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Master in Finance, UC3M
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Introduction
Two Examples
OLS
Goodness of fit
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Introduction
Introduction
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Introduction
i = 1, . . . , n
Y = 0 + 1 X + u (linearity)
varn (Xi ) 6= 0
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Introduction
OLS is unbiased
covn (Xi , Yi )
b1 =
,
varn (Xi )
b0 = Y b1 X
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Introduction
OLS is biased: En (b
ui fertilizeri ) = 0 (only reasonable if land quality
is not related with fertilizer)
What is the direction of this bias?
Master in Finance, UC3M
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We can try to reduce the sample so that omitted factors are not
correlated with Xi
samples will be very small and we will not have a general answer to the
problem
We can add the omitted variable as a second regressor (we see this
today)
We could use another estimator that does not require conditional
mean independence (2SLS, beyond the scope of this course)
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Yi = 0 + 1 X1i + 2 X2i + ui ,
i = 1, . . . , n
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Interpretation
If X1 = 1, X2 = 0 Y = 1
Similarly, if X1 = 0, X2 = 1 Y = 2
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Two Examples
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Two Examples
Polinomials: Y = 0 + 1 X + 2 X 2 + u
1 does not represent the effect on Y of a unitary change in X
keeping everything else constant, because when X changes then X 2
also changes
E(Y |X )
=1 + 2 2 X
X
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Two Examples
Interactions
i = 1, . . . , n
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OLS
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OLS
o
n
b0 , b1 , ..., bk =
min
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OLS
ni=1 ubi
ni=1 ubi X1i
=0
=0
..
.
=0
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OLS
Matrix Form
Let X =
1 X11
1 X12
..
..
.
.
1 X1n
ni=1 X1i
..
.
ni=1 Xki
. . . Xk1
. . . Xk2
..
...
.
and Y =
. . . Xkn
ni=1 X1i
ni=1 X1i2
..
.
ni=1 X1i Xki
...
...
..
.
...
Y1
Y2
..
.
Yn
ni=1 Xki
n X X
i=1 1i ki
..
.
ni=1 Xki2
b0
b0
..
.
b
k
ni=1 Yi
n Y X
i=1 i 1i
..
.
ni=1 Yi Xki
X 0 X b = X 0 Y
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OLS
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The issue
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cov (educ, ) = 0
cov (IQ, ) = 0
Since = wages 0 1 educ 2 IQ,
cov (educ, wages) 1 var (educ) 2 cov (educ, IQ) = 0
cov (IQ, wages) 1 cov (IQ, educ) 2 var (IQ) = 0
This is a system of two linear equations and two unknowns (1 and
2 )
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Uncorrelated regressors
If educ and IQ are uncorrelated, cov (educ, IQ) = 0 and the system
becomes
cov (educ, wages) 1 var (educ) = 0
cov (IQ, wages) 2 var (IQ) = 0
The first condition coincides with the orthogonality condition in the
BLP (short) model
cov (educ, wages) 1 var (educ) = 0
(educ,wages)
Hence, 1 = 1 = covvar
if cov (educ, IQ) = 0
(educ)
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Goodness of fit
Goodness of fit
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Goodness of fit
n
1
ubi2
n k 1 i=1
2
bi Yb
Y
ESS
R2 =
=
2
TSS
ni=1 Yi Y
ni=1
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Goodness of fit
Properties of the R 2
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Goodness of fit
all these factors account for about 4 percent of the total variation in
the arrests
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Goodness of fit
\
narr
86 = 0.712 0.150 pcnv 0.034 ptime86 0.104 qemp86,
R 2 = 0.0413
We now add as a new factor the average sentence length in months
\
narr
86 = 0.707 0.151 pcnv + 0.0074 avgsen 0.037 ptime86
0.103 qemp86,
R 2 = 0.0422
there is very little improvement in the R 2 the expected number of
arrests depends negatively on
the estimates of the other coefficients hardly change
the sign of the coefficient estimate for avgsen is unusual
should we keep avgsen in the regression?
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Summary
Summary
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