LM08 Hypothesis Testing 2025 Level I Notes

LM08 Hypothesis Testing

1. Introduction ...........................................................................................................................................................2
2. Hypothesis Tests for Finance ..........................................................................................................................2
3. Tests of Return and Risk in Finance .............................................................................................................8
4. Parametric Versus Nonparametric Tests ................................................................................................ 16
Summary................................................................................................................................................................... 17

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LM08 Hypothesis Testing 2025 Level I Notes

1. Introduction
This learning module covers:
• Hypothesis testing process
• Impact of errors in the hypothesis testing process
• Parametric and nonparametric tests
2. Hypothesis Tests for Finance
Hypothesis testing is the process of making judgments about a larger group (a population)
on the basis of observing a smaller group (a sample). The results of such a test then help us
evaluate whether our hypothesis is true or false.
For example, let’s say you are a researcher and you believe that the average return on all
Asian stocks was greater than 2%. To test this belief, you can draw samples from a
population of all Asian stocks and employ hypothesis testing procedures. The results of this
test can tell you if your belief is statistically valid.
In this learning module we will look at hypothesis tests concerning the mean and variance.
The Process of Hypothesis Testing
A hypothesis is defined as a statement about one or more populations. In order to test a
hypothesis, we follow these steps:
1. State the hypothesis.
2. Identify the appropriate test statistic and its probability distribution.
3. Specify the significance level.
4. State the decision rule.
5. Collect data and calculate the test statistic.
6. Make a decision.
1. Stating the Hypothesis
For each hypothesis test, we always state two hypotheses: the null hypothesis (H0) and the
alternative hypothesis (Ha).
Null hypothesis (H0): It is the hypothesis that the researcher wants to reject.
Alternative hypothesis (Ha): It is the hypothesis that the researcher wants to prove. If the
null hypothesis is rejected then the alternative hypothesis is considered valid.
Suppose you are a researcher and believe that the average return on all Asian stocks was
greater than 2%. In this case, you are making a statement about the population mean (µ) of
all Asian stocks.
For this example, the null and alternative hypotheses are:
H0: µ ≤ 2%

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LM08 Hypothesis Testing 2025 Level I Notes

Ha: µ > 2%
(The value 2% is known as µ0, the hypothesized value of the population mean.)
Instructor’s Note:
An easy way to differentiate between the two hypotheses is to remember that the null
hypothesis always contains some form of the equal sign.
Two-Sided vs. One-Sided Hypotheses
The alternative hypothesis can be one-sided or two-sided depending on the proposition
being tested. A one-sided test is also called a one-tailed test, and a two-sided test is also
called a two-tailed test.
If we want to determine whether the estimated value of a population parameter is less than
(or greater than) a hypothesized value we use a one-tailed test. However, if we want to
determine whether the estimated value of a population parameter is different than a
hypothesized value, we use a two tailed test.
Two-sided test: Suppose we want to test if the population mean is equal to 2%. The null and
alternative hypothesis can be expressed as:
H0: µ = 2%
Ha: µ ≠ 2%
Since the alternative hypothesis contains a ≠ sign this is a two-sided test.
One-sided test (right side): Suppose we want to test if the population mean is greater than
2%. The null and alternative hypothesis can be expressed as:
H0: µ ≤ 2%
Ha: µ > 2%
Since the alternative hypothesis contains a > sign this is a one-sided test, and we are
interested in the right side.
Instructor’s Note
The sign in the alternative hypothesis points to the direction of the tail that we should use in
our test. Since in our example the alternative hypothesis has a ‘>’ sign it points to the right,
therefore we are interested in the right tail.
One-sided test (left side): Suppose we want to test if the population mean is less than 2%.
The null and alternative hypothesis can be expressed as:
H0: µ ≥ 2%
Ha: µ < 2%
Since the alternative hypothesis contains a < sign this is a one-sided test, and we are
interested in the left side.

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LM08 Hypothesis Testing 2025 Level I Notes

Selecting the Appropriate Hypothesis

The easiest approach is to specify the alternative hypothesis first and then specify the null.
Using a ‘<’ or ‘>’ sign in the alternative hypothesis instead of a ‘≠’ sign reflects that belief of
the researcher more strongly. However, a researcher may sometimes select a two-sided test
to depict neutrality in his beliefs.
2. Identify the Appropriate Test Statistic
A test statistic is calculated from sample data and is compared to a critical value to decide
whether or not we can reject the null hypothesis. The test statistic that should be used
depends on what we are testing. For example, the test statistic for the test of a population
mean is calculated as:
sample statistic − value of the parameter under H0 X̅ − μ0
test statistic = = σ
standard error of the sample statistic
√n

Continuing with our Asian stocks example, suppose we want to test if the population mean is
greater than a particular hypothesized value. We draw 36 observations and get a sample
mean of 4. We are also told that the standard deviation of the population is 4. If the
hypothesized value of the population mean is 2, the test statistic is calculated as:
̅ − μ0
X 4−2
test statistic = σ = 4 =3
√n √36

However, if the hypothesized value of the population mean is 0, then the test statistic is
calculated as:
̅
X − μ0 4−0
test statistic = σ = 4 =6
√n √36

Identifying the Distribution of the Test Statistic

Exhibit 2 from the curriculum shows which test-statistics should be used depending on what
we want to test and their corresponding distributions.
Instructor’s Note: You will understand this table better, after you finish reading the
remaining sections.
What We Want to Probability Distribution Degrees of
Test Test Statistic of the Statistic Freedom
Test of a single X − 0 t-Distributed n–1
t =
mean s
n

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LM08 Hypothesis Testing 2025 Level I Notes

Test of the ( X1 − X 2 ) − (1 −  2 ) t-Distributed n1 + n2 – 2

t =
difference in means s 2p s 2p
+
n1 n2

Test of the mean of d − d 0 t-Distributed n–1

t =
differences sd

Test of a single s 2 (n − 1) Chi-square distributed n–1

2 =
variance 02

Test of the s12 F-distributed n1 – 1, n2 – 1

F =
difference in s22
variances
Test of a r n−2 t-Distributed n–2
t=
correlation 1 − r2

Test of m (O ij − E ij )2 Chi-square distributed (r – 1)(c – 1)

independence  =
2
 E ij
i =1
(categorical data)

3. Specify the Level of Significance

In reaching a statistical decision, we can make two possible errors:
• Type I error: We may reject a true null hypothesis.
• Type II error: We may fail to reject a false null hypothesis.
The following table shows the possible outcomes of a test.
True condition
Decision
H0 true H0 false
Do not reject H0 Correct decision Type II error
Reject H0 (accept Ha) Type I error Correct decision
The probability of a Type I error is also known as the level of significance of a test and is
denoted by ‘α’. A related term, confidence level is calculated as (1 - α ). For example, a level
of significance of 5% for a test means that there is a 5% probability of rejecting a true null
hypothesis and corresponds to the 95% confidence level.
Controlling the two types of errors involves a trade-off. If we decrease the probability of a
Type I error by specifying a smaller significance level (for e.g., 1% instead of 5%), we
increase the probability of a Type II error. The only way to reduce both types of error
simultaneously is by increasing the sample size, n.

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LM08 Hypothesis Testing 2025 Level I Notes

The probability of a Type II error is denoted by ‘β’. The power of test is calculated as (1 - β).
It represents the probability of correctly rejecting the null when it is false.
The different probabilities associated with the hypothesis testing decisions are presented in
the table below:
True condition
Decision
H0 true H0 false
Do not reject H0 Confidence level (1 - α ) β
Reject H0 (accept Ha) Level of significance (α) Power of the test (1 - β)
The most commonly used levels of significance are: 10%, 5% and 1%.
4. State the Decision Rule
A decision rule involves determining the critical values based on the level of significance;
and comparing the test statistic with the critical values to decide whether to reject or not
reject the null hypothesis. When we reject the null hypothesis, the result is said to be
statistically significant.
Determining Critical Values
One-tailed test:
Continuing with our Asian stocks example, suppose we want to test if the population mean is
greater than 2%. Say we want to test our hypothesis at the 5% significance level. This is a
one-tailed test and we are only interested in the right tail of the distribution. (If we were
trying to assess whether the population mean is less than 2%, we would be interested in the
left tail.)
The critical value is also known as the rejection point for the test statistic. Graphically, this
point separates the acceptance and rejection regions for a set of values of the test statistic.
This is shown below:

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LM08 Hypothesis Testing 2025 Level I Notes

The region to the left of the test statistic is the ‘acceptance region’. This represents the set of
values for which we do not reject (accept) the null hypothesis. The region to the right of the
test statistic is known as the ‘rejection region’.
Using the Z –table and 5% level of significance, the critical value = Z0.05= 1.645
Two-tailed test:
In a two-tailed test, two critical values exist, one positive and one negative. For a two-sided
test at the 5% level of significance, we split the level of significance equally between the left
0.05
and right tail i.e. = 0.025 in each tail.
2
This corresponds to rejection points of +1.96 and -1.96. Therefore, we reject the null
hypothesis if we find that the test statistic is less than -1.96 or greater than +1.96. We fail to
reject the null hypothesis if -1.96 ≤ test statistic ≤ +1.96. Graphically, this can be shown as:

5. Collect Data and Calculate the Test Statistic

In this step we first ensure that the sampling procedure does not include biases, such as
sample selection or time bias. Then, we cleanse the data by removing inaccuracies and other
measurement errors in the data. Once we are convinced that the sample data is unbiased and
accurate, we use it to calculate the appropriate test statistic.
6. Make a Decision
A statistical decision simply consists of rejecting or not rejecting the null hypothesis. If the
test statistic lies in the rejection region, we will reject H0. On the other hand, if the test
statistic lies in the acceptance region, then we cannot reject H0.
An economic decision takes into consideration all economic issues relevant to the decision,
such as transaction costs, risk tolerance, and the impact on the existing portfolio. Sometimes
a test may indicate a result that is statistically significant, but it may not be economically
significant.

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LM08 Hypothesis Testing 2025 Level I Notes

The Role of p-Values

The p-value is the smallest level of significance at which the null hypothesis can be rejected.
It can be used in the hypothesis testing framework as an alternative to using rejection points.
• If the p-value is lower than our specified level of significance, we reject the null
hypothesis.
• If the p-value is greater than our specified level of significance, we do not reject the
null hypothesis.
For example, if the p-value of a test is 4%, then the hypothesis can be rejected at the 5% level
of significance, but not at the 1% level of significance.
Relationship between test-statistic and p-value
A high test-statistic implies a low p-value.
A low test-statistic implies a high p-value.
3. Tests of Return and Risk in Finance
Tests Concerning a Single Mean
One of the decisions we need to make in hypothesis testing is deciding which test statistic
and which corresponding probability distribution to use. We use the following table to make
this decision:
Small sample Large sample
Sampling from
size (n<30) size (n≥30)
Normal Variance known z z
distribution Variance unknown t t (or z)
Non –normal Variance known NA z
distribution Variance unknown NA t (or z)
If the population variance is known and our sample size is large, we can use the z-statistic
and z-distribution to compute the critical value. However, if we do not know the population
variance and we have a small sample size, then we have to use the t-statistic and t-
distribution to compute the critical values.
Example
An analyst believes that the average return on all Asian stocks was less than 2%. The sample
size is 36 observations with a sample mean of -3. The standard deviation of the population is
4. Will he reject the null hypothesis at the 5% level of significance?
Solution:
In this case, our null and alternative hypotheses are:
H 0: µ ≥ 2
Ha : µ < 2

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LM08 Hypothesis Testing 2025 Level I Notes

σ 4
The standard error of the sample is: σx̅ = = = 0.67
√ n √36

The test statistic is:

sample statistic − value of the parameter under H0 −3 − 2
test statistic = = = −7.5
standard error of the sample statistic 0.67
The critical values corresponding to a 5% level of significance is -1.645.
When we consider the left tail of the distribution, our decision rule is as follows: Reject the
null hypothesis if the test statistic is less than the critical value and vice versa. Since our
calculated test statistic of -7.5 is less than the critical value of -1.645, we reject the null
hypothesis.

Example
Fund Alpha has been in existence for 20 months and has achieved a mean monthly return of
2% with a sample standard deviation of 5%. The expected monthly return for a fund of this
nature is 1.60%. Assuming monthly returns are normally distributed, are the actual results
consistent with an underlying population mean monthly return of 1.60%?
Solution:
The null and alternative hypotheses for this example will be:
H0: µ = 1.60 versus Ha: µ ≠ 1.60
̅
X − μ0 2 − 1.60
test statistic = s = 5 = 0.36
√n √20
Using this formula, we see that the value of the test statistic is 0.36.
The critical values at a 0.05 level of significance can be calculated from the t-distribution
table. Since this is a two-tailed test, we should look at a 0.05/2 = 0.025 level of significance
with df = n - 1 = 20 – 1 = 19. This gives us two values of -2.1 and +2.1.
Since our test statistic of 0.35 lies between -2.1 and +2.1, i.e., the acceptance region, we do
not reject the null hypothesis.
Test Concerning Difference Between Means with Independent Samples
Instructor’s Note:
Focus on the basics of this topic, the probability of being tested on the details is low.
In this section, we will learn how to calculate the difference between the means of two
independent and normally distributed populations. We perform this test by drawing a
sample from each group. If it is reasonable to believe that the samples are normally
distributed and also independent of each other, we can proceed with the test. We may also
assume that the population variances are equal or unequal. However, the curriculum focuses
on tests under the assumption that the population variances are equal.

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LM08 Hypothesis Testing 2025 Level I Notes

The test statistic is calculated as:

̅1 − ̅
(X X2 ) − (μ1 − μ2 )
t= s2 s2p
(np + )1/2
1 n2

The term 𝑠𝑝2 is known as the pooled estimator of the common variance. It is calculated by the
following formula:
(n1 − 1)s12 + (n2 − 1)s22
sp2 =
n1 + n2 − 2
The number of degrees of freedom is n1 + n2 – 2.
Example
(This is based on Example 1 from the curriculum.)
An analyst wants to test if the returns for an index are different for two different time
periods. He gathers the following data:
Period 1 Period 2
Mean 0.01775% 0.01134%
Standard deviation 0.31580% 0.38760%
Sample size 445 days 859 days
Note that these periods are of different lengths and the samples are independent; that is,
there is no pairing of the days for the two periods.
Test whether there is a difference between the mean daily returns in Period 1 and in Period
2 using a 5% level of significance.

Solution:
The first step is to formulate the null and alternative hypotheses. Since we want to test
whether the two means were equal or different, we define the hypotheses as:
H0: µ1 - µ2 = 0
Ha: µ1 - µ2 ≠ 0
We then calculate the test statistic:
(n1 − 1)s12 + (n2 − 1)s22 (445 − 1)0.09973 + (859 − 1)0.15023
sp2 = = = 0.1330
n1 + n2 − 2 445 + 859 − 2
̅1 − ̅
(X X2 ) − (μ1 − μ2 ) (0.01775 − 0.01134) − 0
t= = 0.1330 0.1330 1/2 = 0.3099
s2p s2p
(n + )1/2 ( + )
n2 445 859
1

For a 0.05 level of significance, we find the t-value for 0.05/2 = 0.025 using df = 445 + 859 -
2=1302. The critical t-values are ±1.962. Since our test statistic of 0.3099 lies in the
acceptance region, we fail to reject the null hypothesis.

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LM08 Hypothesis Testing 2025 Level I Notes

We conclude that there is insufficient evidence to indicate that the returns are different for
the two time periods.
Test Concerning Differences between Means with Dependent Samples
Instructor’s Note:
Focus on the basics of this topic, the probability of being tested on the details is low.
In the previous section, in order to perform hypothesis tests on differences between means
of two populations, we assumed that the samples were independent. What if the samples are
not independent? For example, suppose you want to conduct tests on the mean monthly
return on Toyota stock and mean monthly return on Honda stock. These two samples are
believed to be dependent, as they are impacted by the same economic factors.
In such situations, we conduct a t-test that is based on data arranged in paired
observations. Paired observations are observations that are dependent because they have
something in common.
We will now discuss the process for conducting such a t-test.
Example:
Suppose that we gather data regarding the mean monthly returns on stocks of Toyota and
Honda for the last 20 months, as shown in the table below:
Month Mean return of Mean monthly return Difference in mean monthly
Toyota stock of Honda stock returns (di)
1 0.5% 0.4% 0.1%
2 0.7% 1.0% -0.3%
3 0.3% 0.7% -0.4%
… … … …
20 0.9% 0.6% 0.3%
Average 0.750% 0.600% 0.075%
Here is a simplified process for conducting the hypothesis test:
Step 1: Define the null and alternate hypotheses
We believe that the mean difference is not 0. Hence the null and alternate hypotheses are:
H0 : µd = µd0 versus Ha : µd ≠ µd0
µd stands for the population mean difference and µd0 stands for the hypothesized value for
the population mean difference.
Step 2: Calculate the test-statistic
Determine the sample mean difference using:
n
1
d̅ = ∑ di
n
i=0

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LM08 Hypothesis Testing 2025 Level I Notes

For the data given, the sample mean difference is 0.075%.

Calculate the sample standard deviation. The process for calculating the sample standard
deviation has been discussed in an earlier reading. The simplest method is to plug the
numbers (0.1, -0.3, -0.4…0.3) into a financial calculator. The entire data set has not been
provided. We’ll take it as a given that the sample standard deviation is 0.150%.
Use this formula to calculate the standard error of the mean difference:
sd
sd̅ =
√n
For our data this is 0.150 / √20 = 0.03354.
We now have the required data to calculate the test statistic using a t-test. This is calculated
using the following formula using n - 1 degrees of freedom:
d̅ − μd0
t=
sd̅
0.075 – 0
For our data, the test statistic is = 2.24.
0.03354

Step 3: Determine the critical value based on the level of significance

We will use a 5% level of significance. Since this is a two-tailed test we have a probability of
2.5% (0.025) in each tail. This critical value is determined from a t-table using a one-tailed
probability of 0.025 and df = 20 – 1 = 19. This value is 2.093.
Step 4: Compare the test statistic with the critical value and make a decision
In our case, the test statistic (2.23) is greater than the critical value (2.093). Hence we will
reject the null hypothesis.
Conclusion: The data seems to indicate that the mean difference is not 0.
The hypothesis test presented above is based on the belief that the population mean
difference is not equal to 0. If µd0 is the hypothesized value for the population mean
difference, then we can formulate the following hypotheses:
1. If we believe the population mean difference is greater than 0:
H0 : µd ≤ µd0 versus Ha : µd > µd0
2. If we believe the population mean difference is less than 0:
H0 : µd ≥ µd0 versus Ha : µd < µd0
3. If we believe the population mean difference is not 0:
H0 : µd = µd0 versus Ha : µd ≠ µd0
Test Concerning a Single Variance
Instructor’s Note:
Focus on the basics of this topic, the probability of being tested on the details is low.

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LM08 Hypothesis Testing 2025 Level I Notes

In tests concerning the variance of a single normally distributed population, we use the chi-
square test statistic, denoted by χ2.
Properties of the chi-square distribution
The chi-square distribution is asymmetrical and like the t-distribution, is a family of
distributions. This means that a different distribution exists for each possible value of
degrees of freedom, n - 1. Since the variance is a squared term, the minimum value can only
be 0. Hence, the chi-square distribution is bounded below by 0. The graph below shows the
shape of a chi-square distribution:

There are three hypotheses that can be formulated (σ2 represents the true population
variance and σ02 represents the hypothesized variance):
1. H0 : σ2 = σ20 versus Ha : σ2 ≠ σ20 . This is used when we believe the population
variance is not equal to 0, or it is different from the hypothesized variance. It is a two-
tailed test.
2. H0 : σ2 ≥ σ20 versus Ha : σ2 < σ20 . This is used when we believe the population
variance is less than the hypothesized variance. It is a one-tailed test.
3. H0 : σ2 ≤ σ20 versus Ha : σ2 > σ20 . This is used when we believe the population variance
is greater than the hypothesized variance. It is a one-tailed test.
After drawing a random sample from a normally distributed population, we calculate the
test statistic using the following formula using n - 1 degrees of freedom:
(n − 1)(s 2 )
χ2 =
σ20
where:
n = sample size
s = sample variance
We then determine the critical values using the level of significance and degrees of freedom.
The chi-square distribution table is used to calculate the critical value.
Example
Consider Fund Alpha which we discussed in an earlier example. This fund has been in
existence for 20 months. During this period the standard deviation of monthly returns was

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LM08 Hypothesis Testing 2025 Level I Notes

5%. You want to test a claim by the fund manager that the standard deviation of monthly
returns is less than 6%.
Solution:
The null and alternate hypotheses are: H0: σ2 ≥ 36 versus Ha: σ2 < 36
Note that the standard deviation is 6%. Since we are dealing with population variance, we
will square this number to arrive at a variance of 36%.
We then calculate the value of the chi-square test statistic:
2 = (n - 1) s2 / σ02 = 19 x 25/36 = 13.19
Next, we determine the rejection point based on df = 19 and significance = 0.05. Using the
chi-square table, we find that this number is 10.117.
Since the test statistic (13.19) is higher than the rejection point (10.117) we cannot reject H0.
In other words, the sample standard deviation is not small enough to validate the fund
manager’s claim that population standard deviation is less than 6%.
Test Concerning the Equality of Two Variances
Instructor’s Note:
Focus on the basics of this topic, the probability of being tested on the details is low.
In order to test the equality or inequality of two variances, we use an F-test which is the ratio
of sample variances.
The assumptions for a F-test to be valid are:
• The samples must be independent.
• The populations from which the samples are taken are normally distributed.
Properties of the F-distribution
The F-distribution, like the chi-square distribution, is a family of asymmetrical distributions
bounded from below by 0. Each F-distribution is defined by two values of degrees of
freedom, called the numerator and denominator degrees of freedom. As shown in the figure
below, the F-distribution is skewed to the right and is truncated at zero on the left hand side.

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LM08 Hypothesis Testing 2025 Level I Notes

The rejection region is always in the right-side tail of the distribution.

When working with F-tests, there are three hypotheses that can be formulated:
1. H0 : σ12 = σ22 versus Ha : σ12 ≠ σ22 . This is used when we believe the two population
variances are not equal.
2. H0 : σ12 ≤ σ22 versus Ha : σ12 > σ22 . This is used when we believe the variance of the first
population is greater than the variance of the second population.
3. H0 : σ12 ≥ σ22 versus Ha : σ12 < σ22 . This is used when we believe the variance of the first
population is less than the variance of the second population.
The term σ12 represents the population variance of the first population and σ22 represents
the population variance of the second population.
The formula for the test statistic of the F-test is:
s12
F=
s22
where:
𝑠12 = the sample variance of the first population with n observations
𝑠22 = the sample variance of the second population with n observations
A convention is to put the larger sample variance in the numerator and the smaller sample
variance in the denominator.
df1 = n1 – 1 numerator degrees of freedom
df2 = n2 – 1 denominator degrees of freedom
The test statistic is then compared with the critical values found using the two degrees of
freedom and the F-tables.
Finally, a decision is made whether to reject or not to reject the null hypothesis.
Example
You are investigating whether the population variance of the Indian equity market changed
after the deregulation of 1991. You collect 120 months of data before and after deregulation.
Variance of returns before deregulation was 13. Variance of returns after deregulation was
18. Check your hypothesis at a confidence level of 99%.
Solution:
Null and alternate hypothesis: H0: σ12 = σ22 versus HA: σ12 ≠ σ22
18
F-statistic: 13 = 1.4
df = 119 for the numerator and denominator
α = 0.01 which means 0.005 in each tail. From the F-table: critical value = 1.6
Since the F-stat is less than the critical value, do not reject the null hypothesis.

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LM08 Hypothesis Testing 2025 Level I Notes

4. Parametric Versus Nonparametric Tests

The hypothesis-testing procedures we have discussed so far have two characteristics in
common:
• They are concerned with parameters, such as the mean and variance.
• Their validity depends on a set of assumptions.
Any procedure which has either of the two characteristics is known as a parametric test.
Nonparametric tests are not concerned with a parameter and/or make few assumptions
about the population from which the sample are drawn. We use nonparametric procedures
in three situations:
• Data does not meet distributional assumptions.
• Data has outliers
• Data are given in ranks. (Example: relative size of the company and use of
derivatives.)
• The hypothesis does not concern a parameter. (Example: Is a sample random or not?)

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LM08 Hypothesis Testing 2025 Level I Notes

Summary
LO: Explain hypothesis testing and its components, including statistical significance,
Type I and Type II errors, and the power of a test.
LO: Construct hypothesis tests and determine their statistical significance, the
associated Type I and Type II errors, and power of the test given a significance level.
A hypothesis is a statement about the value of a population parameter developed for the
purpose of testing a theory.
In order to test a hypothesis, we follow these steps:
1. State the hypothesis.
2. Identify the appropriate test statistic and its probability distribution.
3. Specify the significance level.
4. State the decision rule.
5. Collect data and calculate the test statistic.
6. Make a decision.
A test statistic is a quantity, calculated on the basis of a sample, and is used to decide
whether to reject or not to reject the null hypothesis. The formula for computing the test
statistic is:
sample statistic − value of the parameter under H0
test statistic =
standard error of the sample statistic
In reaching a statistical decision, we can make two possible errors: We may reject a true null
hypothesis (a Type I error), or we may fail to reject a false null hypothesis (a Type II error).
The level of significance of a test is the probability of a Type I error. As α gets smaller the
critical value gets larger and it becomes more difficult to reject the null hypothesis.
The power of a test is the probability of correctly rejecting the null (rejecting the null when it
is false). It is expressed as:
Power of a test = 1 – P (Type II error)
LO: Compare and contrast parametric and nonparametric tests, and describe
situations where each is the more appropriate type of test.
A parametric test is a hypothesis test concerning a parameter or a hypothesis test based on
specific distributional assumptions. In contrast, a nonparametric test is either not concerned
with a parameter or makes minimal assumptions about the population from which the
sample is drawn.
A nonparametric test is primarily used in three situations: when data do not meet
distributional assumptions, when data is given in ranks, or when the hypothesis we are
addressing does not concern a parameter.

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