QUANTS: RATES AND RETURNS

Interest Rates and Time Value of Money

Determinants of Interest Rates
Rates of Return
Holding Period Return
Arithmetic or Mean Return
Geometric Mean Return
The Harmonic Mean
Money-Weighted and Time-Weighted Return
Calculating the Money Weighted Return
Annualized Return
Non-annual Compounding
Annualizing Returns
Continuously Compounded Returns
Other Major Return Measures and Their Applications
Gross and Net Return
Pre-Tax and After-Tax Nominal Return
Real Returns
Leveraged Return
Comment: In this module, we just know some concepts of interest rate and how to identify it
in the problem. Know how to compute returns and meaning of some returns and master the
compounding rule.
LOS 1: Explain the time value of money. Interest rate (or yield) is the rate of return that
reflects the relationship between different dated timed cash flow.
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
- Interpret interest rates
1. Required rate of return or minimum rate of return: Investors when they put money
into something they require a rate of return of that investment/project in term of
interest rate
 2. discount rate: To compare Future value to present value. 1000 in on year equivalent
to 950 today or 50/950 discount rate
3. opportunity cost: Represent you have to earn how much when you delay spending
the money or what you have to pay in order to have the money early
Comment: They are 3 different names that you find in CFA. Whenever you find 3
terms like this in the problem you know that the interest rate
- interest rate as the sum of a real risk-free rate and premiums
r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity
premium + Maturity premium
● The real risk-free rate is the single-period return on a risk-free security assuming zero
inflation.
● An inflation premium is added to the real risk-free rate to reflect the expected loss in
purchasing power over the term of a loan.
● default risk premium compensates investors for the risk that the borrower might fail
to make promised payments in full in a timely manner.
● The liquidity premium compensates investors for any difficulty that they might face
in converting their holdings readily into cash at their fair value. For example, the
more liquid investment the less interest rate it requires (for example deposit has less
interest rate than bond because deposit is more liquid)
● The maturity premium compensates investors for the higher sensitivity of the market
values of longer-term debt instruments to changes in interest rates. (1 year deposit
rate is higher than 6-month deposit)
Nominal risk-free rate = real risk-free rate + inflation premium
Comment: Liquidity and default usually come together that means the more liquid
the investment, the less like it is going to default. However, it is not always the case.
For example, in real estate for house in Hoan Kiem district for example, the liquidity is
so low because no one sell the house they just keep the house for renting, but the
likely default of the house (that is, risk with the house for example like there is project
making road cross out the house) is extremely low.
LOS 2: calculate and interpret different approaches to return measurement over time and
describe their appropriate uses (2 sources of return: periodic return vs capital gain or loss)
- Holding Period Return
 (P! − P" ) + I!
HPR =
P"
A holding period return can be computed for a period longer than one year.
HPR = [(1 + R! ) × (1 + R # ) × (1 + R $ )] − 1
- Arithmetic or Mean Return

- Geometric Mean Return

The arithmetic mean return assumes that the amount invested at the beginning of
each
period is the same. A geometric mean return provides a more accurate
representation of the growth in portfolio value over a given time period than the
arithmetic mean return.

In general, the arithmetic return is biased upward unless each of the underlying
holding period returns are equal. The difference between the arithmetic and
geometric means increases with the variability within the sample.
Geometric mean is always less than or equal to the arithmetic mean with 1
exception: Equal when there is no variability in the observations.
- The Harmonic Mean

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. So, the harmonic
mean is quite useful as a measure of central tendency in the presence of outliers.
The harmonic mean is used most often when the data consist of rates and ratios,
such as P/Es.
 A well-known application arises in the investment strategy known as cost averaging,
which involves the periodic investment of a fixed amount of money.
Arithmetic mean * harmonic mean = Geometric mean ^2
- Other means
Both the trimmed and the 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.
For example: If we have 1,2,3,4,20 which results in mean = 6
then trimmed mean will remove 1 and 60 and we have 2,3,4 which results in mean =
3
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.
For example: If we have 1,2,3,4,20 which results in mean = 6
then trimmed mean will remove 1 and 60 and we have 2,3,4 which results in mean =
3
Comment: We can understand this chart simply just if you have a set of return if it does not
have significant outlier (extreme high or low return) and the return is in the same time frame
(for example the return of all small cap company in 2022) then you use arithmetic return
If the data set does not have outlier and the data is time series (for example the quarterly
return of a single fund for the last 10 years) then we use geometric mean return
Other than that, if the data set of return have outliers, we use harmonic/trimmed/winsorized
mean to neglect the effect of outliers.
LOS 3: compare the money-weighted and time-weighted rates of return and evaluate the
performance of portfolios based on these measures
Comment: Sometimes you will see people invest 9 times successful but only 1 time fails and
they lose all their money. That is, the amount invest in 10th is much bigger than the last 9
investments or arithmetic/geometric mean does not account for the different money
invested in each period of return.
- Money-weighted return
MWR and its calculation are like the internal rate of return and a bond’s yield to
maturity.
The internal rate of return is the discount rate at which the sum of present values of
cash flows will equal zero.

Ex 1. Money-Weighted Return for a Dividend-Paying Stock

 It is the return that make Net present value = 0
It seems like the rate at which you can retrieve your investment. The above example
said first year you spent 200, second year you spent 220, and third year you got 480
back. It seems like it takes 3 years for you to get all your money back. But the money
does not make sense very much. How do you compare this to other option? You have
to calculate in order to get equivalent interest rate

Importantly, two investors in the same mutual fund or with the same portfolio of
underlying investments may have different money-weighted returns because they
invested different amounts in different years.
We can use BA calculator: BA Calculator: CF0 = -200, CF1 = -220, CF2 = 480 press CPT
IRR = 9.39%
As we see if the positive CF 480 is moving closer that is in second year (time 1) for
example, the IRR should be higher. (You can try by switch 480 with -220 and use BA
calculator)
- Time-Weighted Returns
TWR is not sensitive to the additions and withdrawals of funds. It measures the
compound rate of growth of USD1 initially invested in the portfolio over a stated
measurement period.
Comment: The time weighted is a kind of geometric return. It is different in the fact
that it carefully chooses the period return that exclude inflow/outflow of money

Let’s look at example

 Usually if we use geometric means we would take (ending value – beginning value).
However, we note that between that we have inflow/outflow so TWR takes the beginning
and ending balance that does not include the cash flow. In period 1 it is between amounting
invested 5,000,000 and ending value 6,000,000

LOS 4: calculate and interpret annualized return measures and continuously compounded
returns, and describe their appropriate uses
The period during which a return is earned or computed can vary and often we have
to annualize a return that was calculated for a period that is shorter (or longer) than
one year.
Comment: If we have different investment with different period of compounding then
in order to compare them, we have to convert them into the same period
compounding (usually yearly)

- Non-annual Compounding
 Above it is the formula of from yearly interest rate you change to period interest rate
in order to have the true effective interest rate (check the prerequisite)
We can face 12% compounded monthly vs 12.1% compounded semiannually which
one is better? è You need to a common reference time (1 year) to compare by
combining rates and compounding periods à We calculate EAR (Effective annual
rate) or Return Annual
For 12% rate à periodic interest rate(monthly) = 12/12= 1% à EAR =
(1+0.01)^12 -1 = 12.68% (monthly = compounding 12 times a year )
For 12.1% rate à EAR = (1+0.121/2) ^2-1= 12.47% (semiannually =
compounding 2 times a year)

- Annualizing Returns

One major limitation of annualizing returns is the implicit assumption that returns
can be repeated precisely, that is, money can be reinvested repeatedly while earning
a similar return.

- Continuously Compounded Returns

The continuously compounded return from t to t + 1 is

LOS 5: calculate and interpret major return measures and describe their appropriate uses
- Gross and Net Return
Gross return is an appropriate measure for evaluating and comparing the investment
skill of asset managers because it does not include any fees related to the
management and administration of an investment.
 Net return accounts for (i.e., deducts) all managerial and administrative expenses
that reduce an investor’s return.
- Pre-Tax and After-Tax Nominal Return
Capital gains and income may be taxed differently, depending on the jurisdiction.
Capital gains come in two forms: short-term capital gains and long-term capital
gains. Long-term capital gains receive preferential tax treatment in several countries.
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.
The after-tax nominal return is computed as the total return minus any allowance for
taxes on dividends, interest, and realized gains. Bonds issued at a discount to the par
value may be taxed based on accrued gains instead of realized gains.
- Real Returns
(1 + nominal risk–free rate) = (1 + real risk–free rate) * (1 + inflation premium)
- Leveraged Return
There are two ways of creating a claim on asset returns that are greater than the
investment of one’s own money. First, an investor may trade futures contracts in
which the money required to take a position may be as little as 10 percent of the
notional value of the asset. In this case, the leveraged return, the return on the
investor’s own money, is 10 times the actual return of the underlying security. Both
the gains and losses are amplified by a factor of 10.
For example: You have 200 million as your equity (or your own money) and you borrow 100
million at the rate = 7% à you have 300 million total

QUANTS: THE TIME VALUE OF MONEY IN FINANCE

Time Value of Money in Fixed Income and Equity
Fixed-Income Instruments
Equity Instruments
Implied Return and Growth
Implied Return for Fixed-Income Instruments
Equity Instruments, Implied Return, and Implied Growth
Cash Flow Additivity
Implied Forward Rates Using Cash Flow Additivity
Forward Exchange Rates Using No Arbitrage
Option Pricing Using Cash Flow Additivity
Comment: In this section, you have to master time value of money (check the slide or the
prerequisite for all the case), there is no way to master time value of money than practice
pressing BA calculator, as long you know the concept, you have all the helps from BA
Calculator if you choose the right parameters. Master TVM is not difficult to master. About
the Time value of money, please check the slides and do more problems in the prerequisite.
The cash flow from Fixed income and equity is moderate, not too much difficult. You
just bear the concept that all the value of the instrument comes from their future cash flow.
Understand cash flow of bond/mortgage/equity then it is not that difficult. Fixed
income/mortgage is straightforward but equity is little bit more math heavily, making it
more difficult to understand but then if you come to Equity and go back it will be much
easier.
The cash flow additivity is difficult since you do not know the concept, the most
important concept is arbitrage. Option pricing is the most difficult because it lacks of
concepts to explain so if you do not understand it right now it is ok, you can learn derivative
and come back to this and will find it easier.
LOS 1: calculate and interpret the present value (PV) of fixed-income and equity
instruments based on expected future cash flows.
Compounding:
FV% = PV(1 + r)%
 If the number of compounding periods t is very large, that is, t→∞:
FV% = PVe&%
Discounting:
PV = FV% (1 + r)'%
PV = FV% e'&%
Comment: Whether you use e for continuous they will tell in the problem, you can
check out more problems in the prerequisite curriculum
- Fixed-Income Instruments
• Discount Instruments

PV(Discount Bond) = FV% /(1 + r)%

This type of bond is often referred to as a zero-coupon bond
Comment: This case refers to case 1 of time value of money in the slide. The
calculation is pretty straightforward. In this case, PV <FV and the difference represent
the interest rate over the period of time
• Coupon Instrument
 PMT! PMT# PMT( + FV(
PV(Coupon Bond) = + + ⋯+
(1 + r)! (1 + r)# (1 + r)(
Comment: This is more like of common case, a bond that has payment and pay at the
end of the period, in this case PV is not necessarily bigger than FV because we
already have the PMT (green boxes) account for the interest. That is why you don’t
see like the discount bond they say FV-PV represents the interest
Special case: perpetual bond, as N→∞
PMT
PV(Perpetual Bond) =
r

• Annuity Instruments
 &(*+)
Periodic annuity cash flow (A): A = !'(!-&)!"
Comment: The mortgage is very popular and as we can see the more time has
passed, you pay less interest you pay and the more principal.
Example: An investor seeks a fixed rate 30-year mortgage loan to finance 80% of the
purchase price USD 1,000,000 for a residential building.
Calculate investor’s monthly payment if the annual mortgage rate is 5.25%

Look at the PMT we see the word “monthly” and the rate is “annual” then we have to
calculate monthly rate = 0.4375%= 5.25/12
Then we have PV = 80%*1,000,000 = 800,000
We put in BA Calculator n = 30*12 = 360 (since the rate is monthly the number of
periods is number of months)
We press PMT

Or we use the formula

First month interest = 800,000*0.4375% = 3500
-> Remaining principal that we pay = 4,417.63-3500= 917.63
à Remaining principal we have to pay till the end = 800,000-917.63 = 799,082.37
Second month interest = 799,082.37*0.4375%= 3,495.99
-> Remaining principal that we pay = 4,417.63-3,495.99= 921.64
à Remaining principal we have to pay till the end = 799,082.37-921.64 = 798,160.73
 In the 360th payment we pay minimum interest rate and mostly principal repayment
- Equity Instruments
Unlike fixed-income instruments, equity investments have no maturity date and are
assumed to remain outstanding indefinitely, or until a company is sold, restructured,
or liquidated.
• Constant Dividends

/
D% D%
PV% = F =
(1 + r). r
01!
Comment: This is the same as perpetuities in bond, just change the Annuity by the
Dividend (D)
• Constant Dividend Growth Rate
We have if the dividend grows at constant rate g <r (discount rate) then the present
value of the stock will be:
 D%-! = D% (1 + g) or generally in i periods as: D%-. = D% (1 + g).
/
D% (1 + g). D% (1 + g) D%-!
PV% = F = =
(1 + r). r−g r−g
.1!
Where r – g > 0
Comment: There is a little bit of math here to get the formula but you need to remember the
result.
If t=0 then PV = D(1+g)/(r-g)
If t=3 mean the present value of the cash flow at the end of year 3 that is including all the
cash flow from year 4 and so on = D(1+g) ^4/(r-g).
So we can conclude that the PV = dividend next period/(r-g)
• Changing Dividend Growth Rate
The simplest form of changing dividend growth is the two-stage model.

3 / 3
D% (1 + g 2 ). D%-3 (1 + g 4 )5 D% (1 + g 2 ). E(S%-3 )
PV% = F + F = F +
(1 + r). (1 + r)5 (1 + r). (1 + r)3
.1! 513-! .1!
 where the stock value of the stock in n periods, E(S%-3 ) is referred to as the terminal
value and is equal to the following:
D%-3-!
E(S%-3 ) =
r − g4
Comment: The formula looks scary but if we break it out it is simple. The problem is if the
dividend grows at the first growth rate gs in 3 years and grow with the second growth rate gL
from year 4 and to infinity.
So we have dividend in year 1,2,3 is D(1+gs), D(1+gs)2, D(1+gs)3 and year 4 forward is
D(1+gs)3(1+gL)….

As we discussed earlier in the constant dividend growth rate model, we have the following
formula
/
L6 (1 + M)0 L6 (1 + M) L6-!
JK6 = F = =
(1 + N)0 N−M N−M
01!

So PV3 = (Dividend in year 4)/(r-g) = D(1+gs)3(1+gL)/(r-gL) =terminal value

That is the present value of the stock = D(1+gs)/(1+r) + D(1+gs)2/(1+r)
+D(1+gs)3/(1+r)3+PV3/(1+r)3
LOS 2: calculate and interpret the implied return of fixed-income instruments and
required return and implied growth of equity instruments given the present value (PV)
and cash flows.
Market participants often face a situation in which both the present and future values of
instruments or cash flows may be known. In this case it becomes possible to solve for the
implied return or growth rate implied by the current price and features of the future cash
flows. In this sense, solving for the implied growth or return provides a view of the market
expectations that are incorporated into the market price of the asset.
- Implied Return for Fixed-Income Instruments
• Discount Instruments
!
"FV% RK6 6
implied r = P −1=Q S −1
PV JK
• Coupon Instrument
Implied r = YTM
PV(Market price of Coupon Bond)
PMT! PMT# PMT( + FV(
= + + ⋯ +
(1 + YTM)! (1 + YTM)# (1 + YTM)(
Use Microsoft Excel or Google Sheets YIELD function:
= YIELD (settlement, maturity, rate, pr, redemption, frequency, [basis])
Comment: This part is simple since you know FV, PV you can calculate r and reverse.
Not much to say there. The yield function in the note instead you can use BA
 calculator to solve for r because all the payment in bond is usually equal to each
other.
- Implied Return and Implied Growth for Equity Instruments
• Constant Dividend Growth Rate
D% (1 + g) D%-!
implied r = +g= +g
PV% PV%
N ∗ PV% − D% D%-!
implied g = =r−
PV% + D% PV%
Given a price-to-earnings ratio and dividend payout ratio, we can solve for either
required return or implied dividend growth rate.
D%
PV% E% × (1 + g)
=
E% r−g
In practice, the forward price-to-earnings ratio or ratio of its share price to an
estimate of its next period (t + 1) earnings per share is commonly used.
D%-!
PV% E
= %-!
E%-! r − g

LOS 3: explain the cash flow additivity principle, its importance for the no-arbitrage
condition, and its use in calculating implied forward interest rates, forward exchange
rates, and option values.
Under cash flow additivity, the present value of any future cash flow stream indexed
at the same point equals the sum of the present values of the cash flows.
Comment: All of these 3 instruments lie in the rule of arbitrage. No arbitrage saying
that you can not earn money without engaging in any risk in a right pricing market.
That is, for example 6-month lending rate in VCB is 6%- and 6-month deposit in
VPBank is 7%. No arbitrage rule says that such pricing between 2 banks are not
possible since the customer will borrow from VCB and deposit in VPBank without
engaging in any risk. As a result, VPBank will see that and lower interest rate of
depositing or VCB will raise its lending rate, or VCB will control so that if you borrow
from it you have to prove purpose of borrowing and the VCB staff will keep track of
the cash flow.
- Implied Forward Rates
Ex 2. Consider two risk-free discount bonds with different maturities as follows:
One-year bond: r1 = 2.50%
Two-year bond: r2 = 3.50%
A risk neutral investor seeking to earn a return on GBP100 over a two-year
investment horizon has two possible strategies:
Investment strategy 1: Invest today for two years at a known annualized yield
of 3.50%
GBP100 = FV2 / (1+r2)2
 FV2 = GBP107.12
Investment strategy 2: Invest today for one year at a known yield of 2.50%
and reinvest in one year’s time for one year at a rate of F1,1 (the one-year
forward rate starting in one year)

Under the cash flow additivity principle,

u GBP100 = FV2 / (1+r2)2 à FV2 = GBP107.12

u F1,1 = 4.51%
u Comment: What if the market rate of F1,1 is 5%. Then A would borrow 100 GBP by the
rate of 2 year of 3.5% (has to pay back 107,12USD after 2 years) then lend out at rate
of 2.5% then lend out at rate 5% after that:
u A gets 102.5 at the end of year 1
A get 102.5 *105 %= 107,63 > 107,12 USD à A is making money without engaging
in any risk à Violating the no arbitrage rule in a correct pricing market.
- Forward Exchange Rates Using No Arbitrage
Ex 3. Assume that you have USD1,000 to invest for six months. You are considering a
riskless investment in either US or Japanese six-month government debt.
Let’s assume that the current exchange rate between Japanese yen (JPY) and US
dollars (USD) is 134.40 (i.e., JPY134.40 = USD1).
The six-month Japanese yen risk-free rate is assumed to be 0.05 percent, and the
six-month US dollar risk-free rate is 2.00 percent.
This example assumes continuous compounding.
Investment strategy 1: Invest USD1,000 in a six-month US Treasury bill.
At time t = 0: Invest USD1,000 at the 2.00 percent US-dollar risk-free
rate for six months.
At time t = T in six months: Receive USD1,010.05 (= 1,000e(0.02 × 0.5)).
 Investment strategy 2: Convert the USD1,000 into Japanese yen at the
current exchange rate of 134.40, invest in a six-month Japanese Treasury,
and convert this known amount back into US dollars in six months at a six-
month forward exchange rate set today of 133.096.
At time t = 0: Convert USD1,000 into JPY134,400. Lend the JPY134,400
at the 0.05 percent JPY risk-free rate for six months.
At time t = T in six months: Receive JPY loan proceeds of 134,433.60
(=134,400e (0.0005 × 0.5)). Exchange JPY loan proceeds for US dollars at
the forward rate of 133.096 to receive USD1010.05
(=134,433.60/133.096)

- Option Pricing Using Cash Flow Additivity

Ex 4. Sim
Let’s assume an asset has a current price of 40 Chinese yuan (i.e., CNY40). The asset
is risky in that its price may rise 40 percent to CNY56 during the next time period or
its price may fall 20 percent to CNY32 during the next time period.
An investor wishes to sell a contract on the asset in which the buyer of the contract
has the right, but no obligation, to buy the noted asset for CNY50 at the end of the
next time period.
One-Period Binomial Tree for the Asset’s Price and the Contract’s Price

Assume at t = 0 an investor creates a portfolio in which the contract is sold at a price

of c0 and 0.25 units of the underlying asset are purchased. Tis portfolio is called a
replicating portfolio in that it is designed specifically to create a matching future cash
flow stream to that of a risk-free asset.
V0 = 0.25 × 40 – c0
V1u = 0.25 × 56 – 6 = 8
V1d = 0.25 × 32 – 0 = 8
V0 = V1u / (1+rf) = V1d / (1+rf) => c0 = CNY2.38
The proportion of the underlying asset (0.25) is known as the hedge ratio in option
pricing.