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FRM Part I · FRM Exam Part I · Regression Diagnostics

A regression of daily portfolio returns on a market factor shows that the variance of residuals is much larger in high-volatility periods than in calm periods, but residuals are uncorrelated over time. Which statement is correct about OLS?

This is heteroskedasticity. OLS coefficients stay unbiased and consistent, but the conventional standard errors are unreliable, so t-tests and confidence intervals can mislead. The remedy is heteroskedasticity-robust standard errors or weighted estimation.

  1. AThe coefficient estimates are biased and the usual standard errors are too small
  2. BThe coefficient estimates remain unbiased, but the usual standard errors are unreliableCorrect
  3. CThe coefficient estimates remain unbiased and the usual standard errors remain valid
  4. DThe estimates are inconsistent because errors are serially correlated

Explanation

Non-constant error variance is heteroskedasticity. OLS coefficients remain unbiased and consistent, but conventional standard errors are incorrect, so inference is invalid unless robust (White) errors are used. Residuals are stated to be uncorrelated, so serial correlation does not apply.

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