Irrational Exuberance: Correcting Bias in Probability Estimates

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Gareth James discusses the common setting where one observes probability estimates for a large number of events, such as default risks for numerous bonds. Unfortunately, even with unbiased estimates, selecting events corresponding to the most extreme probabilities can result in systematically underestimating the true level of uncertainty. James discusses an empirical Bayes approach “excess certainty adjusted probabilities” (ECAP), using a variant of Tweedie’s formula, which updates probability estimates to correct for selection bias.

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