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Lars Forsberg

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 1 / 103

Econometrics - Objectives and exam

Causes - Account for possible causes of heteroscedastic errors

Consequences - Know what heteroscedasticity does to the OLS

estimators (expectation and variance)

Detection - Account for an informal way to detect heteroscedasticity

(graphing)

Detection - Account for two tests for heteroscedasticity (Explain the

rationale behind them how they are done, and being able to perform

them when given all the relevant numbers

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 2 / 103

Econometrics - Objectives and exam

Remedy - Know what to do in the presence of heteroscedasticity

Explain the idea behind the Weighted Least Squares

Perform a WLS estimation using scalar algebra (transformation of the

regression equation and then OLS on the transformed equation)

Interpret the parameters of the original equation after doing WLS

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 3 / 103

Heteroscedasticity - Questions

Outline

How to spell it?

What - is Heteroscedasticity?

Causes - How does Heteroscedasticity come about?

Consequences - Is it a problem? In what way? When/in what

situations?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 4 / 103

Violation of OLS assumption - Heteroscedasticity -

Questions

Outline (cont.)

Detection - How do we know if there is a Heteroscedasticity

problem? (Informal methods, graphs)

Detection - How to test for Heteroscedasticity?

Remedial measures - What can we do about it?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 5 / 103

OLS - Assumptions - Violations - Heteroscedasticity -

How to spell it

Hetero-

sce-

dasti-

city

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 6 / 103

Heteroscedasticity - The word?

Constant- Variance

Equal- Variation

Same- Spread

Homo- Scedasticity

That is, constant variance of the Error Term (for the di¤erent values of

the regressor(s))

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 7 / 103

Heteroscedasticity - Animal?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 8 / 103

Heteroscedasticity - Animal?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 9 / 103

Heteroscedasticity - What?

observation

Yi = β1 + β2 X2,i + ui

The assumption (for OLS) is Homoscedasticity

Var (ui ) = σ2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 10 / 103

Heteroscedasticity - What?

recall assumption

E (ui ) = 0

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 11 / 103

Heteroscedasticity - What?

We can write

E ui2 = σ2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 12 / 103

Heteroscedasticity - What?

E ui2 = σ2i

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 13 / 103

Heteroscedasticity - Why?

When there are natural constraints on the variables,

Consumption - Income

Learning, e.g. number of errors vs time practicing

Improved data quality

Over time

Among the X’s

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 14 / 103

Heteroscedasticity - Why?

Outliers

Misspeci…cation of model

Skewness of variables

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 15 / 103

Heteroscedasticity - OLS Consequences

Should we worry?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 16 / 103

Heteroscedasticity - OLS Consequences

Should we worry?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 17 / 103

Heteroscedasticity - OLS Consequences - Expectation

still UNBIASED

That is, it is on average correct

The sampling distribution of the estimator b

βj is centered around

the true value βj

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 18 / 103

Heteroscedasticity - Consequences - Variance

it no longer have minimum variance

It is NOT BLUE

Not Best, in the sense it has minimun variance among, Linear

Unbiased Estimators

(It is only LUE - Note - Not standard notation...)

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 19 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

heterosceasticity, let us study the simplest case possible, let

Yi = β + ui

where

ui N 0, σ2

That is, a regression on only a constant.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 20 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

β, will be Ȳ , and that it is

unbiased, i.e.

E (Ȳ ) = β

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 21 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

2

V (Ȳ ) = E [Ȳ E (Ȳ )]

2

V (Ȳ ) = E (Ȳ β)

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 22 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

" #2

1 n

n i∑

V (Ȳ ) = E Yi β

=1

because

Yi = β + ui

we have " #2

1 n

n i∑

V (Ȳ ) = E ( β + ui ) β

=1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 23 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

(Again)

" ! #2

n

1

V (Ȳ ) = E

n ∑ ( β + ui ) β

i =1

" ! #2

n

1

V (Ȳ ) = E nβ + ∑ ui β

n i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 24 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

1

Multiply in n to get

2

nβ ∑ni=1 ui

V (Ȳ ) = E + β

n n

2

∑ni=1 ui

V (Ȳ ) = E β + β

n

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 25 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

(again)

2

∑ni=1 ui

V (Ȳ ) = E β + β

n

2

∑ni=1 ui

V (Ȳ ) = E

n

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 26 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

1

Take the constant n outside the square, and thus, square it, we have

" #2

2 n

1

V (Ȳ ) =

n

E ∑ ui

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 27 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

Studying

" #2

n

∑ ui

i =1

" #2

n

∑ ui = [u1 + u2 + ... + un ]2

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 28 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

Again

" #2

2 n

1

V (Ȳ ) =

n

E ∑ ui

i =1

" #

n n i 1

1

V (Ȳ ) =

n2

E ∑ ui2 + 2 ∑ ∑ ui uj

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 29 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

n i 1

2∑ ∑ ui uj = 2u2 u1 + 2u3 u1 + 2u3 u2 + 2u4 u1 + 2u4 u2 + 2u4 u3 + 2u5 u1 + ...

i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 30 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

" #

n n i 1

1

V (Ȳ ) = E ∑ ui2 + 2 ∑ ∑ ui uj

n2 i =1 i =2 j =1

" #

n n i 1

1

V (Ȳ ) =

n2 ∑E ui2 +2∑ ∑ E (ui uj )

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 31 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

Again study

n i 1

∑ ∑ E (ui uj )

i =2 j =1

We assume that

E (ui uj ) = 0, i 6= j

that is, we have...?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 32 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

So (again)

" #

n n i 1

1

V (Ȳ ) = 2

n ∑E ui2 + 2 ∑ ∑ E (ui uj )

i =1 i =2 j =1

" #

n n i 1

1

V (Ȳ ) = 2

n ∑E ui2 + 2 ∑ ∑0

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 33 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

That is

" #

n

1

V (Ȳ ) = 2

n ∑E ui2 + 0

i =1

" #

n

1

V (Ȳ ) = 2

n ∑E ui2

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 34 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

E ui2 = σ2i

Again

" #

n

1

V (Ȳ ) =

n2 ∑E ui2

i =1

n

1

V (Ȳ ) =

n2 ∑ σ2i

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 35 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

So in the model

Yi = β + ui

the variance of the sample mean (the OLS-estimator) is given by

∑n σ 2

V (Ȳ ) = V b

β = i =12 i

n

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 36 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

Note that if σ2i would be the same for all i that is, we would have

(homoscedasticity)

E ui2 = σ2

Then

" #

n

1

V (Ȳ ) =

n2 ∑E ui2

i =1

" #

n

1

V (Ȳ ) =

n2 ∑ σ2

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 37 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

n

∑c =n c

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 38 / 103

Heteroscedasticity - Consequences - Variance - Y-bar

So, we have

" #

n

1

V (Ȳ ) =

n2 ∑ σ2

i =1

1

= n σ2

n2

nσ2

=

n2

σ2

V (Ȳ ) =

n

which is the "usual" variance of the sample mean.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 39 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Yi = β1 + β2 Xi + ui

2

V β̂2 = E β̂2 E β̂2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 40 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Recall

∑nj=1 (Xi X̄ ) ui

β̂2 = β2 +

2

∑ (X X̄ )

and

E β̂2 = β2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 41 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

So

h 2

i

V β̂2 = E β̂2 E β̂2

20 12 3

∑nj=1 (Xi X̄ ) ui

V β̂2 = E 4 @ β2 + 2

β2 A 5

∑ (X X̄ )

20 12 3

n

4 @ ∑ j =1 i

(X X̄ ) ui

V β̂2 = E A 5

2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 42 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

2 3

2

6 ∑nj=1 (Xi X̄ ) ui 7

V β̂2 = E 4 5

2 2

∑ (X X̄ )

h i

2

E (∑ni=1 (Xi X̄ ) ui )

V β̂2 =

2 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 43 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

2 !2 3

n

Numerator = E 4 ∑ (Xi X̄ ) ui 5

i =1

" #

n n

Numerator = E ∑ ∑ (Xi X̄ ) (Xj X̄ ) ui uj

i =1 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 44 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

2 !2 3

n

Num. = E 4 ∑ (Xi X̄ ) ui 5

i =1

" #

n n

Num. = E ∑ ∑ (Xi X̄ ) (Xj X̄ ) ui uj

i =1 j =1

" ! !#

n n i 1

∑ (Xi ∑ ∑ 2 (Xi

2

Num. = E X̄ ) ui2 + X̄ ) (Xj X̄ ) ui uj

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 45 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Split up expecation

! !

n n i 1

∑ (Xi 2∑ ∑ (Xi

2

Num. = E X̄ ) ui2 +E X̄ ) (Xj X̄ ) ui uj

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 46 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

The Xi0 s are constants, so we can move them out of the expectation,

(again)

! !

n n i 1

∑ (Xi 2∑ ∑ (Xi

2

Num. = E X̄ ) ui2 +E X̄ ) (Xj X̄ ) ui uj

i =1 i =2 j =1

n n i 1

∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi

2

Num. = X̄ ) (Xj X̄ ) E (ui uj )

i =1 i =2 j =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 47 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Recall that

E (ui uj ) = 0, i 6= j

assuming ?, so

n n i 1

∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi

2

Num. = X̄ ) (Xj X̄ ) E (ui uj )

i =1 i =2 j =1

n n i 1

∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi

2

Num. = X̄ ) (Xj X̄ ) 0

i =1 i =2 j =1

n

∑ (Xi

2

Num. = X̄ ) E ui2 + 0

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 48 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

E ui2 = σ2i

so

n

∑ (Xi

2

Num. = X̄ ) E ui2

i =1

n

∑ (Xi

2

Num. = X̄ ) σ2i

i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 49 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

V β̂2 =

2 2

∑ (X X̄ )

" #

n n n

∑ ∑ (Xi ∑ (Xi

2

E X̄ ) (Xj X̄ ) ui uj = X̄ ) σ2i

i =1 j =1 i =1

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 50 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

2

∑ni=1 (Xi X̄ ) σ2i

V β̂2 =

2 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 51 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

heteroscedastiticy is given by

2

∑ni=1 (Xi X̄ ) σ2i

V β̂2 =

2 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 52 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Note that if

σ2i = σ2 for all i

that is, if we would have homoscedasticity, we have

2

∑ (Xi X̄ ) σ2i

V β̂2 =

2 2

∑ (X X̄ )

2

∑ (Xi X̄ ) σ2

V β̂2 =

2 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 53 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Recall

a 1

=

a2 a

here

∑ (Xi

2

a= X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 54 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

so

2

σ2 ∑ (Xi X̄ )

V β̂2 =

2 2

∑ (X X̄ )

σ2

V β̂2 =

2

∑ (X X̄ )

σ2

V β̂2 = 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 55 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Homo- Hetero-

Scedasticity Scedasticity

(A) (B)

2

σ2 ∑ni=1 (X i X̄ ) σ2i

V β̂2 = 2 V β̂2 = 2 2

∑ (X X̄ ) ( ∑ (X X̄ ) )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 56 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

in‡ates the variance, here there is no general result.

So if we use

σ2

V β̂2 = 2

∑ (X X̄ )

when we should use

2

∑ni=1 (Xi X̄ ) σ2i

V β̂2 =

2 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 57 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

2

∑ni=1 (Xi X̄ ) σ2i σ2

>

2 2 ∑ (X X̄ )

2

∑ (X X̄ )

or

2

∑ni=1 (Xi X̄ ) σ2i σ2

<

2 2 ∑ (X X̄ )

2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 58 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

following reasoning, introduce the (temporary) notation

2

∑ni=1 (Xi X̄ ) σ2i

VTRUE β̂2 =

2 2

∑ (X X̄ )

σ2

VFALSE β̂2 = 2

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 59 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

H0 : β j = 0

H1 : β j 6 = 0

Using

b

βj 0

zobs =

σ bβ

j

where s

σ2

σ bβ = 2

j

∑ (X X̄ )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 60 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

know σ2 , thus we use

b

βj 0

zobs =

σ bβ

j

since we assume that the error term is normal, and the estimator is a linear

estimator, thus also normal.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 61 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

Σb

ui2

b2 =

σ

n k

where, of course

bi = Yi

u b

β1 + b

β2 Xi ,2

in this case 2. Then we use

b

βj 0

tobs = tn k

b bβ

σ

j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 62 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

If we UNDER-estimate the true variance, that is

σ bβ to SMALL

j

+

b

βj

σ bβ to BIG

j

+

Reject H0 : βj = 0 to Often

+

Signi…cance to Often

that it actually is

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 63 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

On the other hand, If we OVER-estimate the true variance, that is

σ bβ to BIG

j

+

b

βj

σ bβ to SMALL

j

+

Never Reject H0 : βj = 0

+

Never Signi…cance

that it actually is

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 64 / 103

Heteroscedasticity - Consequences - Variance - Slope est.

estimate the variance when ignoring heteroscedasticity.

heteroscedastic robust standard errors.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 65 / 103

Heteroscedasticity - Detection - Graphs

Quick and dirty preliminary analysis: Just plot Y vs X

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 66 / 103

Heteroscedasticity - Detection - Tests

Parks test

Gleijser test

Goldfeldt-Quandt test (GQ-test)

Breusch-Pagan-Godfrey test (BPG-test)

White’s test

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 67 / 103

Heteroscedasticity - Detection - Tests - Parks test

Parks test:

σ2i = σ2 X2,i e v

β

bi2 = β1 + β2 ln (X2,i ) + vi

ln u

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 68 / 103

Heteroscedasticity - Detection - Tests - Gleiser test

Gleiser test:

jubi j = β1 + β2 X2,i + vi

or other functions of X2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 69 / 103

Heteroscedasticity - Detection - Tests - BPG test

BPG - Test: Idea

Regress

bi2

u

= β1 + β2 X2,i + β3 X3,i + ei

σ̂2

Test statistic

ExplSS

χ2

2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 70 / 103

Heteroscedasticity - Detection - Tests - White’s tests

Run regression of f (u ) on g (X )

White’s test:

u

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 71 / 103

Heteroscedasticity - Detection - Tests - White’s tests

To see if the residual variance increases with the increasing values of the

regressors, we do a

F test of

H0 : βj = 0, j > 1

H1 : At least one βj 6= 0 j = 2, ..., k

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 72 / 103

Heteroscedasticity - Detection - Tests - White’s tests

u

H0 : βj = 0, j > 1

H1 : At least one βj 6= 0 j = 2, ..., k

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 73 / 103

Heteroscedasticity - Detection - Tests - White’s tests

What regressors to include in the auxiliry regression

What functional form?

What regressors to square?

What, if any, crossproducts to include?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 74 / 103

Heteroscedasticity - Detection - Tests - Goldfeld-Quandt

σ2i = σ2 Xi2

Yi = β1 + β2 Xi + ui

2 Estimate the model on each part

3 Test using

RSS1 /df1

RSS2 /df2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 75 / 103

Heteroscedasticity - Detection - Tests - Properties - Size

White, White + cross terms, BPG, F and χ2 :

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 76 / 103

Heteroscedasticity - Detection - Tests - Properties - Power

Power comparison

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 77 / 103

Heteroscedasticity - Remedy

White’s consistent estimator

WLS (Weighted Least Squares)

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 78 / 103

Heteroscedasticity - Remedy - Whites HAC estimator

Idea: Use u

2

∑n (Xi X̄ ) u bi2

V\β̂2 = i =1

2 2

∑ (X X̄ )

use this estimate of the variance instead of the usual.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 79 / 103

Heteroscedasticity - Remedy - WLS

Without matrix algebra notation, hard to show exactly what is going on.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 80 / 103

Heteroscedasticity - Remedy - WLS

E ui2 = σ2i

some function of (some) X .

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 81 / 103

Heteroscedasticity - Remedy - WLS

σ2i = σ2 Xi2

σ2i = σ2 jXi j

p

σ2i = σ2 Xi

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 82 / 103

Heteroscedasticity - Remedy - WLS

V (ui ) = cσ2

get the standardized variable, say ui , to have variance σ2 ?

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 83 / 103

Heteroscedasticity - Remedy - WLS

Hint recall

V (aY ) = a2 V (Y )

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 84 / 103

Heteroscedasticity - Remedy - WLS

We try

ui

ui =p

c

then

u

V (ui ) = V pi

c

1

= p 2

V (ui )

c

1

= V (ui )

c

V (ui )

V (ui ) =

c

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 85 / 103

Heteroscedasticity - Remedy - WLS

Recall

V (ui ) = cσ2

so (again)

V (ui )

V (ui ) =

c

cσ2

=

c

V (ui ) = σ2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 86 / 103

Heteroscedasticity - Remedy - WLS

Yi = β1 + β2 Xi + ui

Assuming

σ2i = σ2 jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 87 / 103

Heteroscedasticity - Remedy - WLS

p

Do the transformation, that is divide by jXi j to get

Y 1 Xi ui

p i = β1 p + β2 p +p

jXi j jXi j jXi j jXi j

Yi = β1 Xi + β2 Xi + ui

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 88 / 103

Heteroscedasticity - Remedy - WLS

(again)

Yi = β1 Xi + β2 Xi + ui

study the "transformed" error term

ui

ui = p

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 89 / 103

Heteroscedasticity - Remedy - WLS

Expectation

!

u

E (ui ) = E p i

jXi j

1

= p E (ui )

jXi j

1

= p 0

jXi j

= 0

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 90 / 103

Heteroscedasticity - Remedy - WLS

= E (ui 0)2

V (ui ) = E (ui )2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 91 / 103

Heteroscedasticity - Remedy - WLS

Focus on E (ui )2

Replace

ui

ui = p

jXi j

and we get

!2

u

E (ui )2 = E p i

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 92 / 103

Heteroscedasticity - Remedy - WLS

h i

E (a ui )2 = E a2 (ui )2

= a2 E (ui )2

here

1

a=

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 93 / 103

Heteroscedasticity - Remedy - WLS

(again)

!2

u

E (ui )2 = E p i

jXi j

2 !2 3

1

E (ui )2 = E 4 p (ui )2 5

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 94 / 103

Heteroscedasticity - Remedy - WLS

1

E (ui )2 = p 2

E ui2

jXi j

1

= E ui2

jXi j

E ui2

E (ui )2 =

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 95 / 103

Heteroscedasticity - Remedy - WLS

We have heteroscedasticity, so

E ui2 = σ2i

That is (again)

E ui2

E (ui )2 =

jXi j

σ2i

E (ui )2 =

jXi j

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 96 / 103

Heteroscedasticity - Remedy - WLS

σ2i = σ2 jXi j

We have, (again)

σ2i

E (ui )2 =

jXi j

σ2 jXi j

E (ui )2 =

jXi j

E (ui )2 = σ2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 97 / 103

Heteroscedasticity - Remedy - WLS

Yi = β1 Xi + β2 Xi + ui

V (ui ) = σ2

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 98 / 103

Heteroscedasticity - Remedy - WLS

We started with

Yi = β1 + β2 Xi + ui

but we estimate

Yi = β1 Xi + β2 Xi + ui

How do we interpret β1 and β2 ?

Note that, in e¤ect, when tranforming the PRF, we transform the data -

not the parameters, so in terms of the original regression, we keep the

interpretation of the parameters.

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 99 / 103

Heteroscedasticity - Remedy - WLS

heterscedasticity, again, for the single linear regression

Yi = β1 + β2 Xi + ui

Assuming

σ2i = σ2 Xi2

given all Xi > 0

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 100 / 103

Heteroscedasticity - Remedy - WLS

Do

q the transformation, we divide the terms of the PFR by that is divide by

Xi2 = Xi to get

Yi 1 Xi ui

= β1 + β2 +

Xi Xi Xi Xi

Yi = β1 Xi + β2 + ui

Yi = β2 + β1 Xi + ui

It is straightforward to see that now Var (ui ) = σ2 , i.e. constant. We

have transformed away the heteroscedasticity

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 101 / 103

Heteroscedasticity - Remedy - WLS

Yi = β2 + β1 Xi + ui

β2 as the slope in the orginal regression

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 102 / 103

Heteroscedasticity - Remedy - WLS

What if we assume the wrong functional form?

If we assume the wrong functional form, we might induce even

"more" heteroscedasticity than we had to begin with, thus, causing

more damage than good.

So, if uncertain of what kind of functional form we have on the

Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 103 / 103

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