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CFA
Quantitative Methods
CFA FRM CQF SII
20104

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FRM
CFAFRM
CQFCISIMIT

CFA Level I 40CFA Level II 20 CFA Level 10

CFA2CFA2FRM
310CFRM3CISI2
GMAC14
ISTP

86-13917952237
Email: wuyi4020@yahoo.com.cn

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Time Value of Money

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Time Value of Money

Interest Rate
A Single Sum
Time Value of
Money

Annuity
Application of
TMV,PV,FV

Perpetuity
Uneven Cash
Flows

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Interest Rate
LOS 5a. Interpret interest rates as required rate of return, discount rate or
opportunity cost.
Required rate of return is
affected by the supply and demand of funds in the market;
the return that investors and savers require to get them to willingly lend their
funds;
usually for particular investment.
Discount rate is
the interest rate we use to discount payments to be made in the future.
usually used interchangeably with the interest rate.
Opportunity cost is
also understood as a form of interest rate. It is the value that investors forgo by
choosing a particular course of action.
Required Rate of Return/Discount Rate/Opportunity Cost/Cost of Capital

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Interest Rate
LOS 5b. Explain an interest rate as the sum of a real risk-free rate, expected
inflation, and premiums that compensate investors for distinct types of risk
Decompose required rate of return:
(1)Real Risk Free Rate: Consumption delay
(2)Expected Inflation Ratehistorical inflation rateExpected Inflation rate
(3)Risk Premium
Default Risk Premium is the return for the possibility that the borrower may fail to
make the repayment of the agreed amount at the agreed time.
Liquidity Risk Premium the return for the risk of loss with regard to the fair value
on an investment when it is converted to cash in a timely manner.
Maturity Risk Premiumthe return to compensate for the uncertainty about the fair
value of an investment when maturity is prolonged. Generally speaking, long-term
bonds demand for larger maturity premium than the short-term ones.
Real Risk Free Rate=(1)
Nominal Risk Free Rate=(1)+(2) also called Risk Free RateRFR
Required Rate of Return=(1)+(2)+(3)

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Interest Rate
LOS 5c. calculate and interpret the effective annual rate, given the stated annual
interest rate and the frequency of compounding, and solve time value of money
problems when compounding periods are other than annual

EAR calculation:

EAR=(1+periodic rate) 1
Where: periodic rate = stated annual rate/m
m= the number of compounding periods per year

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Interest Rate
LOS5d. calculate and interpret the FV and PV of a single sum of money,
ordinary annuity, a perpetuity (PV only), an annuity due, or a series of uneven
cash flows
If interests are compounded annually, given the quoted interest rate r, the FV
formula is:
FV=PV(1+r)N
If interests are compounded m times per year,
FV=PV1+ r/mmn
Where: m is the compounding frequency;
r is the nominal/quoted annual interest rate.
When we calculate the future value of continuously compounding, the formula is:
r
FV=PV lim (1+ ) nm =PVe n r
m
m

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Ordinary Annuity vs. Annuity Due

Difference between an ordinary annuity and an annuity due?

Ordinary Annuity
0

i%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
i%
PMT
PV

FV

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Interest Rate
An example of ordinary annuities:
Example 1:Whats the FV of an ordinary annuity that pays 150 per year at the end
of each of the next15 years, given the discount rate is 6%
Solutions: enter relevant data for calculate.

N=15, I/Y=6, PMT=-150, PV=0, CPTFV=3491.4

Notice: if we were given that FV= 3491.4, N=15, I/Y=6, PMT=-150, we also
could calculate PV.
0

+150

+150

+150

13

14

15

+150

+150

+150

FV=3491.4

PV=0

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Interest Rate
About an annuity due,
Definition: an annuity where the annuity payments occur at the beginning of
each compounding period.
Calculation:
Measure 1: put the calculator in the BGN mode and input relevant data.
Measure 2: treat as an ordinary annuity and simply multiple the resulting PV by
(1+I/Y)
About perpetuity annuity
Definition: A perpetuity is a financial instruments that pays a fixed amount of
money at set intervals over an infinite period of time.
Calculation:

PMT
PMT
PMT
PMT
PV=
+
+
+...=
2
3
1+I/Y (1+I/Y) (1+I/Y)
I/Y

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Interest Rate
An example of uneven cash flow:
There is a 6-year period investment, compute the PV of the uneven cash flow series.
Suppose the discount rate is 9%.
0

-800

-500

+30

+350

+700

+1000

1000
700 1.091
350 1.092

FV=280.9959

30 1 .09 3
500 1.09 4

8001.095

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12

NPV and IRR

LOS6a. calculate and interpret the net present value (NPV) and the internal
rate of return (IRR) of an investment, contrast the NPV rule to the IRR rule,
and identify problems associated with the IRR rule

NPV

= CF

NPV = 0 = CF 0 +

CF

( 1 + r )1

CF

CF1
(1 + IRR )1

(1 + r ) 2

+ ... +

CF 2
(1 + IRR ) 2

+ ... +

CF

(1 + r ) N

CF N
(1 + IRR )N

t=0

CF

(1 + r ) t

(1 + IRR )
t =0

CF t

IRRInternal Rate of Return

The rate of return that makes the NPV equals 0.
Multiple solutions Problem of the IRR calculation (# sign changes)

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13

Holding Period Return

LOS6.b. define, calculate and interpret a holding period return (total return)
Define: the holding period return is simply the percentage change in the value of an
investment over the period it is hold.
Calculate:

P1 P0 + CF1
HPR =
P0
CF1DI

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14

Money-weighted & Time-weighted Returns

LOS6c. calculate, interpret, and distinguish between the money-weighted
and time- weighted rates of return of a portfolio and appraise the
performance of portfolios based on these measures
Money-weighted and time-weighted Rate of Return

Money-weighted rate of return: IRR, is appropriate for the clients who can
control the CF addition and drawings.

Time-weighted rate of return: Geometric Mean Return

Time-weighted Rate of Return method is not affected by the timing of
cash flow where the money weighted method is.
Time-weighted is preferred to money weighted.

IRRMoney-weighted return
time weighted rate of return

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15

Market Returns
LOS6d. calculate and interpret the bank discount yield, holding period yield,
effective annual yield, and money market yield for a U.S. Treasury bill; and
interpret and convert among holding period yields, money market yields,
effective annual yields and the bond equivalent yields

rB D

( F P0 ) 3 6 0
=

F
t

P1 P0 + CF1
HPY =
P0

EAY = (1 + HPY ) 365 / t 1

(1 + BEY / 2) 2 = 1 + EAR

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Probability and Statistics

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17

Frequency
LOS7c. calculate and interpret relative frequencies and cumulative relative
frequencies, given a frequency distribution, and describe the properties of a
dataset presented as a histogram or a frequency polygon
Relative frequency
The relative frequency is calculated by dividing the absolute frequency of each
turn interval by the total number of observations.
Frequency Distribution
A frequency distribution is a tabular presentation of statistical data that aids the
analysis of large data sets.
Cumulative frequency/Cumulative Relative Frequency
Could be calculated by summing the absolute or relative frequencies starting at
the lowest interval and progressing through the highest.

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18

Frequency
LOS7e. describe, calculate and interpret quartiles, quintiles, deciles, and
percentiles

Media/Quartile /Quintile/Deciles/Percentile
Calculation Ly = (n+1)y/100, Ly is the position.
Example:
Observers8 10 12 13 15 17 17 18 19 23 24
N=11Ly=(11+1)*75%=9,i.e. the 9th number is 75%
quintiles = 19

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19

Measures of Central Tendency

LOS7d. define, calculate, and interpret measures of central tendency,
including the population mean, sample mean, arithmetic mean, weighted
average or mean (including a portfolio return viewed as a weighted mean),
geometric mean, harmonic mean, median, and mode
N

The arithmetic mean

X

i =1

n
N

The geometric mean G = N X1X 2 X 3 ... X N = (

X i )1/ N

i =1

The harmonic mean

XH =

n
n

(1/ X )
i

i =1

harmonic mean<= geometric mean<=arithmetic mean

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20

Measures of Dispersion
LOS7f. define, calculate, and interpret 1) a range and mean absolute deviation, and2) a
sample and a population variance and standard deviation

Range = highest value lowest value

For our formal case, data

1, 2, 3, 4, 5

MAD =

Range is 4

Xi

MAD is 1.2

i =1

N
N

For population:

2 =

2
(
X

)
i
i =1

2 =2
s 2 = 2.5

N
n

For sample:

s2 =

2
(
X

X
)
i
i =1

n 1

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21

Measures of Dispersion
LOS7g. calculate and interpret the proportion of observations falling within a
specified number of standard deviations of the mean, using Chebyshevs
inequality

Chebyshevs inequality

2
P{ X < } 1 2

1
P { X < k } 1 2
k
For any set of observations (samples or population), the proportion of the values that
lie within k standard deviations of the mean is at least = k , where k is any
constant greater than 1. ( 1 1 k 2 )

This relationship applies regardless of the shape of the distribution

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22

Coefficient of Variation and Sharpe Ratio

LOS7h. define, calculate, and interpret the coefficient of variation and the
Sharpe ratio;
Definition:
Coefficient of variation measures the amount of dispersion in a distribution
relative to the distributions mean..
The sharp ratio measures excess return per unit of risk.
Calculation:

CV =

sx
100%
X

Sharp ratio =

RP R f

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23

Skewness
LOS7i. define and interpret skewness, explain the meaning of a positively or
negatively skewed return distribution;

Mean=Median=Mode
Symmetrical

Mode<Median<Mean
Positive (right) skew

Mean<Median<Mode
Negative (left) skew

Positive skewedMode<median<mean, having a right fat tail

Negative skewedMode>media>mean, having a left fat tail

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24

Kurtosis
LOS7j. define and interpret measures of sample skewness and
kurtosis.
Leptokurtic vs. platykurtic
It deals with whether or not a distribution is more or less peaked than a
normal distribution
n
Sample kurtosis

1
n

4
(
X

X
)
i
i =1

s4

Excess kurtosis = sample kurtosis 3

leptokurtic

Normal distribution

platykurtic

Sample kurtosis

>3

=3

<3

Excess kurtosis

>0

=0

<0

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25