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Level 1

SS 2

Quantitative Methods (QM)

Expect to see 28 questions that relate to QM, SS 2 and SS3


14 questions from SS2 and 14 questions from SS3

If you can handle the follow items from SS2 you should be in good shape for the exam.
1. Calculate EAR given stated annual interest rate
2. Calculate PV and FV for Annuities and Lump Sums and Perpetuities
3. Calculate NPV and IRR
4. State Problem with IRR
5. Calculate HPR (Total Return)
6. Calculate TWRR and MWRR
7. State difference between TWRR and MWRR
8. Calculate BDY, HPR, EAY, BEY and MMKT YIELD for a T-Bill
9. Calculate relative and cumulative frequencies
10. Comment on dataset presented
11. Calculate mean, Geometric Mean, harmonic mean, median and mode
12. Calculate range, mean absolute
13. Calculate standard deviation for a sample
14. Use Chebyshev
15. Calculate CV and Sharpe
16. Comment on skewness
17. Calculate covariance and correlation using probabilities
18. Calculate standard deviation using probability
19. Calculate standard deviation and expected return for a portfolio
20. Use Bayes formula
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EAR Example:
Calculate the EAR given the following situations:
a) 8% return compounded semiannually
b) 8% return compounded monthly
TVM Examples:
1.
As of January 1, 2006, an annuity offers $5,000 per year for seven years with the first payment due
January 1, 2011. If the annual interest rate is 11.5%, what is the present value of the annuity?
A
B
C
D
2.

$13,453
$23,185
$15,000
$30,348

What is the present value of a ten-payment annuity of $1,000 at 8% interest?


A
B
C
D

$5,002
$6,247
$6,710
$7,247

MWRR vs. TWRR Example:


An equity portfolio is worth $10,000 at the beginning for the year. After 6 months the portfolio pays a dividend
of $100 and the investor contributes $300 more to the portfolio. Just before the contribution and dividends, the
portfolio was worth $10,050. At the end of the year, the investor receives $100 in dividends and withdraws an
additional $150 from the portfolio, which has an ending value of $10,700 after the withdrawal has been made.
1. Calculate the MWRR

2. Calculate the TWRR

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T-Bill Example:
A T-Bill matures in 75 days and has a yield of 3.75%
Based on the information given above, calculate the following:
a) Holding Period Return
b) Money Markey Yield
c) Bank Discount Yield
d) Effective Annual Yield

Measures of Central Tendency Examples:


1.
A portfolio manager generates a 5% return in 2009, a 12% return in 2010, a negative 6% return in 2011
and a return of 2% (unannualized) in the first quarter of 2012. The annualized return for the entire period
is:
A
B
2.

4.59%
3.76%

Sharpe ratio
0.333
2.222
3.00
0.333

Coef. of Variation
0.80
0.1875
1.25
1.25

You are looking at an asset with a mean return of 15% and a standard deviation of 5%. Using
Chebyshevs Inequality as an approximation, what is proportion of the assets returns should fall in the
interval (0%, 30%)?
A. 75%.
B. 33%.

4.

4.16%
3.25%

Company As returns exhibit a variance of 0.0225 and a mean return of 0.12. Assume the risk free rate is
0.07, what is the Sharpe ratio and Coefficient of Variation for Company A?
A.
B.
C.
D.

3.

C
D

C. 89%.
D. 11%.

An investor gathers the following P/E Ratio data for MOT, AAPL and RIMM common shares:
MOT: 29x
AAPL: 55x
RIMM: 76x
Based on the information given above, the harmonic mean is closest to:
A. 53.3x
B. 19.9x

C. 15.9x
D. 52.1x

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Questions 8 and 9 are based on the following information.


Probability
Stock X
Stock Y

Bear Market
0.2
-20%
-15%

Normal Market
0.5
18%
20%

Bull Market
0.3
50%
10%

8. Based on the information above calculate:


a) The expected return for Stock X and Stock Y.

b) The standard deviation for Stock X and Stock Y.

c) The covariance for Stock X and Stock Y.

d) The correlation for Stock X and Stock Y.

9. Based on the information above and your answers to parts a) to d) calculate:


a) The portfolio expected return, assuming that an investor holds 60% of his assets in Stock Y.

b) The portfolio standard deviation, assuming that an investor holds 60% of his assets in Stock Y.

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Bayes Example:
1.
An analyst expects that 10 percent of all publicly traded companies will experience a decline in earnings
per share (EPS) next year. This analyst has developed a ratio to help forecast a decline in a companys
EPS. If a company is headed for an EPS decline, there is a 70 percent probability that the ratio will be
negative. If the company is not headed for an EPS decline, there is a 20 percent probability that the ratio
will be negative. The analyst randomly selects a company and its ratio is negative. Based on Bayes
theorem, the posterior probability that the company will experience an EPS decline next year is closest
to:
A.
B.
C.
D.

3%.
7%.
18%.
28%.

Geometric Mean vs. Arithmetic Mean:

Example:
1.
Knowing that you are a CFA Level 1 Candidate, your boss has asked you to comment on the following
statements made by the one of the investment managers at the last investor conference.
Statement I:

The geometric mean is more representative than the arithmetic mean as a measure of
central tendency of a data set when it has large outliers.
Statement II. The geometric mean is larger than the arithmetic mean when a distribution is negatively
skewed.
Based on the information presented above, you would be most likely to reply:
A.
B.
C.
D.

Only statement I is correct.


Only statement II is correct.
Statement I and statement II are both correct.
Statement I and statement II are both incorrect.

Answers:
Bayes Example: D
Geo Mean Example: A
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Mean Absolute, Variance and Standard Deviation of a Sample:


The mean absolute deviation represents the mean of the absolute values of the deviations from the mean.

The variance is the mean of the squared deviations from the mean. The standard deviation is the positive
squared root of the variance.

Example:
Given the following sample data, calculate the mean absolute, the variance and the standard deviation.
65

69

71

56

60

Mean Absolute:
XAB = Actual - Expected
n

Variance:
2 = (Actual Expected)2
n-1

Standard Deviation:

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Skewness:
In a distribution skewed to the left (negatively skewed):
Mean < Median < Mode
In a distribution skewed to the right (positively skewed):
Mode < Median < Mean

Example:
1.
Knowing that you are a CFA Level 1 Candidate, your boss has asked you to comment on the following
statements made by the one of the investment managers at the last investor conference.
In a negatively skewed distribution the 90th Percentile is smaller than the 10th
percentile.
Statement II: In a positively skewed distribution the mean is greater than the median and this last one
in turn is greater than the mode.
Statement I:

Based on the information presented above, you would be most likely to reply:
A.
B.
C.
D.

Only statement I is correct.


Only statement II is correct.
Statement I and statement II are both correct.
Statement I and statement II are both incorrect.

Answer:
Skewness Example: B
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Frequency Distribution Example:


The annual returns of 708 Portfolio Managers were measured relative to the market index. Of the 708 PMs, 117
matched the index return exactly, (ie. Alpha = 0). The rest of the performance data is given below. Based on
this information calculate the ?
missing items.

Alpha

Absolute
Frequency

Cumulative
Frequency

Relative
Frequency

0
1
2
3
4
5
6
7
8
9
10
11

117
157
158
115
78
?
21
7
6
1
3
1
708

117
274
432
?
625
669
690
697
703
704
707
708

.165
.222
?
.162
.110
.062
.030
.010
.008
.001
.004
.001
.998

Cumulative
Relative
Frequency
.165
.387
.610
.773
.883
?
.975
.983
.993
.994
.999
1.000

Based on the data above, calculate the following:


a) The percentage of PMs who had an Alpha of 1 or less.
= 0.165 + 0.222 = 0.387 or 38.7%

b) The proportion of PMs who had Alphas of 8 and above.


= 0.008 + 0.001 + 0.004 + 0.001 = 0.14 or 14%

c) The percentage of PMs who had an Alpha between 4 and 7.


= 0.110 + 0.062 + 0.30 + 0.10 = 0.212 or 21.2%

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Probability Concepts:
Combinations: When Order Does Not Matter
nCr

n!
.
(n r)!(r!)

Permutations: When Order Does Matter


nP r

n! .
(n r)!

Examples:
1.
You hold 10 stocks and wish to sell 6 of them. How many possible combinations are there:

2.

a)

if order is unimportant?

b)

if order is important?

A portfolio manager has a list of 12 recommended stocks to hold in her portfolio. She is constrained to
hold exactly 6 stocks in her portfolio but can choose among any on the recommended list. How many
possible portfolios are possible given these constraints?
A.
B.
C.
D.

12!.
6!.
12!/6!.
12!/(6! 6!)

Answers:
a)
nCr = 10! / [(6!)(4!)] = 3,628,800 / [(720)(24)] = 210
b)
nPr = 10! / (4!) = 3,628,800 / 24 = 151,200
2.D

Note that in constructing the portfolio the order of the companies chosen is not important, therefore the
correct formula is the combination formula.

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