Chartered Financial Analyst (CFA) Practice Exam Level 2

The Likelihood Ratio Test is used to compare what?

1. Two independent variables

2. Fit of reduced and full models

3. Variance of different models

4. Hypothesis testing between two groups

The correct answer is: Fit of reduced and full models

The Likelihood Ratio Test is utilized to compare the fit of reduced and full statistical models. In this context, a "full model" includes all the variables of interest and provides a comprehensive representation of the data, while a "reduced model" is a simpler version that typically omits one or more variables. The test assesses whether the additional parameters in the full model significantly improve the model's fit compared to the reduced model. The likelihood ratio itself is calculated by taking the ratio of the maximum likelihoods of the two models. If the ratio indicates that the full model provides a significantly better fit, this would support the inclusion of the additional parameters. This process helps determine if complexities in the data warrant the added variables or if a simpler model suffices, contributing to more parsimonious model development. In this scenario, other options do not accurately represent the primary use of the Likelihood Ratio Test. The test is not specifically meant for comparing independent variables or assessing variances between models, nor is it designed for hypothesis testing strictly between two groups. Its core application lies in evaluating model specifications against each other.