FRM Part I · FRM Exam Part I · Regression Diagnostics
Which approach is a standard remedy when a regression's residuals exhibit serial correlation and the analyst wants valid inference without changing the coefficient estimates?
Newey-West, or HAC, standard errors are the standard remedy. They adjust the estimated variance of the coefficients for serial correlation and heteroskedasticity while keeping the OLS coefficient estimates unchanged, so t-tests and confidence intervals become valid.
- ADrop the intercept from the regression
- BUse heteroskedasticity and autocorrelation consistent (Newey-West) standard errorsCorrect
- CIncrease the significance level to 10%
- DReplace the dependent variable with its square
Explanation
Newey-West (HAC) standard errors correct the standard error estimates for serial correlation and heteroskedasticity while leaving OLS coefficients unchanged. Dropping the intercept misspecifies the model, changing the significance level does not fix the standard errors, and squaring the dependent variable alters the model altogether.
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