Violations of assumptions of

the CLRM
Multicollinearity
• Multicollinearity is a problem that arises from high
correlations among the independent variables used
in a multiple regression model.

• Technically, multicollinearity is caused by independent

variables in the regression model that contain common
information.
• In a very extreme case, two or more variables may be
perfectly correlated.

• The result of this would be that some variables are fully

explained by others and, thus, provide no additional
information.

• In most problems in finance, however, the independent

variables are not perfectly correlated but may be
correlated to a high degree.
• In general, due to multicollinearity, the standard errors
of the regression coefficients will be inflated.

• This renders the t-ratios of many independent variables

too small to indicate significance.

• This happens despite the fact that the regression model

itself is highly significant (from the F-test).
• However, all of the estimated regression coefficients are
insignificant at the 5% level of significance as judged by
the t-tests.

• This is an indication that the standard errors are

inflated due to MC.

• The coefficient of correlation between GDP and

consumption is 0.999.

• Thus, it seems that the problem of MC is due to the joint

appearance of these two variables.
 Methods of detection of MC

• High R-squared but few (or no) significant regression

coefficients.

• High pair-wise correlations among explanatory variables.

EViews procedure to get the VIF’s
To obtain the fitted regression model, click on:

Quick Estimate Equation…

In the Equation Estimation window, type:
imports c gdp stock_formation consumption
and then click on OK
To get the VIF’s, click on View in the equation window, select
Coefficient Diagnostics and then Variance Inflation Factors
We can see that the VIF’s (centered VIF) corresponding to GDP and
consumption are greater than 10.

This is an indication that these two variables are responsible for MC.
 Remedial measures

• To circumvent the problem of MC, some of the

possibilities are:

• Include additional observations maintaining the

original model so that a reduction in the correlation
among variables is attained.
• Drop one of the collinear variables

• Removing an explanatory variable that is responsible for

strong MC will surely solve the problem.

• However, this may not be acceptable if there are strong

theoretical reasons for including both variables in the
model (model misspecification)
• Consider the above example.

• Variance inflation factors indicated that the joint

appearance of GDP and Consumption has caused MC.

• Thus, one possibility would be dropping Consumption

from the regression model.