You believe there is a relationship between book-to-market ratios and subsequent returns. The output from a cross-sectional regression and a graph of the actual and predicted relationship between the book-to-market ratio and return are shown below.
Results from Regressing Returns on the Book-to-Market Ratio

A. You are concerned with model specification problems and regression assumption violations.
Focusing on assumption violations, discuss symptoms of conditional heteroskedasticity based on the graph of the actual and predicted relationship.
B. Describe in detail how you could formally test for conditional heteroskedasticity in this regression.
C. Describe a recommended method for correcting for conditional heteroskedasticity.

Transcribed Image Text:

Coefficient Standard Error t-Statistic Intercept 3.3874 12.0130 3.5464 Book value 8.4454 -9.2209 -1.0918 Market value ANOVA df MSS Significance F Regression 154.9866 154.9866 1.1921 0.2831 Residual 32 4162.1895 130.0684 Total 33 4317.1761 Residual standard error 11.4048 R-squared 0.0359 Observations 34 Return (%) Return versus Book-to-Market Ratio: Actual and Predicted 48 RITURN 40 32 24 16 0.00 0.16 0.32 0.48 0.64 0.80 0.96 1.12 Book-to-Market Ratio