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101 Concepts for the Level I Exam

Essential Concept 5: Problems in Regression Analysis

Problem Effect Solution
Heteroskedasticity: variance of error term is not constant.
Test using BP test
BP = nR^{2}$ 		F-test is unreliable. Standard error underestimated.
t-stat overstated.		 Robust standard errors
Generalized least squares
Serial correlation: error terms are correlated. Test using DW stat.
DW \approx 2(1 – r)		 F-stat too high. Standard error underestimated.
t-stat overstated.		 Hansen method
Modify the regression equation
Multicollinearity: two or more independent variables are highly correlated. Inflated SE’s; t-stats of coefficients artificially small
High R^{2}$ 		Omit one or more of the independent variables

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