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CFA Level 1 - Section 2 Quantitative

CFA Level 1 - Section 2 Quantitative

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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
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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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