Deriving Heteroskedasticity Consistent Standard Errors

Heteroskedasticity leads to inaccurate standard errors in linear regression, but can be corrected using robust / heteroskedasticity consistent corrected (HCC) standard errors.

Recall, the matrix form of the regression equation:

y = XB + ϵ

with the estimator b = (X’X)^-1X’y substituting for y we get

b =  (X’X)^-1X’ (XB + ϵ)

=  (X’X)^-1 [X’XB +X’ ϵ]

=  (X’X)^-1 X’XB +(X’X)^-1X’ ϵ

= B +(X’X)^-1X’ ϵ

VAR(b) = E[(b-B)(b-B)]

From the above we know: b = B +(X’X)^-1X’ ϵ

(b-B) = B +(X’X)^-1X’ ϵ - B

= (X’X)^-1X’ ϵ

Therefore VAR(b)=  E[(b-B)(b-B)] = E[((X’X)^-1X’ ϵ)( (X’X)^-1X’ ϵ)]

=E[(X’X)^-1X’ ϵ ϵ’X(X’X)^-1]

=(X’X)^-1X’E[ϵ ϵ’]X(X’X)^-1

Let  E[ϵ ϵ’] = Φ  then we have VAR(b) = (X’X)^-1X’ Φ X(X’X)^-1   ‘general form’

If Φ = σ²I then VAR(b) = (X’X)^-1X’ σ²I X(X’X)^-1   = σ²(X’X)^-1  ‘case of homoskedasticity’

For heteroskedasticity corrected standard errors VAR(b) =

N/(N-k) (X’X)^-1X’ Φ̂  X(X’X)^-1   where Φ̂ = diag(e_i²)

References:

Greene, Econometric Analysis. 1990

Using Heteroskedasticity Consistent Standard Errors in the Linear Regression Model. J.Scott Long and Laurie H. Ervin. The American Statistician Vol. 54 No 3 (Aug 2000) pp. 217-224