Quantitative Techniques

Topic 7
Heteroscedasticity

GHJ (Ch. 11)

1
 Summary

The Nature of Heteroscedasticity

OLS Estimation in the presence of
Heteroscedasticity
Consequences of Heteroscedasticity
Detection of Heteroscedasticity
Remedial Measures

2
The Nature of Heteroscedasticity
Heteroscedasticity is a systematic pattern in the errors
where the variances of the errors are not constant.

Ordinary least squares assumes that all observations are

equally reliable.

For efficiency (accurate estimation/prediction) reweight

observations to ensure equal error variance.

3
 Regression Model
Yi = 1 + 2Xi + ui

zero mean: E(ui) = 0

homoskedasticity: var(ui) = 2
nonautocorrelation: cov(ui, uj)= 0, i j

heteroskedasticity: var(ui) = i2
4
 Homoscedastic pattern of errors
consumption
Yi
.
. . . .
.. . . . .
. . . ...
... .. .
. . .. . .
. .. . . . .
..
. .
.

income Xi 5
 The Homoscedastic Case

f(Yi) Yi
on
i
pt
u m
s
co
n
.
.
.
.
X1 X2 X3 X4 Xi
income 6
 Heteroscedastic pattern of errors
consumption
.
Yi .
. .
. . . .
. .
. . . .
. . . . .
. . . .. . . .
. . . . . . .
. . . . .
. . . . .
. .

income Xi 7
 The Heteroscedastic Case

f(Yi)

Y
i
on
p ti
u m
s
.
on
c

. rich people

.
poor people

x1 x2 x3 income Xi 8
 Sources of Heteroscedasticity

1. Error learning model

2. Improvement in data collection
3. Outliers
4. Violating the assumption of no
specification bias
5. Incorrect data transformation

9
 Consequances of Heteroscedasticity

1. Least squares still linear and unbiased.

2. Least squares not efficient.

3. Usual formulas give incorrect standard errors for

least squares.

4. Confidence intervals and hypothesis tests based on

usual standard errors are wrong.
10
 Detecting Heteroscedasticity

Determine existence and nature of heteroscedasticity :

1. Residual Plots provide information on the

exact nature of heteroscedasticity to aid in
correcting for it.

11
 Detecting Heteroscedasticity
1. Park test
2. Glejser test
3. Whites general hetroscedasticity test

12
Detecting Heteroscedasticity: Park test

13
Whites general hetroscedasticity test

14
 Detecting Heteroscedasticity
4. Other tests
a) Spearmans rank correlation test
b) Goldfeld-Quandt test
c) Bartletts homogeniety of variable test
d) Peak test
e) Breusch-Pagan-Godfrey test
f) CUSUMSQ test
15
 Remedial Measures

1. The Method of Weighted Least Squares (WLS)

a) When i2 is known
b) When True i2 is not known

2. Whites Heteroscedasticity Corrected Standard

Errors Test

16
 Proportional Heteroscedasticity
Yi = 1 + 2Xi + ui

E(ui) = 0 var(ui) = i2 cov(ui, uj) = 0 i =j

The variance is
assumed to be
where i2 = 2 Xi proportional to
the value of Xi
17
 std.dev. proportional to Xi

Yi = 1 + 2Xi + ui
variance: var(ui) = i2 i2 = 2 Xi
standard deviation: i = Xi

To correct for heteroskedasticity divide the model by Xi

Yi 1 Xi ui
= 1 + 2 +
Xi Xi Xi Xi 18
 Yi 1 Xi ui
= 1 + 2 +
Xi Xi Xi Xi

Y*i = X*i1 + Xi2* + ui *

ui 1 1
*
var(ui ) = var( )= var(ui) = X 2 Xi
Xi Xi i

var(u*i ) = 2
ui is heteroscedastic, but u*i is homoscedastic.19
 Generalized Least Squares
These steps describe weighted least squares:
1. Decide which variable is proportional to the
heteroscedasticity (Xi in previous example).

2. Divide all terms in the original model by the square

root of that variable (divide by Xi ).

3. Run least squares on the transformed model which

* * *
has new Yi,Xi1and Xi2 variables
but no intercept. 20