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HOW HETROSKEDASTICITY CAN BE
DETECTED
Heteroskedasticity is a systematic pattern in the errors where the variances of the errors are not
constant. The word Hetero means different or unequal and is the opposite of Homo which
means same or equal. Word Skedastic means spread or scatter. Hence Homoskedasticity
means equal spread and Heteroskedasticity means unequal spread.
Assumption 5 of the CLRM states that the disturbances should have a constant (equal) variance
independent of t:
Var(ut)=σ2
Therefore, having an equal variance means that the disturbances are homoskedastic. If the
homoskedasticity assumption is violated then
Var(ut)=σt2
Where the only difference is the subscript t, attached to the σt2, which means that the variance
can change for every different observation in the sample t=1, 2, 3, 4, …………….., n.
CONSEQUENCES OF
HETROSKEDASTICITY
1. The OLS estimators are still unbiased and consistent. This is because none of the
explanatory variables is correlated with the error term. So a correctly specified equation
will give us values of estimated coefficient which are very close to the real parameters.
2. Affects the distribution of the estimated coefficients increasing the variances of the
distributions and therefore making the OLS estimators inefficient.
INFORMAL METHOD
AS
6. White’s Test
Step 3: Compute LM=nR2, where n and R2 are from the auxiliary regression.
Step 4: If LM-stat>χ2p-1 critical reject the null and conclude that there is significant evidence of
heteroskedasticity
2) The Glesjer LM Test
|^ut|=a 1 +a 2 Z 2t +a 3 Z 3 t +. . .+a p Z pt +v t
Step 2: Run the following auxiliary regression:
Step 3: Compute LM=nR2, where n and R2 are from the auxiliary regression.
Step 4: If LM-stat>χ2p-1 critical reject the null and conclude that there is significant evidence of
heteroskedasticity
Step 3: Compute LM=nR2, where n and R2 are from the auxiliary regression.
Step 4: If LM-stat>χ2p-1 critical reject the null and conclude that there is significant evidence of
heteroskedasticity
2
ln { u^ t =a1 +a2 ln Z 2t +a3 ln Z 3 t +. . .+a p ln Z pt +v t ¿
Step 2: Run the following auxiliary regression:
Step 3: Compute LM=nR2, where n and R2 are from the auxiliary regression.
Step 4: If LM-stat>χ2p-1 critical reject the null and conclude that there is significant evidence of
heteroskedasticity
5) The Engle’s ARCH Test
Engle introduced a new concept allowing for hetero-skedasticity to occur in the variance of the
error terms, rather than in the error terms themselves.
The key idea is that the variance of ut depends on the size of the squarred error term lagged
one period u2t-1 for the first order model or:
Var(ut)=γ1+γ2u2t-1
Var(ut)=γ1+γ2u2t-1+…+ γpu2t-p
Step 2: Regress the squared residuals to a constant and lagged terms of squared residuals, the
number of lags will be determined by the hypothesized order of ARCH effects.
Step 3: Compute the LM statistic = (n-ρ)R2 from the LM model and compare it with the chi-
square critical value.
Step 4: Conclude
Step 1: Identify one variable that is closely related to the variance of the disturbances, and order
(rank) the observations of this variable in descending order (starting with the highest and going
to the lowest).
Step 2: Split the ordered sample into two equally sized sub-samples by omitting c central
observations, so that the two samples will contain ½(n-c) observations.
Step 3:Run and OLS regression of Y on the X variable that you have used in step 1 for each
sub-sample and obtain the RSS for each equation.
Step 4: Caclulate the F-stat=RSS1/RSS2, where RSS1 is the RSS with the largest value.
Step 3: Compute LM=nR2, where n and R2 are from the auxiliary regression.
Step 4: If LM-stat>χ2p-1 critical reject the null and conclude that there is significant evidence of
heteroskedasticity