Quantitative Methods - Reading 6-9

QUANTITATIVE METHODS: BASIC CONCEPTS
THE TIME VALUE OF MONEY

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READING 6 THE TIME VALUE OF MONEY 2

INTERPRETATION OF INTEREST RATES
Interest rates can be thought of in three ways:
 Required rate of return is the minimum rate of return an investor must receive
in order to accept the investment.
 The discount rate is the rate that must be applied to a cash flow in order to
determine its present value.
 The opportunity cost is the value that investor forgo by choosing a particular
course of action.

INTEREST RATE AS THE SUM OF A REAL RISK-FREE RATE, AND PREMIUMS THAT
COMPENSATE INVESTORS FOR BEARING RISKS
COMPENSATION
FOR THE RISK OF
LOSS RELATIVE TO
REFLECTS THE TIME AN INVESTMENT’S
PREFERENCES OF FAIR VALUE IF THE
INDIVIDUALS FOR INVESTMENT
CURRENT VERSUS NEEDS TO BE
FUTURE REAL CONVERTED TO
CONSUMPTION. CASH QUICKLY
REAL EXPECTED DEFAULT

INTEREST LIQUIDITY MATURITY
RISK‐FREE INFLATION RISK
RATE PREMIUM PREMIUM
RATE PREMIUM PREMIUM
COMPENSATION COMPENSATION
FOR POSSIBILITY FOR INTEREST
NOMINAL THAT THE RATE SENSITIVITY
RISK‐FREE BORROWER WILL
RATE FAIL TO MAKE A (LONG-TERM
PROMISED DEBTS MORE
PAYMENT IN TIME SENSITIVE,
AND IN FULL OTHER THINGS
AMOUNT EQUAL)

CALCULATE AND INTERPRET THE EFFECTIVE ANNUAL RATE, GIVEN THE STATED
ANNUAL INTEREST RATE AND THE FREQUENCY OF COMPOUNDING
Saving account after 1 year
𝐹𝑉1 = 𝑃𝑉 + 𝑃𝑉 × 𝑟𝑎𝑡𝑒 = 𝑃𝑉(1 + 𝑟𝑎𝑡𝑒)
Saving account after 2 years
𝐹𝑉2 = 𝐹𝑉1 + 𝐹𝑉1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉1 (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 2
…
Saving account after n years
𝐹𝑉𝑛 = 𝐹𝑉𝑛−1 + 𝐹𝑉𝑛−1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉𝑛−1 × (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 𝑛
𝐹𝑉𝑛 = 𝑃𝑉 × (1 + 𝑟) 𝑛

The stated annual rate (SAR) is a rate used in calculation of EAR.

The effective annual rate (EAR) – is a rate which an investor really gets.
SAR does not account for intra-year compounding, while EAR does.
Suppose the stated annual interest rate on a savings account is 10%, and you put
$100 into this savings account.
If there is no intra-year compounding, then after one year, it would be $110.
EAR = SAR
But, if the account has a intra-year compounding feature, then effective rate of
return will be higher than 10% and it would be more than $110
EAR ≥ SAR

EXAMPLE
Stated annual interest rate on a savings account with quarterly compounding
feature is 10%. The initial investment is $100.
WITHOUT WITH
QUARTER DIFFERENCE
COMPOUNDING COMPOUNDING
0 100 100 -
1 102,5000 102,5000 -
2 105,0000 105,0625 +0.0625
3 107,5000 107,6891 +0.1891
4 110,0000 110,3813 +0.3813

EAR = (1 + 𝑟/𝑚)𝑚 −1
r – SAR (another name is annual percentage rate (APR))
m - the number of compounding periods per year
Sberbank offers an account that pays 9%, compounded monthly, for any deposits
of 10 000 000 RUB or more that are left in the account for a period of 5 years.
The effective annual rate of interest on this account is:
SAR = 9% and m = 12
then
EAR = (1 + 9%/12)12 −1 ≈ 9.38%

As number of compounding periods per year increases EAR increases but at

decreasing rate.
M EAR
1 (no intra-year compounding) 9,0000%
2 (semi-annually) 9,2025%
4 (quarterly) 9,3083%
12 (monthly) 9,3807%
365 (daily) 9,4162%
525 600 (every minute) 9,4174%

DISCRETE AND CONTINUOUS
As number of compounding periods per year goes to infinity (continuous

compounding) EAR goes to its upper limit.
𝑟 𝑚
𝐸𝐴𝑅 = lim (1 + ) −1 = 𝑒 𝑟 − 1
𝑚→∞ 𝑚

QUESTION
John has funds on deposit with ABC bank. It is currently earning 2% interest.
If he withdraws $500 to purchase a laptop, the 2% interest rate can be best
thought of as a(n):
A) discount rate.
B) opportunity cost.
C) required rates of return.
2% interest can be best characterized as an opportunity cost - the return he could

earn by postponing his laptop purchase until the future.

QUESTION
Mr. Holmes has just inherited 70 000 pounds and wants to set some of it aside for a
vacation in France one year from today. His bank account earns 1% interest. To
determine how much must be set aside and held for the vacation, he should use
the 1% as a:
A) opportunity cost.
B) discount rate.
C) required rates of return.
He needs to figure out how much the trip will cost in one year, and use the 1% as a
discount rate to convert the future cost to a present value.
QUESTION
Yield of short-term highly liquid OFZ (Russian government bond nominated in

Russian rubles) can be thought of as:
A) real risk-free rates because they contain an inflation premium.
B) nominal risk-free rates because they do not contain an inflation premium.
C) nominal risk-free rates because they contain an inflation premium.
OFZ is a government issued security and is therefore considered to be default risk

free. Short-term and highly liquid mean that bond is maturity risk free and liquidity
risk free respectively.
QUESTION
Which one of the following statements best describes the components of the
required interest rate on a security?
A) The nominal risk-free rate, average inflation rate, the default risk premium, a
liquidity premium and a premium to reflect the risk associated with the maturity of
the security.
B) The real risk-free rate, the default risk premium and the liquidity premium.
C) The real risk-free rate, the expected inflation rate, the default risk premium, a
liquidity premium and a premium to reflect the risk associated with the maturity of
the security.
The components of the required interest rate are the nominal rate (the real risk-
free rate plus the expected inflation rate), the default risk premium, the liquidity
premium and premium to reflect the risk associated with the maturity of the
security.
QUESTION
As the number of compounding periods increases, what is the effect on the EAR?
A) EAR increases at a decreasing rate.
B) EAR decreases at an increasing rate.
C) EAR remains the same.
As number of compounding periods increases the value of EAR goes to its upper
limit (𝑒 𝑆𝑡𝑎𝑡𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 −1)

QUESTION
Microfinance company offers you to borrow $10 loan and repay $11 one week later.
Assuming 52 weeks in one year. What would the stated annual interest rate and
EAR be on this loan, with weekly compounding.
A) 520%, 18027%
B) 10%, 14104%
C) 520%, 14104%
Stated Weekly Rate= 11/10 − 1 = 10%

Stated Annual Rate = 10% * 52 = 520%
520% 52
EAR = (1 + ) −1 = 14104%
52

SOLVE TIME VALUE OF MONEY PROBLEMS FOR DIFFERENT
FREQUENCIES OF COMPOUNDING
𝑟 𝑡𝑚
𝐹𝑉 = 𝑃𝑉 1 +
𝑚
If you had $100 right now, and interest rates were 10% with quarterly
compounding, what would be the FV of your money in three years?
𝑃𝑉 = 100
𝑟 = 10%
m =4
𝑡 =3
0.10 3х4
𝐹𝑉 = 100 (1 + ) = 134.491
4

SINGLE CASH FLOW FORMULAS
𝑟 𝑡𝑚
𝐹𝑉 = 𝑃𝑉 1 +
𝑚
𝐹𝑉
𝑃𝑉 = 𝑡𝑚
𝑟
1+
𝑚
𝑟 𝑡𝑚 𝐹𝑉
= −1
𝑚 𝑃𝑉
𝐹𝑉
𝑡𝑚 = 𝑙𝑜𝑔(1+ 𝑟 )
𝑚 𝑃𝑉

𝐹𝑉𝑛
𝑃𝑉 =
(1 + 𝑟)𝑛
Calculating the PV involves determining the value in today’s terms of a cash flow
or cash flow stream that will be received in the future.
If you were offered a payment of $103 a year from today, and interest rates were
3%, calculating the PV of this cash flow would involve determining the amount,
which invested today at 3%, would yield $103 in a year.
𝐹𝑉 = 103
𝑟 = 3%
n =1
103
𝑃𝑉 = = 100
(1 + 3%)1

AN ORDINARY ANNUITY, AN ANNUITY DUE AND A PERPETUITY
Calculating FVs and PVs for annuities is different from calculating FVs and PVs for
single cash flows because we have to find the value of a stream of periodic
payments.
SET OF IDENTICAL CASH FLOWS
FINITE SET INFINITE SET
CASH FLOWS OCCUR CASH FLOWS OCCUR

AT THE END OF EACH AT THE BEGINNING OF
COMPOUNDING EACH COMPOUNDING PERPETUITY
PERIOD. PERIOD.
ORDINARY ANNUITY
ANNUITY DUE

FORMULA OF SUM OF GEOMETRIC SEQUENCE
Sum of geometric sequence 𝑏 − first term

𝑆 = 𝑏 + 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞𝑛−1 𝑞 − common ratio
Let’s multiply both sides by q

𝑆𝑞 = 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞𝑛−1 + 𝑏𝑞𝑛
Let’s add b to both sides
𝑆𝑞 + 𝑏 = (𝑏 + 𝑏𝑞 + 𝑏𝑞 2 + ⋯ + 𝑏𝑞𝑛−1 ) + 𝑏𝑞𝑛
Let’s substitute (𝑏 + 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞 𝑛−1 ) with S
𝑆𝑞 + 𝑏 = 𝑆 + 𝑏𝑞𝑛
Let’s group
𝐹𝑜𝑟 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑒 𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒
𝑆 𝑞 − 1 = 𝑏 𝑞𝑛 − 1 𝑏
𝑖𝑓 𝑞 < 1, 𝑡ℎ𝑒𝑛 lim 𝑞𝑛 = 0 ⇒ 𝑆 =
𝑛→∞ 1−𝑞
Here is our formula
𝒒𝒏 − 𝟏 𝑖𝑓 𝑞 ≥ 1, 𝑡ℎ𝑒𝑛 𝑆 = ∞
𝑺=𝒃
𝒒−𝟏

PV OF AN ANNUITY
𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

𝑃𝑉 = + + + ⋯ +
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 𝑛
We have a geometric sequence with

𝑷𝑴𝑻 𝟏
the first term 𝑏 = and common ratio 𝑞 =
(𝟏+𝒓) (𝟏+𝒓)
As sum of a geometric sequence equals

𝒒𝒏 − 𝟏
𝑺=𝒃
𝒒−𝟏
𝑷𝑴𝑻 𝟏
Substituting b and q with (𝟏+𝒓)
and (𝟏+𝒓)
respectively we get
(1 + 𝑟)𝑛 −1
𝑃𝑉(𝑎𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑃𝑀𝑇
𝑟 (1 + 𝑟)𝑛

PV OF AN PERPETUITY
𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

𝑃𝑉 = + 2
+ 3
+⋯
1+𝑟 1+𝑟 1+𝑟
And again, we have a geometric sequence with

𝑃𝑀𝑇 1
the first term 𝑏 = and common ratio 𝑞 =
(1+𝑟) (1+𝑟)
𝑏
since 𝑞 < 1, 𝑡ℎ𝑒𝑛 lim 𝑞𝑛 = 0 ⇒ 𝑆 =
𝑛→∞ 1−𝑞
𝑷𝑴𝑻 𝟏
Substituting b and q with (𝟏+𝒓)
and (𝟏+𝒓)
respectively, we get
𝑃𝑀𝑇
𝑃𝑉(𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟

QUESTION
If a person needs $10 000 in 10 years from now and interest rates are currently 2%
how much do they need to invest today if interest is compounded annually?
A) 8 150
B) 8 200
C) 8 250
10000
𝑃𝑉 = 10
= 8203
(1 + 0.02)

QUESTION
If a person has $5 000 right now and needs $10 000 in 10 years from now. What
interest rate can help him to meet her goal.
A) 7.05%
B) 7.15%
C) 7.25%
𝑟 𝑡𝑚 𝐹𝑉 10 10000
= −1= − 1 = 7.17%
𝑚 𝑃𝑉 5000

QUESTION
Suppose we have an ordinary annuity that pays $300 every year for 3 years. Interest
rates equal 3%. What is the future value of this annuity at the end of Year 3?
A) $848.05
B) $927.27
C) $963.49
The first method

2 1 1.033 −1
300 (1 + 0.03) + 300 (1 + 0.03) + 300 = 300 = 927.27
1.03 −1
The second method
END MODE
PMT = −$300; N = 3; I/Y = 3; PV = 0 CPT FV = $927.27
QUESTION
An investor wants to receive $777 at the beginning of each of the next 7 years with
the first payment starting today. If the investor can earn 7 percent interest, how
much does the investor have to put aside?
A) $4 190.
B) $3 885.
C) $4 480.
The first method

END MODE. PMT = $777; N = 7; I/Y = 7; FV = 0 CPT PV = $4187.48
4 187.48 * 1.07 = 4 480.60
The second method

BGN MODE. PMT = $777; N = 7; I/Y = 7; FV = 0 CPT PV = $4480.60

TIME LINE IN MODELING AND SOLVING TVM PROBLEMS
Drawing up timelines can help you avoid some mistakes.
A general timeline for the TVM concept

What is the FV after 8 years of five $500 payments to be received at the end of
each of the first 5 years assuming that the interest rate will be constant at 2% for
the next 8 years?
Let’s use the timeline to solve this problem
Step 1: Find FV of this 5-year annuity at the end of Year 5:

N = 5; I/Y = 2; PMT = −$500; CPT FV = $2602.02
Step 2: Find the FV at t = 8:

N = 3; I/Y = 2; PMT = 0; PV = −$2602.02; CPT FV = $2761.28
What is the PV of 5 annual payments of $500 if the first

payment will be received after 6 years and the interest rate is 2%?
Step 1: Find the value of this 5-year annuity at the end of Year 5:
N = 5; I/Y = 2; PMT = −$500; FV = 0; CPT PV = $2356.73
Step 2: Find the value of «$2356.73» as of today:

N = 5; I/Y = 2; PMT = 0; FV = –$2345.73; CPT PV = $2134.56

Present and Future Value of Unequal Cash Flows

When you deal with series of unequal cash flows, you have to calculate the value of
each individual cash flow separately.
The PV (FV) of the cash flow stream is calculated by calculating the PV(FV) of each
of the individual cash flows, and then adding them up.
FV = $350; I/Y = 10; N = 2; PMT = 0; CPT PV = − $289.26
FV = $500; I/Y = 10; N = 3; PMT = 0; CPT PV = − $375.66
FV = $200; I/Y = 10; N = 4; PMT = 0; CPT PV = − $136.60
FV = $1000; I/Y = 10; N = 5; PMT = 0; CPT PV = − $620.92
PV of cash flow stream = Sum of individual future values = $1422.44

If you make a $100 deposit at the beginning of each of the next six months with the
first deposit starting today. How much will you have 7 months from today assuming
a 6% interest rate?
Step 1: Find the FV of annuity due as of the end of month 6:

BGN MODE N = 6; I/Y = 0.5%; PV = 0; PMT = −$100; CPT FV = $610.59
Step 2: Find the future value of 610.59 at the end of month 7:

N = 1; I/Y = 0.5; PV = −$610.59; PMT = 0; CPT FV = $613.64

QUESTION
Ivan Smirnoff is getting a 3 000 000 RUB loan, with an 15% annual interest rate to
be paid in 60 equal monthly installments. If the first payment is due at the end of
the first month, the interest and principal values for the second payment are
closest to:
A) 37 500; 34 300
B) 37 000; 34 000
C) 37 000; 34 300
N = 60; I/Y = 1.25; PV = 3 000 000; FV = 0; CPT PMT = -71 370
Interest for the first payment = 3 000 000 * 1.25% = 37 500

Principal for the first payment = 71370 – 37500 = 33 870
Interest for the second payment = (3 000 000 - 33 870)* 1.25% = 37075
Principal for the first payment = 71370 – 37075 = 34 295

QUESTION
Using a 20% discount rate find the PV of following cash flow stream
YEAR CASH FLOW

1 - 2 000
2 - 3 000
3 -
4 1 000
5 10 000
A) 901.24
B) 625.85
C) 751.03
N = 1; I/Y = 20; PMT = 0; FV = -2000; CPT PV = 1 666.67
N = 2; I/Y = 20; PMT = 0; FV = -3000; CPT PV = 2 083.33
N = 4; I/Y = 20; PMT = 0; FV = 1000; CPT PV = 482.25
N = 5; I/Y = 20; PMT = 0; FV = 10000; CPT PV = 4 018.78
PV of cash flow stream = 751.03

HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2018) Volume I  Reading 6
PRACTICE PROBLEMS
CFA® Level I Curriculum (2018) Volume I  Reading 6  PRACTICE PROBLEMS
MOODLE  CFA® Level I 2018  TESTS  QM #1

DISCOUNTED CASH FLOW APPLICATIONS
DISCLAIMER

READING 7 DISCOUNTED CASH FLOW APPLICATIONS 2

INTERPRETATION OF THE NPV AND THE IRR OF AN INVESTMENT
The NPV is the sum of present value of a project’s cash flows.

Discount rate is the firm’s cost of capital.
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛

𝑁𝑃𝑉 = 𝐶𝐹0 + + 2
+ 3
+ ⋯+ 𝑛
1+𝑟 1+𝑟 1+𝑟 1+𝑟
The IRR is the discount rate that makes the NPV = 0

𝑁𝑃𝑉 = 0 = 𝐶𝐹0 + + 2
+ 3
+ ⋯+ 𝑛
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅

CONTRAST THE NPV RULE TO THE IRR RULE,
AND IDENTIFY PROBLEMS ASSOCIATED WITH THE IRR RULE
ARE PROJECTS INDEPENDENT
NO YES
ACCEPT A PROJECT WITH ACCEPT ALL PROJECTS WITH

HIGHEST NON-NEGATIVE NPV POSITIVE NPV
RELATIVE VALUE OF IRR WHICH IS EQUIVALENT TO

CAN BE MISLEADING IRR > FIRM’S COST OF CAPITAL

𝑁𝑃𝑉 = 0 = 𝐶𝐹0 + + 2
+ 3
+ ⋯+ 𝑛
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅
𝑛−1 𝑛−2
𝐶𝐹0 1 + 𝐼𝑅𝑅 + 𝐶𝐹1 1 + 𝐼𝑅𝑅 + ⋯ + 𝐶𝐹𝑛
=0
1 + 𝐼𝑅𝑅 𝑛
Assuming 𝟏 + 𝑰𝑹𝑹 ≠ 𝟎
𝑛−1 𝑛−2
𝐶𝐹0 1 + 𝐼𝑅𝑅 + 𝐶𝐹1 1 + 𝐼𝑅𝑅 + ⋯ + 𝐶𝐹𝑛 = 0
Solving for IRR is the same as solving polynomial equation
(𝒂𝒙𝒏 + 𝒃𝒙𝒏−𝟏 + … + 𝒛 = 𝟎)
When project cash flows have multiple sign changes there can be
multiple values of the IRR or NO values.

NPV ($)
𝐼𝑅𝑅
𝑁𝑃𝑉 > 0
𝑁𝑃𝑉 > 0
𝑁𝑃𝑉 < 0 DISCOUNT RATE

𝑁𝑃𝑉 < 0
𝐼𝑅𝑅
THE IRR HAS MULTIPLE VALUES (EXAMPLE)
$6000 −$5000 𝐼𝑅𝑅1 = 0%

𝑁𝑃𝑉 = 0 = −$1000 + + 𝐼𝑅𝑅2 = 400%
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 2

𝑁𝑃𝑉 > 0
NPV ($)
DISCOUNT RATE
THE IRR HAS NO VALUES
−$1000 $2000
𝑁𝑃𝑉 = 0 = $1000 + + 𝐼𝑅𝑅 ∈ ∅
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 2

QUESTION
If the cost of capital is 15% what’s the NPV of the project?
YEAR CASH FLOW

0 - 7 000
1 2 000
2 2 000
3 2 000
4 5 000
5 10 000
A) 5600
B) 5800
C) 5400
CFO = -7000; CF1 = 2,000; CF2 = 2,000; CF3 = 2000;

CF4= 5000; CF5 = 10000; I = 15; CPT NPV = 5397
QUESTION
What’s the IRR of the project?
YEAR CASH FLOW

0 - 7 000
1 2 000
2 2 000
3 2 000
4 5 000
5 10 000
A) 35.75%
B) 15%
C) 37.35%
CFO = -7000; CF1 = 2,000; CF2 = 2,000; CF3 = 2000;

CF4= 5000; CF5 = 10000; CPT IRR = 35.75%
QUESTION
Which of the following statements regarding making investment decisions using

NPV and IRR is correct?
A) For mutually exclusive projects company should always choose the project with
the highest IRR.
B) Projects with a positive IRR increase shareholder wealth.
C) Zero-NPV projects don’t create wealth for shareholders.
IRR ranking is a bad tool for comparing projects.

QUESTION
Suppose that you have a project (cost of capital is 10%) with these cash flows:
Year 1: $1 000 000

Year 2: -$3 000 000
Year 3: $2 500 000
What’s the main problem with this project?
A) It has no IRR
B) Project’s NPV is negative
C) It has multiple IRR values
CFO = 0; CF1 = 1; CF2 = 3; CF3 = 2.5; CPT IRR = ERROR

HOLDING PERIOD RETURN (TOTAL RETURN)
Holding period Yield (holding period return) is the total return for holding an
investment over a certain period of time:
𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 + 𝐶𝐹

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒
Investor purchased Apple stock at $450 one year ago and sold it now at $420.
During the year investor received $10 in dividend. HPY is
$420 − $450 + $10

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 = = −4.444%
$450

MONEY-WEIGHTED AND TIME-WEIGHTED RATES OF RETURN OF A PORTFOLIO
AND THE PERFORMANCE OF PORTFOLIOS BASED ON THESE MEASURES
Money-weighted return is a measure of the rate of return for a portfolio that sets
the present value of all cash flows and terminal values equal to the initial
investment. In other words, the money-weighted rate of return is simply the
Internal Rate of Return (IRR). The money-weighted return is actually highly
sensitive to the timing and amount of withdrawals and additions to the portfolio.
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑙𝑢𝑒 = + + ⋯+
1 + 𝑀𝑊𝑅 1 + 𝑀𝑊𝑅 2 1 + 𝑀𝑊𝑅 𝑛
Time-weighted rate of return is a measure of the compound rate of return of a

portfolio over a stated period of time. It requires a set of sub-period returns to be
calculated whenever there is an external cash flow, such as a deposit or withdrawal
from the portfolio. In essence, it calculates the geometric total and mean return as
opposed to the arithmetic total and mean return. it is not sensitive to
contributions or withdrawals.
1
𝑇𝑊𝑅 = [ 1 + 𝐻𝑃𝑅1 1 + 𝐻𝑃𝑅2 … 1 + 𝐻𝑃𝑅𝑛 ]#𝑝𝑒𝑟𝑖𝑜𝑑𝑠 −1

QUESTION
Mike bought a 5% (paid semi annually) Eurobond for 98 8/32 and sold it seven
months later for 100. What’s the holding period return?
A) 7.42%.
B) 4.33%.
C) 7.67%.
$100 − $98.25 + $2.5

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 = = 4.33%
$98.25
QUESTION
On January 1, portfolio was valued at $50 000. During the year investor received
$3000 in interest and $4000 in dividends. The value of the portfolio on December
31 of the same year was $62 000. What’s the holding period return?
A) 24%.
B) 38%.
C) 34%.
$62000 − $50000 + $3000 + $4000

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 = = 38%
$50000
QUESTION
Manager buys one share of stock for $100. At the end of year one he buys one
additional share at $97 per share. At the end of year two he sells all two shares for
$98 each. The stock paid a dividend of $0.70 per share at the end of year one and
year two. What is the investor’s time-weighted rate of return?
A) -0.275%.
B) -0.30%.
C) -0.25%.
$97 − $100 + $0.7

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑1 = = −2.3%
$100
$196 − $194 + $1.4

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑2 = = 1.75%
$194
TWR = [(1 -0.02300)(1 + 0.0175)]0.5 - 1 = -0.295%.

QUESTION
Which of the following statements about MWR and TWR is correct?
A) The TWR is an equivalent to IRR
B) MWR takes into consideration not only the amount of the cash flow but also the
timing of the cash flow.
C) If the investment period is greater than one day/month/year/etc., an analyst

must use the geometric mean to calculate MWR.
The MWR is an equivalent to IRR.

If the investment period is greater than one day/month/year/etc., an analyst must
use the geometric mean to calculate TWR.
BANK DISCOUNT YIELD, HOLDING PERIOD YIELD, EFFECTIVE ANNUAL YIELD, AND MONEY
MARKET YIELD FOR US TREASURY BILLS AND OTHER MONEY MARKET INSTRUMENTS
𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 + 𝐶𝐹

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒
365
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 = (1 + 𝐻𝑃𝑌) 𝑑𝑎𝑦𝑠 −1
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 360
𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = х
𝐹𝑎𝑐𝑒 𝑑𝑎𝑦𝑠
360 ∗ 𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑

𝑀𝑜𝑛𝑒𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑦𝑖𝑒𝑙𝑑 =
360 − 𝑑𝑎𝑦𝑠 ∗ 𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑

BANK DISCOUNT YIELD, HOLDING PERIOD YIELD, EFFECTIVE ANNUAL YIELD, AND MONEY
MARKET YIELD FOR US TREASURY BILLS AND OTHER MONEY MARKET INSTRUMENTS
100-day T-Bill quoted at $920 (nominal value is $1 000)
1000 − 920
𝐻𝑃𝑌 = = 8.695%
920
365
𝐸𝐴𝑌 = (1 + 𝐻𝑃𝑌) 𝑑𝑎𝑦𝑠 −1 = 35.57%
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 360 80 360

𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = х = х = 28.8%
𝐹𝑎𝑐𝑒 𝑑𝑎𝑦𝑠 1000 100
360 ∗ 𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑

𝑀𝑜𝑛𝑒𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑦𝑖𝑒𝑙𝑑 = = 31.3%
360 − 𝑑𝑎𝑦𝑠 ∗ 𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑

RELATIONSHIPS AMONG HOLDING PERIOD YIELDS, MONEY MARKET YIELDS,
EFFECTIVE ANNUAL YIELDS, AND BOND EQUIVALENT YIELDS
𝑑𝑎𝑦𝑠
𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 ∗
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑖𝑒𝑙𝑑 = 360
𝑑𝑎𝑦𝑠
1 − 𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 ∗
360
365
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 = (1 + 𝐻𝑃𝑌) 𝑑𝑎𝑦𝑠 −1
𝑑𝑎𝑦𝑠
𝐻𝑃𝑌 = (1 + 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑) 365 −1
360
𝑀𝑜𝑛𝑒𝑦 𝑚𝑎𝑟𝑘𝑒𝑡 𝑦𝑖𝑒𝑙𝑑 = 𝐻𝑃𝑌 х
𝑑𝑎𝑦𝑠
𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 2 1 + 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 − 1

QUESTION
A Treasury bill has 72 days to maturity, a par value of $1 000, and was just
purchased for $970. Its bank discount yield is closest to:
A) 3,093%.
B) 15%.
C) 21.26%.
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 360 1000 − 970 360

𝐵𝑎𝑛𝑘 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = х = х = 15%
𝐹𝑎𝑐𝑒 𝑑𝑎𝑦𝑠 1000 72

QUESTION
A Treasury bill has 72 days to maturity, a par value of $1 000, and was just
purchased for $970. Its effective annual yield is closest to:
A) 3,093%.
B) 16.7%.
C) 21.26%.
365 1000 − 970 365

𝐸𝐴𝑌 = 1 + 𝐻𝑃𝑌 𝑑𝑎𝑦𝑠 = (1 + ) 72 −1 = 16.7%
970
QUESTION
Bond’s effective annual yield for debt security is 6%. 𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 is
A) 6.09%.
B) 5.913%.
C) 6%.
𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 2 1 + 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 − 1

𝐵𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 2 1 + 0.06 − 1 = 5.913%
QUESTION
A Treasury bill has 120 days until its maturity and a effective annual yield of 1.1%.
Its holding period yield is closest to:
A) 0.33%.
B) 3.3%.
C) 0.36%.
𝑑𝑎𝑦𝑠
𝐻𝑃𝑌 = (1 + 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑) 365 −1
120
𝐻𝑃𝑌 = (1 + 0.011) 365 −1 = 0.36%
HOMEWORK ASSIGNMENT
READING
PRACTICE PROBLEMS

STATISTICAL CONCEPTS AND MARKET RETURNS
DISCLAIMER

READING 8 STATISTICAL CONCEPTS AND MARKET RETURNS 2

THE POPULATION AND A SAMPLE
DESCRIPTIVE STATISTICS AND INFERENTIAL STATISTICS
Population is a complete set of items that share at least one property in common
that is the subject of a statistical analysis.
Sample is a subset of the population used to draw inferences about the population.
Descriptive statistics provide simple summaries about the sample and the
measures. Together with simple graphics analysis, they form the basis of virtually
every quantitative analysis of data.
Inferential statistics are used to make probabilistic statements about a population

based on a sample.

MEASUREMENT SCALES
Scale of measure is a classification that describes the nature of information.
Nominal scale differentiates between items or subjects based only on their names
(BMW, AUDI, Mercedes, …)
Ordinal scale data is put into categories that can be ordered with respect to some
characteristic (the grades are A, B, C, D and F — A being the highest and F, denoting
failure, the lowest).
Interval scale allows for the degree of difference between items, but not the ratio
between them. Ratios are not allowed since 20 °C cannot be said to be "twice as
hot" as 10 °C
Ratio scale possesses a meaningful (unique and non-arbitrary) zero value.

Examples include mass, length, duration, plane angle, energy and electric charge.

PARAMETER, A SAMPLE STATISTIC, AND A FREQUENCY DISTRIBUTION
A parameter is the characteristics used to describe a population.
A statistic is the characteristics of a sample used to infer information about the

population.
A frequency distribution is a table that displays the frequency of various outcomes

in a sample. Each observation must fall into only one interval or only one group (no
overlapping), and the set of intervals or groups must cover the entire range of
values represented in the data.
Number of M&Ms in a bag

7
6
5
FREQUENCY
4
3
2
1
0
52 53 54 55 56 57 58 59 60
COUNT

CALCULATE AND INTERPRET RELATIVE FREQUENCIES AND CUMULATIVE RELATIVE
FREQUENCIES, GIVEN A FREQUENCY DISTRIBUTION
Absolute frequency is the actual number of observations in a given interval
Relative frequency is the percentage of total observations falling within an

interval.
Cumulative absolute frequency and cumulative relative frequency are results from
cumulating the absolute and relative frequencies from the first to the last interval
(class)
Absolute Relative Cumulative Absolute Cumulative Relative

Age
Frequency Frequency Frequency Frequency
18-22 6 12% 6 12%

23-27 14 28% 20 40%
28-32 16 32% 36 72%
33-37 11 22% 47 94%
38-42 3 6% 50 100%

QUESTION
Calendar data set is an example of:
A) Name scale
B) Interval scale
C) Ratio scale
Interval scale allows for the degree of difference between items, but not the ratio
between them. Ratios are not allowed since January 15 cannot be said to be 3
times January 5.
QUESTION
Which of the following statements is correct?
A) Descriptive statistics are used to make probabilistic statements about a

population based on a sample.
B) Noun, verb, preposition, pronoun, etc are examples of nominal scale.
C) Sample is a complete set of items that share at least one property in common
that is the subject of a statistical analysis.
Nominal scale differentiates between items or subjects based only on their names.
QUESTION
Which of the following is an example of a parameter?
A) Sample 4th central moment.
B) Sample 3rd central moment.
C) Population 4th central moment.
A parameter is the characteristics used to describe a population.

QUESTION
Which of the following statements about frequency distribution is correct?
A) Classes must be mutually exclusive.
B) Frequency distributions doesn’t work with Nominal scales.
C) All classes must cover at least 70% of the range of values represented in the data
Intervals (classes) must be mutually exclusive.

QUESTION
CAR BRAND FREQUENCY

BMW 117
AUDI 123
LADA 161
What is the relative frequency of LADA class?
A) 401
B) 161
C) 40.15%
161/ (117+123+161) ~ 0.4015

QUESTION
INTERVAL FREQUENCY CUMULATIVE FREQUENCE
0%-25% 10 X
25%-50% Y 26
50%-75% Z 29
75%-100% 15 A
What is the product of X, Y and Z ?
A) 44
B) 480
C) 300
10 * 16 * 3 = 480
A HISTOGRAM AND A FREQUENCY POLYGON
A histogram is used to graphically represent the data contained in frequency
distribution. To construct a histogram, the intervals are listed on the horizontal axis,
while the frequencies are scaled on the vertical axis.
A frequency polygon plots the midpoint of each interval on the horizontal axis and
the absolute frequency for that interval on the vertical axis, and connects the
midpoints with straight lines. The advantage of histograms and frequency polygons
is that we can quickly see where most of the observations lie.

CENTRAL TENDENCY (THE POPULATION MEAN, SAMPLE MEAN, ARITHMETIC MEAN,
WEIGHTED AVERAGE OR MEAN, GEOMETRIC MEAN, HARMONIC MEAN, MEDIAN, AND MODE)
In statistics, a central tendency (or, more commonly, a measure of central

tendency) is a central or typical value for a probability distribution. The most
common measures of central tendency are the arithmetic mean, the median and
the mode.
The arithmetic mean is the most frequently used measure of central tendency. It is
simply the average of all the observations. The arithmetic mean can be calculated
for the entire population (μ) and for a sample (X).
𝑛 𝑛
𝑖=1 𝑋𝑖 𝑖=1 𝑋𝑖
μ= 𝑋=
𝑛 𝑛
Weighted mean – an arithmetic mean that incorporates weighting to certain data

elements.
𝑛
𝑋𝜔 = 𝜔𝑖 𝑋𝑖
𝑖=1
EQUAL WEIGHTS
THE ARITHMETIC MEAN
𝑛 𝑛
𝑖=1 𝑋𝑖 𝑖=1 𝑋𝑖
μ= 𝑋=
𝑛 𝑛
CENTER OF MASS
DIFFERENT WEIGHTS
WEIGHTED MEAN
𝑛
𝑖=1

Median – the middle value that separates the higher half from the lower half of the
data set. The median and the mode can be used for ordinal data, in which values
are ranked relative to each other but are not measured absolutely. Median is not
sensitive to extreme values and is most useful when dealing with skewed
distributions. However, the median does not use all information about the size and
magnitude of observations and only focuses on their relative positions.
For a data set with odd number of observation the median is the value of the item
𝑁+1
in [ ] position.
2
For a data set with even number of observation the median is the average of items
𝑁 𝑁+2
occupying positions [ ] and [ ].
2 2

Mode – the most frequent value in the data set. This is the only central tendency
measure that can be used with nominal data, which have purely qualitative
category assignments.
A data set that has one mode is said to be unimodal, while one that has two modes
is said to be bimodal. It is also possible for a data set to have no mode, where all
values are different and no value occurs more frequently than others. For grouped
data, the modal interval is the interval with the highest frequency.
The mode is the only measure of central tendency that can be used with nominal
data.
BIMODAL
Number of M&Ms in a bag
7
6
FREQUENCY
5
4
3
2
1
0
52 53 54 55 56 57 58 59 60
COUNT
Geometric mean – the nth root of the product of the data values, where there are n of
these. This measure is valid only for data that are measured absolutely on a strictly positive
scale.
𝑛
𝐺= 𝑋1 𝑋2 … 𝑋𝑛
Weighted mean – an arithmetic mean that incorporates weighting to certain data elements.
𝑛
𝑖=1
The harmonic mean can be used to find an average price of financial instrument for equal
periodic investments.
𝑛
𝑋𝐻 =
𝑛 1
𝑖=1 𝑋
𝑖

Arithmetic mean
• All observations are used in the computation of the arithmetic mean.
• The sum of the deviations from the arithmetic mean is always 0.
• Arithmetic mean is sensitive to extreme values
• An arithmetic mean is unique i.e., a data set only has one arithmetic mean.
Geometric mean
• It is always less than, or equal to the arithmetic mean.
• It equals the arithmetic mean only when all the observations are identical.
• The difference between the geometric and arithmetic mean increases as the
dispersion in observed values increases.
Harmonic mean
• It is always less than, or equal the geometric mean.

CALCULATION AND INTERPRETATION OF
QUARTILES, QUINTILES, DECILES, AND PERCENTILES
A quantile is a value at, or below which a stated proportion of the observations in a

data set lie.
Percentiles divide the distribution into hundredths.

Deciles divide the data into tenths.
Quintiles divide the distribution into fifths.
Quartiles divide the distribution in quarters or four equal parts.
For example the formula for the position of the i-th decile in a data set with n
observations sorted in ascending order is:
𝑛+1 𝑖
𝐿𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑑𝑒𝑐𝑖𝑙𝑒 =
10

QUESTION
A) A histogram and a frequency polygon both plot the absolute frequency on the
horizontal axis.
B) A frequency polygon is constructed by plotting the midpoint of each interval on

the vertical axis.
C) A histogram is a bar chart of data that has been grouped into a frequency
distribution.
A frequency polygon plots the midpoint of each interval on the horizontal axis and
the absolute frequency for that interval on the vertical axis, and connects the
midpoints with straight lines.
QUESTION
In a frequency distribution histogram, the frequency of an interval (class) is given by

the:
A) height of corresponding bar multiplied by the width of the corresponding bar.
B) width of the corresponding bar.
C) height of the corresponding bar.
The frequency of the particular class is given by the value on the vertical axis, or the
height of the corresponding bar.
QUESTION
The most recent 5 years prices of the stock are

$120; $110%; $34; $73; $109.
Which of the following statements isn’t correct?
A) harmonic mean is $71.73
B) geometric mean is $81.39
C) arithmetic mean is $69.20
AM ≥ GM ≥ HM
QUESTION
Over the last 4 years, the portfolio's annual returns were: -6%, -3%, 0%, 11%
The geometric mean is
A) 0.0%
B) 0.5%
C) 0.3%
4
GM = 1 + −0.06 1 + −0.03 1 + 0 1 + 0.11 − 1 = 0.3%
QUESTION
What is the 2nd quartile of the following data?
0 11 45 55 57 99 101 131
A) 56
B) 4.5
C) 55
8+1 2
𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 = = 4.5
4
55 + (57 – 55)0.5 = 56
QUESTION
What is the 3rd quintile of the following data?
13 14 19 23 45 46 47 99 101 131
A) 46.6
B) 6.6
C) 46
10+1 3
𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 = = 6.6
5
46 + (47 – 46)0.6 = 46.6
A RANGE AND A MEAN ABSOLUTE DEVIATION AND THE VARIANCE AND STANDARD
DEVIATION OF A POPULATION AND OF A SAMPLE
The range is the difference between the highest and lowest values in a data set.
Range = Max. value − Min. value
MAD is the average of the absolute values of deviations of observations in a data

set from its mean.
𝑛
𝑖=1 |𝑋𝑖 − 𝑋 |
𝑀𝐴𝐷 =
𝑛
Variance is a measurement of the spread between numbers in a data set. The

variance measures how far each number in the set is from the mean.
𝑛
𝑖=1(𝑋𝑖 −𝜇)2
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝑝𝑜𝑝𝑢𝑙. 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛)2 = σ2 =
𝑛
𝑛
−𝑋)2
𝑖=1(𝑋𝑖
𝑆𝑎𝑚𝑝𝑙𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝑠𝑎𝑚𝑝𝑙𝑒 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛)2 = 𝑠2 =
𝑛 −1

THE PROPORTION OF OBSERVATIONS FALLING WITHIN A SPECIFIED NUMBER OF
STANDARD DEVIATIONS OF THE MEAN USING CHEBYSHEV’S INEQUALITY
Chebyshevs inequality states:

for any distribution the proportion of the observations within k (for k > 1) standard
1
deviations of the mean is at least (1 − 2).
𝑘
For any distribution at least 75% of observations lie within ± 2 SD of the mean.
For normal distribution 96% of observations lie within ± 2 SD of the mean.
For any distribution at least 89% of observations lie within ± 3 SD of the mean.
For normal distribution more than 99% of observations lie within ± 3 SD of the
mean.
NORMAL
DISTRIBUTION

THE PROPORTION OF OBSERVATIONS FALLING WITHIN A SPECIFIED NUMBER OF
STANDARD DEVIATIONS OF THE MEAN USING CHEBYSHEV’S INEQUALITY

THE COEFFICIENT OF VARIATION AND THE SHARPE RATIO
Coefficient of variation is the ratio of the standard deviation to the mean
𝑠
𝑪𝒐𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒕 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏 = 𝐶𝑉 =
𝑋
The Sharpe ratio measures excess return per unit of risk:
(𝒓𝒆𝒕𝒖𝒓𝒏𝒑 − 𝒓𝒊𝒔𝒌 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆)

𝑺𝒉𝒂𝒓𝒑𝒆 𝒓𝒂𝒕𝒊𝒐 =
𝝈𝒑

QUESTION
Find the mean absolute deviation (MAD) and sample standard deviation
of a series of stock price?
37 41 40 48 52 39 41 46
MAD Sample SD
A) 4.25 5.13
B) 0 4.8
C) 4.25 4.8
37 + 41 + 40 + … + 46
𝑋= = 43
8
𝑛
𝑖=1 |𝑋𝑖 − 𝑋 | 37 − 43 + 41 − 43 + … + |46 − 43|
𝑀𝐴𝐷 = = = 4.25
𝑛 8
𝑛
−𝑋)2
𝑖=1(𝑋𝑖 (37 − 43)2 +(41 − 43)2 + … + (46 − 43)2
𝑠= = = 5.13
𝑛 −1 8 −1
QUESTION
Find the population standard deviation of a series of the stock return?
4% 4% 4%
A) 0.0
B) 4.0
C) 2.0
𝑇ℎ𝑒𝑟𝑒 𝑖𝑠 𝑛𝑜 𝑎𝑛𝑦 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

QUESTION
According to Chebyshev's Inequality, what is the minimum percentage of

observations that will lie within 5 standard deviations of the mean?
A) 96.0%
B) 95.0%
C) > 99.0%
1 1
(1 − 2 ) =(1 − 2 ) = 96%
𝑘 5
QUESTION
Sample of taxi fares in Russia is positively skewed. What’s the minimum percentage
of observations lies within plus or minus 1.5 standard deviations of the mean?
A) 68.0%
B) 55.5%
C) 33.3%
1 1
(1 − 2 ) =(1 − ) = 55.5%
𝑘 1.52
QUESTION
Which of the following statement is correct?
Mean Return Standard Deviation

Stock A 5% 8%
Stock B 6% 9%
Stock C 7% 10%
A) Stock A is the riskiest
B) The coefficient of variation of stock B is 0.667
C) Stock C is riskier than Stock B
8 9 10
𝐶𝑉𝐴 = = 1.6; 𝐶𝑉𝐵 = = 1.5; 𝐶𝑉𝐶 = ~1.43
5 6 7
QUESTION
Calculate the Sharpe ratio for a portfolio with a mean return of 6% and standard
deviation of 8% given that the risk‐free rate is 2%.
A) 0.5
B) 2.0
C) 0.75
(𝑟𝑒𝑡𝑢𝑟𝑛𝑝 − 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒) (6% − 2%)

The Sharpe ratio = = = 0.5
σ𝑝 8%
SKEWNESS
A POSITIVELY AND NEGATIVELY SKEWED RETURN DISTRIBUTIONS
Skewness is a measure of the asymmetry of the probability distribution of random

variable about its mean.
A right-skewed distribution has positive skewness.

A left-skewed distribution has negative skewness.
Sample skew with an absolute value greater than 0.5 is considered significantly
different from zero.

RELATIVE LOCATIONS OF THE MEAN, MEDIAN, AND MODE
FOR A UNIMODAL, NONSYMMETRICAL DISTRIBUTION
Negatively - Skewed: Mean < median < mode

Positively - Skewed: Mean > median > mode
Symmetric: Mean = median = mode

SAMPLE SKEWNESS AND KURTOSIS;
Kurtosis measures the extent to which a distribution is more or less peaked than a
normal distribution. A normal distribution has a kurtosis of 3. Excess kurtosis with
an absolute value greater than 1 is considered significant.
Leptokurtic: More peaked than normal;

Fat tails; excess kurtosis > 0
Platykurtic: Less peaked than normal;

Flatter than a normal; thin tails;
excess kurtosis < 0
Mesokurtic:
Excess kurtosis = 0

THE USE OF ARITHMETIC AND GEOMETRIC MEANS
IN INVESTMENT RETURN ANALYSIS.
AM isn’t a good tool for performance presentation

(50% loss one year and 50% gain next year is a good example).
AM return is appropriate for forecasting single period returns in future periods,

while the GM is appropriate for forecasting future compound returns over multiple
periods.
𝑥+𝑦
AM ( ) always bigger than GM ( 𝑥𝑦 ).
2
𝑥+𝑦
≥ 𝑥𝑦
2
x + y ≥ 2 𝑥𝑦
(𝑥 + 𝑦)2 ≥ 4𝑥𝑦
(𝑥 − 𝑦)2 ≥ 0

QUESTION
Which of the following statement isn’t correct?
A) Sample skew with an absolute value greater than 0.5 is considered significantly
B) For skewed distribution the magnitude of positive deviations from the mean is
different from the magnitude of negative deviations from the mean.
C) For skewed distribution mean=mode=median
In asymmetrical distributions the mean, 𝑡ℎ𝑒 median 𝑎𝑛𝑑 𝑡ℎ𝑒 𝑚𝑜𝑑𝑒

are not the same
QUESTION
A) A distribution that is not symmetrical has excess skew equals 3.
B) A Insurance buyer can have a positively skewed distribution.
C) Symmetrical distribution has zero skewness .
Sample skew with an absolute value greater than 0.5 is considered significantly
QUESTION
Which of the following statement about skewed distribution isn’t correct?
A) median > mode > mean.
B) mode > median > mean
C) Mean > median > mode.
Median is always between mode and mean

QUESTION
Which of the following statement about positively-skewed distribution is correct?
A) mean > median > mode.
B) mode > median > mean
C) mean > median < mode.
Positively - Skewed: Mean > median > mode

QUESTION
Which of the following statements about kurtosis isn’t correct?
A) Kurtosis is 4th central moment.
B) Kurtosis is a measure of the heaviness of the tail of the distribution.
C) Negative excess kurtosis is called leptokurtic.
Negative excess kurtosis is called platykurtic.

QUESTION
Which of the following statements concerning a mesokurtic distribution with zero

skewness is correct?
A) The mode will be greater than the median.
B) It has a lower percentage of small deviations from the mean than a normal
distribution.
C) It has zero excess kurtosis.
Mesokurtic distribution has zero excess kurtosis.

QUESTION
Investment has produced annual returns of -2%, 0%, 2%, and 4%. The most
appropriate estimate of the next year’s return, based on these historical returns, is
the:
A) arithmetic mean.
B) geometric mean.
C) quadratic mean.
AM return is appropriate for forecasting single period returns in future periods

QUESTION
Given the portfolio performance for the past 5 years the GM is:
A) best estimator of the compound annual rate of return over multiple periods.
B) best estimator of the next year’s performance.
C) upward biased estimator
GM is appropriate for forecasting future compound returns over multiple periods.

HOMEWORK ASSIGNMENT
READING
PRACTICE PROBLEMS

PROBABILITY CONCEPTS
DISCLAIMER

READING 9 PROBABILITY CONCEPTS 2

A RANDOM VARIABLE, AN OUTCOME, AN EVENT,
MUTUALLY EXCLUSIVE EVENTS, AND EXHAUSTIVE EVENTS
A random variable is an uncertain value determined by chance.

An outcome is the observed value of a random variable.
An event could be a single outcome or a set of outcomes.
Mutually exclusive events are events that cannot happen simultaneously.

The occurrence of one precludes the occurrence of the other.
Exhaustive events cover all the distinct possible outcomes.
𝐄𝐯𝐞𝐧𝐭𝐬 𝐀 𝐚𝐧𝐝 𝐀 𝐚𝐫𝐞

𝐞𝐱𝐡𝐚𝐮𝐬𝐭𝐢𝐯𝐞 𝐞𝐯𝐞𝐧𝐭𝐬

THE TWO DEFINING PROPERTIES OF PROBABILITY AND DISTINGUISH AMONG
EMPIRICAL, SUBJECTIVE, AND A PRIORI PROBABILITIES
An empirical probability estimates the probability of an event based on the

frequency of its occurrence in the past.
A subjective probability based on personal judgment.
A priori probability measures predetermined probabilities based on analysis and

reasoning;
The two properties of probability are:
The probability of any event, 𝐴𝑖 , is a number from 0 to 1.

Therefore, 0 ≤ P(𝐴𝑖 ) ≤ 1, where P(𝐴𝑖 ) is the probability of event, i, occurring.
The sum of the probabilities of all possible mutually exclusive events is 1.

P 𝐴𝑖 = 1

THE PROBABILITY OF AN EVENT IN TERMS OF ODDS FOR AND AGAINST THE EVENT
The probability of winning bet is 0.25
Odd for: 0.25/ (1 – 0.25) = 1/3 = 1-to-3
The probability of losing bet is 0.75
Odd against: 0.75/ (1 – 0.75) = 3/1 = 3-to-1

QUESTION
If event A1 and event A2 cannot occur simultaneously, then events A1 and A2 are:
A) mutually exclusive events.
B) exhaustive events
C) independent events.
Mutually exclusive events are events that cannot happen simultaneously. The
occurrence of one precludes the occurrence of the other.
QUESTION
Which of the following statement about rolling a standard dice isn’t correct?
A) Rolling an even number and rolling an odd number are exhaustive events.
B) Rolling an even number two times in a row is an outcome.
C) Rolling 1 is an event.
An outcome is the observed value of a random variable.

QUESTION
Which of the following sets does meet the requirements for a set of probabilities?
A) (0.20, 0.20, 0.20, 0.40).
B) (1.23, -0.23).
C) (0.15, 0.15, 0.35, 0.25).
The probability of any event, A, is a number from 0 to 1.

Therefore, 0 ≤ P(𝐴𝑖 ) ≤ 1, where P(𝐴𝑖 ) is the probability of event, i, occurring.
The sum of the probabilities of all possible mutually exclusive events is 1.

ΣP(𝐴𝑖 ) = 1.
QUESTION
Which of the following is an example of subjective probability?
A) The probability of flipping a symmetric coin heads 3 times is 0.125
B) John thinks that the probability of Manchester City winning Barclays Premier
League is 0.7
C) The probability of passing all three CFA exam on the first try is less than 0.10
based on candidates statistics.
A subjective probability based on personal judgment.

QUESTION
A) The odds for rolling an even number when rolling a die is 1-to-1.
B) The odds for rolling an odd number when rolling a die is 1-to-2.
C) The odds for rolling an odd number when rolling a die is 1-to-1.
The odds for rolling an odd number when rolling a die is 1-to-1.
QUESTION
Which of the following statement is correct?
A) The odds against rolling a number bigger than 2 when rolling a die is 2-to-1.
B) The odds for rolling a number bigger than 1 when rolling a die is 5-to-1.
C) The odds for rolling a particular even number when rolling a die is 1-to-2.
B) The odds for rolling a number bigger than 1 when rolling a die is 5-to-1.
UNCONDITIONAL AND CONDITIONAL PROBABILITIES
THE MULTIPLICATION, ADDITION, AND TOTAL PROBABILITY RULES
Unconditional or marginal probabilities estimate the probability of an event irrespective of
the occurrence of other events. Conditional probabilities express the probability of an event
occurring given that another event has occurred.
The multiplication rule of probability is used to determine the joint probability of two
events: P(AB) = P(A|B) x P(B)
The addition rule of probability is used to determine the probability that at least one of two
events will occur: P(A or B) = P(A) + P(B) − P(AB)
The total probability rule is used to determine the unconditional probability of an event,
given conditional probabilities: P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) +...+ P(A|BN)P(BN),
where B1, B2,...BN is a mutually exclusive and exhaustive set of outcomes
QUESTION
The probability that at least one of two events will occur is determined by using
the:
A) total probability rule.
B) addition rule of probability.
C) multiplication rule of probability.
The addition rule of probability is used to determine the probability that at least
one of two events will occur: P(A or B) = P(A) + P(B) − P(AB)
QUESTION
The total probability rule of is used to calculate the:
A) probability of at least one of two events.
B) unconditional probability of an event, given conditional probabilities.
C) joint probability of two events.
The total probability rule is used to determine the unconditional probability of an

event, given conditional probabilities :
P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) +...+ P(A|BN)P(BN)

THE JOINT PROBABILITY OF TWO EVENTS
A JOINT PROBABILITY OF ANY NUMBER OF INDEPENDENT EVENTS
THE PROBABILITY THAT AT LEAST ONE OF TWO EVENTS WILL OCCUR, GIVEN THE
PROBABILITY OF EACH AND THE JOINT PROBABILITY OF THE TWO EVENTS
Events A and B are mutually exclusive. Events A and B are not mutually exclusive.

DEPENDENT AND INDEPENDENT EVENTS.
The probability of an independent event is unaffected by the occurrence of other

events, but the probability of a dependent event is changed by the occurrence of
another event.
Events A and B are independent if: P(A|B) = P(A), or equivalently, P(B|A) = P(B)

QUESTION
The probability that event A will occur is 0.30.

The probability that event B will occur is 0.90.
Events A and B are independent events.
The probability that at least one of the events will occur is:
A) 1.2
B) 0.90
C) 0.93
For independent events = P(AB) = P(A)P(B)

P(A or B) = P(A) + P(B) − P(AB) = 0.3 + 0.9 – 0.27 = 0.93
QUESTION
The probability that event A will occur is 0.30.

The probability that event B will occur is 0.90.
Events A and B are mutually exclusive.
The probability that at least one of the events will occur is:
A) 0.60
B) 0.93
C) It’s impossible
P(A or B) = P(A) + P(B) − P(AB) = 0.3 + 0.9 – 0 = 1.2 > 1

CALCULATION OF UNCONDITIONAL PROBABILITY USING THE TOTAL PROBABILITY RULE
Law of Total Probability

𝑛
𝑃 𝐴 = 𝑃 𝐴 𝑆𝑖 𝑃(𝑆𝑖 )
𝑖=1
In this particular case unconditional probability is
𝑃 𝐴 = 𝑃 𝐴 𝑆1 𝑃 𝑆1 + 𝑃 𝐴 𝑆2 𝑃 𝑆2 + 𝑃 𝐴 𝑆3 𝑃 𝑆3 + 𝑃 𝐴 𝑆4 𝑃(𝑆4 )

QUESTION
Probability of a Probability of
Scenario
scenario occurring default occurring
A 0.3 0.05
B 0.3 0.2
C 0.4 0.7
The unconditional probability of default is
A) 0.355
B) 0.95
C) 1
P(default) = 0.3 x 0.05 + 0.3 x 0.2 + 0.4 x 0.7 = 0.355

QUESTION
Which of the following statement about unconditional probability formula is most

likely correct?
𝑛
𝑃 𝐴 = 𝑃 𝐴 𝑆𝑖 𝑃(𝑆𝑖 )
𝑖=1
A) 𝑆𝑖 is - a set of mutually exclusive events.
B) 𝑆𝑖 is - a set of mutually exclusive and exhaustive events.
C) 𝑆𝑖 is - a set of independent events
𝑆_𝑖 is - a set of mutually exclusive and exhaustive events.

CONDITIONAL EXPECTATION IN INVESTMENT APPLICATIONS
THE USE OF A TREE DIAGRAM TO REPRESENT AN INVESTMENT PROBLEM
Conditional expected values are calculated using conditional probabilities taking

into account all the possible scenarios that can occur.
A tree diagram shows the probabilities of two events and the conditional
probabilities of two subsequent events

QUESTION
The expected option price is:

INTEREST RATES
A) information is not sufficient GO UP P = 0.6
OPTION PRICE $11
B) 5.32
OPTION PRICE $10

C) 4.92
OPTION PRICE $4
VOLATILITY
GOES DOWN P = 0.8
OPTION PRICE $3
INTEREST RATES
GO DOWN P = 0.5
E(option price) = 0.2x0.6x11 + 0.2x0.4x10 + 0.8x0.5x4 + 0.8x0.5x3= 4.92

COVARIANCE AND CORRELATION
𝑉𝑎𝑟 𝑋 = 𝐸 𝑋 − 𝐸 𝑋 𝑋−𝐸 𝑋 = 𝐸 (𝑋 + −𝐸(𝑋))2

𝑛
𝑉𝑎𝑟 𝑋 = (𝜎𝑥 )2 = 𝑃(𝑋𝑖 )(𝑋𝑖 − 𝐸(𝑋))2

𝑖=1
FOR TWO VARIABLES
𝑉𝑎𝑟 𝑋 + 𝑌 = 𝐸 (𝑋 + 𝑌 − 𝐸(𝑋 + 𝑌))2 =
= 𝐸 (𝑋 + 𝑌 − 𝐸 𝑋 − 𝐸(𝑌))2 = 𝐸 (𝑿 − 𝑬 𝑿 + 𝒀 − 𝑬(𝒀))2 =
𝐸 𝑋−𝐸 𝑋 𝑋−𝐸 𝑋 + WHEN X AND Y ARE INDEPENDENT

𝐸 𝑌−𝐸 𝑌 𝑌−𝐸 𝑌 + THIS PART (COVARIANCE)
𝐸 𝑋−𝐸 𝑋 𝑌−𝐸 𝑌 + EQUALS ZERO
𝐸 𝑌−𝐸 𝑌 𝑋−𝐸 𝑋 =
= 𝑉𝑎𝑟 𝑋 + 𝑌 = 𝑉𝑎𝑟 𝑋 + 𝑉𝑎𝑟 𝑌 + 2 × 𝑬 𝑿 − 𝑬 𝑿 𝒀−𝑬 𝒀

Covariance is a measure of how much two random variables change together.
𝐶𝑜𝑣 𝑋, 𝑌 = 𝐸( 𝑋 − 𝐸 𝑋 𝑌−𝐸 𝑌 )
Covariance is symmetric, i.e. 𝐶𝑜𝑣 𝑋, 𝑌 = 𝐶𝑜𝑣 𝑌, 𝑋

Covariance can range from −∞ 𝑡𝑜 + ∞.
𝐶𝑜𝑣 𝑋, 𝑋 = 𝐸 𝑋 − 𝐸 𝑋 𝑋−𝐸 𝑋 = 𝑉𝑎𝑟(𝑋)
When the covariance of returns of two assets is negative, it means that when the
return on one asset is above its expected value, the return on the other tends to be
below its expected value.
When the covariance of returns of two assets is positive, it means that when the
return on one asset is above its expected value, the return on the other also tends
to be above its expected value. Also holds for negative.
Random variables whose covariance is zero are called uncorrelated.

The correlation coefficient measures the strength and direction of the linear
relationship between two random variables. It is calculated by dividing the
covariance of the two random variables by the product of their standard deviations.
𝐶𝑜𝑣(𝑋, 𝑌)
𝐶𝑜𝑟𝑟 𝑋, 𝑌 =
𝜎𝑋 𝜎𝑌
Can range from –1 and +1.
–1 indicates a perfect negative linear relationship between two random variables.
+1 indicates a perfect positive linear relationship between two random variables.
0 indicates no linear relationship between two random variables.
It has no unit.

QUESTION
A) Covariance has unit.
B) If correlation coefficient is zero then two random variables are independent.
C) The covariance of a variable with itself is correlation coefficient.
Zero correlation coefficient indicates no linear relationship

The covariance of a variable with itself is variance
QUESTION
The covariance of the returns of assets X and Y is 7.1.

The standard deviation of returns on asset X is 4
The variance of returns on asset Y is 9.
The correlation coefficient is closest to?
A) 0.592.
B) 0.049.
C) 0.197.
𝐶𝑜𝑣(𝑋, 𝑌) 7.1
𝐶𝑜𝑟𝑟 𝑋, 𝑌 = = = 0.592
𝜎𝑋 𝜎𝑌 (4) 9
THE EXPECTED VALUE, VARIANCE, AND STANDARD DEVIATION OF A RANDOM
VARIABLE AND OF RETURNS ON A PORTFOLIO;
𝑛
𝐓𝐡𝐞 𝐞𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 = 𝐸 𝑅 = 𝑃(𝑅𝑖 )(𝑅𝑖 ) .

𝑖=1
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐩𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 = 𝜔𝑖 𝐸(𝑅𝑖 ) .

𝑖=1
𝐓𝐡𝐞 𝐯𝐚𝐢𝐫𝐚𝐧𝐜𝐞 = 𝑉𝑎𝑟 𝑅 = 𝑃(𝑅𝑖 )(𝑅𝑖 −𝐸(𝑅))2 = (𝜎𝑅 )2

𝑖=1
𝐓𝐡𝐞 𝐬𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐝𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 = 𝜎𝑅 = 𝑉𝑎𝑟 𝑅
𝑻𝒉𝒆 𝒗𝒂𝒊𝒓𝒂𝒏𝒄𝒆
= (𝜔1 )2 (𝜎1 )2 + 𝜔2 2 𝜎2 2 +2𝜔1 𝜔2 𝐶𝑜𝑣 𝑅1 , 𝑅2
𝐨𝒇 𝒕𝒘𝒐 𝒂𝒔𝒔𝒆𝒕𝒔 𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐

QUESTION
Investor’s portfolio consist of two assets.
Market value of asset A is $70 000

Market value of asset B is $210 000
𝐸 𝐴 = 21%, 𝐸 𝐵 = 7%, 𝜎𝐴 = 30%, 𝜎𝐵 = 10%, 𝐶𝑜𝑟𝑟 𝐴, 𝐵 = 0.3
Portfolio expected return is closest to:
A) 0.105.
B) 0.140.
C) 0.170.
70 000 210 000

𝐸 𝑃 = 0.21 + 0.07 = 0.105
210 000 + 70 000 210 000 + 70 000
QUESTION
Investor’s portfolio consist of two assets.
Market value of asset A is $70 000

Market value of asset B is $210 000
𝐸 𝐴 = 21%, 𝐸 𝐵 = 7%, 𝜎𝐴 = 30%, 𝜎𝐵 = 10%, 𝐶𝑜𝑟𝑟 𝐴, 𝐵 = 0.3
Portfolio variance is closest to:
A) 1.4625%.
B) 1.4625%2 .
C) 12.1%.
Variance 𝑃 = 0.252 0.302 + 0.752 0.102 + 2(0.25)(0.75)(0.3)(0.3)(0.1) = 0.014625

CALCULATION OF COVARIANCE GIVEN A JOINT PROBABILITY FUNCTION
Given the joint probabilities for pairs of Xi and Yi

𝑛
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝑋, 𝑌) = 𝑃(𝑋 = 𝑋𝑖 ; 𝑌 = 𝑌𝑖 )(𝑋𝑖 − 𝐸 𝑋 )(𝑌𝑖 − 𝐸 𝑌 )

𝑖=1
Y
X 𝑌 = 𝑌1 𝑌 = 𝑌2 … 𝑌 = 𝑌𝑖
𝑋 = 𝑋1 𝑃1,1 𝑃1,2 … 𝑃1,𝑖
𝑋 = 𝑋2 𝑃2,1 𝑃2,2 … 𝑃2,𝑖
… … … … …
𝑋 = 𝑋𝑖 𝑃𝑖,1 𝑃𝑖,2 … 𝑃𝑖,𝑖

QUESTION
RETURN ON ASSET B
RETURN ON ASSET A R(A) = - 0.25 R(B) = 0.4
R(A) = 0.15 0.1 0.2
R(A) = 0.00 0.3 0.4
Given the joint probability table portfolio covariance is closest to:
A) 0.
B) 0.00195.
C) -0.00195.
𝐸 𝐴 = 0.15 ∙ 0.3 + 0.00 ∙ 0.70 = 0.045
𝐸 𝐵 = −0.25 ∙ 0.4 + 0.40 ∙ 0.6 = 0.140
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝐴, 𝐵 =
0.1 ∙ 0.15 − 0.045 ∙ −0.25 − 0.14 +
0.2 ∙ 0.15 − 0.045 ∙ 0.4 − 0.14 +
0.3 ∙ 0.00 − 0.045 ∙ −0.25 − 0.14 +
0.4 ∙ 0.00 − 0.045 ∙ 0.4 − 0.14 = -0.004095+0.00546+0.005265-0.00468 = 0.00195
USING BAYES’ FORMULA
Bayes’ formula meaning is
𝑃(𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛|𝐸𝑣𝑒𝑛𝑡) ∙ 𝑃(𝐸𝑣𝑒𝑛𝑡)
𝑃 𝐸𝑣𝑒𝑛𝑡 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 =
𝑃(𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛)
𝑃(𝐵𝑙𝑢𝑒|𝐸𝑣𝑒𝑛 𝑛𝑢𝑚𝑏𝑒𝑟) ∙ 𝑃(𝐸𝑣𝑒𝑛 𝑛𝑢𝑚𝑏𝑒𝑟)

𝑃 𝐸𝑣𝑒𝑛 𝑛𝑢𝑚𝑏𝑒𝑟 𝐵𝑙𝑢𝑒 =
𝑃(𝐵𝑙𝑢𝑒)
0.5 ∙ 0.5 2
𝑃 𝐸𝑣𝑒𝑛 𝑛𝑢𝑚𝑏𝑒𝑟 𝐵𝑙𝑢𝑒 = =
0.375 3

QUESTION
FERRARI BMW AUDI
RED 70 50 20
YELLOW 10 10 20
GREEN 20 40 60
The chance that a random yellow car is Ferrari is closest to:
A) 0.25.
B) 0.10.
C) 0.133.
10 100
∙
𝑃 𝐹𝑒𝑟𝑟𝑎𝑟𝑖 𝑌𝑒𝑙𝑙𝑜𝑤 = 100 300 = 0.25
40
300
FACTORIAL, COMBINATION, AND PERMUTATION CONCEPTS.
The number of ways to order n objects is factorial

𝑛! = 𝑛 𝑛 − 1 𝑛 − 2 … 1
The number of ways to assign k different labels to N items, where 𝑛𝑖 is the

number of items with the label i is calculated using labeling formula
𝑁!
;
𝑛1 ! 𝑛2 ! … 𝑛𝑘 !
The number of ways to choose a subset of size r from a set of size n when order
𝑛!
doesn’t matter is combinations ( );
𝑛−𝑟 !𝑟!
𝑛!
when order matters, there are permutations ( ).
𝑛−𝑟 !

QUESTION
There are ten people in the room and everyone shakes hands, how many total
handshakes are there?
A) 45
B) 90
C) 50.
The number of ways to choose a subset of size r from a set of size n when order
𝑛! 10!
doesn’t matter is combinations = = 45
𝑛 − 𝑟 ! 𝑟! 8! 2!
QUESTION
A sponsor is evaluating 8 students for their annual academic achievement review.

According to the scholarship policy:
2 of them will be evaluated as “full tuition scholarships”
3 of them will be evaluated as “partial tuition scholarships”
3 of them will be evaluated as “standard academic scholarships“
How many different ways is it possible for the sponsor to assign these scholarships?
A) 280
B) 336
C) 560
The number of ways to assign k different labels to N items, where 𝑛𝑖 is the

number of items with the label i is calculated using labeling formula
𝑁! 8!
= = 560
𝑛1 ! 𝑛2 ! … 𝑛𝑘 ! 3! 3! 2!
HOMEWORK ASSIGNMENT
READING
PRACTICE PROBLEMS

Quantitative Methods - Reading 6-9

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QUANTITATIVE METHODS: BASIC CONCEPTS

THE TIME VALUE OF MONEY

CFA®, AND CHARTERED FINANCIAL ANALYST® ARE

READING 6 THE TIME VALUE OF MONEY 2

Interest rates can be thought of in three ways:

READING 6 THE TIME VALUE OF MONEY 3

REAL EXPECTED DEFAULT

READING 6 THE TIME VALUE OF MONEY 4

Saving account after 1 year

𝐹𝑉1 = 𝑃𝑉 + 𝑃𝑉 × 𝑟𝑎𝑡𝑒 = 𝑃𝑉(1 + 𝑟𝑎𝑡𝑒)

Saving account after 2 years

𝐹𝑉2 = 𝐹𝑉1 + 𝐹𝑉1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉1 (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 2

𝐹𝑉𝑛 = 𝐹𝑉𝑛−1 + 𝐹𝑉𝑛−1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉𝑛−1 × (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 𝑛

READING 6 THE TIME VALUE OF MONEY 5

The stated annual rate (SAR) is a rate used in calculation of EAR.

If there is no intra-year compounding, then after one year, it would be $110.

READING 6 THE TIME VALUE OF MONEY 6

2 105,0000 105,0625 +0.0625

3 107,5000 107,6891 +0.1891

4 110,0000 110,3813 +0.3813

READING 6 THE TIME VALUE OF MONEY 7

EAR = (1 + 9%/12)12 −1 ≈ 9.38%

READING 6 THE TIME VALUE OF MONEY 8

As number of compounding periods per year increases EAR increases but at

1 (no intra-year compounding) 9,0000%

365 (daily) 9,4162%

525 600 (every minute) 9,4174%

READING 6 THE TIME VALUE OF MONEY 9

As number of compounding periods per year goes to infinity (continuous

READING 6 THE TIME VALUE OF MONEY 10

C) required rates of return.

2% interest can be best characterized as an opportunity cost - the return he could

READING 6 THE TIME VALUE OF MONEY 11

C) required rates of return.

Yield of short-term highly liquid OFZ (Russian government bond nominated in

A) real risk-free rates because they contain an inflation premium.

B) nominal risk-free rates because they do not contain an inflation premium.

C) nominal risk-free rates because they contain an inflation premium.

OFZ is a government issued security and is therefore considered to be default risk

A) EAR increases at a decreasing rate.

B) EAR decreases at an increasing rate.

C) EAR remains the same.

READING 6 THE TIME VALUE OF MONEY 15

Stated Weekly Rate= 11/10 − 1 = 10%

READING 6 THE TIME VALUE OF MONEY 16

READING 6 THE TIME VALUE OF MONEY 17

SINGLE CASH FLOW FORMULAS

READING 6 THE TIME VALUE OF MONEY 18

READING 6 THE TIME VALUE OF MONEY 19

SET OF IDENTICAL CASH FLOWS

FINITE SET INFINITE SET

CASH FLOWS OCCUR CASH FLOWS OCCUR

READING 6 THE TIME VALUE OF MONEY 20

Sum of geometric sequence 𝑏 − first term

Let’s multiply both sides by q

READING 6 THE TIME VALUE OF MONEY 21

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

We have a geometric sequence with

As sum of a geometric sequence equals

READING 6 THE TIME VALUE OF MONEY 22

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

And again, we have a geometric sequence with

READING 6 THE TIME VALUE OF MONEY 23

READING 6 THE TIME VALUE OF MONEY 24