Financial Risk Manager Part 1

The correct answer is C. When a crucial explanatory variable is omitted from the regression model, and this omitted variable has significant influence on both the included explanatory variables and the dependent variable, it creates a violation of the OLS (Ordinary Least Squares) assumptions. Specifically, the error term will not be conditionally independent of the explanatory variables, leading to omitted variable bias. This bias can incorrectly increase the apparent explanatory power of the regression model, making it seem like the included variables explain more of the variation in the dependent variable than they actually do.

Key points:

1. Omitted variable bias occurs when a relevant variable is left out of the regression model
2. The omitted variable must be correlated with both the dependent variable and the included explanatory variables
3. This violates the assumption that the error term is uncorrelated with the explanatory variables
4. The result is biased coefficient estimates and potentially inflated R-squared values

Why other options are incorrect:

• A: Normally distributed residuals are actually desirable and don't overstate explanatory power
• B: Lack of correlation among explanatory variables (no multicollinearity) is desirable and doesn't overstate explanatory power
• D: The number of explanatory variables alone doesn't necessarily overstate explanatory power; it's the quality and completeness of the model that matters