SPECIFICATION TESTS

Anum Hameed
1121-MSBF-20
Applied Financial Econometrics
SPECIFICATION TESTS

• If a strong instrumental variable is available, the IV

estimator is consistent and approximately normally
distributed in large samples.

• If we use a weak instrument, or an instrument that is

invalid in the sense that it is not uncorrelated with the
regression error, then IV estimation can be as bad as,
or worse than, using the OLS estimator.
HAUSMAN TEST
 The Hausman test (also called the Durbin-Wu-
Hausman test) is used to check whether an estimate
for an unknown parameter is consistent or not.
 It is also applied in the context of linear regression to
decide whether to choose a fixed effect model or a
random effect model.
THE HAUSMAN TEST FOR
ENDOGENEITY
 The question we address in this section is how to test
for the presence of a correlation between an
explanatory variable and the error term, so that we can
use the appropriate estimation procedure.
 If the null hypothesis is true, both the OLS estimator b
and the instrumental variables estimator β̂ are
consistent.
CONT…….
 Thus, in large samples the difference between
them converges to zero. That is, q = ( b − β̂ ) → 0.
Naturally, if the null hypothesis is true, use the
more efficient estimator, which is the least squares
estimator.
 If the null hypothesis is false, the OLS estimator is
not consistent, and the instrumental variables
estimator is consistent. Consequently, the
difference between them does not converge to zero
in large samples.
THE LOGIC OF THE HAUSMAN
TEST
 We presented the Hausman test for whether or not an
explanatory variable is endogenous using an artificial
regression. Let us explore how this test works. The
simple regression model is y = β1 + β2x + e (10.32) If
x is correlated with the error term e, then x is
endogenous and the OLS estimator is biased and
inconsistent. An instrumental variable z must be
correlated with x but uncorrelated with e in order to be
valid. A correlation between z and x implies that there
is a linear association between them. This means that
we can describe their relationship as a regression x =
γ1 + θ1z + v
CONT………
 A correlation between z and x implies that
there is a linear association between them. This
means that we can describe their relationship as
a regression
 x = γ1 + θ1z + v
TESTING INSTRUMENT
VALIDITY
 A valid instrument z must be contemporaneously
uncorrelated with the regression error term, so that
cov( zi , ei ) = 0.
 If this condition fails then the resulting moment
condition, like (10.16), is invalid and the IV estimator
will not be consistent.
 In order to compute the IV estimator for an equation
with B possibly endogenous variables, we must have at
least B instruments. The validity of this minimum
number of required instruments cannot be tested.
CONT….
 If all the instruments are valid, then we would expect
all the IV estimates to be similar. Rather than do this,
there is a test of the validity of the surplus moment
conditions that is easier to compute.
CONT….

 THANK YOU