Autocorrelation and

Heteroskedasticity
Introduction
Assess the main ways of remedying
autocorrelation
Describe the problem of non-constant
error terms
Assess the main test for heteroskedasticity
Examine the main remedies for
heteroskedasticity
Introduce the multivariate approach to
regression analysis
Cochrane-Orcutt methodology
This approach to remedying
autocorrelation relies on the generalised
difference equation approach
It is an iterative procedure, the estimates
of the parameters converge towards their
actual value.
It assumes the autocorrelation follows a
first order autoregressive process
(simplest form)
Cochrane-Orcutt Procedure
t t t
t t t
u u
u x y
c
| o
+ =
+ + =
1
Procedure (Based on previous
slide)
Run regression and collect the error term
(u).
Run a second regression of u against u(t-
1) to obtain an estimate of .
Form the generalised difference equation,
to obtain new estimates of the parameters
Re-run this equation, obtain u and repeat
process until there is no significant
difference from one iteration to the next.
Restricted Version of the GDE
The generalised difference equation
can be written in the following form,
which includes a restriction, the
product of the coefficients on y(-1) and
x is equal to the negative of the
coefficient on x(-1) :
t t t t t
x x y y c | | o + + + =
1 1
) 1 (
Unrestricted version of the GDE
In the unrestricted version of the equation in
the previous slide, there are no restrictions
on the values of the coefficients:
t t t t t
x x y y c o o o o + + + + =
1 3 2 1 1 0
The Common Factor Test
To determine whether the restricted or unrestricted
versions are best, we can use the common factor test,
under the null hypothesis that the restriction holds, the
test statistic is:
squares of sum sidual RSS
ns observatio of number T
RSS
RSS
T
unres
res
e
Re

log

Heteroskedasticity
This occurs when a Gauss-Markov
assumption is broken, it indicates non-
constant variance of the error term.
It is often caused by variables which have
substantial differences in the values of the
observations, i.e. GDP differing between
the USA and Cuba
With heteroskedasticity the estimator is no
longer BLUE, as it is not the best.
Tests for Heteroskedasticity
Goldsfeldt-Quandt test (not used much
now)
Whites Test (used in E-views computer
software).
LM test (Similar to the LM test for
heteroskedasticity)
Whites Test
This test follows a similar pattern to the LM test
for autocorrelation discussed earlier.
Based on the same first equation as in slide 4,
we estimate the model and collect the residual u.
Square the residual to form the variance of the
residual
Run a secondary regression of the squared
residual on the explanatory variable and this
variable squared
Whites Test
This secondary regression appears like the
following:
t t t t
x x u c o o o + + + =
2
2 1 0
2
Whites Test
Collect the R-squared statistic and multiply by
the number of observations to obtain the test
statistic.
This follows a chi-squared distribution, the d of f
equal the number of parameters in the
secondary regression (i.e. 2 in above example)
The null hypothesis is no heteroskedasticity.
If there were 2 explanatory variables, you could
include the cross product of these variables, in
the secondary regression.
Remedies for heteroskedasticity
If the standard deviation of the residual is
known, the heteroskedasticity can be removed
by dividing the regression equation through by
the standard deviation of the residual (weighted
Least Squares)
If this is not known, as is likely, we need to
stipulate what the standard deviation is equal to.
We can then divide the regression equation
through by this variable to obtain a constant
variance residual.
Remedying Heteroskedasticity
If we assume the error variance is
proportional to x, the explanatory variable
and we have the usual model:

t t t
t t
u x y
x u E
+ + =
=
| o
o
2 2
) (
Remedying Heteroskedasticity
If we divide our model through by the
square root of x:
t
t
t
t
t t
t
x
u
x
x
x x
y
+ + = |
o
Remedying Heteroskedasticity
Taking the new error term, we can show it is
no longer suffering from heteroskedasticity
by proving it is now constant:
2
2 2
2
2
2
) (
) (
) (
) ( o
o
= = = =
t
t
t
t
t
t
t
t
x
x
x
u E
x
u E
x
u
E
Multivariate Regression
Regressions with more than one explanatory
variable are similar to the bi-variate case, we
can interpret the coefficients and t-statistics in
much the same way as before.
We now have a potential problem with
multicollinearity, when the explanatory variables
are correlated
The formula for the contains an expression for
the covariance between the explanatory
variables.
Multivariate Regression Analysis
The regression coefficients are more likely to be
accurate, the less closely related are the explanatory
variables
This allows testing for the significance of groups of
variables
The R-squared increases with the more explanatory
variables
We need to consider whether all relevant effects are
included in the model
When estimating the t-tests, we need to account for the
extra degrees of freedom
There is a trade off between the number of explanatory
variables and the ease of interpreting the model
Conclusion
The common factor test can be used to
determine the best solution to the problem
of autocorrelation
In the presence of heteroskedasticity, the
estimator is no longer BLUE.
Whites test is the most common test for
heteroskedasticity
Weighted Least Squares can be used to
remedy the heteroskedasticity problem.