What is Hypothesis Testing

Chapter 5: Hypothesis Testing

Classical Null And Alternative Hypothesis

Chapter 5: Hypothesis Testing

 Type I and Type II errors
•
In financial econometrics, Type I and Type II errors are associated with hypothesis testing, particularly in the context of
testing the validity of a financial model or the presence of certain characteristics in financial data.
• Type I Error:
• Definition: Type I error occurs when the null hypothesis is incorrectly rejected when it is actually true.
• Financial Econometrics Example: Suppose a financial analyst tests a hypothesis that a particular trading strategy has no effect on
returns. A Type I error would occur if the analyst incorrectly concludes that the strategy is effective when, in reality, it is not.
• Type II Error:
• Definition: Type II error occurs when the null hypothesis is not rejected when it is actually false.
• Financial Econometrics Example: Continuing with the trading strategy example, a Type II error would occur if the analyst fails to
identify the effectiveness of the strategy (i.e., does not reject the null hypothesis) when, in reality, the strategy does have a significant
impact on returns.
• In the context of financial econometrics, the consequences of Type I and Type II errors can be significant. Type I errors
may lead to incorrect investment decisions or the adoption of ineffective financial models, while Type II errors may result
in missed opportunities or the continuation of suboptimal strategies.
• Balancing the trade-off between Type I and Type II errors is crucial. The significance level (�α) chosen for hypothesis
testing influences the likelihood of Type I errors, and statistical power (1 - Type II error rate) reflects the ability to detect
true effects. Financial analysts must carefully consider these errors and their implications when evaluating the validity of
financial models or investment strategies.

Chapter 5: Hypothesis Testing

Chapter 5: Hypothesis Testing
Chapter 5: Hypothesis Testing
Chapter 5: Hypothesis Testing
Chapter 5: Hypothesis Testing
 what are the limitations of t test?
The t-test, while a widely used statistical method, has certain limitations that researchers should be aware of:
• Assumption of Normality: The t-test assumes that the data follow a normal distribution. If the data significantly deviate from
normality, the results of the t-test may be unreliable. Non-parametric tests may be considered as alternatives when normality
assumptions are violated.
• Sensitivity to Outliers: The t-test is sensitive to outliers in the data, which can disproportionately influence the results. Outliers may
distort the estimate of the mean and standard deviation, impacting the validity of the t-test.
• Assumption of Homogeneity of Variance: The t-test assumes homogeneity of variance, meaning that the variances of the
compared groups are roughly equal. Violations of this assumption can affect the accuracy of the test. Welch's t-test is an alternative
that does not assume equal variances.
• Sample Size Limitations: The t-test may not perform well with small sample sizes. As sample sizes increase, the t-distribution
approaches the normal distribution, making the test more reliable. For small samples, other non-parametric tests or exact methods
may be more appropriate.
• Limited to Two Groups: The traditional t-test is designed for comparing means between two groups. When dealing with more than
two groups, multiple t-tests may lead to an increased risk of Type I errors. Analysis of variance (ANOVA) is a more suitable method
for comparing means across multiple groups.
• Violation of Independence Assumption: The t-test assumes that observations within each group are independent. If this
assumption is violated, such as in the case of repeated measures or correlated samples, alternative methods like paired t-tests or
mixed-effects models may be necessary.
• Not Robust to Skewed Distributions: The t-test can be influenced by skewed distributions. In the presence of substantial skewness,
transformation of the data or the use of non-parametric tests might be considered.
• Causation vs. Association: The t-test can establish associations but does not imply causation. Even if a significant difference is found
between groups, it does not necessarily mean that one variable causes the observed difference in the other.
Chapter 5: Hypothesis Testing