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Revision Notes
CFA Level I

Quantitative
Methods

House of Knowledge Private Limited

- By Darsh D. Doshi

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Using a Financial Calculator: For Time Value of Money

1. N = Number of compounding periods
2. I/Y = Interest rate per compounding period
3. PV = Present value
4. FV = Future value
5. PMT = Annuity payments, or EMI
6. CPT = Compute
For NPV/IRR
1. CF = used to input different cash flows
a. CF0 = Cash Flow at T0
b. C01 = Continued Cash Flow after T0
c. F01 = Frequency of Continuation of CO1
d. C02, F02, C03, F03 and so on

2. NPV = used to calculate the NPV of the input cash flows

a. I/Y = the discounting rate used for NPV
b. NPV = Press CPT (Compute) to calculate the NPV

3. IRR = used to calculate IRR for the input cash flows (Press CPT)

NPV is the sum of PV of all cash flows | IRR is the rate that will make NPV = 0.
TVM Concepts:
1. Compound Interest = Interest on Principal + Interest on all Past Interests.
2. PV = Present Value
3. FV = Future Value
Time Lines:
For Time Value of Money
1. T0 = Today
2. Tn = nth period in time
3. Outflows are ve Cash Flows
4. Inflows are +ve Cash Flows
*

Remeber: Simply multiply the PV and the FV with (1+Discounting Factor)

to get the PV/FV for Annuity Due.

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Interest Rates:
Real Risk-free Rate: Rate of Interest with no exceptions of future inflation

Nominal Risk-free Rate = Real Risk-free Rate + Expected Inflation Rate

Different Types of Risk (for which the interest is a compensation):
I.
II.
III.

Default Risk : Risk of Non-payment.

Liquidity Risk : Risk of losing on fair value if because market liquidity is less.
Maturity Risk : Longer the time horizon, higher the risk. (Risk, Long > Short)

All risks have their own risk premiums that add to Nominal Rate to get
required Rate of Interest/Discount.
Required Rate = Nominal Risk-free Rate
+ Default Risk Premium
+ Liquidity Risk Premium
+ Maturity Risk Premium

Effective Annual Rate (EAR)

It is given as annual rate with the compounding frequency (m).
Eg. 8% p.a., compounding half yearly | 12% p.a., compounding monthly.
EAR = (1 + Periodic Rate)m 1

Eg. If periodic rate is 2% p.m. compounded monthly, then, m = 12

EAR = (1 + 0.02)12 1
= 1.268242 1
= 0.268242 or 26.82% (and not 12 x 2 = 24%)
Time Value of Money
1. Future Value (FV) = PV x (1+I/Y)N
2. Present Value (PV) = FV / (1+I/Y)N

[tomorrows value of todays cash flow]

[todays value of cash flow in future]

Here, 1 / (1+I/Y)N - Discounting Factor or PV Value Factor

I/Y
- Rate of Interest per period (after adjusting for compounding)
N
- Number of periods
(after adjusting for compounding)

USE TVM FOR SINGLE STREAM CALCULATIONS OR FOR ANNUITY SUMS ONLY.

* Always remember to clear TVM before every sum. Infact, clear TVM twice, before
and after every sum. You can never be over cautious in this case.
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I.

NPV = Sum of PV of all Cash Flows

= PV of Inflows PV of Outflows

II. IRR = Rate of Interest/Discount that makes NPV = 0

CF1
+
CF2 +
CF3
+ + CFN
= CF0 +
(1+IRR)
(1+IRR)2 (1+IRR)3
(1+IRR)N

Rules of Acceptance
NPV
NPV > 0
NPV < 0
NPV = 0

IRR
IRR > Disc. Rate
IRR < Disc. Rate
IRR = Disc. Rate

Relation between IRR and NPV

When IRR < Discounting Rate, NPV < 0 and vice versa.
When IRR = Discounting Rate, NPV = 0.

Result
Accept
Reject
Indifferent

When IRR and NPV create conflict between the options available, go with NPV.
Measures of Return:
1. Holding Period Return (HPR)
HPR = End Value + Cash Flows Received - 1
Beginning Value

2. Money Weighted Rate of Return (MWRR)

a. Calculate Cash Flow for each time period. (CF0, CF1, CF2, CF3, )
b. Discount each Cash Flow with the rate of discounting
c. The rate for which PVInflows = PVOutflows is the MWRR. Simply, its the IRR!
3. Time Weighted Rate of Return (TWRR)
a. Find the HPR for each period.
b. TWRR = [(1+HPR1) x (1+HPR2) x (1+HPR3) x x (1+HPRn)]1/n
Its just the Geometric Mean of all the individual periods HPR.

4. Bank Discount Yield (BDY / rBD)

rBD = Dollar Discount x 360 = D x 360
Face Value
t
F
t
5. Holding Period Yield HPY is same as HPR for less than 1 year
6. Effective Annual Yield (EAY) = (1 + HPY)365/t 1
= HPY x (360/#days)
7. Money Market Yield (rMM)
8. Bond Equivalent Yield (BEY) = 2 x Semi-annual Discount Rate
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Statistics
Descriptive
Summarizes important
characteristics of large data to
produce useful information.

Inferential
Procedures to make forecasts,
estimates, judgment on total
population based on sample

Population = Set of all possible outcomes. (Too costly and time consuming)
Sample
= Its a subset of Population. A Group of few outcomes of the population.
Statistic
Population
Sample
Size
N
n
Mean
Variance
2
s2
Std. Dev.

Measurement Scales:
1. Nominal = Gives least information. Used for counting/classification. No order.
2. Ordinal = Used with specific characteristic to classify or rank. Eg. A-list stocks
3. Interval = Like Ordinal, however the difference between classes is equal. Eg. OC
4. Ratio
= Most refined. Gives Rank, Equal Class Interval and True Origin.
Frequency Distribution Table
Class
Freq.
Cum.
(Xi)
(f)
Freq. ()
1
5
5
2
25
30
3
40
70
4
65
135
5
35
170
6
20
190
7
10
200
200

Arithmetic Mean
Median
Mode
Variance
Standard Deviation
Geometric Mean
Harmonic Mean
Coefficient of variance
Mean Average Deviation

( )
(M)
(Z)
(2)
()
(GM)
(HM)
(CV)
(MAD)

Cum.
Freq. ()
200
195
170
130
65
30
10
= 4.00
= 3.00
= 4.00
= 1.96
= 0.98
= 3.72
= 3.40
= 0.24
= 1.05

Rel.
Freq.
2.50%
12.50%
20.00%
32.50%
17.50%
10.00%
5.00%
100%

Class x Freq.
(Xi) x (f)
5
50
120
260
175
120
70
800

Deviation2
9
4
1
0
1
4
9
28

[800/200]
[(n+1/2)th term = 100.5th term]
[Maximum Frequency]
[f(Xi - )2/(f -1) = (390/199)]
[(f(Xi- )2/(f-1))1/2 = (390/199)1/2]
[200th root of product of all Xi^f]
[200/ (f/Xi)]
[/ = 0.98/4]
[f(|Xi |)/ f = 210/200]

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MEASURES OF CENTRAL TENDENCIES

Mean
Arithmetic Mean ( )
= Sum of All Observations / Number of Observations
= (X) = [(f) x (Xi)]
n
f
Geometric Mean ( )
= nth root of product of all observations
= (X1 * X2 * X3 * * Xn)1/n
Harmonic Mean ( )
= n / (1/X)
= f / (f/X)
Median (M)
M = (n+1)/2th Term
* Interpolate to the decimal using,
Lower Limit + (n+1)/2th Term - Lower Limit
Lower Limit-Upper Limit
Mode (Z)
Z = The Observation with Maximum Frequency
Quartiles/Quintiles/Deciles/Percentiles
Quartile = 4
parts [25th, 50th, 75th, 100th percentile]
Quintiles = 5
parts [20th, 40th, 60th, 80th, 100th percentile]
Deciles
= 10 parts [10th, 20th, 30th, 40th, 50th, 60th, 70th, 80th, 90th, 100th percentile]
Percentile = 100 parts

Ly = (n+1) x (Y/100)th Term

[* Interpolate]

Variance (2)/Standard Deviation ()

2 = (Xi - )2/(n -1)
= f(Xi - )2/(f -1)
Mean Average Deviation = |Xi - |/(n -1)
Coeffieicent of Variance = /
Sharpe Ratio = (Rp Rf)/
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Frequency Distribution
1. Normal Distribution

Mean = Median = Mode

2. Skewness

3. Kurtosis

Mean = Median = Mode

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I.

Probability concepts
A. 2 properties of probabilities
- Probability of any event E will always be between 0 & 1. [0 P(E) 1]
- If a set of events, E1, E2 En, is mutually exclusive and exhaustive, the
probabilities of those events sum to 1 (i.e., P(Ei) = 1).
B. Calculation of probability
P(E) = n(E)
[Number of outcomes of event E]
n(S)
[Number of outcomes of the population]
C. Probability Rules
Multiplication Rule
Addition Rule

: P(AB) = P(A | B) X P(B)

: P(A or B) = P(A) + P(B) P(AB)

Total Probability Rule:

P(A) = P(A | B1) x P(B1) + P(A | B2) x P(B2) + + P(A | BN) x P(BN)
where B1, B2 BN is a mutually exclusive and exhaustive set of outcomes.

Joint Probability

: P(A | B) = P(AB) / P(B)

Independent events

: P(A | B) = P(A) and P(B | A) = P(B)

Expected Value

: E(X) = P(Xi)Xi = P(X1)X1 + P(X2)X2 + + P(Xn)Xn

Variance
: Var(X) = 2(X) = {P(Xi)*[Xi E(Xi)]2}
Standard Deviation = (Variance)1/2
Covariance (Ri and Rj) : Cov(Ri, Rj) = E{[Ri E(Ri)][Rj E(Rj)]}
Cov(RA, RA) = Var(RA)

Correlation (Ri and Rj) : Corr(Ri, Rj) = Cov(Ri, Rj) / [(Ri) * (Rj)]

Bayes Updated Prob. : Prob. of new info for given event x Prior Prob. of Event
Unconditional Prob. of new info.

Factorials (n!)

: 1 x 2 x 3 x ... x n (Product of all whole numbers till n)

Number of Outcomes
Combination : nCr =
n!
(n-r)! r!

Permutation : nPr =

Binomial Probability = n!/[(n-x)!*x!] * px * (1-p)n-x

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II. Probability Distribution

E(x)
z=0
68%
95%

The three confidence intervals:

- The 90% confidence interval for X is X - 1.65s to X + 1.65s.
- The 95% confidence interval for X is X - 1.96s to X + 1.96s.
- The 99% confidence interval for X is X - 2.58s to X + 2.58s.

Z-value:
z = Observation Mean
Standard Deviation

=x

To find the Confidence Intervals in units:

Confidence Interval = + z*

Risks & Measure of Errors

A. Shortfall Risk:
Shortfall risk is the probability that a portfolio value or return will fall below
a particular (target) value or return over a given period of time.
B. Roys Safety First Ratio (SFRatio) = [E(RP) RL] / P
C. Sharpe Ration
= [E(RP) RF] / P

Monte Carlo simulation uses randomly generated values for risk factors, based
on their assumed distributions, to produce a distribution of possible security
values. Its limitations are that it is fairly complex and will provide answers that
are no better than the assumptions used.

Historical simulation uses randomly selected past changes in risk factors to

generate a distribution of possible security values, in contrast to Monte Carlo
simulation, which uses randomly generated values. A limitation of historical
simulation is that it cannot consider the effects of significant events that did not
occur in the sample period.
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Sampling Techniques
Standard Error ( ) : x/(n)1/2
Confidence Interval (for population mean)
Known Population Variance
: + z*/(n)1/2
Unknown Population Variance : + t*s/(n)1/2

(Use z-statistic)
(Use t-statistic)

Sample Size Selection

Increasing the sample size will generally improve parameter estimates and
narrow confidence intervals. The cost of more data must be weighed against
these benefits, and adding data that is not generated by the same
distribution will not necessarily improve accuracy or narrow confidence
intervals.
Sampling Biases
Potential mistakes in the sampling method can bias results. Biases include:
- Data Mining (significant relationships that have occurred by chance)
- Sample Selection Bias (selection is non-random)
- Look-Ahead Bias (test at a point in time, on data not available at that time)
- Survivorship Bias (using only surviving mutual funds, hedge funds, etc.)
- Time-Period Bias (the relation does not hold over other time periods)

Hypothesis Testing
The hypothesis testing process requires
- a null hypothesis
- an alternative hypothesis
- appropriate test statistic
- significance level

- a decision rule
- the calculation of a sample statistic
- a decision regarding the hypotheses
- a decision based on the test results.

The null hypothesis (H0) is what the researcher wants to reject. The alternative
hypothesis (Ha) is what the researcher wants to prove, and it is accepted when
the null hypothesis is rejected.
A two-tailed test results from a two-sided alternative hypothesis (e.g., Ha:
A one-tailed test results from a one-sided alternative hypothesis (e.g., Ha: >

0).

0)

A Type I error is the rejection of the null hypothesis when it is actually true.
A Type II error is the failure to reject the null hypothesis when it is actually false.
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Test Statistic

Sample Mean Hypothesized Mean

Standard Error

Population Mean Testing

Single Mean

known 2

unknown 2

z-statistic

t-statistic

Normal
Distribution
Hypothesized Value

z=

- 0
/(n)1/2

Students T
Distribution
0

z=

- 0
s/(n)1/2

Comparison

Students T
Distribution
t-statistic

When pooled
variance:
t=
12
2
sp + sp2
n1 n2

Population Variance Testing

Single Variance
Chi-square
Distribution
Chi-square
02

X2(n-1) = (n-1)s2
02

Comparison
F-Distribution
F-statistic

F = s12
s22

When cannot
pool variance:
t=
12
2
s1 + s22
n1 n2

Pooled Variance sp2 = (n1-1)s1 + (n2-1)s2

n1 + n2 - 2

Degree of Freedom (df) for non-pooled variance =

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