HETEROSCEDASTICITY

The assumption of equal variance

Var(ui) = 2, for all i, is called
homoscedasticity, which means
equal scatter (of the error terms
ui around their mean 0)

 Equivalently, this means that

the dispersion of the observed
values of Y around the
regression line is the same
across all observations
If the above assumption of
homoscedasticity does not hold,
we have heteroscedasticity
(unequal scatter)
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Consequences of ignoring
heteroscedasticity during the OLS
procedure
The estimates and forecasts based on
them will still be unbiased and
consistent
However, the OLS estimates are no
longer the best (B in BLUE) and thus
will be inefficient. Forecasts will also
be inefficient
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 The estimated variances and

covariances of the regression
coefficients will be biased and
inconsistent, and hence the t- and
F-tests will be invalid

Testing for heteroscedasticity

1. Before any formal tests,
visually examine the models
residuals i
Graph the i or i2 separately
against each explanatory
variable Xj, or against i, the
fitted values of the dependent
variable
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2. The Goldfeld-Quandt test

Step 1. Arrange the data from small
to large values of the indp variable Xj
Step 2. Run two separate regressions,
one for small values of Xj and one for
large values of Xj, omitting d middle
observations (app. 20%), and record
the residual sum of squares RSS for
each regression: RSS1 for small
values of Xj and RSS2 for large Xjs.
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Step 3. Calculate the ratio

F = RSS2/RSS1, which has an F
distribution with
d.f. = [n d 2(k+1)]/2 both in the
numerator and the denominator,
where n is the total # of
observations, d is the # of omitted
observations, and k is the # of
explanatory variables.
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 Step4. Reject H0: All the variances

i2 are equal (i.e., homoscedastic) if
F > Fcr, where Fcr is found in the
table of the F distribution for
[n-d-2(k+1)]/2 d.f. and for a
predetermined level of significance
, typically 5%.

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 Drawbacks of the the

Goldfeld-Quandt test
It cannot accommodate
situations where several
variables jointly cause
heteroscedasticity
The middle d
observations are lost
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3. Lagrange Multiplier (LM) tests

(for large n>30)
The Breusch-Pagan test
Step 1. Run the regression of i2
on all the explanatory variables. In
our example (CN p. 37), there is
only one explanatory variable, X1,
therefore the model for the OLS
estimation has the form:
i2 = 0 + 1X1i + vi
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Step 2. Keep the R2 from this

regression. Lets call it R22
Calculate either
(a) F = (R22/k)/[(1-R22)/(n-(k+1)],
where k is the # of explanatory
variables; the F statistic has an F
distribution with d.f. = [k, n-(k+1)]
Reject H0: All the variances i2 are
equal (i.e., homoscedastic) if F >Fcr
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or
(b) LM = n R22, where LM is called
the Lagrangian Multiplier (LM)
statistic and has an asymptotic chisquare (2) distribution with d.f. = k
Reject H0: All the variances i2 are
equal (i.e., homoscedastic)
if LM> cr2
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 Drawbacks of the Breusch-

Pagan test
It has been shown to be
sensitive to any violation of the
normality assumption
Three other popular LM tests: the
Glejser test; the Harvey-Godfrey
test, and the Park test, are also
sensitive to such violations (wont
be covered in this course)
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One LM test, the White

test, does not depend

on the normality
assumption; therefore
it is recommended
over all the other tests

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 The White test

Step 1.The test is based on the regr.
of 2 on all the explanatory variables (Xj), their squares (Xj2), and
all their cross products. E.g., when
the model contains k = 2 explanat.
variables, the test is based on an estim. of
the model: 2 =0+ 1X1
+2X2+3X12+4X22 + 5X1X2 + v
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Step 2. Compute the statistic

2 = nR22, where n is the sample size
and R22 is the unadjusted R-squared
from the OLS regression in Step 1. The
statistic 2 = nR22, has an asymptotic
chi-square (2) distrib. with d.f. = k,
where k is the # of ALL explanatory
variables in the AUXILIARY model.
Reject H0: All the variances i2 are
equal (i.e., homoscedastic) if 2 > cr2
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Estimation Procedures when H0 is

rejected
1. Heteroscedasticity with a known
proportional factor
If it can be assumed that the error variance is
proportional to the square of the indep. variable
Xj2, we can correct for heteroscedasticity by
dividing every term of the regression by X1i and
then reestimating the model using the transformed
variables. In the two-variable case, we will have to
reestimate the following model (CN, p. 39):
Yi/X1i = 0/X1i + 1 + ui/X1i
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 2. Heteroscedasticity consistent covariance

matrix (HCCM)
As we know, the usual OLS inference is
faulty in the presence of hetero-scedasticity
because in this case the estimators of
variances Var(bj) are biased. Therefore, new
ways have been developed for estimation of
hetero-scedasticity-robust variances.
The most popular is the HCCM procedure
proposed by White.
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The heteroscedasticity consistent

covariance matrix (HCCM)
procedure.
Lets consider the model: Yi = 0 +
1X1i + 2X2i + ... + kXki + ui
Step 1. Estimate the initial model by
the OLS method. Let i denote the
OLS residuals from the initial
regression of Y on X1, X2, .., Xk
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 Step 2. Run the OLS regression of

Xj (each time for a different j) on
all other independent variables. Let
ij denotes the ith residual from
regressing Xj on all other
independent variables.

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 Step 3. Let RSSj be the residual

sum of squares from this
regression: RSSj = SXjXj(1-R2).
RSSj can also be calculated as
RSSj = [n-(k+1)]SER2, where SER
is the standard error of regression
and can easily be found in the
Excels OLS solution.
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 Step 4. The heteroscedasticityrobust variance Var(bj) can be

calculated as follows:
Var(bj) = ij2i2/RSSj2.
The square root of Var(bj) is called
the heteroscedasticity-robust
standard error for bj.
Example: CN, p. 44.
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 3. Feasible Generalized Least

Squares (FGLS) method
Step 1. Compute the residuals i
from the OLS of the initial
regression model

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 Step 2. Regress i2 against a constant

term and all the explanatory variables
from either the Breusch-Pagan test for
heteroscedasticity (e.g., when k =2:
i2 = 0 + 1X1i + 2X2i + vi )
or the White test for heteroscedasticity:
i2 = 0 + 1X1i + 2X2i + 3X1i2 + 4X2i2 +
5X1i X2i + vi
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 Step 3. Estimate the original model

by OLS using the weights zi = 1/i,
where i2 are the predicted values
of the dependent variable (the i2)
in the Breusch-Pagan (or White)
model. Note: the model must be
estimated without a constant term.
Such OLS procedure is called
WLS (weighted least squares).
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 It may happen that the predicted

values i2 of the dependent variable
may not be positive, so we cannot
calculate the corresponding weights
zi = 1/i. If this situation arises for
some observations, then we can use
the original i2 and take their
positive square roots.
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