Financial Risk Manager Part 1
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An analyst applies the following time series model to daily data:
Rₜ = returns
D₁ - dummy variable for Monday and zero otherwise
D₂ - dummy variable for Tuesday and zero otherwise
D₃ - dummy variable for Wednesday and zero otherwise
D₄ - dummy variable for Thursday and zero otherwise
What is the interpretation of the parameter estimate for the intercept?
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Community
NNikitesh
A
It's the average return for the 5 days from Monday to Friday
B
It's the Friday deviation from the mean return for the week
C
It's the average return on Monday
D
It's the average return on Friday
Explanation:
The correct answer is D: It's the average return on Friday.
Explanation:
In this dummy variable regression model:
- Rₜ = β₀ + β₁D₁ + β₂D₂ + β₃D₃ + β₄D₄ + εₜ
- D₁ = 1 for Monday, 0 otherwise
- D₂ = 1 for Tuesday, 0 otherwise
- D₃ = 1 for Wednesday, 0 otherwise
- D₄ = 1 for Thursday, 0 otherwise
For Friday, all dummy variables (D₁, D₂, D₃, D₄) equal 0, so the equation reduces to: Rₜ = β₀ + εₜ
Therefore, β₀ represents the average return on Friday. The average returns for other days are:
- Monday: β₀ + β₁
- Tuesday: β₀ + β₂
- Wednesday: β₀ + β₃
- Thursday: β₀ + β₄
This is a standard dummy variable regression setup where one category (Friday in this case) serves as the reference category, and the intercept represents the mean of that reference category.
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