Fully modified estimation of cointegrating vectors via var prewhitening: A simulation study

Abstract

In this paper we investigate, by simulation methods, the finite samples properties of the Fully Modified Least Squares (FMLS) estimator of cointegrating vectors when the long run covariance matrix is estimated via VAR prewhitening. We compare this estimator to the FMLS estimator based on an automatic or a fixed bandwidth kernel estimator of the long run covariance matrix. By and large, FMLS estimator based on VAR prewhitening perform better than FMLS based on fixed bandwidth or automatic bandwidth, with the latter behaving almost in the same way in finite samples. More importantly, the empirical distribution of a Wald test statistic built from VAR prewhitened FMLS is closer to the asymptoticχ2 distribution than those obtained from alternative kernel estimators. Thus, our findings strongly favor the use of VAR prewhitening in the FM correction of the OLS estimator.