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Quantitative Investment Analysis, 2nd Ed.,
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Quantitative Investment Analysis, 3rd Ed.,
4
Lecture:
Mondays 14:00 - 16:50
Pls bring your textbook, workbook and a calculator)
Assessments:
• Online test 1: 5% 28th March
• Online test 2: 5% 11th April
• Individual assignment: 30% 10th May
• Examination: 60% (Hurdle: 50%)
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Topics covered
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Topics covered
Week 6: Hypothesis tests
Week 7: Regression analysis
Week 8: Multiple regression analysis
Week 9: Time series analysis.
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My expectation to you
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Chapter 1
Time value of Money
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Time value of Money
1. You want some compensation for postponing your current consumption.
3. You want some compensation to account for the fact that the borrower may
fail to return your money in an year. Essentially you will recover this
money from good debt than bad debt.
4. you want some compensation to account for the loss of liquidity, i.e, you
can not get your cash back whenever you want within that year.
5. You also want some compensation because you are lending the money for a
longer period.
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Interest Rate
• So what are these terms?
– Real risk free rate
– Inflation premium
– Default risk premium
– Liquidity premium
– Maturity premium
• The value of money does not remain constant over time, i.e,
money earns interest over time. So it is important from the
view point of capital budgeting and investing and many other
investment related decisions.
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Time value of Money
Future value (FV):
The value of a current asset at a specified date in the future based on
an assumed rate of growth (interest rate)
Present value (PV):
The current worth of a future asset given a specified interest rate.
Suppose A wants to borrow $10,000 from B for a year. Let the market
rate of interest be 10%. How much should A pay B in a year?
PV $10,000
r 8%
N 2
FVN PV (1 r ) N
$10,000(1 0.08) 2
$11,664
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Frequency of Compounding
mN
rs
FVN PV 1
m
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Future Value with Quarterly Compounding
PV $10,000
rs 8%
m4
N2
mN
r
FVN PV1 s
m
$10,000(1.02)8
$11,716.59
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Frequency of Compounding
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Continuous Compounding
Interest can be compounded in discrete intervals
such as daily, monthly or quarterly, or it can
compound continuously.
For continuous compounding we use,
FVN PVe rs N
e 2.7182818
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Present Value (PV)
Present value is the amount of money today that yields a
certain amount in the future at a fixed rate of interest.
Suppose we loan someone an amount of PV today for n years
at a rate of r p.a. What is the total amount to be repaid after n
periods?
FV = PV(1 + r )n .
FV n
PV FV (1 r )
(1 r ) n
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Figure :The Relation Between an Initial Investment
(PV), and Its Future Value (FV)
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Present Value of a Lump Sum
An insurance company promises to pay
$100,000 in six years with an 8% rate. What
amount must the insurer invest today at 8% to
make the promised payment?
1
PV FVN N
(1 r )
1
$100,000 6
(1 .08)
$63,016.96
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Present Value of a Lump Sum
Find the present value of 5 million received 10 years
from today if the interest rate is 6% and monthly
compounding is used.
mN
rs
PV FVN 1
m
12 (10 )
.06
5,000,0001
12
2,748,163.67
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Present Value with Continuous
Compounding
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Stated and Effective Rates
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Present Value (PV) and Future Value (FV)
1/ N
FV
r 1
PV
ln( FV / PV )
N
ln(1 r )
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Solving for Interest Rates/Growth Rates
r 4 8,445 / 8,436 1
1.000267 1
0.000267
Solving for Number of Periods to Reach a
Certain Value
N ln(1 r ) ln(2)
ln(2)
N
ln(1 r )
Stated and Effective Rates
Find the EAR if the stated interest rate is 8%
and semiannual compounding is used.
m
rs
EAR 1 1
m
2
.08
1 1
2
.0816
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Stated and Effective rates
EAR e 1 rs
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Annuity
Annuity: a series of equal spaced and level sequential cash
flows extending over a finite number of periods.
• (Ordinary) Annuity:
• Annuity due:
An immediate cash flow + ordinary annuity
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The Future Value of (Ordinary) Annuity
FV A[(1 r) N 1 (1 r) N 2 (1 r) N 3 . . . (1 r) 1]
which simplifies to
(1 r) N 1
FV A
r
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Geometric Progression/series
(NOT examinable)
x
k 0
k
x 0 x1 x 2 x 3 . . . x n
n
(1 x) x k
k 0
n
1 x n 1 n
x m x n 1
A x A
k
, A x A
k
k 0 1- x k m 1 - x
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The Present Value of Annuity
which simplifies to
1
1
(1 r) N
PV N A
r
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Examples: Ordinary Annuity
1
1
(1 r) N
PV N A
r
1
1
(1 .12) 5
1,000
.12
3,604.78
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Annuity due:
An immediate cash flow + ordinary annuity
Suppose you will receive $200,000/yr for 20 years, with the
first payment today. What is the PV if the interest rate is 7%?
1
1
(1 r) N -1
PVN A A
r
1
1
(1 .07)19
200,000 200,000
.07
200,000 2,067,119.05
2,267,119.05
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Perpetuity
A
PVN
r
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Present Value of a Perpetuity
A British consol bond promises to pay £100
per year in perpetuity. If the required rate is
5%, what is the bond worth today?
A
PV N
r
100
0 . 05
2 , 000
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Solving for the Annuity
FV
A
(1 r ) N 1
r
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Computing the Annuity that will Grow to FV
FV $1,000,000
A $12,648.91
(1 r ) 1 (1.06) 1
N 30
r .06
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Solving for the Annuity
If we borrow certain ammount, what is the
annuity, A, that will be needed to repay the loan.
PV
A
1
1
(1 r ) N
r
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Annuity payments
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