Scandinavian Working Papers in Economics

Research Reports,
University of Gothenburg, Statistical Research Unit, School of Business, Economics and Law

No 2007:3: Consequences of using the probability of a false alarm as the false alarm measure

David Bock ()
Additional contact information
David Bock: Statistical Research Unit, Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: Statistical Research Unit, Göteborg University, Box 640, SE 40530 GÖTEBORG

Abstract: In systems for on-line detection of regime shifts, a process is continually observed. Based on the data available an alarm is given when there is enough evidence of a change. There is a risk of a false alarm and here two different ways of controlling the false alarms are compared: a fixed average run length until the first false alarm and a fixed probability of any false alarm (fixed size). The two approaches are evaluated in terms of the timeliness of alarms. A system with a fixed size is found to have a drawback: the ability to detect a change deteriorates with the time of the change. Consequently, the probability of successful detection will tend to zero and the expected delay of a motivated alarm tends to infinity. This drawback is present even when the size is set to be very large (close to 1). Utility measures expressing the costs for a false or a too late alarm are used in the comparison. How the choice of the best approach can be guided by the parameters of the process and the different costs of alarms is demonstrated. The technique is illustrated by financial transactions of the Hang Seng Index.

Keywords: Monitoring; Surveillance; Repeated decisions; Moving average; Shewhart method

JEL-codes: C10

20 pages, January 1, 2007

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