Financial Risk Manager Part 1
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A financial analyst wishes to conduct an ADF test on the log of 20-year real GDP from 1999 to 2019. The result of the tests is shown below:
| Deterministic | γ | δ₀ | δ₁ | Lags | 5% CV | 1% CV |
|---|---|---|---|---|---|---|
| None | -0.004 (-1.555) | 8 | -1.940 | -2.570 | ||
| Constant | -0.008 (-1.422) | 0.010 (1.025) | 4 | -2.860 | -3.445 | |
| Trend | -0.084 (-4.376) | 0.188 (-4.110) | 3 | -3.420 | -3.984 |
The output of the ADF reports the results at the different number deterministic terms (first column), and the last three columns indicate the number of lags according to AIC and the 5% and 1% critical values that are appropriate to the underlying sample size and the deterministic terms. The quantities in the parenthesis (below the parameters) are the test-statistics. What deterministic term is most preferred for this model?
Other
Community
NNikitesh
A
Constant
B
Trend
C
None (No deterministic components)
D
Both the constant and the trend
Explanation:
The recommended method of choosing appropriate deterministic terms is by including the deterministic terms that are significant at the 10% level. The trend deterministic is chosen because the absolute value of its test statistic is greater than 1.645. That is, |-4.376| > |1.645|. Also, since the absolute value of the trend test statistic is greater than both 5% critical value (CV) and 1% CV, then there is no evidence of unit roots and thus, the null hypothesis is rejected.
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