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CFA Quantitative Methods III Updated
CFA Quantitative Methods III Updated
CFA Quantitative Methods III Updated
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Mapping to Curriculum
Reading 10: Sampling and Estimation
Reading 11: Hypothesis Testing
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Sampling
A probability sample is a sample selected such that each item or person in the population being studied
has a known likelihood of being included in the sample.
The sampling distribution of the sample mean is a probability distribution consisting of all possible sample
means of a given sample size selected from a population.
Need for Sampling:
The physical impossibility of checking all items in the population.
The cost of studying all the items in a population.
The sample results are usually adequate.
Contacting the whole population would often be time-consuming.
The destructive nature of certain tests.
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For a population with a mean and a variance 2 the sampling distribution of the means of all possible
samples of size n generated from the population will be approximately normally distributed.
The mean of the sampling distribution equal to and the variance equal to 2/n.
How is variance related to standard error?
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Sampling Error
The sampling error is the difference between a sample statistic and its corresponding population
parameter. It is found by subtracting the value of a Parameter from the value of a Statistic.
For example, if a poll was conducted where the population included all students in that school and the
sample was a class. If the sample had a mean GPA of 3.4, and the populations mean GPA was 3.2, then the
sample error was 0.2.
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Optional Topic
Suppose theres a population of 4 oldest scientists in a university: Jack, Andrew, Michelle and Tom
Random variable, X is the ages of the individuals
79
Ages of Population
78
77
76
75
74
73
72
Average Age
X
i 1
71
70
69
Andrew
N
78 76 72 74
75
4
0.3
Jack
Michelle
Tom
Prob. Of selection
0.25
0.2
X
i 1
0.15
2.236
0.1
0.05
0
Andrew
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Jack
Michelle
Tom
Optional Topic
1st
Obs
78
76
74
72
16 Sample Means
2nd Observation
78 76 74 72
1st
2nd Observation
Observ 78 76 74 72
78
78
77
76
75
76
77
76
75
74
74
76
75
74
73
72
75
74
73
72
0
72
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74
75
76
77
78
10
Optional Topic
X
i 1
72 73 73 78
75
16
X
N
i 1
1.58
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Population Variance
Sample Size
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It is appropriate distribution to use when constructing confidence intervals based on small samples (n<30)
from population with unknown variance & a normal, or approximately normal, distribution
It is symmetrical
It is defined by a single parameter, the degrees of freedom (df):
Degrees of freedom = n-1
It has more probability in the tails (fatter tails)
than normal distribution; which means higher kurtosis.
As the degrees of freedom gets larger, the shape of t-distribution
more closely approaches a standard normal distribution
Confidence Interval CI= m t * s
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Population with unknown variance given a large sample from any type of distribution
If the distribution is non-normal but the population variance is known, the z-statistic can be used as long
as sample size is large (n>=30)
If the distribution is non-normal but the population variance is unknown, the t-statistic can be used as
long as sample size is large (n>=30)
This means that while sampling from non-normal distribution, we cannot create a confidence interval if
the sample size is less than 30
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For example, if using P/BV ratios, the BV may not be available till sometime in the following quarter.
Time-Period Bias
Arises when the analysis is based on a time period that may make the results time-period specific.
For example, a time period too short may give results that may not hold in the long run.
A time period too long has a potential for structural changes in which one segment cannot be compared
to the other segment. It could result in two different returns distribution.
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Question
1. As compared to normal distribution, the t-distribution has:
A. Similar tails
B. Fatter tails
C. Narrower tails
2. Which of the following is most likely to be a property of an estimator?
A. Correctness
B. Reliability
C. Consistency
3. The mean age of all CFA candidates is 30 years. The mean age of random sample of 100 candidates is
found to be 27.5 years. The difference , 30-27.5=2.5, is called the:
A. Random error
B. Sampling error
C. Population error
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Questions (Cont)
4. Assume that a population has a mean of 14 with a standard deviation of 3. If a random sample of 64
observations is drawn from this population, the standard error of the sample mean is closest to:
A. 0.575
B. 0.375
C. 0.575
5. The population mean is 30 & the mean of a sample of size 144 is 28.5. The variance of the sample is
25. The standard error of the sample mean is closest to:
A. 0.450
B. 0.317
C. 0.417
6. A random sample of 100 mobile store customers spent an average of $150 at the store. Assuming the
distribution is normal & the population standard deviation is $10, the 95% confidence interval for the
population mean is closest to:
A. $148.04 to $151.96
B. $144.08 to $159.96
C. $149.04 to $152.96
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Questions (Cont)
7. The Central Limit Theorem is best described as stating that the sampling distribution of the sample
mean will be approximately normal for large-size samples:
A. if the population distribution is normal.
B. if the population distribution is symmetric.
C. for populations described by any probability distribution.
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Solution
1. B. The t-distribution has fatter tails compared to normal distribution
2. C. Consistency, Efficiency & unbaisedness are desirable properties of an estimator
3
64
5. C.
5
144
= 3/8 = 0.375
= 5/12 = 0.417
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P-Value
T-test
F-test, Chi-square test
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Hypothesis Testing
A statistical hypothesis test is a method of making statistical decisions from and about experimental data.
Null-hypothesis testing answers the question:
How well the findings fit the possibility that chance factors alone might be responsible."
Example: Does your score of 6/10 imply that I am a good teacher???
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0.2
0.15
Critical Value
(Xc)
0.1
0.05
0
-10
-5
0
$19,000
10
Sample mean values greater than $19,000--that is x-values on the right-hand side of the sampling
distribution centered on = $19,000--suggest that H0 may be false.
More important the farther to the right x is , the stronger is the evidence against H 0
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sx
s
$400
n
Substitute the values of zc, s, and (under the assumption that H0 is "just" true )
Critical Value xc
xc = + zcs = $19,658.
In this case, since the observed sample statistic (20,000) is greater than the critical value (19,658), so
the null hypothesis is rejected =>
Decision Rule
If the sample mean household income is greater than $19,658, reject the null hypothesis and introduce the new course
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Test Statistic
The value of the test statistic is simply the z-value corresponding to = $20,000.
x
2.5
sx
0.25
0.2
0.15
= 0.05
0.1
There is a significant
difference in the
hypothesized population
parameter and the observed
sample statistic =>
Mean income > 19,000 =>
Launch the course
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0.05
0
-10
-5
0
=$19,000
Z=0
Do not Reject H0
x=
5 $ 20,000
Z=2.5
10
Reject H0
X c $19,658
Z c 1.645
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Errors in Estimation
Please note: You are inferring for a population, based only on a sample
This is no proof that your decision is correct & Its just a hypothesis
There is still a chance that your inference is wrong. How do I quantify the prob. of error in inference?
Type I and Type II Errors:
Type I error occurs if the null hypothesis is rejected when it is true
Type II error occurs if the null hypothesis is not rejected when it is false
Significance Level:
-> Significance level : The upper-bound
probability of a Type I error
1 - ->confidence level : The complement
of significance level
The power of a test is the probability
of correctly rejecting the null.
Actual
H0 is True
Inference
H0 is True
Correct Decision
Confidence
Level=1-
Type-I Error
H0 is False Significance
Level=
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H0 is False
Type-II Error
P(Type-II
Error)=
Power=1-
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P-value
The probability of obtaining an observed value of
x (From the sample) as high as $20,000 or more
when actual populations mean () is only
$19,000 = 0.00621
Calculated probability of rejecting the null
hypothesis (H0) when that hypothesis (H0) is true
(Type I error)
0.2
0.15
0.1
= 0.05
0.05
0
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=$19,000
Z=0
Do not Reject H0
p-value= 0.00621
Reject H0
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They would perceive the training to be of inferior quality, if their household income is > US$19,000 and
hence not buy the training?
How would the decision criteria change? What should be the testing strategy?
Hint: From the question wording infer: Two tailed testing
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0.25
0.2
0.15
Ha: $19,000
= 0.025
Since we are checking for significance difference
on both the ends, so its a two tailed test
0.1
= 0.025
0.05
0
-10
-5
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Reject H0
=$19,000
Z=0
Do not
Reject H0
10
Reject H0
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t-test
The t-distribution is a probability distribution defined by a single parameter known as degrees of
freedom (df).
Like the standard normal distribution, a t-distribution has a mean of zero.
However, unlike a standard normal distribution that has a variance of one, a t-distribution has a variance
greater than one.
The t-distribution also has fatter tails than a normal distribution.
The t-distribution approaches a normal distribution as the degrees of freedom increases.
A sample size greater or equal to 30 is treated as a large sample and a sample less than 30 is treated as a
small sample.
t n -1
X - 0
s/ n
The test statistic for a sample size n (and degrees of freedom n-1) is given by.
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Question
1. A researcher has a sample of 400 observations from a population whose standard deviation is known
to be 136. The mean of the sample is calculated to be 17.2. The null hypothesis is stated as Ho: mean =
4. The p-value under the alternative hypothesis H1: mean > 4 equals
A. 3.92%
B. 2.6%
C. 5.2%
2. Buchanan thinks that KKR is unable to perform because of Ganguly. He sees the statistics and conducts
leadership survey, which reveals that Ganguly scores low on Leadership qualities. Buchanan
Hypothesize
Ho: Ganguly Not a Leader,
HA: Ganguly a Leader
Buchanan removes Ganguly as KKR captain, but KKR keeps losing. Subsequent analysis shows that
ShahRukh Khan was causing the problem. By Removing Ganguly, Buchanan:
A. Made a Type II error.
B. Is correct.
C. Made a Type I error.
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Question
3. If the standard deviation of a population is 100 and a sample size taken from that population is 64, the
standard error of the sample means is closest to:
A. 0.08.
B.1.56.
C. 12.50.
4. Which of the following statements about the hypothesis testing is most accurate?
A. A Type II error is rejecting the null when it is actually true
B. The significance level equals one minus the probability of a Type I error
C. A two-tailed test with a significance level of 5% has z-critical values of + 1.96
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Solution
1. B. 2.6%.
The z-statistic under the null is calculated to be (17.2 - 4)/(136/(400^.5)) = 1.94.
The right-tailed probability of observing a z-statistic at least as big as 1.94 equals 1.0 - 0.9738 = 0.026 =
2.6%. This is the p-value of the right-tailed test in this sample.
2. C. Made a Type II error.
Type II error is an which occurs when you fail to reject a hypothesis when it is actually false (also
known as the power of the test). A Type I error is the rejection of a hypothesis when it is actually true
(also known as the significance level of the test). P(Type II) = P(Accepting H0| H0 false).
3. C. 12.5
100 100
12.5
8
n
64
4. C. Rejecting the null when it is true is a Type I error. A Type II error I failing to reject the null hypothesis
when it is false
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Example
Hypothesis
2
H0: =
HA : 2
02
02
Chi-Square
Test Statistic
2 ,( n1)
(n 1) s 2
2
0
Example
Hypothesis
H0: 12 22 = 0
HA: 12 22 0
F-test Statistic
F ,ndf ,ddf
s12
2
s2
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Chi-square test
It is used for hypothesis tests concerning the variance of a normally distributed population
Hypothesis for two-tailed test of single-population variance:
H0 : 2 2 0 verses Ha : 2 2 0
Hypothesis for one-tailed test are structured as:
H 0 : 2 2 0 verses H a : 2 2 0 , or
H 0 : 2 2 0 verses H a : 2 2 0
Steps:
1) Collect the sample & calculate the sample statistics
2) Make a decision regarding the hypothesis
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0 4 8 12 16 20 24 28
d.f. = 1
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0 4 8 12 16 20 24 28
d.f. = 5
0 4 8 12 16 20 24 28
d.f. = 15
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Example : F-test
Q : William Waugh is examining the earnings for two different industries. He suspects that the earnings for chemical
industry are more divergent than those of petroleum industry. To confirm, he took a sample of 35 chemical manufacturers
& a sample of 45 petroleum companies. He measured the sample standard deviation of earnings across the chemical
industry to be $3.5 & that of petroleum industry to be $3.00. Determine if the earnings of the chemical industry have
greater standard deviation than those of the petroleum industry.
A: 1) State the hypothesis:
H0 : 2 2 0 verses Ha : 2 2 0
12
2
the petroleum industry = 2
12 2 2
2
S
F 12
S2
Reject H 0 if F 1.74
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$3.502
F 12
1.1165
$3.002
S2
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BSE
30
NSE
50
Mean
3.27
2.53
Std dev
1.5
1.4
Is there a difference in the variances between the BSE & NSE at the = 0.05 level?
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df1 = n1 1 = 30 1 = 29
Denominator:
df2 = n2 1 = 50 1 = 49
F.05/2, 29, 49 = 1.881
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2
1
2
2
s
s
1.50
1.148
2
1.40
Do not
reject H0
F/2 =1.881
Reject H0
F = 1.148 is not greater than the critical F value of 1.881, so we do not reject H0
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Questions
1.
An analyst is testing a hypothesis about stock returns. He would like to minimise the chances of rejecting the
null hypothesis when it is true. Which of the following is most likely to be the level of significance?
A. 0.05
2.
B. 0.95
C. 0.01
An analyst would like to compare the returns of two sample portfolios derived from the S&P 500 index. If he
performs a two sample test to test the hypothesis with a 5% level of significance, which of the following is
most likely?
A. The probability of Type I error is 95%
3.
B.
The probability that the null hypothesis would not be rejected when it is true is 5%
C.
What is the power of the test if the significance level of the test is 0.05 & the probability of the Type II error is
0.25?
A. 0.250
B.
0.750
C.
C. 0.850
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Questions
4. Which of the following statements of the central limit theorem is least likely true?
A. For large n if the population distribution is uniform, the sample distribution is always normal
B. The standard deviation of the sample is always less than the population standard deviation
C. The interval within which the sample mean is expected to fall is z.
5. The probability of an investment earning an average return of 15% is 33% out of a given portfolio of
investment options. The probability distribution of such investments options would follow which of the
following distributions?
A. Binomial distribution
B. Poisson distribution
C. Normal distribution
6. Which of the following is false about the t statistic and the z values?
A. For a given confidence interval, as the degrees of freedom increases the t- values approach the
normal z values
B. The students t test is used when the population is normal but its standard deviation is unknown.
C. The z value is used for hypothesis testing when the sample variance is known.
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Questions
7. The F Statistic is:
A. Always +ve and is +ve skewed
8. Which of the following statements about the F-distribution & chi-square distribution is least accurate?
Both distributions:
A. Are asymmetrical
B. Are bound by zero on the left
C. Have means that are less than their standard deviations
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Solutions
1. C. As here the analysts want to minimize the chances of rejecting the null hypothesis when it is true
then he will use the least possible level of significance 0.01
2. C. The probability of Type I error is 5%
3. B. Power of the test = 1 P(Type II error) = 1 - 0.25 0.750
4. A. For large n if the population distribution is uniform, the sample distribution is always normal
5. A. In this case, the investment options will follow Binomial Distribution
6. C. The z value is used for hypothesis testing when the sample variance is known.
7. A. F Statistic is ratio of 2 variances and hence always +ve. F Distribution is also +vely skewed.
8. C. There is no consistent relationship between the mean & the standard deviation of the chi-square
distribution or F-distribution
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Line Charts
A line chart is the most basic and simplest type of stock charts
that are used in technical analysis.
The line chart is also called a close-only chart as it plots the
closing price of the underlying security, with a line connecting the
dots formed by the close price.
The price data used in line charts is usually the close price of the
underlying security. The uncluttered simplicity of the line chart is
its greatest strength as it provides a clean, easily recognizable,
visual display of the price movement. This makes it an ideal tool
for use in identifying the dominant support and resistance
levels, trend lines, and certain chart patterns.
However, the line chart does not indicate the highs and lows and,
hence, they do not indicate the price range for the session
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Chart Patterns
Continuation patterns : indicate a higher probability for the continuation of the existing trend. These are
usually momentary consolidation or retracements within the trend. Common continuation patterns
include flags and pennants, and the various triangle patterns.
Reversal patterns : indicate a high probability that the existing trend has come to an end and will reverse
direction. The common reversal patterns include double and triple tops, double and triple bottoms, head
and shoulders, rising and falling wedges.
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Definitions
market prices reflect both rational and irrational investor behavior; implies that
the efficient markets hypothesis does not hold
it is reflected in trends and patterns that tend to repeat and can be identified
and used for forecasting prices
If prices have changes exponentially over draw a chart on a logarithmic scale instead of a linear scale
long periods of time what might an
analyst do to his charts?
What are the three main types of
charts?
1) line charts
2) bar charts
3) candlestick charts
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Definitions
What is an uptrend?
if prices are consistently reaching higher highs and retracing to higher lows;
demand is increasing relative to supply
What is a downtrend?
if prices are consistently declining to lower lows and retracing to lower highs;
supply is increasing relative to demand
What is a breakout?
when price crosses the trendline from a downtrend by what the analyst
considers a significant amount
What is a breakdown?
when price crosses the trendline from an uptrend by what the analyst
considers a significant amount
belief that breached resistance levels become support levels and that
breached support levels become resistance levels
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Definitions
a reversal pattern that suggests the demand that has been driving the uptrend
is fading, especially if each of the highs in the pattern occurs on declining
volume
1) inverse head-and-shoulders
2) double bottom
3) triple bottom
Form when prices reach lower highs and higher lows over a period of time.
Trendlines on the highs and on the lows thus converge when they are
projected forward. they can be symmetrical, ascending or descending;
suggests buying and selling pressure have become roughly equal temporarily
but they do not imply a change in direction of a trend
mean of the last 'x' closing prices; often viewed as support or resistance levels
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Definitions
when short-term average crosses the long-term average from below; 'buy'
signal; emerging uptrend
when a short-term average crosses the long-term average from above, 'sell
signal'; emerging downtrend
constructed based on the standard deviation of closing prices over the last 'n'
periods; move away from each other when volatility increases and move closer
together when prices are less volatile
markets get overbought or oversold because most investors tend to buy and
sell at the wrong times, and thus it can be profitable to trade in the opposite
direction
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Definitions
What is an oscillator?
100 x latest closing price - closing price from n period earlier; buy when ROC
changes from negative to positive during an uptrend and sell when ROC
changes from positive to negative during downtrend
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Questions
1. Which of the following is most likely to be considered a momentum indicator?
A. Put-call ratio
B. Breadth of market
C. Mutual fund cash position
2. A low price range in which buying activity is sufficient to stop a price decline is best described as:
A. Support
B. Resistance
C. Change in polarity
3. A technical analyst has detected a price chart pattern with three segments. The left segment shows a
decline followed by a reversal to the starting price level. The middle segment shows a more
pronounced decline than in the first segment and again a reversal to near the starting price level. The
third segment is roughly a mirror image of the first segment. This chart pattern is most accurately
described as:
A. A triple bottom
B. A head and shoulders
C. An inverse head and shoulders
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Solution
1. B. List and describe examples of each major category of technical trading rules and indicators.
Breadth of market is a momentum indicator. Put-call ratio and mutual fund cash position are contraryopinion rules.
2. A. Support is defined as a low price range in which buying activity is sufficient to stop the decline in
price.
3. C. An inverse head and shoulders pattern consists of a left segment that shows a decline followed by a
reversal to the starting price level, a middle segment that shows a more pronounced decline than in
the first segment and again a reversal to near the starting price level, and a third segment that is
roughly a mirror image of the first segment.
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H0 is False
Inference
Correct Decision
H0 is True
Confidence Level=1-
Type-I Error
H0 is False
Significance Level=
Type-II Error
P(Type-II Error)=
Power=1-
0.2
0.15
0.1
0.05
Actual
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0.25
0.25
0.2
0.15
0.1
0.05
t-Distribution
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