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Chow Test

- The document discusses issues with structural breaks in data like sudden policy changes, and introduces the Chow test to determine if a structural break has occurred. It provides an example showing a stock price regression with an obvious break in 1997. - The Chow test involves running separate regressions before and after the suspected break, and comparing the sums of squared residuals to an F-statistic. In the example, the test rejects stability, showing a break in 1997. - The document also introduces the problem of multicollinearity when explanatory variables are strongly correlated. It provides ways to measure and remedy multicollinearity like removing variables or transforming the data.

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967 views23 pages

Chow Test

- The document discusses issues with structural breaks in data like sudden policy changes, and introduces the Chow test to determine if a structural break has occurred. It provides an example showing a stock price regression with an obvious break in 1997. - The Chow test involves running separate regressions before and after the suspected break, and comparing the sums of squared residuals to an F-statistic. In the example, the test rejects stability, showing a break in 1997. - The document also introduces the problem of multicollinearity when explanatory variables are strongly correlated. It provides ways to measure and remedy multicollinearity like removing variables or transforming the data.

Uploaded by

YaronBaba
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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F-tests continued

Introduction
Discuss the problems associ ated with structural breaks in the data. Examine the Chow test for a structural break. Assess an example of the use of the Chow test and ways to solve the problem of structural breaks. Introduce the probl em of multicollinearity.

Structural Breaks
Structural breaks can occur in t ime series dat a or cross sect ional data, when there is a sudden change in the relationship being examined. Examples include sudden policy changes such as a change in government or sudden move in asset prices (1987) or serious int ernational disaster such as a civil war We then need to decide whet her 2 separate regression lines are more efficient than a single regression.

Structural Break in 1997


Index
stock prices

30 20 10 0 1985

1990

1995

2000

2005

2010

date SP Linear (SP)

Structural Break
In this example a single regression line is not a good fi t of the data due to the obvious structural break in 1997. We need to test i f a structural break has occurred in 1997, usual ly the break is not as obvious as this. We will use the Chow test, which is a variation of the F-test for a restri ction

Chow Test (stages in using test)


Run the regressi on using all the observations, before and after the structural break, collect the RSS Run 2 separate regressi ons, one before, RSS(1) and one after, RSS(2) the structural break. Calculate the test stati stic using the following formulae:

Chow Test
RSS c - ( RSS 1 + RSS 2 ) / k FRSS 1 + RSS 2 / n - 2 k RSS c - combined _ RSS RSS 1 - pre - break _ RSS RSS 2 - post - break _ RSS

Chow Test
The final stage of the Chow Test is to compare the test stati stic with the critical value from the F-Tables. The null hypothesis in this case is structural stability, if we reject the null hypothesis, it means we have a structural break in the data We then need to deci de how to overcome this break.

Chow Test
If there is evidence of a structural break, it may mean we need to split the data into 2 samples and run separate regressi ons. Another method to overcome thi s problem is to use dummy variables (To be covered later in term), the benefit of this approach is that we do not lose any degrees of freedom through a l oss of observati ons.

Chow Test Example


The following model is regressed using dat a in quarterly form from 1990 to 2005 (64 observations)for Malaysian stock prices against output (structural break in 1997).

st = a 0 + a1 yt + ut

Chow Test
The first regression using all the data produced a RSS( c) of 0.56, then 2 regressions were run on a sub-sample of the data from 1990-1997, giving a RSS(1) of 0.23. The final regression was on the sample from 1998 to 2005, producing a RSS(2) of 0.17, n=64, k=2.

0.56- (0.23+ 0.17) / 2 0.08 F= =12 0.23+ 0.17/ 64- 2*2 0.00667

Chow Test
As the critical value for F(2,60) =3.15(5%) As 12> 3.15, we reject the null hypothesis of structural stability. We conclude that there i s a structural break in this model, we need to spl it the data into 2 sub-samples or use another method to overcome the break.

Problems with Chow Test


The test may suggest spl itting the data, this may mean fewer degrees of freedom When shoul d the cut off poi nt be for the test, usually there shoul d be a theoreti cal basis for this. There is the potenti al for structural instability across the whol e data range. It is possible to test every observation for a structural break.

Multicollinearity
Multicollinearity occurs when two explanatory variables are strongly correlated with each other. In all multiple regression models there is some degree of collinearity between the explanatory variables, however not enough to cause a serious problem. However in some cases t he collinearit y between variables is so high, it affects the regression, producing coef ficients with high standard errors.

Multicollinearity
It may be that mul ticollinearity is not a problem if the other condi tions are favourable: - High number of observati ons - Sample variance of expl anatory variables is high - Variance of the resi dual is low

Models which can have multicollinearity


Models with large numbers of l ags. Models which use asset returns or i nterest rates, i.e. 3 month and 10 year interest rates. (This can be overcome by using a term structure of i nterest rates vari able, i.e. one rate minus the other) Demand model s which include different prices of goods.

Measuring Multicollinearity
The main way of testing for multicollinearity is to check the t-statistics and R-squared statistic. If the regression produces a high R-squared statistic (>0.9) but low t-statistics which are not significant, then multicollinearity could be a problem We could then produce a pair-wise correlation coefficient to determine if the variables are suffering from high levels of multicollinearity. The problem with this approach is to decide on when the correlation is so large that multicollinearity is present.

Remedies for Multicollinearity


Remove one of the variables from the regression which is causing the multicollinearity or alternatively replace it with a variable that is not collinear (This can cause omit ted variable bias). Find data that has more observations. Transform the variables, i.e. put data into ratio form or take logarithms of the data Ignore the problem, after all the estimators are still BLUE.

Increasing Observations
To overcome multicollinearity, it may be necessary to increase the number of observations by: Extending data series. Increasing the frequency of the data, with financial data it is often possible to get daily data. Pooling the data, it could be that cross section and time series dat a could be combined.

Multicollinearity Example
t = 0.4 + 0 .8 yt + 0 .2lit - 0 .1sit s (0.9) (1.2) (0.4)
2

(0.1)

R = 0.98 , (standard errors in parenthese s) (n = 60). where : st - stock prices y t - output lit - long - run interest rates sit - short - run interest rates

Multicollinearity
The example in the previous slide shows evidence of multicollinearity, with a high Rsquared statistic and low t-statistics. T-statistics are: y-0.667, li-0.5 and si-1, where the critical value is 2.00. The long and short interest rates are probably highly collinear. The remedy in this case is to use a different variable and combine both interest rates into a single variable, which is the long rate minus the short rate. (called the term structure of interest rates)

Dummy Variables
Dummy Variables are a common way of solving structural breaks, as it does not involve splitting the data. These variables consist of 1s and 0s and are often termed on-off variables. They can be used to determine the importance of policy actions on models and are often used to account for qualitative effects. Their coefficients and t-statistics can then be interpreted in the usual way.

Conclusion
The F-test can be used to test a specific restriction on a model, such as const ant returns to scale. The Chow test is used to determine if the data is structurally stable. If there is a structural break, we need to split the data or use dummy variables Multicollinearity occurs when the explanatory variables are closely correlated.

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