Question

List the basic assumption of the regression analysis and explain the applications of regression analysis in business and management decisions. Include an example in your discussion.

Answer 1

Assumptions in Regression analysis:

1. Explanatory variables contain information about the dependent variable.
2. There is no correlation between the explanatory variables.
3. Homoscedasticity
4. The underlying distribution is multivariate/univariate normal.
5. There’s no autocorrelation in the data.

There are many use of regression analysis in business and management studies. One major use is the explanatory power of regression. Others include prediction and identifying important variables.

E.g.: Suppose you have returns n a financial asset and you know that this financial asses depends on some risk factors (such as interest rates) and you have returns of the risk factors as well. Now if you want to attribute to what proportion of return is due to a particular risk factor, one good way to analyze it is to run the regression and get the coefficient. Then for a given change in risk factor, the implied change in the return of asses will be simply

BX Arisk factor return)

These kind of tools help in statistically identify the effect of one risk factor over a process.