Forecasting and VAR Models

Franz Eigner

UK Econometric Forecasting
Prof. Kunst, SS09

June 21th, 2009

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Contents
1 Introduction in multivariate forecasting 3

2 Vector autoregressive models (VAR) 4

2.1 Definition of a stationary VAR(p) . . . . . . . . . . . . . . . . . . 4
2.2 Definition of a stationary bivariate VAR(1) . . . . . . . . . . . . 5
2.3 Specification, estimation and extensions . . . . . . . . . . . . . . 6
2.4 Structural analyses of the VAR . . . . . . . . . . . . . . . . . . . 6

3 Forecasting with VAR models 7

3.1 Naive forecast (MMSE) . . . . . . . . . . . . . . . . . . . . . . . 7
3.2 Simulation-based forecast . . . . . . . . . . . . . . . . . . . . . . 7
3.3 Conditional forecast . . . . . . . . . . . . . . . . . . . . . . . . . 8

4 VAR models and Cointegration 9

4.1 Integration and Cointegration . . . . . . . . . . . . . . . . . . . . 9
4.2 Vector error correction model (VECM) . . . . . . . . . . . . . . . 10

5 Applications for VAR/VEC 10

6 Final discussion about forecast quality 11

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1 Introduction in multivariate forecasting
Multivariate data are given, when observations are taken on two or more time
series for the same time periods, describing e.g. measures of economic activity
like GDP or the inflation index. Multivariate modelling can then be assessed,
examining the structure, that is the interrelationship among the series in order
to obtain more accurate forecasts of the series of interest. Especially for eco-
nomic series mutual interactions between economic variables is often present,
e.g. the dependency between wages and prices. Therefore one may believe that
the neglection of the relationship between economic variables, which is done
in univariate forecasting, is not adequate for forecasting economic series. As a
consequence, multivariate forecasting, aiming at understanding the underlying
structure of a given system, seems to be very appealing.
The main focus of this paper lies in the description of multivariate forecasting
procedures. In order not to lose one’s head due to the large number of forecasting
procedures, a brief overview is given in advance in Figure 1.

univariate forecasting multivariate forecasting

feedback?
model-free: models: no yes

smoothing ARIMA,
filtering GARCH
open loop system closed loop system
(single equation) (multiple equation)

multiple regression stationary:

transfer function VAR,SVAR
nonstationary:
VEC,SVEC

Figure 1: Overview of forecasting procedures

Whereas in univariate forecasting the distinction between model-free and

model-based is important, the crucial question in multivariate modelling is the
presence of feedback.
In a single equation system, the variation in a dependent or response vari-
able is explained by the variation in one or several predictor (independent)
variables and no feedback is assumed, this means no effects from the dependent
variable (output) back to the predictor variables (input). A single equation sys-
tem is therefore denoted as an open-loop system. Popular open-loop systems
are multiple regression models and transfer equation models. In the presence
of feedback, data are generated by a closed-loop system and a single equation
system is not adequate anymore. The most popular closed loop systems are
nowadays the VAR models, which are the multivariate version of the univariate

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AR. The VAR model became popular by Sims (1980), who advocated them
as an alternative to simultaneous equations models, which do not focus on the
dynamic structure of the variables. One advantage of VAR may be that they
treat all variables as endogenous, whereas in econometric modeling one gener-
ally needs to classify variables as exogenous, predetermined and endogenous.
However this classification is not always known and theoretical considerations
to find the correct one may be wrong. There is a broad variety of VAR mod-
els, integrating moving average terms (VARMA), structural features (SVAR) or
bayesian methods (BVAR). Cointegration can be implemented in form of the
vector error correction model (VEC).
Before modelling multivariate time-series data, a careful examination of the
data set should be assessed in advance. One important tool is the CCF (cross
correlation function), which is a generalization of the ACF to the multivariate
case. One can use it for identification of the model, which means finding the
optimal lag and for identification of the leading series by looking at the maximum
cross-correlation. However especially in case of time dependence within the
component series and of feedback between the series, final statements from the
empirical CCV are difficult to make.

2 Vector autoregressive models (VAR)

This chapter focuses on the analysis of covariance stationary multivariate time
series using VAR models.

2.1 Definition of a stationary VAR(p)

A VAR consists of a set of K endogenous variables yt = (y1t , . . . , ykt , . . . , yKt )
for k = 1, . . . , K. The VAR(p) process is then defined as:

yt = Φ1 yt−1 + . . . + Φp yt−p + ut
with Φi as (KxK) coefficient matrices for i = 1, . . . , p and ui is a K dimensional
white noise process. This means it holds: E(ut ) = 0, E(ut út ) = Σu , E(ut us ) =
0 for t 6= s
The VAR(p) process is stable, when it generates stationary time series, implying
that the equation returns to an equilibrium after a shock. This can be checked
by the characteristic matrix polynomial.

det(IK − Φ1 z − . . . − Φp z p ) 6= 0 for z ≤ 1 (1)

The process is stable if all roots of the matrix polynomial are larger than one
in absolute value. If the solution of above equation has a root for z = 1,
then either some or all variables in the VAR(p) process are integrated of order
one. The stability of a VAR(p) process can also be examined by considering
the companion form and calculating the eigenvalues of the coefficient matrix.
A VAR with p lags can always be equivalently rewritten as a VAR with only
one lag (so called companion form) by appropriately redefining the dependent
variable. The transformation amounts to merely stacking the lags of the VAR(p)
variable in the new VAR(1) dependent variable.

Yt = ΦYt−1 + vt

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  
Φ1 Φ2 ... Φp−1 Φp  
  ui
yt  I 0 ... 0 0 
..
   0 
where Yt = 

 ,Φ = 
  0 I ... 0 0 , vt = 
 
..

. .. .. .. .. ..

   . 
yt−p+1  . . . . . 
0
0 0 ... I 0
It holds: If the moduli of the eigenvalues are less than one, the VAR process is
stable.

2.2 Definition of a stationary bivariate VAR(1)

Further descriptions and analyses are presented using the simple bivariate VAR(1)
process.

y1t = φ11 y1,t−1 + φ12 y2,t−1 + u1t

y2t = φ21 y1,t−1 + φ22 y2,t−1 + u2t

This can be rewritten as:

yt = Φ1 yt−1 + ut
 
φ11 φ12
where uTt = (uit , u2t ) and Φ1 =
φ21 φ22
uTt is bivariate white noise, which means that innovations have zero means and
are uncorrelated through time, within and between series. However, u1t and
u2t may be correlated at the same time point. Notice that the all equations
have the same regressors. Therefore the VAR(1) as well as the VAR(p) model
are just a seemingly unrelated regression (SUR) models with lagged variables
as common regressors.”

!11
Y1,t-1 Y1,t ...
!2
! 12 1
Y2,t ...
Y2,t-1
!22

Figure 2: Dependence within and between yt

VAR models provide the possibility for analyzing the relation between the
variables involved. These relations or dependences between and within time
series are expressed in the coefficient matrix Φ and are shown in Figure 2. One
calls a variable y1t causal for a variable y2t , if the information in y1t is helpful
for improving the forecasts of y2t . Obviously, y1t is not causal for y2t when
the coefficient variable φ21 equals zero. Then granger causality goes only in one
direction, that is from y2t to y1t , which would lead to an open-loop system, with

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yit following an AR(1) process. Because Granger-noncausality is characterized
by such zero restrictions on the levels VAR representation, standard F-tests can
be applied for causality analysis. It is obvious that unidirectional causality ex-
ists, if the coefficient matrix Φi can be reordered as an lower (upper) triangular.
If this is not the case, there is mutually dependency between the variables and
the VAR model should be more adequate than transfer models.

2.3 Specification, estimation and extensions

“The unrestricted VAR(p) model may inadequate to represent sufficiently the
main characteristics of the data.” (Chatfield, 2001). This simple VAR model
e.g. assumes stationarity of all time series. This is rarely the case for original
economic series. One can account for trends and seasonality by including deter-
ministic elements into the equation, for instance dummy variables. Additionally,
stochastic exogenous variables could be implemented as well. Data set may be
also transformed by taking differences (e.g. first-differences or seasonal differ-
ences), in order to make them stationary. However, differencing nonstationary
series is not without its weaknesses, which will be explained later.
The Multivariate Least Square (MLS) can be assessed to estimate the co-
efficients. As the explanatory variables are the same in each equation, MLS
is equivalent to the Ordinary least squares estimator applied to each equation
separately. The question of lag order selection can be solved by using a F-
test, testing if the additional explained sum of squares is significant. However
mostly nowadays one takes the model with the optimal information criterion.
One should restrict the maximum number of lags in advance. A VAR(4)-model
with 3 variables you have to estimate already 36 coefficients. A large number
of parameters leads to a reduction of accuracy in prediction of the separate
parameters. Furthermore estimation will suffer from potential overfitting bi-
ases, delivering poor out-of-sample forecasts. Thus one often estimates special
restricted VAR models (e.g. SVAR), setting some coefficients to zero on the
ground of theoretical considerations. A special branch of restricted VAR models
are Bayesian VAR models. They prevent over-fitting by shrinking parameters
higher than first order towards zero, e.g. by using Minnesota priors. Other
extensions are the VARX and VARMAX models, which allow for exogenous
variables whose dynamics do not depend on the modelled endogenous variables.
For forecasting, this may be inconvenient, because these endogenous variables
require an extrapolation technique or assumptions on their future behaviour.

2.4 Structural analyses of the VAR

“The general VAR(p) model has many parameters, and they may be difficult to
interpret due to complex interactions and feedback between the variables in the
model. As a result, the dynamic properties of a VAR(p) are often summarized
using various types of structural analysis. [...] In structural analysis, certain
assumptions about the causal structure of the data under investigation are im-
posed, and the resulting causal impacts of unexpected shocks or innovations to
specified variables on the variables in the model are summarized.” (Zivot/Wang,
2002). The granger causality, which was explained before, is such a summariza-
tion tool. Other summarization tools are the impulse response functions and
the forecast error variance decomposition.

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 While Granger causality falls short of quantifying the impact of the impulse
variable on the response variable over time, the impulse response analysis can
be used. For meaningful results it is important to isolate the actual shocks of
interest, which requires imposing some structure on the VAR.
These orthogonal shock matrices can then further be used for the forecast er-
ror variance decomposition (FEVD), which answers the question: what portion
of the variance of the forecast error in predicting yi,t+1 is due to the structural
shock?

3 Forecasting with VAR models

3.1 Naive forecast (MMSE)
Forecasting from a VAR model is similar to forecasting from a univariate AR
model and the following gives a brief description. Similar to AR models, mini-
mum mean square error (MMSE) forecasts can be easily computed for the VAR
models. Future values of yt are simply replaced with MMSE forecasts, while
assuming future error terms as zero. Past values of yt and ut are replaced by
observed values. It is also called naive forecast. In the naive case, the presence
of forecast error is ignored.
Having a VAR(1) process as

yt = Φ1 yt−1 + ut
the best one-step-ahead forecast is given by

ŷN (1) = Φ̂1 yN

For the two-step-ahead forecast holds

ŷN (2) = Φ̂1 ŷN (1) = Φ̂21 ŷN

where the unknown lags of yN +1 are replaced by the respective point forecast.
Forecasts for longer horizons h (h-step forecasts) may be obtained using the
chain-rule of forecasting as

ŷN (h) = Φ̂h1 ŷN

Notice that forecasts are obtained by multiplicating matrices Φ1 , as opposed to
the AR(1) where scalars were multiplicated.

3.2 Simulation-based forecast

Because this method does not take into account any errors of the forecasts,
forecasts may be biased. One could then use bootstrapping forecast methods.
Although simulation-based forecasts are still obtained by replacing unknown
lags with point forecasts, they also incorporate forecast errors when estimating
higher step forecasts by adding a drawn value of the estimated error vector ut
from the VAR model in the estimation. If correctly specified, it is less biased,
but also much more computational intensive, according to Zivot/Wang (2002).

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3.3 Conditional forecast
Forecasts from VAR models are quite flexible because they can be made con-
ditional on the potential future paths of specified variables in the model. “For
example, when forecasting multivariate macroeconomic variables using quar-
terly data from a VAR model, it may happen that some of the future values
of certain variables in the VAR model are known, because data on these vari-
ables are released earlier than data on the other variables. By incorporating
the knowledge of the future path of certain variables, in principle it should be
possible to obtain more reliable forecasts of the other variables in the system.
Another use of con- ditional forecasting is the generation of forecasts conditional
on different “policy” scenarios. These scenario-based conditional forecasts allow
one to answer the question: if something happens to some variables in the sys-
tem in the future, how will it affect forecasts of other variables in the future?”
(Zivot/Wang, 2002).

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4 VAR models and Cointegration
The following chapter describes the analysis of nonstationary multivariate time
series using VAR models that incorporate cointegration relationships.

4.1 Integration and Cointegration

By so far one assumed that all time series are covariance stationary. If one re-
laxes this assumption, so allow for non-stationarity in the data, VAR modelling
is inadequate because the stability assumption (1) is not fulfilled anymore. One
could get rid of the problem by differencing the data set or assess other trans-
formations to make time series stationary. However, sometimes the structure of
the trend is of interest by itself, especially whether it is stochastic or determin-
istic. Are there more reasons for not differencing? Most economic theories are
expressed in levels. Therefore being obliged to difference the data set would be
a substantial obstacle in testing economic theories. Furthermore by differencing
one eliminates important dynamic and long-term features from the data and you
furthermore lose observations. Therefore it is always kind of disappointing if one
is obliged to difference the data. An alternative and more advanced approach
would be to assess vector error correction models, which integrate cointegration
techniques into VAR. Ignoring cointegrating relationships by simply differenc-
ing the data would imply ignoring equilibrium conditions. Forecasts, which base
on such misspecified models may then violate these theory-based plausability
conditions.
The idea behind cointegration is to find a linear combination between two
I(d) variables that yields a variable with lower order of integration. Although the
individual series are nonstationary, they are tied together by the cointegrating
vector.
Definition of integration: A time series yt ∼ I(d) (integrated of order d) if
4d yt is stable but 4d−1 yt is not.
Definition of cointegration: yt ∼ I(d) is cointegrated, if there exists a kx1
fixed vector β 6= 0, so that β́yt is integrated of order < d. ( I(0) is stable).
Let us consider the bivariate cointegrated VAR(1) process. One may find a
linear combination of y1t and y2t , that is (y1t − ky2t ), which is stationary. Then
y1t and y2t are called cointegrated. The linear combination can be interpreted as
a constrain implying a long-run relationship. The two variables are fit together
in the long run by the cointegrating vector. This long-run relationship can be
incorporated as lagged cointegrating error term in a VECM, allowing estimation
without differencing the data, therefore not neglecting long-term information.
Before describing the VECM, one has to know in which cases the VECM is
adequate.

Consider the bivariate VAR(2)

yt = Φ1 yt−1 + Φ2 yt−2 + ut

with the matrix polynomial for z=1 (→ stability condition)

Φ(1) = (I − Φ1 − Φ2 ) = Π

where rank(Π) equals the cointegration rank of the system yt .

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 • 0 ... no cointegration (→ difference VAR)
• 1 ... one cointegrating vector (→ VECM)

• 2 ... process is stable (→ VAR)

When the cointegration rank equals zero, no cointegration can be found. One is
unfortunately obliged to difference the data and go on with estimating a VAR.
The case of interest is the second one, when the cointegration rank lies between
1 and p-1, (p is here 2). This means one can find one or several cointegrating
vector and therefore the VECM should be estimated.

4.2 Vector error correction model (VECM)

This cointegration relationship can be integrated into a bivariate VAR(2) process
by subtracting yt−1 on both sides and rearranging terms so as to obtain

4yt = yt − yt−1 = Πyt−1 + Γ1 4yt−1 + ut

which is the so-called VECM form, where Γ1 = −Φ2 is the transition matrix
and Π = αβ́ holds
• α as the »loading matrix« (speed of adjustment)

• β́ consisting the independent cointegrating vector

• β́Yt−1 as the lagged disequilibrium error

• Πyt−1 as the error correction term (long-run part)
(to catch the idea: consider bivariate VAR(1) equation: 4y1t = α1 (y1,t−1 − βy2,t−1 ) +
u1t with long-run equilibrium y1t = βy2t )

The VECM form tells us: changes in yt can be explained by their own history,
lagged changes of the other variables, and the error from the long-run equilib-
rium in the previous period. All variables in the VECM are stationary, also
yt−1 , which is made stationary by Π. The long term equation is implemented
in Πyt−1 , whereas short-run coefficients are described in Γ1 . To summarize,
“the long-run or cointegration relations are often associated with specific eco-
nomic relations which are of particular interest, whereas the short-run dynamics
describe the adjustment to the long-run relations when disturbances have oc-
curred.” (Lütkepohl, 2007).
Estimation of such a VECM needs a specific procedure called reduced rank
estimation and forecasts can then be estimated following the MMSE (naive
forecasting) method in VAR. One may forecast the changes in the variables,
∆Y, or the levels of the variables Y.

5 Applications for VAR/VEC

Information, especially for VEC, is taken from Zivot/Wang (2002).

VAR can be used for stationary time series forecasting, e.g. interest rates, some

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exchange rates and some asset returns. One could also analyse many economic
variables on the basis of its growth rate.
VEC can always be used when one is able to verify long-term equilibirium con-
ditions in theoretical economics. Such cointegration relationships can be found
in economics and finance.

Economics:
• Money demand models imply cointegration between money, income, prices
and interest rates.
• Growth theory models imply cointegration between income, consumption
and investment, with productivity being the common trend.
• Purchasing power parity implies cointegration between the nominal ex-
change rate and foreign and domestic prices.
• The Fisher equation implies cointegration between nominal interest rates
and inflation.
Finance:
• Cointegration at a high frequency is motivated by arbitrage arguments.
The Law of One Price implies that identical assets must sell for the same
price to avoid arbitrage opportunities. This implies cointegration between
the prices of the same asset trading on different markets, for example.
• Cointegration at a low frequency is motivated by economic equilibrium
theories linking assets prices or expected returns to fundamentals. For
example, the present value model of stock prices states that a stock’s price
is an expected discounted present value of its expected future dividends
or earnings. This links the behavior of stock prices at low frequencies to
the behavior of dividends or earnings.

6 Final discussion about forecast quality

Multivariate modelling seems to be appealing on theoretical grounds. Unfor-
tunately, forecast competitions show that situation is not that clear. If VAR
forecasts perform better than their univariate pendants is controversial and var-
ious on several topics data set. According to Chatfield, you may have a slightly
better than 50:50 chance to obtain improved forecasts by using multivariate
forecasting methods. This may be a result from the more complex model selec-
tion, which is susceptible to errors and can therefore lead to misspecified mod-
els. Considering forecasts of BVAR, Chatfield emphasizes the results of Boero
(1990), “Bayesian VAR model is better than a large-scale econometric model for
short-term forecasting, but not for long-term forecasts where the econometric
model can benefit from judgemental interventions by the model user and may be
able to pick up non-linearities not captured by (linear) VAR models.” As said
before, (unrestricted) VAR model forecasts often seem to suffer from too many
parameters, which give a spuriously good fit within the sample, but lead to poor
out-of-sample forecasts. Therefore as Chatfield mentions, “a main motivation
for VAR modelling often lies in trying to get a better understanding of a given
system, rather than in trying to get better forecasts.

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 References

Chatfield, C. (2001) Time-series Forecasting. Chapman & Hall.

Helmut Luetkepohl, (2007) "Econometric Analysis with Vector Autoregressive

Models," Economics Working Papers ECO2007/11, European University In-
stitute.

Lesage, J.P. (1990) A comparison of the forecasting ability of the ECM and
VAR models, Review of Economics and Statistics, 72, 664-71.

Shoesmith, G.L. (1992) Cointegration, error correction and improved regional

VAR forecasting, Journal of Forecasting, 11, 91-109.

Shoesmith, G.L. (1995) Long term forecasting of noncointegrated and cointe-

grated regional and national models, Journal of Regional Science, 35, 43-64.

Zivot E., Wang J. (2002) Modeling Financial Time Series with S-PLUS.

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