Qm
Statistics

The regression that refuses to run: the dummy variable trap

multicollinearitydummy-variablesols

Your stocks fall into four sectors. You create four 0/1 dummy variables, one per sector, and include all four plus an intercept in the regression. The software either errors out on a singular matrix or silently drops a column.

Explain why this happens and how to fix it.

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The theory behind this question.

Correlation Filtering and Redundant FeaturesDummy Variables and Interaction TermsThe Frisch-Waugh-Lovell TheoremThe Gauss–Markov TheoremLeverage and Influential Observations

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