CFA CFA Level 2 Unit Root Test of Nonstationarity

Unit Root Test of Nonstationarity

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    • Avatar of Beezy849Beezy849
        • CFA Level 2

        Can anyone help clarify on this? I’ve been having trouble wrapping my head around the concept, specifically with how it applies to random walk and first difference. 

      • Avatar of ec_testec_test
          • CFA Charterholder

          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! 

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