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FRM Part I · FRM Exam Part I · Regression Diagnostics

A regression of bond spread changes on equity returns shows a clear curved pattern in the residuals plotted against fitted values, suggesting the true relation is quadratic. Which is the most appropriate response?

Add a squared term of the regressor. A curved residual pattern indicates the linear functional form is misspecified, effectively omitting a nonlinear term. Robust standard errors only correct inference for heteroskedasticity and would leave the biased fit unchanged.

  1. AApply White standard errors, since the problem is heteroskedasticity
  2. BAdd a squared term of the regressor to capture the nonlinearityCorrect
  3. CDrop the intercept to remove the pattern
  4. DUse first differences to remove serial correlation

Explanation

A systematic curved residual pattern signals a misspecified functional form, which is a form of omitted variable bias. Adding a squared term addresses it. Robust standard errors fix inference under heteroskedasticity but not the biased coefficients caused by the wrong functional form.

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