07 Hetero212

Violation of constant variance of εi’s but they are
still independent.
V(ε ) = σ i i
2
COV (ε , ε i j ) = 0, ∀i ≠ j
σ 12 0 L 0 
 
0 σ 22 O M 
V(ε) = Σ = 

M O O 0
 2
 0 L 0 σ n 
(c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 1

The error term (ε) is said to be heteroscedastic.
What happened to OLS estimators?

• What is Heteroscedasticity? ==> OLS is still LUE but not BLUE.
==> Large sample properties ???
• Weighted Least Square (WLS) Weighted Least Square (WLS)
wiYi = β1wi X 1i + β 2 wi X 2i + ... + β K wi X Ki + wiε i
• Tests for Variance equation
Y i = β1 X 1i + β 2 X 2i + ... + β K X Ki + ν i
• Remedies where
1
• Generalized Heteroscedasticity wi =
σi
Y i = wiYi X ki = wi X ki , k = 1,..., K ν i = wiε i
(c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 2 (c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 4
Matrix form Explanatory variables
Y = Σ Y, X = Σ X, ν = Σ ε
1 1 1
• observation index i
− − −
2 2 2
 σ1 0 L 0 • some or all the X’s

 1 1  • conditional mean of Y given X
 0 σ2 O M
• variable Z’s not in the model
1
−
Σ =
2
M O O 0
  • lagged variables (to be discussed in
0 L 0

1
σn 

Time Series Analysis)
Note that Y = Xβ + ε is CLNRM and

ν is homoscedastic. Detection
V(ν ) = 1, ∀i = 1,..., n
• squared residual plots
i
V(ν) = I n
WLS estimator βˆ = XT X XT Y
−1
  • White’s Test
V(βˆ ) = XT X
−1


Note that, given Σ, the estimator β̂ is BLUE.

 • Other LM tests
Functional form of the variance equation must
• squared residuals against the suspected be assumed in most tests. For example,
explanatory variable (S) • Breusch-Pagan’s test assumes a linear
• test against only one variable at a time function of suspected variables
• functional forms, e.g., linear, log-lin, • Glesjer’s test sets the form of standard
deviation σi instead of the variance
log-log, quadratic, polynomial, • White’s test adds squared and cross terms
reciprocal, etc. to the variance equation of BP test.
εî2 • Harvey-Godfrey’s test assumes a log-lin or

Linear V (ε i ) = exp(γ 1 + γ 2 S 2i + γ 3 S3i + .. + γ P S Pi )
V (ε i ) = γ 1 + γ 2 Si Note that HG assures positive fitted variances
while others do not.
Si • Park test assumes double log form.
εî2 Reciprocal • Goldfeld-Quandt does not assume the form of
1
V (ε i ) = γ 1 + γ 2 the variance function. Instead, it checks for
or log-lin Si
equality of the variances between the high
ln(V (ε i )) = γ 1 + γ 2 S i
group and the low group using variance ratio
Si test(F-test). See text.
White’s General Heteroscedasticity Test Accept H0 ==> No heteroscedasticity
Concept: The variables that are suspected to If reject H0, no specific remedy can be done.
cause heteroscedasticity are the X’s, their Without any remedy, V(βˆ ) must be re-calculated
squared terms and their cross terms. since the old one is inconsistent (wrong). White’s
V(ε ) = γ + γ X + .. + γ X
i 1 2 2i K Ki
Heteroscedasticity Consistent Covariance is
+ γ 22 X 22i + γ 23 X 2i X 3i + .. + γ 2 K X 2i X Ki
T −1 
[ 
] [ ]
n
n
+ γ 33 X 32i + γ 34 X 3i X 4i + .. + γ 3 K X 3i X Ki V(βˆ ) = X X ∑ εî2 X iT X i  X T X
−1
n−k  i =1 
O
+ γ KK X Ki2 + ε i where Xi is the ith observation of X.
Run OLS on the auxiliary regression of the Feasible Generalized Least Squares (FGLS)
squared residuals and all the suspected
variables above. Assume X1i = 0 for all i. • Estimate the variance equation using
Perform the overall F-test or LM test for the auxiliary regression of squared residuals on
auxiliary regression run on the following ≠
the explanatory variables (for the variance
hypothesis. equation), e.g.,
H : γ 2 = γ 3 = ... = γ K = γ 22 = γ 23 = ... = γ 2 K = .... = γ KK = 0 1
0 εî2 = V (ε i ) + ξ i = γ 1 + γ 2 + ξi
H : γ 2 ≠ γ 3 ≠ ... ≠ γ K ≠ γ 22 ≠ γ 23 ≠ ... ≠ γ 2 K ≠ .... ≠ γ KK ≠ 0 Si
1 where ξ is the error term for the variance
EViews also provide a quick solution for
i
White’s test. equation

• Calculate the fitted value of squared Example 2 V(ε ) = σ (S ) 2 2
residuals or estimate V(εi) i i
εî2 = σ 2 (Si )2 + ξ i
V(ε ) = εˆ = γˆ + γˆ 1
i i
2
1 2
where σ 2 is a positive constant.
Si
1
• Use the weight w = i in WLS Apply WLS with w = 1 S i i
V(ε ) i
Note that V(νi)=σ 2 for all i=1,…,n
• FGLS is biased but consistent. ==> WLS estimator is unbiased. No FGLS
needed. (c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 19
Variance equation with single parameter, e.g., Violation of constant variance and/or independence of εi’s
Example 1 V(ε ) = σ S1 or εˆ = σ S1 + ξ 2 2 2 V(ε ) = σ i i
2
i i i
COV (ε i , ε j ) = σ ij ≠ 0 for some i, j
where σ 2 is a positive constant.
i i
 σ 12 σ 12 σ 1n 
Apply WLS with w = S i i 
σ σ 22
L
O M

V(ε ) = Σ =  12 
Note that V(νi)=σ 2 for all i=1,…,n  M

O O σ n −1 ,n 

==> WLS estimator is unbiased. No FGLS σ 1n L σ n −1 ,n σ n2 
needed The error term (ε) is said to be generalized heteroscedastic.

OLS or WLS estimators are still LUE but not If Σ is known up to a proportion,
BLUE.
Generalized Least Square (GLS) φ12 φ12 L φ1n 
 
Y = WY , X = WX , ν = W ε φ φ 2
O M
where W is a nxn symmetric matrix such that Σ = σ 2Ω = σ 2  12 2 
M O O φn −1,n 
 2 
Σ −1 = WW φ
 1n L φ n −1, n φ n 

where σ2 is unknown but Ω matrix is known.
Note that Y = Xβ + ν is CLNRM and

ν is homoscedastic. V(ν i ) = 1, ∀i = 1,..., n Choose the weighting matrix W such that
V(ν) = I n WW = Ω −1
GLS estimator βˆ = XT X XT Y
−1
  Define Y = WY , X = WX , ν = Wε
V(βˆ ) = XT X Note that Y = Xβ + ν is CLNRM and
−1
 
 
ν is homoscedastic or V(ν) = σ I n 2
Note that if V(ε) is known, W can be calculated.

==> GLS estimator is BLUE
So is β̂ . ==>the estimator β̂ is BLUE.
V(ε) is restricted in parameters. For example,
V(ε) = ΣΡΣ
σ 1 0 0
L 1 ρ12 L ρ1n 
  ρ M 
σ2 O M  1 O
Σ =  0 ,Ρ = 
12
M O O 0  M O O ρ n −1,n 
   
 0 L 0 σ n   ρ1n L ρ n −1,n 1 

07 Hetero212

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Violation of constant variance of εi’s but they are

(c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 1

What happened to OLS estimators?

 σ1 0 L 0 • some or all the X’s

Note that Y = Xβ + ε is CLNRM and

εˆi2 • Harvey-Godfrey’s test assumes a log-lin or

White’s test. equation

residuals or estimate V(εi) i i

needed The error term (ε) is said to be generalized heteroscedastic.

Note that Y = Xβ + ν is CLNRM and

Note that if V(ε) is known, W can be calculated.

(c) Pongsa Pornchaiwiseskul, Faculty of Economics, Chulalongkorn University 25

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