Question

7,Before lending someone money, banks must decide whether they believe the applicant will repay the loan. One strategy used is a point system. Loan officers assess information about the applicant, totaling points they award for the person's income level, credit history, current debt burden, and so on. The higher the point total, the more convinced the bank is that it's safe to make the loan. Any applicant with a lower point total than a certain cutoff score is denied a loan. We can think of this as a hypothesis test. Since the bank makes its profit from the interest collected on repaid loans, their null hypothesis is that the applicant will repay the loan and so should get the money. Only if the person's score falls below the minimum cutoff will the bank reject the null and deny the loan. This system is reasonably reliable, but, of course, sometimes there are mistakes. a) When a person defaults on a loan, which type of error did the bank make? b) Which type of error is it when the bank misses an opportunity to make a loan to someone who would have repaid it?

Answer 1

Null hypothesis: H₀ : Applicant will repay the loan and so should get the money ( score is greater than minimum cutoff )

Alternative : H₁ : Applicant will not repay the loan and so should not get the money ( score is less than minimum cutoff )

a) When person defaults a loan, which mean the person passed the minimum criteria (score is greater than minimum cutoff ) and he did not pay the loan, here bank accepted H₀ but in reality it is false hence it is type-II error.

b) Bank misses an opportunity to make a loan to someone who would have repaid it.

here the person doesnot met the minimum criteria ( score is less than minimum cutoff ) but he could have repaid it.

Here bank rejected H₀ when in reality it is true hence it is type-I error.