Tuba:
I did AR(2) both ways (run the add-in with 2 lag vs. using the 3 equations I mentioned) and the results are pretty frustrated. Since my first-differenced series' sample correlogram has a clear geometrically declining oscillatory pattern, I thought AR(2) would be the answer. I agree with you that AR(2) most likely means the multivariate regression, but both Bartlett's test stat and Box-Pierce's Q stat come out significant (tests are on the residuals). I don't know what else to do/try since no MA component was suggested in my first-differenced series' sample correlogram...I am going to start a new post and am really hoping those who used 1945-1978 3-mon T-bill can give me some insight.
Jacob: What do we expect from first differences of interest rates? Do we expect to find an oscillatory pattern?
Rachel: Some oscillatory patterns are real. Others stem from measurement error or rounding.
Illustration: Suppose the starting interest rate is 10.0%, and interest rates have a random walk with a drift of 0.04% a month. For simplicity, assume there is no stochasticity.
The interest rates are 10.00%, 10.04%, 10.08%, 10.12%, 10.16%, 10.20%, 10.24%, 10.28%, 10.32%, 10.36%, 10.40%, and so forth. The first differences are 0.04% each month.
If interest rates are rounded to one decimal place, the interest rates are 10.0%, 10.0%, 10.1%, 10.1%, 10.2%, 10.2%, 10.2%, 10.3%, 10.3%, 10.4%, 10.4%, and so forth. The first differences are 0.0%, 0.1%, 0.0%, 0.1%, 0.0%, 0.0%, 0.1%, 0.0%, 0.1%, 0.0%, and so forth.
The first differences have a spurious oscillatory pattern. It is caused by the rounding rule, and it has nothing to do with the time series process.
Jacob: Is this rounding problem common?
Rachel: This problem is very common, and it causes much of the apparent oscillatory patterns in stock prices and interest rates. The interest rates on the NEAS web site have two decimal places; we expect this type of spurious pattern.
Jacob: What if the drift is zero? Do we still see a spurious oscillatory pattern?
Rachel: A second reason for an oscillatory pattern is inaccurate measurement and other random errors.
Illustration: Suppose the interest rate is 8.0% each month and the stochasticity is small. The interest rate is measured with an error of –0.1% or +0.1% each month. The error need not be measurement error. Other causes of error are random fluctuations in demand for Treasury bills that affect the auction price but do not affect the underlying economics.
We examine the autocorrelation of the first differences. Each month the interest rate is 9.9% or 10.1%. The first difference is 0.0%, +0.2%, or –0.2%. For interest rates in any three month period, we have three possible scenarios:
| Month 1 | Month 2 | Month 3 | Difference 1 | Difference 2 |
1 | 7.9% | 7.9% | 7.9% | 0.0% | 0.0% |
2 | 7.9% | 7.9% | 8.1% | 0.0% | 0.2% |
3 | 7.9% | 8.1% | 7.9% | 0.2% | -0.2% |
4 | 7.9% | 8.1% | 8.1% | 0.2% | 0.0% |
5 | 8.1% | 7.9% | 7.9% | -0.2% | 0.0% |
6 | 8.1% | 7.9% | 8.1% | -0.2% | 0.2% |
7 | 8.1% | 8.1% | 7.9% | 0.0% | -0.2% |
8 | 8.1% | 8.1% | 8.1% | 0.0% | 0.0% |
The average first difference is zero, since the drift in interest rates is zero. Of the eight scenarios, six have at least one first difference of zero, and two scenarios have the opposite first differences. The autocorrelation is negative.
Jacob: What is the implication for model building?
Rachel: Many oscillatory patterns reflect rounding, measurement error, and random fluctuations, not the underlying time series process. We carefully examine apparent oscillatory patterns. We can not always determine the cause of the oscillatory pattern, but we can suggest possible causes.