© CFA Institute. For candidate use only. Not for distribution.

CONTENTS

How to Use the CFA Program Curriculum   vii

CFA Institute Learning Ecosystem (LES)   vii
Designing Your Personal Study Program   vii
Errata   viii
Other Feedback   viii

Quantitative Methods

Learning Module 1 Rates and Returns   3

Introduction   3
Interest Rates and Time Value of Money   5
Determinants of Interest Rates   6
Rates of Return   8
Holding Period Return   8
Arithmetic or Mean Return   9
Geometric Mean Return   10
The Harmonic Mean   14
Money-Weighted and Time-Weighted Return   19
Calculating the Money Weighted Return   19
Annualized Return   28
Non-annual Compounding   29
Annualizing Returns   30
Continuously Compounded Returns   32
Other Major Return Measures and Their Applications   33
Gross and Net Return   33
Pre-Tax and After-Tax Nominal Return   34
Real Returns   34
Leveraged Return   36
Practice Problems   38
Solutions   42

Learning Module 2 Time Value of Money in Finance   45

Introduction   45
Time Value of Money in Fixed Income and Equity   46
Fixed-Income Instruments and the Time Value of Money   47
Equity Instruments and the Time Value of Money   55
Implied Return and Growth   60
Implied Return for Fixed-Income Instruments   60
Equity Instruments, Implied Return, and Implied Growth   65
Cash Flow Additivity   69
Implied Forward Rates Using Cash Flow Additivity   71
Forward Exchange Rates Using No Arbitrage   74
Option Pricing Using Cash Flow Additivity   76
Practice Problems   81
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iv Contents

Solutions   84

Learning Module 3 Statistical Measures of Asset Returns   87

Introduction   87
Measures of Central Tendency and Location   89
Measures of Central Tendency   90
Dealing with Outliers   92
Measures of Location   93
Measures of Dispersion   100
The Range   101
Mean Absolute Deviations   101
Sample Variance and Sample Standard Deviation   101
Downside Deviation and Coefficient of Variation   102
Measures of Shape of a Distribution   110
Correlation between Two Variables   117
Scatter Plot   117
Covariance and Correlation   119
Properties of Correlation   120
Limitations of Correlation Analysis   121
Practice Problems   127
Solutions   130

Learning Module 4 Probability Trees and Conditional Expectations   133

Introduction   133
Expected Value and Variance   134
Probability Trees and Conditional Expectations   136
Total Probability Rule for Expected Value   137
Bayes' Formula and Updating Probability Estimates   141
Bayes’ Formula   142
Practice Problems   151
Solutions   152

Learning Module 5 Portfolio Mathematics   153

Introduction   153
Portfolio Expected Return and Variance of Return   155
Covariance   155
Correlation   158
Forecasting Correlation of Returns: Covariance Given a Joint Probability
Function   164
Portfolio Risk Measures: Applications of the Normal Distribution   167
References   173
Practice Problems   174
Solutions   175

Learning Module 6 Simulation Methods   177

Introduction   177
Lognormal Distribution and Continuous Compounding   178
The Lognormal Distribution   178
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Contents v

Continuously Compounded Rates of Return   181

Monte Carlo Simulation   184
Bootstrapping   189
Practice Problems   193
Solutions   194

Learning Module 7 Estimation and Inference   195

Introduction   195
Sampling Methods   197
Simple Random Sampling   197
Stratified Random Sampling   198
Cluster Sampling   199
Non-Probability Sampling   200
Sampling from Different Distributions   202
Central Limit Theorem and Inference   205
The Central Limit Theorem   205
Standard Error of the Sample Mean   207
Bootstrapping and Empirical Sampling Distributions   209
Practice Problems   214
Solutions   215

Learning Module 8 Hypothesis Testing   217

Introduction   217
Hypothesis Tests for Finance   219
The Process of Hypothesis Testing   219
Tests of Return and Risk in Finance   224
Test Concerning Differences between Means with Dependent
Samples   228
Test Concerning the Equality of Two Variances   229
Parametric versus Nonparametric Tests   236
Uses of Nonparametric Tests   237
Nonparametric Inference: Summary   237
Practice Problems   238
Solutions   242

Learning Module 9 Parametric and Non-Parametric Tests of Independence   245

Introduction   245
Tests Concerning Correlation   246
Parametric Test of a Correlation   247
Non-Parametric Test of Correlation: The Spearman Rank Correlation
Coefficient   251
Tests of Independence Using Contingency Table Data   255
Practice Problems   263
Solutions   264

Learning Module 10 Simple Linear Regression   265

Introduction   265
Estimation of the Simple Linear Regression Model   267
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vi Contents

Introduction to Linear Regression   267

Estimating the Parameters of a Simple Linear Regression   270
Assumptions of the Simple Linear Regression Model   277
Assumption 1: Linearity   277
Assumption 2: Homoskedasticity   279
Assumption 3: Independence   281
Assumption 4: Normality   282
Hypothesis Tests in the Simple Linear Regression Model   284
Analysis of Variance   284
Measures of Goodness of Fit   285
Hypothesis Testing of Individual Regression Coefficients   287
Prediction in the Simple Linear Regression Model   297
ANOVA and Standard Error of Estimate in Simple Linear Regression   297
Prediction Using Simple Linear Regression and Prediction Intervals   299
Functional Forms for Simple Linear Regression   304
The Log-Lin Model   305
The Lin-Log Model   306
The Log-Log Model   308
Selecting the Correct Functional Form   309
Practice Problems   312
Solutions   325

Learning Module 11 Introduction to Big Data Techniques   329

Introduction   329
How Is Fintech used in Quantitative Investment Analysis?   330
Big Data   331
Advanced Analytical Tools: Artificial Intelligence and Machine Learning   334
Tackling Big Data with Data Science   337
Data Processing Methods   337
Data Visualization   338
Text Analytics and Natural Language Processing   339
Practice Problems   341
Solutions   342

Learning Module 12 Appendices A-E   343

Appendices A-E   343

Glossary   G-1
 © CFA Institute. For candidate use only. Not for distribution.
vii

How to Use the CFA

Program Curriculum
The CFA® Program exams measure your mastery of the core knowledge, skills, and
abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
A broad outline that lists the major CFA Program topic areas (www​
.cfainstitute​.org/​programs/​cfa/​curriculum/​cbok/​cbok)
Topic area weights that indicate the relative exam weightings of the top-level
topic areas (www​.cfainstitute​.org/​en/​programs/​cfa/​curriculum)
Learning outcome statements (LOS) that advise candidates about the
specific knowledge, skills, and abilities they should acquire from curricu-
lum content covering a topic area: LOS are provided at the beginning of
each block of related content and the specific lesson that covers them. We
encourage you to review the information about the LOS on our website
(www​.cfainstitute​.org/​programs/​cfa/​curriculum/​study​-sessions), including
the descriptions of LOS “command words” on the candidate resources page
at www​.cfainstitute​.org/​-/​media/​documents/​support/​programs/​cfa​-and​
-cipm​-los​-command​-words​.ashx.
The CFA Program curriculum that candidates receive access to upon exam
registration
Therefore, the key to your success on the CFA exams is studying and understanding
the CBOK. You can learn more about the CBOK on our website: www​.cfainstitute​
.org/​programs/​cfa/​curriculum/​cbok.
The curriculum, including the practice questions, is the basis for all exam questions.
The curriculum is selected or developed specifically to provide candidates with the
knowledge, skills, and abilities reflected in the CBOK.

CFA INSTITUTE LEARNING ECOSYSTEM (LES)

Your exam registration fee includes access to the CFA Institute Learning Ecosystem
(LES). This digital learning platform provides access, even offline, to all the curriculum
content and practice questions. The LES is organized as a series of learning modules
consisting of short online lessons and associated practice questions. This tool is your
source for all study materials, including practice questions and mock exams. The LES
is the primary method by which CFA Institute delivers your curriculum experience.
Here, candidates will find additional practice questions to test their knowledge. Some
questions in the LES provide a unique interactive experience.

DESIGNING YOUR PERSONAL STUDY PROGRAM

An orderly, systematic approach to exam preparation is critical. You should dedicate
a consistent block of time every week to reading and studying. Review the LOS both
before and after you study curriculum content to ensure you can demonstrate the
 © CFA Institute. For candidate use only. Not for distribution.
viii How to Use the CFA Program Curriculum

knowledge, skills, and abilities described by the LOS and the assigned reading. Use
the LOS as a self-check to track your progress and highlight areas of weakness for
later review.
Successful candidates report an average of more than 300 hours preparing for each
exam. Your preparation time will vary based on your prior education and experience,
and you will likely spend more time on some topics than on others.

ERRATA
The curriculum development process is rigorous and involves multiple rounds of
reviews by content experts. Despite our efforts to produce a curriculum that is free of
errors, in some instances, we must make corrections. Curriculum errata are periodically
updated and posted by exam level and test date on the Curriculum Errata webpage
(www​.cfainstitute​.org/​en/​programs/​submit​-errata). If you believe you have found an
error in the curriculum, you can submit your concerns through our curriculum errata
reporting process found at the bottom of the Curriculum Errata webpage.

OTHER FEEDBACK
Please send any comments or suggestions to info@​cfainstitute​.org, and we will review
your feedback thoughtfully.
 © CFA Institute. For candidate use only. Not for distribution.

Quantitative Methods
© CFA Institute. For candidate use only. Not for distribution.
 © CFA Institute. For candidate use only. Not for distribution.

LEARNING MODULE

1
Rates and Returns
by Richard A. DeFusco, PhD, CFA, Dennis W. McLeavey, DBA, CFA, Jerald
E. Pinto, PhD, CFA, David E. Runkle, PhD, CFA, and Vijay Singal, PhD,
CFA.
Richard A. DeFusco, PhD, CFA, is at the University of Nebraska-Lincoln (USA). Dennis W.
McLeavey, DBA, CFA, is at the University of Rhode Island (USA). Jerald E. Pinto, PhD,
CFA, is at CFA Institute (USA). David E. Runkle, PhD, CFA, is at Jacobs Levy Equity
Management (USA). Vijay Singal, PhD, CFA, is at Virginia Tech (USA).

LEARNING OUTCOMES
Mastery The candidate should be able to:

interpret interest rates as required rates of return, discount rates, or

opportunity costs and explain an interest rate as the sum of a real
risk-free rate and premiums that compensate investors for bearing
distinct types of risk
calculate and interpret different approaches to return measurement
over time and describe their appropriate uses
compare the money-weighted and time-weighted rates of return and
evaluate the performance of portfolios based on these measures
calculate and interpret annualized return measures and continuously
compounded returns, and describe their appropriate uses
calculate and interpret major return measures and describe their
appropriate uses

INTRODUCTION
Interest rates are a critical concept in finance. In some cases, we assume a particular
1
interest rate and in others, the interest rate remains the unknown quantity to deter-
mine. Although the pre-reads have covered the mechanics of time value of money
problems, here we first illustrate the underlying economic concepts by explaining
the meaning and interpretation of interest rates and then calculate, interpret, and
compare different return measures.
 © CFA Institute. For candidate use only. Not for distribution.
4 Learning Module 1 Rates and Returns

LEARNING MODULE OVERVIEW

■ An interest rate, r, can have three interpretations: (1) a

required rate of return, (2) a discount rate, or (3) an opportu-
nity cost. An interest rate reflects the relationship between differently
dated cash flows.
■ An interest rate can be viewed as the sum of the real risk-free inter-
est rate and a set of premiums that compensate lenders for bearing
distinct types of risk: an inflation premium, a default risk premium, a
liquidity premium, and a maturity premium.
■ The nominal risk-free interest rate is approximated as the sum of the
real risk-free interest rate and the inflation premium.
■ A financial asset’s total return consists of two components: an income
yield consisting of cash dividends or interest payments, and a return
reflecting the capital gain or loss resulting from changes in the price of
the financial asset.
■ A holding period return, R, is the return that an investor earns for a
single, specified period of time (e.g., one day, one month, five years).
■ Multiperiod returns may be calculated across several holding periods
using different return measures (e.g., arithmetic mean, geometric
mean, harmonic mean, trimmed mean, winsorized mean). Each return
computation has special applications for evaluating investments.
■ The choice of which of the various alternative measurements of mean
to use for a given dataset depends on considerations such as the
presence of extreme outliers, outliers that we want to include, whether
there is a symmetric distribution, and compounding.
■ A money-weighted return reflects the actual return earned on an
investment after accounting for the value and timing of cash flows
relating to the investment.
■ A time-weighted return measures the compound rate of growth of one
unit of currency invested in a portfolio during a stated measurement
period. Unlike a money-weighted return, a time-weighted return is not
sensitive to the timing and amount of cashflows and is the preferred
performance measure for evaluating portfolio managers because cash
withdrawals or additions to the portfolio are generally outside of the
control of the portfolio manager.
■ Interest may be paid or received more frequently than annually. The
periodic interest rate and the corresponding number of compounding
periods (e.g., quarterly, monthly, daily) should be adjusted to compute
present and future values.
■ Annualizing periodic returns allows investors to compare different
investments across different holding periods to better evaluate and
compare their relative performance. With the number of compound-
ing periods per year approaching infinity, the interest is compound
continuously.
■ Gross return, return prior to deduction of managerial and adminis-
trative expenses (those expenses not directly related to return gener-
ation), is an appropriate measure to evaluate the comparative perfor-
mance of an asset manager.
 © CFA Institute. For candidate use only. Not for distribution.
Interest Rates and Time Value of Money 5

■ Net return, which is equal to the gross return less managerial and
administrative expenses, is a better return measure of what an investor
actually earned.
■ The after-tax nominal return is computed as the total return minus
any allowance for taxes on dividends, interest, and realized gains.
■ Real returns are particularly useful in comparing returns across time
periods because inflation rates may vary over time and are particularly
useful for comparing investments across time periods and perfor-
mance between different asset classes with different taxation.
■ Leveraging a portfolio, via borrowing or futures, can amplify the port-
folio’s gains or losses.

INTEREST RATES AND TIME VALUE OF MONEY

2
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

The time value of money establishes the equivalence between cash flows occurring on
different dates. As cash received today is preferred to cash promised in the future, we
must establish a consistent basis for this trade-off to compare financial instruments in
cases in which cash is paid or received at different times. An interest rate (or yield),
denoted r, is a rate of return that reflects the relationship between differently dated
– timed – cash flows. If USD 9,500 today and USD 10,000 in one year are equivalent
in value, then USD 10,000 – USD 9,500 = USD 500 is the required compensation for
receiving USD 10,000 in one year rather than now. The interest rate (i.e., the required
compensation stated as a rate of return) is USD 500/USD 9,500 = 0.0526 or 5.26 percent.
Interest rates can be thought of in three ways:
■ First, they can be considered required rates of return—that is, the minimum
rate of return an investor must receive to accept an investment.
■ Second, interest rates can be considered discount rates. In the previous
example, 5.26 percent is the discount rate at which USD 10,000 in one year
is equivalent to USD 9,500 today. Thus, we use the terms “interest rate” and
“discount rate” almost interchangeably.
■ Third, interest rates can be considered opportunity costs. An opportunity
cost is the value that investors forgo by choosing a course of action. In the
example, if the party who supplied USD 9,500 had instead decided to spend
it today, he would have forgone earning 5.26 percent by consuming rather
than saving. So, we can view 5.26 percent as the opportunity cost of current
consumption.
 © CFA Institute. For candidate use only. Not for distribution.
6 Learning Module 1 Rates and Returns

Determinants of Interest Rates

Economics tells us that interest rates are set by the forces of supply and demand, where
investors supply funds and borrowers demand their use. Taking the perspective of
investors in analyzing market-determined interest rates, we can view an interest rate
r as being composed of a real risk-free interest rate plus a set of premiums that are
required returns or compensation for bearing distinct types of risk:

r = Real risk-free interest rate + Inflation premium + Default risk premium +

Liquidity premium + Maturity premium. (1)

■ The real risk-free interest rate is the single-period interest rate for a com-
pletely risk-free security if no inflation were expected. In economic theory,
the real risk-free rate reflects the time preferences of individuals for current
versus future real consumption.
■ The inflation premium compensates investors for expected inflation and
reflects the average inflation rate expected over the maturity of the debt.
Inflation reduces the purchasing power of a unit of currency—the amount
of goods and services one can buy with it.
■ The default risk premium compensates investors for the possibility that the
borrower will fail to make a promised payment at the contracted time and in
the contracted amount.
■ The liquidity premium compensates investors for the risk of loss relative
to an investment’s fair value if the investment needs to be converted to
cash quickly. US Treasury bills (T-bills), for example, do not bear a liquidity
premium because large amounts of them can be bought and sold without
affecting their market price. Many bonds of small issuers, by contrast, trade
infrequently after they are issued; the interest rate on such bonds includes a
liquidity premium reflecting the relatively high costs (including the impact
on price) of selling a position.
■ The maturity premium compensates investors for the increased sensitivity
of the market value of debt to a change in market interest rates as maturity
is extended, in general (holding all else equal). The difference between the
interest rate on longer-maturity, liquid Treasury debt and that on short-term
Treasury debt typically reflects a positive maturity premium for the
longer-term debt (and possibly different inflation premiums as well).
The sum of the real risk-free interest rate and the inflation premium is the nominal
risk-free interest rate:
The nominal risk-free interest rate reflects the combination of a real risk-free rate
plus an inflation premium:

(1 + nominal risk-free rate) = (1 + real risk-free rate)(1 + inflation premium).

In practice, however, the nominal rate is often approximated as the sum of the
real risk-free rate plus an inflation premium:

Nominal risk-free rate = Real risk-free rate + inflation premium.

Many countries have short-term government debt whose interest rate can be
considered to represent the nominal risk-free interest rate over that time horizon in
that country. The French government issues BTFs, or negotiable fixed-rate discount
Treasury bills (Bons du Trésor à taux fixe et à intérêts précomptés), with maturities
of up to one year. The Japanese government issues a short-term Treasury bill with
maturities of 6 and 12 months. The interest rate on a 90-day US T-bill, for example,
represents the nominal risk-free interest rate for the United States over the next three
 © CFA Institute. For candidate use only. Not for distribution.
Interest Rates and Time Value of Money 7

months. Typically, interest rates are quoted in annual terms, so the interest rate on a
90-day government debt security quoted at 3 percent is the annualized rate and not
the actual interest rate earned over the 90-day period.
Whether the interest rate we use is a required rate of return, or a discount rate,
or an opportunity cost, the rate encompasses the real risk-free rate and a set of risk
premia that depend on the characteristics of the cash flows. The foundational set of
premia consist of inflation, default risk, liquidity risk, and maturity risk. All these premia
vary over time and continuously change, as does the real risk-free rate. Consequently,
all interest rates fluctuate, but how much they change depends on various economic
fundamentals—and on the expectation of how these various economic fundamentals
can change in the future.

EXAMPLE 1

Determining Interest Rates

Exhibit 1 presents selected information for five debt securities. All five invest-
ments promise only a single payment at maturity. Assume that premiums relating
to inflation, liquidity, and default risk are constant across all time horizons.
​

Exhibit 1: Investments Alternatives and Their Characteristics

​

Maturity Interest Rate

Investment (in years) Liquidity Default Risk (%)

1 2 High Low 2.0

2 2 Low Low 2.5
3 7 Low Low r3
4 8 High Low 4.0
5 8 Low High 6.5
​

Based on the information in Exhibit 1, address the following:

1. Explain the difference between the interest rates offered by Investment 1

and Investment 2.
Solution:
Investment 2 is identical to Investment 1 except that Investment 2 has low
liquidity. The difference between the interest rate on Investment 2 and In-
vestment 1 is 0.5 percent. This difference in the two interest rates represents
a liquidity premium, which represents compensation for the lower liquidity
of Investment 2 (the risk of loss relative to an investment’s fair value if the
investment needs to be converted to cash quickly).

2. Estimate the default risk premium affecting all securities.

Solution:
To estimate the default risk premium, identify two investments that have the
same maturity but different levels of default risk. Investments 4 and 5 both
have a maturity of eight years but different levels of default risk. Investment
5, however, has low liquidity and thus bears a liquidity premium relative to
Investment 4. From Part A, we know the liquidity premium is 0.5 percent.
The difference between the interest rates offered by Investments 5 and 4 is
2.5 percent (6.5% − 4.0%), of which 0.5 percent is a liquidity premium. This
 © CFA Institute. For candidate use only. Not for distribution.
8 Learning Module 1 Rates and Returns

implies that 2.0 percent (2.5% − 0.5%) must represent a default risk premium
reflecting Investment 5’s relatively higher default risk.

3. Calculate upper and lower limits for the unknown interest rate for Invest-
ment 3, r3.
Solution:
Investment 3 has liquidity risk and default risk comparable to Investment 2,
but with its longer time to maturity, Investment 3 should have a higher ma-
turity premium and offer a higher interest rate than Investment 2. Therefore,
the interest rate on Investment 3, r3, should thus be above 2.5 percent (the
interest rate on Investment 2).
If the liquidity of Investment 3 was high, Investment 3 would match Invest-
ment 4 except for Investment 3’s shorter maturity. We would then conclude
that Investment 3’s interest rate should be less than the interest rate offered
by Investment 4, which is 4 percent. In contrast to Investment 4, however,
Investment 3 has low liquidity. It is possible that the interest rate on Invest-
ment 3 exceeds that of Investment 4 despite Investment 3’s shorter maturity,
depending on the relative size of the liquidity and maturity premiums. How-
ever, we would expect r3 to be less than 4.5 percent, the expected interest
rate on Investment 4 if it had low liquidity (4% + 0.5%, the liquidity premi-
um). Thus, we should expect in the interest rate offered by Investment 3 to
be between 2.5 percent and 4.5 percent.

3 RATES OF RETURN

calculate and interpret different approaches to return measurement

over time and describe their appropriate uses

Financial assets are frequently defined in terms of their return and risk characteristics.
Comparison along these two dimensions simplifies the process of building a portfolio
from among all available assets. In this lesson, we will compute, evaluate, and compare
various measures of return.
Financial assets normally generate two types of return for investors. First, they
may provide periodic income through cash dividends or interest payments. Second,
the price of a financial asset can increase or decrease, leading to a capital gain or loss.
Some financial assets provide return through only one of these mechanisms. For
example, investors in non-dividend-paying stocks obtain their return from price
movement only. Other assets only generate periodic income. For example, defined
benefit pension plans and retirement annuities make income payments over the life
of a beneficiary.

Holding Period Return

Returns can be measured over a single period or over multiple periods. Single-period
returns are straightforward because there is only one way to calculate them.
Multiple-period returns, however, can be calculated in various ways and it is important
to be aware of these differences to avoid confusion.
 © CFA Institute. For candidate use only. Not for distribution.
Rates of Return 9

A holding period return, R, is the return earned from holding an asset for a single
specified period of time. The period may be one day, one week, one month, five years,
or any specified period. If the asset (e.g., bond, stock) is purchased today, time (t = 0),
at a price of 100 and sold later, say at time (t = 1), at a price of 105 with no dividends
or other income, then the holding period return is 5 percent [(105 − 100)/100)]. If the
asset also pays income of two units at time (t = 1), then the total return is 7 percent.
This return can be generalized and shown as a mathematical expression in which P
is the price and I is the income, as follows:
_(​ ​P1​  ​​ − ​P0​  ​​)​ + ​I1​  ​​
​R = ​  ​P​   ​​
​​ , (1)
0

where the subscript indicates the time of the price or income; (t = 0) is the begin-
ning of the period; and (t = 1) is the end of the period. The following two observations
are important.
■ We computed a capital gain of 5 percent and an income yield of 2 per-
cent in this example. For ease of illustration, we assumed that the income
is paid at time t = 1. If the income was received before t = 1, our holding
period return may have been higher if we had reinvested the income for the
remainder of the period.
■ Return can be expressed in decimals (0.07), fractions (7/100), or as a percent
(7 percent). They are all equivalent.
A holding period return can be computed for a period longer than one year. For
example, an analyst may need to compute a one-year holding period return from
three annual returns. In that case, the one-year holding period return is computed
by compounding the three annual returns:
R = [(1 + R1) × (1 + R2) × (1 + R3)] − 1,
where R1, R2, and R3 are the three annual returns.

Arithmetic or Mean Return

Most holding period returns are reported as daily, monthly, or annual returns. When
assets have returns for multiple holding periods, it is necessary to normalize returns
to a common period for ease of comparison and understanding. There are different
methods for aggregating returns across several holding periods. The remainder of
this section presents various ways of computing average returns and discusses their
applicability.
The simplest way to compute a summary measure for returns across multiple
periods is to take a simple arithmetic average of the holding period returns. Thus,
three annual returns of −50 percent, 35 percent, and 27 percent will give us an average
of 4 percent per year = ( ​  − 50 %   + 35
________________
​​    3
%   + 27%
 ​ )​​. The arithmetic average return is easy to
compute and has known statistical properties. _
In general, the arithmetic or mean return is denoted by ​​​ R ​​  i​​​and given by the
following equation for asset i, where Rit is the return in period t and T is the total
number of periods:
_ ​Ri1
​  ​​  + ​R​ i2​​ + … + ​Ri,T−1
​  ​​  + ​R​ iT​​ T
​​​ R ​​  i​​  = ​ ____________________
     
T
1
​  = ​ _
T ​ ​∑ ​​​ ​Rit
​  ​​​. (2)
t=1
 © CFA Institute. For candidate use only. Not for distribution.
10 Learning Module 1 Rates and Returns

Geometric Mean Return

The arithmetic mean return assumes that the amount invested at the beginning of each
period is the same. In an investment portfolio, however, even if there are no cash flows
into or out of the portfolio the base amount changes each year. The previous year’s
earnings must be added to the beginning value of the subsequent year’s investment—
these earnings will be “compounded” by the returns earned in that subsequent year.
We can use the geometric mean return to account for the compounding of returns.
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 geometric mean return is denoted by ​​​ R ​​  Gi​​​and given by the following equation
for asset i:
_ _________________________________________
​​​ R ​​  Gi​​  = ​ √ (​      ​  )​​ ​ × … × ​(1 + ​Ri,T−1
​  )​​ ​ × ​(1 + ​Ri2 )​​ ​ × ​(1 + ​RiT
​  )​​ ​ ​ − 1​
T
1 + ​Ri1 ​  (3)
____________

√∏
T T
​= ​   
​ ​ ​(1 + ​Rt​  ​​)​​ ​ − 1 ​,
t=1

where Rit is the return in period t and T is the total number of periods.
In the example in the previous section, we calculated the arithmetic mean to be
4.00 percent. Using Equation 4, we can calculate the geometric mean return from the
same three annual returns:
_ 3
_____________________________
​​​ R ​​  Gi​​  = ​ √ (​   
1 − 0.50)​ × ​(1 + 0.35)​ × ​(1 + 0.27)​ ​ − 1 =   − 0.0500​.
Exhibit 2 shows the actual return for each year and the balance at the end of each
year using actual returns.

Exhibit 2: Portfolio Value and Performance

Actual Return Year-End Amount Year-End Amount

for the Year Year-End Using Arithmetic Using Geometric
(%) Amount Return of 4% Return of −5%

Year 0 EUR1.0000 EUR1.0000 EUR1.0000

Year 1 −50 0.5000 1.0400 0.9500
Year 2 35 0.6750 1.0816 0.9025
Year 3 27 0.8573 1.1249 0.8574

Beginning with an initial investment of EUR1.0000, we will have a balance of EUR0.8573

at the end of the three-year period as shown in the fourth column of Exhibit 2. Note
that we compounded the returns because, unless otherwise stated, we earn a return
on the balance as of the end of the prior year. That is, we will receive a return of 35
percent in the second year on the balance at the end of the first year, which is only
EUR0.5000, not the initial balance of EUR1.0000. Let us compare the balance at the
end of the three-year period computed using geometric returns with the balance we
would calculate using the 4 percent annual arithmetic mean return from our earlier
example. The ending value using the arithmetic mean return is EUR1.1249 (=1.0000 ×
1.043). This is much larger than the actual balance at the end of Year 3 of EUR0.8573.
In general, the arithmetic return is biased upward unless each of the underlying
holding period returns are equal. The bias in arithmetic mean returns is particularly
severe if holding period returns are a mix of both positive and negative returns, as
in this example.
We will now look at three examples that calculate holding period returns over
different time horizons.
 © CFA Institute. For candidate use only. Not for distribution.
Rates of Return 11

EXAMPLE 2

Holding Period Return

1. An investor purchased 100 shares of a stock for USD34.50 per share at the
beginning of the quarter. If the investor sold all of the shares for USD30.50
per share after receiving a USD51.55 dividend payment at the end of the
quarter, the investor’s holding period return is closest to:
A. −13.0 percent.
B. −11.6 percent.
C. −10.1 percent.
Solution:
C is correct. Applying Equation 2, the holding period return is −10.1 per-
cent, calculated as follows:
R = (3,050 − 3,450 + 51.55)/3,450 = −10.1%.
The holding period return comprised of a dividend yield of 1.49 percent (=
51.55/3,450) and a capital loss of −11.59 percent (= −400/3,450).

EXAMPLE 3

Holding Period Return

1. An analyst obtains the following annual rates of return for a mutual fund,
which are presented in Exhibit 3.
​

Exhibit 3: Mutual Fund Performance, 20X8–20X0

​

Year Return (%)

20X8 14
20X9 −10
20X0 −2
​

The fund’s holding period return over the three-year period is closest to:
A. 0.18 percent.
B. 0.55 percent.
C. 0.67 percent.
Solution:
B is correct. The fund’s three-year holding period return is 0.55 percent,
calculated as follows:
R = [(1 + R1) × (1 + R2) × (1 + R3)] − 1,

R = [(1 + 0.14)(1 − 0.10)(1 − 0.02)] − 1 = 0.0055 = 0.55%.

 © CFA Institute. For candidate use only. Not for distribution.
12 Learning Module 1 Rates and Returns

EXAMPLE 4

Geometric Mean Return

1. An analyst observes the following annual rates of return for a hedge fund,
which are presented in Exhibit 4.
​

Exhibit 4: Hedge Fund Performance, 20X8–20X0

​

Year Return (%)

20X8 22
20X9 −25
20X0 11
​

The fund’s geometric mean return over the three-year period is closest to:
A. 0.52 percent.
B. 1.02 percent.
C. 2.67 percent.
Solution:
A is correct. Applying Equation 4, the fund’s geometric mean return over
the three-year period is 0.52 percent, calculated as follows:
_
​​​ R ​​  G​​​= [(1 + 0.22)(1 − 0.25)(1 + 0.11)](1/3) − 1 = 1.0157(1/3) − 1 = 0.0052
= 0.52%.

EXAMPLE 5

Geometric and Arithmetic Mean Returns

1. Consider the annual return data for the group of countries in Exhibit 5.
​

Exhibit 5: Annual Returns for Years 1 to 3 for Selected Countries’

Stock Indexes
​

52-Week Return (%) Average 3-Year Return

Index Year 1 Year 2 Year 3 Arithmetic Geometric

Country A −15.6 −5.4 6.1 −4.97 −5.38

Country B 7.8 6.3 −1.5 4.20 4.12
Country C 5.3 1.2 3.5 3.33 3.32
Country D −2.4 −3.1 6.2 0.23 0.15
Country E −4.0 −3.0 3.0 −1.33 −1.38
Country F 5.4 5.2 −1.0 3.20 3.16
Country G 12.7 6.7 −1.2 6.07 5.91
Country H 3.5 4.3 3.4 3.73 3.73
Country I 6.2 7.8 3.2 5.73 5.72
 © CFA Institute. For candidate use only. Not for distribution.
Rates of Return 13

52-Week Return (%) Average 3-Year Return

Index Year 1 Year 2 Year 3 Arithmetic Geometric

Country J 8.1 4.1 −0.9 3.77 3.70
Country K 11.5 3.4 1.2 5.37 5.28
​

Calculate the arithmetic and geometric mean returns over the three years
for the following three stock indexes: Country D, Country E, and Country F.
Solution:
The arithmetic mean returns are as follows:
​

Annual Return (%) Arithmetic

Sum
3 Mean Return
Year 1 Year 2 Year 3 ​​∑ ​​Ri​  ​​ (%)
i=1
Country D −2.4 −3.1 6.2 0.7 0.233
Country E −4.0 −3.0 3.0 −4.0 −1.333
Country F 5.4 5.2 −1.0 9.6 3.200
​

The geometric mean returns are as follows:

​

1 + Return in Decimal Form

(1 + Rt) Product 3rd root Geometric
​1⁄ 3​
​  (​ 1 + ​Rt​  )​​ ​​​ ​​​[​∏ ]
​​
T T mean
Year 1 Year 2 Year 3 ∏
t t
​  ​(1 + ​Rt​  ​​)​ ​​​  ​​ return (%)

Country D 0.976 0.969 1.062 1.00438 1.00146 0.146

Country E 0.960 0.970 1.030 0.95914 0.98619 −1.381
Country F 1.054 1.052 0.990 1.09772 1.03157 3.157
​

In Example 5, the geometric mean return is less than the arithmetic mean return
for each country’s index returns. In fact, the geometric mean is always less than or
equal to the arithmetic mean with one exception: the two means will be equal is when
there is no variability in the observations—that is, when all the observations in the
series are the same.
In general, the difference between the arithmetic and geometric means increases
with the variability within the sample; the more disperse the observations, the greater
the difference between the arithmetic and geometric means. Casual inspection of the
returns in Exhibit 5 and the associated graph of means in Exhibit 6 suggests a greater
variability for Country A’s index relative to the other indexes, and this is confirmed
with the greater deviation of the geometric mean return (−5.38 percent) from the
arithmetic mean return (−4.97 percent). How should the analyst interpret these results?
 © CFA Institute. For candidate use only. Not for distribution.
14 Learning Module 1 Rates and Returns

Exhibit 6: Arithmetic and Geometric Mean Returns for Country Stock

Indexes, Years 1 to 3
Country

A
B
C
D
E
F
G
H
I
J
K

6 –4 –2 0 2 4 6 8
Mean Return (%)
Geometric Mean Arithmetic Average

The geometric mean return represents the growth rate or compound rate of return on
an investment. One unit of currency invested in a fund tracking the Country B index
at the beginning of Year 1 would have grown to (1.078)(1.063)(0.985) = 1.128725 units
of currency, which is equal to 1 plus Country B’s geometric mean return of 4.1189 per-
cent compounded over three periods: [1 + 0.041189]3 = 1.128725. This math confirms
that the geometric mean is the compound rate of return. With its focus on the actual
return of an investment over a multiple-period horizon, the geometric mean is of key
interest to investors. The arithmetic mean return, focusing on average single-period
performance, is also of interest. Both arithmetic and geometric means have a role to
play in investment management, and both are often reported for return series.
For reporting historical returns, the geometric mean has considerable appeal
because it is the rate of growth or return we would have to earn each year to match
the actual, cumulative investment performance. Suppose we purchased a stock for
EUR100 and two years later it was worth EUR100, with an intervening year at EUR200.
The geometric mean of 0 percent is clearly the compound rate of growth during the
two years, which we can confirm by compounding the returns: [(1 + 1.00)(1 − 0.50)]1/2
− 1 = 0%. Specifically, the ending amount is the beginning amount times (1 + RG)2.
However, the arithmetic mean, which is [100% + −50%]/2 = 25% in the previous
example, can distort our assessment of historical performance. As we noted, the
arithmetic mean is always greater than or equal to the geometric mean. If we want to
estimate the average return over a one-period horizon, we should use the arithmetic
mean because the arithmetic mean is the average of one-period returns. If we want
to estimate the average returns over more than one period, however, we should use
the geometric mean of returns because the geometric mean captures how the total
returns are linked over time.

The Harmonic Mean

_
The harmonic mean, ​​​ X ​​  H​​​, is another measure of central tendency. The harmonic
mean is appropriate in cases in which the variable is a rate or a ratio. The terminology
“harmonic” arises from its use of a type of series involving reciprocals known as a
harmonic series.
 © CFA Institute. For candidate use only. Not for distribution.
Rates of Return 15

Harmonic Mean Formula. The harmonic mean of a set of observations X1, X2,
…, Xn is:
_
​​​ X ​​  H​​  = ​ _
n
n  ​​, (4)
​∑​(1 / ​Xi​  ​​)​
i=1

with Xi > 0 for i = 1, 2, …, n.

The harmonic mean is the value obtained by summing the reciprocals of the
observations,
n
​​∑ ​ ​(1 / ​Xi​  ​​)​​​,
i=1

the terms of the form 1/Xi, and then averaging their sum by dividing it by the
number of observations, n, and, then finally, taking the reciprocal of that average,
_
n
​​  n  ​​.
​∑​(1 / ​Xi​  ​​)​
i=1

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. For example, if there
is a sample of observations of 1, 2, 3, 4, 5, 6, and 1,000, the harmonic mean is 2.8560.
Compared to the arithmetic mean of 145.8571, we see the influence of the outlier (the
1,000) to be much less than in the case of the arithmetic mean. 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. Suppose three peer companies have P/Es of 45, 15, and 15. The arithmetic
mean is 25, but the harmonic mean, which gives less weight to the P/E of 45, is 19.3.
The harmonic mean is a relatively specialized concept of the mean that is appro-
priate for averaging ratios (“amount per unit”) when the ratios are repeatedly applied
to a fixed quantity to yield a variable number of units. The concept is best explained
through an illustration. A well-known application arises in the investment strategy
known as cost averaging, which involves the periodic investment of a fixed amount
of money. In this application, the ratios we are averaging are prices per share at
different purchase dates, and we are applying those prices to a constant amount of
money to yield a variable number of shares. An illustration of the harmonic mean to
cost averaging is provided in Example 6.

EXAMPLE 6

Cost Averaging and the Harmonic Mean

1. Suppose an investor invests EUR1,000 each month in a particular stock for

n = 2 months. The share prices are EUR10 and EUR15 at the two purchase
dates. What was the average price paid for the security?
Solution:
Purchase in the first month = EUR1,000/EUR10 = 100 shares.

Purchase in the second month = EUR1,000/EUR15 = 66.67 shares.

The investor purchased a total of 166.67 shares for EUR2,000, so the average
price paid per share is EUR2,000/166.67 = EUR12.
The average price paid is in fact the harmonic mean of the asset’s prices at
the purchase dates. Using Equation 5, the harmonic mean price is 2/[(1/10)
+ (1/15)] = EUR12. The value EUR12 is less than the arithmetic mean pur-
chase price (EUR10 + EUR15)/2 = EUR12.5.
 © CFA Institute. For candidate use only. Not for distribution.
16 Learning Module 1 Rates and Returns

Because they use the same data but involve different progressions in their respec-
tive calculations, the arithmetic, geometric, and harmonic means are mathematically
related to one another. We will not go into the proof of this relationship, but the basic
result follows:
Arithmetic mean × Harmonic mean = (Geometric mean)2.
Unless all the observations in a dataset are the same value, the harmonic mean is always
less than the geometric mean, which, in turn, is always less than the arithmetic mean.
The harmonic mean only works for non-negative numbers, so when working with
returns that are expressed as positive or negative percentages, we first convert the
returns into a compounding format, assuming a reinvestment, as (1 + R), as was done
in the geometric mean return calculation, and then calculate (1 + harmonic mean),
and subtract 1 to arrive at the harmonic mean return.

EXAMPLE 7

Calculating the Arithmetic, Geometric, and Harmonic

Means for P/Es
Each year in December, a securities analyst selects her 10 favorite stocks for
the next year. Exhibit 7 presents the P/Es, the ratio of share price to projected
earnings per share (EPS), for her top 10 stock picks for the next year.
​

Exhibit 7: Analyst’s 10 Favorite Stocks for Next Year

​

Stock P/E

Stock 1 22.29
Stock 2 15.54
Stock 3 9.38
Stock 4 15.12
Stock 5 10.72
Stock 6 14.57
Stock 7 7.20
Stock 8 7.97
Stock 9 10.34
Stock 10 8.35
​

1. Calculate the arithmetic mean P/E for these 10 stocks.

Solution:
The arithmetic mean is calculated as:
121.48/10 = 12.1480.

2. Calculate the geometric mean P/E for these 10 stocks.

Solution:
The geometric mean P/E is calculated as:
_ _____________________
​​​_
√
P 10 _ _ _ _
 ​  E ​​​  ​​  = ​ ​​  P
    P P P
E ​​  ​​ × ​​ E ​​  ​​ × … × ​​ E ​​  ​​ × ​​ E ​​  ​​ ​ ​
Gi 1 2 9 10

10
__________________________
​= ​ √ 22.29
    × 15.54…× 10.34 × 8.35 ​​
 © CFA Institute. For candidate use only. Not for distribution.
Rates of Return 17

10
______________
​=  ​ √   
38, 016, 128, 040 ​ = 11.4287. ​
The geometric mean is 11.4287. This result can also be obtained as:
_ ln​(38,016,128,040)​
ln​(22.29×15.54…×10.34×8.35)​
______________________ ______________
​​​_
P    
​     24.3613/10​
 ​  10 ​  = ​ ​e​​    
​  10 ​ = ​e​​ 
E ​​​  ​​  = ​e​​ 
Gi
​ = 11.4287​.

3. Calculate the harmonic mean P/E for the 10 stocks.

Solution:
The harmonic mean is calculated as:
_
​​​ X ​​  H​​  = ​ _
n
n  ​​,
​∑ ​ ​(1 / ​Xi​  ​​)​
i=1

_ 10
​​​ X ​​  H​​  = ​ _______________________________
  
    1  ​​,
​(​  22.29 ​)​ + ​(​  15.54 ​)​ + … + ​(​  10.34 ​)​ + ​(​  8.35 ​)​
_ 1 _1 _ 1 _

_
​​​ X ​​  H​​  = 10 / 0.9247 = 10.8142​.
In finance, the weighted harmonic mean is used when averaging rates and
other multiples, such as the P/E ratio, because the harmonic mean gives
equal weight to each data point, and reduces the influence of outliers.
These calculations can be performed using Excel:

■ To calculate the arithmetic mean or average return, the

=AVERAGE(return1, return2, … ) function can be used.
■ To calculate the geometric mean return, the =GEOMEAN(return1,
return2, … ) function can be used.
■ To calculate the harmonic mean return, the =HARMEAN(return1,
return2, … ) function can be used.

In addition to arithmetic, geometric, and harmonic means, two other types of

means can be used. Both the trimmed and the winsorized means seek to minimize
the impact of outliers in a dataset. Specifically, the 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.
A winsorized mean replaces the extreme observations in a dataset to limit the
effect of the outliers on the calculations. The winsorized mean is calculated after
replacing extreme values at both ends with the values of their nearest observations,
and then calculating the mean by averaging the remaining observations.
However, the key question is: Which mean to use in what circumstances? The
choice of which mean to use depends on many factors, as we describe in Exhibit 8:
■ Are there outliers that we want to include?
■ Is the distribution symmetric?
■ Is there compounding?
■ Are there extreme outliers?
 © CFA Institute. For candidate use only. Not for distribution.
18 Learning Module 1 Rates and Returns

Exhibit 8: Deciding Which Measure to Use

Collect Sample

Include all
values, Yes
Arithmetic Mean
including
outliers?

Yes
Compounding? Geometric Mean

Yes Harmonic mean,

Extreme Trimmed mean,
outliers? Winsorized mean

QUESTION SET

A fund had the following returns over the past 10 years:

Exhibit 9: 10-Year Returns

​

Year Return

1 4.5%
2 6.0%
3 1.5%
4 −2.0%
5 0.0%
6 4.5%
7 3.5%
8 2.5%
9 5.5%
10 4.0%
​

1. The arithmetic mean return over the 10 years is closest to:

A. 2.97 percent.
B. 3.00 percent.
C. 3.33 percent.
Solution:
B is correct. The arithmetic mean return is calculated as follows:
 © CFA Institute. For candidate use only. Not for distribution.
Money-Weighted and Time-Weighted Return 19

_
​​ R ​ = ​30.0%/10 = 3.0%.

2. The geometric mean return over the 10 years is closest to:

A. 2.94 percent.
B. 2.97 percent.
C. 3.00 percent.
Solution:
B is correct. The geometric mean return is calculated as follows:
_ 10
_____________________________________________
​​​ R ​​  G​​  = ​ √ (​     
1 + 0.045)​ × ​(1 + 0.06)​ × … × ​(1 + 0.055)​ × ​(1 + 0.04)​ ​ − 1​
_ 10
_
​​​ R ​​  G​​  = ​ √ 1.3402338 ​ − 1​= 2.9717%.

MONEY-WEIGHTED AND TIME-WEIGHTED RETURN

4
compare the money-weighted and time-weighted rates of return and
evaluate the performance of portfolios based on these measures

The arithmetic and geometric return computations do not account for the timing of
cash flows into and out of a portfolio. For example, suppose an investor experiences
the returns shown in Exhibit 2. Instead of only investing EUR1.0 at the start (Year
0) as was the case in Exhibit 2, suppose the investor had invested EUR10,000 at the
start, EUR1,000 in Year 1, and EUR1,000 in Year 2. In that case, the return of –50
percent in Year 1 significantly hurts her given the relatively large investment at the
start. Conversely, if she had invested only EUR100 at the start, the absolute effect of
the –50 percent return on the total return is drastically reduced.

Calculating the Money Weighted Return

The money-weighted return accounts for the money invested and provides the
investor with information on the actual return she earns on her investment. The
money-weighted return and its calculation are similar to the internal rate of return
and a bond’s yield to maturity. Amounts invested are cash outflows from the investor’s
perspective and amounts returned or withdrawn by the investor, or the money that
remains at the end of an investment cycle, is a cash inflow for the investor.
For example, assume that an investor invests EUR100 in a mutual fund at the
beginning of the first year, adds another EUR950 at the beginning of the second year,
and withdraws EUR350 at the end of the second year. The cash flows are presented
in Exhibit 10.
 © CFA Institute. For candidate use only. Not for distribution.
20 Learning Module 1 Rates and Returns

Exhibit 10: Portfolio Balances across Three Years

Year 1 2 3

Balance from previous year EUR0 EUR50 EUR1,000

New investment by the investor (cash inflow for the
mutual fund) at the start of the year 100 950 0
Net balance at the beginning of year 100 1,000 1,000
Investment return for the year −50% 35% 27%
Investment gain (loss) −50 350 270
Withdrawal by the investor (cash outflow for the
mutual fund) at the end of the year 0 −350 0
Balance at the end of year EUR50 EUR1,000 EUR1,270

The internal rate of return is the discount rate at which the sum of present values
of cash flows will equal zero. In general, the equation may be expressed as follows:
T _ C ​Ft​  ​​
​  ​∑ ​​​ ​  t ​  = 0​, (5)
t=0 (​​ 1 + IRR)​​​  ​

where T is the number of periods, CFt is the cash flow at time t, and IRR is the internal
rate of return or the money-weighted rate of return.
A cash flow can be positive or negative; a positive cash flow is an inflow where
money flows to the investor, whereas a negative cash flow is an outflow where money
flows away from the investor. The cash flows are expressed as follows, where each cash
inflow or outflow occurs at the end of each year. Thus, CF0 refers to the cash flow at
the end of Year 0 or beginning of Year 1, and CF3 refers to the cash flow at end of Year
3 or beginning of Year 4. Because cash flows are being discounted to the present—that
is, end of Year 0 or beginning of Year 1—the period of discounting CF0 is zero.
​CF​  0​​  = − 100
​CF​  1​​  = − 950
​CF​  2​​  = + 350
​CF​  3​​  = + 1, 270
    
    
     ​​ ​CF​  ​​ ​ ​C​ F​  ​​ ​CF​  2​​ ​CF​  3​​
​ ​​.​
_ 0 _ 1 _ _
​ ( 0  ​  + ​  1  ​  + ​  2  ​  + ​  3  ​
​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​
) ( ) ( ) ( )
− 100 _ − 950 + 350 + 1270
= ​ _ _ _
1 ​  + ​  (​​ 1 + IRR)​​​  1 ​ ​ + ​  ​​(1 + IRR)​​​  2 ​ ​ + ​  ​​(1 + IRR)​​​  3 ​ = 0
​
IRR = 26.11%
The investor’s internal rate of return, or the money-weighted rate of return, is 26.11
percent, which tells the investor what she earned on the actual euros invested for the
entire period on an annualized basis. This return is much greater than the arithmetic
and geometric mean returns because only a small amount was invested when the
mutual fund’s return was −50 percent.
All the above calculations can be performed using Excel using the =IRR(values)
function, which results in an IRR of 26.11 percent.

Money-Weighted Return for a Dividend-Paying Stock

Next, we’ll illustrate calculating the money-weighted return for a dividend paying
stock. Consider an investment that covers a two-year horizon. At time t = 0, an inves-
tor buys one share at a price of USD200. At time t = 1, he purchases an additional
share at a price of USD225. At the end of Year 2, t = 2, he sells both shares at a price
of USD235. During both years, the stock pays a dividend of USD5 per share. The t
=1 dividend is not reinvested. Exhibit 11 outlines the total cash inflows and outflows
for the investment.
 © CFA Institute. For candidate use only. Not for distribution.
Money-Weighted and Time-Weighted Return 21

Exhibit 11: Cash Flows for a Dividend-Paying Stock

Time Outflows

0 USD200 to purchase the first share

1 USD225 to purchase the second share

Time Inflows

1 USD5 dividend received from first share (and not reinvested)

2 USD10 dividend (USD5 per share × 2 shares) received
2 USD470 received from selling two shares at USD235 per share

To solve for the money-weighted return, the first step is to group net cash flows by
time. For this example, we have −USD200 for the t = 0 net cash flow, −USD220 = −
USD225 + USD5 for the t = 1 net cash flow, and USD480 for the t = 2 net cash flow.
After entering these cash flows, we use the spreadsheet’s (such as Excel) or calculator’s
IRR function to find that the money-weighted rate of return is 9.39 percent.
​CF​  0​​  = − 200
​CF​  1​​  = − 220
​CF​  2​​  = + 480
​​ ​CF​  0​​  ​  + ​ _
   
   
​   
_ ​ ​CF​  1​​  ​  + ​ _
 ​​ ​CF​  2​​ ​ .​
 ​
)0 )1
​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​
( ( ( )2
− 200 − 220 480
= ​ _ _ _
1 ​  + ​  ( )1
 ​  + ​  ( )2
 ​ = 0
​​ 1 + IRR ​​​  ​ ​​ 1 + IRR ​​​  ​
IRR = 9.39%
All these calculations can be performed using Excel using the =IRR(values) function,
which results in an IRR of 9.39 percent.
Now we take a closer look at what has happened to the portfolio during each of
the two years.
In the first year, the portfolio generated a one-period holding period return of
(USD5 + USD225 − USD200)/USD200 = 15%. At the beginning of the second year,
the amount invested is USD450, calculated as USD225 (per share price of stock) × 2
shares, because the USD5 dividend was spent rather than reinvested.
At the end of the second year, the proceeds from the liquidation of the portfolio
are USD470 plus USD10 in dividends (as outlined in Exhibit 11). So, in the second
year the portfolio produced a holding period return of (USD10 + USD470 − USD450)/
USD450 = 6.67%. The mean holding period return was (15% + 6.67%)/2 = 10.84%.
The money-weighted rate of return, which we calculated as 9.39 percent, puts a
greater weight on the second year’s relatively poor performance (6.67 percent) than
the first year’s relatively good performance (15 percent), as more money was invested
in the second year than in the first. That is the sense in which returns in this method
of calculating performance are “money weighted.”
Although the money-weighted return is an accurate measure of what the investor
earned on the money invested, it is limited in its applicability to other situations.
For example, it does not allow for a return comparison between different individ-
uals or different investment opportunities. 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.
 © CFA Institute. For candidate use only. Not for distribution.
22 Learning Module 1 Rates and Returns

EXAMPLE 8

Computation of Returns
Ulli Lohrmann and his wife, Suzanne Lohrmann, are planning for retirement
and want to compare the past performance of a few mutual funds they are con-
sidering for investment. They believe that a comparison over a five-year period
would be appropriate. They gather information on a fund they are considering,
the Rhein Valley Superior Fund, which is presented in Exhibit 12.
​

Exhibit 12: Rhein Valley Superior Fund Performance

​

Assets under Management

at the Beginning of Year Annual Return
Year (euros) (%)

1 30 million 15
2 45 million −5
3 20 million 10
4 25 million 15
5 35 million 3
​

The Lohrmanns are interested in aggregating this information for ease of

comparison with other funds.
​

Exhibit 13: Rhein Valley Superior Fund Annual Returns and

Investments (euro millions)
​

Year 1 2 3 4 5

Balance from previous year 0 34.50 42.75 22.00 28.75

New investment by the investor (cash
inflow for the Rhein fund) 30.00 10.50 0 3.00 6.25
Withdrawal by the investor (cash
outflow for the Rhein fund) 0 0 −22.75 0 0
Net balance at the beginning of year 30.00 45.00 20.00 25.00 35.00
Investment return for the year 15% –5% 10% 15% 3%
Investment gain (loss) 4.50 –2.25 2.00 3.75 1.05
Balance at the end of year 34.50 42.75 22.00 28.75 36.05
​

1. Compute the fund’s holding period return for the five-year period.
Solution:
The five-year holding period return is calculated as:
R = (1 + R1)(1 + R2)(1 + R3)(1 + R4)(1 + R5) – 1

R = (1.15)(0.95)(1.10)(1.15)(1.03) – 1 =

R = 0.4235 = 42.35%.
 © CFA Institute. For candidate use only. Not for distribution.
Money-Weighted and Time-Weighted Return 23

2. Compute the fund’ s arithmetic mean annual return.

Solution:
The arithmetic mean annual return is calculated as:
_ 15 %  − 5 %  + 10 %  + 15 %  + 3%
​​​ R ​​  i​​  = ​ ________________________
    5  
 ​  = 7.60%​.

3. Compute the fund’s geometric mean annual return. How does it compare
with the arithmetic mean annual return?
Solution:
The geometric mean annual return can be computed as:
_ 5
___________________________
​​​ R ​​  Gi​​  = ​ √ 1.15
    × 0.95 × 1.10 × 1.15 × 1.03 ​ − 1,​
_ 5
_
​​​ R ​​  Gi​​  = ​ √ 1.4235 ​ − 1 = 0.0732 = 7.32%​.
Thus, the geometric mean annual return is 7.32 percent, which is slightly
less than the arithmetic mean return of 7.60 percent.

4. The Lohrmanns want to earn a minimum annual return of 5 percent. The

annual returns and investment amounts are presented in Exhibit 13. Is the
money-weighted annual return greater than 5 percent?
Solution:
To calculate the money-weighted rate of return, tabulate the annual returns
and investment amounts to determine the cash flows, as shown in Exhibit
13:
CF0 = –30.00, CF1 = –10.50, CF2 = +22.75, CF3 = –3.00, CF4 = –6.25, CF5
= +36.05.
We can use the given 5 percent return to see whether or not the present val-
ue of the net cash flows is positive. If it is positive, then the money-weighted
rate of return is greater than 5 percent, because a 5 percent discount rate
could not reduce the present value to zero.
_ − 30.00 _ − 10.50 _ 22.75 − 3.00 − 6.25 36.05
​​  (  ​  + ​   ​  + ​   ​  + ​ _ ​  + ​ _ ​  + ​ _ ​  = 1.1471​.
​​ 1.05)​​​  0​ ​​(1.05)​​​  1​ ​​(1.05)​​​  2​ ​​(1.05)​​​  3​ ​​(1.05)​​​  4​ ​​(1.05)​​​  5​
Because the value is positive, the money-weighted rate of return is greater
than 5 percent. The exact money-weighted rate of return (found by setting
the above equation equal to zero) is 5.86 percent.
These calculations can be performed using Excel using the =IRR(cash flows)
function, which results in an IRR of 5.86 percent.

Time-Weighted Returns
An investment measure that is not sensitive to the additions and withdrawals of funds
is the time-weighted rate of return. The time-weighted rate of return measures the
compound rate of growth of USD1 initially invested in the portfolio over a stated
measurement period. For the evaluation of portfolios of publicly traded securities, the
time-weighted rate of return is the preferred performance measure as it neutralizes
the effect of cash withdrawals or additions to the portfolio, which are generally outside
of the control of the portfolio manager.
 © CFA Institute. For candidate use only. Not for distribution.
24 Learning Module 1 Rates and Returns

Computing Time-Weighted Returns

To compute an exact time-weighted rate of return on a portfolio, take the following
three steps:
1. Price the portfolio immediately prior to any significant addition or with-
drawal of funds. Break the overall evaluation period into subperiods based
on the dates of cash inflows and outflows.
2. Calculate the holding period return on the portfolio for each subperiod.
3. Link or compound holding period returns to obtain an annual rate of return
for the year (the time-weighted rate of return for the year). If the investment
is for more than one year, take the geometric mean of the annual returns to
obtain the time-weighted rate of return over that measurement period.
Let us return to our dividend stock money-weighted example in the section,
“Money-Weighted Return for a Dividend-Paying Stock” and calculate the time-weighted
rate of return for that investor’s portfolio based on the information included in Exhibit
11. In that example, we computed the holding period returns on the portfolio, Step
2 in the procedure for finding the time-weighted rate of return. Given that the port-
folio earned returns of 15 percent during the first year and 6.67 percent during the
second year, what is the portfolio’s time-weighted rate of return over an evaluation
period of two years?
We find this time-weighted return by taking the geometric mean of the two holding
period returns, Step 3 in the previous procedure. The calculation of the geometric
mean exactly mirrors the calculation of a compound growth rate. Here, we take the
product of 1 plus the holding period return for each period to find the terminal value
at t = 2 of USD1 invested at t = 0. We then take the square root of this product and
subtract 1 to get the geometric mean return. We interpret the result as the annual
compound growth rate of USD1 invested in the portfolio at t = 0. Thus, we have:
​​​  2​ = ​
(​​ 1 + Time-weighted return)____________
(1.15)(​​ 1.0667)​
    
​​ ​ ​​.
Time-weighted return = ​√ (​   1.15)(​​ 1.0667)​ ​ − 1 = 10.76%
The time-weighted return on the portfolio was 10.76 percent, compared with the
money-weighted return of 9.39 percent, which gave larger weight to the second year’s
return. We can see why investment managers find time-weighted returns more mean-
ingful. If a client gives an investment manager more funds to invest at an unfavorable
time, the manager’s money-weighted rate of return will tend to be depressed. If a client
adds funds at a favorable time, the money-weighted return will tend to be elevated.
The time-weighted rate of return removes these effects.
In defining the steps to calculate an exact time-weighted rate of return, we said
that the portfolio should be valued immediately prior to any significant addition or
withdrawal of funds. With the amount of cash flow activity in many portfolios, this task
can be costly. We can often obtain a reasonable approximation of the time-weighted
rate of return by valuing the portfolio at frequent, regular intervals, particularly if
additions and withdrawals are unrelated to market movements.
The more frequent the valuation, the more accurate the approximation. Daily
valuation is commonplace. Suppose that a portfolio is valued daily over the course
of a year. To compute the time-weighted return for the year, we first compute each
day’s holding period return. We compute 365 such daily returns, denoted R1, R2, …,
R365. We obtain the annual return for the year by linking the daily holding period
returns in the following way: (1 + R1) × (1 + R2) × … × (1 + R365) − 1. If withdrawals
and additions to the portfolio happen only at day’s end, this annual return is a precise
time-weighted rate of return for the year. Otherwise, it is an approximate time-weighted
return for the year.
 © CFA Institute. For candidate use only. Not for distribution.
Money-Weighted and Time-Weighted Return 25

If we have several years of data, we can calculate a time-weighted return for each
year individually, as above. If Ri is the time-weighted return for year i, we calculate an
annualized time-weighted return as the geometric mean of N annual returns, as follows:
​  ​​  = ​​[​(1 + ​R1​  ​​)​ × ​(1 + ​R2​  ​​)​ × … × ​(1 + ​RN
​​RTW ​  ​​)​]​​​  1/N​ − 1​. (6)

Example 9 illustrates the calculation of the time-weighted rate of return.

EXAMPLE 9

Time-Weighted Rate of Return

Strubeck Corporation sponsors a pension plan for its employees. It manages
part of the equity portfolio in-house and delegates management of the balance
to Super Trust Company. As chief investment officer of Strubeck, you want to
review the performance of the in-house and Super Trust portfolios over the
last four quarters. You have arranged for outflows and inflows to the portfolios
to be made at the very beginning of the quarter. Exhibit 14 summarizes the
inflows and outflows as well as the two portfolios’ valuations. In Exhibit 11, the
ending value is the portfolio’s value just prior to the cash inflow or outflow at
the beginning of the quarter. The amount invested is the amount each portfolio
manager is responsible for investing.
​

Exhibit 14: Cash Flows for the In-House Strubeck Account and the
Super Trust Account (US dollars)
​

Quarter

1 2 3 4
Panel A: In-House Account
Beginning value 4,000,000 6,000,000 5,775,000 6,720,000
Beginning of period inflow
(outflow) 1,000,000 (500,000) 225,000 (600,000)
Amount invested 5,000,000 5,500,000 6,000,000 6,120,000
Ending value 6,000,000 5,775,000 6,720,000 5,508,000
​

Panel B: Super Trust Account

Beginning value 10,000,000 13,200,000 12,240,000 5,659,200
Beginning of period inflow
(outflow) 2,000,000 (1,200,000) (7,000,000) (400,000)
Amount invested 12,000,000 12,000,000 5,240,000 5,259,200
Ending value 13,200,000 12,240,000 5,659,200 5,469,568
​

1. Calculate the time-weighted rate of return for the in-house account.

Solution:
To calculate the time-weighted rate of return for the in-house account, we
compute the quarterly holding period returns for the account and link them
into an annual return. The in-house account’s time-weighted rate of return
is 27.01 percent, calculated as follows:
 © CFA Institute. For candidate use only. Not for distribution.
26 Learning Module 1 Rates and Returns

1Q HPR:  ​r​ 1​​  = ​(USD6,000,000 − USD5,000,000)​ / USD5,000,000 = 0.20

2Q HPR:  ​r​ 2​​  = ​(USD5,775,000 − USD5,500,000)​ / USD5,500,000 = 0.05
       
       
       
​​ ​​​ ​​
3Q HPR:  ​r​ 3​​  = ​(USD6,720,000 − USD6,000,000)​ / USD6,000,000 = 0.12
4Q HPR:  ​r​ 4​​  = ​(USD5,508,000 − USD6,120,000)​ / USD6,120,000 = − 0.10

​  ​​  = ​(1 + ​r​ 1​​)​​(1 + ​r​ 2​​)​​(1 + ​r​ 3​​)​​(1 + ​r​ 4​​)​ − 1​,

​​RTW

​​RTW
​  ​​  = ​(1.20)(​​ 1.05)(​​ 1.12)(​​ 0.90)​ − 1 = 0.2701 or 27.01%​.

2. Calculate the time-weighted rate of return for the Super Trust account.
Solution:
The account managed by Super Trust has a time-weighted rate of return of
26.02 percent, calculated as follows:
1Q HPR:  ​r​ 1​​  = ​(USD13, 200, 000 − USD12, 000, 000)​ / USD12, 000, 000 = 0.10
2Q HPR:  ​r​ 2​​  = ​(USD12, 240, 000 − USD12, 000, 000)​ / USD12, 000, 000 = 0.02
       
       
       
​​  ​​
​ ​​
3Q HPR:  ​r​ 3​​  = ​(USD5, 659, 200 − USD5, 240, 000)​ / USD5, 240, 000 = 0.08
4Q HPR:  ​r​ 4​​  = ​(USD5, 469, 568 − USD5, 259, 200)​ / USD5, 259, 200 = 0.04

​  ​​  = ​(1 + ​r​ 1​​)​​(1 + ​r​ 2​​)​​(1 + ​r​ 3​​)​​(1 + ​r​ 4​​)​ − 1​,

​​RTW

​​RTW
​  ​​  = ​(1.10)(​​ 1.02)(​​ 1.08)(​​ 1.04)​ − 1 = 0.2602 or 26.02%​.
The in-house portfolio’s time-weighted rate of return is higher than the
Super Trust portfolio’s by 99 basis points. Note that 27.01 percent and 26.02
percent might be rounded to 27 percent and 26 percent, respectively. The
impact of the rounding the performance difference (100 bp vs. 99 bp) may
seem as trivial, yet it’s impact on a large portfolio may be substantive.

Having worked through this exercise, we are ready to look at a more detailed case.

EXAMPLE 10

Time-Weighted and Money-Weighted Rates of Return Side

by Side
Your task is to compute the investment performance of the Walbright Fund for
the most recent year. The facts are as follows:
■ On 1 January, the Walbright Fund had a market value of USD100
million.
■ During the period 1 January to 30 April, the stocks in the fund gener-
ated a capital gain of USD10 million.
■ On 1 May, the stocks in the fund paid a total dividend of USD2 mil-
lion. All dividends were reinvested in additional shares.
■ Because the fund’s performance had been exceptional, institutions
invested an additional USD20 million in Walbright on 1 May, raising
assets under management to USD132 million (USD100 + USD10 +
USD2 + USD20).
■ On 31 December, Walbright received total dividends of USD2.64
million. The fund’s market value on 31 December, not including the
USD2.64 million in dividends, was USD140 million.
■ The fund made no other interim cash payments during the year.
 © CFA Institute. For candidate use only. Not for distribution.
Money-Weighted and Time-Weighted Return 27

1. Compute the Walbright Fund’s time-weighted rate of return.

Solution:
Because interim cash flows were made on 1 May, we must compute two
interim total returns and then link them to obtain an annual return. Exhibit
15 lists the relevant market values on 1 January, 1 May, and 31 December, as
well as the associated interim four-month (1 January to 1 May) and eight-
month (1 May to 31 December) holding period returns.
​

Exhibit 15: Cash Flows for the Walbright Fund

​

1 January Beginning portfolio value = USD100 million

1 May Dividends received before additional investment = USD2 million
Ending portfolio value = USD110 million
Four-month holding period return:
USD2 + USD10
____________
​R = ​   USD100
 ​ = 12% ​

New investment = USD20 million

Beginning market value for last two-thirds of the year = USD132
million
31 December Dividends received = USD2.64 million
Ending portfolio value = USD140 million
Eight-month
USD2.64 holding
USD140period
+    return:
− USD132
_______________________
​R = ​     USD132
 ​ = 8.06% ​
​

Now we must geometrically link the four- and eight-month holding period
returns to compute an annual return. We compute the time-weighted return
as follows:
​​RTW
​  ​​​= 1.12 × 1.0806 − 1 = 0.2103.
In this instance, we compute a time-weighted rate of return of 21.03 percent
for one year. The four-month and eight-month intervals combine to equal
one year. (Note: Taking the square root of the product 1.12 × 1.0806 would
be appropriate only if 1.12 and 1.0806 each applied to one full year.)

2. Compute the Walbright Fund’s money-weighted rate of return.

Solution:
To calculate the money-weighted return, we need to find the discount rate
that sets the sum of the present value of cash inflows and outflows equal to
zero. The initial market value of the fund and all additions to it are treated
as cash outflows. (Think of them as expenditures.) Withdrawals, receipts,
and the ending market value of the fund are counted as inflows. (The end-
ing market value is the amount investors receive on liquidating the fund.)
Because interim cash flows have occurred at four-month intervals, we must
solve for the four-month internal rate of return. Exhibit 15 details the cash
flows and their timing.
CF0 = –100

CF1 = –20

CF2 = 0
 © CFA Institute. For candidate use only. Not for distribution.
28 Learning Module 1 Rates and Returns

CF3 = 142.64
CF0 refers to the initial investment of USD100 million made at the begin-
ning of the first four-month interval on 1 January. CF1 refers to the cash
flows made at end of the first four-month interval or the beginning of the
second four-month interval on 1 May. Those cash flows include a cash in-
flow of USD2 million for the dividend received and cash outflows of USD22
million for the dividend reinvested and additional investment, respectively.
The second four-month interval had no cash flow so CF2 is equal to zero.
CF3 refers to the cash inflows at the end of the third four-month interval.
Those cash inflows include a USD2.64 million dividend received and the
fund’s terminal market value of USD140 million.
Using a spreadsheet or IRR-enabled calculator, we use −100, −20, 0, and
USD142.64 for the t = 0, t = 1, t = 2, and t = 3 net cash flows, respectively.
Using either tool, we get a four-month IRR of 6.28 percent.

_ ​CF​  0​​ ​CF​  1​​ ​CF​  2​​ ​CF​  3​​

​ (  ​  + ​ _  ​  + ​ _  ​  + ​ _ ​ = 0
​​ 1 + IRR)​​​  0​ ​​(1 + IRR)​​​  1​ ​​(1 + IRR)​​​  2​ ​​(1 + IRR)​​​  3​
_ − ​​ 100
    
      − 20 0 142.64 ​ ​.​​
​  1 ​  + ​ _  ​  + ​ _ ​  + ​ _ ​ = 0
(​​ 1 + IRR)​​​  1​ (​​ 1 + IRR)​​​  2​ (​​ 1 + IRR)​​​  3​
IRR = 6.28%
The quick way to annualize this four-month return is to multiply it by 3. A
more accurate way is to compute it on a compounded basis as: (1.0628)3 – 1
= 0.2005 or 20.05 percent.
These calculations can also be performed using Excel using the =IRR(cash
flows) function, which results in an IRR of 6.28 percent.

3. Interpret the differences between the Fund’s time-weighted and mon-

ey-weighted rates of return.
Solution:
In this example, the time-weighted return (21.03 percent) is greater than the
money-weighted return (20.05 percent). The Walbright Fund’s performance
was relatively poorer during the eight-month period, when the fund had
more money invested, than the overall performance. This fact is reflected in
a lower money-weighted rate of return compared with the time-weighted
rate of return, as the money-weighted return is sensitive to the timing and
amount of withdrawals and additions to the portfolio.

The accurate measurement of portfolio returns is important to the process of

evaluating portfolio managers. In addition to considering returns, however, analysts
must also weigh risk. When we worked through Example 9, we stopped short of
suggesting that in-house management was superior to Super Trust because it earned
a higher time-weighted rate of return. A judgment as to whether performance was
“better” or “worse” must include the risk dimension, which will be covered later in
your study materials.

5 ANNUALIZED RETURN

calculate and interpret annualized return measures and continuously

compounded returns, and describe their appropriate uses
 © CFA Institute. For candidate use only. Not for distribution.
Annualized Return 29

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. You might buy a short-term treasury bill with a maturity of three months,
or you might take a position in a futures contract that expires at the end of the next
quarter. How can we compare these returns?
In many cases, it is most convenient to annualize all available returns to facili-
tate comparison. Thus, daily, weekly, monthly, and quarterly returns are converted
to annualized returns. Many formulas used for calculating certain values or prices
also require all returns and periods to be expressed as annualized rates of return.
For example, the most common version of the Black–Scholes option-pricing model
requires annualized returns and periods to be in years.

Non-annual Compounding
Recall that interest may be paid semiannually, quarterly, monthly, or even daily. To
handle interest payments made more than once a year, we can modify the present
value formula as follows. Here, Rs is the quoted interest rate and equals the periodic
interest rate multiplied by the number of compounding periods in each year. In gen-
eral, with more than one compounding period in a year, we can express the formula
for present value as follows:
​Rs​  ​​ −mN
​PV = ​FV​  N​​ ​​(1 + ​ _
m ​)​​​  ​​, (7)
where

m = number of compounding periods per year,

Rs = quoted annual interest rate, and

N = number of years.
The formula in Equation 8 is quite similar to the simple present value formula. As
we have already noted, present value and future value factors are reciprocals. Changing
the frequency of compounding does not alter this result. The only difference is the use
of the periodic interest rate and the corresponding number of compounding periods.
The following example presents an application of monthly compounding.

EXAMPLE 11

The Present Value of a Lump Sum with Monthly

Compounding
The manager of a Canadian pension fund knows that the fund must make a
lump-sum payment of CAD5 million 10 years from today. She wants to invest
an amount today in a guaranteed investment contract (GIC) so that it will grow
to the required amount. The current interest rate on GICs is 6 percent a year,
compounded monthly.

1. How much should she invest today in the GIC?

Solution:
By applying Equation 8, the required present value is calculated as follow:
 © CFA Institute. For candidate use only. Not for distribution.
30 Learning Module 1 Rates and Returns

​FV​  N​​  = CAD 5,000,000

​ s​  ​​  = 6 %   = 0.06
R
m = 12
​Rs​  ​​/ m = 0.06 / 12 = 0.005
N = 10
  
  
   
   
   
  
   
mN ​​ ​​ (10)​  = 120​
= 12​ ​  ​​
​ ​ ​ .​
​Rs​  ​​ −mN
PV = ​FV​  N​​ ​​(1 + ​ _
m ​)​​​  ​
= CAD 5,000,000 ​​(1.005)​​​  −120​
= CAD 5,000,000​(0.549633)​
= CAD 2,748,163.67
In applying Equation 8, we use the periodic rate (in this case, the monthly
rate) and the appropriate number of periods with monthly compounding (in
this case, 10 years of monthly compounding, or 120 months).

Annualizing Returns
To annualize any return for a period shorter than one year, the return for the period
must be compounded by the number of periods in a year. A monthly return is com-
pounded 12 times, a weekly return is compounded 52 times, and a quarterly return
is compounded 4 times. Daily returns are normally compounded 365 times. For an
uncommon number of days, we compound by the ratio of 365 to the number of days.
If the weekly return is 0.2 percent, then the compound annual return is 10.95
percent (there are 52 weeks in a year):
​Rannual
​  ​​  = ​​(1 + ​Rweekly
​  ​​)​​​  52​ − 1 = ​​(1 + 0.2%)​​​  52​ − 1
     
​​  ​​.​
= ​​(1.002)​​​  52​ − 1 = 0.1095 = 10.95%
If the return for 15 days is 0.4 percent, then the annualized return is 10.20 percent,
assuming 365 days in a year:
​Rannual
​  ​​  = ​​(1 + ​R15​  )​​ ​​​  365/15​ − 1 = ​​(1 + 0.4%)​​​  365/15​ − 1
     
​​  ​​.​
= ​​(1.004)​​​  365/15​ − 1 = 0.1020 = 10.20%
A general equation to annualize returns is given, where c is the number of periods in
a year. For a quarter, c = 4 and for a month, c = 12:
​​Rannual
​  ​​  =   ​​(1  + ​Rperiod
​  ​​)​​​  c​ − 1​. (8)

How can we annualize a return when the holding period return is more than one
year? For example, how do we annualize an 18-month holding period return? Because
one year contains two-thirds of 18-month periods, c = 2/3 in the above equation. For
example, an 18-month return of 20 percent can be annualized as follows:
​​Rannual
​  ​​  = ​​(1 + ​R18month
​  ​​)​​​  2/3​ − 1 = ​​(1 + 0.20)​​​  2/3​ − 1 = 0.1292 = 12.92%​.
Similar expressions can be constructed when quarterly or weekly returns are needed
for comparison instead of annual returns. In such cases, c is equal to the number of
holding periods in a quarter or in a week. For example, assume that you want to convert
daily returns to weekly returns or annual returns to weekly returns for comparison
between weekly returns. To convert daily returns to weekly returns, c = 5, assume
that there are five trading days in a week. However, daily return calculations can be
annualized differently. For example, five can be used for trading-day-based calculations,
giving approximately 250 trading days a year; seven can be used on calendar-day-based
calculations. Specific methods used conform to specific business practices, market
 © CFA Institute. For candidate use only. Not for distribution.
Annualized Return 31

conventions, and standards. To convert annual returns to weekly returns, c = 1/52.

The expressions for annual returns can then be rewritten as expressions for weekly
returns as follows:
​​Rweekly
​  ​​  = ​​(1 + ​Rdaily
​  ​​)​​​  5​ − 1;  ​Rweekly
​  ​​  = ​​(1 + ​Rannual
​  ​​)​​​  1/52​ − 1​. (9)

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. This type of return is not always possible. An investor may earn a
return of 5 percent during a week because the market rose sharply that week, but it
is highly unlikely that he will earn a return of 5 percent every week for the next 51
weeks, resulting in an annualized return of 1,164.3 percent (= 1.0552 − 1). Therefore,
it is important to annualize short-term returns with this limitation in mind.

EXAMPLE 12

Annualized Returns
An analyst seeks to evaluate three securities she has held in her portfolio for
different periods of time.
■ Over the past 100 days, Security A has earned a return of 6.2 percent.
■ Security B has earned 2 percent over the past four weeks.
■ Security C has earned a return of 5 percent over the past three
months.

1. Compare the relative performance of the three securities.

Solution:
To facilitate comparison, the three securities’ returns need to be annualized:

■ Annualized return for Security A: RSA= (1 + 0.062)365/100 − 1 = 0.2455

= 24.55%
■ Annualized return for Security B: RSB = (1 + 0.02)52/4 − 1 = 0.2936 =
29.36%
■ Annualized return for Security C: RSC = (1 + 0.05)4 − 1 = 0.2155 =
21.55%
Security B generated the highest annualized return.

EXAMPLE 13

Exchange-Traded Fund Performance

An investor is evaluating the returns of three recently formed exchange-traded
funds. Selected return information on the exchange-traded funds (ETFs) is
presented in Exhibit 16.
 © CFA Institute. For candidate use only. Not for distribution.
32 Learning Module 1 Rates and Returns

Exhibit 16: ETF Performance Information

​

ETF Time Since Inception Return Since Inception (%)

1 146 days 4.61

2 5 weeks 1.10
3 15 months 14.35
​

1. Which ETF has the highest annualized rate of return?

A. ETF 1
B. ETF 2
C. ETF 3
Solution:
B is correct. The annualized rate of return for the three ETFs are as follows:
ETF 1 annualized return = (1.0461365/146) – 1 = 11.93%

ETF 2 annualized return = (1.011052/5) – 1 = 12.05%

ETF 3 annualized return = (1.143512/15) – 1 = 11.32%

Despite having the lowest value for the periodic rate, ETF 2 has the highest
annualized rate of return because of the reinvestment rate assumption and
the compounding of the periodic rate.

Continuously Compounded Returns

An important concept is the continuously compounded return associated with a holding
period return, such as R1. The continuously compounded return associated with a
holding period return is the natural logarithm of one plus that holding period return,
or equivalently, the natural logarithm of the ending price over the beginning price
(the price relative). Note that here we are using r to refer specifically to continuously
compounded returns, but other textbooks and sources may use a different notation.
If we observe a one-week holding period return of 0.04, the equivalent continuously
compounded return, called the one-week continuously compounded return, is ln(1.04)
= 0.039221; EUR1.00 invested for one week at 0.039221 continuously compounded
gives EUR1.04, equivalent to a 4 percent one-week holding period return.
The continuously compounded return from t to t + 1 is
rt,t+1 = ln(Pt+1/Pt) = ln(1 + Rt,t+1). (10)
For our example, an asset purchased at time t for a P0 of USD30 and the same asset one
period later, t + 1, has a value of P1 of USD34.50 has a continuously compounded return
given by r0,1 = ln(P1/P0) = ln(1 + R0,1) = ln(USD34.50/USD30) = ln(1.15) = 0.139762.
Thus, 13.98 percent is the continuously compounded return from t = 0 to t = 1.
The continuously compounded return is smaller than the associated holding period
return. If our investment horizon extends from t = 0 to t = T, then the continuously
compounded return to T is
r0,T = ln(PT/P0). (11)
Applying the exponential function to both sides of the equation, we have exp(r0,T) =
exp[ln(PT/P0)] = PT/P0, so
PT = P0exp(r0,T).
 © CFA Institute. For candidate use only. Not for distribution.
Other Major Return Measures and Their Applications 33

We can also express PT/P0 as the product of price relatives:

PT/P0 = (PT/PT−1)(PT−1/PT−2) . . . (P1/P0). (12)
Taking logs of both sides of this equation, we find that the continuously compounded
return to time T is the sum of the one-period continuously compounded returns:
r0,T = rT−1,T + rT−2,T−1 + . . . + r0,1. (13)
Using holding period returns to find the ending value of a USD1 investment involves
the multiplication of quantities (1 + holding period return). Using continuously com-
pounded returns involves addition (as shown in Equation 14), which is a desirable
property of continuously compounded returns and which we will use throughout the
curriculum.

OTHER MAJOR RETURN MEASURES AND THEIR

APPLICATIONS 6
calculate and interpret major return measures and describe their
appropriate uses

The statistical measures of return discussed in the previous section are generally
applicable across a wide range of assets and time periods. Special assets, however,
such as mutual funds, and other considerations, such as taxes or inflation, may require
more specific return measures.
Although it is not possible to consider all types of special measures, we will discuss
the effect of fees (gross versus net returns), taxes (pre-tax and after-tax returns), infla-
tion (nominal and real returns), and the effect of leverage. Many investors use mutual
funds or other external entities (i.e., investment vehicles) for investment. In those cases,
funds charge management fees and expenses to the investors. Consequently, gross and
net-of-fund-expense returns should also be considered. Of course, an investor may be
interested in the net-of-expenses after-tax real return, which is in fact what an investor
truly receives. We consider these additional return measures in the following sections.

Gross and Net Return

A gross return is the return earned by an asset manager prior to deductions for manage-
ment expenses, custodial fees, taxes, or any other expenses that are not directly related
to the generation of returns but rather related to the management and administration
of an investment. These expenses are not deducted from the gross return because
they may vary with the amount of assets under management or may vary because
of the tax status of the investor. Trading expenses, however, such as commissions,
are accounted for in (i.e., deducted from) the computation of gross return because
trading expenses contribute directly to the return earned by the manager. Thus, 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 is a measure of what the investment vehicle (e.g., mutual fund) has earned
for the investor. Net return accounts for (i.e., deducts) all managerial and administra-
tive expenses that reduce an investor’s return. Because individual investors are most
concerned about the net return (i.e., what they actually receive), small mutual funds
with a limited amount of assets under management are at a disadvantage compared
 © CFA Institute. For candidate use only. Not for distribution.
34 Learning Module 1 Rates and Returns

with the larger funds that can spread their largely fixed administrative expenses over
a larger asset base. As a result, many small mutual funds waive part of the expenses
to keep the funds competitive.

Pre-Tax and After-Tax Nominal Return

All return measures discussed up to this point are pre-tax nominal returns—that is,
no adjustment has been made for taxes or inflation. In general, all returns are pre-tax
nominal returns unless they are otherwise designated.
Many investors are concerned about the possible tax liability associated with their
returns because taxes reduce the net return that they receive. 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 a number of 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.
Because taxes are paid on realized capital gains and income, the investment manager
can minimize the tax liability by selecting appropriate securities (e.g., those subject
to more favorable taxation, all other investment considerations equal) and reducing
trading turnover. Therefore, taxable investors evaluate investment managers based
on the after-tax nominal return.

Real Returns
Previously this learning module approximated the relationship between the nominal
rate and the real rate by the following relationship:
​​(1 + nominal risk–free rate)​ = ​
(1 + real risk–free rate)​​(1 + inflation premium)​. ​
This relationship can be extended to link the relationship between nominal and real
returns. Specifically, the nominal return consists of a real risk-free rate of return to
compensate for postponed consumption; inflation as loss of purchasing power; and
a risk premium for assuming risk. Frequently, the real risk-free return and the risk
premium are combined to arrive at the real “risky” rate and is simply referred to as
the real return, or:
 ​(1 + real risk–free rate)​​(1+ risk premium)​
​​(1 + real return)​  = ​ ______________________________
    1   
+ inflation premium ​​. (14)

Real returns are particularly useful in comparing returns across time periods because
inflation rates may vary over time. Real returns are also useful in comparing returns
among countries when returns are expressed in local currencies instead of a constant
investor currency and when inflation rates vary between countries (which are usually
the case).
Finally, the after-tax real return is what the investor receives as compensation for
postponing consumption and assuming risk after paying taxes on investment returns.
As a result, the after-tax real return becomes a reliable benchmark for making invest-
ment decisions. Although it is a measure of an investor’s benchmark return, it is not
commonly calculated by asset managers because it is difficult to estimate a general
tax component applicable to all investors. For example, the tax component depends