FRM Part I · FRM Exam Part I · Nonstationary Time Series
A risk analyst models monthly retail sales of a department store, which spike every December. She wants to capture the seasonal pattern using a deterministic approach in a regression with an intercept. How many seasonal dummy variables should she include for monthly data to avoid the dummy variable trap?
Eleven dummy variables are needed. With an intercept present, one month acts as the reference category, and including all twelve would create perfect multicollinearity (the dummy variable trap) because the dummies would sum to the intercept column.
- A11Correct
- B12
- C13
- D1
Explanation
With an intercept and 12 monthly categories, one month must serve as the base category. Including all 12 dummies with an intercept creates perfect multicollinearity. Therefore 11 dummies are used; 12 would only be valid if the intercept were dropped.
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