FIN201 CORPORATE FINANCE

Assoc. Prof. Doan Anh Tuan

International School of Business

1. TIME SERIES FORECASTING — ARIMA MODELS

ARIMA stands for Auto Regressive Integrated Moving Average. There are seasonal
and Non-seasonal ARIMA models that can be used for forecasting

Non-Seasonal ARIMA model:

This method has three variables to account for

P = Periods to lag for eg: (if P= 3 then we will use the three previous periods of our
time series in the autoregressive portion of the calculation) P helps adjust the line that is
being fitted to forecast the series

Purely autoregressive models resemble a linear regression where the predictive

variables are P number of previous periods

D = In an ARIMA model we transform a time series into stationary one(series without

trend or seasonality) using differencing. D refers to the number of differencing
transformations required by the time series to get stationary.

Stationary time series is when the mean and variance are constant over time. It is
easier to predict when the series is stationary.

Differencing is a method of transforming a non-stationary time series into a stationary

one. This is an important step in preparing data to be used in an ARIMA model.

The first differencing value is the difference between the current time period and the
previous time period. If these values fail to revolve around a constant mean and variance,
then we find the second differencing using the values of the first differencing. We repeat
this until we get a stationary series

The best way to determine whether or not the series is sufficiently differenced is to plot
the differenced series and check to see if there is a constant mean and variance.
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 Q = This variable denotes the lag of the error component, where error component is a
part of the time series not explained by trend or seasonality

Autocorrelation function plot (ACF):

Autocorrelation refers to how correlated a time series is with its past values whereas
the ACF is the plot used to see the correlation between the points, up to and including the
lag unit. In ACF, the correlation coefficient is in the x-axis whereas the number of lags is
shown in the y-axis.

The Autocorrelation function plot will let you know how the given time series is
correlated with itself

Normally in an ARIMA model, we make use of either the AR term or the MA term.
We use both of these terms only on rare occasions. We use the ACF plot to decide which
one of these terms we would use for our time series

If there is a Positive autocorrelation at lag 1 then we use the AR model

If there is a Negative autocorrelation at lag 1 then we use the MA model

After plotting the ACF plot we move to Partial Autocorrelation Function plots (PACF).
A partial autocorrelation is a summary of the relationship between an observation in a time
series with observations at prior time steps with the relationships of intervening observations
removed.

The partial autocorrelation at lag k is the correlation that results after removing the
effect of any correlations due to the terms at shorter lags.

If the PACF plot drops off at lag n, then use an AR(n) model and if the drop in
PACF is more gradual then we use the MA term

Autoregressive component: A purely AR model forecasts only using a combination of

the past values sorta like linear regression where the number of AR terms used is directly
proportional to the number of previous periods taken into consideration for the forecasting.

Use AR terms in the model when the

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 • ACF plots show autocorrelation decaying towards zero

• PACF plot cuts off quickly towards zero

• ACF of a stationary series shows positive at lag-1

Moving Averages: Random jumps in the time series plot whose effect is felt in two or
more consecutive periods. These jumps represent the error calculated in our ARIMA model
and represent what the MA component would lag for. A purely MA model would smooth
out these sudden jumps like the exponential smoothing method.

Use MA terms in the model when the model is

• Negatively Autocorrelated at Lag — 1

• ACF that drops sharply after a few lags

• PACF decreases more gradually

Integrated component: This component comes into action when the time series is not
stationary. The number of times we have to difference the series to make it stationary is the
parameter(i-term) for the integrated component

We can represent our model as ARIMA (ar-term, ma-term, i-term)

Finding the correct model is an iterative process.

Seasonal ARIMA (SARIMA) models:

As the name suggests, this model is used when the time series exhibits seasonality.
This model is similar to ARIMA models; we just have to add in a few parameters to account
for the seasons

We write SARIMA as

ARIMA(p,d,q)(P, D, Q)m,

• p — the number of autoregressive

• d — degree of differencing

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 • q — the number of moving average terms

• m — refers to the number of periods in each season

• (P, D, Q)— represents the (p,d,q) for the seasonal part of the time series

Seasonal differencing takes into account the seasons and differences the current value
and its value in the previous season eg: Difference for the month may would be value in May
2018 — value in may 2017.

• In Purely seasonal AR model, ACF decays slowly while PACF cuts off to zero

• AR models are used when seasonal auto-correlation is positive

• In Purely seasonal MA model, ACF cuts off to zero and vice versa

• MA models are used when seasonal auto-correlation is negative

Final steps

• Step 1 — Check stationarity: If a time series has a trend or seasonality

component, it must be made stationary before we can use ARIMA to forecast.

• Step 2 — Difference: If the time series is not stationary, it needs to be

stationarized through differencing. Take the first difference, then check for
stationarity. Take as many differences as it takes. Make sure you check seasonal
differencing as well.

• Step 3 — Filter out a validation sample: This will be used to validate how
accurate our model is. Use train test validation split to achieve this

• Step 4 — Select AR and MA terms: Use the ACF and PACF to decide whether
to include an AR term(s), MA term(s), or both.

• Step 5 — Build the model: Build the model and set the number of periods to
forecast to N (depends on your needs).

• Step 6 — Validate model: Compare the predicted values to the actuals in the
validation sample.

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 Link of video guidance:

https://www.youtube.com/watch?v=8xt4q7KHfBs

2. EXAMPLE CODING:

ARIMA DATA
PRACTICES.xlsx

Transform the date:

generate DATE_M = mofd(DATE)
format DATE_M %tm
tsset DATE_M, monthly
dfuller SALEGROWTH , trend

Running and forcasting the ARIMA:

arima SALEGROWTH, arima(1,0,16)
tsappend, add(12)
predict SALEGROWTH_F , y dynamic(tm(2020m3))
twoway (line SALEGROWTH DATE_M ) (line SALEGROWTH_F DATE_M )
----------
twoway lfitci SALEGROWTH_F SALEGROWTH, stdp || scatter SALEGROWTH_F
SALEGROWTH