MAF759: Analytical Methods

Dr. Ruipeng Liu

Unit Chair, Senior Lecturer
Office: LB4.121, Burwood campus
Tel: 03 9244 6359
Fax: 03 9244 6283
Email: ruipeng.liu@deakin.edu.au
Office hours: 9:30-11:30am Thursdays
Prescribed Textbook

Quantitative Investment Analysis,

2nd or 3rd Ed., Wiley.
Richard A. Defusco, Dennis W. McLeavey,
Jerald E. Pinto and David E. Runkle

Workbook of Quantitative Investment Analysis

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Quantitative Investment Analysis, 2nd Ed.,

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Quantitative Investment Analysis, 3rd Ed.,

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 Lecture:
Mondays 14:00 - 16:50
Pls bring your textbook, workbook and a calculator)

 Assessments:
• Online test 1: 5% 28th March
• Online test 2: 5% 11th April
• Individual assignment: 30% 10th May
• Examination: 60% (Hurdle: 50%)

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 Topics covered

 Week 1: Time value of money.

 Week 2: Discounted cash flow and its
applications; Money market yields
 Week 3: Statistical concepts
 Week 4: Probability concepts
 Week 5: Probability distributions

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 Topics covered
 Week 6: Hypothesis tests
 Week 7: Regression analysis
 Week 8: Multiple regression analysis
 Week 9: Time series analysis.
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 Week 10-11: Qualitative approaches for

accounting research.

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My expectation to you

 Preview unit materials prior to lecture;

 Lecture attendance (on-campus only);
 Review after each topic lecture;
 An full-time student workload:
10 hours per unit per week.

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 Chapter 1
Time value of Money

 Suppose you as an investor lend $100,000 to Y for a

year. How much do you want after a year?

 You want your $100,000 back plus some

compensation in the year end.

 What does this compensation consist of?

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 Time value of Money
1. You want some compensation for postponing your current consumption.

2. You want some compensation to account for the expected inflation in a

year.

3. You want some compensation to account for the fact that the borrower may
fail to return your money in an year. Essentially you will recover this
money from good debt than bad debt.

4. you want some compensation to account for the loss of liquidity, i.e, you
can not get your cash back whenever you want within that year.

5. You also want some compensation because you are lending the money for a
longer period.

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Interest Rate
• So what are these terms?
– Real risk free rate
– Inflation premium
– Default risk premium
– Liquidity premium
– Maturity premium

• The value of money does not remain constant over time, i.e,
money earns interest over time. So it is important from the
view point of capital budgeting and investing and many other
investment related decisions.

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 Time value of Money
 Future value (FV):
The value of a current asset at a specified date in the future based on
an assumed rate of growth (interest rate)
 Present value (PV):
The current worth of a future asset given a specified interest rate.

 Suppose A wants to borrow $10,000 from B for a year. Let the market
rate of interest be 10%. How much should A pay B in a year?

FV = PV + interest at the rate of 10% p.a.

= PV + PV *10%
= PV(1 + 10%)
= PV(1 + r)
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 Future value of a Lump Sum
 Suppose you invest $10000 today at 8% p.a,
how much will this be worth in 2 years?

PV  $10,000
r  8%
N 2

FVN  PV (1  r ) N
 $10,000(1  0.08) 2
 $11,664

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Frequency of Compounding
mN
 rs 
FVN  PV 1  
 m

rs  stated annual rate

m  number of compounding periods in a year
e.g. 4 for quarterly, 12 for monthly
N  number of years

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 Future Value with Quarterly Compounding

 Find the FV of $10,000 after two years invested today at 8%

and if the interest is compounded quarterly.

PV  $10,000
rs  8%
m4
N2

mN
 r 
FVN  PV1  s 
 m
 $10,000(1.02)8
 $11,716.59
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Frequency of Compounding

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 Continuous Compounding
 Interest can be compounded in discrete intervals
such as daily, monthly or quarterly, or it can
compound continuously.
For continuous compounding we use,

FVN  PVe rs N
e  2.7182818

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 Present Value (PV)
 Present value is the amount of money today that yields a
certain amount in the future at a fixed rate of interest.
 Suppose we loan someone an amount of PV today for n years
at a rate of r p.a. What is the total amount to be repaid after n
periods?

FV = PV(1 + r )n .

FV n
PV   FV (1  r )
(1  r ) n

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Figure :The Relation Between an Initial Investment
(PV), and Its Future Value (FV)

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 Present Value of a Lump Sum
 An insurance company promises to pay
$100,000 in six years with an 8% rate. What
amount must the insurer invest today at 8% to
make the promised payment?
 1 
PV  FVN  N
 (1  r ) 
 1 
 $100,000  6
 (1  .08) 
 $63,016.96

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Present Value of a Lump Sum
 Find the present value of 5 million received 10 years
from today if the interest rate is 6% and monthly
compounding is used.

 mN
 rs 
PV  FVN 1  
 m
12 (10 )
 .06 
 5,000,0001  
 12 
 2,748,163.67

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Present Value with Continuous
Compounding

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 Stated and Effective Rates

 Stated rates do not account for the number of

compounding periods and so we need to
compute the effective annual rate (EAR)

EAR  (1  Periodic interest rate)  1

m

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Present Value (PV) and Future Value (FV)

1/ N
 FV 
r  1
 PV 
ln( FV / PV )
N
ln(1  r )
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 Solving for Interest Rates/Growth Rates

 Limited Brands, Inc. recorded net sales of $8,436

million in 1998 and $8,445 in 2002. What is the
annual growth rate from 1998 to 2002?

r  4 8,445 / 8,436  1
 1.000267  1
 0.000267
 Solving for Number of Periods to Reach a
Certain Value

 Suppose we are interested in the number of periods it

takes to double our money.
(1  r ) N  2

taking the natural log of both sides yields,

N ln(1  r )  ln(2)

ln(2)
N
ln(1  r )
 Stated and Effective Rates
 Find the EAR if the stated interest rate is 8%
and semiannual compounding is used.
m
 rs 
EAR  1    1
 m
2
 .08 
 1   1
 2 
 .0816

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 Stated and Effective rates

 Suppose the EAR is 16% and let’s say semi

annual compounding is used what is the
periodic rate?
m
 rs 
EAR   1   1
 m 
rs
(( 0 . 16  1 ) 1/ 2
 1) 
m
 . 0770
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 Stated and Effective Rates

 The effective annual rate with continuous

compounding is

EAR  e  1 rs

 Find the EAR under continuous compounding

if the stated annual rate is 4%?
EAR  e 0.04
 1  0.040811
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The Future Value of a Series of Cash Flows

 Suppose we save $1000 each period

(beginning next year) at an interest rate of 5%
for 5 periods, how much money will we have
after the last deposit is made?

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 Annuity
Annuity: a series of equal spaced and level sequential cash
flows extending over a finite number of periods.

• (Ordinary) Annuity:

• Annuity due:
An immediate cash flow + ordinary annuity

• Perpetuity: cash flow continues forever

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 The Future Value of (Ordinary) Annuity

FV  A[(1  r) N 1  (1  r) N 2  (1  r) N 3  . . .  (1  r)  1]

which simplifies to
 (1  r) N  1
FV  A  
 r 

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 Geometric Progression/series
(NOT examinable)

A sequence in which each element is obtained by multiplying

the preceding element by a constant.
n

x
k 0
k
 x 0  x1  x 2  x 3  . . .  x n

n
(1  x) x k
k 0

n
1  x n 1  n
 x m  x n 1 
 A  x  A
k
,  A  x  A
k

k 0  1- x  k m  1 - x 

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 The Present Value of Annuity

 Suppose you will receive $A each period for

N periods (beginning next year) with interest
rate of r, what is this stream of payments
worth today?
A A A A A
PV     ...  N 1

(1  r) (1  r) (1  r) (1  r) (1  r)
N 2 3 N

which simplifies to

 1 
 1  
(1  r) N
PV N  A  
 r 
 

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 Examples: Ordinary Annuity

 How much you should pay to receive 1,000 per

year for 5 yrs, with the first payment one year
from now and if the required return is 12%?

 1 
1 
 (1  r) N 
PV N  A  
 r 
 
 1 
1 
 (1  .12) 5 
 1,000  
 .12 
 
 3,604.78

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 Annuity due:
An immediate cash flow + ordinary annuity
 Suppose you will receive $200,000/yr for 20 years, with the
first payment today. What is the PV if the interest rate is 7%?
 1 
1 
 (1  r) N -1 
PVN  A  A  
 r 
 
 1 
1 
 (1  .07)19 
 200,000  200,000  
 .07 
 
 200,000  2,067,119.05
 2,267,119.05

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 Perpetuity

 What is $A received every year (beginning next

year) forever, worth to us today?

 1 
PVN  A   t 
t 1  (1  r) 
which simplifies to

A
PVN 
r
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 Present Value of a Perpetuity
 A British consol bond promises to pay £100
per year in perpetuity. If the required rate is
5%, what is the bond worth today?
A
PV N 
r
100

0 . 05
 2 , 000

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 Solving for the Annuity

If we want to accumulate FV in N periods, what

amount, A, do we need to deposit each period to
reach this goal.

FV
A
 (1  r ) N  1
 
 r 

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 Computing the Annuity that will Grow to FV

 Suppose you would like to save for 30 years (beginning next

year). How much will you need to save each year so you will
have $1 million after the last deposit is made if the interest
rate is 6%?

FV $1,000,000
A   $12,648.91
 (1  r )  1  (1.06)  1
N 30

   
 r   .06 

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 Solving for the Annuity
 If we borrow certain ammount, what is the
annuity, A, that will be needed to repay the loan.

PV
A
 1 
1 
 (1  r ) N 
 
 r 
 

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Annuity payments

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