www.thealphareview.

com

LEVEL 1 REVIEW QUANTITATIVE METHODS

STUDY SESSION 2:

Quant methods can either be fairly easy points or it can be a constant struggle. The material is very basic and worth some significant
points across all three CFA exam levels. The study session is worth 12% of the CFA Level 1 and between 5-10% of the second test.
While there is no new material in CFA Level III, you will need to use the material learned in the other two tests to work through the
essay section.

Many candidates, having convinced themselves that they hate math, neglect the topic and pay for it with a failing score. Yes, most of
this stuff will be performed by computer in your daily responsibilities but understandings of the concepts will not only move you
closer to those three little letters; it will make you a better professional. Embrace the horror that you now work in an analytical
field and need to know how to calculate basic quantitative formulas.

Time Value of Money

The most important thing here is be able to use your calculator to solve for any one of the missing variables. Note that the
Institute usually keeps problems within the realm of possible reality so if you get an answer that seems extremely high or low then
you need to go back through the calculation to make sure you did it correctly. Remember that payments

Make sure you divide the annual rate by the number of times it is compounded within your formula. (i.e. $100 at 8% compounded
8 2
quarterly for two years = $100 (1.02) is different than simply $100 (1.08)

Most calculators calculate cash flows as an ordinary annuity, where payments come at the end of the period. Make sure you set the
“begin” key for any annuity due problems where payments come at the beginning of the period. Also, remember that the payment
and present value inputs will have opposite signs (i.e. since the payment represents an outflow use a negative sign).

*Important: Get in the habit of clearing out your calculator before or after you work a problem. It is as easy as two quick
nd
keystrokes (2 and Clr Wk) and can save you points on the test.
Discounted Cash Flow

This is arguably the most important reading in the study session and you will see the concepts across all three exams.

The first section covers NPV and IRR which are really two sides of the same coin. NPV is the value today of the series of cash flows at
a discount rate. IRR is the discount rate at which NPV is zero. Either one can be used in a budgeting decision. As with much of the
material, understand the situations where each is more appropriate and the strengths/weaknesses of each concept.

Time-weighted returns measure the rate of growth over a defined period between cash flows. It should be used when the portfolio
manager does not control cash in and out of the account (as is usually the case). Money-weighted returns can be done easily using
the cash flow function on your calculator but may not be as applicable unless you have discretion on cash flows.

Know the difference and how to calculate the material in money market yields section (i.e. money market yield, bond equivalent
yield, and HPY). These are good formulas for flash cards if you’re having problems.
 www.thealphareview.com

Statistical Concepts and Market Returns

As with much of the quant methods material, you should start with an understanding of the basic concepts before worrying too
much about the different variations. It is much more important to master the concept of standard deviation than to work through
the material too quickly trying to get a vague idea of everything.

Geometric and Arithmetic averages are important. The arithmetic mean is simply the sum of observations divided by the number of
observances while the geometric mean is the compound return by taking the nth root of the product.

The Sharpe ratio is a key concept throughout the curriculum and you need to understand what it means as well as how to calculate
it. It measures the excess return on an investment or portfolio and can be used to rank opportunities. You will use iterations of this
formula in many other concepts (i.e. Roy’s Safety First). The drawback is that, since it uses standard deviation as a measure of risk, it
is most applicable for symmetric distributions and may overstate risk-adjusted performance.

Understand that the mean, median and mode are the same in a normal distribution but different with skewness. Don’t worry too
much about calculating kurtosis or skewness, just understand their implication. (i.e. how it affects dispersion and returns)

Probability Concepts

The most important material here is covariance, correlation and being able to do the calculations for expected value, variance and
standard deviation for a two-asset portfolio. The formulas can get kind of long but they are pretty basic. This is the material that will
be used most through the other levels of the exams as well.

Remember, the expected return is just the weights of each asset times their respective expected returns. Correlation between two
assets ranges from -1 (perfect negative relationship) and +1 (perfect positive relationship).

Besides outright learning the material (always best) you need to put yourself in the shoes of the CFA exam developer. Within a
multiple choice format it is far easier to test list-type questions (advantages and disadvantages of different options) and calculable
answers than it is to dig deeply into the material.

STUDY SESSION 3:

Study session three in the CFA Level 1 curriculum wraps up quantitative methods topic. The readings here are, in my opinion, not as
important as the material in study session two. You may see a question or two but the concepts, other than the normal distribution,
are not used as much in other topic areas.

That said you still need to spend some time understanding the basic concepts and rules. For me, this study session was part of my
(secondary) group of curriculum. I spent most of my time on core areas like Ethics, FRA, Equity & Fixed Income along with
miscellaneous readings from the other topics. In these core areas, I would work to at least 80% on practice problems and mock
exams. For the remainder of the curriculum, I aimed for maybe 70% mastery of the material. Don’t neglect the secondary material
but do not dwell on it at the expense of your core areas.
 www.thealphareview.com

Common Probability Distributions

Most of the introductory material here is fairly unimportant. The binomial distribution is a little more important because it relates to
some of the derivatives material. The normal distribution is really where you want to spend your time.

Remember that 90% of the distribution will be between 1.65 standard deviations, 95% within 1.96 deviations and 99% within 2.58
deviations. You will be given a z-table but need to know the formula and the applicable number of standard deviations. You need to
pay attention to the question and look for which part of the curve you are being asked to measure. Do you need an interval around
the mean or just one side? All the stuff around the z-score (the formula and finding probabilities) is fairly basic so spend some time
and master it.

Understand the applications, limitations and differences between Monte Carlo Simulation and Historical Simulation.

Sampling and Estimation

Again, fairly unimportant material but it is mostly conceptual. You won’t need much in the way of formulas but will want to
understand the ideas and differences between the different sampling plans. Remember that a good estimator is unbiased, efficient
and consistent.

Understand the difference between simple random, systematic and stratified sampling.

A carryover from the previous reading, be able to calculate and interpret confidence intervals for the different distributions.
Remember, if the sample size is larger than 30 then the z-score can be used as a proxy for the t-score.

Probably the most important material in the reading is that on data mining, sample selection, survivorship, look-ahead and time-
period biases. Understand these and the different situations in which they might occur.

Hypothesis Testing

Understand the difference between the null and alternative hypothesis and be able to calculate the test statistic. The p-value is the
lowest level of significance at which the null hypothesis is rejected.

Understand the difference between a Type I and Type II error

Type I is where you reject the true null hypothesis (i.e. saying that the statistic falls outside of the confidence interval in a normal
distribution when it does not)

Type II is where you do not reject a false null hypothesis (i.e. saying that the statistic lies within the confidence interval when it does
not)

Remember the rules for setting a low or high level of significance (1% or 10%) depending on the penalty for committing either error
(i.e. 1% significance if you do not want to make Type I error, 10% significance if you do not want to make Type II error)
 www.thealphareview.com

Technical Analysis

Most of the curriculum puts little faith in technical analysis and refutes much of it in the efficient market hypothesis. The reading is
basically a list of points that you should be familiar with just to have a basic understanding of what technicians do. Throw the
material on some flash cards (no more than a couple of sentences on the definition side), review them a few times and it should be a
few easy points on the exam.