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

A researcher finds that the residuals from a linear regression of company revenue on years since founding fan out and show a curved pattern, while revenue grows at a roughly constant percentage rate. The most appropriate remedy is to:

The best remedy is to use the natural log of revenue as the dependent variable, creating a log-lin model. Constant percentage growth is exponential, and taking logs makes it linear, which should reduce the curved, fanning residual pattern.

  1. Aadd an intercept dummy variable to the linear model
  2. Bre-estimate using the natural log of revenue as the dependent variableCorrect
  3. Cre-estimate using the natural log of years as the independent variable only

Explanation

Constant percentage growth implies exponential growth, which a log-lin model linearizes by taking the log of the dependent variable. Option C is a lin-log form and suits diminishing absolute effects, not constant growth rates. Option A does not address curvature.

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