Financial Risk Manager Part 1

Explanation

The significance level (α) represents the probability of committing a Type I error, which occurs when we reject a true null hypothesis (H₀).

Correct Answer: B - P(reject H₀ | H₀ is true)

• This is the definition of Type I error probability
• Significance level = α = P(reject H₀ | H₀ is true)

Why other options are incorrect:

Option A: P(reject H₀ | H₀ is false) represents the power of the test, which is the probability of correctly rejecting a false null hypothesis.

Option C: P(not reject H₀ | H₀ is false) represents a Type II error, which occurs when we fail to reject a false null hypothesis.

Option D: P(not reject H₀ | H₀ is true) represents the confidence level (1-α), which is the probability of correctly not rejecting a true null hypothesis.

In hypothesis testing:

• Type I error: Rejecting H₀ when it's actually true
• Type II error: Failing to reject H₀ when it's actually false
• Power: 1 - P(Type II error) = P(reject H₀ | H₀ is false)