R package for fitting the partially cointegrated model

A collection of time series is partially cointegrated if a linear combination of these time series can be found so that the residual spread is partially autoregressive - meaning that it can be represented as a sum of an autoregressive series and a random walk. This concept is useful in modeling certain sets of financial time series and beyond, as it allows for the spread to contain transient and permanent components alike. Partial cointegration has been introduced by Clegg and Krauss (2017) , along with a large-scale empirical application to financial market data. The partialCI package comprises estimation, testing, and simulation routines for partial cointegration models in state space. Clegg et al. (2017) provide an in in-depth discussion of the package functionality as well as illustrating examples in the fields of finance and macroeconomics. If a collection of time series is partially cointegrated, then the spread between them can be interepreted as a mean-reverting series that has possibly been contaminated with a (hopefully small) random walk.

The developer version can be find on Github. To use the developer version of the partialCI package, you will need to start by installing it, which can be done using devtools:

> install.packages("devtools")   # if devtools is not already installed
> install_github("matthewclegg/partialCI")

To find the partially cointegrated model that best fits two series X and Y, use:

> fit.pci(Y, X)

An interface to Yahoo! Finance permits you to find the best fits for two particular stocks of interest:

> yfit.pci("RDS-B", "RDS-A")
Fitted values for PCI model
  Y[t] = alpha + X[t] %*% beta + M[t] + R[t]
  M[t] = rho * M[t-1] + eps_M [t], eps_M[t] ~ N(0, sigma_M^2)
  R[t] = R[t-1] + eps_R [t], eps_R[t] ~ N(0, sigma_R^2)

           Estimate Std. Err
alpha        0.2063   0.8804
beta_RDS-A   1.0531   0.0133
rho          0.9055   0.0355
sigma_M      0.2431   0.0162
sigma_R      0.0993   0.0350

-LL = 41.30, R^2[MR] = 0.863

This example was run on 1/7/2016. RDS-A and RDS-B are two classes of shares offered by Royal Dutch Shell that differ slightly in aspects of their tax treatment. The above fit shows that the spread between the two shares is mostly mean-reverting but that it contains a small random walk component. The mean-reverting component accounts for 86.3% of the variance of the daily returns. The value of 0.9055 for rho corresponds to a half-life of mean reversion of about 7 trading days.

To test the goodness of fit, the test.pci function can be used:

> h <- yfit.pci("RDS-B", "RDS-A")
> test.pci(h)

    Likelihood ratio test of [Random Walk or CI(1)] vs Almost PCI(1) (joint penalty method)

data:  h

Hypothesis              Statistic    p-value
Random Walk                 -4.94      0.010
AR(1)                       -4.08      0.010
Combined                               0.010

The test.pci function tests each of two different null hypotheses: (a) the residual series is purely a random walk, and (b) the residual series is purely autoregressive. In addition, the union of these hypothesis is also tested. For practical applications, one is usually most interested in rejecting the first of these null hypotheses, e.g., that the residual series is purely a random walk.

The partialCI package also contains a function for searching for hedging portfolios. Given a particular stock (or time series), a search can be conducted to find the set of stocks that best replicate the target stock. In the following example, a hedge is sought for SPY using sector ETF’s.

> sectorETFS <- c("XLB", "XLE", "XLF", "XLI", "XLK", "XLP", "XLU", "XLV", "XLY")
> prices <- multigetYahooPrices(c("SPY", sectorETFS), start=20140101)
> hedge.pci(prices[,"SPY"], prices)
     -LL   LR[rw]    p[rw]    p[mr]      rho  R^2[MR]   Factor |   Factor coefficients
  490.67  -1.7771   0.1782   0.0100   0.9587   0.8246      XLF |   6.8351 
  283.26  -4.3988   0.0137   0.0786   0.9642   1.0000      XLK |   3.6209   2.2396 
  168.86  -6.4339   0.0100   0.0100   0.7328   0.6619      XLI |   2.3191   1.6542   1.1391 

Fitted values for PCI model
  Y[t] = alpha + X[t] %*% beta + M[t] + R[t]
  M[t] = rho * M[t-1] + eps_M [t], eps_M[t] ~ N(0, sigma_M^2)
  R[t] = R[t-1] + eps_R [t], eps_R[t] ~ N(0, sigma_R^2)

           Estimate Std. Err
alpha       14.2892   1.5598
beta_XLF     2.3191   0.1439
beta_XLK     1.6542   0.0804
beta_XLI     1.1391   0.0662
rho          0.7328   0.1047
sigma_M      0.2678   0.0315
sigma_R      0.2056   0.0401

-LL = 168.86, R^2[MR] = 0.662

The top table displays the quality of the fit that is found as each new factor is added to the fit. The best fit consisting of only one factor is found by using XLF (the financials sector). The negative log likelihod score for this model is 490.67. However, the random walk hypothesis (p[rw]) cannot be rejected at the 5% level. When adding XLK (the technology sector), the negative log likelihood drops to 283.26 and the random walk hypothesis for the spread can now be rejected. This means that SPY is at least partially cointegrated and possibly fully cointegrated with a portfolio consisting of XLF and XLK in the right proportions. The best overall fit is obtained by also adding XLI (industrials) to the hedging portfolio. The final fit is

  SPY = $14.29 + 2.32 XLF + 1.65 XLK + 1.14 XLI

For this fit, the proportion of variance attributable to the mean reverting component is 66.2%, and the half life of mean reversion is about 2.2 days.

Please feel free to write to us if you have questions or suggestions.

Matthew Clegg

Christopher Krauss

Jonas Rende

March 05, 2018