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
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.