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CFA Level I · CFA Level I Exam · Applications of Simple Linear Regression in Finance

A regression of a company's earnings growth on GDP growth was estimated using GDP growth between 1% and 4%. An analyst uses it to forecast earnings growth if GDP growth is 9%, then reports a narrow 95% prediction interval. The analyst's approach is most likely:

The approach is inappropriate because 9% GDP growth lies far outside the 1% to 4% sample range. Forecast uncertainty rises with distance from the mean of X, and the linear relationship may not hold there, so the true interval would be wider than the narrow one reported.

  1. Aappropriate, because the slope coefficient is statistically significant
  2. Binappropriate, because the forecast lies far outside the sample range and the true interval would be widerCorrect
  3. Cappropriate, because a larger value of X reduces the forecast standard error

Explanation

Extrapolating beyond the observed range makes the forecast standard error larger and the linear relationship may not hold there. A significant slope does not justify this, and larger distance from the mean increases rather than reduces the error.

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