FRM Part I · FRM Exam Part I · Regression Diagnostics

A plot of residuals against fitted values from a regression of firm-level credit spreads shows a funnel shape: residuals are tightly clustered for low fitted values and widely dispersed for high fitted values. Which is the most appropriate response?

A funnel-shaped residual plot indicates heteroskedasticity, meaning error variance changes with the fitted value. The appropriate response is to use heteroskedasticity-robust standard errors or weighted least squares. The pattern does not indicate multicollinearity or autocorrelation, so dropping the intercept or adding lags would not address it.

1. AUse heteroskedasticity-robust standard errors or weighted least squares, since the pattern suggests nonconstant error varianceCorrect
2. BDrop the intercept, since the funnel shape indicates perfect multicollinearity
3. CAdd a lagged dependent variable, since the funnel shape indicates first-order autocorrelation
4. DIgnore the pattern, since OLS coefficients are biased only when residual variance is constant