Quantitative Analysis

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© EduPristine CFA - Level – I
 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

© EduPristine CFA - Level – I 2

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Required Interest rate

Future value Present value Annuities NPV
• Real interest rate
• Default Risk
Series of equal cash flows • Liquidity Risk
Value of current cash flow in Present value of future T Ct • Maturity Risk
Future – Compounding cash flow – Discounting occurring at evenly NPV = ∑ − C0
t =1 (1 + r) • Inflation Rate
t
spaced interval

Amount to which investment Ordinary annuity: cash flow NPV is expressed in monetary
Current value of some future
grows after one or more time at end-of-time period units ($), IRR is the true
cash flow PV = FV /(1 + 1/Y)N.
period FV = PV*(1+1/Y)N. interest yield (%age).
In general NPV is a better
Annuity due: cash flow at measure.
Q: Q: beginning-of-time period
If interest rate of 8%, what will If interest rate of 10%, What
be the value of sum of $1,000 sum invested today will grow
invested today will grow in 5 to $1,000 in 5 years? PV of Annuity Due = PV of
years? Ans: Ordinary Annuity * (1 + r)
Ans: PV = FV * (1/(1 + r)N)
FV=PV*(1+r)n = ($1,000)*(1/(1.1)^5) = 621 Perpetuities: annuities with
=1,000*(1.08)5 an infinite life PVperpetuity =
= $1,469.3 PMT / discount rate
We need to know the first
three rows of TI BA-II Plus/ Q:
Professional calculator for What is the worth of perpetuity
CFA Exam paying $100 annually at an
interest rate of 10%?
Ans:
PVPerpetuity = A/r
= $100/0.1 = $1,000
© EduPristine CFA - Level – I 3
 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Holding Period Return

IRR Rates of Return on a Portfolio
(Total Return)

Discount rate that makes NPV
of all cash flows equal to zero
For mutually exclusive
projects, NPV and IRR can give
conflicting rankings. NPV is a
better measure in such cases.
Q:
If I have to invest today $2,000
for a project which gives me
$100 next year, $200 the next,
and $250 after that till
perpetuity, should I make this
investment?
Cost of Capital = 10%.
Ans:
Value of Perpetuity
(At Y2) = 250/0.1 = 2,500
Year Cash PV
0 -2000 -2000
1 100 90.91
2 200+2500 2231.40
NPV 322.31
Money Weighted
Total return: • PVs of Cash Inflow = PVs of
Rt= [(Pt+Dt)/Pt-1]-1 Cash Outflows
• Solve for discounting rate 'r'
Effective Annual Yield
EAY = (1+HPY)365/t - 1 Time Weighted
• Form subperiods over the
accounting period
• Compute HPR for each
Bank Discount Yield
subperiod
RBD = D/F * 360/t
• Multiply (1+HPR) for each
subperiod to get the total
return
Money Market Yield
rMM = 360 * RBD /(360 – t * RBD)
Q: A stock is bought today at
$10. It pays a dividend of $1
& you sell it at $15 next year.
What is the HPR?
Ans:
HPR = (15+1-10)/10 = 60%

© EduPristine CFA - Level – I 4

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Means Variance & Std. Deviation Measurement Scales

N
 Xi  Average of squared deviations from Nominal
Arithmetic mean: =
∑  N 
i =1
mean. Population variance: Only classification, doesn’t rank Eg:
Types of hedge funds
∑ (X −X)
N 2
i

Geometric mean: Calculating investment σ2 = i =1

N Ordinal
returns over multiple period or to measure Sample variance: Ranks as per scale Eg: Credit Rating
compound growth rates 2
RG = [(1+R1)*..*(I+RN)]1/N-1
N
 −

∑  Xi − X 
i =1  
Interval
s =
2
Classifies elements in an interval. Eg:
n −1
Temperature
N
 1 
Harmonic mean = ∑  X  Standard deviation:
i =1  i Ratio
σ or s = Variance
Strongest form of measurement. Eg:
Q: Length, return on stocks
ABC was inc. on Jan 1, 2004. Its expected Chebyshev's Inequality: % of
annual default rate of 10%. Assume a constant observations lying within k-standard
quarterly default rate. What is the probability deviations of the mean >= 1-1/k2
that ABC will not have defaulted by April 1,
2004?
Ans: Calculate the standard deviation of
P(No Default Year) = P(No def all Quarters) following data set:
= (1-PDQ1)*(1-PDQ2)*(1-PDQ3) * (1-PDQ4) Data Set A: 10,20,30,40,50
PDQ1 = PDQ2= PDQ3 = PDQ4 = PDQ Data Set B: 10,20,70,120,130
P(No Def Year) = (1-PDQ)4
P(No Def Quarter) = (0.9)^1/4 = 97.4%

© EduPristine CFA - Level – I 5

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Expected Return / Std. Deviation Correlation & Covariance

Correlation = Corr(Ri, Rj) = Cov(Ri, Rj) / σ(Ri)*σ(Rj)

Expected Return:
Expected return, Variance of 2-stock portfolio:
E(X)=P(x1)x1+P(x2)x2+…….+P(xn)xn
E(Rp) = wAE(RA) + wBE(RB)
VaR(Rp) =wA2σ2(RA)+ wB2σ2(RB) +2wA wBσ(RA) σ(RB)ρ(RA,, RB)
Probabilistic variance:
σ2(x) = ∑ P ( xi )[ xi − E ( X )]2

= P(x1)[x1-E(X)]2+P(x2)[x2-E(X)]2+…….+
P(xn)[xn-E(X)]2
Q:
Amit has invested $300 in Security A, which has a mean return
of 15% and standard deviation of 0.4. He has also invested
$700 in security B, which has a mean return of 7% and variance
of 9%. If the correlation between A and B is 0.4, What is his
overall expectation and Standard deviation of portfolio?
Return = 9.4%, Std Deviation = 7.8%
Return = 9.4%, Std Deviation = 24%
Return = 9.4%, Std Deviation = 28%
Ans:
The correct answer is Return = 9.4%, Std Deviation = 24%
w 2σ A2 + (1 - w) 2 σ B2 + 2w(1 - w) Cov(A, B)

Calculate the correlation between the following data set:

Data Set A: 10,20,30,40,50
Data Set B: 10,20,70,120,130

© EduPristine CFA - Level – I 6

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Sharpe Ratio Coefficient of Variation Measurement Scales

Measures excess return per unit of risk.
Sharpe ratio = r p − r f
σ p
Roy's safety- First ratio: r −r
p t arg et
σ p
Sharpe Ratio uses risk free rate,
Roys Ratio uses Min. hurdle rate
For both ratios, larger is better.
Dispersion relative to mean of a
distribution; CV=σ/μ (σ is std dev.)
Q:
If the threshold return is higher than the
risk-free rate, what will be the
relationship b/w Roy's safety-first ratio
(SF) and Sharpe's ratio?
• Denominator (Sharpe) =
Denominator (SF)
• Rtarget > Rf
• R – Rf > R - Rtarget
• Sharpe > SF
Ans:
R – Rf > R - Rtarget
Nominal Scale: Observations classified with no order. e.g.
Participating Cars assigned numbers from 1 to 10 in the car race.
Ordinal Scale: Observations classified with a particular ranking
out of defined set of rankings. e.g. Driver assigned a pole position
according to their performance in heats.
Interval Scale: Observations classified with relative ranking.
It's an ordinal scale with the constant difference between the
scale values. e.g. Average temperature of different circuits.
Ratio Scale: It's an interval scale with a constant ratio of the scale
values. True Zero point exists in the ratio scale. e.g. Average
speed of the cars during the competition.
Q:
Which of the following type of scale is used when interest rates
on Treasury bill is mentioned for 60 years?
A. Ordinal scale
B. Interval scale
C. Ratio scale
Ans: Ratio Scale

Expect 1 questions form Measurement Scales

© EduPristine CFA - Level – I 7

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Definition & Properties Sum Rule and Bayes' Theorem Dependent and Independent Events

•Empirical probability: Derived from A and B are independent if and only if

• P(B) = P(A∩B)+ P(Ac ∩B)
historical data P(A|B) = P(A)
= P(B│A)*P(A) + P(B│Ac)*P(Ac)
• A Priori probability: Derived by formal
reasoning
• P(A|B) = P(B│A)*P(A) / If the above condition is not satisfied,
•Subjective probability: Derived by
[P(B│A)*P(A)+P(B│Ac)*P(Ac)] they are dependent events
personal judgment

•P(A) = No. of fav. Events / Total
possible events
•0 < P(A) <1, P(Ac) = 1-P(A)
•P(AUB) = P(A) + P(B) - P(A∩B)
•If A,B Mutually exclusive:
P(AUB) = P(A)+P(B)
•P(A│B) = P(A∩B)/P(B)
•P(A∩B) = P(A│B)P(B)
•If A,B Independent: P(A∩B) = P(A)P(B)
Q:
The subsidiary will default if the parent
defaults, but the parent will not
necessarily default if the subsidiary
defaults. Calculate Prob. of a subsidiary
& parent both defaulting. Parent has a
PD = 0.5% subsidiary has PD of.9%
Ans:
P(P∩S) = P(S/P)*P(P)
= 1*0.5%
= 0.5%

© EduPristine CFA - Level – I 8

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Normal Distribution Binomial Distribution

Normal Distribution Z-Score Skewness and Kurtosis

• Continuous Distribution
No. of σ a given observation is away from
• Described by mean & variance
population mean.
• Symmetric about its mean
Z=(x-µ)/σ
• Standard Normal Distribution
- Mean = 0; Variance =1

Q:
At a particular time, the market value of assets of the firm is
68% of
$100 Mn and the market value of debt is $80 Mn. The
Data standard deviation of assets is $10 Mn. What is the distance
to default?
95% of Ans:
Data
99.7% z = (A-K)/σA
of Data = (100-80)/10
-4 -3 -2 -1 0 1 2 3 4 =2

Q: Q:
If Z is a standard normal R.V. An event X is defined to happen if either Which of the following is likely to be a probability distribution function?
-1< Z < 1 or Z > 1.5. What is the prob. of event X happening if N(1) = 0.8413, For X=[1,2,3,4,5], Prob[Xi]= 49/(75-Xi2)
N(0.5) = 0.6915 and N(-1.5) = 0.0668, where N is the CDF of a standard normal For X=[0,5,10,15], Prob[Xi]= Xi/30
variable? For X=[1,4,9,16,25], Prob[Xi]= [(Xi)1/2 – 1]/5
Ans: Ans:
P(X)= P(-1< Z < 1) + P(Z > 1.5) The correct answer is For X=[0,5,10,15], Prob[Xi]= Xi/30
= N(1) - (1-N(1)) + N(-1.5) For all values of X, probability lies within [0,1] and sum of all the probabilities is
= 2*0.8413-1 + 0.0668 -1 +1 1.5 equal to 1.
= 0.7494

© EduPristine CFA - Level – I 9

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Normal Distribution Binomial Distribution

Normal Distribution Z-Score Skewness and Kurtosis

Negative-Skewed
Median Mode Skewness Kurtosis

Mean

Positively: Leptokurtic: More peaked than

Mean > median > mode normal (fat tails); excess kurtosis > 0
Negatively: Platykurtic: Less peaked / Flatter than
Mean < median < mode a normal; excess kurtosis <0
Symmetric
Skewness of Normal = 0 Mesokurtic: Kurtosis of Normal = 3
Mean = Median = Mode

Q:
If distributions of returns from
financial instruments are
leptokurtotic. How does it compare
with a normal distribution of the same
Positive-Skewed
mean and variance?
Mode Median Ans:
Leptokurtic refers to a distribution
Mean
with fatter tails than the normal,
which implies greater kurtosis.

© EduPristine CFA - Level – I 10


Time Value Descriptive
of Money Statistics
Normal Distribution
Roy's Safety First Criterion:
For optimal portfolio, minimize SF
Ratio,
SF Ratio = [E(RP) – RL] / σP
Shortfall Risk = Probability
corresponding to SF Ratio
© EduPristine CFA - Level – I
Quantitative Analysis
Probability Hypothesis Technical
Probability Sampling
Distributions Testing Analysis
Tracking Error Uniform Distribution Binomial Distribution
Tracking Error • Continuous Distribution
= Total return on a portfolio • Outcomes uniformly distributed
(gross of fees) - the total return between a and b
on the benchmark
In an Index Fund, the tracking
error should be minimal
Example: If a portfolio of U.S.
stocks has a return of 5% in a
period when a comparable U.S.
stock index increases by 6%(both
on a total return basis), the
portfolio's tracking error for that
period is -1%
11
 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Normal Distribution Tracking Error Binomial Distribution

Discrete Distribution:
• Variables can take 2 values (success / failure)
• Expected Value = np
• Variance = np (1-p) (constant)
• Can describe changes in the value of an asset
or portfolio
• The probability distribution for a Binomial Random
Variable is given by:
P( X = x)= nC x p x (1 − p) n− x
• Mean = np, variance = np(1-p)

Q:
The Prob. of a stock moving up is 0.8 and moving
down is 0.2 in a particular day. What is the probability
that it would move up at least twice in the 5 working
days of the week?
Ans:
P = 0.8, q = 0.2, n = 5
P(X> = 2) = 1-P(X = 0) – P(X = 1)
=1- nCr(5,0)*(0.8)0*(0.2)5 – nCr(5,1)*(0.8)1*(0.2)4
= 1-(0.2)5 – 5*(0.8)1*(0.2)4
= 0.99328

© EduPristine CFA - Level – I 12

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Central Limit Theorem Sampling Distribution Standard Error (SE)

Probability distribution of all possible sample SE (σx) of the sample mean is σ of the dist. of
statistics computed from a set of equal-size sample means
samples randomly drawn from the same • Known pop. Var. σx= σ/ √(n)
population • Unknown pop. var sx= s/ √(n)

Sampling Biases Q:
•Data Mining 25 observation are taken from a sample of
•Sample Selection unknown variance. Sample mean of 70 and
•Survivorship σ = 60. You wish to conduct a 2-tailed test of
•Look-Ahead null hypothesis that the mean is equal to 50.
As Sample Size increases, Sampling Distribution •Time-Period What is most appropriate test statistic?
Becomes Almost Normal regardless of shape of Ans:
population Standard Error of mean
(σx) = σ/ √(n) = 60/sqrt(25) = 12
Degrees of freedom = 24
Use t-statistic = (x – μ)/ σx = (70 – 50)/12 = 1.67

Expect 1 question on the calculation of standard error!!!

© EduPristine CFA - Level – I 13

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Null Hypothesis: Alternative Confidence Intervals Hypothesis Tests One Tailed Two Tailed
H0 Hypothesis: Ha (CI) for Variances Test Test

Range of values within which H0 Cannot be

Hypothesis that the researcher Concluded if there is significant rejected (say 90% or 95%).
wants to reject evidence to reject H0 Known variance, 2 Tailed test, CI is:
X"± zα/2(σ/√t)

Test Statistic = (sample statistic – Real State of Affairs

hypothesized value)/standard error of Inference Based on
sample statistic Sample Data
H0 is True H0 is False

Type-I error: Rejection of H0 when it is Correct decision Type II error

actually true H0 is True
Type-II error: Fail to reject H0 when it is Confidence level = 1- α P (Type II error) = β
actually false Type I error Correct decision
Power of a test: probability of correctly H0 is False
rejecting the null hypothesis when it is false Significance level = α* Power = 1-β

Q: Co. ABC would give bonus to employees, *Term α represents the maximum probability of committing a Type I error,
if they get a rating higher than 7/10 from Type II error cannot be computed easily
customers. A random sample of 30
customers is conducted with rating of
7.1/10. Formulate Hypothesis?
• Null Hypothesis: H0: Mean<=7
• Alternate Hypothesis: H1: Mean>7
• Statistic to be measured: t-statistic,
with 29 DoF
© EduPristine CFA - Level – I 14
 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Null Hypothesis: Alternative Confidence Intervals Hypothesis Tests One Tailed Two Tailed
H0 Hypothesis: Ha (CI) for Variances Test Test

Test if the value is greater than or

Tests for a Single Tests for a two Test if the value is different from K
less than K
Population Variances Population Variances H0; µ=0 vs. Ha: µ≠ 0
H0; µ<=K vs. Ha: µ>K

Chi-Square test F test 0.2 0.2

0.15 0.15

α= 0.05
0.1 0.1
α= 0.025

s12
α= 0.025

H0: σ2 = c (n − 1)s 2 H0: σ12 – σ22 = 0

0.05 0.05

HA: σ2 ≠ c χ2 = HA: σ12 – σ22 ≠ 0 F= 2

σ2 s2 -5 Z=0
0
0 Z=2.5
5 Reject H0 -5
0
Z=0
Reject H0
Do not Reject H0
Reject H0
Do not Reject H0

H0: σ12 – σ22 = 0 Q:

Upper tail test:
HA: σ12 – σ22 ≠ 0 If standard deviation of a normal population is known to be 10 & the mean
H0: σ2 ≤ σ02
is hypothesized to be 8. Suppose a sample size of 100 is considered. What is
HA: σ2 > σ02
the range of sample means in which hypothesis can be accepted at
α significance level of 0.05?
α/2
Ans: SE = σ n = 10/√100 =1
χ2 F
Do not reject H0 Reject H0 Do not Reject H0 z = (x-µ)/ SE = (x-8)/1
χ2α reject H0 Fα/2 At 95% -1.96<z<1.96
Therefore 6.04<x<9.96

© EduPristine CFA - Level – I 15

 Quantitative Analysis

Time Value Descriptive Probability Hypothesis Technical

Probability Sampling
of Money Statistics Distributions Testing Analysis

Trend Analysis Elliot Wave Theory Technical Analysis Indicators

• It is based on the observation that market In a Bull Market Price Based Indicators
participants tend to act in herds and that trends tend An impulse wave consists • Moving Average Lines – mean of last n closing prices
to stay in place for some time. 1 = up • Bollinger Bands – standard deviation of closing prices
• In an uptrend, the security's prices goes to higher 2=down over the last n days
highs and higher lows 3=up • Oscillators
• A downward trend makes lower lows and lower highs 4=down Based on market prices, scaled to oscillate around a
Support: 5=up given value
A low price range in which buying activity is sufficient A Corrective Wave • Rate of change oscillators
to stop the decline in price. a=down • Relative Strength Index
b=up • Moving Average Convergence/Divergence
Resistance: c=down • Stochastic Oscillator
A high price range in which selling is sufficient to stop In a Bear Market, the impulse waves
the rise in price. are named A-E and the corrective
waves are numbered 1-3. Sentiment Based Indicators
Change in polarity principle: • Put/Call Ratio
Once a support level is breached, it becomes a • Volatility Index
resistance level and once a resistance level is Fibonacci Sequence: • Margin Debt
breached, it becomes a support level. • 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 … • Short Interest Ratio
Fibonacci ratios: • Arms Index (TRIN)
• ½=0.5, 2/3=0.67, 3/5=0.6, 5/8=0.625 • Mutual Fund Cash Position
• Supply-Demand dictate prices etc… • New Equity Issuance
• Driven by rational & irrational behavior • 2/1=2, 3/2=1.5, 5/3=1.67, 8/5=1.60,
• Prices move in trends that persist for long periods 13/8=1.625
• Observe the actual shifts in supply / demand in • The second series of numbers
market prices converge to around 1.618, called the
Golden Ratio
© EduPristine CFA - Level – I 16
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