OLS Model Assumptions and Problems
• Ordinary least squares (OLS) regression relies on several key assumptions for reliable results,
including linearity, independence of errors, homoscedasticity, and normality of errors, with potential
problems arising from violations of these assumptions.
• Here's a breakdown of the assumptions and potential problems:
Key Assumptions of OLS Model:
• Linearity: the relationship between the independent and dependent variables must be linear.
• Independence
with each other.
of errors: residuals (the difference between observed and predicted values) should be uncorrelated
• Homoscedasticity: residuals should have constant variance across all levels of the independent variables.
• Normality of errors: residuals should be normally distributed.
• No multicollinearity: independent variables should not be highly correlated with each other.
• No autocorrelation: in time series data, residuals should not be correlated with past values.
• Zero mean error: the expected value of the error term should be zero.
Potential problems and solutions:
• Non-linearity:
• If the relationship is not linear, the model may not accurately capture the relationship,
leading to biased estimates.
• Solutions: transform the variables, use non-linear regression models, or consider adding
interaction terms.
•
NON-LINEARITY
Heteroscedasticity:
• If the variance of the residuals is not constant, the standard errors and confidence
intervals may be unreliable.
• Solutions: use robust standard errors, transform the data, or consider using weighted
least squares.
Heteroscedasticity
Multicollinearity:
• High correlation between independent variables can lead to unstable coefficient
estimates and difficulty in interpreting the model.
• Solutions: remove one of the correlated variables, combine them into a single variable,
or use regularization techniques.
Multicollinearity
Autocorrelation:
• If residuals are correlated in time series data, the model may not be able to capture the
true relationship.
• Solutions: use time series models that account for autocorrelation, such as arima
models.
Autocorrelation
Non-normality:
• If the errors are not normally distributed, the statistical tests and confidence intervals
may not be valid.
• Solutions: transform the data, use non-parametric tests, or use robust standard errors.
Non-normality
Endogeneity:
• If the independent variables are correlated with the error term, the estimates will be
biased.
• Solutions: use instrumental variables, or consider using panel data methods.
Endogeneity
THANK YOU
Bhatti Sahb
