Unit Roots and regression residuals

Applied Financial Econometrics

by

Sunil Paul
Madras School of Economics

October 27, 2016

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Spurious regression
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If some or all of the variables in a regression are I (1) then the

usual statistical results may or may not hold.

In the presence of nonstationary variables there might be

spurious regression [Granger and Newbold (1974)]

Spurious regression is one in which the dependent (Y ) and the

independent variables(Xs) have no relationship but diagnostic
statistics, such as the R 2 or the coefficient t statistics,indicate
that the X have a significant effect on Y .

Symptoms:
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high R 2 in conjunction with low value of DW statistic.

highly serially-correlated regression residuals

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Spurious regression-Imp articles

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Granger and Newbold (1974) showed that regressing one I(1)

variable on an unrelated I(1) variable resulted in a spurious
regression;
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that is, there would seem to be a relationship although none

was actually present.

Phillips (1986) established the theoretical insights behind this

result and showed that the problem was present
asymptotically, not just in finite samples.

Granger et al. (2001) showed that a spurious regression

problem occurs in finite (but large) samples with stationary
variables that are serially correlated.

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Granger and Newbold (1974)

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The levels of many economic time series are I (1)

Regression equations which relate such time series frequently

have high R2

Yet also typically display highly autocorrelated residuals,

indicated by very low D-W

If error are autocorrelated

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Estimates of the regression coefficients are inefficient.

Forecasts based on the regression equations are sub-optimal.
The usual significance tests on the coefficients are invalid.

When errors are autocorrelated the only conclusion that can be

reached is that the equation is mis-specified,

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Granger and Newbold (1974) Results

Consider the following two independent RW

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Yt = Yt1 + yt
Xt = Xt1 + xt
yt WN(0, y2 ); xt WN(0, x2 ) and E (yt xt ) = 0

Granger and Newbold generated many samples Xt and Yt and

estimated
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Yt = 0 + 1 Xt + et
H0 : 1 = 0 is rejected at 5% sig level in 75 % cases, high R 2
with high autocorrelated errors

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Spurious regression
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Classical regression assumes residuals to have zero mean and

finite variance

But if a regression of two I (1) variables Y on X are necessarily

meaningless if et I (1)

In this case et has a stochastic trend then error at time period

t never decays ( deviations are permanent)
P
P
et = Yt 0 1 Xt = et = ti=1 yt 0 1 ti=1 xt
(assuming Y0 = X0 = 0)

Hence var (et ) = as t

One remedy: use first difference

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Spurious regression- Phillips(1986)

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The following results about the behavior of 1 in the spurious

regression are due to Phillips (1986):
1 diverge increasingly far away from its true value of zero as
the sample size increases.
The usual OLS t-statistics for testing 1 = 0 diverge to
as T .
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Hence, with a large enough sample it will appear that Yt is

related to Xt when it is not if the usual asymptotic normal
inference is used.
bias in this test towards the rejection of no relationship will
increase with T

The usual R 2 from the regression converges to unity as

T so that the model will appear to fit well even though
it is misspecified.
We need to pretest the variables before estimating the
regression model
Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Regression with two or more variables

Case 1: If Xt I (0) and Yt I (0) then the classical

regression model is appropriate.

Case 2: if Xt and Yt are integrated of different orders and

et I (1) : regression is meaningless.
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For example Yt = P
Yt1 + yt . Xt =P
Xt1 + xt , where
t
t
|| < 1 then et = i=1 yt 0 i=1 1i xt thus et I (1)

Case 3: If Xt I (1) and Yt I (1) and et I (1) spurious

regression

Case 4: If Xt I (1) and Yt I (1) and

et I (0) Cointegration.

Sunil Paul

Lecture Notes

Unit Roots and regression residuals

Reference

Granger, C. W. J., and P. Newbold (1974) Spurious regressions

in econometrics, Journal of Econometrics 2, 11120.

Granger, C. W., Hyung, N., and Y. Jeon (2001) Spurious

regressions with stationary series, Applied Economics 33,
899904.

Phillips, P. C. B. (1986) Understanding spurious regressions in

econometrics, Journal ofEconometrics 33, 31140.

Sunil Paul

Lecture Notes