FinQuiz - Curriculum Note, Study Session 2-3, Reading 5-12 - Quant

The Time Value of Money
Money has a time value because a unit of money received today is worth more than a unit of money to be received
tomorrow.
2.
INTEREST RATES: INTERPRETATION
Interest rates can be interpreted in three ways.

1) Required rates of return: It refers to the minimum rate
of return that an investor must earn on his/her
investment.
2) Discount rates: Interest rate can be interpreted as the
rate at which the future value is discounted to
estimate its value today.
3) Opportunity cost: Interest rate can be interpreted as
the opportunity cost which represents the return
forgone by an investor by spending money today
rather than saving it. For example, an investor can
earn 5% by investing $1000 today. If he/she decides to
spend it today instead of investing it, he/she will forgo
earning 5%.
Interest rate = r = Real risk-free interest rate + Inflation
premium + Default risk premium +
Liquidity premium + Maturity
premium
3.
Real risk-free interest rate: It reflects the single-period

interest rate for a completely risk-free security when
no inflation is expected.
Inflation premium: It reflects the compensation for
expected inflation.
Nominal risk-free rate = Real risk-free interest rate +
Inflation premium
o E.g. interest rate on a 90-day U.S. Treasury bill (T-bill)
refers to the nominal interest rate.
Default risk premium: It reflects the compensation for
default risk of the issuer.
Liquidity premium: It reflects the compensation for
the risk of loss associated with selling a security at a
value less than its fair value due to high transaction
costs.
Maturity premium: It reflects the compensation for
the high interest rate risk associated with long-term
maturity.
THE FUTURE VALUE OF A SINGLE CASH FLOW
The future value of cash flows can be computed using

the following formula:
= 1 +
Simple interest = Interest rate Principal

If at the end of year 1, the investor decides to extend
the investment for a second year. Then the amount
accumulated at the end of year 2 will be:
where,
PV
FVN
Pmt
N
r
(1 + r)N
= Present value of the investment

= Future value of the investment N periods from
today
= Per period payment amount
= Total number of cash flows or the number of a
specific period
= Interest rate per period
= FV factor
Example:
Suppose,
PV = $100, N = 1, r = 10%. Find FV.
= 1001 + 0.10 = 110

The interest rate earned each period on the original
investment (i.e. principal) is called simple interest e.g.
$10 in this example.
= 1001 + 0.101 + 0.10 = 121

or
= 1001 + 0.10 = 121
Note that FV2> FV1 because the investor earns
interest on the interest that was earned in previous
years (i.e. due to compounding of interest) in
addition to the interest earned on the original
principal amount.
The effect of compounding increases with the
increase in interest rate i.e. for a given compounding
period (e.g. annually), the FV for an investment with
10% interest rate will be > FV of investment with 5%
interest rate.
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FinQuiz Notes 2 0 1 5
Reading 5
Reading 5
NOTE:
For a given interest rate, the more frequently the
compounding occurs (i.e. the greater the N), the
greater will be the future value.
For a given number of compounding periods, the
higher the interest rate, the greater will be the future
value.
Important to note:
Both the interest rate (r) and number of compounding
periods (N) must be compatible i.e. if N is stated in
months then r should be 1-month interest rate, unannualized.
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PV = $100,000
N=2
rs = 8% compounded quarterly
m=4
rs / m = 8% / 4 = 2%
mN = 4 (2) = 8
FV = $100,000 (1.02)8 = $117,165.94
Practice: Example 4, 5 & 6,

Volume 1, Reading 5.
3.2
When the number of compounding periods per year

becomes infinite, interest rate is compounded
continuously. In this case, FV is estimated as follows:

3.1
The Frequency of Compounding
With more than one compounding period per year,

= 1 +
where,
Continuous Compounding

rs = stated annual interest rate

m = number of compounding periods per year
N = Number of years
=

where,
e = 2.7182818
The continuous compounding generates the

maximum future value amount.
Example:
Suppose, an investor invests $10,000 at 8% compounded
continuously for two years.
FV = $10,000 e 0.08 (2) = $11,735.11
Stated annual interest rate: It is the quoted interest rate

that does not take into account the compounding
within a year.
3.3
Stated and Effective Rates
Stated annual interest rate = Periodic interest rate

Number of compounding
periods per year
Periodic interest rate = Stated annual interest rate /

Number of compounding periods
in one year (i.e. m)
Periodic interest rate = rs / m = Stated annual interest

rate / Number of
compounding periods
per year
E.g. m = 4 for quarterly, m = 2 for semi-annually

compounding, and m = 12 for monthly compounding.
where,
Number of compounding periods per year = Number of
compounding periods in one year number of years =
mN
NOTE:
The more frequent the compounding, the greater will be
the future value.
Example:
Effective (or equivalent) annual rate (EAR = EFF %): It is

the annual rate of interest that an investor actually earns
on his/her investment. It is used to compare investments
with different compounding intervals.
EAR (%) = (1 + Periodic interest rate) m 1
Given the EAR, periodic interest rate can be
calculated by reversing this formula.
Periodic interest rate = [EAR(%) + 1]1/m 1
For example, EAR% for 10% semiannual investment will
be:
Suppose,
A bank offers interest rate of 8% compounded quarterly
on a CD with 2-years maturity. An investor decides to
invest $100,000.
m=2
stated annual interest rate = 10%
EAR = [1 + (0.10 / 2)] 2 1 = 10.25%
Reading 5
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Now taking the natural logarithm of both sides we have:

This implies that an investor should be indifferent
between receiving 10.25% annual interest rate and
receiving 10% interest rate compounded
semiannually.
EAR + 1 = lners (since ln e = 1)

EAR + 1 = rs
NOTE:
EAR with continuous compounding:
Annual percentage rate (APR): It is used to measure the

cost of borrowing stated as a yearly rate.
EAR = ers 1
Given the EAR, periodic interest rate can be
calculated as follows:
EAR + 1 = ers
Now taking the natural logarithm of both sides we
have:
ln (EAR + 1) = ln e rs (since ln e = 1)
ln (EAR + 1) = rs
4.
APR = Periodic interest rate Number of payments

periods per year
THE FUTURE VALUE OF A SERIES OF CASH FLOWS
Annuity:
Annuities are equal and finite set of periodic outflows/
inflows at regular intervals e.g. rent, lease, mortgage,
car loan, and retirement annuity payments.
Ordinary Annuity: Annuities whose payments begin
at the end of each period i.e. the 1st cash flow
occurs one period from now (t = 1) are referred to as
ordinary annuity e.g. mortgage and loan payments.
Annuity Due: Annuities whose payments begin at the
start of each period i.e. the 1st cash flow occurs
immediately (t = 0) are referred to as annuity due
e.g. rent, insurance payments.
The future value of an ordinary annuity stream is

=

1 +
= 1 + + 1 + +
+
Or
1 + 1
= 1 + =

FV annuity factor =
1 + 1

Present value and future value of Annuity Due:

The present value of an annuity due stream is calculated
as follows (section 6).
PV AD
Present value and future value of Ordinary Annuity:
1 1
( N 1)
(
1 + r)
+ Pmt at t = 0
= Pmt
Or
The future value of an ordinary annuity stream is

PV AD
FVOA = Pmt [(1+r)N1 + (1+r)N2 + +(1+r)1+(1+r)0]

1

=
=

1 +

where,
Pmt = Equal periodic cash flows
r
= Rate of interest
N = Number of payments, one at the end of each
period (ordinary annuity).
1 1
N
(
1 + r)
= Pmt
(1 + r )
PVAD = PVOA+ Pmt
where,
Pmt = Equal periodic cash flows
r
= Rate of interest
N
= Number of payments, one at the beginning of
each period (annuity due).
It is important to note that PV of annuity due > PV of
ordinary annuity.
Reading 5
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NOTE:
PV of annuity due can be calculated by setting
calculator to BEGIN mode and then solve for the PV of
the annuity.
The future value of an annuity due stream is calculated
as follows:
FV AD
(1 + r )N 1
= Pmt
(1 + r )
r
Or
FVAD = FVOA (1 + r)
Using a Financial Calculator: N= 5; PMT = -100; I/Y = 10;

PV=0; CPTFV = $610.51
Annuity Due: An annuity due can be viewed as = $100
lump sum today + Ordinary annuity of $100
per period for four years.
Calculating Present Value for Annuity Due:
= 100
It is important to note that FV of annuity due >FV of

ordinary annuity.
1
.
0.10
+ 100 = 416.98
Calculating Future value for Annuity Due:
Example:
= 100
Suppose a 5-year, $100 annuity with a discount rate of

10% annually.
1.10 1
1.10 = 671.56
0.10
Practice: Example 7, 11, 12 & 13,

Calculating Present Value for Ordinary Annuity:

=
100
100
100
100
100
+
+
+
+
1.10 1.10 1.10 1.10 1.10
4.2
Unequal Cash Flows
= 379.08
Or

1
.
=
= 379.08
0.10
Source: Table 2.
FV at t = 5 can be calculated by computing FV of each

payment at t = 5 and then adding all the individual FVs
e.g. as shown in the table above:
Using a Financial Calculator: N= 5; PMT = 100; I/Y
= 10; FV=0; CPTPV
= $379.08
Calculating Future Value for Ordinary Annuity:
FVOA
=100(1.10)4+100(1.10)3+100(1.10)2+100(1.10)1+100=610.51
Or
(1.10 ) 1
FVOA = 100
= 610.51
0.10
5
FV of cash flow at t =1 is estimated as

FV = $1,000 (1.05) 4 = $1,215.51
5.1
Finding the Present Value of a Single Cash Flow
The present value of cash flows can be computed using

the following formula:
PV =
FV
1 + r
The PV factor = 1 / (1 + r) N; It is the reciprocal of the

FV factor.
Reading 5
NOTE:
6.3
For a given discount rate, the greater the number of

periods (i.e. the greater the N), the smaller will be the
present value.
For a given number of periods, the higher the
discount rate, the smaller will be the present value.
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Present Values Indexed at Times Other than t =0
Suppose instead of t = 0, first cash flow of $6 begin at the

end of year 4 (t = 4) and continues each year thereafter
till year 10. The discount rate is 5%.
It represents a seven-year Ordinary Annuity.
Practice: Example 8 & 9,

a) First of all, we would find PV of an annuity at t = 3 i.e.

N = 7, I/Y = 5, Pmt = 6, FV = 0, CPTPV 3 = $34.72
b) Then, the PV at t = 3 is again discounted to t = 0.
5.1
N = 3, I/Y = 5, Pmt = 0, FV = 34.72, CPT PV 0 = $29.99
The Frequency of Compounding
With more than one compounding period per year,

= 1 +

Practice: Example 15,

where,
rs = stated annual interest rate

m = number of compounding periods per year
N = Number of years
An annuity can be viewed as the difference

between two perpetuities with equal, level
payments but with different starting dates.
Example:

6.2
The Present Value of an Infinite Series of Equal

Cash Flows i.e. Perpetuity
Perpetuity: It is a set of infinite periodic outflows/ inflows

at regular intervals and the 1st cash flow occurs one
period from now (t=1). It represents a perpetual annuity
e.g. preferred stocks and certain government bonds
make equal (level) payments for an indefinite period of
time.
PV = Pmt / r
This formula is valid only for perpetuity with level
payments.
Perpetuity 1: $100 per year starting in Year 1 (i.e. 1st

payment is at t =1)
Perpetuity 2: $100 per year starting in Year 5 (i.e. 1st
payment is at t = 5)
A 4-year Ordinary Annuity with $100 payments per
year and discount rate of 5%.
4-year Ordinary annuity = Perpetuity 1 Perpetuity 2
PV of 4-year Ordinary annuity = PV of Perpetuity 1 PV
of Perpetuity 2
i.
ii.
iii.
iv.
PV0 of Perpetuity 1 = $100 / 0.05 = $2000

PV4 of Perpetuity 2 = $100 / 0.05 = $2000
PV0 of Perpetuity 2 = $2000 / (1.05) 4 = $1,645.40
PV0 of Ordinary Annuity = PV 0 of Perpetuity 1 - PV 0
of Perpetuity 2
= $2000 - $1,645.40
= $354.60
Example:
Suppose, a stock pays constant dividend of $10 per
year, the required rate of return is 20%. Then the PV is
calculated as follows.
PV = $10 / 0.20 = $50

6.4
The Present Value of a Series of Unequal Cash

Flows
Suppose, cash flows for Year 1 = $1000, Year 2 = $2000,

Year 3 = $4000, Year 4 = $5000, Year 5 = 6,000.
A. Using the calculators CFLO register, enter the cash
flows
CF0 = 0
CF1 = 1000
CF2 = 2000
CF3 = 4000
Reading 5
CF4 = 5000
CF5 = 6000
Enter I/YR = 5, press NPVNPV or PV = $15,036.46
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=
Or
#$ %&
B. PV can be calculated by computing PV of each

payment separately and then adding all the
individual PVs e.g. as shown in the table below:
1
.'''(
0.006667
= 136.283494
Pmt = PV / Present value annuity factor

= $100,000 / 136.283494 = $733.76
Thus, the $100,000 amount borrowed is equivalent to
360 monthly payments of $733.76.
IMPORTANT Example:
Calculating the projected annuity amount required to
fund a future-annuity inflow.
Source: Table 3.
7.1
Solving for Interest Rates and Growth Rates
An interest rate can be viewed as a growth rate (g).

g = (FVN/PV)1/N 1
Suppose Mr. A is 22 years old. He plans to retire at age 63

(i.e. at t = 41) and at that time he would like to have a
retirement income of $100,000 per year for the next 20
years. In addition, he would save $2,000 per year for the
next 15 years (i.e. t = 1 to t = 15) by investing in a bond
mutual fund that will generate 8% return per year on
average.
So, to meet his retirement goal, the total amount he
needs to save each year from t = 16 to t = 40 is
estimated as follows:

Calculations:
7.2
Solving for the Number of Periods

N = [ln (FV / PV)] / ln (1 + r)
Suppose, FV = $20 million, PV = $10 million, r = 7%.

Number of years it will take $10 million to double to $20
million is calculated as follows:
N = ln (20 million / 10 million) / ln (1.07) = 10.24 10 years
7.3
Solving for the Size of Annuity Payments
Annuity Payment = Pmt =

!"
Suppose, an investor plans to purchase a $120,000

house; he made a down payment of $20,000 and
borrows the remaining amount with a 30-year fixed-rate
mortgage with monthly payments.
The amount borrowed = $100,000
1st payment is due at t = 1
Mortgage interest rate = 8% compounding monthly.
o PV = $100,000
o rs = 8%
o m = 12
o Period interest rate = 8% / 12 = 0.67%
o N = 30
o mN = 12 30 = 360
It should be noted that:

PV of savings (outflows) must equal PV of retirement
income (inflows)
a) At t =15, Mr. A savings will grow to:
= 2000
1.08 1
= $54,304.23
0.08
b) The total amount needed to fund retirement goal i.e.

PV of retirement income at t = 15 is estimated using
two steps:
i. We would first estimate PV of the annuity of
$100,000 per year for the next 20 years at t = 40.
= $100,000
1
.)
0.08
= $981,814.74
ii. Now discount PV 40 back to t = 15. From t = 40 to t

= 15 total number of periods (N) = 25.
N = 25, I/Y = 8, Pmt = 0, FV = $981,814.74, CPT PV
= $143,362.53
Since, PV of savings (outflows) must equal PV of
retirement income (inflows)
The total amount he needs to save each year (from
t = 16 to t = 40) i.e.
Reading 5
Annuity = Amount needed to fund retirement goals

- Amount already saved
= $143,362.53 - $54,304.23 = $89,058.30
The annuity payment per year from t = 16 to t = 40 is
estimated as:
Pmt = PV / Present value annuity factor
o PV of annuity = $89,058.30
o N = 25
o r = 8%

1
.)
0.08
10.674776
Annuity payment = pmt = $89,058.30 / 10.674776

= $8,342.87
Source: Example 21, Volume 1, Reading 5.
7.4
Examples include amortized loans i.e. mortgages, car

loans etc.
Example:
Suppose, an investor invests $4,329.48 in a bank today at
5% interest for 5 years.
# $
%
+
/

$4,329.48
+
/
. .
$1,000
Thus, a lump sum initial investment of $4,329.48 can

generate $1,000 withdrawals per year over the next
5 years.
$1,000 payment per year for 5 years represents a 5year ordinary annuity.
Principle 2: An annuity is equivalent to the FV of the
lump sum.
For example from the example above stated.
FV of annuity at t = 5 is calculated as:
N = 5, I/Y = 5, Pmt = 1000, PV = 0,
CPTFV = $5,525.64
And the PV of annuity at t = 0 is:
N = 5, I/Y = 5, Pmt = 0, FV = 5,525.64,
CPT PV =$4,329.48.
The Cash Flow Additivity Principle
The Cash Flow Additivity Principle: The amounts of

money indexed at the same point in time are additive.
Example:
Interest rate = 2%.

Series As cash flows:
t=00
t = 1 $100
t = 2 $100
Series Bs cash flows:
t=00
t = 1 $200
t = 2 $200
Series As FV = $100 (1.02) + $100 = $202
Series Bs FV = $200 (1.02) + $200 = $404
FV of (A + B) = $202 + $404 = $606
FV of (A + B) can be calculated by adding the cash
flows of each series and then calculating the FV of the
combined cash flow.
Equivalence Principle
Principle 1: A lump sum is equivalent to an annuity i.e. if

a lump sum amount is put into an account
that generates a stated interest rate for all
periods, it will be equivalent to an annuity.
7.5
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At t = 1, combined cash flows = $100 + $200 = $300

At t = 2, combined cash flows = $100 + $200 = $300
Thus, FV of (A+ B) = $300 (1.02) + $300 = $606
Example:
Suppose,
Discount rate = 6%
At t = 1 Cash flow = $4
At t = 2 Cash flow = $24
It can be viewed as a $4 annuity for 2 years and a lump
sum of $20.
N = 2, I/Y = 6, Pmt = 4, FV = 0,
CPT PV of $4 annuity = $7.33
N = 2, I/Y = 6, Pmt = 0, FV = 20,
CPTPV of lump sum = $17.80
Total = $7.33 + $17.80 = $25.13
Practice: End of Chapter Practice

Problems for Reading 5.
Discounted Cash Flow Applications
2.
NET PRESENT VALUE AND INTERNAL RATE OF RETURN
Capital Budgeting refers to an investment decisionmaking process used by an organization to evaluate

and select long-term investment projects.
Capital Structure is the mix of debt and equity used to
finance investments and projects.
Working capital management refers to the
management of the companys short-term assets (i.e.
inventory) and short-term liabilities (i.e. accounts
payable).
Capital budgeting usually uses the following
assumptions:
Independent projects are projects whose cash flows are

independent of each other. Since projects are
unrelated, each project is evaluated on the basis of its
own profitability.
Mutually exclusive projects compete directly with each
other e.g. if Projects A and B are mutually exclusive, you
can choose A or B, but you cannot choose both.
2.1
Net Present Value and the Net Present Value Rule
NPV = Present value of cash inflows - initial investment

=
1. Decisions are based on cash flows; not on accounting

profits (i.e. net income):
In addition, intangible costs and benefits are often
ignored because it is assumed that if these benefits
or costs are real, they will eventually be reflected in
cash flows.
The relevant cash flows need to be considered are
incremental cash flows. Sunk costs should be ignored
in the analysis.
2. Timing of cash flows is critical i.e. cash flows that are
received earlier are more valuable than cash flows
that are received later.
3. Cash flows are based on opportunity costs:
Opportunity costs should be included in project costs.
These costs refer to the cash flows that could be
generated from an asset if it was not used in the
project.
4. Cash flows are analyzed on an after-tax basis. Cash
flows on after-tax basis should be incorporated in the
analysis.
5. Financing costs are ignored. Financing costs are
reflected in the required rate of return which is used to
discount after-tax cash flows and investment outlays
to estimate net present value (NPV) i.e. only projects
with expected return > cost of the capital (required
return) will increase the value of the firm.
Financing costs are not included in the cash flows;
because when financing costs are included in both
cash flows and in the discount rate, it results in
double-counting the financing costs.
6.

1 +
where,
CFt = After-tax cash flow at time t
r
= required rate of return for the investment
CF0 = investment cash outflow at time zero
Decision Rule:
Accept a project if NPV 0
Do not Accept a project if NPV< 0
Independent projects: All projects with positive NPV are
accepted.
Mutually exclusive projects: A project with the highest
NPV is accepted.
Positive NPV investments increase shareholders
wealth.
NPV is inversely related to opportunity cost of capital
i.e. the higher the opportunity cost of capital, the
smaller the NPV.
Advantages:
1) NPV directly measures the increase in value to the
firm.
2) NPV assumes that cash flows are reinvested at r
(opportunity cost of capital).
Capital budgeting cash flows are not accounting net

income.
For details, refer to Reading 35, Capital Budgeting.
Reading 6
Reading 6
2.2
The Internal Rate of Return and the Internal Rate of

Return Rule
IRR is the discount rate that makesPresent value of

future cash inflows = initial investment
In simple words, IRR is the discount rate where NPV =
0.
IRR is calculated using trial and error method or by
using a financial calculator.
As the name implies, internal rate of return (IRR) depends
only on the cash flows of the investment i.e. no external
data is needed to calculate it.
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Limitations of IRR:
1) IRR is based on the assumption that cash flows are
reinvested at the IRR; however, this may not always
be realistic.
2) IRR provides result in percentages; however,
percentages can be misleading and involves difficulty
in ranking projects i.e. a firm rather earn 100% on a
$100 investment, or 10% on a $10,000 investment.
3) In case of non-conventional cash flow pattern, there
are or can be multiple IRRs or No IRR at all.

Example:
IRR is found by solving the following:
2.3
2500
3000
3500
2000
+
+
+
10,000 =
1 +
1 +
1 +
1 +

4000
+
1 +

Problems with the IRR Rule
No conflict exists between the decision rules for NPV and

IRR when:
1) Projects are independent.
2) Projects have conventional cash flow pattern.
Solution:
IRR = 13.45%
Important to Note:
In the equation of calculating IRR, the IRR must be
compatible with the timing of cash flows i.e. if cash flows
are semi-annual (quarterly), the IRR will be semi-annual
(quarterly).
When projects cash flows are a perpetuity, IRR can be
estimated as follows:

=

+
=0

Decision Rule:
Accept a project if IRR Cost of Capital.
Do not Accept a project if IRR< Cost of Capital.
NOTE:
Conflict exists between the decision rules for NPV and IRR
when:
1) Projects are mutually exclusive.
2) Projects have non-conventional cash flow pattern.
NPV and IRR rank projects differently due to following
reasons:
1) Differences in cash flow patterns.
2) Size (scale) differences: Required rate of return favors
small projects because the higher the opportunity
cost, the more valuable these funds are. Sometimes,
the larger, low-rate-of-return project has the better
NPV.
3) Timing differences: Project with shorter payback
period provides more CF in early years for
reinvestment. Therefore, when required rate of return
is high, it favors project with early CFs.
NPV versus IRR:
When IRR = opportunity cost of capital NPV = 0.

When IRR> opportunity cost of capital NPV> 0.
When IRR< opportunity cost of capital NPV< 0.
If projects are independent, accept both if IRR of
both projects Cost of Capital.
If projects are mutually exclusive and project A IRR>
project B IRR and both IRR Cost of Capital, accept
Project A because IRRA>IRRB .
NPV rule is based on external market-determined

discount rate because it assumes reinvestment at r
(opportunity cost of capital).
IRR assumes that cash flows are reinvested at IRR;
thus, IRR and IRR rankings are not affected by any
external interest rate or discount rate.
It is more realistic to assume reinvestment at
opportunity cost r; thus, NPV method is best.
Advantages of IRR:
1)
2)
3)
4)
5)
IRR considers time value of money.

IRR considers all cash flows.
IRR involves less subjectivity.
It is easy to understand.
It is widely accepted.
It implies that whenever there is a conflict between NPV

and IRR decision rule and to choose between mutually
exclusive projects, we should always use NPV rule.
Reading 6
3.
PORTFOLIO RETURN MEASUREMENT
Holding Period Return (HPR): A holding period return

refers to the return earned by an investor from holding
an asset for a specified period of time e.g. 1 day, 1
week, 1 month, 5 years etc.
Total return = Capital gain (or loss) yield + Dividend yield

+

=
=
+

= +
+
1
=

where,
P
D
t-1
t
=
=
=
=
price
dividend
beginning of the period
end of period
3.1
Money-Weighted Rate of Return
The money-weighted rate of return (MWR) measures the

compound growth rate in the value of all funds invested
in the account over the entire evaluation period. In U.S.,
it is known as dollar-weighted return. It represents an
internal rate of return (IRR) of an investment. Like IRR,
Amounts invested (initial market value of the
portfolio) are cash outflows for the investor.
All additions to the portfolio are cash outflows for the
investor.
Amounts returned (receipts) or withdrawn by the
investor are cash inflows for the investor.
The ending market value of the portfolio is a cash
inflow for the investor.
It is computed as follows:

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=0
1 +

where,
IRR represents the MWR.
T = number of periods
CFt = cash flow at time t
MWR is preferred to use to evaluate the
performance of the portfolio manager when the
manager has discretion over the deposits and
withdrawals made by clients.
Advantages of MWR: MWR requires an account to be
valued only at the beginning and end of the evaluation
period.
Disadvantages of MWR:
MWR is highly affected by the size and timing of
external cash flows to an account.

It is not appropriate to use when investment
manager has little or no control over the external
cash flows to an account.
Example:
Assume,
Amount invested in a mutual fund at the beginning
of 1st year = $100
Amount invested in a mutual fund at the beginning
of 2nd year = $950
Amount withdrawn at the end of 2nd year = $350
Value of investments at the end of 3rd year = $1,270
CF0 = 100
CF1 = 950
CF2 = +350
CF3 = +1,270

+
+
+
+
1 +
1 +
1 +
1 +

100
950
+350
=
+
+
1 +
1 +

1
+1,270
+
=0
1 +

Solve for IRR, we have IRR = 26.11%
3.2
Time-Weighted Rate of Return
The time-weighted rate of return (TWR) measures the

compound rate of growth over a stated evaluation
period of one unit of money initially invested in the
account.
In TWR, the account needs to be valued whenever
an external cash flow occurs.
TWR measures the actual rate of return earned by
the portfolio manager.
TWR is preferred to use to evaluate the performance
of the portfolio manager when the manager has no
control over the deposits and withdrawals made by
clients.
When there are no external cash flows, TWR is computed
as follows:
MV MV
= r =
MV
In order to calculate time weighted return, first of all,
holding period return for each sub-period is computed
and then these sub-period returns must be linked
together (known as chain-linking process) to compute
the TWR for the entire evaluation period.
Reading 6
rtwr = (1+rt,1)(1+rt,2) (1+rt,n) 1

Note that unless the sub-periods represent a year,
the time-weighted rate of return will not be
expressed as an annual rate.
Each subperiod return within the full evaluation
period has a weight = (length of the subperiod /
length of the full evaluation period).
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Disadvantage of TWR:
TWR requires determining a value for the account
each time any cash flow occurs.
Marking to market an account on daily basis is
administratively more cumbersome, expensive and
potentially more error-prone.
Example:
If the investment is for more than one year, timeweighted return can be annualized by calculating
geometric mean of n annual returns:
Time weighted return = [(1+R1)(1+R2)(1+Rn)]1/n 1
Beginning portfolio value for period 1 = $10,000

Ending portfolio value for period 1 = $10,050
Dividends received before additional investment in
period 1 = $100
Where,
Rit = return for year i
n = total number of annual returns
Beginning portfolio value for period 2 = $10,350

Ending portfolio value for period 2 = $10,850
Dividends received in period 2 = $100
Method of computing Time-weighted Return for the Year:

i. Calculate holding period return for each day (i.e. 365
days daily returns) using the following formula:
=

where,
ri = r1, r2, r365
( )

10,050 10,000 + 100
= 1.50%
=
10,000
( )
10,850 10,350 + 100
=
= 5.80%
10,350
The annual return (based on the geometric average)
over the entire period is
ii. Calculate annual return for the year by linking the

daily holding period returns as follows:
r = [(1.0150)(1.05850)] 1=0.0739 or 7.39%
Time weighted return = [(1+R1)(1+R2)(1+R365)] 1
TWR versus MWR:
This annual return represents the precise time-weighted

return for the year IF withdrawals and additions to the
portfolio occur only at the end of day. Otherwise, it
represents the approximate time-weighted return for the
year.
Time-weighted return can be annualized by calculating
geometric mean of n annual returns:
Time-weighted return = [(1+R1)(1+R2)(1+Rn)]1/n 1
where,
Rit = return in period t
n = total number of periods
Advantage of TWR: TWR is not sensitive to any external
cash flows to the account i.e. additions and withdrawals
of funds.
When funds are contributed to an account prior to a

period of strong (positive) performance, MWR>TWR.
When funds are withdrawn from an account prior to
a period of strong (positive) performance,
MWR<TWR.
When funds are contributed to an account prior to a
period of weak (negative) performance, MWR<TWR.
When funds are withdrawn from an account prior to
a period of weak (negative) performance,
MWR>TWR.
Under normal situations, both TWR and MWR provide
similar results.
When large external cash flows occur (i.e. > 10% of
account) and during that evaluation period,
accounts performance is highly volatile, then MWR
and TWR will provide significantly different results.

Reading 6
4.
MONEY MARKET YIELDS
Money market instruments are short-term debt

instruments i.e. having maturities of one year or less.
These instruments pay par value (face value) at maturity
and are usually discount instruments i.e. they do not pay
coupons, but instead are sold below (at discount from)
their par (face) value. For example, T-bills are discount
instruments where,
Investor buys the T-bill at (Face value discount) and
receives face value at maturity.
Investor earns a dollar return equal to the discount
when he/she holds the T-bill to maturity.
Other types of money-market instruments include
commercial paper and bankers acceptances which
are discount instruments and negotiable certificates of
deposit which are interest bearing instruments (that pay
coupons).
1) Bank Discount Basis: T-bills are quoted on a 360-day
discount basis rather than price basis using the bank
discount rate(a 360-day year is commonly used in
pricing money market instruments). The bank discount
rate is defined as:

360 !

! = "1
!
#
360
where,
rBD = Annualized yield on a bank discount basis
n = Actual number of days remaining to maturity
Limitations of Yield on a bank discount basis: Bank
discount yield is not a meaningful measure of investors
return because:
1.
2.
3.
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It is based on the FV (par value) of the bond instead

of its purchase price; but returns should be
evaluated relative to the amount invested (i.e.
purchase price).
It is annualized based on a 360-day year rather than
a 365-day year.
It is annualized based on simple interest; thus, it
ignores the compound interest.
The discount rate for the T-bill can be used to find PV
of other cash flows with risk characteristics similar to
those of the T-bill.
However, when risk of cash flows is higher than that
of T-bill, the T-bill's yield can be used as a base rate
and a risk premium is added to it to represent higher
risk of cash flows.
2) Holding period yield (HPY): HPY reflects the return

earned by an investor by holding the instrument to
maturity.
$ =
+
where,
P0 = initial purchase price of the instrument
P1 = Price received for the instrument at its maturity
D1 = Cash distribution paid by the instrument at its
maturity (i.e. interest)
For interest-bearing instruments: The purchase and sale
prices must include any accrued interest* when the
bond is purchased/sold between interest payment
dates.
*Coupon interest earned by the seller from the last
coupon date but not received by the seller as the next
coupon date occurs after the date of sale.
NOTE:
When the price is quoted including accrued interest,
it is called Full price.
When the price is quoted without accrued interest, it
is called Clean price.
3) Effective annual yield (EAY):
EAY = (I + HPY) 365/t - 1
Rule: The bank discount yield < effective annual yield.
4) Money market yield (or CD equivalent yield): Money
market yield can be used to compare the quoted
yield on a T-bill to quoted yield on interest-bearing
money-market instruments that pay interest on a 360day basis.
Generally, the money market yield is equal to the
annualized holding period yield (assuming a 360-day
year) i.e.
Money market yield = rMM = (HPY) (360/ t)
Unlike bank discount yield, the money market yield is
based on purchase price.
%"" = (%#$ ) &
'()* +(,-* ./ 01* 23*(4-35 67,,

9
8-3)1(4* 837)*
Thus, money market yield > bank discount yield.

Or
Reading 6
%"" :
360 !
360 > !
5) Bond-equivalent yield: When a semi-annual yield is

annualized by multiplying it by 2, it is referred to as the
bond-equivalent yield. It ignores compounding of
interest. The bond equivalent yield is calculated as
follows:
Practice: Example 7, Volume 1,

Reading 6 & End of Chapter
Practice Problems for Reading 6.
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2.1
Statistical Concepts and Market Returns
The Nature of Statistics
Statistics refer to the methods used to collect and

analyze data. Statistical methods include descriptive
statistics and statistical inference (inferential statistics).
Descriptive statistics: It describes the properties of a
large data set by summarizing it in an effective
manner.
Statistical inference: It involves use of a sample to
make forecasts, estimates, or judgments about the
characteristics of a population
2.2
Populations and Samples
A population is a complete set of outcomes or all

members of a specified group.
A parameter describes a characteristic of a
population e.g. mean value, the range of
investment returns, and the variance.
Since analyzing the entire population involves high costs,
it is preferred to use a sample.
A sample is a subset of a population.
A sample statistic or statistic describes a
characteristic of a sample.
2.3
Measurement Scales
Measurement scales are the specific set of rules used to

assign a symbol to the event in question. There are four
types of measurement scales.
a) Nominal Scale: It is a simple classification system
under which the data is categorized into various
types.
It does not rank the data.
It is the weakest level of measurement.
Example:
Mutual funds can be categorized according to their
investment strategies i.e.
Mutual Fund 1 refers to a small-cap value fund.
Mutual Fund 2 refers to a large-cap value fund.
b) Ordinal Scale: This scale categorizes data into various
categories and also rank them into an order based on
some characteristic.
scale cannot be compared with each other.

Example:
Under Morningstar and Standard & Poor's star ratings for
mutual funds,
A fund that is assigned 1 star represents a fund with
relatively the worst performance.
A fund that is assigned 5 stars represents a fund with
relatively the best performance.
c) Interval Scale: This scale rank the data into an order
based on some characteristic and the differences
between scale values are equal e.g. Celsius and
Fahrenheit scales.
The zero point of an interval scale does not reflect a
true zero point or natural zero e.g. 0C does not
represent absence of temperature; rather, it reflects
a freezing point of water.
As a result, it cannot be used to compute ratios e.g.
40C is two times larger than 20C; however, it does
not represent two times as much temperature.
Since difference between scale values are equal,
scale values can be added and subtracted
meaningfully.
Example:
The difference in temperature between 15C and 20C is
the same amount as the difference between 40C and
45C. Also, 10C + 5C = 15C
d) Ratio Scale: It is the strongest level of measurement.
Under this scale,
The data is ranked order based on some
characteristic.
The differences between scale values are equal;
therefore, scale values can be added and
subtracted meaningfully.
A true zero point as the origin exists. E.g. zero money
means no money.
o Thus, it can be used to compute ratios and to add
and subtract amounts within the scale.
Example:
Money is measured on a ratio scale i.e. the purchasing
power of $100 is twice as much as that of $50.
It is a stronger level of measurement relative to

nominal scale.
However, the intervals separating the ranks in ordinal
Reading 7
Reading 7
3.
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SUMMARIZING DATA USING FREQUENCY DISTRIBUTIONS
Data can be summarized using a frequency distribution.

In a Frequency distribution, data is grouped into
mutually exclusive categories and shows the number of
observations in each class.
It is also useful to identify the shape of the
distribution.
Construction of a Frequency Distribution table:
Step 1: Arrange the data in ascending order.
Step 2: Calculate the range of the data.
Range = Maximum Value - Minimum value
Step 3: Choose the appropriate number of classes (k):
Determining the number of classes involves
judgment.
not overlap.
Step 5: Set the individual class limits i.e.
Ending points of intervals are determined by
successively adding the interval width to the
minimum value.
The last interval would be the one which includes the
maximum value.
NOTE:
The notation [20,000 to 25,000) means 20,000
observation < 25,000 A square bracket shows that the
endpoint is included in the interval.
Step 6: Count the number of observations in each class
interval.
NOTE:
A large value of k is useful to obtain detailed information
regarding the extreme values of a distribution.
Step 4: Determine the class interval or width using the
following formula i.e.
Absolute Frequency: The actual number of observations

in a given class interval is called the absolute frequency
or simply frequency; as shown in the table below i.e.
there are 8 observations that fall under the price interval
15 up to 18.
i (H-L)/k
where,
i= Class interval
H = Highest observed value
L = Lowest observed value
k= Number of classes
Relative frequency:
Relative frequency = Absolute frequency / Total number
of observations
Interval: An interval represents a set of values within

which an observation lies.
If too few intervals are used, then the data is oversummarized and may ignore important
characteristics.
If too many intervals are used, then the data is
under-summarized.
The smaller (greater) the value of k, the larger
(smaller) the interval.
Cumulative Absolute Frequency: The cumulative

absolute frequency is found by adding up the absolute
frequencies. It reflects the number of observations that
are less than the upper limit of each interval.
Example:
Suppose,
H = $35,925
L = $15,546
k= 7
Class interval = ($35,925 - $15,546)/7 = $2,911 $3,000.
It is important to note that:
We will always round up (not down), to ensure that
the final class interval includes the maximum value
of the data.
The class intervals (also known as ranges or bins) do
Cumulative Relative Frequency: The cumulative relative

frequency is found by adding up the relative
frequencies. It reflects the percentage of observations
that are less than the upper limit of each interval.
Reading 7
E.g. in the table above after the relative frequency,

the cumulative relative frequency for the
2nd class interval would be 0.10 + 0.2875 = 0.3875 it
indicates that 38.75% of the observations lie below
the selling price of 21.
3rd class interval would be 0.3875 + 0.2125 = 0.60 it
indicates that 60% of the observations lie below the
selling price of 24.
E.g. in the table below cumulative relative frequency for
the 2nd class interval would be 0.10 + 0.2875 = 0.3875 and
for the 3rd class interval would be 0.3875 + 0.2125 = 0.60
4.2
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The Frequency Polygon and the Cumulative

Frequency Distribution
Frequency polygon: It also graphically represents the

frequency distribution.
The mid-point of each class interval is plotted on the
horizontal axis.
The corresponding absolute frequency of the class
interval is plotted on the vertical axis.
The points representing the intersections of the class
midpoints and class frequencies are connected by a
line.
NOTE:
The frequency distributions of annual returns cannot be
compared directly with the frequency distributions of
monthly returns.
For details, refer to discussion before table 4,
4.1
Cumulative frequency distribution: This graph can be

used to determine the number or the percentage of the
observations lying between a certain values. In this
graph,
The Histogram
A histogram is the graphical representation of a

frequency distribution.
The classes are plotted on the horizontal axis.
The class frequencies are plotted on the vertical axis.
The heights of the bars of histogram represent the
absolute class frequencies.
Since the classes have no gaps between them,
there would be no gaps between the bars of the
histogram as well.
Cumulative absolute or cumulative relative

frequency is plotted on the vertical axis.
The upper interval limit of the corresponding class
interval is plotted on the horizontal axis.
o For extreme values (both negative and positive),
the cumulative distribution tends to flatten out.
o Steeper (flatter) slope of the curve indicates large
(small) frequencies (# of observations).
NOTE:
Change in the cumulative relative frequency = Relative
frequency of the next interval.
Reading 7
5.
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MEASURES OF CENTRAL TENDENCY
A measure of central tendency indicates the center of

the data. The most commonly used measures of central
tendency are:
1. Arithmetic mean or mean: It is the sum of the
observations in the dataset divided by the number of
observations in the dataset.
2. Median: It is the middle number when the
observations are arranged in ascending or
descending order. A given frequency distribution has
only one median.
5. Geometric mean (GM): The geometric mean can be

used to compute the mean value over time to
compute the growth rate of a variable.
=
with Xi 0for i= 1, 2, , n.
Or
1

=
( )
or as
3. Mode: It is the observation that occurs most frequently

in the distribution. Unlike median, a mode is not
unique which implies that a distribution may have
more than one mode or even no mode at all.
4. Weighted mean: It is the arithmetic mean in which
observations are assigned different weights. It is
computed as:
= = + + +

=

G = elnG
It should be noted that the geometric mean can be
computed only when the product under the radical
sign is non-negative.

The geometric mean return over the time period can be

computed as:

= 1 + 1 + 1 + / 1
where,
X1, X2,,Xn = observed values
w1, w2,,w3 = Corresponding weights, sum to 1.
An arithmetic mean is a special case of weighted
mean where all observations are equally weighted
by the factor 1/ n (or l/N).
A positive weight represents a long position and a
negative weight represents a short position.
Expected value: When a weighted mean is
computed for a forward-looking data, it is referred to
as the expected value.
Example:
Geometric mean returns are also known as

compound returns.
Advantages of Measures of central tendency:
Widely recognized.
Easy to compute.
Easy to apply.
5.1.1) The Population Mean
It is the arithmetic mean of the total population and is
computed as follows:
Weight of stocks in a portfolio = 0.60

Weight of bonds in a portfolio = 0.40
Return on stocks = 1.6%
Return on bonds = 9.1%
=

where,
A portfolio's return is the weighted average of the returns
on the assets in the portfolio i.e.
Portfolio return = (w stock R stock) + (w bonds R bonds)
= 0.60(-1.6%) + 0.40 (9.1%) = 2.7%.
= Population mean
N = Number of observations in the entire population
Xi = ith observation.
The population mean is a population parameter.
A given population has only one mean.
Reading 7
5.1.2) The Sample Mean

The sample mean is the arithmetic mean value of a
sample; it is computed as:
=

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o The bottom 2.5 % of values are set = 2.5th

percentile value.
o The upper 2.5% of values are set = 97.5th percentile
value.
5.2
The Median
where,

Xi
n
= sample mean
= ith observation
= number of observations in the sample
The sample mean is a statistic.
It is not unique i.e. for a given population; different
samples may have different means.
Cross-sectional mean: The mean of the cross-sectional

data i.e. observations at a specific point in time is called
cross-sectional mean.
Population median: A population median divides a

population in half.
Sample median: A sample median divides a sample in
half.
Steps to compute the Median:
1. Arrange all observations in ascending order i.e. from
smallest to largest.
2. When the number of observations (n) is odd, the
median is the center observation in the ordered list i.e.
( )
Median will be located at =
position

Time-series mean: The mean of the time-series data e.g.

monthly returns for the past 10 years is called time-series
mean.
(n+1)/2 only identifies the location of the median,

not the median itself.
3. When the number of observations (n) is even, then
median is the mean of the two center observations in
the ordered list i.e.
Median will be located at mean of
5.1.3) Properties of the Arithmetic Mean

Property 1: The sum of the deviations* around the mean
is always equal to 0.
*The difference between each outcome and the mean
is called a deviation.
Property 2: The arithmetic mean is sensitive to extreme
values i.e. it can be biased upward or
downward by extremely large or small
observations, respectively.
Advantages of Arithmetic Mean:
The mean uses all the information regarding the size
and magnitude of the observations.
The mean is also easy to calculate.
Easy to work with algebraically

( )

Advantage: Median is not affected by extreme

observations (outliers).
Limitations:
It is time consuming to calculate median.
The median is difficult to compute.
It does not use all the information about the size and
magnitude of the observations.
It only focuses on the relative position of the ranked
observations.
Example:
Suppose, current P/Es of three firms are 16.73, 22.02, and
29.30.
n = 3 (n + 1) / 2 = 4/ 2 = 2nd position.
Thus, the median P/E is 22.02.
Limitation: The arithmetic mean is highly affected by

outliers (extreme values).
Trimmed Mean: It is the arithmetic mean of the
distribution computed after excluding a stated small
% of the lowest and highest values.
Winsorized mean: In a winsorized mean, a stated %
of the lowest values is assigned a specified low value
and a stated % of the highest values is assigned a
specified high value and then a mean is computed
from the restated data. E.g. in a 95% winsorized
mean,
Reading 7
5.3
The Mode
Population mode: A population mode is the most

frequently occurring value in the population.
Sample mode: A sample mode is the most frequently
occurring value in the sample.
Unimodal Distribution: A distribution which has only one
mode is called a unimodal distribution.
Bimodal Distribution: A distribution which has two modes
is called a bimodal distribution.
Trimodal Distribution: A distribution which has three
modes is called a Trimodal distribution.
when all the observations in the series are the same),

geometric mean = arithmetic mean
The greater the variability of returns over time, the
more the geometric mean will be lower than the
arithmetic mean.
The geometric mean return decreases with an
increase in standard deviation (holding the
arithmetic mean return constant).
In addition, the geometric mean ranks the two funds
differently from that of an arithmetic mean.

5.4.3) The Harmonic Mean
A distribution would have no mode when all the values in

a data set are different.
Modal Interval: Data with continuous distribution (e.g.
stock returns) may not have a modal outcome. In such
cases, a modal interval is found i.e. an interval with the
largest number of observations (highest frequency). The
modal interval always has the highest bar in the
histogram.
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1

. =
/ ( )

with Xi> 0 for i = 1,2, , n.
It is a special case of the weighted mean in which

each observation's weight is inversely proportional to
its magnitude.
Important to note: The mode is the only measure of

central tendency that can be used with nominal data.
Practice: Example on 5.4.3,
Important to note:
5.4.2) The Geometric Mean
Geometric mean v/s Arithmetic mean:
The geometric mean return represents the growth
rate or compound rate of return on an investment.
The arithmetic mean return represents an average
single-period return on an investment.
The geometric mean is always arithmetic mean.
When there is no variability in the observations (i.e.
6.
OTHER MEASURES OF LOCATION: QUANTILE
Measures of location: Measures of location indicate both

the center of the data and location or distribution of the
data. Measures of location include measures of central
tendency and the following four measures of location:
Quartiles
Quintiles
Deciles
Percentiles
Harmonic mean formula cannot be used to

compute average price paid when different
amounts of money are invested at each date.
When all the observations in the data set are the
same, geometric mean = arithmetic mean =
harmonic mean.
When there is variability in the observations,
harmonic mean < geometric mean < arithmetic
mean.
Collectively these are called Quantiles.

6.1
Quartiles, Quintiles, Deciles, and Percentiles
1) Quartiles divide the distribution into four different

parts.
First Quartile = Q1 = 25th percentile i.e. 25% of the
observations lie at or below it.
Second Quartile = Q2 = 50th percentile i.e. 50% of the
Reading 7

Third Quartile = Q3 = 75th percentile i.e. 75% of the
2) Quintiles divide the distribution into five different parts.
In terms of percentiles, they can be specified as P20,
P40, P60, & P80.
3) Deciles divide the distribution into ten different parts.
4) Percentiles divide the distribution into hundred
different parts. The position of a percentile in an array
with n entries arranged in ascending order is
determined as follows:
=
+ 1

100
where,
y = % point at which the distribution is being divided.
Ly = location (L) of the percentile (Py).
n = number of observations.
The larger the sample size, the more accurate the
calculation of percentile location.
Example:
Dividend Yields on the components of the DJ
Euros STOXX 50
No.
Company
Dividend
Yield(%)
AstraZeneca
0.00
BP
0.00
Deutsche Telekom
0.00
HSBC Holdings
0.00
Credit Suisse Group
0.26
LOreal
1.09
SwissRe
1.27
Roche Holding
1.33
Munich Re Group
1.36
10
General Assicurazioni
1.39
11
Vodafone Group
1.41
12
Carrefour
1.51
13
Nokia
1.75
14
Novartis
1.81
15
Allianz
1.92
16
Koninklije Philips Electronics
2.01
17
Siemens
2.16
18
Deutsche Bank
2.27
19
Telecom Italia
2.27
No.
FinQuiz.com
Company
Dividend
Yield(%)
20
AXA
2.39
21
Telefonica
2.49
22
Nestle
2.55
23
Royal Bank of Scotland Group
2.60
24
ABN-AMRO Holding
2.65
25
BNP Paribas
2.65
26
UBS
2.65
27
Tesco
2.95
28
Total
3.11
29
GlaxoSmithKline
3.31
30
BT Group
3.34
31
Unilever
3.53
32
BASF
3.59
33
Santander Central Hispano
3.66
34
Banco Bilbao VizcayaArgentaria
3.67
35
Diageo
3.68
36
HBOS
3.78
37
E.ON
3.87
38
Shell Transport and Co.
3.88
39
Barclays
4.06
40
Royal Dutch Petroleum Co.
4.27
41
Fortus
4.28
42
Bayer
4.45
43
DiamlerChrysler
4.68
44
Suez
5.13
45
Aviva
5.15
46
Eni
5.66
47
ING Group
6.16
48
Prudential
6.43
49
Lloyds TSB
7.68
50
AEGON
8.14
Source: Example 9,Table 17, Volume 1, Reading 7.
Calculating 10th percentile (P10):Total number of

observations in the table above = n = 50
L10 = (50 + 1) (10 / 100) = 5.1
It implies that 10th percentile lies between 5th
observation (X5 = 0.26) and 6th observation (X6 =
1.09).
Reading 7
Thus,
P10 = X5 + (5.1 5) (X6 X5) = 0.26 + 0.1 (1.09 0.26)
= 0.34%
Calculating 90th percentile (P90):
FinQuiz.com
It implies that P75 lies between the 38th observation

(X38 = 3.88) and 39th observation (X39 = 4.06).
Thus,
L90 = (50 + 1) (90 / 100) = 45.9

It implies that 90th percentile lies between the 45th
5.66).
Thus,
P90 = X45 + (45.9 45) (X46 X45) = 5.15 + 0.90 (5.66 5.15)
= 5.61%
P75 = Q3 = X38 + (38.25 38) (X39 X38)

= 3.88 + 0.25 (4.06 3.88)
= 3.93%
Calculating 20th percentile (P20) = 1st Quintile:
L20 = (50 +1) (20 /100) = 10.2
Calculating 1stQuartile (i.e.P25):

Thus,
L25 = (50 + 1) (25 / 100) = 12.75

25th
12th
It implies that
percentile lies between the
1.75).
1st quintile = P20 = X10 + (10.2 10) (X11 X10) = 1.39 + 0.20
(1.41 1.39) = 1.394% or 1.39%
Source: Example 9, Volume 1, Reading 7, P. 356.
6.2
Thus,
P25 = Q1 = X12 + (12.75 12) (X13 X12) = 1.51 + 0.75 (1.75
1.51) = 1.69%
Calculating 2nd Quartile (i.e.P50):
L50 = (50 + 1) (50 / 100) = 25.5
Since, X25 = X26 = 2.65, no interpolation is needed.
Quantiles in Investment Practice
Quantiles are frequently used by investment analysts to

rank performance i.e. portfolio performance. For
example, an analyst may rank the portfolio of
companies based on their market values to compare
performance of small companies with large ones i.e.
1st decile contains the portfolio of companies with
the smallest market values.
10th decile contains the portfolio of companies with
the largest market values.
Quantiles are also used for investment research
purposes.
Thus,
P50 = Q2 = 2.65% = Median
Calculating 3rd Quartile (i.e.P75):
L75 = (50 + 1) (75 / 100) = 38.25
7.
MEASURES OF DISPERSION
The variability around the central mean is called

Dispersion. The measures of dispersion provide
information regarding the spread or variability of the
data values.
Relative dispersion: It refers to the amount of
dispersion/variation relative to a reference value or
benchmark e.g. coefficient of variation. (It is discussed
below).
Absolute Dispersion: It refers to the variation around the
mean value without comparison to any reference point
or benchmark. Measures of absolute dispersion include:
1) Range:
Range = Maximum value - Minimum value
Advantage: It is easy to compute.

Disadvantages:
It does not provide information regarding the shape
of the distribution of data.
It only reflects extremely large or small outcomes
that may not be representative of the distribution.
NOTE:
Interquartile range (IQR) = Third quartile - First quartile
= Q3 Q1
It reflects the length of the interval that contains the
Reading 7
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#$
%$
! = 98.5 = 9.9%
middle 50% of the data.

The larger the interquartile range, the greater the
dispersion, all else constant.
7.4.1) Sample Variance

2) Mean absolute deviation (MAD):It is the average of
the absolute values of deviations from the mean.
| |
=
where,

n
= Sample mean
= Number of observations in the sample
The greater the MAD, the riskier the asset.
It is computed as:
'
where,

(
=Sample mean
n=Number of observations in the sample
The sample mean is defined as an unbiased
estimator of the population mean.
(n 1) is known as the number of degrees of
freedom in estimating the population variance.
Example:
7.4.2) Sample Standard Deviation
Suppose, there are 4 observations i.e. 15, -5, 12, 22.

Mean = (15 5 + 12 + 22)/4 = 11%
MAD = (|15 11| + |5 11| + |12 11| + |22 11|)/4
= 32/4 = 8%
Advantage:
'="

(
Important to note:
MAD is superior relative to range because it is based on

all the observations in the sample.
Drawback:
MAD is difficult to compute relative to range.
3) Variance: Variance is the average of the squared
deviations around the mean.
4) Standard deviation (S.D.): Standard deviation is the
positive square root of the variance. It is easy to
interpret relative to variance because standard
deviation is expressed in the same unit of
measurement as the observations.
7.3.1) Population Variance
The population variance is computed as:
! =
where,

= Population mean
N = Size of the population
Example:
Returns on 4 stocks: 15%, 5%, 12%, 22%
Population Mean () = 11%
! =
It is computed as:
15 11 + 5 11 + 12 11 + 22 11

4
= 98.5
7.3.2) Population Standard Deviation
It is computed as:
!="

The MAD will always be S.D. because the S.D. gives

more weight to large deviations than to small ones.
When a constant amount is added to each
observation, S.D. and variance remain unchanged.

7.5
Semivariance, Semideviation, and Related

Concepts
Semivariance is the average squared deviation below

the mean.

/
1
Semi-deviation (or semi-standard deviation) is the

positive square root of semivariance.
Semi-deviation will be < Standard deviation because
standard deviation overstates risk.
Reading 7
Example:
Two S.D. interval around the mean must contain at

least 75% of the observations.
Three S.D. interval around the mean must contain at
least 89% of the observations.
Returns (in %): 16.2, 20.3,9.3, -11.1, and -17.0.

Thus, n = 5
Mean return = 3.54%
Example:
Two returns, -11.1 and -17.0, are < 3.54%.
When k = 1.25, then according to Chebyshev's

inequality,
Semi-variance =[(-11.1 - 3.54)2 + (-17.0- 3.54)2] / 5 1

=636.2212/4 = 159.0553
The minimum proportion of the observations that lie

within + 1.25s is [1 - 1/ (1.25)2] = 1 - 0.64 = 0.36 or 36%.
Semi-deviation= 159.0553 = 12.6%.

Target semi-variance is the average squared deviation
below a stated target.

FinQuiz.com

) /
1
7.7
where,
B = target value,
n = number of observations.
Coefficient of Variation
Coefficient of Variation (CV) measures the amount of

risk (S.D.) per unit of mean value.
#
*+ = ,
Target semi-deviation is the positive square root of the

target semi-variance.
NOTE:
Semivariance (or Semideviation) and target
Semivariance (or target Semideviation) are difficult
to compute compared to variance.
For symmetric distributions, semi-variance =
variance.
Example:
Stock returns = 16.2, 20.3, 9.3%, 11.1% and 17.0%.
Target return = B = 10%
Target semi-variance = [(9.3 10.0)2 + (11.1 10.0)2 + (
17.0 10.0)2]/(5 1)
= 293.675
Target semi-deviation = 293.675 = 17.14%
7.6
#
*+ = , - 100%
When stated in %, CV is:
where,
s
= sample S.D.
= sample mean.
CV is a scale-free measure (i.e. has no units of
measurement); therefore, it can be used to directly
compare dispersion across different data sets.
Interpretation of CV: The greater the value of CV, the
higher the risk.
An inverse CV
X
= It indicates unit of mean
S
value (e.g. % of return) per unit of S.D.
Chebyshev's Inequality
Chebyshev's inequality can be used to determine the

minimum % of observations that must fall within a given
interval around the mean; however, it does not give any
information regarding the maximum % of observations.
According to Chebyshev's inequality:
The proportion of any set of data lying within k standard
deviations of the mean is always at least [1 1/ (K2)]
for all k >1.
Regardless of the shape of the distribution and for
samples and populations and for discrete and
continuous data:

7.8
The Sharpe Ratio
The Sharpe ratio for a portfolio p, based on historical

returns is:
#. $

.$/0 $1

'2 / $1
=
#. . / 3$/0 $1
Reading 7
# =

#
closer to 0 cannot be interpreted as superior to other

portfolio.
Excess return on Portfolio = Mean portfolio returnMean Risk free return it reflects the extra return
required by investors to assume additional risk.
The larger the Sharpe ratio, the better the riskadjusted portfolio performance.
When Sharpe ratio is positive, it decreases with an
increase in risk, all else equal.
When Sharpe ratio is negative, it increases with an
increase in risk; thus, in case of negative Sharpe
ratio, larger Sharpe ratio cannot be interpreted as
better risk-adjusted performance.
When two portfolios have same S.Ds, then the
portfolio with the negative Sharpe ratio closer to 0 is
superior to other portfolio.
However, when two portfolios have different S.Ds,
then the portfolio with the negative Sharpe ratio
8.
A symmetrical distribution has skewness = 0

Characteristics of the normal distribution:
3)
Ex-ante Sharpe Ratio: It is the forward-looking sharp ratio

for a portfolio based on expected mean return, the riskfree return and the S.D. of return.
Limitation of Sharpe Ratio: It uses standard deviation as a
measure of risk; however, Standard deviation is
appropriate to use as a risk measure for symmetric
distributions. Thus, it overstates risk-adjusted
performance.

SYMMETRY AND SKEWNESS IN RETURN DISTRIBUTIONS
Symmetrical return distribution or Normal distribution: It is

a return distribution that is symmetrical about its mean
i.e. equal loss and gain intervals have same frequencies.
It is referred to as normal distribution.
1)
2)
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In a normal distribution, mean = median.

A normal distribution is completely described by two
parameters i.e. its mean and variance.
Approximately:
68% of the observations lie between one standard
deviation from the mean.
95% of the observations lie between two standard
deviations.
99% of the observations lie between three
standard deviations.
b) Negatively skewed or left-skewed Distribution: It is a

return distribution that reflects frequent small gains
and a few extreme losses i.e. unlimited but less
frequent upside.
It has a long tail on its left side.
It has skewness< 0.
In a negatively skewed unimodal distribution
mean < median < mode.
Sample skewness (or sample relative skewness) is

computed as follows:
Skewed distribution: The distribution that is not

symmetrical around the mean is called skewed.
a) Positively skewed or right-skewed Distribution: It is a
return distribution that reflects frequent small losses
and a few extreme gains i.e. limited but frequent
downside.
It has a long tail on its right side.
It has skewness> 0.
In a positively skewed unimodal distribution mode
< median < mean.
Generally, investors prefer positive skewness (all else
equal).
# = 4

5

1
2
#
where,
n
= number of observations in the sample
s
= sample S.D.
n / (n-1)(n 2) = It is used to correct for downward bias
in small samples.
Reading 7
For larger values of n, sample skewness is computed as:

1
# ,
#
FinQuiz.com

For n 100 a skewness coefficient of +/- 0.5 is

considered unusually large.
9.
KURTOSIS IN RETURN DISTRIBUTIONS
Kurtosis is used to identify how peaked or flat the

distribution is relative to a normal distribution.
Leptokurtic: It is a distribution that is more peaked (i.e.
greater number of observations closely clustered around
the mean value) and has fatter tails (i.e. greater number
of observations with large deviations from the mean
value) than the normal distribution.
It has more frequent extremely large deviations from
the mean than a normal distribution.
Ignoring fatter tails in analysis results in
underestimation of the probability of extreme
outcomes.
The more leptokurtic the distribution is, the higher the
risk.
Platykurtic: It is a distribution that is less peaked than
normal.
Mesokurtic: It is a distribution that is identical to the
normal distribution.
The Sample excess kurtosis is computed as:

6 = 7
=
!
88 + 9
;8 9#
"< <
?
8 98 :8 ;
8 :8 ;
>
For a normal distribution (mesokurtic), kurtosis = 3.0.

For a leptokurtic distribution, kurtosis> 3.
For a platykurtic distribution, kurtosis < 3.
NOTE:
Kurtosis is free of scale (i.e. it has no units of
measurement).
It is always positive number because the deviations are
raised to the 4th power.
Excess kurtosis = Kurtosis 3
A normal or mesokurtic distribution has excess
kurtosis = 0.
A leptokurtic distribution has excess kurtosis > 0.
A platykurtic distribution has excess kurtosis < 0.
For larger sample size(n), Excess Kurtosis is computed
using the following formula:
$ 3
1 $
=
3

#$
#$
For n 100 (taken from a normal distribution), a
sample excess kurtosis of 1.0 would be considered
unusually large.

10.
USING GEOMETRIC AND ARITHMETIC MEANS
For estimating single-period average return,

arithmetic mean should be used.
In contrast, for estimating average returns for more
than one period, geometric mean should be used.
@ABCADEFG CAHI EADJEI
KEFDLCADFG CAHI EADJEI
MNOPN8QR ST ORUVO8
:
Reading 7
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Important to Note:
To plot past performance on a graph, it is more
appropriate to use semi-logarithm scale rather than
using arithmetic scale.
Semi-logarithm graph: In this graph,
There is an arithmetic scale on the horizontal axis for
time.
There is a logarithmic scale on the vertical axis for
the value of the investment.
The values plotted on the vertical axis are gaped
according to the differences between their
logarithms.
o Suppose, values of investment are $1, $10, $100
and $1,000. Each value are equally spaced on a
logarithm scale because the difference in their
logarithms is equal i.e. ln10 ln1 = ln100 ln10 =
ln1000 ln100 = 2.30.
On the vertical axis, equal changes between values
represent equal % changes.
The growth at a constant compound rate is plotted
as a straight line i.e. upward (downward) sloping
curve reflects increasing (decreasing) growth rates
over time.
Important to Note:
The arithmetic mean is appropriate to use for
analyzing future (or expected) performance.
In contrast, the geometric mean is appropriate to
use for analyzing past performance.
Example:
Suppose,
Total amount invested = $100,000
Probability of earning 100% return = 50%.
Probability of earning -50% return = 50%.
o With 100% return, return in one period = 100%
$100,000 = $200,000.
o With 50% return in the other period, return = 50%
$100,000 = $50,000
Geometric mean return =9 W 9XX% Z 9 [ \X% 1 = 0
With 50/50 chances of 100% or 50% returns, consider
four equally likely outcomes i.e. $400,000, $100,000,
$100,000, and $25,000.
Arithmetic mean ending wealth=($400,000 + $100,000 +

$100,000 + $25,000) / 4
= $156,250.
Actual returns are calculated as follows
$$&&,&&&($&&,&&&
o
Z 100 _ 300%
$&&,&&&
$&&,&&&($&&,&&&
o
o
o
$&&,&&&
$&&,&&&($&&,&&&
$&&,&&&
$),&&&($&&,&&&
$&&,&&&
Z 100 _ 0%
Z 100 _ 0%
Z 100 _ 75%
Arithmetic mean return for two-period = (300% + 0% + 0%

75%) / 4
= 56.25%.
Arithmetic mean return for single-period = [(1+56.25 %)1/2
1] 100 = 25%
25%
According to this arithmetic mean return, arithmetic
mean ending wealth = $100,000 1.5625 = $156,250.
Conclusion: In order to reflect the uncertainty in the cash
flows, the expected terminal wealth of $156,250 should
be discounted at 25% arithmetic mean rate not the
geometric mean rate.
Source: Volume 1, Reading 7.

Probability Concepts
2.
PROBABILITY, EXPECTED VALUE, AND VARIANCE
Random variable: A variable that has uncertain

outcomes is referred to as random variable e.g. the
return on a risky asset.
Empirical (or statistical) probability: It is a probability

based on observations obtained from probability
experiments (historical data). The empirical frequency
of an event E is the relative frequency of event E i.e.
Event: An event is an outcome or a set of outcomes of a

random process e.g. 10% return earned by the portfolio
or tossing a coin three times.
When an event is certain or impossible to occur, it is
not a random outcome.
Probability: Probability is a measure of the likelihood or
chance that an event will occur in the future.
P(E) =

Empirical probability of an event cannot be

computed for an event with no historical record or
for an event that occurs infrequently.
Example:
Total sample of dividend changes = 16,189.
If an event is possible to occur, it has a probability

between 0 and 1.
If an event is impossible to occur, it has a probability
of 0.
If an event is certain to occur, it has a probability of 1.
Properties of a Probability:
1) The probability of any event E is a number that lies
between 0 and 1 i.e.
0 P(E) 1
Where, P(E) = Probability of event E.
Frequency of observations that change in

dividends is increase = 14,911.
Frequency of observations that change in
dividends is decrease = 1,278.
Probability that a dividend change is a dividend
,
increase =
0.92
,
Subjective probability: It is a probability based on

personal assessment, educated guesses, and estimates.
Priori probability: It is a probability based on logical
analysis, reasoning & inspection rather than on
observation or personal judgment.
Priori and empirical probabilities are referred to as
objective probabilities.
2) The sum of the probabilities of any set of mutually

exclusive and exhaustive events always equals 1 e.g.
if there are three events A, B & C, then their
probabilities i.e. P(A) + P(B) + P(C) = 1.
Mutually exclusive events: When events are mutually
exclusive, events cannot occur at the same time e.g.
when a coin is tossed, the event of occurrence of a
head and the event of occurrence of a tail are mutually
exclusive events. The following events are mutually
exclusive.
Event A: The portfolio earns a return = 8%.
Event B: The portfolio earns a return < 8%.
Exhaustive events: When events are exhaustive, it means
that all possible outcomes are covered by the events
e.g. following events are exhaustive.
Event A: The portfolio earns a return = 8%.
Event B: The portfolio earns a return < 8%.
Event C: The portfolio earns a return > 8%.
Odds for Event E can be stated as:

E=

()
[ ]
For example, given odds for E = "a to b," it implies that

the
For a occurrences of E, we expect b cases of
non-occurrence.
Probability of E =

()
Odds against Event E can be stated as:

E=
[ ]

For example, given odds against E =a to b," it implies

that the

Probability of E =
()
In the probability distribution of the random variable,

each random outcome is assigned a probability.
Reading 8
Reading 8
Example:
Suppose odds for E = 1 to 7." Thus, total cases = 1 + 7 =
8.It means that out of 8 cases there is 1 case of
occurrence and 7 cases of non-occurrence.
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probability of A and B is the sum of the probabilities of

their common outcomes.
P(AB) = P(BA).
The probability of E = 1/ (1 + 7) = 1/ 8.
Example:
Suppose,
Winning probability = 1 / 16
Losing probability = 15 / 16
Profit when a person wins = $15
Loss when a person losses = $ -1
Expected profit = (1 / 16)($15) + (15/ 16)(-$1) = $0
Types of Probability:
1) Unconditional Probability: An unconditional
probability is the probability of an event occurring
regardless of other events e.g. the probability of this
event A denoted as P(A). It may be viewed as standalone probability. It is also called marginal
probabilities.
2) Conditional Probability: A conditional probability is the
probability of an event occurring, given that another
event has already occurred.
P(A|B) Probability of A, given B.
|
=
()

=
() 0
()

Multiplication Rule for Probability: For two events, A and

B, the joint probability that both events will happen is
found as follows:
P(A and B) = P(AB) = P(A|B) P(B)
P(B and A) = P(BA) = P(B|A) P(A)
Addition Rule for Probabilities: The probability that event

A or B will occur (i.e. at least one of the two events
occurs) is found as follows:
P(A or B) = P(A) + P(B) P *(A and B)
NOTE:
The conditional probability of an event can be greater
than, equal to, or less than the unconditional probability,
depending on the facts.
Example:
Unconditional Probability: The probability that the stock
earns a return above the risk-free rate (event A).
()
Sum of the probabilities of stock returns above the risk free rate
=
Sum of the probabilities of possible returns (i. e. 1)
Conditional Probability: The probability that the stock
earns a return above the risk-free rate (event A), given
that the stock earns a positive return (event B).
P(A|B) =
The conditional probability of A given that B has

occurred:

!
"
"
# "
"#
*To avoid double counting of probabilities of shared outcomes
When events A and B are mutually exclusive, P(AB) = 0;

thus, the addition rule can be simplified as:
P(A or B) = P(A) + P(B)
Independent Events: Two events are independent if the

occurrence of one of the events does not affect the
probability of the other event. Two events A and B are
independent if

!
"
"$%%
Joint Probability: The probability of occurrence of all

events is referred to as joint probability. For example, the
joint probability of A and B denoted as P(AB) read as the
P(B |A) = P(B)

Or if
P(A |B) = P(A)
Reading 8
Dependent Events: Two events are dependent when the

probability of occurrence of one event depends on the
occurrence of the other.
Multiplication Rule for Independent Events:
P(A and B) = P(AB) = P(A) P(B)
P(A and B and C) = P(ABC) = P(A) P(B) P(C)

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P(A) = P(AS) P(S) + P(ASC) P(SC)

0.55 = P(AS) (0.55) + 0.40 (0.45)
P(AS) = [0.55 0.40 (0.45)] / 0.55 = 0.673
Source: Example 7, CFA Curriculum, Volume 1, Reading 8.
Expected value of a random variable: The expected

value of a random variable is the probability-weighted
average of the possible outcomes of the random
variable.
Variance of a random variable: The variance of a
random variable is the expected value of squared
deviations from its expected value:
Example:
Suppose the unconditional probability that a fund is a
loser in either period 1 or 2 = 0.50 i.e.
P(fund is a period 1 loser) = 0.50
P(fund is a period 2 loser) = 0.50
Calculating the probability that fund is a Period 2 loser
and fund is a Period 1 loser i.e. P(fund is a Period 2 loser
and fund is a Period 1 loser).
2 (X) = E {[X E (X)] 2}

where,
2 (X) = variance of random variable X
Variance 0.
When variance = 0, there is no dispersion or risk
the outcome is certain and quantity X is not random
at all.
The higher the variance, the higher the dispersion or
risk, all else equal.
Using the multiplication rule for independent events:

P(Fund is a period 2 loser and fund is a period 1 loser) =
P(fund is a period 2 loser) P(fund is a period 1 loser) =
0.50 0.50 = 0.25
Complement Rule: For an event or scenario S, the event

not-S is called the complement of S and is denoted as
SC. Since either S or not-S must occur,
P(S) +
P(SC)
=1
The Total Probability Rule: According to the total

probability rule, the probability of any event P(A) can be
stated as a weighted average* of the probabilities of the
event, given scenarios i.e. P(AS1).
*where, weights = P(S1) P(AS1)
It is expressed as follows:
P(A) = P(AS) + P(ASC) = P(AS) P(S) + P(ASC) P(SC)
P(A) = P(AS1) + P(AS2) + P(ASn)
= P(AS1) P(S1) + P(AS2) P(S2)+P(ASn) P(Sn)
Where, S1, S2,Sn are mutually exclusive and exhaustive
scenarios or events.
The total probability rule states an unconditional
probability in terms of conditional probabilities.
Example:
Calculating P(AS). Suppose, P(A) = 0.55, P(S) = 0.55,
P(SC) = 0.45 and P(ASC) = 0.40.
Standard deviation: It is the positive square root of

variance. It is easier to interpret than variance because
it is in the same units as the random variable.
Example:
EPS ($)
Probability
2.60
0.15
2.45
0.45
2.20
0.24
2.00
0.16
1.00
Expected value of EPS = E (EPS) = 0.15 ($2.60) + 0.45

($2.45) + 0.24 ($2.20) + 0.16 ($2.00) = $2.3405
2 (EPS) = P ($2.60) [$2.60 E (EPS)] 2 + P ($2.45) [$2.45 E
(EPS)] 2 + P ($2.20) [$2.20 E (EPS)] 2 + P ($2.0)
[$2.0 E (EPS)] 2
2 (EPS) = 0.15 ($2.60 $2.34)2 + 0.45 ($2.45 $2.34)2 +
0.24 ($2.20 $2.34)2 + 0.16 ($2.00 $2.34)2
= 0.01014 + 0.005445 + 0.004704 + 0.018496
= $0.038785
S.D of EPS = $0.038785 = $0.20
Source: Example 8 & 9, CFA Curriculum, Volume 1, Reading 8.
Conditional expected values: The conditional expected

value refers to the expected value of a random variable
X given an event or scenario S. It is denoted as E(XS) i.e.
E(X|S) = P(X1IS)X1+ P(X2IS)X2 +P(XnIS)Xn
Reading 8
Conditional Variance: The conditional variance refers to

the variance of a random variable X given an event or
scenario.
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The unconditional probability that EPS will be $2.45

= 0.60 0.75 = 0.45
0. 25
The Total Probability Rule for Expected Value: It is

expressed as follows:
Prob. Of declining
interest rates = 0.60
E(X) = E(X|S)P(S)+ E(X|SC) P(SC)

E(X) = E(X|S1)P(S1)+ E(X|S2) P(S2)++E(X|Sn) P(Sn)
EPS = $2.60 with

Prob. = 0.15
0. 75
EPS = $2.45 with

Prob. = 0.45
0. 60
EPS = $2.20 with

Prob. = 0.24
E(EPS) = $2.34
where,
E (XSi) = Expected value of X given Scenario i
P(Si)
= Probability of Scenario i
Prob. Of stable
interest rates = 0.40
0.40
S1, S2...,Sn are mutually exclusive and exhaustive

scenarios or events.
EPS = $2.00 with

Prob. = 0.16
Example: Suppose,
Thus,
Current Expected EPS of BankCorp = $2.34
Probability that BankCorp will operate in a declining
interest rate environment in the current fiscal year =
0.60.
Probability that BankCorp will operate in a stable
interest rate environment in the current fiscal year =
0.40.
Under declining interest rate environment:
The probability that EPS will be $2.60 = 0.25
The probability that EPS will be $2.45 = 0.75
The unconditional probability that EPS will be $2.60 =
interest rate environment in the current fiscal year The
probability that EPS will be $2.60 given declining interest
rate environment
The unconditional probability that EPS will be $2.60 = 0.60
0.25 = 0.15
The unconditional probability that EPS will be $2.45 =
interest rate environment in the current fiscal year The
probability that EPS will be $2.45 given declining interest
rate environment
E (EPS declining interest rate environment) =

0.25($2.60) + 0.75($2.45) = $2.4875
When interest rates are stable:
E (EPS stable interest rate environment) = 0.60($2.20) +
0.40($2.00) = $2.12
E (EPS)={E (EPS declining interest rate environment)
P(declining interest rate environment)} + {E(EPS
stable interest rate environment) P(stable
interest rate environment)}
= $2.4875 (0.60) + $2.12 (0.40) = $2.3405 $2.34.
Calculation of Conditional variances i.e. the variance of
EPS given a declining interest rate environment and the
variance of EPS given a stable interest rate environment.
2 (EPS declining interest rate environment) =
P($2.6declining interest rate environment) [$2.60 E(EPS declining interest rate environment)2+ P($2.45
declining interest rate environment) [$2.45 - E(EPS
declining interest rate environment)2
= 0.25($2.60 - $2.4875)2+ 0.75($2.45 - $2.4875)2= 0.004219
2 (EPS stable interest rate environment)=P($2.2stable
interest rate environment) [$2.20 - E(EPS stable
interest rate environment)2+ P($2.00 stable interest rate
environment) [$2.00 - E(EPS stable interest rate
environment)2
= 0.60 ($2.20 $2.12)2 + 0.40 ($2.00 $2.12)2 = 0.0096
NOTE:
The unconditional variance of EPS = Expected value of
the conditional variances + Variance of conditional
expected values of EPS.
Reading 8
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Where,
Example:
Expected value of the conditional variances =

2 (EPS) = P (declining interest rate environment) 2
(EPS| declining interest rate environment) + P
(stable interest rate environment) 2 (EPS|
stable interest rate environment)
=0.60 (0.004219) + 0.40 (0.0096)
=0.006371
Suppose,
Variance of conditional expected values of EPS =

2 [E (EPS | interest rate environment)] = 0.60 ($2.4875
$2.34)2 + 0.40
($2.12 $2.34)2
= 0.032414
Thus,
Unconditional Variance of EPS = 0.006371 + 0.032414
= 0.038785
Source: Example, CFA Curriculum, Volume 1, Reading 8.
P(Bond defaults) = 0.60

P (Bond does not default) = 0.40
Return on T-bill RF = 5.8%
Bond value when it defaults = $0.
Bond value when it does not default = $ (1 + R)
Expected value of bond = E (bond) = $0 P(bond

defaults) + $ (1 + R) [1 P(bond defaults)]
E (bond) = $ (1 + R) [1 P(bond defaults)]
Since,
T-bill is risk-free,
Expected value of the T-bill per $1 invested = (1 + Rf) It
is a certain value.
Calculating default premium:

Volume 1, Reading 8, P. 451.
Expected value of Bond = Expected value of T-bill

$ (1 + R) [1 P(bond defaults)] = (1 + Rf)
R = {(1 + Rf) / [1 P(bond defaults)]} 1
R = [1.058 / (1 0.06)] 1 = 1.12553 1 = 0.12553 = 12.55%
Default risk premium = R Rf = 12.55% - 5.8% = 6.75%
3.
PORTFOLIO EXPECTED RETURN AND VARIANCE OF RETURN
Properties of Expected Value:

1. The expected value of a constant random variable
= Constant Expected value of the random variable
i.e.
E(wiRi) = wi E(Ri)
where,
When the returns on both assets tend to move together

i.e. there is a positive relationship between returns
Covariance of returns is positive (i.e. >0).
When the returns on both assets are inversely related
Covariance of returns is negative (i.e. < 0).
When returns on the assets are unrelated Covariance
of returns is 0.
wi = weight of variable i
Ri = random variable i
2. The expected value of a weighted sum of random
variables = Weighted sum of the expected values,
using the same weights i.e.
E(w1R1 + w2R2 + +wnRn) = w1E(R1) + w2E(R2) ++wnE(Rn)
Expected return on the portfolio: The expected return on
the portfolio is a weighted average of the expected
returns on the component securities i.e.
E(Rp) = E(w1R1 + w2R2 ++wnRn)
=w1E(R1)+w2E(R2) + +wnE(Rn)
Covariance: The covariance is a measure of how two
assets move together. Given two random variables Ri
and Rj, the covariance between Ri and Rj is stated as:
As the number of assets (securities) increases,

importance of covariance increases, all else equal.
Like variance, covariance is difficult to interpret.
Important to Note:
The covariance of a random variable with itself (own
covariance) is its own variance i.e.
Cov (R, R) = E {[R - E(R)] [R - E(R)]} = E {[R - E(R)] 2}
= 2(R)
Cov (Ri, Rj) = Cov (Rj, Ri)
Covariance Matrix: It a square format of presenting
covariances.
SEE: Table7, Volume 1, Reading 8.
Cov(Ri, Rf) =
)
'(
[p(Ri
ERi)(Rj ERf)]
Portfolio variance: It is calculated as:
Reading 8
negative (inverse) linear relationship.
+ =
!' !, " #', ,
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NOTE:
'( ,(
For example, given three assets with returns R1, R2 and R3,
portfolio variance is calculated as:
* + = !* * + !** * * + !-* * -
+ 2! !* " # , * + 2! !- " # , -
+ 2!* !- " # * , -
When the correlation is positive (negative): R1 = a +

bR2 + error b > (<) 0.
When the correlation is zero: R1 = a + bR2 + error b
= 0.
NOTE:
Correlation only deals with linear relationships.
Where,
2 = Corresponding variance of each asset in the
portfolio
The smaller the covariance between assets, the
greater the diversification benefits and the greater
the cost of not diversifying (in terms of risk-reduction
benefits forgone), all else equal.
When the returns on the three assets are independent,
covariances = 0 and S.D. of portfolio return would be:
S.D. =
[w212
(R1) +
w222
(R2) +
w232
(R3)]
Generally for n number of securities, we need to

estimate:
n (n - 1 )/2 distinct covariances.
n distinct variances.

JOINT PROBABILITY FUNCTION:

Let, RA = Return on stock BankCorp and RB = Return on
stock NewBank.
Joint Probability Function of BankCorp and NewBank
Returns (Entries Are Joint Probabilities)
RB = 20%
RB = 16%
RB = 10%
RA = 25%
0.20
RA = 12%
0.50
RA = 10%
0.30
Source: Table 12, CFA Curriculum, Volume 1, Reading 8.
Properties of Variance and Covariance:

a) The variance of a constant multiplied by a random
variable = Constant squared multiplied by the
variance of the random variable i.e.
2 (wR) = w2 2 (R)
b) Variance of a constant = 0.
c) The variance of a constant + random variable =
Variance of the random variable.
d) The covariance between a constant and a random
variable is 0.
Correlation: The correlation between two random
variables, Ri, and Rj, is estimated as follows:
(Ri, Rj) = Cov (Ri,Rj) (Ri) (Rj)
The value of correlation lies between -1 and + 1 i.e.
for two random variables, X and Y:
1 $%, & +1
When correlation = 0, variables are unrelated and
do not have any linear relationship.
When correlation > 0, variables have positive linear
relationship.
When correlation < 0, variables have negative
(inverse) linear relationship.
When correlation = +1, variables have perfect
positive linear relationship.
When correlation = -1, variables have perfect
Expected return on BankCorp stock = 0.20(25%) +

0.50(12%) + 0.30(10%) = 14%.
Expected return on NewBank stock = 0.20(20%) +
0.50(16%) + 0.30(10%) = 15%
" #. , / =
(.,' , /,, ) .,' '. /,' '/

'
Cov(RA, RB) = P(25, 20) [(25 14)(2015)] + P(12, 16) [(12

14)(16 15)] + P(10, 10)[(10 14) (10 15)]
= 0.20(11)(5) + 0.50(2)(1) + 0.30(4)(5)
=11 1 + 6 = 16
Independent Random Variables: Two random variables
X and Y are independent if and only if:
P(X, Y) = P(X) P(Y)
Independence is a stronger property compared to a
correlation of 0 because correlation deals with only
linear relationships.
Multiplication Rule for Expected Value of the Product of
Uncorrelated Random Variables: When two random
variables (e.g. X & Y) are uncorrelated,
Expected value of (XY)= Expected value of X Expected
value of Y
Reading 8
E (XY) = E(X) E(Y)

4.1
Bayes' Formula
Bayes' formula is a method for updating a probability

given additional information. It is also called an inverse
probability. It is computed using the following formula:
Updated probability of event given the new information
( () * +#( (#(
=
,- ( () *
(#(
. * |'#()
'#( | . * =
('#()
. *
The updated probability is referred to as the
posterior probability.
P(DriveMed expands) = P(DriveMed expands |EPS

exceeded consensus) P(EPS
exceeded consensus) +
P(DriveMed expands |EPS met
consensus) P(EPS met
consensus) + P(DriveMed
expands |EPS fell short of
consensus) P(EPS fell short of
consensus)
= 0.75(0.45) + 0.20(0.30) +
0.05(0.25)
= 0.4, or 41%
Using the Bayes Formula, P(EPS exceeded consensus
given that DriveMed expands) is estimated as:
'/ (0-((( - 1(121 |3#(4( (01

3#(4( (01|'/ (0-((( - 1(121)
'/ (0-((( - 1(1
=
3#(4( (01
= (0.75/0.41)(0.45) = 1.829268(0.45) = 0.823171
Diffuse priors: When the prior probabilities are equal,

they are referred to as diffuse priors.
Important to Note: When the prior probabilities are
equal:
Probability of information given an event = Probability of
an event
given the
information.
Example:
Suppose three mutually exclusive and exhaustive events
i.e.
i. Last quarter's EPS of DriveMed exceeded the
consensus EPS estimate.
ii. Last quarter's EPS of DriveMed exactly met the
iii. Last quarter's EPS of DriveMed fell short of the
Prior probabilities (or priors) of three events before any
new information are as follows:
P(EPS exceeded consensus) = 0.45
P(EPS met consensus) = 0.30
P(EPS fell short of consensus) = 0.25
Suppose the new information isDriveMed expands and
the conditional probabilities (likelihoods) are:
P(DriveMed expands | EPS exceeded consensus) = 0.75
P(DriveMed expands | EPS met consensus) = 0.20
P(DriveMed expands | EPS fell consensus) = 0.05
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Source: CFA Curriculum, Volume 1, Reading 8.

4.2
Principles of Counting
Multiplication Rule of Counting: If one event can occur in

n1 ways and a second event (given the first event) can
occur in n2 ways, then the number of ways the two
events can occur in sequence =n1 n2.
Similarly, the number of ways the k events can occur
= (n1) (n2) (n3) (nk).
It is referred to as n factorial (n!) i.e.
n! = n (n 1) (n 2) (n 3) 1
Multinomial Formula (General Formula for Labeling
Problems): The number of ways that n objects can be
assigned k different labels i.e. is given by:
!
! * ! 0 !
Combination Formula (Binomial Formula): A
combination is the number of ways to choose r objects
from a group of n objects without regard to order.
n"1
= )1 = )1!1!
)!
It is read as n choose r or n combination r.

where,
Calculating the unconditional probability for DriveMed

expanding i.e.P(DriveMed expands):
n = total number of objects

r = number of objects selected
Example:
Reading 8
In how many different ways 3 books can be read from a

list of 5 books if the order doesnt matter?
5C3
= 5!/(5 3)!3!
=(5)(4)(3)(2)(1)/(2)(1)(3)(2)(1)=120/12=10 ways
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Example:
In how many different ways 3 books can be read from a
list of 5 books if the order does matter?
5P3
= 5! / (5 - 3)! = 5! / 2! =
2-*
*
= 120/ 2 = 60 ways
NOTE:
5C3
2!
*!-!
and 5C2 =
Summary:
2!
-!*!
Suppose jurors want to select three companies out of a

group of five to receive the first-, second-, and thirdplace awards for the best annual report. In how many
ways can the jurors make the three awards?
Count ordered listings such as first place, New Company;
second place, Fir Company; third place, Well Company.
An ordered listing is known as a permutation.
Permutation: A permutation is any arrangement of r
objects selected from a total of n objects, when the
order of arrangement does matter.
n1
5 )1!
)!
When the objective is to assign every object from a

total of n objects one of n slots (or tasks), n
factorial should be used.
When the objective is to count the number of ways
that n objects can be assigned k different labels,
multinomial formula should be used.
that r objectives can be selected from a total of n
when order in which they are selected does not
matter, combination formula should be used.
that r objectives can be selected from a total of n
when order in which they are selected does matter,
permutation formula should be used.
When Multiplication rule of counting cannot be
used, the possibilities need to be counted one by
one, or by using more advanced techniques.

Common Probability Distributions
1.
INTRODUCTION TO COMMON PROBABILITY DISTRIBUTIONS
Probability distribution: A probability distribution

describes the values of a random variable and the
probability associated with these values.
2.
Types of distribution:
1.
2.
3.
4.
Uniform
Binomial
Normal
Lognormal
DISCRETE RANDOM VARIABLES
Random variable: A variable which has uncertain future

outcomes is called random variable. The two basic types
of random variables are:
1) Discrete random variables: Discrete random variables
have a countable number of outcomes i.e. all
possible outcomes can be listed without missing any
of them. For example, counts, dice, number of
students, quoted price of a stock etc. A discrete
random variable can take
On a limited (finite) number of outcomes i.e. x1, x2,
,xn.
On an unlimited (infinite) number of outcomes i.e. y1,
y 2,
2) Continuous random variables: Continuous random
variables have an infinite and uncountable range of
possible outcomes; thus, we cannot list all possible
outcomes. For example, time, weight, distance, rate
of return etc. The range of possible outcomes of a
continuous random variable is the real line i.e.
between - and + or some subset of the real line.
P(X = 5) = P (5) probability of 5 heads (x) in 15 flips of a

coin.
For a continuous random variable, the probability
function is called the probability density function
(pdf) and is denoted as f(x).
Properties of a probability function:
1) 0 P(x) 1, for all x.
2) The sum of the probabilities p(x) over all values of X =
1 i.e. = 1.
Cumulative distribution function or distribution function:
The cumulative distribution function describes the
probability that a random variable X particular value x
i.e. P(X x). For both discrete and continuous random
variables, it is denoted as F(x) = P(X x).
F(x) = Sum of all the values of the probability function for
all outcomes x.
Properties of Cumulative distribution function (cdf):
1) The cdf lies between 0 and 1 for any x i.e. 0 F(x) 1.
2) With an increase in x the cdf either increases or
remains constant.
For detailed understanding, please refer to
Example given after Table 1
Probability function: The probability function describes

the probability of a specific value that the random
variable can take.
2.1
The Discrete Uniform Distribution
It the simplest form of probability distribution.

For a discrete random variable, it is denoted as:
P(X = x) read as the probability that a random
variable X takes on the value x.
where,
X represents the name of the random variable.
x represents the value of the random variable.
Example:
Suppose, X = number of heads in 15 flips of a coin.
The discrete uniform distribution has a finite number

of specified outcomes.
The probability of each outcome in a discrete
uniform distribution is equally likely.
2.2
The Binomial Distribution
A distribution that involves binary outcomes is referred to

as binomial distribution. It has following properties:
1. A binomial distribution has fixed number of trials i.e.
Reading 9
Reading 9
n.
2. Each trial in a binomial distribution has two possible
outcomes i.e. a success and a failure.
3. Probability of success is denoted as P (success) =p
and Probability of failure is denoted as P (failure)
=1p for all trials.
4. The trials are independent, which means that the
outcome of one trial does not affect the outcomes
of any other trials.
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One-Period Stock Price as a Bernoulli Random Variable
Assumptions of the binomial distribution:

a) The probability of success (i.e. p) is constant for all
trials.
b) The trials are independent.
Bernoulli trial: A trial that generates one of two
outcomes is called a Bernoulli trial.
In a Bernoulli trial with n number of trials, we can
have 0 to n successes.
If the outcome of an individual trial is random, then
the total number of successes in n trials is also
random.
Binomial random variable X: It represents the number of
successes in n Bernoulli trials i.e.
X = sum of Bernoulli random variables
X = Y1 + Y2 + + Yn
where,
Yi = Outcome on the ith trial
Number of sequences in n trials that result in x up moves

(or successes) and n x down moves (or failures) is
!
! !
where,
n! = n factorial = n(n - 1) (n - 2) ... 1 (and 0! = 1 by
convention).
Probability function for a binomial random variable:

1

!

! ! 1
for x=0, 1, 2, , n
A binomial random variable is completely described

by two parameters i.e. n and p. It is stated as X~ B (n,
p) read as X has a binomial distribution with
parameters n and p.
Thus, a Bernoulli random variable is a binomial
random variable with n = 1 i.e. Y~B (1, p).
where,
x
=
nx =
p
=
1p=
n
=
# successes out of n trials

# failures out of n trials
probability of success
probability of failure
number of trials
Probability function of the Bernoulli random variable Y is:

Probability of success:
When the outcome is success Y = 1.
When the outcome is failure Y =0.
p (l) = P(Y= 1) = p = probability of success
p (0) = P( Y = 0) = 1 p = probability of failure
For example, a stock price is a Bernoulli random variable
with probability of success (an up move) = p and
probability of failure (a down move) = 1 p.
Suppose, Stock price today = S.
When the stock price increases, ending price = uS =
(1 + rate of return if the stock moves up) S
When the stock price decreases, ending price = dS
1

1

1
P(X = 1) = p1 (1 p)11 = p
1
Probability of failure:
1
P( X = 0) = p 0 (1 p )1 0 = 1 p
0
NOTE:
When the probability of success on a trial is 0.50, the
binomial distribution is symmetric; otherwise, it is
asymmetric or skewed.
Reading 9
Example:
3.1
If a coin is tossed 20 times, what is the probability of

getting exactly 10 heads?
p
1p
n
x
=
=
=
=
0.50
0.5
20
10

10
10
(0.5) (0.5) = 0.176
10

20

Stock price movement on three consecutive days:

Each day is an independent trial.
When the stock moves up u = 1 + rate of return for
an up move.
When the stock moves down d = 1 + rate of return
for a down move.
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Continuous Uniform Distribution
The continuous uniform distribution is the simplest

continuous probability distribution. The uniform
distribution has two main uses.
It plays an important role in Monte Carlo simulation.
It is an appropriate probability model to represent an
uncertainty in beliefs with equally likely outcomes.
Probability density function (pdf): It is used to assign the
probabilities to a continuous random variable and is
denoted as f (x). According to pdf,
The probability that value of x lies between a and b
is the area under the graph of f(x) that lies between
a and b or the integral of f(x) over the range a to b.
1
for a x b
f ( x) = b a
0 elsewhere
Over the range of values from a to b, density of the

distribution of a random variable x =
.

A binomial tree is shown below. Each boxed value which

represents successive moves(branch in the tree) is called
a node.
Elsewhere, density of the distribution of a random

variable x = 0.
In the fig below, a node reflects the potential value

for the stock price at a specified time.
At each node, the transition probability for an up
move is p and for a down move is (1 P).
Finding probability: The probabilities can be estimated
as follows:
!

# # "
"
F (x) = area under the curve graphing the pdf.

Under a Continuous uniform distribution, probabilities
for values of a continuous random variable x are
assigned across an interval of values of x; thus, the
probability that x takes on a specific value = 0.
Since the probabilities at the endpoints a and b = 0
for any continuous random variable X, P (a X b)
= P (a < X b) = P (a X< b) = P (a< X < b).
Each of the sequences uud, udu, and duu, has
probability = p2 (l p).
Stock price after three moves = P (S3 = uudS) = 3p2 (l p).
e.g. Number of ways to get 2 up moves in three periods
= 3! / (3 2)! 2! = 3
For a continuous uniform random variable:

Mean = = (a + b) / 2
Variance = 2 = (b a) 2 / 12
S.D. =

Note that S.D. is not a useful risk measure for a
uniform distribution; rather, the S.D. is a good risk
measure for Normal Distribution.
Reading 9
Example:
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The smaller the S.D., the more the observations are

concentrated around the mean.
Suppose,
At the lower bound = a =100,000 km total cost
= $40,000.
At the upper bound = b =150,000 km total cost
= $60,000.
Outside the lower and upper bound total cost = $0.
x = total anticipated annual travel costs in thousands of
dollars
Over the range of values from $40,000 to $60,000,
the distribution has density f(x) = 1/ (60 - 40) = 1/20.
Elsewhere, the distribution has density f(x) = 0.
The probability that travel costs are between 40 and 60 =

Total area under the density function f(x) between 40
and 60 = height length (or base) = (1/20) (6040) = 1
The probability that travel costs are between 40 and 50 =
Area under the curve between 40 & 50 = (1/20) (5040)
= 0.50
3.2
The Normal Distribution
A normal distribution is a distribution that is symmetric

about the centre (mean) and is bell-shaped. Thus,
o Mean = median = mode.
o Skewness = 0.
o Kurtosis = 3 and Excess kurtosis = 0.
The range of possible outcomes of the normal
distribution is the entire real line i.e. all real numbers
lying between - and +.
The tails of the normal distribution never touches the
horizontal axis and extend without limit to the left
and to the right; however, as we move away from
the center, the tails get closer and closer to the
horizontal axis. This characteristic is referred to as the
distribution is asymptotic to the horizontal axis.
The normal distribution is described by two
parameters i.e. its mean () and its variance (2) or
standard deviation (). It is stated as:
X ~ N (, 2) read X follows a normal distribution
with mean and variance 2.
o When the mean increases (decreases), the curve
shifts to the right (left).
When the standard deviation increases (decreases),
the curve flattens (steepens).
Since the normal distribution is symmetrical, it tends

to underestimate the probability of extreme returns.
Thus, it is not appropriate to use for Options.
The normal distribution can be used to model
returns; however, is not appropriate to use to model
asset prices.
According to the central limit theorem, sum and
mean of a large number of independent random
variables is approximately normally distributed.
It is important to note that a linear combination of
two or more normal random variables is also
normally distributed.
A univariate normal distribution describes the probability
of a single random variable.
A multivariate normal distribution describes the
probabilities for a group of related random variables. It is
completely defined by three parameters:
1. The list of the mean returns on the individual
securities i.e. total means = n.
2. The list of the securities variances of return i.e. total
variances = n.
3. The list of all the distinct pair-wise return correlations
i.e. total distinct correlations = n (n - 1) / 2.
For example, a bivariate normal distribution (i.e. a
distribution with 2 stocks) has:
Means = 2
Variances = 2
Correlation = 2 (2 1) / 2 = 1
For a normal random variable:
Standard deviation of sample skewness = 6/ n
Standard deviation of sample kurtosis = 24/ n
Normal density function: It is expressed as follows:
=
%2&
'
( ()
) for < < +
2%
The probability that a normally distributed variable x

takes on values in the range from a to b = Area
under f(x) between a and b.
Reading 9
The total area under the curve = 1.

The area under the curve to the left of centre = 0.5
and the area right of centre = 0.5.
o Approximately 50% of all observations fall in the
interval (2/ 3) .
interval .
interval 2.
interval 3.
More-precise intervals are 1.96 for 95% of the
observations and 2.58 for 99% of the
observations.
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Example:
Finding P (Z > 1.23):
Finding P (-0.75 < Z < 1.23):
Standard normal distribution or unit normal distribution: It

is a normal distribution with:
The mean ( ) = 0
Standard deviation () =1
When X is normally distributed, it can be standardized
using the following formula:
Z=
Finding P (Z< -2.33):

Z score indicates how many standard deviations

away from the mean the point x lies.
Example:
Example:
Suppose, a normal random variable, X = 9.5 with = 5

and = 1.5.
Z = (9.5 - 5) / 1.5 = 3
Example:
Finding the Probability i.e. P (Z < 2.67). It is found by first
finding 2.6 in the left hand column, and then moving
across the row to the column under 0.07. (Refer to table
below). Thus,
The average () on a corporate finance test was 78 with

a standard deviation of 8 (). If the test scores are
normally distributed, find the probability that a student
receives a test score greater than 85.
Z=

= 0.875 0.88
The area to the left of z = 2.67 = 0.9962.

In order to find the area to the right of z, we use the
Standard Normal Table given below to find the area
that corresponds to z-value and then subtract the
area from 1.
Probability to the right of x = 1.0 - N(x).
Since the normal distribution is symmetric around its
mean, the area and the probability to the right of x =
area and the probability to the left of -x, N (-x).
The probability to the right of x i.e. P (Z -x) = N(x).
P(x> 85) = P (z> 0.88) = 1 P(z< 0.88) = 1 0.8106

= 0.1894 .
Reading 9
FinQuiz.com
NOTE:
P (Z 1.282) = 0.90 = 90% It implies that 90th
percentile point = 1.282 and % of values in the right
tail = 10%.
P (Z 1.65) = 0.95 = 95% It implies that the 95th
tail = 5%.
P (Z 2.327) = 0.99 = 99% It implies that the 99th
tail = 1%.
3.3
Applications of the Normal Distribution
The mean-variance analysis is based on the

assumption that returns are normally distributed.
Safety-first rule: Safety-first rule focuses on shortfall
risk i.e. the risk that portfolio value will fall below
some minimum acceptable level over some
specified time horizon. For example, the risk that the
assets in a defined benefit plan will fall below plan
liabilities.
According to Roy's safety-first criterion, the optimal
portfolio is the one that minimizes the probability that
portfolio return (Rp) falls below the threshold level (RL).
When returns are normally distributed, the safety-first
optimal portfolio is the portfolio that maximizes the
safety-first ratio (SFRatio):
!* = +,* * -/%
Investors prefer the portfolio with the highest SFRatio.
Probability that the portfolio return < threshold level =
P (Rp< RL) = N (-SFRatio).
The optimal portfolio has the lowest P (Rp< RL).
Example:
Portfolio 1 expected return = 12% and S.D. = 15%

Portfolio 2 expected return = 14% and S.D. = 16%
Threshold level = 2%
Assumes that returns are normally distributed.
SFRatio of portfolio 1 = (12 2) / 15 = 0.667
SFRatio of portfolio 2 = (14 2) / 16 = 0.75
Since SFRatio of portfolio 2 >SFRatio 1, the superior

Portfolio is Portfolio 2.
Probability that return < 2% = N (0.75) = 1 N (0.75)
= 1 0.7734*
23%.
Reading 9
*Refer to table above.
FinQuiz.com
Mean (L) of a lognormal random variable =

exp ( + 0.502)
Sharpe Ratio:
Sharpe ratio = [E (Rp) Rf] / p
The portfolio with the highest Sharpe ratio is the one
that minimizes the probability that portfolio return will
be less than the risk-free rate (assuming returns are
normally distributed).
Managing Financial risk: Two important measures used

to manage financial risk include:
Variance (L2) of a lognormal random variable

= exp (2+ 2) [exp (2) 1].
Strengths of lognormal distribution:
The lognormal distribution is more appropriate
(relative to normal distribution) to use to model asset
prices because asset prices cannot be negative.
It is used in Black-Scholes-Merton model which
assumes that the assets price underlying the option
is lognormally distributed.
It is important to note that when a stock's continuously
compounded return is normally distributed, then future
stock price is necessarily lognormally distributed.
ST = S0exp (r0,T)
Value at risk (VAR): It provides the minimum value of

losses (in money terms) expected over a specified
time period (e.g. a day, quarter, year etc.) at a
specified level of probability (e.g. 5%, 1%). VAR
estimated using variance-covariance or analytical
method assumes that returns are normally
distributed.
Example:
A one week VAR of $10 million for a portfolio with 5%
probability implies that portfolio is expected to loss
$10 million or more in a single week.
Stress testing/scenario analysis: It involves a use of
set of techniques to estimate losses in extremely
worst combinations of events or scenarios.
3.4
The Lognormal Distribution
A random variable (i.e. Y) whose natural logarithm (i.e. ln

Y) has a normal distribution, is said to have a Lognormal
distribution.
Unlike Normal distribution, Lognormal random
variables cannot be negative.
Reason:
Since, negative values do not have logarithms, Y is
always > 0 and thus the distribution is positively skewed
(unlike normal distribution that is bell-shaped).
Where,
exp = e
r0,t = Continuously compounded return from 0 to T
Since ST is proportional to the log of a normal
random variable ST is lognormal.
Price relative = Ending price / Beginning price = St+1/ St=1
+ Rt, t+1
where,
Rt, t+1 = holding period return on the stock from t to t + 1.
Continuously compounded return associated with a
holding period from t to t + 1:
rt, t+1= ln(1 + holding period return)
Or
rt, t+1 = ln(price relative) = ln (St+1 / St) = ln (1 + Rt,t+1)
NOTE:
The continuously compounded return < associated
holding period return.
Continuously compounded return associated with a
holding period from 0 to T:
R0,T= ln (ST / S0)
Or
, =
, +
, + +
,
Where,
rT-I, T = One-period continuously compounded returns
Like normal distribution, it is completely described by

two parameters i.e. the mean and variance of In Y,
given that Y is lognormal.
Reading 9
FinQuiz.com
Example:
Volatility:
Suppose, one-week holding period return = 0.04.
Volatility reflects the deviation of the continuously

compounded returns on the underlying asset around its
mean. It is estimated using a historical series of
continuously compounded daily returns.
Equivalent continuously compounded return =

one-week continuously compounded return = ln (1.04)
= 0.039221
The intervals within which a certain percentage of
the observations of a normally distributed random
variable are expected to lie are symmetric around
the mean.
The intervals within which a certain percentage of
the observations of a lognormally distributed
random variable are expected to lie are not
symmetric around the mean.
Annualized volatility = sample S.D. of one period

continuously compounded returns
0
where,
T = Number of trading days in a year = 250.
Example:
Michelin Daily Closing Prices
In many investment applications, it is assumed that

returns are independently and identically distributed
(IID).
Returns are independently distributed implies that
investors cannot forecast future returns using past
returns (i.e., weak-form market efficiency).
Returns are identically distributed implies that the
mean and variance of return do not change from
period to period (i.e. stationarity).
When one-period continuously compounded returns (i.e.
r0,1) are IID random variables with mean and variance
2, then
,.
, / = ,.
, / + ,.
, / + + ,.
, / = (0
And
1
= % .
, / = % 0
Closing Price ()
31 March
25.20
01 April
25.21
03 April
25.52
03 April
26.10
04 April
26.14
Since, rt, t+1 = ln (St+1 / St) = ln (1 + Rt,t+1)
ln (25.21 / 25.20) = 0.000397

ln (25.52 / 25.21) = 0.012222
ln (26.10 / 25.52) = 0.022473
ln (26.14 / 26.10) = 0.001531
Sum = 0.036623
Mean = 0.009156
Variance = 0.000107
S.D. = 0.010354
S.D. = (r0,T) = 0
It implies that when the one-period continuously
compounded returns are normally distributed, then
the T holding period continuously compounded
return (i.e. r0,T) is also normally distributed with mean
T and variance 2T.
According to Central limit theorem, the sum of oneperiod continuously compounded returns is
approximately normal even if they are not normally
distributed.
4.
Date (2003)
Annualized volatility = 0.010354 250 = 0.163711

Expected continuously compounded annual return
= Sample mean T
= 0.009156 (250)
= 2.289
MONTE CARLO SIMULATION
Monte Carlo simulation involves the use of a computer

to generate a large number of random samples from a
probability distribution. It can be used in conjunction
with (i.e. as a complement) analytical methods.
Uses:
It is used in planning and managing financial risk.
It can be used in valuing complex securities e.g.
European-style options, mortgage-backed securities.
It can be used to estimate VAR e.g. using Monte

Carlo simulation, portfolio's profit and loss
performance for a specified time horizon are
simulated to generate a frequency distribution for
changes in portfolio value; the point that reflects the
end point of the least favorable 5% of simulated
changes is 95% VAR.
It can be used to examine a model's sensitivity to
changes in the assumptions.
Reading 9
Advantages: Monte Carlo simulation can be used to

value complex securities i.e. European-style
options.
FinQuiz.com
8) This process is repeated until a specified number of

trials, i, is completed (e.g. tens of thousands of trials).
NOTE:
Drawbacks: Unlike analytical methods (e.g. BlackScholes-Merton option pricing model),

Monte Carlo simulation provides only
statistical estimates, not exact results. In
addition, unlike black-scholes model,
Monte Carlo simulation model cannot be
used to quickly measure the sensitivity of
call option value to changes in current
stock price and other variables.
Steps of Monte Carlo simulation technique to examine a
model's sensitivity to changes in assumptions:
1) Specify the underlying variable or variables e.g. stock
price for an equity call option.
2) Specify the beginning values of the underlying
variables e.g. stock price.
C iT = Value of the option at maturity T. The subscript I
reflects a value resulting from the ith simulation trial.
3) Specify a time period.
Time increment = t
= Calendar time / Number of subperiods
(K)
4) Specify the regression model for changes in stock
price.

(

%

3
where,
Zk= Risk factor in the simulation. It is a standard normal
random variable.
5) K random variables are drawn for each risk factor
using a computer program or spreadsheet function.
6) Now the underlying variables are estimated by
substituting values of random observations in the
model specified in Step 4.
7) The value of a call option at maturity i.e. CiT is
calculated and then this value is discounted back at
time period 0 to get Ci0.
For obtaining each extra digit of accuracy in results, the

appropriate increase in the number of trials depends on
the problem. For example, in option value, tens of
thousands of trials may be appropriate. Generally, the
number of trials should be increased by a factor of 100.
9) Finally, mean value and S.D. for the simulation are
calculated.
Mean value = Average value of the option over all trials
in the simulation
The mean value will be the Monte Carlo estimate of
the value of the call option.
Random number generator: An algorithm that generates
uniformly distributed random numbers between 0 and 1is
referred to as random number generator. It is important
to note that random observations from any distribution
can be generated using a uniform random variable.
Steps to generate random observations on variable X:
1) Generate a uniform random number (i.e. T) between
0 and 1 using the random number generator.
2) Evaluate the inverse of cumulative distribution
function F(x) i.e. F-1 (x) to obtain a random
observation on variable X.
Historical simulation or Back simulation: Under a
historical simulation, samples are generated using a
historical record of underlying variables to simulate a
process. It is based on the assumption that historical
data can be used to predict future.
Drawback of Historical simulation: Unlike Monte Carlo
simulation, historical simulation cannot be used to
perform what if analyses.

Volume 1, Reading 9 & End of
Chapter Practice Problems for
Reading 9.
Sampling and Estimation
2.
Sampling is the process of obtaining a sample from a

population.
Benefits of Sampling:
Sampling saves time and energy because it is
difficult to examine every member of the population.
Sampling saves money; thus, it is more economically
efficient.
Two methods of random sampling are:
1. Simple random sampling
2. Stratified random sampling
SAMPLING
Sampling distribution of a Statistic: The sampling

distribution of a statistic is the probability distribution of a
sample statistic over all possible samples of the same size
drawn randomly from the same population.
2.2
Stratified Random Sampling
In stratified random sampling, the population is divided

into homogeneous subgroups (strata) based on certain
characteristics. Members within each stratum are
homogeneous, but are heterogeneous across strata.
Then, a simple random or a systematic sample is taken
from each stratum proportional to the relative size of the
stratum in the population. These samples are then
pooled to form a stratified random sample.
Two types of data:

1. Cross-sectional data
2. Time-series data
NOTE:
Any statistics computed using sample information are
only estimates of the underlying population parameters.
A sample statistic is a random variable.
2.1
Simple Random Sampling
Sampling Plan: Sampling plan is a set of rules that specify

how a sample will be taken from a population.
Simple Random Sample or random sample: A simple
random sample is a sample selected from a population
in such a way that every possible sample of the same
size has equal chance/probability of being selected. This
implies that every member is selected independently of
every other member.
Simple random sampling: The procedure of drawing a
random sample is known as Simple random sampling.
Random sample (for a finite/limited population) can be
obtained using random numbers table. In this method,
members of the population are assigned numbers in
sequence e.g. if the population contains 500 members,
they are numbered in sequence with three digits,
starting with 001 and ending with 500.
Systematic sampling: It is the sampling process that
involves selecting individuals within the defined
population from a list by taking every Kth member until a
sample of desired size is selected. The gap, or interval
between k successive elements is equal and constant.
Sampling Error: Since all members of the population are
not examined in sampling, it results in sampling error. The
sampling error is the difference between the sample
mean and the population mean.
The strata should be mutually exclusive (i.e. every

population member should be assigned to one and
only one stratum) and collectively exhaustive (i.e. no
population members should be omitted).
The size of the sample drawn from each stratum is
proportionate to the relative size of that stratum in
the total population.
Stratified sampling is used in pure bond indexing or
full-replication approach in which an investor
attempts to fully replicate an index by owning all the
bonds in the index in proportion to their market value
weights. However, pure bond indexing is difficult and
expensive to implement due to high transaction
costs involved.
Advantages: Stratified random sampling generates more
precise sample and generate more precise parameters
(i.e. smaller variance) relative to simple random
sampling.
Drawback: Stratified Random Sampling approach
generates a sample that is just approximately (i.e. not
completely) random.
Example:
Suppose, population of index bonds is divided into 2
issuer classifications, 10 maturity classifications and 2
coupon classifications.
Total strata or cells = (2) (10) (2) = 40
A sample, proportional to the relative market weight
of the stratum in the index to be replicated, is
selected from each stratum.
For each cell, there should be 1 issuer i.e. the
portfolio must have at least 40 issuers.
Reading 10
Reading 10
2.3
FinQuiz.com
Important to Note:
Time-Series and Cross-Sectional Data
Time series data: A time series data is a set of

observations on the values collected at different times at
discrete and equally spaced time intervals e.g. monthly
returns for past 5 years.
Cross-sectional data: Cross-sectional data are data on
one or more variables collected at the same point in
time e.g. 2003 year-end book value per share for all New
York Stock Exchange-listed companies.
Panel Data: It is a set of observations on a single
characteristic of multiple observational units collected at
different times e.g. the annual inflation rate of the
Eurozone countries over a 5-year period.
Longitudinal Data: It is a set of observations on different
characteristics of the single observational unit collected
at different times e.g. observations on a set of financial
ratios for a single company over a 10-year period.
All data should be collected from the same

underlying population. For example, summarizing
inventory turnover data across all companies is not
appropriate because inventory turnover vary among
types of companies.
Sampling should not be done from more than one
distribution because when random variables are
generated by more than one distribution (e.g.
combining data collected from a period of fixed
exchange rates with data from a period of floating
exchange rates), the sample statistics computed
from such samples may not be the representatives of
one underlying population and size of the sampling
error is not known.
The data should be stationary i.e. the mean or
variance of a time series should be constant over
time.
3.
3.1
DISTRIBUTION OF THE SAMPLE MEAN
The Central Limit Theorem
Standard Error of the Sample Mean =
According to central limit theorem: When the sample

size is large,
1) Sampling distribution of mean () will be
approximately normal regardless of the probability
distribution of the sampled population (with mean
and variance 2) when the sample size (i.e. n) is
large.
Variance of the distribution of the sample mean =
S.D. =
2
n
2
n
Standard Error: S.D. of a sample statistic is referred to as

the standard error of the statistic.
When the population S.D. () is known,
When the population S.D. () is not known,
s
Standard Error of the Sample Mean =
sX =
where,
s = sample S.D.
The estimate of s =

=
Generally, when n 30, it is assumed that the sample

mean is approximately normally distributed.
2) Sample mean = Population mean =
3) The sampling distribution of sample means has a
standard deviation equal to the population standard
deviation divided by the square root of n.
X =
s2
And
=

1
Finite population correction factor (Fpc): It is a shrinkage

factor that is applied to the estimate of standard error of
the sample mean. However, it can be applied only
when sample is taken from a finite population without
replacement and when sample size of (n)is not very
small compared to population size(N).
( N n)
Fpc =
( N 1)
1/ 2
New adjusted estimate of standard error = (Old

estimated standard error Fpc)
Reading 10
FinQuiz.com
4.
POINT AND INTERVAL ESTIMATES OF THE POPULATION MEAN
Two branches of Statistical inference include:

1) Hypothesis testing: In a hypothesis testing, we have a
hypothesis about a parameter's value and seek to
test that hypothesis e.g. we test the hypothesis the
population mean = 0.
2) Estimation: In estimation, we estimate the value of
unknown population parameter using information
obtained from a sample.
Point Estimate: It refers to a single number representing
the unknown population parameter. In any given
sample, due to sampling error, the point estimate may
not be equal to the population parameter.
Confidence Interval: It refers to a range of values within
which the unknown population parameter with some
specified level of probability is expected to lie.
Sample mean is an efficient estimator of the

population mean.
Sample variance s2 is an efficient estimator of
population variance 2.
An efficient estimator is also known as best unbiased
estimator.
3) Consistency: An estimator is consistent when it tends
to generate more and more accurate estimates of
population parameter when sample size increases.
The sample mean is a consistent estimator of the
population mean i.e. as sample size increases, its
standard error approaches 0.
However, for an inconsistent estimator, we cannot
increase the accuracy of estimates of population
parameter by increasing the sample size.
NOTE:
4.1
Point Estimators
Estimation formulas or estimators: The formulas that are

used to estimate the sample mean and other sample
statistics are known as estimation formulas or estimators.
An estimator has a sampling distribution.
The estimation formula generates different outcomes
when different samples are drawn from the
population.
Estimate: The specific value that is calculated from
sample observations using an estimator is called an
estimate e.g. sample mean. An estimate does not have
a sampling distribution.
Three desirable properties of estimators:
1) Unbiasedness (lack of bias): An estimator is unbiased
when the expected value (i.e. sample mean) =
population parameter. The sample variance (i.e.

) is an unbiased estimator of the population
Unbiasedness and efficiency properties of an

estimator's sampling distribution hold for any size
sample.
The larger the sample size, the smaller the variance
of sampling distribution of the sample mean.
4.2
Confidence Intervals for the Population Mean
Confidence Interval: A confidence interval is a range of

values within which the population parameter is
expected to lie with a given probability 1 - n, called the
degree of confidence.
For the population parameter, the confidence
interval is referred to as the 100(1 - ) % confidence
interval.
The lower endpoint of a confidence interval is called
lower confidence limit.
The upper endpoint of a confidence interval is
called upper confidence limit.
variance (2).
NOTE:
When a sample variance is calculated as Sample
Variance =

it is a biased estimator because
its expected value < population variance.

2) Efficiency: The efficiency of an unbiased estimator is
measured by its variance i.e. an unbiased estimator
with the smallest variance is referred to as an efficient
estimator.
There are two ways to interpret confidence intervals i.e.

1) Probabilistic interpretation: In probabilistic
interpretation, it is interpreted as follows e.g. in the
long run, 95% or 950 of such confidence intervals will
include/contain the population mean.
Reading 10
2) Practical interpretation: In the practical interpretation,

it is interpreted as follows e.g. we are 95% confident
that a single 95% confidence interval contains the
population mean.
NOTE:
Significance level () = The probability of rejecting the
null hypothesis when it is in fact correct.
Construction of Confidence Intervals: A 100(1 - ) %
confidence interval for a parameter is estimated as
follows:
Point estimate (Reliability factor Standard error)
/

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The reliability factor is based on the standard normal

distribution with mean = 0 and a variance = 1.
Reliability Factors for Confidence Intervals Based on the
Standard Normal Distribution:
For 90% confidence intervals: Reliability factor = Z 0.05
= 1.65
= 1.96
= 2.58
Confidence Intervals for the Population Mean (Normally
Distributed Population but with Unknown Variance): In
this case, a 100(1 - ) % confidence interval can be
calculated using two approaches.
where,
Point estimate
= It is a point estimate of the parameter

(i.e. a value of a sample statistic)
Reliability factor = It is a number based on the assumed
distribution of the point estimate and
the degree of confidence (1 - ) for
the confidence interval
1) Using Z-alternative: Confidence Intervals for the

Population Mean-The Z- Alternative (Large Sample,
Population Variance Unknown) is given by:
/

where,
Z /2 = Reliability factor = Z-value corresponding to an
area in the upper (right) tail of a standard normal
distribution.
n
Standard error
= Sample size
= Standard error of the sample statistic
= Standard deviation of the sampled population

Precision of the estimator = (Reliability factor standard
error) the greater the
value of (Reliability factor
standard error), the lower
the precision in estimating
the population parameter.
For example, reliability factor for 95% confidence interval
is stated as Z0.025 = 1.96; it implies that 0.025 or 2.5% of the
probability remains in the right tail and 2.5% of the
probability remains in the left tail.
Suppose, sample mean = 25, sample S.D.
= 20 / 100 = 2. Then,
s = sample standard deviation.

This approach can be used to construct the
confidence intervals only when sample size is large
i.e. n 30.
Since the actual standard deviation of the
population () is unknown, sample standard
deviation (s) is used to compute the confidence
interval for the population mean, .
2) Using Students t-distribution: It is used when the
population variance is not known for both small and
large sample size.
In case of unknown population variance, the
theoretically correct reliability factor is based on the
t-distribution.
t-distribution is considered a more conservative
approach because it generates more conservative
(i.e. wider) confidence intervals.
Confidence Intervals for the Population Mean is given
by:
Confidence interval 25 (1.96 2) i.e.

Lower limit = 25 - (1.96 2) = 21.08
Upper limit = 25 + (1.96 2) =28.92
Confidence Intervals for the Population Mean (Normally
Distributed Population with Known Variance): In this case,
a 100(1 -)% confidence interval is given by
/

= X t/2
S
n
where,
t= critical value of the t-distribution with degrees of
freedom (d.f.) = n-1 and an area of /2 in each tail.
t/2 /2 of the probability remain in the right tail for the
specified number of d.f.
t-distribution:
Reading 10
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Like standard normal distribution, t-distribution is bellshaped and perfectly symmetric around its mean of
0.
t-distribution is described by a single parameter
known as degrees of freedom (df) = n - 1. t values
depend on the degree of freedom.
t-distribution has fatter tails than normal distribution
i.e. a larger portion of the probability areas lie in the
tails.
t-distribution is affected by the sample size n i.e. as
the sample size increases degrees of freedom
increase the t-distribution approaches the Z
distribution.
Similarly, as the degrees of freedom increase the
tails of the t-distribution become less fat.
Z=
x
/ n
It follows normal distribution with a mean

= 0 and S.D. = 1.
t=
x
s/ n
It follows the t-distribution with a mean = 0

and d.f = n - 1.
Unlike Z-ratio, t-ratio is not normal because it

represents the ratio of two random variables (i.e. the
sample mean and the sample S.D.); whereas, Z-ratio
is based on only 1 random variable i.e. sample
mean.
Example:
Suppose, n = 3, df = n 1 = 3 -1 =2. = 0.10 /2 = 0.05.
Looking at the table below, for df = 2 and for t0.05, tvalue = 2.92.
Basis of Computing Reliability Factors

Sampling from:
Statistic for Small

Sample Size
Statistic for Large

Sample Size
Normal
distribution with
know variance
Normal
distribution with
unknown
variance
t*
Nonnormal
distribution with
known
variance
not available
Nonnormal
distribution with
unknown
variance
not available
t*
*Use of z also acceptable

Source: Table 3, Volume 1, Reading 10.
Reading 10
NOTE:
When the population distribution is not known but
sample size is large (n 30), confidence interval can be
constructed by applying the central limit theorem.
FinQuiz.com
Increasing the sample size may result in additional

expenses.
4.3
Selection of Sample Size
The required sample size can be found to obtain a

desired standard error and a desired width for a
confidence interval with a specified level of confidence
(1 - ) % by using the following formula:

n = Z22 / e2
and
n = [(t /2 s) / E]2
Factors that affect width of the confidence interval:

a) Choice of Statistic (i.e. t or Z)
b) Choice of degree of confidence i.e. the greater the
degree of confidence the wider the confidence
interval and the lower the precision in estimating the
population parameter.
c) Choice of sample size (n) i.e. the larger the n, the
smaller the standard error, as a result, the narrower
the width of a confidence interval the greater the
precision with which population parameter can be
estimated (all else equal).
Limitations of using large sample size:
E = Reliability factor Standard error: The smaller the

value of E the smaller the width of the confidence
interval.
2E = Width of confidence intervals width.
As the number of degrees of freedom increases, the
reliability factor decreases.
Increasing the sample size may result in sampling

from more than one population.
5.
MORE ON SAMPLING
Sampling-related issues include:

1) Data-mining bias or Data snooping:
Data-mining bias occurs when the same dataset is
extensively researched to find statistically significant
patterns. Thus, data mining involves overuse of data.
Intergenerational data mining: It involves using
information developed by prior researches as a
guideline for testing the same data patterns and
overstating the same conclusions.
Detecting data mining bias: Data mining bias can be
detected by conducting out-of-sample tests of the
proposed variable or strategy. Out-of-sample refers to
the data that was not used to develop the statistical
model i.e. when a variable/model is not statistically
significant in out-of-sample tests, it indicates that the
variable/model suffers from data-mining bias.
Two signs that indicate potential existence of data
mining bias:
a) Too much digging/too little confidence: Generally,
the number of variables examined in developing a
model is not disclosed by many researchers; however,
the use of terms i.e. "we noticed (or noted) that" or
"someone noticed (or noted) that may indicate
data-mining problem.
b) No story/no future: The absence of any explicit

economic rationale behind a variable or trading
strategy being statistically significant indicate datamining problem.
2) Sample selection bias:
Sample selection bias occurs when sample
systematically tends to exclude a certain part of a
population simply due to the unavailability of data. This
bias exists even if the quality and consistency of the
data are quite high. For example, sample selection bias
may result when dataset exclude or delist (due to
merger, bankruptcy, liquidation, or migration to another
exchange) companys stock an exchange.
Types of Sample selection bias:
Survivorship bias occurs when the database used to
conduct a research exclude information on companies,
mutual funds, etc. that are no longer in existence.
Self-selection bias occurs when hedge funds with poor
track records may voluntarily do not disclose their
records.
3) Look-ahead bias
Look-ahead bias occurs when the research is
conducted using the information that was not actually
available on the test date but it is assumed that it was
available on that particular day. For example, in price-
Reading 10
to-book value ratio (P/B) for 31st March 2010, the stock
price of a firm is immediately available for all market
participants at the same point in time; however, firms
book-value is generally not available until months after
the start of the year. Thus, price does not reflect the
complete information.
FinQuiz.com
4) Time-period bias:
Time-period bias occurs when the results of a model are
time-period specific and do not exist for outside the
sample period. For example, a model may appear to
work over a specific time period but may not generate
the same outcomes in future time periods (i.e. due to
structural changes in the economy).
Practice: Example 7, Volume 1,

Reading 10 & End of Chapter
Practice Problems for Reading 10.
Hypothesis Testing
1.
INTRODUCTION
Statistical inference refers to a process of making

judgments regarding a population on the basis of
information obtained from a sample. Two branches of
Statistical inference include:
1) Hypothesis testing: It involves making statement(s)
regarding unknown population parameter values
based on sample data. In a hypothesis testing, we
have a hypothesis about a parameter's value and
2.
seek to test that hypothesis e.g. we test the hypothesis

the population mean = 0.
Hypothesis: Hypothesis is a statement about one or
more populations.
2) Estimation: In estimation, we estimate the value of
unknown population parameter using information
obtained from a sample.
HYPOTHESIS TESTING
Steps in Hypothesis Testing:

1. Stating the hypotheses: It involves formulating the null
hypothesis (H0) and the alternative hypothesis (Ha).
2. Determining the appropriate test statistic and its
probability distribution: It involves defining the test
statistic and identifying its probability distribution.
3. Specifying the significance level: The significance
level should be specified before calculating the test
statistic.
4. Stating the decision rule: It involves identifying the
rejection/critical region of the test statistic and the
rejection points (critical values) for the test.
Critical Region is the set of all values of the test
statistic that may lead to a rejection of the null
hypothesis.
Critical value of the test statistic is the value for
which the null is rejected in favor of the alternative
hypothesis.
Acceptance region is the set of values of the test
statistic for which the null hypothesis is not rejected.
5. Collecting the data and calculating the test statistic:

The data collected should be free from measurement
errors, selection bias and time period bias.
6. Making the statistical decision: It involves comparing
the calculated test statistic to a specified possible
value or values and testing whether the calculated
value of the test statistic falls within the acceptance
region.
7. Making the economic or investment decision: The
hypothesized values should be both statistically
significant and economically meaningful.
Null Hypothesis: The null hypothesis (H0) is the claim that
is initially assumed to be true and is to be tested e.g. it is
hypothesized that the population mean risk premium for
Canadian equities 0.
The null hypothesis will always contain equality.
Alternative Hypothesis: The alternative hypothesis (Ha) is
the claim that is contrary to H0. It is accepted when the
null hypothesis is rejected e.g. the alternative hypothesis
is that the population mean risk premium for Canadian
equities > 0.
The alternative hypothesis will always contain an
inequality.
Formulations of Hypotheses: The null and alternative
hypotheses can be formulated in three different ways:
1. H0: = 0 versus Ha: 0
It is a two-sided or two-tailed hypothesis test.
In this case, the H0 is rejected in favor of Ha if the
population parameter is either < or >0.
Details are given below.
Reading 11
Reading 11
Hypothesis Testing
FinQuiz.com
=
Thus,
Test statistic =

2. H0: 0 versus Ha: >0

It is a one-sided right tailed hypothesis test.
population parameter is >0.
3. H0: 0 versus Ha: <0

It is a one-sided left tailed hypothesis test.
population parameter is <0.
When a null hypothesis is tested, it may result in four

possible outcomes i.e.
1. A false null hypothesis is rejected this is a correct
decision and is referred to as the power of the test.
Power of a test = 1 probability of a Type-II error
When more than one test statistic is available to
conduct a hypothesis test, then the most powerful
test statistic should be selected.
2. A true null hypothesis is rejected this is an incorrect
decision and is referred to as a Type-I error.
3. A false null hypothesis is not rejected this is an
incorrect decision and is referred to as a Type-II
error.
4. A true null hypothesis is not rejected this is a
correct decision.
Type I and Type II Errors in Hypothesis Testing
True Situation
Decision
H0 True
H0 False
Do not reject H0
Correct Decision
Type II Error
Reject H0
(Accept Ha)
Type I Error
Correct Decision
Source: Table 1, CFA Program Curriculum, Volume 1,

Reading 11.
where,
= Value of population parameter
0 = Hypothesized value of population parameter
NOTE:
Ha: >0and Ha: <0 more strongly reflect the beliefs of
the researcher.
Test Statistic: A test statistic is a quantity that is
calculated using the information obtained from a
sample and is used to decide whether or not to reject
the null hypothesis.
Test statistic =

The smaller the standard error of the sample statistic,

the larger the value of the test statistic and the
greater the probability of rejecting the null
hypothesis (all else equal).
As the sample size (n) increases, the standard error
decreases (all else equal).
*When the population S.D. is unknown, the standard
error of the sample statistic is given by
Type-I and Type-II errors are mutually exclusive errors.

The probability of a Type-I error is referred to as a
level of significance and is denoted by alpha, .
o The lower the level of significance at which the null
hypothesis is rejected, the stronger the evidence
that the null hypothesis is false.
The probability of a Type-II error is denoted by beta,
. The probability of type-II error is difficult to quantify.
All else equal, the smaller the significance level, the
smaller the probability of making a type-I error and
the greater the probability of making a type-II error.
Type I and II errors probabilities can be
simultaneously reduced by increasing the sample
size (n).
Type-I error is more serious than Type-II error.
Rejection Points Approach to Hypothesis Testing:
Critical region for two-tailed test at 5% level of
significance (i.e. = 0.05):
Null hypothesis: H0: = 0
Alternative hypothesis: Ha: 0
Reading 11
Hypothesis Testing
The two critical/rejection points are Z 0.025 = 1.96 and

Z0.025 = 1.96.
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Confidence Interval Approach to Hypothesis Testing: The

95% confidence interval for the population mean is
stated as:
X 1.96s x
It implies that there is 95% probability that the interval
X 1.96s x contains the population mean's value.

Lower limit 0
Acceptance region
The Null hypothesis is rejected when Z < -1.96 or Z >
1.96; otherwise, it is not rejected.
Critical region for one-tailed test at 5% level of
Null hypothesis: H0: 0
Alternative hypothesis: Ha: >0
The critical/rejection point is Z0.05 = 1.645.
< X 1.96sx
Upper limit 0 > X + 1.96s x

When the hypothesized population mean (0) < the
lower limit, H0 is rejected.
When the hypothesized population mean (0) > the
upper limit, H0 is rejected.
When the hypothesized population mean (0) lies
between the lower and upper limit, H0 is not
rejected.
P-value Approach to hypothesis testing: The p-value is
also known as the marginal significance level. The pvalue is the smallest level of significance at which the
null hypothesis can be rejected.
The smaller the p-value, the greater the probability
of rejecting the null hypothesis.
The p-value approach is considered more efficient
relative to rejection points approach.
Decision Rule:
When p-value < reject H0.
When p-value do not reject H0.
The Null hypothesis is rejected when Z > 1.645;

otherwise, it is not rejected.
Critical region for one-tailed test at 5% level of
Null hypothesis: H0: 0
Alternative hypothesis: Ha: <0
3.1
Tests Concerning a Single Mean
Calculating the test statistic for hypothesis tests

concerning the population mean of a normally
distributed population:
A. When the sample size is large or small but population
S.D. is known, the test statistic is calculated as follows:
The critical/rejection point is Z0.05 = 1.645.
Z=
X 0
where,
= Sample mean
0 = the hypothesized value of the population mean
= the known population standard deviation
The Null hypothesis is rejected when Z < -1.645;

otherwise, it is not rejected.
Sample size, n 30 is treated as large sample.

Sample size, n 29 is treated as small sample.
Reading 11
Hypothesis Testing
B. When the sample size is large but population S.D. is

unknown, the test statistic is calculated as follows:
Z=
B. Significance level of = 0.05.

1. H0: = 0 versus Ha: 0. The rejection points are
z0.025 = 1.96 and z0.025 = -1.96.
Decision Rule: Reject the null hypothesis if z > 1.96 or
if z < -1.96.
2. H0: 0 versus Ha: >0. The rejection points are z0.05
= 1.645.
Decision Rule: Reject the null hypothesis if z > 1.645.
3. H0: 0 versus Ha: <0. The rejection points are -z0.05
= -1645.
Decision Rule: Reject the null hypothesis if z < -1.645.
X 0
s
n
where,
s = the sample standard deviation
C. When the population S.D. is unknown and
Sample size is large or
Sample size is small but the population sampled is
normally distributed, or approximately normally
distributed.
C. Significance level of = 0.01.

z0.005 = 2.575 and z0.005 = -2.575.
Decision Rule: Reject the null hypothesis if z > 2.575 or
if z < -2.575.
= 2.33.
3. H0: 0 versus Ha: <0. The rejection points are -z0.01
= -2.33.
Decision Rule: Reject the null hypothesis if z < -2.33.
The test statistic is calculated as follows:
t n 1 =
X 0
s
n
where,
tn1 = t-statistic with n 1 degrees of freedom (n is the
sample size)
= the sample mean
= the hypothesized value of the population mean
s = the sample standard deviation
NOTE:
As the sample size increases, the difference between the
rejection points for the t-test and z-test decreases.
Test Concerning the Population Mean
(Population Variance Unknown)
Large Sample (n
30
Small Sample
(n<30)
Population
normal
t-Test (z-Test
alternative)
t-Test
Population nonnormal
t-Test (z-Test
alternative)
Not Available
FinQuiz.com
Example:
Suppose,
n
= 25.
H0: = 368.
Ha: 368.
=5% = 0.05.
= 372.5
= 15
Since, it is a two-tailed test, critical values are 1.96.

Decision Rule: Reject H0 when calculated value of Z >
+1.96 or <1.96.
Z=
.

= 1.50

Reading11.
Rejection Points for a z-Test:

A. Significance level of = 0.10.
z0.05 = 1.645 and z0.05 = -1.645.
Decision Rule: Reject the null hypothesis if z > 1.645
or if z < 1.645.
= 1.28.
3. H0: 0 versus Ha: <0. The rejection points are z0.10 = -1.28.
Decision Rule: Reject the null hypothesis if z < 1.28.
Since, calculated Z-value is neither > 1.96 nor < 1.96,

we do not reject H0 at 5% level of significance.
Example:
Suppose,
n
H 0:
H a:
= 5%
= 25.
368.
> 368.
= 0.05.
Reading 11
Hypothesis Testing
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Since hypothesized value of mean return i.e. 2.10%

falls within this confidence interval, H0 is not rejected.
= 372.5
= 15
Since, it is a one-tailed test, critical value is 1645.

Decision Rule: Reject H0 when calculated value of Z
>1.645.
Z=
.


= 1.50
3.2
Tests Concerning Differences between Means
1. H0: 1 2 = 0 versus Ha: 1 2 0 or 1 2

2. H0: 1 2 0 versus Ha: 1 2> 0 or 1>2
3. H0: 1 2 0 versus Ha: 1 2< 0 or1<2
where,
1 = population mean of the first population
2 = population mean of the second population
Since, calculated Z-value is not > 1.645, we do not
reject H0 at 5% level of significance.
Example:
Suppose, an equity fund has been in existence for 25
months. It has achieved a mean monthly return of 2.50%
with sample S.D. of 3.00%. It was expected to earn a
2.10% mean monthly return during that time period.
H0: Underlying mean return on equity fund () = 2.10%
Ha: Underlying mean return on equity fund () 2.10%
Test Statistic for a Test of the Difference between Two

Population Means (Normally Distributed Populations,
Population Variances Unknown but Assumed Equal)
based on Independent samples: A t-test based on
independent random samples is given by:
=
! (! )

#

$
#

$
!/
where,
Sp2= Pooled estimator of the Common variance.
Level of significance = = 10%.

Since, population variance is not known, a t-test is
used with degree of freedom = n -1 = 25 1 = 24.
The rejection points or critical values = t /2, n-1 = t 0.10/2,
25-1 = t 0.05, 24 t-value from t-table are 1.711 and 1.711.
Decision Rule: Reject the null hypothesis when t > 1.711
or t < 1.711.
t-statistic =
..!
.

= 0.667
Since, calculated t-value is neither > 1.711 nor < 1.711, we do not reject the null hypothesis at 10%
significance level.
Using Confidence interval approach:

+ "/

where,
t/2/2 of the probability remains in the right tail.
t -/2 -/2 of the probability remains in the left tail.
90% confidence interval is:
2.5 (1.711) (0.60) = 1.473 AND 2.5 + (1.711) (0.60) =
3.5266 [1.473, 3.5266].
% =
! 1! + 1
! + 2
The number of degrees of freedom is n1 + n2 2.

Test Statistic for a Test of the Difference between Two
Population Means(Normally Distributed Populations,
Unequal and Unknown Population Variances) based on
independent samples: In this case, an approximate t-test
based on independent random samples is given by:
=
! (! )

#
$
#
$
!/
In this case, modified degrees of freedom is used. It is

=
#
$
#
& '$ (
$

#
$

#
& '$ (
$
Reading 11
3.3
Hypothesis Testing
Tests Concerning Mean Differences
When samples are dependent, the test concerning

mean differences is referred to as paired comparisons
test and is conducted as follows.
1. H0: d= d0 versus Ha: d d0
2. H0: d d0 versus Ha: d>d0
3. H0: d d0 versus Ha: d<d0
where,
d
= difference between two paired observations = xAi xBi

xAi and xBi are the ith pair i = 1, 2, , n. on the two
random variables.
d = population mean difference.
d0 = hypothesized value for the population mean
difference
Test Statistic for a Test of Mean Differences (Normally
Distributed Populations, Unknown Population Variances):
=
)
)
where,
$
1
= = *
FinQuiz.com
Suppose,
Sample mean difference between Portfolio A and
Portfolio B =
= -0.60% per quarter.

Sample S.D of differences = 6.50.
Total sample size = n = 6 years 4 = 24.
The standard error of the sample mean difference =
s d = 6.50 / 24 = 1.326807.
t-value from the table with degrees of freedom = n 1 = 24 - 1 = 23 and .10/ 2 = 0.05 significance level is t
1.714.
Decision rule: Reject H0 if t > 1.714 or if t <1.714.
Calculated test statistic = t =
,.-, ,
../0-1,2
= 0.452213
Since, calculated t statistic is not < -1.714, we fail to

reject the null hypothesis at 10% significance level.
Thus, we conclude that the difference in mean quarterly
returns is not statistically significant at 10% significance
level.
*+!
=
)

$*+!!* "
=
1
4.1
Tests Concerning a Single Variance
We can formulate hypotheses as follows:

Sample S.D. =
n = number of pairs of observations

# $ $ #% & =
)
=

Example:
H0: The mean quarterly return on Portfolio A = Mean
quarterly return on Portfolio B from 2000 to 2005.
Ha: The mean quarterly return on Portfolio A Mean
quarterly return on Portfolio B from 2000 to 2005.
The two portfolios share the same set of risk factors; thus,
their returns are dependent (not independent). Hence,
a paired comparisons test should be used.
The following test is conducted:
H0: d = 0 versus Ha: d 0 at a 10% significance level.
where,
d = population mean value of difference between the
returns on the two portfolios 2000 to 2005.
1. H0: 2= 20 versus Ha: 2 20

2. H0: 2 20versus Ha: 2>20
3. H0: 2 20versus Ha: 2<20
where,
20 = hypothesized value of 20.
Test Statistic for Tests Concerning the Value of a
Population Variance (Normal Population): If we have n
independent observations from a normally distributed
population, the appropriate test statistic is chi-square
test statistic, denoted 2.
=
1
'
where,
n 1 = degrees of freedom.
= sample variance, ca1culated as follows.
s2
$*+!*
1
Assumptions of the chi-square distribution:
=
The sample is a random sample or

The sample is taken from a normally distributed
Reading 11
Hypothesis Testing
FinQuiz.com
population.
Properties of the chi-square distribution:
Unlike the normal and t-distributions, the chi-square
distribution is asymmetrical.
Unlike the t-distribution, the chi-square distribution is
bounded below by 0 i.e. 2 values cannot be
negative.
Unlike the t-distribution, the chi-square distribution is
affected by violations of its assumptions and give
incorrect results when assumptions do not hold.
Like the t-distribution, the shape of the chi-square
distribution depends upon the degrees of freedom
i.e. as the number of degrees of freedom increases,
the chi-square distribution becomes more symmetric.
Rejection Points for Hypothesis Tests on the Population
Variance:
Example:
Suppose,
H0: The variance, 2 0.25.
Ha: The variance, 2> 0.25.
It is a right-tailed test with level of significance () = 0.05
and d.f. = 41 1 = 40 degrees. Using the chi-square
table, the critical value is 55.758.
Decision rule: Reject H0 if 2 > 55.758.
Using the X2test, the standardized test statistic is:
1. Two-tailed test: H0: 2= 20 versus Ha: 2 20

Decision Rule: Reject H0 if
i. The test statistic > upper /2 point (2/2) of the chisquare distribution with df = n 1 or
ii. The test statistic < lower /2 point (21-/2) of the chisquare distribution with df = n 1.
2 =
(n 1) s 2 (41 1)(0.27)
=
= 43.2
0.25
2
Since, 2 is not > 55.758, we fail to reject the H0.
2. Right-tailed test: H0: 2 20 versus Ha: 2>20.

Decision Rule: Reject H0 if the test statistic > upper
point of the chi-square distribution with df = n -1.
3. Left-tailed test: H0: 2 20 versus Ha: 2<20
Decision Rule: Reject H0 if the test statistic < lower
point of the chi-square distribution with df = n -1.
Finding the critical values for the chi-square distribution
from a table:
For a right-tailed test, use the value corresponding to
d.f. and .
For a left-tailed test, use the value corresponding to
d.f. and 1 - .
For a two-tailed test, use the values corresponding to
d.f.& and d.f.& 1 .
Chi-square confidence intervals for variance: Unlike

confidence intervals based on z or t-statistics, chi-square
confidence intervals for variance are asymmetric. A
two-sided confidence interval for population variance,
based on a sample of size n is as follows:
Lower limit = L = (n-1) s2 / 2/2
Upper limit = U = (n -1) s2 / 2 1-/2.
When the hypothesized value of the population variance
lie within these two limits, we fail to reject the null
hypothesis.
Reading 11
4.2
Hypothesis Testing
Tests Concerning the Equality (Inequality) of Two

Variances
1. H0: 2 1 = 22 versus Ha: 21 22

2 1 = 22 implies that 2 1 / 22 = 1.
2. H0: 21 22 versus Ha: 2 1 >22
3. H0: 21 22 versus Ha: 2 1 <22
Tests concerning the difference between the variances
of two populations based on independent random
samples are based on an F-test and F-distribution. F-test
is a ratio of sample variances.
Properties of F-distribution:
Like the chi-square distribution, the F-distribution is
non-symmetrical distribution i.e. it is skewed to the
right.
Like the chi-square distribution, the F-distribution is
bounded from below by 0 i.e. F 0.
The F-distribution depends on two parameters n and
m (numerator and denominator degrees of
freedom, respectively).
Unlike the chi-square test, the F-test is NOT sensitive
to violations of its assumptions.
FinQuiz.com
s22 = sample variance of the second sample with n2

observations.
df1 = n1 -1 numerator degrees of freedom.
df2 = n2 -1 denominator degrees of freedom.
NOTE:
The value of the test statistic is always 1.
Convention regarding test statistic: We use the larger of
the two ratios s21 / s22or s22 / s21 as the actual test statistic.
Rejection Points for Hypothesis Tests on the Relative
Values of Two Population Variances:
A. When the convention of using the larger of the two
ratios s21 / s22 or s22 / s21is followed:
1. Two-tailed test: H0: 21 = 22 versus Ha: 21 22
Decision Rule: Reject H0 at the significance level if
the test statistic > upper / 2 point of
the F-distribution with the specified
numerator and denominator degrees
of freedom.
2. Right-tailed test: H0: 21 22 versus Ha: 21>22
the test statistic > upper point of the
F-distribution with the specified
of freedom.
3. Left-tailed test: H0: 21 22 versus Ha: 21 < 22
Relationship between the chi-square and F-distribution:

F = (12 / m) (22 / n)
It follows an F-distribution with m numerator and n
denominator degrees of freedom.
where,
12
is one chi-square random variable with m degrees of

freedom.
22 is another chi-square random variable with n degrees
of freedom.
Test Statistic for Tests Concerning Differences between
the Variances of Two Populations (Normally Distributed
Populations):
Assumption: The samples are random and independent
and taken from normally distributed populations.
S 21
F= 2
S 2
where,
s21 = sample variance of the first sample with nl
observations.

the test statistic > upper point of the
F-distribution with the specified
of freedom.
B. When the convention of using the larger of the two
ratios s21 / s22 or s22 / s21 is NOT followed: In this case if
the calculated value of F < 1, F-table can still be used
by using a reciprocal property of F-statistics i.e.,
F n, m = 1/ Fm, n
Important to Note:
For a two-tailed test at the level of significance, the
rejection points in F-table are found at / 2
significance level.
For a one-tailed test at the level of significance,
the rejection points in F-table are found at
significance level.
Reading 11
Hypothesis Testing
Example:
Suppose,
H 0: 21 22
Ha: 21>22
n1 = 16
n2 = 16
S21 = 5.8
S22 =1.7
df1=df2 = 15
From F table with 15 and 15 df and = 0.05, the critical

value of F = 2.40 (from the table below).
Decision Rule: Reject H0 if calculated F-statistic > critical
value of F.
Since S21 > S22, we will use convention F = s21 / s22.
F=
s12 5.8
=
= 3.41
s22 1.7
Since calculated F-statistic (3.41) > 2.40, we reject H0

at 5% significance level.
F-values for = 0.05

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Reading 11
Hypothesis Testing
5.
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OTHER ISSUES: NONPARAMETRIC INFERENCE

Reading 11.
Parametric test: A parametric test is a hypothesis test

regarding a parameter or a hypothesis test that is based
on specific distributional assumptions.
5.1
Parametric tests are robust i.e. they are relatively
unaffected by violations of the assumptions.
Parametric tests have greater statistical power
relative to corresponding non-parametric tests.
Non parametric test: A non parametric test is a test that
is either not regarding a parameter or is based on
minimal assumptions about the population.
Nonparametric tests are considered distribution-free
methods because they do not rely on any
underlying distributional assumption.
Nonparametric statistics are useful when the data
are not normally distributed.
A non parametric test is mainly used in three situations:
1) When data do not meet distributional assumptions.
2) When data are given in ranks.
3) When the hypothesis is not related to a parameter.
In a nonparametric test, generally, observations (or a
function of observations) are converted into ranks
according to their magnitude. Thus, the null hypothesis is
stated as a thesis regarding ranks or signs. The nonparametric test can also be used when the original data
are already ranked.
Important to Note: Non-parametric test is less powerful
i.e. the probability of correctly rejecting the null
hypothesis is lower. So when the data meets the
assumptions, parametric tests should be used.
Example: If we want to test whether a sample is random
or not, we will use the appropriate nonparametric test (a
so-called runs test).
Parametric
Nonparametric
Tests
concerning a
single mean
t-test
z-test
Wilcoxon signedrank test
Tests
concerning
differences
between
means
t-test
Approximate ttest
Mann-Whitney U
test
Tests
concerning
mean
differences
(Paired
comparisons
tests)
t-test
Tests Concerning Correlation: The Spearman Rank

Correlation Coefficient
When the population under consideration does not

meet the assumptions, a test based on the Spearman
rank correlation coefficient rS can be used.
Steps of Calculating rS:
1. Rank the observations on X in descending order i.e.
from largest to smallest.
The observation with the largest value is assigned
number 1.
The observation with second-largest value is
assigned number 2, and so on.
If two observations have equal values, each tied
observation is assigned the average of the ranks that
they jointly occupy e.g. if the 4th and 5th-largest
values are tied, both observations are assigned the
rank of 4.5 (the average of 4 and 5).
2. Calculate the difference, di, between the ranks of
each pair of observations on X and Y.
3. The Spearman rank correlation is calculated as:
(# = 1
6 $*+! !
( 1)
a) For small samples, the rejection points for the test

based on rS are found using Table 11 below.
b) For large samples (i.e. n> 30), t-test can be used to
test the hypothesis i.e.
=
( 2)!/ (#
(1 (# )!/
With degrees of freedom = n 2.

Example:
Suppose,
H 0: = 0
Ha: 0
where,
Wilcoxon signedrank test Sign test
= Population correlation of X and Y after ranking.
Reading 11
Hypothesis Testing
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Spearman Rank Correlation Distribution Approximate

Upper-Tail Rejection Points
Portfolio Managers
1
Sharpe Ratio (X)
1.50
1.00
0.90
1.00
0.95
Management
Fee (Y)
1.25
0.95
0.90
0.98
0.90
X Rank
3.5
3.5
Y Rank
4.5
4.5
di( X Y)
0.5
3.5
1.5
2.5
d2i
16
0.25
12.25
2.25
6.25
Sum of d2i = 37
The first two rows in the table above contain the
original data.
In the row of X Rank, the Sharpe ratios are converted
into ranks.
In the row of Y Rank, the management fees are
converted into ranks.
It is a two-tailed test with a 0.05 significance level and
sample size (n) = 5.
NOTE:
Both variables X and Y are not normally distributed; the ttest assumptions are not met.
rS = 1 [(6 d2i) / n (n2 1)]
rS = 1 (6 37) / 5 (25 1) = -0.85
Important to Note: Since the sample size is small i.e. (n <
30), the rejection points for the test must be looked up in
Table 11.
Upper-tail rejection point for n = 5 and /2 = 0.05/ 2 =
0.025 from table 11 is 0.9000.
Decision Rule: Reject H0 if rS> 0.900 or rS<0.900.
Since rs is neither < -0.900 nor > 0.900, we do not reject
the null hypothesis.
Sample
Size: n
= 0.05
= 0.025
= 0.01
0.8000
0.9000
0.9000
0.7714
0.8286
0.8857
0.6786
0.7450
0.8571
0.6190
0.7143
0.8095
0.5833
0.6833
0.7667
10
0.5515
0.6364
0.7333
11
0.5273
0.6091
0.7000
12
0.4965
0.5804
0.6713
13
0.4780
0.5549
0.6429
14
0.45930
0.5341
0.6220
15
0.4429
0.5179
0.6000
16
0.4265
0.5000
0.5824
17
0.4118
0.4853
0.5637
18
0.3994
0.4716
0.5480
19
0.3895
0.4579
0.5333
20
0.3789
0.4451
0.5203
21
0.3688
0.4351
0.5078
22
0.3597
0.4241
0.4963
23
0.3518
0.4150
0.4852
24
0.3435
0.4061
0.4748
25
0.3362
0.3977
0.4654
26
0.3299
0.3894
0.4564
27
0.3236
0.3822
0.4481
28
0.3175
0.3749
0.4401
29
0.3113
0.3685
0.4320
30
0.3059
0.3620
0.4251
NOTE:
The corresponding lower tail critical value is obtained by
changing the sign of the upper-tail critical value
Reading 11.
Practice: Example before Table 10,

Volume 1, Reading 11 & End of
Chapter Practice Problems for
Reading 11.
Technical Analysis
2.
TECHNICAL ANALYSIS: DEFINITION AND SCOPE
Technical analysis is a security analysis technique that

involves forecasting the future direction of prices by
studying past market data, primarily price and volume.
Technical analysis can be used for a wide range of
financial instruments i.e. equities, bonds, commodity
futures, and currency futures.
Technical analysis can be applied over any time
interval e.g. short-term price movements or longterm movements of annual closing prices.
Technical analysis is based on three factors:
1) Prices are determined by the equilibrium between
supply and demand. Supply and demand
depend on various factors both rational and
irrational
2) Changes in prices are caused by changes in
supply and demand.
3) Charts of past prices and other technical tools
can be used to identify historical price patterns
and to predict future price movements.
Fundamental analysis is based on identifying the
fundamental economic and political factors to
determine a securitys price.
2.1
Principles and Assumptions
Assumptions:
1. Market trends and patterns reflect both the rational
and irrational human behavior.
2. Historical market trends and patterns tend to repeat
themselves and are, therefore, predictable to some
extent.
3. Technical analysis is based on the concept that
securities are traded in a freely traded market where
all the available fundamental information, as well as
other information, i.e. traders expectations and the
psychology of the market is reflected in market prices
on timely basis.
Note that in a freely traded market, only those
market participants who actually buy or sell a
security have an impact on price and the greater
the volume of a participants trades, the more
impact that market participant will have on price.
4.
The price and volume is determined by the trade

which is affected by investor sentiments.
5.
Investors follow the market trend.
2.2
Technical and Fundamental Analysis
Comparison:
Technical analysis solely involves analyzing markets
and the trading of financial instruments; therefore,
technical analysis does not require detailed
knowledge of the instrument.
o Fundamental analysis involves financial and
economic analysis as well as analysis of societal
and political trends.
Technical analysis is less time consuming than
fundamental analysis; thus, short-term investors (i.e.
traders) tend to prefer technical analysis (not
always, however).
Unlike fundamental analysis, technical analysis is
based on the assumption that markets are inefficient
and reflect irrational human behavior e.g. an
investor may sell a security with favorable
fundamentals for other reasons e.g. pessimistic
investor sentiment, margin calls, to meet child's
college tuition fees etc.
Technical analysis is based on objective and
concrete data i.e. price and volume data; whereas,
the fundamental analysis is based on less objective
data because analyzing financial statements
involves numerous estimates and assumptions.
Fundamental analysis is considered to be more
theoretical approach because it seeks to determine
the underlying long-term (or intrinsic) value of a
security; whereas, technical analysis is considered to
be more practical approach because it involves
studying prevailing prices and market trends.
Fundamental analysis is widely used in the analysis of
fixed-income and equity securities whereas
technical analysis is widely used in the analysis of
commodities, currencies, and futures.
Technicians trade when a security has started
moving to its new equilibrium whereas, a
fundamental analyst identifies undervalued
securities that may or may not adjust to correct
prices.
Technicians seek to forecast the price level at which
a financial instrument will trade without caring about
the reasons behind buying and selling of market
participants; whereas fundamental analysts seek to
forecast the price level at which a financial
instrument should trade.
Technical analysis is based on the theory that
security price movements occur before
fundamental developments are disclosed.
Therefore, stock prices are one of the 12
components of the National Bureau of Economic
Research's Index of Leading Economic Indicators.
Reading 12
Reading 12
Technical Analysis
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Important to Note:
An important principle of technical analysis is that
the equity market moves approximately six months
ahead of inflection points in the broad economy.
In case of securities fraud, technical analysis is
considered to be a superior tool relative to
fundamental analysis.
Drawbacks of Technical Analysis:
1) Technical analysis only focuses on studying market
movements and ignores other predictive analytical
methods.
3) Market trends are not evident at first and changes in

trends under technical analysis can be identified only
when these changes are already in progress.
4) Technical analysis is based on rules that require
subjective judgment.
5) Technical analysis is not appropriate to use for:
Markets that are subject to large outside
manipulation.
Illiquid markets.
Bankrupt and financially distressed companies.
2) Although market trends are determined by collective

investor sentiments, these trends may change without
warning.
3.
TECHNICAL ANALYSIS TOOLS
The two primary tools used in technical analysis are:

1) Charts: Charts are the graphical representation of
price and volume data. Chart analysis involves
identifying market trends, patterns, and cycles.
Advantage: A line chart is simple to construct and easy

to understand.
2) Technical Indicators: They include various measures of

relative price level e.g. price momentum, market
sentiments and funds flow.
3.1
Charts
Under chart analysis, prices are plotted on the Y-axis

(vertical axis) and time is plotted on the X-axis (horizontal
axis). The most commonly used charts that are used to
identify price patterns to predict future price movements
are:
a) Line charts
b) Bar charts
c) Candlestick charts
d) Point-and-figure charts
The selection of the type of chart used in technical
analysis depends on the purpose of analysis.
3.1.1) Line Chart
A line chart plots the closing prices over time. It has one
data point per time interval.
Prices are plotted on the vertical axis (Y-axis).
Time is plotted on the horizontal axis (X-axis).
The data points (i.e. closing prices) over time are
connected using a line.
3.1.2) Bar Chart

A bar chart reflects the trading activity for a particular
trading period (e.g., 1 day) by a single vertical line on
the graph.
A single bar (like in the figure below), indicates one
day of trading.
A bar chart can be constructed for any time period.
Unlike line charts, a bar chart provides four prices in
each data entry i.e. as shown in the figure below:
i. The top of the vertical line reflects the highest
price at which a security is traded at during the
day.
ii. The bottom of the vertical line reflects the lowest
price at which a security is traded during the
day.
iii. The horizontal line on the top of the right side of
the bar reflects the closing price of a security.
iv. The horizontal line on the bottom of the left side
Reading 12
Technical Analysis
of the bar reflects the opening price of a

security.
The nature of a particular day's trading:
The length of the vertical line represents the trading
range or volatility for that security for that particular
period.
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high and low price.

When the body of the candle is filled / shaded
(black), it indicates that the opening price was
higher than the closing price.
When the body of the candle is clear/ hollow
(white), it indicates that the opening price was lower
than the closing price.
A short bar indicates little price movement during

the day the high, low, and closing price are near
the opening price.
A long bar indicates a large price movement the
high price significantly deviates from the low price
for the day.
Bar Chart of a Stock
Source: Exhibit 4, CFA Program Curriculum,

Nature of Trading:
The wider the difference between the high and low
price of the day, the greater the volatility.
When a security opens near the low of the day and
closes near the high, it indicates a steady rally during
the day.
Generally, the longer the body of the candle, the
more strong the buying or selling pressure and the
greater the price movement.
Bullish pattern: Long white candlesticks, where the stock
opened at (or near) its low and closed near its high,
indicate buying pressure i.e. trading is controlled by
bullish traders for most of the period.
The top part of the chart above shows the open,
close, high, and low price levels.
The bottom part shows volume of trade.
Advantages of Bar Chart: A bar chart provides more
information than a line chart because it shows the high,
low, open and close price for particular trading day.
3.1.3) Candlestick Chart
A candlestick chart reflects price movements of a
security over time. It is a combination of a line-chart and
a bar-chart.
Like a bar chart, a candlestick chart also provides four
prices at each data entry i.e. the opening, closing, high
and low prices during the period.
Bearish Pattern: Long black candlesticks, where the

stock opened at (or near) its high and dropped
significantly to close near its low, indicate selling pressure
i.e. trading is controlled by bearish traders for most of the
period.
Doji: When the high price is nearly the same as low price;
and the opening and closing price is the same, it creates
a cross-pattern (as shown below) and is referred to as
doji (used in Japanese terminology).
Doji is considered to be neutral patterns i.e. the
forces of supply and demand are in equilibrium
the market is in balance.
When a doji occurs at the end of a long uptrend or
downtrend, it indicates that the trend will/may
reverse.
As shown in the figure below:

A vertical line represents the range of the security
price movement during the time period. This line is
referred to as the wick or shadow. It indicates the
Doji
Reading 12
Technical Analysis
Advantages of the candlestick:

Candlestick chart facilitates faster analysis as price
movements are much more visible in the candlestick
chart relative to bar chart.
In bar charts, the market volatility is reflected by the
height of each bar only; whereas in candlestick
chart, the difference between opening and closing
prices and their relationship to the highs and lows of
the day are clearly shown.
3.1.4) Point and Figure Chart
A point and figure chart plots day-to-day changes in
price (i.e. increase and decrease). Thus, it can be used
to detect significant price trends and reversals.
Construction of a point and figure chart: A point and
figure chart is drawn on a grid and consists of two
columns i.e. column X and column O.
Number of changes in price is plotted on the
horizontal axis.
The discrete increments of price are plotted on the
vertical axis.
Neither time nor volume is plotted on this chart.
The horizontal axis reflects the passage of time but
not evenly.
The data entry is made only when the price changes
by the box size*.
*Box size: The box size reflects the change in price and
shows the number of points required to make an X or O.
It is represented by the height of each box. Generally,
the boxes are square in shape and the width of the box
has no meaning.
In a chart with box size of $3, boxes would be $3
apart e.g. $30, $33, $36.
The box size varies with the security price i.e. for a
security with a very low price, the box size can be
reduced to cents; for a security with a very high
price, larger box sizes are used.
Typically, a box size of 1 is used.
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o An increase in price is represented by X.

o A decrease in price is represented by O.
o Whenever the security closing price is equal to the
box size, an X is drawn in a column.
o Whenever the security price increases by twice the
box size, two Xs are drawn to fill in two boxes i.e.
one on top of the other.
Thus, the larger the price movement, the more
boxes are filled.
o The starting point of the resulting column reflects
the opening price level and the ending point
reflects the closing price level.
o As long as the security continues to be closed at
higher prices (i.e. upward trend continues), the
boxes are continued to be filled with Xs.
o When the increase in price is < box size, no
indication is made on the chart; and if this situation
persists, the chart is not updated.
Suppose, the box size is $1 and the reversal size is $3.
When a price level decreases by $3, we would shift
to the next column i.e. start a new column of Os.
NOTE:
Each price reversal results in the start of a new column.
In this new column of Os, the box that is filled first is
the one that is to the right and below the highest X in
the previous column.
Each filled box in the column of Os reflects $1 (i.e.
box size) decrease in the security price.
As long as the security continues to be closed at
lower prices (i.e. downward trend continues), the
boxes are continued to be filled with Os.
When a price level increases by at least the amount
of the reversal size, we would shift to the next column
and start a series of Xs again.
Reversal size: The reversal size is the price change

needed to determine when to create a new column.
For example, a four box reversal size means $4
decrease in price level would result in a shift to the
next column and start of a new column of Os or 4
increase in price level would result in a shift to the
next column and start of a new column of Xs.
Typically, a reversal size of 3 is used.
The reversal size is a multiple of the box size i.e. the
reversal size changes with a change in the box size
e.g. if the box size is three points and the reversal
amount is two boxes, then prices must reverse
direction six points (three multiplied by two) in order
to change columns.
The larger the reversal size, the fewer columns in the
chart and the longer uptrends and down trends.
Analysis of a point and figure chart:

The changing of columns indicates a change in the
trend of prices i.e.
When a new column of Xs appears, it shows that
prices are rallying higher.
When a new column of Os appears, it shows that
prices are moving lower.
Reading 12
Technical Analysis
Buy signal: When an X in a new column exceeds the

highest X in the immediately preceding X column, it
indicates a buy signal.
For columns of Xs or up trends, long position is
maintained.
Reversal size represents the amount of loss at which
the long position will be closed and short position is
established.
Sell signal: When an O in a new column < lowest O in the
immediately preceding O column, it indicates a sell
signal.
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The horizontal axis of the chart shows the passage of

time. The appropriate time interval depends on two
factors:
i. Nature of the underlying data used.
ii. Specific use of the chart.
For example, an active trader may prefer to use
short-term data e.g. 10-minutes, 5-minutes data.
Generally, the greater the volatility of the data, the
more analysts prefer to use more-frequent data
sampling.
3.1.6) Volume
For columns of Os or down trends, short position is

maintained.
Congestion areas: These are the areas on a chart with a
series of short columns of Xs and Os indicating a
narrower trading range of a security.
Large and persistent price moves are represented by
long columns of X's (when prices are increasing) or O's
(when prices are decreasing).
Advantages:
Point and figure charts help to remove noise (i.e.
short-term trading volatility) in the price data by
smoothing down the price movements that are
shown in a bar chart.
Point and figure charts clearly show price levels that
indicate the end of a downward or upward trend.
Thus, they are useful to identify buy and sell signals.
Point and figure charts clearly show price levels at
which a security is expected to trade frequently.
Point and figure charts can be used to identify
significant price movements.
Drawbacks:
Point and figure charts only focus on price
movements and ignores holding periods (time).
Point and figure charts are not commonly used for
longer time periods as it is quite time consuming and
tiresome to manually construct them over a longer
period of time.
3.1.5) Scale
The vertical axis of any chart (i.e. line, bar, or
candlestick) can be constructed with either using a
linear scale (also called arithmetic scale) or a
logarithmic scale.
Linear scale is appropriate to use for narrower range
of values e.g. prices from $45 to $55.
Logarithmic Scale: In a logarithmic scale, equal
vertical distances on the chart represent an equal
percentage change. It is appropriate to use for
wider range of values e.g., from 10 to 10,000.
Volume refers to the number of shares traded between

buyers and sellers. It is plotted at the bottom of many
charts.
It is used to identify the intensity of confidence of
buyers and sellers in determining a securitys price.
The greater the volume, the more significant price
movements are.
When the volume and price of a security increase
simultaneously it indicates that more and more
investors are buying over time.
When volume and price of a security moves in
opposite direction e.g. the volume is decreasing but
price is rising it indicates that fewer and fewer
market participants are willing to buy that stock at
the new price.
3.1. 7) Time Intervals
Charts can be constructed using any time interval i.e.
one-minute, daily, weekly, monthly, annually etc.
Longer time intervals (i.e. weekly, monthly, annually)
can be used to plot longer time periods because
long intervals have fewer data points.
Shorter time intervals (i.e. daily, hourly) can be used
to have detailed analysis of the data.
3.1.8) Relative Strength Analysis
Relative strength analysis is used to compare the
performance of a particular asset (e.g. a common
stock) with that of some benchmark e.g. S&P 500 Index
or the performance of another security to identify under
or out performance of a particular asset to some other
index or asset. Under a relative strength analysis, a line
chart of the ratios* of two prices is constructed.
*Ratio =

(

)

A rising (falling) line indicates that the asset is

outperforming (underperforming) the benchmark.
A flat line indicates that the assets performance is
the same as that of a benchmark (i.e. neutral
performance).
Reading 12
Technical Analysis
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Example:
Suppose, on 10th August 2010, the share price of
Company A closed at $8.42 and the S&P 500 closed at
$676.53.
Relative strength data point = 8.42/ 676.53 = 0.0124
2) Downtrend line: A downtrend is a sequence of lower

lows and lower highs. It is a negatively sloped line and
is drawn by connecting two or more high points. In
order to have a negative slope, the second low point
on a line must be less than the first one.

3.2
Trend
A trend line is a straight line that connects periodic high

or low prices on a chart and then extends into the future.
Two common types of trend lines are:
A downtrend line acts as resistance (discussed

below) indicating bearish pattern i.e. there are
more sellers than buyers (i.e. supply exceeds
demand).
When price remains below the downtrend line, it
gives a signal to go short/sell.
When the closing price is significantly above the
downtrend line (e.g. 5-10% above the trendline), it
indicates that the downtrend is over and gives a
signal to go long/buy.
The longer the price remains above the trendline,
the more meaningful the breakout in price is
considered to be.
1) Uptrend line: An uptrend is a sequence of higher highs

and higher lows. It is a positively sloped line and is
drawn by connecting two or more low points. In order
to have a positive slope, the second low point on a
line must be greater than the first one.
An uptrend line acts as support (discussed below)
indicating bullish pattern i.e. there are more buyers
than sellers (i.e. demand exceeds supply).
When price remains above the uptrend line, it gives
a signal to buy.
When the closing price is significantly below the
uptrend line (e.g. 5-10% below the trendline), it
indicates that the uptrend is over and gives a signal
to sell.
The longer the price remains below the trendline, the
more meaningful the breakdown in price is
considered to be.
NOTE:
Retracement refers to a reversal in the movement of the
security's price.
NOTE:
From the technical analysis perspective, the reason
behind selling or buying is irrelevant.
In up trends, it is rare that a security with unattractive
fundamentals has an attractive technical position.
In downtrends, a security may have attractive
fundamentals but a currently negative technical
position.
Important to Note:
It is not always possible to draw a trend line for every
security.
Technical analysis is less useful when a security is not
Reading 12
Technical Analysis
in a trend.
Trend lines can provide useful information; however,
they may give false signals when used improperly.
The trading decisions should not solely be based on
trend lines.
Trendlines and trendline breakdown/breakout vary
with time interval i.e. a chart with a shorter timeinterval may have a different trendline as well as a
different trendline breakdown relative to a chart with
a longer time-interval.
Support: Support is the level at which a securitys price
stops falling because buying activity increases such that
supply no longer exceeds demand.
Resistance: Resistance is the level at which a securitys
price stops rising because selling activity increases such
that supply becomes greater than demand.
Support and resistance levels can be sloped lines or
horizontal lines.
Change in Polarity Principle: According to this principle,
once a support (resistance) level is breached, it
becomes a resistance (support) level.
Congestion occurs when a security trades in a narrow
price range on low volumes. A congestion area
indicates that the forces of supply and demand are
evenly balanced.
When the price breaks out of the congestion area
by penetrating the support it gives a signal to sell.
When the price breaks out of the congestion area
by penetrating resistance it gives a signal to buy.
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2) Continuation patterns: A continuation pattern

indicates that the ongoing trend will continue for
some time i.e. the direction of the price movement
will continue to follow the same trend as it was before
the formation of the pattern.
From the supply/demand perspective, a
continuation pattern indicates a change in
ownership from one group of investors to another.
Generally, it is referred to as a healthy correction
because, for example, if the price is declining, it will
quickly start rising as another set of investors will start
buying indicating that the long-term market trend
will continue to be the same.
Its types are discussed in section 3.3.2.1 to 3.3.2.3
below.
3.3.1.1 Head and Shoulders
The head and shoulders pattern is a type of a reversal
pattern and it is most often observed in uptrends.
It must be noted that without a prior uptrend, there
cannot be a Head and Shoulders reversal pattern.
The formation of a head and shoulders pattern is
considered to be a bearish indicator (i.e. end of
uptrend).
It consists of three parts i.e.
1) Left shoulder: It reflects the high point of the current
uptrend with a strong volume. After this point, the rally
reverses back (price falls) to the initial price level at
which the left shoulder started i.e. forming an inverted
V pattern with lower volume.
It reflects the first peak and is associated with high
volume i.e. highly aggressive buying pressure.
NOTE:
Rally refers to a period of sustained increases in the
prices of stocks.
3.3
Chart Patterns
Chart patterns refer to some type of recognizable shape

in price charts that graphically reflect the collective
behavior of the market participants at a given time.
These patterns can be used to predict security prices.
However, it is important to note that chart patterns have
no predictive value without a clear trend in place prior
to the pattern.
Chart patterns can be divided into two categories:
1) Reversal patterns: A reversal pattern indicates the end
of a trend i.e. change in the direction of price
movement of a financial instrument. Its types are
discussed in section 3.3.1.1 to 3.3.1.6 below.
2) Head: The head refers to a part that starts from the

low point of the left shoulder and shows a more
pronounced uptrend (rally), however, with a lower
volume relative to upward side of the left shoulder.
After reaching the peak point, the price again starts to
fall to the same level at which the left shoulder started
and ended. This price level is referred to as the
neckline* and is below the uptrend line preceding the
beginning of the head and shoulders pattern.
The head pattern gives the first signal of a reversal
indicating the end of the rally.
It reflects the middle peak (highest) and is
associated with moderate volumeless aggressive
buying fewer bullish market participants.
The top of the head reflects a new higher price but
without increase in volume. This situation is referred
Reading 12
Technical Analysis
to as divergence.
3) Right shoulder: The right shoulder is a mirror image (or
roughly a mirror image) of the left shoulder but with
lower volume. It is formed when the price rises from
the low of the head.
It reflects the third peak and is associated with lower
volume relative to head indicating significantly
lower demand, resulting in decline in prices.
This peak is lower than that of the head and is
approximately the same as the first peak.
The head and shoulders pattern is complete when the
rally reverses and the downtrend line from the low of the
right shoulder breaks the neckline.
*Neckline: It is referred to as the price level at which the
first rally should start and the left shoulder and head
should decline. It is formed by connecting two low
points i.e.
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3.3.1.3 Setting Price Targets with Head and Shoulders

Pattern
Under a head and shoulders pattern, a technician seeks
to generate profit by short selling the security under
analysis. For this purpose, the price target is set as follows.
In a head and shoulders pattern, once the neckline
support is broken,
Expected decrease in price of the security below the
neckline = Change in price from the neckline to the top
of the head Head price - Neckline price
And
Price Target = Neckline price (Head price - Neckline
price)
3.3.1.2 Inverse Head and Shoulders

i. Point 1: The end of the left shoulder and the
beginning of the head.
ii. Point 2: The end of the head and the beginning of
the right shoulder.
The neckline represents a support level; and
according to the change in polarity principle,
once a support level is breached, it becomes a
resistance level.
Depending on the relationships between the two
points, the necklines can be upward sloping lines,
downward sloping lines or horizontal lines.
The inverted head and shoulders pattern is typically

observed in downtrends.
It must be noted that without a prior downtrend,
there cannot be an inverted Head and Shoulders
reversal pattern.
The formation of an inverse head and shoulders
pattern is considered to be a bullish indicator (i.e.
end of downtrend).
It consists of three parts i.e.
1) Left shoulder: This shoulder indicates a strong decline
in prices with strong volume and the slope of this
downtrend is greater than the prior downtrend. After
this point of trough, the rally reverses back (i.e. price
rises) to the initial price level at which the left shoulder
started i.e. forming a V pattern, but on lower volume.
It reflects the first trough and is associated with
strong volume i.e. highly intense selling pressure.
Once the head and shoulders pattern has formed, the

share price is expected to decline down through the
neckline price. Different filtering rules are used to identify
the breakdown of the neckline e.g.
Waiting to trade until the price declines to some
significant level below the neckline i.e. 3% or 5%.
Waiting to trade until the price remains below the
neckline for some significant time period e.g. for
daily price chart, time limit can be several days to a
week.
2) Head: The head refers to a part that starts from the

high point of the left shoulder and shows a more
pronounced downtrend, however, with a lower
volume.
After reaching the bottom point, the price again
starts to rise to the same level at which the left
shoulder started and ended. This price level is
referred to as the neckline* and is above the
uptrend line preceding the beginning of the inverse
head and shoulders pattern.
The head pattern gives the first signal of a reversal
indicating the end of the decline in prices.
o It reflects the middle trough (lowest point) and is
associated with moderate volume less
aggressive selling pressure fewer bearish market
participants.
Reading 12
Technical Analysis
3) Right shoulder: The right shoulder is a mirror image (or

roughly a mirror image) of the left shoulder but with
lower volume. It is formed when the price falls from
the high point of the head.
The price declines down to roughly the same level as
the first shoulder; however, the bottom point is higher
than that of the head and is approximately the
same as the first trough.
It reflects the third trough (or bottom point) and is
associated with lower volume relative to head
indicating significantly lower selling pressure, resulting
in rise in prices.
The inverted head and shoulders pattern is complete
when the market rallies and the uptrend line from the
low of the right shoulder breaks the neckline.
*Neckline in an Inverse Head and Shoulders: It is referred
to as the price level at which the first trough should start
and the left shoulder and head should rise. It is formed
by connecting two low points i.e.
iii. Point 1: The end of the left shoulder and the
beginning of the head.
iv. Point 2: The end of the head and the beginning of
the right shoulder.
The neckline in an inverse head and shoulder
pattern represents a resistance level; and according
to the change in polarity principle, once a
resistance level is breached, it becomes a support
level.
Depending on the relationships between the two
points, the necklines can be upward sloping lines,
downward sloping lines or horizontal lines.
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Expected Increase in price of the security above the

neckline = Change in price from the neckline to the top
of the head Neckline price - Head price
And
Price Target = Neckline price + (Neckline price - Head
price)
3.3.1.5 Double Tops and Bottoms
Double tops or bottoms are frequently used to identify a
price reversal.
Double tops: A double top is formed when the price of a
security rises, drops, rises again to the same or similar
level as the initial rise, and finally drops again. The two
rises form a resistance level for the security.
The double top pattern looks like the letter M on a
chart.
It must be noted that without a prior uptrend, there
cannot be a double top reversal pattern.
Volume is lower on the second peak relative to the
first peak indicating weakening demand.
The formation of a double top is considered to be a
bearish indicator i.e. end of uptrend.
For an uptrend, a double top implies that selling
pressure develops and reverses the uptrend.
The longer the time is between the two tops and the
intense the selling pressure after the 1st peak (top),
more significant the pattern is considered to be.
Setting Price targets: Under a double top pattern, a
technician seeks to generate profit by short selling the
security under analysis. For this purpose, the price target
is set as follows.
Expected decrease in price of the security below the low
of the valley between the two tops the distance from
the breakout point less the height of the pattern.
Height of the double top pattern = Highest high in the
pattern Lowest low
in the pattern
Price target = Lowest low in the pattern Height of the
pattern
3.3.1.4 Setting Price Targets with Inverse Head and

Shoulders Pattern
Under an inverse head and shoulders pattern, a
technician seeks to generate profit by taking long
position in the security under analysis. For this purpose,
the price target is set as follows.
In an inverse head and shoulders pattern, once the
neckline resistance is broken,
Reading 12
Technical Analysis
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Example:
Suppose,
The lowest low of the double top = $250.
The highest high of the double top = $280.
Height of the pattern = $280 - $250 = $30
Target Price = $250 - $30 = $220
Example:
Suppose,
The lowest low of the double bottom = $200.
The highest high of the double bottom = $270.
Double bottoms: A double bottom is formed when the

price of a security drops, rebounds, drops again to the
same or similar level as the initial drop, and rebounds
again. The two drops form a support level for the
security.
The double bottom pattern looks like the letter W
on a chart.
It must be noted that without a prior downtrend,
there cannot be a double bottom reversal pattern. It
is just the mirror image of a double top.
The formation of a double bottom is considered to
be a bullish indicator i.e. end of downtrend.
Volume and buying pressure during the advance off
of the second trough is greater than that of the first
trough.
For a downtrend, a double bottom implies that
buying pressure develops and reverses the
downtrend.
Height of the pattern = $270 - $200 = $70

Target Price = $270 + $70 = $340
3.3.1.6 Triple Tops and Bottoms
Triple Tops: Triple tops occur when the price of a security
rises to a resistance level, drops, rises again to the same
or similar resistance level as the initial rise, drops again
and finally rises again to the resistance level for a third
time before declining.
It consists of three peaks at roughly the same price
level.
Volume decreases as the pattern forms i.e. the
volume at the first peak is greater than that of the
second peak and third peak.
The triple top pattern is complete when prices fall
below the lowest low in the pattern. The lowest low is
also called the "confirmation point."
Setting Price targets: Under a double bottom pattern, a

technician seeks to generate profit by taking long
position in the security under analysis. For this purpose,
the price target is set as follows.
Expected increase in price of the security above the
peak between the two bottoms
The distance from the breakout point plus the height of
the pattern.
Height of the double bottom pattern = Highest high in
the pattern
Lowest low in the
pattern
Price target = Highest high in the pattern + Height of the
pattern
Triple bottoms: Triple bottoms occur when the price of a

security drops to a support level, rebounds, drops again
to the same or similar support level as the initial drop,
rises again and finally drops again to the support level
for the third time before rising.
It consists of three troughs at roughly the same price
level.
Reading 12
Technical Analysis
Challenges of the double top& bottom and triple top&

bottom patterns:
Double top and triple top patterns cannot be
identified ex-ante.
There is no guarantee that downtrend (uptrend)
must end with a double bottom (double top).
Important to note:
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Measuring Implication: It refers to the height of a

triangle,
where,
Height of a triangle = Price at the start of the downward
sloping trendline Price at the start
of the upward sloping trendline
The vertical bar in Exhibit 20 below represents the
measuring implication.
Double tops and bottoms are considered to be

more significant patterns than single tops and
bottoms.
Triple tops and bottoms are considered to be more
significant patterns than double tops and bottoms.
The greater the number of times the price reverses at
the same level, and the greater the time interval
during which this pattern occurs the more
significant the pattern is considered to be.
3.3.2.1 Triangles
Triangle patterns are a type of continuation pattern.
These patterns are formed when the distance between
high and low prices narrows. In this pattern, a triangle is
formed by connecting two trendlines i.e.
i. One trendline connects the high prices.
ii. Other trendline connects the low prices.

Types of Triangle Patterns: There are three types of

triangle patterns.
2) Ascending triangles: They are typically formed in an

uptrend and are considered to be bullish indicators.
1) Symmetrical triangles: A symmetrical triangle is

formed by connecting two trendlines i.e. a
descending resistance line and an ascending support
line. These two lines must have the same slope in
order to reflect a symmetrical pattern.
In an ascending triangle,
These patterns are formed in markets where both the

buyers and sellers are uncertain about the direction
of price movement.
These patterns indicate that buyers are becoming
more bullish while, simultaneously, sellers are
becoming more bearish such that the forces of
supply and demand are nearly equal.
These patterns end in the same direction as the
trend that preceded it i.e. either uptrend or
downtrend.
The trendline that connects the high prices is

horizontal in shape reflecting that sellers are
earning profits at around the same price point.
The trendline that connects the low prices is an
upward sloping line.
An ascending triangle indicates that:
The security is being sold by market participants at
the same price level over a period of time
resulting in an end to uptrend.
However, the buyers are becoming more and more
bullish resulting in rise in prices.
Then, buying pressure weakens and price fall,
although at a higher level than before.
But demand again rises and prices increase at their
previous high level.
Eventually, prices breakout through the previous high
level and continue rising as demand increases
representing a rally.
As shown in the figure below, the rally continues beyond
the triangle and it is considered to be a bullish signal.
Reading 12
Technical Analysis
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selling shares at a specific price level which results in

an end to a rally.
2. One trendline connects low prices it represents the
horizontal support line at the bottom of the rectangle
indicating that market participants are repeatedly
buying shares at the same price level which results in
a reverse of downtrend.
3) Descending triangles: They are typically formed in a
downtrend and are considered to be bearish
indicators.
In a descending triangle,
The trendline that connects the low prices is
horizontal in shape reflecting that sellers are
earning profits at around the same price point.
The trendline that connects the high prices is a
downward sloping line.
A descending triangle indicates that:
As the prices fall due to selling pressure, demand
increases resulting in an end to a downtrend
prices rise.
However, higher price attracts more sellers and
prices drop to their previous low level.
Then, selling pressure weakens and prices begin to
rise, but at a lower level than before reflecting
that selling pressure has greater impact on prices
than that of buying.
But, selling pressure again rises and prices decrease
at their previous low level.
Eventually, prices breakdown through the previous
low level and continue declining as supply increases.
Thus, supply and demand seems evenly balanced at

the moment.
Rectangle patterns signal the continuation of a
market move in the direction of the original trend.
Bullish Rectangle: A bullish rectangle occurs following an
uptrend; therefore, the support level in a bullish
rectangle is natural.
For a bullish Rectangle, the first point (the point
farthest left, i.e., the earliest point) is at the top.
Once the rectangle pattern occurs, the price is
going to breakout the resistance line and keeps
moving upwards i.e. the uptrend continues.
Bearish rectangle: A bearish rectangle occurs following

a downtrend and the support level may represent
market participants are buying the security.
For a bearish Rectangle, the first point is at the
bottom.
Once the rectangle pattern occurs, the price is
going to breakdown the support line and keeps
moving downwards i.e. the downtrend continues.
Important to Note:
The longer the time period during which the triangle
pattern occurs, the more volatile and sustained the
subsequent price movement is likely to be.
Typically, triangles should break out about half to
three-quarters of the way through the pattern
formation.
3.3.2.2 Rectangle Pattern
A rectangle pattern is a type of continuation pattern
and graphically represents the collective market
sentiments. It is formed by two parallel trendlines i.e.
1. One trendline connects high prices it represents the
horizontal resistance line at the top of the rectangle
indicating that market participants are repeatedly
3.3.2.3 Flags and Pennants

Flags and pennants are considered minor continuation
patterns because they are formed over short periods of
time i.e. on a daily price chart, typically over a week.
Flag Pattern: It is formed by parallel trendlines, creating a
parallelogram and looks like a flag of a country.
The trendlines forming a flag pattern slope against
the trend i.e. in an uptrend (downtrend), the
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trendlines slope downwards (upwards).

Flag patterns signal the continuation of a market
move in the direction of the original trend.
Expected change in price Change in price from the
start of the trend to the
formation of the flag
Thus,
Price Target = Price level at which the flag ends (Price
level at which the trend starts - Price level
at which the flag starts to form)
Pennant Pattern: It is formed by two trendlines that
converge to create a triangle and looks like the
pennants of many sports teams or pennants flown on
ships.
It is important to note that a pennant is a short-term
pattern and is typically smaller in size (volatility) and
duration; whereas, a triangle is a long-term pattern.
Pennant patterns signal the continuation of a market
move in the direction of the original trend.
Expected change in price Change in price from the
start of the trend to the formation of the pennant
Thus,
Price Target = Price level at which the pennant ends
(Price level at which the trend starts - Price
level at which the pennant starts to form)
Example:
Suppose,
A downtrend begins at point A, at price = $104.
A pennant begins to form at point B, at price = $70.
The pennant ends at point C, at price = $76.
Price Target = $76 ($104 - $70) = $42

Reading 12
3.4
Technical Analysis
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Technical Indicators
Technical indicators measure the effect of potential

changes in supply and demand on a securitys price.
They can be used to forecast changes in prices. They
include:
Price-based
indicators
Momentum
oscillators
Sentiment
indicators
Moving
average
Momentum or
rate of change
oscillator
Opinion polls
Arms Index
Relative
strength index
Calculated
statistical
indices
Margin Debt
Bollinger bands
These include:
Mutual fund
cash position
Stochastic
oscillator
1. Put/call ratio
Flow-of-funds
indicators
2.CBOE
volatility index
3. Margin debt
Moving
average
convergence/d
ivergence
oscillator
3.4.1) Price-Based Indicators

Price-based indicators use information contained in the
current and past history of market prices. They include:
1) Moving Average (section 3.4.1.1): A moving average
is the average of closing prices over the last N periods
e.g.
5-day moving average Average of the last 5 daily
closing prices
30-day moving average Average of the last 30 daily
closing prices
It helps to smooth out short term price fluctuations
(trading volatility) in the data. Thus, it facilitates
investors to identify price trends and trend reversals
more easily.
Moving averages are also used to identify support
and resistance.
A moving average is less volatile relative to price.
Like most tools of technical analysis, moving
averages should be used along with other
complementary tools.
Effect of number of days used to compute Moving
Average: The greater the number of days used to
compute the average, the smoother and less volatile
the moving-average line will be and the less sensitive
the average will be to price changes.
The number of days used depend on the purpose of
New equity
issuance
4. Short interest
Secondary
offerings
use of the moving average.

o A month contains approximately 20 trading days.
o A quarter contains approximately 60 trading days.
Types of Moving Average:
a) Simple Moving Average: In a simple moving average,
each closing price of a security is weighted equally.
Simple Moving average =
P1 = P2 + P3 + ... + Pn
N
b) Exponential moving average/Exponentially smoothed

moving average: In an exponential moving average,
recent closing prices are given the greatest weight
while the older prices are given exponentially less
weight. An exponential moving average is more
sensitive to changes in price.
Trading Rules using Moving Averages: Moving Averages
are easy to compute and can be used in different ways.
1) Analyzing whether price is above or below its moving
average:
When the market price crosses through the moving
average line from above and moves downwards, it
gives a signal to sell.
When the market price crosses through the moving
average line from below and moves upwards, it
gives a signal to buy.
Reading 12
Technical Analysis
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a) Moving average of the closing price + Higher band

Where, higher band Moving average + a set
number of standard deviations from average price
(e.g. 2 S.Ds above the mean)
b) Moving average of the closing price + Lower band
Where, lower band Moving average - a set
number of standard deviations from average price
(e.g. 2 S.Ds below the mean)
2) Analyze the distance between the moving-average

line and price i.e.
When a price starts to move upwards toward its
moving average, it acts as a resistance level.
When a price reaches the moving-average line, it
gives a warning signal that rally is about to end; thus,
security should be sold.
3) Analyzing short-term and long-term moving average:
When a short-term moving average crosses a longterm average from below, it is considered to be a
bullish indicator and is referred to as Golden Cross.
When a short-term moving average crosses a longterm average from above, it is considered to be a
bearish indicator and is referred to as Dead Cross.
Since standard deviation is a measure of volatility, the

bands are self-adjusting i.e. they widen during volatile
markets and contract during less volatile periods.
The difference between the bands represents
volatility i.e. the higher the price volatility, the wider
the range between the two outer bands.
Trading rules using Bollinger Bands:
a) Contrarian strategy i.e. sell (buy) a security when its
price reaches the upper (lower) band.
This strategy assumes that the security price will
remain within the bands.
This strategy results in a large number of trades and
consequently higher trading costs; however, it also
reduces risk of loss as investors can exit unprofitable
trades.
This strategy is not profitable in case of large price
movements and changes in trend.
b) When the bands tighten (i.e. as volatility decreases),
sharp price changes tend to occur.
c) When prices move outside the bands, it indicates
that the current trend will continue i.e.
When a price significantly* breaks out above the
upper band it signals that a change in trend is
expected to persist for some time thus, long-term
investors may prefer to buy.
When a price significantly* breaks down below the
lower band it signals that a change in trend is
expected to persist for some time thus, long-term
investors may prefer to sell.

NOTE:
A trading strategy derived from an optimized
moving average computed for one security may not
work for other similar and/or dissimilar securities.
A trading strategy derived from an optimized
moving average computed for one security may not
be useful if market conditions change.
2) Bollinger Bands (3.4.1.2): Bollinger Bands are plotted
at standard deviation levels above and below a
moving average. i.e.
(*e.g. 5%-10% or for a certain period of time e.g. week

for a daily price chart)
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Technical Analysis
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Divergence gives a warning signal that uptrend may

soon end.
Uses of Momentum Oscillators/indicators:
a) Oscillators can be used to determine the strength of a
trend i.e. extremely overbought (oversold) condition
indicates that uptrend (downtrend) may soon end.
As the value of the oscillator approaches the upper
extreme value, the security is considered to be
overbought.
As the value of the oscillator approaches the lower
extreme, the security is considered to be oversold.
Source: Exhibit 24, CFA Program Curriculum, Volume 1,
Reading 12, Page 662.
b) When oscillators reach historically high or low levels,

they indicate that a trend is expected to reverse i.e.
When momentum indicators cross above the
oscillator line into an overbought territory, it gives
buy signals.
When momentum indicators cross below the
oscillator line into an oversold territory, it gives sell
signals.
c) Oscillators are useful for short-term trading strategies in
a non-trending markets i.e.
Buying (selling) at oversold (overbought) levels.
Limitations of price-based indicators: It is difficult to

identify trend changes in unusual or uncommon market
sentiments using price-based indicators.
3.4.2) Momentum Oscillators
Momentum oscillators are calculated using price data
such that they oscillate between a high and low (i.e. 0
and 100) or oscillate around a number (i.e. 0 or 100).
Therefore, extreme high or low prices can be easily
identified using momentum oscillators.
Unlike price-based indicators, momentum oscillators
can be used to trend changes in unusual or
uncommon market sentiments.
Momentum oscillators also help traders to identify
overbought or oversold conditions.
Momentum oscillators must be considered
separately for every security.
Convergence: Convergence occurs when the oscillator
moves in the same direction as the security being
analyzed e.g. both price and momentum oscillator
reach a new high level at the same time.
Divergence: Divergence occurs when the oscillator
moves in the opposite direction as the security being
analyzed e.g. price reaches a new high (bullish
indicator) but momentum oscillator does not reach a
new high at the same time.
1) Momentum Oscillator or Rate of Change Oscillator

(ROC) (section 3.4.2.1): The Rate of Change (ROC) is
a simple technical indicator that shows the
percentage difference between the current price
and the price n periods ago. It measures the
percentage increase or decrease in price over a
given period of time. The ROC oscillator is calculated
as follows:
ROC =
Today's change Change n periods ago

100
Change n periods ago
where, n periods ago typically refer to 10 days

Momentum oscillator value = M
= (Most recent or last closing
price - closing price x days
ago*) 100 = (V Vx) 100
ROC is an oscillator that fluctuates above and below the
zero line.
When the price rises, the ROC moves up.
When the price falls, the ROC moves down.
The greater the change in the price, the greater is
the change in the ROC.
Reading 12
Technical Analysis
RSI is computed as follows:
Trading rules using ROC:

a) When the ROC oscillator crosses above the zero line
into the positive (overbought) territory, it is viewed as
a buy signal.
b) When the ROC oscillator crosses below the zero line
into the negative (oversold) territory, it is viewed as a
sell signal.
Generally, the higher (lower) the ROC, the more
overbought (sold) security is considered to be.
However, in many cases, the extremely
overbought/oversold ROC may indicate that the
recent trend is going to continue.
It is important to note that as long as the ROC
remains positive (negative), it signals that prices are
constantly increasing (decreasing).
NOTE:
Generally, When the ROC oscillator crosses the 0 level in
the opposite direction as that of the trend, it is ignored
by technicians.
Alternative method of calculating oscillators: Oscillators
can be calculated using the following formula by setting
them in a way so that they fluctuate above and below
100, instead of 0.
Momentum oscillator value = M =
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100
Trading rule: When the oscillator moves above (below)

outside this range by a significant amount, it indicates
that the security's close was the highest (lowest) price
that the security has traded during the preceding n-time
periods.
= 100
where,

+

=
Up changes for the period under consideration

. .
|Down changes for the period under consideration|
=
Total of gains during the first 14 periods

Total of losses during the first 14 periods
Note that sum of losses is also reported as positive

value.
Trading Rule: *As mentioned above, RSI converts the
information into number that lies within 0 and 100.
When RSI 70 it indicates market is overbought
dont buy (long) Sell signal.
When RSI 30 it indicates market is oversold
dont sell (short) Buy signal.
Generally, less volatile stocks (i.e. utilities) may trade in a
narrower range whereas more volatile stocks (i.e. smallcapitalization technology stocks) may trade in a wider
range.
NOTE:
The range of RSI is not necessarily symmetrical around 50
e.g. uptrend may range from 40-80 and downtrend may
range from 20-60.
Example:
Computing an RSI for one month.
It would be a 22-day RSI with 21 price changes i.e.
NOTE:
Like all technical indicator, the ROC oscillator should be
used in conjunction with other tools of technical analysis.
2) Relative Strength Index(section 3.4.2.2): Relative
strength index (RSI) measures the relative strength of a
security against itself i.e. it graphically compares the
magnitude of recent gains of a security to its recent
losses and this information is converted into a number
that ranges from 0 to 100*. It helps to determine
whether the security is overbought or oversold.
RSI is also known as Wilder RSI.
RSI is computed over a rolling time period.
RSI uses a single parameter that is the number of
time periods in its calculation (generally, 14-day time
period is used).
o Shorter time periods (i.e. 14-days) can be used to
analyze short-term price behavior.
o Longer time periods (i.e. 200 days) can be used to
smooth out short-term price volatility.
11 up changes.
9 down changes.
1 no change.
In order to compute RSI, we would:
Add 11 up changes, suppose they sum to $1.50.
Add 9 down changes, suppose they sum to $1.57.
RS =
RSI = 100 -

. !
$.
$.
= $0.96
= 100 51.02 = 48.98
Practice: Example given below

exhibit 26, Volume 1, Reading 12.
Reading 12
Technical Analysis
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IMPORTANT TO NOTE:
NOTE:
RSI is a momentum oscillator and is different from the

relative strength analysis (which plots the ratio of two
security prices over time).
Like RSI, stochastic oscillator is not necessarily

symmetrical around 50.
3) Stochastic Oscillator (section 3.4.2.3): The stochastic

oscillator measures the relationship between the
close, high and low prices and is based on the
assumption that:
a) During uptrends, prices tend to close at or near top
of each period's trading range.
b) During downtrends, prices tend to close at or near
bottom of each period's trading range.
Trading rules:
a) Bullish signal: If a securitys price constantly rises
during the day and also closes near the top of the
range, it indicates buying pressure.
b) Bearish signal: If a securitys price constantly falls
during the day and also closes near the bottom of the
range, it indicates selling pressure.
c) If securitys price constantly rises (falls) during the day
but then starts to decline (rise) by the close, it signals
that the rally (downtrend) is not expected to
continue.
Drawback of using shorter time period: The shorter the
time period is used, the more volatile the oscillator is and
the more false signals it generates.
Computation of stochastic oscillator: The stochastic
oscillator is composed of two lines, known as %K and %D.
They are calculated as follows:
% = 100
C L14

H14 L14
where,
C = latest closing price
L14 = lowest price in past 14 days
H14 = highest price in past 14 days
%K is the faster moving line.
%K line shows that latest closing price was in the %K
percentile of the high-low range.
And
%D = Average of the last three %K values calculated
daily
%D is slower moving, smoother line and is referred to
as the Signal line.
Trading rules:
a) Buy signals occur when the stochastic oscillator
crosses above 20% level.
b) Sell signals occur when the stochastic oscillator
crosses below 80% level.
c) When the %K crosses %D line from below, it is

considered a bullish short-term trading signal.
d) When the %K crosses %D line from above, it is
considered a bearish short-term trading signal.
Like RSI, the stochastic oscillator always ranges between
0% and 100% and generally uses 14-day time period
(however it can be adjusted).
When the stochastic oscillator is 0% (100%), it shows
that the security's close was the lowest (highest)
price that the security has traded during the
preceding n-time periods.
NOTE:
Like all technical indicator, the stochastic oscillator
should be used in conjunction with other tools of
technical analysis.
When both the stochastic oscillator and other tools
give same signals, it is referred to as
convergence/confirmation condition.
When the stochastic oscillator and other tools give
conflicting signals, it is referred to as divergence
condition and suggests that trader should do further
analysis.
4) Moving-Average Convergence/Divergence Oscillator
(section 3.4.2.4): The moving-average
convergence/divergence oscillator is commonly
referred to as MACD, pronounced as Mack Dee. The
MACD is the difference between a short-term and a
long-term moving average of the security's price. The
MACD is composed of two lines i.e.
1. MACD line: It is the difference between 26-day and
12-day exponential moving average.
2. Signal line: It is a 9-day exponentially smoothed
moving average. This line is plotted on top of the
MACD line to reflect buy/sell opportunities.
The resulting outcome is an MACD oscillator indicator
that oscillates around zero and has no upper or lower
limit.
Trading rules: MACD in technical analysis can be used in
three ways.
a) Crossovers of the MACD line and the signal line:
When the MACD crosses above the signal line into
overbought territory, it gives Buy signals.
When the MACD crosses below the signal line into
oversold territory, it gives Sell signals.
Reading 12
Technical Analysis
b) Comparing the current level of the MACD oscillator for

a security with its historical level to discern when a
security is trading beyond its normal sentiment range:
When the current level of the MACD oscillator is
unusually low compared to its historical level, it
indicates that the security is oversold and gives a
bullish signal.
When the current level of the MACD oscillator is
unusually high compared to its historical level, it
indicates that the security is overbought and gives
an early warning of a bearish signal.
c) Analyzing trend lines on the MACD itself:
When both the MACD and the price trend in the
same direction, it is referred to as convergence and
it signals the continuation of the current trend.
When the MACD and the price trend in opposite
direction, it is referred to as divergence and signals
the end of the current trend.
d) Analyzing whether the MACD is above or below zero:
When the MACD is above zero short-term (i.e. 12day) average is above the long-term (i.e. 26-day)
average it indicates that current expectations are
more bullish than previous expectations thus, it
signals a bullish market.
When the MACD is below zero short-term (i.e. 12day) average is below the long-term (i.e. 26-day)
average it signals a bearish market.
NOTE:
The zero line often acts as an area of support and
resistance for the MACD oscillator.
3.4.3) Sentiment Indicators
Sentiment indicators measure the sentiments and
expectations of various market participants. Sentiment
indicators are of two types:
1) Opinion Polls (Section 3.4.3.1): Opinion polls refer to
the surveys that are conducted to identify sentiments
of investors about the equity market. For example,
Surveys conducted on investment professionals
include Investors Intelligence Advisors Sentiment
reports, Market Vane Bullish Consensus, Consensus
Bullish Sentiment Index, and Daily Sentiment Index.
Surveys conducted on individual investors include
reports of the American Association of Individual
Investors (AAII) etc.
In order to forecast the future market trend, previous
market activity is compared with highs or lows in
sentiments and inflection points in sentiment currently
observed. These surveys are useful in predicting major
market turns only when they are published over several
cycles.
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2) Calculated Statistical Indices (Section 3.4.3.2): These

indicators are calculated using market data i.e.
security prices. These include:
a) Put/Call Ratio:
Put options are purchased by bearish investors
whereas call options are purchased by bullish
investors.
Volume of put options traded
/ =
Volume of call options traded
Normally, put/call ratio < 1.0 because over time, the
volume traded in call options > volume traded in put
options.
Interpretation: This ratio is a considered to be a
contrarian indicator; thus,
Higher or rising ratio indicates investors are bearish.
Lower or falling ratio indicates investors are bullish.
However,
When the ratio is extremely high market sentiment is
excessively negative securitys price is likely to
increase.
When the ratio is extremely low market sentiment is
excessively positive securitys price is likely to
decrease.
The value of ratio and its normal range differs for
each security or market.
When the ratio deviates from its historical normal
range, it may indicate the change of market
sentiment and market movements.
b) CBOE Volatility Index (VIX): It is used to measure shortterm market volatility and is calculated by the
Chicago Board Options Exchange.
Rising VIX indicates market participants are bearish
and thus bidding up the price of puts.
Interpretation: VIX is used with other technical tools and
is interpreted from a contrarian perspective i.e.
When other technical indicators indicate that the
market is oversold and VIX value is extremely high
it gives a Buy signal.
When other technical indicators indicate that the
market is overbought and VIX value is extremely low
it gives a Sell signal.
c) Margin Debt: Margin debt is the amount borrowed by
investors from the brokerage firm to fund a part of the
investment cost. Margin debt and index level have
positive correlation i.e.
When index level increases margin debt rises.
When index level decreases margin debt falls.
Reading 12
Technical Analysis
When the market is rising demand for securities

increases as a result, margin debt of a security
increases indicating intense buying pressure
resulting in further increase in stock prices due to
higher demand.
Eventually, as all of the available credit has been
utilized, buying pressure and demand decrease
resulting in decrease in prices this leads to margin
calls and forced selling and prices further decrease.
d) Short Interest: Short interest refers to the total number
of shares currently sold short in the market. It is
interpreted differently by various investors e.g.
High value of short interest may indicate that
investors are bearish as it may reflect informed
selling by institutional investors and/or a large
number of short sellers.
High value of short interest may indicate that
investors are bullish as the short interest may
represent future (latent) demand for the securities,
implying that all short sales must be covered which
will ultimately increase the buying demand and
price of a security.
The short interest ratio represents the number of days of
trading activity represented by short interest.
!!" # =
Shortinterest
Averagedailytradingvolume
*Average daily trading volume is used to normalize

the value of short interest to facilitate comparisons of
large and small companies.
Its interpretation is similar to that of short interest.
3.4.4) Flow of Funds Indicators

Flow of funds indicators are used to measure the
potential supply and demand for equities.
Demand side indicators include margin debt, mutual
fund cash position.
Supply side indicators include new or secondary
issuance of stock.
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$%& '( ) *+

Number of advancing issues Number of declining issues
=
Volume of advancing isues Vomue of declining issues
When TRIN = 1.0, the market is in balance.
When TRIN> 1.0, volume in declining stocks >
volume in rising stock, indicating selling pressure
bear market.
When TRIN< 1.0, volume in declining stocks <
volume in rising stock, indicating buying pressure
bull market.
2) Margin Debt (Section 3.4.4.2):

When margin borrowing against current holdings (i.e.
margin balances) increases, it indicates rising
demand for securities and gives a bullish signal.
When margin borrowing against current holdings (i.e.
margin balances) decreases, it indicates declining
demand for securities and gives a bearish signal.
3) Mutual Fund Cash Position (Section 3.4.4.3):
The percentage of mutual fund assets held in cash* can
be used to predict market trend. It is also considered to
be a contrarian indicator.
When cash holdings by mutual funds and other

institutional investors (i.e. insurance companies,
pension funds) increases, it indicates rising demand
for securities and gives a bullish signal.
When cash holdings by mutual funds and other
institutional investors (i.e. insurance companies,
pension funds) decreases, it indicates falling
demand for securities and gives a bearish signal.
*Cash is received from customer deposits, interest
earned, dividends or sale of securities. Cash is held to
pay bills and to meet redemption payments. It is
important to note that cash is held in the form of a
deposit, which earns interest. Thus,
When interest rates are low and market rises, holding
cash negatively affect funds performance.
When interest rates are high and market falls,
holding cash is less costly.
Types of Flow of Funds Indicators:

1) Arms Index (Section 3.4.4.1): Arms index is also known
as TRIN (i.e. trading index). It is applied to a broad
market (i.e. S&P 500 index) to measure the relative
strength of a market rise or fall by analyzing the speed
with which money is moving into or out of rising and
declining stocks. It is computed as:
Limitation: These indicators only indicate the potential

buying power of various large investors; they do not
provide any information about the probability that those
investors will buy.
Reading 12
Technical Analysis
3.5.2) 18-Year Cycle
4)
New Equity Issuance (Section 3.4.4.4): According to

the new equity issuance indicator,
When the number of initial public offerings (IPOs)

increases the aggregate supply of shares available for
investors to purchase increases indicating that the
upward price trend may be about to end and is
considered as a bearish indicator.
5) Secondary Offerings (3.4.4.5): Secondary offerings
refer to the existing shares that are sold by insiders to
the general public.
They do not increase the supply of shares; rather,
they only increase the supply of shares available for
trading or the float.
When the secondary offerings increase, the supply
of shares available for trading increase and is
considered as a bearish indicator.
3.5
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Cycles
The cyclical analysis is useful to predict prices and

market trends provided that the cycle should have a
strong track record (i.e. appropriate sample). Like other
technical indicators, cycles should be used in
conjunction with other technical tools.
3.5.1) Kondratieff Wave
It is a long-term, 54-year cycle that is identified in
commodity prices and economic activity of Western
economies. It is named after a Russian economist
Kondratieff and is referred to as the Kondratieff Wave
or K Wave.
The up-wave represents rising prices, a growing
economy, and slightly bullish stock markets.
The plateau represents stable prices, economic
working at its peak capacity, and strong bullish stock
markets.
The down-wave represents falling prices, slowing
economy, highly bear markets, and condition of a
major war.
4.
The long-term, 54-year cycle (K-wave) is made up of

three 18-year cycles, implying that the K-wave has only
repeated itself three times in the stock market.18-year
cycle can be found in equities, real estate prices and
other markets.
3.5.3) Decennial Pattern
The decennial pattern is the pattern of average stock
market returns (based on the DJIA). According to this
pattern, stock market appears to have a price pattern
that reflects similar characteristics every ten years.
Under decennial pattern theory, the price pattern is
broken down on the basis of the last digit in the year i.e.,
the theory states that
Years ending with a 0 have had the worst
performance reflecting down years.
Years ending with a 5 have had the best
performance reflecting advancing years.
3.5.4) Presidential Cycle
This cycle is based on the theory that the performance
of the DJIA is linked with the presidential election that
occurs every four years in the United States. Under this
theory, years are categorized as follows:
Third year or Pre-election year: It is the year before the
next election. It is associated with the best performance
of stocks as the politicians who are up for re-election
take steps to stimulate the economy in order to improve
their chances to be re-elected.
Election years: These years also show positive
performance of the stock market, however, with less
consistency.
Post-election years or Mid-term: In the post-election
years, stock prices fall (i.e. worst performance of stock
market) as the newly elected president takes unpopular
steps to make adjustments to the economy.
Limitations of the Cycles:
All cycles and the theories related to them are
based on small sample size and thus are not
statistically reliable e.g. only 56 presidential elections
have been held so far, only 4 completed Kondratieff
cycles have occurred in U.S. history.
These theories do not always generate the same
outcome.
ELLIOTT WAVE THEORY
The Elliott Wave Theory was proposed by Ralph Nelson

Elliott in 1938.This theory states that the movement of the
stock market could be predicted by observing and
identifying a repetitive pattern of waves. Thus, according
to the Elliot wave theory,
The stock market moves in regular and repeated waves

or cycles.
Basic concepts of the Elliott Wave Theory:
1) Action is followed by reaction.
Reading 12
Technical Analysis
2) The basic pattern is made up of eight waves i.e. five

up and three down.
Five waves move up in a bull market in the following
pattern are referred to as Impulse waves:
1 = up, 2 = down, 3 = up, 4 = down and 5 = up.
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Commonly, wave 2 reverses the gain in wave 1 by

certain percentages (reflecting Fibonacci ratios,
explained below) i.e. 50-62%.
Wave 2 never reduced all of the gains from Wave 1.
Wave 2 is made up of three smaller waves.
Wave 3 an up wave and is higher than that of the first
wave.
NOTE:
Opposite will occur in case of bear market.
Three waves follow the impulse waves in the
following pattern and are referred to as Correctives
waves.
a = down, b = up and c = down
It reflects strong breadth, volume, and price

movement.
It reflects the highest price movement in an uptrend.
In wave 3, prices are 1.68 times (a Fibonacci ratio)
higher than the length of Wave 1.
Wave 3 is made up of five smaller waves.
Wave 4 is a corrective wave.
in price during wave 4
= ,-'
in price during wave 3
NOTE:
Opposite will occur in case of bear market.
o This implies that waves a, b, and c always move in
the opposite direction of waves 1 through 5.
3) The main trend is formed by waves 1 through 5 and
can be either upward or downward.
4) Each wave can be broken down into smaller and
smaller sub-waves.
Commonly, wave 4 reverses the gain in wave 3 by

38%.
Wave 5 is also an up wave.
Generally, the price movement in Wave 5 < Wave 3.
However, when Wave 5 becomes extended (e.g.
due to euphoria in the market), the price movement
in Wave 5 may be > Wave 3.
The impulse and corrective waves in a bull market

Corrective waves: After Wave 5 is completed, three
corrective waves are formed in the
market labeled as a, b and c.
Wave a: In a bull (bear) market, Wave a is a down
(up) wave. It is made up of three waves.
Wave b: In a bull (bear) market, Wave b is an up
(down) wave. It is made up of five waves.
o Wave b represents a false rally and is often called
a bull trap.
Wave c: Wave c is the final corrective wave. In a
bull (bear) market, it does not move below (above)
the start of the prior Wave 1 pattern. It is made up of
three sub-waves.
. ( =
"
# $

#

%
$

"
#

#

%
$


Characteristics of each wave:

Wave 1 forms a basic pattern and represents an
increase in price, volume and breadth*.
Wave 2 moves down and represents a slight reverse of
uptrend in wave 1.
Summary: According to the theory,

When the market is a bull market,
On the first wave a market rises, on wave 2 it
declines, begins to rise again on the wave 3. The
third wave is followed by a period of declining prices
known as the wave 4, and finally completes the rise
on the wave 5.
Then the five wave sequence is followed by the
declining period referred to as the correction period.
During this time the market theoretically declines for
Reading 12
Technical Analysis
wave a, begins to rise for wave b, and falls again for

wave c.
NOTE:
Opposite will occur in case of Bear market.
Types of Major Cycles:
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
Grand supercycle: The longest of the waves is

known as the "grand super cycle" and it is formed
over centuries. Grand Supercycle waves are
comprised of Supercycles, and Supercycles are
comprised of Cycles.
Super-cycle
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drawn on the charts. These lines help to identify future

changes in trends.
In case of upward price movements, prices
generally increase by some Fibonacci ratio of prior
highs (e.g., 1.5 or 1.62).
In case of downward price movements, prices
generally decrease by a Fibonacci ratio (e.g., 0.50
or 0.667).
*Most important Ratios are:
The ratio of a preceding number to its Fibonacci sequence
number:
1/ 2 = 0.50, 2/ 3 = 0.6667, 3/ 5 = 0.6, 5/ 8 = 0.625, 8/ 13 = 0.6154
And
Cycle
Primary
The ratio of a Fibonacci sequence number to its preceding

number:
2/ 1 = 2, 3/ 2 = 1.5, 5/3 = 1.6667, 8/5 = 1.600, 13/ 8 = 1.6250
Intermediate
Minor
Minute
Minuette
Subminuette it is formed over several minutes.
Mathematical Foundation of Elliott Wave Theory: The

Elliott Wave Theory is based on the Fibonacci number
sequence. The Fibonacci number sequence is a
sequence that starts with the numbers 0,1,1 and then
each subsequent number is added to the previous
number to arrive at the new number i.e.,
0+1=1, 1+1=2, 2+1=3, 3+2=5, 5+3=8, 8+5=13, etc.
The Elliott Wave Theory uses the wave count in
conjunction with the Fibonacci numbers to predict the
time interval and magnitude of future market trends and
concludes that:
Market waves follow patterns that are basically the
ratios* of the numbers in the Fibonacci sequence.
Explanation: After making make initial judgments on
wave counts, lines representing Fibonacci ratios are
5.
The Golden Ratio: The ratios of the numbers in the

Fibonacci sequence converge around the number
1.618. This number (1.618) is known as the golden ratio.
This ratio is found in astronomy, biology, botany, art,
architecture and many other fields.
This ratio and its inverse are extensively used by
technical analysts to predict price moves.
Advantage of Elliott Wave Theory: Like other technical
analysis tools, Elliott Wave Theory can be applied in both
very short-term trading as well as in very long-term
economic analysis.
Limitations of Elliott Wave Theory:
The quality of predictive value under Elliott Wave
Theory is dependent on an accurate wave count.
It is quite difficult to identify the waves as they are
occurring because determining where one wave
starts and another wave ends involves highly
subjective judgment.
In addition, the waves are not clearly evident at first.
INTERMARKET ANALYSIS
Inter-market analysis is a form of technical analysis that

involves a combined analysis of major types of securities
(i.e. equities, bonds, currencies, and commodities) to
identify market trends and changes in a trend.
A. Relationship between stock prices and bond prices:
Stock prices have positive (inverse) relation with bond
prices (interest rates) i.e.
When bond prices are high (i.e. interest rates are
low) stock prices are increasing.
Reason: When interest rates are low, borrowing costs are
low using discounted cash flow analysis in
fundamental analysis, it will result in higher equity

valuations (due to lower discount rate used).
Thus, rising (declining) bond prices are bullish
(bearish) indicator.
B. Relationship between commodity prices and bond
prices:
Bond prices are inversely related to interest rates.
Interest rates are positively related to expectations to
future prices of commodities or inflation.
Reading 12
Technical Analysis
Thus, bond prices are inversely related to future prices of

commodities i.e.
Rising (falling) bond prices indicate possible
declining (rising) commodity prices.
C. Relationship between currencies and commodity
prices: Commodity prices are inversely related to
currencies. We know that majority of the commodity
trading is denominated in U.S. dollars. Thus,
A strong (weak) dollar results in lower (higher)
commodity prices.
Inter-market analysis also focuses on analyzing industry
subsectors and the relationships among the major stock
markets of countries with the largest economies (i.e. New
York, London, and Tokyo stock exchanges). It is based
on the fact that with the increase in the globalization of
the world economy, markets have become more interrelated than before.
Inter-market Relationships: As markets are interrelated, inflection points in one market can be used
as an indicator of change in trend in a related
market. Inter-market relationships can be identified
using various tools e.g. relative strength analysis.
Relative strength analysis: It graphically compares a
security's price change with that of a "base" security by
plotting the ratio of the price of one security to the price
of another on the chart. It can be used to identify the
strongest performing securities in a sector i.e.
When the Relative Strength indicator is moving up, it
shows that the security is performing better than the
base security.
When the indicator is moving sideways, it shows that
performance of both securities is the same (i.e., rising
and falling by the same percentages).
When the indicator is moving down, it shows that the
security is underperforming relative to the base
security (i.e., not rising as fast or falling faster).
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Inter-market analysis can be used to identify the

strongest performing sectors in the equity market in
relation with the business (economic) cycles i.e.
Sectors that tend to outperform at the beginning of
an economic cycle include utilities, financials,
consumer nondurables, and transportation stocks.
Sectors that tend to outperform during the
economic recovery include retailers, manufacturers,
health care, and consumer durables.
Lagging sectors: Sectors that are linked with commodity
prices (i.e. energy and basic industrial commodities) and
technology stocks are referred to as Lagging sectors.
Inter-market analysis can also be used to allocate
funds across national markets.
NOTE:
Some economies are more closely tied to commodities
relative to others; however, these relationships must be
regularly monitored as they change with the changes in
economies.


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The Time Value of Money

INTEREST RATES: INTERPRETATION

Interest rates can be interpreted in three ways.

Real risk-free interest rate: It reflects the single-period

THE FUTURE VALUE OF A SINGLE CASH FLOW

The future value of cash flows can be computed using

Simple interest = Interest rate Principal

= Present value of the investment

= 1001 + 0.10 = 110

= 1001 + 0.101 + 0.10 = 121

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The Time Value of Money

Practice: Example 4, 5 & 6,

When the number of compounding periods per year

Practice: Example 1, 2 & 3,

The Frequency of Compounding

With more than one compounding period per year,

rs = stated annual interest rate

The continuous compounding generates the

Stated annual interest rate: It is the quoted interest rate

Stated and Effective Rates

Stated annual interest rate = Periodic interest rate

Periodic interest rate = Stated annual interest rate /

Periodic interest rate = rs / m = Stated annual interest

E.g. m = 4 for quarterly, m = 2 for semi-annually

Effective (or equivalent) annual rate (EAR = EFF %): It is

The Time Value of Money

Now taking the natural logarithm of both sides we have:

EAR + 1 = lners (since ln e = 1)

EAR with continuous compounding:

Annual percentage rate (APR): It is used to measure the

APR = Periodic interest rate Number of payments

THE FUTURE VALUE OF A SERIES OF CASH FLOWS

The future value of an ordinary annuity stream is

Present value and future value of Annuity Due:

The future value of an ordinary annuity stream is

FVOA = Pmt [(1+r)N1 + (1+r)N2 + +(1+r)1+(1+r)0]

PVAD = PVOA+ Pmt

The Time Value of Money

Using a Financial Calculator: N= 5; PMT = -100; I/Y = 10;

It is important to note that FV of annuity due >FV of

Calculating Future value for Annuity Due:

Suppose a 5-year, $100 annuity with a discount rate of

Practice: Example 7, 11, 12 & 13,

Calculating Present Value for Ordinary Annuity:

Unequal Cash Flows

FV at t = 5 can be calculated by computing FV of each

FV of cash flow at t =1 is estimated as

Finding the Present Value of a Single Cash Flow

The present value of cash flows can be computed using

The PV factor = 1 / (1 + r) N; It is the reciprocal of the

The Time Value of Money

For a given discount rate, the greater the number of

Present Values Indexed at Times Other than t =0

Suppose instead of t = 0, first cash flow of $6 begin at the

Practice: Example 8 & 9,

a) First of all, we would find PV of an annuity at t = 3 i.e.

N = 3, I/Y = 5, Pmt = 0, FV = 34.72, CPT PV 0 = $29.99

The Frequency of Compounding

With more than one compounding period per year,

Practice: Example 15,

rs = stated annual interest rate

= 1001 + 0.10 = 110

= 1001 + 0.101 + 0.10 = 121

( )