Question #3
Reading: Reading 1 Multiple Regression
PDF File: Reading 1 Multiple Regression.pdf
Page: 1
Status: Unattempted
Correct Answer: A
Question
An analyst is trying to determine whether fund return performance is persistent. The analyst divides funds into three groups based on whether their return performance was in the top third (group 1), middle third (group 2), or bottom third (group 3) during the previous year. The manager then creates the following equation: R = a + b1D1 + b2D2 + b3D3 + ε, where R is return premium on the fund (the return minus the return on the S&P 500 benchmark) and Di is equal to 1 if the fund is in group i. Assuming no other information, this equation will suffer from:
Answer Choices:
A. multicollinearity
B. serial correlation
Explanation
When we use dummy variables, we have to use one less than the states of the world. In
this case, there are three states (groups) possible. We should have used only two dummy
variables. Multicollinearity is a problem in this case. Specifically, a linear combination of
independent variables is perfectly correlated. X1 + X2 + X3 = 1.
There are too many dummy variables specified, so the equation will suffer from
multicollinearity.