In Search of Statistically Valid Risk Factors
20 Pages Posted: 16 Dec 2012 Last revised: 4 Aug 2014
Date Written: August 3, 2014
An influential observation has the potential to render a model unsuitable for estimation with an OLS regression. This is well known in the statistics literature. However, the use of standard measures for detecting and managing influential observations is not common practice in empirical finance. In this article, we examine a leverage point, which is an outlier in an independent variable, from an economic perspective since it represents an actual market event. It is also interesting and subtle from a statistical perspective: it materially deflates the volume of regression confidence ellipsoids but has a limited effect on the regression coefficients, thereby enabling pure noise to masquerade as statistical significance.
Keywords: Factor volatility, variance, statistical significance, leverage point, beta, OLS regression, median regression, t-statistic, incremental explanatory power, outlier, VIX, FVIX
JEL Classification: G12, G11, C51, C52, C53, C12, C13
Suggested Citation: Suggested Citation