1. Regression with Qualitative Data a. Suppose you want to study how the bond cr
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Question
1. Regression with Qualitative Data a. Suppose you want to study how the bond credit rating influences the bond price. From the best to the worst there are four levels, that is, A, B, C, and D. Besides those rating levels, other relevant factors like interest rate, inflation rate are included in Z which is a vector How will you set up your model, and how do you avoid the dummy variable trap? b. Suppose vou want to study the labor participation of people above 60 years old. We know that labor participation P is shown as a binary variable in the data (either 0 or 1). From the class, what kind of model will you choose. What are the advantages and disadvantages of this model? Feel free to describe them by words.Explanation / Answer
Bond price = b1+b2D1+ b3D2+ b4D3+ b5Z + u
I have used D1, D2, D3 as dummy variables. In this case we will prevent the dummy variable trap by taking n-1 qualitative variables . The coefficient b2, b3, b4, b5 measure the effect of change in variable on bond price.
B)
Labour participation = b1+ b2age + u , b2 = 1 ( if age >=60 or 0 otherwise)
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