## Analyzing Forecasts

When you have completed this section, you will be able to use ratio analysis to assess a firm's performance to compare its performance to itself, its competitors, its industry, and across time. You will learn the categories of ratios, how to compute ratios and how to interpret the numeric values of a ratio as a comment on the firm's performance. Ratio analysis is used to consider the impact of certain financial transactions on a firm.

Regression Analysis is a causal / econometric forecasting method that is widely used for prediction and forecasting improvement.

#### LEARNING OBJECTIVE

Explain how regression analysis works

#### KEY POINTS

- Regression Analysis is a causal / econometric forecasting method. Some forecasting methods use the assumption that it is possible to identify the underlying factors that might influence the variable that is being forecast.
- Regression analysis includes several classical assumptions.
- Regression analysis includes many techniques for modeling and analyzing several variables when the focus is on the relationship between a dependent variable and one or more independent variables.
- A large body of techniques for carrying out regression analysis has been developed. Familiar methods, such as linear regression and ordinary least squares regression, are parametric.

#### TERMS

- Ordinary least squares regression
In statistics, ordinary least squares (OLS) or linear least squares is a method for estimating the unknown parameters in a linear regression model. This method minimizes the sum of squared vertical distances between the observed responses in the data set and the responses predicted by the linear approximation.

- linear regression
In statistics, linear regression is an approach to modeling the relationship between a scalar dependent variable y and one or more explanatory variables denoted X.

- independent
not contingent or depending on something else

#### EXAMPLE

- One can forecast based on linear relationships. If one variable is linearly related to the other for a long enough period of time, it may be beneficial to predict such a relationship in the future.

#### Regression Analysis

Regression Analysis is a causal / econometric forecasting method. Some forecasting methods are based on the assumption that it is possible to identify underlying factors that might influence a variable that is being forecast. For example, including information about weather conditions might improve the ability of a model to predict umbrella sales. This is a model of seasonality that shows a regular pattern of up and down fluctuations. In addition to weather, seasonality can also result from holidays and customs such as predicting that sales in college football apparel will be higher during football season as opposed to the off season.

Regression analysis includes a large group of methods that can be used to predict future values of a variable using information about other variables. These methods include both parametric (linear or non-linear) and non-parametric techniques.

Classical assumptions for regression analysis include:

- The sample is representative of the population for the inference prediction.
- The error is a random variable with a mean of zero conditional on the explanatory variables.
- The independent variables are measured with no error. (Note: If this is not so, modeling may be performed instead, using errors-in-variables model techniques).
- The predictors are linearly independent, i.e. it is not possible to express any predictor as a linear combination of the others.
- The errors are uncorrelated, that is, the variance– co-variance matrix of the errors is diagonal, and each non-zero element is the variance of the error.
- The variance of the error is constant across observations (homoscedasticity). (Note: If not, weighted least squares or other methods might instead be used).

In statistics, regression analysis includes many techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables. More specifically, regression analysis helps one understand how the typical value of the dependent variable changes when any one of the independent variables is varied, while the other independent variables are held fixed.

Regression Analysis

Regression analysis shows the relationship between a dependent variable and one or more independent variables.

Most commonly, regression analysis estimates the conditional expectation of the dependent variable given the independent variables – that is, the average value of the dependent variable when the independent variables are fixed. Less commonly, the focus is on a quantile, or other location parameter of the conditional distribution of the dependent variable given the independent variables. In all cases, the estimation target is a function of the independent variables called the regression function. In regression analysis, it is also of interest to characterize the variation of the dependent variable around the regression function, which can be described by a probability distribution.

#### Forecast Improvement

Regression analysis is widely used for prediction and forecasting, where its use has substantial overlap with the field of machine learning. Regression analysis is also used to understand which among the independent variables is related to the dependent variable, and to explore the forms of these relationships. In restricted circumstances, regression analysis can be used to infer causal relationships between the independent and dependent variables. However, this can lead to illusions or false relationships, so caution is advisable.

A large body of techniques for carrying out regression analysis has been developed. Familiar methods, such as linear regression and ordinary least squares regression, are parametric, in that the regression function is defined in terms of a finite number of unknown parameters that are estimated from the data. Nonparametric regression refers to techniques that allow the regression function to lie in a specified set of functions, which may be infinite-dimensional.

The performance of regression analysis methods in practice depends on the form of the data generating process and how it relates to the regression approach being used. Since the true form of the data-generating process is generally not known, regression analysis often depends to some extent on making assumptions about this process. These assumptions are sometimes testable if a large amount of data is available. Regression models for prediction are often useful even when the assumptions are moderately violated, although they may not perform optimally. However, in many applications, especially with small effects or questions of causality based on observational data, regression methods give misleading results.