CFA

Quantitative Analysis
C FA

CF A

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 Framework
Framework

Time Value R5 The Time Value of Money

Calculation
F A
R6 Discounted Cash Flow Application
C
Probability& and
R7 Statistics Concepts Market Returns
R8 A
Descriptive Statistics
F
CR9 Common Probability Distributions
Probability Concepts

Inferential Statistics R10 Sampling and Estimation
R11 Hypothesis Testing
R12 Technical Analysis

2-30
 R5 C FA

CFA
Time Value Calculation

3-30
Interest rate
Required rate of return
Discount rate
Opportunity cost
Nominal risk-free rate=real risk-free rate + expected inflation rate
Required interest rate on a security=nominal risk-free rate + default risk

A
premium + liquidity risk premium + maturity risk premium
EAR
C F

m
r
EAR 1 1


F
m

C A


continuous compounding: EAR er 1

The greater the compounding frequency
The greater the EAR will be in comparison to the stated rate
The greater the difference between EAR and the stated rate
Annuity
Ordinary annuity
Annuity due (1) BGN(2) ordinary annuity
Perpetuity
4-30
 C FA
R6

F A
Discounted Cash Flow Applications
C

5-30
NPV&IRR
N
(1 r )
CF1 CF2 CFN CFt
NPV CF0 ...
(1 r )1 (1 r )2 (1 r )N t
t 0
N

(1 IRR)
CF1 CF2 CFN CFt
NPV 0 CF0 ...
(1 IRR )1 (1 IRR )2 (1 IRR )N t 0
t

When NPV=0,the discount rate

C FA
IRR

IRR method assumes the projects cash flows will be reinvested at
the IRR

CF A
Multiple solutions Problem of the IRR calculation (#sign changes)

Independent Projects:
Accept it if NPV>0
Accept it if IRR>r (required rate of return)
Decision Rule Mutually Exclusive Projects:
NPV method : Choose the one with higher NPV
IRR method : Choose the one with higher IRR
NPV and IRR methods may conflict with each other,NPV
6-30

r ( F P0 ) 360
BD
F t
360
rMM HPY
P1 P0 CF1
t BEY 2
HPY
P0 EAY (1 HPY ) 365 / t
1 (1+
2
) =1+EAR

TWRR& MWRR
C FA
TWRR
MWRR

CF A

HPR


nHPR MWRR=IRR

MWRR

7-30
 R7 C FA

F A
Statistical Concepts and Market Return
C

8-30
Types of measurement scales

Nominal scales Ordinal scales Interval scales Ratio scales

(>,<) (>,<,+, -) (>,<,+ ,-,*,/)

mode Modemedian Most refined

C FA

arithmetic meanweighted meangeometric meanharmonic mean

CF A
Mean

harmonic mean <=geometric mean <= arithmetic mean

arithmetic mean
or ending valuegeometric mean

Quartile/Quintile/Deciles/Percentile
Quantiles L=(n+1)y/100
The third quartile > mean 9-30

N n
X
N

MAD i 1
i X (X i ) 2
(X i X )2
For population: 2 i 1
For sample: s 2 i 1
n N n 1

C FA
Chebyshev
Inequality
Regardless of the shape of the distribution;

The proportion of the values that lie within k standard deviations of

F A
the mean is at least 1-1/k2
C


Standard deviation (risk) per unit of sample mean
s
CV= x
X
CV
Scale-free
Relative dispersion
R -R
Sharp ratio= P f
Sharpe excess return per unit of risk P
Ratio

10-30
Skewness ()
Fight fat tail
Positive
Mode<median<mean
skewed
Frequent small losses and a few extreme gains (mean=0)
prefer positive skewness
Left fat tail
Negative Mode>median> mean
C FA
Kurtosis ()
skewed Frequent small gains and a few extreme losses.(mean=0)

CF A
Sample kurtosis>3;Excess kurtosis>0

Leptokurtic
more frequent extremely large deviations from the
mean than a normal distribution
normal distribution
Investors dislike this distribution

Platykurtic Sample kurtosis<3; Excess kurtosis<0

Normal Sample kurtosis=3; Excess kurtosis=0

11-30
 R8 C FA

C F A
Probability Concepts

12-30

0 P(E) 1
Properties of
P(E1)+P(E2)++P(En)=1
Probability
E1En : mutually exclusive and Exhaustive
Empirical probability:
Priori probability:
C FA
Subjective probability:

F A
Mutually exclusive
C
P(AB)=P(A|B)=P(B|A)=0

P(AB)=P(A) P(B)
If exclusive , must not
Independence
independence
Independence =0,

Multiplication rule P(AB)=P(A|B)P(B)=P(B|A)P(A)

() Addition rule P(A or B)=P(A)+P(B)-P(AB)

13-30
Covariance & Correlation

How one random variable moves
with another random variable
Covariance COV E (X E(X))(Y E(Y)) The covariance of X with itself is

FA
equal to the variance of X
C

Covariance ranges from negative
infinity to positive infinity

CF A Correlation measures the linear

(,)
relationship between tow random
variable
xy =
Correlation () Correlation has no units, ranges from
-1 to +1,standardization of covariance
If =0,this doesnt indicates
independence

14-30
Expected return and variance of a portfolio
n

Expected return E (rp ) wi E ( Ri )

i 1

1.
C FA
p 2 =

w1212+w2222+2w1w2121,2
2.
CF A

Variance = 1p= w11+w22p2
= -1p= [w11-w22]p2
p2

n
p2
ncovi,jp2
15-30
Bayes Formula ()
80%

30%
20%

C FA

10%
70%

A
90%

CF
P(A B)
P(B A)
P(A)

P(B)

Multiplication rule n1 n2 ...... nk

Factorial n!
n!
Labeling (or Multinomial)
n1! n2 ! ... nk !
Combination nCr ()
Permutation () 16-30
n Pr
 R9 C FA

F A
Common Probability Distribution
C

17-30
 Probability Distribution

The number of Measurable and
Discrete
outcomes is counted. positive probability
The number of P(x)=0 even though x

A
Continuous
outcomes is infinite.

C Fcan occur
Cumulative probability function F(x)=P(X<=x)

Discrete probability Distribution

CF A &

Discrete uniform
X 1,2,3,4,5,p(x) 0.2

1
Bernoulli random
P(Y=1)=p , P(Y=0)=1-p
variable
Expectation =p , Variance=p(1-p)
n
Binomial random p(x) P(X x) nCxp (1 p)
x n x

variable 18-30
Expectation =np , Variance = np(1-p)
 Continuous Probability Distribution
&
Uniform (a , b)
Distribution P(x1 X x 2) (x 2 x1) / (b a)
X ~ N(, 2 )
Symmetrical distribution : skewness=0;kurtosis = 3
Properties A linear combination of normally distributed is also normally distributed

FA
The tails get thin and go to zero but extend infinitely
C



:(, +)

68% confidence interval ,

90% confidence interval 1.65, 1.65
A
Confidence
Normal
Distribution
intervals

CF 95%confidence interval 1.96, 1.96

99%confidence interval 2.58, 2.58


Standard , X
Z F(-3)=1-F(3)
Z
Shortfall risk: RL= threshold level return, minimum return required
Safety-first
SFR E(Rp ) RL / P
criterion
Maximize SFR<=> Minimize P(Rp<RL)
If ln is normal , then X is lognormal
Lognormal Right skewed
distribution Bounded from below by zero(0)
19-30
Lognormal the price of asset ; normal the return of asset
 Monte Carlo simulation & Historical simulation ()

Based on their assumed distributions , to produce a

Monte Carlo distribution of possible security values;
simulation It is fairy complex and will assume a parameter distribution;
It is not an analytic method but a statistical one

C FA

Selected historical data to generate a distribution;

Historical simulation
F A
The past can not indicate the future;
C

Historical simulation cannot address the sort of what
if questions that Monte Carlo simulation can

20-30
 R10 C FA

F A
Sampling and Estimation
C

21-30
 Sampling

Simple random sampling

Stratified random sampling : to separate the population into
smaller groups

C FA
Data

Time-series data : data taken over a period of time
Cross-sectional data : data taken at a single point of time

CF A

Sampling error of the mean = sample mean-population mean
Sample statistic The sample statistic itself is a random variable
Central Limit Theory : n>=30sample mean ~ N(, 2 / n)
Standard error = / n or s / n

22-30
 Estimation
Unbiasedness: expected value of the estimator is equal to the
Desirable parameter that are trying to estimate
properties Efficiency: dispersion is smaller
Consistency: the accuracy increases as n increases
Point Estimate:
Estimation Confidence
interval estimate
s

A
x z / 2 x t / 2
n or n

C F

zt
n>=30,z

CF A
Symmetrical: skewness = 0

Degrees of freedom (df): n-1
Less peaked than a normal distribution (fatter tails), kurtosis < 3
T
As the degrees of freedom gets larger, the shape of t-distribution approaches
standard normal distribution
significance leveltconfidence level
bias
Data-mining bias Look-ahead bias
Sample selection bias Time-period bias
23-30
Survivorship bias
 R11 C FA

CF A
Hypothesis Testing

24-30

Two-tailed H0:=0 H0:0
1. One-tailed H0:0 H0 :0 or ,H0 :0 H0 :<0
H0 is what we want to reject
x 0
2.test statistic Test statistic=
s/ n

C FA

A
3.critical value

CF
Reject H0 if |test statistic|> critical value
*****is significantly different from *****
4.
Fail to reject H0 if |test statistic|< critical value
*****is not significant different from *****

P-value P-value < reject H0

25-30
 Type 1 error and type 2 error
Decision H0 is true H0 is false
Incorrect Decision
Do not reject H0 Correct decision
Type 2 error
Incorrect decision Correct decision
Reject H0
Significance level =P(type 1 error)
C FA
Power of test =1-P(type 2 error)

Type 1 error Type 2 error

Increase the Sample Size type 1 error & type 2 error

CF A

Test type
Assumption H0 Test-statistic

Independent populations 1 2 0
Mean t
Paired comparisons test () d 0
Normally distributed population (1) 2 02 2
variance
Two independent population (2) 12 2 2 F text

26-30
 Nonparametric tests ( )

Parametric texts Specific to population parameters

Nonparametric texts are used:

The assumptions that support a parametric test are not met

C FA
When data are ranks (ordinal measurement scale)rather than
Nonparametric
tests
values

F A
The hypothesis does not involve the parameters of the
C
distribution , such as testing whether a variable is normally
distributed

27-30
 R12 C FA

CF A
Technical Analysis

28-30
 Technical analysis ()
Prices are determined by the interaction of supply and demand
Principles Only participants who actually trade affect prices
Price and volume reflect the collective behavior of buyers and sellers
Investor behavior is reflected in trends and patterns that trend to repeat
Assumptions
Efficient markets hypothesis does not hold
Fundamentalists believe that prices react quickly to changing stock values ,

A
while technicians believe that the reaction is slow
Actual price and volume data are observable
C F


Technical analysis itself is objective, while much of the data used in

A
fundamental analysis is subject to assumptions or restatements
Advantages

CF
It can be applied to the prices of assets that do not produce future cash flows ,

such as commodities
It can also be useful when financial statement fraud occurs

Disadvantages Illiquid markets

Head-and-shoulders pattern : Price target=Neckline-(Head-Neckline)

Inverse head and shoulders: price target= neckline+(neckline-head)
Prevailing up trend: upward moves in prices consist of 5 waves and downward

moves occur in 3 waves

Prevailing down trend: downward moves in prices consist of 5 waves and
29-30
upward moves occur in 3 waves
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CF A

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