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1 4. Simple regression QBUS6840 Predictive Analytics

2 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

3 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

4 The simple linear model I In this chapter, the forecast and predictor variables are assumed to be related by the simple linear model: y = β 0 + β 1 x + ε. An example of data from such a model is shown in Figure 4.1. The parameters β 0 and β 1 determine the intercept and the slope of the line respectively. The intercept β 0 represents the predicted value of y when x = 0. The slope β 1 represents the predicted increase in Y resulting from a one unit increase in x.

5 QBUS6840 Predictive Analytics 4. Simple regression 5/41 The simple linear model II Figure 4.1: An example of data from a linear regression model.

6 The simple linear model III Notice that the observations do not lie on the straight line but are scattered around it. We can think of each observation y i consisting of the systematic or explained part of the model, β 0 + β 1 x i, and the random error, ε i. The error term does not imply a mistake, but a deviation from the underlying straight line model. It captures anything that may affect y i other than x i. We assume that these errors: 1. have mean zero; otherwise the forecasts will be systematically biased. 2. are not autocorrelated; otherwise the forecasts will be inefficient as there is more information to be exploited in the data. 3. are unrelated to the predictor variable; otherwise there would be more information that should be included in the systematic part of the model. It is also useful to have the errors normally distributed with constant variance in order to produce prediction intervals and to perform statistical inference. While these additional conditions make the calculations simpler, they are not necessary for forecasting.

7 The simple linear model IV Another important assumption in the simple linear model is that x is not a random variable. If we were performing a controlled experiment in a laboratory, we could control the values of x (so they would not be random) and observe the resulting values of y. With observational data (including most data in business and economics) it is not possible to control the value of x, and hence we make this an assumption.

8 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

9 Least squares estimation I In practice, of course, we have a collection of observations but we do not know the values of β 0 and β 1. These need to be estimated from the data. We call this fitting a line through the data. There are many possible choices for β 0 and β 1, each choice giving a different line. The least squares principle provides a way of choosing β 0 and β 1 effectively by minimizing the sum of the squared errors. That is, we choose the values of β 0 and β 1 that minimize N ε 2 i = i=1 N (y i β 0 β 1 x i ) 2. i=1

10 QBUS6840 Predictive Analytics 4. Simple regression 10/41 Least squares estimation II Using mathematical calculus, it can be shown that the resulting least squares estimators are and N i=1 ˆβ 1 = (y i ȳ)(x i x) N i=1 (x i x) 2 ˆβ 0 = ȳ ˆβ 1 x, where x is the average of the x observations and ȳ is the average of the y observations. The estimated line is known as the regression line and is shown in Figure 4.2.

11 QBUS6840 Predictive Analytics 4. Simple regression 11/41 Least squares estimation III Figure 4.2: Estimated regression line for a random sample of size N.

12 Least squares estimation IV We imagine that there is a true line denoted by y = β 0 + β 1 x (shown as the dashed green line in Figure 4.2, but we do not know β 0 and β 1 so we cannot use this line for forecasting. Therefore we obtain estimates β 0 and β 1 from the observed data to give the regression line (the solid purple line in Figure 4.2). The regression line is used for forecasting. For each value of x, we can forecast a corresponding value of y using ŷ = ˆβ 0 + ˆβ 1 x.

13 Fitted values and residuals The forecast values of y obtained from the observed x values are called fitted values. We write these as ŷ i = ˆβ 0 + ˆβ 1 x i, for i = 1,..., N. Each ŷ i is the point on the regression line corresponding to observation x i. The difference between the observed y values and the corresponding fitted values are the residuals: e i = y i ŷ i = y i ˆβ 0 ˆβ 1 x i. The residuals have some useful properties including the following two: N e i = 0 i=1 and N x i e i = 0. As a result of these properties, it is clear that the average of the residuals is zero, and that the correlation between the residuals and the observations for predictor variable is also zero. i=1

14 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

15 Forecasting with regression I Forecasts from a simple linear model are easily obtained using the equation ŷ = ˆβ 0 + ˆβ 1 x where x is the value of the predictor for which we require a forecast. That is, if we input a value of x in the equation we obtain a corresponding forecast ŷ. When this calculation is done using an observed value of x from the data, we call the resulting value of ŷ a fitted value. This is not a genuine forecast as the actual value of y for that predictor value was used in estimating the model, and so the value of ŷ is affected by the true value of y. When the values of x is a new value (i.e., not part of the data that were used to estimate the model), the resulting value of ŷ is a genuine forecast.

16 Forecasting with regression II Assuming that the regression errors are normally distributed, an approximate 95% forecast interval (also called a prediction interval) associated with this forecast is given by ŷ ± 1.96s e N (x x)2 + (N 1)sx 2, (4.2) where N is the total number of observations, x is the mean of the observed x values, s x is the standard deviation of the observed x values and s e is the standard error of the residuals. Similarly, an 80% forecast interval can be obtained by replacing 1.96 by 1.28 in equation (4.2). Equation (4.2) shows that the forecast interval is wider when x is far from x. That is, we are more certain about our forecasts when considering values of the predictor variable close to its sample mean.

17 Forecasting with regression III The estimated regression line in the Car data example is ŷ = x. For the Chevrolet Aveo (the first car in the list) x 1 = 25 mpg and y 1 = 6.6 tons of CO2 per year. The model returns a fitted value of ŷ 1 = 7.00, i.e., e 1 = 0.4. For a car with City driving fuel economy x = 30 mpg, the average footprint forecasted is ŷ = 5.90 tons of CO2 per year. The corresponding 95% and 80% forecast intervals are [4.95,6.84] and [5.28,6.51] respectively.

18 Forecasting with regression IV Figure 4.6: Forecast with 80% and 95% forecast intervals for a car with x = 30 mpg in city driving.

19 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

20 Non-linear functional forms I Although the linear relationship assumed at the beginning of this chapter is often adequate, there are cases for which a non-linear functional form is more suitable. The scatter plot of Carbon versus City in Figure 4.3 is an example where a non-linear functional form is required. Simply transforming variables y and/or x and then estimating a regression model using the transformed variables is the simplest way of obtaining a non-linear specification. The most commonly used transformation is the (natural) logarithmic (see Section 2/4). A log-log functional form is specified as log y i = β 0 + β 1 log x i + ε i. In this model, the slope β 1 can be interpeted as an elasticity: β 1 is the average percentage change in y resulting from a 1% change in x.

21 Non-linear functional forms II Figure 4.7 shows a scatter plot of Carbon versus City and the fitted log-log model in both the original scale and the logarithmic scale. The plot shows that in the original scale the slope of the fitted regression line using a log-log functional form is non-constant. The slope depends on x and can be calculated for each point (see Table 4.1). In the logarithmic scale the slope of the line which is now interpreted as an elasticity is constant. So estimating a log-log functional form produces a constant elasticity estimate in contrast to the linear model which produces a constant slope estimate.

22 QBUS6840 Predictive Analytics 4. Simple regression 22/41 Non-linear functional forms III Figure 4.7: Fitting a log-log functional form to the Car data example. Plots show the estimated relationship both in the original and the logarithmic scales.

23 QBUS6840 Predictive Analytics 4. Simple regression 23/41 Non-linear functional forms IV Figure 4.8: Residual plot from estimating a log-log functional form for the Car data example.

24 Non-linear functional forms V Other useful forms are the log-linear form and the linear-log form: Model Functional form Slope Elasticity linear y = β 0 + β 1 x β 1 β 1 x/y log-log log y = β 0 + β 1 log x β 1 y/x β 1 linear-log y = β 0 + β 1 log x β 1 /x β 1 y log-linear log y = β 0 + β 1 x β 1 y β 1 x Table 4.1: Summary of selected functional forms. Elasticities that depend on the observed values of y and x are commonly calculated for the sample means of these.

25 QBUS6840 Predictive Analytics 4. Simple regression 25/41 Non-linear functional forms VI Figure 4.9: The four non-linear forms shown in Table 4.1.

26 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

27 Regression with time series data I When using regression for prediction, we are often considering time series data and we are aiming to forecast the future. There are a few issues that arise with time series data but not with cross-sectional data that we will consider in this section. Figure 4.10: Percentage changes in personal consumption expenditure for the US.

28 Regression with time series data II Figure 4.10 shows time series plots of quarterly percentage changes (growth rates) of real personal consumption expenditure (C) and real personal disposable income (I ) for the US for the period March 1970 to Dec Also shown is a scatter plot including the estimated regression line Ĉ = I, with the estimation results are shown below the graphs. These show that a 1% increase in personal disposable income will result to an average increase of 0.84% in personal consumption expenditure. We are interested in forecasting consumption for the four quarters of Using a regression model to forecast time series data poses a challenge in that future values of the predictor variable (Income in this case) are needed to be input into the estimated model, but these are not known in advance. One solution to this problem is to use scenario based forecasting.

29 Scenario based forecasting I In this setting the forecaster assumes possible scenarios for the predictor variable that are of interest. For example the US policy maker may want to forecast consumption if there is a 1% growth in income for each of the quarters in Alternatively a 1% decline in income for each of the quarters may be of interest. The resulting forecasts are calculated and shown in Figure 4.11.

30 QBUS6840 Predictive Analytics 4. Simple regression 30/41 Scenario based forecasting II Figure 4.11: Forecasting percentage changes in personal consumption expenditure for the US.

31 Scenario based forecasting III Forecast intervals for scenario based forecasts do not include the uncertainty associated with the future values of the predictor variables. They assume the value of the predictor is known in advance. An alternative approach is to use genuine forecasts for the predictor variable. For example, a pure time series based approach can be used to generate forecasts for the predictor variable (more on this in Chapter 9) or forecasts published by some other source such as a government agency can be used.

32 Ex-ante versus ex-post forecasts I When using regression models with time series data, we need to distinguish between two different types of forecasts that can be produced, depending on what is assumed to be known when the forecasts are computed. Ex ante forecasts are those that are made using only the information that is available in advance. For example, ex ante forecasts of consumption for the four quarters in 2011 should only use information that was available before These are the only genuine forecasts, made in advance using whatever information is available at the time. Ex post forecasts are those that are made using later information on the predictors. For example, ex post forecasts of consumption for each of the 2011 quarters may use the actual observations of income for each of these quarters, once these have been observed. These are not genuine forecasts, but are useful for studying the behaviour of forecasting models.

33 Ex-ante versus ex-post forecasts II The model from which ex-post forecasts are produced should not be estimated using data from the forecast period. That is, ex-post forecasts can assume knowledge of the predictor variable (the x variable), but should not assume knowledge of the data that are to be forecast (the y variable). A comparative evaluation of ex ante forecasts and ex post forecasts can help to separate out the sources of forecast uncertainty. This will show whether forecast errors have arisen due to poor forecasts of the predictor or due to a poor forecasting model.

34 Linear trend I A common feature of time series data is a trend. Using regression we can model and forecast the trend in time series data by including t = 1,..., T, as a predictor variable: y t = β 0 + β 1 t + ε t. Figure 4.12 shows a time series plot of aggregate tourist arrivals to Australia over the period 1980 to 2010 with the fitted linear trend line ŷ t = t. Also plotted are the point and forecast intervals for the years 2011 to 2015.

35 QBUS6840 Predictive Analytics 4. Simple regression 35/41 Linear trend II Figure 4.12: Forecasting international tourist arrivals to Australia for the period using a linear trend. 80% and 95% forecast intervals are shown.

36 Residual autocorrelation I With time series data it is highly likely that the value of a variable observed in the current time period will be influenced by its value in the previous period, or even the period before that, and so on. Therefore when fitting a regression model to time series data, it is very common to find autocorrelation in the residuals. In this case, the estimated model violates the assumption of no autocorrelation in the errors, and our forecasts may be inefficient there is some information left over which should be utilized in order to obtain better forecasts. The forecasts from a model with autocorrelated errors are still unbiased, and so are not wrong, but they will usually have larger prediction intervals than they need to. Figure 4.13 plots the residuals from Examples 4.3 and 4.4, and the ACFs of the residuals (see Section 2/2 for an introduction to the ACF). The ACF of the consumption residuals shows a significant spike at lag 2 and the ACF of the tourism residuals shows significant spikes at lags 1 and 2. Usually plotting the ACFs of the residuals are adequate to reveal any potential autocorrelation in the residuals. More formal tests for autocorrelation are discussed in Section 5/4.

37 Residual autocorrelation II Figure 4.13: Residuals from the regression models for Consumption and Tourism. Because these involved time series data, it is important to look at the ACF of the residuals to see if there is any remaining information not accounted for by the model. In both these examples, there is some remaining autocorrelation in the residuals.

38 Spurious regression I More often than not, time series data are non-stationary; that is, the values of the time series do not fluctuate around a constant mean or with a constant variance. We will deal with time series stationarity in more detail in Chapter 8, but here we need to address the effect non-stationary data can have on regression models. For example consider the two variable plotted in Figure 4.14, which appear to be related simply because they both trend upwards in the same manner. However, air passenger traffic in Australia has nothing to do with rice production in Guinea. Selected output obtained from regressing the number of air passengers transported in Australia versus rice production in Guinea (in metric tons) is also shown in Figure 4.14.

39 Spurious regression II Figure 4.14: Trending time series data can appear to be related, as shown in this example in which air passengers in Australia are regressed against rice production in Guinea.

40 Spurious regression III Regressing non-stationary time series can lead to spurious regressions. High R 2 s and high residual autocorrelation can be signs of spurious regression. We discuss the issues surrounding non-stationary data and spurious regressions in detail in Chapter 9. Cases of spurious regression might appear to give reasonable short-term forecasts, but they will generally not continue to work into the future.

41 Outline The simple linear model Least squares estimation Forecasting with regression Non-linear functional forms Regression with time series data Scenario based forecasting Ex-ante versus ex-post forecasts Linear trend Residual autocorrelation Spurious regression

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