magnitude,
this criterion performed best in their simulation among
those

they considered.

For

large panels,

all three forms of the penalty

function

are essentially

equivalent.

the Number of Nonstationary


Factors
Determining
When
the common component
it may be a linear combination
of
cn in (1) is nonstationary,
we
and
Once
factors.
have determined the total number of factors using
stationary
nonstationary
Copyright

2007

John Wiley

& Sons,

Ltd.

J.

Appl.

Econ.

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22: 383-400
(2007)
DOI:
10.1002/jae

H. R. MOON AND B. PERRON

388

the above information criteria on either first differences or residuals, our next task is to determine
how many of these factors are nonstationary. For this purpose, we will draw from two approaches.
The first one is an extension of the information criteria above. The second is a testing procedure
proposed in Bai and Ng (2004) that tests the rank of the long-run covariance matrix of the factors.
Bai (2004) proposed new information criteria to select the number of nonstationary
factors in a
panel. These are closely related to the information criteria in Bai and Ng (2002) discussed above,
but they are applied to the levels of the series rather than the first differences or the residuals. The
three

are

criteria

n+ T
^~o
( nT \
,
IPCdr) = a2u(r)+ raTa2u(Kmm)?? ln I
?^
j
IPC2(r)

IPCi(r)
uit =

=
=

a2u(r) +
a2u(r) +

ln(min{?,

T}),

(8)

raTa2u(K^)?-^
+ T~
raTa2u(Kmax)n

T
ln(nD

ni

from level data zu and


cit are the estimated
components
idiosyncratic
are
to
the
criteria
IC
and
PC
used
estimate
the
total number of factors
r/[41nln(r)].
use
on
IPC
and
while
the
of
these
criteria
levels
estimates the number
(stationary
nonstationary),
of nonstationary factors. The criterion we will use is the IPC\ criterion. Bai also suggested the use
of BIC on level data to estimate the number of nonstationary factors. This seems to perform better

where
ccT=

zu

dit

Thus,

for smaller panels. Note that the consistency


result in Bai (2004) requires that the idiosyncratic
we
next
In
the
be
section,
component
stationary.
provide evidence that suggests that this condition
is in fact met in our data.
In addition to these information criteria, we will look at the modified Qc (MQC) statistic of
Bai and Ng (2004) to determine the number of nonstationary
factors in our panels. The statistic
tests whether the smallest eigenvalue of the matrix of a first-order VAR is unity and proceeds
in
a sequential fashion as in the standard Johansen technique. We first start by assuming that all K
If this is the case, all of the eigenvalues
from the VAR matrix are unity,
factors are nonstationary.
and we cannot reject the null hypothesis
that the number of nonstationary
factors equals the total
number of factors. If we can reject this null hypothesis, we move on to tests whether there are
K ? 1 nonstationary
factors and so on. We stop when we cannot reject that the smallest eigenvalue
is 1. The limiting distribution of theMQC statistic is nonstandard, and critical values are provided
in Bai and Ng (2004) for up to six factors. Finally, to confirm our results, we will compute the
KPSS statistic for testing stationarity on each estimated factor. This procedure has been shown to
be valid

in Bai and Ng

(2005).

on Estimated

Factors
has
obtained inferential results for
Bai
(2004)
Recently,
allow one to test whether some observable variable can
the estimated
factors
The inherent problem with
a
some
are
to
basis
normalization
space
only). The
(they
Inference

to first rotate the estimated

factors

factors. In particular, these


nonstationary
be argued to represent these factors.
is that they are only identified up to
idea of Bai to circumvent this problem is
series of interest by estimating

towards the observed

the linear

regression:
Rt=a
Copyright

2007

John Wiley

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+ #Ft +
Ltd.

rit.
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(9)
Appl.

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22: 383-400
(2007)
DOI:
10.1002/jae

AN EMPIRICALANALYSIS OF NONSTATIONARITY 389

where Rt is some observed series and Ft are the estimated factors. In our results below, we will
report the R2 of this regression for each individual series in the panels and some spreads (in levels
and in first differences to prevent against a spurious regression) for one and two factors. Of course,
we could also search for observables
that are proxied by these factors outside of our panels, but
the series in the panels are natural first candidates.
Bai also proposed a procedure for testing whether one of the factors represents the observed
series Rt and the fitted values from (9), Rt.
series, Rt. The idea is to compare the observed
intervals for Rt requires the factors to be nonstationary with
The construction of these confidence
stationary idiosyncratic errors, otherwise the above regression is a spurious regression (see Phillips,
(i.e., for each t), which means that if a factor truly
1986). These distributional results are pointwise
we
see
should
observed
series
the
Rt,
(under independence) a% of the observations fall
represents
?
interval constructed in this fashion. In consequence, we will also
outside of a 1 a% confidence
that fall outside the appropriate 95%
report in our tables below the percentage of observations
confidence
interval. If the asymptotic analysis is accurate and one of the included factors in the
above regression represents the observed series, we should expect to see entries close to 5% in
these

3.2.

columns.

Empirical

Results

apply our procedures to the analysis of our panel of nominal yields. We first
the total number of factors. Typically,
the term structure literature employs
the number of factors does not
three factors (see Litterman and Scheinkman,
1988). However,
seem to be well estimated by the Bai and Ng information criteria. The ICi suggests the presence
number we allowed), while BIC suggests seven factors.
of eight factors (the maximum
our
the MQC
factors. Using
Table II reports
evidence regarding the number of nonstationary
number of factors.
factor, regardless of the maximum
statistic, we find a single nonstationary
of eight nonstationary
However, results with information criteria are more fragile. With amaximum
In this section, we
start by estimating

factors, the IPC criterion finds four nonstationary factors while the BIC finds three. After setting
the maximum number of factors to four, the IPC finds three factors and the BIC finds two factors.
If we allow only two factors, all criteria find a single one as with theMQC statistic. Finally, the
KPSS statistic rejects stationarity for only one factor. Thus, our results point to the presence of a
single

nonstationary

factor.

To determine whether our estimated factors proxy some variables of interest, we regressed each
interest rate on a constant and either the first one or two estimated factors. The results from this
regression are presented in Table III for each interest rate in the panel and for some interest rate
spreads. The first two columns of the table report the R2 from regression (9) when a single factor
Table
Max.

II. Estimated

number

of nonstationary

factors

12345678

11111111
112
1112

MQC
IPC
BIC

4
3

3
3

Note:

The table reports the estimated number of nonstationary


number of factors in the first row.
the maximum

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4
3

4
3

factors with

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22: 383-400
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DOI:
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390

H. R. MOON AND B. PERRON

Table III. R2 of regression each interest rate on factors. Sample of 25 monthly

interest rates 1985-2004


Pr (zu j CI)
_R2 (%)_

K=\
Levels
Canadian
1-month

T-bill
T-bill

91.4
93.5
95.5
1 year
97.0
2 years
98.1
3 years
97.8
96.2
5 years
7 years
93.9
10
91.3
years

Long-term
Mid-term

First differences

Levels

First

K=\

K=2

differences

rates

3-month
T-bill
6-month

1-month
3-month
1-month

K=2

commercial
paper
commercial
paper
bankers'
acceptances
(Scotia)
(Scotia)

corporate
corporate

US rates
3-month Treasury
6-month Treasury
1-year
Treasury
2-year
Treasury
3-year
Treasury
5-year
Treasury
Treasury
7-year
10-year Treasury
1-month commercial
paper

Spreads
Canadian
10y-3m
3m US-3m
Canadian

91.8
93.5
91.9
85.9
91.8

78.6
79.8
81.4
84.6
86.6
88.5
88.4
87.6
77.5
85.2AAA
Moody's
81.3BAA
Moody's
42.7
42.8
2.8
10y-3mUS

42.3
67.2
76.0
79.3
79.8
78.3
76.2
72.5
66.0
48.5
66.7
49.5
56.2
67.1

98.6 82.4
63.8
48.3
99.4 96.9
57.8
22.0
99.4 89.1
44.8
37.9
98.9
83.6
32.8
98.2
27.2
79.9
54.7
97.9
33.6
79.8
53.9
97.1
51.7
82.3
67.2
95.8
80.3
58.2
94.5
63.4
78.7
69.8
99.1 89.5 60.3
32.3
99.6 96.9
56.0
14.7
99.289.7 60.8
32.8
88.2 67.9
74.1
78.5
92.675.8 65.5
82.8

33.7
40.2
47.1
47.9
46.4
44.6
44.2
41.0
20.2
32.6
29.6

78.7 34.4
82.3
91.8
79.8 45.0
80.6
90.5
82.1 57.9
84.1
88.8
87.5 69.0
81.5
75.9
73.7
71.6
91.3 73.6
72.8
96.2 76.0
43.5
65.5
25.0
97.7 79.3
98.3 77.6
67.2
18.1
77.8 20.4
85.8
93.5
61.2
69.2
96.1
37.1
65.5
63.1
61.6
91.3

8.0
42.7
3.0

93.9 84.1
57.6 77.1
32.3

53.9

70.3

37.5
92.2
94.0
87.9
100.0
36.9

85.3

is included on the right-hand side. The table reveals that all rates are highly correlated with the first
factor, with the highest correlation for the 2-year Canadian rate. The next two columns report the
R2 from regression (9) when a second factor is added to the regression. We see a large increase in
the R2 for the spreads, in particular the Canadian term spread. Finally, the last two columns provide
intervals for the rotated factors using the Bai (2004)
the rejection rates of the 95% confidence
observable variable, we would
the corresponding
the
estimated
factor
If
proxied
methodology.
corroborates the information
to
time.
in
these
columns
The
information
of
5%
the
expect
reject
from the R2. The lowest rejection rate with one factor is with the 2-year Canadian rate, and the
of a second factor, has most impact on the Canadian term spread. There is much less
we see
on
the US term spread or on the spread between the two countries. Nevertheless,
impact
that all rejection rates in the table are much above the nominal 5% level. This suggests that the
first two factors do not represent one of the rates or spread in our panel.
Figure 1 plots the time series of the 2-year Canadian bond rate against the limits of the 95%
confidence interval for the rotated first factor. For illustration we use the case with a single factor,
addition

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AN EMPIRICALANALYSIS OF NONSTATIONARITY 391

14 I-1-1-1-1

0I-1-1-1-1

V'

1990
1985

1995

2005
2000

Figure 1.Time plot of 2-year Canadian bond (solid line) vs. 95% CI for rotated factor (dashed lines)?single
factor

but the picture with two or even three factors is almost identical. We see that the fit is generally
pretty good, but that large parts of the series lie outside the bands. If the factor proxied the 2-year
Canadian rate, we would see (under independence over time) 5% of the observations outside the
limits of the confidence band. Since about 27% of them do, we must conclude that no single
interest rate in the panel can proxy for our first estimated factor.
In the empirical literature on the term structure, many models with unobservable
factors are
to account for the
used. In these studies, it is common to find that three factors are necessary
or
term structure (see Litterman and Scheinkman,
et
Andersen
Diebold
and Li,
1988;
al., 2004;
recent
these
for
with
three
associated
with
factors
2006;
'level', 'slope' and
usually
examples),
'curvature'. It is clear that our first factor can be labeled a level factor that shifts the entire set
of yields. Usually,
this level factor is proxied by a short rate, but our results suggest that a 1- or
rate
that this first factor affects all rates similarly
2-year
provides a better fit. Further evidence
comes from the fact that the loadings are similar for all rates in the panel (results available from
the authors upon request).
The second factor, the 'slope' or steepness of the yield curve, is usually proxied by a spread
between a long rate and a short rate. It is therefore reasonable that the inclusion of a second
factor in the regression has a large impact on term spreads, mostly Canadian but also American
as evidenced by the much higher R2 (multiplied by 10 in first differences for both term spreads).
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392

H. R. MOON AND B. PERRON

I-1-1-1-1

V'"^'

-3-

_4 I_i-1-1-1

19901985

2005
2000

1995

Figure 2. Time plot of Canadian spread (solid line) vs. 95% CI for rotated factors (dashed lines)?two

factors

of these two factors seems to have much to do with the yield differentials between the two
countries; however. Figure 2 plots the Canadian term spread and the limits of the 95% confidence
bands for the case with two factors. Once again, we see that the overall fit is pretty good, but that
the confidence
interval does not contain the observed series for many periods, mostly associated
with large swings (either up or down) in the spread. Note that there are only two episodes when

Neither

the Canadian yield curve was inverted (negative spread) for more than one month,
in early 1986
and late 1989-early
interval appears rather narrow, and this could be due
1990. The confidence
to the fact that we have treated this second factor as nonstationary
in the construction. Our results
above

that this second 'slope' factor is in fact stationary. This would


suggest the strong possibility
invalidate the reported intervals. It is also interesting to note that the loadings on this second
with the term to maturity of Canadian government
factor decrease monotonically
bonds. Thus,
the second factor affects the relative magnitude
of short versus long Canadian bonds. The pattern
among loadings is not as clear among US Treasury bonds.
recent literature on the links between
term structure models
There has been much
and
et al. (2006) try to compare their three-factor
macroeconomic
variables. For example, Diebold
term structure model with macro variables. They find that their level factor is highly correlated
with inflation. They interpret this evidence as being consistent with the Fisher equation of a link
between nominal yields and inflationary expectations. Their second factor, on the other hand, is
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AN EMPIRICALANALYSIS OF NONSTATIONARITY 393

closely linked to levels of economic activity. They find a high correlation between their second
factor and a measure of capacity utilization. This correlation is also the source of the use of the
term spread to forecast business cycle fluctuations as in Estrella and Mishkin
(1998). The yield
curve tends to be downward-sloping
(short rates are higher than longer rates) prior to or at the
beginning of recessions. Our second factor is therefore likely to be related to the business cycle.

4. ANALYSIS OF IDIOSYNCRATICCOMPONENTS
step in our analysis of the nonstationary
properties of our panel is to look at the
our
in
uit
(1). The analysis of the nonstationarity of the
decomposition
idiosyncratic components,
more
is
much
than
the analysis of the stationarity properties of
developed
idiosyncratic component
is
factors and proceeds in two steps: in the first step some estimate of the idiosyncratic components
a
a
root
test
is
of
in
second
The
the
while
unit
estimation
obtained,
step panel
idiosyncratic
applied.
is equivalent to obtaining estimates of the deterministic
and common components.
component
to obtain estimates of
In the previous section, we used principal components on first differences
the factors. The idiosyncratic components could then be obtained as the residuals after removing

Our

second

from the observed data. We chose this method because


the estimated common components
it
us to use inferential procedures on the estimated factors. Other available methods
for
the common and idiosyncractic
components do not provide inferential procedures for
estimating
include principal components on residuals as inMoon and Perron (2004),
factors. These methods
the moment-based
method of Phillips and Sul (2003), and the cross-sectional
orthogonalization
Pesaran
of
Choi
and
average
(2006a)
(2007, this issue). Both the Bai and Ng and the Moon and
Perron methods estimate general dynamic factor models with an unknown number, K, of factors.
On the other hand, Phillips and Sul's method
is designed for a model with a single i.i.d. factor,
while Choi uses an error-component model
(which is a single-factor model with homogeneous
allowed

factor loadings).
The second step in our analysis consists in
unit root. We will use a total of seven unit root
correlation is captured via a factor model. This
T to diverge since a large n is necessary for

testing the estimated idiosyncratic components for a


tests in this paper. Each assumes that cross-sectional
restricts us to focus on tests that require both n and

consistent estimation of the factors. Other methods


correlation do not face this restriction and may be better suited for
of dealing with cross-sectional
smaller panels. We will not review all the tests in detail since recent surveys are available in Choi
(2006b), Hurlin and Mignon
(2004) and Breitung and Pesaran (forthcoming, 2007).
The null hypothesis of interest is that all idiosyncratic components are nonstationary:
Hq

whereas

the alternative

hypothesis

: pt =

1 for

all

i=

1,

...,

takes the form


HA

:pt <

1 for some

root in the time series of individual /.


where pt is the largest autoregressive
For the tests to be consistent,
it is necessary that a positive fraction of the units fall under the
alternative (stationary) hypothesis,
i.e., lim?_+oo i YX=\ HPi < 1) > 0, where 1 ( ) is the indicator
function.

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394

H. R. MOON AND B. PERRON

and Wu,
1999;
Early panel unit root tests (e.g., Levin et al, 2002; Im et al, 2003; Maddala
is
Choi, 2001) assumed independence of observed data across individual units. This assumption
clearly unrealistic in empirical settings as suggested by the large correlations reported in Table I.
once factors have been extracted from the data, similar methods
can be applied to the
However,
In other words, once we have estimated idiosyncratic components, we
idiosyncratic components.
could apply the pooling approach of Levin et al (2002), the averaging approach of Im et al.
and Wu (1999) or Choi (2001) to test
(2003), or the p-value combination
approach of Maddala
the joint null hypothesis of nonstationary
idiosyncratic components.
The seven tests we consider are those of Moon and Perron (2004), Bai and Ng (2004), Phillips
and Sul (2003), Choi (2006a), Pesaran (2007, this issue), a panel version of the Sargan and
in Moon
and Perron (2005), and a common point optimal test
(1983) test developed
Bhargava
= 1. These tests
c
et
Moon
in
with
al.
(2006)
vary according to the way they eliminate
proposed
the factors and the way they aggregate the individual information. We will first use the defactoring
of Moon and Perron (2004) before applying these last two tests.
The CIPS test developed by Pesaran (2007, this issue) is slightly different in nature. Pesaran
showed that by augmenting
the usual ADF regression with the first difference and the first lag
of the cross-sectional
mean, one can account for the cross-sectional
dependence
arising through
a single stationary factor. Thus, no direct estimation of the idiosyncratic component
is needed in

method

this approach. This can be beneficial for small panels where estimation of factors is difficult.
As with the factors, we will perform stationarity tests on the estimated idiosyncratic components.
In order to do so, it is first necessary to project the estimated idiosyncractic
components onto the
a
to
constant
the
The
this approach has
and
factors.
of
space orthogonal
validity
nonstationary
been shown in Bai and Ng (2005). Note, however,
that we can only perform individual KPSS
tests on the estimated idiosyncratic components. Pooling is not possible owing to the presence of
factors as the nonstationarity will be transmitted to the residuals in a non-vanishing
nonstationary
way under the null hypothesis of stationarity.
that do not rely on a factor
Other tests for panel unit roots with cross-sectional
dependence
structure are available. Recent tests of this kind that have been proposed by Chang (2002), Breitung
and Das (2005), Shin and Kang (2006), and Choi and Chue (2007, this issue), while an earlier one
was proposed by Taylor and Sarno (1998). These tests allow for general cross-sectional
dependence
of the error terms and, typically, do not need to let the number of cross-sections,
n, diverge since
no estimation of the factors is necessary.

4.1.

Empirical

Results

Our unit root test results are presented in Table IV. For the tests that require the estimation of the
number of factors (Moon and Perron, Bai and Ng, and the two optimal tests combined with the
Moon and Perron defactoring procedure), we report results as the number of factors varies between
one and eight since the estimated idiosyncratic components depends on the assumed number of
does not appear to be
factors. We report results in this way because the number of cross-sections
sufficient to get a good estimate of the number of factors, as we saw above. For the tests that are
based on individual ADF tests and the CIPS test, we choose the number of lagged first differences
to be included by AIC in all cases with a maximum
of 12 lags. When needed, long-run variances
are computed with a quadratic spectral kernel estimate with bandwidth selected
and covariances
the rule of Andrews
(1991) and with prewhitening.
following
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AN EMPIRICALANALYSIS OF NONSTATIONARITY 395

Table IV. Results of unit root tests on idiosyncratic components. Sample of 25 monthly Canadian and US
interest rates, January 1985-April 2004
12345678 K=
Moon-Perron

-6.496*

-2.217*
Bai-Ng
-5.611*
(Z)
Phillips-Sul
Choi
(Z)
Pesaran
-3.059*
(CIPS)
-1.263
Sargan-Bhargava
Moon-Perron-0.792

Phillips (c= 1)
Number of stationary

25

-5.923*
0.912

-3.807*
-2.790*

-4.622*
-1.214

KICl

KBic3

-4.261*
-1.124

-4.678*
-0.965

-4.703*
-5.190*

-4.589*
-7.196*

8
8

7
7

-1.942*
-2.125*

-2.604*
-2.585*

-2.406*
-2.451*

-3.671*
-4.115*

8
8

7
7

-7.914*
-1.489
-0.574

25

-2.685*
-2.637*

-2.352*
-1.934*

25

24

2423
25

23

components
*

at the 5% level.

Significant

the results from the application of panel unit root tests are clear and do not depend
Fortunately,
much on the estimated number of factors. With the exception of the Moon-Perron-Phillips
and
one
or
two
tests
the
Bai
test
with
factors
and
and
with
and
two,
four,
five,
Sargan-Bhargava
Ng
six factors, we reject the null hypothesis of a unit root in all idiosyncratic components.
The results from the KPSS tests confirm these results. The last row of Table IV includes the
number of idiosyncratic series for which we cannot reject stationarity at the 5% level. Regardless
of the number of factors we allow, we cannot reject stationarity for at least 23 series. Moreover,
we

reject stationarity for a total of only six out of the 200 tests that we perform. As discussed
above, it is not possible to aggregate these individual tests in order to control the overall rejection
these results are indicative and further support our claim that most, if not
probability. However,
all, idiosyncratic components are stationary.
The presence of nonstationary
that
factor(s) and stationary idiosyncratic
components means
the nominal yields in our panel are cointegrated. Similar conclusions
factors
and
(nonstationary
stationary idiosyncratic components) are obtained when applying our approach to the yields of each
in the term
country separately. This corroborates many empirical results supporting cointegration
structure dating back to Campbell and Shiller (1987) and Evans and Lewis (1994) and provides
in the term structure such as that of Carstensen
support for models of cointegration
(2003).

5. CONCLUSION
This paper has analyzed a panel of interest rates with different maturities and risk characteristics.
Our application
of recently developed methods
for nonstationary
the units are
panels where
correlated through a factor structure suggests that a single nonstationary
factor is sufficient to
model these data. However,
the number of stationary factors needed to model the cross-sectional
correlation
is not well
identified. Since we can reject the nonstationarity
of all idiosyncratic
these results suggest that interest rates are cointegrated. The dominant factor in
components,
the interest rate panel is a level factor that is highly correlated with all rates and could be the
result of inflationary expectations. The second factor has an interpretation as a slope factor, that is
the differential between a long rate and a short rate, since it affects short and long rates differently
and might be a measure of the business cycle.
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Appl.

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22: 383-400
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DOI:
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H. R. MOON AND B. PERRON

396

APPENDIX: SIMULATIONEVIDENCE
to document
In this appendix, we present limited simulation
the behavior of the
evidence
tests for the nonstationarity
of the idiosyncratic
in this paper. Other
considered
components
simulation evidence can be found in Gutierrez
(more comprehensive)
(2006) and
comparative
et al. (2005).
Gengenbach
The data-generating process is a slightly modified version of the data-generating process of Moon
and Perron (2004). The modification
greatly increases the level of cross-sectional
dependence by
replacing the _V (0, 1) factor loadings with U [0, 1] factor loadings.
The data-generating

process

is given by equations
Zit

with

Oti +

(2):

z?it

A-4-1 + yit

a single factor structure for the error terms as in equation


yu

All

shocks are assumed

(3):

tPift + eit.

i.i.d. standard normal:

(ftj,eit)~i.i.d.N(0,I2)
while
neous,

the factor loadings


a.;

Af

(0,

are Pij ~

i.i.d.U

[0, 1], and the deterministic

components

are heteroge

1).

is considered for pt =
~ U
0.99, Pi
[0.98, 1]. Finally,
common versus
of
importance
= 10, 20, and 100) and two
(n
even though it is not necessary

1 for all /. We fix the alternative to be uniform with a mean of


we consider two values of the parameter controlling
the relative
values
We
choose
for n
1
and
3.
three
shocks
r,
idiosyncratic
values for T (T = 100 and 300). We estimate long-run variances
to do so (since shocks are independent over time). When necessary
for the factor extraction method employed by a given test, the number of factors is estimated by
of eight factors. Note that this design
the /Ci criterion of Bai and Ng (2002) with a maximum
We
of the Choi test since factor loadings are heterogeneous.
does not satisfy the assumptions
therefore expect to see large size distortions for this test.
Note that our design is also limited since the factors and idiosyncratic components are restricted
to have the same order of integration. Under the null hypothesis, Az? is made up of a stationary
common component and a stationary idiosyncratic shock so that both components are nonstationary
sum of two stationary components.
in levels. Under the alternative hypothesis,
zft is the
The results are presented in Tables V (size), VI (power), and VII (size-adjusted
power). The
Size

first thing to notice is that all tests that require the estimation of the number of factors (MPP,
for the
Moon
and Perron, Sargan and Bhargava, and Bai and Ng) have severe size distortions
of the number of factors as reported inMoon
smallest choice of n. This is due to overestimation
number of factors
and Perron (2004). For n = 10, the ICi criterion tends to choose the maximum
allowed (8). For n > 20, this problem disappears since the estimated number of factors is almost
always equal to the true one. The CIPS and Phillips and Sul tests are not affected by this problem
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DOI:
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AN EMPIRICALANALYSIS OF NONSTATIONARITY 397

Table V. Size of tests


DGP: Zit = oho +
z?t
+ eit
z?t=z?t-1+TPift
~ i.i.d.iV
*,7
(0, 1)
a,-o,/*,
i.i.d.U [0, 1]
ft
n

MPP
c=

x=

r=

Moon-Perron
c=

10
20
100
10
20
100

100
100
100
300
300
300

30.8

35.4

4.3
4.9
30.3
4.4
4.7

6.0
5.9
34.5
6.2
5.3

10
20
100
10
20
100

100
100
100
300
300
300

40.1
4.5
5.0
35.5
4.0
4.4

45.0
6.4

CIPS

Sargan

Choi

Bai-Ng

Phillips-Sul

2
5.6

23.0

17.5

16.9

5.3

2.9
3.9
24.5
3.3
3.7

7.0
7.1

24.5
69.7
6.2

6.0

5.6
6.1
4.9
5.2
5.7

5.9
6.4
5.1
5.6
6.5

40.6
8.2
9.2
35.0
7.2
6.4

6.0
5.4
5.8
5.4
5.1
5.7

33.1
2.4

29.5
7.4
7.0
29.8
7.4

5.6
40.7
5.9
5.0

3.8
29.3
2.8
4.0

16.4
6.7
5.7

5.9
7.5

17.7

23.5
35.0

6.7
7.0
17.3
6.3
6.6

64.3
9.4
13.4
33.5

5.3
6.1
6.8
5.3
5.0
6.9

Each entry represents


the percentage
of replications
in which
the null hypothesis
of a unit root is rejected for the
5% test with the number of factors estimated
criterion
using the 7Ci information
appropriate
by Bai and Ng
suggested
critical values. The number of replications
is 5000.
(2002) using the asymptotic

Note:

VI.

Table

MPP
c=

t=1

t =

Note:

10
20
100
10
20
100

100
100
100
300
300
300

10
20
100
10
20
100

100
100
100
300
300
300

51.1
56.9
99.6
74.3

of tests against
linear
DGP: zu = ?/o +
z?,
=
+ *? '
4
P?4-i+*#/'
1)
ai0,ft,eit~iA.dJN(0,
i.i.d.U
[0, 1]
ft
~
U [0.98, 1]
Pi

Power

Moon-Perron
c=

alternative

CIPS

Sargan

39.8
42.2

Choi

Bai-Ng

Phillips-Sul

95.8
100.0

57.3
64.9
99.7
80.0
97.1
100.0

51.7
69.9
99.8
76.6
97.6
100.0

8.0
8.9
11.0
18.0
25.8
45.3

57.9
45.3
89.7
72.9
78.8
93.1

63.8
53.2
90.6
78.7
81.3
93.4

59.8
60.3
92.1
75.5
84.1
93.7

7.0
7.5
7.2
16.8
20.9
36.0

99.1
67.8
93.7
100.0

25.5
44.1
94.9
48.9
97.1
100.0

59.6
87.4
99.8
88.0
98.7
99.9

11.6
17.9
50.9
28.9
52.3
97.8

48.6
33.0
88.6
66.5
75.9
93.8

24.1
36.4
82.4
42.2
83.5
97.9

56.7
74.8
90.6
75.0
87.8
96.3

8.8
13.9
36.3
20.0
31.2
69.2

See Table V.

since the first one does not estimate factors directly, while the second one imposes (correctly in
this case) the presence of a single factor. As expected,
the Choi test has large size distortions.
These are reduced when T is large and r is small. The Moon and Perron and Bai and Ng tests
tend to overreject for n > 20. The MPP tends to slightly underreject for c = 1 and overreject for
Copyright

2007

John Wiley

& Sons,

Ltd.

J.

Appl.

Econ.

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22: 383-400
(2007)
DOI:
10.1002/jae

H. R. MOON AND B. PERRON

398

Table

VII.

Size-adjusted

of

tests

linear

alternative

CIPS

Sargan

Bai-Ng

7.4
8.1
9.3
18.8
25.0
42.2

10.0
53.2
99.3
23.9
95.8
100.0

51.1
89.8
22.4
81.6

6.1
7.0
6.3
15.9
20.5

8.9
43.2
89.8
20.0
80.1

93.4

32.3

94.1

power

against

DGP:zit=ctio+z?t
=
+ eit
zl
Pizl_l+Tpift
~i.i.d._V(0,
1)
otio,ft,eit
~ i.i.d.
U [0, 1]
Pi
~ U
Pi
[0.98, 1]

nT
MPP
c=

c=\
10

r=l

20
100
10
20
100
t =

3
20
100
10
20
100

Note:

Each

Moon-Perron

10.3
60.6
99.6
22.3
96.2
100.0

10.4
62.0
99.7
23.7
96.6
100.0

100
100
100
300
300

10 8.6
47.7
89.7

8.4
49.0
89.9
20.8
80.3
93.4

300

11.3
62.2
99.7
27.3
96.5
100.0
10.6

the percentage
of replications
in which
entry represents
5% test using the empirical
critical values. The number

appropriate

Phillips-Sul

100
100
100
300
300
300

19.1
80.0
93.4

Choi

8.4
36.2
93.0
20.4
96.0
100.0

10.2
30.3
53.5
16.3
96.6
45.9
85.8
28.6
98.4
99.9
96.9

7.0
31.0 11.7
77.0
16.0
80.7
97.4

49.8

8.2
24.3
33.0
51.2
30.9
66.0

19.0
31.2

79.0
89.7
65.8

the null hypothesis


of a unit root
is 5000.
of replications

is rejected

for the

c=

2. Nonetheless,
it is clear that the combination
of the Moon and Perron (2004) defactoring
procedure with this common point optimal tests leads to reasonable size control.
The size-adjusted power results suggest that the MPP, Moon and Perron, and Sargan-Bhargava
tests dominate and are pretty much equivalent. The Bai and Ng test is next, followed by Phillips
et al. (2006) that the
and Sul, and finally CIPS. Table VII also reproduces the result in Moon
?
10). Finally, the table
power of their test is not sensitive to the choice of c (except maybe for n
also shows that, as expected, power goes down with the degree of cross-sectional
correlation; i.e.,
= 3 than for r = 1.
power is lower for r
In conclusion,
in this study, the CIPS test of Pesaran (2007, this
among the tests considered
issue) is best at controlling size, in particular for smaller panels. It is also the easiest to compute.
its power for alternatives
that are close to the unit root null hypothesis
is quite low.
However,
in situations with small panels and alternatives of interest that
It should therefore be emphasized
are not too close to unity. In other cases, tests that estimate the factor model are called for. In
is suspected, the Bai and Ng procedure must be given precedence
since
particular, if cointegration
it is the only valid procedure in such cases.

ACKNOWLEDGEMENTS
on Unit Roots
in
of this paper circulated under the titles 'Panel Evidence
'An
and
and
Interest
Rates
with
Cross-sectional
Analysis
Dependence'
Exchange
Empirical
thank
in Panels of Exchange Rates and Interest Rates with Factors'. We
of Nonstationarity
at Texas
three anonymous
Werner Ploberger, Hashem Pesaran,
referees, seminar participants
on Panel
and Toronto and the 11th International Conference
A&M, Rice, Rochester,
Queen's
versions

Previous

Rates

Copyright

2007

John Wiley

& Sons,

Ltd.

J.

Appl

Econ.

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22: 383-400
(2007)
DOI:
10.1002/jae

AN EMPIRICALANALYSIS OF NONSTATIONARITY 399

Data for valuable comments. We thank Isabelle Belley-Ferris


for outstanding research assistance.
Financial support from the Faculty Development
Award of USC, the Social Science and Humanities
Research Council of Canada, FQRSC (Fonds quebecois de recherche sur la societe et la culture),
is gratefully
of Information Technology
and Complex
and MITACS
(Mathematics
Systems)
errors
are
own
our
acknowledged. Any remaining
responsibility.

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