Skip to content

FRM Part I · FRM Exam Part I · Regression Diagnostics

A regression of bond spread changes on equity returns shows a clear U-shaped pattern in the residuals when plotted against the fitted values. Which is the most appropriate interpretation and response?

The U-shaped residual pattern indicates a misspecified functional form, meaning the true relationship is nonlinear. The appropriate response is to add a squared term or transform the variables, rather than treating the problem as multicollinearity or ignoring it.

  1. AHeteroskedasticity is the only issue; use a larger sample and keep the model
  2. BThe pattern suggests a misspecified functional form; consider adding a squared term or transforming the variablesCorrect
  3. CMulticollinearity is present; drop the equity return variable
  4. DThe residuals are normally distributed; no action is needed

Explanation

A systematic curved pattern in residuals versus fitted values indicates a nonlinear relationship the linear model fails to capture, which is a functional form misspecification. Adding a quadratic term or transforming variables addresses it. Multicollinearity concerns correlation among regressors, not residual patterns.

Did you get it right without looking?

One question tells you little. A timed set on Regression Diagnostics shows your real accuracy, how long you take and where you lose marks.

Practise Regression DiagnosticsFree diagnostic mock

More Regression Diagnostics questions