ECO 312 Fall 2013 Chris Sims LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY

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1 ECO 312 Fall 2013 Chris Sims LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY (1) A distributio that allows asymmetry differet probabilities for egative ad positive outliers is the asymmetric double expoetial, with pdf { e αx if x 0 p(x α, β) e βx if x < 0 The symbol stads for is proportioal to To make this distributio itegrate to oe, we have to multiply the expressios above by αβ/(α + β) (Ad this is importat for geeratig the likelihood fuctio from the pdf) Suppose we have a iid sample {x 1, x } from this distributio (a) Write dow the likelihood for the sample Show that the sum of the positive x j s ( x + j ) ad the sum of the egative x j s ( x j ), as a pair, form a sufficiet statistic Because the sample is iid, the pdf is the product of the idividual observatio pdf s, ie p( x) = αβe αx+ j +βx j α + β j=1 = ( ) αβ e α x+ j β (x j α + β Sice this sample pdf depeds o the data x oly via the two umbers x + j ad x j, these are sufficiet statistics [Note that i geeral the pdf could deped o the data i other ways as well, so log as the pdf factors ito oe piece that depeds o the sufficiet statistics ad the ukow parameters, ad aother that does ot deped o the ukow parameters The part that does ot deped o the ukow parameters drops out whe we cosider the pdf as a fuctio of the parameters (ie as a likelihood) ad ormalize it, or its product with a prior pdf, to itegrate to oe] (b) The mode of this distributio is obviously x = 0 Calculate the mea of the distributio as a fuctio of α ad β [Hit: The mea of a expoetially distributed variable (with pdf αe αx o (0, )) is 1/α The mea of x is the mea of the positive part of x times the probability of x > 0 plus the mea of the egative part of x times the probability of x < 0] The expected value of x coditioial o x > 0 is the pdf over that regio, ormalized to itegrate to oe, ie the stadard expoetial with parameter α So the mea coditioal o x > 0 is 1/α The mea coditioal o x < 0 is, by the same argumet with sig reversed, 1/β The itegral of e αx over x > 0 is 1/α, ad the itegral of e βx over β < 0 is 1/β Therefore P[x > 0]/P[x < 0] = β/α, which c 2013 by Christopher A Sims This documet is licesed uder the Creative Commos Attributio-NoCommercial-ShareAlike 30 Uported Licese

2 2 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY i tur implies P[x > 0] = β/(α + β) The ucoditioal mea of x is P[x > 0]E[x x > 0] + P[x < 0]E[x x < 0] = β α(α + β) α β(α + β) = β α αβ : (c) Calculate the maximum likelihood estimates of α ad β as a fuctio of the sufficiet statistics This ivolves solvig a pair of oliear equatios i two ukows, but they ca be solved by had You get the equatios to solve by fidig first order coditios for a maximum of the likelihood (or the log likelihood, which is a little more coveiet) The log likelihood is log(αβ) log(α + β) α x + j = β x j The first order coditios with respect to α ad β are α : α α + β x + j β : β α + β + x j If my algebra is right, the solutio is α = β = 1 + S S, where S + = x + j, S = x j, ad = S S + (d) For the the Bad day o Wall Street daily per cet chage i the DJIA data of Stock ad Watso, the sum of the positive values is ad the sum of the egative values is The umber of observatios is 7561 Fid the correspodig maximum likelihood α ad β, as well as the implied mea retur Are these estimates cosistet with the idea that large egative values of the variable are more likely tha large positive oes? Pluggig the give values ito the equatios for the MLE s gives us α = , β = They imply more rapid decay toward zero i the left (egative) tail of the distributio tha i the right So they cotradict the otio that large egative values are more likely tha large positive values The sample data of largest absolute value are egative, but there are oly a few of these i the distat tail Of course this result might also reflect the fact that the sample mea of the data is positive, ad if the model is to imply a positive mea retur, it must have α < β (e) Suppose we had a prior pdf o α ad β that made them idepedet, ad with the idetical pdf s 10e 10α, 10e 10β What would the posterior pdf be? what would be the values of α ad β that maximize the posterior pdf? [Hit:

3 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY 3 The posterior pdf ca be put ito a form that looks just like the likelihood, but with altered values for x + j ad x j, so the same formulas you used to maximize the likelihood ca be re-used] With this prior pdf, the sample pdf times the prior pdf becomes ( ) αβ e α( x+ j +10)+β (x j 10 α + β As a fuctio of α ad β, this is just the origial likelihood with S + ad S both icreased i absolute value by 10 Pluggig these modified values of S + ad S ito the formulas for the MLE s, we get α = , β = Sice the prior desity is mootoe decreasig away from zero, it is expected that the MLE s get pulled toward zero, but despite the rather strog priors, the estimates are chaged oly slightly The large sample makes the likelihood domiate ther prior eve though the prior probability of, eg, a β as large as the MLE is less tha

4 4 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY (2) We might also cosider a t distributio for the Bad Day o Wall Street data These data are available as a R data file bdwsrdata that ca be loaded ito R with the load() fuctio, or as a csv file that ca be loaded ito R with readcsv() or used i aother program If it is loaded by bdws <- load( bdwsrdata ), bdws$pctchg will be the percetage chage time series we are iterested i As displayed i class, the t pdf with ν degrees of freedom, locatio parameter µ, ad scale parameter σ, is give by p(x µ, σ, ν) = Γ((ν + 1))/2) Γ(ν/2)σ νπ ( ν ( ) ) x µ 2 (ν+1)/2 σ [Note: If you use the R built-i facilities for computig desities, cdf s, ad quatiles of distributios, you do t eed to make ay use of the expressio above for this problem set] The pdf of a iid sample from this distributio does ot have a sufficiet statistic The maximum likelihood values for the parameters of this distributio for the bdws$pctchg data are µ = , σ = , ν = (a) Make a ormal quatile-quatile plot (qqorm() does this i R) for the data, icludig a referece lie showig what the slope would be if the data were ormal The referece lie ca be produced with qqlie() i R Its default settigs simply calculate ad plot a straight lie through the two poits defied by the 25 ad 75 quatiles of the sample distributio ad referece distributio (which is by default ormal) (b) Make a quatile-quatile plot of the data agaist the maximum likelihood t distributio Commet o whether it looks better tha the ormal q-q plot, ad explai your coclusio This plot requires usig qqplot(), which requires that you specify the theoretical quatile fuctio to be used i the plot The R qt() fuctio produces quatiles of the t, but its oly parameter is the degrees of freedom ν To accout for the locatio ad scale parameters, you eed to give as the distributio argumet i qqlie fuctio(p) qt(p, df= )*sig + mu The call to qqplot() should have x = qt(ppoits(n), df= )*sig + mu, where N is the umber of observatios, legth(bdws$pctchg) The examples at the bottom of the R help page o qqplot may be helpful Here s the ormal qq plot, from qqorm(bdws$pctchg) followed by qqlie(bdw$pctchg)

5 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY 5 Normal Q Q Plot Sample Quatiles Theoretical Quatiles Here s the t qqplot The formula at the bottom shows how it was computed The default qqorm() ad qqplot() plot idividual poits, ot lies I used type="l" to make it a lie But this requires usig sort(bdws$pctchg) as the argumet rather tha bdws$pctchg itself, as otherwise the lies zigzag all over the place

6 6 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY sort(bdws$pctchg) qt(seq(05/n, 1, by = 1/N), df = ) * (c) [extra credit] Create a plot cotaiig the estimated smoothed pdf for the data obtaied with desity(), the t desity with maximum likelihood parameters for the sample, ad the ormal desity with maximum likelihood parameters for the data (ie, mea(bdws$pctchg) ad sd(bdwd$pctchg)) Use differet colors for the three lies This is extra credit because gettig these fuctios scaled ad shifted so they all itegrate to oe requires some care ad thought Note that if p(x) is the desity of x, p(y/σ)/σ is the desity of y = xσ Turs out this is ot that hard to set up I used this R code: plot(desity(bdws$pctchg)) lies(seq(-10, 10, legth=500), dt((seq(-10, 10, legth=500) )/ , df= )/ , col="red", lwd=3) The lwd=3 is to make the t desity plot a slightly fatter lie, so oe ca see that it lies almost perfectly o top of the smoothed sample pdf for the data

7 LIKELIHOOD, POSTERIORS, DIAGNOSING NON-NORMALITY 7 desitydefault(x = bdws$pctchg) Desity N = 7571 Badwidth = Oe fial ote The largest egative value of the variable is -2563, or a deviatio from µ of 2568 The probability of this big a deviatio from µ i the egative directio is less tha 1 i 100,000, uder our estimated t distributio But we have over 7,000 observatios It turs out that the probability of seeig a deviatio this big i a sample this size is about 07 So the occurrece of this big egative value is slightly surprisig, but, i cotrast with what would be implied by a ormal distributio, ot at all impossible