Application of discriminant analysis, Finance Basics

Application of Discriminant Analysis

Application of Discriminant Analysis to the Selection of Applicants, Discriminative analysis is a statistical model such can be used to accept or refuse a prospective credit customer. The discriminate analysis is as same to regression analysis however it assumed as the observations come from two different universal sets or in credit analysis, the good and bad customers.  To demonstrate let us suppose that two factors are significant in evaluating a credit applicant the quick ratio and total worth to total assets ratio.

The discriminate function will be of the form as.

ft = a1(X1) + a2(X2)

Whereas:    X1 is quick ratio

                    X2 is the network to total assets

                    a1 and a2 are parameters

The parameters can be computed with the employ of the following equations as:

a1      =        (Szz dx - Sxzdz)/Sxx Sxx - Sxz²

a2      =        (Szz dx - Sxzdz)/Szz Sxx - Sxz²

Whereas:    Sxx represents the variances of X1

Szz represents the variances of X2

Sxz is the covariance of variables of X1 and X2

dx is the difference between the average of X1's bad accounts and X2's good accounts

dz represents the difference between the average of X's bad accounts and X's good accounts.

The next step is to determine the minimum cut-off value of the function below at which credit will not be given.  This value is referred to as the discriminate value and is denoted by f*.

Once the discriminate function has been developed it can then be used to analyze credit applicants.  The important assumption here is that new credit applicants will have the same characteristics as the ones used to develop the mode.

More than two variables can be utilized to determine the discriminate function.  In that a case the discriminate function will be of the form of.

ft  =  a1x1 + a2x2 + ... + anxn

Posted Date: 1/31/2013 8:23:32 AM | Location : United States

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