FRM Part I · FRM Exam Part I · Regression with Multiple Explanatory Variables
An analyst regresses monthly excess fund returns on the market excess return and a dummy variable D that equals 1 in months when the VIX is above 25 and 0 otherwise. The estimated model is: Return = 0.40 + 0.95*Market + (-0.70)*D. For a month with VIX below 25, holding the market excess return at zero, what is the expected fund return?
The expected return is 0.40%. When the dummy equals zero, which is the low-VIX case, its coefficient does not enter the equation. With the market excess return at zero, only the intercept of 0.40% remains as the prediction.
- A-0.30%
- B0.40%Correct
- C-0.70%
- D1.10%
Explanation
When D = 0 the dummy term drops out, so the intercept is the baseline. With market return zero, expected return = 0.40 + 0 + 0 = 0.40%. The -0.30% option wrongly applies the dummy when D = 0 (it is the D = 1 case).
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