Hypothesis Testing and Confidence Intervals

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FRMFinancial Risk Manager

Mean and Variance

N

Population Mean

i=1

N
n

Sample Mean

X=

i=1

n
N

Population Variance

2=

Xi
i=1

X
n

Sample Variance

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S2 =

i=1

n-1

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Central Limit Theorem

For simple random samples of size n from a population with a mean

and a variance , the sampling distribution of the sample mean
approaches N(, /n) if the sample size is sufficiently large (n 30).
2

X N ( ,
)
n

Standard error of the sample mean

x / n

Known population variance

Unknown population variance s x s / n

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FRMFinancial Risk Manager

Point Estimation and Confidence Interval Estimate

Point Estimation

Confidence Interval Estimation

Level of significance ()

Degree of Confidence (1 )

Confidence Interval = [ Point Estimate (reliability factor)

Standard error]

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Confidence Interval Estimate

If the population has a normal distribution with a known variance, a confidence

interval for the population mean can be calculated as:

X z 2

X 1.96

X 1.96

95%
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FRMFinancial Risk Manager

AnswerB
The confidence interval for the interest rate coefficient is:
[1.50-1.960.20,1.50+1.960.20]= [1.11, 1.89]

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FRMFinancial Risk Manager

Example
The 95% confidence interval of the sample mean of employee age for a major
corporation is 19 years to 44 years based on a z-statistic. The population of
employees is more than 5,000 and the sample size of this test is 100. Assuming
the population is normally distributed, the standard error of mean employee age
is closest to:
A. 1.96.
B. 2.58.
C. 6.38.
D. 12.50.

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FRMFinancial Risk Manager

Confidence Interval Estimate

If the distribution of the population is normal with unknown variance, we can use

the t-distribution to construct a confidence interval:

X t 2

X 2

s
n

X 2

95%
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FRMFinancial Risk Manager

Hypothesis Testing

Hypothesis: a statement about the value of a population parameter

to be tested
The null hypothesis (H0) and alternative hypothesis (Ha)

One-tailed test vs. Two-tailed test

One-tailed test
H0: 0

Ha: <0

H0: 0

Ha: >0

Two-tailed test

H0: =0
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Ha: 0
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Test Statistic and Critical Value

Test statistic
sample statistic - hypothesized value
test statistic =
standard error of the sample statistic

Critical value

The distribution of test statistic (z, t, , F)

Significance level ()

One-tailed or two-tailed test

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Decision Rule

Reject H0 if |test statistic|>critical value

Fail to reject H0 if |test statistic|<critical value
2.5%

2.5%

95%

-1.96

Reject H0

1.96

Fail to
Reject H0

5%

95%

1.645

Reject H0

Fail to
Reject H0

Reject H0

We can never say accept H0

State the conclusion: is (not) significantly different from 0
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FRMFinancial Risk Manager

P value testing
2.5%

2.5%

1.07%

1.07%

Critical value for 5%

significance level

Negative of the
test statistic

Positive of the
test statistic

P - value=2.14%
If Pvalue < alpha, we reject null hypothesis
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FRMFinancial Risk Manager

Test of Single Population Mean

H0: =0
z-test vs. t-test
Normal population, n<30

n30

Known population variance ()

z-test

z-test

Unknown population variance

t-test

t-test or z-test

z-statistic Z x 0

/ n

t-statistic t n 1

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x 0
s/ n

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Test of Single Population Variance

H0: =0
The chi-square test (-test)

(n 1) s 2

2
0

df=n-1

n=sample size
s2=sample variance
02=hypothesized value for the population variance

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FRMFinancial Risk Manager

Test of Variances Difference

H0: 1=2

The F-test

s12
F 2
s2

df1=n1-1; df2=n2-1

Always put the larger variance in the numerator ( s12 > s 22 )

The rejection region is always the right-side tail, no matter the
test is one-tailed or two-tailed

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FRMFinancial Risk Manager

Summary of Hypothesis Testing

Test type

Assumptions

H0

Test-statistic

Normally distributed population,

known population variance

=0

Mean
hypothesis
testing Normally distributed population,
unknown population variance
Normally distributed population
Variance
hypothesis
testing Two independent normally
distributed populations

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=0

=0

1=2

x 0

/ n
x 0

N(0,1)

t(n-1)

s/ n

Critical value

(n 1) s 2

2
s
1
F

2
0

s 22

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2 (n 1)
F (n1 1, n2 1)

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FRMFinancial Risk Manager


72. An analyst believes that the average return of hedge funds was12% over the past year.
The analyst picks a random sample of 10 hedge funds and finds that their average return
was 29% with a standard of 24% over the past year. The analyst decides to test at a 95%
confidence level the null hypothesis H0: the average return of hedge funds was 12%. The
possible related critical values of the t-statistic are provided below:

The conclusion drawn from the t-test should be to:

A. Reject the null hypothesis since the t-statistic is greater than the critical value.
B. Reject the null hypothesis since the t-statistic is less than the critical value.
C. Fail to reject the null hypothesis since the t-statistic is greater than the critical value.
D. Fail to reject the null hypothesis since the t-statistic is less than the critical value.
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FRMFinancial Risk Manager


H0: =12%

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Ha: 12%

x 0

29% 12%
tn1

2.2399 2.262
s / n 24% / 10

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Type I and Type II Errors

Type I error: reject the null hypothesis when its actually true

Type II error: fail to reject the null hypothesis when its actually false
Significance level (): the probability of making a Type I error
Significance level =P (Type I error)

Power of a test: the probability of correctly rejecting the null hypothesis when it is false
Power of a test = 1P(Type II error)

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FRMFinancial Risk Manager

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FRMFinancial Risk Manager

Chebyshevs Inequality

k
1 - 1/kk>1
P(|X-| k) 1 - 1/k
k>1

1
1 3
1 2 1 75%
4 4
2
1
1 8
At
1 2 1 89%
9 9
least
3
1

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1
1 15

94%
2
16 16
4

Lie
within

3
4

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Standard
deviations
of the mean

Example

For a skewed distribution, what is the minimum percentage of the

observations that will lie between 2.5 standard deviations of the mean
based on Chebyshev's inequality?
A. 56%
B. 75%
C. 84%
D. 95%

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FRM

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FRMFinancial Risk Manager