Quantitative Methods 2019 Level I High Yield Notes

2019 CFA® Exam Prep

IFT High-Yield Notes®

Quantitative Methods
Level I

This document should be read in conjunction with the corresponding readings in the 2019 Level
I CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2018, CFA Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
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Table of Contents
Foreword ................................................................................................................................................................ 2
R6 Time Value of Money ................................................................................................................................. 3
R7 Discounted Cash Flow Applications................................................................................................... 6
R8 Statistical Concepts and Market Returns..................................................................................... 11
R9 Probability Concepts .............................................................................................................................. 18
R10 Common Probability Distributions .............................................................................................. 24
R11 Sampling and Estimation................................................................................................................... 32
R12 Hypothesis Testing ............................................................................................................................... 36
R13 Technical Analysis ................................................................................................................................ 44

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Quantitative Methods 2019 Level I High Yield Notes

Foreword

The IFT High-Yield Course is based on Pareto’s 80-20 rule according to which 80% of the
exam questions are likely to be based on 20% of the curriculum. Hence this course focuses
on the 20% material which is most testable.

We call this the “High-Yield Course” because your investment (time and money) is low but
the potential return (passing the exam) is high! As with high-yield investments in the
world of finance, there is risk. Your exam will contain some questions which are not
addressed in the High-Yield Course. However, we believe that such questions will be few
and if you complement the High-Yield course with sufficient practice, the probability of
passing the exam is high.

The IFT High-Yield course has three components: notes, lectures and questions.
1. IFT High-Yield Notes® summarize the most important concepts from each reading
in 2 to 5 pages. Key formulas and facts are presented in blue boxes while examples
appear in gray boxes.
2. IFT High-Yield Lectures® are online video lectures based on the notes. Each
reading is covered in 10 to 20 minutes.
3. High-Yield Q-Bank® has between 600 and 700 questions covering concepts which
are most likely to show up on the exam.

The High-Yield Course can be used on a ‘stand-alone’ basis if you are time-constrained.
However, if you do have time, we recommend taking the High-Yield Course along with IFT’s
regular material. This will help ensure sufficient mastery of the entire curriculum.

Many candidates complain that they forget material covered earlier. The High-Yield Course
addresses this problem by helping you to quickly revise key concepts.

Thank you for trusting IFT to help you with your exam preparation.

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Quantitative Methods 2019 Level I High Yield Notes

R6 Time Value of Money

Interpretation of interest rates
Interest rates can be interpreted as:
• Required rate of return: If you invest $100 today on the condition that you get
$110 after a year, then your required rate of return is 10%.
• Discount rate: For the same example, if you discount the future cash flow of $110
using a discount rate of 10%, you get a present value of $100.
• Opportunity cost: If you spend the $100 today instead of investing, then you lose
the opportunity of earning 10% interest. In this sense interest rates can also be
thought of as opportunity costs.

Components of interest rates

Interest rates have the following components:
• Real risk-free rate: Return on an investment with zero risk, assuming no inflation.
• Inflation premium: Extra return required to compensate for inflation.
• Default risk premium: Extra return required to compensate for the risk that the
borrower will not make the promised payments.
• Liquidity premium: Extra return required to compensate for the risk of receiving
less than the fair value of an investment if it must be sold quickly for cash.
• Maturity premium: The prices for longer-term bonds are more volatile than
shorter-term bonds i.e. they have more maturity risk. Extra return required to
compensate for maturity risk is called maturity premium.
Interest rate = real risk-free rate + inflation premium + default risk premium + liquidity
premium + maturity premium.
Nominal interest rate = real risk-free rate + inflation premium

In a country ABC, the real risk-free rate is 4% and the expected inflation is 3%. Company X
domiciled in this country issues a 5-year bond with an estimated default risk premium of
2%, liquidity premium of 1% and maturity premium of 1%. Calculate the interest rate of
this bond.
Solution:
The interest rate for this bond will be 4 + 3 + 2 + 1 + 1 = 11%.

Effective annual rate

The stated annual rate is a quoted interest rate that does not consider the effect of
compounding. The effective annual rate (EAR) is the rate at which money invested will
grow in a year when we do consider compounding.
The EAR when there are m compounding periods in a year is:

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Quantitative Methods 2019 Level I High Yield Notes

stated annual rate m

Effective annual rate = (1 + ) −1
m
The EAR for continuous compounding is:
Effective annual rate = estated annual rate − 1

Calculate the EAR for:

1. A stated annual rate of 12% and semiannual compounding.
2. A stated annual rate of 12% and quarterly compounding.
3. A stated annual rate of 12% and monthly compounding.
4. A stated annual rate of 12% and continuous compounding.
Solution:
1. EAR = 1.062 – 1 = 12.36%
2. EAR = 1.034 – 1 = 12.55%
3. EAR = 1.0112 –1 = 12.68%
4. EAR = e0.12 –1 = 12.75%
Note that for the same stated annual rate, the EAR increases as the frequency of
compounding increases.

Non-annual compounding frequencies

Step 1: Divide the stated annual interest rate by the number of compounding periods per
year (m).
Step 2: Multiply the number of years by the number of compounding periods per year (m).
Step 3: Use the following formula to calculate future value.
stated interest rate mN
Future value = present value (1 + )
m

You invest $10,000 in a 5-year bond. The bond offers a stated annual interest rate of 12%
compounded semi-annually. What will be the value of the investment at the end of five
years?
Solution:
Step 1: 12 / 2 = 6%
Step 2: 5 x 2 = 10 periods
Step 3: FV = 10,000 (1.06)10 = $17,908.47

Calculating PV and FV of different cash flows

Present value is the current value of a future cash flow.
• Longer the time period till the future amount is received, lower the present value.
• Higher the discount rate, lower the present value.
Future value is the value to which an investment will grow after one or more
compounding periods.

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Quantitative Methods 2019 Level I High Yield Notes

• Longer the time period till which the investment is allowed to grow, higher the
future value.
• Higher the interest rate, the higher the future value.
The future value and the present value of a single sum of money can be calculated by using
the formulae given below or by using the TVM keys on a financial calculator (recommended
approach for the exams).
FV = PV (1 + I/Y)N
PV = FV / (1 + I/Y)N

You invest $100 today at an interest rate of 10% for 5 years. How much will you receive
after five years?
Solution:
Plug the following values in the calculator.
N = 5; I/Y = 10; PV = 100, PMT = 0; CPT FV = $161.05
An ordinary annuity is series of finite but equal cash flows which occur at the end of each
period.
How much should you invest today at an interest rate of 10% to receive $100 at the end of
each year for 5 years?
Using the calculator: N = 5; I/Y = 10; PMT = 100; FV = 0; CPT PV = $379.08
An annuity due is a series of finite but equal cash flows which occur at the start of each
period.
How much should you invest today at an interest rate of 10% to receive $100 at the
beginning of each year for 5 years?
Solution:
Put the calculator in BGN mode and plug the following values. (Remember to exit the BGN
mode once you are done with your calculations.)
N = 5; I/Y = 10; PMT = 100, FV = 0; CPT PV = $416.98
A perpetuity is a series of equal cash flows at regular intervals occurring forever. The
present value of perpetuity can be calculated as:
PMT
PV of a perpetuity =
I/Y

How much should you invest today at an interest rate of 10% to receive $100 at the end of
each year forever?
Solution:
PV = 100/0.1 = $1,000
The present (future) value of any series of cash flows is equal to the sum of the present
(future) values of the individual cash flows.

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Quantitative Methods 2019 Level I High Yield Notes

What is the future value of the following series of cash flows, given an interest rate of 10%?
$1,000 at the end of year 1, $2,000 at the end of year 2, $3,000 at the end of year 3, $4,000
at the end of year 4 and $5,000 at the end of year 5.
Solution:
The future value is 5000 + 4000 x 1.1 + 3000 x 1.12 + 2000 x 1.13 + 1000 x 1.14 = $17,156

Using time lines

A time-line is a diagram that shows the inflow and outflow of money at various time
periods. Constructing a time-line will help you solve time value of money problems.
Consider the following simple example.
Suppose you will receive $100 at the end of Year 3, Year 4 and Year 5. What is the PV at
time 0 given a discount rate of 5%?
Time: 0 1 2 3 4 5
5%
| | | | | |
Cash flows: PV=? $0 $0 $100 $100 $100
Solution:
To solve this problem you can draw the above time-line, depicting the cash flows. The three
payments of $100 can be treated as an ordinary annuity and we can calculate its PV at the
end of year 2.
Plug the following values in the calculator:
N = 3; I/Y = 5; PMT = $100, FV = 0; CPT PV = $272.32
The time line now simplifies to:
Time: 0 1 2 3 4 5
5%
| | | | | |
Cash flows: PV=? 0 $272.32 $0 $0 $0
To discount to time 0, plug the following values in the calculator:
N = 2; I/Y = 5; PMT = 0; FV = 272.32; CPT PV = $247.

R7 Discounted Cash Flow Applications

Net present value (NPV) & Internal rate of return (IRR)
The NPV of an investment is the present value of its cash inflows minus the present value
of its cash outflows. The NPV of a project is calculated as:
CF1 CF2 CF3
NPV = CF0 + [(1+r)1 ] + [(1+r)2 ] + [(1+ r)3 ]

Consider a project which requires an initial investment of $10,000. It is expected to

generate $5,000 in the first year, $6,000 in the second year and $7,000 in the third year.

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Quantitative Methods 2019 Level I High Yield Notes

The cost of capital for this project is 10%. Calculate the NPV of this project.
Solution:
5,000 6,000 7,000
NPV = −10,000 + (1.1)1 + (1.1)2 + (1.1)3
NPV = $4,763.33
Using the financial calculator: CF0 = -10,000; CF1 = 5,000; CF2 = 6,000; CF3 = 7,000; I = 10.
CPT NPV = 4,763.33
The IRR is the discount rate the makes the NPV equal to zero. i.e. it equates the PV of the
cash inflows to the PV of the cash outflows. The IRR of a project is calculated as:
CF1 CF2 CF3
CF0 = [(1+IRR)1 ] + [(1+IRR)2 ] + [(1+IRR)3 ]

Consider a project which requires an initial investment of $10,000. It is expected to

generate $5,000 in the first year, $6,000 in the second year and $7,000 in the third year.
Calculate the IRR of this project.
Solution:
5,000 6,000 7,000
10,000 = [(1+IRR)1 ] + [(1+IRR)2 ] + [(1+IRR)3 ]
IRR = 33.87%
Using the financial calculator: CF0 = -10,000; CF1 = 5,000; CF2 = 6,000; CF3 = 7,000; I = 10;
CPT IRR = 33.87

Conflict between NPV & IRR

NPV Rule
• For independent projects, accept a project if NPV > 0.
• For mutually exclusive projects, select the project with the highest positive NPV.
An independent project is one where the decision to accept or reject the project has no
effect on any other projects being considered by the company. Hence, if a company is
evaluating two independent projects, it can invest in both projects.
A mutually exclusive project is one where the acceptance of such a project will have an
effect on the acceptance of another project. Hence, if a company is evaluating two mutually
exclusive projects, then it can invest in only one of the projects.
IRR Rule
• For independent projects, accept if IRR > required rate of return.
• For mutually exclusive projects, select the project with the highest IRR.
Problems associated with IRR
• IRR wrongly assumes that the interim cash flows are reinvested at the IRR rate and
not at the cost of capital.
• A project may have multiple IRRs or no IRR.

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Quantitative Methods 2019 Level I High Yield Notes

• For mutually exclusive projects, due to differences in project size or timing of cash
flows, the IRR and NPV rankings may differ. If there is a conflict in ranking, go with
the NPV rule.

Holding period return

The holding period return is the total return for holding an investment over a given time
period. It is calculated as:
P1 −P0 +D1
HPR = P0
where:
P0 = price at the start of the holding period
P1 = price at the end of the holding period
D1 = dividend/coupon paid by the investment at the end of the holding period

An investor bought a stock for $100. Five months later, he received a dividend of $4 and he
sold the stock for $108. Compute the HPR.
Solution:
108 – 100 + 4
HPR = = 0.12 = 12%
100

Money-weighted & Time weighted rate of return

Money-weighted rate of return
• The money-weighted rate of return is simply the IRR of a portfolio taking into
account all cash inflows and outflows.
• If a manager controls the cash inflows and outflows of a portfolio, then use money-
weighted return to measure performance.
An investor buys a stock for $10 at time t=0. At the end of Year 1, he receives a dividend of
$1 and purchases another stock for $12. At the end of Year 2, he receives a dividend of $0.5
per share and sells both shares for $13. Calculate the money-weighted return.
Solution:
Year Outflow Inflow Net Cash Flow
0 $10 to purchase the first -10
share
1 $12 to purchase the $1 dividend received on first -11
second share share
2 $1.00 dividend ($0.50 x 2 +27
shares) received
$26 received from selling 2
shares @ $13 per share
Enter the following in a calculator: CF0 = -10; CF1 = -11; CF2 = 27; CPT IRR = 18.28%. The

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Quantitative Methods 2019 Level I High Yield Notes

money weighted return is 18.28%.

Time-weighted rate of return
• Time-weighted rate of return is the compound growth rate at which $1 invested in a
portfolio grows over a given measurement period.
• If a manager cannot control the cash inflows and outflows of a portfolio, then use
time-weighted return to measure performance.
An investor buys a stock for $10 at time t=0. At the end of Year 1, he receives a dividend of
$1 and purchases another stock for $12. At the end of Year 2, he receives a dividend of $0.5
per share and sells both shares for $13. Calculate the time-weighted rate of return.
Solution:
1. Break the measurement period into two sub-periods based on the timing of the cash
flows.
Holding period 1 Beginning value = $10
Dividends paid = $1
Ending value = $12
Holding period 2 Beginning value = $24 (12 x 2)
Dividends paid = $1 (0.5 x 2)
Ending value = $26 (13 x 2)
2. Compute the HPY for each sub-period.
HPY1 = (12 – 10 +1)/10 = 30%
HPY2 = (26 – 24 + 1)/24 = 12.5%
3. Calculate the compounded annual rate by taking the geometric mean of the two sub-
periods.
(1 + TWRR)2 = 1.30 x 1.125; TWRR = 20.93%

Yield measures for money market instruments

D 360
Bank discount yield (BDY) = ( F ) × ( )
t
P1 – P0 + D1
Holding period yield (HPY) = P0
365
Effective annual yield (EAY) = (1 + HPY) t −1
360
Money market yield (MMY) = HPY × t

Consider a T-Bill with a face value of $100 and 60 days to maturity. It is selling at a discount
of $2 i.e. at a price of $98. Calculate BDY, HPY, EAY and MMY.
Solution:
2 360
Bank discount yield(BDY) = (100) ∗ ( 60 ) = 12%
100 – 98 + 0
Holding period yield (HPY) = = 2.04%
98

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Quantitative Methods 2019 Level I High Yield Notes

365
Effective annual yield(EAY) = (1 + 0.0204) 60 − 1 = 13.07%
360
Money market yield (MMY) = 2.04% × = 12.24%
60

Conversion among yield measures

We can convert back and forth between holding period yields, money market yields, and
effective annual yields by using the holding period yield, which is common to all the
calculations. To calculate HPY use the following formulae. Then convert HPY to the
required yield measure.
𝑡
HPY = MMY × 360
t
HPY = (1 + EAY)365 − 1
From BDY→ compute discount and initial price P0 →compute HPY.

An investor purchased a $100 T-bill that will mature in 60 days. The money market yield
on the T-bill was 12.24% at the time of purchase. Compute HPY and EAY.
Solution:
60
HPY = 12.24 × = 2.04%
360
365
EAY = (1 + 0.0204) 60 − 1 = 13.07%

An investor purchased a $100 T-bill that will mature in 60 days. The bank discount yield on
the T-bill was 12.00% at the time of purchase. Compute HPY and MMY.
Solution:
D 360 D 360
BDY = ( F ) ∗ ( ) ; 0.12 = (100) ∗ ( 60 ) ; D = 2, P0 = 98
t
P1 – P0 + D1 100 – 98 + 0
HPY = = = 2.04%
P0 98
360 360
MMY = HPY × = 2.04% × = 12.24%
t 60

To calculate bond-equivalent yield, first convert to semiannual YTM, then use the
following formula.
Bond-equivalent yield = 2 x semi-annual YTM

A 3-month investment has a holding period yield of 2%. What is the yield on a bond
equivalent basis?
Solution:
First calculate the semiannual YTM = (1+ 3-month HPY)2 – 1 = 1.022 – 1 = 4.04%
BEY = 2 x semiannual YTM = 2 x 4.04 = 8.08%

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Quantitative Methods 2019 Level I High Yield Notes

R8 Statistical Concepts and Market Returns

Fundamental concepts
Descriptive statistics refer to how large data sets can be summarized effectively to
describe their important characteristics.
Inferential statistics refers to making forecasts, estimates or judgments about a large data
set based on a small representative set.
Population includes all members of a particular group.
Sample is a subset drawn from a population.
Measurement Scales: Data can be measured using the following scales:
• Nominal scales: put data in categories but do not rank them.
• Ordinal scales: nominal scale + data can be ranked with respect to some
characteristic.
• Interval scales: ordinal scale + the differences in the data values are meaningful.
• Ratio scales: interval scale + the ratios of value, such as twice or half as much are
meaningful.
The scale on which data is measured determines the type of analysis that can be performed
on the data.

Parameter, sample statistic & frequency distributions

Parameter is a descriptive measure of a population.
Sample statistic is a descriptive measure of a sample.
Frequency distribution is a tabular display of data categorized into a relatively small
number of intervals or classes. It allows us to evaluate how data is distributed.
Frequency distribution of the marks scored by 100 students.
Marks Interval Absolute Frequency
0 - 25 10
26 - 50 30
51 - 75 40
76 - 100 20

Relative frequencies and cumulative relative frequencies

Relative frequency is calculated as the absolute frequency of an interval divided by the
total number of observations.
Cumulative relative frequency for an interval, is calculated as the sum of the relative
frequencies of all intervals lower than and including that interval.
Frequency distribution of the marks scored by 100 students.

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Quantitative Methods 2019 Level I High Yield Notes

Marks Absolute Relative Cumulative Relative

Interval Frequency Frequency Frequency
0 - 25 10 10% 10%
26 - 50 30 30% 40%
51 - 75 40 40% 80%
76 - 100 20 20% 100%

Histograms & frequency polygon

Histogram is a bar chart of data that has been grouped together into a frequency
distribution. The height of each bar is equal to the absolute frequency of each interval.

Histogram of Students scores

60

40

20

0
0-25 26-50 51-75 76-100

Frequency polygon plots the midpoints of each interval on the X-axis and the absolute
frequency of that interval on the Y-axis, and connects these points with straight lines.

Frequency Pologon of Students's Scores

50 40
40 30
30 20
20 10
10
0
0-25 26-50 51-75 76-100

Measures of central tendency

Arithmetic mean is the sum of all the observations divided by the total number of
observations. A population average is called population mean (µ). A sample average is
called sample mean (x̅). The sample mean is used as the ‘best guess’ approximation of the
population mean.
∑N
i=1 Xi
µ=
N

A stock had the following returns in the past three years: 10%, -5%, and 20%. Calculate the
arithmetic mean.

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Quantitative Methods 2019 Level I High Yield Notes

Solution:
Arithmetic mean = (10 – 5 + 20)/3 = 8.33%
Median is the midpoint of a data set that has been sorted from largest to smallest. If we
have an even number of observations, then the median is the average of the two middle
observations.
Calculate the medians for the following data sets:
A) 1, 2, 3, 4, 5
B) 1, 2, 3, 4, 5, 6
Solution:
A) Median = 3
B) Median = (3+4)/2 = 3.5
Mode is the value that occurs most frequently in a data set. A data set can have more than
one mode, but only one mean and one median.
Calculate the mode for the following data set: 1, 2, 2, 3, 4, 4, 4, 5, 5
Solution:
Mode = 4
Geometric mean is used to calculate compound growth rate.
R G = [(1 + R1) (1 + R2) … … . (1 + Rn)]1/n − 1

A stock had the following returns in the past three years: 5%, -5%, and 20%. Calculate the
geometric mean.
Solution:
R G = [(1.05) (0.95)(1.20)]1/3 − 1 = 6.17%
In a weighted mean different observations are given different weights as per their
proportional influence on the mean.
̅ w = ∑ni=1 wi Xi
X

An investor has 20% of his portfolio in Stock A, 30% in Stock B and 50% in Stock C. If the
returns were 4% on Stock A, 7% on Stock B and 8% on Stock C. Calculate portfolio return.
Solution:
Portfolio return = 0.2 x 4 + 0.3 x 7 + 0.5 x 8 = 6.9%
Harmonic mean is used to find average purchase price for equal periodic investments.
1
XH = n / ∑ni=1 (X )
i

An investor purchased $1,000 worth of stock A each month for the past three months at
prices of $5, $6 and $7. Calculate the average purchase price of the stock.
Solution:

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Quantitative Methods 2019 Level I High Yield Notes

Average purchase price = 3 / (1/5 + 1/6 + 1/7) = 5.88

If returns are constant over time: AM = GM = HM

If returns are variable over time: AM > GM > HM

Quartiles, quintiles, deciles, & percentiles

A quantile is a value at or below which a stated fraction of the data lies. Some examples of
quantiles include:
• Quartiles: distribution is divided into quarters
• Quintiles: distribution is divided into fifths.
• Deciles: distribution is divided into tenths.
• Percentile: distribution is divided into hundredths.
The formula for the position of a percentile in a data set with n observations sorted in
ascending order is:
Ly = (n+1) y /100

Calculate the first quartile of a distribution that consists of the following portfolio returns:
3%, 4%, 6%, 9%, 11%, 12%, 14%
Solution:
The first quartile = (7+1) 25/100 = 2nd item in the data set (4%). i.e. 25% of the
observations lie below the second observations from the left.

Measures of dispersion
Range is the difference between the maximum and minimum values in a data set.
Range = maximum value – minimum value

The annual returns of a portfolio manager for the past 4 years are 4%, 2%, 6%, 8%.
Calculate the range.
Solution:
Range = 8% - 2% = 6%
Mean absolute deviation (MAD) is the average of the absolute values of deviations from
the mean.
MAD = [∑ni=1|Xi − ̅
X|]/n

The annual returns of a portfolio manager for the past 4 years are 4%, 2%, 6%, 8%.
Calculate MAD.
Solution:
X = (4 + 2 + 6 + 8)/4 = 5

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Quantitative Methods 2019 Level I High Yield Notes

|4−5|+|2−5|+|6−5|+|8−5| 1+3+1+3
MAD = = =2
4 4

Variance is defined as the mean of the squared deviations from the arithmetic mean.
Population variance σ2 = ∑N 2
i=0(X i − μ) / N
Sample variance s 2 = ∑ni=0(Xi − ̅X ) 2 / (n − 1)
Standard deviation is the positive square root of the variance. It is often used as a
measure of risk.
The annual returns of a portfolio manager for the past 4 years are 4%, 2%, 6%, 8%.
Calculate the population and sample standard deviations.
Solution:
It is advisable to use the financial calculator instead of the formula on the exams. The
keystrokes for the above example are: [2nd] [DATA], [2nd] [CLR WRK], 4 [ENTER], [↓] [↓] 2
[ENTER], [↓] [↓] 6 [ENTER], [↓] [↓] 8 [ENTER], [2nd] [STAT] [ENTER], [2nd] [SET] press
repeatedly till you see 1-V. Keep pressing [↓] to see the following values: N = 4, X = 5, Sx =
2.58, σx = 2.24.
Note: If you are asked to calculate the variances, simply square the standard deviations.

Chebyshev’s inequality
According to Chebyshev’s inequality, the proportion of the observations within k standard
deviations of the arithmetic mean is at least:
1 - 1/k2 for all k > 1.

Determine the minimum percentage of observations in a data set that lie within 2 standard
deviations from the mean.
Solution:
% of population within 2 std deviations = 1-1/k2 = 1 – 1/22 = 75%
Thus, Chebyshev’s inequality permits us to make probabilistic statements about the
proportion of observations within various intervals around the mean for any distribution
with finite variance. As a result of Chebyshev’s inequality, a two-standard deviation interval
around the mean must contain at least 75 percent of the observations, no matter how the
data is distributed.

Coefficient of variation & Sharpe ratio

Coefficient of variation measures the risk per unit of return. When evaluating
investments, a lower value is better.
𝑠
CV = 𝑋̅

Calculate the coefficient of variation for the following portfolios and interpret the results.
Mean return Standard deviation

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Quantitative Methods 2019 Level I High Yield Notes

Portfolio A 10% 9%
Portfolio B 6% 4%
Portfolio C 9% 2%
Solution:
CVA = 9/10 = 0.9
CVB = 4/6 = 0.66
CVC = 2/9 = 0.22
Portfolio C has the lowest risk per unit of return, so it is the most attractive investment.
Sharpe ratio measures excess return per unit of risk. When evaluating investments, a
higher value is better.
𝑅̅𝑝 − 𝑅̅𝐹
𝑆𝑝 = 𝑠𝑝

A portfolio has a mean return of 8% and a standard deviation of 10%. Calculate the Sharpe
ratio, given that the risk-free rate is 3%.
Solution:
Sharpe ratio = (8 – 3)/10 = 0.5

Symmetry and skewness in return distributions

A distribution is said to be symmetrical when the distribution on either side of the mean is
a mirror image of the other. In a symmetrical distribution, mean = median = mode.

If a distribution is non-symmetrical, it is said to be skewed. Skewness can be negative or

positive.
A positively skewed distribution has a long tail on the right side, which means that there
will be frequent small losses and few large gains. Here the mean > median >mode. The
extreme values affect the mean the most which is pulled to the right. They affect the mode
the least.

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A negatively skewed distribution has a long tail on the left side, which means that there
will be frequent small gains and few large losses. Here the mean < median < mode. The
extreme values affect the mean the most which is pulled to the left. They affect the mode
the least.

Kurtosis
Kurtosis is a measure of the degree to which a distribution is more or less peaked than a
normal distribution, which has a kurtosis of 3. Excess kurtosis = kurtosis - 3. An excess
kurtosis with an absolute value greater than 1 is considered significant.
• A leptokurtic distribution is more peaked and has fatter tails than a normal
distribution.
• A platykurtic distribution is less peaked and has thinner tails than a normal
distribution.
• A mesokurtic distribution is identical to a normal distribution.

Using geometric and arithmetic means

The geometric mean is appropriate to measure past performance over multiple periods.
The portfolio returns for the past two years were 100% in year 1 and -50% in year 2. What
was the mean return?
Solution:

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Quantitative Methods 2019 Level I High Yield Notes

Past return = geometric mean = (2 x 0.5)0.5 – 1 = 0%

The arithmetic mean is appropriate for forecasting single period returns.
Two possible returns for the next year are 100% and -50%. What is the expected return?
Solution:
Expected return = arithmetic mean = (100 – 50)/2 = 25%

R9 Probability Concepts
Fundamental concepts
A random variable is an uncertain quantity/number.
An outcome is the observed value of a random variable.
An event can be a single outcome or a set of outcomes.
Mutually exclusive events are events that cannot happen at the same time.
Exhaustive events are those that include all possible outcomes.
• When you roll a die, the result is a random variable.
• If you roll a 2, it is an outcome.
• You can define an event as rolling a 2 or rolling an even number.
• Rolling a 2 and rolling a 3 are examples of mutually exclusive events. They cannot
happen at the same time.
• Rolling an even number or Rolling an odd number are exhaustive events. They cover all
possible outcomes.

Properties of probability
The two properties of probability are:
• The probability of any event has to be between 0 and 1.
• The sum of the probabilities of mutually exclusive and exhaustive events is equal to
1.
The methods of estimating probabilities are:
• Empirical probability: based on analyzing the frequency of an event’s occurrence in
the past.
• A priori probability: based on formal reasoning and inspection rather than personal
judgment.
• Subjective probability: informed guess based on personal judgment.

Odds for and against the event

Odds for an event are defined as the probability of the event occurring to the probability of
the event not occurring.
Odds against an event are defined as the probability of the event not occurring to the

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Quantitative Methods 2019 Level I High Yield Notes

probability of the event occurring.

Odds for E = P (E) / [1 – P (E)]
Odds against E = [1 – P (E)]/P(E)

If the probability of the market rising tomorrow is 0.2. Calculate the odds for the market
rising and against the market rising.
Solution:
Odds for the market rising = 0.2/0.8 = 1 to 4
Odds against the market rising = 0.8/0.2 = 4 to 1

Unconditional v/s conditional probabilities

Unconditional probability is the probability of an event occurring irrespective of the
occurrence of other events. It is denoted as P(A).
Conditional probability is the probability of an event occurring given that another event
has occurred. It is denoted as P(A|B), which is the probability of event A given that event B
has occurred.

Multiplication, addition, and total probability rules

Multiplication rule is used to determine the joint probability of two events.
P (AB) = P (A│B) P (B)
For independent events, P (A|B) = P (A). Hence the formula simplifies to
P(AB) = P(A) P(B)

We are given the following information:

• Probability that the economy will improve P(E) = 0.6
• Probability that stock price will increase given that the economy has improved P(S|E) =
0.4
Compute the probability that the stock price will increase and the economy will improve.
Solution:
P(SE) = P(S|E) x P(E) = 0.4 x 0.6 = 0.24
Addition rule is used to determine the probability that at least one of the events will occur.
P (A or B) = P(A) + P(B) − P(AB)
For mutually exclusive events P (AB) = 0. Hence the formula simplifies to
P(A or B) = P(A) + P(B)

We are given the following information:

• Probability that price of Stock A increases = P(A) = 0.4
• Probability that price of Stock B increases = P(B) = 0.5
• Probability that price of Stock A and Stock B increases = P(AB) = 0.2

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Compute the probability that the price of stock A or the price of stock B increases.
Solution:
P (A or B) = P(A) + P(B) − P(AB) = 0.4 + 0.5 – 0.2 = 0.7
Total probability rule is used to calculate the unconditional probability of an event, given
conditional probabilities.
P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) + ... + P(A|Bn)P(Bn)

We are given the following information:

• Probability of above average economic growth = P(B1) = 0.4
• Probability of average economic growth = P(B2) = 0.5
• Probability of below average economic growth = P(B3)= 0.1
• Probability of stock price rising given above average economic growth = P(A|B1) = 0.9
• Probability of stock price rising given average economic growth = P(A|B2) = 0.6
• Probability of stock price rising given below average economic growth = P(A|B3) = 0.1
Compute the probability that the stock price will increase.
Solution:
P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) + P(A|B3)P(B3) = 0.9 x 0.4 + 0.6 x 0.5 + 0.1 x 0.1 = 0.67

Dependent v/s independent events

If the occurrence of one event does not influence the occurrence of the other event, then
the events are called independent events. i.e. P(A|B) = P(A) or P(B|A) = P(B)
If the probability of an event is affected by the occurrence of another event, then it is called
a dependent event.

Using tree diagrams to represent an investment problem

A tree diagram helps plot the probabilities of various outcomes and depict expected values
based on the paths chosen at each node.
There is a 0.6 probability of a good economy and a 0.4 probability of a poor economy. If
there is a good economy, there is 0.70 probability that the stock price will be 100 and 0.3
probability that the stock price will be 90. If the economy is poor, there is a 0.2 probability
that the stock price will be 80 and a 0.8 probability that the stock price will be 70. Calculate
the expected stock price.
Solution:
Construct a tree diagram depicting the given scenario. The unconditional probability of
stock price being 100 can be calculated by multiplying P (good economy) x P (stock price
being 100 when the economy is good) = 0.6 x 0.7 = 0.42. Similarly, we can calculate the
unconditional probabilities for all remaining prices.

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The expected stock price is 0.42 x 100 + 0.18 x 90 + 0.08 x 80 + 0.32 x 70 = 87

Covariance & correlation

Covariance is a measure of how two variables move together. A positive covariance
indicates that the variables tend to move together in the same direction. Whereas, a
negative covariance indicates that the variables tend to move in opposite directions.
If two variables X and Y have expected values of E(X) and E(Y), then the covariance can be
calculated as:
Cov (X,Y) = E[X - E(X)] [Y - E(Y)]

Calculate the covariance of two stocks A and B given two possible states of the economy.
Refer to the table below.
Scenario P(Scenario) Expected Returns of A Expected Returns of B
Recession 0.2 1% 3%
Expansion 0.8 8% 6%
Solution:
The expected return of A is: 0.2 x 1 + 0.8 x 8 = 6.6%
The expected return of B is: 0.2 x 3 + 0.8 x 6 = 5.4%
The covariance can be calculated as:
0.2 (1 - 6.6) (3 - 5.4) + 0.8 (8 - 6.6) (6 - 5.4) = 2.688 + 0.672 = 3.36
Correlation is a standardized measure of the linear relationship between two variables. It
is obtained by dividing the covariance of two variables by the product of their standard
deviations. The correlation coefficient can range from -1 to +1.
Corr (X,Y) = Cov (X,Y) / σ (X) σ (Y)

From the previous example, the covariance between Stock A and Stock B is 3.36. Calculate

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the correlation given that the standard deviation of Stock A is 2.8 and the standard
deviation of Stock B is 1.2
Solution:
Corr (A,B) = 3.36/(2.8)(1.2) = 1

Expected value, variance, and standard deviation of a random variable & of returns
on a portfolio
Random variable
The expected value of a random variable is the probability-weighted average of the
possible outcomes of the random variable. The standard deviation / variance can be found
using a financial calculator.
E(X) = X1P(X1) + X2P(X2) + ... + XnP(Xn)

A stock’s projected EPS for the upcoming year depends on the state of the economy as
shown in the table below. Calculate the expected value of EPS, variance, and standard
deviation.
State of Economy Probability EPS
Good 0.4 $9
Average 0.5 $6
Weak 0.1 $1
Solution:
E(X) = X1P(X1) + X2P(X2) + X3P(X3) = 9 x 0.4 + 6 x 0.5 + 1 x 0.1 = $6.7
The expected value and standard deviation can also be directly found using a financial
calculator. The keystrokes are given below. [2nd] [DATA], [2nd] [CLR WRK], 9 [ENTER], [↓]
40 [ENTER], [↓] 6 [ENTER], [↓] 50 [ENTER], [↓] 1 [ENTER], [↓] 10 [ENTER], [2nd] [STAT],
[2nd] [SET] press repeatedly till you see 1-V. Keep pressing [↓] to see: N = 100, X = 6.7, Sx =
2.38, σx = 2.37.
Note: We use the population standard deviation and not the sample standard deviation
because we have entered all outcomes which means that we have covered the entire
population.
To calculate the population variance, we square the standard deviation.
Population variance = 2.372 = 5.6169
Returns on a portfolio
The expected returns and the variance of a two-asset portfolio are given by:
E (RP) = w1 E (R1) + w2 E (R2)
σ2 (RP) = w12σ12 (R1) + w22σ22 (R2) + 2w1w2 ρ (R1, R2) σ (R1) σ (R2)

A portfolio consists of 70% stocks and 30% bonds. The expected return on stocks is 10%
and the expected return on bonds is 5%. The standard deviation of stock returns is 0.3 and

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the standard deviation of bond returns is 0.1. The correlation between stock returns and
bond returns is 0.2. Calculate the expected return and the variance of the portfolio.
Solution:
Expected return = 0.7 x 10 + 0.3 x 5 = 8.5%
Variance = 0.72 x 0.32 + 0.32 x 0.12 + 2 x 0.7 x 0.3 x 0.2 x 0.3 x 0.1 = 0.04752

Calculating covariance from a joint probability function

Calculate the covariance between the returns of Stock A and Stock B, given the following
joint probability table.
RA = 1% RA = 8%
RB = 3% 0.2 0
RB = 6% 0 0.8
Solution:
The expected return of A is: 0.2 x 1 + 0.8 x 8 = 6.6%
The expected return of B is: 0.2 x 3 + 0.8 x 6 = 5.4%
The covariance can be calculated as:
0.2 (1 - 6.6) (3 - 5.4) + 0.8 (8 - 6.6) (6 - 5.4) = 2.688 + 0.672 = 3.36

Bayes’ formula
Bayes’ formula is used to update the probability of an event based on new information. The
formula for calculating the updated probability is:
P(Information|Event)
P(Event|Information) = × P(Event)
P(Information)

The probability of a recession is 0.4 and the probability of an expansion is 0.6. If there is an
expansion, the probability that the stock price will increase is 0.8. If there is a recession, the
probability that the stock price will increase is 0.3. It turns out that the stock price did
increase, what is the probability that we are in a recession?
Solution:
P(E): The unconditional probability of recession = 0.4
P(Ec): The unconditional probability of an expansion = 0.6
P(I|E): The probability of increase in stock price given that we are in a recession = 0.3
P(I|Ec): The probability of increase in stock price given that we are in an expansion = 0.8
P(I): The unconditional probability of an increase in stock price. This can be calculated
using total probability rule.
P(I) = P(I|E) x P(E) + P(I|Ec) x P(Ec)
= 0.3 x 0.4 + 0.8 x 0.6 = 0.6
Using Bayes’ formula, the probability that we are in a recession given that the stock price
increased is:
P(E|I) = P(I|E) x P(E) / P(I)

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Quantitative Methods 2019 Level I High Yield Notes

= 0.3 x 0.4 / 0.6 = 0.2

Principles of counting
Permutations is the number of ways to choose r objects from a total of n objects when the
order in which the r objects are chosen is important.
n!
nPr = (n−r)!

A portfolio manager wants to sell 4 stocks from a portfolio that consist of 10 stocks. In how
many ways can the 4 stocks be chosen, when the order of sale is important?
Solution:
10!
10P4 = (10−4)!
= 5,040

Note: On the exam use the calculator function. The key strokes are:
10 [2nd] [-] 4 [=] 5,040
Combinations is the number of ways to choose r objects from a total of n objects when the
order in which the r objects are chosen is not important.
n!
nCr = (nr) = (n−r)!r!

A portfolio manager wants to sell 4 stocks from a portfolio that consists of 10 stocks. In
how many ways can the 4 stocks be chosen, when the order of sale is not important?
Solution:
10!
10C4 = (10
4
)= (10−4)!4!
= 210
Note: On the exam use the calculator function. The key strokes are:
10 [2nd] [+] 4 [=] 210

R10 Common Probability Distributions

Probability distribution, discrete v/s continuous random variables
Probability distribution
A random variable is a variable whose outcome cannot be predicted. A probability
distribution lists all possible outcomes of a random variable along with their associated
probabilities.
Consider a probability distribution for the roll of a dice. It has six possible outcomes: 1, 2, 3,
4, 5 and 6 and each has a probability of 1/6.
Discrete random variable is one for which the number of possible outcomes can be
counted. It has measurable probabilities associated with each specific outcome.
The probability of each possible outcome is expressed in the form of a probability function

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Quantitative Methods 2019 Level I High Yield Notes

P(X=x) or p(x). This is the probability that the random variable X takes on the value x.
The number of days it rains in a month is a discrete random variable. The probability that it
rains for 10 days can be expressed in the form of a probability function as P(X = 10) or
p(10).
Continuous random variable is one for which we cannot count the number of possible
outcomes. Therefore, probabilities cannot be associated with specific outcomes; instead, it
has to be assigned to a particular range. The probability that a specific outcome lies within
a range are expressed as a probability density function f(x).
The returns of a stock for a particular year is a continuous random variable. The probability
that the return is between 10% and 20% can be expressed as f(x) = P(10 <X < 20).

Set of possible outcomes of a specified discrete random variable

The set of possible outcomes of a discrete random variable is finite.
• p(x) = 0 means that x cannot occur.
• p(x) > 0 means that x can occur.
• p(x) = 1 means that x is the only possible outcome.

Cumulative distribution function

The cumulative distribution function gives the probability that the random variable will be
less than or equal to a specific value. It is denoted by F(x) = P(X ≤ x)
If you consider a roll of a dice, F(3) = probability of getting (1 or 2 or 3)
F(5) = probability of getting (1 or 2 or 3 or 4 or 5)
If we are given the cumulative distribution function for a random variable, we can use it to
calculate the probability of an event. Let’s understand this with the following example.
The probability function and the cumulative distribution function for a dice roll is given
below. Calculate P(2 ≤ X ≤ 5).
Probability Function Cumulative Distribution Function F(x) =
X=x
p(x) = P(X = x) P(X ≤ x)
1 1/6 1/6
2 1/6 2/6
3 1/6 3/6
4 1/6 4/6
5 1/6 5/6
6 1/6 6/6
Solution:
Using cumulative distribution function:

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P(2 ≤ X ≤ 5) = F(5) – F(1) = 5/6 – 1/6 = 0.667

Using probability function:
P(2 ≤ X ≤ 5) = p(2) +p(3) + p(4) + p(5) = 1/6 + 1/6 + 1/6 + 1/6 = 0.667
As you can see we get the same results for both methods.

Discrete uniform random variable, Bernoulli random variable & binomial random
variable
Discrete uniform random variable is one where the probability of all the possible
outcomes is equal. For example, the roll of a dice.
Bernoulli trial is an experiment that has only two possible outcomes: a success or a
failure. For example, the toss of a coin.
If a Bernoulli trial is carried out n times, the number of successes (denoted by X) is called a
binomial random variable.
The distribution that X follows is known as the binomial distribution.
If we toss a coin 10 times, the number of times we get a ‘head’ is a binomial random
variable. If we repeat this experiment several times, the number of times we get a head will
keep changing. If we plot this number on a graph, the distribution we get is a binomial
distribution.
The expected value and the variance for a binomial variable are given by:
Expected value = np
Variance = np(1 - p)

On any given day the probability of a market up move is 0.7. What is the expected number
of up moves in the market in the next 10 days? What is the variance?
Solution:
Expected value = 0.7 x 10 = 7 up moves
Variance = 10 x 0.7(1 - 0.7) = 2.1

Probabilities for discrete uniform and the binomial distribution functions

Probabilities for a discrete uniform distribution
If the total number of outcomes is n, then the probability of each outcome = 1/n
A card is drawn randomly from a deck. What is the probability of getting an ace of spades?
Solution:
Total number of outcomes = 52
Probability of each outcome = 1/52
Probabilities for a binomial distribution
The probability distribution of a binomial random variable for the probability of x
successes in n trials is calculated using the following formula:

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Quantitative Methods 2019 Level I High Yield Notes

P(x) = P(X = x) = nCx px (1 - p)n – x

On any given day the probability of a market up move is 0.7. What is the probability that
the market will move up on 6 out of the next 10 days?
Solution:
P(6) = P(X = 6) = 10C6 0.76 0.34 = 0.2

Binomial tree
A binomial tree can be used to model stock price movements. Refer to the tree diagram
below. ‘S’ represents the initial stock price. ‘u’ represents an up move and ‘d’ represents a
down move. The nodes show each possible value of the stock after 1, 2 and 3 time periods.

Consider an initial stock price of $100. In one time period, the stock can either rise by a
factor of 1.1 or go down by a factor of 1/1.1. In any given time period, the probability of an
up move is 0.6 and the probability of a down move is 0.4. After two periods, what are the
possible stock prices and their respective probabilities? What is the expected stock price?
Solution:
uuS = 1.1 x 1.1 x 100 = 121 with probability 0.6 x 0.6 = 0.36
udS = 1.1 x 1/1.1 x 100 = 100 with probability 0.6 x 0.4 = 0.24
duS = 1/1.1 x 1.1 x 100 = 100 with probability 0.4 x 0.6 = 0.24
ddS = 1/1.1 x 1/1.1 x 100 = 82.64 with probability 0.4 x 0.4 = 0.16
Expected stock price = 121 x 0.36 + 100 x 0.24 + 100 x 0.24 + 82.64 x 0.16 = $104.78

Continuous uniform distribution

The continuous uniform distribution is defined over a range from a lower limit a to an
upper limit b. These limits serve as the parameters of the distribution.

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Quantitative Methods 2019 Level I High Yield Notes

The probability of the random variable taking any set of values outside the parameters a
and b is 0. The probability that the random variable will take a value between x1 and x2,
where x1 and x2 both lie within the range is given by:
x2 −x1
P(x1 ≤ X ≤ x2 ) = b−a

X is a uniformly distributed continuous random variable between 10 and 20. Calculate the
probability that X will fall between 12 and 18.
Solution:
18−12
P(12 ≤ X ≤ 18) = = 0.6
20−10

The cumulative distribution function for a continuous random variable is shown below:

Normal distribution

• As shown in the above figure, a normal distribution is a bell-shaped curve, with two

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Quantitative Methods 2019 Level I High Yield Notes

identical halves.
• It is completely described by two parameters its mean (µ) and its variance (σ2). This is
stated as X ~ N (µ, σ 2).
• It has a skewness of 0 and a kurtosis of 3.
• A linear combination of two or more random variables is also normally distributed.

Univariate v/s multivariate distribution

Univariate distribution describes the probability distribution of a single random variable.
For example, the distribution of expected return of one stock from a portfolio.
Multivariate distribution describes the probability distribution for a group of related
random variables. For example, the distribution of expected return of a portfolio with
multiple stocks. A multivariate normal distribution for the returns on n stocks is
completely defined by following three sets of parameters:
• Mean returns on the individual stocks (n means in total).
• Variances of the individual stocks (n variances in total).
• Pairwise return correlations between the stocks (n (n - 1)/2 distinct correlations in
total)

Confidence intervals for the population mean

A confidence interval represents a range within which we have a given level of confidence
of finding the actual outcome of a random variable. A 90% confidence interval between 10
and 20 means that we can be 90% confident that the random variable will lie between 10
and 20. The confidence intervals for a normal distribution are:
• 90% of all observations are in the interval x ± 1.65s
• 95% of all observations are in the interval x ± 1.96s
• 99% of all observations are in the interval x ± 2.58s
The average annual return of a stock is 10% and the standard deviation is 2%. Assuming
normal distribution, calculate the 95% confidence interval for the stock return for the next
year.
Solution:
The 95% confidence interval is 10 ± 1.96 (2) = 6.08% to 13.92%

Standard normal distribution

The normal distribution with mean (µ) = 0 and standard deviation (σ) = 1 is called the
standard normal distribution. The formula for standardizing a random variable X is:
(X− µ)
Z=
σ

The Z-table is used to find the probability that X will be less than or equal to a given value.
A stock has a mean return of 10% and a standard deviation of return of 2%. What is the

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Quantitative Methods 2019 Level I High Yield Notes

probability that the return will be less than 11%?

Solution:
(11− 10)
Z= = 0.5
2
F(0.5) = P(Z < 0.5) = P(X < 11) = 0.6915 (from the Z table)

Safety first ratio

Shortfall risk is the risk that portfolio’s return will fall below a specified minimum level of
return over a given period of time.
Safety first ratio is used to measure shortfall risk. It is calculated as:
E(RP )−RT
SFratio = σP

A portfolio with higher safety first ratio is preferred over a portfolio with a lower safety
first ratio.
An investor is considering two portfolios A and B. Portfolio A has an expected return of
10% and a standard deviation of 2%. Portfolio B has an expected return of 15% and a
standard deviation of 10%. The minimum acceptable return for the investor is 8%.
According to Roy’s safety first criteria, which portfolio should the investor select?
Solution:
10−8
SFA = =1
2
15−8
SFB = = 0.7
10
Since A has a higher safety first ratio, the investor should select portfolio A.
Roy’s safety first criteria states that an optimal portfolio minimizes the probability that
the actual portfolio return will fall below the target return.

Lognormal distributions
If x is a random variable that is normally distributed, then to create a lognormal
distribution of x we take ex and plot the values on a graph. The properties of a lognormal
distribution are:
• It cannot be negative.
• The upper end of its range extends to infinity.
• It is positively skewed.
A lognormal distribution is often used to model asset prices because the asset prices need
to be positive, they cannot be negative.

Discretely v/s continuously compounded rates of return

Discretely compounded rates of returns have defined compounding periods such as
quarterly, monthly etc. As we decrease the length of the compounding period, the effective

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Quantitative Methods 2019 Level I High Yield Notes

annual rate rises. For continuous compounding, the EAR is given by:
EAR = er - 1
If we are given the holding period return over any time period, we can calculate the
equivalent continuously compounded rate of return for that period as:
r = ln (HPR + 1)

If the holding period return of a stock was 10% for a period of one year. What is the
equivalent continuously compounded rate of return for the year?
Solution:
r = ln (0.1 + 1) = 0.0953 = 9.53%
Key strokes for calculating ln(1.1) are
1.1 [ln]

Monte Carlo simulation

Monte Carlo simulation is a computer simulation used to simulate possible security prices
based on risk factors. As input, it uses randomly generated values for risk factors based on
their assumed distributions. It processes this information as per the specified model and
runs thousands of iterations. It gives the distribution of the expected value of the security
as output.
Major applications include:
• financial planning.
• developing VAR estimates.
• valuing complex securities.
Limitations include:
• It is fairly complex and will provide answers that are no better than the
assumptions.
• Simulation is not an analytical method but a statistical one.

Monte Carlo simulation v/s historical simulation

The historical simulation uses actual past distribution of risk factors as input. Whereas,
Monte Carlo simulation uses randomly generated values of the risk factors based on
assumed distribution.
The limitations of historical simulation are:
• It cannot take into account the effect of significant events that did not occur during
the sample period.
• It cannot perform a ‘what if’ analysis when the ‘if’ scenario has not happened in the
past.

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Quantitative Methods 2019 Level I High Yield Notes

R11 Sampling and Estimation

Simple random sampling & sampling distribution
Simple random sampling is the process of selecting a sample from a larger population in
such a way that each element of the population has the same probability of being included
in the sample.
Sampling distribution: If we draw samples of the same size several times and calculate
the sample statistic. The sample statistic will be different each time. The distribution of
values of the sample statistic is called a sampling distribution.

Sampling error
Sampling error is the difference between a sample statistic and the corresponding
population parameter. The sampling error of the mean is given by:
Sampling error of the mean = x̅ − μ

You want to calculate the average returns of 10,000 stocks. You draw a sample of 100
stocks and calculate the average return of these 100 stocks as 15%. However, the actual
average of the 10,000 stocks was 12%. Then the sampling error = 15% - 12% = 3%.

Simple random v/s stratified random sampling

Simple random sampling: As discussed earlier, simple random sampling is the process of
selecting a sample from a larger population in such a way that each element of the
population has the same probability of being included in the sample.
Stratified random sampling: Whereas, in stratified random sampling, the population is
divided into sub groups based on one or more distinguishing characteristics. Samples are
then drawn from each sub group, with sample size proportional to the size of the sub group
relative to the population. Finally, samples from each sub group are pooled together to
form a stratified random sample. The advantage of stratified random sampling is that the
sample will have the same distribution of key characteristics as the overall population. This
can reduce the sampling error.
You divide the universe of 10,000 stocks as per their market capitalization such that you
have 5,000 large cap stocks, 3,000 mid cap stocks, and 2,000 small cap stocks. In stratified
random sampling, to select a total sample of 100 stocks, you will randomly select 50 large
cap stocks, 30 mid cap stocks, and 20 small cap stocks.

Time-series & cross-sectional data

Time series data consists of observations for a single subject taken at specific and equally
spaced intervals of time.
The quarterly EPS of a particular stock from the S&P 500 for the last 10 years.

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Cross-sectional data consists of observations for multiple subjects taken at a specific

point in time.
Last quarter’s EPS of all stocks from the S&P 500.

Central limit theorem

According to the central limit theorem, if we draw a sample from a population with a mean
µ and a variance σ2, then the sampling distribution of the sample mean:
• will be normally distributed (irrespective of the type of distribution of the original
population).
• will have a mean of µ.
• will have a variance of σ2/n.
Suppose the average return of the universe of 10,000 stocks is 12% and its standard
deviation is 10%. Through central limit theorem, we can conclude that if we keep drawing
samples of 100 stocks and plot their average returns, we will get a sampling distribution
that will be normally distributed with mean = 12% and variance of 102/100 = 1%.

Standard error of the sample mean

The standard deviation of the distribution of the sample means is known as the standard
error of the sample mean.
When we know the population standard deviation, the standard error of the sample mean
can be calculated as:
σ
σX̅ = n
√

When we do not know the population standard deviation (σ) we can use the sample
standard deviation (s) to estimate the standard error of the sample mean:
s
sX̅ = n
√

The average returns of all large cap stocks in an economy is 10% with a standard deviation
of 6%. For a random sample of 100 stocks calculate the standard error.
Solution:
σ 6
σX̅ = = = 0.6
√n √100

Desirable properties of an estimator

The three desirable properties of an estimator are:
• Unbiasedness: expected value is equal to the parameter being estimated.
• Efficiency: has the lowest variance as compared to other unbiased estimators of the
same parameter.
• Consistency: as sample size increases, the sampling error decreases and the

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Quantitative Methods 2019 Level I High Yield Notes

estimates get closer to the actual value.

Point estimate v/s confidence interval estimate of a population parameter

Point estimate is a single value estimate that serves as an approximation for the actual
value of the parameter.
Confidence interval is a range of values, within which the actual value of the parameter
will lie with a given probability. Confidence interval is calculated as:
Confidence interval = point estimate ± (reliability factor x standard error of point estimate)
The reliability factor depends on the assumed distribution of the point estimate and the
level of confidence of the interval (1 – α).

Student’s t-distribution
Student’s t-distribution has the following properties:
• It is symmetrical, bell-shaped and similar to a normal distribution.
• It has a lower peak and fatter tails as compared to a normal distribution.
• It is defined by a single parameter, degrees of freedom (df).
Degrees of freedom = n - 1

If you are given a sample size of 25, the degrees of freedom would be 25 – 1 = 24.
• As the degrees of freedom increase, the shape of the t-distribution starts
approaching the shape of the normal distribution.

Calculating confidence intervals

To calculate a confidence interval for a population mean, follow these steps:
Refer to the table below and select t statistic or z statistic as per the scenario.
Sampling from Small Large
sample size sample size
Normal distribution Variance known z z

Variance unknown t t (or z)

Non–normal distribution Variance known NA z
Variance unknown NA t (or z)

Use the following formulae to calculate the confidence interval:

σ
Confidence interval = ̅
X ± zα/2 n
√
s
̅ ± t α/2
Confidence interval = X
√n

For a Z distribution,

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90% confidence → critical value = 1.65

95% confidence → critical value = 1.96
99% confidence → critical value = 2.58
You take a random sample of 100 large cap stocks. The average returns of these stocks for
the past year is 12%. Assume that the average returns for all large-cap stocks in the
economy follow a normal distribution with a standard deviation of 3%. Construct a 99%
confidence interval for the average return all large-cap stocks for the past year.
Solution:
Since the population variance is known (the standard deviation of all large cap stocks), we
will use Z statistic.
For confidence level of 99%, 1% error in both tails i.e. 0.5% (0.005) in one tail. Zα/2 = Z0.005
= 2.58 (From Z-table)
The confidence interval can be calculated as
3
Confidence interval = 12 ± 2.58 = 11.226 to 12.774
√100

You construct a sample of monthly returns of Stock A for the past two years. The stock has
a mean return of 2% and a standard deviation of 8%. Compute the 95% confidence interval
for the average monthly returns for this stock.
Solution:
Since the population variance is unknown (the variance of monthly returns of Stock A over
its entire history, we only have data for the past two years) we will use t statistic.
Degrees of freedom = 24 – 1 = 23 (two years = 24 months)
For confidence level of 95%, 5% error in both tails, i.e. 2.5%(0.025) in one tail tα/2 = t24, 0.025
= 2.069
The confidence interval can be calculated as:
8
Confidence interval = 2 ± 2.069 = −1.38% to 5.38%
√24

Selection of sample size & sampling biases

Increasing the sample size reduces the standard error and gives us narrower confidence
intervals. However, while increasing sample size we must consider two things:
• Cost involved: Compare the cost of getting more data to the potential benefits of
increasing precision.
• Risk of sampling from a different population: In the process of increasing sample
size if we get data from a different population, then the accuracy will not improve.
Biases observed in sampling methods are:
• Data-mining bias: Analyzing the same data repeatedly, till a pattern is identified.
To avoid this bias test the pattern on out of sample data.
• Sample selection bias: Excluding certain assets from the analysis due to

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unavailability of data. A type of sample selection bias is the survivorship bias, in

which companies are excluded from analysis because they have gone out of
business.
• Look-ahead bias: Analyzing past data using information that became available
now.
• Time-period bias: If the selected time period is too short, the results may not be
useful. If the time period is too long, then the results may not consider major
structural changes in the economy.

R12 Hypothesis Testing

Steps of hypothesis testing
Hypothesis is a statement about the value of a population parameter developed for the
purpose of testing a theory.
Hypothesis testing is the process of assessing the accuracy of a statement about a
population on the basis of analysis conducted on a sample. In order to test a hypothesis, we
follow the following steps:
1. State the hypothesis.
2. Identify the appropriate test statistic.
3. Specify the level of significance.
4. State a decision rule to accept or reject the hypothesis.
5. Collect sample data and calculate the test statistic.
6. Decide if the hypothesis can be accepted/rejected.
7. Make an economic or investment decision.
Null hypothesis (H0) is the hypothesis that the researcher wants to reject. It should always
include the ‘equal to’ condition.
Alternative hypothesis (Ha) is the hypothesis that the researcher wants to prove. If the
null hypothesis is rejected, then the alternative hypothesis is considered valid.
If you want to test if the average returns of all stocks in the S&P 500 are greater than 10%.
H0: µ ≤ 10% and Ha: µ > 10%
If you want to test if the average returns of all stocks in the S&P 500 are less than 10%.
H0: µ ≥ 10% and Ha: µ < 10%
If you want to test if the average returns of all stocks in the S&P 500 are not equal to 10%.
H0: µ = 10% and Ha: µ ≠ 10%

One-tailed v/s two-tailed tests

Hypothesis tests can be one-tailed or two-tailed.
In one-tailed tests, we are assessing if the value of a population parameter is greater than

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Quantitative Methods 2019 Level I High Yield Notes

or less than a hypothesized value.

You are testing if the average returns of all stocks in the S&P 500 are greater than 10%.
Assume a 95% confidence level.
H0: µ ≤ 10% and Ha: µ > 10%
We will reject the null hypothesis only if the test statistic (explained later) is in the right tail
(shaded portion). Hence, it is a one-tailed test.

In two-tailed tests, we are assessing if the value of a population parameter is different

from a hypothesized value.
You are testing if the average returns of all stocks in the S&P 500 are not equal to 10%.
Assume a 95% confidence level
H0: µ = 10% and Ha: µ ≠ 10%
We will reject the null hypothesis if the test statistic is either in the right tail or the left tail
(shaded portions). Hence, this is a two-tailed test.

Test statistic, type I and type II errors & significance level

Test statistic is calculated from sample data and is compared to a critical value to decide
whether or not we can reject the null hypothesis. Which test statistic to use depends on the

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Quantitative Methods 2019 Level I High Yield Notes

properties of the population and the sample size. The two commonly used test statistics
are:
̅ −μ0
X
z − statistic = σ
√n
̅ −μ0
X
t − statistic = s/√n

Critical values come from z and t tables and are based on the level of confidence that the
researcher wants to use. If the test statistic is outside the range of the critical value, then
we can reject the null hypothesis.
In reaching a statistical decision, we can make two possible errors:
• Type I error: We may reject a true null hypothesis.
• Type II error: We fail to reject a false null hypothesis.

True condition
Decision
H0 true H0 false
Do not reject H0 Correct decision Type II error
Reject H0 (accept Ha) Type I error Correct decision
Level of significance (α) of a test is the probability of making a Type I error i.e. rejecting a
null when it is true.
Level of significance (α) = (1 – level of confidence)
Level of significance (α) = P (Type I error)
For example, if the level of confidence is 95%, then α = 5%. As α gets smaller, the critical
value gets larger and it becomes more difficult to reject the null hypothesis.

Decision rule, power of a test, & relation between confidence intervals and
hypothesis tests
Decision rule consists of comparing the computed test statistic to the critical values
(rejection points) based on the level of significance to decide whether to reject or not to
reject the null hypothesis.
Power of a test
Power of a test = 1 – P (Type II error)
A test that is more likely to reject a false null, is considered powerful. Similarly, a test that is
less likely to reject a false null is considered weak.
Relation between confidence interval and hypothesis tests
A confidence interval gives us the range of values within which a population parameter is
expected to lie. Confidence intervals and hypothesis tests are linked through critical values.
The null hypothesis will be rejected only if the test statistic lies outside the confidence

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Quantitative Methods 2019 Level I High Yield Notes

interval.
In the diagram below, the white portion is the confidence interval, within which the
population mean is expected to lie, we will reject H0 only if it lies outside the confidence
interval.

Statistical result v/s economically meaningful result

The statistical decision consists of rejecting or not rejecting the null hypothesis. The
economic decision takes into consideration all economic issues relevant to the decisions
such as transaction costs, risk tolerance and the impact on the existing portfolio.
Sometimes a test may indicate a statistically significant result which may not be
economically significant.

p-value
The p-value is the smallest level of significance at which the null hypothesis can be rejected.
It can be used in the hypothesis testing framework as an alternative to using rejection
points.
• If the p-value is lower than our specified level of significance, we reject the null
hypothesis.
• If the p-value is greater than our specified level of significance, we do not reject the
null hypothesis.
If the p-value of a test is 4% then the hypothesis can be rejected at the 5% level of
significance, but not at the 1% level of significance.

Hypothesis tests concerning a single mean

We use the following table to decide which test statistic and which corresponding
probability distribution to use for hypothesis testing.

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Sampling from Small Large

sample size sample size
Normal distribution Variance known z z

Variance unknown t t (or z)

Non–normal distribution Variance known NA z
Variance unknown NA t (or z)

You believe that the average returns of all stocks in the S&P 500 is greater than 10%. You
draw a sample of 49 stocks. The average return of these 49 stocks is 12%. The standard
deviation of returns of all stocks in the S&P 500 is 4%. Using a 5% level of significance,
determine if your belief is correct.
Solution:
Step 1: State the hypothesis
H0: µ ≤ 10%
Ha: µ > 10%
Step 2: Calculate the test statistic
The population variance is known hence we will use z-statistic.
̅ −μ0
X 12−10
z − statistic = σ = 4 = 3.5
√n √49
Step 3: Calculate the critical value
This is a one-tailed test and we will be looking at the right tail. Using the Z –table and 5%
level of significance
Critical value = Z0.05 = 1.65
Step 4: Decision
Since the test statistic (3.5) > critical value (1.65), we reject H0. Hence at 5% level of
significance, your belief that the average returns of all stocks in the S&P 500 is greater than
10% is correct.

You believe that the average returns of all stocks in the S&P 500 is greater than 10%. You
draw a sample of 25 stocks. The average return of these 25 stocks is 12% and the standard
deviation of their returns is 7%. Using a 5% level of significance, determine if your belief is
correct.
Solution:
Step 1: State the hypothesis
H0: µ ≤ 10%
Ha: µ > 10%
Step 2: Calculate the test statistic

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Quantitative Methods 2019 Level I High Yield Notes

The population variance is not known hence we will use t-statistic.

̅ −μ0
X 12−10
t − statistic = s = 7 = 1.43
√n √25
Step 3: Calculate the critical value
This is a one-tailed test and we will be looking at the right tail. Using the t –table and 5%
level of significance and degrees of freedom = 25 -1 = 24
Critical value = t24,0.05= 1.71
Step 4: Decision
Since the test statistic (1.43) < critical value (1.71), we cannot reject H0. Hence at 5% level
of significance, your belief that the average returns of all stocks in the S&P 500 is greater
than 10% is incorrect.

Hypothesis tests concerning differences between means

(Note: This section has high difficulty and low probability of being tested. Do this section
once you have mastered all remaining topics)
Unknown but equal variance
When we can assume that the two populations are normally distributed and that the
unknown population variances are equal, the t-test based on independent random samples
is given by:
̅1− X
(X ̅ 2 )−(μ1 −μ2 )
t= s2 s2
p p
( + )1/2
n1 n2

The term 𝑠𝑝2 is known as the pooled estimator of the common variance. It is calculated by
the following formula:
(n1 − 1)s21 +((n2 − 1)s22
sp2 = n1 + n2 −2
The number of degrees of freedom is n1 + n2 – 2.
Unknown and unequal variance
When we can assume that the two populations are normally distributed and that the
unknown population variances are unequal, an approximate t-test based on independent
random samples is given by:
̅1− X
(X ̅ 2 )−(μ1 −μ2 )
t= s 2s 2
( 1 + 2 )1/2
n1 n2

In this formula, we use the tables of the t-distribution using the ‘modified’ degrees of
freedom. The ‘modified’ degrees of freedom are calculated using the following formula:
s 2s 2
( 1 + 2 )2
n1 n2
df = (s2 2 2 2
1 /n1 ) + (s2 /n2 )
n1 n2

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Quantitative Methods 2019 Level I High Yield Notes

Hypothesis tests concerning mean differences

(Note: This section has high difficulty and low probability of being tested. Do this section
once you have mastered all remaining topics)
If the samples of the populations whose means we are comparing are dependent, then the
paired comparison test is used. The hypothesis is structured as the difference between
means of two populations.
H0: µd = µd0
Ha: µd ≠ µd0
where:
µd stands for the population mean difference and
µd0 stands for the hypothesized value for the population mean difference, which is usually
zero.
In order to arrive at the test statistic, we first determine the sample mean difference using:
1
d̅ = ∑ni=0 di
n
The standard error of the mean difference as follows:
s
sd̅ = dn
√
Once we have these two values, we can calculate the test statistic using a t-test. This is
calculated using the following formula using n - 1 degrees of freedom:
̅−μd0
d
t= sd
̅

The value of calculated test statistic is compared with the t-distribution values in the usual
manner to arrive at a decision on our hypothesis.

Hypothesis tests concerning variance

(Note: This section has high difficulty and low probability of being tested. Do this section
once you have mastered all remaining topics)
Single population variance
In tests concerning the variance of a single normally distributed population, we use the chi-
square test statistic, denoted by χ2.
After drawing a random sample from a normally distributed population, we calculate the
test statistic using the following formula with n - 1 degrees of freedom:
(n−1)(s2 )
χ2 = σ20
where:
n = sample size
s = sample variance
We then determine the critical values using the level of significance and degrees of

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freedom. The chi-square distribution table is used to calculate the critical value.
Two population variance
In order to test the equality or inequality of two variances, we use an F-test which is the
ratio of sample variances.
The formula for the test statistic of the F-test is:
s21
F= s22
where:
𝑠12 = the sample variance of the first population with n observations
𝑠22 = the sample variance of the second population with n observations
A convention is to put the larger sample variance in the numerator and the smaller sample
variance in the denominator.
df1 = n1 – 1 numerator degrees of freedom
df2 = n2 – 1 denominator degrees of freedom
The test statistic is then compared with the critical values found using the two degrees of
freedom and the F-tables.
Finally, a decision is made whether to reject or not to reject the null hypothesis.

Types of Test Statistics

Hypothesis test of Use
One population mean t-statistic or z-statistic
Two population mean t-statistic
One population variance Chi-square statistic
Two-population variance F-statistic

Parametric v/s nonparametric tests

Parametric tests like a t-test, F-test or chi-square test are based on specific assumptions
about the distribution of the population from which samples are drawn.
Nonparametric tests are either not concerned with a parameter or make minimal
assumptions about the population from which the sample comes. A nonparametric test is
primarily used in three situations:
• when data does not meet distributional assumptions.
• when data is given in ranks.
• when we are concerned about quantities other than the parameters of the
distribution.

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R13 Technical Analysis

Principles & assumptions of technical analysis
Technical analysis is a form of security analysis that involves examination of past price and
volume data to predict future behavior of the market or individual security.
Assumptions:
• Market prices are determined by supply and demand.
• Market prices reflect both rational and irrational investor behavior.
• Investor behavior is reflected in trends and patterns that tend to repeat.
• Price and volume information can be used to understand investor sentiment and
make investment decisions.
Technical analysis can also be used on assets such as commodities, currencies and futures
that do not have underlying income streams or financial statements.

Charts
Line charts
• Graphic display of prices over time.
• Only one data point per time interval – the closing price.
• Price is plotted on the Y-axis and time on the X-axis.
• The closing prices for each trading period are connected by a line.
Bar charts
• Four data points per time interval – opening price, highest and lowest price, and
closing price.
• Price is plotted on the Y-axis and time on the X-axis
• They give a better sense of the trend in the market.
• A short bar indicates low volatility, a long bar indicates high volatility

Candlestick charts
• Has the same four data points per time interval as a bar chart– opening price,
highest and lowest price, and closing price.
• Price is plotted on the Y-axis and time on the X-axis

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Quantitative Methods 2019 Level I High Yield Notes

• If the market closed up, the body of the candle is clear.

• If the market closed down, the body of the candle is shaded.

Volume charts
• Often displayed below a line, bar or candlestick chart.
• Number of units of the security traded is plotted on the Y-axis and time on the X-
axis.
Point and figure charts
• Drawn as a grid consisting of columns of X’s alternating with columns of O’s. X
represents an increase in price while an O represents a decrease in price.
• Y-axis measures box size increments in price whereas X-axis measures the number
of price changes.
• To construct this chart, you need to specify a box size and a reversal size.

Trends
Uptrend: A security is said to be in an uptrend if prices are reaching higher highs and

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Quantitative Methods 2019 Level I High Yield Notes

higher lows. An upward trendline can be drawn by connecting the increasing low points
with a straight line.
Downtrend: A security is said to be in a downtrend if prices are reaching lower highs and
lower lows. A downward trendline can be drawn by connecting the decreasing high points
with a straight line.
Support is the price level at which there is sufficient buying pressure to stop further
decline in prices.
Resistance is the price level at which there is sufficient selling pressure to stop the further
increase in prices.
Change in polarity: Once a support level is breached, it often becomes a new resistance
level. Similarly, once a resistance level is breached; it often becomes a new support level.

Common chart patterns

Reversal Patterns signal the end of a trend. The four kinds of reversal patterns are:
Head and shoulders pattern:
• Consists of the left shoulder, the head, and the right shoulder.
• Indicates the end of an uptrend.
• You can profit by going short on the security, the price target is:
Price target = neckline – (head – neckline)
Inverse head and shoulders pattern:
• Is a mirror image of the head and shoulders pattern.
• Indicates the end of a downtrend.
• You can profit by going long on the security, the price target is:
Price target = neckline + (head – neckline)
Double tops and bottoms:
• A double top is formed when prices hit the same resistance level twice and fall

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Quantitative Methods 2019 Level I High Yield Notes

down. It indicates the end of an uptrend.

• A double bottom is formed when prices bounce back from the same support level
twice. It indicates the end of a down-trend.
Triple tops and bottoms:
• Triple tops are formed when prices hit the same resistance level thrice.
• Triple bottoms are formed when prices bounce back from the same support level
thrice.
Continuation patterns signal a temporary pause in the trend, and that the trend will
continue in the same direction as before. The four kinds of continuation patterns are:
Triangles:
• There are three forms - symmetrical triangles, ascending triangles and descending
triangles.
• One trendline connects the highs and a second trendline connects the lows.
• As the distance between the highs and lows narrows, the trendlines converge,
forming a triangle.
Rectangles:
• One trendline connects the highs and a second trendline connects the lows.
• As the distance between the highs and lows is constant, the trendlines are parallel to
each other and form a rectangle.
Flags:
• Is similar to a rectangle and is formed by two parallel trendlines.
• However, it forms over a much shorter time interval.
Pennants:
• Is similar to a triangle and is formed by two converging trend lines.
• However, it forms over a much shorter time interval.

Technical indicators
Price-based indicators incorporate information contained in the current and past market
prices. The common types are:
Moving average:
• Average of the closing prices over a specified number of periods.
• Used to smooth out short-term price fluctuations and helps identify the trend.
Bollinger bands:
• They are drawn at a given number of standard deviations above and below a moving
average.
• Price are expected to reverse when they touch the upper/lower band.

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Momentum oscillators help to identify changes in the market sentiment. The common
types are:
Rate of change (ROC) oscillator:
• Oscillates around 0 (or around 100 if an alternative formula is used for calculation)
• When the ROC oscillator crosses zero into the positive territory, it is considered
bullish.
• When the ROC oscillator crosses zero into the negative territory, it is considered
bearish.
Relative strength index (RSI):
• RSI graphically compares a security’s gains with its losses over a given period. The
popular time period is 14 days.
• The value of the RSI is always between 0 and 100. A value above 70 represents an
overbought situation while a value below 30 suggests that an asset is oversold.
Stochastic oscillator:
• Based on the observation that in uptrends, prices tend to close at or near the high
end of their recent range. Similarly in downtrends, they tend to close near the low
end.
• Composed of two lines, called %K and %D.
• Has a default setting of 14-days.
• Oscillates between 0 and 100. A value above 80 indicates overbought situation and
value below 20 indicates oversold situation.
Moving-average convergence/divergence oscillator:
• Difference between a short-term and a long-term moving average of the security’s
price.
• Composed of two lines - MACD line and signal line.
• Oscillates around 0 and has no upper or lower limit.
Sentiment indicators gauge investor activity for signs of bullishness or bearishness. The
common types are:
Opinion polls:
• Regular polls are conducted of investors and investment professionals to gauge the
overall market sentiment.
Calculated statistical indices:
• The put/call ratio is the volume of put options traded divided by the volume of call
options traded. A high ratio indicates that the market is bearish. Whereas, a low
ratio indicates that the market is bullish.
• The CBOE volatility index (VIX) is a measure of near-term market volatility
calculated from option prices of S&P 500 stocks. The VIX rises when market

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participants become fearful of a market decline.

• Margin debt is loans taken by individual investors to fund their stock purchases.
When stock margin debt is increasing, investors are aggressively buying and the
stock prices will rise because of increased demand.
• Short interest refers to the number of shares of a particular security that are
currently sold short. The short interest ratio is calculated as:
Short interest
Short interest ratio = Average daily trading volume

A high ratio suggests an overall negative outlook on the security.

Flow-of-funds indicators indicate the change in potential demand and supply. The
common types are:
The arms index :(also known as TRIN)
• Calculated as:
number of advancing issues ÷ number of declining issues
Arms index = volume of advancing issues ÷ volume of declining issues

• When this index is near 1, the market is in balance. A value above 1 means that there
is more volume in declining stocks and that the market is in a selling mood. A value
below 1 means that there is more volume in increasing stocks and that the market is
in a buying mood.
Margin debt:
• Margin loans may increase the purchases of stocks and declining margin balances
may force the selling of stocks.
Mutual funds cash position:
• Mutual funds must hold some of their assets in cash to pay for miscellaneous
expenses and to fund redemptions.
• During a bullish market, the cash positions tend to be low.
• During a bearish market, the cash positions tend to be high.
New equity issuance:
• IPOs are often timed with bullish markets to get the best valuations.
• A large number of IPOs may indicate that a market is near its peak.
Secondary offerings:
• Like IPOs, technicians also monitor secondary offerings to gauge potential changes
in the supply of equities.

Cycles
Kondratieff wave (K-wave):
• States that western economies have a 54-year old cycle.

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18-year cycle:
• Three 18-year cycles make up the longer 54-year Kondratieff Wave.
• This cycle is often mentioned in real estate markets, but it can also be found in
equities and other markets.
Decennial pattern:
• This pattern links average stock market returns with the last digit of the year.
• Years ending in 0 have shown poor performance whereas years ending in 5 have
shown good performance.
Presidential cycle:
• This cycle connects the performance of the U.S. market with the U.S. presidential
elections.
• Historically, the third year following an election has shown the best performance.

Elliott wave theory

• According to this theory, the market moves in regular waves or cycles.
• In a bull market, the market moves up in five waves in the following pattern: 1 = up,
2 = down, 3 = up, 4 = down and 5 = up.
• Each wave can be broken into smaller waves over a shorter time period.
• Market waves follow patterns that are ratios of the numbers in the Fibonacci
sequence. Hence, ratios of the numbers in the Fibonacci sequence can be used to set
price targets while trading.
The Fibonacci Sequence is the series of numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, ... The
next number is found by adding up the two numbers before it.

Intermarket analysis
• Inter-market analysis is based on the principle that different markets such as stocks,
bonds, commodities, currencies etc. are interrelated and influence each other.
• Technicians often use relative strength analysis to look for the inflection point in
one market as a warning sign to start looking for a change in another related
market.
• The relative strength analysis can also be used to identify attractive asset classes
and attractive sectors within these classes to invest in.

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