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FRM Part I · FRM Exam Part I · Hypothesis Testing

An analyst tests whether the mean daily return of a fund differs from zero. She sets H0: mu = 0 against H1: mu != 0 and chooses a 5% significance level. Which statement correctly describes what the 5% level represents?

The significance level is the probability of rejecting the null hypothesis when it is actually true, which is the Type I error rate. At 5%, the test is designed so that a true null is wrongly rejected in about 5% of repeated samples.

  1. AThe probability of rejecting H0 when H0 is actually true is 5%Correct
  2. BThe probability that H0 is true given that it was rejected is 5%
  3. CThe probability of failing to reject H0 when H0 is false is 5%
  4. DThe probability that the sample mean equals zero is 5%

Explanation

The significance level is the probability of a Type I error, meaning rejecting a true null hypothesis. The second option confuses it with a posterior probability of H0. The third describes the Type II error rate (beta), not alpha.

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