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CHAPTER 11 Cointegration and State Space Models n this chapter, we introduce the concepts of cointegrated processes and Istate space models, as well as the relative estimation methods. State space models were introduced in the engineering literature in the 1960s especially through the work of Rudolf E. Kalman. Cointegration analy- sis is a more recent econometric tool. The first articles to introduce coin- tegrated models were penned by Engle and Granger in the second half of the 1980s. Though vector autoregressive (VAR) processes and state space mod- els are equivalent representations of the same processes, deeper insight into the relationship between state space models and cointegration was gained more recently when it was understood that cointegration implies a reduced number of common stochastic trends. The idea behind cointe- gration that there are feedback mechanisms that force processes to stay close together is therefore intimately related to the idea that the behav- ior of large sets of processes is driven by the dynamics of a smaller num- ber of variables. COINTEGRATION Cointegration is one of the key concepts of modern econometrics. Let’s start by giving an intuitive explanation of cointegration and its proper- ties. Two or more processes are said to be cointegrated if they stay close to each other even if they “drift about” as individual processes. A color- ful illustration is that of the drunken man and his dog: Both stumble about aimlessly but never drift too far apart. Cointegration is an impor- 373 374 FINANCIAL ECONOMETRICS tant concept both for economics and financial modeling. It im