Tests for consistency, Financial Management

Assignment Help:

Tests for Consistency

The consistency of the index numbers have been tested over the years. The most important of these tests are:

  1. The time reversal test

  2. The factor reversal test

  3. The circular test.

Time Reversal Test

Time reversal test has been developed by Prof. Irving Fisher. The test implies that for a price/quantity index, if the time periods are reversed, the resulting index should be the reciprocal of the original price/quantity index. 

If I0,1 denotes the original index for the current year with a given base year, and if I1, 0 denotes the resulting index, with time periods reversed, for the base year with the current year as a base year, then according to the time reversal test,

I0, 1 = 

1571_time reversal test.png  (or) I0, 1 x I1, 0 = 1

Let us test the consistency of the indices by interchanging 0 and 1 with 1 and 0 respectively.

It can be shown that Fisher's Ideal Index, Marshall-Edgeworth Index and Fixed Weights Aggregate Index satisfy this test. Laspeyres Index and Paasche Index do not. 

Factor Reversal Test

This test was also suggested by Prof. Irving Fisher. According to Prof. Fisher just as each formula should permit the interchange of the two time periods without giving inconsistent results, it ought to permit interchanging of the prices and quantities without giving inconsistent result, i.e. the two results multiplied together should give the true value ratio.

The product of change in prices in the current year and the change in quantities in the current year should be equal to  246_time reversal test1.png  (Value ratio)

where,

P1=Prices in the current year

P0=Prices in the base year

Q1=Quantities in the current year

Q0=Quantities in the base year

The test can be applied to the index numbers by interchanging P to Q and Q to P.

Except Fischer's Ideal Index, all other elementary indices, simple as well as weighted, fail to satisfy this test. 

Circular Test

Circular test is an extension of the time reversal test. This test is used while measuring price changes over a number of years with the shifting of base occurring frequently. According to this test, an index constructed for the year 'X' on base year 'Y' and for the year 'Y' on base year 'Z' should yield the same result as an index constructed for 'X' on base year 'Z'.

i.e. I0,1 x I1,2 x I2,0 = 1.

Laspeyres, Paasche and Fisher's indices fail to satisfy this test. Only the fixed weight aggregates method and simple aggregates method satisfy this test.

The indices satisfying the circular test would be amenable to change from year to year without referring to the base year. The indices have the advantage of reduced computational work in the event of a change in the base year.


Related Discussions:- Tests for consistency

Advantages and disadvantages of pay back period, Advantages: It is ...

Advantages: It is easy to calculate and catch. With the help of this technique, projects can be ranked in terms of their economic merits without much of complication.

What is the bonds value, Third Inc. wishes to issue a perpetual callable bo...

Third Inc. wishes to issue a perpetual callable bond. The current interest rate is 6%. Next year, there is a 30% chance that the interest rate will be 4.5% and a 70% chance that th

Baumol, To what extent does empirical evidence on corporate objectives supp...

To what extent does empirical evidence on corporate objectives support the predictions of Baumol’s “Sales Maximisation Hypothesis?”

Constructing index numbers - aggregates method, Aggregates Method Unde...

Aggregates Method Under the aggregates method of constructing an index number, we could have unweighted aggregates index and the weighted aggregates index. Unweighted Aggr

How is finance related to accounting and economics, How is finance related ...

How is finance related to the disciplines of accounting and economics? Financial management is fundamentally a combination of economics and accounting. First financial managers

Pass-through vs. pay-through structures, In a pass-through structure,...

In a pass-through structure, each certificate holder will be allotted a proportion of the cash flow from the underlying pool of loans or receivables on a pro rat

Explain the aspects of financing decision, Explain the aspects of financing...

Explain the aspects of financing decision The financing decision covers two interrelated aspects: (1) capital structure theory (2) capital structure decision.

Prepare a report for the managing director, The Managing Director of your f...

The Managing Director of your firm is thinking aloud about an appropriate gearing level for the company: "The consultants I spoke to yesterday explained that some academic th

Compare and contrast a forward contract and an option, QUESTION (a) Bri...

QUESTION (a) Briefly define foreign exchange rate risk and the three different types of exchange rate risks (b) Identify and outline the different methods of internal and ex

Portfolio management and asset pricing, I am facing some problems in my ass...

I am facing some problems in my assignment of Portfolio Management. Can anybody suggest me the proper explanation for it?

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd