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HETEROSKEDASTICITY

HETEROSKEDASTICITY

Heteroskedasticity arises when the error term of a

regression equation does not have a constant

variance:

y Var(e

i

) ı

2

.

That is, the error term can VARY with a change in one of

the explanatory variables.

y For example, household expenditure on food will likely be

heteroskedastic because expenditure on food will rise with

income.

It is most likely ± but not limited to ± to appearing in

regressions taken from CROSS-SECTIONAL DATA.

CONSEQUENCES:

y The OLS estimator is NO LONGER BLUE:

It is still LINEAR and UNBIASED but is no longer BEST.

y The Estimated Standard Errors are no longer correct.

Therefore hypothesis testing may give misleading results.

MATHEMATICALLY

The maths behind the

consequences are shown to the

side.

Normally, the variance for the

OLS estimator ǃhat is given by

the top equation.

However, because the variance

isn·t constant, the variance is

given by the bottom equation:

The variance term now

varies for all ¶i·, and is

multiplied by a non-

constant factor, as shown.

Hence, the reason why we can·t

trust OLS standard errors:

y We would be assuming the top

equation for the variance,

which is wrong, rather than the

bottom.

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CORRECTING FOR HETEROSKED. I

To still be able to use OLS

estimation and retrieve reliable

estimated standard errors, we can

calculate WHITE·S

HETEROSKEDASTICITY-

CONSISTENT ERRORS.

These are calculated by simply

substituting the variance term

for the ¶ith· residual term.

To calculate the residual term, run

the regression:

y Y = B1 + B2Xi + ei

Then retrieve the residual errors

(the distance from the data points

to the FITTED line):

y Residual ¶i· = yi ² b1 ² b2xi

However:

y This method allows us to use

hypothesis testing...

y BUT is still not the BEST

method of estimation.

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CORRECTING FOR HETEROSKED II

GENERALIZED LEAST SQUARES:

If there is Heterosked, we may impose an

assumption to make it easier to deal

with.

For example, assume that in the model:

y Y = B1 + B2 X + E

That Y is expenditure on food and X is

income.

We suspect that X is the explanatory

variable driving heterosked in the model.

Therefore, we can model the variance of

the model as being dependent on X ²

shown in the top equation.

Hence, if we work backwards ² as shown

² we can calculate that we have to divide

all the terms by the SQUARE ROOT of X.

We then have a constant variance.

HOWEVER:

NO LONGER A CONSTANT TERM.

This method is called the Weighted

Least Squares Estimator.

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F F

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W

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DIFFERENT TYPES OF HETEROSKED

What we have been discussing up to now is

PROPORTIONAL HETEROSKEDASTICITY.

There is another type ² PARTITION

HETEROSKEDASTICITY.

The former is where the variance of the error

term scales proportionally with one or more of

the variables.

The latter is a more discrete affair ² consider the

price of tea in China and the UK. If the variance

differs in the two areas, then we have partition

heterosked.

To fix this, simply WEIGHT BY THE

RESPECTIVE VARIANCE OF THAT AREA.

DETECTING HETEROSKED I

FOUR main ways to detect Heterosked in a

regression:

y Residual Plots:

Should see a ¶fanning· of residuals in a residual plot ²

homoskedasticity would show up as all residuals being an even

distance from the origin/fitted line.

y Goldfeld ² Quandt Test

Specifically designed for Partitioned heterosked.

Uses an F distribution and a test statistic of:

Where ¶K· is the number of explanatory variables in the model;

usually will be the same for both sub samples.

Will test the restriction that the true population variance

(the denominators of both ratios) are EQUAL: variance of

China = variance of UK.

Hence, the statistic is a ratio of the two ESTIMATED STD.

ERRORS.

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UK UK China China

K N K N

UK UK

China China

F F

=

,

2 2

2 2

~

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Ö

W W

W W

DETECTING HETEROSKED II

y Lagrange Mulitplier / Breusch-Pagan

It is a LARGE SAMPLE test which uses the CHI-SQUARED

distribution.

It·s also devilishly simple to calculate:

LM = N * R

2

~ ǘ

2

(

K-1

)

Where R

2

is the R

2

¶goodness of fit· statistic gained from running an

OLS regression, and K-1 is the number of explanatory variables.

Also comes in an F ² test form, but no need to go into it.

It works by testing the variance function:

Var(yi) = h(a

1

+ a

2

z

2

+...a

K

z

K

)

Where the ¶z· terms are the variables we think are affecting heterosked

on the model. The Null hypothesis is that all Zi = 0, leaving just a1 ² a

constant.

y The White Test

The problem with the LM/B-P test is that it doesn·t specify what ¶Zi·

may be in the case that the alternative hypothesis (all z aren·t 0,

there is heterosked.) proves true.

The White test specifies that each ¶z· term is either an explanatory

variable OR a square of an explanatory variable, OR a cross product of

two explanatory variables.

It·s the same Chi squared/F test as before though.

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