Financial Risk Manager Part 1
Get started today
Ultimate access to all questions.
Deep dive into the quiz with AI chat providers.
We prepare a focused prompt with your quiz and certificate details so each AI can offer a more tailored, in-depth explanation.
After finding that sales of a company vary seasonally over each quarter, an analyst is trying to incorporate such seasonality effect and build the regression model using dummy variables. Which of the following statements is (are) correct?
I. There are four dummy variables required
II. There are three dummy variables required
III. A dummy variable, takes on a value of 1 if a particular condition is true and 0 if that condition is false.
Other
Community
NNikitesh
A
Only II
B
I and III
C
II and III
D
Only I
Explanation:
Explanation:
Statement I: There are four dummy variables required - This is incorrect. When dealing with categorical variables with k categories (in this case, 4 quarters), we need k-1 dummy variables to avoid the dummy variable trap (perfect multicollinearity). If we include all 4 dummy variables plus a constant term, the model would be perfectly collinear.
Statement II: There are three dummy variables required - This is correct. For 4 quarters, we need 3 dummy variables. For example:
- D1 = 1 for Q1, 0 otherwise
- D2 = 1 for Q2, 0 otherwise
- D3 = 1 for Q3, 0 otherwise
- Q4 would be the reference category (all dummies = 0)
Statement III: A dummy variable takes on a value of 1 if a particular condition is true and 0 if that condition is false - This is correct. This is the fundamental definition of a dummy (indicator) variable in regression analysis.
Therefore, statements II and III are correct, making option C the correct answer.
Comments
Loading comments...