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Quantitative Methods: House of Knowledge
Quantitative Methods: House of Knowledge
Revision Notes
CFA Level I
Quantitative
Methods
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
3. IRR = used to calculate IRR for the input cash flows (Press CPT)
NPV is the sum of PV of all cash flows | IRR is the rate that will make NPV = 0.
TVM Concepts:
1. Compound Interest = Interest on Principal + Interest on all Past Interests.
2. PV = Present Value
3. FV = Future Value
Time Lines:
For Time Value of Money
1. T0 = Today
2. Tn = nth period in time
3. Outflows are ve Cash Flows
4. Inflows are +ve Cash Flows
*
2
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HOUSE OF KNOWLEDGE
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Interest Rates:
Real Risk-free Rate: Rate of Interest with no exceptions of future inflation
All risks have their own risk premiums that add to Nominal Rate to get
required Rate of Interest/Discount.
Required Rate = Nominal Risk-free Rate
+ Default Risk Premium
+ Liquidity Risk Premium
+ Maturity Risk Premium
USE TVM FOR SINGLE STREAM CALCULATIONS OR FOR ANNUITY SUMS ONLY.
* Always remember to clear TVM before every sum. Infact, clear TVM twice, before
and after every sum. You can never be over cautious in this case.
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HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
I.
Rules of Acceptance
NPV
NPV > 0
NPV < 0
NPV = 0
IRR
IRR > Disc. Rate
IRR < Disc. Rate
IRR = Disc. Rate
Result
Accept
Reject
Indifferent
When IRR and NPV create conflict between the options available, go with NPV.
Measures of Return:
1. Holding Period Return (HPR)
HPR = End Value + Cash Flows Received - 1
Beginning Value
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
Statistics
Descriptive
Summarizes important
characteristics of large data to
produce useful information.
Inferential
Procedures to make forecasts,
estimates, judgment on total
population based on sample
Population = Set of all possible outcomes. (Too costly and time consuming)
Sample
= Its a subset of Population. A Group of few outcomes of the population.
Statistic
Population
Sample
Size
N
n
Mean
Variance
2
s2
Std. Dev.
Measurement Scales:
1. Nominal = Gives least information. Used for counting/classification. No order.
2. Ordinal = Used with specific characteristic to classify or rank. Eg. A-list stocks
3. Interval = Like Ordinal, however the difference between classes is equal. Eg. OC
4. Ratio
= Most refined. Gives Rank, Equal Class Interval and True Origin.
Frequency Distribution Table
Class
Freq.
Cum.
(Xi)
(f)
Freq. ()
1
5
5
2
25
30
3
40
70
4
65
135
5
35
170
6
20
190
7
10
200
200
Arithmetic Mean
Median
Mode
Variance
Standard Deviation
Geometric Mean
Harmonic Mean
Coefficient of variance
Mean Average Deviation
( )
(M)
(Z)
(2)
()
(GM)
(HM)
(CV)
(MAD)
Cum.
Freq. ()
200
195
170
130
65
30
10
= 4.00
= 3.00
= 4.00
= 1.96
= 0.98
= 3.72
= 3.40
= 0.24
= 1.05
Rel.
Freq.
2.50%
12.50%
20.00%
32.50%
17.50%
10.00%
5.00%
100%
Class x Freq.
(Xi) x (f)
5
50
120
260
175
120
70
800
Deviation2
9
4
1
0
1
4
9
28
[800/200]
[(n+1/2)th term = 100.5th term]
[Maximum Frequency]
[f(Xi - )2/(f -1) = (390/199)]
[(f(Xi- )2/(f-1))1/2 = (390/199)1/2]
[200th root of product of all Xi^f]
[200/ (f/Xi)]
[/ = 0.98/4]
[f(|Xi |)/ f = 210/200]
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
[* Interpolate]
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
Frequency Distribution
1. Normal Distribution
2. Skewness
3. Kurtosis
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
I.
Probability concepts
A. 2 properties of probabilities
- Probability of any event E will always be between 0 & 1. [0 P(E) 1]
- If a set of events, E1, E2 En, is mutually exclusive and exhaustive, the
probabilities of those events sum to 1 (i.e., P(Ei) = 1).
B. Calculation of probability
P(E) = n(E)
[Number of outcomes of event E]
n(S)
[Number of outcomes of the population]
C. Probability Rules
Multiplication Rule
Addition Rule
Joint Probability
Independent events
Expected Value
Variance
: Var(X) = 2(X) = {P(Xi)*[Xi E(Xi)]2}
Standard Deviation = (Variance)1/2
Covariance (Ri and Rj) : Cov(Ri, Rj) = E{[Ri E(Ri)][Rj E(Rj)]}
Cov(RA, RA) = Var(RA)
Correlation (Ri and Rj) : Corr(Ri, Rj) = Cov(Ri, Rj) / [(Ri) * (Rj)]
Bayes Updated Prob. : Prob. of new info for given event x Prior Prob. of Event
Unconditional Prob. of new info.
Factorials (n!)
Number of Outcomes
Combination : nCr =
n!
(n-r)! r!
Permutation : nPr =
n!
(n-r)!
HOUSE OF KNOWLEDGE
CFA | FRM | CFP Classrooms
II. Probability Distribution
E(x)
z=0
68%
95%
Z-value:
z = Observation Mean
Standard Deviation
=x
Monte Carlo simulation uses randomly generated values for risk factors, based
on their assumed distributions, to produce a distribution of possible security
values. Its limitations are that it is fairly complex and will provide answers that
are no better than the assumptions used.
HOUSE OF KNOWLEDGE
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Sampling Techniques
Standard Error ( ) : x/(n)1/2
Confidence Interval (for population mean)
Known Population Variance
: + z*/(n)1/2
Unknown Population Variance : + t*s/(n)1/2
(Use z-statistic)
(Use t-statistic)
Hypothesis Testing
The hypothesis testing process requires
- a null hypothesis
- an alternative hypothesis
- appropriate test statistic
- significance level
- a decision rule
- the calculation of a sample statistic
- a decision regarding the hypotheses
- a decision based on the test results.
The null hypothesis (H0) is what the researcher wants to reject. The alternative
hypothesis (Ha) is what the researcher wants to prove, and it is accepted when
the null hypothesis is rejected.
A two-tailed test results from a two-sided alternative hypothesis (e.g., Ha:
A one-tailed test results from a one-sided alternative hypothesis (e.g., Ha: >
0).
0)
A Type I error is the rejection of the null hypothesis when it is actually true.
A Type II error is the failure to reject the null hypothesis when it is actually false.
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HOUSE OF KNOWLEDGE
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Test Statistic
known 2
unknown 2
z-statistic
t-statistic
Normal
Distribution
Hypothesized Value
z=
- 0
/(n)1/2
Students T
Distribution
0
z=
- 0
s/(n)1/2
Comparison
Students T
Distribution
t-statistic
When pooled
variance:
t=
12
2
sp + sp2
n1 n2
Single Variance
Chi-square
Distribution
Chi-square
02
X2(n-1) = (n-1)s2
02
Comparison
F-Distribution
F-statistic
F = s12
s22
When cannot
pool variance:
t=
12
2
s1 + s22
n1 n2
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