November 22, 2012

Tauchen and Hussey Numerical Integration

Numerical integration is often an important tool for solving forward looking dynamic models (i.e. models with rational expectations). There are lots of smart ways to approximate an integral such that computation does not become a major issue.  Tauchen and Hussey (1991) have a routine for approximating integrals using numerical quadrature that works very well in asset pricing models (among other things).

Here is my implementation of Martin Floden's matlab code for the routine.
Click here to download the script.

import scipy.stats as st
import scipy as sp

def tauchenhussey(N,mu,rho,sigma, baseSigma):
    Function tauchenhussey

    Purpose:    Finds a Markov chain whose sample paths
                approximate those of the AR(1) process
                    z(t+1) = (1-rho)*mu + rho * z(t) + eps(t+1)
                where eps are normal with stddev sigma

    Format:     {Z, Zprob} = TauchenHussey(N,mu,rho,sigma,m)

    Input:      N         scalar, number of nodes for Z
            mu        scalar, unconditional mean of process
            rho       scalar
            sigma     scalar, std. dev. of epsilons
            baseSigma scalar, std. dev. used to calculate Gaussian
            quadrature weights and nodes, i.e. to build the
            grid. I recommend that you use
                        baseSigma = w*sigma +(1-w)*sigmaZ where sigmaZ = sigma/sqrt(1-rho^2),
                and w = 0.5 + rho/4. Tauchen & Hussey recommend
                baseSigma = sigma, and also mention baseSigma = sigmaZ.

    Output:     Z       N*1 vector, nodes for Z
                Zprob   N*N matrix, transition probabilities

    Author:     Benjamin Tengelsen, Carnegie Mellon University (python)
                Martin Floden, Stockholm School of Economics (original)
                January 2007 (updated August 2007)

    This procedure is an implementation of Tauchen and Hussey's
    algorithm, Econometrica (1991, Vol. 59(2), pp. 371-396)
    Z     = sp.zeros((N,1))
    Zprob = sp.zeros((N,N))
    [Z,w] = gaussnorm(N,mu,baseSigma**2)
    for i in range(N):
        for j in range(N):
            EZprime    = (1-rho)*mu + rho*Z[i]
            Zprob[i,j] = w[j] * st.norm.pdf(Z[j],EZprime,sigma) / st.norm.pdf(Z[j],mu,baseSigma)
    for i in range(N):
        Zprob[i,:] = Zprob[i,:] / sum(Zprob[i,:])
    return Z.T,Zprob

def gaussnorm(n,mu,s2):
    Find Gaussian nodes and weights for the normal distribution
    n  = # nodes
    mu = mean
    s2 = variance
    [x0,w0] = gausshermite(n)
    x = x0*sp.sqrt(2.*s2) + mu
    print s2,mu
    print x
    w = w0/sp.sqrt(sp.pi)
    return [x,w]

def gausshermite(n):
    Gauss Hermite nodes and weights following 'Numerical Recipes for C' 

    MAXIT = 10
    EPS   = 3e-14
    PIM4  = 0.7511255444649425

    x = sp.zeros((n,1))
    w = sp.zeros((n,1))

    m = int((n+1)/2)
    for i in range(m):
        if i == 0:
            z = sp.sqrt((2.*n+1)-1.85575*(2.*n+1)**(-0.16667))
        elif i == 1:
            z = z - 1.14*(n**0.426)/z
        elif i == 2:
            z = 1.86*z - 0.86*x[0]
        elif i == 3:
            z = 1.91*z - 0.91*x[1]
            z = 2*z - x[i-1]
        for iter in range(MAXIT):
            p1 = PIM4
            p2 = 0.
            for j in range(n):
                p3 = p2
                p2 = p1
                p1 = z*sp.sqrt(2./(j+1))*p2 - sp.sqrt(float(j)/(j+1))*p3
            pp = sp.sqrt(2.*n)*p2
            z1 = z
            z = z1 - p1/pp
            if sp.absolute(z-z1) <= EPS:
        if iter>MAXIT:
            error('too many iterations'), end
        x[i,0]     = z
        x[n-i-1,0] = -z
        w[i,0]     = 2./pp/pp
        w[n-i-1,0] = w[i]
    x = x[::-1]
    return [x,w]

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