B2 - 1410 - Heteroscedasticity - 99 Slides PDF

Violation of OLS assumption - Heteroscedasticity
What, why, so what and what to do?
Lars Forsberg
Uppsala Uppsala University, Department of Statistics
October 22, 2014
Lars Forsberg (Uppsala University) 1410 - Hetero-sce-dasti-city October 22, 2014 1 / 103
Econometrics - Objectives and exam
Violations of assumptions - Heteroscedasticity:
What - Explain what is meant by heteroscedasticity

Causes - Account for possible causes of heteroscedastic errors
Consequences - Know what heteroscedasticity does to the OLS
estimators (expectation and variance)
Detection - Account for an informal way to detect heteroscedasticity
(graphing)
Detection - Account for two tests for heteroscedasticity (Explain the
rationale behind them how they are done, and being able to perform
them when given all the relevant numbers
Econometrics - Objectives and exam
Violations of assumptions - Heteroscedasticity:

Remedy - Know what to do in the presence of heteroscedasticity
Explain the idea behind the Weighted Least Squares
Perform a WLS estimation using scalar algebra (transformation of the
regression equation and then OLS on the transformed equation)
Interpret the parameters of the original equation after doing WLS
Heteroscedasticity - Questions
Outline
How to spell it?
What - is Heteroscedasticity?
Causes - How does Heteroscedasticity come about?
Consequences - Is it a problem? In what way? When/in what
situations?
Violation of OLS assumption - Heteroscedasticity -
Questions
Outline (cont.)
Detection - How do we know if there is a Heteroscedasticity
problem? (Informal methods, graphs)
Detection - How to test for Heteroscedasticity?
Remedial measures - What can we do about it?
OLS - Assumptions - Violations - Heteroscedasticity -
How to spell it
Hetero-
sce-
dasti-
city
Heteroscedasticity - The word?
The assumption here is Homo-Scedasticity
Constant- Variance
Equal- Variation
Same- Spread
Homo- Scedasticity
That is, constant variance of the Error Term (for the di¤erent values of
the regressor(s))
Heteroscedasticity - Animal?
Heteroscedasticity - Animal?
Heteroscedasticity - What?
To keep it simple, we have the single linear regression, for a arbitrary

observation
Yi = β1 + β2 X2,i + ui
The assumption (for OLS) is Homoscedasticity
Var (ui ) = σ2
Recall de…ntion of variance
Var (ui ) = E [ui E (ui )]2
recall assumption
E (ui ) = 0
We can write
Var (ui ) = E [ui 0]2
Var (ui ) = E ui2
So the assumption can be written
E ui2 = σ2
Note no i on the sigma-two.
If not homoscedasticity, then we have heteroscedasticity
E ui2 = σ2i
i.e. it depends on i where the i refers to the di¤erent Xi
Remember the income - consumption example.
Heteroscedasticity - Why?
Why do we have heteroscedasticity?

When there are natural constraints on the variables,
Consumption - Income
Learning, e.g. number of errors vs time practicing
Improved data quality
Over time
Among the X’s
Heteroscedasticity - Why?
Why do we have heteroscedasticity? (cont)

Outliers
Misspeci…cation of model
Skewness of variables
Heteroscedasticity - OLS Consequences
Should we worry?
Heteroscedasticity - OLS Consequences
Should we worry?
Heteroscedasticity - OLS Consequences - Expectation
OLS: In the presence of Heteroscedastiticy, the OLS-estimator is

still UNBIASED
That is, it is on average correct
The sampling distribution of the estimator b
βj is centered around
the true value βj
Heteroscedasticity - Consequences - Variance
Even though the OLS-estimator is unbiased

it no longer have minimum variance
It is NOT BLUE
Not Best, in the sense it has minimun variance among, Linear
Unbiased Estimators
(It is only LUE - Note - Not standard notation...)
Heteroscedasticity - Consequences - Variance - Y-bar
To see what happens to the variance in the presence of

heterosceasticity, let us study the simplest case possible, let
Yi = β + ui
where
ui N 0, σ2
That is, a regression on only a constant.
We know that the OLS estimator of β, that is b

β, will be Ȳ , and that it is
unbiased, i.e.
E (Ȳ ) = β
Let’s study the variance

2
V (Ȳ ) = E [Ȳ E (Ȳ )]
2
V (Ȳ ) = E (Ȳ β)
Use de…nition of the sample mean

" #2
1 n
n i∑
V (Ȳ ) = E Yi β
=1
because
Yi = β + ui
we have " #2
1 n
n i∑
V (Ȳ ) = E ( β + ui ) β
=1
(Again)
" ! #2
n
1
V (Ȳ ) = E
n ∑ ( β + ui ) β
i =1
Split up sum and since β is a constant ∑ni=1 β = nβ, we have

" ! #2
n
1
V (Ȳ ) = E nβ + ∑ ui β
n i =1
1
Multiply in n to get
2
nβ ∑ni=1 ui
V (Ȳ ) = E + β
n n
2
∑ni=1 ui
V (Ȳ ) = E β + β
n
(again)
2
∑ni=1 ui
V (Ȳ ) = E β + β
n
2
∑ni=1 ui
V (Ȳ ) = E
n
1
Take the constant n outside the square, and thus, square it, we have
" #2
2 n
1
V (Ȳ ) =
n
E ∑ ui
i =1
Studying
" #2
n
∑ ui
i =1
again, we have the situation
(a + b + c )2 = a2 + b2 + c 2 + 2ab + 2ac + 2bc
but now with, not three, but n terms...

" #2
n
∑ ui = [u1 + u2 + ... + un ]2
i =1
= u12 + u22 + ...un2 + 2u1 u2 + 2u1 u3 ...
Again
" #2
2 n
1
V (Ȳ ) =
n
E ∑ ui
i =1
" #
n n i 1
1
V (Ȳ ) =
n2
E ∑ ui2 + 2 ∑ ∑ ui uj
i =1 i =2 j =1
It can be instructive to study

n i 1
2∑ ∑ ui uj = 2u2 u1 + 2u3 u1 + 2u3 u2 + 2u4 u1 + 2u4 u2 + 2u4 u3 + 2u5 u1 + ...
i =2 j =1
Split up the expectation, (again)

" #
n n i 1
1
V (Ȳ ) = E ∑ ui2 + 2 ∑ ∑ ui uj
n2 i =1 i =2 j =1
" #
n n i 1
1
V (Ȳ ) =
n2 ∑E ui2 +2∑ ∑ E (ui uj )
i =1 i =2 j =1
Again study
n i 1
∑ ∑ E (ui uj )
i =2 j =1
We assume that
E (ui uj ) = 0, i 6= j
that is, we have...?
So (again)
" #
n n i 1
1
V (Ȳ ) = 2
n ∑E ui2 + 2 ∑ ∑ E (ui uj )
i =1 i =2 j =1
" #
n n i 1
1
V (Ȳ ) = 2
n ∑E ui2 + 2 ∑ ∑0
i =1 i =2 j =1
That is
" #
n
1
V (Ȳ ) = 2
n ∑E ui2 + 0
i =1
" #
n
1
V (Ȳ ) = 2
n ∑E ui2
i =1
Since now, (under heteroscedasticity)
E ui2 = σ2i
Again
" #
n
1
V (Ȳ ) =
n2 ∑E ui2
i =1
n
1
V (Ȳ ) =
n2 ∑ σ2i
i =1
So in the model
Yi = β + ui
the variance of the sample mean (the OLS-estimator) is given by
∑n σ 2
V (Ȳ ) = V b
β = i =12 i
n
Note that if σ2i would be the same for all i that is, we would have
(homoscedasticity)
E ui2 = σ2
Then
" #
n
1
V (Ȳ ) =
n2 ∑E ui2
i =1
" #
n
1
V (Ȳ ) =
n2 ∑ σ2
i =1
and we know that, for all constants

n
∑c =n c
i =1
So, we have
" #
n
1
V (Ȳ ) =
n2 ∑ σ2
i =1
1
= n σ2
n2
nσ2
=
n2
σ2
V (Ȳ ) =
n
which is the "usual" variance of the sample mean.
Heteroscedasticity - Consequences - Variance - Slope est.
Now, back to the (simple linear) regression model
Yi = β1 + β2 Xi + ui
For the OLS estimator of β2 :

2
V β̂2 = E β̂2 E β̂2
Recall
∑nj=1 (Xi X̄ ) ui
β̂2 = β2 +
2
∑ (X X̄ )
and
E β̂2 = β2
So
h 2
i
V β̂2 = E β̂2 E β̂2
20 12 3
∑nj=1 (Xi X̄ ) ui
V β̂2 = E 4 @ β2 + 2
β2 A 5
∑ (X X̄ )
20 12 3
n
4 @ ∑ j =1 i
(X X̄ ) ui
V β̂2 = E A 5
2
∑ (X X̄ )
2 3
2
6 ∑nj=1 (Xi X̄ ) ui 7
V β̂2 = E 4 5
2 2
∑ (X X̄ )
h i
2
E (∑ni=1 (Xi X̄ ) ui )
V β̂2 =
2 2
∑ (X X̄ )
2 !2 3
n
Numerator = E 4 ∑ (Xi X̄ ) ui 5
i =1
" #
n n
Numerator = E ∑ ∑ (Xi X̄ ) (Xj X̄ ) ui uj
i =1 j =1
Study numerator (Num.)

2 !2 3
n
Num. = E 4 ∑ (Xi X̄ ) ui 5
i =1
" #
n n
Num. = E ∑ ∑ (Xi X̄ ) (Xj X̄ ) ui uj
i =1 j =1
" ! !#
n n i 1
∑ (Xi ∑ ∑ 2 (Xi
2
Num. = E X̄ ) ui2 + X̄ ) (Xj X̄ ) ui uj
i =1 i =2 j =1
Split up expecation
! !
n n i 1
∑ (Xi 2∑ ∑ (Xi
2
Num. = E X̄ ) ui2 +E X̄ ) (Xj X̄ ) ui uj
i =1 i =2 j =1
The Xi0 s are constants, so we can move them out of the expectation,
(again)
! !
n n i 1
∑ (Xi 2∑ ∑ (Xi
2
Num. = E X̄ ) ui2 +E X̄ ) (Xj X̄ ) ui uj
i =1 i =2 j =1
n n i 1
∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi
2
Num. = X̄ ) (Xj X̄ ) E (ui uj )
i =1 i =2 j =1
Recall that
E (ui uj ) = 0, i 6= j
assuming ?, so
n n i 1
∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi
2
Num. = X̄ ) (Xj X̄ ) E (ui uj )
i =1 i =2 j =1
n n i 1
∑ (Xi X̄ ) E ui2 + 2 ∑ ∑ (Xi
2
Num. = X̄ ) (Xj X̄ ) 0
i =1 i =2 j =1
n
∑ (Xi
2
Num. = X̄ ) E ui2 + 0
i =1
and that now, (under heteroscedasticity)
E ui2 = σ2i
so
n
∑ (Xi
2
Num. = X̄ ) E ui2
i =1
n
∑ (Xi
2
Num. = X̄ ) σ2i
i =1
That was the numerator of the variance expcession. Recall
E ∑ni=1 ∑nj=1 (Xi X̄ ) (Xj X̄ ) ui uj

V β̂2 =
2 2
∑ (X X̄ )
we just showed that

" #
n n n
∑ ∑ (Xi ∑ (Xi
2
E X̄ ) (Xj X̄ ) ui uj = X̄ ) σ2i
i =1 j =1 i =1
Putting it together we get

2
∑ni=1 (Xi X̄ ) σ2i
V β̂2 =
2 2
∑ (X X̄ )
(Why cannot we just move the σ2i outside the summation?)
So the (correct) variance of the OLS-estimator for β2 in the presence of

heteroscedastiticy is given by
2
∑ni=1 (Xi X̄ ) σ2i
V β̂2 =
2 2
∑ (X X̄ )
Note that if
σ2i = σ2 for all i
that is, if we would have homoscedasticity, we have
2
∑ (Xi X̄ ) σ2i
V β̂2 =
2 2
∑ (X X̄ )
2
∑ (Xi X̄ ) σ2
V β̂2 =
2 2
∑ (X X̄ )
Recall
a 1
=
a2 a
here
∑ (Xi
2
a= X̄ )
so
2
σ2 ∑ (Xi X̄ )
V β̂2 =
2 2
∑ (X X̄ )
σ2
V β̂2 =
2
∑ (X X̄ )
σ2
V β̂2 = 2
∑ (X X̄ )
i.e. the "usual" variance of the estimator.
Compare the two variance expresstions
Homo- Hetero-
Scedasticity Scedasticity
(A) (B)
2
σ2 ∑ni=1 (X i X̄ ) σ2i
V β̂2 = 2 V β̂2 = 2 2
∑ (X X̄ ) ( ∑ (X X̄ ) )
Now, unlike in the case of multicollinearity, where multicollinearity always

in‡ates the variance, here there is no general result.
So if we use
σ2
V β̂2 = 2
∑ (X X̄ )
when we should use
2
∑ni=1 (Xi X̄ ) σ2i
V β̂2 =
2 2
∑ (X X̄ )
Do we under or over-estimate true variance?
That is, is there a way of knowing

2
∑ni=1 (Xi X̄ ) σ2i σ2
>
2 2 ∑ (X X̄ )
2
∑ (X X̄ )
or
2
∑ni=1 (Xi X̄ ) σ2i σ2
<
2 2 ∑ (X X̄ )
2
∑ (X X̄ )
If we mistakenly ignore heteroscedasticity. What happens? For the

following reasoning, introduce the (temporary) notation
2
∑ni=1 (Xi X̄ ) σ2i
VTRUE β̂2 =
2 2
∑ (X X̄ )
σ2
VFALSE β̂2 = 2
∑ (X X̄ )
So, in testing the signi…cance of the individual parameters
H0 : β j = 0
H1 : β j 6 = 0
Using
b
βj 0
zobs =
σ bβ
j
where s
σ2
σ bβ = 2
j
∑ (X X̄ )
Note that here we are dealing with population quantities (pretending to

know σ2 , thus we use
b
βj 0
zobs =
σ bβ
j
since we assume that the error term is normal, and the estimator is a linear
estimator, thus also normal.
Of course in practice, we do not know σ2 and need to estimate it by
Σb
ui2
b2 =
σ
n k
where, of course
bi = Yi
u b
β1 + b
β2 Xi ,2
and k is the number of estimated coe¢ cients in the regressrion equation,

in this case 2. Then we use
b
βj 0
tobs = tn k
b bβ
σ
j
If we UNDER-estimate the true variance, that is
VUsed but FALSE β̂2 < VTRUE β̂2
σ bβ to SMALL
j
+
b
βj
σ bβ to BIG
j
+
Reject H0 : βj = 0 to Often
+
Signi…cance to Often
Think model is "better"

that it actually is
On the other hand, If we OVER-estimate the true variance, that is
VUsed but FALSE β̂2 > VTRUE β̂2
σ bβ to BIG
j
+
b
βj
σ bβ to SMALL
j
+
Never Reject H0 : βj = 0
+
Never Signi…cance
Think model is "worse"

that it actually is
In practice, unfortuently, there is no way of knowing if we under or over

estimate the variance when ignoring heteroscedasticity.
One would need to be careful in the analysis, and/or use Whites

heteroscedastic robust standard errors.
Heteroscedasticity - Detection - Graphs
Quick and dirty preliminary analysis: Just plot Y vs X
Heteroscedasticity - Detection - Tests
Some tests of Heteroscedasticity, outline:

Parks test
Gleijser test
Goldfeldt-Quandt test (GQ-test)
Breusch-Pagan-Godfrey test (BPG-test)
White’s test
Heteroscedasticity - Detection - Tests - Parks test
Parks test:
σ2i = σ2 X2,i e v
β
bi2 = β1 + β2 ln (X2,i ) + vi
ln u
Heteroscedasticity - Detection - Tests - Gleiser test
Gleiser test:
jubi j = β1 + β2 X2,i + vi
or other functions of X2
Heteroscedasticity - Detection - Tests - BPG test
Breusch-Pagan-Godfrey (BPG) test:

BPG - Test: Idea
Regress
bi2
u
= β1 + β2 X2,i + β3 X3,i + ei
σ̂2
Test statistic
ExplSS
χ2
2
Heteroscedasticity - Detection - Tests - White’s tests
Run regression of f (u ) on g (X )
White’s test:
Using square regresors
bi2 = β1 + β2 X2 + β3 X22 + β4 X3 + β5 X32 + e

u
What problem could we encounter running this regression?
To see if the residual variance increases with the increasing values of the
regressors, we do a
F test of
H0 : βj = 0, j > 1
H1 : At least one βj 6= 0 j = 2, ..., k
We can include cross-terms in the regression
bi2 = β1 + β2 X2 + β3 X22 + β4 X3 + β5 X32 + β6 X2 X3 + e

u
Again perform a F test of
H0 : βj = 0, j > 1
H1 : At least one βj 6= 0 j = 2, ..., k
Note: With many regressors

What regressors to include in the auxiliry regression
What functional form?
What regressors to square?
What, if any, crossproducts to include?
Heteroscedasticity - Detection - Tests - Goldfeld-Quandt
Golfeld-Quandt (GQ) test:
σ2i = σ2 Xi2
1 Divide sample into two parts with respect to X

2 Estimate the model on each part
3 Test using
RSS1 /df1
RSS2 /df2
Heteroscedasticity - Detection - Tests - Properties - Size
Sample size 10 and 50:

White, White + cross terms, BPG, F and χ2 :
Heteroscedasticity - Detection - Tests - Properties - Power
Power comparison
Heteroscedasticity - Remedy
OK, we have heterosceasticity, what can we do?

White’s consistent estimator
WLS (Weighted Least Squares)
Heteroscedasticity - Remedy - Whites HAC estimator
bi2 as a proxy for σ2i

Idea: Use u
2
∑n (Xi X̄ ) u bi2
V\β̂2 = i =1
2 2
∑ (X X̄ )
use this estimate of the variance instead of the usual.
Heteroscedasticity - Remedy - WLS
Instead of OLS, we should use the Weighted Least Squares (WLS))

Without matrix algebra notation, hard to show exactly what is going on.
How can we "do" WLS without matrix algebra?
Assume a functional form for
E ui2 = σ2i
We usually assume that the increasing variance of ui is proportional to

some function of (some) X .
Commonly used (assumed, mathematically convenient) functional forms:
σ2i = σ2 Xi2
σ2i = σ2 jXi j
p
σ2i = σ2 Xi
In general, if we have the variable ui that has the variance
V (ui ) = cσ2
What transform can we do on ui , that is, how can we standardize ui to

get the standardized variable, say ui , to have variance σ2 ?
Hint recall
V (aY ) = a2 V (Y )
We try
ui
ui =p
c
then
u
V (ui ) = V pi
c
1
= p 2
V (ui )
c
1
= V (ui )
c
V (ui )
V (ui ) =
c
Recall
V (ui ) = cσ2
so (again)
V (ui )
V (ui ) =
c
cσ2
=
c
V (ui ) = σ2
Back to the regression.
How to implement, we start with
Assuming
σ2i = σ2 jXi j
p
Do the transformation, that is divide by jXi j to get
Y 1 Xi ui
p i = β1 p + β2 p +p
jXi j jXi j jXi j jXi j
Yi = β1 Xi + β2 Xi + ui
Note: No constant in the "new", transformed regression line.
(again)
study the "transformed" error term
ui
ui = p
jXi j
Expectation
!
u
E (ui ) = E p i
jXi j
1
= p E (ui )
jXi j
1
= p 0
jXi j
= 0
Study the variance of ui
Var (ui ) = E (ui E (ui ))2
= E (ui 0)2
V (ui ) = E (ui )2
Focus on E (ui )2
Replace
ui
ui = p
jXi j
and we get
!2
u
E (ui )2 = E p i
jXi j
Recall for any constant a

h i
E (a ui )2 = E a2 (ui )2
= a2 E (ui )2
here
1
a=
jXi j
(again)
!2
u
E (ui )2 = E p i
jXi j
2 !2 3
1
E (ui )2 = E 4 p (ui )2 5
jXi j
1
E (ui )2 = p 2
E ui2
jXi j
1
= E ui2
jXi j
E ui2
E (ui )2 =
jXi j
We have heteroscedasticity, so
E ui2 = σ2i
That is (again)
E ui2
E (ui )2 =
jXi j
σ2i
E (ui )2 =
jXi j
Recall that we assumed that σ2i had the functional form
σ2i = σ2 jXi j
We have, (again)
σ2i
E (ui )2 =
jXi j
σ2 jXi j
E (ui )2 =
jXi j
E (ui )2 = σ2
In the transformed regression,
we have constant variance, i.e. homoscedasticity
V (ui ) = σ2
So, here, WLS is equivalent to using OLS on transformed data!
We started with
but we estimate
How do we interpret β1 and β2 ?
Note that, in e¤ect, when tranforming the PRF, we transform the data -
not the parameters, so in terms of the original regression, we keep the
interpretation of the parameters.
What if we choose (assume) another functional form of the

heterscedasticity, again, for the single linear regression
Assuming
σ2i = σ2 Xi2
given all Xi > 0
Do
q the transformation, we divide the terms of the PFR by that is divide by
Xi2 = Xi to get
Yi 1 Xi ui
= β1 + β2 +
Xi Xi Xi Xi
Yi = β1 Xi + β2 + ui
Note: The coe¢ cients has changed "roles".

It is straightforward to see that now Var (ui ) = σ2 , i.e. constant. We
have transformed away the heteroscedasticity
The transformed regression again
Once estimated, we interpret b

β2 as the slope in the orginal regression
For the WLS - some words of caution:

What if we assume the wrong functional form?
If we assume the wrong functional form, we might induce even
"more" heteroscedasticity than we had to begin with, thus, causing
more damage than good.
So, if uncertain of what kind of functional form we have on the

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Violation of OLS assumption - Heteroscedasticity

What, why, so what and what to do?

Uppsala Uppsala University, Department of Statistics

October 22, 2014

Violations of assumptions - Heteroscedasticity:

What - Explain what is meant by heteroscedasticity

Violations of assumptions - Heteroscedasticity:

The assumption here is Homo-Scedasticity

To keep it simple, we have the single linear regression, for a arbitrary

Recall de…ntion of variance

Var (ui ) = E [ui E (ui )]2

Var (ui ) = E [ui 0]2

Var (ui ) = E ui2

So the assumption can be written

Note no i on the sigma-two.

If not homoscedasticity, then we have heteroscedasticity

i.e. it depends on i where the i refers to the di¤erent Xi

Remember the income - consumption example.

Why do we have heteroscedasticity?

Why do we have heteroscedasticity? (cont)

OLS: In the presence of Heteroscedastiticy, the OLS-estimator is

Even though the OLS-estimator is unbiased

To see what happens to the variance in the presence of

We know that the OLS estimator of β, that is b

Let’s study the variance

Use de…nition of the sample mean

Split up sum and since β is a constant ∑ni=1 β = nβ, we have

again, we have the situation

(a + b + c )2 = a2 + b2 + c 2 + 2ab + 2ac + 2bc

but now with, not three, but n terms...

= u12 + u22 + ...un2 + 2u1 u2 + 2u1 u3 ...

It can be instructive to study

Split up the expectation, (again)

Since now, (under heteroscedasticity)

and we know that, for all constants

Now, back to the (simple linear) regression model

For the OLS estimator of β2 :

Study numerator (Num.)

and that now, (under heteroscedasticity)

That was the numerator of the variance expcession. Recall

E ∑ni=1 ∑nj=1 (Xi X̄ ) (Xj X̄ ) ui uj

we just showed that

Putting it together we get

(Why cannot we just move the σ2i outside the summation?)

So the (correct) variance of the OLS-estimator for β2 in the presence of

i.e. the "usual" variance of the estimator.

Compare the two variance expresstions

Now, unlike in the case of multicollinearity, where multicollinearity always

Do we under or over-estimate true variance?

That is, is there a way of knowing

If we mistakenly ignore heteroscedasticity. What happens? For the

So, in testing the signi…cance of the individual parameters

Note that here we are dealing with population quantities (pretending to

Of course in practice, we do not know σ2 and need to estimate it by

and k is the number of estimated coe¢ cients in the regressrion equation,

VUsed but FALSE β̂2 < VTRUE β̂2

Think model is "better"

VUsed but FALSE β̂2 > VTRUE β̂2

Think model is "worse"

In practice, unfortuently, there is no way of knowing if we under or over

One would need to be careful in the analysis, and/or use Whites

Some tests of Heteroscedasticity, outline:

Breusch-Pagan-Godfrey (BPG) test: