Proving Prediction Prudence
23 Pages Posted: 5 Jun 2020 Last revised: 24 Jun 2020
Date Written: May 7, 2020
We study how to perform tests on samples of pairs of observations and predictions in order to assess whether or not the predictions are prudent. Prudence requires that that the mean of the difference of the observation-prediction pairs can be shown to be significantly negative. For safe conclusions, we suggest testing both unweighted (or equally weighted) and weighted means and explicitly taking into account the randomness of individual pairs. The test methods presented are mainly specified as bootstrap and normal approximation algorithms. The tests are general but can be applied in particular in the area of credit risk, both for regulatory and accounting purposes.
Keywords: Paired difference test, weighted mean, credit risk, PD, LGD, EAD, CCF
JEL Classification: G21, C12
Suggested Citation: Suggested Citation