Scribd
Upload
20 views

55

Chapter 11 discusses heteroscedasticity, which occurs when the variance of error terms in a regression model is nonconstant, violating the assumption of homoscedasticity. It outlines various causes of heteroscedasticity, such as learning effects, income variability, and data collection improvements, and explains the consequences of using ordinary least squares (OLS) estimation in its presence. The chapter also presents detection methods and remedial measures, including the Method of Weighted Least Squares and White heteroskedasticity consistent standard errors.

Uploaded by

l226451
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
20 views

55

Chapter 11 discusses heteroscedasticity, which occurs when the variance of error terms in a regression model is nonconstant, violating the assumption of homoscedasticity. It outlines various causes of heteroscedasticity, such as learning effects, income variability, and data collection improvements, and explains the consequences of using ordinary least squares (OLS) estimation in its presence. The chapter also presents detection methods and remedial measures, including the Method of Weighted Least Squares and White heteroskedasticity consistent standard errors.

Uploaded by

l226451
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 22

Chapter 11

Heteroscedasticity: What
Happens If the Error
Variance Is Nonconstant?
Dr. Muhammad Sabeeh Iqbal
The Nature of Heteroscedasticity
• One of the important assumptions of the
classical linear regression model is that the
variance of each disturbance term ui ,
conditional on the chosen values of the
explanatory variables, is some constant
number equal to 2.
• This is the assumption of homoscedasticity,
or equal (homo) spread (scedasticity), that is,
equal variance.
Reasons
• There are several reasons why the variances of ui may be variable, some of which are
as follows.
• Following the error-learning models, as people learn, their errors of behavior become
smaller over time or the number of errors becomes more consistent. For example the
number of typing errors made in a given time period on a test to the hours put in
typing practice.
• As incomes grow, people have more discretionary income. Similarly, companies with
larger profits are generally expected to show greater variability in their dividend
policies than companies with lower profits.
• As data collecting techniques improve, variance is likely to decrease. Thus, banks that
have sophisticated data processing equipment are likely to commit fewer errors in the
monthly or quarterly statements of their customers than banks without such facilities.
• Heteroscedasticity can also arise as a result of the presence of outliers.
• Another source of heteroscedasticity arises from violating Assumption 9 of the classical
linear regression model (CLRM), namely, that the regression model is correctly
specified.
Reasons
• Another source of heteroscedasticity arises from violating Assumption
9 of the classical linear regression model (CLRM), namely, that the
regression model is correctly specified.
• Another source of heteroscedasticity is skewness in the distribution of
one or more regressors included in the model. Examples are economic
variables such as income, wealth, and education. It is well known that
the distribution of income and wealth in most societies is uneven, with
the bulk of the income and wealth being owned by a few at the top.
• Other sources of heteroscedasticity: As David Hendry notes,
heteroscedasticity can also arise because of (1) incorrect data
transformation (e.g., ratio or first difference transformations) and (2)
incorrect functional form (e.g., linear versus log–linear models)
Granted that it is still linear
unbiased and consistent, is it
“efficient” or “best”?
The Method of Generalized Least
Squares (GLS) Can you minimize
the sum of
squared errors
after the
transformation?
The Method of Generalized Least
Squares (GLS)
Consequences of Using OLS in the
Presence
of Heteroscedasticity
• OLS Estimation Allowing for Heteroscedasticity OLS Estimation
Allowing for Heteroscedasticity
• Variances, t-test, confidence intervals
• OLS Estimation Disregarding Heteroscedasticity
• The bias arises from the fact that the conventional estimator
of sigma^2 is no longer an unbiased estimator of the latter
when heteroscedasticity is present. As a result, we can no
longer rely on the conventionally computed confidence
intervals and the conventionally employed t and F tests.
• In short, if we persist in using the usual testing procedures
despite heteroscedasticity, whatever conclusions we draw or
inferences we make may be very misleading.
Detection
• Informal Methods
• Nature of the Problem
• Graphical Method
Formal Methods
Remedial Measures
• As we have seen, heteroscedasticity does not destroy the unbiasedness
and consistency properties of the OLS estimators, but they are no
longer efficient, not even asymptotically (i.e., large sample size).
• This lack of efficiency makes the usual hypothesis-testing procedure
of dubious value. Therefore, remedial measures may be called for.
• The Method of Weighted Least Squares
• White Heteroskedasticity consistent standard errors.

You might also like