Financial Risk Manager Part 1

Explanation

The correct sequence of steps in hypothesis testing is:

1. State the hypothesis - Define both null hypothesis (H₀) and alternative hypothesis (H₁)
2. Select the level of significance - Choose α (typically 0.05, 0.01, or 0.10) which represents the probability of Type I error
3. Formulate the decision rule - Establish criteria for rejecting H₀ based on the test statistic and critical values
4. Compute the test statistic - Calculate the appropriate test statistic from sample data
5. Make a decision - Compare test statistic with decision rule to accept or reject H₀

Why B is correct:

• The decision rule must be formulated BEFORE computing the test statistic because the decision rule establishes the critical values and rejection regions that will be used to evaluate the computed test statistic
• The level of significance must be selected before formulating the decision rule, as α determines the critical values

Why other options are incorrect:

• A: Computes test statistic before formulating decision rule - this is backward
• C: Formulates decision rule before selecting significance level - significance level determines the decision rule
• D: Starts with decision rule before stating hypotheses - hypotheses must be defined first

This systematic approach ensures proper statistical inference and minimizes errors in hypothesis testing.