# On Small Sample Properties of Permutation Tests: A Significance Test for Regression Models

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1 On Small Sample Properties of Permutation Tests: A Significance Test for Regression Models Hisashi Tanizaki Graduate School of Economics Kobe University ABSTRACT In this paper we consider a nonparametric permutation test on the correlation coefficient which is applied to a significance test on regression coefficients. Because the permutation test is very computer-intensive there are few studies on small-sample properties although we have numerous studies on asymptotic properties with regard to various aspects. In this paper we aim to compare the permutation test with the t test through Monte Carlo experiments where an independence test between two samples and a significance test for regression models are taken. For both the independence and significance tests we obtain the results through Monte Carlo experiments that the nonparametric test performs better than the t test when the underlying sample is not Gaussian and that the nonparametric test is as good as the t test even under a Gaussian population. 1 Introduction In the regression models we assume that the disturbance terms are mutually independently and identically distributed. In addition in the case where we perform the significance test on the regression coefficients we assume that the error terms are normally distributed. Under these assumptions it is known that the ordinary least squares (OLS) estimator of the regression coefficients follows the t distribution with n k degrees of freedom where n and k denote the sample size and the number of regression coefficients. As the sample size n increases the t distribution approaches the standard normal distribution N(0 1). From the central limit theorem it is known that the OLS estimator of the regression coefficient is normally distributed for a sufficiently large sample size if the variance of the OLS estimator is finite. However in the case where the error term is non-gaussian and the sample size This research was partially supported by Japan Society for the Promotion of Science Grants-in-Aid for Scientific Research (C) #

2 is small the OLS estimator does not have the t distribution and therefore we cannot apply the t test. To improve these problems in this paper we consider a significance test of the regression coefficient that includes the case where the error term is non-gaussian and the sample size is small. A nonparametric test (or a distribution-free test) is discussed. Generally we can regard the OLS estimator of the regression coefficient as the correlation between two samples. The nonparametric tests based on Spearman s rank correlation coefficient and Kendall s rank correlation coefficient are very famous. See for example Hollander and Wolfe (1973) Randles and Wolfe (1979) Conover (1980) Sprent (1989) Gibbons and Chakraborti (1992) and Hogg and Craig (1995) for the rank correlation tests. In this paper the permutation test proposed by Fisher (1966) is utilized and we compute the correlation coefficient for each of all the possible combinations and all the possible correlation coefficients are compared with the correlation coefficient based on the original data. This permutation test can be directly applied to the regression problem. The outline of this paper is as follows. In Section 2 we introduce a nonparametric test based on the permutation test where we consider testing whether X is correlated with Y for the sample size n. Moreover we show that we can directly apply the correlation test to the regression problem without any modification. In Section 3 we compare the powers of the nonparametric tests and the conventional t test when the underlying data are non-gaussian. In the case where k = 2 3 is taken for the number of regression coefficients we examine whether the empirical sizes are correctly estimated when the significance level is α = The Nonparametric Test on Regression Coefficients 2.1 On Testing the Correlation Coefficient Let (X 1 Y 1 ) (X 2 Y 2 ) (X n Y n ) be a random sample where the sample size is n. Consider testing if there is a correlation between X and Y i.e. if the correlation coefficient ρ is zero or not. The correlation coefficient ρ is defined as: ρ = Cov(X Y) V(X)V(Y) where Cov(X Y) V(X) and V(Y) represent the covariance between X and Y the variance of X and the variance of Y respectively. Then the sample correlation coefficient ˆρ is written as: ˆρ = S XY S X S Y where S XY S X and S Y denote the sample covariance between X and Y the sample variance of X and the sample variance of Y which are given by: S XY = 1 n n (X i X)(Y i Y) S 2 X = 1 n i=1 X and Y represent the sample means of X and Y. n (X i X) 2 S Y 2 = 1 n i=1 n (Y i Y) 2. i=1 2

3 If X is independent of Y we have ρ = 0 and the oint density of X and Y is represented as a product of the marginal densities of X and Y i.e. f xy (x y) = f x (x) f y (y) where f xy (x y) f x (x) and f y (y) denote the oint density of X and Y the marginal density of X and the marginal density of Y. The equation above implies that for all i and we consider randomly taking n pairs of X i and Y. Accordingly for fixed X 1 the possible combinations are given by (X 1 Y ) = 1 2 n where we have n combinations. Similarly for fixed X 2 the possible combinations are (X 2 Y ) = 2 3 n i.e. n 1 combinations. Moreover we have n 2 combinations for X 3 n 3 combinations for X 4 and so on. Therefore the total number of possible combinations between X and Y are given by n!. For each combination we can compute the correlation coefficient. Thus n! correlation coefficients are obtained. The n correlation coefficients are compared with the correlation coefficient obtained from the original pairs of data. If the correlation coefficient obtained from the original data is in the tail of the empirical distribution constructed from the n correlation coefficients the hypothesis that X is correlated with Y is reected. The testing procedure above is distribution-free or nonparametric and can be applied in almost all cases. The nonparametric test discussed above is known as a permutation test which has developed by Fisher (1966). For example see Stuart and Ord (1991). The order of X i i = 1 2 n is fixed and we permute Y = 1 2 n randomly. Based on the n! correlation coefficients we can test if X is correlated with Y. Let the n! correlation coefficients be ˆρ (i) i = 1 2 n!. Suppose that ˆρ (1) is the correlation coefficient obtained from the original data. The estimator of the correlation coefficient ρ denoted by ˆρ is distributed as: P(ˆρ < ˆρ (1) ) = Number of combinations less than ˆρ(1) out of ˆρ (1) ˆρ (n!) Number of all possible combinations (i.e. n!) P(ˆρ = ˆρ (1) ) = Number of combinations equal to ˆρ(1) out of ˆρ (1) ˆρ (n!) Number of all possible combinations (i.e. n!) P(ˆρ > ˆρ (1) ) = Number of combinations greater than ˆρ(1) out of ˆρ (1) ˆρ (n!) Number of all possible combinations (i.e. n!) Thus the above three probabilities can be computed. The null hypothesis H 0 : ρ = 0 is reected by the two-sided test if P(ˆρ < ˆρ (1) ) or P(ˆρ > ˆρ (1) ) is small enough. Note as follows. S XY is rewritten as: S XY = 1 n n X i Y i XY. i=1 The sample means X and Y take the same values without depending on the order of X and Y. Similarly S X and S Y are independent of the order of X and Y. Therefore ˆρ depends on n i=1 X i Y i. That is for the empirical distribution based on the n! correlation coefficients ˆρ is a monotone function of n i=1 X i Y i which implies that we have a one-to-one correspondence between ˆρ and n i=1 X i Y i. Therefore for n i=1 X i Y i we may compute the n! combinations by changing the order of Y i i = 1 2 n. Thus by utilizing n i=1 X i Y i rather than ˆρ the computational burden can be reduced.. 3

4 As for a special case suppose that (X i Y i ) i = 1 2 n are normally distributed i.e. ( ) Xi N ( ( ) ( µx σ 2 ) X ρσ X σ Y ). Y i µ Y ρσ X σ Y σ 2 Y Under the null hypothesis H 0 : ρ = 0 the sample correlation coefficient ˆρ is distributed as the following t distribution: ˆρ n 2 1 ˆρ 2 t(n 2). Note that we cannot use a t distribution in the case of testing the null hypothesis H 0 : ρ = ρ 0. For example see Lehmann (1986) Stuart and Ord ( ) and Hogg and Craig (1995). Generally it is natural to consider that (X Y) is non-gaussian and that the distribution of (X Y) is not known. If the underlying distribution is not Gaussian but the t distribution is applied to the null hypothesis H 0 : ρ = 0 the appropriate testing results cannot be obtained. However the nonparametric permutation test can be applied even in the Non-Gaussian cases because it is distribution-free. 2.2 On Testing the Regression Coefficient Using exactly the same approach as the nonparametric test on the correlation coefficient discussed in Section 2.1 we consider a nonparametric significance test on the regression coefficients. The regression model is given by: Y i = X i β + u i i = 1 2 n where the OLS estimator of β i.e. ˆβ is represented as: ˆβ = (X X) 1 X Y = Note as follows: Y 1 Y 2 Y =. Y n X = n (X X) 1 X i Y i. (1) i=1 X 1 X 2. X n β = β 1 β 2. β k ˆβ = where Y i denotes the i-th element of a n 1 vector Y and X i indicates the i-th row vector of a n k matrix X. From the structure of equation (1) when X i in Section 2.1 is replaced by (X X) 1 X i we can find that the same discussion as in Section 2.1 holds with only one difference i.e. X i is a scalar in Section 2.1 while (X X) 1 X i is a k 1 vector in this section. We have n! regression coefficients by changing the order of Y. Let ˆβ (i) i = 1 2 n! be the n! regression coefficients and ˆβ (i) be the -th element of ˆβ (i) i.e ˆβ (i) = (ˆβ (i) 1 ˆβ (i) 2 ˆβ (i) k ). Suppose that ˆβ (1) represents the -th element of the regression coefficient vector obtained from the original data series. Under the null hypothesis ˆβ 1 ˆβ 2. ˆβ k 4

5 H 0 : β = 0 the empirical distribution of ˆβ which is the -th element of the OLS estimator of β is given by: P(ˆβ < ˆβ (1) ) = Number of combinations less than ˆβ (1) out of ˆβ (1) ˆβ (n!) Number of all possible combinations (i.e. n!) P(ˆβ = ˆβ (1) ) = Number of combinations equal to ˆβ (1) out of ˆβ (1) ˆβ (n!) Number of all possible combinations (i.e. n!) P(ˆβ > ˆβ (1) ) = Number of combinations greater than ˆβ (1) out of ˆβ (1) ˆβ (n!). Number of all possible combinations (i.e. n!) For all = 1 2 k we can implement the same computational procedure as above and compute each probability. We can perform the significance test by examining where ˆβ (1) is located among the n! regression coefficients. The null hypothesis H 0 : β = 0 is reected by the two-sided test if P(ˆβ < ˆβ (1) ) or P(ˆβ > ˆβ (1) ) is small enough. Generally as for the testing procedure of the null hypothesis H 0 : β = β we may consider a nonparametric permutation test between (X X) 1 X i and Y i X i β because ˆβ β is transformed into: ˆβ β = (X X) 1 X Y β = (X X) 1 X (Y Xβ) n = (X X) 1 X i (Y i X i β). i=1 Note as follows. As for the conventional parametric significance test the error terms u i i = 1 2 n are assumed to be mutually independently and normally distributed with mean zero and variance σ 2. Under the null hypothesis H 0 : β = β the -th element of the OLS estimator (i.e. ˆβ ) is distributed as: ˆβ β S a t(n k) where a denotes the -th diagonal element of (X X) 1. β and S 2 represent β = (β 1 β 2 β k ) and S 2 = (Y X ˆβ) (Y X ˆβ)/(n k) respectively. Thus only when u i is assumed to be normal we can use the t distribution. However unless u i is normal the conventional t test gives us the incorrect inference in the small sample. As it is well known in a large sample n(ˆβ β ) is asymptotically normal when the variance of u i is finite. Thus the case of a large sample is different from that of a small sample. In this paper under the non-gaussian assumption we examine the powers of the nonparametric tests on the correlation coefficient through Monte Carlo experiments. Moreover in the regression analysis we examine how robust the conventional t test is when the underlying population is not Gaussian. 5

6 Table 1: Empirical Sizes and Sample Powers (H 0 : ρ = 0 and H 1 : ρ 0) n ρ α Nonparametric Permutation Test Parametric t Test N X U L C N X U L C

7 ˆp(1 ˆp) Figure 1: Standard Error of ˆp ˆp (The sample power shown in Tables 1 and 2) 3 Monte Carlo Experiments 3.1 On Testing the Correlation Coefficient Each value in Table 1 represents the reection rates of the null hypothesis H 0 : ρ = 0 against the alternative hypothesis H 1 : ρ 0 (i.e. the two-sided test is chosen) by the significance level α = where the experiment is repeated 10 4 times. That is in Table 1 the number which the correlation coefficient obtained from the original observed data is less than α/2 or greater than 1 α/2 is divided by In other words we compute the probabilities P(ˆρ < ˆρ (1) ) and P(ˆρ > ˆρ (1) ) and repeat the experiment 10 4 times. The probabilities correspond to the sample powers where ˆρ (1) denotes the correlation coefficient computed from the original data. The ratio of P(ˆρ < ˆρ (1) ) α/2 or P(ˆρ > ˆρ (1) ) α/2 is shown in Table 1. α = is examined. N X U L and C indicate the distributions of (X Y) which denote the standard normal distribution N(0 1) the chi-squared distribution χ 2 (1) 1 the uniform distribution U( 1 1) the logistic distribution e x /(1 + e 1 ) 2 and the Cauchy distribution (π(1 + x 2 )) 1 respectively. The standard error of the empirical power denoted by ˆp is obtained by ˆp(1 ˆp)/100 which is displayed in Figure 1. For example when ˆp = 0.5 the standard error takes the maximum value which is In this paper the random draws of (X i Y i ) are obtained as follows. Let u i and v i be the random variables which are mutually independently distributed. Each of u i and v i is generated as the standard normal random variable N(0 1) the chi-squared random variable χ 2 (1) 1 the uniform random variable U( 1 1) the logistic distribution e x /(1 + e 1 ) 2 or the Cauchy distribution (π(1 + x 2 )) 1. Denote the correlation coefficient between X and Y by ρ. Given the random draws of (u i v i ) and ρ (X i Y i ) is transformed into: ( ) ( ) ( ) Xi 1 ρ = ui Y i 0 1 ρ 2. v i In the case of the Cauchy distribution the correlation coefficient does not exist because the Cauchy random variable has neither mean nor variance. Even in the case of the Cauchy distribution however we can obtain the random draws of (X i Y i ) given (u i v i ) and ρ utilizing the above formula. 7

8 Using the artificially generated data given the true correlation coefficient ρ = we test the null hypothesis H 0 : ρ = 0 against the alternative hypothesis H 1 : ρ 0. Taking the significance level α = and the two-sided test the reection rates out of 10 4 experiments are shown in Table 1. In addition taking the sample size n = both the nonparametric permutation test and the parametric t test are reported in the table. As it is easily expected for the normal sample (i.e. N) the t test performs better than the nonparametric test but for the other samples (i.e. X U L and C) the nonparametric test is superior to the t test. Each value in the case of ρ = 0 represents the empirical size which should be theoretically equal to the significance level α. The results are as follows. In the case of N and L each value is quite close to α for the t test. However for all n = the t tests of X and C are overreected especially in the case of α = Taking an example of n = 6 X is and C is when α = 0.05 while X is and C is when α = The t test of U is also slightly over-reected in the case of α = Thus we often have the case where the t test over-reects the null hypothesis H 0 : ρ = 0 depending on the underlying distribution. However the nonparametric test reects the null hypothesis with probability α for all the underlying distributions. Accordingly through a comparison of the empirical size we can conclude that the nonparametric test is more robust than the t test. Next we examine the cases of ρ = to compare the sample powers of the two tests (note that each value of ρ = in Table 1 corresponds to the sample power). As for X and C it is not meaningful to compare the sample powers because the empirical sizes are already over-estimated. Regarding the sample powers of N U and L the nonparametric test is close to the t test. Especially for N it is expected that the t test is better than the nonparametric test but we can see that the nonparametric test is as good as the t test in the sense of the sample power. Thus the permutation-based nonparametric test introduced in this paper is useful because it gives us the correct empirical size and is powerful even though it does not need to assume the distribution function. 3.2 On Testing the Regression Coefficient In Table 2 the testing procedure taken in Section 3.1 is applied to the regression analysis. Let X i = (X 1i X 2i X ki ) where X 1i = 1 and X i N(0 1) for = 2 3 are set. X 2i and X 3i are mutually independently generated. The error term u i is assumed to have the standard normal distribution N(0 1) the chi-squared distribution χ 2 (1) 1 the uniform distribution U( 1 1) the logistic distribution e x /(1 + e 1 ) 2 or the Cauchy distribution (π(1 + x 2 )) 1. Under the null hypothesis H 0 : β = 0 we obtain y i = u i. Therefore we consider the correlation between (X X) 1 X i and y i. The sample size is n = and the number of the regression coefficient to be estimated is k = 2 3. The nonparametric test is compared with the t test in the criterion of the empirical size. Each value in Table 2 represents the reection rate out of 10 4 simulation runs. Therefore theoretically each value in the table should be equivalent to the probability which reects the null hypothesis H 0 : β = 0 against the alternative hypothesis H 1 : β 0 for = which probability corresponds to the significance level α. As in Section 3.1 in the case of N the t test should be better than the nonparametric test i.e. 8

9 Table 2: Significance Tests on Regression Coefficients: Empirical Sizes k = 2 k = 3 n α Nonparametric t Test Nonparametric t Test Test Test β 1 β 2 β 1 β 2 β 1 β 2 β 3 β 1 β 2 β N X U L C

10 the t test should be closer to the significance level α than the nonparametric test because the OLS estimator of β follows the t distribution with n k degrees of freedom when the error terms u i i = 1 2 n are mutually independently and normally distributed with mean zero. The superscripts and in the table imply that the empirical size is statistically different from α by the two-sided test of the significance levels 5% and 1% respectively. That is each value without the superscript and gives us the correct size. The superscripts or are put as follows. By the central limit theorem we can approximate as ( ˆp p)/ p(1 p)/g N(0 1) when G is large enough where p is a parameter and ˆp denotes its estimate. G represents the number of simulation runs where G = 10 4 is taken in this paper. Under the null hypothesis H 0 : p = α against the alternative hypothesis H 1 : p α the test statistic ( ˆp α)/ α(1 α)/g is asymptotically normally distributed. Thus we can test whether p is different from α. The results are as follows. For the t tests of X and U the constant term (i.e. β 1 ) gives us the over-estimated empirical sizes in both cases of k = 2 3. On the contrary for the t tests of C the constant term (i.e. β 1 ) yields the under-estimated empirical sizes. However for the nonparametric tests almost all the values in Table 2 are very close to the significance level α. Therefore we can conclude that the nonparametric test is superior to the t test in the sense of the corrected empirical size. Power Comparison: Next we compare the sample powers in the case of k = 3. Figures 2 4 display differences of the sample powers between the two tests for β 3 = where β 1 = β 2 = 0 and α = 0.1 are taken. Since the sample powers of the permutation test are subtracted from those of the t test the values above the horizontal line imply that the permutation test is more powerful than the t test. Take the case n = 6 as an example i.e. Figure 2. For all β 3 of L and C the differences are positive and accordingly we can conclude that for L and C the permutation test is superior to the t test. Furthermore the differences are positive for β 3 = of N and X but negative for β 3 greater than 0.6. Thus we can observe through Figures 2 4 that except for a few cases the permutation test is more powerful than the t test for all n = at least when β 3 is small. From the three figures in addition each difference becomes small as n is large. Therefore the permutation test is close to the t test as the sample size is large. CPU Time: As mentioned above in the case where we perform the significance test of the regression coefficient we need to compute the n! regression coefficients (for example n! is equal to about 3.6 million when n = 10). In Table 3 CPU time in one simulation run is shown for n = and k = where a Pentium III 1GHz CPU personal computer and a WATCOM Fortran 77/32 Compiler (Version 11.0) are utilized. The order of computation is about n! k. The case of sample size n is n times more computer-intensive than that of sample size n 1. For example it might be expected that the case of n = 15 and k = 4 takes about one week (i.e minutes) to obtain a result. This is not feasible in practice. Thus the permutation test discussed in this paper is very computer-intensive. Therefore we need to consider less computationally intensive procedure. In order to reduce the computational burden when n! is large it might be practical to choose some of the n! combinations and perform the same testing procedure discussed in this paper. That is taking N combinations out of the n! combinations randomly we compute the probabilities P(ˆβ < ˆβ (1) ) and P(ˆβ > ˆβ (1) ). If either of them is smaller than α = 0.1 the null hypothesis H 0 : β = 0 is reected. We examine 10

11 Figure 2: Difference of the Sample Powers between the Two Tests (n = 6 k = 3 β 1 = β 2 = 0 and α = 0.1) β N X U L C Figure 3: Difference of the Sample Powers between the Two Tests (n = 8 k = 3 β 1 = β 2 = 0 and α = 0.1) N X U L C β 3 11

12 Figure 4: Difference of the Sample Powers between the Two Tests (n = 10 k = 3 β 1 = β 2 = 0 and α = 0.1) N X U L C β 3 Table 3: CPU Time (minutes) n \ k whether empirical sizes depend on N. The results are in Table 4 where k = 2 and N = ! are taken. The case of N = 10! corresponds to the nonparametric test of β 2 in the case of α = 0.1 and k = 2 of Table 2 where the empirical sizes are computed using all the possible combinations. All the cases of N = are very close to those of N = 10!. N = 10 4 is sufficiently large in this case but more than N = 10 4 should be taken for safety. Thus we can choose some out of the n! combinations and compute the corresponding probabilities. A less computationally intensive procedure might be possible when n is large i.e. when n is larger than 14 in my case. Table 4: Empirical Sizes: n = 10 k = 2 β 1 = β 2 = 0 and α = 0.1 N ! N X U L C

13 4 Summary Only when the error term is normally distributed we can utilize the t test for testing the regression coefficient. Since the distribution of the error term is not known we need to check whether the normality assumption is plausible before testing the hypothesis. As a result of testing in the case where the normality assumption is reected we cannot test the hypothesis on the regression coefficient using the t test. In order to improve this problem in this paper we have shown a significance test on the regression coefficient which can be applied to any distribution. In Section 3.1 we tested whether the correlation coefficient between two samples is zero and examined the sample powers of the two tests. For each of the cases where the underlying samples are normal chi-squared uniform logistic and Cauchy 10 4 simulation runs are performed and the nonparametric permutation test is compared with the parametric t test with respect to the empirical sizes and the sample powers. As it is easily expected the t test is sometimes a biased test under the non-gaussian assumption. That is we have the cases where the empirical sizes are over-estimated. However the nonparametric test gives us the correct empirical sizes without depending on the underlying distribution. Specifically even when the sample is normal the nonparametric test is very close to the t test (theoretically the t test should be better than any other test when the sample is normal). In Section 3.2 we have performed Monte Carlo experiments on the significance test of the regression coefficients. It might be concluded that the nonparametric test is closer to the true size than the t test for almost all the cases. Moreover the sample powers are compared for both tests. As a result we find that the permutation test is more powerful than the t test when the null hypothesis is close to the alternative hypothesis i.e. when β 3 is small in Figures 2 4. Thus we find through the Monte Carlo experiments that the nonparametric test discussed in this paper can be applied to any distribution of the underlying sample. However the problem is that the nonparametric test is too computer-intensive. We have shown that when n! is too large it is practical to choose some of the n! combinations and perform the testing procedure. Taking an example of n = 10 and k = 2 we have obtained the result that we can perform the testing procedure taking the 10 4 combinations out of all the possible combinations (10! in this case) randomly. Thus it has been shown in this paper that we can reduce the computational burden. References W.J. Conover (1980) Practical Nonparametric Statistics (Second Edition) John Wiley & Sons. Fisher R.A. (1966) The Design of Experiments (eighth edition) New York: Hafner. J.D. Gibbons and S. Chakraborti (1992) Nonparametric Statistical Inference (Third Edition revised and Expanded) Marcel Dekker. R.V. Hogg and A.T. Craig (1995) Introduction to Mathematical Statistics (Fifth Edition) Prentice Hall. M. Hollander and D.A. Wolfe (1973) Nonparametric Statistical Methods John Wiley & Sons. E.L. Lehmann (1986) Testing Statistical Hypotheses (Second Edition) John Wiley & Sons. R.H. Randles and D.A. Wolfe (1979) Introduction to the Theory of Nonparametric Statistics John Wiley & Sons. 13

14 P. Sprent (1989) Applied Nonparametric Statistical Methods Chapman and Hall. A. Stuart and J.K. Ord (1991) Kendall s Advanced Theory of Statistics Vol.2 (Fifth Edition) Edward Arnold. A. Stuart and J.K. Ord (1994) Kendall s Advanced Theory of Statistics Vol.1 (Sixth Edition) Edward Arnold. 14

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