Dummy variables are those that are used to indicate presence of some factor that may have an effect on the final outcome. Dummy variables usually take a finite number of values, generally values of 0 or 1. They are used mainly in statistics, in the field of regression analysis.
Dummy variables can be used as stand-ins for a variety of qualitative facts, in a mathematical regression model. In a regression model, it is not only the quantitative model that can have an effect but the qualitative factors have some effects as well. The dummy variables are inserted just as other quantitative variables.
Suppose we want to determine total net score of a finance student for a finance role job. Suppose total score depends to an extent on doing a CFA certification, it can be made a dummy variable. Let’s say, ‘CFA’.
Total score = a + b (education) + c (CFA) + d...
So, basically here, the dummy variable CFA can be set to either 1 or 0 depending on whether the candidate has done the certification or not.