Classical Linear Regression Model Assumptions and Diagnostics

Chapter 5
Classical linear regression model assumptions

and diagnostics
‘Introductory Econometrics for Finance’ © Chris Brooks 2013 1

Violation of the Assumptions of the CLRM
• Recall that we assumed of the CLRM disturbance terms:
1. E(ut) = 0
2. Var(ut) = 2 < 
3. Cov (ui,uj) = 0
4. The X matrix is non-stochastic or fixed in repeated samples
5. ut  N(0,2)

Investigating Violations of the
Assumptions of the CLRM
• We will now study these assumptions further, and in particular look at:
- How we test for violations
- Causes
- Consequences
in general we could encounter any combination of 3 problems:
- the coefficient estimates are wrong
- the associated standard errors are wrong
- the distribution that we assumed for the
test statistics will be inappropriate
- Solutions
- the assumptions are no longer violated
- we work around the problem so that we
use alternative techniques which are still valid
Statistical Distributions for Diagnostic Tests
• Often, an F- and a 2- version of the test are available.
• The F-test version involves estimating a restricted and an unrestricted

version of a test regression and comparing the RSS.
• The 2- version is sometimes called an “LM” test, and only has one degree
of freedom parameter: the number of restrictions being tested, m.
• Asymptotically, the 2 tests are equivalent since the 2 is a special case of the
F-distribution:
 2 m
 F m, T  k  as T  k  
m
• For small samples, the F-version is preferable.

Assumption 1: E(ut) = 0
• Assumption that the mean of the disturbances is zero.
• For all diagnostic tests, we cannot observe the disturbances and so

perform the tests of the residuals.
• The mean of the residuals will always be zero provided that there is a
constant term in the regression.

Assumption 2: Var(ut) = 2 < 
• We have so far assumed that the variance of the errors is constant, 2 - this
is known as homoscedasticity.
û + t
• If the errors do not have a
constant variance, we say
that they are heteroscedastic
e.g. say we estimate a regression
and calculate the residuals, ut.
x 2t

Detection of Heteroscedasticity: The GQ Test
• Graphical methods
• Formal tests: There are many of them: we will discuss Goldfeld-Quandt
test and White’s test
The Goldfeld-Quandt (GQ) test is carried out as follows.

1. 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.
2. The null hypothesis is that the variances of the disturbances are equal,
H0:  12   22

The GQ Test (Cont’d)
3. The test statistic, denoted GQ, is simply the ratio of the two residual
variances where the larger of the two variances must be placed in
the numerator.
s12
GQ  2
s2
4. The test statistic is distributed as an F(T1-k, T2-k) under the null of
homoscedasticity.
5. A problem with the test is that the choice of where to split the
sample is that usually arbitrary and may crucially affect the
outcome of the test.

Detection of Heteroscedasticity using White’s Test
• White’s general test for heteroscedasticity is one of the best

approaches because it makes few assumptions about the form of the
heteroscedasticity.
• The test is carried out as follows:
1. Assume that the regression we carried out is as follows
yt = 1 + 2x2t + 3x3t + ut
And we want to test Var(ut) = 2. We estimate the model, obtaining
the residuals,
ut
2. Then run the auxiliary regression
uˆt2  1   2 x2t   3 x3t   4 x22t   5 x32t   6 x2t x3t  vt
Performing White’s Test for Heteroscedasticity
3. Obtain R2 from the auxiliary regression and multiply it by the

number of observations, T. It can be shown that
T R2  2 (m)
where m is the number of regressors in the auxiliary regression
excluding the constant term.
4. If the 2 test statistic from step 3 is greater than the corresponding

value from the statistical table then reject the null hypothesis that the
disturbances are homoscedastic.

Consequences of Using OLS in the Presence of
Heteroscedasticity
• OLS estimation still gives unbiased coefficient estimates, but they are
no longer BLUE.
• This implies that if we still use OLS in the presence of

heteroscedasticity, our standard errors could be inappropriate and
hence any inferences we make could be misleading.
• Whether the standard errors calculated using the usual formulae are too
big or too small will depend upon the form of the heteroscedasticity.

How Do we Deal with Heteroscedasticity?
• If the form (i.e. the cause) of the heteroscedasticity is known, then we can
use an estimation method which takes this into account (called generalised
least squares, GLS).
• A simple illustration of GLS is as follows: Suppose that the error variance is
related to another variable zt by
var ut    2 zt2
• To remove the heteroscedasticity, divide the regression equation by zt
yt 1 x2 t x3t
 1   2  3  vt
zt zt zt zt
ut
where vt  is an error term.
zt
u  var ut   2 zt2
• Now var vt   var  t   2
 2
  2
for known zt.
 zt  z t z t

Other Approaches to Dealing
with Heteroscedasticity
• So the disturbances from the new regression equation will be

homoscedastic.
• Other solutions include:

1. Transforming the variables into logs or reducing by some other measure
of “size”.
2. Use White’s heteroscedasticity consistent standard error estimates.
The effect of using White’s correction is that in general the standard errors
for the slope coefficients are increased relative to the usual OLS standard
errors.
This makes us more “conservative” in hypothesis testing, so that we would
need more evidence against the null hypothesis before we would reject it.

Background –
The Concept of a Lagged Value
t yt yt-1 yt
1989M09 0.8 - -
1989M10 1.3 0.8 1.3-0.8=0.5
1989M11 -0.9 1.3 -0.9-1.3=-2.2
1989M12 0.2 -0.9 0.2--0.9=1.1
1990M01 -1.7 0.2 -1.7-0.2=-1.9
1990M02 2.3 -1.7 2.3--1.7=4.0
1990M03 0.1 2.3 0.1-2.3=-2.2
1990M04 0.0 0.1 0.0-0.1=-0.1
. . . .
. . . .
. . . .
Autocorrelation
• We assumed of the CLRM’s errors that Cov (ui , uj) = 0 for ij, i.e.
This is essentially the same as saying there is no pattern in the errors.
• Obviously we never have the actual u’s, so we use their sample

counterpart, the residuals (the ut’s).
• If there are patterns in the residuals from a model, we say that they are
autocorrelated.
• Some stereotypical patterns we may find in the residuals are given on

the next 3 slides.

Positive Autocorrelation
+
û t û t
+
- +
uˆ t 1
Time
Positive Autocorrelation is indicated by a cyclical residual plot over time.

Negative Autocorrelation
+ û t
û t
+
- +
uˆ t 1
Time
- -
Negative autocorrelation is indicated by an alternating pattern where the residuals

cross the time axis more frequently than if they were distributed randomly
No pattern in residuals –
No autocorrelation
û t
+
û t +
- uˆ t +1
-
-
No pattern in residuals at all: this is what we would like to see

Detecting Autocorrelation:
The Durbin-Watson Test
The Durbin-Watson (DW) is a test for first order autocorrelation - i.e.

it assumes that the relationship is between an error and the previous
one
ut = ut-1 + vt (1)
where vt  N(0, v2).
• The DW test statistic actually tests
H0 : =0 and H1 : 0
• The test statistic is calculated by T
  ut  ut 1 2
DW  t  2 T
 ut 2
t 2

The Durbin-Watson Test:
Critical Values
• We can also write

DW  2(1   ) (2)
where  is the estimated correlation coefficient. Since  is a
correlation, it implies that  1  pˆ  1.
• Rearranging for DW from (2) would give 0DW4.
• If  = 0, DW = 2. So roughly speaking, do not reject the null

hypothesis if DW is near 2  i.e. there is little evidence of
autocorrelation
• Unfortunately, DW has 2 critical values, an upper critical value (du)

and a lower critical value (dL), and there is also an intermediate region
where we can neither reject nor not reject H0.

The Durbin-Watson Test: Interpreting the Results
Conditions which Must be Fulfilled for DW to be a Valid Test

1. Constant term in regression
2. Regressors are non-stochastic
3. No lags of dependent variable
Another Test for Autocorrelation:
The Breusch-Godfrey Test
• It is a more general test for rth order autocorrelation:

ut  1ut 1  2ut  2  3ut  3 ... r ut  r  vt , vt N(0,  v2 )
• The null and alternative hypotheses are:
H0 : 1 = 0 and 2 = 0 and ... and r = 0
H1 : 1  0 or 2  0 or ... or r  0
• The test is carried out as follows:
1. Estimate the linear regression using OLS and obtain the residuals, ut .
2. Regress ut on all of the regressors from stage 1 (the x’s) plus ut 1 , ut  2 ,..., ut  r
Obtain R2 from this regression.
3. It can be shown that (T-r)R2  2(r)
• If the test statistic exceeds the critical value from the statistical tables, reject
the null hypothesis of no autocorrelation.
Consequences of Ignoring Autocorrelation
if it is Present
• The coefficient estimates derived using OLS are still unbiased, but
they are inefficient, i.e. they are not BLUE, even in large sample sizes.
• Thus, if the standard error estimates are inappropriate, there exists the
possibility that we could make the wrong inferences.
• R2 is likely to be inflated relative to its “correct” value for positively

correlated residuals.

“Remedies” for Autocorrelation
• If the form of the autocorrelation is known, we could use a GLS

procedure – i.e. an approach that allows for autocorrelated residuals
e.g., Cochrane-Orcutt.
• But such procedures that “correct” for autocorrelation require

assumptions about the form of the autocorrelation.
• If these assumptions are invalid, the cure would be more dangerous

than the disease! - see Hendry and Mizon (1978).
• However, it is unlikely to be the case that the form of the

autocorrelation is known, and a more “modern” view is that residual
autocorrelation presents an opportunity to modify the regression.

Dynamic Models
• All of the models we have considered so far have been static, e.g.
yt = 1 + 2x2t + ... + kxkt + ut
• But we can easily extend this analysis to the case where the current
value of yt depends on previous values of y or one of the x’s, e.g.
yt = 1 + 2x2t + ... + kxkt + 1yt-1 + 2x2t-1 + … + kxkt-1+ ut
• We could extend the model even further by adding extra lags, e.g.
x2t-2 , yt-3 .

Why Might we Want/Need To Include Lags
in a Regression?
• Inertia of the dependent variable

• Over-reactions
• Measuring time series as overlapping moving averages
• However, other problems with the regression could cause the null
hypothesis of no autocorrelation to be rejected:
– Omission of relevant variables, which are themselves autocorrelated.
– If we have committed a “misspecification” error by using an
inappropriate functional form.
– Autocorrelation resulting from unparameterised seasonality.

Models in First Difference Form
• Another way to sometimes deal with the problem of autocorrelation is

to switch to a model in first differences.
• Denote the first difference of yt, i.e. yt - yt-1 as yt; similarly for the x-
variables, x2t = x2t - x2t-1 etc.
• The model would now be

yt = 1 + 2 x2t + ... + kxkt + ut
• Sometimes the change in y is purported to depend on previous values

of y or xt as well as changes in x:
yt = 1 + 2 x2t + 3x2t-1 +4yt-1 + ut
The Long Run Static Equilibrium Solution
• One interesting property of a dynamic model is its long run or static

equilibrium solution.
• “Equilibrium” implies that the variables have reached some steady state
and are no longer changing, i.e. if y and x are in equilibrium, we can say
yt = yt+1 = ... =y and xt = xt+1 = ... =x
Consequently, yt = yt - yt-1 = y - y = 0 etc.
• So the way to obtain a long run static solution is:
1. Remove all time subscripts from variables
2. Set error terms equal to their expected values, E(ut)=0
3. Remove first difference terms altogether
4. Gather terms in x together and gather terms in y together.
• These steps can be undertaken in any order

The Long Run Static Equilibrium Solution:
An Example
If our model is
yt = 1 + 2 x2t + 3x2t-1 +4yt-1 + ut
then the static solution would be given by

0 = 1 + 3x2t-1 +4yt-1
4yt-1 = - 1 - 3x2t-1
 1 3
y  x2
4 4

Problems with Adding Lagged Regressors
to “Cure” Autocorrelation
• Inclusion of lagged values of the dependent variable violates the

assumption that the RHS variables are non-stochastic.
• What does an equation with a large number of lags actually mean?
• Note that if there is still autocorrelation in the residuals of a model

including lags, then the OLS estimators will not even be consistent.

Multicollinearity
• This problem occurs when the explanatory variables are very highly correlated
with each other.
• Perfect multicollinearity
Cannot estimate all the coefficients
- e.g. suppose x3 = 2x2
and the model is yt = 1 + 2x2t + 3x3t + 4x4t + ut
• Problems if Near Multicollinearity is Present but Ignored

- 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.

Measuring Multicollinearity
• The easiest way to measure the extent of multicollinearity is simply to

look at the matrix of correlations between the individual variables. e.g.
Corr x2 x3 x4
x2 - 0.2 0.8
x3 0.2 - 0.3
x4 0.8 0.3 -
• But another problem: if 3 or more variables are linear
- e.g. x2t + x3t = x4t
• Note that high correlation between y and one of the x’s is not
muticollinearity.

Solutions to the Problem of Multicollinearity
• “Traditional” approaches, such as ridge regression or principal

components. But these usually bring more problems than they solve.
• Some econometricians argue that if the model is otherwise OK, just

ignore it
• 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

Adopting the Wrong Functional Form
• We have previously assumed that the appropriate functional form is linear.

• This may not always be true.
• We can formally test this using Ramsey’s RESET test, which is a general test
for mis-specification of functional form.
• Essentially the method works by adding higher order terms of the fitted values
(e.g. yt2 , yt3 etc.) into an auxiliary regression:
Regress ut on powers of the fitted values:
ut  0  1 yt2  2 yt3 ...  p 1 ytp  vt
Obtain R2 from this regression. The test statistic is given by TR2 and is
distributed as a  2 ( p  1) .
• So if the value of the test statistic is greater than a  2 ( p  1) then reject the null
hypothesis that the functional form was correct.
But what do we do if this is the case?
• The RESET test gives us no guide as to what a better specification

might be.
• One possible cause of rejection of the test is if the true model is

yt  1   2 x2t   3 x22t   4 x23t  ut
In this case the remedy is obvious.
• Another possibility is to transform the data into logarithms. This will

linearise many previously multiplicative models into additive ones:
yt  Axt eut  ln yt     ln xt  ut

Testing the Normality Assumption
• Why did we need to assume normality for hypothesis testing?
Testing for Departures from Normality
• The Bera Jarque normality test

• A normal distribution is not skewed and is defined to have a
coefficient of kurtosis of 3.
• The kurtosis of the normal distribution is 3 so its excess kurtosis (b2-3)
is zero.
• Skewness and kurtosis are the (standardised) third and fourth moments
of a distribution.

Normal versus Skewed Distributions
f(x) f(x)
x x
A normal distribution A skewed distribution

Leptokurtic versus Normal Distribution
0.5
0.4
0.3
0.2
0.1
0.0
-5.4 -3.6 -1.8 -0.0 1.8 3.6 5.4

Testing for Normality
• Bera and Jarque formalise this by testing the residuals for normality by
testing whether the coefficient of skewness and the coefficient of excess
kurtosis are jointly zero.
• It can be proved that the coefficients of skewness and kurtosis can be
expressed respectively as:
E[u3 ] E[u4 ]
b1  and b2  2 2
2 3/ 2
   
• The Bera Jarque test statistic is given by

 b12 b2  32 
W T   ~  2 
2
6 24 
• We estimate b1 and b2 using the residuals from the OLS regression, u .

What do we do if we find evidence of Non-Normality?
• It is not obvious what we should do!
• Could use a method which does not assume normality, but difficult and
what are its properties?
• Often the case that one or two very extreme residuals causes us to reject
the normality assumption.
• An alternative is to use dummy variables.

e.g. say we estimate a monthly model of asset returns from 1980-1990, and
we plot the residuals, and find a particularly large outlier for October 1987:

What do we do if we find evidence
of Non-Normality? (cont’d)
û t
+
Oct Time
1987
• Create a new variable:

D87M10t = 1 during October 1987 and zero otherwise.
This effectively knocks out that observation. But we need a theoretical
reason for adding dummy variables.
Omission of an Important Variable or
Inclusion of an Irrelevant Variable
Omission of an Important Variable

• Consequence: 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 this condition is satisfied, the estimate of the coefficient on the
constant term will be biased.
• The standard errors will also be biased.
Inclusion of an Irrelevant Variable

• Coefficient estimates will still be consistent and unbiased, but the
estimators will be inefficient.

Parameter Stability Tests
• So far, we have estimated regressions such as yt = 1 + 2x2t + 3x3t + ut
• We have implicitly assumed that the parameters (1, 2 and 3) are
constant for the entire sample period.
• We can test this implicit assumption using 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

The Chow Test
• The steps involved are:

1. Split the data into two sub-periods. Estimate the regression over the
whole period and then for the two sub-periods separately (3 regressions).
Obtain the RSS for each regression.
2. The restricted regression is now the regression for the whole period
while the “unrestricted regression” comes in two parts: for each of the sub-
samples.
We can thus form an F-test which is the difference between the RSS’s.
RSS   RSS1  RSS2  T  2k

The statistic is 
RSS1  RSS2 k

The Chow Test (cont’d)
where:
RSS = RSS for whole sample
RSS1 = RSS for sub-sample 1
RSS2 = RSS for sub-sample 2
T = number of observations
2k = number of regressors in the “unrestricted” regression (since it comes
in two parts)
k = number of regressors in (each part of the) “unrestricted” regression
3. Perform the test. If the value of the test statistic is greater than the
critical value from the F-distribution, which is an F(k, T-2k), then reject
the null hypothesis that the parameters are stable over time.
A Chow Test Example
• Consider the following regression for the CAPM  (again) for the
returns on Glaxo.
• Say that we are interested in estimating Beta for monthly data from
1981-1992. The model for each sub-period is
• 1981M1 - 1987M10
0.24 + 1.2RMt T = 82 RSS1 = 0.03555
• 1987M11 - 1992M12
0.68 + 1.53RMt T = 62 RSS2 = 0.00336
• 1981M1 - 1992M12
0.39 + 1.37RMt T = 144 RSS = 0.0434

A Chow Test Example - Results
• The null hypothesis is
H0: 1  2 and 1  2
• The unrestricted model is the model where this restriction is not imposed
00434
.   00355
.  000336
.  144  4
Test statistic  
00355
.  000336
. 2
= 7.698
Compare with 5% F(2,140) = 3.06
• We reject H0 at the 5% level and say that we reject the restriction that the
coefficients are the same in the two periods.
The Predictive Failure Test
• Problem with the Chow test is that we need to have enough data to do the
regression on both sub-samples, i.e. T1>>k, T2>>k.
• An alternative formulation is the predictive failure test.
• What we do with the predictive failure test is estimate the regression over a “long”
sub-period (i.e. most of the data) and then we predict values for the other period
and compare the two.
To calculate the test:
- Run the regression for the whole period (the restricted regression) and obtain the RSS
- Run the regression for the “large” sub-period and obtain the RSS (called RSS1). Note
we call the number of observations T1 (even though it may come second).
RSS  RSS1 T1  k
Test Statistic  
RSS1 T2
where T2 = number of observations we are attempting to “predict”. The test statistic
will follow an F(T2, T1-k).
Backwards versus Forwards Predictive Failure Tests
• There are 2 types of predictive failure tests:
- Forward predictive failure tests, where we keep the last few

observations back for forecast testing, e.g. we have observations for
1970Q1-1994Q4. So estimate the model over 1970Q1-1993Q4 and
forecast 1994Q1-1994Q4.
- Backward predictive failure tests, where we attempt to “back-cast”

the first few observations, e.g. if we have data for 1970Q1-1994Q4,
and we estimate the model over 1971Q1-1994Q4 and backcast
1970Q1-1970Q4.

Predictive Failure Tests – An Example
• We have the following models estimated:

For the CAPM  on Glaxo.
• 1980M1-1991M12
0.39 + 1.37RMt T = 144 RSS = 0.0434
• 1980M1-1989M12
0.32 + 1.31RMt T1 = 120 RSS1 = 0.0420
Can this regression adequately “forecast” the values for the last two years?
0.0434  0.0420 120  2
Test Statistic   = 0.164
0.0420 24
• Compare with F(24,118) = 1.66.
So we do not reject the null hypothesis that the model can adequately
predict the last few observations.

How do we decide the sub-parts to use?
• As a rule of thumb, we could use all or some of the following:

- Plot the dependent variable over time and split the data accordingly to any
obvious structural changes in the series, e.g. 1400
1200
1000
Value of Series (yt)

800
600
400
200
105
131
157
183
209
235
261
287
313
339
365
391
417
443
27
53
79
1
Sample Period
- Split the data according to any known important

historical events (e.g. stock market crash, new government elected)
- Use all but the last few observations and do a predictive failure test on those.
Measurement Errors
• If there is measurement error in one or more of the explanatory variables,

this will violate the assumption that the explanatory variables are non-
stochastic
• Sometimes this is also known as the errors-in-variables problem
• Measurement errors can occur in a variety of circumstances, e.g.
– Macroeconomic variables are almost always estimated quantities
(GDP, inflation, and so on), as is most information contained in
company accounts
– Sometimes we cannot observe or obtain data on a variable we require
and so we need to use a proxy variable – for instance, many models
include expected quantities (e.g., expected inflation) but we cannot
typically measure expectations.
‘Introductory Econometrics for Finance’ © Chris Brooks 2013

52
Measurement Error in the Explanatory Variable(s)
• Suppose that we wish to estimate a model containing just one

explanatory variable, xt:
• yt = β1 + β2xt + ut,
where ut is a disturbance term
• Suppose further that xt is measured with error so that instead of observing
its true value, we observe a noisy version, , that comprises the actual
xt plus some additional noise, vt that is independent of xt and ut:
• Taking the first equation and substituting in for xt from the second:
• We can rewrite this equation by separately expressing the composite

error term, (ut − β2vt)

53
Measurement Error in the Explanatory Variable(s)
• It should be clear from this equation and the one for the explanatory
variable measured with error, and the composite error term,
(ut − β2vt), are correlated since both depend on vt
• Thus the requirement that the explanatory variables are non-stochastic
does not hold
• This causes the parameters to be estimated inconsistently
• The size of the bias in the estimates will be a function of the variance of
the noise in xt as a proportion of the overall disturbance variance
• If β2 is positive, the bias will be negative but if β2 is negative, the bias
will be positive
• So the parameter estimate will always be biased towards zero as a result
of the measurement noise.
54
Measurement Error and Tests of the CAPM
• The standard approach to testing the CAPM pioneered by Fama and

MacBeth (1973) comprises two stages
• Since the betas are estimated at the first stage rather than being directly
observable, they will surely contain measurement error
• The effect of this has sometimes been termed attenuation bias.
• Tests of the CAPM showed that the relationship between beta and returns
was smaller than expected, and this is precisely what would happen as a
result of measurement error
• Various approaches to solving this issue have been proposed, the most
common of which is to use portfolio betas in place of individual betas
• An alternative approach (Shanken,1992) is to modify the standard errors
in the second stage regression to adjust directly for the measurement
errors.
55
Measurement Error in the Explained Variable
• Measurement error in the explained variable is much less serious than in

the explanatory variable(s)
• This is one of the motivations for the inclusion of the disturbance term in
a regression model
• When the explained variable is measured with error, the disturbance term
will in effect be a composite of the usual disturbance term and another
source of noise from the measurement error
• Then the parameter estimates will still be consistent and unbiased and the
usual formulae for calculating standard errors will still be appropriate
• The only consequence is that the additional noise means the standard
errors will be enlarged relative to the situation where there was no
measurement error in y.
56
A Strategy for Building Econometric Models
Our Objective:
• To build a statistically adequate empirical model which
- satisfies the assumptions of the CLRM
- is parsimonious
- has the appropriate theoretical interpretation
- has the right “shape” - i.e.
- all signs on coefficients are “correct”
- all sizes of coefficients are “correct”
- is capable of explaining the results of all competing models

2 Approaches to Building Econometric Models
• There are 2 popular philosophies of building econometric models: the

“specific-to-general” and “general-to-specific” approaches.
• “Specific-to-general” was used almost universally until the mid 1980’s,

and involved starting with the simplest model and gradually adding to it.
• Little, if any, diagnostic testing was undertaken. But this meant that all
inferences were potentially invalid.
• An alternative and more modern approach to model building is the “LSE”

or Hendry “general-to-specific” methodology.
• The advantages of this approach are that it is statistically sensible and also
the theory on which the models are based usually has nothing to say about
the lag structure of a model.
The General-to-Specific Approach
• First step is to form a “large” model with lots of variables on the right hand
side
• This is known as a GUM (generalised unrestricted model)
• At this stage, we want to make sure that the model satisfies all of the
assumptions of the CLRM
• If the assumptions are violated, we need to take appropriate actions to remedy
this, e.g.
- taking logs
- adding lags
- dummy variables
• We need to do this before testing hypotheses
• Once we have a model which satisfies the assumptions, it could be very big
with lots of lags & independent variables
The General-to-Specific Approach:
Reparameterising the Model
• The next stage is to reparameterise the model by

- knocking out very insignificant regressors
- some coefficients may be insignificantly different from each other,
so we can combine them.
• At each stage, we need to check the assumptions are still OK.
• Hopefully at this stage, we have a statistically adequate empirical model

which we can use for
- testing underlying financial theories
- forecasting future values of the dependent variable
- formulating policies, etc.
Regression Analysis In Practice - A Further Example:
Determinants of Sovereign Credit Ratings
• Cantor and Packer (1996)

Financial background:
• What are sovereign credit ratings and why are we interested in them?
• Two ratings agencies (Moody’s and Standard and Poor’s) provide credit
ratings for many governments.
• Each possible rating is denoted by a grading:

Moody’s Standard and Poor’s
Aaa AAA
…… …..
B3 B-

Purposes of the Paper
- to attempt to explain and model how the ratings agencies arrived at

their ratings.
- to use the same factors to explain the spreads of sovereign yields

above a risk-free proxy
- to determine what factors affect how the sovereign yields react to

ratings announcements

Determinants of Sovereign Ratings
• Data
Quantifying the ratings (dependent variable): Aaa/AAA=16, ... , B3/B-=1
• Explanatory variables (units of measurement):
- Per capita income in 1994 (thousands of dollars)
- Average annual GDP growth 1991-1994 (%)
- Average annual inflation 1992-1994 (%)
- Fiscal balance: Average annual government budget surplus as a
proportion of GDP 1992-1994 (%)
- External balance: Average annual current account surplus as a proportion
of GDP 1992-1994 (%)
- External debt Foreign currency debt as a proportion of exports 1994 (%)
- Dummy for economic development
- Dummy for default history
Income and inflation are transformed to their logarithms.
The model: Linear and estimated using OLS
Dependent Variable
Expected Average Moody’s S&P Moody’s / S&P
Explanatory Variable sign Rating Rating Rating Difference
Intercept ? 1.442 3.408 -0.524 3.932**
(0.663) (1.379) (-0.223) (2.521)
Per capita income + 1.242*** 1.027*** 1.458*** -0.431***
(5.302) (4.041) (6.048) (-2.688)
GDP growth + 0.151 0.130 0.171** -0.040
(1.935) (1.545) (2.132) (0.756)
Inflation - -0.611*** -0.630*** -0.591*** -0.039
(-2.839) (-2.701) (2.671) (-0.265)
Fiscal Balance + 0.073 0.049 0.097* -0.048
(1.324) (0.818) (1.71) (-1.274)
External Balance + 0.003 0.006 0.001 0.006
(0.314) (0.535) (0.046) (0.779)
External Debt - -0.013*** -0.015*** -0.011*** -0.004***
(-5.088) (-5.365) (-4.236) (-2.133)
Development dummy + 2.776*** 2.957*** 2.595*** 0.362
(4.25) (4.175) (3.861) (0.81)
Default dummy - -2.042*** -1.63** -2.622*** 1.159***
(-3.175) (-2.097) (-3.962) (2.632)
Adjusted R2 0.924 0.905 0.926 0.836
Notes: t-ratios in parentheses; *, **, and *** indicate significance at the 10%, 5% and 1% levels
respectively. Source: Cantor and Packer (1996). Reprinted with permission from Institutional Investor.

Interpreting the Model
From a statistical perspective

• Virtually no diagnostics
• Adjusted R2 is high
• Look at the residuals: actual rating - fitted rating
From a financial perspective

• Do the coefficients have their expected signs and sizes?
Do Ratings Add to Publicly Available Available Information?

• Now dependent variable is
- Log (Yield on the sovereign bond - yield on a US treasury bond)

Do Ratings Add to Publicly Available Available
Information? Results
Dependent Variable: Log (yield spread)

Variable Expected Sign (1) (2) (3)
Intercept ? 2.105*** 0.466 0.074
(16.148) (0.345) (0.071)
Average - -0.221*** -0.218***
Rating (-19.175) (-4.276)
Per capita - -0.144 0.226
income (-0.927) (1.523)
GDP growth - -0.004 0.029
(-0.142) (1.227)
Inflation + 0.108 -0.004
(1.393) (-0.068)
Fiscal Balance - -0.037 -0.02
(-1.557) (-1.045)
External - -0.038 -0.023
Balance (-1.29) (-1.008)
External Debt + 0.003*** 0.000
(2.651) (0.095)
Development - -0.723*** -0.38
dummy (-2.059) (-1.341)
Default dummy + 0.612*** 0.085
(2.577) (0.385)
Adjusted R2 0.919 0.857 0.914
Notes: t-ratios in parentheses; *, **, and *** indicate significance at the 10%, 5% and 1% levels
respectively. Source: Cantor and Packer (1996). Reprinted with permission from Institutional Investor.
What Determines How the Market Reacts
to Ratings Announcements?
• The sample: Every announcement of a ratings change that occurred

between 1987 and 1994 - 79 such announcements spread over 18
countries.
• 39 were actual ratings changes
• 40 were “watchlist / outlook” changes
• The dependent variable: changes in the relative spreads over the US

T-bond over a 2-day period at the time of the announcement.

to Ratings Announcements? Explanatory variables.
0 /1 dummies for
- Whether the announcement was positive
- Whether there was an actual ratings change
- Whether the bond was speculative grade
- Whether there had been another ratings announcement in the previous 60 days.
and
- The change in the spread over the previous 60 days.
- The ratings gap between the announcing and the other agency

to Ratings Announcements? Results
Dependent Variable: Log Relative Spread

Independent variable Coefficient (t-ratio)
Intercept -0.02
(-1.4)
Positive announcements 0.01
(0.34)
Ratings changes -0.01
(-0.37)
Moody’s announcements 0.02
(1.51)
Speculative grade 0.03**
(2.33)
Change in relative spreads from day –60 to day -1 -0.06
(-1.1)
Rating gap 0.03*
(1.7)
Other rating announcements from day –60 to day -1 0.05**
(2.15)
2
Adjusted R 0.12
Note: * and ** denote significance at the 10% and 5% levels respectively. Source: Cantor and Packer
(1996). Reprinted with permission from Institutional Investor.
Conclusions
• 6 factors appear to play a big role in determining sovereign credit

ratings - incomes, GDP growth, inflation, external debt, industrialised
or not, and default history.
• The ratings provide more information on yields than all of the macro
factors put together.
• We cannot determine well what factors influence how the markets will
react to ratings announcements.

Comments on the Paper
• Only 49 observations for first set of regressions and 35 for yield

regressions and up to 10 regressors
• No attempt at reparameterisation
• Little attempt at diagnostic checking
• Where did the factors (explanatory variables) come from?

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Chapter 5

Classical linear regression model assumptions

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 1

• Recall that we assumed of the CLRM disturbance terms:

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 2

• Often, an F- and a 2- version of the test are available.

• The F-test version involves estimating a restricted and an unrestricted

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 4

• Assumption that the mean of the disturbances is zero.

• For all diagnostic tests, we cannot observe the disturbances and so

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 5

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 6

The Goldfeld-Quandt (GQ) test is carried out as follows.

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 7

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 8

• White’s general test for heteroscedasticity is one of the best

3. Obtain R2 from the auxiliary regression and multiply it by the

4. If the 2 test statistic from step 3 is greater than the corresponding

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 10

• This implies that if we still use OLS in the presence of

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 11

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 12

• So the disturbances from the new regression equation will be

• Other solutions include:

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 13

• Obviously we never have the actual u’s, so we use their sample

• Some stereotypical patterns we may find in the residuals are given on

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 15

Positive Autocorrelation is indicated by a cyclical residual plot over time.

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 16

Negative autocorrelation is indicated by an alternating pattern where the residuals

No pattern in residuals at all: this is what we would like to see

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 18

The Durbin-Watson (DW) is a test for first order autocorrelation - i.e.

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 19

• We can also write

• If  = 0, DW = 2. So roughly speaking, do not reject the null

• Unfortunately, DW has 2 critical values, an upper critical value (du)

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 20

Conditions which Must be Fulfilled for DW to be a Valid Test

• It is a more general test for rth order autocorrelation:

• R2 is likely to be inflated relative to its “correct” value for positively

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 23

• If the form of the autocorrelation is known, we could use a GLS

• But such procedures that “correct” for autocorrelation require

• If these assumptions are invalid, the cure would be more dangerous

• However, it is unlikely to be the case that the form of the

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 24

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 25

• Inertia of the dependent variable

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 26

• Another way to sometimes deal with the problem of autocorrelation is

• The model would now be

• Sometimes the change in y is purported to depend on previous values

• One interesting property of a dynamic model is its long run or static

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 28

then the static solution would be given by

‘Introductory Econometrics for Finance’ © Chris Brooks 2013 29

• Inclusion of lagged values of the dependent variable violates the