CFA Level 1: Quantitative Methods - Complete Study Guide

1. The Time Value of Money (TVM)

Core Concept (In Simple Terms): The idea that "a dollar today is worth more than a
dollar tomorrow." This is because a dollar you have today can be invested to earn
interest. It's the foundation for all valuation in finance.
●​ Analogy: TVM is like "planting money seeds." A seed (principal) planted today
grows over time (earns interest) and yields a larger harvest (future value) in the
future.
Key Concepts:
●​ Annuity vs. Annuity Due:
○​ Ordinary Annuity: Cash flows occur at the end of each period (calculator in
END mode).
○​ Annuity Due: Cash flows occur at the beginning of each period (BGN mode).
An annuity due will have a higher present and future value than an ordinary
annuity.
●​ Perpetuity: An annuity with an infinite life.
○​ Formula: PV = PMT / r
●​ Components of a Required Rate of Return:
○​ The minimum return an investor demands is a reflection of various risks.
○​ Formula: Required Rate = Real Risk-Free Rate + Expected Inflation + Default
Risk Premium + Liquidity Risk Premium + Maturity Risk Premium
Interest Rate Calculations:
●​ Effective Annual Rate (EAR): The true annual rate of return, taking the effect of
compounding into account.
○​ Formula: EAR = (1 + periodic rate)^m - 1 (where m = number of compounding
periods per year)
●​ Continuous Compounding:
○​ Formula: EAR = e^(APR) - 1

⭐ Exam Tip: Master your financial calculator (e.g., BA II Plus). Always

clear the TVM worksheet (2nd -> CLR TVM) and check the BGN/END
setting before starting a new problem. Use the ICONV worksheet for EAR
calculations.

2. Discounted Cash Flow (DCF) Applications

Core Concept (In Simple Terms): Using TVM principles to decide if an investment is
worthwhile and to measure the performance of a portfolio.

Investment Decision Rules:

●​ Net Present Value (NPV): The sum of all future cash flows discounted to the
present, minus the initial investment. It shows the absolute amount of value an
investment adds to the firm.
○​ Analogy: NPV is the "total profit" in today's money. If you invest $1 million and
the present value of future profits is $1.2 million, the NPV is $200,000,
meaning you've created $200,000 in value.
○​ Formula: NPV = Σ [ CFt / (1+r)^t ] - CF₀
○​ Rule: Accept projects with NPV > 0.
●​ Internal Rate of Return (IRR): The discount rate that makes NPV equal to zero. It
can be thought of as the project's "expected rate of return."
○​ Rule: Accept projects where IRR > required rate of return.

Portfolio Return Measurement:

●​ Time-Weighted Return (TWRR): Measures the compound rate of growth. It is
not affected by the timing of cash flows, making it the industry standard for
evaluating a manager's pure performance. It uses the geometric mean.
●​ Money-Weighted Return (MWRR): An IRR calculation that is sensitive to the
timing and size of cash flows. It measures an individual investor's actual return.
⭐ Exam Tip: When NPV and IRR give conflicting rankings for mutually
exclusive projects (you can only choose one), always choose the project
with the higher NPV. NPV's assumption of reinvesting cash flows at the
cost of capital is more realistic than IRR's assumption of reinvesting at the
IRR itself.

3. Statistical Concepts & Market Returns

Core Concept (In Simple Terms): Using numbers and tools to describe the key
features of a set of data, like investment returns (e.g., what's the average, how spread
out is it, what's its shape?).
●​ Central Tendency & Dispersion:
○​ Mean Relationship: Always Harmonic Mean ≤ Geometric Mean ≤ Arithmetic
Mean.
○​ Standard Deviation (σ): Measures the total risk (price volatility) of an
investment.
○​ Sharpe Ratio: Measures risk-adjusted return (excess return per unit of total
risk). Higher is better.
 ■​ Formula: Sharpe Ratio = (Rp - Rf) / σp
●​ Shape of the Distribution:
○​ Skewness: Measures asymmetry. Positive skew (long right tail) is desirable
for investment returns, as it indicates a potential for large positive outcomes.
○​ Kurtosis: Measures the "fatness" of the tails. Leptokurtosis (Kurtosis > 3) is
common in financial returns and indicates a higher probability of extreme
events (both large gains and large losses) than a normal distribution.
●​ Chebyshev's Inequality:
○​ Gives the minimum percentage of observations that lie within k standard
deviations of the mean for any distribution.
■​ Formula: 1 - (1/k²) (for k > 1)

⭐ Exam Tip: Use the Geometric Mean to evaluate historical, multi-period

investment performance (TWRR). Use the Arithmetic Mean as the best
forecast for the next single period's return.

4. Probability & Common Distributions

Core Concept (In Simple Terms): Quantifying uncertainty and understanding the
common patterns that asset prices and returns follow.
●​ Key Probability Distributions:
○​ Normal Distribution: The symmetric "bell curve." Used to model asset
returns.
○​ Lognormal Distribution: Used to model asset prices. Prices cannot be
negative, so this distribution, which is skewed to the right, is appropriate.
○​ Student's t-distribution: Used for hypothesis testing with small samples (n <
30) and unknown population variance. It has fatter tails than the normal
distribution.
●​ Portfolio Risk:
○​ Covariance and Correlation: Covariance indicates if two assets move in the
same direction. Correlation indicates the direction and the strength of that
relationship.
○​ Portfolio Variance (2-Asset):
■​ Formula: Var(Rp) = wA²σA² + wB²σB² + 2wAwBρ(A,B)σAσB
●​ Roy's Safety-First Criterion:
○​ Selects the portfolio that minimizes the probability of returns falling below a
minimum threshold (R_L).
○​ Rule: Choose the portfolio with the highest SF Ratio.
○​ Formula: SF Ratio = [E(Rp) - R_L] / σp

⭐ Exam Tip: You must memorize the confidence intervals for the Normal
 Distribution: 68% of observations lie within ±1σ, 95% within ±1.96σ, and
99% within ±2.58σ. This is frequently used in hypothesis testing.

5. Sampling, Estimation, & Hypothesis Testing

Core Concept (In Simple Terms): Using a small group (a sample) to make an
educated guess about the entire population, and then statistically testing if that guess
is likely to be correct.
●​ Central Limit Theorem (CLT): A powerful theorem stating that for any
population, the distribution of sample means will be approximately normal if the
sample size is large (n ≥ 30). This allows us to use normal distribution statistics for
testing.
●​ Confidence Intervals:
○​ A range that is expected to contain the true population parameter (e.g., the
mean) with a certain degree of confidence.
○​ Formula: CI = Point Estimate ± (Reliability Factor × Standard Error)
●​ Hypothesis Testing:
○​ Analogy: It's like a "court trial." The null hypothesis (H₀) is "innocent (= no
change, no difference)," and the alternative hypothesis (Hₐ) is "guilty (= there
is a change or difference)." If the evidence (data) is very rare under the
assumption of innocence, we reject innocence and conclude guilt (reject H₀).
○​ Process: 1) State hypotheses (H₀, Hₐ); 2) Choose test statistic (z or t); 3) Set
significance level (α); 4) State decision rule; 5) Conclude.
○​ p-value: The probability of getting your observed data (or more extreme
data) if the null hypothesis were true.
■​ Rule: "If the p is low, the null must go." (If p-value < α, reject H₀).

⭐ Exam Tip: The choice between a z-statistic and t-statistic is critical.

Use the z-statistic if the population variance is known OR n ≥ 30. Use the
t-statistic if the population variance is unknown and n < 30. In practice,
the t-statistic is used most often.

6. Technical Analysis
Core Concept (In Simple Terms): An approach to forecasting future price
movements by analyzing past market data, primarily price and volume charts, instead
of a company's financial statements. It assumes market psychology appears in
patterns on charts.
●​ Core Assumptions:
○​ Market action discounts everything.
○​ Prices move in trends.
 ○​ History tends to repeat itself (patterns are recurring).
●​ Key Chart Patterns:
○​ Reversal Patterns: Signal a change in the trend. Examples: Head and
Shoulders, Double Tops/Bottoms.
○​ Continuation Patterns: Signal a temporary pause in a trend. Examples:
Triangles, Flags.
●​ Key Technical Indicators:
○​ Moving Averages: Smooth out price data to visualize the trend direction.
○​ Bollinger Bands: Bands placed above and below a moving average (usually
±2σ). Prices are considered overbought at the upper band and oversold at the
lower band.
○​ Relative Strength Index (RSI): A momentum oscillator that indicates
overbought/oversold conditions. Generally, RSI > 70 is overbought, and RSI <
30 is oversold.
⭐ Exam Tip: Technical analysis is based on the assumption that markets
are NOT weak-form efficient. If the market were weak-form efficient,
past price data would have no predictive power, making technical analysis
useless.