Durbin and Watson have suggested a test to detect the presence of autocorrelation which applies to small samples. However, the test is appropriate only for the first-order autoregressive scheme ($u_t = \rho u_{t-1} + \varepsilon_t$).

### Step by Step procedure for the Durbin-Watson Test

**Step 1: Null and Alternative Hypothesis**

The null hypothesis is $H_0:\rho=0$ (that is, $u$’s are not autocorrelated with a first-order scheme)

The alternative hypothesis is $H_1: \rho \ne 0$ (that is, $u$’s are autocorrelated with a first-order scheme)

**Step 2: Level of Significance**

Choose the appropriate level of significance, such as 5%, 1%, 10%, etc.

**Step 3: Test Statistics**

To test the null hypothesis, the Durbin-Watson Test statistic is

$$d = \frac{\sum\limits_{t=2}^n (u_t – u_{t-1})^2}{\sum\limits_{t=1}^n e_t^2}$$

The value of $d$ lies between 0 and 4, when $d=2$, then $\rho=0$. It means that $H_0:\rho=0$ is equivalent to testing $H_0:d=2$.

\begin{align*}

d&= \frac{\sum\limits_{t=2}^n (u_t – u_{t-1})^2}{\sum\limits_{t=1}^n u_t^2}\\

&=\frac{ \sum\limits_{t=2}^n (u_t^2 + u_{t-1}^2 – 2u_t u_{t-1} ) }{\sum\limits_{t=1}^n u_t^2} \\

&=\frac{ \sum\limits_{t=2}^n u_t^2 + \sum\limits_{t=2}^n u_{t-1}^2 – 2 \sum\limits_{t=2}^n u_t u_{t-1} }{\sum\limits_{t=1}^n u_t^2}

\end{align*}

Durbin-Watson Test Statistic is simply the ratio of the sum of squared differences in the successive residuals to the residual sum of squares. In the numerator, there will be $n-2$ observations because of lag values.

For large samples $\sum\limits_{t=2}^n u_t^2$, $\sum\limits_{t=2}^n u_{t-1}^2$ and $\sum\limits_{t=1}^n u_t^2$ are all approximately equal. Therefore,

\begin{align*}

d &\approx \frac{2 \sum u_t^2 – 1}{\sum u_{t-1}^2} – \frac{2 \sum_{t=2}^n u_tu_{t-1} }{ \sum u_{t-1}^2 }\\

& \approx 2 \left[ 1- \frac{\sum u_t u_{t-1} }{ \sum u_{t-1}^2 }\right]\\

\text{but }\,\,\, \hat{\rho} &= \frac{\sum u_t u_{t-1}}{\sum u_{t-1}^2}

\end{align*}

Therefore $d\approx 2(1-\hat{\rho})$

It is obvious that the values of $d$ lie between 0 and 4.

**Firstly: **If there is no autocorrelation $\hat{\rho}=$ then $d=2$, it means that from the sample data $d^*\approx 2$. We accept that there is no autocorrelation.

**Secondly: **If $\hat{\rho}=+1$, we have perfect positive autocorrelation. Therefore, if $2<d^* <4$ there is some degree of positive autocorrelation (which is stronger the higher for the higher value of $d^*$).

**Thirdly: **If $\hat{\rho}=-1, d=4$. We have perfect negative autocorrelation. Therefore, if $2<d^*<4$, there is some degree of negative autocorrelation (which is stronger for the higher value of $d^*$).

The next step is to use the sample residual ($u_t$’s) and compute the empirical value of the Durbin-Watson statistic $d^*$.

Finally, the empirical $d^*$ must be compared with the theoretical values of $d$, that is, the values of $d$ which define the critical region of the test.

The problem with this test is that the exact distribution of $d$ is not known. However, Durbin and Watson have established upper ($d_u$) and lower ($d_l$) limits for the significance level of $d$ which are appropriate to the hypothesis of zero first-order autocorrelation against the alternative hypothesis of positive first-order autocorrelation. Durbin and Watson have tabulated these upper and lower values at 5% and 1% level of significance.

**Critical Region of $d$ Durbin-Watson test**

- If $d^*<d_l$ we reject the null hypothesis of no autocorrelation and accept that there is positive autocorrelation of the first order.
- If $d^* >( 4-d_l)$ we reject the null hypothesis of no autocorrelation and accept that there is negative autocorrelation of the first order.
- If $d_u < d^* < (4-d_u)$ we accept the null hypothesis of no autocorrelation
- if $d_l < d^* < d_u$ or if $(4-d_u)<d^*<(4-d_l)$ the test is inconclusive.

**Assumptions underlying the $d$ Statistics**

- The regression model includes the intercept term. It is not present as in the case of the regression through the origin, it is essential to return the regression including the intercept term to obtain the RSS.
- The explanatory variables, $X$ are non-stochastic or fixed in repeated sampling.
- The disturbances $u_t$ are generated by the first-order autoregressive scheme: $u_t=\rho + u_{t-1} +\varepsilon_t$ (it cannot be used to detect higher-order autoregression schemes.
- The error term $u_t$ is assumed to be normally distributed.
- The regression model does not include the lagged values(s) of the dependent variable as one of the explanatory variables. The Durbin-Watson test is inappropriate to the model of this type $$Y_t=\beta_1 + \beta_2X_{2t} + \beta_3 X_{3t} + \cdots+ \beta_k X_{kt} + \gamma Y_{t-1}+u_t$$, where $Y_{t-1}$ is the one period lagged values of $Y$.
- There are no missing observations in the data.

**Limitations or Shortcomings of Durbin-Watson Test Statistics**

Durbin-Watson test has several shortcomings:

- The $d$ statistics is not an appropriate measure of autocorrelation if, among the explanatory variables, there are lagged values of the endogenous variables.
- Durbin-Watson test is inconclusive if the computed value lies between $d_l$ and $d_u$.
- It is inappropriate for testing higher-order serial correlation or for other forms of autocorrelation.

**An Asymptotic or Large Sample Test**

Under the null hypothesis that $\rho=0$ and assuming that the sample size $n$ is large, it can be shown that $\sqrt{n}\hat{\rho}$ follows the normal distribution with 0 mean and variance 1, i.e. asymptotically,

$$\sqrt{n}\,\, \hat{\rho} \sim N(0, 1)$$