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Research Methods in Finance

Abdul Qadeer Khan (PhD Scholar & Research Associate)

nd
D-Block 2 Floor, Room # 218
Mohammad Ali Jinnah University, Islamabad
Office: 051-4486701 Ext: 212
Cell: 0333-6487274
dr.aqkhan@live.com; abdul.qadeer@jinnah.edu.pk

Section 1, 2 & 3
Lecture # 5
July 9-11, 2012
In this lecture, we will discuss:

1. Detection of Heteroscedasticity via:

a. Breusch-Pagan Test
b. Harvey Test
c. Glejser Test
d. PARK Test
e. White Test

2. Removal of Heteroscedasticity via:

a. Consistent OLS
b. Weighted LS

3. General Misspecification Test

Please recall the assumptions of Classical Linear Regression Model; one of them is given below:

Homoskedasticity: The term Homoskedasticity means same spread from the regression line. Variance of
error term must be constant. If spread from the regression line deviate then Heteroscedasticity will exist
in the data.
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Effects of Heteroscedasticity:

i) β: (efficient and consistent) Whether Heteroscedasticity exists or not, there would be no

effect on beta, it will remain efficient and consistent. In other words, slope of the regression
line will be same.
ii) Standard Error (Inefficient, incorrect and may affect hypothesis testing): Standard error
(for sample) and standard deviation (for population). Due to the Heteroscedasticity standard
error may increase or decrease based on different spread of the data.
iii) T-Statistics (Inefficient and may affect hypothesis testing): Due to Heteroscedasticity,
standard error will increase or decrease that will ultimately upset t-statistics which is
calculated by: t = β / S.E

More precisely in simplest words:

If Standard Error increase then t-statistics decrease (due to the denominator effect).
Ultimately due to t-statistics, hypothesis testing will be incorrect. So such variable that was
significant in nature will become insignificant.

If Standard Error decrease then t-statistics increase (due to the denominator effect).
Ultimately due to t-statistics, hypothesis testing will be incorrect. So such variable that was
insignificant in nature will become significant.

iv) F-Statistics: Due to Heteroscedasticity regression line (OLS, CLRM or linear line are same
name) not remain best fit. So decision making will be inefficient.

In simple words, F-Statistics is joint hypothesis of X1 and X2 (these are our independent
variables), that means whether X1 and X2 jointly can influence Y that is dependent variable
or not. Following are results:

Breusch Pagan Test:

Please follow these steps:

i. Generate variables and paste data and save it.

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ii. Regress these variables, go to quick menu, estimate equation and write equation; x1 as
dependent variable and x2 x3 and x4 as independent variables. x1 c x2 x3 x4 click OK.
Following results will be displayed.
iii. In Breusch Pagan Test, we use square root of error term because generation or error term is
assumption of Breusch Pagan Test; by doing square root all negative values will become
positive. So we will first generate error term then we will take square root or error term.
Equation is: genr ut=resid (press enter) then genr utsq=ut^2, (press enter) as shown in
picture.
iv. Again go to quick menu and estimate equation. Now utsq will become dependent variable.
Equation will be: utsq c x2 x3 x4. From the results we will pick the value of R-square which is
0.041560 in this case (as shown in picture below). We use R-square value for computing
calculated value by formula: LM = n*R2
= 39*0.041560
= 1.62084 -----------------------------This value is called Calculated Value.
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v. For final decision about Heteroscedasticity (whether the problem of Heteroscedasticity exist
or not), we need critical value or tabulated value. We will generate chi-square as: genr
chi=@qchisq(0.95,3). Here 0.95 is confidence interval and 3 means that we have 3
independent variables namely x2 x3 and x4. After generating chi square “chi” file name will
appear. Please open, series of single constant value will appear. This value is called
tabulated or critical value.

Decision Criteria:

Calculated Value = 1.62084

Tabulated Value/Critical Value = 7.81472

o If Calculated value > Tabulated/critical value then Heteroscedasticity (In other words, there is
significant relationship)

o If Calculated value < Tabulated/critical value then Homoskedasticity (In other words, there is
insignificant relationship).

On the basis of above decision criteria, we conclude that there is Homoskedasticity or insignificant
relationship.
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Alternative Method for Confirmation:

Following shortcut steps:

i. Generate variables
ii. Go to quick and estimate equation with x1 c x2 x3 x4
iii. Go to view of that small window and click on residual diagnostics then Heteroscedasticity
Tests; as shown in given below:

iv. Select Breusch-Pagan Test and click OK, results will display as given below picture. There are
same results as previous method. As shown in picture below, we will check Prob. Chi-Square
(3), if this probability is insignificant then it means there is Homoskedasticity, if significant
there will exist Heteroscedasticity. In this case Chi-Square (3) is 0.6547 that is insignificant or
existence of Homoskedasticity.
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Glejser Test:

Follow these steps:

i. Generate Variables
ii. Regress those: x1 as dependent and x2, x3 and x4 as independent variable
iii. Genr ut=resid (as you previously generated in Bruesch Pagan Test)
iv. But for Glejser Test, don’t create error term square
v. Create: genr absut=abs(ut)
(Glejser says that don’t use square root but absolute value of error term should be used, so
using absolute value is the assumption of Glejser Test).
vi. Now Regress as: absut c x2 x3 x4
vii. Pick the value of R-Square
viii. Apply the formula: LM = n*R2 -------------Called Calculated Value
ix. Generate chi-square as: genr chi=@qchisq(0.95,3)-------------Called Tabulated or critical value
x. Compare and take decision (Decision Criteria is same as given in page 4)

Harvey Test:

Follow these steps:

i. Generate Variables
ii. Regress those: x1 as dependent and x2, x3 and x4 as independent variable
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iii. Genr ut=resid (as you previously generated in Bruesch Pagan Test)
iv. But for Harvey Test: generate error term square as genr utsq=ut^2
v. Then genr Lutsq=log(utsq)
(Harvey says that don’t use square root or absolute value of error term but log of error term
square should be used, so using log of error term square is the assumption of Harvey Test).
vi. Now Regress as: Lutsq c x2 x3 x4
vii. Pick the value of R-Square
viii. Apply the formula: LM = n*R2 -------------Called Calculated Value
ix. Generate chi-square as: genr chi=@qchisq(0.95,3)-------------Called Tabulated or critical value
x. Compare and take decision (Decision Criteria is same as given in page 4)

White Test: (Use three variables Y as DV and x1 x2 x3 as IV-Excel file is attached)

Follow these steps:

i. Generate Variables
ii. Regress those: Y as dependent and x1, x2 and x3 as independent variable
iii. Genr ut=resid (as you previously generated in Bruesch Pagan Test)
iv. Generate error term square as genr utsq=ut^2
(In this test we use linear and non linear; means we use both product and square form)
Suppose if our Regression Equation include:
X1 + X2+X3 --------------------linear form
X12 + X22+X32 ------------------in square form (non linear)
So, we will generate:
genr x1sq=x1^2
genr x2sq=x2^2
genr x3sq=x3^2

And their possible combinations:

genr x1x2=x1*x2
genr x1x3=x1*x3
genr x2x3=x2*x3

In non-linear form there is square on x1 x2 and x3 that’s why we created square of x1, x2 and x3
(as x1sq x2sq x3sq)

v. Now, regress utsq c x1(space)x2(space) x3(space)x1sq(space)x2sq(space) x3sq(space)x1x2(space)x1x3(space)x2x3

vi. Pick the value of R-Square
vii. Apply the formula: LM = n*R2 -------------Called Calculated Value
viii. Generate chi-square as: genr chi=@qchisq(0.95,3)-------------Called Tabulated or critical value
ix. Compare and take decision (Decision Criteria is same as given in page 4)
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Park Test:

i. Generate Variables
ii. Regress those: Y as dependent and x1, x2 and x3 as independent variables
iii. Genr ut=resid (as you previously generated in Bruesch Pagan Test)
iv. Generate error term square as genr utsq=ut^2
v. Genr Lutsq=log(utsq)
vi. Now regress as: Lutsq c log(x1) log(x2) log(x3)
vii. Error Message: as shown in picture below “Log of non positive number” this means that in
error term there are zero or negative numbers. Log of zero or negative is not possible.

Shortcut Method for all Tests:

All steps are same:

i. Regress simple
ii. Go to view----residual diagnostics and choose Heteroscedasticity Test
iii. Choose one by one all tests
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Decision Criteria:

If Chi-square probability is higher than 5% or 0.05 then there will be Homoskedasticity otherwise
Heteroscedasticity. This is the easiest way for detection.

Two ways for Removal of Heteroscedasticity:

i. Consistent LS
ii. Weighted LS

Steps for first method:

i. Regress simple but don’t click OK, go to options

ii. As shown in picture below: Three sub-options under “Coefficient covariance matrix” is the
first method for removal of Heteroscedasticity.
iii. We choose HAC (Newey-West) ---- [Heteroscedasticity Autocorrelation Consistent] when
both Heteroscedasticity and Autocorrelation exist in data.
iv. We choose “white” when only Heteroscedasticity exist in our data.
v. Better is HAC (Newey-West) than White.
vi. After selecting click OK, now results are free from Heteroscedasticity.
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vii. Now we compare pre and post Heteroscedasticity results:

Pre Heteroscedasticity:

In order to compare pre and post Heteroscedasticity, simply regress as: dpo c g lev p s t; small window
will open containing basic information. Copy (Press Ctrl +A) and paste in excel.

Dependent Variable: DPO

Method: Least Squares
Date: 07/13/12 Time: 07:49
Sample: 1 1216
Included observations: 1216

Variable Coefficient Std. Error t-Statistic Prob.

C 6.425187 0.803205 7.999441 0.0000

G -0.000642 0.003938 -0.162905 0.8706
LEV 0.027036 0.009071 2.980436 0.0029
P -0.000369 0.000733 -0.503198 0.6149
S 8.60E-05 1.92E-05 4.481479 0.0000
T -4.611950 1.387832 -3.323133 0.0009

R-squared 0.032547 Mean dependent var 4.592576

Adjusted R-squared 0.028549 S.D. dependent var 13.00190
S.E. of regression 12.81496 Akaike info criterion 7.944026
Sum squared resid 198710.1 Schwarz criterion 7.969207
Log likelihood -4823.968 Hannan-Quinn criter. 7.953505
F-statistic 8.141269 Durbin-Watson stat 1.527158
Prob(F-statistic) 0.000000
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Post Heteroscedasticity:

HAC (Newey-West) Press OK. Now

Simple regress variables as: dpo c g lev p s t ; then go to options select
Heteroscedasticity Autocorrelation Consistent results are in front of you. Copy (Press Ctrl + A) and paste
in excel. Results are shown in picture below:

Dependent Variable: DPO

Method: Least Squares
Date: 07/13/12 Time: 08:07
Sample: 1 1216
Included observations: 1216
HAC standard errors & covariance (Bartlett kernel, Newey-West fixed
bandwidth = 7.0000)

Variable Coefficient Std. Error t-Statistic Prob.

C 6.425187 1.221207 5.261340 0.0000

G -0.000642 0.002761 -0.232395 0.8163
LEV 0.027036 0.036655 0.737587 0.4609
P -0.000369 0.000381 -0.967747 0.3334
S 8.60E-05 5.12E-05 1.681144 0.0930
T -4.611950 2.153979 -2.141131 0.0325

R-squared 0.032547 Mean dependent var 4.592576

Adjusted R-squared 0.028549 S.D. dependent var 13.00190
S.E. of regression 12.81496 Akaike info criterion 7.944026
Sum squared resid 198710.1 Schwarz criterion 7.969207
Log likelihood -4823.968 Hannan-Quinn criter. 7.953505
F-statistic 8.141269 Durbin-Watson stat 1.527158
Prob(F-statistic) 0.000000
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Now, compare pre and post Heteroscedasticity results with respect to:

a. β (Regression Coefficient)
b. Standard Error
c. T-Statistics
d. F-Statistics

For Weighted LS:

Process is same:

i. Simple regress as: dpo c g lev p s t then go to options

ii. Now click on weighted and you will see four options i.e. Inverse Standard, Inverse Variance,
Standard Deviation and Variance. Choose any one, our results will be same. In weight series
write the name of that variable where Heteroscedasticity exist. In this case, we wrote S
(size). As shown in picture below.
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iii. Results are:

After adopting these two methods for the removal of Heteroscedasticity, check your results. Go to view
after simply regression: dpo c g lev p s t or x1 c x2 x3 x4 and then go to view-----residual diagnostics----
Heteroscedasticity and choose any one. If Prob. Chi-Square (5) is insignificant then it means, our data is
free from Heteroscedasticity. If P value is significant (less then.05) then Heteroscedasticity exits. If
Heteroscedasticity exist after the removal process then repeat same process and change the variable in
(write the name of variable in weight series) which Heteroscedasticity exits.

General Misspecification Test:

To check the issue of misspecification, Ramsey RESET is used.

For testing general misspecification, there is one test “Ramsey RESET Test”. Steps are:

i. Simple regress
ii. Go to view---stability diagnostics then click Ramsey RESET Test
iii. Number of fitted terms by default is “1”
iv. Use 1---for square ; 2 for quadratic
v. As shown in picture below, we use 1
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vi. Results are:

Ramsey RESET Test

Equation: UNTITLED
Specification: X1 X2 X3 Y C
Omitted Variables: Squares of fitted values

Value df Probability
t-statistic 0.113634 34 0.9102
F-statistic 0.012913 (1, 34) 0.9102
Likelihood ratio 0.014809 1 0.9031

F-test summary:
Mean
Sum of Sq. df Squares
Test SSR 0.219004 1 0.219004
Restricted SSR 576.8755 35 16.48216
Unrestricted SSR 576.6565 34 16.96049
Unrestricted SSR 576.6565 34 16.96049

LR test summary:
Value df
Restricted LogL -107.8729 35
Unrestricted LogL -107.8655 34
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Decision Criteria:

o Probability of F-statistics > .05 or insignificant then there is no general misspecification.

o Probability of F-statistics < .05 or significant then there is general misspecification. Then it
means that equation must include square [as we insert 1 for square].

“Knowledge is power. Information is power. The secreting or hoarding of knowledge or information may be an act
of tyranny camouflaged as humility.” (Robin Morgan)

Note: Please convey, if you found any mistake. Comments for improvement will be highly appreciated. Thanks
Abdul Qadeer Khan