CFA L1 - 2025

Quantitative Methods
LEARNING
MODULE

1
RATES AND RETURNS
LEARNING OUTCOMES
The candidate should be able to:

❑ Interpret interest rates as required rates of return,

discount rates, or opportunity costs 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.
❑ Calculate and interpret different approaches to return
measurement over time and describe their appropriate
uses.
❑ Compare the money-weighted and time-weighted
rates of return and evaluate the performance of
portfolios based on these measures.
❑ Calculate and interpret annualized return measures
and continuously compounded returns, and describe
their appropriate uses.
❑ Calculate and interpret major return measures and
describe their appropriate uses.

Source: CFA Program Curriculum

LEARNING MODULE 1: RATES AND RETURNS
1.1: INTEREST RATES AND TIME VALUE OF MONEY
❑ The time value of money establishes the equivalence between cash flows occurring on different dates.
❑ An interest rate (or yield): denoted r, is a rate of return that reflects the relationship between differently dated
cash flows.

❑ Interest rates can be thought of in three ways:

❑ Required rates of return: the minimum rate of return an investor must receive to accept an investment.
❑ Discount rates: the required compensation for having the money after a period of time.
❑ Opportunity cost: is the value that investors forgo by choosing a course of action, the cost of deferring
consumption to the future.

❑ Economics tells us that interest rates are set by the forces of supply and demand, where investors supply funds
and borrowers demand their use.
❑ From an investors prospective to determine market-determined interest rates, we can view an interest rate as
being composed of:
❑ Real risk-free interest rate: single-period interest rate for a completely risk-free security if no inflation were
expected. It reflects the time preferences of individuals for current versus future real consumption.
❑ Inflation premium: compensates investors for expected inflation and reflects the average inflation rate
expected over the maturity of the debt.

Source: CFA Program Curriculum 3

LEARNING MODULE 1: RATES AND RETURNS
1.1: INTEREST RATES AND TIME VALUE OF MONEY
❑ From an investors prospective to determine market-determined interest rates, we can view an interest rate as
being composed of:
❑ Real risk-free interest rate
❑ Inflation premium
❑ Default risk premium: compensates investors for the possibility that the borrower will fail to make a
promised payment at the contracted time and in the contracted amount.
❑ 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.
❑ Maturity premium: compensates investors for the increased sensitivity of the market value of debt to a
change in market interest rates as maturity is extended.

❑ The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate:
❑ (1 + nominal risk-free rate) = (1 + real risk-free rate)(1 + inflation premium).
❑ Practically, the nominal rate is often approximated as: Nominal risk-free rate = Real risk-free rate + inflation
premium.

❑ Interest rate = real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium +
Maturity premium.

Source: CFA Program Curriculum 4

LEARNING MODULE 1: RATES AND RETURNS
1.2: RATES OF RETURN
❑ Financial assets normally generate two types of return for investors:
❑ Periodic income: through cash dividends or interest payments.
❑ Capital gain or loss: the increase or decrease in the price of a financial asset.
❑ Some financial assets provide return through only one of these mechanisms.

1.2.1: Holding Period Return

❑ Holding period return, R, is the return earned from holding an asset for a single specified period of time.
❑ The period may be one day, one week, one month, five years, or any specified period.

❑ Return can be expressed in decimals, fractions, or as a percent, They are all equivalent.
❑ A holding period return can be computed for a period longer than one year.
❑ An analyst may need to compute a one-year holding period return from three annual returns.
❑ R = [(1 + R1) × (1 + R2) × (1 + R3)] − 1, where R1, R2, and R3 are the three annual returns.

Source: CFA Program Curriculum 5

LEARNING MODULE 1: RATES AND RETURNS
1.2: RATES OF RETURN

1.2.2: Arithmetic or Mean Return

❑ Most holding period returns are reported as daily, monthly, or annual returns. When assets have returns for
multiple holding periods, it is necessary to normalize returns to a common period for ease of comparison and
understanding.
❑ The simplest way to compute a summary measure for returns across multiple periods is to take a simple
arithmetic average of the holding period returns.

1.2.3: Geometric Mean Return

❑ The arithmetic mean return assumes that the amount invested at the beginning of each period is the same.
❑ In an investment portfolio, however, even if there are no cash flows into or out of the portfolio the base
amount changes each year. Thus, the previous year’s earnings must be added to the beginning value of the
subsequent year’s investment.
❑ We can use the geometric mean return to account for the compounding of returns.
❑ It more accurate representation of the growth in portfolio value over a given time period.

Source: CFA Program Curriculum 6

LEARNING MODULE 1: RATES AND RETURNS
1.2: RATES OF RETURN
EXAMPLE: Arithmetic Mean Return vs. Geometric Mean Return
❑ Calculate the arithmetic mean return and the geometric mean return for an investment that generates a
yearly return of -50% , 37% and 27% during the last three years.
❑ Arithmetic mean return = (-50 + 37% + 27%)/3 = 4%
3
❑ Geometric mean return = 1− 0.50 1+ 0.37 1+ 0.27 −1= −0.05 = −5%

1.2.4: Harmonic Mean

❑ The harmonic mean is appropriate in cases in which the variable is a rate or a ratio.

❑ The harmonic mean may be viewed as a special type of weighted mean in which an observation’s weight is
inversely proportional to its magnitude.
❑ Cost averaging is a well-known application arises in the investment strategy, which involves the periodic
investment of a fixed amount of money.
EXAMPLE: Harmonic Mean
❑ Suppose an investor invests EUR1,000 each month in a particular stock for n = 2 months. The share prices are
EUR10 and EUR15 at the two purchase dates. What was the average price paid for the security?
❑ The investor purchased a total of 166.67 shares (100 + 66.67) for EUR2,000, so the average price paid per share
is EUR2,000/166.67 = EUR12. The harmonic mean price is 2/[(1/10) + (1/15)] = EUR12.
Source: CFA Program Curriculum 7
LEARNING MODULE 1: RATES AND RETURNS
1.2: RATES OF RETURN
1.2.5: Trimmed Mean & Winsorized Mean
❑ Trimmed and Winsorized means seek to minimize the impact of outliers in a dataset.
❑ Trimmed mean removes a small defined percentage of the largest and smallest values from a dataset
containing our observation before calculating the mean by averaging the remaining observations.
❑ Winsorized mean replaces the extreme observations in a dataset to limit the effect of the outliers on the
calculations. The Winsorized mean is calculated after replacing extreme values at both ends with the
values of their nearest observations, and then calculating the mean by averaging the remaining
observations.

EXAMPLE: Trimmed & Winsorized Means

❑ A population of set of observations of {6.0, 8.1, 8.3, 9.1, and 9.9).
6.0 + 8.1+ 8.3 + 9.1+ 9.9
❑ The arithmetic mean = = 8.28
5
8.1+ 8.3 + 9.1
❑ 40% Trimmed mean = = 8.5
3
8.1 + 8.1+ 8.3 + 9.1+ 9.1
❑ 40% Winsorized mean = = 8.54
5

Source: CFA Program Curriculum 8

LEARNING MODULE 1: RATES AND RETURNS
1.2: RATES OF RETURN

❑ The choice of which mean to use depends on many factors:

❑ Are there outliers that we want to include?
❑ Is the distribution symmetric?
❑ Is there compounding?
❑ Are there extreme outliers?

Source: CFA Program Curriculum 9

LEARNING MODULE 1: RATES AND RETURNS
1.3: MONEY-WEIGHTED AND TIME-WEIGHTED RETURN
❑ The arithmetic and geometric return computations do not account for the timing of cash flows into and out of
a portfolio.

1.3.1: Money-Weighted Return

❑ The money-weighted return accounts for the money invested and provides the investor with information on
the actual return she earns on her investment.
❑ The money-weighted return and its calculation are similar to the internal rate of return and a bond’s yield to
maturity.
❑ Amounts invested are cash outflows from the investor’s perspective and amounts returned or withdrawn by
the investor, or the money that remains at the end of an investment cycle, is a cash inflow for the investor.
❑ The internal rate of return is the discount rate at which the sum of present values of cash flows will equal zero.

❑ A positive cash flow is an inflow where money flows to the investor, whereas a negative cash flow is an outflow
where money flows away from the investor.

Source: CFA Program Curriculum 10

LEARNING MODULE 1: RATES AND RETURNS
1.3: MONEY-WEIGHTED AND TIME-WEIGHTED RETURN
1.3.1: Money-Weighted Return
EXAMPLE: Money-Weighted Return
❑ Assume that an investor invests EUR100 in a mutual fund at the beginning of the first year, adds another EUR950
at the beginning of the second year, and withdraws EUR350 at the end of the second year.
❑ Using the financial calculator to find IRR:
CF0 = − 100
CF1 = − 950
CF2 = + 350
CF3 = + 1,270

IRR = 26.11%

❑ Although the money-weighted return is an accurate measure of what the investor earned on the money
invested, it is limited in its applicability to other situations.
❑ It does not allow for a return comparison between different individuals or different investment opportunities.

Source: CFA Program Curriculum 11

LEARNING MODULE 1: RATES AND RETURNS
1.3: MONEY-WEIGHTED AND TIME-WEIGHTED RETURN
1.3.2: Time-Weighted Return
❑ The time-weighted rate of return is not sensitive to the additions and withdrawals of funds.
❑ The time-weighted rate of return measures the compound rate of growth of USD1 initially invested in the
portfolio over a stated measurement period.
❑ For the evaluation of portfolios of publicly traded securities, the time-weighted rate of return is the preferred
performance measure as it neutralizes the effect of cash withdrawals or additions to the portfolio, which are
generally outside of the control of the portfolio manager.

EXAMPLE: Time-Weighted Return

❑ Consider an investment that covers a two-year horizon. At time t = 0, an investor buys one share at a price of
USD200. At time t = 1, he purchases an additional share at a price of USD225. At the end of Year 2, t = 2, he
sells both shares at a price of USD235. During both years, the stock pays a dividend of USD5 per share. The t =1
dividend is not reinvested.
❑ HPR1 = (225 + 5)/200 -1 = 15%
❑ HPR2 = (470 + 10)/450 -1 = 6.67%
2
❑ Time-weighted return = (1.15)(1.0667) − 1 = 10.76%

Source: CFA Program Curriculum 12

LEARNING MODULE 1: RATES AND RETURNS
1.3: MONEY-WEIGHTED AND TIME-WEIGHTED RETURN
1.3.2: Time-Weighted Return
❑ If a client gives an investment manager more funds to invest at an unfavorable time, the manager’s money-
weighted rate of return will tend to be depressed.
❑ If a client adds funds at a favorable time, the money-weighted return will tend to be elevated. The time-
weighted rate of return removes these effects.

Source: CFA Program Curriculum 13

LEARNING MODULE 1: RATES AND RETURNS
1.4: ANNUALIZED RETURN
1.4.1: Non-annual Compounding
❑ The interest may be paid semiannually, quarterly, monthly, or even daily. To handle this type of interest
payments, we can modify the future value & present value formulas to be:
FV = PV (1 + Rs/m)mN
PV = FV (1 + Rs/m)−mN
❑ Rs: is the quoted interest rate and equals the periodic interest rate multiplied by the number of compounding
periods in each year.

EXAMPLE: Non-annual Compounding

❑ The manager of a Canadian pension fund knows that the fund must make a lump-sum payment of CAD5
million 10 years from today. She wants to invest an amount today in a guaranteed investment contract (GIC)
so that it will grow to the required amount. The current interest rate on GICs is 6% a year, compounded
monthly. How much should she invest today in the GIC?
FVN = CAD 5,000,000 Quoted rate, Rs = 6% = 0.06
Frequency of compounding, m = 12 Period rate, Rs / m = 0.06 / 12 = 0.005
❑ PV = FV (1 + Rs/m)−mN = 5,000,000 (1 + 0.06/12)−12*10
= CAD 2,748,163.67

Source: CFA Program Curriculum 14

LEARNING MODULE 1: RATES AND RETURNS
1.4: ANNUALIZED RETURN
1.4.2: Annualizing Compounding
❑ The period during which a return is earned or computed can vary, thus, we need to annualize a that return for
a period that is shorter (or longer) than one year.
❑ The most convenient way is to annualize all available returns to facilitate comparison.
❑ The return for the period must be compounded by the number of periods in a year. A monthly return is
compounded 12 times, a weekly return is compounded 52 times, a quarterly return is compounded 4 times,
and a daily returns are compounded 365 times.
❑ For an uncommon number of days, we compound by the ratio of 365 / no. of days.
❑ A general equation to annualize returns is given, where c is the number of periods in a year. For a quarter, c =
4 and for a month, c = 12: Rannual = (1 + Rperiod)c − 1.
❑ To convert annual returns to weekly returns, c = 1/52. The expressions for annual returns can then be rewritten
as expressions for weekly returns as follows:
Rweekly = (1 + Rdaily)5 − 1 and Rweekly = (1 + Rannual)1/52 − 1.
❑ A major limitation of annualizing returns is the implicit assumption that returns can be repeated precisely,
money can be reinvested repeatedly while earning a similar return.

Source: CFA Program Curriculum 15

LEARNING MODULE 1: RATES AND RETURNS
1.4: ANNUALIZED RETURN
1.4.2: Annualizing Compounding
EXAMPLE: Annualized Return
❑ An analyst seeks to evaluate three securities she has held in her portfolio for different periods of time.
❑ Over the past 100 days, Security A has earned a return of 6.2 percent.
❑ Security B has earned 2 percent over the past four weeks.
❑ Security C has earned a return of 5 percent over the past three months.
❑ Compare the relative performance of the three securities.
❑ Annualized return for Security A: RA= (1 + 0.062)365/100 − 1 = 0.2455 = 24.55%
❑ Annualized return for Security B: RB = (1 + 0.02)52/4 − 1 = 0.2936 = 29.36%
❑ Annualized return for Security C: RC = (1 + 0.05)4 − 1 = 0.2155 = 21.55%

1.4.3: Continuously Compounded Returns

❑ The continuously compounded return associated with a holding period return is the natural logarithm of one
plus that holding period return, or equivalently, the natural logarithm of the ending price over the beginning
price (the price relative).
❑ Example: If a one-week holding period return is 4%, the equivalent continuously compounded return, called
the one-week continuously compounded return, is ln(1.04) = 0.039221; EUR1.00 invested for one week at
0.039221 continuously compounded gives EUR1.04, equivalent to a 4% one-week holding period return.
rt,t+1 = ln(Pt+1/Pt) = ln(1 + Rt,t+1).

Source: CFA Program Curriculum 16

LEARNING MODULE 1: RATES AND RETURNS
1.5: OTHER MAJOR RETURN MEASURES
1.5.1: Gross and Net Return
❑ Gross return:
❑ The return earned by an asset manager prior to deductions for management expenses, custodial fees,
taxes, or any other expenses not directly related to the generation of returns but rather related to the
management and administration of an investment.
❑ Net return:
❑ A measure of what the investment has earned for the investor.
❑ It accounts for all managerial and administrative expenses that reduce an investor’s return.
❑ Investors are most concerned about the net return.

1.5.2: Pre-Tax and After-Tax Nominal Return

❑ In general, all returns are pre-tax nominal returns unless they are otherwise designated.
❑ Capital gains and income may be taxed differently, depending on the jurisdiction.
❑ Long-term capital gains may receive preferential tax treatment than short-term capital gains.
❑ Interest income is taxed as ordinary income in most countries.
❑ Dividend income may be taxed as ordinary income, may have a lower tax rate, or may be exempt from
taxes depending on the country and the type of investor.

Source: CFA Program Curriculum 17

LEARNING MODULE 1: RATES AND RETURNS
1.5: OTHER MAJOR RETURN MEASURES

1.5.2: Pre-Tax and After-Tax Nominal Return

❑ The after-tax nominal return is computed as the total return minus any allowance for taxes on dividends,
interest, and realized gains.
❑ Investment manager can minimize the tax liability by selecting appropriate securities and reducing trading
turnover.

1.5.3: Real Returns

❑ The relationship between the nominal rate and the real rate by the following relationship:
❑ (1 + nominal risk–free rate) = (1 + real risk–free rate)(1 + inflation premium).

❑ Real returns are useful in comparing returns:

❑ across time periods because inflation rates may vary over time.
❑ among countries when returns are expressed in local currencies instead of a constant investor currency
and when inflation rates vary between countries.

Source: CFA Program Curriculum 18

LEARNING MODULE 1: RATES AND RETURNS
1.5: OTHER MAJOR RETURN MEASURES
1.5.4: Leveraged Return
❑ Investors can invest more than their own money by borrowing money to purchase the asset. This approach is
easily done in stocks and bonds, and very common when investing in real estate.
❑ If half (50%) of the money invested is borrowed, then the gross return to the investor is doubled, but the interest
to be paid on borrowed money must be deducted to calculate the net return.
❑ When total return earned on the leveraged portfolio, RP, exceeds the cost of borrowing, rD, taking on leverage
increases the return on the portfolio.

❑ Where VE is the equity of the portfolio and VB is the debt or borrowed funds.
❑ If RP < rD then leverage decreases RL.

EXAMPLE: Leverage Return

❑ A EUR10 million equity portfolio that generates an 8% total investment return, RP, over one year and is financed
30% with debt at 5%, then the leveraged return, RL, is:

EUR3 million
❑ RL = 8% + (8% −5%) = 8% + 0.43×3% = 9.29%.
EUR7 million

Source: CFA Program Curriculum 19

LEARNING MODULE 1: RATES AND RETURNS
Practical Questions
1. Which of the following risk premiums is most relevant in explaining the difference in yields between 30-year
bonds issued by the US Treasury and 30-year bonds issued by a small, private US corporate issuer?
A) Inflation
B) Maturity
C) Liquidity

2. Consider the following annual return for Fund Y over the past five years:
Year Return (%)
Year 1 19.5
Year 2 −1.9
Year 3 19.7
Year 4 35.0
Year 5 5.7
The geometric mean return for Fund Y is closest to:
A) 14.9%.
B) 15.6%.
C) 19.5%.

Source: CFA Program Curriculum 20

LEARNING MODULE 1: RATES AND RETURNS
Practical Questions
3. A portfolio manager invests EUR5,000 annually in a security for four years at the following prices:
Year Purchase Price (euros per unit)
Year 1 62.00
Year 2 76.00
Year 3 84.00
Year 4 90.00
The average price is best represented as the:
A) harmonic mean of EUR76.48.
B) geometric mean of EUR77.26.
C) arithmetic average of EUR78.00.

4. Which of the following statements regarding arithmetic and geometric means is correct?
A) The geometric mean will exceed the arithmetic mean for a series with non-zero variance.
B) The geometric mean measures an investment’s compound rate of growth over multiple periods.
C) The arithmetic mean measures an investment’s terminal value over multiple periods.

5. The price of a stock at t = 0 is USD208.25 and at t = 1 is USD186.75. The continuously compounded rate of return,
r1,T for the stock from t = 0 to t = 1 is closest to:
A) –10.90 percent.
B) –10.32 percent.
C) 11.51 percent. 21
Source: CFA Program Curriculum
LEARNING MODULE 1: RATES AND RETURNS
Practical Questions
6. A fund receives investments at the beginning of each year and generates returns for three years as follows:
Year of Investment AUM at the Beginning of year Return during Year
1 USD1,000 15%
2 USD4,000 14%
3 USD45,000 −4%
Which return measure over the three-year period is negative?
A) Geometric mean return
B) Time-weighted rate of return
C) Money-weighted rate of return

7. At the beginning of Year 1, a fund has USD10 million under management; it earns a return of 14% for the year.
The fund attracts another net USD100 million at the start of Year 2 and earns a return of 8 % for that year. The
money-weighted rate of return of the fund is most likely to be:
A) less than the time-weighted rate of return.
B) the same as the time-weighted rate of return.
C) greater than the time-weighted rate of return.

Source: CFA Program Curriculum 22

LEARNING MODULE 1: RATES AND RETURNS
Practical Questions
8. An investment manager’s gross return is:
A) an after-tax nominal, risk-adjusted return.
B) the return earned by the manager prior to deduction of trading expenses.
C) an often used measure of an investment manager’s skill because it does not include expenses related to
management or administration.

9. A USD25 million equity portfolio is financed 20% with debt at a cost of 6% annual cost. If that equity portfolio
generates a 10% annual total investment return, then the leveraged return is:
A) 11.0%.
B) 11.2%.
C) 13.2%.

10. At the beginning of the year, an investor holds EUR10,000 in a hedge fund. The investor borrowed 25 % of the
purchase price, EUR2,500, at an annual interest rate of 6% and expects to pay a 30% tax on the return she earns
from his investment. At the end of the year, the hedge fund reported a gross return of 8.46%, trading expenses of
1.10%, & a managerial and administrative expenses of 1.60%. The investor’s after-tax return on the hedge fund
investment is closest to:
A) 3.60%.
B) 3.98%.
C) 5.00%.
Source: CFA Program Curriculum 23