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Quantitative Methods - Reading 6
Quantitative Methods - Reading 6
Quantitative Methods - Reading 6
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.
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
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)
…
Saving account after n years
𝐹𝑉𝑛 = 𝑃𝑉 × (1 + 𝑟) 𝑛
Suppose the stated annual interest rate on a savings account is 10%, and you put
$100 into this savings account.
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
WITHOUT WITH
QUARTER DIFFERENCE
COMPOUNDING COMPOUNDING
0 100 100 -
1 102,5000 102,5000 -
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
M EAR
2 (semi-annually) 9,2025%
4 (quarterly) 9,3083%
12 (monthly) 9,3807%
𝑟 𝑚
𝐸𝐴𝑅 = lim (1 + ) −1 = 𝑒 𝑟 − 1
𝑚→∞ 𝑚
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.
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.
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.
READING 6 THE TIME VALUE OF MONEY 12
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.
READING 6 THE TIME VALUE OF MONEY 14
QUESTION
As the number of compounding periods increases, what is the effect on the EAR?
As number of compounding periods increases the value of EAR goes to its upper
limit (𝑒 𝑆𝑡𝑎𝑡𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 −1)
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%
520% 52
EAR = (1 + ) −1 = 14104%
52
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
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
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.
ORDINARY ANNUITY
ANNUITY DUE
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
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
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)
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
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
END MODE
PMT = −$300; N = 3; I/Y = 3; PV = 0 CPT FV = $927.27
READING 6 THE TIME VALUE OF MONEY 26
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.
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 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
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
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?
A) 37 500; 34 300
B) 37 000; 34 000
C) 37 000; 34 300
Interest for the second payment = (3 000 000 - 33 870)* 1.25% = 37075
Principal for the first payment = 71370 – 37075 = 34 295
Using a 20% discount rate find the PV of following cash flow stream
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
PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume I Reading 6 Practice Problems