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discriminant analysis in credit rating agencies

discriminant analysis in credit rating agencies

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Published by Indermohan Singh

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Published by: Indermohan Singh on Dec 11, 2009
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MBA International
L.H.S.B Page 1
Written ReportStatistical Package for Social ScienceDiscriminant analysis
SUBMITTED BY:Indermohan Singh A23Umesh Sharma A22Karanjeet Singh A21Gaganpreet Kaur A24MBA International
Lect. Abishek KalraLPU (Phagwara)
MBA International
L.H.S.B Page 2
General Purpose
Discriminant function analysis is used to determine which variables discriminatebetween two or more naturally occurring groups. For example, an educational researcher maywant to investigate which variables discriminate between high school graduates who decide(1) to go to college, (2) to attend a trade or professional school, or (3) to seek no furthertraining or education. For that purpose the researcher could collect data on numerousvariables prior to students' graduation. After graduation, most students will naturally fall intoone of the three categories.
 Discriminant Analysis
could then be used to determine whichvariable(s) are the best predictors of students' subsequent educational choice.A medical researcher may record different variables relating to patients' backgrounds in orderto learn which variables best predict whether a patient is likely to recover completely (group1), partially (group 2), or not at all (group 3). A biologist could record differentcharacteristics of similar types (groups) of flowers, and then perform a discriminant functionanalysis to determine the set of characteristics that allows for the best discrimination betweenthe types.
Computational Approach
Computationally, discriminant function analysis is very similar to analysis of variance(
). Let us consider a simple example. Suppose we measure height in a random sampleof 50 males and 50 females. Females are, on the average, not as tall as males, and thisdifference will be reflected in the difference in means (for the variable
). Therefore,variable height allows us to discriminate between males and females with a better thanchance probability: if a person is tall, then he is likely to be a male, if a person is short, thenshe is likely to be a female.We can generalize this reasoning to groups and variables that are less "trivial." For example,suppose we have two groups of high school graduates: Those who choose to attend collegeafter graduation and those who do not. We could have measured students' stated intention tocontinue on to college one year prior to graduation. If the means for the two groups (those
MBA International
L.H.S.B Page 3
who actually went to college and those who did not) are different, then we can say thatintention to attend college as stated one year prior to graduation allows us to discriminatebetween those who are and are not college bound (and this information may be used by careercounselors to provide the appropriate guidance to the respective students).To summarize the discussion so far, the basic idea underlying discriminant function analysisis to determine whether groups differ with regard to the mean of a variable, and then to usethat variable to predict group membership (e.g., of new cases).
Analysis of Variance.
Stated in this manner, the discriminant function problem can berephrased as a one-way analysis of variance (ANOVA) problem. Specifically, one can ask whether or not two or more groups are
significantly different 
from each other with respect tothe mean of a particular variable. To learn more about how one can test for the statisticalsignificance of differences between means in different groups you may want to read theOverviewsection to
. However, it should be clear that, if the means for avariable are significantly different in different groups, then we can say that this variablediscriminates between the groups.In the case of a single variable, the final significance test of whether or not a variablediscriminates between groups is the
test. As described in 
is essentially computed as the ratio of the between-groups variance in the dataover the pooled (average) within-group variance. If the between-group variance issignificantly larger then there must be significant differences between means.
Multiple Variables.
Usually, one includes several variables in a study in order to see whichone(s) contribute to the discrimination between groups. In that case, we have a matrix of totalvariances and covariances; likewise, we have a matrix of pooled within-group variances andcovariances. We can compare those two matrices via multivariate
tests in order todetermined whether or not there are any significant differences (with regard to all variables)between groups. This procedure is identical to multivariate analysis of variance or 
. As in
, one could first perform the multivariate test, and, if statistically significant,proceed to see which of the variables have significantly different means across the groups.Thus, even though the computations with multiple variables are more complex, the principalreasoning still applies, namely, that we are looking for variables that discriminate betweengroups, as evident in observed mean differences.

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