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CFA Level 1 - Section 2 QuantitativeRatings:

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03/18/2014

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CFA Level 1 - Quantitative Methods

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2.1 - Introduction

The Quantitative Methods section of the CFA curriculum has traditionally been placed second in the sequence

of study topics, following the Ethics and Professional Standards review. It's an interesting progression: the

ethics discussions and case studies will invariably make most candidates feel very positive, very high-minded

about the road on which they have embarked. Then, without warning, they are smacked with a smorgasbord of

formulas, graphs, Greek letters, and challenging terminology. We know \u2013 it's easy to become overwhelmed. At

the same time, the topics covered in this section \u2013 time value of money, performance measurement, statistics

and probability basics, sampling and hypothesis testing, correlation and linear regression analysis \u2013 provide the

candidate with a variety of highly essential analytical tools and are a crucial prerequisite for the subsequent

material on fixed income, equities, and portfolio management. In short, mastering the material in this section

will make the CFA's entire Body of Knowledge that

much easier to handle.

The list of topics within Quantitative Methods may

appear intimidating at first, but rest assured that one does

not need a PhD in mathematics or require exceptional

numerical aptitude to understand and relate to the

quantitative approaches at CFA Level 1. Still, some

people will tend to absorb quantitative material better

than others do. What we've tried to do in this study guide

is present the full list of topics in a manner that

summarizes and attempts to tone down the degree of

technical detail that is characteristic of academic

textbooks. At the same time, we want our presentation to

be sufficiently deep that the guide can be effectively utilized as a candidate's primary study resource. For those

who have already purchased and read the textbook, and for those who already clearly understand the material,

this guide should allow for a relatively speedy refresher in those hectic days and weeks prior to exam day.

Along the way, we'll provide tips (primarily drawn from personal experience) on how to approach the CFA

Level 1 exam and help give you the best chance of earning a passing grade.

2.2 - What Is The Time Value Of Money?

The principle of time value of money \u2013 the notion that a

given sum of money is more valuable the sooner it is

received, due to its capacity to earn interest \u2013 is the

foundation for numerous applications in investment

finance.

Central to the time value principle is the concept of

interest rates. A borrower who receives money today for

consumption must pay back the principal plus an interest

rate that compensates the lender. Interest rates are set in

the marketplace and allow for equivalent relationships to be determined by forces of supply and demand. In

other words, in an environment where the market-determined rate is 10%, we would say that borrowing (or

lending) $1,000 today is equivalent to paying back (or receiving) $1,100 a year from now. Here it is stated

another way: enough borrowers are out there who demand $1,000 today and are willing to pay back $1,100 in a

year, and enough investors are out there willing to supply $1,000 now and who will require $1,100 in a year, so

that market equivalence on rates is reached.

Exam Tips and Tricks

The CFA exam question authors frequently test knowledge of

FV, PV and annuity cash flow streams within questions on

mortgage loans or planning for college tuition or retirement

savings. Problems with uneven cash flows will eliminate the

use of the annuity factor formula, and require that the

present value of each cash flow be calculated individually,

and the resulting values added together.

2.3 - The Five Components Of Interest Rates

CFA Institute's LOS 5.a requires an understanding of the

components of interest rates from an economic (i.e. non-

quantitative) perspective. In this exercise, think of the

total interest rate as a sum of five smaller parts, with each

part determined by its own set of factors.

1.Real Risk-Free Rate \u2013 This assumes no risk or

uncertainty, simply reflecting differences in

timing: the preference to spend now/pay back later

versus lend now/collect later.

2.Expected Inflation - The market expects

aggregate prices to rise, and the currency's

purchasing power is reduced by a rate known as the inflation rate. Inflation makes real dollars less

valuable in the future and is factored into determining the nominal interest rate (from the economics

material: nominal rate = real rate + inflation rate).

3.Default-Risk Premium - What is the chance that the borrower won't make payments on time, or will be unable to pay what is owed? This component will be high or low depending on the creditworthiness of the person or entity involved.

4.Liquidity Premium- Some investments are highly liquid, meaning they are easily exchanged for cash

(U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss

expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must

compensate the holder by offering a higher interest rate.

5.Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate

fluctuations the longer to maturity it is.

<< Back

Next >>

2.4 - Time Value Of Money Calculations

Here we will discuss the effective annual rate, time value of money problems, PV of a perpetuity, an ordinary annuity, annuity due, a single cash flow and a series of uneven cash flows. For each, you should know how to both interpret the problem and solve the problems on your approved calculator. These concepts will cover LOS' 5.b and 5.c.

The Effective Annual Rate

CFA Institute's LOS 5.b is explained within this section. We'll start by defining the terms, and then presenting

the formula.

The stated annual rate, or quoted rate, is the interest rate on an

investment if an institution were to pay interest only once a year.

In practice, institutions compound interest more frequently,

either quarterly, monthly, daily and even continuously.

However, stating a rate for those small periods would involve

quoting in small fractions and wouldn't be meaningful or allow easy comparisons to other investment vehicles;

as a result, there is a need for a standard convention for quoting rates on an annual basis.

The effective annual yield represents the actual rate of return, reflecting all of the compounding periods during

the year. The effective annual yield (or EAR) can be computed given the stated rate and the frequency of

compounding. We'll discuss how to make this computation next.

Formula 2.1

Effective annual rate (EAR) = (1 + Periodic interest rate)m \u2013 1

Where: m = number of compounding periods in one year, and

periodic interest rate = (stated interest rate) / m

Example: Effective Annual Rate

Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we get for EAR:

EAR = (1 + (0.09/12))12 \u2013 1 = (1.0075)12 \u2013 1 = (1.093807) \u2013 1 = 0.093807 or 9.38%

Keep in mind that the effective annual rate will always be higher than the stated rate if there is more than one

compounding period (m > 1 in our formula), and the more frequent the compounding, the higher the EAR.

Solving Time Value of Money Problems

Approach these problems by first converting both the rate r and the time period N to the same units as the

compounding frequency. In other words, if the problem specifies quarterly compounding (i.e. four

compounding periods in a year), with time given in years and interest rate is an annual figure, start by dividing

the rate by 4, and multiplying the time N by 4. Then, use the resulting r and N in the standard PV and FV

formulas.

Example: Compounding Periods

Assume that the future value of $10,000 five years from now is at 8%, but assuming quarterly compounding, we

have quarterly r = 8%/4 = 0.02, and periods N = 4*5 = 20 quarters.

FV = PV * (1 + r)N = ($10,000)*(1.02)20 = ($10,000)*(1.485947) = $14,859.47

Assuming monthly compounding, where r = 8%/12 = 0.0066667, and N = 12*5 = 60.

FV = PV * (1 + r)N = ($10,000)*(1.0066667)60 = ($10,000)*(1.489846) = $14,898.46

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