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Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Review: Random Variables,
Sampling, Estimation, and
Inference

© Christopher Dougherty, 2016. All rights reserved.

 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2


We have seen that the variance of a random variable X is given by the expression above.

1
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

Given a sample of n observations, the usual estimator of the variance is the sum of the
squared deviations around the sample mean divided by n – 1, typically denoted ˆ X .
2

2
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

Since the variance is the expected value of the squared deviation of X about its mean, it
makes intuitive sense to use the average of the sample squared deviations as an estimator.
But why divide by n – 1 rather than by n?
3
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

The reason is that the sample mean is by definition in the middle of the sample, while the
unknown population mean is not, except by coincidence.

4
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

As a consequence, the sum of the squared deviations from the sample mean tends to be
slightly smaller than the sum of the squared deviations from the population mean.

5
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

Hence a simple average of the squared sample deviations is a downwards biased estimator
of the variance. However, the bias can be shown to be a factor of (n – 1)/n. Thus one can
allow for the bias by dividing the sum of the squared deviations by n – 1 instead of n.
6
 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

Variance 
var X    X2  E  X   X 
2

1 n
  
2
Estimator ˆ 
2
X  X
X
n  1 i 1 i

Covariance cov X , Y    XY  E   X   X  Y  Y  

1 n
Estimator ˆ XY  
n  1 i 1
 X i  X   Yi  Y 

A similar adjustment has to be made when estimating a covariance. For two random variables X
and Y an unbiased estimator of the covariance sXY is given by the sum of the products of the
deviations around the sample means divided by n – 1.
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 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

 XY
Correlation  XY 
 X2  Y2

The population correlation coefficient rXY for two variables X and Y is defined to be their
covariance divided by the square root of the product of their variances.

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 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

 XY
Correlation  XY 
 X2  Y2

1
ˆ XY n1
  X  X   Y Y 
Estimator ˆ XY  
ˆ X2 ˆ Y2 1 1
     
2 2
X  X Y  Y
n1 n1


  X  X   Y Y 
   
2 2
X  X Y  Y

The sample correlation coefficient, rXY, is obtained from this by replacing the covariance
and variances by their estimators.

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 ESTIMATORS OF VARIANCE, COVARIANCE, AND CORRELATION

 XY
Correlation  XY 
 X2  Y2

1
ˆ XY n1
  X  X   Y Y 
Estimator ˆ XY  
ˆ X2 ˆ Y2 1 1
     
2 2
X  X Y  Y
n1 n1


  X  X   Y Y 
   
2 2
X  X Y  Y

The 1/(n – 1) terms in the numerator and the denominator cancel and one is left with a
straightforward expression.

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Copyright Christopher Dougherty 2016.

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Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
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2016.04.13