CFA L1 Quants: Rates & Returns .
LEARNING MODULE
RATES & RETURNS
Interpret interest rates as required rates of return, discount rates, or opportunity costs
Learning
Outcome and explain an interest rate as the sum of a real risk-free rate and premiums that
compensate investors for bearing distinct types of risk.
Interest rates can be thought of in three ways:
1. Required rate of return: the minimum rate of return an investor
Interpretation of must receive in order to accept the investment.
Interest Rates 2. Discount rate: the rate used to discount the future cash flows.
3. Opportunity cost: the value that investors forgo by choosing a
particular course of action.
r = Real Rf interest rate + Inflation premium + Default risk premium +
Liquidity premium + Maturity premium.
Here,
- Real Rf interest rate is the single-period interest rate for a completely
risk-free security if no inflation were expected.
- The Inflation premium compensates investors for expected inflation.
Composition of Note: Real Rf Rate + Inflation premium = Nominal Rf Rate
Interest Rate - The Default risk premium compensates investors for the possibility of
default on the bond issue.
- The Liquidity premium compensates investors for the risk of loss relative
to an investment’s fair value if the investment needs to be converted to
cash quickly.
Note: US T-Bills do not bear a liquidity premium.
- Longer maturity bonds have more maturity risk than shorter-term bonds
and require a Maturity risk premium.
Learning Calculate and interpret different approaches to return measurement over time and
Outcome describe their appropriate uses
A holding period return is the return earned from holding an asset for a
single specified period.
HPR = (P1 – P0 + I1)/P0
Here, P1 = Price of the bond at the end of the period.
Holding Period P0 = Price of the bond at the end of the period.
Return (HPR) I1 = Interest earned at the end of the period.
The HPR can be computed for a period longer than one year.
For example, HPR for a holding period of 3 years could be calculated as:
HPR = [(1 + R1) × (1 + R2) × (1 + R3)] − 1
. CFA Level 1
By Gourav Kabra
Formula:
AM = (R1 + R2 + …. + Rn)/n
.
Arithmetic or Mean 1. Advantage: The arithmetic mean has known statistical properties, such
Return as the standard deviation. The standard deviation helps measure the
volatility or variability of the returns around the average.
2. Disadvantage: The arithmetic mean return assumes that the amount
invested at the beginning of each period is the same.
1. A geometric mean return provides a more accurate representation of
the growth in portfolio value over a given time period than does an
arithmetic mean return.
2. In general, the arithmetic return is biased upward unless each of the
Geometric Mean underlying holding period returns are equal i.e. AM > GM.
Return 3. The geometric mean measures an investment’s compound rate of
growth over multiple periods.
Formula:
GM = [(1 + R1) × (1 + R2) × … × (1 + Rn-1) × (1 + Rn)]1/n − 1
.
.
What shall be the HPR given the following information?
Price per share at the beginning of the period: $10 (par value)
Number of shares purchased: 10
Dividend during the period: 5%
Example #1
Price per share at the end of the period: $11
a) 15%
b) 10%
c) 20%
.
.
If, R1 = 14%; R2 = -12% and R3 = -2%; Which of the following option is most
likely correct?
Example #2 a) HPR = 0.18%; Geometric Mean = 0.55%; Arithmetic Mean = 0.67%
b) HPR = 0.55%; Geometric Mean = 0.18%; Arithmetic Mean = 0.67%
c) HPR = 0.18%; Geometric Mean = 0.67%; Arithmetic Mean = 0.55%
.
1. The harmonic mean is used most often when the data consist of
rates (ex: average price per share) and ratios, (ex: average P/E
Ratio).
2. Harmonic Mean = N/(1/x1 + 1/x2+..........1/xn).
3. Harmonic mean can also be applied in the process of extreme
Harmonic Mean outliers.
4. Example: Calculate Average cost per share if an investor had made
the two transactions:
T1 - $1,000 @ $10/share
T2 - $1,000 @ $15/share
Answer: $12
CFA L1 Quants: Rates & Returns .
Important
Arithmetic mean x Harmonic mean = (Geometric mean)2
Observation
The trimmed mean removes a certain percentage of extreme values from
the data and calculates the average of the remaining values, while the
Trimmed Mean &
winsorized mean replaces the extreme values with less extreme values
Winsorized Mean
before calculating the average. Both methods are useful for reducing the
impact of outliers on the overall average.
Learning Compare the money-weighted and time-weighted rates of return and evaluate the
Outcome performance of portfolios based on these measures
Money Weighted Rate of Return (MWRR), also known as the internal rate
of return (IRR), is a measure used to assess the performance of an
investment or portfolio by considering the timing and size of cash flows. It
represents the rate at which the present value of cash inflows equals the
present value of cash outflows.
Money-weighted
rate of return The properties of the Money Weighted Rate of Return (MWRR) include:
(MWRR) 1. MWRR considers both the timing and size of cash flows. This
property reflects the actual investment behaviour of an investor.
2. Large cash flows at favourable or unfavourable times can
significantly impact the calculated rate of return.
3. MWRR cannot be easily compared across different investments or
portfolios. It is specific to the investor's unique cash flow profile
and investment decisions.
.
What will be the MWRR given the following cash flows?
Year 0 1 2 3 4 5
CF -60 -21 45.50 -6 -12.50 72.10
Example #3
a) 6.56%
b) 8.86%
c) 5.86%
.
Time-Weighted Rate of Return (TWRR) is a measure used to evaluate the
performance of an investment portfolio over time while eliminating the
impact of cash inflows and outflows. It focuses on the investment's return
independent of the timing and size of contributions or withdrawals made
Time-weighted rate by the investor. TWRR is usually annualised.
.
of return (TWRR)
Formula (say, daily return data is available):
TWRR = [(1 + r1) × (1 + r2) × … × (1 + r365)] − 1.
.
Formula (say, annual return data is available):
TWRR = [(1 + R1) × (1 + R2) × … × (1 + Rn-1) × (1 + Rn)]1/n − 1
. CFA Level 1
By Gourav Kabra
The properties of the Time Weighted Rate of Return (TWRR) include:
1. TWR is particularly useful for comparing the performance of
investment managers or investment strategies, as it focuses on the
Time-weighted rate underlying investment returns and removes the impact of external
of return (TWRR) cash flows.
2. TWRR calculates the average compound rate of return over a
specified time period, giving equal weight to each sub-period
return.
What will be the TWRR if R1 = 10%; R2 = 2%; R3 = 8% and R4 = 4%?
a) 26.02%
Example #4
b) 27.01%
c) 29.05%
Learning Calculate and interpret annualized return measures and continuously compounded
Outcome returns, and describe their appropriate uses
1. Rannual = (1 + RNdays)365/N – 1
2. Rannual = (1 + RNmonths)12/N – 1
Annualizing 3. Rannual = (1 + RNweeks)52/N - 1
Returns
Limitation of annualized return:
Annualized returns assume that the returns can be repeated precisely.
What will be the annualized return in the following cases?
Case 1: 4.61% in 126 days
Case 2: 2.10% in 5 weeks
Case 3: 12.20% in 15 months
Example #5
Solution:
Case 1: (1.0461)365/126 – 1 = 13.95%
Case 2: (1.0210)52/5 – 1 = 24.13%
Case 3: (1.1220)12/15 – 1 = 9.65%
Continuously
1. Compounded Return = ln(1 + HPR).
Compounded
2. Compounded Return = ln(P1/P0).
Return
CFA L1 Quants: Rates & Returns .
Learning
Outcome Calculate and interpret major return measures and describe their appropriate uses
Gross return, return prior to deduction of managerial and administrative
expenses (those expenses not directly related to return generation), is an
Gross Return
appropriate measure to evaluate the comparative performance of an asset
manager.
Net return, which is equal to the gross return less managerial and
Net Return administrative expenses, is a better return measure of what an investor
actually earned.
1. The after-tax nominal return is computed as the total return minus
Pre-tax and any allowance for taxes on dividends, interest, and realized gains.
Post-tax Return 2. Taxable investors evaluate investment managers based on the
after-tax nominal return.
1. (1 + Nominal Rf Return) = (1 + Real Rf Return)(1 + Inflation Prem)
2. Risk Premium = [(1 + Nominal Return)/(1 + Nominal Rf Rate)] – 1
3. Inflation Prem = [(1 + Nominal Rf Return)/(1 + Real Rf Rate)] – 1
4. Real returns are particularly useful in comparing returns across
Real Return
time periods because inflation rates may vary over time and are
particularly useful for comparing investments across time periods
and performance between different asset classes with different
taxation.
RL = RP + D/E(RP – KD)
Here, RL = Leveraged return; RP = Net return on the portfolio
Leveraged
D = Debt value; E = Equity value; KD = Cost of debt
Return
Leveraging a portfolio, via borrowing or futures, can amplify the portfolio’s
gains or losses if RP > KD.