CFA CFA Level 2 Unit Root Test of Nonstationarity

Unit Root Test of Nonstationarity

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    • Avatar of ec_testec_test
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        Hello there! 

        An AR(1) model equation should be Xt=b0 + b1 X(t-1) + Et

        For an AR(1) to have an adequate forecasting utility, b1 < 1

        A unit root means that the coefficient (b1) of the AR(1) model is equal to 1

        In other words, the slope of the coefficient is one (b1=1). Picture a perfectly straight line in a 45 degree angle in an X and Y graph. 

        When there is a “unit root” b1=1 and a random walk occurs.

        There are two types of random walks: Without a drift and with a drift

        No drift – b0=0 and b1=1 (no intercept) 

        Xt = b0 + b1 X(t-1) + Et
        Xt = 0 + (1) X(t-1) +Et
        Xt = X(t-1) + Et

        With a drift b0>0 and b1=1(there is an intercept)

        Xt = b0 + b1 X(t-1) + Et
        Xt = b0 + (1) X(t-1) + Et
        Xt = b0 + X(t-1) + Et

        Why b1=1 – unit roots a problem? Because the mean reverting level is undefined

        Mean Reverting Level = b0/(1-b1), if b1=1, then the Mean Reverting Level is b0/0 which is undefined. 
        When the Mean Reverting Level is undefined, the time series is non-stationary. 

        I hope this helps! 

        bbruen32 voted up
      • Avatar of inhellerinheller
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          • CAIA Level 2
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          • When b1 is less than 1, the impact of past values (X(t-1)) on the current value (Xt) gradually weakens over time. This means the series eventually stabilizes around a certain mean, making it predictable for forecasting.
          • If b1 is equal to 1 (unit root), the past value has a full impact on the current value, and this effect continues indefinitely. The series keeps moving in the direction of the previous change, making it difficult to predict future values.

          uno online

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