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FRM Part I · FRM Exam Part I · Regression with Multiple Explanatory Variables

An analyst omits a relevant explanatory variable that is positively correlated with an included variable, and whose true coefficient is positive. What is the effect on the estimated coefficient of the included variable?

The included variable's coefficient is biased upward. Omitted variable bias takes the sign of the omitted variable's true coefficient times its correlation with the included variable, and both are positive here, so the included variable picks up part of the omitted effect.

  1. AIt is biased upwardCorrect
  2. BIt is biased downward
  3. CIt is unbiased but less efficient
  4. DIt is unbiased and the standard error falls

Explanation

Omitted variable bias has the sign of the product of the omitted variable's true coefficient and its correlation with the included variable. Positive times positive gives upward bias. Unbiasedness with inefficiency describes adding irrelevant variables.

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