Quantitative Analysis B

Expected Correlation &

Time Value Descriptive Probability Central limit Hypothesis Technical Means Variance & Measurement Sharpe Ratio
Probability Return / Std. Covariance
of Money Statistics Distributions theorem testing Analysis Std. Deviation Scales
Deviation

A B
Normal
Distribution
• Described by mean & variance
• Symmetric about its mean
• Standard Normal Distribution
- Mean = 0; Variance =1
68% of Data
95% of Data
N
 Xi  Measures excess return per unit
C D E Arithmetic mean: =   N 
i 1
BA BB BC of risk. p
 f
r r
Correlation = Corr(Ri, Rj) =
Cov(Ri, Rj) / σ(Ri)*σ(Rj)

• Supply-Demand dictate prices Sharpe ratio:
Expected return, Variance of 2-
Normal Distribution Binomial Distribution • Driven by rational & irrational
behavior
Geometric mean: Calculating Coef f icient of p
Roy’s saf ety- First ratio:
r r
p t arg et stock portfolio:

investment returns over variation E(Rp) = wAE(RA) + wBE(RB)
• Prices move in trends that multiple period or to measure p
VaR(Rp) =wA2σ2(RA)+ wB2σ2(RB)
Discrete Distribution: Sharpe Ratio uses risk f ree rate,
persist f or long periods compound growth rates +2wA wBσ(RA) σ(RB)ρ(RA,RB)
• Variables can take 2 values Roys Ratio uses Min. hurdle rate
Skewness and • Observe the actual shifts in RG = [(1+R1)*..*(I+RN )]1/N -1 Dispersion relative to
Z-Score (success / f ailure) For both ratios, larger is better.
Kurtosis supply / demand in market price mean of a distribution;
• Variance is constant
• Can describe changes in the
N
 1  CV=σ/μ (σ is std dev.)
value of an asset or portf olio
Harmonic mean =   X  Q. σ2 return of stock P=100.0
No. of σ a given Two views to analyze i 1  i Q. If the threshold return is higher than the
• Mean = np, variance = np(1-p) • σ2 return of stock Q=225.0
FA observation is away • Contrarian: Majority is wrong; Do risk-f ree rate, what will be the relationship b/w
• Cov(P, Q) =53.2
f rom population mean. the opposite majority Roy’s saf ety-f irst ratio (SF) and Sharpe’s ratio?
Q. ABC was inc. on Jan 1, 2004. Its • Current Holding $1 Mn in P.
Z=(x-µ)/σ Q.The Prob. of a stock moving • Follow the smart money: Smart • Denominator (Sharpe) = Denominator (SF)
expected annual def ault rate of • New Holding: $1 million in Q and $3 million in
up is 0.8 and moving down is investors know best; follow the • Rtarget > Rf
10%. Assume a constant quarterly stock P. what %age of portf olio risk (σP) is
Q. At a particular time, the 0.2 in a particular day. What is trend and momentum • R – Rf > R - Rtarget
def ault rate. What is the probability reduced?
market value of assets of the the probability that it would • Sharpe > SF
that ABC will not have def aulted by Ans.
f irm is $100 Mn and the move up at least twice in the 5 Ans. R – Rf > R - Rtarget
σP= w  A  (1 - w)  B  2w(1- w) Cov(A, B)
2 2 2 2
Contrarian: April 1, 2004?
market value of debt is $80 working days of the week?
• Mutual f und ratio = mutual f und cash Ans. P(No Def ault Year) = P(No def w= 0.75
Mn. The standard deviation Ans. P=0.8, q=0.2, n=5
/ total f und assets all Quarters) BA σP 2 = 100*(0.75)2 + 225*(0.25)2+2*0.25*0.75*53.2
of assets is $ 10 Mn. What is P(X>=2) = 1-P(X=0) – P(X=1)
• CBOE put call ratio = puts / call = (1-PDQ1)*(1-PDQ2)*(1-PDQ3 ) * σP= 9.5 old σ = √100 = 10
the distance to def ault? =1- nCr(5,0)*(0.8)0*(0.2)5 –
• Volume ratio = OTC volume / NYSE (1-PDQ4) Reduction = 5%
Ans. z = (A-K) / σA nC (5,1)*(0.8)1*(0.2)4
r
volume PDQ1=PDQ2=PDQ3=PDQ4=PDQ
= (100-80)/10 = 1- (0.2)5 – 5*(0.8)1*(0.2)4 Average of squared deviations f rom
• Investment advisory services = P(No Def Year) = (1-PDQ)4

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N
 X i  m
99.7% of Data =2

= 0.99328 mean.
2
BC
bearish opinions / total opinions P(No Def Quarter) = (0.9)4 = 97.4%
-3 -2 -1 0 1 2 3 4 • Investor credit balances in brokerage Population variance σ2 = i 1
If Z is a standard normal R.V. An event X is defined to happen if either -1< Z < 1 or N
Z > 1.5. What is the prob. of event X happening if N (1) =0.8413, N (0.5) = 0 .6915 accounts 2
• Stock index f utures N
 

  X
and N (-1.5) = 0.0668, where N is the CDF of a standard normal variable? Expected Return E(X)=P(x 1)x 1+P(x 2)x 2+…….+P(x n)x n
Ans. P(X)= P(-1< Z < 1) + P(Z > 1.5) Sample variance s 2= i X
Follow the smart money: 
 P( x )[ x
i 1
= N(1)-(1-N(1)) + N(-1.5) • Conf idence index = quality bond yield  E ( X )]2
= 2*0.8413-1 + 0.0668 Standard deviation: n 1 Probabilistic variance: σ2(x)= i i
= 0.7494 / average bond yields
• T-bill Eurodollar yield spread σ or s= Variance
-1 +1 1.5 =P(x 1)[x 1-E(X)] 2+P(x 2)[x 2-E(X)] 2+…….+P(x n)[x n-E(X)] 2
• specialist short sale ratio =
specialists’ short sales/total short sales
• Debit balances in brokerage accounts
C

• Pristine is authorized training provider for CFA®, FRM®, Counting principles Def inition & Properties Sum rule and Baye’s theorem

PRM and Other global certifications • P(A) = no. of f av. Events / Total

• Founded by industry professionals of IIT/IIMs No. of ways select r

out of n objects:
• High success rate nC = n!/(r!*(n-r)!)
r r
• Complimentary free online classes Q. A portfolio consists of 17
• Free Mock Tests, Visualize CFA® charts
uncorrelated bonds. The 1-year
marginal def ault prob. of each bond
is 5.93%. If spread of def ault prob.
No. of ways arrange r
objects in n places:
possible events
• 0 < P(A) <1, P(Ac )=1-P(A)
• P(B)= P(A∩B)+ P(A c ∩B)
= P(B│A)*P(A) + P(B│A c )*P(Ac )
• P(AUB)=P(A)+P(B)-P(A∩B)
nP =n!/(n-r)!
• P(A|B)=P(B│A)*P(A) / [P(B│A)*P(A)
• If A,B Mutually exclusive: +P(B│Ac )*P(Ac )]
P(AUB)=P(A)+P(B)
• P(A│B)= P(A∩B)/P(B)
• P(A∩B)=P(A│B)P(B)
Q. The subsidiary will def ault if the
•If A,B Independent:
P(A∩B)=P(A)P(B) parent def aults, but the parent will not
necessarily def ault if the subsidiary

• Placement Support is even over the year, Calculate

prob. of exactly 2 bonds def aulting • Empirical probability: derived f rom historical data
def aults. Calculate Prob. of a
subsidiary & parent both def aulting.
in f irst month? • Priori probability: derived by f ormal reasoning Parent has a PD = .5% subsidiary has
Ans. 1-month def ault rate = • Subjective probability: derived by personal judgment PD of .9%
1-(1-0.593)1/12= 0.00508 Ans. P(P∩S) = P(S/P)*P(P)
Selection of 2 bonds out of = 1*0.5%
17= 17C2=(17*16)/2 = 0.5%
P(Exactly 2 def aults) =
(17*16/2)*(0.00508)2 * (1-0.00508)15 D
= 0.325%

Central limit theorem Sampling Distribution Standard Error (SE)

Probability distribution of all possible SE (σx ) of the sample mean is σ

sample statistics computed f rom a
Contact Us: set of equal-size samples randomly
drawn f rom the same population
of the dist. of sample means
• Known pop. Var. σx = σ/ √(n)
• Unknown pop. var s x = s/ √(n)

Maitri +91 99308 65533 maitri@edupristine.com

Q. 25 observation are taken f rom a sample of unknown variance.
Sarita +91 95601 02806 sarita@edupristine.com Sample mean of 70 and σ = 60. You wish to conduct a 2-tailed test of
null hypothesis that the mean is equal to 50. What is most appropriate
test statistic?
Ans. Standard Error of mean (σx ) = σ/ √(n) = 60/sqrt(25) = 12

VisualizeCFATM VisualizeFRMTM As Sample Size increases, Sampling Distribution Becomes

Almost Normal regardless of shape of population
Degrees of f reedom = 24
Use t-statistic = (x – μ)/ σx = (70 – 50)/12 = 1.67

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