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Error Term

The error term represents the firm-specific returns. As firm-specific occurrences are unpredictable, the error term’s expected value is zero.

What is Error Term?

The error term (i) represents the firm-specific return otherwise unexplained by the model. Because firm-specific occurrences are unpredictable, the error term’s expected (or default) value is zero.

When a statistical or mathematical model fails to accurately capture the genuine relationship between the independent and dependent variables, an error term is formed as a residual variable.

Example of Error Term

Y=αX+ βp+ ϵi

where:

α,β=Constant parameters

X,ρ=Independent variables

ϵ=Error term​

Why is Error Term important in the regression model?

Because independent variables are never ideal predictors of dependent variables in real life, a regression line always has an error term. Instead, the line is a guess based on the data supplied. As a result, the error term indicates how confident you can be in the formula and be sure about your risk analysis.

Owais Siddiqui
1 min read
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