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Heteroskedasticity

1) Define heteroscedasticity and give examples of situations where heteroscedasticity is likely to


exist;
Heteroscedasticity refers to data with unequal variability (scatter) across a set of predictor
variables. In other words, variances for all observations are not the same, hence it is a violation
of one of the Gauss Markov assumptions.

2) Explain the consequences of heteroscedasticity for the OLS estimator


OLS estimator will still be unbiased but it is no longer efficient.

3) Examine residual plots for heteroscedasticity


Heteroscedastic data tends to follow a cone shape on a scatter graph.

4) Test for heteroscedasticity using the White, Goldfeld-Quandt, and Breusch-Pagan tests

Goldfield Quandt Breusch Pagan White General Test

5) Explain the use of Whites standard errors


The White Standard Error is vitally important in determining whether there is a true relationship
between Y and X in the population. If the Standard Errors are small, then the explanatory
variables are positively related to Y.

6) Explain how to obtain generalized least squares estimates by applying OLS to a transformed
model
The generalized least square estimates is obtained by dividing the regression

Autocorrelation
1) Dene autocorrelation and give examples of situations where autocorrelation is likely to exist
Auto correlation is often encountered in studies involving time series analysis. Violation often
occurs in time series data because the error in time t for an observation will be correlated to the
error for some observation in the past

2) Explain the consequences of autocorrelation for the OLS estimator


When autocorrelation occurs (violation of MR4), OLS is still unbiased and consistent BUT it will
be inefficient. OLS can still be used.

3) Examine residual plots and correlograms for autocorrelation


If the visual bar touches the limit then autocorrelation exists.

4) Test for autocorrelation using DW and LM tests;

Breush- Godfrey (LM test) Durbin Watson Test

5) Explain how to obtain generalised least squares estimates by applying OLS to a transformed
model
We need to adjust the way we compute standard errors via Eviews Heteroskedasticity and
Autocorrelation (HAC) feature. Heteroscedasticity-consistent standard errors are used to allow
the fitting of a model that does contain heteroscedastic residuals.

6) Explain how to estimate a model with rst-order autoregressive errors using nonlinear least
squares.

Endogeneity
1) Dene endogeneity and give examples of situations where it is likely to arise;
Endogeneity is a problem that occurs when an explanatory variable is correlated with the
error term. Reasons behind endogeneity could be omitted variables, errors in variables or even
simultaneous equations. Omitted variables are when potential explanatory variables that was
supposed to be included in the model was instead included in the error term.

2) Explain the consequences of endogeneity for the OLS estimator


OLS is biased and inconsistent when endogeneity occurs.

3) Test for endogeneity using a Hausman test;

4) Explain how to obtain consistent estimates of the unknown parameters using the instrumental
variables (IV) estimator;
If we detect endogeneity, the fix is to use the TSLS method on Eviews where we have to obtain
some instrumental variables (zi) to include in the regression. Valid IV should be:
Instrumental Relevance
Cov(zi,xi) 0
Instrumental Variable is correlated with the Explanatory variable, xi
Instrumental Exogeneity
Cov(zi,ei) 0
No correlation between the instrumental variable and the error term

Strong Instruments Weak Instruments


Instruments that are highly correlated Instruments that are weakly correlated
with the endogenous explanatory with the endogenous explanatory
variables variables

Assessing Validity Test (Over-Identifying Restriction)


An instrument is only valid if it is uncorrelated with the error term. An instrument can be
stronger or weaker in the sense of being correlated to the explanatory variable, BUT it must be
uncorrelated with the error term. To assess this, carry out validity test:

Hypothesis
H0: The instrumental variables are uncorrelated
with the error term
H1: Not H0

Test Statistic
N x R2 > X crit then reject H0

Conclusion
Reject the null hypothesis. Hence, the instrumental
Variables is correlated with the error terms. Thus,
They are not valid instruments.

5) Test the strength of the available instruments in the case where there is only one endogenous
variable;

Hypothesis
H0 : Cov (x,z)=0 / the coefficients of the instrumental are zero
H1: Not H0

Decision
If F>10: IV is strong
If F<10: IV is weak