Quantitative Methods: Basic Concepts

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Quantitative Methods: Basic Concepts Quantitative Methods: Basic Concepts
Study Session 2:
Quantitative Methods Quantitative Methods –
Study Sessions 2-3 Basic Concepts
5. Time Value of Money
6. Discounted Cash Flow Applications
Topic Weight: 12% 7. Statistical Concepts and Market Returns
8. Probability Concepts
Quantitative Methods - Book 1 Quantitative Methods - Book 1
Quantitative Methods:
LOS 5.a Interpret: CFAI pg 250 Sch pg 100 Basic Concepts
Quantitative Methods: Basic Concepts

Interpreting Interest Rates
 Equilibrium interest rates are the required

Time Value of Money rate of return for a particular investment
 Interest rates are also referred to as
discount rates
 We can also view interest rates as the
opportunity cost of current consumption

because future consumption could be i%
higher
Quantitative Methods - Book 1
Quantitative Methods: Quantitative Methods:

LOS 5.b Explain: CFAI pg 251 Sch pg 101 Basic Concepts LOS 5.b Explain: CFAI pg 251 Sch pg 101 Basic Concepts
Components of Interest Rates Components of Interest Rates

Required (nominal) interest rate on a
security = Real risk-free rate 4%
Inflation 3%
real risk-free rate • Default risk
+ expected inflation Nominal risk-free rate 7% premium
+ default risk premium • Liquidity

Risk premium 3% premium
+ liquidity premium Maturity
Required rate of return 10% •
+ maturity risk premium premium
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LOS 5.b Explain: CFAI pg 251 Sch pg 101 Basic Concepts LOS 5.c Calcu/Interp: CFAI pg 260 Sch pg 101 Basic Concepts
Time Value and Your Calculator Nominal vs. Effective Rates

 Nominal rate (stated rate) represents the
 Calculator notation: contractual rate (think APR). This is the
– N = number of years or number of quoted interest rate.
payments
– I/Y = interest rate per period  Effective rate represents the rate of return
– PV = present value actually being earned.
– FV = future value
– PMT = payments (for annuities) Effective rate = (1 + periodic rate)m – 1

LOS 5.c Calcu/Interp: CFAI pg 260 Sch pg 101 Basic Concepts LOS 5.c Calcu/Interp: CFAI pg 260 Sch pg 101 Basic Concepts
Effective Annual Rates - Example Example: Effective Annual Rate

Assume the stated annual rate is 12%
Compute the effective rate of 8%, compounded
12 quarterly.
Semiannual Compounding i = =6 m=2
2
EAR = 1.062  1 = 12.36%
12
Quarterly Compounding i= =3 m=4
4
EAR = 1.03  1 = 12.55%
4
12
Monthly Compounding i= = 1 m = 12
12
EAR = 1.0112  1 = 12.68%

Basic Concepts LOS 5.c Calcu/Interp: CFAI pg 260 Sch pg 101 Basic Concepts
Example: Effective Annual Rate TVM With m ≠ 1 – Problem

Compute the effective rate of 8%, compounded A $100,000 CD with quarterly compounding will
quarterly.
return $123,528 in two years. What are the effective
annual rate and the stated annual rate for this CD?
Method 1: Effective annual:

(1 + 0.02)4 – 1 = 1.0824 – 1 = 8.24%
Stated annual:


LOS 5.c Calcu/Interp: CFAI pg 260 Sch pg 101 Basic Concepts LOS 5.e Calculate CFAI pg 252 Sch pg 104 Basic Concepts
TVM With m ≠ 1 – Solution FV of Single Sum

A $100,000 CD with quarterly compounding will What is the future value of $200 invested today in
return $123,528 in two years. What are the effective two years when the interest rate is 10%?
annual rate and the stated annual rate for this CD?
Effective annual: N = 2, PMT = 0, PV = –100,000,
FV = 123,528, CPT→I/Y = 11.14%, OR 0 1 2 3
(123,528 / 100,000)1/2 – 1 = 0.1114 = 11.14% I = 10%
$200 ?
Stated annual: N = 8, PMT = 0, PV = –100,000,
FV = 123,528, CPT→I/Y = 2.676 × 4 = 10.7%,
FV n  PV 1  r 
n
OR
(123,528 / 100,000)1/8 – 1 = 0.02676 × 4 = 10.7% or use TVM buttons

LOS 5. e Calculate CFAI pg 252 Sch pg 104 Basic Concepts LOS 5. e Calculate CFAI pg 252 Sch pg 104 Basic Concepts
FV of Single Sum PV of Single Sum

What is the present value of $200 to be received
in two years when the interest rate is 10%?
0 1 2 3
I = 10% 0 1 2 3
$200 ? I = 10%
? $200
N = 2; I/Y = 10; PV = 200; PMT = 0;
CPT → FV = – 242.00 or FV n or use TVM buttons and adjust
200 (1.1) (1.1) =200(1.12) = 242 PV 
1  r n for non-annual compounding if
needed

PV of Single Sum PV of an Ordinary Annuity

in two years when the interest rate is 10%
at the end of each year for three years when the
interest rate is 10%?
0 1 2 3
I = 10%
? 0 1 2 3
$200
N = 2; I/Y = 10; FV = –200; PMT = 0; CPT → PV = $165.29
I = 10%
or ? $200 $200 $200
FIRST
FV 200 PAYMENT
PV = = $165.29
(1 + i)n 1.12


Basic Concepts LOS 5. e Calculate CFAI pg 252 Sch pg 104 Basic Concepts
PV of an Ordinary Annuity PV of a Perpetuity

FIRST A preferred stock will pay $8/year forever
PAYMENT
and the rate of return is 10%. What is its
0 1 2 3
value?
I = 10%
PMT
? $200 $200 $200 PV 
r
For the above problem (in END mode):
N = 3; I/Y = 10; PMT = –200; CPT → PV = $497.37
NOTE: Either clear TVM or enter FV = 0

PV of a Perpetuity FV of an Ordinary Annuity

A preferred stock will pay $8/year What is the value in 3 years time of $200 to be
forever and the rate of return is 10%. received at the end of each year for three years
What is its value? when the interest rate is 10%?
8 8 8 8 0 1 2 3
PV = + 2 + 3 + 4 + .............. I = 10%
1.1 1.1 1.1 1.1
$200 $200 $200
?
8 FIRST
PV = = $80 PMT = 10%  80 = $8 / yr. DEPOSIT
0.1

FV of an Ordinary Annuity PV of an Annuity Due

0 1 2 3 at the start of each year for three years when the
I = 10% interest rate is 10%?
$200 $200 $200 ?
FIRST
DEPOSIT ? 0 1 2 3
I = 10%
$200 $200 $200
N = 3; I/Y = 10; PMT = –200; CPT → FV = 662.00 Annuity Due: CFs at the beginning of each period
NOTE: Either clear TVM or enter PV = 0


PV of an Annuity Due FV of an Annuity Due

?
0 1 2 3 0 1 2 3
I = 10%
I = 10%
$200 $200 $200 ?
$200 $200 $200
Annuity Due: CFs at the beginning of each period
200 + 200 / 1.1 + 200 / 1.12 = $547.11, or w/TVM functions
Method 1: N = 2; I/Y = 10; PMT = –200; FV = 0;

CPT → PV = $347.11 + $200 = $547.11
Method 2: Put calculator in BGN mode:
N = 3; I/Y = 10; PMT = –200; FV = 0; CPT → PV = $547.11

FV of an Annuity Due PV of Uneven Cash Flows

0 1 2 3
I = 10% 0 1 2 3
? I = 10%
$200 $200 $200
? $300 $600 $200
Method 1(END mode): N = 3; I/Y = 10; PMT =-200;

PV = 0; CPT → FV = $662.00 × 1.1 = $728.20
Method 2(BGN mode): N = 3; I/Y = 10;PMT = -200;

PV = 0; CPT → FV = $728.20

PV of Uneven Cash Flows FV of Uneven Cash Flows

0 1 2 3 0 1 2 3
I = 10% I = 10%
? $300 $600 $200 $300 $600 $200
?
200 / 1.13 + 600 / 1.12 + 300 / 1.1 = $918.86 = PV
N = 1; I/Y = 10; FV = 300; CPT → PV = $272.73
N = 2; I/Y = 10; FV = 600; CPT → PV = $495.87
N = 3; I/Y = 10; FV = 200; CPT → PV = $150.26
$918.86


FV of Uneven Cash Flows Mortgage Example

1) What is the monthly payment on a $100K
0 1 2 3 30-year home loan with stated rate of 6%?
I = 10%
$300 $600 $200
?
2) How much is the remaining principal (payoff
300(1.1)2 + 600(1.1) + 200 = $1,223 amount) just after the 85th payment is made?
N = 2; I/Y = 10; PV = –300; CPT → FV = $363
N = 1; I/Y = 10; PV = –600; CPT → FV = $660
$200
Can also use CF functions
CPT NPV w/Cf0 = 0 $1,223

Mortgage Example Retirement Savings – Problem

1) What is the monthly payment on a $100K Client has $75,000 in savings now, will retire 20 years
30-year home loan with stated rate of 6%? from today, and needs 25 payments of $62,000/year to
begin then. Account expected to earn 7%/year. What
N = 30 × 12 = 360; I/Y = 6 / 12 = 0.5;
annual deposit must she make at the end of each year
for 20 years to reach her goal?
PV = 100,000; FV = 0; CPT → PMT = –599.55
2) How much is the remaining principal (payoff

amount) just after the 85th payment is made?
N = 360 – 85 = 275 payments left
CPT → PV = 89,488

Retirement Savings Calculating I/Y– Problem

Client has $75,000 in savings now, will retire 20 years from Elmer has won his $4 million state lottery and has been
today, and needs 25 payments of $62,000/year to begin offered 20 annual payments of $200,000 each beginning
then. Account expected to earn 7%/year. What annual today or a single payment of $2,267,000. What is the
deposit must she make at the end of each year for 20 annual discount rate used to calculate the lump-sum
years to reach her goal? payout amount?
Step 1: How much needed at t = 20?
[END mode] N = 24, FV = 0, PMT = –62,000, I/Y = 7,
CPT → PV = 711,099 + 62,000 = $773,099
or [BGN mode] N = 25…………… = $ 773,099
Step 2: FV = 773,099, I/Y = 7, N = 20, PV = –75,000

CPT→ PMT = –11,778.68


Calculating I/Y Calculating N – Problem

Elmer has won his $4 million state lottery and has been
Elmer has won his $4 million state lottery and has
offered 20 annual payments of $200,000 each beginning
been offered 20 annual payments of $200,000 today or a single payment of $2,267,000. If Elmer can
each beginning today or a single payment of choose the amount of his annual payout, based on a 7%
$2,267,000. What is the annual discount rate discount rate, how many payments of $232,631 could
used to calculate the lump-sum payout amount? Elmer receive if his first payment were today?
In BGN mode, N = 20, FV = 0,

PMT = –200,000, PV = 2,267,000,
CPT→I/Y = 7%

LOS 5. e Calculate CFAI pg 252 Sch pg 104 Basic Concepts Basic Concepts
Calculating N Example Questions

What immediate lump sum would be acceptable
Elmer has won his $4 million state lottery and has
been offered 20 annual payments of $200,000 each to a pensioner instead of 15 annual payments
beginning today or a single payment of $2,267,000. of $75,000 starting at the end of the year?
If Elmer can choose the amount of his annual Assume an interest rate of 5%.
payout, based on a 7% discount rate, how many
payments of $232,631 could Elmer receive if his A $1,125,000
first payment were today? B $1,618,392
C $778,474
In BGN mode, FV = 0,
PMT = –232,631,PV = 2,267,000, I/Y = 7%,
CPT → N = 15

Basic Concepts Basic Concepts
Example Questions Example Questions

What immediate lump sum would be acceptable What immediate lump sum would be acceptable
to a pensioner instead of 15 annual payments to a pensioner instead of 15 annual payments
of $75,000 starting at the end of the year? of $75,000 starting at the end of the year?
Assume an interest rate of 5%. Assume an interest rate of 5%.
A $1,125,000 A $1,125,000
B $1,618,392 B $1,618,392
C $778,474 C $778,474
Answer: C


If 12 annual payments of $13,000 started at the If 12 annual payments of $13,000 started at the
beginning of 2000, what is the future value at the beginning of 2000, what is the future value at the
end of 2012? Assume an interest rate of 4% end of 2012? Assume an interest rate of 4%
A $195,335 A $195,335
B $211,275 B $211,275
C $162,240 C $162,240
Answer: B
The future value of the regular annuity is:
$13,000 x {[(1+0.04)12 – 1] divided by 0.04} x (1.04)2 =
$211,275

A financial product offers to pay a sum of $2,500 A financial product offers to pay a sum of $2,500
per annum for an infinite period in return for an per annum for an infinite period in return for an
upfront investment of $38,462. What is the interest upfront investment of $38,462. What is the interest
rate implicit within this product? rate implicit within this product?
A 6.5% A 6.5%
B 7% B 7%
C 7.5% C 7.5%
Answer: B
The present value of the perpetuity at 6.5% is:
$2,500/0.065 = $38,462
LOS 6.a Calculate/Interpret: CFAI pg 306 Sch pg 138 Basic Concepts

Net Present Value (NPV)
The sum of the present values of a series of
cash flows
Discounted Cash Flow CF1 CF2 CFn
NPV  CF0    ... 
Applications 1
(1  k) (1  k)2
(1  k)n
NPV can be computed using your

financial calculator


LOS 6.a Calculate/Interpret: CFAI pg 306 Sch pg 138 Basic Concepts LOS 6.a Calculate/Interpret: CFAI pg 306 Sch pg 138 Basic Concepts
Net Present Value (NPV) TIBA II Plus Calculator Keystrokes

[CF] Select CF function.
Example using a 9% discount rate [2nd] [CLR Work] This is to clear out any previous inputs
End of Year Project X Discounted [100][+/-] [ENTER] CF0 = – 100

Cash Flow –100.00 [][25][ENTER] C01 = 25
+ 22.94 [] F01 = 1
0 –$100 –$100.00 [][50][ENTER] C02 = 50
1 25 22.94 + 42.08 [] F02 = 1
+ 57.91 [][75][ENTER] C03 = 75
2 50 42.08 [] F03 = 1
3 75 57.91
NPV = $22.93
[NPV] Select NPV function.
[9] [ENTER] I=9
NPV is the change in wealth in present value [][CPT] NPV = 22.93
terms from a series of cash flows [IRR] Select IRR function.

[CPT] IRR = 19.44

LOS 6.b Contra/identi: CFAI pg 310 Sch pg 141 Basic Concepts LOS 6.b Contra/identi: CFAI pg 310 Sch pg 141 Basic Concepts
Internal Rate of Return (IRR) Internal Rate of Return (IRR)

 IRR is the discount rate that equates the
PV of a series of cash flows to their cost End of Year Project X Discounted
Because NPV = 0
CFs Cash Flow
IRR = 19.4%
at 19.4%
 The IRR is the discount rate that makes 0 –$100 –100.00
the NPV = 0 1 $25 +20.94
2 $50 +35.07
CF1 CF2 CFn
NPV  0  CF0    ...  3 $75 +44.06
(1  IRR)1 (1  IRR)2 (1  IRR)n
∑ = 0.00 = NPV
CPT IRR with CF function

LOS 6.b Contra/identi: CFAI pg 310 Sch pg 141 Basic Concepts LOS 6.c Calc/Interp: CFAI pg 313 Sch pg 143 Basic Concepts
Possible Problems With IRR Holding Period Return (HPR)

The percentage increase in wealth over a period
1. When a series of cash flows goes from
negative to positive, then back to negative This can be calculated as:
again, there can be more than one IRR 1) Capital appreciation
2) Cash flows
2. Series of cash flows can be ranked by their
NPVs, but IRR rankings can differ P1  P0  D1
HPR 
P0
More on NPV and IRR in Corporate Finance


LOS 6.c Calc/Interp: CFAI pg 313 Sch pg 143 Basic Concepts LOS 6.c Calc/Interp: CFAI pg 313 Sch pg 143 Basic Concepts
Holding Period Return (HPR)-Example Holding Period Return (HPR)

Example: Investment purchased nine months ago
for $9 is now valued at $10.20. Example: Investment purchased nine months ago
9-month HPR for $9 is now valued at $10.20.
9-month HPR is 10.20 / 9 – 1 = 1.20 / 9 = 13.33%
Example: Stock purchased one year ago for $29
just paid a dividend of $1.30 and is valued at Example: Stock purchased one year ago for $29
$30.50. just paid a dividend of $1.30 and is valued at
1-year HPR $30.50.
1-year HPR is (30.50 + 1.30) / 29 – 1 = 9.66%

LOS 6.d Calc./Comp./Eval.: CFAI pg 314 Sch pg 143 Basic Concepts LOS 6.d Calc./Comp./Eval.: CFAI pg 314 Sch pg 143 Basic Concepts
Time-Weighted Returns Money-Weighted Returns

Annual time-weighted returns are effective
annual compound returns. Money-weighted returns are like an IRR
1
measure
 End Value1   End Value2   End ValueN   #YEARS
TWR =    .....   1
 Begin Value1   Begin Value2   Begin ValueN   CF1 CFN
CF0 + + ... + =0
1+ MWR 
N
1+ MWR
Periods can be any length
Calculate HPRs for periods Periods must be equal length, use shortest
between significant cash flows
period with no significant cash flows.
1 + HPR1

LOS 6.d Calc./Comp./Eval.: CFAI pg 314 Sch pg 143 Basic Concepts Basic Concepts
MWR and TWR – Problem MWR and TWR

Invest $1,000 in an account at t = 0 Invest $1,000 in an account at t = 0
Value at end of Year 1 is $1,200, investor adds $800. Value at end of Year 1 is $1,200, investor adds $800.
Value at end of Year 2 is $2,200. Value at end of Year 2 is $2,200.
Calculate the annual TWR and MWR. Calculate the annual TWR and MWR.
TWR = [(1.2)(1.1)]1/2 – 1 = 14.89%

MWR = 13.623% 800 2,200
1000 + + =0
1.13623 1.136232
CF0 = –1,000 CF1 = –800 CF2 = 2,200 IRR = 13.623%
MWR places more weight on second period returns


LOS 6.e Calculate/Interpret: CFAI pg 320 Sch pg 147 Basic Concepts LOS 6.e Calculate/Interpret: CFAI pg 320 Sch pg 147 Basic Concepts
BDY, HPY, EAY, MMY Yield Example: 90-day T-bill priced at $980
Simple
Discount 360 annualized
Bank discount yield = × discount
Face days to maturity
Ending value
Holding period yield = 1 90-day HPY
Beginning value
365
Effective annual yield = (1 + HPY) days  1 Effective rate

360
Money market yield = HPY ×
days to maturity Simple annualized

LOS 6.f Convert: CFAI pg 320 Sch pg 150 Basic Concepts LOS 6.f Convert: CFAI pg 320 Sch pg 150 Basic Concepts
Bond Equivalent Yield (BEY) Bond Equivalent Yield (BEY)

BEY is two times the effective semi-annual yield BEY is two times the effective semi-annual yield
Annual effective yield is 8%, calculate BEY Annual effective yield is 8%, calculate BEY
Effective semi-annual yield is 1.081/2 – 1 = 3.92%
BEY = 2 × 3.92 = 7.84%
Monthly effective yield is 0.75%, calculate BEY Monthly effective yield is 0.75%, calculate BEY
Effective semi-annual yield is 1.00756 – 1 = 4.59%
BEY = 2 × 4.59 = 9.18%

LOS 6.f Convert: CFAI pg 320 Sch pg 150 Basic Concepts LOS 6.f Convert: CFAI pg 320 Sch pg 150 Basic Concepts
Yield Measures – Problem Yield Measures

A 90-day T-bill is purchased for $997.40. What are the A 90-day T-bill is purchased for $997.40. What are the
discount yield, holding period yield, money market yield, discount yield, holding period yield, money market yield,
and the effective yield? and the effective yield?
Discount yield: [(1,000 – 997.40) / 1,000] × 4 = 1.04%
90-day HPY: 1,000 / 997.4 – 1 = 0.2607%
Money market yield: 0.2607 (360 / 90) = 1.0428%
Effective annual yield:(1,000 / 997.4)365/90 – 1 =

1.0614%



If a bank offers a stated annual interest rate of If a bank offers a stated annual interest rate of
3.98%, and compounds quarterly, what is the 3.98%, and compounds quarterly, what is the
effective annual rate the bank is offering? effective annual rate the bank is offering?
A 13.33%
A 13.33% B 16.90%
B 16.90% C 4.040%
C 4.040%
Answer: C
The effective annual rate is (1 + stated rate/compounding
periods per year) number of compounding periods p.a. – 1 = (1 + 3.98%/4)4 –
1 = (1.04040 – 1) x 100 = 4.040%

Start-up Industries has committed to investing $7,500,000 in Start-up Industries has committed to investing $7,500,000 in
a project with expected cash flows of $2,000,000 at the a project with expected cash flows of $2,000,000 at the end
end of year 1, $3,500,000 at the end of year 4 and of year 1, $3,500,000 at the end of year 4 and $4,500,000 at
$4,500,000 at the end of year 5. What is the internal the end of year 5. What is the internal rate of return for this
rate of return for this investment? investment?
A 6.67%
A 6.67% B 7.95%
B 7.95% C 33.33%
C 33.33% Answer: B
Use Cash Flow worksheet: to enter:
 CF0 = -7.5
 C01 = 2 (F01 =1)
 C04 = 3.5 (F04 =1)
 C05 = 4.5 (F05 =1)
 Press IRR and then CPT  7.949%

Supersuds is planning to spend $8 million on advertising. The Supersuds is planning to spend $8 million on advertising. The
company expects this expenditure to result in annual incremental company expects this expenditure to result in annual incremental
cash flows of $1.2 million in perpetuity. What is the net present cash flows of $1.2 million in perpetuity. What is the net present
value and IRR of this project if Supersuds’ opportunity cost of value and IRR of this project if Supersuds’ opportunity cost of
capital is 11%? capital is 11%?
NPV IRR
NPV IRR A $2.91 million 4%
A $2.91 million 4% B $10.91 million 4%
B $10.91 million 4% C $2.91 million 15%
C $2.91 million 15%
Answer: C
PV of incremental cash flow = 1.2/0.11 = 10.91m
NPV = 10.91 – 8 = 2.91m
IRR = 1.2/8 = 15%


A stock was purchased for $73 a year ago, it is A stock was purchased for $73 a year ago, it is
sold for $93 today and a dividend of $8 was paid sold for $93 today and a dividend of $8 was paid
during the year. What is the holding period return? during the year. What is the holding period return?
A 30.1%
B 27.4%
A 30.1%
C 38.4%
B 27.4%
C 38.4% Answer: C
The holding period return is the price/sales proceeds
now plus the dividend, minus the purchase price
divided by the purchase price expressed as a
percentage.93 + 8 – 73 divided by 73 x 100 = 38.4%
LOS 7.a Distingush: CFAI pg 337 Sch pg 163 Basic Concepts

Statistics
 Descriptive statistics describe the
properties of a large data set
Statistical Concepts  Inferential statistics uses a sample from a
population to make probabilistic statements

and Market Returns about the characteristics of a population
 A population is a complete set of
outcomes
 A sample is a subset of outcomes drawn
from a population

LOS 7.a Distingush: CFAI pg 337 Sch pg 163 Basic Concepts LOS 7.b Define: CFAI pg 337 Sch pg 164 Basic Concepts
Measurement Scales (NOIR) Statistics Terms

 Nominal – only names make sense  A parameter describes a characteristic of a
(e.g., robin, parrot, seagull) population
 A sample statistic describes a characteristic of a
 Ordinal – order makes sense
sample (drawn from a population)
(e.g., large-cap, mid-cap, small-cap)  A relative frequency distribution shows the
 Intervals – intervals make sense percentage of a distribution’s outcomes in each
interval
(e.g., 40oF is 10o greater than 30oF)
 A cumulative frequency distribution shows the
 Ratio – ratios make sense (absolute zero)
percentage of observations less than the upper
(e.g., $200 is twice as much as $100) bound of each interval


LOS 7.c Calc./Interp.: CFAI pg 342 Sch pg 166 Basic Concepts LOS 7.c Calc./Interp.: CFAI pg 342 Sch pg 166 Basic Concepts
A Histogram A Frequency Polygon

7 7
Frequency
5
Frequency
5
3
3
1
1
–10% to 0
0 to 10%
10% to 20%
20% to 30%
30% to 40%
40% to 50%
–30% to –20%
–20% to –10%
08-L1-SS2-S158
–25 –15 –5 5 15 25 35 45
08-L1-SS2-S157
IntervalM idpoints
Interval

LOS 7.e Calc./Interp.: CFAI pg 353 Sch pg 169 Basic Concepts LOS 7.e Calc./Interp.: CFAI pg 353 Sch pg 169 Basic Concepts
Measures of Central Tendency:  Geometric mean is used to calculate

Population and Sample Means periodic compound growth rates
 If the returns are constant over time,
Population and sample means have geometric mean equals arithmetic mean
different symbols but are both arithmetic
 The greater the variability of returns over
means N
time, the more the arithmetic mean will
X i
exceed the geometric mean
Population Mean : μ = i=1
1
N Periodic Rcompound = [(1+R1 )(1+R2 )........(1+Rn )] n  1
n Actually, the compound rate of return is the

X i geometric mean of the price relatives, minus
Sample Mean : X = i=1
one
n

Geometric Mean: Example Geometric Mean

An investment account had returns of +50% An investment account had returns of +50%
over the first year and returns of –50% over the over the first year and returns of –50% over the
second year. second year.
Calculate the average annual compound rate of Calculate the average annual compound rate of
return (time weighted rate of return). return (time weighted rate of return).


Weighted Mean Harmonic Mean

A mean in which different observations Used to find the average cost per share of
have different proportional influence on stock purchased over time in constant dollar
the mean amounts
n
XW =  wiRi = w1R1 + w 2R2 +...........wnRn N
i=1 XHarmonic = N
1

i=1 Xi
where :
R1, R2 , ..... Rn are the returns for assets 1,2,....,n
where : N = number of purchases (equal $ amounts)
and w1, w 2 , ....,wn are the portfolio weights, so that
Xi = share price for each purchase
w1 + w 2 + ....wn = 1

Harmonic Mean - Example Harmonic Mean

Investor buys $3,000 of a stock at the end of Investor buys $3,000 of a stock at the end of
month 1 at $20 a share, and $3,000 at the month 1 at $20 a share, and $3,000 at the
end of month 2 at $25 per share. end of month 2 at $25 per share.
What is the average cost per share of stock? What is the average cost per share of stock?
2(3,000) 2
= = $22.22 per share
3,000 + 3,000 1 +1
20 25 20 25

Calculating Means – Example Calculating Means

Calculate the arithmetic, geometric, and Calculate the arithmetic, geometric, and
harmonic means of 2, 3, and 4. harmonic means of 2, 3, and 4.
Arithmetic: Arithmetic: 2 + 3 + 4 = 3
Largest Largest 3
Geometric: Geometric:
3
Harmonic: Harmonic: = 2.77
1 +1 +1
Smallest Smallest 2 3 4


Portfolio Return – Example Portfolio Return

Dr. Hoover had the following portfolio at the Dr. Hoover had the following portfolio at the
beginning of the year: cash = $4 million, bonds = $6 beginning of the year: cash = $4 million, bonds = $6
million, equities = $10 million. million, equities = $10 million.
If returns were 5% on cash, 7% on bonds, and 12% If returns were 5% on cash, 7% on bonds, and 12%
on equities, what was the portfolio return? on equities, what was the portfolio return?
Return Weight
Cash 5% × 4/20 = 1.00%
Bonds 7% × 6/20 = 2.10%
Stocks 12% × 10/20 = 6.00%
9.10%
Same method works for expected portfolio returns!

Median Mode
 Midpoint of a data set, half above and half below
Value occurring most frequently in a data set
 With an odd number of observations 2, 4, 5, 5, 7, 8, 8, 8, 10, 12
2, 5, 7, 11, 14 Median = 7
Mode = 8
 With an even number of observations, median is
the average of the two middle observations
3, 9, 10, 20 Median = (9 + 10) / 2 = 9.5
Data sets can have more than one mode
Less affected by extreme values than the mean (bimodal, trimodal, etc.)

LOS 7.f Calc./Interp.: CFAI pg 370 Sch pg 174 Basic Concepts LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts
Quantiles Range and MAD

 75% of the data points are less than the 3rd Annual returns data: 15%, –5%, 12%, 22%
quartile
 60% of the data points are less than the 6th Range (the difference between the largest and
decile smallest value in a data set) =
 50% of the data points are less than the 50th
percentile Mean Absolute Deviation (MAD): Average of the
For data with 17 observations, the 70th percentile absolute values of deviations from the mean
is at observation (17 + 1) × 0.70 = 12.6 Mean = (15 – 5 + 12 + 22) / 4 = 11%
Calculate MAD =
For ordered observations, this is six-tenths of the
way from observation 12 to observation 13


LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts
Range and MAD Population Variance and

Standard Deviation
Annual returns data: 15%, –5%, 12%, 22%
Variance is the average Standard deviation is
Range (the difference between the largest and of the squared deviations the square root of
smallest value in a data set) = 22% – (–5%) = 27% variance
from the mean
Mean Absolute Deviation (MAD): Average of the
N
absolute values of deviations from the mean
 X  μ
2
i
Mean = (15 – 5 + 12 + 22) / 4 = 11%
MAD = (|15 – 11| + |–5 – 11| + |12 – 11| + |22 – 11|) / 4 σ2 = i=1
σ = σ2
N
= 32 / 4 = 8%

LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts
Population Variance (σ2) - Example TIBA II Plus Calculator Keystrokes

[2nd] [7] Data entry
Returns on 4 stocks are 15%, -5%, 12%, 22% [2nd] [CLR Work] This is to clear out any previous inputs
What is the Population Standard Deviation? [15][ENTER] X01 = 15

[] [] Y01 Probability of X variable
Population Mean (µ)= 11% [5][+/-][ENTER] X02 = -5
[] [] Y02 Probability of X variable
[12][ENTER] X03 = 12
15  11   5  11  12  11   22  11
2 2 2 2
σ2 = = 98.5 [] [] Y03 Probability of X variable

4 [22][ENTER] X04 = 22
[2nd] [8] Stats mode

  98.5  9.9% [2nd][ENTER] Select mode 1-V [one variable]
[] View statistics

LOS 7.g Calc./Interp.: CFAI pg 376 Sch pg 175 Basic Concepts LOS 7.h Calculate/Interpret: CFAI pg 386 Sch pg 179 Basic Concepts
Sample Variance (s2) and Chebyshev’s Inequality

Sample Standard Deviation (s) Specifies the minimum percentage
of observations that lie within k
  X  X   X  X
n 2 n 2
standard deviations of the mean;
i i
applies to any distribution with k > 1
s2 = i=1
s= i=1
n 1 n 1
1
Min.% is 1 
Note that for Sample Variance, the sum of k2
the squared deviations is divided by n – 1 1 1
Min.% for 2 std. dev. is 1  = 1  = 75%
instead of n 22 4


LOS 7.i Calculate/Interpret: CFAI pg 388 Sch pg 180 Basic Concepts LOS 7.i Calculate/Interpret: CFAI pg 388 Sch pg 180 Basic Concepts
Coefficient of Variation (CV) Coefficient of Variation (CV)

A measure of risk per unit of return A measure of risk per unit of return
Example: Mean Std. Dev. Example: Mean Std. Dev.
Asset A 5% 10% Asset A 5% 10%
Asset B 8% 12% Asset B 8% 12%
Calculate CV for assets A and B Asset B has higher std. dev. and higher return
Lower CV is better, less risk per unit of return
s 10 12
CV = CVA = =2 CVB = = 1.5
X 5 8

LOS 7.i Calculate/Interpret: CFAI pg 388 Sch pg 180 Basic Concepts LOS 7.i Calculate/Interpret: CFAI pg 388 Sch pg 180 Basic Concepts
Sharpe Ratio Sharpe Ratio

Excess Return per unit of risk (CV measures Excess Return per unit of risk (CV measures
risk per unit of return); higher is better risk per unit of return); higher is better
Example: Mean portfolio return = 17%, standard Example: Mean portfolio return = 17%, standard
deviation = 9%, average risk-free rate = 5%. deviation = 9%, average risk-free rate = 5%.
What is the Sharpe ratio for the portfolio? What is the Sharpe ratio for the portfolio?
RP  RF 17  5
Sharpe ratio = = = 1.33
σP 9
Sharpe Ratio is Safety-first with Rf for target return Sharpe Ratio is Safety-first with Rf for target return

LOS 7.j Explain: CFAI pg 394 Sch pg 182 Basic Concepts LOS 7.j Explain: CFAI pg 394 Sch pg 182 Basic Concepts
Skewness Positive Skew = Right Skew

 Skew measures the degree to which a  Positive skew has outliers in the right tail
distribution lacks symmetry  Skew absolute values > 0.5 are significant
 A symmetrical distribution has skew = 0  Mean is most affected by outliers
Symmetrical ‘Pull’ on right
Mean = Median = Mode tail
to get
positive/right
skew
Mean Mean
Median Mean > Median > Mode
Median Mode
Mode 08-L1-SS2-S178


LOS 7.j Explain: CFAI pg 394 Sch pg 182 Basic Concepts LOS 7.l Explain: CFAI pg 396 Sch pg 184 Basic Concepts
Negative Skew = Left Skew Measure of Sample Skew

 Negative skew has outliers in the left tail
 X  X 
n
3
 Again, mean is most affected by outliers
1 i
“Median is in the middle” Sample skewness (Sk )  i1

n s3
Where s = sample standard deviation
Sk = 0  Symmetrical distribution
Sk > 0  Positively skewed distribution
Mean
Sk < 0  Negatively skewed distribution
Median
Mean < Median < Mode
Mode

LOS 7.l Explain: CFAI pg 396 Sch pg 184 Basic Concepts LOS 7.l Explain: CFAI pg 396 Sch pg 184 Basic Concepts
Kurtosis Kurtosis
 Measures the degree to which a distribution is
more or less peaked than a normal distribution  Kurtosis for a normal distribution is 3.0
 Leptokurtic (kurtosis > 3) is more peaked with  Excess kurtosis is kurtosis minus 3
fatter tails (more extreme outliers)  Excess kurtosis is zero for a normal
distribution
Leptokurtic  Excess kurtosis greater than 1.0 in
Higher probability
in tails with absolute value is considered significant
N orm alD istribution higher kurtosis
08-L1-SS2-S180

LOS 7.l Explain: CFAI pg 396 Sch pg 184 Basic Concepts Basic Concepts
Example Questions
Kurtosis
Which one of the following statements is true?
 Kurtosis for a normal distribution is 3.0 A A histogram is a graphical representation of a
 Excess kurtosis is kurtosis minus 3 frequency distribution with bar heights
 Excess kurtosis is zero for a normal distribution representing absolute frequencies
 Excess kurtosis greater than 1.0 in absolute value B Frequency polygon is a graphical representation
is considered significant of a frequency distribution with bar heights
representing absolute frequencies
 X  X 
n
4
C A relative frequency polygon is a graphical
1 i
Sample excess kurtosis  i 1
3 representation of a frequency distribution with
n s4
bar heights representing absolute frequencies
Where s = sample standard deviation


Example Questions An analyst has made the following statements:
Which one of the following statements is true? I When there is variability within a set of data the arithmetic mean of
the data is less than the geometric mean.
A A histogram is a graphical representation of a frequency
distribution with bar heights representing absolute II The geometric mean is particularly useful when looking at
compound returns over multiple periods.
frequencies
B Frequency polygon is a graphical representation of a
Which of the statements are correct or incorrect?
frequency distribution with bar heights representing
absolute frequencies Statement I Statement II
A Correct Correct
C A relative frequency polygon is a graphical representation of
a frequency distribution with bar heights representing B Correct Incorrect
absolute frequencies C Incorrect Correct
Answer: A
Frequency polygons are the equivalent of the histograms with the
frequencies represented with lines linking their midpoints.

An analyst has made the following statements:

I When there is variability within a set of data the arithmetic mean of
Consider the following set of stock returns: 12%;
the data is less than the geometric mean. 23%; 27%; 10%; 7%; 20%; 15%. The third quartile
II The geometric mean is particularly useful when looking at
compound returns over multiple periods. is:
A 21.5%
Statement I Statement II
A Correct Correct B 10.0%
B Correct Incorrect
C Incorrect Correct
C 23.0%
Answer: C
The geometric mean is less than the arithmetic mean, with the difference
increasing with increased variability in the figures used. If there is no
variability the two are the same. The application of the geometric mean
enables the opening investment to increase (or decrease) to the
appropriate closing investment.

An analyst has made the following comments about a negatively

Consider the following set of stock returns: 12%; skewed distribution:
23%; 27%; 10%; 7%; 20%; 15%. The third quartile I There is a longer tail to the right of the distribution
II The mean is less than the median and the mode
is:
A 21.5% Which of the statements are correct or incorrect?
B 10.0% Statement I Statement II
A Correct Correct
C 23.0% B Correct Incorrect
C Incorrect Correct
Answer: C
The third quartile is calculated as: Ly = (7+1)(75/100) = 6. When we
order the observations in ascending order, “23%” is the sixth
observation from the left.


An analyst has made the following comments about a negatively An analyst has made the following comments about a distribution that
skewed distribution: exhibits positive excess kurtosis:
I There is a longer tail to the right of the distribution I The distribution is more peaked than a normal distribution
II The mean is less than the median and the mode II The distribution has fatter tails than a normal distribution
Statement I Statement II Which of the statements are correct or incorrect?
A Correct Correct Statement I Statement II
B Correct Incorrect A Correct Correct
C Incorrect Correct B Correct Incorrect
C Incorrect Correct
Answer: C
A negatively skewed distribution has a mean that is less than the
median and the mode. It exhibits a longer tail to the left because its
gains, although frequent, are relatively small. Its losses are less
frequent but more extreme.
Basic Concepts
An analyst has made the following comments about a distribution that Quantitative Methods: Basic Concepts
exhibits positive excess kurtosis:
I The distribution is more peaked than a normal distribution
II The distribution has fatter tails than a normal distribution
Statement I Statement II
A
B
Correct
Correct
Correct
Incorrect
Probability Concepts
C Incorrect Correct
Answer: A
Positive excess kurtosis is also known as leptokurtic, it has a more
slender and taller peak and fatter tails than the normal distribution.

LOS 8.a Define: CFAI pg 432 Sch pg 201 Basic Concepts LOS 8.b State/Distinguish: CFAI pg 433 Sch pg 201 Basic Concepts
Probability Terminology Two Properties of Probability

Random variable: Uncertain number
Probability of an event, P(Ei), is between 0 and 1
Outcome: Realization of random variable
0 ≤ P(Ei) ≤ 1
Event: Set of one or more outcomes
Mutually exclusive: Cannot both happen For a set of events that are mutually exclusive and
exhaustive, the sum of probabilities is 1
Exhaustive: Set of events includes all possible
outcomes ΣP(Ei) = 1


LOS 8.b State/Distinguish: CFAI pg 433 Sch pg 201 Basic Concepts LOS 8.c State: CFAI pg 434 Sch pg 202 Basic Concepts
Types of Probability Odds For or Against

 Empirical: Based on analysis of data
Probability that a horse will win a race = 20%
 Subjective: Based on personal

Odds for:
perception
 A priori: Based on reasoning, not

experience Odds against:

LOS 8.c State: CFAI pg 434 Sch pg 202 Basic Concepts LOS 8.d Distinguish: CFAI pg 436 Sch pg 203 Basic Concepts
Odds For or Against Conditional vs. Unconditional

Two types of probability:
Probability that a horse will win a race = 20% Unconditional: P(A), the probability of an event
regardless of the outcomes of other events
Odds for: 0.20 / (1 – 0.20) = 1/4 (e.g., probability market will be up for the day)
= one-to-four
Conditional: P(A|B), the probability of A given
that B has occurred (e.g., probability that the
Odds against: (1 – 0.20) / 0.20 = 4/1 market will be up for the day, given that the Fed
= four-to-one raises interest rates)

LOS 8.f Calc./Int.: CFAI pg 437 Sch pg 204 Basic Concepts LOS 8.e Explain: CFAI pg 437 Sch pg 203 Basic Concepts
Joint Probability Probability That at Least One of Two

The probability that both of two events will occur is
Events Will Occur
their joint probability P(A or B) = P(A) + P(B) – P(AB)
We must subtract the joint probability P(AB)
Example using conditional probability:
P (interest rates will increase) = P(I) = 40%
P (recession given a rate increase) = P(R|I) = 70% Don’t double
count P(AB)
Probability of a recession and an increase in rates,

P(RI) = P(R|I) × P(I) = 0.7 × 0.4 = 28%


LOS 8.e Explain: CFAI pg 437 Sch pg 203 Basic Concepts LOS 8.e Explain: CFAI pg 437 Sch pg 203 Basic Concepts
Addition Rule Example Addition Rule – Example

P(I) = prob. of rising interest rates is 40%
P(I) = prob. of rising interest rates is 40%
P(R) = prob. of recession is 34%
P(R) = prob. of recession is 34%
Joint probability P(RI) = 0.28 (calculated earlier)
Joint probability P(RI) = 0.28 (calculated earlier)
Probability of either rising interest rates or recession: What is the probability of either rising interest
rates or recession?
For mutually exclusive events the P(R or I) = P(R) + P(I) – P(RI)
joint probability P(AB) = 0 so: = 0.34 + 0.40 – 0.28 = 0.46
P(A or B) = P(A) + P(B) For mutually exclusive events the
joint probability P(AB) = 0 so:
P(A or B) = P(A) + P(B)

LOS 8.g Distinguish: CFAI pg 441 Sch pg 207 Basic Concepts LOS 8.h Calculate/Interpret: CFAI pg 444 Sch pg 208 Basic Concepts
Joint Probability of any Number of Calculating Unconditional Probability

Independent Events
P (Interest rate increase) = P(I) = 0.4
Dependent events: Knowing the outcome of one
P (No interest rate increase) = P(IC) = 1 – 0.4 = 0.6
tells you something about the probability of the other
P (Recession | Increase) = P(R|I) = 0.70
Independent events: Occurrence of one event does
P (Recession | No Increase) = P(R|IC) = 0.10
not influence the occurrence of the other. For the
joint probability of independent events, just multiply
What is the (unconditional) probability of recession?
Example: Flipping a fair coin, P (heads) = 50%
The probability of 3 heads in succession is simply:
0.5 × 0.5 × 0.5 =0.53 = 0.125 or 12.5%

LOS 8.h Calculate/Interpret: CFAI pg 444 Sch pg 208 Basic Concepts LOS 8.j Explain: CFAI pg 449 Sch pg 212 Basic Concepts
Calculating Unconditional Probability An Investment Tree

EPS = $1.80
Prob = 18%
P (Interest rate increase) = P(I) = 0.4 Prob of good stock performance 30%
P (No interest rate increase) = P(IC) = 1 – 0.4 = 0.6
P(GDP growth > 3%) EPS = $1.70
P (Recession | Increase) = P(R|I) = 0.70 70% Prob = 42%
60%
P (Recession | No Increase) = P(R|IC) = 0.10 Expected
EPS = $1.51
40%
What is the (unconditional) probability of recession? P(GDP growth ≤ 3%) 60% EPS = $1.30
Prob = 24%
P(R) = P(R|I) × P(I) + P(R|IC) × P(IC) EPS = $1.00

Prob of poor stock performance 40%
= 0.70 × 0.40 + 0.10 × 0.60 = 0.34 Prob = 16%


LOS 8.h Diagram/Explain: CFAI pg 444 Sch pg 208 Basic Concepts LOS 8.k Calculate/Interpret: CFAI pg 455 Sch pg 213 Basic Concepts
Expected Value Using Total Covariance

Probability Covariance: A measure of how two variables move
Using the probabilities from the Tree: together
 Values range from minus infinity to positive infinity
Expected(EPS) = $1.51
 Units of covariance difficult to interpret
= 0.18(1.80) + 0.42(1.70) + 0.24(1.30) + 0.16(1.00)
 Covariance positive when the two variables tend to
Conditional Expectations of EPS: be above (below) their expected values at the
E(EPS)|GDP growth > 3% = same time
0.30(1.80) + 0.70(1.70) = $1.73
E(EPS)| GDP growth ≤ 3% = For each observation, multiply each probability
0.60(1.30) + 0.40(1.00) = $1.18 times the product of the two random variables
deviations from their means and sum them

LOS 8.k Calculate/Interpret: CFAI pg 455 Sch pg 213 Basic Concepts LOS 8.k Calculate/Interpret: CFAI pg 455 Sch pg 213 Basic Concepts
Correlation Correlation - Example

 Correlation: A standardized measure of the linear The covariance between two assets is
relationship between two variables
0.0046, σA = 0.0623 and σB = 0.0991. What
Cov(Ri,Rj) is the correlation between the two assets (ρ
Corr(Ri,Rj) =
σ(Ri)σ(Rj) AB)?
 Values range from +1, perfect positive correlation

to –1, perfect negative correlation
 r is sample correlation coefficient
 ρ is population correlation coefficient

LOS 8.k Calculate/Interpret: CFAI pg 455 Sch pg 213 Basic Concepts LOS 8.l Calculate/Interpret: CFAI pg 446 Sch pg 217 Basic Concepts
Correlation - Example Expected Value, Variance, and

Standard Deviation (probability model)
The covariance between two assets is
0.0046, σA = 0.0623 and σB = 0.0991. What Expected Value: E(X) = ΣP(xi)xi
is the correlation between the two assets (ρ
AB)? Economy P(xi) Return P(xi)xi
(Xi)
Recession 0.25 –0.10 –0.025
Normal 0.50 0.08 0.040
Boom 0.25 0.22 0.055
E(X) = 0.070


LOS 8.l Calculate/Interpret: CFAI pg 446 Sch pg 217 Basic Concepts LOS 8.l Calculate/Interpret: CFAI pg 446 Sch pg 217 Basic Concepts
Expected Return, Variance, and

Portfolio Expected Return
Standard Deviation (probability model)
 Variance: σ2(X) = ΣP(xi)[xi – E(X)]2 Expected return on a portfolio is a
weighted average of the expected returns
Economy P(xi) Return(Xi) P(xi)xi P(xi)[xi –E(X)]2 on the assets in the portfolio where the
Recession 0.25 –0.10 –0.025 0.00723 weights are proportions of portfolio value.
Normal 0.50 0.08 0.040 0.00005
Boom 0.25 0.22 0.055 0.00563
E(X) = 0.070 0.01290 = 2
 Standard deviation: Square root of σ2 =

0.1136

LOS 8.l Calculate/Interpret: CFAI pg 446 Sch pg 217 Basic Concepts LOS 8.m Calculate/Interpret: CFAI pg 457 Sch pg 218 Basic Concepts
Portfolio Variance Joint Probability Function

and Standard Deviation Returns RB = 40% RB = 20% RB = 0% E(RB) = 18%
 Portfolio variance also uses the weights of the RA = 20% 0.15 Probabilities
assets in the portfolio, use either formula
RA = 15% 0.60
Var(Rp ) = σ 2A w 2A + σB2 w B2 + 2w A w BCov AB RA = 4% 0.25
E(RA) = 13%
Note : Cov AB = ρABσ A σB
CovAB =
Var(Rp ) = σ 2A w 2A + σB2 w B2 + 2w A w BρABσ A σB

LOS 8.m Calculate/Interpret: CFAI pg 457 Sch pg 218 Basic Concepts LOS 8.n Calculate/Interpret: CFAI pg 463 Sch pg 222 Basic Concepts
Joint Probability Function Bayes’ Formula

Returns RB = 40% RB = 20% RB = 0% E(RB) = 18%  Bayes’ Formula is used to update a given set of prior
probabilities for a given event in response to the
RA = 20% 0.15 Probabilities arrival of new information.
RA = 15% 0.60  It is used for updating probabilities based on the
occurrence of an event O
RA = 4% 0.25
E(RA) = 13% probabilityof newinf ormation for a givenevent
updated  probability 
unconditional  probabilityof newinf ormation
CovAB = 0.15 (0.20 – 0.13) (0.40 – 0.18)  prior  probabilityof event
+ 0.6 (0.15 – 0.13) (0.20 – 0.18)
P (O / I )
P( I / O)   P( I )
+ 0.25 (0.04 – 0.13) (0 – 0.18) = 0.0066 P (O)


LOS 8.n Calculate/Interpret: CFAI pg 463 Sch pg 222 Basic Concepts LOS 8.n Calculate/Interpret: CFAI pg 463 Sch pg 222 Basic Concepts
Bayes’ Formula Bayes’ Formula

Prob. of interest Good earnings (G) 42% Prob. of interest Good earnings (G) 42%
rate cut (C) 70% rate cut (C) 70%
60% 60%
30% Poor earnings (P) 18% 30% Poor earnings (P) 18%
20% 20%
40% Good earnings (G) 8% 40% Good earnings (G) 8%
Prob. of no interest Prob. of no interest
rate cut rate cut
80% Poor earnings (P) 32% 80% Poor earnings (P) 32%
Prob (C|G) = Prob (C|G) = 42 / (42 + 8) = 42 / 50 = 84%

LOS 8.o Identify/Solve: CFAI pg 466 Sch pg 224 Basic Concepts LOS 8.o Identify/Solve: CFAI pg 466 Sch pg 224 Basic Concepts
Factorial for Labeling Factorial for Labeling

Example: Out of 10 stocks, 5 will be rated buy, Example: Out of 10 stocks, 5 will be rated buy,
3 will be rated hold, and 2 will be rated sell. 3 will be rated hold, and 2 will be rated sell.
How many ways are there to do this? How many ways are there to do this?
10!
 2,520
5! 3! 2!

Choosing r Objects from n Choosing r Objects From n Objects

Objects
When order does
When order does not matter and with just two
possible labels, we can use the combination
matter, we use the N!
permutation formula:
nPr =
formula (binomial formula). (n  r)!
Example: You have 5 stocks and want to sell 3,
Example: You have 5 stocks and want to place
one at a time. The order of the stock sales matters.
orders to sell 3 of them. How many different
How many ways are there to choose the 3 stocks to
combinations of 3 stocks are there? sell in order?
5!
= 60
(5  3)!


Choosing r Objects from n

Calculator Solutions: nCr and nPr
Objects
When order does not matter and with just two  How many ways to choose 3 from 5, order
possible labels, we can use the combination doesn’t matter? 5 → 2nd → nCr → 3 → = 10
formula (binomial formula).
Example: You have 5 stocks and want to place  How many ways to choose 3 from 5, order
orders to sell 3 of them. How many different does matter? 5 → 2nd → nPr → 3 → = 60
combinations of 3 stocks are there?
n! 5! Functions only on BAII Plus (and Professional)
n Cr    10
 
n  r !r!  5  3 ! 3!

When choosing stocks for investment, you first apply a screen to When choosing stocks for investment, you first apply a screen to
assess value and then use further financial ratios to establish the assess value and then use further financial ratios to establish the
investment case. If there is a probability of 0.25 that a randomly investment case. If there is a probability of 0.25 that a randomly
selected stock will pass the screen and given this, the probability selected stock will pass the screen and given this, the probability
of passing the investment case test is 0.40, what is the joint of passing the investment case test is 0.40, what is the joint
probability of a stock meeting both criteria? probability of a stock meeting both criteria?
A 0.65 A 0.65
B 0.40 B 0.40
C 0.10 C 0.10
Answer: C
The multiplication rule can be used. If ‘A’ is the stock passing the
investment case and ‘B’ is the stock passing the screen, the P(AB) =
P(A/B) x P(B) = 0.40 x 0.25 = 0.10

In 2005, the volume of defaulted U.S. high-yield debt was In 2005, the volume of defaulted U.S. high-yield debt was
$120 billion. The average market size of the high-yield $120 billion. The average market size of the high-yield
bond market during this year was $960 billion. Calculate bond market during this year was $960 billion. Calculate
the default rate as a probability and state this as an odds the default rate as a probability and state this as an odds
against default. against default.
A 7 to 1
A 7 to 1 B 1 to 7
B 1 to 7 C 8 to 1
C 8 to 1
Answer: A
Probability of default = 120/960 = 12.5%
The odds against an event E =1-P(E)/P(E)=1-0.125/0.125=7


There are three steps in the investment process. The first There are three steps in the investment process. The first
step can be done in 5 ways, the second step can be done in step can be done in 5 ways, the second step can be done in
2 ways and the third can be done in 3 ways. What is the 2 ways and the third can be done in 3 ways. What is the
total number of ways that the investment process can be total number of ways that the investment process can be
carried out? carried out?
A 180
A 180 B 120
B 120 C 30
C 30
Answer: C
Using the multiplication rule it is simply 5 x 2 x 3 = 30

If the stock of a particular company is assessed as having an If the stock of a particular company is assessed as having an
equal chance of going up in price and going down in price equal chance of going up in price and going down in price
between the closes of business on each trading day, what is between the closes of business on each trading day, what is
the probability of seeing 5 consecutive up moves in a week? the probability of seeing 5 consecutive up moves in a week?
A 0.3125
A 0.3125 B zero
B zero C 0.03125
C 0.03125
Answer: C
This is a binomial probability distribution and the probability of 5
consecutive up moves (and therefore no down moves) = (5!/(5 – 0)!.0!) x
0.50 x (1 – 0.5)5 = 120/120 x 0.03125 = 0.03125

Quantitative Methods: Basic Concepts

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Quantitative Methods: Basic Concepts Quantitative Methods: Basic Concepts

Quantitative Methods - Book 1 Quantitative Methods - Book 1

Quantitative Methods: Basic Concepts

 Equilibrium interest rates are the required

opportunity cost of current consumption

Quantitative Methods: Quantitative Methods:

Components of Interest Rates Components of Interest Rates

+ default risk premium • Liquidity

+ maturity risk premium premium

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Quantitative Methods: Quantitative Methods:

Time Value and Your Calculator Nominal vs. Effective Rates

Quantitative Methods: Quantitative Methods:

Effective Annual Rates - Example Example: Effective Annual Rate

Quantitative Methods: Quantitative Methods:

Example: Effective Annual Rate TVM With m ≠ 1 – Problem

Method 1: Effective annual:

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Quantitative Methods: Quantitative Methods:

TVM With m ≠ 1 – Solution FV of Single Sum

Quantitative Methods: Quantitative Methods:

FV of Single Sum PV of Single Sum

Quantitative Methods: Quantitative Methods:

PV of Single Sum PV of an Ordinary Annuity

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Quantitative Methods: Quantitative Methods:

PV of an Ordinary Annuity PV of a Perpetuity

NOTE: Either clear TVM or enter FV = 0

Quantitative Methods: Quantitative Methods:

PV of a Perpetuity FV of an Ordinary Annuity

Quantitative Methods: Quantitative Methods:

FV of an Ordinary Annuity PV of an Annuity Due

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Quantitative Methods: Quantitative Methods:

PV of an Annuity Due FV of an Annuity Due

Method 1: N = 2; I/Y = 10; PMT = –200; FV = 0;

Quantitative Methods: Quantitative Methods:

FV of an Annuity Due PV of Uneven Cash Flows

Method 1(END mode): N = 3; I/Y = 10; PMT =-200;

Method 2(BGN mode): N = 3; I/Y = 10;PMT = -200;

Quantitative Methods: Quantitative Methods:

PV of Uneven Cash Flows FV of Uneven Cash Flows

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Quantitative Methods: Quantitative Methods:

FV of Uneven Cash Flows Mortgage Example

Quantitative Methods: Quantitative Methods:

Mortgage Example Retirement Savings – Problem

2) How much is the remaining principal (payoff

Quantitative Methods: Quantitative Methods:

Retirement Savings Calculating I/Y– Problem

Step 2: FV = 773,099, I/Y = 7, N = 20, PV = –75,000

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Quantitative Methods: Quantitative Methods:

Calculating I/Y Calculating N – Problem

In BGN mode, N = 20, FV = 0,

Quantitative Methods: Quantitative Methods:

Calculating N Example Questions

Quantitative Methods: Quantitative Methods:

Example Questions Example Questions

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Quantitative Methods: Quantitative Methods: