Financial Risk Manager Part 1
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An analyst wishes to use seasonal dummy variables (0s and 1s) to model seasonality. Suppose there are four seasons in a year. Which of the arrangements below would represent the third season (third quarter)?
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A
1, 0, 0, 0,
B
0, 0, 1, 0,
C
0, 0, 0, 1
D
0, 1, 0, 0,
Explanation:
Explanation
When using seasonal dummy variables to model seasonality with four seasons (quarters), we typically use three dummy variables to avoid perfect multicollinearity (the dummy variable trap). However, in this question, the options show four positions, which likely represent the four quarters directly.
For the third season (third quarter), the dummy variable arrangement should have:
- 1 in the third position
- 0 in all other positions
Let's analyze each option:
- A. 1, 0, 0, 0 - This represents the first season (first quarter)
- B. 0, 0, 1, 0 - This represents the third season (third quarter) ✓
- C. 0, 0, 0, 1 - This represents the fourth season (fourth quarter)
- D. 0, 1, 0, 0 - This represents the second season (second quarter)
Therefore, option B (0, 0, 1, 0) correctly represents the third season where the third position has a value of 1 and all other positions have 0.
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