Page 8 - FINAL CFA II SLIDES JUNE 2019 DAY 2
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LOS 7.b: Describe limitations to correlation analysis.                     MODULE 7.1: COVARIANCE & CORRELATION


      1. Outliers: A few extreme values can suggest a significant relationship exists when, in fact, there is none, or that there is no relationship
         when, in fact, there is a relationship.
      2. Spurious Correlation (Correlation ≠ causation (not necessarily)! Pure chance factors!
      3. Nonlinear Relationships: Correlation measures linearity in the form , say, Y = 6 – 3X. However, 2 variables could have a nonlinear yet
         a zero correlation; thus correlation analysis fails to capture strong nonlinear relationships!

     LOS 7.c: Formulate a test of the hypothesis that the population correlation coefficient, r, equals zero and determine
     whether the hypothesis is rejected at a given level of significance.


     As noted before, with the exception of r extremes around ±1.0, we cannot assess r strength without h-testing!

                                                      Ho: r = 0  versus Ha: r ≠ 0



                                                      Assuming normally distribution, test statistic for, r, with n – 2 df:      This is a 2TT
                                                                                                                                 (Why?)


                                                     To be provided! e.g. @ 95%



                                                                                                               Decision rule:
                                                                                                               Reject H if
                                                                                                                       0
                                                          Or Fail to Reject H if                               +t critical  < t; OR t < –t critical
                                                                            0
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