# Quantitatve Analysis ---S6 Diagnostic Tests

Heteroscedasticity

1. The variance of the errors is not constant.
2. Tests:

• GQ test:Split the total sample of length T into two sub-samples of length T1 and T2. The regression model is estimated on each
  sub-sample and the two residual variances are calculated.
• White test: White’s general test for heteroscedasticity is one of the best
  approaches because it makes few assumptions about the form of
  the heteroscedasticity.
  
• Solution:
  (1)
  
  (2) Transform the variables into logs or reducing by some other
  measure of “size”.
  (3) Use White’s heteroscedasticity consistent standard error
  estimates.

Multicollinearity

1. Problems if near multicollinearity is present

• R2 will be high but the individual coefficients will have high standard
  errors.
• The regression becomes very sensitive to small changes in the
  specification.
• Thus confidence intervals for the parameters will be very wide, and
  significance tests might therefore give inappropriate conclusions.

2. Solution:

• ridge regression or principal
  component, usually bring more problems than they solve.
• The easiest ways to “cure” the problems are
  – drop one of the collinear variables
  – transform the highly correlated variables into a ratio
  – go out and collect more data e.g.
  – a longer run of data
  – switch to a higher frequency

Specification & Measurement Errors

2. Omission of an important variable

• The estimated coefficients on all the other variables will be biased
  and inconsistent unless the excluded variable is uncorrelated with all the included variables.
• Even if the condition of uncorrelatedness is satisfied, the estimate of the coefficient on the constant term will be biased.
• The standard errors will also be biased

4. Inclusion of an irrelevant variable

• Also called the error of commission.
• Coefficient estimates will still be consistent and unbiased
• But the variance of the estimators will be inefficient.

5. Measurement Error

Parameter

1. Parameter Stability Tests
   The idea is essentially to split the data into sub-periods and then to estimate up to three models, for each of the sub-parts and for all the data and then to “compare” the RSS of the models
   There are two types of test we can look at:
   – Chow test (analysis of variance test)
   
   – Predictive failure tests