Introduction to Regression Analysis. Dr. Devlina Chatterjee 11 th August, 2017

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1 Introduction to Regression Analysis Dr. Devlina Chatterjee 11 th August, 2017

2 What is regression analysis? Regression analysis is a statistical technique for studying linear relationships. One dependent variable and one or more independent variables, often called predictor variables. Regression is being used more and more in analytics research that affects many aspects of our daily lives, from how much we pay for automobile insurance to which ads appear in our social media.

3 Example of questions where regression analysis is used What is the effect of one more year of education on the income of an individual? What are the factors that indicate whether a particular individual will get a job? Can we predict how the price of a particular stock will change in the next few weeks? How will a particular policy such as change in taxes on cigarettes affect the incidence of smoking in a state? How long will a patient survive after being given a particular treatment as compared to not being given that treatment?

4 Population vs. Sample The research question may be does more education lead to more income? We want to understand the relationship between two variables (education and income) in the population We do not have data for every person in the population Look at data for a smaller sample drawn from the population If the sample is large enough and drawn randomly from the population, then we can make inferences about the population from the relationships observed in the sample The reason we can draw inferences is because of two fundamental theorems in probability: Law of Large Numbers and Central Limit Theorem.

5 Sampling Distributions Suppose that we draw all possible samples of size n from a given population. We compute a statistic (e.g., a mean, proportion, standard deviation) for each sample. The probability distribution of statistic is called a sampling distribution. The standard deviation of this statistic is called the standard error. Mean and Variance of the Sampling Distribution of is given by: E( Y) Y Var( Y) Y Y n 1. As n increases, the distribution of becomes more tightly centered around μ Y (the Law of Large Numbers) 2. Moreover, the distribution of becomes normal (the Central Limit Theorem) 2 Y

6 Law of Large Numbers The law of large numbers states that the sample mean converges to the distribution mean as the sample size increases, and is one of the fundamental theorems of probability.

7 The Central Limit Theorem The Central Limit Theorem states that the sampling distribution of the mean of any independent, random variable will be normal or nearly normal, if the sample size is large enough. Sampling distribution of Y when Y is Bernoulli, p = 0.78:

8 Simple Linear Regression We begin by supposing a general form for the relationship, known as the population regression model: where Y 0 1X1 is the dependent variable and is the independent variable. Our primary interest is to estimate and. These are estimated from a sample of data and are termed and Y X

9 Reasons for doing Regression Determining whether there is evidence that an explanatory variable belongs in a regression model (Statistical significance of a variable) Estimating the effect of an explanatory variable on the dependent variable (Effect Size magnitude of the coefficient ) Measuring the explanatory power of a model (R 2 ) Making individual predictions for individuals not in the original sample

Regression between weight and height e 1 e 3 e 2 106.5 1 1.

10 Regression between weight and height e 1 e 3 e Sample ( height. in. metres) ( height. in. cms) Sample

11 The idea of statistical significance Someone may look at the regression results from Sample 1 and Sample 2 and see that the results are slightly different. How much confidence can we have in the values of and estimated from our first sample? We need to test the hypothesis that there is indeed a non-zero correlation between Y and X Which translates to testing the null hypotheses: 0 0 and

12 Hypothesis Testing Test inferences about population parameters using data from a sample. In order to test a hypothesis in statistics, we must perform following steps: 1. Formulate a null hypothesis and an alternative hypothesis on population parameters. X H 0 : vs. H A : X X 2. Build a statistic to test the hypothesis made. z s / n where is the sample mean and s is the sample standard deviation X 3. Define a decision rule to reject or not to reject the null hypothesis.

13 Statistical Significance p values We have to test the null hypothesis 1 0, that is there is no correlation We find the standard error associated with the estimated betas as follows: Given the estimate of and the standard error of the estimate SE( 1 ) We calculate a t-statistic for : 1 0 t SE( 1) If t statistic > 1.96, we can reject null hypothesis 1 0 with 95% confidence. The p-value associated with each variable gives the probability that we could have observed the value of or larger, if the true value of was in fact 0. Very small p-values indicate there is a very small probability of the real being 0 SE( 1) ( n 2) 1 1 ( Yi Y ) ( X 1 i i 2 X ) 2 Indicates that there is a statistically significant relationship between Y and X that is not just due to chance alone.

14 R output

15 Multiple Linear Regression When there are more than one explanatory variable Y X X k X k Why include more than one variable in your regression? To avoid omitted variable bias (get the most accurate estimates of ) To get a model that has higher explanatory and predictive power 1

16 Omitted variable bias Example: Effect of 1 more year of education on income of an individual. People who attain higher levels of education may often have parents who have higher incomes Children of high income parents may have access to better social connections and so get better jobs. When we regress income over education and do not include parental income as a variable, we miss this effect. We may assume that higher levels of education led to the children getting higher incomes, and arrive at biased estimates of 1 Children of poorer parents may who are as well educated may not in fact get jobs with high income. In order to test whether it was the education or the parental connections that led to higher incomes, we need to include both variables in the model More accurate estimates of the correlation between the independent variable (education) and the dependent variable (income) Thus the 1 will not suffer from omitted variable bias

17 OLS assumptions Assumption 1: Model is linear in parameters and correctly specified Assumption 2: Full Rank of Matrix X or in other words (i) # observations > # variables, (ii) no perfect multicollinearity among independent variabls Assumption 3: Explanatory Variables must be exogenous E( e i X ) 0 Assumption 4: Independent and Identically Distributed Error Terms 2 i iid(0, ) or in other words (i) observations are randomly selected, (ii) constant variance homoscedasticity (iii) no auto-correlation Assumption 5: Normal Distributed Error Terms in Population If these assumptions are made, the OLS estimators will be the BLUE (Best Linear Unbiased Estimator)

18 Different Kinds of Regression Models Generalized Linear Regression Model Type of Dependent Variable Kind of data Kind of Independent Variables Continuous Linear Regression Discrete Logit / Probit Regression Crosssectional Data Panel Data Panel Data Models 1.Entity Fixed Effects 2.Time Fixed Effects 3.Random Effects Time-series Data Time-series models 1.AR 2.MA 3.ARIMA 4.VAR 5.VECM 6.ARCH 7.GARCH Duration Data Survival analysis models 1.Cox Proportional Hazard 2.Accelerated Failure Time (AFT) models Exogenous Endogenous Instrumental Variables Regression Simultaneous Equation Models

19 Panel Data Models Panel data consists of observations on the same n entities at two or more time period, T. Example: Road accidents for all states of India recorded over 20 years Notation for panel data: (X it, Y it ) where i = 1,...,n and t = 1,...,T Balanced panel Variables are observed for each entity for all the time periods. Unbalanced panel if data is missing for one or more time period for some entities Fixed Effects Regression: controls for omitted variable bias when the omitted variables vary across entities but do not change over time. Y it = β 1 X 1,it + + β k X k,it + α i + u it Time Fixed Effects controls for omitted variable bias when the omitted variables vary over time but are constant across entities Y it = β 1 X 1,it + + β k X k,it + λ t + u it

Discrete Dependent Variables (Logit/ Probit) Dependent variable is not continuous but discrete Example: Will a particular individual pass an exam?

20 Discrete Dependent Variables (Logit/ Probit) Dependent variable is not continuous but discrete Example: Will a particular individual pass an exam? Dependent variable is coded as 1 when the individual passes and 0 when the individual fails We define the dependent variable as the probability of the individual passing the exam P( Y 1 X,..., X k ) f ( 0 1X1 2X 2... X 1 k k )

21 Logit vs. Probit Logistic Regression where: Pr (Y = 1 X) = F(β 0 + β 1 X 1 ) 1 F(β 0 + β 1 X) = 1 + e (β 0+β 1 X) Probit Regression Pr (Y = 1 X) = Φ(β 0 + β 1 X) Measures of Fit for Logit and Probit The fraction correctly predicted = fraction of Y s for which the predicted probability is >50% when Y i =1, or is <50% when Yi=0. The pseudo-r 2 measures the improvement in the value of the log likelihood, relative to having no X s. The pseudo-r 2 simplifies to the R 2 in the linear model with normally distributed errors.

22 Time-series models Data recorded at regular intervals of time, like daily, weekly, monthly or annually Example: Want to predict price of stocks based on historical data Primary objective prediction not understanding causality Components of time-series: Trends Seasonal Movements. Cyclical Movements. Irregular Fluctuations. Dependent variable regressed on lagged values of same variable, autocorrelation Need to ensure stationarity of data i.e. the future will be like the past Stationarity q t q t t p t p t t t x x x y y y y

24 Time-series Models AR models Autoregressive model model based on lagged values of the same dependent variable hence auto -regressive MA models Moving average model smoothing past data ARIMA Autoregressive Integrated Moving Average model combining AR and MA components after differencing the data to make it stationary VAR Vector Autoregressive Model -Vector Auto Regressive models (VAR) are econometric models used to capture the linear interdependencies among multiple time series. VECM Vector Error Correction Model - If the variables are not covariance stationary, but their first differences are, they may be modeled with a vector error correction model, or VECM. ARCH - ARCH models are used to model financial time series with time-varying volatility, such as stock prices. GARCH - If an autoregressive moving average model (ARMA model) is assumed for the error variance, the model is a generalized autoregressive conditional heteroscedasticity (GARCH) model.

Econometrics Honor s Exam Review Session. Spring 2012 Eunice Han

Econometrics Honor s Exam Review Session Spring 2012 Eunice Han Topics 1. OLS The Assumptions Omitted Variable Bias Conditional Mean Independence Hypothesis Testing and Confidence Intervals Homoskedasticity