What is 'Heteroskedasticity'

Heteroskedasticity, in statistics, is when the standard deviations of a variable, monitored over a specific amount of time, are nonconstant. Heteroskedasticity often arises in two forms: conditional and unconditional. Conditional heteroskedasticity identifies nonconstant volatility when future periods of high and low volatility cannot be identified. Unconditional heteroskedasticity is used when futures periods of high and low volatility can be identified.

BREAKING DOWN 'Heteroskedasticity'

In finance, conditional heteroskedasticity is often seen in the prices of stocks and bonds. The level of volatility of these equities cannot be predicted over any period of time. Unconditional heteroskedasticity can be used when discussing variables that have identifiable seasonal variability, such as electricity usage.

As it relates to statistics, heteroskedasticity, also spelled heteroscedasticity, refers to the error variance, or dependence of scatter, within a minimum of one independent variable within a particular sample. These variations can be used to calculate the margin of error between data sets, such as expected results and actual results, as it provides a measure for the deviation of data points from the mean value.

For a dataset to be considered relevant, the majority of the data points must be within a particular number of standard deviations from the mean as described by Chebyshev’s theorem, also known as Chebyshev’s inequality. This provides guidelines regarding the probability of a random variable differing from the mean. Based on the number of standard deviations specified, a random variable has a particular probability of existing within those points. For example, it may be required that a range of two standard deviations contain at least 75% of the data points to be considered valid. A common cause of variances outside the minimum requirement are often attributed to issues of data quality.

Unconditional Heteroskedasticity

Unconditional heteroskedasticity is predictable, and most often relates to variables that are cyclical by nature. This can include higher retail sales reported during the traditional holiday shopping period, or the increase in air conditioner repair calls during warmer months.

Changes within the variance can be tied directly to the occurrence of particular events or predictive markers if the shifts are not traditionally seasonal. This can be related to an increase in smartphone sales with the release of a new model as the activity is cyclical based on the event but not necessarily determined by the season.

Conditional Heteroskedasticity

Conditional heteroskedasticity is not predictable by nature. There is no telltale sign that leads analysts to believe data will become more or less scattered at any point in time. Often, financial products are considered subject to conditional heteroskedasticity as not all changes can be attributed to specific events or seasonal changes.

RELATED TERMS
  1. Variability

    The extent to which data points in a statistical distribution ...
  2. Variance

    Variance is the spread between numbers in a data set and their ...
  3. Variable Cost Ratio

    Variable costs expressed as a percentage of sales. The variable ...
  4. Negative Correlation

    In statistics, a perfect negative correlation is a relationship ...
  5. Variable Overhead Spending Variance

    Variable overhead spending variance is the difference between ...
  6. Error Term

    A variable in a statistical and/or mathematical model, which ...
Related Articles
  1. Investing

    Calculating volatility: A simplified approach

    Though most investors use standard deviation to determine volatility, there's an easier and more accurate way of doing it: the historical method.
  2. Trading

    Trading with Gaussian models of statistics

    The study of statistics originated from Carl Friedrich Gauss and helps us understand markets, prices and probabilities, among other applications.
  3. Investing

    Stock and Flow Variables Explained: A Closer Look at Apple

    The difference between stock and flow variables is an essential concept in finance and economics. We illustrate with financial statements from Apple Inc.
  4. Investing

    Understanding The Sharpe Ratio

    The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.
  5. Investing

    Redefining Investor Risk

    Changing the way you think about time and risk can change the way you invest.
  6. Investing

    Roller coaster 2016 for Stocks? Exploring Global Stock Volatility

    Find out how much volatility global equity investors are in for during 2016 by seeing how much they've experienced over the past five years.
  7. Investing

    A Guide to Understanding Market Volatility

    Market volatility is inevitable. Understanding how it works can help investors keep calm during periods of short-term declines.
  8. Managing Wealth

    Variable Annuities: The Pros and Cons

    Variable annuities are one of the most complicated financial instruments—weighing the pros and cons.
  9. Investing

    PRHSX: Risk Statistics of Health Sciences Mutual Fund

    Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
  10. Trading

    How To Convert Value At Risk To Different Time Periods

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
RELATED FAQS
  1. What does standard deviation measure in a portfolio?

    Dig deeper into the investment uses of and mathematical principles behind standard deviation as a measurement of portfolio ... Read Answer >>
  2. What is the difference between standard deviation and variance?

    Understand the difference between standard deviation and variance; learn how each is calculated and how these concepts are ... Read Answer >>
  3. What is the difference between standard deviation and z score?

    Understand the basics of standard deviation and Z-score; learn how each is calculated and used in the assessment of market ... Read Answer >>
  4. What is the best measure of a stock's volatility?

    Understand what metrics are most commonly used to assess a security's volatility compared to its own price history and that ... Read Answer >>
  5. What is price variance in cost accounting?

    Understand what price variance is in relation to cost accounting. Learn the most common way price variance arises and how ... Read Answer >>
Hot Definitions
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  3. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  4. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  5. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center