Misspecification

Getting a regression's form or variables wrong, such as omitting an important variable or using levels where logs are needed. Unlike heteroskedasticity, it can bias the coefficients themselves.

Where you will meet it

Misspecification appears in 2 learning outcomes on the CFA syllabus. A few of them:

• Explain how a wrongly specified model distorts regression output and how the usual specification errors can be prevented
  CFA Level II · Quantitative Methods

  “A model is misspecified when its form or its variables are wrong, and the damage can reach the coefficients themselves.”

• Set out the techniques used to forecast volatility and covariance
  CFA Level III · Asset Allocation

  “Factor models impose structure, estimating each asset's exposure to a few common factors, which reduces estimation error at the cost of possible misspecification.”

See also

Heteroskedasticity

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

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