FORECASTING FIRM RISK IN THE EMERGING MARKET OF CHINA WITH SEQUENTIAL OPTIMIZATION OF INFLUENCE FACTORS ON PERFORMANCE OF CASE‐BASED REASONING: AN EMPIRICAL STUDY WITH IMBALANCED SAMPLES

Abstract

SUMMARYWith the development of the Chinese economy, how to make the right decision regarding firms’ risk is becoming more and more important. Case‐based reasoning (CBR) is a potential method that can help forecast business risk status in advance; it is easy to apply and is able to provide good explanations of output. In order to obtain more accurate prediction with CBR, it is essential to investigate factors that influence CBR's performance, and to optimize these factors sequentially for the improvement of CBR's performance in firm risk prediction in emerging markets under a more practicable assumption. We verified that sequential optimization of feature selection, feature weighting, instance selection and the number of nearest neighbours is a possible alternative for improving predictive performance of CBR forecasting under the assumption that the number of failed samples is smaller than that of nonfailed samples. The detailed implementation includes: (1) selecting significant features through a correlation matrix and reducing feature dimensions with factor analysis; (2) using variance contribution ratios of features from factor analysis as feature weights; (3) eliminating noisy cases via a state matrix; and (4) obtaining the optimal number of nearest neighbours from empirical results among different numbers of nearest neighbours. To validate the usefulness of the sequential optimization approach, we applied it to a real‐world case: firm risk prediction with imbalanced data from the emerging market of China. Experimental results show that predictive accuracy of CBR applied in the emerging market was improved with the sequential optimization approach. Insightful thoughts from the results of the sequential optimization of the CBR forecasting system on modelling social tasks are also provided. Copyright © 2013 John Wiley & Sons, Ltd.