QM Learning Module: 1 The Time Value of Money: Nominal Risk-Free Rate Real Risk-Free Interest Rate +

QM The Time Value of Money
Learning Module: 1
1. INTRODUCTION
FinQuiz Notes – 2 0 2 3
• Money has a time value because a unit of money
received today is worth more than a unit of money
to be received tomorrow.
2. INTEREST RATES
Interest rates can be interpreted in three ways.

• Real risk-free interest rate: It reflects the single-period
1) Required rates of return: It refers to the minimum rate interest rate for a completely risk-free security when
of return that an investor must earn on his/her no inflation is expected.
investment.
• Inflation premium: It reflects the compensation for
2) Discount rates: Interest rate can be interpreted as the expected inflation.
rate at which the future value is discounted to
estimate its value today. Nominal risk-free rate = Real risk-free interest rate +
Inflation premium
3) Opportunity cost: Interest rate can be interpreted as o E.g. interest rate on a 90-day U.S. Treasury bill (T-bill)
the opportunity cost which represents the return refers to the nominal interest rate.
forgone by an investor by spending money today
rather than saving it. • Default risk premium: It reflects the compensation for
default risk of the issuer.
For example, an investor can earn 5% by investing • Liquidity premium: It reflects the compensation for
$1000 today. If he/she decides to spend it today the risk of loss associated with selling a security at a
instead of investing it, he/she will forgo earning 5%. value less than its fair value due to high transaction
costs.
Interest rate = r = Real risk-free interest rate + Inflation
premium + Default risk premium + • Maturity premium: It reflects the compensation for
Liquidity premium + Maturity the high interest rate risk associated with long-term
premium maturity.
3. FUTURE VALUE OF A SINGLE CASH FLOW
The future value of cash flows can be computed using Example:

the following formula:
Suppose,
# PV = $100, N = 1, r = 10%. Find FV.
𝐹𝑉# = 𝑃𝑉(1 + 𝑟)
where,
PV = Present value of the investment
FVN = Future value of the investment N periods from
today 𝐹𝑉+ = 100(1 + 0.10)+ = 110
Pmt = Per period payment amount
N = Total number of cash flows or the number of a
specific period • The interest rate earned each period on the original
r = Interest rate per period investment (i.e. principal) is called simple interest e.g.
(1 + r)N = FV factor $10 in this example.
Learning Module: 1
Simple interest = Interest rate × Principal

NOTE:
If at the end of year 1, the investor decides to extend
the investment for a second year. Then the amount • For a given interest rate, the more frequently the
accumulated at the end of year 2 will be: compounding occurs (i.e. the greater the N), the
greater will be the future value.
• For a given number of compounding periods, the
higher the interest rate, the greater will be the future
value.
𝐹𝑉. = 100(1 + 0.10)(1 + 0.10) = 121 Important to note:
or Both the interest rate (r) and number of compounding

periods (N) must be compatible i.e. if N is stated in
𝐹𝑉. = 100(1 + 0.10). = 121 months then r should be 1-month interest rate, un-
annualized.
• Note that FV2> FV1 because the investor earns
interest on the interest that was earned in previous
years (i.e. due to compounding of interest) in Practice: Example 1, 2 & 3,
addition to the interest earned on the original CFA Institute’s Curriculum.
principal amount.
• The effect of compounding increases with the
increase in interest rate i.e. for a given compounding
period (e.g. annually), the FV for an investment with
10% interest rate will be > FV of investment with 5%
interest rate.
4. NON-ANNUAL COMPOUNDING (FUTURE VALUE)
The more frequent the compounding, the greater will be

With more than one compounding period per year, the future value.
𝑟1 4×# Example:
𝐹𝑉# = 𝑃𝑉 01 + 3
𝑚
Suppose,
where, A bank offers interest rate of 8% compounded quarterly
rs = stated annual interest rate on a CD with 2-years maturity. An investor decides to
m = number of compounding periods per year invest $100,000.
N = Number of years
• PV = $100,000
Stated annual interest rate: It is the quoted interest rate • N=2
that does not take into account the compounding • rs = 8% compounded quarterly
within a year. • m=4
• rs / m = 8% / 4 = 2%
Stated annual interest rate = Periodic interest rate × • mN = 4 (2) = 8
Number of compounding
periods per year FV = $100,000 (1.02)8 = $117,165.94
Periodic interest rate = rs / m = Stated annual interest

rate / Number of Practice: Example 4, 5 & 6,
compounding periods CFA Institute’s Curriculum.
per year
where,
Number of compounding periods per year = Number of
compounding periods in one year × number of years =
m×N
NOTE:
Learning Module: 1
5. CONTINUOUS COMPOUNDING
For example, EAR% for 10% semiannual investment will

be:
Continuous Compounding
m=2
When the number of compounding periods per year stated annual interest rate = 10%
becomes infinite, interest rate is compounded EAR = [1 + (0.10 / 2)] 2 – 1 = 10.25%
continuously. In this case, FV is estimated as follows:
• This implies that an investor should be indifferent
𝐹𝑉# = 𝑃𝑉𝑒 78×# between receiving 10.25% annual interest rate and
where, receiving 10% interest rate compounded
semiannually.
e = 2.7182818
EAR with continuous compounding:

• The continuous compounding generates the
maximum future value amount. EAR = ers – 1
Example: • Given the EAR, periodic interest rate can be

calculated as follows:
Suppose, an investor invests $10,000 at 8% compounded
EAR + 1 = ers
continuously for two years.
• Now taking the natural logarithm of both sides we
have:
FV = $10,000 e 0.08 (2) = $11,735.11
ln (EAR + 1) = ln e rs è (since ln e = 1)
ln (EAR + 1) = rs
5.1 Stated and Effective Rates
Now taking the natural logarithm of both sides we have:
Periodic interest rate = Stated annual interest rate /
Number of compounding periods EAR + 1 = lners è (since ln e = 1)
in one year (i.e. m) EAR + 1 = rs
E.g. m = 4 for quarterly, m = 2 for semi-annually NOTE:

compounding, and m = 12 for monthly compounding.
Annual percentage rate (APR): It is used to measure the
cost of borrowing stated as a yearly rate.
Effective (or equivalent) annual rate (EAR = EFF %): It is
the annual rate of interest that an investor actually earns
APR = Periodic interest rate × Number of payments
on his/her investment. It is used to compare investments
periods per year
with different compounding intervals.
EAR (%) = (1 + Periodic interest rate) m– 1
• Given the EAR, periodic interest rate can be

calculated by reversing this formula.
Periodic interest rate = [EAR(%) + 1]1/m –1
FUTURE VALUE OF A SERIES OF CASH FLOWS, FUTURE VALUE

6.
ANNUITIES
Annuity: • Ordinary Annuity: Annuities whose payments begin

Annuities are equal and finite set of periodic outflows/ at the end of each period i.e. the 1st cash flow
inflows at regular intervals e.g. rent, lease, mortgage, occurs one period from now (t = 1) are referred to as
car loan, and retirement annuity payments. ordinary annuity e.g. mortgage and loan payments.
• Annuity Due: Annuities whose payments begin at the
Learning Module: 1
start of each period i.e. the 1st cash flow occurs where,
immediately (t = 0) are referred to as annuity due Pmt = Equal periodic cash flows
e.g. rent, insurance payments. r = Rate of interest
N = Number of payments, one at the beginning of
each period (annuity due).
• It is important to note that PV of annuity due > PV of

ordinary annuity.
NOTE:
Present value and future value of Ordinary Annuity: PV of annuity due can be calculated by setting
The future value of an ordinary annuity stream is calculator to “BEGIN” mode and then solve for the PV of
calculated as follows: the annuity.
FVOA = Pmt [(1+r)N–1 + (1+r)N–2 + … +(1+r)1+(1+r)0] The future value of an annuity due stream is calculated
as follows:
#
(1 + 𝑟)# − 1
𝐹𝑉9: = ; 𝑃𝑚𝑡= (1 + 𝑟)#>= = 𝑃𝑚𝑡 @
𝑟
B é (1 + r )N - 1ù
=C+ FV AD = Pmt ê ú(1 + r )
# ë r û
(1 + 𝑟) − 1
FV annuity factor = @ B Or
𝑟
FVAD = FVOA × (1 + r)
where,
Pmt = Equal periodic cash flows • It is important to note that FV of annuity due > FV of
r = Rate of interest ordinary annuity.
N = Number of payments, one at the end of each
period (ordinary annuity).
Example:
The present value of an ordinary annuity stream is Suppose a 5-year, $100 annuity with a discount rate of
calculated as follows: 10% annually.
#
𝑃𝑚𝑡
𝑃𝑉9: = ;
(1 + 𝑟)=
=C+
= 𝑃𝑚𝑡+ /(1 + 𝑟)#>+ + 𝑃𝑚𝑡. /(1 + 𝑟)#>. + ⋯
+ 𝑃𝑚𝑡# /(1 + 𝑟)# )
Or
Calculating Present Value for Ordinary Annuity:
# +
𝑃𝑚𝑡 1 − (+S7)T
𝑃𝑉9: = ; = 𝑃𝑚𝑡 R U 100 100 100 100 100
(1 + 𝑟)= 𝑟 𝑃𝑉9: = + + + +
=C+ (1.10)+ (1.10). (1.10)V (1.10)W (1.10)X
= 379.08
Present value and future value of Annuity Due:
Or
The present value of an annuity due stream is calculated
+
as follows (section 6). 1 − (+.+])^
𝑃𝑉9: = 𝑃𝑚𝑡 R U = 379.08
é1 - 1 ( N -1) ù 0.10
PV AD = Pmt ê (1 + r) ú + Pmt at t = 0
ê r ú
êë úû
Or
é1 - 1 ù
PV AD = Pmt ê (1 + r) ú
N
(1 + r )
ê r ú
êë úû Using a Financial Calculator: N= 5; PMT = –100; I/Y
PVAD = PVOA+ Pmt
Learning Module: 1
= 10; FV=0; CPTèPV

= $379.08
Practice: Example 7, 11, 12 & 13,
CFA Institute’s Curriculum.
Calculating Future Value for Ordinary Annuity:
FVOA
=100(1.10)4+100(1.10)3+100(1.10)2+100(1.10)1+100=610.51
Or
Unequal Cash Flows
é (1.10 )5 - 1ù
FVOA = 100ê ú = 610.51
ë 0.10 û
Using a Financial Calculator: N= 5; PMT = -100; I/Y = 10;

PV=0; CPTèFV = $610.51
Source: CFA Institute’s Curriculum, Table 2.
Annuity Due: An annuity due can be viewed as = $100

FV at t = 5 can be calculated by computing FV of each
lump sum today + Ordinary annuity of $100
payment at t = 5 and then adding all the individual FVs
per period for four years.
e.g. as shown in the table above:
Calculating Present Value for Annuity Due:
FV of cash flow at t =1 is estimated as
+
1 − (+.+])(^à) FV = $1,000 (1.05) 4 = $1,215.51
𝑃𝑉:_ = 100 R U + 100 = 416.98
0.10
Calculating Future value for Annuity Due:

(1.10)X − 1
𝐹𝑉:_ = 100 @ B (1.10) = 671.56
0.10
7. PRESENT VALUE OF A SINGLE CASH FLOW
The present value of cash flows can be computed using

the following formula:
Practice: Example 8 & 9,
FVf CFA Institute’s Curriculum.
PV =
(1 + r)f
• The PV factor = 1 / (1 + r) N; It is the reciprocal of the

FV factor.
NOTE:
• For a given discount rate, the greater the number of

periods (i.e. the greater the N), the smaller will be the
present value.
• For a given number of periods, the higher the
discount rate, the smaller will be the present value.
8. NON-ANNUAL COMPOUNDING (PRESENT VALUE)

Learning Module: 1
With more than one compounding period per year,

Practice: Example 10,
𝑟1 >4# CFA Institute’s Curriculum.
𝑃𝑉 = 𝐹𝑉# 01 + 3
𝑚
where,
rs = stated annual interest rate
m = number of compounding periods per year
N = Number of years
PRESENT VALUE OF A SERIES OF EQUAL CASH FLOWS

9.
(ANNUITIES) AND UNEQUAL CASH FLOWS
Enter I/YR = 5, è press NPVèNPV or PV = $15,036.46

The Present Value of a Series of Equal Cash Flows Or
B. PV can be calculated by computing PV of each
Refer to Section 6 payment separately and then adding all the
individual PVs e.g. as shown in the table below:
The Present Value of a Series of Unequal Cash Flows
Suppose cash flows for Year 1 = $1000, Year 2 = $2000,

Year 3 = $4000, Year 4 = $5000, Year 5 = 6,000.
A. Using the calculator’s “CFLO” register, enter the cash

flows
• CF0 = 0
• CF1 = 1000 Source: CFA Institute’s Curriculum, Table 3.
• CF2 = 2000
• CF3 = 4000
• CF4 = 5000
• CF5 = 6000
PRESENT VALUE OF A PERPETUITY AND PRESENT VALUES

10.
INDEXED AT TIMES OTHER THAT T=0
Suppose, a stock pays constant dividend of $10 per

The Present Value of an Infinite Series of Equal Cash year, the required rate of return is 20%. Then the PV is
Flows i.e. Perpetuity calculated as follows.
Perpetuity: It is a set of infinite periodic outflows/ inflows PV = $10 / 0.20 = $50

at regular intervals and the 1st cash flow occurs one
period from now (t=1). It represents a perpetual annuity
e.g. preferred stocks and certain government bonds Practice: Example 14,
make equal (level) payments for an indefinite period of CFA Institute’s Curriculum.
time.
PV = Pmt / r Present Values Indexed at Times Other than t =0
This formula is valid only for perpetuity with level

payments. Suppose instead of t = 0, first cash flow of $6 begin at the
end of year 4 (t = 4) and continues each year thereafter
Example: till year 10. The discount rate is 5%.
• It represents a seven-year Ordinary Annuity.

Learning Module: 1
a) First of all, we would find PV of an annuity at t = 3 i.e. PV of 4-year Ordinary annuity = PV of Perpetuity 1 – PV
of Perpetuity 2
N = 7, I/Y = 5, Pmt = 6, FV = 0, CPTèPV 3 = $34.72
b) Then, the PV at t = 3 is again discounted to t = 0. i. PV0 of Perpetuity 1 = $100 / 0.05 = $2000

ii. PV4 of Perpetuity 2 = $100 / 0.05 = $2000
N = 3, I/Y = 5, Pmt = 0, FV = 34.72, CPTè PV 0 = $29.99 iii. PV0 of Perpetuity 2 = $2000 / (1.05) 4 = $1,645.40
iv. PV0 of Ordinary Annuity = PV 0 of Perpetuity 1 - PV 0
of Perpetuity 2
Practice: Example 15, = $2000 - $1,645.40
CFA Institute’s Curriculum. = $354.60
Source: CFA Institute’s Curriculum, Example 16.
• An annuity can be viewed as the difference

between two perpetuities with equal, level
payments but with different starting dates.
Example:
• Perpetuity 1: $100 per year starting in Year 1 (i.e. 1st

payment is at t =1)
• Perpetuity 2: $100 per year starting in Year 5 (i.e. 1st
payment is at t = 5)
• A 4-year Ordinary Annuity with $100 payments per
year and discount rate of 5%.
4-year Ordinary annuity = Perpetuity 1 – Perpetuity 2

SOLVING FOR INTEREST RATES, GROWTH RATES, AND NUMBER
11.
OF PERIODS
Solving for the Number of Periods

Solving for Interest Rates and Growth Rates
N = [ln (FV / PV)] / ln (1 + r)
An interest rate can be viewed as a growth rate (g).
Suppose, FV = $20 million, PV = $10 million, r = 7%.
g = (FVN/PV)1/N –1 Number of years it will take $10 million to double to $20
million is calculated as follows:
Practice: Example 17, 18 & 19, N = ln (20 million / 10 million) / ln (1.07) = 10.24 ≈ 10 years
SOLVING FOR THE SIZE OF ANNUITY PAYMENTS (COMBINING

12.
FUTURE VALUE AND PRESENT VALUE ANNUITIES)
• The amount borrowed = $100,000

Solving for the Size of Annuity Payments • 1st payment is due at t = 1
• Mortgage interest rate = 8% compounding monthly.
gh o PV = $100,000
Annuity Payment = Pmt = o rs = 8%
gh ijjklmn opqmrs
o m = 12
Suppose, an investor plans to purchase a $120,000 o Period interest rate = 8% / 12 = 0.67%
house; he made a down payment of $20,000 and o N = 30
borrows the remaining amount with a 30-year fixed-rate o mN = 12 × 30 = 360
mortgage with monthly payments.
Learning Module: 1
+
1− ~T
b) The total amount needed to fund retirement goal i.e.
}
|+S0 ~83• PV of retirement income at t = 15 is estimated using
𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 = 78
two steps:
4
+ i. We would first estimate PV of the annuity of

1 − (+.]]€€€•)‚ƒ„
$100,000 per year for the next 20 years at t = 40.
= = 136.283494
0.006667
+
1 − (+.]‡)ˆ„
Pmt = PV / Present value annuity factor 𝑃𝑉W] = $100,000 R U = $981,814.74
= $100,000 / 136.283494 = $733.76 0.08
ii. Now discount PV 40 back to t = 15. From t = 40 to t
• Thus, the $100,000 amount borrowed is equivalent to = 15 è total number of periods (N) = 25.
360 monthly payments of $733.76.
N = 25, I/Y = 8, Pmt = 0, FV = $981,814.74, CPTè PV
IMPORTANT Example: = $143,362.53
Calculating the projected annuity amount required to
fund a future-annuity inflow. • Since, PV of savings (outflows) must equal PV of
retirement income (inflows)
Suppose Mr. A is 22 years old. He plans to retire at age 63 The total amount he needs to save each year (from
(i.e. at t = 41) and at that time he would like to have a t = 16 to t = 40) i.e.
retirement income of $100,000 per year for the next 20 Annuity = Amount needed to fund retirement goals
years. In addition, he would save $2,000 per year for the - Amount already saved
next 15 years (i.e. t = 1 to t = 15) by investing in a bond = $143,362.53 - $54,304.23 = $89,058.30
mutual fund that will generate 8% return per year on • The annuity payment per year from t = 16 to t = 40 is
average. estimated as:
Pmt = PV / Present value annuity factor
So, to meet his retirement goal, the total amount he o PV of annuity = $89,058.30
needs to save each year from t = 16 to t = 40 is o N = 25
estimated as follows: o r = 8%
+
Calculations: 1 − (+.]‡)ˆ^
𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 = R U = 10.674776
It should be noted that: 0.08
PV of savings (outflows) must equal PV of retirement
income (inflows) Annuity payment = pmt = $89,058.30 / 10.674776
= $8,342.87
a) At t =15, Mr. A savings will grow to:
Source: CFA Institute’s Curriculum, Examples 20 & 21.
(1.08)+X − 1
𝐹𝑉 = 2000 @ B = $54,304.23
0.08
PRESENT AND FUTURE VALUE EQUIVALENCE AND THE

13.
ADDITIVITY PRINCIPLE
𝑃𝑉 $4,329.48
Equivalence Principle 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = = = $1,000
+>[(+/(+S7)T )] +>[(+/(+S+.]X)^ )]
7 ].]X
Principle 1: A lump sum is equivalent to an annuity i.e. if
a lump sum amount is put into an account • Thus, a lump sum initial investment of $4,329.48 can
that generates a stated interest rate for all generate $1,000 withdrawals per year over the next
periods, it will be equivalent to an annuity. 5 years.
• $1,000 payment per year for 5 years represents a 5-
Examples include amortized loans i.e. mortgages, car year ordinary annuity.
loans etc.
Principle 2: An annuity is equivalent to the FV of the
Example: lump sum.
Suppose, an investor invests $4,329.48 in a bank today at
5% interest for 5 years. For example from the example above stated.
Learning Module: 1
FV of annuity at t = 5 is calculated as: FV of (A + B) can be calculated by adding the cash

flows of each series and then calculating the FV of the
N = 5, I/Y = 5, Pmt = 1000, PV = 0,
combined cash flow.
CPTèFV = $5,525.64
And the PV of annuity at t = 0 is:
• At t = 1, combined cash flows = $100 + $200 = $300
N = 5, I/Y = 5, Pmt = 0, FV = 5,525.64, • At t = 2, combined cash flows = $100 + $200 = $300
CPTè PV =$4,329.48. Thus, FV of (A+ B) = $300 (1.02) + $300 = $606
The Cash Flow Additivity Principle Example:

Suppose,
The Cash Flow Additivity Principle: The amounts of
money indexed at the same point in time are additive. Discount rate = 6%
At t = 1 → Cash flow = $4
At t = 2 → Cash flow = $24
Example:
Interest rate = 2%. It can be viewed as a $4 annuity for 2 years and a lump
Series A’s cash flows: sum of $20.
t=0è0 N = 2, I/Y = 6, Pmt = 4, FV = 0,

t = 1 è $100 CPTè PV of $4 annuity = $7.33
t = 2 è $100
N = 2, I/Y = 6, Pmt = 0, FV = 20,
Series B’s cash flows: CPTèPV of lump sum = $17.80
t=0è0
Total = $7.33 + $17.80 = $25.13
t = 1 è $200
t = 2 è $200
Practice: Questions from FinQuiz

• Series A’s FV = $100 (1.02) + $100 = $202
• Series B’s FV = $200 (1.02) + $200 = $404 Question bank + CFAI Curriculum
• FV of (A + B) = $202 + $404 = $606 End of Chapter Practice Problems
for Reading 1.
QM Organizing, Visualizing, and Describing Data
Learning Module: 2
1. INTRODUCTION
Data is the key input for security analysis and Organizing, cleaning, and analyzing data is
investment management. The rapid growth in highly important and is a foundation of a
technology has contributed to providing a successful investment strategy. The data is then
data-rich environment featuring large volume, examined to detect - important relationships,
high velocity, and a wide variety of data - valuable insights, underlying structures, and
resulted in investors embracing big data for outliers - within the dataset.
their investment strategies.
2. DATA TYPES
as dividend-paying versus non-

Data represent facts or information in a raw or dividend paying, small-cap versus
organized form. Data is a collection of words, large-cap, etc.
text, characters, numberpanel dates, images,
audio, or video. i. Nominal data: In this classification,
data is categorized into various types
To summarize and analyze effectively, we need without any order or rank. Nominal
to distinguish among different classes of data data is commonly represented by text
types such as: labels or numerical values/codes,
provided these codes do not represent
• numerical versus categorical data ranking.
• cross-sectional vs. time-series vs. panel
data For example, Global industry classification
• structured versus unstructured data standard (GICS) is a method for assigning
companies into sectors, industry groups,
Numerical versus Categorical Data industries, and sub-industries based on the
nature of the companies’ businesses and
operations.
Statistically, data can be classified into
numerical data and categorical data.
ii. Ordinal data: This scale classifies data
1. Numerical Data (a.k.a. quantitative into various categories and also rank
data): are numbers that can be them into an order based on some
divided into two types: characteristics. However, the intervals
separating the ranks in ordinal data
cannot be compared with each other.
a) Continuous data – infinite number
of values between whole numbers.
Data that can take any numerical Example: Under Morningstar and Standard
value within a specific range of & Poor's star ratings for mutual funds, a fund
values such as the future value of that is assigned:
an investment, price returns of a • 1 star represents a fund with
stock, cash dividends per share. relatively poor performance.
• 5 stars represents a fund with
b) Discrete data – finite values relatively superior performance.
Values that result from a counting
process such as the number of Rule of Thumb: How to distinguish numerical
coupon payments (semi-annually, data from categorical data coded in
annually), discrete compounding numerical format?
frequency (monthly, quarterly,
yearly, etc.) Arithmetic operations can be performed on
numerical data but cannot be performed on
2. Categorical Data (a.k.a. qualitative categorical data coded in numerical format.
data): are values that are classified
into various types based on the quality
or characteristics of the dataset. These Practice: Example 1,
values can be mutually exclusive such CFA Institute’s Curriculum.
Learning Module: 2
are readily searchable and readable by

Cross-Sectional versus Time-Series versus computers for processing and analyzing.
Panel Data
For example:
Two data related terminologies: • Market data – data issued by stock
exchanges
a) Variable (field or attribute or feature) – • Fundamental data – data in
that can be measured or categorized, financial reports issued by
and its value is subject to change. For companies
example, stock price, dividend yield, • Analytical data - data obtained
earning per share. from analytics, cash flow
projections, forecasted earnings.
b) Observation – is the value of a specific
variable at a specific time or over a
Unstructured Data - Data that do not follow any
specified period. For example, last
systematically organized format.
quarter’s EPS of LRT Inc. is $2.50.
Unstructured data are usually alternative data
Following are three data classifications based
gathered from unconventional sources such as
on how data are collected:
audio/video/text generated from satellites,
financial news, social media posts,
a) Cross-sectional data
presentations/filings generated by companies
b) Time-series data
in regular business operations.
c) Panel data
Unstructured data must be converted into a
1. Cross-sectional data: Cross-sectional data
format usable by traditional modeling methods
are observations of a specific variable
designed for structured inputs.
collected at the same point in time from
multiple observational units.
Based on the sources from which the data are
generated, three types of unstructured data
E.g., 2020 year-end book value per are the data generated by:
share (the variable) for all New York
Stock Exchange-listed companies (the
1. Individuals – web searches, social
observational units).
media posts
2. Business processes – credit card
2. Time series data: Time series data is a set of transactions, corporate filings such as
observations for a single observational unit Form 10-Q.
of a specific variable collected at different 3. Sensors – satellite imagery, traffic by
times at discrete and equally spaced time mobile devices
intervals.
E.g., monthly returns (the variables) of

UNP for the past 5 years. Practice: Example 2,
3. Panel Data: Mix of time series and cross-
sectional data that are frequently used in
financial analysis. It is a set of observations Data Summarization
on one or more variables for multiple
observational units collected at different
times For quantitative analysis, raw data must be
transformed into structured data for cleaning
and formatting purposes. Depending on the
E.g., The annual inflation rate (the
variables, raw data is organized into one-
variable) of the Eurozone countries (the
dimensional array or two-dimensional array to
observational units) over a 5-year
find patterns and relations between variables.
period.
• Frequency distribution is a useful tool to
Structured versus Unstructured Data summarize one-variable data.
• Contingency tables efficiently sum up
two-variable data.
Structured data - Highly organized data in a
systematic format with repeating patterns that
Learning Module: 2
3. ORGANIZING DATA FOR QUANTITATIVE ANALYSIS
Two-dimensional rectangular array (a.k.a. data

One-dimensional data table)
• Simplest format to organize information One of the most popular forms of organizing
• Suitable for compiling data with single data for computers or humans.
variable. For example, time-series data –
such as closing price of TSLA for the first 10 Data tables are similar to excel spreadsheet
trading days in January 2021. where columns hold multiple variables and
• Time series format facilitates: rows hold multiple observations typically
organized in a time ordered sequence.
o future data updates to the current
dataset.
o in observing trends or patterns in the Practice: Example 3,
data over time CFA Institute’s Curriculum.
4. SUMMARIZING DATA USING FREQUENCY DISTRIBUTIONS
Frequency distribution is a useful tool to

summarize data for on variable. Sector Absolute Relative
(variable) Frequency Frequency
• Frequency distribution (also known as a Health care 21 26.25%
one-way table) - Frequency distribution is Financials 19 23.75%
a tabular display where data is Consumer goods 17 21.25%
categorized into mutually exclusive groups Utilities 14 17.50%
(categorical data) or numerically ordered Real estate 9 11.25%
bins (numerical data) and shows the Total 80 100.00%
number of observations in each bin.
A frequency distribution table provides
• Absolute Frequency: The actual number of valuable information such as, the industry
observations for each unique value of a sector with the largest number of stocks in the
variable is called the absolute frequency portfolio is the ‘health care’ sector - contains 21
or simply frequency. stocks and accounts for 26.25% of the total
stocks of the portfolio.
• Relative frequency: Relative frequency =
!"#$%&'( *+(,&(-./
Constructing Frequency distribution of a
01234 56789: 1; 18<9:=32>15<
numerical data:
Constructing Frequency distribution of a
categorical variable: Step 1:
Arrange the data in ascending order.
• Count the number of observations
for each unique value of the Step 2:
variable Calculate the range of the data.
• List unique values along with Range = Maximum Value - Minimum value
corresponding counts in a table in
ascending or descending order. Step 3:
Choose the appropriate number of bins
(a.k.a. intervals) (k) based on your
Consider a portfolio containing 80 stocks,
judgement. Bins are a set of values within
organized in five sectors. The frequency which an observation lies.
distribution of the portfolio’s stock holdings by
sectors is provided below.
Step 4:
Learning Module: 2
Determine the bin width using the formula:

?@-A( 1.5%, -2.2%, 6.2%, 11.8%, 9.9%, 6.5%, 5.2%, 4.3%,
B$. $* DE-# 7.2%, 10.1%
Example: Suppose, Step 1: Sorting the returns in ascending order

Max. value = 3.5%
Min value = 1.5% -2.2%
Bins on intervals = 5 1.5
4.3
F.G% I J.G%
Bin width = = 0.5% 5.2
K
6.2
6.5
Important 7.2
• If too few intervals are used, then the data 9.9
is over-summarized and may ignore 10.1
important characteristics. 11.8
• If too many intervals are used, then the
data is under-summarized. Step 2: Determine Range
• The smaller (greater) the value of k, the Range = Max. value – Min value = 11.8% – (-
larger (smaller) the interval. 2.2%) = 14%
Step 5: Step 3: Set number of bins

Determine the endpoints of each bin.
Suppose we set k = 4 i.e., four number of bins.
Compute the endpoint of the first bin by
adding bin width to the minimum value. Step 4: Determine bin width
Then compute the 2nd bin’s endpoint by
?@-A( JK%
adding the bin width to the endpoint of the Bin width = = = 3.5%
L K
first bin.
Step 5: Determine the end points of the bins
Determined the next bin by successively
adding the bin width to the endpoints of Endpoints of Bins’ Limits Observation
the previous bin. bins (obs.)
-2.2 + 3.5 = 1.3 [-2.2 to 1.3) −2.2 ≤ 𝑜𝑏𝑠. < 1.3
The last bin would be the one, which
1.3 + 3.5 = 4.8 [1.3 to 4.8) 1.3 ≤ 𝑜𝑏𝑠. < 4.8
includes the maximum value.
4.8 + 3.5 = 8.3 [4.8 to 8.3) 4.8 ≤ 𝑜𝑏𝑠. < 8.3
8.3 + 3.5 = 11.8 [8.3 to 11.8) 8.3 ≤ 𝑜𝑏𝑠. < 11.8
Step 6:
Count the number of observations in each
bin. Note:
Square bracket [ ] indicates endpoints are
Step 7: included in the bin.
Construct a table presenting set of bins
Parentheses ( ) indicate endpoints are not
listed in ascending order showing no. of
included in the bin.
observations falling into each bin.
Step 6 and 7:
Construct a table presenting set of bins listed in
It is important to note that: ascending order displaying no. of observations
• Bins do not overlap. falling into each bin.
• Each observation should fall into one bin
only. Bin Observation Absolute Relative
• Start the first bin/interval with a nearest obs. Frequency Frequency
whole number below the minimum value. (%)
• To ensure that the final interval includes the
A −2.2 ≤ 𝑜𝑏𝑠. 2 0.20
maximum value of the data., always round
< 1.3
up (not down).
B 1.3 ≤ 𝑜𝑏𝑠. 1 0.10
< 4.8
Example:
C 4.8 ≤ 𝑜𝑏𝑠. 4 0.40
< 8.3
Suppose an investment fund has the following
10 observations of monthly returns.
Learning Module: 2
D 8.3 ≤ 𝑜𝑏𝑠. 3 0.30

< 11.8 Cumulative Relative Frequency is computed by
adding up the relative frequencies. It reflects
Cumulative Absolute Frequency is computed the percentage of observations that are less
by adding up the absolute frequencies. It than the upper limit of each interval.
reflects the number of observations that are less
than the upper limit of each interval.
Bin Observation obs. Absolute Relative Cumulative Cumulative Relative

Frequency Frequency Absolute Frequency
(%) Frequency (%)
A −2.2 ≤ 𝑜𝑏𝑠. < 1.3 2 0.20 2 0.20
B 1.3 ≤ 𝑜𝑏𝑠. < 4.8 1 0.10 3 0.30
C 4.8 ≤ 𝑜𝑏𝑠. < 8.3 4 0.40 7 0.70
D 8.3 ≤ 𝑜𝑏𝑠. < 11.8 3 0.30 10 1.00
5. SUMMARIZING DATA USING A CONTINGENCY TABLE
A contingency table is a powerful tool to Sectors Small Mid Large Total

summarize data and to find patterns for two or cap cap cap
more variables simultaneously. A contingency Health care 9 7 5 21
table with two variables is called two-way Financials 4 8 7 19
table. Consumer 8 4 5 17
goods
Constructing a two-way contingency table: Utilities 4 6 4 14
Real estate 4 3 2 9
List all levels(categories) of one variable in rows TOTAL 29 28 23 80
R and all the levels of the other variable in
columns C. An R x C table refers to R levels of • Blue cells in the above contingency
one variable in rows and C levels of the other table are called joint frequencies i.e.,
variable in columns. joining observations of rows and
columns.
• Each variable should have a finite • Green cells in the above contingency
number of levels. table are called marginal frequencies
• Levels can either comprise of ordered i.e., when joint frequencies are added
data or unordered data. across rows and columns.
• Small cap ‘Health Care’ stocks are the
Consider a portfolio of 80 stocks. A table below portfolio’s largest subgroup with 9
shows a 5 x 3 contingency table that stocks in terms of frequency.
summarizes the stocks of the portfolio by two • Large cap ‘Real estate’ stocks are the
variables – sectors and size as market portfolio’s smallest subgroup with 2
capitalization. stocks.
Relative Frequency as percentage of Total

• Sectors have five levels – i) Health
Care ii) Financials iii) Consumer goods count
iv) Utilities v) Real estate
• Size have three levels - i) small cap ii) Relative frequency of each cell =
B$.$* X"#(+Y@'E$-#
mid cap iii) large cap Z$'@% X"#(+Y@'E$-#
.
• Each cell below shows the number of
stocks in each sector with a certain Market Capitalization
level of market cap. Sectors Small cap Mid cap Large cap Total
Health 11.25% 8.75% 6.25% 26.25%
Market Capitalization care
Learning Module: 2
Financials 5.0% 10.0% 8.75% Confusion matrix is a special type of two-way

23.75%
Consumer 10.0% 5.0% 6.25% contingency table where one dimension
21.25%
goods represents actual data, and another dimension
Utilities 5.0% 7.5% 5.0% represents predicted data. This table gives
17.5%
Real 5.0% 3.75% 2.5% better insights into the portions where the
11.25%
estate model is creating errors and where the model is
TOTAL 36.25% 35.0% 28.75% 100%correct.
Uses of Contingency tables Refer to the paragraph above

Example 5.
Contingency tables can be used to examine
the potential association between two
variables. One method used to test for the
potential association between variables is Chi- Practice: Example 5,
square test of independence. CFA Institute’s Curriculum.
6. DATA VISUALIZATION
Visualization – presenting data in a

pictorial/graphical format – is a useful tool to
recognize potential associations and
comparisons among data.
6.1 Histogram and Frequency Polygon
Histogram
A histogram is the graphical representation of
the frequency distribution (absolute frequency
or relative frequency) of numerical data.
• The bins of the variables are plotted on the

horizontal axis.
• The absolute/relative frequencies are
plotted on the vertical axis.
• The heights of the bars of the histogram
Frequency polygon: is another tool to
represent the frequencies i.e., the tallest
graphically represents the frequency
bar would be the bin that has the highest
distribution.
frequency.
• Since the bins have no gaps between
• The mid-point of each bin/interval is
them, there would be no gaps between
plotted on the horizontal axis.
the bars. However, gaps can be added
• The corresponding absolute frequency of
between the bars to improve readability.
the bin is plotted on the vertical axis.
• The points representing the intersections of
Advantage: Histogram is useful for a quick the midpoints and class frequencies, are
inspection of the frequency distribution connected by a line as shown by the black
(shape, center or spread) of a large line in the chart below.
numerical data.
Learning Module: 2
• Each bar indicates a distinct category

arranged with no logical ordering.
• Bars can be plotted horizontally or
vertically.
• The height of the bar represents the
frequency of the corresponding
category.
• Bar charts are used to show
comparisons between categories of
data.
• A bar chart 1 below represents the
frequency distribution of one
categorical variable – sector.
Cumulative frequency distribution: This graph

can be used to determine the number or the
percentage of the observations lying between
certain values. In this graph,
• Cumulative absolute or cumulative relative

frequency is plotted on the vertical axis.
• The upper interval limit of the
corresponding bin is plotted on the
horizontal axis.
o For extreme values (both negative

and positive), the cumulative
distribution tends to flatten out. Note:
Pareto chart – is a bar chart plus a line where
o Steeper (flatter) slope of the curve categories represented by bars are arranged in
indicates large (small) frequencies descending order and a line represents
(number of observations). cumulative relative frequency.
Bar Charts for more than one categorical
variable
• Grouped bar chart (a.k.a. clustered bar

chart) is used to show joint frequencies of
more than one categorical variable.
For example, Bar chart 2 below is a

grouped bar chart. Three bars within
each sector represents size (market cap
levels) denoted by small cap, mid cap
and large cap.
• Stacked bar chart is another style to

present joint frequencies of more than one
categorical variable. In this chart, a single
bar is divided into subsections -
6.2 Bar Charts differentiated by various colors/patterns.
The height of the bar signifies the marginal
• Bar charts are similar to a histogram, frequency for the category.
with the difference that bar charts
represent the frequency distribution of Note: Bar charts are also used when
categorical data. categorical data are also associated with
numerical data
Learning Module: 2
6.4 Word Cloud (a.k.a. Tag cloud)
Word cloud is used to display the unstructured

6.3 Tree map (text) data where key words are sized and
displayed based on their frequency in the data
Tree-map is another visual tool to present file. Higher the frequency of the word, bigger
categorical data. Tree-map consists of a set of the size. Common words such as it, the, etc. are
colored rectangles that represent distinct not included.
groups. The size of the rectangle is proportional
to the value of the corresponding group.
A tree-map below is an example of two

categorical variables. The rectangles are
first split into five sectors. Each sector is then
subdivided into three sub-rectangles: small
cap, mid cap, large cap.
When more than three levels are used, tree-

maps become hard to read.
6.5 Line Chart

A line chart plots data over time and is used to
examine the changes in data and trends and
to predict future
Source: data series.
https://worditout.com/word-
cloud/create
• Ordered observations are plotted on the
vertical axis (Y-axis).
• Time is plotted on the horizontal axis (X-axis).
• The data points over time are connected
using a line
Advantage: Line charts are useful for:

• visualizing large amounts of data.
• comparing more than one set of
data points
Learning Module: 2
• The strength of the association

between data points is determined by
how closely the data points are
clustered together.
Bubble Line Chart

Bubble line chart is a type of line chart used to
display multi-dimensional data in one chart. In
bubble line chart, data points are replaced by
varying-sized color-coded bubbles to add
another dimension.
A Scatter plot matrix is a useful tool to inspect
bivariate (pairwise) relationships between the
combination of variables in one visual. The
scatter plot matrix provides a brief visual
summary of variables and potential correlation
among them.
Refer to Exhibit 32 ‘Pairwise Plot Matrix’,

6.7 Heat Map
Heat map is a graphic summary of data in a

tabular format using a color spectrum to
differentiate high values from low values. Heat
maps are typically used to see the degree of
correlation among different variables.
6.6 Scatter Plot
A scatter plot graphically shows the relationship

between two variables. i.e., how two sets of Practice: Example 6,
data are related. CFA Institute’s Curriculum.
• Observations in the scatter plot are

represented by a point, and the Guide to selecting among
6.8
points are not connected. visualization Types
• If the points on the scatter plot cluster
together in a straight line, the two Data visualization is a useful tool to gain insight.
variables have a strong linear relation. Different visual types are appropriate for
• Randomly distributed points on the different purposes. Some charts are suitable for
scatter plot may indicate no clear numerical data, and some are suitable for
relationship between the variables. categorical data.
Learning Module: 2
variables are significantly different

Following are the four common pitfalls that when there is only a small difference.
analysts should avoid for ethical and 4. Improper scaling of axis.
appropriate use of data visuals.
1. Selecting the wrong chart

2. Selectively plotting data for biased Practice: Example 7,
conclusions CFA Institute’s Curriculum.
3. Truncated graph problem – a y-axis
that does not start at zero. Such
problem may inaccurately imply that
7. MEASURES OF CENTRAL TENDENCY
A measure of central tendency indicates the The sum of the deviations* around the mean is
center of the data. The most used measures of always equal to 0.
central tendency are:
*The difference between each outcome and
•Arithmetic mean the mean is called a deviation.
•Median
•Mode Property 2:
•Weighted mean The arithmetic mean is sensitive to extreme
•Geometric mean values i.e., it can be biased upward or
•Harmonic mean downward by extremely large or small
observations, respectively.
The Arithmetic Mean Advantages of Arithmetic Mean:
It is the sum of the observations in the dataset • The mean uses all the information
divided by the number of observations in the regarding the size and magnitude of
dataset. the observations.
• The mean is also easy to calculate.
The terms ‘mean’ and ‘average’ are used • Easy to work with algebraically
interchangeably.
Limitation: The arithmetic mean is highly
The Sample Mean affected by outliers (extreme values).
The sample mean is the arithmetic mean value
of a sample; it is computed as: Outliers
∑-EfJ 𝑋E Extreme values (outliers) in a dataset may

𝑆𝑎𝑚𝑝𝑙𝑒 𝑚𝑒𝑎𝑛 𝑋c =
𝑛 reflect a rare value in the population or an
error.
where,
Xi = ith observation Three ways of dealing with the outliers are:
n = number of observations in the sample
1. Do nothing. Use the data without any
• The sample mean can be computed for adjustment
individual units or overtime.
• It is not unique i.e. for a given population; Choose this option when it is important to
different samples may have different represent the whole observations and/or
means. outliers contain meaningful information.
Practice: Example 8, 2. Delete all the outliers

When this option is chosen, the measure of
central tendency in this case is trimmed mean.
Properties of the Arithmetic Mean

Trimmed Mean is the arithmetic mean of
Property 1: the distribution computed after excluding a
Learning Module: 2
stated small % of the lowest and highest

values. Example:
Suppose current P/Es of three firms are 16.73,
22.02, and 29.30.
n = 3 → (n + 1) / 2 = 4/ 2 = 2nd position.
3. Replace the outliers with some other value
Thus, the median P/E is 22.02.
When this option is used, the mean is called
winsorized mean.
The Mode
Winsorized mean: In a winsorized mean, a
stated % of the lowest values is assigned a The mode is the most frequently occurring
specified low value and a stated % of the value in a distribution.
highest values is assigned a specified high
value and then a mean is computed from Unimodal Distribution: A distribution that has
the restated data. only one mode is called a unimodal
distribution.
E.g., in a 95% winsorized mean,
o The bottom 2.5 % of values are set = Bimodal Distribution: A distribution that has two
2.5th percentile value. modes is called a bimodal distribution.
o The upper 2.5% of values are set =
97.5th percentile value. Trimodal Distribution: A distribution that has
three modes is called a Trimodal distribution.
The Median A distribution would have no mode when all

the values in a data set are different.
Median is the middle value of a sorted
(ascending or descending) list of items. Modal Interval: Data with continuous
distribution (e.g., stock returns) may not have a
Steps to compute the Median: modal outcome. In such cases, a modal
1. Arrange all observations in ascending order interval is found i.e., an interval with the largest
i.e., from the smallest to the largest. number of observations (highest frequency).
2. When the number of observations (n) is The modal interval always has the highest bar
odd, the median is the center observation in the histogram.
in the ordered list i.e.
(-hJ)
Median will be located at = j position Important to note: The mode is the only
measure of central tendency that can be used
with nominal data.
• (n+1)/2 only identifies the location of
the median, not the median itself.
Other Concepts of Mean
3. When the number of observations (n) is
even, then median is the mean of the two i. The Weighted Mean
center observations in the ordered list i.e.
Weighted mean: It is the arithmetic mean in
Median will be located at mean of which observations are assigned different
-
𝑎𝑛𝑑
(-hJ)
. weights. It is computed as:
j j
-
Advantage: Median is not affected by extreme 𝑋cl = m 𝑤E 𝑋E = (𝑤J 𝑋J + 𝑤j 𝑋j + ⋯ + 𝑤- 𝑋- )
observations (outliers). EfJ
Limitations: where,
X1, X2,…,Xn = observed values
• It is time consuming to calculate w1, w2,…,w3 = Corresponding weights, sum to 1.
median.
• The median is difficult to compute.
• An arithmetic mean is a special case of
• It does not use all the information about
weighted mean where all observations
the size and magnitude of the
are equally weighted by the factor 1/ n
observations.
(or l/N).
• It only focuses on the relative position of
the ranked observations.
Learning Module: 2
• A positive weight represents a long Advantages of Measures of Central Tendency:

position and a negative weight
represents a short position. • Widely recognized.
• Expected value: When a weighted • Easy to compute.
mean is computed for a forward-looking • Easy to apply.
data, it is referred to as the expected
value. Geometric mean versus Arithmetic mean:
Example: • The geometric mean return represents the

growth rate or compound rate of return on
Weight of stocks in a portfolio = 0.60
an investment.
Weight of bonds in a portfolio = 0.40
• The arithmetic mean return represents an
Return on stocks = –1.6%
average single-period return on an
Return on bonds = 9.1%
investment.
• The geometric mean is always ≤ arithmetic
A portfolio's return is the weighted average of
mean.
the returns on the assets in the portfolio i.e.
• When there is no variability in the
observations (i.e. when all the observations
Portfolio return = (w stock × R stock) + (w bonds × R
in the series are the same), geometric
bonds)
mean = arithmetic mean
= 0.60(-1.6%) + 0.40 (9.1%) =
• The greater the variability of returns over
2.7%.
time, the more the geometric mean will be
lower than the arithmetic mean.
Practice: Example 9, • The geometric mean return decreases with
CFA Institute’s Curriculum. an increase in standard deviation (holding
the arithmetic mean return constant).
ii. The Geometric Mean
In addition, the geometric mean ranks the two
funds differently from that of an arithmetic
Geometric mean (GM): The geometric mean
mean.
can be used to compute the mean value over
time to compute the growth rate of a variable.
𝐺 = tr𝑋J 𝑋j 𝑋F … 𝑋- CFA Institute’s Curriculum.
with Xi ≥ 0 for i = 1, 2, …, n.
Or iii. The Harmonic Mean

1
𝐼𝑛 𝐺 = 𝐼𝑛(𝑋J 𝑋j 𝑋F … 𝑋- ) -
𝑛 1
𝐻𝑎𝑟𝑚𝑜𝑛𝑖𝑐 𝑀𝑒𝑎𝑛 𝑋c• = 𝑛/ m( )
𝑋E
or as EfJ
with Xi > 0 for i = 1,2, …, n.
∑-EfJ 𝐼𝑛𝑋-
𝐼𝑛 𝐺 = • It is a special case of the weighted
𝑛
mean in which each observation's
G = elnG weight is inversely proportional to its
magnitude.
• It should be noted that the geometric
mean can be computed only when the Cost Averaging is an investment strategy
product under the radical sign is non- involving periodic investments of fixed amount
negative. of money. Harmonic mean is appropriate when
averaging the ratios, and the ratios are
The geometric mean return over the time repeatedly applied to a fixed quantity to yield
period can be computed as: a variable number of units.
𝑅w($x = [(1 + 𝑅J )(1 + 𝑅j ) … (1 + 𝑅Z )]J/Z − 1 In cost averaging, the ratios to be averaged

are prices per share at the date of the
purchase, and then apply those prices to a
• Geometric mean returns are also known
constant amount of money to yield a variable
as compound returns.
number of shares.
Learning Module: 2
• When there is variability in the

Practice: Example 11 and 12 observations, harmonic mean <
CFA Institute’s Curriculum. geometric mean < arithmetic mean.
Refer to Exhibit 42, CFA Program

Important to note: Curriculum, for “Deciding which central
tendency measure to use?”
• Harmonic mean formula cannot be
used to compute average price paid
when different amounts of money are Practice: Example 13
invested at each date. CFA Institute’s Curriculum.
• When all the observations in the data
set are the same, geometric mean =
arithmetic mean = harmonic mean.
8. QUANTILES
arranged in ascending order is determined

Quantile or Fractile is a general used for a as follows:
value at or below which a stated fraction of
the data lies. 𝑦
𝐿/ = (𝑛 + 1)
100
The following four measures collectively are where,
called quantiles. y = % point at which the distribution is being
divided.
Ly = location (L) of the percentile (Py).
1. Quartiles n = number of observations.
2. Quintiles
3. Deciles
4. Percentiles • The larger the sample size, the more
accurate the calculation of percentile
location.
Quartiles, Quintiles, deciles, and Percentiles Example:
Dividend Yields on the components of the

1) Quartiles divide the distribution into four DJ Euros STOXX 50
different parts.
Dividend
No. Company
• First Quartile = Q1 = 25th percentile i.e. Yield(%)
25% of the observations lie at or below
1 AstraZeneca 0.00
it.
• Second Quartile = Q2 = 50th percentile 2 BP 0.00
i.e. 50% of the observations lie at or
below it. 3 Deutsche Telekom 0.00
• Third Quartile = Q3 = 75th percentile i.e. 4 HSBC Holdings 0.00
75% of the observations lie at or below
it. 5 Credit Suisse Group 0.26
6 L’Oreal 1.09
2) Quintiles divide the distribution into five
different parts. In terms of percentiles, they 7 SwissRe 1.27
can be specified as P20, P40, P60, & P80. 8 Roche Holding 1.33
3) Deciles divide the distribution into ten 9 Munich Re Group 1.36

different parts. 10 General Assicurazioni 1.39
4) Percentiles divide the distribution into 11 Vodafone Group 1.41

hundred different parts. The position of a
12 Carrefour 1.51
percentile in an array with n entries
Learning Module: 2
Dividend Dividend
No. Company No. Company
Yield(%) Yield(%)
13 Nokia 1.75 47 ING Group 6.16
14 Novartis 1.81 48 Prudential 6.43
15 Allianz 1.92 49 Lloyds TSB 7.68
16 Koninklije Philips 2.01 50 AEGON 8.14
Electronics
17 Siemens 2.16 Calculating 10th percentile (P10): Total number
of observations in the table above = n = 50
18 Deutsche Bank 2.27
19 Telecom Italia 2.27 L10 = (50 + 1) × (10 / 100) = 5.1
20 AXA 2.39 • It implies that 10th percentile lies

21 Telefonica 2.49 between 5th observation (X5 = 0.26) and
6th observation (X6 = 1.09).
22 Nestle 2.55
23 Royal Bank of 2.60 Thus,
Scotland Group P10 = X5 + (5.1 – 5) (X6 – X5) = 0.26 + 0.1 (1.09 –
0.26)
24 ABN-AMRO Holding 2.65 = 0.34%
25 BNP Paribas 2.65
Calculating 90th percentile (P90):
26 UBS 2.65 L90 = (50 + 1) × (90 / 100) = 45.9
27 Tesco 2.95
• It implies that 90th percentile lies
28 Total 3.11 between the 45th observation (X45 =
29 GlaxoSmithKline 3.31 5.15) and 46th observation (X46 = 5.66).
30 BT Group 3.34
Thus,
31 Unilever 3.53 P90 = X45 + (45.9 – 45) (X46 – X45) = 5.15 + 0.90
(5.66 – 5.15) = 5.61%
32 BASF 3.59
33 Santander Central 3.66 Calculating 1stQuartile (i.e.P25):
Hispano L25 = (50 + 1) × (25 / 100) = 12.75
34 Banco Bilbao 3.67

• It implies that 25th percentile lies
VizcayaArgentaria
between the 12th observation (X12 =
35 Diageo 3.68 1.51) and 13th observation (X13 = 1.75).
36 HBOS 3.78 Thus,
P25 = Q1 = X12 + (12.75 – 12) (X13 – X12) = 1.51 +
37 E.ON 3.87 0.75 (1.75 – 1.51) = 1.69%
38 Shell Transport and 3.88
Calculating 2nd Quartile (i.e.P50):
Co.
L50 = (50 + 1) × (50 / 100) = 25.5
39 Barclays 4.06
40 Royal Dutch 4.27 • It implies that P50 lies between the 25th
Petroleum Co. observation (X25 = 2.65) and 26th
observation (X26 = 2.65).
41 Fortus 4.28 • Since, X25 = X26 = 2.65, no interpolation is
needed.
42 Bayer 4.45
43 DiamlerChrysler 4.68 Thus,
44 Suez 5.13 P50 = Q2 = 2.65% = Median
45 Aviva 5.15 Calculating 3rd Quartile (i.e.P75):

L75 = (50 + 1) × (75 / 100) = 38.25
46 Eni 5.66
Learning Module: 2
• It implies that P75 lies between the 38th • 1st decile contains the portfolio of
observation (X38 = 3.88) and 39th companies with the smallest market
observation (X39 = 4.06). values.
• 10th decile contains the portfolio of
Thus, companies with the largest market
P75 = Q3 = X38 + (38.25 – 38) (X39 – X38) values.
= 3.88 + 0.25 (4.06 – 3.88)
= 3.93% Quantiles are also used for investment research
purposes.
Calculating 20th percentile (P20) = 1st Quintile:
L20 = (50 +1) × (20 /100) = 10.2 Interquartile range (IQR) = Third quartile - First
quartile
• It implies that P20 lies between the 10th = Q3 – Q1
observation (X10 = 1.39) and 11th
observation (X11 = 1.41). • It reflects the length of the interval that
contains the middle 50% of the data.
Thus, • The larger the interquartile range, the
1st quintile = P20 = X10 + (10.2 – 10) (X11 – X10) = greater the dispersion, all else constant.
1.39 + 0.20 (1.41 – 1.39) = 1.394% or 1.39%
Quantiles in Investment Practice Refer to CFA Institute’s Curriculum, Exhibit 44

and 45 for Box and Whisker Chart
Quantiles are frequently used by investment
analysts to rank performance i.e., portfolio
performance. For example, an analyst may
rank the portfolio of companies based on their Practice: Example 14 and 15
market values to compare performance of CFA Institute’s Curriculum.
small companies with large ones i.e.
9. MEASURES OF DISPERSION
The variability around the central mean is Advantage: It is easy to compute.

called Dispersion. The measures of dispersion
provide information regarding the spread or Disadvantages:
variability of the data values.
• It does not provide information
Relative dispersion: It refers to the amount of regarding the shape of the distribution
dispersion/variation relative to a reference of data.
value or benchmark e.g., coefficient of • It only reflects extremely large or small
variation. (It is discussed below). outcomes that may not be
representative of the distribution.
Absolute Dispersion: It refers to the variation
around the mean value without comparison to
any reference point or benchmark. Measures 2. The Mean Absolute Deviation
of absolute dispersion include:
Mean absolute deviation (MAD) is the average
i. Range of the absolute values of deviations from the
ii. Mean absolute deviation mean.
iii. Variance
iv. Standard deviation ∑-EfJ|𝑋' − 𝑋c|
𝑀𝐴𝐷 =
𝑛
where,
1. The Range 𝑋c = Sample mean
n = Number of observations in the
Range = Maximum value - Minimum value sample
Learning Module: 2
• The greater the MAD, the riskier the • (n – 1) is known as the number of
asset. degrees of freedom in estimating the
population variance.
Example:
Suppose there are 4 observations i.e., 15, -5, 12, 2. Sample Standard Deviation
22.
It is computed as:
Mean = (15 – 5 + 12 + 22)/4 = 11% -
ÊfJ(𝑋E − 𝑋c)j
MAD = (|15 – 11| + |–5 – 11| + |12 – 11| + |22 𝑠= ‰
– 11|)/4 = 32/4 = 8% 𝑛−1
Advantage: MAD is superior relative to Important to note:

range because it is based on all the
observations in the sample. • The MAD will always be ≤ S.D. because
the S.D. gives more weight to large
Drawback: MAD is difficult to compute deviations than to small ones.
relative to range. • When a constant amount is added to
each observation, S.D. and variance
remain unchanged.
Practice: Example 16, CFA

Program Curriculum
CFA Institute’s Curriculum. Refer to CFA Institute’s Curriculum, Exhibit 46
for Steps to Calculate Sample Standard
Deviation and Variance
Sample Variance and Sample
3.
Standard Deviation
Variance: Variance is the average of the
squared deviations around the mean. Program Curriculum
Standard deviation (S.D.): Standard deviation is
the positive square root of the variance. It is
easy to interpret relative to variance because 3. Dispersion and the Relationship between
standard deviation is expressed in the same Arithmetic and the Geometric Means
unit of measurement as the observations.
Geometric mean return
1. Sample Variance 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛
≈ Arithmetic mean return –
2
It is computed as:
-
ÊfJ(𝑋E − 𝑋c)j 𝑠j
𝑠j = 𝑋cw ≈ 𝑋• −
𝑛−1 2
where, The larger the variance of the sample, the
𝑋c=Sample mean wider will be the difference between the
n = Number of observations in the sample geometric mean and the arithmetic mean.
• The sample mean is defined as an

unbiased estimator of the population
mean.
10. DOWNSIDE DEVIATION AND COEFFICIENT OF VARIATION
Downside deviation is a risk measure that

focuses on returns that fall below a minimum Standard deviation considers all deviations
threshold or minimum acceptable return as from the mean. Downside deviations only
investors are typically only concerned about considers the negative deviations from the
the values that fall below some minimum target mean. Therefore, downside deviation is less
return. than the standard deviation S.D.
Learning Module: 2
Coefficient of Variation, (CV), is the ratio of

Target semideviation is the measure of standard deviation of set of values to their
dispersion of observations below the stated mean value.
target.
Coefficient of Variation (CV) measures the
amount of risk (S.D.) per unit of mean value.
-
(𝑋E − 𝐵)j
𝑠Z@+A(' = ž m 𝑆
𝑛−1 𝐶𝑉 = - c ®
*$+ @%% ¡ ¢D 𝑋
where,
B = target value, When stated in %, CV is:
n = number of observations. 𝑆
𝐶𝑉 = - c ® × 100%
𝑋
where,
Example: Stock returns = 16.2, 20.3, 9.3%, –11.1% s = sample S.D.
and –17.0%. 𝑋c = sample mean.
Target return = B = 10%
Target semideviation = • CV is a scale-free measure (i.e., has no

units of measurement); therefore, it can
[(¤.F –J¥.¥)j h (–JJ.J – J¥.¥)j h (–J¦.¥ – J¥.¥)j]
£ be used to directly compare dispersion
GIJ
across different data sets.
Target semideviation = √293.675 = 17.14%
• Interpretation of CV: The greater the
value of CV, the higher the risk.
Practice: Example 18 and 19,
æXö
CFA Program Curriculum = çç ÷÷
• An inverse CV è S ø è It indicates
unit of mean value (e.g., % of return)
per unit of S.D.
Coefficient of Variation
Relative dispersion is the amount of dispersion Practice: Example 20, CFA

relative to a reference value or benchmark. Program Curriculum,
One of such measures is coefficient of CFA Institute’s Curriculum.
variation.
11. THE SHAPE OF DISTRIBUTIONS
Symmetrical return distribution or Normal Skewed distribution: The distribution that is not
distribution: symmetrical around the mean is called
skewed.
It is a return distribution that is symmetrical
about its mean i.e. equal loss and gain intervals a) Positively skewed or right-skewed
have same frequencies. It is referred to as Distribution: It is a return distribution that
normal distribution. reflects frequent small losses and a few
extreme gains i.e. limited but frequent
• A symmetrical distribution has skewness downside.
=0
• It has a long tail on its right side.
Characteristics of the normal distribution: • It has skewness > 0.
1) In a normal distribution, mean = median. • In a positively skewed unimodal
2) A normal distribution is completely distributionè mode < median < mean.
described by two parameters i.e. its mean • Generally, investors prefer positive
and variance. skewness (all else equal).
Learning Module: 2
b) Negatively skewed or left-skewed • It has skewness < 0.

Distribution: It is a return distribution that • In a negatively skewed unimodal
reflects frequent small gains and a few distribution è mean < median < mode.
extreme losses i.e. unlimited but less
frequent upside.
• It has a long tail on its left side.
Sample skewness (for large values of n ≥ 100) is

computed as follows: Platykurtic: It is a distribution that is less peaked
than normal.
1 ∑- (𝑋E − 𝑋c)F
𝑆± ≈ - ® EfJ F
𝑛 𝑆 Mesokurtic: It is a distribution that is identical to
the normal distribution.
n = number of observations in the sample
s = sample S.D.
Note: Cubing in the formula preserves the sign

of the deviation from the mean.
The Shape of the Distributions: Kurtosis
Kurtosis is used to identify how peaked or flat

the distribution is relative to a normal
distribution. The Sample excess kurtosis (for larger sample
size(n)) is computed as:
Leptokurtic: It is a distribution that is more
peaked (i.e., greater number of observations
𝟏 ∑𝑵 ¹ 𝟒
𝒊f𝟏(𝑿𝒊 − 𝑿)
closely clustered around the mean value) and 𝑲𝑬 = ´- ® ½−𝟑
𝒏 𝒔𝟒
has fatter tails (i.e., greater number of
observations with large deviations from the
mean value) than the normal distribution.
• For a normal distribution (mesokurtic),
kurtosis = 3.0.
• It has more frequent extremely large • For a leptokurtic distribution, kurtosis> 3.
deviations from the mean than a • For a platykurtic distribution, kurtosis < 3.
normal distribution.
• Ignoring fatter tails in analysis results in
underestimation of the probability of NOTE: Kurtosis is free of scale (i.e., it has no units
extreme outcomes. of measurement).
• The more leptokurtic the distribution is,
the higher the risk. It is always positive number because the
deviations are raised to the 4th power.
Learning Module: 2
Excess kurtosis = Kurtosis – 3

• A normal or mesokurtic distribution has Program Curriculum
excess kurtosis = 0. CFA Institute’s Curriculum.
• A leptokurtic distribution has excess
kurtosis > 0.
• A platykurtic distribution has excess
kurtosis < 0.
12. CORRELATION BETWEEN TWO VARIABLES
Correlation measures the linear relationship can be calculated using the following
between two variables. formula:
Firstly, determine how two variables vary .$Y@+E@-.( $* @-Ä ¿

𝒓𝑿𝒀 = #@xÅ%( #'@-Ä@+Ä #@xÅ%( #'@-Ä@+Ä
together their covariance. -
Ä(YE@'E$- $*
®-
Ä(YE@'E$- $* ¿
®
Sample covariance measures how to 𝑐𝑜𝑣 ¿

=
variables in a sample move together i.e., (𝑠 )(𝑠¿ )
measures the joint variability of two random or
variables. 𝑐𝑜𝑣(𝑥, 𝑦)
𝑟=
r𝑣𝑎𝑟(𝑥)r𝑣𝑎𝑟(𝑦)
The sample covariance is calculated as:
NOTE:
∑-EfJ(𝑋E − 𝑋c)(𝑌E − 𝑌c)
𝑠 ¿ = Unlike Covariance, Correlation has no unit of
𝑛−1 measurement; it is a simple number.
Example:
where, 𝐶𝑜𝑣É/ = 47.78 𝑆Éj = 40 𝑆/j = 250
n = sample size
Xi = ith observation on variable X 47.78
𝑋c = mean of the variable X observations 𝑟= = 0.478
r(40)(250)
Yi = ith observation on variable Y
𝑌c = mean of the variable Y observations
Positive Covariance: When both variables tend Properties of Correlation

to move in the same direction, they are
referred to as positively correlated and have
1. The correlation coefficient can range
positive covariance.
from -1 to +1.
2. Two variables are perfectly positively
Negative Covariance: When both variables
correlated if correlation coefficient is
tends to move in the opposite direction, they
+1.
are referred to as negatively correlated and
3. Correlation coefficient of -1 indicates a
have negative covariance.
perfect inverse (negative) linear
relationship.
Covariance can range from –𝛼 to + 𝛼.
4. When correlation coefficient equals 0,
there is no linear relationship.
The covariance number doesn’t tell if the
5. The closer the correlation coefficient is
relationship between two variables is strong or
to +1 or -1, the stronger the relationship.
weak. It only tells the direction of the
relationship.
Scatter plots are useful tool for a sensible

Correlation coefficient measures the
interpretation of a correlation coefficient as it
direction and strength of linear association
demonstrates the relationship graphically.
between two variables. The correlation
coefficient between two assets X and Y
Learning Module: 2
Refer to Exhibit 51, CFA Institute’s Curriculum

for “Scatter Plots Showing Various Degrees of i. two variables have only chance
Correlation”. relationships.
ii. two variables that are uncorrelated but
may be correlated if mixed by third
variable.
iii. correlation between two variables
Practice: Example 22, CFA resulting from a third variable.
Program Curriculum
NOTE: Spurious correlation may suggest
investment strategies that appear profitable
but actually would not be so, if implemented.
Limitations of Correlation Analysis
5. Correlation does not tell the whole story:
Knowing two variables’ means, standard
1. Linearity: Correlation only measures linear deviations and their correlation does not
relationships properly. tell the whole story.
2. Outliers: Correlation may be an unreliable

measure when outliers are present in one
or both of the series. For details refer to Case Anscombe’s Quartet
Exhibit 55, CFA Institute’s Curriculum.
3. No proof of causation: Based on correlation
we cannot assume x causes y; there could
be third variable causing change in both
variables.
Practice: End of Chapter
4. Spurious Correlations: Spurious correlation is Questions from CFA Institute’s
a correlation in the data without any Curriculum & FinQuiz Question-
causal relationship. This may occur when: bank.
QM Probability Concepts
Learning Module: 3
1. PROBABILITY CONCEPTS AND ODDS RATIOS
• Event A: The portfolio earns a return = 8%.
Probability, Expected Value, and Variance • Event B: The portfolio earns a return < 8%.
• Event C: The portfolio earns a return > 8%.
Random variable: A variable that has uncertain
outcomes is referred to as random variable e.g. the In the probability distribution of the random variable,
return on a risky asset. each random outcome is assigned a probability.
Event: An event is an outcome or a set of outcomes of a Empirical (or statistical) probability: It is a probability
random process e.g., 10% return earned by the portfolio based on observations obtained from probability
or tossing a coin three times. experiments (historical data). The empirical frequency
of an event E is the relative frequency of event E i.e.
• When an event is certain or impossible to occur, it !"#$%$&'&() #+ ,-./( ,
is not a random outcome. P(E) =
0#(%' !"#$%$&'&()
Probability: Probability is a measure of the likelihood or • Empirical probability of an event cannot be

chance that an event will occur in the future. computed for an event with no historical record or
for an event that occurs infrequently.
• If an event is possible to occur, it has a probability
between 0 and 1. Example:
• If an event is impossible to occur, it has a
Total sample of dividend changes = 16,189.
probability of 0.
• If an event is certain to occur, it has a probability of
1. • Frequency of observations that ‘change in
dividends’ is increase = 14,911.
• Frequency of observations that ‘change in
Properties of a Probability:
dividends’ is decrease = 1,278.
1) The probability of any event ‘E’ is a number that lies
between 0 and 1 i.e. Probability that a dividend change is a dividend
12,411
increase = ≈ 0.92
0 ≤ P(E) ≤ 1 15,164
Where, P(E) = Probability of event E. Subjective probability: It is a probability based on

personal assessment, educated guesses, and estimates.
Priori probability: It is a probability based on logical

analysis, reasoning & inspection rather than on
observation or personal judgment.
2) The sum of the probabilities of any set of mutually

• Priori and empirical probabilities are referred to as
exclusive and exhaustive events always equals 1 e.g.
objective probabilities.
if there are three events A, B & C, then their
probabilities i.e. P(A) + P(B) + P(C) = 1.
Odds for Event E can be stated as:
Mutually exclusive events: When events are mutually !"#$%$&'&() #+ , !(,)
E= =[17! (,)]
exclusive, events cannot occur at the same time e.g. 17!"#$%$&'&() #+ ,
when a coin is tossed, the event of occurrence of a
head and the event of occurrence of a tail are mutually For example, given odds for E = "a to b," è it implies that:
exclusive events. The following events are mutually
exclusive.
• For ‘a’ occurrence of E, we expect ‘b’ cases of
non-occurrence.
• Event A: The portfolio earns a return = 8%.
• Event B: The portfolio earns a return < 8%. %
Probability of E =
(%<$)
Exhaustive events: When events are exhaustive, it means

that all possible outcomes are covered by the events Odds against Event E can be stated as:
e.g. the following events are exhaustive. [ 17 ! (,)]
E=
! (,)
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QM Probability Concepts
Learning Module: 3
For example, given odds against E =“a to b," è it implies • Winning probability = 1 / 16
that the • Losing probability = 15 / 16
$
Probability of E = (%<$) • Profit when a person wins = $15
• Loss when a person losses = $ -1
Example: Suppose odds for E = “1 to 7." Thus, total cases
= 1 + 7 = 8. It means that out of 8 cases è there is 1 case Expected profit = (1 / 16)($15) + (15/ 16)(-$1) = $0
of occurrence and 7 cases of non-occurrence.
The probability of E = 1/ (1 + 7) = 1/ 8.
Example: Suppose,
2. CONDITIONAL AND JOINT PROBABILITY
Types of Probability:
1) Unconditional Probability: An unconditional
probability is the probability of an event occurring
regardless of other events e.g. the probability of this
event A denoted as P(A). It may be viewed as stand-
alone probability. It is also called marginal
probabilities.
2) Conditional Probability: A conditional probability is the

probability of an event occurring, given that another
event has already occurred. The conditional probability of A given that B has
occurred:
P(A|B)è Probability of A, given B.
𝐽𝑜𝑖𝑛𝑡 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐴 𝑎𝑛𝑑 𝐵 𝑃(𝐴𝐵)
𝑷(𝑨|𝑩) = = → 𝑃(𝐵) ≠ 0
NOTE: 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐵 𝑃(𝐵)
The conditional probability of an event can be greater Multiplication Rule for Probability: For two events, A and
than, equal to, or less than the unconditional probability, B, the joint probability that both events will happen is
depending on the facts. found as follows:
Example: P(A and B) = P(AB) = P(A|B) × P(B)
Unconditional Probability: The probability that the stock P(B and A) = P(BA) = P(B|A) × P(A)
earns a return above the risk-free rate (event A).
𝑃 (𝐴) Practice: Example 2,

Sum of the probabilities of stock returns above the risk − free rate
= CFA Institute’s Curriculum.
Sum of the probabilities of 𝒂𝒍𝒍 possible returns (i. e. 1)
Conditional Probability: The probability that the stock

earns a return above the risk-free rate (event A), given Addition Rule for Probabilities: The probability that event
that the stock earns a positive return (event B). A or B will occur (i.e. at least one of the two events
occurs) is found as follows:
XYZ #+ ([. \"#$%$&'&(&.] #+ ](#^_ ".(Y"/] %$#-. ([. "&]_ +".. "%(.
P(A|B) =
XYZ #+ ([. \"#$%$&'&(&.] +#" %'' ".(Y"/] ` a% P(A or B) = P(A) + P(B) – P *(A and B)
Joint Probability: The probability of occurrence of all *To avoid double counting of probabilities of shared outcomes
events is referred to as joint probability. For example, the
joint probability of A and B denoted as P(AB) read as the When events A and B are mutually exclusive, P(AB) = 0;
probability of A and B is the sum of the probabilities of thus, the addition rule can be simplified as:
their common outcomes.
P(A or B) = P(A) + P(B)
• P(AB) = P(BA).
Reading 3 Probability Concepts FinQuiz.com
Practice: Example 4 & 5 Source: Example 8, CFA® Curriculum.

Complement Rule: For an event or scenario S, the event
not-S is called the complement of S and is denoted as
Independent Events: Two events are independent if the SC. Since either S or not-S must occur,
occurrence of one of the events does not affect the
probability of the other event. Two events A and B are P(S) + P(SC) = 1
independent if
The Total Probability Rule: According to the total
P(B |A) = P(B) probability rule, the probability of any event P(A) can be
Or if stated as a weighted average* of the probabilities of the
P(A |B) = P(A) event, given scenarios i.e. P(A│S1).
Dependent Events: Two events are dependent when the
probability of occurrence of one event depends on the *where, weights = P(S1) × P(A│S1)
occurrence of the other.
It is expressed as follows:
Multiplication Rule for Independent Events: P(A) = P(AS) + P(ASC) = P(A│S) P(S) + P(A│SC) P(SC)
P(A and B) = P(AB) = P(A) × P(B)
P(A and B and C) = P(ABC) = P(A) × P(B) × P(C) P(A) = P(AS1) + P(AS2) +… P(ASn)
= P(A│S1) P(S1) + P(A│S2) P(S2)+…P(A│Sn) P(Sn)
Where, S1, S2…,Sn are mutually exclusive and exhaustive

Practice: Example 6 & 7, scenarios or events.
• The total probability rule states an unconditional
probability in terms of conditional probabilities.
Example:
Suppose the unconditional probability that a fund is a Example:
loser in either period 1 or 2 = 0.50 i.e.
Calculating P(A│S). Suppose, P(A) = 0.55, P(S) = 0.55,
P(SC) = 0.45 and P(A│SC) = 0.40.
• P(fund is a period 1 loser) = 0.50
• P(fund is a period 2 loser) = 0.50
P(A) = P(A│S) P(S) + P(A│SC) P(SC)
Calculating the probability that fund is a Period 2 loser 0.55 = P(A│S) (0.55) + 0.40 (0.45)
and fund is a Period 1 loser i.e. P(fund is a Period 2 loser P(A│S) = [0.55 – 0.40 (0.45)] / 0.55 = 0.673
and fund is a Period 1 loser).
Source: Example 9, CFA® Curriculum.
Using the multiplication rule for independent events:
P(Fund is a period 2 loser and fund is a period 1 loser) =
P(fund is a period 2 loser) × P(fund is a period 1 loser) =
0.50 × 0.50 = 0.25
3. EXPECTED VALUE AND VARIANCE,
Expected value of a random variable: The expected the outcome is certain and quantity X is not
value of a random variable is the probability-weighted random at all.
average of the possible outcomes of the random • The higher the variance, the higher the dispersion
variable. or risk, all else equal.
Variance of a random variable: The variance of a

Standard deviation: It is the positive square root of
random variable is the expected value of squared
variance. It is easier to interpret than variance because
deviations from its expected value:
it is in the same units as the random variable.
σ2 (X) = E {[X – E (X)] 2}
Example:
where,
σ2 (X) = variance of random variable X EPS ($) Probability
2.60 0.15
• Variance ≥ 0.
• When variance = 0, there is no dispersion or risk → 2.45 0.45
2.20 0.24 interest rate environment in the current fiscal year × The
probability that EPS will be $2.60 given declining interest
2.00 0.16 rate environment
1.00 The unconditional probability that EPS will be

$2.60 = 0.60 × 0.25 = 0.15
Expected value of EPS = E (EPS) = 0.15 ($2.60) + 0.45
($2.45) + 0.24 ($2.20) + 0.16 ($2.00) = $2.3405 The unconditional probability that EPS will be $2.45 =
Probability that BankCorp will operate in a declining
σ2 (EPS) = P ($2.60) [$2.60 – E (EPS)] 2 + P ($2.45) [$2.45 – E interest rate environment in the current fiscal year × The
(EPS)] 2 + P ($2.20) [$2.20 – E (EPS)] 2 + P ($2.0) probability that EPS will be $2.45 given declining interest
[$2.0 – E (EPS)] 2 rate environment
σ2 (EPS) = 0.15 ($2.60 – $2.34)2 + 0.45 ($2.45 – $2.34)2 +
0.24 ($2.20 – $2.34)2 + 0.16 ($2.00 – $2.34)2 The unconditional probability that EPS will be $2.45
= 0.01014 + 0.005445 + 0.004704 + 0.018496 = 0.60 × 0.75 = 0.45
= $0.038785
EPS = $2.60 with
0. 25 Prob . = 0.15
S.D of EPS = x$0.038785 = $0.20
Prob. Of declining
Source: Example 10 & 11 CFA® Curriculum. interest rates = 0.60
0. 75 EPS = $2.45 with

Conditional expected values: The conditional expected Prob . = 0.45
value refers to the expected value of a random variable
X given an event or scenario S. It is denoted as E(X│S) i.e. E(EPS) = $2.34
EPS = $2.20 with

E(X|S) = P(X1IS)X1+ P(X2IS)X2 …+P(XnIS)Xn 0. 60
Prob . = 0.24
Prob. Of stable
Conditional Variance: The conditional variance refers to
interest rates = 0.40
the variance of a random variable X given an event or
scenario. 0.40 EPS = $2.00 with
Prob . = 0.16
The Total Probability Rule for Expected Value: It is
expressed as follows:
E(X) = E(X|S)P(S)+ E(X|SC) P(SC) Thus,

E(X) = E(X|S1)P(S1)+ E(X|S2) P(S2)+…+E(X|Sn) P(Sn) E (EPS │ declining interest rate environment) =
0.25($2.60) + 0.75($2.45) = $2.4875
where,
When interest rates are stable:
E (X│Si) = Expected value of X given Scenario i
E (EPS │stable interest rate environment) = 0.60($2.20) +
P(Si) = Probability of Scenario i
0.40($2.00) = $2.12
S1, S2...,Sn are mutually exclusive and exhaustive
E (EPS)={E (EPS │declining interest rate environment) ×
scenarios or events.
P(declining interest rate environment)} + {E(EPS
│stable interest rate environment) × P(stable
Example: Suppose,
interest rate environment)}
• Current Expected EPS of BankCorp = $2.34 = $2.4875 (0.60) + $2.12 (0.40) = $2.3405 ≈ $2.34.
• Probability that BankCorp will operate in a
declining interest rate environment in the current Calculation of Conditional variances i.e. the variance of
fiscal year = 0.60. EPS given a declining interest rate environment and the
• Probability that BankCorp will operate in a stable variance of EPS given a stable interest rate environment.
interest rate environment in the current fiscal year
= 0.40. σ2 (EPS │ declining interest rate environment) =
P($2.6│declining interest rate environment) × [$2.60 -
Under declining interest rate environment: E(EPS │ declining interest rate environment)2+ P($2.45 │
declining interest rate environment) × [$2.45 - E(EPS │
• The probability that EPS will be $2.60 = 0.25 declining interest rate environment)2
• The probability that EPS will be $2.45 = 0.75
= 0.25($2.60 - $2.4875)2+ 0.75($2.45 - $2.4875)2= 0.004219
The unconditional probability that EPS will be $2.60 = σ2 (EPS │ stable interest rate environment)=P($2.2│stable
Probability that BankCorp will operate in a declining interest rate environment) × [$2.20 - E(EPS │stable
interest rate environment)2+ P($2.00│ stable interest rate

environment) × [$2.00 - E(EPS │stable interest rate Variance of conditional expected values of EPS =
environment)2 σ2 [E (EPS | interest rate environment)] = 0.60 ($2.4875 –
$2.34)2 + 0.40
= 0.60 ($2.20 – $2.12)2 + 0.40 ($2.00 – $2.12)2 = 0.0096 ($2.12 – $2.34)2
= 0.032414
NOTE:
Thus,
The unconditional variance of EPS = Expected value of
Unconditional Variance of EPS = 0.006371 + 0.032414
the conditional variances + Variance of conditional
= 0.038785
expected values of EPS.
Source: Example, CFA® Curriculum.
Where,
Expected value of the conditional variances = Practice: Example 12,
σ2 (EPS) = P (declining interest rate environment) × σ2 CFA Institute’s Curriculum.
(EPS| declining interest rate environment) + P
(stable interest rate environment) × σ2 (EPS|
stable interest rate environment)
=0.60 (0.004219) + 0.40 (0.0096)
=0.006371
4. PORTFOLIO EXPECTED RETURN AND VARIANCE OF RETURN
Properties of Expected Value:

1. The expected value of a constant × random variable • As the number of assets (securities) increases,
= Constant × Expected value of the random variable importance of covariance increases, all else
i.e. equal.
E(wiRi) = wi E(Ri) • Like variance, covariance is difficult to interpret.
where,
Important to Note:
wi = weight of variable i
Ri = random variable i • The covariance of a random variable with itself
(own covariance) is its own variance i.e.
2. The expected value of a weighted sum of random Cov (R, R) = E {[R - E(R)] [R - E(R)]} = E {[R - E(R)] 2}
variables = Weighted sum of the expected values, = σ2(R)
using the same weights i.e. • Cov (Ri, Rj) = Cov (Rj, Ri)
E(w1R1 + w2R2 +… +wnRn) = w1E(R1) + w2E(R2) +…+wnE(Rn)

Covariance Matrix: It a square format of presenting
covariances.
Expected return on the portfolio: The expected return on
the portfolio is a weighted average of the expected
Portfolio variance: It is calculated as:
returns on the component securities i.e.
• •
E(Rp) = E(w1R1 + w2R2 +…+wnRn) 𝜎 ƒ „𝑅† ‡ = ˆ ˆ 𝜔• 𝜔Š 𝐶𝑜𝑣„𝑅•, 𝑅Š ‡
=w1E(R1)+w2E(R2) + …+wnE(Rn) •€1 Š€1
Covariance: The covariance is a measure of how two For example, given three assets with returns R1, R2 and R3,
assets move together. Given two random variables Ri portfolio variance is calculated as:
and Rj, the covariance between Ri and Rj is stated as:
•
𝜎 ƒ „𝑅† ‡ = 𝜔1ƒ 𝜎 ƒ (𝑅1 ) + 𝜔ƒƒ 𝜎 ƒ (𝑅ƒ ) + 𝜔Žƒ 𝜎 ƒ (𝑅Ž )
Cov(Ri, Rf) = 𝛴•€1 [p(Ri – ERi)(Rj – ERf)] + 2𝜔1 𝜔ƒ 𝐶𝑜𝑣 (𝑅1 , 𝑅ƒ ) + 2𝜔1 𝜔Ž 𝐶𝑜𝑣(𝑅1 , 𝑅Ž )
When the returns on both assets tend to move together + 2𝜔ƒ 𝜔Ž 𝐶𝑜𝑣 (𝑅ƒ , 𝑅Ž )
i.e. there is a positive relationship between returns
èCovariance of returns is positive (i.e. >0). Where,
When the returns on both assets are inversely related σ2 = Corresponding variance of each asset in the
èCovariance of returns is negative (i.e. < 0). portfolio
When returns on the assets are unrelated è Covariance • The smaller the covariance between assets, the
of returns is 0. greater the diversification benefits and the
greater the cost of not diversifying (in terms of risk- ρ (Ri, Rj) = Cov (Ri,Rj) ÷σ(Ri) σ(Rj)
reduction benefits forgone), all else equal.
• The value of correlation lies between -1 and + 1
When the returns on the three assets are independent, i.e. for two random variables, X and Y:
covariances = 0 and S.D. of portfolio return would be: – 1 ≤ 𝜌(𝑋, 𝑌) ≤ +1
• When correlation = 0, variables are unrelated and
S.D. = [w21σ2 (R1) + w22σ2 (R2) + w23σ2 (R3)] ½. do not have any linear relationship.
• When correlation > 0, variables have positive
Generally, for n number of securities, we need to linear relationship.
estimate: • When correlation < 0, variables have negative
(inverse) linear relationship.
• When correlation = +1, variables have perfect
• n (n - 1 )/2 distinct covariances.
positive linear relationship.
• n distinct variances.
• When correlation = -1, variables have perfect
negative (inverse) linear relationship.
Properties of Variance and Covariance:
a) The variance of a constant multiplied by a random NOTE:
variable = Constant squared multiplied by the
variance of the random variable i.e. • When the correlation is positive (negative): R1 = a
+ bR2 + error è b > (<) 0.
σ2 (w×R) = w2 × σ2 × (R) • When the correlation is zero: R1 = a + bR2 + error è
b = 0.
b) Variance of a constant = 0.
c) The variance of a constant + random variable = NOTE:
Variance of the random variable.
Correlation only deals with linear relationships.
d) The covariance between a constant and a random
variable is 0.
Correlation: The correlation between two random CFA Institute’s Curriculum.
variables, Ri, and Rj, is estimated as follows:
5. COVARIANCE GIVEN A JOINT PROBABILITY FUNCTION
= 0.20(11)(5) + 0.50(–2)(1) + 0.30(–4)(–5)

JOINT PROBABILITY FUNCTION: =11 – 1 + 6 = 16
Let, RA = Return on stock BankCorp and RB = Return on
Independent Random Variables: Two random variables
stock NewBank.
X and Y are independent if and only if:
Joint Probability Function of BankCorp and NewBank
P(X, Y) = P(X) P(Y)
Returns (Entries Are Joint Probabilities)
RB = 20% RB = 16% RB = 10% • Independence is a stronger property compared

to a correlation of 0 because correlation deals
RA = 25% 0.20 0 0 with only linear relationships.
RA = 12% 0 0.50 0
Multiplication Rule for Expected Value of the Product of
RA = 10% 0 0 0.30
Uncorrelated Random Variables: When two random
Source: Table 12, CFA® Curriculum. variables (e.g. X & Y) are uncorrelated,
Expected return on BankCorp stock = 0.20(25%) + Expected value of (XY)= Expected value of X × Expected
0.50(12%) + 0.30(10%) = 14%. value of Y
èE (XY) = E(X) E(Y)
Expected return on NewBank stock = 0.20(20%) +
0.50(16%) + 0.30(10%) = 15%

𝐶𝑜𝑣(𝑅• , 𝑅– ) = ˆ ˆ 𝑃(𝑅•,• , 𝑅–,Š ) „𝑅•,• − 𝐸𝑅• ‡„𝑅–,• − 𝐸𝑅– ‡
• Š
Cov(RA, RB) = P(25, 20) [(25 – 14)(20–15)] + P(12, 16) [(12 –

14)(16 – 15)] + P(10, 10)[(10 – 14) (10 – 15)]
6. BAYES' FORMULA
Bayes' formula is a method for updating a probability Prior probabilities (or priors) of three events before any
given additional information. It is also called an inverse new information are as follows:
probability. It is computed using the following formula:
• P(EPS exceeded consensus) = 0.45
Updated probability of event given the new information: • P(EPS met consensus) = 0.30
• P(EPS fell short of consensus) = 0.25
𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑔𝑖𝑣𝑒𝑛 𝑒𝑣𝑒𝑛𝑡
=
𝑈𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛
Suppose the new information is è DriveMed expands
× 𝑃𝑟𝑖𝑜𝑟 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑣𝑒𝑛𝑡
and the conditional probabilities (likelihoods) are:
𝑃𝑟𝑜𝑏 𝑜𝑓 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜 𝑔𝑖𝑣𝑒𝑛 𝑒𝑣𝑒𝑛𝑡
= × 𝑃𝑟𝑖𝑜𝑟 𝑝𝑟𝑜𝑏 𝑜𝑓 𝑒𝑣𝑒𝑛𝑡 P(DriveMed expands | EPS exceeded consensus) = 0.75
𝑈𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑏 𝑜𝑓 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜
P(DriveMed expands | EPS met consensus) = 0.20
P(DriveMed expands | EPS fell short of consensus) = 0.05
𝑃(𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 |𝐸𝑣𝑒𝑛𝑡)
𝑃(𝐸𝑣𝑒𝑛𝑡 | 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛) = 𝑃(𝐸𝑣𝑒𝑛𝑡)
𝑃(𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛)
Calculating the unconditional probability for DriveMed
expanding i.e. P(DriveMed expands):
• The updated probability is referred to as the
posterior probability. P(DriveMed expands) =
P(DriveMed expands |EPS exceeded consensus) ×P(EPS
Diffuse priors: When the prior probabilities are equal, exceeded consensus) + P(DriveMed expands |EPS met
they are referred to as diffuse priors. consensus) ×P(EPS met consensus) + P(DriveMed
expands |EPS fell short of consensus) × P(EPS fell short of
Important to Note: When the prior probabilities are consensus)
equal: = 0.75(0.45) + 0.20(0.30) + 0.05(0.25)
= 0.4, or 41%
Probability of information given an event
= Probability of an event given the information. Using the Bayes’ Formula, P(EPS exceeded consensus
given that DriveMed expands) is estimated as:
Example:
𝑃(𝐸𝑃𝑆 𝑒𝑥𝑐𝑒𝑒𝑑𝑒𝑑 𝑐𝑜𝑛𝑠𝑒𝑛𝑠𝑢𝑠 |𝐷𝑟𝑖𝑣𝑒𝑀𝑒𝑑 𝑒𝑥𝑝𝑎𝑛𝑑𝑠)
Suppose three mutually exclusive and exhaustive events 𝑃(𝐷𝑟𝑖𝑣𝑒𝑀𝑒𝑑 𝑒𝑥𝑝𝑎𝑛𝑑𝑠|𝐸𝑃𝑆 𝑒𝑥𝑐𝑒𝑒𝑑𝑒𝑑 𝑐𝑜𝑛𝑠𝑒𝑛𝑠𝑢𝑠) 𝐸𝑃𝑆 𝑒𝑥𝑐𝑒𝑒𝑑𝑒𝑑
i.e. = 𝑃§ ¨
𝑃(𝐷𝑟𝑖𝑣𝑒𝑀𝑒𝑑 𝑒𝑥𝑝𝑎𝑛𝑑𝑠) 𝑐𝑜𝑛𝑠𝑒𝑛𝑠𝑢𝑠
= (0.75/0.41)(0.45) = 1.829268(0.45) = 0.823171
i. Last quarter's EPS of DriveMed exceeded the
consensus EPS estimate. Source: CFA® Curriculum, Reading 3.
ii. Last quarter's EPS of DriveMed exactly met the
consensus EPS estimate.
iii. Last quarter's EPS of DriveMed fell short of the
consensus EPS estimate.
7. PRINCIPLES OF COUNTING
Multiplication Rule of Counting: If one event can occur in Multinomial Formula (General Formula for Labeling
n1 ways and a second event (given the first event) can Problems): The number of ways that n objects can be
occur in n2 ways, then the number of ways the two assigned k different labels i.e. is given by:
events can occur in sequence =n1× n2.
𝑛!
• Similarly, the number of ways the k events can 𝑛1 ! 𝑛ƒ ! … 𝑛« !
occur = (n1) (n2) (n3) … (nk).
• It is referred to as n factorial (n!) i.e.
n! = n (n – 1) (n – 2) (n – 3) …1
Combination Formula (Binomial Formula): A Example:

combination is the number of ways to choose r objects
In how many different ways 3 books can be read from a
from a group of n objects without regard to order.
list of 5 books if the order does matter?
•!
n𝐶¬ = „•¬‡ = (•7¬)!¬! (-)(2)(Ž)(ƒ)(1)
5P3 = 5! / (5 - 3)! = 5! / 2! = = 120/ 2 = 60 ways
(ƒ)(1)
• It is read as “n choose r” or “n combination r”. Summary:
where, • When the objective is to assign every object from

n = total number of objects a total of n objects one of n slots (or tasks), è n
r = number of objects selected factorial should be used.
• When the objective is to count the number of
Example: ways that n objects can be assigned k different
labels, èmultinomial formula should be used.
In how many different ways 3 books can be read from a • When the objective is to count the number of
list of 5 books if the order does not matter? ways that r objectives can be selected from a
total of n when order in which they are selected
5C3 = 5!/(5 – 3)!3! does not matter, ècombination formula should
=(5)(4)(3)(2)(1)/(2)(1)(3)(2)(1)=120/12=10 ways be used.
• When the objective is to count the number of
NOTE: ways that r objectives can be selected from a
-! -! total of n when order in which they are selected
5C3 = ƒ!Ž! and 5C2 = Ž!ƒ!
does matter, èpermutation formula should be
used.
Suppose jurors want to select three companies out of a • When Multiplication rule of counting cannot be
group of five to receive the first-, second-, and third- used, the possibilities need to be counted one by
place awards for the best annual report. In how many one, or by using more advanced techniques.
ways can the jurors make the three awards?
Count ordered listings such as first place, New Company; Practice: Example 17, 18 & 19 from
second place, Fir Company; third place, Well Company. CFA Curriculum
An ordered listing is known as a permutation.
Permutation: A permutation is any arrangement of r

Practice: Questions from FinQuiz
objects selected from a total of n objects, when the
Question bank + CFAI Curriculum
order of arrangement does matter.
End of Chapter Practice Problems
•!
n𝑃¬ = (•7¬)!
QM Common Probability Distributions
Learning Module: 4
1. DISCRETE RANDOM VARIABLES
Probability distribution: A probability distribution For a discrete random variable, it is denoted as:
describes the probabilities of the possible outcomes of a
P(X = x)è read as the “probability that a random
random variable.
variable X takes on the value x.
Seven types of probability distribution are:
where,
1. Uniform X represents the name of the random variable.

2. Binomial x represents the value of the random variable.
3. Normal
4. Lognormal Example:
5. Student’s t Suppose, X = number of heads in 15 flips of a coin.
6. Chi-square
7. F-distribution P(X = 5) = P (5) è probability of 5 heads (x) in 15 flips of a
coin.
Random Variable
• For a continuous random variable, the probability
function is called the probability density function
A variable that has uncertain future outcomes is called
(pdf) and is denoted as f(x).
random variable. The two basic types of random
variables are:
Properties of a probability function:
1) Discrete random variables: Discrete random variables 1) 0 ≤ P(x) ≤ 1, for all x.
have a countable number of outcomes i.e. all 2) The sum of the probabilities p(x) over all values of X =
possible outcomes can be listed without missing any 1 i.e. ∑*++ ,- 𝑃 (𝑥) = 1.
of them. For example, counts, dice, number of
students, quoted price of a stock etc. A discrete Cumulative distribution function or distribution function:
random variable can take
The cumulative distribution function describes the
probability that a random variable X ≤ particular value x
• On a limited (finite) number of outcomes i.e. x1, x2,
i.e. P(X ≤ x). For both discrete and continuous random
…,xn.
variables, it is denoted as F(x) = P(X ≤ x).
• On an unlimited (infinite) number of outcomes i.e.
y1, y2, …
F(x) = Sum of all the values of the probability function for
all outcomes ≤ x.
2) Continuous random variables: Continuous random
variables have an infinite and uncountable range of Properties of Cumulative distribution function (cdf):
possible outcomes; thus, we cannot list all possible
outcomes. For example, time, weight, distance, rate 1) The cdf lies between 0 and 1 for any x i.e. 0 ≤ F(x) ≤ 1.
of return etc. The range of possible outcomes of a 2) With an increase in x è the cdf either increases or
continuous random variable is the real line i.e. remains constant.
between -∞ and +∞ or some subset of the real line.
Probability function: The probability function describes Practice: Example 1,

the probability of a specific value that the random CFA Institute’s Curriculum .
variable can take.
2. DISCRETE AND CONTINUOUS UNIFORM DISTRIBUTION
• The probability of each outcome in a discrete

The Discrete Uniform Distribution uniform distribution is equally likely.
It the simplest form of probability distribution. Continuous Uniform Distribution
• The discrete uniform distribution has a finite

number of specified outcomes.

Learning Module: 4
The continuous uniform distribution is the simplest • Since the probabilities at the endpoints a and b =
continuous probability distribution. The uniform 0 for any continuous random variable X, èP (a ≤ X
distribution has two main uses. ≤ b) = P (a < X ≤ b) = P (a ≤ X< b) = P (a< X < b).
• It plays an important role in Monte Carlo For a continuous uniform random variable:
simulation.
• It is an appropriate probability model to represent Mean = μ = (a + b) / 2
an uncertainty in beliefs with equally likely Variance = σ2 = (b – a) 2 / 12
outcomes. S.D. = √𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
Probability density function (pdf): It is used to assign the • Note that S.D. is not a useful risk measure for a
probabilities to a continuous random variable and is uniform distribution; rather, the S.D. is a good risk
denoted as f (x). According to pdf, measure for Normal Distribution.
• The probability that value of x lies between a and Example: Suppose,

b is the area under the graph of f(x) that lies At the lower bound = a =100,000 km è total cost
between a and b or the integral of f(x) over the = $40,000.
range a to b. At the upper bound = b =150,000 km è total cost
ì 1 = $60,000.
ï for a £ x £ b
ï
f ( x) = í b - a Outside the lower and upper bound è total cost = $0.
ï x = total anticipated annual travel costs in thousands of
ï 0 elsewhere
î dollars
• Over the range of values from a to b, density of
.
the distribution of a random variable x = (/0*). • Over the range of values from $40,000 to $60,000,
the distribution has density f(x) = 1/ (60 - 40) = 1/20.
• Elsewhere, density of the distribution of a random
• Elsewhere, the distribution has density f(x) = 0.
variable x = 0.
Finding probability: The probabilities can be estimated The probability that travel costs are between 40 and 60 =
as follows: Total area under the density function f(x) between 40
𝑥−𝑎 and 60 = height × length (or base) = (1/20) × (60–40) = 1
𝐹(𝑥) = 𝑓𝑜𝑟 𝑎 < 𝑥 < 𝑏
𝑏−𝑎
The probability that travel costs are between 40 and 50 =
Area under the curve between 40 & 50 = (1/20) × (50–40)
• F (x) = area under the curve graphing the pdf. = 0.50
• Under a Continuous uniform distribution,

probabilities for values of a continuous random Practice: Example 2,
variable x are assigned across an interval of CFA Institute’s Curriculum .
values of x; thus, the probability that x takes on a
specific value = 0.
3. BINOMIAL DISTRIBUTION
2. Each trial in a binomial distribution has two

A distribution that involves binary outcomes is referred to possible outcomes i.e. a “success” and a
as binomial distribution. It has following properties: “failure”.
3. Probability of success is denoted as P (success) =
1. A binomial distribution has fixed number of trials p and Probability of failure is denoted as P
i.e. n. (failure) =1– p → for all trials.
Learning Module: 4
4. The trials are independent, which means that the

outcome of one trial does not affect the
outcomes of any other trials.
Assumptions of the binomial distribution:

a) The probability of success (i.e. p) is constant for all
trials.
b) The trials are independent.
Bernoulli trial: A trial that generates one of two

outcomes is called a Bernoulli trial.
Source: Example 2, CFA Institute’s Curriculum.
• In a Bernoulli trial with n number of trials, we can
have 0 to n successes. Number of sequences in n trials that result in x up moves
• If the outcome of an individual trial is random, (or successes) and n – x down moves (or failures) is
then the total number of successes in n trials is also calculated as follows:
random.
𝑛!
Binomial random variable X: It represents the number of (𝑛 − 𝑥)! 𝑥!
successes in n Bernoulli trials i.e.
where,
X = sum of Bernoulli random variables n! = n factorial = n(n - 1) (n - 2) ... 1 (and 0! = 1 by
X = Y1 + Y2 + …+ Yn convention).
where,
Yi = Outcome on the ith trial Probability function for a binomial random variable:
𝑛
𝑝(𝑥) = 𝑃(𝑋 = 𝑥) = K L 𝑝 , (1 − 𝑃)M0,
• A binomial random variable is completely 𝑥
described by two parameters i.e. n and p. It is 𝑛!
=
stated as X~ B (n, p) è read as “X has a binomial (𝑛 − 𝑥)! 𝑥! 𝑝 , (1 − 𝑝)M0,
distribution with parameters n and p”.
• Thus, a Bernoulli random variable is a binomial for x = 0, 1, 2, …, n
random variable with n = 1 i.e. Y~B (1, p).
where,
Probability function of the Bernoulli random variable Y: x = # successes out of n trials
n–x = # failures out of n trials
• When the outcome is success èY = 1. p = probability of success
• When the outcome is failure èY = 0. 1–p= probability of failure
n = number of trials
p (l) = P(Y= 1) = p = probability of success
Probability of success:
p (0) = P( Y = 0) = 1 – p = probability of failure
!1$
For example, a stock price is a Bernoulli random variable
P(X = 1) = # & p1 (1− p)1−1 = p
"1%
with probability of success (an up move) = p and
probability of failure (a down move) = 1 – p.
Probability of failure:
Suppose, Stock price today = S. æ1ö
P( X = 0) = ç ÷ p 0 (1 - p)1-0 = 1 - p
è0ø
• When the stock price increases, ending price = uS
= (1 + rate of return if the stock moves up) × S NOTE:
• When the stock price decreases, ending price =
dS When the probability of success on a trial is 0.50, the
1 binomial distribution is symmetric; otherwise, it is
= × 𝑆 asymmetric or skewed.
1 + 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑚𝑜𝑣𝑒𝑠 𝑢𝑝
Example:
One-Period Stock Price as a Bernoulli Random Variable
If a coin is tossed 20 times, what is the probability of
getting exactly 10 heads?
Learning Module: 4
p = 0.50
1–p = 0.5
n = 20
x = 10
! 20 $ 10 10
# & (0.5) (0.5) = 0.176
" 10 %
Stock price movement on three consecutive days:
• Each day is an independent trial.

• When the stock moves up è u = 1 + rate of return
for an up move.
• When the stock moves down è d = 1 + rate of
return for a down move.
A binomial tree is shown below. Each boxed value that • Each of the sequences uud, udu, and duu, has
represents successive moves (branch in the tree) is probability = p2 (l – p).
called a node. • Stock price after three moves = P (S3 = uudS) = 3p2
(l - p).
• In the fig below, a node reflects the potential
value for the stock price at a specified time. e.g. Number of ways to get 2 up moves in three periods
• At each node, the transition probability for an up = 3! / (3 – 2)! 2! = 3
move is p and for a down move is (1 – P).
Practice: Example 3 and 4, CFA

Institute’s Curriculum .
4. NORMAL DISTRIBUTION
o When the mean increases (decreases), the

The Normal Distribution curve shifts to the right (left).
• When the standard deviation increases
(decreases), the curve flattens (steepens).
• A normal distribution is a distribution that is • The smaller the S.D., the more the observations are
symmetric about the centre (mean) and is bell- concentrated around the mean.
shaped. Thus,
o Mean = median = mode.
o Skewness = 0.
o Kurtosis = 3 and Excess kurtosis = 0.
• The range of possible outcomes of the normal
distribution is the entire real line i.e. all real
numbers lying between -∞ and +∞.
• The tails of the normal distribution never touches
the horizontal axis and extend without limit to the
left and to the right; however, as we move away
from the center, the tails get closer and closer to
the horizontal axis. This characteristic is referred to
as the distribution is asymptotic to the horizontal • Since the normal distribution is symmetrical, it
axis. tends to underestimate the probability of extreme
• The normal distribution is described by two returns. Thus, it is not appropriate to use for
parameters i.e. its mean (μ) and its variance (σ2) or Options.
standard deviation (σ). It is stated as: • The normal distribution can be used to model
X ~ N (μ, σ2) è read “X follows a normal returns; however, is not appropriate to use to
distribution with mean μ and variance σ2”. model asset prices.
99 Common Probability Distributions FinQuiz.com
• According to the central limit theorem, sum and Practice: Example 5, CFA Institute’s
mean of a large number of independent random Curriculum .
variables is approximately normally distributed.
• It is important to note that a linear combination of
two or more normal random variables is also
normally distributed. Standardizing a Random Variable
A univariate normal distribution describes the probability Standard normal distribution or unit normal distribution: It
of a single random variable. is a normal distribution with:
A multivariate normal distribution describes the

• The mean (μ ) = 0
probabilities for a group of related random variables. It is
• Standard deviation (σ) =1
completely defined by three parameters:
When X is normally distributed, it can be standardized

1. The list of the mean returns on the individual 𝑿0 𝝁
securities i.e. total means = n. using the following formula: Z = 𝝈
2. The list of the securities’ variances of return i.e. • Z –score indicates how many standard deviations
total variances = n. away from the mean the point x lies.
3. The list of all the distinct pair-wise return
correlations i.e. total distinct correlations = n (n - 1)
Example: Suppose, a normal random variable, X = 9.5
/ 2.
with μ = 5 and σ = 1.5 → Z = (9.5 - 5) / 1.5 = 3
For example, a bivariate normal distribution (i.e. a

distribution with 2 stocks) has: Probabilities Using the Standard Normal Distribution
• Means = 2 For probability related questions about X, we use

• Variances = 2 standardized values such as sample mean and sample
• Correlation = 2 (2 –1) / 2 = 1 standard deviations.
Standard normal probabilities are estimated using

For a normal random variable standard deviation of:
spreadsheets, statistical and econometric software and
programming language.
• Sample skewness = 6/ n
• Sample kurtosis = 24/ n Example: Finding the Probability i.e. P (Z < 2.67). It is
found by first finding 2.6 in the left hand column, and
Normal density function: It is expressed as follows: then moving across the row to the column under 0.07.
(Refer to Z-table on the next page). Thus,
1 −(𝑥 − 𝜇)S
𝑓(𝑥) = 𝑒𝑥𝑝 Q T for − ∞ < 𝑥 < + ∞
𝜎√2𝜋 2𝜎 S The area to the left of z = 2.67 = 0.9962.
Probabilities Using the Normal Distribution • In order to find the area to the right of z, we use
the Standard Normal Table given below to find the
area that corresponds to z-value and then
• The probability that a normally distributed variable subtract the area from 1.
x takes on values in the range from a to b = Area • Probability to the right of x = 1.0 - N(x).
under f(x) between a and b. • Since the normal distribution is symmetric around
• The total area under the curve = 1. its mean, the area and the probability to the right
• The area under the curve to the left of centre = of x = area and the probability to the left of -x, N (-
0.5 and the area right of centre = 0.5. x).
o Approximately 50% of all observations fall in the • The probability to the right of –x i.e. P (Z ≥ -x) =
interval μ ± (2/ 3) σ. N(x).
o Approximately 68% of all observations fall in the
interval μ ± σ. Example: The average (μ) on a corporate finance test
o Approximately 95% of all observations fall in the was 78 with a standard deviation of 8 (σ). If the test
interval μ ± 2σ. scores are normally distributed, find the probability that a
o Approximately 99% of all observations fall in the student receives a test score greater than 85.
interval μ ± 3σ.
• More-precise intervals are μ ± 1.96σ for 95% of the Z=
]^0_]
= 0.875 ≈ 0.88
observations and μ ± 2.58σ for 99% of the ]
observations.
P(x> 85) = P (z> 0.88) = 1 -P(z< 0.88) = 1 - 0.8106

= 0.1894 .
The Z-Table
Note: The above z-table only shows probabilities for

positive z-values.
CFA Institute’s Curriculum .
5. APPLICATIONS OF THE NORMAL DISTRIBUTIONS
• The optimal portfolio has the lowest P (Rp< RL).

• The mean-variance analysis is based on the
assumption that returns are normally distributed. Example:
• Safety-first rule: Safety-first rule focuses on shortfall
risk i.e. the risk that portfolio value will fall below
• Portfolio 1 expected return = 12% and S.D. = 15%
some minimum acceptable level over some
• Portfolio 2 expected return = 14% and S.D. = 16%
specified time horizon. For example, the risk that
• Threshold level = 2%
the assets in a defined benefit plan will fall below
• Assumes that returns are normally distributed.
plan liabilities.
SFRatio of portfolio 1 = (12 – 2) / 15 = 0.667

According to Roy's safety-first criterion, the optimal
SFRatio of portfolio 2 = (14 – 2) / 16 = 0.75
portfolio is the one that minimizes the probability that
portfolio return (Rp) falls below the threshold level (RL).
• Since SFRatio of portfolio 2 > SFRatio 1, the superior
When returns are normally distributed, the safety-first Portfolio is Portfolio 2.
optimal portfolio is the portfolio that maximizes the
safety-first ratio (SFRatio): Probability that return < 2% = N (–0.75)
= 1 – N (0.75)
𝑆𝐹𝑅𝑎𝑡𝑖𝑜 = [𝐸(𝑅c ) − 𝑅d ]/𝜎c = 1 – 0.7734*
≈ 23%.
• Investors prefer the portfolio with the highest
SFRatio. *value taken from the z-table provided on the previous
• Probability that the portfolio return < threshold page.
level = P (Rp< RL) = N (-SFRatio).
Sharpe Ratio: analytical method assumes that returns are

Sharpe ratio = [E (Rp) – Rf] / σp normally distributed.
Example:
A one week VAR of $10 million for a portfolio with
• The portfolio with the highest Sharpe ratio is the
5% probability implies that portfolio is expected to
one that minimizes the probability that portfolio
loss $10 million or more in a single week.
return will be less than the risk-free rate (assuming
• Stress testing/scenario analysis: It involves a use of
returns are normally distributed).
set of techniques to estimate losses in extremely
Managing Financial risk: Two important measures used worst combinations of events or scenarios.
to manage financial risk include:
• Value at risk (VAR): It provides the minimum value

of losses (in money terms) expected over a Practice: Example 7,
specified time period (e.g. a day, quarter, year CFA Institute’s Curriculum .
etc.) at a specified level of probability (e.g. 5%,
1%). VAR estimated using variance-covariance or
LOGNORMAL DISTRIBUTIONS AND
6.
CONTINUOUS COMPOUNDING
exp = e
r0,t = Continuously compounded return from 0 to T
The Lognormal Distribution
• Since ST is proportional to the log of a normal

A random variable (i.e. Y) whose natural logarithm (i.e. ln
random variable → ST is lognormal.
Y) has a normal distribution, is said to have a Lognormal
distribution.
Price relative = Ending price / Beginning price =
St+1/ St=1 + Rt, t+1
• Unlike Normal distribution, Lognormal random
variables cannot be negative.
where,
Rt, t+1 = holding period return on the stock from t to t + 1.
Reason:
Since, negative values do not have logarithms, Y is Continuously compounded return associated with a
always > 0 and thus the distribution is positively skewed holding period from t to t + 1:
(unlike normal distribution that is bell-shaped).
rt, t+1= ln(1 + holding period return)
Or
rt, t+1 = ln(price relative) = ln (St+1 / St) = ln (1 + Rt,t+1)
NOTE:
The continuously compounded return < associated
holding period return.
• Like normal distribution, it is completely described
by two parameters i.e. the mean and variance of Continuously compounded return associated with a
In Y, given that Y is lognormal. holding period from 0 to T:
Mean (μL) of a lognormal random variable = R0,T= ln (ST / S0)

exp (μ + 0.50σ2)
Or
Variance (σL2) of a lognormal random variable 𝑟g,i = 𝑟i0.,i + 𝑟i0S,i0. + ⋯ + 𝑟g,.
= exp (2μ+ σ2) × [exp (σ2) – 1].
Where,
rT-I, T = One-period continuously compounded returns
Continuously Compounded Rates of Return
Example:
It is important to note that when a stock's continuously
compounded return is normally distributed, then future Suppose, one-week holding period return = 0.04.
stock price is necessarily lognormally distributed.
Equivalent continuously compounded return =
ST = S0exp (r0,T) one-week continuously compounded return = ln (1.04)
= 0.039221
Where,
• The intervals within which a certain percentage of • It implies that when the one-period continuously
the observations of a normally distributed random compounded returns are normally distributed,
variable are expected to lie are symmetric around then the T holding period continuously
the mean. compounded return (i.e. r0,T) is also normally
• The intervals within which a certain percentage of distributed with mean μT and variance σ2T.
the observations of a lognormally distributed • According to Central limit theorem, the sum of
random variable are expected to lie are not one-period continuously compounded returns is
symmetric around the mean. approximately normal even if they are not
normally distributed.
In many investment applications, it is assumed that
returns are independently and identically distributed Volatility:
(IID).
Volatility reflects the deviation of the continuously
compounded returns on the underlying asset around its
• Returns are independently distributed implies that mean. It is estimated using a historical series of
investors cannot forecast future returns using past continuously compounded daily returns.
returns (i.e., weak-form market efficiency).
• Returns are identically distributed implies that the Annualized volatility = sample S.D. of one period
mean and variance of return do not change from continuously compounded returns
period to period (i.e. stationarity). × √𝑇
When one-period continuously compounded returns (i.e. where,

r0,1) are IID random variables with mean μ and variance T = Number of trading days in a year = 250.
σ2, then
𝐸k𝑟g,i l = 𝐸k𝑟i0.,i l + 𝐸k𝑟i0S,i0. l + ⋯ + 𝐸k𝑟g,. l = 𝜇𝑇
And
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎 S k𝑟g,i l = 𝜎 S 𝑇
S.D. = σ (r0,T) = σ√𝑇
7. STUDENT’S T, CHI-SQUARE, AND F-DISTRIBUTIONS
Student’s t-, chi-square, and F-distributions are used in increase → the t-distribution approaches the Z
statistical analysis (such as sampling, hypothesis testing distribution.
or testing the significance of estimated model • Similarly, as the degrees of freedom increase →
parameters.) Student’s t-distribution like normal the tails of the t-distribution become less fat.
distribution is also used to model asset returns.
Degree of freedom: No. of independent variables used

in defining sample statistics.
Student’s t-distribution
Student’s t-distribution (a.k.a. t-distribution) is used when

the population variance is not known for both small and
large sample size.
• Like standard normal distribution, t-distribution is x-µ

bell-shaped and perfectly symmetric around its Z= èIt follows normal distribution with a mean
mean of 0. s/ n
• t-distribution is described by a single parameter = 0 and S.D. = 1.
known as degrees of freedom (df) = n - 1. t values
depend on the degree of freedom.
• t-distribution has fatter tails than normal x-µ
distribution i.e. a larger portion of the probability t= è It follows the t-distribution with a mean = 0
areas lie in the tails. s/ n
• t-distribution is affected by the sample size n i.e. as and df = n - 1.
the sample size increases → degrees of freedom
• Unlike Z-ratio, t-ratio is not normal because it

represents the ratio of two random variables (i.e. • It follows an F-distribution with m numerator and n
the sample mean and the sample S.D.); whereas, denominator degrees of freedom.
Z-ratio is based on only 1 random variable i.e.
sample mean. where,
χ12 is one chi-square random variable with m degrees of
Chi-Square and F-Distribution freedom.
χ22 is another chi-square random variable with n degrees
The chi-square distribution with k degree of freedom is of freedom.
the distribution of sum of the squares of k independent
standard normally distributed random variables.
Properties of the chi-square distribution: Basis for Hypothesis Tests of Investment Returns
Distributions
• Unlike the normal and t-distributions, the chi-
Student’s t Chi-square F
square distribution is asymmetrical.
Test t-statistic Chi-square F-statistic
• Unlike the t-distribution, the chi-square distribution
Statistic statistic
is bounded below by 0 i.e. χ2 values cannot be
• Single Variance of Equality of
negative.
population normally variances
• Like the t-distribution, as the number of degrees of
mean distributed of two
freedom increases, the chi-square distribution
• Diff. b/w two population normally
becomes more symmetric.
population distributed
Hypothesis means populations
Properties of F-distribution: Tests of: • Mean diff. from two
b/w paired independe
• Like the chi-square distribution, the F-distribution is populations nt random
non-symmetrical distribution i.e. it is skewed to the • Population samples
right. correlation
• Like the chi-square distribution, the F-distribution is coefficient
bounded from below by 0 i.e. F ≥ 0.
• The F-distribution depends on two parameters n
and m (numerator and denominator degrees of
freedom, respectively). Practice: Example 9,
Relationship between the chi-square and F-distribution:

F = (χ12 / m) ÷ (χ22 / n)
.
8. MONTE CARLO SIMULATION
Monte Carlo simulation involves the use of a computer simulated frequency distribution of portfolio
software to generate a large number of random returns)
samples from a probability distribution. • It can be used in valuing complex securities e.g.
European-style options, mortgage-backed
Uses: securities.
• It is widely used to estimate risk and return in Steps of Monte Carlo simulation technique to examine a
investment analysis using simulation (i.e. model's sensitivity to changes in assumptions:
measuring portfolio performance through
1) Specify the underlying variable or variables e.g. stock NOTE:

price for an equity call option. Then specify the
For obtaining each extra digit of accuracy in results, the
beginning values of the underlying variables e.g.
appropriate increase in the number of trials depends on
stock price.
the problem. For example, in option value, tens of
thousands of trials may be appropriate. Generally, the
• C iT = Value of the option at maturity T. The number of trials should be increased by a factor of 100.
subscript I reflects a value resulting from the ith
simulation trial. Finally, mean value and S.D. for the simulation are
calculated.
2) Specify a time period. Time increment = ∆t = Calendar
time / Number of sub-periods (K). Mean value = Average value of the option over all trials
in the simulation
3) Specify the distributional assumptions for the key risk
factors that drive the underlying variables. For • The mean value will be the Monte Carlo estimate
example specify the regression model for changes in of the value of the call option.
stock price.
Random number generator: An algorithm that generates
∆(𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒) = (𝜇 × 𝑃𝑟𝑖𝑜𝑟 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 × ∆𝑡)
+ (𝜎 × 𝑃𝑟𝑖𝑜𝑟 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 × 𝑍q ) uniformly distributed random numbers between 0 and 1
is referred to as random number generator. It is
important to note that random observations from any
where,
distribution can be generated using a uniform random
Zk= Risk factor in the simulation. It is a standard normal variable.
random variable. Steps to generate random observations on variable X:
4) K random variables are drawn for each risk factor 1) Generate a uniform random number (i.e. T)
using a computer program or spreadsheet function. between 0 and 1 using the random number
generator.
5) Now the underlying variables are estimated by 2) Evaluate the inverse of cumulative distribution
substituting values of random observations in the function F(x) i.e. F-1 (x) to obtain a random
model specified in Step 4. observation on variable X.
6) The value of a call option at maturity i.e. CiT is

Note: Monte Carlo simulation is a complement to
calculated and then this value is discounted back at
time period 0 to get Ci0. analytical methods. It only provides statistical estimates,
not exact results.
7) This process is repeated until a specified number of
trials, i, is completed (e.g., tens of thousands of trials). Practice: Example 10, End of
Chapter Practice Problems and
FinQuiz Questions.
QM Sampling and Estimation
Learning Module: 5
1. INTRODUCTION
Analysts often use sample information to assess the Sample is the subset of the population. Sampling is the
behavior of the underlying population. process of obtaining a sample from the population.
2. SAMPLING METHODS
Parameter is a quantity computed from or used to implies that every member is selected independently of
describe a population of data (typically represented by every other member.
Greek letters). Simple random sampling: The procedure of drawing a
random sample is known as Simple random sampling.
Sample Statistic (a.k.a. statistic) is a quantity computed
from or used to describe a sample of data. Random sample (for a finite/limited population) can be
obtained using random numbers table. In this method,
Benefits of Sampling: Sampling saves: members of the population are assigned numbers in
sequence e.g. if the population contains 500 members,
• time and energy because it is difficult or entirely they are numbered in sequence with three digits,
impossible to examine every member of the starting with 001 and ending with 500.
population.
• money; thus, it is more economically efficient. Systematic sampling: It is the sampling process that
involves selecting individuals within the defined
population from a list by taking every Kth member until a
Two types of sampling methods are:
sample of desired size is selected. The gap, or interval
between k successive elements is equal and constant.
1. Probability sampling - gives every member of the
population equal chance of being selected- Sampling Error: Since all members of the population are
therefore its sample is not examined in sampling, it results in sampling error. The
o representative of population. sampling error is the difference between the sample
2. Non-probability sampling – where the chance of mean and the population mean.
a member of population being selected Sampling distribution of a Statistic: The sampling
depends on factors other than probability (such distribution of a statistic is the probability distribution of a
as sampler’s judgement, ease of access to data) sample statistic over all possible samples of the same size
therefore: drawn randomly from the same population.
o its sample is non-representative of
population.
2 Stratified Random Sampling
Note: Probability sampling is more accurate and reliable
than non-probability sampling. In stratified random sampling, the population is divided
into homogeneous subgroups (strata) based on certain
Two types of probability sampling: characteristics. Members within each stratum are
homogeneous, but are heterogeneous across strata.
Then, a simple random or a systematic sample is taken
i. Simple random sampling
from each stratum proportional to the relative size of the
ii. Stratified random sampling
stratum in the population. These samples are then
pooled to form a stratified random sample.
1 Simple Random Sampling
• The strata should be mutually exclusive (i.e. every
Sampling Plan: Sampling plan is a set of rules that specify population member should be assigned to one
how a sample will be taken from a population. and only one stratum) and collectively exhaustive
(i.e. no population members should be omitted).
Simple Random Sample or random sample: A simple • The size of the sample drawn from each stratum is
random sample is a sample selected from a population proportionate to the relative size of that stratum in
in such a way that every possible sample of the same the total population.
size has equal chance/probability of being selected. This • Stratified sampling is used in pure bond indexing
or full-replication approach in which an investor

Learning Module: 5
attempts to fully replicate an index by owning all § Cluster Sampling - A whole cluster is viewed as a
the bonds in the index in proportion to their sampling unit and then sample is made from the
market value weights. However, pure bond sampled clusters.
indexing is difficult and expensive to implement § Stratified Sampling - Specific elements from each
due to high transaction costs involved. stratum makes the sampling unit.
Advantages: Stratified random sampling generates more 4 Non-Probability Sampling

precise sample and generates more precise parameters
(i.e. smaller variance) relative to simple random Non-probability sampling methods depends on
sampling. researcher’s sample selection capabilities instead of a
selection process.
Drawback: Stratified Random Sampling approach
generates a sample that is just approximately (i.e. not Two major types include:
completely) random. i. Convenience sampling
ii. Judgmental sampling
Example:
Suppose, population of index bonds is divided into 2 1. Convenience sampling: The element is selected
issuer classifications, 10 maturity classifications and 2 based on the ease of its accessibility to the
coupon classifications. researcher.
Total strata or cells = (2) (10) (2) = 40 o Advantages: It is cost efficient and time-efficient
i.e., data is collected quickly.
o Disadvantages: Limited level of sample accuracy
• A sample, proportional to the relative market
i.e., sample may not represent the entire
weight of the stratum in the index to be
population
replicated, is selected from each stratum.
• For each cell, there should be ≥ 1 issuer i.e. the
2. Judgmental Sampling: The elements are selectively
portfolio must have at least 40 issuers.
handpicked from the population based on
researcher’s knowledge and professional judgement.
Practice: Example 1, o Advantage: Experienced researchers may select

CFA Institute’s Curriculum. a more accurate representative sample
compared to other methods when there is a
time constraint or when the specialty of
researcher is critical.
3 Cluster Sampling o Disadvantage: Sample may not represent the
entire population. Results may be skewed
because of the researcher’s biasness.
Cluster Sampling – a technique where the population is
divided into subpopulation groups (clusters). Each cluster
is a mini representation of the population. Then certain Practice: Example 2 & 3,
clusters are randomly chosen (using simple random CFA Institute’s Curriculum.
sampling) to form a sample.
i. One-stage sampling: Certain clusters are

randomly chosen from the entire clusters. All the 5 Sampling from Different Distributions
members from these chosen clusters are
selected. Analysts should be careful when sampling from
ii. Two-stage sampling: Certain clusters are population with more than one distribution. Sample
randomly chosen from the entire clusters. A should represent a homogenous distribution.
subsample is then randomly selected from each
chosen cluster. Sampling should not be done from more than one
distribution because when random samples are
Advantages: Time-efficient and cost-efficient selected from more than one distribution (e.g.
combining data collected from a period of fixed
Disadvantages: Cluster sampling attains lower accuracy exchange rates with data from a period of floating
because a sample from a cluster may not fully represent exchange rates), the sample statistics computed
the entire population. from such samples may not be the representatives
of one underlying population.
Difference between Cluster and Stratified Samples:
Learning Module: 5
THE CENTRAL LIMIT THEOREM AND DISTRIBUTION OF THE
3.
SAMPLE MEAN
The Central Limit Theorem Standard Error of the Sample Mean
According to central limit theorem: When the sample Standard Error: S.D. of a sample statistic is referred to as
size is large, the standard error of the statistic.
1) Sampling distribution of mean (𝑋") will be When the population S.D. (σ) is known,
approximately normal regardless of the probability s
distribution of the sampled population (with mean μ Standard Error of the Sample Mean = sX =
and variance σ2) when the sample size (i.e. n) is n
large”. When the population S.D. (σ) is not known,
s
• Generally, when n ≥ 30, it is assumed that the Standard Error of the Sample Mean = sX =
sample mean is approximately normally n
distributed. where,
s = sample S.D.
2) Sample mean = Population mean è 𝜇$" = 𝜇 The estimate of s =&𝑆𝑎𝑚𝑝𝑙𝑒 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = s2
3) The sampling distribution of sample means has a
standard deviation equal to the population standard ∑:7;<(𝑋7 − 𝑋")4
deviation divided by the square root of n. 𝑠4 =
𝑛−1
s2
Variance of the distribution of the sample mean = Note: Standard deviation S.D. and standard error are
n two different concepts:
o S.D measures dispersion of data from the mean
Practice: Example 5, o Standard error measures how much inaccuracy
CFA Institute’s Curriculum. of a population parameter estimates comes
from sampling.
4. POINT ESTIMATES OF THE POPULATION MEAN
Two branches of Statistical inference include:

Confidence Interval: It refers to a range of values within
1) Hypothesis testing: In a hypothesis testing, we have a which the unknown population parameter with some
hypothesis about a parameter's value and seek to specified level of probability is expected to lie.
test that hypothesis e.g. we test the hypothesis “the
population mean = 0”.
4.1 Point Estimators
2) Estimation: In estimation, we estimate the value of
unknown population parameter using information Estimation formulas or estimators: The formulas that are
obtained from a sample. used to estimate the sample mean and other sample
statistics are known as estimation formulas or estimators.
Point Estimate: It refers to a single number representing
the unknown population parameter. In any given • An estimator has a sampling distribution.
sample, due to sampling error, the point estimate may
not be equal to the population parameter.
Learning Module: 5
• The estimation formula generates different • Sample variance s2 is an efficient estimator of

outcomes when different samples are drawn from population variance σ2.
the population. • An efficient estimator is also known as best
unbiased estimator.
Estimate: The specific value that is calculated from
sample observations using an estimator is called an 3) Consistency: An estimator is consistent when it tends
estimate e.g. sample mean. An estimate does not have to generate more and more accurate estimates of
a sampling distribution. population parameter when sample size increases.
Three desirable properties of estimators: • The sample mean is a consistent estimator of the
1) Unbiasedness (lack of bias): An estimator is unbiased population mean i.e. as sample size increases, its
when the expected value (i.e. sample mean) = standard error approaches 0.
population parameter. The sample variance (i.e. • However, for an inconsistent estimator, we cannot
∑@ "
>AB($> ?$)
C increase the accuracy of estimates of population
:?<
) is an unbiased estimator of the population parameter by increasing the sample size.
variance (σ2).
NOTE:
NOTE:
When a sample variance is calculated as Sample • Unbiasedness and efficiency properties of an
C
∑@ "
>AB($> ?$) estimator's sampling distribution hold for any size
Variance = → it is a biased estimator because
:
sample.
its expected value < population variance.
• The larger the sample size, the smaller the
variance of sampling distribution of the sample
2) Efficiency: The efficiency of an unbiased estimator is
mean.
measured by its variance i.e. an unbiased estimator
with the smallest variance is referred to as an efficient
estimator.
• Sample mean 𝑋" is an efficient estimator of the CFA Institute’s Curriculum.
population mean.
CONFIDENCE INTERVALS FOR THE POPULATION MEAN AND

5.
SELECTION OF SAMPLE SIZE
Confidence Interval: A confidence interval is a range of long run, 95% or 950 of such confidence intervals will
values within which the population parameter is include/contain the population mean.
expected to lie with a given probability 1 - n, called the
degree of confidence. 2) Practical interpretation: In the practical interpretation,
it is interpreted as follows e.g. we are 95% confident
• For the population parameter, the confidence that a single 95% confidence interval contains the
interval is referred to as the 100(1 - α) % population mean.
confidence interval.
• The lower endpoint of a confidence interval is NOTE:
called lower confidence limit. Significance level (α) = The probability of rejecting the
• The upper endpoint of a confidence interval is null hypothesis when it is in fact correct.
called upper confidence limit.
Construction of Confidence Intervals: A 100(1 - α) %
confidence interval for a parameter is estimated as
follows:
Point estimate ± (Reliability factor × Standard error)
𝜎
𝜒̅ ± 𝑧H/4
√𝑛
There are two ways to interpret confidence intervals i.e. where,
1) Probabilistic interpretation: In probabilistic Point estimate = It is a point estimate of the parameter
interpretation, it is interpreted as follows e.g. in the (i.e. a value of a sample statistic)
Learning Module: 5
Reliability factor = It is a number based on the assumed

distribution of the point estimate and 1) Using Z-alternative: Confidence Intervals for the
the degree of confidence (1 - α) for Population Mean-The Z- Alternative (Large Sample,
the confidence interval Population Variance Unknown) is given by:
𝑆
• Z α/2 = Reliability factor = Z-value corresponding to 𝜒̅ ± 𝑧H/4
an area in the upper (right) tail of a standard √𝑛
normal distribution. where,
s = sample standard deviation.
n = Sample size
Standard error = Standard error of the sample statistic
• This approach can be used to construct the
confidence intervals only when sample size is
• σ = Standard deviation of the sampled population
large i.e. n ≥ 30.
• Since the actual standard deviation of the
population (σ) is unknown, sample standard
Precision of the estimator deviation (s) is used to compute the confidence
= (Reliability factor × standard error) → the greater the interval for the population mean, µ.
value of (Reliability factor × standard error), the lower
the precision in estimating the population parameter.
2) Using Student’s t-distribution: It is used when the
population variance is not known for both small and
For example, reliability factor for 95% confidence interval
large sample size.
is stated as Z0.025 = 1.96; it implies that 0.025 or 2.5% of the
probability remains in the right tail and 2.5% of the
probability remains in the left tail. • In case of unknown population variance, the
theoretically correct reliability factor is based on
Suppose, sample mean = 25, sample S.D. the t-distribution.
= 20 / √100 = 2. Then, • t-distribution is considered a more conservative
approach because it generates more
Confidence interval è 25 ± (1.96 × 2) i.e. conservative (i.e. wider) confidence intervals.
• Lower limit = 25 - (1.96 × 2) = 21.08 Confidence Intervals for the Population Mean is given
• Upper limit = 25 + (1.96 × 2) =28.92 by:
S
Confidence Intervals for the Population Mean (Normally
µ = X ± ta/2
n
Distributed Population with Known Variance): In this case,
where,
a 100(1 - α)% confidence interval is given by
t= critical value of the t-distribution with degrees of
𝜎 freedom (d.f.) = n-1 and an area of α/2 in each tail.
𝜒̅ ± 𝑧H/4
√𝑛
tα/2 èα/2 of the probability remain in the right tail for the
specified number of d.f.
• The reliability factor is based on the standard
normal distribution with mean = 0 and a variance
t-distribution:
= 1.
• Like standard normal distribution, t-distribution is

Reliability Factors for Confidence Intervals Based on the
bell-shaped and perfectly symmetric around its
Standard Normal Distribution:
mean of 0.
• t-distribution is described by a single parameter
• For 90% confidence intervals: Reliability factor = Z known as degrees of freedom (df) = n - 1. t values
0.05 = 1.65 depend on the degree of freedom.
• For 95% confidence intervals: Reliability factor = Z • t-distribution has fatter tails than normal
0.025 = 1.96 distribution i.e. a larger portion of the probability
• For 99% confidence intervals: Reliability factor = Z areas lie in the tails.
0.005 = 2.58 • t-distribution is affected by the sample size n i.e. as
the sample size increases → degrees of freedom
Confidence Intervals for the Population Mean (Normally increase → the t-distribution approaches the Z
Distributed Population but with Unknown Variance): In distribution.
this case, a 100(1 - α) % confidence interval can be • Similarly, as the degrees of freedom increase →
calculated using two approaches. the tails of the t-distribution become less fat.
Learning Module: 5
x-µ
Z= èIt follows normal distribution with a mean
s/ n
= 0 and S.D. = 1.
x-µ
t= è It follows the t-distribution with a mean = 0
s/ n
and d.f = n - 1.
• Unlike Z-ratio, t-ratio is not normal because it

represents the ratio of two random variables (i.e.
the sample mean and the sample S.D.); whereas,
Z-ratio is based on only 1 random variable i.e.
sample mean.
Example:
Suppose, n = 3, df = n – 1 = 3 -1 =2. a = 0.10 →a/2 = 0.05.
Looking at the table below, for df = 2 and for t0.05, èt-
value = 2.92.
Basis of Computing Reliability Factors
Statistic for Statistic for

Sampling from: Small Large Sample
Sample Size Size
Normal distribution
with know z z
variance
Normal distribution
with unknown t t*
variance
Nonnormal
not
distribution with z
available
known variance
Nonnormal
not
distribution with t*
available
unknown variance
*Use of z also acceptable
Source: Table 3, CFA Institute’s Curriculum.
Learning Module: 5
NOTE:
Selection of Sample Size
When the population distribution is not known but
sample size is large (n ≥ 30), confidence interval can be The required sample size can be found to obtain a
constructed by applying the central limit theorem. desired standard error and a desired width for a
confidence interval with a specified level of confidence
Factors that affect width of the confidence interval: (1 - a) % by using the following formula:
a) Choice of Statistic (i.e. t or Z)
b) Choice of degree of confidence i.e. the greater the n = Z2σ2 / e2
degree of confidence → the wider the confidence and
interval and the lower the precision in estimating the n = [(tα /2 ×s) / E]2
population parameter.
c) Choice of sample size (n) i.e. the larger the n, → the • E = Reliability factor × Standard error: The smaller
smaller the standard error, → as a result, the narrower the value of E → the smaller the width of the
the width of a confidence interval → the greater the confidence interval.
precision with which population parameter can be • 2E = Width of confidence interval.
estimated (all else equal). • As the number of degrees of freedom increases,
the reliability factor decreases.
Limitations of using large sample size:
• Increasing the sample size may result in sampling

from more than one population. Practice: Example 10,
• Increasing the sample size may result in additional CFA Institute’s Curriculum.
expenses.
6. RESAMPLING
Resampling: A technique that repeatedly draws

samples from the observed data samples for the
statistical inference of population parameter.
1. Bootstrap: A resampling technique that repeatedly
draws samples (by putting back sample observations
every time) from the observed data samples. Each 2. Jackknife: It is another resampling technique that
observation drawn is put back into the group, repeatedly draws samples by taking the observed
therefore it can be drawn more than once. data sample and leaving out one observation at a
time from the set.
For example, to calculate the standard error of
sample mean, the process takes many resamples Unlike bootstrap this method does not put back
and then compute the mean of each resample. sample observation.
Bootstrap method uses computer simulation. It mimics This method is used to reduce the bias of the
the process by considering the randomly drawn estimator as well as to find standard error and
sample as if it were the population. confidence interval of an estimator.
Advantages: Bootstrap sampling: For a sample size n, Jackknife typically requires n

repetitions whereas with bootstrap researcher
• is potentially more accurate than other methods determines how many repetitions are appropriate.
• is widely used tool for statistical inference i.e., to
find standard error or to construct confidence
interval or any complicated estimators. Practice: Example 11,
• does not rely on analytical formula to estimate CFA Institute’s Curriculum.
the distribution of the estimators.
Learning Module: 5
7. SAMPLING RELATED BIASES
Sampling-related issues include: on companies, mutual funds, etc. that are no

longer in existence.
1 Data Snooping Bias
o Self-selection bias occurs when hedge funds
with poor track records may voluntarily do not
Data-snooping (or data mining) bias occurs when the disclose their records.
same dataset is extensively researched to find
statistically significant patterns. Thus, data mining Backfill bias:
involves overuse of data. A variation of selection bias where a fund backfills its
entire performance history when it first starts reporting
Intergenerational data mining: It involves using actual performance. It results in overestimation of good
information developed by prior researches as a results and understated volatility.
guideline for testing the same data patterns and
overstating the same conclusions.
3 Look-Ahead Bias
Detecting data mining bias: Data mining bias can be
detected by conducting out-of-sample tests of the Look-ahead bias occurs when the research is
proposed variable or strategy. Out-of-sample refers to conducted using the information that was not actually
the data that was not used to develop the statistical available on the test date, but it is assumed that it was
model i.e. when a variable/model is not statistically available on that particular day.
significant in out-of-sample tests, it indicates that the
variable/model suffers from data-mining bias. For example, in price-to-book value ratio (P/B) for 31st
March 2010, the stock price of a firm is immediately
Two signs that indicate potential existence of data available for all market participants at the same point in
mining bias: time; however, firm’s book-value is generally not
available until months after the start of the year. Thus,
a) Too much digging/too little confidence: Generally, price does not reflect the complete information.
the number of variables examined in developing a
model is not disclosed by many researchers; however, 4 Time-period bias
the use of terms i.e. "we noticed (or noted) that" or
"someone noticed (or noted) that” may indicate
data-mining problem. Time-period bias occurs when the results of a model are
time-period specific and do not exist for outside the
b) No story/no future: The absence of any explicit sample period. For example, a model may appear to
economic rationale behind a variable or trading work over a specific time period but may not generate
strategy being statistically significant indicate data- the same outcomes in future time periods (i.e. due to
mining problem. structural changes in the economy).
2 Sample Selection Bias

Institute’s Curriculum
Sample selection bias occurs when sample
systematically tends to exclude a certain part of a
population simply due to the unavailability of data. This
bias exists even if the quality and consistency of the Practice: CFA Institute’s end of
data are quite high. Chapter Practice Problems and
Questions from FinQuiz Question
For example, sample selection bias may result when Bank.
dataset exclude or delist (due to merger, bankruptcy,
liquidation, or migration to another exchange)
company’s stock an exchange.
Types of Sample selection bias:

o Survivorship bias occurs when the database
used to conduct a research exclude information
QM Introduction to Linear Regression
Learning Module: 7
1. SIMPLE LINEAR REGRESSION
Regression analysis:
Dependent variable (a.k.a. explained variable) Y: The
• is a tool used to examine whether a variable is variable whose variation is being explained by the
useful to explain another variable. independent variable.
• predicts the value of a dependent variable
based on the value of at least one independent Independent variable (a.k.a. explanatory variable) X:
variable. The variable used to explain the dependent variable.
Simple Linear Regression (SLR): A regression that

summarizes the relation between the dependent Practice: Example 1, CFA Institute’s
variable and one independent variable through Curriculum.
estimation of a linear relationship.
If more than one variable is used, it is called Multiple

Regression:
ESTIMATING THE PARAMETERS OF
2.
A SIMPLE LINEAR REGRESSION
Error Term represents the difference between

The Basics of Simple Linear Regression
observation and its expected value i.e., how much
estimatedl ith value differs from the actual ith value.
• Linear regression assumes straight line
relationship between dependent and 𝜀7 = 𝑌7 - 𝑌37
independent variables.
• It is also called least squares regression or SSE (sum of squares error or residual sum of squares):
ordinary least squares regression. • Measures unexplained variation in the
• The objective is to fit a line to the observations on dependent variable.
Y and X to minimize the squared deviations from • It is sum of squared deviations of the value of
the line. the dependent variable and the value of the
dependent variable based on the estimated
Simple Linear Regression (i.e., Y is regressed on X) is regression line
described as:
37 )=
SSE = ∑>7?.(𝑌7 − 𝑌
𝒀𝒊 = 𝒃𝟎 + 𝒃𝟏 𝑿𝒊 + 𝜺𝒊 where 𝑖 = 1,…,n
𝑎𝑠 𝑌37 = 𝑏3- + 𝑏3. 𝑋7
Y = dependent variable
X = independent variable
𝑏- = intercept Therefore, SSE = ∑>7?.(𝑌7 − A𝑏3- + 𝑏3. 𝑋7 B)=
𝑏. = slope coefficient
𝜀 = error term 𝑎𝑠 𝑌7 - 𝑌37 = 𝜀7
𝑏- 𝑎𝑛𝑑 𝑏. are called regression coefficients
Therefore, SSE = ∑>7?.(𝜀7 )=
Estimating the Regression Line
Note: Residuals are stated in the same measurement unit
as the dependent variable.
In a regression model, we cannot observe 𝑏- 𝑎𝑛𝑑 𝑏. . In its
place, we use estimated values 𝑏3- 𝑎𝑛𝑑 𝑏3. .
Interpreting the Regression Coefficients
We select values for the intercept b0 and slope b1 that
minimize the sum of the squared vertical distances How to calculate and interpret regression
between the observations and the regression line. coefficient b1 and b0
5𝒊
Value of dependent variable for the ith observation 𝒀 1) Slope Coefficient (b1): A change in the dependent
variable for a one unit change in the independent
𝑌37 = 𝑏3- + 𝑏3. 𝑋7 variable.

Reading 26 Financial Statement Analysis: Applications FinQuiz.com
o money supply growth, 0 intercept is

meaningful because zero money supply
growth is possible.
Interpretation:
If slope is positive (negative), the change in the
Cross-Sectional vs. Time-Series Regressions
dependent and independent variable will be in the
same(opposite) direction.
Two main types of data used in regression analysis are
∑P N N
LQRAKL MKBAOL MOB time series and cross-sectional:
CDE(F,H) ∑P V V
LQR(TL UT )(WL UW)
𝑏. = = PMR
N BS
= ∑P V )S
EIJ(F) ∑P AOL MO (W UW
LQR LQR L 1) Time-series: It uses many observations from different
PMR
time periods for the same company, asset class or
2) Intercept (b0): The predicted value of the country etc.
dependent variable when the independent
variable is set to zero. 2) Cross-sectional: It uses many observations for the
same time periodof different companies, asset classes
or countries etc.
𝑏- = 𝑌V − 𝑏3. 𝑋V
N 𝑎𝑛𝑑 𝑋V are mean values of X and Y. Mix of two types

where 𝑌
Panel data: It is a mix of time-series and cross-sectional
Interpretation:
data.
In some cases, zero intercept is meaningful but in
some cases it does not make sense.
Practice: Example 2 & 3, CFA
For example, if independent variable is: Institute’s Curriculum.
o money supply, 0 intercept is meaningless
becase zero money supply is not possible.
3. ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL
The four key assumptions of the simple linear regression • If the variance of the residuals differs across
model are: observations, this state is called
heteroskedasticity (different scatter).
1) Linearity • In real-world data, structural changes (regime
2) Homoskedasticity changes) often involve heteroskedasticity.
3) Independence
4) Normality
Assumption 3: Independence
Assumption 1: Linearity
‘The observations (pairs of Xs and Ys) are independent of
each other, which implies the residuals are uncorrelated
‘Relation between the dependent variable and across observations.’
independent variable is linear.’
• If variables are not independent, the residuals will
• If the relationship is nonlinear, the model will be be correlated (display a pattern). This is an
biased (i.e., over or underestimate the indication of autocorrelation.
dependent variable).
• Linearity assumption also implies that
independent variable must not be random (i.e., Assumption 4: Normality
non-stochastic). Otherwise, there will be no linear
relationship. ‘The regression residuals must be normally distributed.’
Assumption 2: Homoskedasticity • In large sample sizes, dropping the normality

assumption does not noticeably influence results.
‘The variance of residuals is the same for all observations.

Note: Normality assumption does not mean that
It is known as Homoskedasticity (same scatter)
dependent or independent variables must be normally
assumption.’
distributed.
Practice: Example 4, CFA Institute’s

Curriculum.
4. ANALYSIS OF VARIANCE
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 (𝑆𝑆𝑇) − 𝑈𝑛𝑒𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 (𝑆𝑆𝐸)

=
Breaking down the Sum of Squares Total into Its 𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 (𝑆𝑆𝑇)
Components
where, 0 ≤ R2≤ 1
Total variation is made up of two parts:
In case of a single independent variable, the coefficient
Sum of squares total (SST) = sum of squares error (SSE) + of determination is: R2 = r2
sum of squares regression (SSR)
where,
SST = SSE + SSR R2 = Coefficient of determination
r = Simple correlation coefficient
Example:
Suppose coefficient of determination between returns of
two assets is 0.64. This means that approximately 64
percent of the variability in the returns of one asset (or
dependent variable) can be explained by the returns of
the other asset (or indepepnent variable).
where,
yV = Average value of the dependent variable
y = Observed values of the dependent variable 2. F-distributed test Statistic or F-Test
𝑦Z = Estimated value of y for the given value of x
F-distributed test statistic tests whether the slopes b1 in
• SST (total sum of squares): Measures total variation regression are equal to zero, against the alternative
in the dependent variable i.e., the variation of the hypothesis that at least one slope is not equal to zero.
yi values around their mean y.
• SSE (error sum of squares): Measures unexplained H0: b1 = 0
variation in the dependent variable. H1: b1 ≠ 0
• SSR / RSS (regression sum of squares): Measures
variation in the dependent variable explained by The F statistic is calculated as the ratio of mean square
the independent variable. regression (MSR) to mean squared errors (MSE).
}~~
yz{ ( ) yz{
Measures of Goodness of Fit F = yz| = •
= yz|
~~€
( )
•M•MR
Goodness of fit (i.e., how well the regression model fits ∑P 3 V S

zz{ LQR(TL UT)
the data) can be measured using several methods such MSR = …
= †
= ∑>7?.(𝑌37 − 𝑌V)=
as:
1. Coefficient of determination 𝑅= where df numerator = k = 1
2. F-statistic
3. Standard error of regression 𝑆] zz| ∑P 3 S
LQR(TL U TL ) ∑P 3 S
LQR(TL U TL )
MSE = = =
Û…U. >U†U. >U=
1. Coefficient of Determination 𝐑𝟐
where df denominator = n – k – 1 = n – 2 (in simple linear
regression)
• The coefficient of determination is the
percentage of the total variation in the Note: F-test is always a one-tailed test (one sided).
dependent variable that is explained by the
independent variable. 3. The Standard Error of Estimate 𝐒𝐞
• The coefficient of determination is also called R-
squared and is denoted as R2.
• It is descriptive measure. • Standard Error of Estimate (𝑆] ) measures the
degree of variability of the actual y-values relative
𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑡𝑖𝑜𝑛 (𝑅= ) =
hFijI7>]k lIJ7Im7D>(nno) to the predicted y-values from a regression
pDmIj lIJ7Im7D> (nnp) equation.
• Smaller the 𝑆h , better the fit.
• 𝑆h is also called standard error of regression or root 𝑆𝑆𝑅™

1
mean square error. 𝑆𝑆𝐸™
nnh (𝑛 − 2)
• 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐸𝑟𝑟𝑜𝑟 𝑜𝑓 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒: 𝑆h = √𝑀𝑆𝐸 = Ž>U†U. =
𝑆𝑆𝐸
∑(HL UHZ)S >
Ž 𝑀𝑆𝐸 =
>U†U. 𝑆𝑆𝐸
Error n-2 = ”(𝑦7
7?. 𝑛−2
where n = Sample size − 𝑦Z)=
k = no. of independent variables = 1.
𝑆𝑆𝑇
>
Example: Total n–1 = ”(𝑦7
n = 100 7?.
SSE = 2,252,363 − 𝑦V)=
Thus,
nnh
𝑆] = Ž>U= = Ž
=,=•=,•‘•
= 151.60 Or
’“
Source of Sum of Mean Sum of

Note: df
Variability Squares Squares
• Co-efficient of determination and F-statistic are
relative measures of fit Regression
1 SSR MSR = RSS/1
• Standard error of the estimate is absolute (Explained)
measure. Error
n-2 SSE MSE = SSE/n-2
(Unexplained)
ANOVA and Standard Error of Estimate in Simple
Total n-1 SST=SSR + SSE
Linear Regression
Analysis of Variance (ANOVA) is a statistical method

used to divide the total variance in a study into Practice: Example 5, , CFA
meaningful pieces that correspond to different sources. Institute’s Curriculum.
Analysis of Variance Table for Simple Linear

Regression
ANOVA df SS MS F
𝑆𝑆𝑅
>
𝑀𝑆𝑅 = 𝐹 =
—no
=
Regression 1 = ”(𝑦Z7 𝑆𝑆𝑅 —nh
7?. 𝑘
− 𝑦V)=
5. HYPOTHESIS TESTING OF LINEAR REGRESSION COEFFICIENTS
5𝟏 U 𝐁𝟏
𝒃
Test statistic 𝒕 =
𝒔𝒃
5
5.1 Hypothesis Tests of the Slope Coefficient 𝟏
where,
𝑏31 = Sample regression slope coefficient
t-statistic is used to test the significance of the individual b1 = Hypothesized slope
coefficients (e.g., slope) in a regression. It is used to test 𝑆› . = Standard error of the slope
whether the population slope is different from a specific
df= n-k-1 = n–2
value.
Decision Rule:
Suppose we want to test a hypothesis about the slope. If test statistic is <– t-critical or > + t-critical with n-2
degrees of freedom, (if absolute value of t > tc), Reject
Null and Alternative hypotheses
H0; otherwise, Do not Reject H0.
H0: b1 = 0 (no linear relationship)
H1: b1 ≠ 0 (linear relationship does exist)
Standard Error of Slope Coefficient A𝒔𝒃5𝟏 B
A t-test statistic is calculated by subtracting the It is the ratio of standard error of estimate 𝑆] to the
hypothesized population slope B1 from the estimated square root of variation of independent variable. for
slope coefficient 𝑏3. and then dividing the difference by simple linear regression:
the standard error of the slope coefficient 𝑠›3R .
𝑠]
𝑠›3R = • In simple linear regressions, the slope is the
Ž∑>7?.(𝑋7 − 𝑋V)= difference in the dependent variable for the
two conditions.
The greater the variability of the independent variable
the lower will be the standard error of slope and
therefore greeter will be the calculated t-statistic. For detailed example: refer to section 5.3) Exhibit
28 and 29 , CFA Institute’s Curriculum.
For details: refer to Exhibit 24 to Exhibit 26 , CFA

Institute’s Curriculum. Test of Hypothesis: Level of Significance and p-
Values
p-value: The p-value is the smallest level of significance

Hypothesis Tests of the Intercept at which the null hypothesis can be rejected.
This test is useful to determine wthether the population For example, if the p-value is 0.05 i.e., 0.05 significance
intercept is a specific value. level, this indicates that there is a 5% chance of rejecting
Intercept is the predicted value of the dependent the hypothesis when actually it is true actually. This is a
variable when the independent variable is set to zero Type 1 error.
. WV S • The smaller the p-value, the smaller the chance

Standard error of the intercept = 𝑠›3Ÿ = Ž + S
> ∑P V
LQR(WL UW) of making type I error (i.e., the greater the
probability of rejecting the null hypothesis).
The test is whether the intercept is different from the • Type I error = False positive = rejecting the null
hypothesized value B0 , using the following formula. hypothesis when it is true.
• Type II error = False negative = not rejecting the
5𝟎 U 𝑩𝟎
𝒃 5𝟎 U 𝑩𝟎
𝒃 null hypothesis when it is wrong.
𝒕𝒊𝒏𝒕𝒆𝒓𝒄𝒆𝒑𝒕 = =
𝒔𝒃
5 𝟏 N𝟐
𝑿
𝟎 ¦𝒏+ 𝟐
∑𝒏 N)
𝒊=𝟏(𝑿𝒊 −𝑿
For details: refer to 5.4 , CFA Institute’s Curriculum.
For details: refer to Exhibit 27 , CFA Institute’s

Curriculum.
Practice: Example 6, , CFA
Institute’s Curriculum.
Hypothesis Tests of Slope When Independent
Variable Is an Indicator Variable
• Indicator variable (or dummy variable) is a

variable that takes on a value of either 1 or 0.
• 1 if a particular condition is true and 0 if that
condition is false.
PREDICTING USING SIMPLE LINEAR REGRESSION AND
6.
PREDICTION INTERVALS
Regression results are used to make prediction about the S

. AWª UWVB
dependent variable. Standard error of forecast = 𝑠¨ = 𝑠] ¦1 + + ∑P V S
> LQR(WL UW)
Prediction intervals are used to realize how sure we are

about the predicted results. as
Prediction interval for a forecasted value of a

s f = s 2f
dependent variable is created by using equation
𝑌3 ± 𝑡C 𝑠¨ 𝑠] = standard error of estimate
n = number of observations
where, X = value of independent variable
. (W UWV)S . (Wª UWV)S 𝑋V = estimated mean of X
𝑠¨= = 𝑠] = ©1 + > + (>U.)«
ª =
S ¬ = 𝑠] -1 + > + ∑P V S® s2X= variance of independent variable
O LQR(WL UW )
tc = critical t-value for n −k −1 degrees of freedom.
The following can be taken from the equation:
1. The better the fit of the regressions, the smaller will For detailed example: refer to Exhibit 31 and the
be the 𝑠] and therefore, the smaller will be the 𝑠¨ . example following the exhibit. CFA Institute’s
2. The larger the n (sample size), the smaller will be Curriculum.
the 𝑠¨ .
3. The closer the 𝑋¨ is to 𝑋V, the smaller will be the 𝑠¨ .
where 𝑋¨ is forecasted independent variable and 𝑋V is Curriculum.
forecasted mean of the independent variable.
7. FUNCTIONAL FORMS FOR SIMPLE LINEAR REGRESSION
Economic and financial data often exhibit nonlinear

relationships between two variables. To apply simple
The Log-Log Model
linear regression model on such data, we need to
modify either the dependent or the independent
variable. In this model, both the dependent and independent
variables are in logarithmic form. This model is also called
Many functional forms can be used to transform data to double-log model.
enable their use in linear regression. Three commonly
used functional forms that involve log transformation are ln 𝑌7 = 𝑏- + 𝑏7 ln𝑋7
as follows:
Slope coefficient → relative change in the dependent
1. The log-lin model variable for a relative change in the independent
2. The lin-log model variable.
3. The log-log model
This model is suitable in calculating elasticities.
The Log-Lin Model
Selecting the Correct Functional Form
In this model, the dependent variable is in logarithmic
form, but the independent variable is in linear form. Selection of the suitable functional form depends on
examining the goodness of fit measures (𝑅= , F-statistic &
ln 𝑌7 = 𝑏- + 𝑏7 𝑋7 𝑆] ) as well as patterns in the residuals.
Slope coefficient → relative change in the dependent Many statistical software packages enable us to visually
variable for an absolute change in the independent examine and inspect the distribution of the residuals
variable.
Note: Curriculum.
Directly comparing the different model values is not
possible because variables are not in the same form.
The Lin-Log Model Practice: End of Chapter Practice

Problems & Questions from FinQuiz
In this model, the independent variable is in logarithmic Question-bank.
form, but the dependent variable is in linear
𝑌7 = 𝑏- + 𝑏7 ln𝑋7
Slope coefficient → absolute change in the dependent

variable for a relative change in the independent
variable.
ECO Topics in Demand and Supply Analysis
Learning Module: 1
1. INTRODUCTION
Economics is the study of production, distribution, and services by individuals whose objective is to
consumption. It can be divided into two broad maximize utility.
categories:
ii. Theory of firms: Theory of firms deals with supply
1. Macroeconomics: It deals with the study of of goods and services by firms with objective
economy as whole i.e. aggregate economic to maximize profit.
quantities and prices e.g. national income,
national output, aggregate consumption etc. Demand and Supply Analysis: It deals with
determination of prices and quantities through
2. Microeconomics: It deals with the study of interaction of buyers and sellers. It is used by analysts
decisions of consumers and businesses and the to forecast effects of changes in consumer tastes,
individual markets. The objective of taxes, subsidies etc. on firms’ revenue, earnings and
microeconomics is to analyze the prices and cash flows.
quantities of individual goods and services.
It deals with two private economic units:
i. Theory of consumer: Theory of consumer deals

with consumption i.e. demand for goods and
2. DEMAND CONCEPTS
I = consumers’ income (as in €1,000s per household

2.1 Demand Concepts
annually)
Py = the price of another good, Y. (e.g. complements or
Law of demand: It states that, all else constant, the
substitutes.)
quantity demanded of a good is inversely related to its
price i.e. when price of the good increases (decreases),
quantity demanded decreases (increases).
Example:
Qxd= 84.5 – 6.39Px + 0.25I – 2Py
The above equation says that the quantity of gasoline

demanded is a function of the price of a liter of gasoline
(Px), consumers’ income in €1,000s (I), and the average
price of an automobile in €1,000s (Py).
§ The negative sign on average automobile price
Demand Function: indicates that if automobiles go up in price, demand
Demand Curve is represented by following demand for automobile will decrease; hence, less gasoline
function: will be consumed.
Qxd = f(Px, I, Py)
This equation states that: quantity demand of good X Inverse demand function:
depends on price of good X, consumer’s income and Demand Function = Qdx = a – bPx
price of a substitute good Y. Inverse Demand Function = Px = a/b – (1/b)Qdx
Where, Inverse demand function of above equation can be

Qxd= quantity demand of good X (such as per stated as follows:
household demand for gasoline in liters per month) Px = 8.92 − 0.156 Qdx
Px= the price per unit of good X (such as € per liter)

ECO Topics in Demand and Supply Analysis FinQuiz.com
Learning Module: 1
§ This equation gives the price of gasoline as a

function of the quantity of gasoline consumed per
month and is referred to as the inverse demand
function.
Demand Curve: It is a graph of the inverse demand

function. It is a graph, which exhibits the relationship
between the price of a good and the quantity
demanded.
• Price is on the vertical axis and quantity

demanded is on the horizontal axis.
• Demand curve is negatively sloped.
Slope of the Demand Curve:

𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐏𝐫𝐢𝐜𝐞
Slope of the Demand Curve =𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐃𝐞𝐦𝐚𝐧𝐝𝐞𝐝
3. PRICE ELASTICITY OF DEMAND
Own-Price Elasticity of Demand
It is the responsiveness of demand to changes in price

(all else held constant). It is computed as the
percentage change in quantity demanded divided by
the percentage change in price.
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐃𝐞𝐦𝐚𝐧𝐝𝐞𝐝

ED =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞
• As we move down along the demand curve, the

price elasticity changes from elastic to unit-elastic to
inelastic. This implies that % change in Quantity
demanded decreases as % change in price
increases.
According to the law of demand, quantity demanded is
inversely related to price. Thus, the price elasticity of
Points to remember:
demand is always negative. • Elasticity is independent of units.
• Elasticity is related to slope but it is not the
• Elastic demand: When % change in demand is same as slope.
greater than % change in price i.e. E > 1 • Elasticity changes along straight-line
demand and supply curves.
• Inelastic demand: When % change in demand is
less than % change in price i.e. E < 1
3.1 Extremes of Price Elasticity
• Unit Elastic: When % change in demand is equal
to % change in price i.e. E = -1.
Learning Module: 1
There are two special cases in which linear demand

curves have the same elasticity at all points: vertical • Vertical Demand Curve: When the curves are
demand curves and horizontal demand curves. vertical, supply & demand curves are referred to
as perfectly inelastic i.e. E =0. It implies that
• Horizontal Demand Curve: When the curves are
changes in price have no effect on consumer
flat (horizontal), supply & demand curves are
demand. There is no demand curve that is
referred to as perfectly elastic i.e. E = infinity. It
perfectly vertical at all possible prices, however,
implies that demand is affected by any change
over some range of prices, the same quantity
in price.
would be purchased at a slightly higher price or
a slightly lower price. Thus, in that price range,
quantity demanded is not at all sensitive to
price, and we would say that demand is
perfectly inelastic in that range.
§ The above graph tells that even a

minute price increase will reduce
demand to zero, but at that given price,
the consumer would buy some large,
unknown amount.
§ The demand curve facing a seller under
conditions of perfect competition is
perfectly elastic.
PREDICTING DEMAND ELASTICITY, PRICE ELASTICITY AND TOTAL

4.
EXPENDITURE
3) The proportion of income taken up by the

Predicting Demand Elasticity product: Larger (smaller) the proportion of one's
budget represented by a good, more (less)
elastic its demand will be.
Determinants of Elasticity: 4) Luxury or Necessity: Demand for necessities is
less elastic whereas demand for luxury goods is
1) Time period: Longer the time interval considered more elastic.
(i.e. in the long run), the more elastic is the
good’s demand curve. For most goods and
services, the long-run demand is much more Elasticity and Total Expenditure
elastic than the short-run demand. For example,
if the price of gasoline rises, quantity demanded
If demand is elastic:
does not decrease immediately; rather,
• Price and total expenditure move in opposite
consumers will adjust their consumption in long
direction, i.e., % ∆ in Qd > % ∆ in P, therefore:
run. Hence, for most goods, long-run elasticity of
o Increasing price results in decrease in total
demand is greater than short-run elasticity.
revenue.
Ø This rule does not apply to Durable goods. If
o Reducing price results in increase in total
the price of durable good (say washing
revenue.
machines falls), consumers would replace
the old machine with new one as they know
If demand is inelastic:
will need to be replaced fairly soon anyway.
• Price and total expenditure move in same
direction, i.e., % ∆ in Qd < % ∆ in P, therefore:
2) Number and closeness of substitutes: Greater
o Increasing price results in increase in
the number of substitutes a good has, more
total revenue.
elastic is its supply and demand.
Learning Module: 1
o Reducing price results in decrease in

total revenue. Ø For a market, the total expenditure by buyers
becomes the total revenue to sellers in that
market.
Ø This market demand is elastic, an increase in
If demand is Unitary inelastic: Changes in Price are not
price will result in decrease in total revenue to
associated with changes in total expenditure. Total
sellers as a whole, and if demand is inelastic,
expenditure is maximized at a point where demand is an increase in price will result in increase in
unit-elastic. total revenue to sellers. However, since
demand is negatively sloped, the increase in
price would decrease total units sold, leading
to decrease in total production cost.
Ø If increasing price both increases revenue and
decreases cost, this will lead to increase in
profits.
Ø If a one-product seller faces inelastic demand,
he/she would tend to raise the price until the
point at which demand becomes elastic.
INCOME ELASTICITY OF DEMAND, CROSS-PRICE ELASTICITY OF

5.
DEMAND
Ø Goods with positive income elasticity

Income Elasticity of Demand are called “normal” goods. E.g.
restaurant meal.
Ø For normal goods, when income rises,
Income elasticity of demand is defined as the the entire demand curve shifts upward
percentage change in quantity demanded and to the right.
(%ΔQdx)divided by the percentage change in Ø Normal goods always follow the law of
income (%ΔI), holding all other things constant, demand.
Negative income elasticity of demand means that
when income rises, quantity demanded decreases.
Ø Goods with negative income elasticity
are called “inferior” goods. Typical
examples of inferior goods are rice,
potatoes, or less expensive cuts of meat.
Ø Although own-price elasticity of demand will Ø For inferior goods, when income rises,
almost always be negative, income elasticity of the entire demand curve shifts
demand can be negative, positive, or zero. downward and to the left.
Positive income elasticity means that as income

rises, quantity demanded also rises. Cross-Price Elasticity of Demand
Learning Module: 1
Cross Elasticity: It is the measure of the responsiveness of

demand of one good to changes in the price of a
related good i.e. substitute or a complement (all else
held constant).
4567589:;5 7<:8;5 =8 >?:89=9@ A5B:8A5A CD ECCA F

ED = 4567589:;5 7<:8;5 =8 G6=75 CD ECCA H
Or
Market Demand = Demand function × number of
Complements: Cross Elasticity of demand is negative for consumers
goods that are complements i.e. when price of one
good rises, demand for other good falls, that is, the e.g. Qxd= 500 ×(3 – 0.5P + 0.007I)
demand curve for other good shifts downward to the
left. where,
Demand function = 3 – 0.5P + 0.007I
Substitutes: Cross Elasticity of demand is positive for
Number of consumers = 500
goods that are substitutes i.e. when price of one good
rises, demand for other good also rises, that is, the
demand curve for other good shifts upward to the right. Practice: Example 1 CFA Institute’s
Curriculum.
Market demand: It is the horizontal sum of all individual
demands (quantity demanded not prices) at each
possible price. For example, if there are two consumers A
and B in the market, then market demand is determined
as follows.
SUBSTITUTION AND INCOME EFFECTS; NORMAL GOODS,

6.
INFERIOR GOODS AND SPECIAL CASES
§ increases, customers demand less of that

product and substitute it with cheaper product.
Substitution and Income Effects
§ decreases, customers’ consumption of that
product increases.
There are two reasons why consumers are expected to
buy more (less) when price of the good falls (rises).
Normal and Inferior Goods
These two reasons are known as the substitution effect
and the income effect. Normal Good: For normal goods, increase in income
cause consumers to buy more and vice versa. In case of
Income effect suggests that a change in price of a good
normal good, the income effect reinforces the
affects the consumer’s real purchasing power.
substitution effect:
§ A rise in price of a good reduces consumer’s
purchasing power and cause the consumer to
purchase less of that good. • when price falls, both effects lead to a rise in
demand.
§ A fall in price of a good increases consumer’s
• when price rises, both effects lead to a drop
purchasing power and cause the consumer to in demand.
purchase more of that good.
Inferior Good: For inferior goods, increase in income

Substitution effect refers to the change in consumption
cause consumers to buy less and vice versa. In case of
as a result of the change in the relative price of the
inferior good, the income effect and the substitution
good (i.e. cheaper goods are substituted for relatively
effect move in opposite directions:
expensive goods).
Relative to other products, as price of a good:

Learning Module: 1
• when price rises, the substitution effect leads Veblen goods & Giffen goods – exceptions to the law
to a decrease in demand, but the income of demand:
effect is opposite. Giffen goods are highly inferior (low income) goods
• when price falls, the substitution effect leads that make up the large portion of consumer budget.
to an increase in demand, but the income
effect is opposite. Veblan goods are luxury goods. whose demand is
• Theoretically, inferior goods may not follow positively related to their price i.e. as price rise,
law of demand when income effect for an quantity demanded increases. Examples of such
inferior good > substitution effect. goods include expensive shoes, designer dress.
• Both Veblen goods and Giffen goods contradict

standard law of demand i.e. have upward
sloping demand curves.
Note: • However, eventually, at some very high price,
• Same good can be normal for some consumers slope of the demand curve of Veblen goods will
and inferior for other consumers. necessarily become negative.
• Direction of income effect depends on whether • Veblen goods are also known as status-symbol
the good is normal or inferior. or ostentatious goods because they represent
conspicuous necessities & consumption.
• Substitution effect is always consistent with the
Law of Demand.
Differences between Giffen and Veblen Goods:
• In Giffen goods, interest in purchasing solely
depends on changes in income i.e. when
income increases, interest in purchasing Giffen
goods reduces.
• In Veblen goods, interest in purchasing depends
on desire for ostentatious consumption or to
have high status in society.

Curriculum.
SUPPLY ANALYSIS: COST, MARGINAL RETURN, AND

7.
PRODUCTIVITY
The firm’s ability and willingness to offer a given quantity § Increasing marginal returns occur when the
for sale depends on firm’s marginal cost, and its costs marginal product of an additional input
depend on both the productivity of its inputs and their increases when additional units of input are
prices. employed e.g. marginal product of worker
exceeds the marginal product of the previous
worker.
Marginal Returns and Productivity § Increasing marginal returns results from
increased specialization and division of labor in
Marginal Product: Marginal product is the additional the production process.
output that can be produced by employing one more § However, after a certain level of output, the
law of diminishing returns starts.
unit of a specific input, all other inputs held constant.
Diminishing Marginal Product or Law of Diminishing

Marginal Productivity:
Learning Module: 1
Holding all other inputs constant, the marginal product Benefits from increased productivity: An increase in
of an input declines when additional units of a variable productivity lowers production costs, which leads to
input are added to fixed inputs e.g. marginal product of greater profitability and investment value in following
a worker is less than the marginal product of the previous way:
worker. • Lower business costs eventually enhance
profitability and increase shareholders’ wealth;
§ Decreasing marginal returns results from and
adding more and more variable input (e.g. • an increase in worker rewards, which motivates
labor) to fixed plant size. further productivity increases from labor.
§ Assuming all workers of equal quality and
same motivation, law of diminishing marginal Firms who transfer some or all of the productivity rewards
productivity is only related to short run when at to non-equity holders (e.g. consumers in the form of
least one factor of production (e.g. plant size,
lower prices and to employees in the form of enhanced
physical capital) is fixed.
compensation) become more competitive and create
§ Marginal returns are directly related to input
productivity. synergies that benefit shareholders over time.
Total, Average, and Marginal Product

Productivity:
of Labor
The Relationship between Production and Cost
Total product (TP or Q) is the total quantity of a good

Cost of Firm’s Inputs: The cost of firm’s inputs depends on
produced in a given period from using all inputs e.g.,
amount of inputs/factors of production + input prices
total output produced using Labor (L).
Assuming two inputs labor L (measured as employee

time; labor hours) & capital K (measured as hours of Ø Total product indicates an output rate i.e. the
number of units produced per unit of time.
capital,)
Ø Total product increases as the quantity of input
e.g. labor employed increases.
TC = (w)(L) + (r)(K) Ø Total product provides information regarding
firm’s production volume relative to the industry
Where, and its potential market share. Greater the total
TC = Total cost of production product of a firm, greater its market share will
be.
w = Wage rate
L = Number of hours of labor
r = rental rate of machines Flaw: Total product does not provide information about
K = Number of hours of capital how efficiently a firm produces its output.
Average product: It is the average amount produced by

Total cost of production
each unit of a variable input i.e.
= (Number of hours of labor × Wage rate) + (Number of
machine hours × rental rate of machines) AP = Total product / Quantity of labor
= TC = (w)(L) + (r)(K) Or
AP = Q / L
Cost Function: is a relation between cost of production
§ It is used to measure average productivity of
and firms output.
inputs.
§ Greater the AP of a firm, more efficient it is.
Cost function C = f(Q) § When a firm maintains its higher average
productivity in the long-run, its costs decrease
and profit increases relative to other firms in
Where (Q) denotes the flow of output in units of the market. Consequently, it can generate the
production per time period. greatest return on investment.
Cost of production at any given level of output falls Marginal Product: Marginal product is the additional
(rises) due to two reasons, i.e., either prices of one or output that can be produced by employing one more
both inputs fall (rise) or productivity of inputs increases unit of a specific input, all other inputs held constant.
(decreases).
MP = ΔTP / ΔL
Learning Module: 1
Or case, AP is the preferred measure of productivity

MPL = ∆ in Output / ∆ in Number of workers performance.
Increasing marginal returns: Increasing marginal returns

§ MP is used to measure the productivity of each
unit of input. occur when the marginal product of an additional input
§ MP is a better productivity measure relative to increases when additional units of input are employed
TP because it provides insight into the e.g. marginal product of worker exceeds the marginal
competitive advantage and production product of the previous worker.
efficiency of a firm.
§ MP represents the slope of the production
function. § Increasing marginal returns results from
§ Production function becomes flatter when increased specialization and division of
marginal product of labor decreases. labor in the production process.
§ When the slope of the total product function is § However, after a certain level of output, the
highest i.e. at point A, then marginal product is law of diminishing returns starts.
highest.
§ When total product is maximum (i.e. at point C),
the slope of the total product function is zero,
and marginal product intersects the horizontal
Curriculum.
axis.
Flaw: It is difficult to measure individual worker

productivity when work is performed collectively. In this
8. ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT
• Explicit costs refer to payments made to non-

Economic Profit = Total Revenue – Explicit Costs – Implicit owner parties for the services or resources
Costs provided by them. These costs require an outlay
of money, e.g. worker’s wages, electricity, cost
Or of machines, rent etc. In addition, total
accounting costs include interest expense i.e.
Economic Profit = Accounting Profit – Implicit Costs payments made to suppliers of debt capital.
• Implicit costs do not require a cash outlay, e.g.,
Or the opportunity costs of the owner’s time and
physical capital (equipment and space).
Economic Profit = Total Revenue – Total Economic Costs
Ø It is also known as abnormal or supernormal Economic cost takes into account the total opportunity
profit. For example, for a publicly traded cost of all factors of production. Opportunity cost is the
company, next best alternative forgone in making a decision.
Economic Profit = Accounting profit – Required return on Sunk Cost: The money spent in the past on the firm’s
equity capital plant and equipment is called a “sunk cost.” Because
sunk costs cannot be altered, they are ignored.
Accounting profit =Total Revenue – Total Accounting
Costs Accounting Depreciation: It refers to distributing the
historical cost of the fixed capital among the units of
Economic Cost vs. Accounting Cost production for financial reporting purposes. Accounting
depreciation is backward looking. This depreciation is
Economic costs = Explicit costs + Implicit costs useful for spreading historical costs for reporting or tax
purposes.
Where,
Economic depreciation: It refers to distributing the
historical cost across units of output that are intended to
Learning Module: 1
produce this period. Economic depreciation is forward Accounting and Economic depreciation do not
looking. It is useful for making managerial decisions necessarily have a direct relationship.
about output.
MARGINAL REVENUE, MARGINAL COST, AND PROFIT

9. MAXIMIZATION; SHORT-RUN COST CURVES: TOTAL, VARIABLE,
FIXED, AND MARGINAL COSTS
Long-run MC is the additional cost of all inputs necessary

Marginal Revenue, Marginal Cost, and Profit to increase the level of output, allowing the firm the
Maximization flexibility of changing both labor and capital inputs to
maximize efficiency.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝚫𝐓𝐑
Marginal Revenue (MR)=
𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚
= 𝚫𝐐 Cost is directly related to input prices and inversely
related to productivity. For example, if the wage rate
§ Change in total revenue (ΔTR), the numerator of rises, cost would also rise. If productivity of labor
the ratio, can be written as (P)(ΔQ) + (Q)(ΔP) è increases, cost would fall.
MR = P + Q(ΔP/ΔQ) è so,
Variable cost (VC): It is a cost that varies with the level of
§ MR is equal to price with an adjustment equal to production or sales.
quantity times the slope of the demand curve.
Total variable cost (TVC) is the sum of all variable costs or
In perfect competition, an individual firm represents a it is equal to:
small seller among a large number of firms in the industry
TVC = VC per unit × Q
selling identical goods/services & no pricing power.
TVC increases (decreases) when quantity increases
• In perfect competition, a firm faces an infinitely (decreases).
elastic demand curve i.e. zero slope.
• For a perfectly competitive firm, in the equation, Average variable cost (AVC) is the ratio of total
MR = P + Q(ΔP/ΔQ) if we substitute ΔP/ΔQ as 0 variable cost to total output:
then MR = P
• Firms in imperfect competition faces negatively 𝑻𝑽𝑪
AVC =
sloped demand curve i.e. ΔP/ΔQ < 0 𝑸
• For firms operating in inperfectly competitive
market, in the equation, MR = P + Q(ΔP/ΔQ) as If the wage rate rises, AVC would also rise. If
ΔP/ΔQ is negative therefore MR < P productivity of labor increases, AVC would fall. This
relationship is captured by the following expression
Marginal cost (MC): It is the increase in Total Cost from
𝒘
producing one more unit AVC =
𝑨𝑷𝑳
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 𝚫𝐓𝐂
Marginal Cost =
𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚
= 𝚫𝐐
Ø As the Marginal productivity of labor (MPL)
increases, SMCs decline. Eventually, as more
Note: Labor is variable over the short run, but capital is
and more labor is added to a fixed amount of
not variable over the short run.
capital, the MPL must fall, causing SMCs to rise.
Shor-run MC is the additional cost of the variable input Ø A profit-seeking firm should increase Q if MR >
(e.g. labor), that must be incurred to increase the level MC.
of output by one unit.
SMC = w/MPL
Learning Module: 1
Profit-maximization decision for an operating firm Ø Please refer to chart below. As output quantity
depends on two conditions, that is, Produce the level of increases, AFC declines because TFCs are
output such that spread over a larger number of units.
Ø Both ATC and AVC take on a bowl-shaped
pattern in which each curve initially declines,
i. MR = MC and
reaches a minimum average cost output level,
ii. MC is not falling.
and then increases after that point.
Ø The MC curve intersects both the ATC and the
If MC is falling with additional output, MPL would be
AVC at their minimum points—points S and T.
rising and firm will continue adding labor.
Ø When MC is less than AVC, AVC will be
decreasing. When MC is greater than AVC, AVC
§ When MR > MC→ profit can be increased
will be increasing.
by increasing output.
§ When MR < MC→ profit can be increased
by decreasing its output.
Understanding the Interaction between Total,

Variable, Fixed, and Marginal Cost and Output
Fixed cost (FC): It is any cost that does not depend on

the firm’s level of output e.g. loan payments, rent etc. In
short run, firms have no control over fixed costs.
• S is the point where MC equals AVC. Beyond
Therefore, fixed costs are also known as sunk costs.
quantity QAVC, MC is greater than AVC; thus,
the AVC curve begins to rise. Note that it occurs
Quasi-fixed cost: It is the fixed cost that changes when at a quantity lower than the minimum point on
production moves beyond certain range e.g. certain the ATC curve.
utilities, administrative salaries etc. • T is the point where MC equals ATC. Beyond
Fixed cost can be viewed as normal profit because it quantity QATC, MC is greater than ATC; thus, the
represents a return required by investors on their equity ATC curve is rising.
• A is the amount of AFC and is represented by
capital irrespective of the output level.
the difference between ATC and AVC at output
quantity Q1.
Total fixed cost (TFC) is the sum of all fixed costs. It • R indicates the lowest point on the MC curve.
remains constant over a range of production level e.g. Beyond this point of production, fixed input
debt service, real estate lease agreements etc. constraints reduce the productivity of labor.
• X indicates the difference between ATC and
AVC at quantity Q2. It is less than A because
Total variable cost (TVC) is the sum of all variable
AFC (Y) falls with output.
expenses; TVC rises with increased production and falls
with decreased production. At zero production, TC is
TC increases as the firm expands output and decreases
equal to TFC because TVC at this output level is zero. The
when production is reduced. TC increases at a
curve for TC always lies parallel to and above the TVC
decreasing rate up to a certain output level. Thereafter,
curve by the amount of TFC as depicted below.
the rate of increase accelerates as the firm reaches its
full capacity utilization level. The rate of change in TC
mirrors the rate of change in TVC.
Relationship between average and marginal costs:

• If MC < average cost, average cost must fall,
and
• If MC > average cost, average cost must rise.
• Initially, the MC curve declines because of
increasing marginal returns to labor, but at some
point, it begins to increase because of the law of
diminishing marginal returns.
Learning Module: 1
Ø However, it should be noted that the minimum

point on the AVC does not represent the least-
cost quantity for average total cost.
𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕
Average total cost (ATC) = =
𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚
or
ATC = AFC + AVC
Ø The average total-cost (ATC) curve is U-shaped.

At very low levels of output, ATC is high because
fixed cost is spread over only a few units.
Ø ATC declines as output increases because fixed
cost is spread over more units.
Ø As output increases further, AFC falls and leads
Dividing TFC by quantity yields AFC. AFC decreases to decrease in ATC. However, AVC rises with
increase in quantity and leads to increase in
throughout the production span, reflecting the
ATC.
spreading of a constant cost over more and more
Ø The lowest AVC quantity does not correspond to
production units. At high production volumes, AFC may the least-cost quantity for ATC because AFC is
be so low that it is a small proportion of ATC. still declining.
Ø The minimum point of the ATC represents the
Average fixed cost (AFC): It is the total fixed cost (TFC) least cost output level. İt represents the output
divided by the number of units of output (q). It level where the per-unit profit (not total profit) is
decreases with the increase in output. maximized.
Average variable cost (AVC): It is the total variable cost

(TVC) divided by the number of units of output (q).
Curriculum.
Ø Initially, AVC decreases when output increases

and then reaches a minimum point. Afterwards,
AVC increases with an increase in production
level.
10. PERFECT AND IMPERFECT COMPETITION, PROFIT MAXIMIZATION
Revenue under Conditions of Perfect and Imperfect sell an additional unit, so its MR is less than
Competition price (P).
§ The TR curve for the firm under conditions of
perfect competition is linear, with a slope
Perfectly competitive market: If a market is perfectly equal to price per unit.
competitive, the firm must take the market price of its
output as given, so it faces a perfectly elastic, horizontal Imperfect Competition: Under conditions of
imperfect competition (e.g. monopoly), price is a
demand curve. In this case, the firm’s will be equal to
function of quantity: P = f(Q), and TR = f(Q) × Q.
price of its product.
§ Initially, a decrease in price increases total
Additionally, the firm’s average revenue (AR), or revenue expenditure by buyers and TR to the firm
per unit, is also equal to price per unit. Under conditions because the decrease in price is
of perfect competition, TR (as always) is equal to price outweighed by the increase in units sold. But
times quantity. as price continues to fall, the decrease in
price outweighed the increase in quantity,
and total expenditure (revenue) falls.
§ However, a firm that faces a negatively
§ The TR curve for the monopolist first rises (in
sloped demand curve must lower its price to
the range where MR is positive, and
demand is elastic) and then falls (in the
Learning Module: 1
range where MR is negative and demand is possible in the short run, but in the long run,
inelastic) with output. competitors would enter the market to capture
some of those profits and would drive the
market price down to a level equal to each
firm’s ATC.
Profit-Maximization, Breakeven, and Shutdown Points Demand and Average and Marginal Cost Curves for the
of Production Monopolistic Firm
Demand and Average and Marginal Cost Curves for the Refer to the graph below. Q* is the level of output where
Firm under Conditions of Perfect Competition SMC is equal to MR. At this output, the optimal price to
charge is given by the firm’s demand curve at P*. This
• The following graph shows that the firm is monopolist is earning positive economic profit because
maximizing profit by producing Q*, where price its price exceeds its ATC. Due to monopolistic power of
is equal to SMC and SMC is rising. this firm, the outside competitors would not be able to
compete away this firm’s profits.
• Note that at output level, Qʹ′, where P = SMC,
but at that point, SMC is still falling, so this cannot
be a profit-maximizing output.
• If market price rises, the firm’s demand and MR

curve would simply shift upward, and the firm
would reach a new profit-maximizing output
level to the right of Q*.
• If market price falls, the firm’s demand and MR

curve would shift downward, resulting in a new
and lower level of profit-maximizing output.
• In following case, this firm is currently earning a

positive economic profit because market price
exceeds ATC at output level Q*. This profit is
11. BREAKEVEN ANALYSIS AND SHUTDOWN DECISION
Economic costs = Total accounting costs + Implicit

Breakeven Analysis opportunity costs
Break-even price: It refers to a price where economic • When a firm’s revenue is equal to its economic
costs, it means it is covering the opportunity cost
profit is zero i.e. P = ATC. It is the output level where P =
of all of its factors of production, including capital.
AR = MR = ATC or where TR = TC. Such a firm is earning normal profit, but not
positive economic profit.
Learning Module: 1
• A firm that operates in a very competitive

environment with no barriers to entry from other
competitors cannot earn a positive economic
profit because the excess rate of return would
attract entrants who would produce more output
– pushing downward pressure on price. However,
this situation does not imply that the firm is earning
zero accounting profit.
In figure ‘B’ above, the level of output at which SMC is

equal to MR, price is just equal to ATC. This shows that a
firm is breaking even and earning economic profit.
ECONOMIES AND DISECONOMIES OF SCALE WITH SHORT-RUN

12.
AND LONG-RUN COST ANALYSIS
operate. At a price below P2, the minimum AVC, the firm

The Shutdown Decision could not even cover its variable cost and should shut
down. At prices between P2 and P1, the firm should
continue to operate in the short run because it is able to
The Shutdown Point: The firm will shut down if total
cover all of its variable cost as well as some of its fixed
revenues generated by a firm are not enough to cover
costs. The shutdown point is the minimum AVC point and
average variable costs.
the minimum ATC point is the breakeven point.
• A firm should continue to produce as long as

Price > Average variable cost. However, it
should be noted that that at that price, firm
incurs losses. Sunk costs must be ignored in the
decision to continue to operate in the short run.
• When Price < AVC, it is preferable for a firm to
shut down temporarily in order to save the
variable costs. However, firm still has to pay fixed
costs.
• If price is greater than AVC, the firm is not only
covering all of its variable cost but also a portion
of fixed cost.
• If all fixed costs are sunk costs, then the
shutdown point is when the market price falls
below minimum average variable cost. At this
price, the firm incurs only fixed cost and loses less
money than when operating at a price that
does not cover variable cost.
Refer to the graph next: At any price above P1, the firm
can earn a positive profit and clearly should continue to
Learning Module: 1
In the long-run (under perfect competition), profit is The long run is the time period during which all factors of
maximized at the level of output where the firm’s long- production are variable. In addition, in the long-run, firms
run average total cost is at minimum level i.e. minimum can enter or exit the market based on decisions
point of the firm’s long-run average total cost curve. In regarding profitability.
the short-run, supply curve of a competitive firm is that
part of MC curve that lies above the Average Variable The long run is also referred to as the “planning horizon”
Cost. However, in the long run, a firm must have its MC > in which the firm can choose the short-run position or
AC in order to remain in the industry. If MC < AC, firm will optimal operating size that maximizes profit over time.
exit the industry in the long run. The firm always operates in the short run but plans in the
Summary: long-run.
The time required for long-run adjustments varies by

• The firm must cover its variable cost to remain in
industry. For example, for a small business, the long-run
business in the short run; if TR cannot cover TVC,
may be less than a year, whereas, for a capital-intensive
the firm shuts down production to minimize loss.
firm, the long run may be more than a decade. Costs
Loss = Amount of fixed cost and profits would differ between the short run and the
long run.
• If TVC exceeds TR in the long run, the firm will exit
the market to avoid the loss associated with
fixed cost at zero production. Short- and Long-Run Cost Curves
• When TR is enough to cover TVC but not all of
TFC, the firm can continue to produce in the The short-run total cost includes all the inputs (i.e., labor
short run but will be unable to maintain financial
and capital) the firm is using to produce output.
solvency in the long run.
Typically, a short-run total cost (STC) curve tends to rise

with output, first at a decreasing rate because of
specialization economies and then at an increasing
rate, reflecting the law of diminishing marginal returns to
labor.
Vertical intercept of the STC curve is determined by total

fixed cost (the quantity of capital input multiplied by the
rental rate on capital). At higher levels of fixed input,
both TFC and production capacity of the firm are
greater.

Understanding Economies and Diseconomies of

Scale
The firm selects an operating size or scale that maximizes

profit over any time frame. The short run is the time
period during which at least one of the factors of
production, such as technology, physical capital, and
plant size, is fixed.
Learning Module: 1
• In the above graph, Plant Size 1 is the smallest discounted prices on resources when bought in
and has the lowest fixed cost; hence, its STC1 large quantities etc.
curve has the lowest vertical intercept. It is • When a firm faces economies of scale, costs
important to note that STC1 begins to rise more can be lowered, and profit can be increased by
steeply with output, reflecting the lower plant increasing production capacity.
capacity.
• Plant Size 3 is the largest of the three and has
both a higher fixed cost and a lower slope at Scale-up production: It involves increasing all of inputs in
any level of output. If a firm decided to produce
order to increase the level of output in the long-run.
an output between zero and Qa, it would plan
on building Plant Size 1 because for any output
Scaling down: It involves decreasing all of the inputs in
level in that range, its cost is less than it would be
for Plant Size 2 or 3. Accordingly, if the firm were order to produce less in the long run.
planning to produce output greater than Qb, it
would choose Plant Size 3 because its cost for Short-run Average Total Cost Curves for Various Plant
any of those levels of output would be lower Sizes and Their Envelope Curve, LRAC: Economies of
than for Plant Size 1 or 2. In this case, Plant Size 2 Scale
would be chosen for output levels between Qa
and Qb.
• The long-run total cost curve is derived from the
lowest level of STC for each level of output
because in the long run, the firm is free to
choose which plant size it will operate. This curve
is called an “envelope curve.”
Note: For each STC curve, there is also a corresponding

short-run average total cost (SATC) curve and a
corresponding long-run average total cost (LRAC) curve, Diseconomies of scale or Decreasing returns to scale: It
the envelope curve of all possible short-run average
occurs when the % change in output < % change in
total cost curves. inputs. E.g. a 50% rise in factor inputs raises output by
only 25%.
Defining Economies of Scale and Diseconomies of

Scale • When an industry/firm has decreasing returns to
scale, its long-run average total cost increases
as the quantity of output increases i.e. long-run
Economies of scale or Increasing returns to scale: It
supply curve is upward sloping. Such an industry
occurs when the % change in output > % change in is called Increasing-cost industry.
inputs. E.g. a 20% rise in factor inputs leads to a 35% rise • Sources: problems associated with large
in output. organizations e.g. Problems of management,
maintaining effective communication,
coordinating activities – often across the globe,
• When an industry/firm enjoys external De-motivation and alienation of staff, Divorce of
economies i.e. has increasing returns to scale, its
ownership, and control etc.
long-run average total cost decreases as the
• When a firm faces diseconomies of scale, costs
quantity of output increases i.e. long-run supply
can be lowered and profit can be increased by
curve is downward sloping. Such an industry is downsizing and becoming more competitive.
called a decreasing-cost industry.
• However, it should be noted that individual firm’s
supply curve is still upward sloping when
industry’s long-run supply curve is negatively Short-run Average Total Cost Curves for Various Plant
sloped i.e. in the long-run, when industry costs ↓, Sizes and Their Envelope Curve, LRAC: Diseconomies of
firm supply curve shifts rightward and it results in Scale
decrease in price charged by a firm for each
quantity.
• Sources of economies of scale: These include
specialization due to greater production,
workers become more efficient due to
specialization, better use of market information,
Learning Module: 1
c) Overlapping and duplication of business functions

and product lines.
d) Higher resource prices due to supply constraints
when buying inputs in large quantities.
Economies and diseconomies of scale can occur at the

same time. If economies of scale dominate
diseconomies of scale, LRAC decreases with increases in
output. Opposite is true if diseconomies of scale
dominate. We can see in the graph below that there is
certain range of output over which LRAC falls
(economies of scale) and then a range over which
As the firm’s size increases, it benefits from economies of LRAC is constant, followed by a range over which
scale and a lower ATC owing to following factors: diseconomies of scale prevail
a) Increasing returns to scale, which occurs when a

production process allows for increases in output
that are proportionately larger than the increase
in inputs.
b) Having a division of labor and management in a
large firm with numerous workers, which allows
each worker to specialize in one task rather than
perform many duties.
c) Using more expensive & efficient equipment and
adapting the latest in technology that increases
productivity. Minimum efficient scale: The minimum point on the LRAC
d) Effectively reducing waste and lowering costs
curve is referred to as the minimum efficient scale. The
through marketable byproducts, less energy
consumption, and enhanced quality control. minimum efficient scale is the optimal firm size under
e) Using market information and knowledge in a perfect competition over the long run. Theoretically,
better way for more effective managerial under perfect competition, the firm should operate at
decision making. this level over the long-run in order to maintain its
f) Obtaining discounted prices on resources when viability.
buying in larger quantities.
The factors that can lead to diseconomies of scale, Practice: Example 7, CFA Institute’s
Curriculum.
inefficiencies, and rising costs when a firm increases in
size include the following:
a) Decreasing returns to scale, which occurs when a Practice: CFAI End of Chapter
production process leads to increases in output Practice Problems and Questions
that are proportionately smaller than the increase from FinQuiz Question bank.
in inputs.
b) Difficulty in managing the firm properly owing to
its large size.
ECO The Firm and Market Structures
Learning Module 2
1. INTRODUCTION & ANALYSIS OF MARKET STRUCTURES
In the long run, the forces associated with the market 4) Monopoly
structure within which the firm operates determine the
profitability of the firm.
Factors That Determine Market Structure
• In a highly competitive market, long-run profits are Following five factors determine market structure.
decreased by the forces of competition.
• In less competitive markets, large profits can
1) The number and relative size of firms supplying
persist in the long-run.
the product i.e., greater the number of firms
• In the short-run, any outcome is possible.
supplying the product, greater will be the
competition.
Analysis of Market Structure
2) The degree of product differentiation: Higher
product differentiation provides pricing leverage
Economists’ Four Types of Structure
i.e., control over pricing decisions.
Market: A market is a group of buyers and sellers that are
3) The power of the seller over pricing decisions.
aware of each other and are able to agree on a price
for the exchange of goods and services.
4) The relative strength of the barriers to market
entry and exit: Barriers can result from large
Some markets are highly concentrated i.e. sales
capital investment requirements, patents, high
generated from a small number of firms represent the
exit costs etc. Smaller the barriers to entry and
majority of total sales; whereas some markets are very
exit, greater will be the competition.
fragmented.
5) The degree of non-price competition: Non-price
There are four types of market structure:
competition refers to product differentiation
through marketing. It prevails in market structures
1) Perfect competition where product differentiation is essential e.g.
monopolistic competition.
2) Monopolistic competition
3) Oligopoly
Degree of Pricing
Number of Barriers Non-Price
Market Structure Product Power of
Sellers to Entry Competition
Differentiation Firm
Homogeneous/ Very
Perfect Competition Many None None
Standardized Low
Advertising and
Monopolistic
Many Differentiated Low Some Product
Competition
Differentiation
Some or Advertising and
Homogeneous/
Oligopoly Few High Considera Product
Standardized
ble Differentiation
Very Considera
Monopoly One Unique Product Advertising
High ble

Learning Module 2
• From the consumers’ perspective, the most A financial analyst should evaluate the following factors
desirable market structure is the one with the when analyzing market conditions in which firm operates
greatest degree of competition, due to low and its profitability:
prices.
1. Threat of substitutes i.e. evaluate whether the
• From the perspective of producers the most product is differentiated or not.
desirable market structure is the one in which the 2. Threat of entry
seller has the most control over prices. 3. Intensity of competition among incumbents i.e.
evaluate how many sellers are there in the
industry.
Porter’s Five Forces and Market Structure 4. Bargaining power of customers
5. Bargaining power of suppliers
2. PERFECT COMPETITION
Characteristics In perfect competition, total quantity supplied and

demanded is mainly determined by price while non-
1) Free entry and exit to industry i.e. low barriers to price factors are not important.
entry and exit.
2) Homogenous product i.e. identical goods and Total revenue increases by a constant amount i.e. price
thus no consumer preference. level with per-unit increase in quantity. At zero quantity,
3) Large number of buyers and sellers i.e. no total revenue is equal to zero.
individual seller can influence price.
4) Sellers are price takers i.e. they have no market- When there is perfect competition, Marginal Revenue =
pricing power. Average Revenue = Price = Demand
5) There is no non-price competition. i.e. MR = AR = P = D.
Whereas in imperfect competition, MR decreases as

Advantages of Perfect Competition:
output increases and MR is less than AR at any positive
quantity level.
• High degree of competition helps in efficient
allocation of resources. Marginal revenue, Average revenue, & Price only
• In the long run, firms can make only normal profit. changes when there is shift in demand and/or supply
• Firms operate at maximum efficiency. curve i.e. if demand increases and demand curve shifts
• Consumers benefit because it provides the largest upward, MR, AR and price increase.
quantity of a good at the lowest price.
The Average Total-Cost (ATC) and Marginal Cost curves
Demand Analysis in Perfectly Competitive are U-shaped.
Markets
Initially, MC and Average Cost decrease when output
In perfect competition, an individual firm represents a increases. Afterwards, MC and AC increase with an
small seller among a large number of firms in the industry increase in output due to law of diminishing returns.
selling identical goods/services.
Average cost (AC) = MC at the output level where AC is
In perfect competition, a firm faces an infinitely elastic minimized.
demand curve i.e. a horizontal line at the market
equilibrium price as shown in the figure below. (Unlike a Short-run: In the short-run, firms make economic
monopolist who faces downward sloping demand profit/loss.
curve).
In the long-run, other firms enter the industry to take
Price is determined by the market supply and demand advantage of abnormal profit→ Supply increases →
which implies that shifts in supply curve of a single firm price falls and consequently firms make normal profit
does not affect market price i.e. competitive firm is a only.
price taker. Whereas in imperfect competition, an
individual firm has some control over the price at which it This implies that in the long run, a perfectly competitive
sells its product and thus has downward sloping demand firm generates zero economic profit due to low barriers
curve. to entry and homogeneous products.

Learning Module 2
3. ELASTICITY OF DEMAND
Impact on Total Revenue:

It is the responsiveness of quantity demanded to change
When demand is elastic:
in price (all else held constant). It is computed as the
percentage change in quantity demanded divided by Price and total revenue move in opposite direction.
the percentage change in price. % Δ in Qd > % Δ in P, therefore:
Percentage change in quantity demanded • Increasing price results in decrease in total

𝐄𝐃 =
Percentage change in price revenue.
• Reducing price results in increase in total revenue.
:! ;:"
" • This implies that if a firm is operating at elastic
%∆𝑸 (: =:! )
! "
𝑬= = ?! ;?" portion of demand curve, increasing prices leads
%∆𝑷 "
(?" =?! ) to decrease in total revenue.
!
If demand is inelastic:
• According to the law of demand, quantity
demanded is inversely related to price. Thus the Price and total revenue move in same direction.
price elasticity of demand is always negative.
% Δ in Qd < % Δ in P, therefore:
Elastic demand: When % change in demand is greater
than % change in price i.e. |E|>| • Increasing price results in increase in total
revenue.
Inelastic demand: When % change in demand is less • Reducing price results in decrease in total
than % change in price i.e. |E|<| revenue.
• This implies that if a firm is operating at inelastic
Unit Elastic: When % change in demand is equal to % portion of demand curve, increasing prices leads
change in price i.e. |E|=1. to increase in total revenue.
If demand is unitary inelastic: Changes in Price are not

associated with changes in total expenditure.
Total revenue is maximized at a point where demand is

unit-elastic.
Total revenue is maximized at a point where Marginal

revenue (MR) = 0.
• When MR is positive, selling additional units results

in increase in total revenue.
• When MR is negative, selling additional units results
• As we move down along the demand curve, the
in decrease in total revenue.
price elasticity changes from elastic to unit-elastic
• Relationship between MR and price elasticity:
to inelastic.
MR = P {1 – (1 / price elasticity)}
• This implies that % change in Quantity demanded
decreases as % change in price increases.
Effect of steepness/flatness of demand & supply curve
on the price elasticity:
NOTE:
The steeper the curve at a given point, the less elastic
• Elasticity is independent of units. supply or demand will be.
• Elasticity is related to slope but it is not the same
as slope. When the curves are flat (horizontal), supply & demand
• Elasticity changes along straight-line demand and curves are referred to as perfectly elastic i.e. E = infinity. It
supply curves. implies that demand is affected by any change in price.
This is the demand schedule faced by a perfectly

competitive firm because it is a price taker.
Learning Module 2
When the curves are vertical, supply & demand curves

are referred to as perfectly inelastic i.e. E = 0. It implies Generally: Higher (lower) the price, more (less) elastic
that changes in price have no effect on consumer demand will be.
demand.
Determinants of Elasticity:
1) Time period: Longer the time interval considered (i.e.
in the long run), more elastic is the good’s demand
curve.
2) Number and closeness of substitutes: Greater the

number of substitutes a good has, more elastic is its
demand.
3) The proportion of income taken up by the product:

The larger (smaller) the proportion of one's budget
represented by a good, the more (less) elastic its
demand will be.
4) Luxury or Necessity: Demand for necessities is less

elastic whereas demand for luxury goods is more
elastic.
4. OTHER FACTORS AFFECTING DEMAND
Income Elasticity of Demand: It is the measure of NOTE:

responsiveness of demand to changes in income of
A good that is normal for one income group can be
consumers (all else held constant).
inferior for other income group.
Percentage change in quantity (Q) Technical Difference between Price elasticity and
𝐄𝐃 =
Percentage change in Income(I) Income elasticity:
:! ;:"
" • In case of price elasticity, demand is adjusted by
%∆𝑄 (: =:! )
! "
𝐸= = F! ;F"
a movement along the demand schedule.
%∆𝐼 " • In case of income elasticity, demand is adjusted
(F =F )
! " !
by a shift in the demand curve because as
income increases, consumer’s purchasing power
Normal Good: When demand of a good rises (falls) as increases.
income rises (falls), it is referred to as normal good.
Normal goods have positive income elasticity e.g.
Cross Elasticity: It is the measure of the responsiveness of
restaurant meal.
demand of one good to change in the price of a
related good i.e. substitute or a complement (all else
• Increase in income causes the demand curve to held constant).
shift upward and to the right, which results in
increase in demand. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋
𝐸G =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑌
Inferior Good: When demand of a good falls (rises) as
income rises (falls), it is referred to as inferior good. Complements: Cross Elasticity of demand is negative for
Inferior goods have negative income elasticity e.g. goods that are complements i.e. when price of one
potatoes, rice. good rises, demand for other good falls.
• Increase in income causes the demand curve to • When price of one good rises, demand curve for
shift downward and to the left, which results in other good shifts downward to the left.
decrease in demand.
Learning Module 2
Substitutes: Cross Elasticity of demand is positive for • Greater the number of substitutes available and
goods that are substitutes i.e. when price of one good closer the substitutes, lower the pricing power of
rises, demand for other good also rises. firms selling in that market.
• When price of one good rises, demand curve for

other good shifts upward to the right.
5. CONSUMER SURPLUS: VALUE MINUS EXPENDITURE
Consumer Surplus: It is stated as follows: • As shown in the figure, consumer surplus

CS = Value that a consumer places on units consumed – represents the area under consumer's demand
Price paid to buy those units curve above market price up to quantity that
CS = Value – Expenditure consumer buys.
• This area is computed as follows:
Area = ½ (Base × Height) = ½ {Q0 × (intercept –P0)}
• Demand curve can be viewed as a marginal
revenue curve as it shows the highest price
consumers would be willing to pay for each
additional unit.
SUPPLY ANALYSIS & OPTIMAL PRICE AND OPTIMAL OUTPUT IN

6.
PERFECTLY COMPETITIVE MARKETS
The quantity supplied of a good is directly related to its 2 3 4 3+4=7

price i.e. when price of the good increases (decreases),
quantity supplied increases (decreases).
Optimal price and output in
perfectly competitive markets
Please refer to Section 2
Market supply: It is the horizontal sum of all individual

supplies (quantity supplied not prices) at each possible
price.
For example, if there are two producers A and B in the

market, then market supply is determined as follows.
Price of Producer Producer Market

pencil A B Supply
($) Supply Supply
0.50 0 0 0 + 0 =0
1 1 0 1 + 0 =1
Learning Module 2
7. LONG-RUN EQUILIBRIUM IN PERFECTLY COMPETITIVE MARKETS
The Perfectly Competitive Firm in Long-Run Equilibrium How an Increase in Demand Changes Long-Run
Equilibrium for the Firm and Industry
• As shown in the figure, the long-run MC schedule

represents the supply curve of a perfectly How a Decrease in Demand Changes Long-Run
competitive firm. Equilibrium for the Firm and Industry
• In the long-run, profit is maximized at the output
level where MC = Minimum of Average cost.
• At equilibrium point, P = MC = Min AC so that TR =
TC.
• This implies that in the long-run, a perfectly
competitive firm generates zero economic profit
due to low barriers to entry and homogeneous
products.
In the long-run, other firms enter the industry to take

advantage of abnormal profit→ Supply increases →
price falls and consequently firms make normal profit
only.
8. MONOPOLISTIC COMPETITION
Monopolistic competition is a hybrid market because Demand Analysis in Monopolistically Competitive

each firm may have a tiny ‘monopoly’ due to Markets
differentiation of their product and each firm generates
zero economic profit in the long-run. Monopolistic competition firm has a downward sloping
demand curve due to its product differentiation.
Characteristics:
Along the demand curve, at higher prices, demand is
1. Many buyers and sellers elastic and at lower prices, demand is inelastic.
2. Products differentiated i.e. each firm produces a
product that is at least slightly different from Like monopoly, price exceeds marginal cost.
those of other firms. The products represent close
substitutes for products offered by other firms. Like competitive market, price equals average total cost
3. Entry and Exit possible with fairly low costs. in the long-run.
4. Firm has some control over price.
5. Suppliers differentiate their products through Due to downward-sloping demand curve, marginal
advertising and other non-price strategies. revenue is less than price.
Learning Module 2
The Monopolistically Competitive Firm in the Short Run: • Demand for the incumbent firms’ products fall,
In the short-run, Profit is maximized where MR = MC. and their profits decline.
There is no well-defined supply schedule in monopolistic Short-run economic losses encourage firms to exit the
competition i.e. supply curve is neither represented by market. This leads to:
MC nor AC curve.
• Decrease in the number of products offered.
Output level is determined at a point where MR = MC • Increase in the demand faced by the remaining
and price is charged on the basis of market demand. firms.
• Shifts the remaining firms’ demand curves to the
Short-run economic profits encourage new firms to enter right.
the market. This leads to: • Increase in the remaining firms’ profits.
• Increase in the number of products offered.

• Reduction in demand faced by firms already in
the market.
• Incumbent firms’ demand curves shift to the left.
9. LONG-RUN EQUILIBRIUM IN MONOPOLISTIC COMPETITION
Like in case of perfect competition, free entry and exit

drive economic profit to zero. In monopolistic competition, output is less than the
efficient scale of perfect competition.
Differences between Monopolistic Competition and
Perfect Competition: For a competitive firm, P = MC; whereas for a
monopolistically competitive firm, P > MC. Consequently,
In perfect competition, there is no excess capacity in the an extra unit sold at the posted price indicates greater
long run. Due to free entry, competitive firms produce at profit for the monopolistically competitive firm. This results
the point where average total cost is minimized, which is in deadweight loss.
the efficient scale of the firm.
Unlike perfect competition, in monopolistic competition,
But in monopolistic competition, equilibrium occurs at a economic costs include advertising or marketing costs.
higher level of average cost instead of output level
where AC is the minimized.
10. OLIGOPOLY AND PRICING STRATEGIES
Characteristics: charge. However, even in absence of price collusion, a

dominant firm can easily become a price maker in the
1. Few sellers offering similar or identical products. market. When firms collude:
2. Industry dominated by small number of large
firms. • Profit increases.
3. Products offered by each seller are close • Uncertainty of cash flows reduces.
substitutes of products offered by other firms. • Provide opportunities to create barriers to entry.
4. Interdependent firms i.e. their price decisions are
interdependent on each other. Cartel: Cartel refers to collusive agreements that are
5. Barriers to entry and exist are high i.e. fairly high made openly and formally e.g. OPEC cartel.
costs.
6. Firms have substantial control over price. Oligopoly firms can generate higher profits by
7. Products are differentiated through advertising cooperating / joining together and acting like a
and other non-price strategies. monopolist i.e. by producing a small quantity of output
and charging a price above marginal cost.
Duopoly: A duopoly is an oligopoly with only two firms. It
is the simplest type of oligopoly. Factors necessary for a collusion to be successful:
Price Collusion: Price collusion refers to agreement 1) There is small number of firms in the industry.
among firms on the quantity to produce and price to
Learning Module 2
2) Product produced by the firms is identical /

similar.
3) Firms have similar cost structure.
4) Orders received by firms are small in size and are
frequent i.e. receive on a regular basis.
5) Firms face severe threat of retaliation by other
firms in the market; therefore, there are few
opportunities to keep actions secret.
6) The degree of external competition.
Demand Analysis and Pricing Strategies in

10.1 This implies that in case of a kinked demand curve,
Oligopoly
individual firms are disadvantaged by reducing prices.
In oligopoly, demand depends on the degree of price Therefore, these markets tend to be characterized by
interdependence. price rigidities.
In case of price collusion, aggregate market demand NOTE:

curve is composed of individual sellers. In case of Kinked demand curve, each demand curve
will have its own marginal revenue structure.
In case of non-collusion, each firm faces an individual
demand curve. In non-colluding oligopoly, market • Demand function (DP ↑) and Marginal revenue
demand depends on the pricing strategies of the firms.
structure (MRP ↑) associated with higher prices.
There are three basic pricing strategies.
• Demand function (DP ↓) and Marginal revenue
1) Pricing Interdependence: In this strategy, firm’s pricing
structure (MRP ↓) associated with lower prices.
decisions depend on each other. This strategy is used
in the market where there are price wars e.g.
Commercial Airline industries. The two demand structures intersect at the prevailing
price i.e. where price increase = price decrease = 0.
In this strategy, when a firm reduces its price, the

competitor follows the same and ignores price See: Exhibit 13 & 14, CFA Institute’s
increase. This implies that firms face two demand Curriculum.
structures i.e. one related to price increase and other
related to price decrease. It is referred to as kinked
demand curve i.e. In oligopoly, firm’s demand curve is represented by
relevant portion of demand schedule when price
increases and relevant portion of demand schedule
when price decreases.
• When one firm increases price, competitor firm’s
market share increases, when other does not
Overall Demand = DP ↓+ DP ↑
match price increase.
= Demand segment associated with
• When one firm reduces price, there is no change
price decrease + Demand segment
in competitor firm’s market share, when other
associated with price increase
matches price decrease.
• Due to kinked demand curve, oligopoly markets

Reason: Price elasticity of demand is greater at higher
have stable and rigid pricing structure.
prices because firm’s rivals have lower prices; whereas
price elasticity of demand is lower at lower prices
because firm’s rivals will match decrease in price.
Learning Module 2
11. THE COURNOT ASSUMPTION
• Compared to perfect price competition, Cournot

Cournot Assumption: In a Cournot model, it is assumed equilibrium price will be higher and equilibrium
that firms make pricing and output decisions output level will be lower.
simultaneously. In Cournot assumption, profit maximizing • Compared to monopoly, Cournot equilibrium
output by each firm is determined by assuming no price will be lower and equilibrium output level will
change in other firm’s output i.e. there is no retaliation be higher. This implies that total profits are less
than the monopoly profit. See exhibit 14.
by other firms.
• As the number of sellers in an oligopoly grows
larger, an oligopolistic market looks more and
In this strategy, this pattern continues until each firm
more like a competitive market. The price
reaches its long-run equilibrium position. In the long-run, approaches marginal cost, and the quantity
both price and output are stable and change in either produced approaches the socially efficient level.
price or output will not increase profits for any firm.
12. THE NASH EQUILIBRIUM
Nash Equilibrium: Game theory refers to the study of how • Joint profit is maximized when both firms charge
people behave in strategic situations. It is used by higher prices for their products i.e. joint profit =
decision makers to analyze responses by rival decision $500 + $300 = $800.
makers.
Stackelberg Model: In a Stackelberg model, it is
In game theory, a Nash equilibrium is a situation in which assumed that firms make pricing and output decisions
different firms in oligopoly interacting with one another, sequentially i.e.
choose their best strategy, given the strategies that all
the others have chosen (i.e. Dominant Strategy). In
oligopoly, this implies that in Nash equilibrium, no firm • The leader firm chooses its output first because it
can increase its profits by independently changing its has the first mover advantage.
pricing strategy. Thus, • After observing the leader’s output, the follower
firm chooses its output.
• To force the follower firm to reduce production or
• Firms have interdependent actions because their to exit the market, the leader firm may
profit depends not only on how much they aggressively overproduce. It is referred to as “Top
produce but also on how much the other firms Dog” strategy.
produces. • Compared to Cournot model, the leader firm
• These actions are non-cooperative i.e. each firm’s earns more while the follower firm earns less in a
decisions are made to maximize its own profits. Stackelberg model.
• Firms do not collude to maximize joint profits.
• Equilibrium occurs when all firms choose their best
strategy given the actions of their rivals.

Learning Module 2
OLIGOPOLY MARKETS: OPTIMAL PRICE, OUTPUT

13.
& LONG-RUN EQUILIBRIUM
difference between market demand and the

Supply Analysis in Oligopoly Markets supply of fringe firms.
• Sum of MC of price followers (fringe firms) > than
that of a price leader (dominant firm). Due to this,
• Like monopolistic competition, there is no well- demand curve of the dominant firm and total
defined supply schedule in oligopoly i.e. supply demand curve are not parallel.
curve is neither represented by MC nor AC curve. • At price P1, the supply of fringe firms = market
• Output level is determined at a point where MR = demand; thus, at price P1 the dominant firm cannot
MC and price is charged on the basis of market sell anything.
demand and output level is determined based • At a price P2 or less, fringe firms will not supply any of
on the relationship between MR and MC. the good, so the dominant firm faces the market
demand curve. Reason is that the dominant firm is
Dominant Firm in Oligopoly: A firm is referred to as low cost producer and therefore, as price
dominant when its market shares ≥ 40%. A firm decreases, fringe (small) firms will not be able to
dominates an oligopoly market because it has: profitably remain in the market and will exit the
market as they will not be able to cover their costs.
• Greater capacity Consequently, as price decreases, dominant firm’s
• Lower cost structure market share increases.
• First mover advantage • At prices between P1 and P2, the dominant firm
• Greater customer loyalty faces the demand curve DD.
• Profit is maximized at output level where Marginal
revenue MRD = marginal cost MCD i.e. at the output
In absence of collusion, a dominant firm becomes a level QD and the corresponding price is P*.
price maker like a monopolist and other firms in the • At this price P*, level of output sold by fringe firms is
market follow its price patterns. QF and Total sales are equal to QT.
Optimal Price and Output in Oligopoly

13.1
Markets
In oligopoly, there is no single optimum price and output

analysis that is appropriate for all oligopoly market
situations due to interdependence among the few firms.
In case of kinked demand curve, the optimum price is

the prevailing price at the kink in the demand curve.
However, kinked demand curve analysis does not
provide information regarding determination of the
prevailing price.
In the long run: Firms generate either positive profits or

break-even because over time:
• Market share of dominant firm decreases.

• Due to efficient production and techniques, MC
See: Exhibit 17, of new firms decreases.
CFA Institute’s Curriculum. • Demand and MR curve of dominant firm shrinks
and profits decline.
In the Figure above:
Generally: In oligopoly markets, reducing prices lead to
• D represents the market demand curve, and SF decline in total revenue for all the firms.
represents the supply curve (i.e., the aggregate
marginal cost curve) of the smaller fringe firms.
• The dominant firm must determine its demand
curve DD. As the figure shows, this curve is the

Learning Module 2
MONOPOLY MARKETS: DEMAND/SUPPLY & OPTIMAL

14.
PRICE/OUTPUT
Characteristics: Relative to a competitive industry, a monopolist:
1. There is a single seller and product is highly • Produces a smaller quantity: QM < QC
differentiated. • Charges a higher price: PM> PC
2. The product offered by a firm has no close • Earns an economic profit
substitutes.
3. There are high barriers to entry and thus, firm Supply Analysis in Monopoly Markets
faces no threat of competition.
4. Firm has significant control over pricing OR Optimal Price and Output in Monopoly Markets
output/supply.
5. The product is differentiated by the seller by using
non-price strategies i.e. advertising and Like other imperfect market structures, monopolist does
marketing. not have a well-defined supply function.
Factors that allow Monopoly to exist: • Price is determined by the demand curve i.e. PM.
• Optimal level of quantity is determined by the
1) There are barriers to entry in the market in the intersection of MC and MR i.e. at QM.
form of patent or copyright. • Profit maximizing price and output exist at the
2) Firm has significant control over critical resources elastic portion of demand curve because MR =
that are used for production. MC.
3) Natural monopolies exist in industries where the
production is based on significant economies of Relationship between MR and Price elasticity in
scale and declining cost structure in the market Monopoly:
e.g. electricity power generation, natural gas MR = P [1 – 1 / EP] = MC
distribution etc.
4) There is a strong brand loyalty for a firm’s
product, which acts as a barrier to entry. • This relationship can be used by a monopolist to
5) Firm has greater market power due to increasing determine its profit-maximizing price if a firm
returns associated with network effects. Networks knows its cost structure and price elasticity of
demand.
effect arises due to synergies related to
increasing market penetration.
Natural Monopoly in a Regulated Pricing Environment: A
natural monopoly exists when a single firm (that
Demand Analysis in Monopoly Markets produces all of an industry’s output) has large cost
advantage due to increasing returns to scale but the
initial fixed cost required to set up the business is very
• Individual firm’s demand is represented by the
high (i.e. high barriers to entry).
market demand; thus, monopolist has downward
demand curve.
Pricing and output solutions:
• The downward sloping demand curve implies that
to sell additional quantity of output, the firm needs
to lower price. As a result, the marginal revenue 1. When there is no regulation, monopolist produces
(MR) curve is steeper than the demand curve. If at level of output where Long-run MC = MR.
the demand curve is linear, then MR curve is twice 2. Competitive market pricing in case of regulation
as steeper as demand curve. i.e. higher quantity and lower price would be
• In a monopoly market, Average revenue curve = unfair because in this case, a firm cannot cover
Market demand curve. its average cost. In such pricing, firms may be
• Monopolist’s profit is maximized at quantity of subsidized by the amount represented by
output where MR = MC. difference between long-run AC and
competitive price Pc for each unit sold.
3. Setting price at a point where Long-run average
cost = average revenue. In this case, monopolist
P = MC at the perfectly competitive firm’s profit-
firm is allowed to earn normal return on its
maximizing quantity of output.
investment.
P > MR = MC at the monopolist’s profit-maximizing
quantity of output.

Learning Module 2
NOTE:
See: Exhibit 19,
CFA Institute’s Curriculum. Although monopolies attempt to maximize profits,
however, all monopolies do not necessarily generate
Monopolies are not always inefficient because through economic profits because in case of regulation, prices
economies of scale and government regulation, are set by regulators i.e. firms can earn a normal return
on their investment only.
monopolies may be more efficient than perfect
competition.
15. PRICE DISCRIMINATION AND CONSUMER SURPLUS
By reducing output and raising prices above marginal according to the quantity purchased by consumers
cost, a monopolist captures some of the consumer i.e. the consumer who purchases larger amount is
surplus as profit and causes deadweight loss. To avoid charged higher price and the consumer who
deadweight loss, government policy attempts to purchases smaller amount is charged relatively low
prevent monopoly behavior. price. Producers also charge different prices
according to the quality of product i.e. high quality
Price Discrimination: It refers to charging consumers products are sold at higher price.
different prices for the same good. Price discrimination is
profitable when consumers have different price 3. Third-degree price discrimination: In third-degree
sensitivities. price discrimination, monopolists segregate
consumers by demographic or other traits e.g. airlines
Types of Price Discrimination: charge higher prices to business travelers who want to
fly somewhere and wants to come back the same
1. First-degree price discrimination: In first-degree price
day i.e. one-day round trip is expensive relative to a
discrimination, monopolist charges each consumer a
return flight at a later date.
highest price that he/she is willing to pay. It is also
known as perfect-price discrimination. In this case,
Two-part tariff pricing: Some sellers attempt to capture
some consumers are better-off while some are worse-
consumer’s surplus by using creative pricing schemes
off; therefore, perfect-price discrimination does not
e.g. two-part tariff pricing. In two-part tariff pricing, seller
create inefficiency.
charges consumer two prices i.e.
• Profit is maximized when higher prices are

i. Per-unit price of the item purchased
charged to low-elasticity consumers and lower
ii. Per-month fee (a.k.a. membership fee).
prices are charged to high elasticity consumers.
• In this case, consumers do not get any consumer

surplus. The entire surplus is captured by the Practice: Example 3,
monopolist in the form of profit. CFA Institute’s Curriculum.
2. Second-degree price discrimination: In second-

degree price discrimination, monopolist charges price
16. MONOPOLY MARKETS: LONG-RUN EQUILIBRIUM
An unregulated monopoly can generate economic production. Therefore, subsidy is provided to

profits in the long-run. However, profits will not persist in compensate it for the losses.
the long run unless there is a barrier to entry. 2) In the long-run, monopoly can be nationalized by
the government.
Regulated monopolies have different long-run solutions: 3) In the long-run, a government regulatory entity
can be established to regulate prices charged
1) In the long-run, price can be set equal to MC, by monopoly firm e.g. the most appropriate way
firm will not be able to cover the average cost of to regulate it is to set price equal to long-run
Learning Module 2
average cost (P = LRAC). This price will ensure

that a firm earns normal profit on its investment.
4) In the long-run, a monopolistic firm can be Practice: Example 4,
franchised by the government through a bidding CFA Institute’s Curriculum.
war. In this case, a firm is selected on the basis of
P = LRAC.
17. IDENTIFICATION OF MARKET STRUCTURE
1) Concentration Ratio: It is the sum of the market shares

Econometric Approaches
of the N largest firms. It is computed as follows:
Measures to estimate market power: CR = Sum of sales values of the largest 10 firms / Total
1) Market power can be measured by estimating the market sales
elasticity of demand and supply in a market.
• CR is always between 0% and 100%.
• When demand is highly elastic → it indicates that • CR = 100% for monopoly.
market is close to perfect competition. • CR ≈ 0% for a perfectly competitive industry.
• When demand is inelastic → it indicates that firms
may have market power. Advantage: It is simple and easy to compute.
Disadvantages:
Limitations:
i. It is not a direct measure of market power i.e. a
i. This analysis has endogeneity problem i.e. the high CR does not necessarily indicate a
equilibrium price and output are jointly monopoly power; because when barriers to entry
determined by the interaction of demand and are low, even a single firm in the industry behaves
supply. like a firm in perfect competition.
Thus, a model with two separate equations (i.e. ii. It ignores the affect of mergers among the top
one equation for Quantity demanded and one market players i.e. CR does not change much
for Quantity supplied) is needed to correctly when the largest and second-largest incumbents
estimate the demand and supply. merge; they are likely to have greater pricing
ii. Elasticity can be computed using regression power after merger.
analysis but it requires large number of
observations.
iii. The regression analysis is based on historical data,
which is not necessarily a good predictor of Practice: Example ‘Calculating The
future. Concentration Ratio ’, CFA
2) Using cross-sectional regression analysis instead of
time-series analysis. In this analysis, sales from different
firms in the market are analyzed during the same year 2) Herfindahl-Hirschman index (HHI): The Herfindahl-
or for single transactions from many buyers & Hirschman Index equals the sum of the square market
companies. share of the top N companies in an industry.
Limitations: HHI = ∑ Xi2

where,
i. This method is complex.
ii. Different specifications of explanatory variables Xi2 is squared market share of the ith firm.
e.g. using total GDP instead of per-capita GDP to HHI = 1 for monopoly.
use as a proxy for income will provide different HHI ≈ 0 for a perfectly competitive industry.
estimates.
When there are M firms in the market with equal market
share, then
Simple Measures
HHI = (1 / M)
Learning Module 2
Interpretation: ii. It is less useful for financial analyst estimating

potential profitability of firm or group of firms
For example, HHI of 0.20 means that market is shared because it ignores elasticity of demand.
equally by five firms in the market.
Disadvantages: Practice: Example 5,

i. Like CR, it is not a direct measure of market
power i.e. a high HHI does not necessarily
indicate a monopoly power; because when Practice: CFA Institute’s End of
barriers to entry are low, even a single firm in the Chapter Practice Problems and
industry behaves like a firm in perfect Questions from FinQuiz Question
competition. Bank.
ECO Aggregate Output, Prices, and Economic Growth
Learning Module: 3
2. AGGREGATE OUTPUT AND INCOME
Aggregate output: The aggregate output of an • Output definition: The market value of all final
economy is defined as the value of all the goods and goods and services produced within the
services produced in a specified period of time. economy in a given period of time.
• Income definition: The aggregate income earned
Aggregate income: The aggregate income of an by all households, all companies and the
economy is defined as the value of all the payments government within the economy in a given period
earned by the suppliers of factors used in the production of time.
of goods and services.
Three broad criteria used to ensure that GDP is measured
Aggregate output and aggregate income within an
consistently over time and across countries:
economy must be equal.
1) All goods and services, which are included in the
Forms of payments:
calculation of GDP must be produced during the
measurement period. This implies that following items
i. Income (compensation of employees) i.e. wages, are excluded:
private pension plans benefits and health insurance
etc.
• Items produced in previous periods i.e. cars,
ii. Rent: It is a payment for the use of property.
houses, machinery.
iii. Interest: It is a payment for lending funds.
• Transfer payments from the government sector to
iv. Profits: It is the return earned by owners of a
individuals i.e. unemployment compensation or
company by using their capital and assuming
welfare benefits.
financial risk.
• Capital gains that accrue to individuals due to
appreciation of value of their assets.
Aggregate expenditure: Aggregate expenditure refers
to the total amount spent on the goods and services
2) Only those goods and services are included in the
produced in the (domestic) economy during the
calculation of GDP whose value can be determined
specified period of time.
by being sold in the market.
Aggregate expenditure must be equal to aggregate
output and aggregate income. • However, owner-occupied housing and
government services (although not sold in the
marketplace) are still included in the
measurement of GDP.
• The value of government services provided by
police officers, firemen, judges etc. is included in
GDP at their cost.
• Activities in the so-called underground economy
and barter transactions are also excluded.
3) Only the market value of final goods and services is

included in GDP whereas value of intermediate
goods is excluded to avoid double counting. Where,
• Final goods and services: Goods/services that are

not resold.
• Intermediate goods: Goods that are resold or used
to produce another good.
An intermediate approach to measure GDP:

GDP = Sum of all the value added during the production
Gross Domestic Product and distribution processes.
Gross domestic product (GDP) measures the flow of The most direct approach to measure GDP:
output and income in the economy.
GDP = Sum of market value of all the final goods and
services produced within the economy in a given
time period.
Learning Module: 3
Contribution to GDP = Amount received by the company where,

for its product – Amount paid by
Pt = prices in year t
the company for its inputs
Qt = quantity produced in year t
a) Contribution to GDP = final sale price
Real GDP: Value of goods and services measured at
base prices. It is more useful & informative because it
Or
exactly captures increase in output. Therefore, real GDP
and real GDP growth should be used to compare one
b) Contribution to GDP = Sum of the value added at
nation’s economy to another.
each stage
Receipts at Value Added (= Real GDP t = PB ×Q t
Each Stage Income Created)
(€) at Each Stage (€) where,
Receipts of Value PB = Prices in the base year
farmer from 0.15 0.15 added by
miller farmer NOTE:
Receipts of Value Real GDP changes only when output changes.
miller from 0.46 0.31 added by
baker miller
Example:
Receipts of Value
baker from 0.78 0.32 added by Total output produced in 2009 = 300,000. Price in 2009 =
retailer baker $18750. Suppose that the auto manufacturer produced
3% more vehicles in 2010 than in 2009.
Receipts of Value
retailer from 1.00 0.22 added by
final customer retailer • Real GDP would increase by 3% from 2009 to 2010.
• Prices increase by 7%.
1.00 1.00
Total Value Nominal GDP 2010 = (1.03 × 300,000) × (1.07 × $18750)

Value of final added = = $6,199,312,500.
output Total income
created
Implicit price deflator for GDP or GDP deflator: It is used
to measure changes in prices across the overall
Source: CFA Institute’s Curriculum, Exhibit 2. economy i.e. inflation. It represents increase in Nominal
GDP.
CFA Institute’s Curriculum Implicit price deflator for GDP or GDP deflator =
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠

Issues with measuring GDP: × 100
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
1) Due to presence of underground economy, it is
difficult to obtain reliable GDP data. Real GDP = [(Nominal GDP / GDP deflator) ÷ 100]
2) Due to presence of underground economy, it is
difficult to capture a significant portion of economic 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
𝐆𝐃𝐏 𝐝𝐞𝐟𝐥𝐚𝐭𝐨𝐫 = × 𝟏𝟎𝟎
activity. 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷
3) Poor data collection practices.
4) Unreliable statistical methods within the official Real economic growth = % change in real GDP
accounts.
NOTE:
Nominal and Real GDP The inflation rate = % change in the index.
It is important to note that higher (lower) level income
caused by changes in the price level does not indicate
a higher (lower) level of economic activity; therefore, it is Practice: Example 2,
useful to use real GDP which removes the effect of CFA Institute’s Curriculum
changes in the general price level on GDP.
Nominal GDP: Value of goods and services measured at

current prices. The Components of GDP
Nominal GDP t = Pt × Qt
Learning Module: 3
Four major sectors of the economy are as follows: investment in inventory, property, plant and
1. Household sector equipment.
2. Business sector • Investment flows from the goods market back to
3. Government sector firms because the business sector demands and
4. Foreign or external sector produces the goods that are required to build
productive capacity i.e., capital goods.
GDP = C + I + G + (X – M)
where, NOTE:
C = consumer spending on final goods and services
I = Gross private domestic investment, which includes • Expenditures on capital goods represent a
business investment in capital goods e.g. plant and significant portion of GDP in developed
equipment and changes in inventory (inventory economies.
investment) • Investment spending is the most volatile
G = government spending on final goods and services component of the economy.
X = exports
M = imports
The Government Sector
Taxes: The government sector collects taxes from
2.2.1) The Household and Business Sectors
households and businesses.
Government expenditure: Government sector purchases

goods and services from the business sector. It also
includes spending on the military, police and fire
protection, postal services etc.
Transfer Payments: Government also makes transfer

payments to households. The transfer payments are not
part of government expenditures.
Net Taxes = Taxes – transfer payments
• The government has a fiscal deficit when

government expenditure (G) > net taxes (T).
• The government has a fiscal surplus when
government expenditure (G) < net taxes (T).
• When the government has fiscal deficit, it needs to
borrow in the financial markets.
The External Sector

Net exports = Exports – Imports = X – M
where,
Exports (X) = Value of goods and services sold to
The figure above shows that: foreigners
Imports (M) = Value of goods and services purchased
from the rest of the world
• Services of labor, land and capital flows through
the factor market to business firms.
When imports > exports, trade deficit occurs. It implies
• Income flows back from firms to households.
that an economy is spending more than it produces and
• Households spend part of their income on current
domestic saving is not sufficient to finance domestic
consumption and save part of their income for
investment plus the government’s fiscal balance.
future consumption.
• Current consumption expenditure flows through
the goods market to business sector. • A trade deficit must be funded by borrowing from
• Household saving flows into the financial markets. the rest of the world through the financial markets
• Businesses obtain funding from financial markets to i.e. financial account surplus.
borrow or raise equity capital to finance
Learning Module: 3
When imports < exports, trade surplus occurs. • It is the most relevant and most closely watched
measure of income for household spending and
GDP, National Income, Personal Income, and saving decisions.
Personal Disposable Income
Household saving = PDI – consumption expenditures -
Approaches to measure GDP:
interest paid by consumers to
business - personal transfer
There are two approaches to determine GDP.
payments to foreigners
Business sector saving = Undistributed corporate profits +
1) Income Approach: GDP is equal to the total amount
Capital consumption
earned by households and companies in the
allowance.
economy.
2) Expenditure Approach:
GDP = National income + capital consumption
allowance + statistical discrepancy GDP = Total amount spent on the goods and services
produced within the economy during a given
where, period.
National Income (NI): Income received by all factors of
production used in the generation of final output i.e. • Market analysts prefer to use Expenditure approach
because the expenditure data are more timely and
NI = Compensation of employees (i.e. wages) + reliable than data for the income components.
Corporate and government enterprise profits before
taxes + Interest income + unincorporated business GDP = Consumer spending on goods and services +
net income (proprietor’s income) + rent + indirect Business gross fixed investment + change in
business taxes less subsidies inventories + Government spending on goods
and services + Government gross fixed investment
Corporate profits before taxes include: + Exports – Imports + Statistical discrepancy
1) Dividends paid to households For the economy as a whole, total income must = total
2) Undistributed corporate profits (R/E) expenditures. This implies that the two approaches
3) Corporate taxes paid to government should provide the same estimate of GDP.
Interest income: Interest received by households, • However, practically, they provide different
government, and foreigners for providing loan to estimates due to differences in data sources. This
businesses. difference is accounted for by a statistical
discrepancy.
Unincorporated net income (including rent): Income
earned by unincorporated proprietors and farm
operators for running their own businesses.
CFA Institute’s Curriculum
Capital consumption allowance (CCA): It refers to the
amount that firms must earn and reinvest in order to
maintain the existing productivity of the capital i.e. it is a
measure of depreciation. Note that Relationship among Saving, Investment, the Fiscal
Balance and the Trade Balance
Profit + CCA = total amount earned by capital
Total Expenditure = Household consumption (C) +
Personal income: It refers to all income received by
Investments (I) + Government
households, both earned and unearned.
spending (G) + Net exports (X-M)
PI = National income – Indirect business taxes –
Personal disposable income = GDP (Y) + transfer
Corporate income taxes – Undistributed corporate
payments (F) – (R/E +
profits + Transfer payments
Depreciation) – direct
and indirect taxes (R)
• It is one of the key determinants of consumption where,
spending.
R/E + Depreciation = business saving (SB)
Personal disposable income (PDI) = Personal income –
Y + F – SB – R = C + household saving (SH)
personal taxes.
Y = C + total private sector saving* + Net taxes
Learning Module: 3
= C + (SB + SH) + (R – F) • The marginal propensity to save (MPS) = 1 – MPC.

It represents the amount that is not spent or
*Private saving = Household saving + undistributed consumed.
corporate profits + Capital • Average propensity to consume (APC) = C / Y.
consumption allowance o Higher APC indicates that economy is more
Since Total expenditures must be = aggregate income, sensitive to changes in disposable household
income relative to other economies.
C + S+ T = C+I+G+(X-M)
Investment: The primary source of investment spending is
Domestic saving = Investment + Fiscal balance + Trade
businesses.
balance
= I + (G – T) + (X – M)
• Gross investment = Total investment including
Fiscal balance = G – T = (S – I) – (X – M) replacement of worn-out capital.
• Net investment refers to addition of new capacity.
• GDP includes gross investment.
• When [(G – T) > 0], there is a fiscal/budget deficit.
It implies that budget deficit is financed through:
o Higher domestic saving i.e. (S – I) > 0 Investment Function:
o Lower business investment (I) or I = I (r, Y)
o Borrowing from foreigners (X – M) i.e. the country where,
must run a trade deficit i.e. (X – M) < 0.
• The fiscal balance decreases (smaller deficit or I = investment spending
larger surplus) as aggregate income Y increases. r = real interest rate
• The fiscal balance increases as income declines. Y = aggregate income
This effect is known as automatic stabilizer
because it tends to remove changes in • When output is low (i.e. an economy is
aggregate output. underutilizing its resources) and companies have
excess capacity, the expected return on new
NOTE: investments is low. This leads to decrease in
investment spending.
Tax policy of a government can be viewed as an • Conversely, when output is high and companies
exogenous policy tool. have little spare capacity, the expected return on
new investments is high. This leads to increase in
investment spending.
Practice: Example 4, • When real interest rate ↑, investment spending ↓
CFA Institute’s Curriculum and vice versa.
Net exports = (X – M)
Consumption Function:
C = C (Y – T) • As domestic income ↑, Imports ↑ and net exports ↓.
• When income in the rest of the world ↑, exports ↑
• When real income (Y) ↑, aggregate consumption and thus net exports ↑.
↑. • When domestic currency depreciates, →
• When taxes ↓, aggregate consumption ↑. domestically produced goods and services
• The marginal propensity to consume (MPC) become relatively cheap and lead to an increase
represents the proportion of an additional unit of in net exports.
disposable income that is consumed or spent.
3. AGGREGATE DEMAND AND AGGREGATE SUPPLY
The aggregate demand curve shows the relationship

Aggregate Demand
between the price level and the quantity of real GDP
demanded by households, firms, and the government at
Aggregate demand (AD) represents the quantity of which two conditions are satisfied.
goods and services demanded by households,
businesses, government and foreign customers at any
given level of prices.
Learning Module: 3
The AD curve signifies the combination of aggregate

income and the price level at which the following two • the demand for money ↑ and the interest rate ↑,
conditions are satisfied. assuming money supply is fixed.
• With higher prices, we have less extra money
1) Aggregate expenditure equals aggregate income available to put in the bank account for saving.
2) Real money supply is willingly held by households and • Higher interest rates ↓ the demand for
businesses. consumption and investment expenditure in
businesses due to ↑ borrowing costs, which
As we know, GDP = C + I + G + (X-M) ultimately leads to ↓ in demand for goods and
services.
Aggregate Demand Curve: Aggregate demand curve
represents an inverse relationship between the price
Opposite occurs when price level ↓.
level and real income.
The Real Exchange Rate Effect
Real exchange rate is nominal exchange rate adjusted

for price level.
When domestic price level ↑,
• Real exchange rate ↑, exports ↓ as domestic

goods become more expensive in other countries,
imports ↑ as non-domestic goods become less
expensive domestically, which leads to ↓ in
demand for goods and services.
• Interest rates ↑, demand for domestic currency ↑
for non-domestic investors in foreign exchange
market, domestic currency appreciates, which in
turn ↓ the real exchange rate.
Why AD curve slopes downward:
Consider G (government spending) to be exogenous, Opposite occurs when price level ↓.
three effects that cause the AD slope to be downward
are the:
Important: Refer to Exhibit 13, ‘Summary of Key
1. Wealth effect Effects’, CFA Institute Curriculum.
2. Interest rate effect
3. Real exchange rate effect
The Wealth Effect Practice: Example 5,

When price level ↑,
• Purchasing power of a person (whose income is

fixed) in nominal terms ↓. Aggregate Supply
• Quantity of goods/services that can be
purchased with the nominal wealth ↓. Aggregate supply (AS) represents the quantity of goods
• Real value of nominal assets (e.g., stocks and and services that producers are willing to supply at any
bonds) ↓ (i.e., consumers are poorer in real terms. given level of prices. AS also reflects the amount of labor
• Demand for goods and services ↓ and capital that households are willing to offer at given
real wage rates and cost of capital.
Opposite occurs when price level ↓.
The aggregate supply curve summarizes the relationship
The Interest Rate Effect between the price level and the quantity of output
supplied in the economy.
As we know that price of money is interest rate.
Very short-run, comprised of a few months or quarters:
When price level ↑, Companies can increase or decrease output to some
Learning Module: 3
degree but without changing price. Hence, a short run • The long-run equilibrium level of output, Y1
aggregate supply curve (VSRAS) is horizontal. represents the full employment or natural level of
output. At natural level of output, economy’s
• When demand is higher, → companies earn resources are fully employed and labor
higher profit by increasing output as long as they unemployment is at its natural rate.
can cover their variable costs.
• When demand is weaker, → in order to avoid
• The intersection of very SRAS and AD indicates Y0,
losses, companies decrease their output.
the short run equilibrium.
• The intersection of LRAS and AD indicates the long
Short-run period: SRAS curve is upward sloping because run equilibrium of the economy (Y*, potential
more costs become variable. output).
• Wages and other input costs are relatively The amount of output produced depends on the fixed
inflexible. amount of capital and labor and the available
technology i.e.
Long-run period comprised of few years and perhaps a
decade: Only wages, prices and expectations can P, 𝑳
Y = F (𝑲 R) = 𝒀
P
change but physical capital is a fixed input. Also, capital
where,
and the available technology to use that capital remain
fixed. K = fixed amount of capital
L = available labor supply.
Long-run period comprised of multiple decades: In this
case, wages, prices and expectations and even the Shifts in Aggregate Demand and Supply
capital stock are variable.
The business cycle represents short-term fluctuations of

• In the long-run, when the aggregate price level
changes → wages and other input prices change real GDP. It consists of periods of economic expansion
and contraction.
proportionately. Consequently, higher aggregate
price level has no impact on aggregate supply
and output remains fixed at the level of potential Expansion: Expansion is associated with following
characteristics:
output.
• Thus, the long run aggregate supply curve (LRAS)
is vertical. • Real GDP is increasing.
• The unemployment rate is declining.
• Capacity utilization is rising.
Contraction: Contraction is associated with following

characteristics:
• Real GDP is decreasing.

• The unemployment rate is rising.
• Capacity utilization is declining.
Shifts in Aggregate Demand
• Any shift in the IS-LM model that is caused by a

change in prices is represented as a movement
along the AD curve.
• Any other shift in the IS curve or the LM curve that
increases aggregate level of expenditures will
cause the AD curve to shift rightwards.
• Any change in the IS-LM model that reduces
aggregate level of expenditures will cause the AD
curve to shift leftwards.
The figure shows that:
Determinants of aggregate demand: Factors that shift
• As prices increase from P1 to P2, the quantity of the aggregate demand curve include:
output supplied remains unchanged at Q1 in the
long run.
Learning Module: 3
1) Household wealth decreases (increases) → AD curve shifts to the left

2) Consumer and business expectations (right).
3) Capacity utilization
4) Monetary policy Monetary Policy:
5) The exchange rate
6) Growth in global economy Money = currency in circulation + deposits at
7) Fiscal policy (government spending and taxes) commercial banks.
Central bank can affect aggregate output and prices

Household wealth: Household wealth includes the value
through monetary policy tools i.e. changes in bank
of both financial assets (e.g. cash, savings accounts,
reserves, reserve requirements or its target interest rate.
investment securities, and pensions) and real assets (e.g.
real estate).
• When money supply increases (decreases), AD
curve shifts to the right (left).
• When value of financial and/or real assets
increase e.g. when equity prices increase,
households wealth increases, → consumer Central bank can increase (decrease) the money supply
spending increases and the aggregate demand by:
curve shifts to the right.
• Conversely, when households’ wealth decreases, 1) Buying (selling) securities from (to) banks. It is
→ consumer spending decreases and the known as Open market operations.
aggregate demand curve shifts to the left. 2) Lowering (increasing) the required reserve ratio.
3) Reducing (increasing) target interest rate at
which banks borrow and lend reserves among
themselves. It results in increase (decrease) in
Practice: Example 6, consumer and investment spending.
Consumer and Business Expectations:
• When consumers become more (less) confident

about their future income and the stability/safety
of their jobs, consumer spending increases
(decreases) and the AD curve shifts to the right
(left).
• Similarly, when businesses become more (less)
optimistic about their future growth and
profitability, investment spending on capital
projects increases (declines) and AD curve shifts
to the right (left).
Capacity Utilization:
• When companies have excess capacity, they

have little incentive to invest in new property,
plant and equipment. Thus, investment spending Case of expansionary monetary policy: When money
declines and AD curve shifts to the left. supply ↑, AD curve shifts to the right, from AD1 to AD2.
• In contrast, when companies are operating at or
near full capacity, investment spending increases
• In the very short run, output will increase from Y1 to
in order to expand production and the AD curve
Y2 without an increase in the price level.
shifts to the right.
• In the short-run, price increases and input prices
rise, the AS curve will steepen and prices will
Fiscal policy: increase to P3 while output declines to Y3.
• In the long-run, input prices become more
• When government spending increases flexible, the AS curve becomes vertical and
(decreases), AD curve shifts to the right (left). output returns to the long-run natural level, Y1 and
• When taxes increase (decrease), the proportion prices increase to P4.
of personal income and corporate pre-tax profits
Learning Module: 3
Thus, expansionary monetary policy increases output in An Increase in

the short-run only; in the long run it affects only the price Shifts the AD
the Following Reason
level. Curve
Factors
Important to Note: Monetary Policy will be ineffective in investment

a “Liquidity Trap” which occurs when: and possibly
higher
a) Banks prefer to hold excess reserves instead of consumption
making loans; Exchange rate Leftward: Lower exports
b) Demand for money balances by households and (Foreign currency Decrease in AD and higher
companies is not sensitive to changes in the level per unit domestic imports
of income. currency)
Global growth Rightward: Higher exports
Exchange rate: When domestic currency depreciates
Increase in AD
(appreciates), exports become cheaper (expensive) in
the world markets and imports become expensive
(cheaper). Thus, exports ↑ (↓) and imports ↓ (↑). This leads Source: CFA Institute’s Curriculum, Exhibit 18.
to rightward (leftward) shift in the AD curve.
Growth in the Global Economy: Practice: Example 7 (Important),

• When economic growth in foreign markets
increases (decreases), foreigners tend to buy
more (less) products from domestic producers
Shifts in Short-run Aggregate Supply
and increase (decrease) exports. Hence, AD
curve shifts to the right (left). SRAS curve shifts due to changes in factors that change
the cost of production or expected profit margins. It is
Important to Note: When AD curve shifts to the right, the important to note that factors that shift the long-run AS
interest rate increases at each price level. Because curve will also shift the SRAS curve by a corresponding
when the money supply is constant, the interest rate amount. These factors include changes in:
must rise as income increases.
1) Nominal wages
An Increase in 2) Input prices
Shifts the AD 3) Expectations about future output prices and the
the Following Reason
Curve overall price level
Factors
4) Business taxes and subsidies
Stock prices Rightward: Higher 5) Exchange rate
Increase in AD consumption
Housing prices Rightward: Higher When the economy’s resources and technology
Increase in AD Consumption increases, → the full employment (natural) level of output
increases, → and both the LRAS and SRAS shift to the
Consumer Rightward: Higher right.
confidence Increase in AD Consumption
Business Rightward: Higher Change in Nominal Wages:
confidence Increase in AD investment
• When nominal wages increase, → production
Capacity Rightward: Higher
costs increase. It leads to decrease in AS and a
utilization Increase in AD investment
leftward shift in the SRAS curve.
Government Rightward: Government • Conversely, lower wages shift the AS curve to the
spending Increase in AD spending a right.
component of
AD It is important to note that changes in nominal wages do
Taxes Leftward: Lower not affect the LRAS curve.
Decrease in AD consumption
and % change in unit labor cost = % change in nominal
investment wages – % change in
productivity
Bank reserve Rightward: Lower interest
Increase in AD rate, higher
Learning Module: 3
Potential GDP is a measure of the productive capacity of

the economy. It represents the level of real GDP an
economy can produce at full employment. Potential
GDP is not a static concept; rather, it increases as the
economy’s resource capacity grows. This implies that,
Change in Input Prices: factor that increases the resource base of an economy
causes the LRAS curve to shift to the right.
• When input prices fall, the cost of production
decreases. It leads to increase in AS and a
rightward shift in the SRAS curve.
• Conversely, higher input prices increase
production costs, AS decreases and the SRAS
curve shifts to the left.
Change in Expectations about Future Prices:
• Companies produce more today when they

expect future prices and costs to be higher. Thus,
AS increases and SRAS curve shifts to the right.
However, companies will produce more today These factors include changes in:
only when the cost of carrying inventory
(financing, storage, and spoilage) < cost savings 1) Supply of labor and quality of labor forces
by producing more today and less in the future. (human capital)
• Conversely, companies produce less today when 2) Supply of natural resources
they expect future prices and costs to be lower. 3) Supply of physical capital
Thus, AS decreases and SRAS curve shifts to the 4) Productivity and technology
left.
Supply of Labor:
NOTE:
The impact of expectations about future prices on AS • When the supply of labor ↑ (↓), → output ↑ (↓) and
and AS curve may be modest and/or temporary. LRAS curve shifts to the right (left).
• The labor supply depends on 3 factors:
i. Growth in the population
ii. Labor force participation rate (% change of
the population working or looking for work)
iii. Net immigration.
Change in Business Taxes and Subsidies: Supply of Natural Resources: Natural resources include
available land, oil and water etc. When natural
• When business taxes increase, production costs resources increase (decrease), the LRAS curve shifts to
per unit increase and shift the short-run AS curve the right (left).
to the left.
• When business subsidies (i.e. payment from Supply of Physical Capital: Increase in growth in business
government to businesses) increase, production investment leads to increases in the supply of physical
costs decrease and the SRAS curve shifts to the capital and shifts the LRAS curve to the right.
right.
Supply of Human Capital: Increase in human capital and
improvement in the quality of human capital shift the
Change in the Exchange Rate:
LRAS curve to the right. Human capital can be increased
through training, skills development and education.
• When domestic currency depreciates
(appreciates), imports (i.e. imported inputs) Labor Productivity and Technology: Productivity is used
become expensive and increase (decrease) the to measure the efficiency of labor. It is estimated as the
cost of production of firms. Consequently, AS amount of output produced by workers in a given
decreases (increases) and AS curve shifts to the period of time e.g. output per hour worked. When
left (right). productivity increases (decreases), labor cost decreases
(increases), profit increases (decreases), output/AS
3.3.3) Shifts in Long-run Aggregate Supply increases (decreases) and LRAS curve shifts to the right
(left).
Learning Module: 3
Determinants of labor productivity are:
i. Physical capital per worker

ii. Quality of the workforce.
iii. Technology: Advances in technology shift the
LRAS curve to the right.

CFA Institute’s Curriculum Short-run equilibrium in the goods & services market
occurs at the price level P1 where AD and SRAS intersect.
An Increase in Shifts SRAS Shifts LRAS Reason • If the price level is above P1, then the quantity of
output supplied > amount demanded. This would
Supply of Rightward Rightward Increases result in falling prices.
labor resource base
• If the price level is below P1, then the quantity of
Supply of Rightward Rightward Increases aggregate output demanded > quantity of
natural resource base aggregate output supplied. This would result in a
resources shortage of goods and would push prices
Supply of Rightward Rightward Increases upward.
human resource base
capital Important: The short-run macroeconomic equilibrium
Supply of Rightward Rightward Increases may occur at a level above or below full employment.
physical resource base
capital Long-Run Equilibrium
Productivity Rightward Rightward Improves
and efficiency of
Long-run equilibrium in the goods & services market
technology inputs occurs at the price level P1 where AD and LRAS intersect.
This equilibrium occurs at Y1 that represents potential real
Nominal Leftward No Increases labor GDP i.e. in the long-run, equilibrium GDP is equal to
wages impact* cost
potential GDP.
Input prices Leftward No Increase cost of
(e.g. energy) impact* production • Practically, it is difficult to accurately measure
Expectation Rightward No Anticipation of Potential GDP because it is not directly
of future impact* higher costs observable and depends on factors that are
prices and/or themselves difficult to measure.
perception of
improved
pricing power Four possible types of macroeconomic equilibrium:
Business taxes Leftward No Increases cost of

impact* production
1. Long-run full employment
2. Short-run recessionary gap
Subsidy Rightward No lowers cost of 3. Short-run inflationary gap
impact* production 4. Short-run stagflation
Exchange Rightward No Lowers cost of
rate impact* production Recessionary Gap
* The LRAS would shift only if there will be a permanent change.
When AD curve shifts leftwards from AD1 to AD2, GDP
decreases from Y1 to Y2, prices fall from P1 to P2 and
Source: CFA Institute’s Curriculum Exhibit 20.
economy contracts i.e.
Equilibrium GDP and Prices

• Demand declines → unemployment rate rises; →
economy goes into a recession.
Equilibrium occurs where the AD and AS curves intersect.
At equilibrium,
Quantity of aggregate output demanded (or the level Recessionary gap = Y2 - Y1

of aggregate expenditures) = Quantity of aggregate
output supplied.
Learning Module: 3
• Value of unfilled orders

• Number of new housing starts
• Number of hours worked
• Changes in inventories
If these statistics indicate that a recession is caused by a

decline in AD, the following conditions are likely to
occur:
a) Corporate profits will decline

b) Commodity prices will decline
• A recessionary gap occurs when the AD curve c) Interest rates will decline
intersects the short-run AS curve at a short-run d) Demand for credit will decline
equilibrium level of GDP below potential GDP.
In case of decrease in AD the following investment
Factors that lead to decrease in AD/causes of a strategy is preferred:
recession:
1) Reduce or avoid investments in cyclical
• Tight monetary policy companies (e.g. automobile and chemical
• Higher taxes companies).
• More pessimistic consumers and businesses 2) Reduce or avoid investments in commodities
• Lower equity and housing prices and/or commodity-oriented companies
because when commodity prices ↓, revenue
growth ↓ and profit margins ↓.
There are two ways that an economy can move back to
3) Increase investments in defensive companies
its potential GDP:
(e.g. food and pharmaceutical companies).
4) Increase investments in investment-grade or
1) Automatic mechanism: Due to decline in prices and
government-issued fixed income securities.
higher unemployment, workers demand lower
Because when interest rate ↓, the prices of these
nominal wages. Consequently, due to lower wages
securities ↑.
and input prices, the SRAS curve shifts to the right and
5) Increase investments in long-maturity fixed
push the economy back to full employment and
income securities because when interest rates
potential GDP.
fall, their prices will increase more than that of
shorter-maturity securities.
Drawback: This price mechanism works very slowly and
6) Reduce investments in speculative equity
can take several years to work.
securities and in fixed income securities with low
credit quality ratings.
2) Using fiscal and monetary policy tools:
NOTE:
a) Fiscal policy i.e. by reducing taxes or increasing
government spending, AD increases. It is important to understand that this strategy will be
b) Monetary policy i.e. the central bank can lower most successful only if it is implemented before other
interest rates or increase the money supply. market participants recognize the opportunities and
asset prices adjust.
Drawback: These policies are not effective as they are
implemented with the time lag.
NOTE:
Recession is a period during which real GDP decreases
for at least two successive quarters. Inflationary Gap
Investment Implications of a Decrease in AD: Statistics When AD curve shifts leftwards from AD1 to AD2, GDP
that provide an indication of the direction of aggregate increases from Y1 to Y2, prices rise from P1 to P2 and
demand include: economy expands i.e.
• Consumer sentiment • Demand increases → unemployment rate falls, →

• Factory orders for durable and nondurable goods economy goes into expansion. If expansion drives
Learning Module: 3
the economy beyond its production capacity, When economic statistics suggest that an expansion is
inflation will occur. caused by an increase in AD, the following conditions
are likely to occur.
Inflationary gap = Y2 - Y1
a) Corporate profits will rise
b) Commodity prices will increase
• An inflationary gap occurs when the economy’s
c) Interest rates will rise
short-run level of equilibrium GDP is above
d) Inflationary pressures will build
potential GDP, which results in increase in prices.
In case of increase in AD the following investment

strategy is preferred:
1) Increase investment in cyclical companies.

2) Reduce or avoid investments in defensive
companies.
3) Increase investments in commodities and
commodity-oriented equities.
4) Reduce or avoid investments in fixed income
securities, particularly longer-maturity securities,
because when interest rate ↑, their prices ↓.
5) Increase investment in speculative fixed income
securities (junk bonds) because default risks
decrease in an economic expansion.
Factors that lead to increase in AD/causes of an
expansion:
Stagflation: Both High Inflation and High
Unemployment
• Expansionary monetary policy
• Expansionary fiscal policy Structural fluctuations in real GDP occur due to
• More optimistic consumers and businesses fluctuations in SRAS.
• Weaker domestic currency
• Rising equity and housing prices Stagflation: During stagflation, both inflation and
unemployment increases. Stagflation arises due to
decrease in AS. Conversely, when AS increases, →
There are two ways that an economy can move back to
economic growth ↑ and inflation ↓.
its potential GDP:
1) Automatic mechanism: Due to rise in prices and lower

unemployment, workers demand higher nominal
wages. Consequently, due to higher wages and input
prices, the SRAS curve shifts to the left and push the
economy back to full employment and potential
GDP.
Drawback: This price mechanism works very slowly and

can take several years to work.
2) Using fiscal and monetary policy tools:
a) Fiscal policy i.e. by increasing taxes or reducing

government spending, AD decreases. The figure shows that when AS decreases e.g. due to
b) Monetary policy i.e. the central bank can unexpected increase in basic material and oil prices:
reduce bank reserves, increase interest rates or
decrease the money supply. • The equilibrium level of GDP shifts from point A to
B.
Drawback: These policies are not effective as they are • GDP falls from Y1 to Y2.
implemented with time lag. • The price level, instead of falling, rises from P1 to
P2.
Investment Implications of an Increase in AD Resulting in
an Inflationary Gap: There are two ways that an economy can move back to
its potential GDP:
Learning Module: 3
1) Automatic mechanism: Over time, decrease in output • If increase in AD > (<) increase in AS, → the price
and employment put downward pressure on wages level will ↑ (↓).
and input prices. Consequently, SRAS curve shifts
back to the right and the economy is back at full
2. Both AD and AS decrease: If both AD and AS
employment equilibrium at point A. However, this
decrease, real GDP and employment will decrease,
mechanism works slowly.
but the impact on inflation is ambiguous because:
2) Fiscal and Monetary Policy: Fiscal and monetary
policy can be used to shift the AD curve to the right. • A decrease in AD decreases the price level,
However, it results in permanently higher price level at whereas a decrease in AS increases the price
Point C (figure above). level.
• If decrease in AD > (<) decrease in AS, → the price
level will ↓ (↑).
Investment Implications of Shift in AS: The direction of
shifts in short-run aggregate supply is determined by cost 3. AD increases and AS decreases: If AD increases but
of inputs and productivity i.e. AS declines, → the price level will increase, but the
effect on real GDP is ambiguous because:
• Increase (decrease) in input prices lead to
decrease (increase) in AS which result in lower • An increase in AD increases real GDP, whereas a
(higher) economic growth and higher (lower) decrease in AS decreases real GDP.
prices. • If increase in AD > (<) decrease in AS, GDP will rise
• Higher (lower) rates of productivity growth shift the (fall).
AS to the right (left), which result in higher (lower)
output and lower (higher) unit input prices. 4. AD decreases and AS increases: If AD decreases but
AS increases, the price level will decrease but the
In case of decrease in AS the following investment impact on real GDP is ambiguous because:
strategy is preferred:
• A decrease in AD decreases real GDP, whereas an
1) Reduce or avoid investment in fixed income increase in AS increases real GDP.
because when output prices ↑, nominal interest • If decrease in AD > (<) increase in AS, real GDP will
rates ↑. fall (rise).
2) Reduce or avoid investment in most equity
securities because profit margins ↓ and output ↓. Effect of Combined Changes in AS and AD
3) Increase investment in commodities or
commodity based companies because prices Change Change Effect on Effect on
and profits ↑. in AS in AD Real GDP Aggregate
Price Level
In case of increase in AS: Reduce or avoid investment in Increase Increase Increase Indeterminate
commodities or commodity-based companies.
Decrease Decrease Decrease Indeterminate
Conclusions on AD and AS Increase Decrease Indeterminate Decrease
Decrease Increase Indeterminate Increase

• An increase (decrease) in AD raises (lowers) real
Source: CFA Institute’sCurriculum, Exhibit 26.
GDP, lowers (raises) the unemployment rate, and
increases (decreases) the aggregate level of
Demand-driven expansions and Demand-driven
prices.
contractions:
• An increase (decrease) in AS raises (lowers) real
GDP, lowers (raises) the unemployment rate and
lowers (raises) the aggregate level of prices. • Demand-driven expansions are associated with
higher inflation and interest rates.
o It is caused by stimulative fiscal and monetary
Effect of shifts in both AD and AS curves:
policies.
o During demand-driven expansions, it is preferred
1. Both AD and AS increase: If both AD and AS increase,
to reduce investments in fixed-income securities
real GDP will increase but the impact on inflation will
and defensive companies and increase
be ambiguous because:
investment in cyclical companies and
commodities.
• An increase in AD increases the price level, • Demand-driven contractions are associated with
whereas an increase in AS decreases the price lower inflation and interest rates.
level.
Learning Module: 3
Supply-driven expansions and Supply-driven

contractions:
• Supply-driven expansions are associated with

lower inflation and interest rates.
• Supply-driven contractions are associated with
rising inflation and interest rates.
o It is caused by decline in labor productivity.
o During supply-driven contraction, it is preferred
to reduce investments in both fixed-income and
equity securities and increase investment in
commodities.
4. ECONOMIC GROWTH AND SUSTAINABILITY
Economic growth = Annual % change in real GDP Two-factor production function: Where the two factors
Or include
Economic growth = Annual change in real per capital
GDP 1) Capital
where, 2) Labor
Per capita GDP = real GDP ÷ population
Y = AF (L, K)
Sustainable Rate of Economic Growth =
where,
Rate of increase in the economy’s productive capacity
or Potential GDP Y = level of aggregate output in the economy
L = quantity of labor or number of workers in the
• Growth in real GDP indicates how rapidly the total economy
economy is expanding. K = capital stock or the equipment and structures used
• Per capita GDP indicates standard of living in to produce goods and services
each country i.e. ability of the average person to A = technological knowledge or total factor productivity
buy goods and services. The higher the growth (TFP)
rates of per capita GDP, the higher the
economy’s standard of living and the higher the Total factor productivity: TFP is a scale factor that
economic growth. represents the portion of economic growth that is not
• However, it is important to understand that faster accounted for by the capital and labor inputs. TFP is
growth is not always better because increase in mainly affected by the technological change; therefore,
growth leads to higher inflation, potential it can be used as a proxy for technological progress and
environmental damage and the lower organizational innovation. Like potential GDP, TFP is
consumption and higher savings needed to estimated because it cannot be observed directly.
finance the growth.
• The greater the inputs and/or technology
advancements, the higher the output.
The Production Function and Potential GDP • Keeping other inputs constant, the more
technologically advanced an economy is, the
According to neoclassical or Solow growth model, the greater the output.
economy’s productive capacity and potential GDP
increase due to two factors i.e. TFP growth = Growth in potential GDP – [WL (Growth in
labor) + WC (Growth in capital)]
1) Accumulation of inputs i.e. capital, labor and where,
raw materials used in production. WC = relative share of capital in national income
2) Discovery and application of new technologies. WL = relative share of labor in national income
The Production Function The Model Assumptions

This model is based on production function.
Assumptions of production function:
Learning Module: 3
1. Production function has constant returns to scale • The greater the share of capital (labor), the larger
e.g. if all the inputs in the production process are impact it has on potential GDP growth.
increased by the 2%, then output will rise by 2%.
2. Production function exhibits diminishing marginal Growth accounting equation in terms of per capita GDP:
productivity with respect to any individual input
i.e. output decreases at some point with increase Growth in per capita potential GDP =
in units of the input. Growth in technology + Wc (growth in capital-to-labor
ratio)
NOTE:
Marginal productivity represents change in output from • The capital-to-labor ratio measures the amount of
a one-unit increase in an input keeping other inputs capital available per worker.
unchanged. • This equation implies that, improvements in
technology are more important than capital for
Implications of Diminishing marginal productivity of improving economy’s standard of living.
capital for potential GDP: Diminishing marginal
productivity of capital has two major implications for
Sources of Economic Growth
potential GDP:
1. Long-term sustainable growth cannot be achieved There are five important sources of growth for an
simply by increasing investment in capital stock and economy.
keeping other inputs unchanged due to diminishing
returns. 1. Technology
2. Labor supply
• This implies that, due to diminishing returns to 3. Physical capital
capital, long-term sustainable growth or potential 4. Technology
GDP per capita can only be achieved through 5. Natural resources
technological change or growth in TFP.
• When TFP increases (i.e. ‘A’ increases), production 1. Technology
function shifts upwards i.e. output increases using Technology refers to the process used by a company to
the same level of labor and capital inputs. transform inputs into outputs. Technological advances
2. Growth rates of developing countries should be > are very important because they facilitate an economy
those of developed countries and developing to achieve sustainable long-term growth rate by
countries income should converge to that of overcoming the limits imposed by diminishing marginal
developed countries over time because in returns.
developing countries:
2. Labor Supply
• Capital is relatively scarce Labor supply refers to growth in the number of people
• Due to scarcity, productivity of capital is high. available for work (quantity of workforce). The potential
size of the labor input can be estimated as the total
number of hours available for work i.e.
Growth Accounting Equation
Total hours worked = Labor force × Average hours
Growth in potential GDP = Growth in technology + WL
worked per worker
(Growth in Labor) + WC
(Growth in capital)
• Labor force refers to as the fraction of the working
age population (over the age of 16) that is
where, employed or available for work but not working
WC = relative share of capital in national income (unemployed).
WL = relative share of labor in national income • Average hours worked is highly sensitive to the
business cycle.
Capital share = (Corporate profits + net interest income +
net rental income + depreciation) / GDP 3. Human Capital
Human capital refers to the accumulated knowledge
Labor share = Employee compensation / GDP and skill that is acquired through education, training and
life experience. It is used to measure the quality of the
• The growth accounting equation shows that long- workforce.
term growth depends on the respective shares of
capital in national income and respective shares
of labor in national income.
Learning Module: 3
• Education has a spillover effect i.e. it improves the Government actions and support are very critical to
quality of the labor force and also encourages deal with negative externalities.
growth through innovation.
• Human capital can also be improved through Factors that influence a country’s economic growth
investment in health. include:
o The effective legal and political environment
o Developed financial markets
4. Physical capital stock
o Political stability
Physical capital stock includes accumulated amount of
o Country’s openness to trade
buildings, machinery, and equipment used to produce
o Property rights
goods and services. The higher the growth in physical
o Laws and regulations etc.
capital stock, the higher the GDP growth rate.
• When net investment (i.e. gross investment -

depreciation of capital) is positive, physical Practice: Example 15,
capital stock increases. CFA Institute’s Curriculum
• This implies that the countries with a higher rate of
investment should have a growing physical
capital stock and a higher rate of GDP growth.
Measures of Sustainable Growth
5. Natural Resources Sustainable rate of economic growth refers to the rate of

There are two categories of natural resources: increase in the economy’s productive capacity or
potential GDP.
i. Renewable Resources are those that can be
where,
replenished i.e. a forest.
ii. Non-renewable Resources are finite resources Growth in potential GDP = Growth in technology + WL
that are depleted once they are consumed. (Growth in labor) + WC
(Growth in capital)
• The greater the natural resource base, the higher
Issues:
the economic growth or per capita income.
• However, natural resources are not necessary to
achieve high economic growth. • Both potential GDP and TFP cannot be directly
observed and need to be estimated.
• Data on the capital stock and labor and capital
6. Public Infrastructure
shares of national income are not available for
many countries, especially the developing
Public infrastructure assets countries.
• include roads, water systems, utilities, mass
transportation etc.
Due to these issues, it is preferred to use the productivity
• generate significant economies of scale
of the labor force i.e.
• have few substitutes
• create externalities – i.e., create spillover 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷
effects of production or consumption onto 𝐋𝐚𝐛𝐨𝐫 𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐯𝐢𝐭𝐲 =
𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒉𝒐𝒖𝒓𝒔
others who are not directly involved in such
activities. • It indicates the quantity of goods and services
(real GDP) that a worker can produce in one hour
7. Other Factors Driving Growth of work.
• The greater the productivity, the higher the
Research & development and public education create standard of living.
positive externalities as benefits go beyond the individual • Productivity increases with better education,
firm and as a result potential GDP increases. increase in investments in physical capital and
improvements in technology.
Externalities also have a negative effect. For example,
air, environmental problems (climate change, pollution Labor productivity can be derived from the production
of air or water) affect the whole planet. function (assuming constant returns to scale) i.e.
There is a strong correlation between per capita GDP Y/L = AF (1, K/L)
and pollution. Developed countries have better air and
water quality. where,
Learning Module: 3
Y/L = output per worker; a measure of labor productivity

Potential growth rate = Long-term growth rate of labor
• This equation indicates that labor productivity force + Long-term labor
depends on physical capital per worker (K/L) and productivity growth rate
technology A.
• Productivity is positively related to TFP or the Important:
capital-to-labor ratio.
• The higher the level of labor productivity, the • If growth rate of actual GDP > growth rate of
higher the output. potential GDP, it indicates:
o Growing inflationary pressures → restrictive
Growth Rate of Labor Productivity = % increase in monetary policy.
productivity over a o In this case, it is preferred to reduce investment
year in fixed-income securities.
• If growth rate of actual GDP < growth rate of
potential GDP, it indicates:
• Higher the productivity growth reflects that same
o Growing resource slack → less inflationary
number of workers can produce more and more
pressures → expansionary monetary policy.
goods and services.
o In this case, it is preferred to increase investment
• In addition, higher productivity results in rising
in fixed-income securities.
profits and higher stock prices.
• In contrast, low rates of productivity growth results
in slow growth in profits and flat or declining stock
prices. Practice: Example 17 & 18

Practice: CFA Institute’s End of
Measuring Sustainable Growth Bank.
Potential GDP = Aggregate hours worked × Labor

productivity
ECO Understanding Business Cycles
Learning Module: 4
2. OVERVIEW OF THE BUSINESS CYCLE
Business Cycles: Recurrent expansion and contractions • Fluctuations in business activity around the long-
in economic activity that affect the major sectors of the term potential or trend growth level.
economy. • The focus is on whether the actual economic
activity is below or above the trend growth in
• Business cycles are associated with economies economic activity.
that are based on business enterprises rather • It divides economic activities into long-run and
than agrarian societies or centrally planned short-run trends.
economies. • Compared to classical cycle, in this cycle peaks
• A business cycle has expected sequence of are reached earlier and troughs later in time.
phases such as upturns are followed by
downturns. 3. Growth Cycle:
• These phases occur at about the same time
throughout the economy.
• Fluctuations in growth rate of economic activity
• It is important to note that cycles are recurrent
(GDP growth rate).
rather than periodic; this implies that all phases
• Compared to the other two cycles, this cycle
of cycles do not have the exact same intensity
recognizes peaks and troughs earlier.
and/or duration.
• Duration of cycles is between 1 and 12 years.
Practice: Refer to Exhibit 2, 3 & 4,
Phases of the Business Cycle Reading 11, CFA Institute’s Curriculum.
A business cycle is primarily divided into two segments Practical Issues

with two turning points. The two segments are:
• Typically, definitions of business cycle are
1. Expansion or upswing somewhat ambiguous and are used
2. Contraction or downturn interchangeably.
• Classical cycle concept is rarely used in practice.
The two turning points are: • Growth cycle concept is often used to identify
i. Peak (highest point of the cycle) fluctuations around potential output.
ii. Trough (lowest point of the cycle)
A business cycle can be divided into several phases. Four Phases of the Cycle
However, the above mentioned two segments are easy
to identify in retrospect. The four phases of business cycle are:
Types of Cycles 1. Recovery

2. Expansion
3. Slowdown
• Classical cycle 4. Contraction
• Growth cycle
• Growth rate cycle 1. Recovery
• Economy is going through trough phase
1. Classical Cycle: • Actual output is at its lowest level relative to
potential output.
• Economic output is below potential but is
• Fluctuations in the level of economic activity starting to increase
measured by GDP in volume.
• Contraction phase: 2. Expansion
o is short in duration
o starts from a peak and ends at a trough During expansion, aggregate economic activity is
• Expansion phase: increasing, and actual output is above potential output.
o is long in duration
o starts from a trough and ends at a peak
• Spending ↑
• Production ↑
2. Growth Cycle: • Employment ↑
• Prices & interest rates ↑

ECO Understanding Business Cycles FinQuiz.com
Learning Module: 4
• GDP ↑ can benefit from portfolio management if they can

forecast future changes in these variables. This benefit
can be for diversified portfolios (e.g., when to increase
allocation to equities) as well as for equity positions
3. Slowdown
concentrated in sectors (e.g., when to increase
• Actual output is highest relative to potential
exposure to the auto sector).
output i.e., largest positive output gap and that
gap begins to narrow.
1. Recovery phase
• Inflation and price levels may decrease
Risky assets (e.g., stocks) become more attractive for
• Businesses may rely on overtime than new hiring
investors (i.e. prices shoot up) when a recession is
• Consumers are still optimistic
expected to end soon. Expectations cause stock prices
to start rising a few months before the actual pickup in
4. Contraction:
the economic activity.
• Actual output is below potential output
• Consumer and business confidence ↓
2. Expansion phase
• Employment and overtime ↓
The economy experiences a ‘boom’ as the economic
• Economic activity ↓
expansion continues for some time. Firms may increase
• Usually, this phase is shorter than expansion
production capacity and shortages of qualified human
phase
resources can become an issue. Concerns for
• If decline is prolonged it may lead to recession &
overheating of the economy may bring actions from the
then depression
government/central bank.
Refer to Exhibit 5: Business Cycle Phase 3. Slowdown phase

Characteristics, CFA Institute’s Curriculum. Stocks perform better than bonds during economic
booms (i.e., higher returns). Higher production and
higher corporate profits lead to higher stock prices.
Bonds are unattractive for investors and are available at
Leads and Lags in Business and lower prices (offering higher yields compared to the
Consumer Decision Making past).
Relative to the expected turning points, sometimes the 4. Contraction phase

turning points may exhibit leads and lags due to the Investors prefer to invest in bonds. Stocks of companies
behavior of businesses and households. with stable cash flows (and dividends) also become
attractive.
Market Conditions and Investor Behavior
Many macro-economic variables (e.g., GDP growth) Curriculum.
and economic sectors (e.g., consumer discretionary)
have exhibited changes cyclically in the past. Investors
3. CREDIT CYCLES AND THEIR RELATIONSHIP TO BUSINESS CYCLES
Credit cycles - fluctuations in prices and availability of o financial frictions (variation in access to external
credit, particularly private sector credit which is critical financing)
for business investments and real estate properties. o relation between busines and credit cycles.
Credit cycles tend to be longer and deeper
Cyclical developments of financial variables are than business cycles.
examined using credit and property prices.
When economy is: Consequences for Policy

o strong/improving – lenders extend credit
o weak/weakening – lenders tighten credit Recognizing credit cycle stage helps investors in
assessing:
Applications of Credit Cycles
1. business cycle expansions and contractions
2. growth in housing and construction markets
Loose credit conditions cause asset price and real 3. policy makers’ actions
estate bubbles. Duration and magnitude of recessions or
recoveries are intensified and affected by:
Learning Module: 4

Curriculum.
4. BUSINESS CYCLE FLUCTUATIONS FROM A FIRM’S PERSPECTIVE
The Workforce and Company Costs Refer to Exhibit 8 ‘Capital Spending during the
Economic Cycle’, Reading 11, CFA Institute’s
Contraction Phase: Curriculum.
• Businesses eliminate overtime but retain workers.
• Companies secure a bond of loyalty with
workers due to the high cost of training
newcomers. Practice: Example 3, Reading 11,
• As the contraction phase prolongs, businesses CFA Institute’s Curriculum.
liquidate inventories and cut costs such as
advertising, consultants, new equipment, etc.
• Banks reduce lending as bankruptcy risk
Fluctuations in Inventory Levels
increases.
• Lower aggregate demand lowers wages, wage
growth, input prices, and interest rates. Although, inventories represent a small part of the overall
economy, they can have greater effect on economic
Turning Point of Busines Cycle growth because fluctuations in inventory levels occur
• Lower prices and interest rates stimulate rapidly.
consumer and business spending, and as a
result, aggregate demand and economic The key indicator used to analyze fluctuations in
activity start to increase. inventory levels is the inventory-sales ratio. It reflects the
outstanding stock of available inventories to the level of
sales.
Refer to Exhibit 7 ‘Business Cycle Phases- Level of
Employment’, CFA Institute’s Curriculum.
Refer to Exhibit 9 ‘Inventories throughout the

Cycle’, CFA Institute’s Curriculum.
Fluctuations in Capital Spending
• Capital spending fluctuates with business cycle and

changes in economic activity Practice: Example 4, CFA Institute’s
• Companies’ spending decisions are driven by: Curriculum.
o expectations
o business conditions
o level of capacity utilization
• Investment is one of the most procyclical and
volatile element of GDP.
5. CONSUMER BEHAVIOR
Household consumption represents the largest sector of • When durables’ spending is rising, it indicates a
a developed economy. Measures of household general economic recovery.
consumption include: 2) Non-durable goods i.e. food, medicine,
cosmetics, clothing.
a) Retail sales, utilities sales, household services etc. 3) Services i.e. medical treatment, hairdressers etc.
Three major divisions are:
b) Household consumption can be analyzed through
1) Durable goods i.e. autos, appliances. consumer confidence or sentiment. Such information
Consumption of durable goods is affected by can be obtained through surveys. However, these
short-term uncertainties. surveys are biased and do not reflect actual
• When durables’ spending is weak /declining, it consumer behavior.
indicates a general economic weakness.
Learning Module: 4
c) Household consumption can be analyzed through economic weakening. However, in the long-term,
growth in income i.e. after-tax income or disposable higher savings may indicate potential for
income. According to permanent income hypothesis, recovery.
households adjust consumption based on perceived
permanent income level instead of temporary
fluctuations in income.
Refer to Exhibit 10 ‘Inventories throughout the
• Savings refer to the percent of household’s Cycle’, Reading 11, CFA Institute’s Curriculum.
income that is not spent.
• Saving rate also reflects future perceived
uncertainties in income (known as precautionary
savings).
Practice: Example 5, Reading 11,
• Rise in precautionary savings indicates consumers’
ability to spend despite possible lower income in
the future.
• In the short-term, rise in savings may indicate a
certain caution among households and
6. HOUSING SECTOR BEHAVIOR
Housing sector activity includes: disproportionately i.e. despite of increase in

• Home sales (new and existing) household incomes, housing costs may rise.
• Residential Construction o When housing costs rise, house sales slowdown
and result in cyclical downturn in home buying.
Although, housing sector represents a small part of the Afterwards, as the inventory of unsold houses
overall economy, it can have greater effect on accumulates, construction activity decreases.
economic growth because of rapid fluctuations in o If housing prices have risen rapidly in the recent
housing sector. past, home buying may increase in response to
increase in housing prices to gain exposure to
• Housing sector is highly sensitive to interest rates the expected price appreciation. However, due
relative to other sectors because mostly home to large inventory of unsold homes, real estate
purchases are financed with a mortgage i.e. the prices eventually fall.
lower (greater) the mortgage rates, the greater • House buying is affected by following factors:
(lower) the home buying and construction o Housing prices
activity. o Rate of family formation
• Housing sector also follows its own internal cycle o Speculation on housing prices
i.e.
o When housing prices are low relative to
average incomes, and when mortgage rates
are also low, → the cost of owning a house ↓, Practice: Example 6, Reading 11,
and → demand for housing ↑. CFA Institute’s Curriculum.
o When the expansionary cycle matures, housing
prices and mortgage rates rise
7. EXTERNAL TRADE SECTOR BEHAVIOR
An economy with a large external trade sector is highly

affected by the business cycles of the large open • When a domestic currency appreciates,
economies in the world. o Foreign goods seem cheaper than domestic
goods to the domestic population, → imports
Imports respond to domestic cycle: All else equal, when rise (all else equal).
domestic GDP growth increases → demand for o Exports become expensive on global markets, →
purchases of goods and services from abroad increases exports fall (all else equal).
and → imports rise. • Currency depreciation has opposite effects.
• It is important to note that currency movements
Exports respond to cycles in the rest of the world: All else will only have a significant effect on trade and the
equal, when foreign GDP growth increases → exports balance of payments when they occur in a single
rise. If these external cycles are strong (all else equal), direction for some period of time.
exports will grow in spite of decline in domestic economy
growth.
Learning Module: 4

Refer to Exhibit 11 ‘External Trade’, CFA Institute’s Institute’s Curriculum.
Curriculum.
8. THEORETICAL CONSIDERATIONS
Historical Context • Government should not intervene as business

cycles are caused by government intervention.
• Money plays an important role. Low interest
Classical-oriented economists believe in no intervention rates and high credit growth during booms
(i.e., invisible hands themselves handle the proper
cause overinvestment in low return projects and
functioning of the markets).
subsequent failure of the economy.
Keynesian-oriented economists believe government
should intervene to resolve frequent market failures and Monetarism
rigidities.
Monetarists’ theory focuses on maintaining a steady
Neoclassical Economics growth of the money supply and a very limited
government intervention in the economy.
Neoclassical and RBC (real business cycle) theorists
emphasize no government intervention in the economy According to Monetarists school,
due to the following explanations:
• Aggregate demand and supply should find
• Expansions and contractions, in an efficient their own equilibrium
economy, are natural response to external real • Business cycles may occur due to two reasons:
shocks. i. Exogenous shocks
• These theorists focus on movements in the ii. Government intervention
supply curve, which is affected by: • Boom and inflation occur when money supply
o technology grows too fast.
o natural calamities • Recession occurs when money supply grows
o key input price changes too slowly.
o supply-side constraints
• Government intervention (fiscal and monetary
policies) disrupts the economy by forming lags Keynesianism
(lag between plan development and
implementation). Keynesian theory believes that movement in aggregate
• These late policy actions usually amplify the demand curve cause changes in the overall economic
next cycle instead of fixing it. output.
• They stress the importance of market efficiency.
Eliminating asymmetric information leads to Keynesians gives no importance to supply curve and
market efficiency and quick price adjustments. believes supply curve is relatively flat i.e., prices are sticky
• For example, if price ↑ is due to ↑ in in the short run i.e.,
demand, firms should ↑ production. But
if it is due to inflation, firms should not ↑
production. • Wages are downward sticky. Even if wages fall, it
• Neoclassical economists believe that policies results in decline in AD. Hence, demand for all
should not preclude “creative destruction”. sorts of goods decline and moves in “domino
Innovations change existing supply curve as effect” through the economy i.e. AD curve
new/better products eradicate existing enters into a downward spiral and continuously
businesses. shifts towards left.
• Also, growth cannot be increased simply by
lowering interest rates (i.e., expansionary
The Austrian School monetary policy).
Austrian school believes that markets are flexible, and Hence, Keynes suggested that when recession occurs,
prices adjust easily to varying situations. According to government should intervene in the form of
Austrian school: expansionary fiscal policy i.e., increasing government
Learning Module: 4
spending to limit the negative effect of economic crises implemented with a time lag which may make
in the short term. them less effective.
However, it should be noted that Keynes did not

advocate a continuous presence of the government in Modern Approach to Business Cycles
the economy.
Today’s economics is a combination of the following
The practical criticisms about Keynesian Fiscal Policy three macroeconomic theories:
are:
1. Neoclassical and RBC
1) Fiscal deficits (i.e., government spending > taxes) 2. Monetarism
may lead to higher government debt. 3. Keynesian
2) Keynesian cyclical policies are for short-term only.
In the long-run, expansionary policy may lead to Regarding business cycle discussion, some experts favor
unsustainable fast economic growth, higher government intervention, and some are against it. An
inflation and other problems. analyst’s investment decision should not be influenced
3) Fiscal policies are implemented with a time lag. by his personal opinions.
Differences between Monetarism and Keynesianism However, central banks tend to manage business cycle
(i.e., change AD curve) through changing interest rates
1) The Keynesian model ignores the role of money when economy is growing rapidly or weakening.
supply.
2) Keynes theory focused on short-term; thus, it failed
to consider the long-term impact of government Practice: Example 9, CFA Institute’s
intervention i.e., fiscal deficit may result in growing Curriculum.
government debt and high cost of interest on this
debt.
3) The timing of governments’ economic policy
responses was not certain and fiscal policies are
9. ECONOMIC INDICATORS
An economic indicator is a variable that provides

information on the state of the overall economy.
Types of Indicators Composite Indicators
There are three types of economic indicators. Composite economic indicator: It is an aggregate
measure of leading, lagging and coincident indicators
1. Leading economic indicators (LEI): Leading indicators to measure the cyclical state of the economy.
are variables that change before the changes in the
overall economy. They are useful for predicting the
Leading Indicators
economy’s future state, usually short-term.
2. Coincident economic indicators: Coincident In the U.S., a composite leading indicator is known as
economic indicators are variables that change close the Conference Board Leading Economic Index (LEI)-
to the changes in the overall economy. They provide (published by conference board). It is composed of 10
information regarding present/current state of the components.
economy.
Refer to Exhibit 15 ‘Index of Leading Indicators’,
3. Lagging economic indicators: Lagging economic CFA Institute’s Curriculum.
indicators are variables that change after the
changes in the overall economy. They provide
information regarding the economy’s past condition.
9.4 Using Economic Indicators
Refer to Exhibit 14 ‘Types of Economic
Indicators’, CFA Institute’s Curriculum.
Learning Module: 4
Because of the advent of big data and massive

Refer to Exhibit 16 ‘Use of Statistics to Identify
increase in information, the number of variables in
Business Cycle Phase’, CFA Institute’s Curriculum.
various composite indicators has been increased.
Other Composite Leading Indicators Nowcasting
• Organization of Economic Co-operation Nowadays, policymakers and experts are monitoring

Development (OECD) calculates: financial and economic variables in real-time using a
o OECD CLI (Composite Leading Indicators) to large variety of data.
measure business cycle of the economy using
growth cycle concept. Nowcast – a term contracted from ‘now’ and
• These indices are consistent across countries, and ‘forecasting’ to monitor the economic condition in real-
therefore can be easily used for comparison time such as GDP growth, inflation, unemployment etc.
purposes.
GDPNow
Surveys
GDPNow – a recent estimate of real GDP growth using
Composite indicators at regional or country level are data from the recent measured quarter to forecast GDP
used to form economic tendency surveys. These monthly for the current quarter (before-quarter end)
or quarterly surveys:
o are usually released by central banks, statistical Many entities such as investment banks, asset
offices, research institutes and trade associates. management, institutions are producing Nowcasts for
o mostly include qualitative questions about their clients or internal use.
finances, level of activity and confidence in the
future.
The Use of Big Data in Economic Indicators Institute’s Curriculum.
10. UNEMPLOYMENT
Unemployment
Labor force: The labor force is the total number of
workers i.e. it is the sum of the employed and the
Generally, unemployed. This number excludes retirees, children,
stay-at-home parents, fulltime students and other
• Just when the recovery starts, unemployment is at categories of people who are neither employed nor
its highest level. actively seeking employment.
• At the peak of the economy, unemployment is at
its lowest level. Unemployed: A person is unemployed if he or she is
temporary jobless and is looking for a job or is waiting for
During an expansionary phase and when demand for the start date of a new job. Some special categories
labor > supply of labor, → unemployment is very low, → include:
inflation occurs. Due to expectations of rising prices,
workers demand higher wages. Because of an upward • Long-term unemployed: A person who has been
pressure on wages, employers are also induced to without a job for a long time i.e. more than 3- 4
increase prices in advance to keep their profit margins months but is still looking for a job.
stable and results in a price-wage inflationary spiral. To • Frictionally unemployed: A person is frictionally
control inflation, central bank may adopt tight monetary unemployed if he/she just left one job and are
policy; however, these policies may lead to a deep about to start another job. Frictional
recession. unemployment results from the time that it takes
to match workers with jobs.
Definitions: • Structural unemployment refers to unemployment
that is due to changes in the structure of demand
Employed: A person with a job is referred to as for labor; e.g., when certain skills become
employed. This number excludes people working in the obsolete or geographic distribution of jobs
informal sector e.g. unlicensed cab drivers. changes.
Learning Module: 4
unemployed people who have severe

Unemployment rate: It is the ratio of unemployed to disabilities and could never seek work.
labor force. 2) Businesses are reluctant to adjust their labor in
response to business cycles i.e. they are reluctant
Activity (or participation) ratio: It is the ratio of labor to lay off people during recession and reluctant
force to total population of working age (i.e. persons to hire people as the recovery develops.
between 16 and 64 years of age).
Flaws in Unemployment rate:
Underemployed: A person is referred to as
underemployed if he/she has a job but has the
Unemployment rate:
qualification to do a significantly higher-paying job.
Discouraged worker: Discouraged worker is a person
who would like to work but has given up looking for jobs • Does not include discouraged workers
after an unsuccessful search. Discouraged workers are • Includes part-time workers
not part of labor force; thus they are not included in the • Does not measure underemployment
official unemployment rate.
• It is important to note that when comparing
unemployment among countries, analysts must
• During deep recessions, many discouraged
take into account different unemployment
workers stop looking for a job. As a result, the
measurement methods used by different
unemployment rate may decrease in spite of
countries.
weak economy.
• Hence, we should observe both participation rate
and the unemployment rate to understand Overall Payroll Employment and
whether unemployment is decreasing because of Productivity Indicators
an improved economy or because of an increase Payroll growth is a measure used to get a better picture
in discouraged workers. of the employment cycle i.e.
Hidden unemployment: It includes discouraged workers • When payroll shrinks, it indicates weak economy.
and underemployed people. • When payroll rises, it indicates economic
recovery.
Voluntarily unemployed: A person is referred to as
voluntarily unemployed when he/she is not willing to
However, it is a biased measure because it is difficult to
work because he is in school, retired early, or very rich.
count employment in smaller businesses.
Such people are also not considered in the labor force in
unemployment statistics.
Some other measures include:
The Unemployment Rate Hours worked (particularly overtime): When businesses
start reducing (increasing) work hours particularly
The unemployment rate is the ratio of unemployed to
overtime, it indicates economic weakness (recovery).
labor force. It indicates % of the overall workforce who
are unemployed but are willing to work if they could find
Use of temporary workers: When businesses start
it. However, unemployment rate is considered a lagging
reducing (increasing) part-time and temporary staff, it
economic indicator of the business cycle and is not
indicates economic weakness (recovery).
helpful in pointing to cyclical directions due to following
two reasons:
Productivity (i.e. output ÷ hours worked):
1) The unemployment rate reflects a past economic

• When output falls in a downturn but businesses
condition because the labor force changes in
tend to keep workers on the payroll → productivity
response to the economic environment. In
declines. It indicates sign of economic weakness.
addition, during deep recession, many
• Similarly, productivity rises as output recovers.
discouraged workers stop looking for a job. As a
result, the unemployment rate may decrease in
spite of poor job market situation. In contrast, NOTE:
when an economy improves, people start Productivity generally increases with advancement of
searching for a job but since it takes time to get technology or improved training techniques. When such
the job, the unemployment rate may increase in changes are strong enough, they can lead to increase
spite of strong job market situation. in unemployment; however, these effects occur over
• Some agencies prefer to measure the long-term.
workforce in terms of the working-age
population because it remains constant
regardless of the state of the labor market. But Practice: Example 11, CFA
the flaw in this approach is that it includes Institute’s Curriculum.
Learning Module: 4
11. INFLATION
Inflation refers to a continuous (not one time) increase in • Expansionary fiscal policy i.e. increase in
the overall level of prices in an economy. During government spending without any increase in
inflation, the value of money actually decreases. taxes.
• Increase in the supply of money by the Central
Inflation rate: The inflation rate is the % change in a price bank to support government spending.
index. It is pro-cyclical i.e. it increases and decreases • Shortage of supply of goods created during or
with the cycle, but with a lag of a year or more. after a war, economic regime transition or
prolonged economic distress due to political
• It is used to get a better picture of the state of the instability.
economy, expected changes in monetary policy,
expected changes in political risks etc. Disinflation: Disinflation refers to decrease in the inflation
• It is used by Central bank in conducting monetary rate i.e. from around 15 to 20% to 5 or 6%. Disinflation is
policy. not the same as deflation because even after a period
• A high inflation rate combined with a high (slow) of disinflation, the inflation rate remains positive and the
economic growth and low (high) unemployment aggregate price level keeps rising.
indicates that the economy is in the state of
overheating (stagflation i.e. stagnation +
inflation). Measuring Inflation: The Construction of Price Indices
Various price indices are used to measure the overall Price Index: A price index represents the average prices
price level (known as aggregate price level). of basket of goods and services. A price index is
calculated as follows.
Stagflation: Stagflation (stagnation plus inflation) refers to
an economic state with a high inflation rate, high level of Example to calculate Laspeyres price index:
unemployment and economic slowdown. When an
economy is in state of stagflation, short-term economic Time January 2010 February 2010
policy is not considered effective; rather, the economy
should be left to correct itself. Goods Quantity Price Quantity Price
Rice 50 kg ¥3/kg 70kg ¥4/kg
Deflation, Hyperinflation and Disinflation Gasoline 70 liters ¥4.4/liter 60liters ¥4.5/liter
Deflation: Deflation refers to a persistent decrease in Value of consumption basket in Jan 2010 = value of rice
aggregate price level i.e., negative inflation rate (< 0%). + value of gasoline = (50 × 3) + (70 × 4.4) = ¥458.
• During deflation, the value of money (or • To weight the price in the index, a price index uses
purchasing power of money) increases. the relative weight of a good in a basket. Thus,
• The liability (in fixed monetary amounts) of a
borrower increases in real terms during deflation.
Value of consumption basket in Feb 2010 = value of rice
• Due to decrease in price level, revenue of typical
+ value of gasoline = (50 × 4) + (70 × 4.5) = ¥515.
companies also decline. Consequently,
investment spending ↓, layoff ↑ → unemployment ↑
→ economy further contracts. • The price index on the base period is usually set to
100. In this example, Jan 2010 is the base year. So
the price index in Jan 2010 is 100. Then,
NOTE:
To avoid deflation, developed economies prefer an Price index in Feb 2010 = (515/458) × 100 = ¥ 112.45*
inflation rate of around 2% per year. Inflation rate = (112.45 / 100) – 1 = 12.45%
Hyperinflation: Hyperinflation refers to an extremely rapid * it is Laspeyres price index.

increase in aggregate price level i.e. high inflation rate
e.g. 500 to 1000% per year. During hyperinflation, Laspeyres index: It is a price index that is created by
consumers’ spending increases at a faster rate in using a fixed consumption basket.
expectation of further increase in future prices and
money circulates more rapidly.
• Most price indices around the world are Laspeyres
indices because the survey data regarding the
Hyperinflation occurs due to:
Learning Module: 4
consumption basket are only available with a

time lag. Price Indices and Their Usage
• The consumption basket is updated every five
years (in most of the countries).
A. Consumer price index (CPI): CPI reflects the prices of
a basket of goods and services that is typically
Biases in Laspeyres index: purchased by a normal household. CPI is used to
compare the price of a fixed basket of goods and
i. The substitution bias: The basket does not change to services to the price of the basket in the base year.
reflect consumer reaction to changes in relative CPI is a Laspeyres index. Most of the countries use
prices e.g. consumers substitute toward relatively their own consumer price index (CPI) to measure
cheaper goods. Hence, the Laspeyres Index inflation in the domestic economy. It is difficult to
overstates the measured inflation rate and results in compare CPIs of different countries because of:
an upward bias by not considering consumer
substitution.
• Different names
• Different weights to various categories of goods
• The substitution bias can be resolved by using and services.
chained price index formula. For example: • Different scope of the index e.g. some countries
collect data for CPI which covers both urban and
a) Fisher Index: It is the geometric mean of the rural areas.
Laspeyres index.
b) Paasche Index:
(#$ ×')) (*$ ×'.,) Uses:
Paasche Index (Feb 2010) = Ip = (#$ ×-)) (*$ ×'.') ×
100 • CPI is used by U.S.’s Treasury inflation protected
= 116.03* securities (TIPS) to adjust the bond’s principal
according to the U.S. CPI-U index.
The value of the Fisher Index is calculated as follows: • The terms of labor contracts and commercial real
estate leases may adjust periodically according
Fisher Index (Feb 2010) = .𝐼𝑝 × 𝐼𝐿 = √116.03 × 112.45 to the CPI.
= 114.23 • CPI is used by Central bank to monitor inflation.
where, IL = Laspeyres index Flaw in CPI: Since, CPI-U is a Laspeyres index, it has
upward biases.
ii. The Quality bias: When the quality of a good
improves over time, the value of a dollar rises, even if B. Personal consumption expenditures (PCE) index: PCE
the price of the good stays the same. Hence, the is a price index that reflects all personal consumption
Laspeyres Index overstates the measured inflation (i.e. complete range of consumer spending) rather
rate and results in an upward bias by not adjusted for than just a basket. PCE index is a Fisher index.
quality.
• Due to upward biases in CPI, Fed prefers to use
• Quality bias can be resolved by using Hedonic PCE index.
pricing technique.
C. Producer price index (PPI): PPI measures the cost of a
iii. New product bias: Since, the Laspeyres Index is based basket of raw materials, intermediate inputs, and
on fixed basket of goods and services, it does not finished products. It is also known as wholesale price
include new products. New products benefit index WPI.
consumers by providing them greater variety, which
in turn increases the value of dollar. Hence, the • PPI can affect future CPI because producers pass
Laspeyres Index overstates the measured inflation increase in prices eventually to consumers.
rate and results in an upward bias by not including • PPI include items i.e. fuels, farm products,
new products. machinery & equipment, chemical products etc.
These products are further categorized by stage-
• New products bias can be resolved by of-processing categories i.e. raw materials,
introducing new products into the basket over intermediate materials, finished goods.
time. • Like CPI, scope and weights of PPI vary among
countries.
NOTE:
It is relatively easy to resolve the quality bias and new Flaw in PPI or WPI: It understates market prices because it
does not consider retail margins.
product bias.
Learning Module: 4
D. GDP deflator: Financial analysts also use GDP deflator, Due to increase in wages, AS curve shifts to the left,
which measures the price of the basket of goods and resulting in increase in price and decrease in output.
services produced within an economy in a given
year. NOTE:
Since, unemployment fails to consider economy’s full
Headline Inflation: It is an inflation rate that is calculated
labor potential, some practitioners prefer to observe
using a price index that includes all goods and services
participation rate of people in the workforce.
in an economy. The ultimate objective of policymakers is
to control headline inflation.
Non-accelerating inflation rate of unemployment
(NAIRU) or Natural rate of unemployment (NARU): The
Flaws:
natural rate of unemployment is achieved when labor
markets are in balance that is the number of job seekers
• It is affected by short-term fluctuations in food equals the number of job vacancies. NARU does not
and energy prices. Therefore, headline inflation is mean zero unemployment; it is the unemployment rate
considered a noisy predictor of future inflation. at which the inflation rate will not rise because of a
• It does not accurately detect movements in a shortage of labor. The natural rate of unemployment is
sub-index or a relative price, which are useful for also referred to as the full employment.
analyzing the prospects of an industry or a
company.
• NARU is a better measure than unemployment
rate because it better indicates when an
Where,
economy will face bottlenecks in the labor market
o Sub-index: Price index for a particular category
and wage-push inflationary pressures.
of goods or services is known as sub-index.
• It should be noted that the NARU is not fixed;
o Relative prices: The price of a specific good or
rather, it depends on the demographic makeup
service in comparison with those of other goods
of the labor force and the laws and customs of
and services is called relative price.
the nations. For example, if the skill set of a large
part of the workforce does not meet the hiring
Core Inflation: It is an inflation rate that is calculated need of the employers, the NAIRU of such an
using a price index that includes all goods and services economy can be quite high.
except food and energy prices, which tend to be • Also, the concept of NARU or NAIRU is not related
unpredictable. to any particular school of macroeconomic
models.
• Core inflation is a less volatile measure of inflation;
therefore, policymakers prefer to use core Issues with NARU and NAIRU:
inflation.
• Domestically driven inflation is better reflected by 1) They are not directly observable.
core inflation because the changes in the prices 2) NARU or NAIRU is not fixed; it changes over time with
of food and energy are internationally changes in technology, social factors and
determined and do not reflect domestic business economic structure.
cycle.
• Various Wage-cost indicators include hourly wage
gauges, weekly earnings, and overall labor costs.
• Productivity (i.e. output per hour):
Practice: Example 12, Reading 11. o The greater the productivity, the lower the price
CFA Institute’s Curriculum. is charged by businesses for each unit of output
to cover hourly labor costs.
o Also, the greater the productivity, the faster the
wages can increase without putting undue
Expecting Inflation upward pressure on businesses’ costs per unit of
output.
1. Cost-Push Inflation
𝑼𝒏𝒊𝒕 𝒍𝒂𝒃𝒐𝒓 𝒄𝒐𝒔𝒕 (𝑼𝑳𝑪) 𝒊𝒏𝒅𝒊𝒄𝒂𝒕𝒐𝒓
Cost-push inflation is a type of inflation caused by Total labor compensation per hour per worker
substantial increase in the costs of production (i.e. =
Output per hour per worker
increase in the cost of important inputs where no
suitable alternative is available) e.g. increase in labor
wages, costs of raw materials etc. It is also known as
wage-push inflation. Practice: Example 13, Reading 11.
Lower unemployment rate results in labor shortages,
which consequently puts upward pressure on wages.
Learning Module: 4
2. Demand-pull Inflation 3. Inflation Expectations
Demand-pull inflation arises when demand in an Expectations about inflation can cause inflation to
economy increases at a faster rate than that of supply. It occur. Such expectations can make inflation to persist in
tends to occur when spending is greater than the an economy even after its initial cause has disappeared.
productive capability of the economy, rate of capacity It may result in an upward spiral of prices and wages
utilization is high, and when an economy is close to or at and inflation continues to rise.
full employment level (i.e. actual GDP is close to
potential GDP). It is quite difficult to measure inflation expectations.
Similarly, inflation decreases, or deflation arises when • Inflation expectations can be measured by
economy operates below its potential GDP level or the observing past inflation trends because market
rate of capacity utilization is low. As a result, there is less participants largely extrapolate their past
supply pressure. experiences.
• Inflation expectations can be measured using
According to Monetarists school, inflation is basically a surveys of inflation expectations. But these surveys
monetary phenomenon i.e. increase in the supply of are biased by the way questions are asked.
money results in increased liquidity → which results in • Inflation expectations can be measured by
rapid rise in demand and consequently leads to comparing interest available on TIPS and with
inflation. other non-inflation adjusted government bonds
e.g. Suppose
• Accelerations in money growth (without any o Today’s yield on 10-year nominal bond of a
specific reason) indicate the potential for certain country is 4%.
inflationary pressure. o The yield on 10-year inflation-protected bond of
• If growth in money supply > growth of nominal the same country is 2%.
GDP, it indicates the potential for inflationary Hence,
pressure. Opposite occurs when money growth < Market is pricing in = 4% – 2% = 2% average
growth in nominal GDP. annual inflation over the next 10 years.
Velocity of Money: NOTE:

𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 Calculating inflation expectations using this method is
𝐕𝐞𝐥𝐨𝐜𝐢𝐭𝐲 𝐨𝐟 𝐦𝐨𝐧𝐞𝐲 =
𝐌𝐨𝐧𝐞𝐲 𝐒𝐮𝐩𝐩𝐥𝐲 not reliable because the market for inflation-linked
bonds is relatively small; also, yields on inflation-linked
• Prices are stable when velocity of money remains bonds can be influenced by other market factors i.e.
stable around a constant or a historical trend. demand & supply.
• When velocity falls, it may indicate the potential
for inflationary pressure. However,
o If velocity has fallen due to decrease in Nominal Practice: Example 14, CFA
GDP rather than increase in money supply, it Institute’s Curriculum.
may indicate potential for cyclical upswing.
o If velocity has fallen due to an increase in the
money supply, then it may indicate potential for
inflationary pressures. Practice: CFA Institute’s End of
• When velocity rises e.g. due to decrease in Chapter Practice Problems and
money supply, it indicates shortage of money in
the economy and disinflation.
Bank.
ECO Monetary and Fiscal Policy
Learning Module: 5
1. INTRODUCTION TO MONETARY AND FISCAL POLICY
The decisions made by governments can have a much
larger impact on the economy compared to decisions 1. Monetary policy refers to policy used by central bank
made by a single household or a business because: to influence the macro economy by changing the
quantity of money and credit in the economy.
1) In most of the developed economies, a significant
proportion of the population is employed by 2. Fiscal policy refers to the policy used by the
public sector. government to influence the macro economy by
2) Governments are usually responsible for a changing government spending and taxation.
significant proportion of spending in an economy.
3) Governments are the largest borrowers in world’s
debt markets. Practice: Example 1,
Types of Government Policy:
There are two types of government policy.
2. MONEY: FUNCTIONS, CREATION, AND DEFINITION
1) Must be readily acceptable by buyers and sellers

Money as payment for goods and services.
2) Must have a known value.
3) Must be easily divisible i.e. can be divided into
Barter is the direct exchange of goods and services for smaller units to accommodate transactions of
other goods and services.
differing value.
4) Must have a high value relative to its weight; it
Drawbacks of Barter System:
implies that money must be portable and easy to
use.
1) Barter system requires a double coincidence of 5) Must be difficult to counterfeit.
wants. Both people have to have what the other
one wants and be willing to swap with each
Functions of Money: Money fulfills three important
other.
functions.
2) In barter system, it was difficult to undertake
transactions associated with indivisible goods.
3) It was difficult to undertake transactions 1) Money acts as a medium of exchange.
associated with goods whose value was difficult 2) As a store of value, money provides a way to
to store i.e. it was difficult to retain value of individuals to keep some of their wealth in a
perishable goods for the future if a person does readily spendable form for future needs.
not wish to exchange all of their goods on other 3) Money serves as a unit of account and provides a
goods and services. convenient way of measuring value.
4) In a barter economy, there was no
standard/common measure of value; this makes Precious metals (e.g. gold) were acceptable as a
multiple transactions difficult. medium of exchange because of the following
characteristics:
• Known value
The Functions of Money
• Easily divisible
• High value relative to their weight
Money is anything that is generally accepted as a • Not perishable (store of value)
medium of exchange. Money eliminates the double • Not easily counterfeited
coincidence of the "wants" problem that exists in a
barter economy.
Paper Money and the Money Creation Process
As a medium of exchange, or means of payment,
money must possess following characteristics: The paper money was invented in the following way i.e.

ECO Monetary and Fiscal Policy FinQuiz.com
Learning Module: 5
• The individuals started placing excess gold with

goldsmiths. Practice: Example 2,
• On receiving that gold, goldsmiths used to give CFA Institute’s Curriculum.
the depositors a receipt stating how much gold
they had deposited.
• Hence, instead of physically transferring gold for
undertaking transactions, people started using 2.3 Definitions of Money
those receipts as a means of payment.
• These depository receipts were called promissory
In an economy with money but without promissory notes
notes because they represented a promise to pay
and fractional reserve banking, Money is the total
a certain amount of gold on demand. In this way,
amount of gold and silver coins in circulation, or their
paper money was created and became a means
equivalent.
of payment for goods and services.
• In addition, those goldsmiths started lending a
Narrow money = M1
certain amount of gold that was not being
= currency held outside banks +
withdrawn and used for transaction purposes to
checking accounts + traveller’s check
others at a rate of interest. This process results in
Where,
creation of money.
• Currency held outside banks: Notes and coins in

Fractional reserve banking system: Like goldsmiths, these
circulation in an economy
days, banks lend a certain amount of deposits of money
• Checking accounts: Balances can be withdrawn
that is not likely to be withdrawn to others. This practice is
by using check
known as fractional reserve banking. In this system,
• Traveller’s check: Issued in specific
denominations, these are treated as cash
Total amount of money created = New deposit/ Reserve
requirement
Broad money = M2
Hence, the amount of money that the banking system = M1 + time deposits + saving deposits
creates through the practice of fractional reserve Where,
banking is
• Time deposits (fixed deposits): Interest-earning
𝟏 deposits with a specified maturity, which are
=
𝐑𝐞𝐬𝐞𝐫𝐯𝐞 𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭 𝐨𝐫 𝐫𝐞𝐬𝐞𝐫𝐯𝐞 𝐫𝐚𝐭𝐢𝐨 subject to penalty for early withdrawal.
= Money Multiplier • Savings deposits: Interest-earning deposits with no
specific maturity.
e.g., if reserve requirement is 20% or reserve ratio is 1/5.
M3 = M2 + deposits with non-bank financial institution
Money multiplier = 5 (e.g., deposits of finance companies and post office
savings)
• The smaller the reserve requirement, the greater
the money multiplier effect. Credit card: Credit card is not a form of money because
• Reserve requirement is set by the central bank. when a person uses a credit card, he/she is simply
• Central banks can increase money supply in the deferring payment for the item. Hence, credit card only
economy by lowering the reserve requirement. serves as a temporary medium of exchange but not a
store of value.
Source: CFA Institute’s Curriculum, Exhibit 2.
For detail explanation, paragraphs after Exhibit 2, Refer to: Exhibit 3,

CFA Institute’s Curriculum. CFA Institute’s Curriculum.
.
MONEY: QUANTITY THEORY, SUPPLY

3.
AND DEMAND, FISHER EFFECT
the price level i.e., total spending (in money terms) is

proportional to the quantity of money.
Quantity theory of money
Quantity theory of money (QTM): Quantity theory of M×V=P×Y

money expresses the relationship between money and where,
Learning Module: 5
M = Quantity of money • These balances will tend to be larger for

V = Velocity of circulation of money (the average individuals or organizations that enter into a high
number of times in a given period that a unit of level of transactions over time.
currency changes hands). • These precautionary balances are positively
P = Average price level related to the volume, value of transactions in the
Y = Real output economy and GDP.
According to the quantity theory of money, over a given

3) Speculative or Portfolio demand for money:
period,
Speculative money balances involve a trade-off
between holding liquid (or less risky) assets and risky
Amount of money used to buy all goods and services in
assets i.e. bonds.
an economy (i.e. M × V) = Value of Output in money
terms (i.e. P × Y)
• Interest rate is the opportunity cost of holding
Assuming velocity of money as approximately constant, liquidity i.e. when interest rate ↑, speculative
Spending (i.e. P × Y) is approximately proportional to M demand for money (i.e. demand for less risky
assets) ↓.
According to QTM, if money is assumed to be neutral, • When the perceived risk in other financial
then if money (M) is increased, it will only lead to instruments ↑, speculative demand for money (i.e.
increase in P and Y & V will remain unchanged. demand for less risky assets) ↑.
• When the expected return on other financial
However, if Velocity of circulation of money falls or real assets ↑, speculative demand for money (i.e.
output rises, then prices will remain unchanged if money demand for less risky assets) ↓.
is increased.
In equilibrium, individuals will tend to increase their
• Hence, according to Monetarists school, Inflation holdings of money relative to riskier assets until the
is a purely monetary phenomenon i.e. inflation Marginal benefit of holding lower risk assets = Marginal
can be decreased by decreasing money supply cost of forgoing a unit of expected return on the riskier
in the economy. So, the quantity theory of money assets.
states that the central bank, which controls the
money supply, has ultimate control over the rate
of inflation. Practice: Example 3,
• However, this concept is criticized on the basis CFA Institute’s Curriculum.
that quantity of money in circulation is
determined by the level of economic activity
rather than vice versa.
The Supply and Demand for Money
The Demand for Money Price of money: The price of money is the nominal
interest rate that an individual can earn by lending
money to others.
Demand for money refers to the amount of wealth that
the individuals in an economy prefer to hold in the form
of money rather than as bonds or equities. • The money supply curve (MS) is vertical because
we assume that there is a fixed nominal amount
Motives for holding money: of money circulating at any one time and it is
determined by the Central bank.
There are three basic motives for holding money. • The money demand curve (MD) is downward
sloping because as interest rates rise, the
1) Transactions-related: Money balances that are held speculative demand for money falls.
for transaction purposes. • Equilibrium interest rate is the interest rate where
the supply of money is equal to the demand for
• It is positively related to the number of money i.e. where the MS intersects MD (i.e. I0 in
transactions in an economy and GDP. However, it the figure below).
should be noted that the ratio of transactions
balances to GDP remains fairly stable over time.
2) Precautionary: Precautionary money balances are

held to have some liquidity in emergencies or
uncertainties.
Learning Module: 5
The Fisher Effect
According to the Fisher effect, an increase in the

inflation rate raises the nominal interest rate by the same
amount that the inflation rate increases, with no effect
on the real interest rate. Thus,
Nominal interest rate = Real rate of interest + Expected

rate of Inflation
Rnom = Rreal + πe
Money neutrality: In the long-run, an exogenous change

in the supply of money does not change the output and
• When the interest rate on bonds > I0 (i.e. I1), there employment level and real rate of interest; it only affects
would be excess supply of money (M0 – M1). Due inflation and inflation expectations. Hence, using
to higher interest rate, demand for bonds rises; as monetary policy to influence real economic variables
a result, prices of bonds increase and interest rate indicates that central bank believes that money is not
will move back to I0. neutral-at least not in the short run.
• Similarly, when the interest rate on bonds < I0 (i.e.
I2), there would be excess demand for money (M2
– M0). Due to lower interest rate, demand for Nominal interest rates are actually comprised of three
bonds decreases i.e. people seek to sell bonds components:
whereas, demand for money balances will
increase; as a result, prices of bonds decrease 1) A required real return.
and interest rate will move back to I0. 2) A return required to compensate investors for
expected inflation.
Effect of increase in the Supply of money: When the 3) A risk premium to compensate investors for
central bank increases the supply of money from M0 to uncertainty i.e. the greater the uncertainty, the
M2, the vertical supply curve shifts to the right, there will greater the required risk premium.
be excess supply of money in the economy and the
interest rate falls. Because:
When supply of money ↑, → demand for money Practice: Example 4,

balances ↓, → lending ↑, → demand for bonds ↑, → price CFA Institute’s Curriculum.
of bonds ↑ and consequently, interest rates ↓.
ROLES OF CENTRAL BANKS & OBJECTIVES OF MONETARY

4.
POLICY
6. A central bank is the supervisor of the banking

The Roles of Central Banks system. However, in some countries, this role is
assumed by a separate authority.
7. A central bank is responsible for the operation of
1. A central bank is the monopoly supplier of the a country's monetary policy.
currency and guardian of the value of the fiat*
currencies (i.e. have a duty to maintain Money in all major economies today is a legal tender i.e.
confidence in the currencies). it must be accepted when offered in exchange for
2. A central bank is the banker to the government. goods and services.
3. A central bank is the bankers' bank.
4. A central bank is the lender of last resort i.e. by
*Fiat Money: Money that is not convertible into any other
printing money, central bank can supply funds to
commodity is known as fiat money. Fiat money does not
banks that are facing a severe shortage. have any intrinsic value; it is used as money because of
5. A central bank is the regulator and supervisor of government decree and because it is accepted by
the payments system i.e. coordinate payments people as a medium of exchange. As long as people
systems internationally with other central banks,
accept fiat money as a medium of exchange and as
manage country's foreign currency reserves and
long as the fiat money holds its value over time, it will
gold reserves.
also be able to serve as a unit of account.
Learning Module: 5
4.1 The Objectives of Monetary Policy
• To maintain full employment and output. CFA Institute’s Curriculum.
• To maintain confidence in the financial system.
• To promote understanding of the financial sector.
• To maintain price stability (i.e. to control inflation).
In other words, to achieve stable & positive
economic growth with stable & low inflation.
5. THE COSTS OF INFLATION
Unexpected Inflation: It is the level of inflation that is

Expected Inflation: It is the level of inflation that either below or above the level of expected inflation i.e.
economic agents expect in the future. it is the component of inflation that is a surprise.
The costs of Expected inflation: The cost of Unexpected Inflation:

1) Inequitable redistributions of wealth between
1) Menu costs: The costs associated with changing
borrowers and lenders:
prices e.g. cost of printing new menus, cost of printing
& mailing new catalogs.
• If inflation < expected, lenders benefit and
borrowers lose because the real value of
• The higher is inflation, the more frequently firms
borrowing increases.
must change their prices and incur these costs.
• If inflation > expected, lenders lose and borrowers
• However, due to computerization, menu costs
benefit because the real value of borrowing
have decreased. So, when input prices rise, firms
declines.
increase their prices and consequently inflation
increases.
2) Give rise to risk premia in borrowing rates and the
prices of other assets: When inflation is very uncertain
2) Shoe-leather cost: The costs and inconveniences
or very volatile and unpredictable, investors demand
associated with reducing money balances to avoid
a premium to compensate them for this uncertainty.
the inflation tax as inflation ↑ ⇒ i↑⇒ real money
Consequently, interest rate ↑, cost of borrowing ↑, →
holdings ↓.
investment spending ↓, → AD falls.
• We know that in long run, inflation does not affect 3) Reduce the information content of market prices,
real income or real spending; thus, when real increase uncertainty in the market and can intensify
money balances ↓ but monthly spending remains and/or create economic booms and busts.
the same, ⇒ a person has to make more frequent
trips to the bank to withdraw smaller amounts of In addition, unanticipated and high levels of inflation
cash. can affect employment, investment and profits.
Therefore, controlling inflation should be one of the main
goals of macroeconomic policy.
6. MONETARY POLICY TOOLS
• When central bank purchases government bonds

Central banks have three primary monetary policy tools from commercial banks, the reserves of
available. commercial banks increase, → lending to
corporations and households increases and →
consequently, the money supply increases.
1. Open Market Operations • When open market operations tool is used, the
central bank may target a desired level of
Open Market Operations: It involves purchases and sales commercial bank reserves or a desired interest
of government bonds from and to commercial banks rate for these reserves.
and/ or designated market makers. It is one of the most
direct ways of changing the money supply.
2. Central Bank’s Policy Rate
Learning Module: 5
Policy rate/Refinancing rate or Discount rate: It is the rate

of interest the central bank charges on loans to banks. Reserve requirements or Legal reserve ratio: Legal
reserve is the ratio of cash reserves to deposits that
• When central bank lowers the policy rate, banks’ banks are required to maintain.
borrowing from the central bank and lending to
the public increases; consequently, money supply • By lowering the ratio (or decreasing the reserve
increases. requirements), banks will have more reserves to
lend and invest → consequently, money supply
This policy rate can be achieved by using short-term increases.
collateralized lending rates, known as repo rates. E.g.,
central bank can increase the money supply by buying
4. The Transmission Mechanism
bonds (usually government bonds) from the banks, with
an agreement to sell them back at some pre-specified
time in the future. This transaction is known as a The monetary transmission mechanism is the process
repurchase agreement. through which a central bank's interest rate gets
transmitted through the economy and eventually affects
• A repurchase agreement represents a secured the increase in the aggregate price level i.e. inflation.
loan to the banks (borrowers).
• Central bank (lender) earns the repo rate.
• Normally, the maturity of repo agreements ranges
from overnight to 2 weeks.
Generally, when a central bank increases the policy

rate, a commercial bank increases its base rate
because commercial banks do not want to lend at a
rate of interest that would be lower than the rate they
are charged by the central bank. Base rate is the
reference rate on which a bank bases lending rates to
all other customers e.g. a bank may lend to a client at Source: Bank of England
base rate + 2%.
Suppose central bank increases its policy rate, it will get
• Federal funds rate: It is the interbank lending rate transmitted through the economy via four interrelated
on overnight borrowings of reserves. It is the most channels.
important interest rate used in U.S. monetary
policy. 1. Bank lending rates
2. Asset prices
3. Reserve Requirements 3. Agents’ expectations
4. Exchange rates
Bank Lending Rate Channel
Base rates of The cost of borrowing

Central bank commercial for individuals &
increases its banks and companies over both
policy rate. interbank rates short & long-term
rise. horizons rise.
Fall in AD puts
Consumption
downward Borrowing
AD ↓ & investment
pressure on decreases
spending ↓
inflation.
Learning Module: 5
Asset Prices Channel
Price of assets i.e.

Central bank Household
bonds or value of
increases its financial wealth
capital projects fall
policy rate. decreases.
due to ↑ discount rate.
Fall in AD puts Borrowing to finance

AD ↓ due
downward asset purchases ↓
to fall in C
pressure on and/or investment
and I.
inflation. spending ↓
Agents’ expectations Channel
Market participants start

Central bank Borrowing to
expecting slower
increases its finance asset
economic growth,
policy rate. purchases ↓.
reduced profits.
Fall in AD puts
downward pressure AD ↓
on inflation.
Exchange rates Channel
Central bank Domestic Domestic Exports

increases its currency become
policy rate. appreciates. expensive.
Fall in AD puts
downward pressure AD ↓ Exports fall
on inflation.
7. INFLATION TARGETING
a) A clear, symmetric and forward-looking medium-

Inflation Targeting term inflation target.
b) Target inflation rate should be sufficiently > 0% to
avoid the risk of deflation (negative inflation) but
Inflation-targeting is used to control inflation and to should also be low enough to maintain price
maintain price stability. It is recommended that the stability.
central banks should have: • Most central banks in developing economies
target an inflation rate of 2% based on a CPI.
Learning Module: 5
• Central banks are permitted to use a range Central banks do not target current inflation; rather, they
around the central target of + 1% or -1% e.g. with focus on inflation two years ahead due to two reasons:
a 2% target, target is to keep inflation between 1%
and 3%. 1) The target inflation rate reflects a past inflation
rate because it is based on headline inflation rate
The success of inflation-targeting depends on three key which indicates rise in the price of basket of
concepts: goods and services over the previous 12 months.
2) Changes in interest rates (monetary policy) affect
the real economy with a time lag.
1. Central bank independence

The Main Exceptions to the Inflation-Targeting Rule:
Central bank independence: In order to be able to Two prominent central banks that do not use a formal
implement monetary policy objectively, the central bank inflation target include the Bank of Japan and the U.S.
should have a degree of independence from Federal Reserve System.
government. The degree of independence varies
among economies. Impediments to the successful operation of any
Monetary Policy in Developing Countries:
• Operationally independent: A central bank is
operationally independent when it determines the 1) Due to the absence of a sufficiently liquid
level of interest rate, the definition of inflation that government bond market and developed
it target, the target inflation rate, and the inflation- interbank market, it is difficult to conduct
targeting horizon. monetary policy.
• Target independent: A central bank is target 2) Due to rapid changes in an economy, it is difficult
independent when it determines only the level of to determine the neutral rate and the equilibrium
interest rate; the definition & level of target relationship between monetary aggregates and
inflation is determined by the government. the real economy.
3) Due to rapid financial innovation taking place in

developing countries, it is difficult to determine
2. Credibility
the standard definition of money supply.
Credibility: In order to be able to implement monetary 4) Central banks in developing countries lack
policy objectively, the central bank should be credible credibility due to poor track record in controlling
among economic agents because when economic inflation in the past; it makes monetary policy less
agents believe that the central bank will hit the target, effective.
the belief itself could become self-fulfilling.
5) Central banks in developing countries lack
3. Transparency independence.
Transparency: In order to be able to implement

monetary policy objectively, the central bank should be Practice: Example 9,
transparent in its goals, objectives and decision making. CFA Institute’s Curriculum.
8. EXCHANGE RATE TARGETING
Exchange Rate Targeting buying and selling the national/domestic currency in

foreign exchange markets i.e.
Many developing economies use exchange rate
targeting to operate monetary policy instead of using
inflation-targeting. • When domestic inflation rises relative to the
economy of major currency, with a floating
Exchange rate targeting involves setting either a fixed exchange rate system, domestic currency would
level of band of values for the exchange rate against a depreciate against the major currency; to guard
major currency. The central bank supports this target by the domestic currency from depreciating (i.e. to
meet the exchange rate target), central bank
Learning Module: 5
starts selling foreign currency reserves and buying

its own domestic currency. As a result, domestic NOTE:
money supply decreases and short-term interest For exchange rate targeting to be successful, the
rates increase. Hence, inflation falls and monetary authority must be independent, credible, and
exchange rate rises against the major currency transparent in decision making; otherwise, speculators
(e.g. dollar). may trade against the monetary authority.
• Opposite occurs when domestic inflation falls
relative to the economy of major currency. Managed exchange rate policy: In managed exchange
rate policy, a central bank seeks to limit the movement
Rationale to use Exchange rate Targeting: The rationale of domestic currency by actively intervening in the
behind using an Exchange rate targeting is to import the market.
inflation experience of the low inflation economy by
tying domestic economy’s currency to the currency of
an economy with a good track record on inflation.
Drawback of using exchange rate targeting: Due to
exchange-rate targeting, domestic interest rates and
money supply can become more volatile.
MONETARY POLICIES: CONTRACTIONARY,

9.
EXPANSIONARY, LIMITATIONS
Contractionary and Expansionary Monetary Policies

and the Neutral Rate
Contractionary Monetary Policy: It involves increasing

interest rates and thereby reducing liquidity to slow
down the economy and inflation.
Neutral Rate: The neutral rate is the rate of interest that

neither overheats the economy nor slows down the
economy. It should correspond to the average policy
rate over a business cycle.
• When policy rates are > neutral rate, monetary

policy is contractionary.
• When policy rates are < neutral rate, monetary
policy is expansionary.
Expansionary Monetary Policy: It involves decreasing Two components of the Neutral rate are as follows:
interest rates and thereby increasing liquidity to speed
up economy and inflation. 1) Real trend rate of growth of the underlying economy
i.e. the rate of economic growth that an economy
can achieve in the long-run with a stable inflation
rate.
2) Long-term expected inflation.
Neutral rate = Trend growth + Inflation target

Learning Module: 5
For example, • As a result, due to fall in expected inflation rates

Neutral rate = 2% + 2.5% = 4.5% demand for long-term bonds ↑, → long-term
interest rates decrease. Decrease in long-term
• The central bank's monetary policy will be rates makes long-term borrowing cheaper for
contractionary (expansionary) when its policy rate companies and households, → consumption and
> (<) 4.5%. investment spending increases.
• Hence, the more credible the monetary authority,
What’s the Source of the Shock the more stable the long end of the yield curve.
to the inflation Rate?
NOTE:
The Sources of the Shock to the Inflation Rate: Bond market vigilantes are bond market participants
who may reduce (increase) their demand for long-term
The monetary authority must first try to identify the source
bonds, resulting in yields to rise (fall) and bond prices to
of the shock to the inflation rate before adopting a
fall (rise), when it is believed that monetary authority
contractionary or expansionary monetary policy. There
lacks credibility in inflation rate targeting.
are two sources of the shock to the Inflation Rate:
a) Demand shock: When inflation increases due to

Interest Rate Adjustment in a Deflationary
increase in consumption and investment growth rates
Environment and Quantitative Easing as a Response
resulting from increase in the confidence of
consumers and business leaders, it is referred to as It is more difficult for conventional monetary policy to
demand shock. deal with deflation than inflation because, once nominal
interest rates are reduced to 0% to stimulate economy,
• When inflation rises due to demand shock, it is the central bank cannot reduce them any further.
appropriate to use tight monetary policy. During deflation,
b) Supply shock: When inflation increases due to • The real value of debt rises.
increase in the costs of production (e.g. costs of • Consumers are encouraged to postpone
inputs), it is referred to as supply shock. consumption today, leading to fall in demand
that leads to further deflationary pressure.
• When inflation rises due to supply shock, it is not
appropriate to use tight monetary policy because Deflationary trap: It has following characteristics:
increasing interest rates further reduce profits and
consumption and eventually further increase • Weak consumption growth
unemployment. • Falling prices
• Increases in real debt levels
Limitations of Monetary Policy

Liquidity trap:
Problems in the Monetary Transmission Mechanism Liquidity trap occurs when the demand for money
becomes infinitely elastic (money demand curve is
Central banks cannot always control the money supply
horizontal) i.e. demand for money balances increases
because:
without any change in the interest rate.
• Central banks cannot control the amount of This implies that during liquidity trap, monetary policy
money that households and corporations put in becomes ineffective because increasing money supply
banks on deposit. will not further lower interest rates or affect real activity.
• Central banks cannot easily control the willingness
of banks to make loans. Liquidity trap is associated with the phenomenon of
deflation.
For an effective monetary policy, the monetary authority
must have credibility. Once interest rates are at 0%, central bank can use
following two approaches to stimulate economy:
For example, suppose
1) Convincing market participants that interest rates
• The central bank increases the interest rate but will remain low for a long time period even if the
bond market participants think that short-term inflation picks up. This action will tend to lower
rates are already too high and raising interest rate interest rates along the yield curve.
will result in a recession, and the central bank will
not be able to meet its inflation target. 2) Increasing the money supply [Quantitative
easing].
Learning Module: 5
NOTE:
Quantitative easing (QE) refers to purchasing
Financing government deficit by printing money is called
government or private securities by the central bank
monetization of the government deficit.
from the private sector and financing those purchases
by printing money.
Operationally, it is similar to open market purchase Practice: Example 12,

operations but conducted on a much larger scale. CFA Institute’s Curriculum.
10. ROLES AND OBJECTIVES OF FISCAL POLICY
Fiscal policy involves using government spending and

taxes to affect the economic activity. Important to understand: When the economy operates
at its potential GDP (full employment) level, then an
expansionary fiscal policy will not have any significant
Roles and Objectives of Fiscal Policy
effect on output or AD because at full employment
level, there are few spare or unused resources (e.g. labor
The primary objective of fiscal policy is to affect the or idle factories); in such a case, fiscal expansion will only
overall level of aggregate demand in an economy and lead to increase in aggregate price level i.e. inflation.
the level of economic activity i.e. to meet government's
economic objectives of low inflation and high
• According to Keynesians School, fiscal policy can
employment. Other objectives include:
have significant impact on AD, output, and
employment only when economy operates below
• Distribution of income and wealth among its potential GDP level or when the rate of
different segments of the population. capacity utilization is low.
• Allocation of resources between different sectors • According to Monetarists, monetary policy is a
and economic agents. more effective tool than fiscal policy because
fiscal policy can only have a temporary effect on
Fiscal Policy and Aggregate Demand AD.
In a recession with rising unemployment, Expansionary
fiscal policy can be conducted through following ways: Government Receipts and Expenditure
in Major Economies
• Decreasing personal income tax rate to raise Government revenue = Tax revenues - transfer
disposable income, which eventually leads to rise payments.
in aggregate demand.
Limitations: during recession, increase in Government spending includes public spending on
disposable income due to lower tax rate may social goods and infrastructure (i.e. hospitals and
lead to increase in precautionary savings instead schools) and interest payments on the government
of increase in consumption spending. Hence, it debt.
may further leads to decrease in AD.
• Reducing sales (indirect) taxes to lower prices, Balanced budget: When government spending =
which raises real incomes and eventually leads to government revenues, then the budget is balanced.
increase in consumer demand.
• Reducing corporation (company) taxes to Budget deficit: When government spending >
improve business profits so that capital spending government revenue, a budget is in deficit.
increases. Budget surplus: When government spending <
• Reducing tax rates on personal savings to raise government revenue, a budget is in surplus.
disposable income, which eventually leads to an
increase in consumer demand.
• Increasing public spending on social goods and • An increase in a budget surplus is associated with
infrastructure (i.e. hospitals and schools) to contractionary fiscal policy.
improve personal incomes and the aggregate • An increase in a budget deficit is associated with
demand. expansionary fiscal policy.
NOTE: Total government revenues as a percentage of GDP: It

refers to the % of a country's total output that is gathered
Opposite occurs in Contractionary fiscal policy. by the government through taxes, fees, charges, fines,
Learning Module: 5
and capital transfers. Generally, the higher the total Advantage of automatic stabilizers: They help to reduce
government revenues as a % of GDP, the greater a output fluctuations caused by ‘shocks’ to autonomous
government is involved both directly and indirectly in the parts of aggregate expenditure.
economic activity of a country.
Automatic stabilizers v/s Discretionary fiscal policy:
Automatic Stabilizers: Automatic stabilizers are features Unlike Automatic stabilizers, discretionary fiscal policies
of fiscal policy that stabilize real GDP without any explicit (i.e. tax changes and/ or spending cuts or increases) are
action by the government e.g. income tax, VAT, and actively used by the government to stabilize the AD and
social benefits. In this case, budget surplus and deficit economy.
fluctuate with business cycle (real GDP) i.e.
Structural or cyclically adjusted budget deficit: It refers to
• When an economy slows and unemployment rises the budget deficit that exists when the economy is at full
(e.g. during recession), → tax revenues ↓, employment (or full potential output). It is the most
government spending on social insurance and appropriate indicator of fiscal policy.
unemployment benefits will ↑, and budget surplus
decreases (or budget deficit rises). Important to understand: When the government
o This acts as a fiscal stimulus. increases its spending, it is not always expansionary
• Similarly, when an economy expands and because government may simultaneously increase taxes
employment and incomes are high, → progressive by a larger amount than that of increase in government
income and profit taxes ↑ and the budget surplus spending.
increases (or budget deficit falls).
11. DEFICITS AND THE NATIONAL DEBT
• The increasing ratio of debt to GDP does not

Budget Deficit: When government spending or indicate a severe problem because the debt is
expenditure > government revenue, a budget is in owed internally to fellow citizens.
deficit. • The increasing ratio of debt to GDP is not harmful
because a proportion of the borrowed money
Government (or national) debt: National debt is the may be used for capital investment projects or
accumulated budget deficit over time. training, education of human capital, which
would eventually lead to higher future output and
How budget deficits are financed: Government deficits tax revenues.
are financed by borrowing from the private sector. • Large fiscal deficits may help to reduce distortions
caused by existing tax structures by introducing
• When the ratio of debt to GDP and the ratio of tax changes.
interest rate payments to GDP rise beyond a • Fiscal deficits may have no net impact because
certain unknown point, the solvency of the the private sector may increase savings in
country deteriorates. expectations of higher future tax rates. It is known
• When the real growth in the economy < the real as "Ricardian equivalence".
interest rate on the debt → debt burden (real • In case of unemployment in an economy, debt
interest rate × debt) grows faster than the rather helps to increase employment.
economy; hence, the debt ratio will increase in
spite of growing economy. The arguments in favor of being concerned about
national debt relative to GDP are as follows:
Effect of inflation on the real value of outstanding debt:
When inflation and nominal GDP increase, → the real • High debt to GDP ratio may lead to higher future
value of the outstanding debt ↓. Thus, the ratio of debt tax rates to earn higher tax revenues to finance
to GDP falls. the deficit. Higher marginal tax rates reduce labor
effort and entrepreneurial activity and results in
Effect of deflation on the real value of outstanding debt: lower growth in the long-run.
When inflation and nominal GDP decrease, → the real • When government deficit is financed through
value of the outstanding debt ↑. Thus, the ratio of debt printing money, inflation increases.
to GDP rises. • Crowding out effect: When deficits are financed
through borrowing, it leads to crowding out effect
The arguments against being concerned about national i.e. due to higher government demands, cost of
debt relative to GDP are as follows: borrowing (interest rates) ↑ and as a result, private
sector investing decreases.
Learning Module: 5

NOTE:
Both tax distortions and crowding out effect are more
serious in the long-run rather than in the short-run.
12. FISCAL POLICY TOOLS
1) Simplicity: The tax system ought to be easy and

relatively inexpensive to adminster i.e. the tax system
Fiscal Policy Tools and the Macro Economy
should have low costs of administration and
compliance. Also, the final tax liability should be
Government spending includes: certain and not easily manipulated.
a) Transfer payments include welfare payments,
payments for state pensions, housing benefits, tax 2) Efficiency: The tax system should not interfere with the
credits and income support for poorer families, child efficient allocation of resources i.e. taxes should raise
benefits, unemployment benefits, and job search revenue without negative distortions such as reducing
allowances. Transfer payments are made to: work-incentives for individuals and investment
incentives for companies.
• Guarantee a minimum level of income for poorer 3) Fairness: The tax system ought to be fair in its relative
people. treatment of different individuals.
• Redistribute income & wealth.
a) Horizontal Equity: Individuals who are identical
b) Spending on goods and services e.g. health, should pay the same taxes.
education, and defense to benefit citizens, to b) Vertical Equity: Individuals who have greater ability
improve country's skill level and overall labor to pay and are rich, should pay more taxes.
productivity.
• Progressive tax system: Tax rate increases
c) Spending on infrastructure projects e.g. roads, proportionately with the increase in income.
hospitals, prisons, and schools to improve country’s • Flat tax system: Tax rate is constant regardless of
economic growth. taxable income.
Government revenues include:
4) Revenue sufficiency: Taxes are primarily used to raise
a) Direct taxes include taxes that are levied on income, revenue to fund government operations. Thus, a
wealth, and corporate profits. For example, capital good tax system must generate sufficient revenue to
gains taxes, national insurance (or labor) taxes, fund projected government expenditures and at the
corporate taxes, local income or property tax for both same time should help in equitable distribution of
individuals and businesses, and inheritance tax on a income and economic stability. This implies that only
deceased's estate. one tax that yields more revenue should be imposed
instead of imposing many taxes that yield low
b) Indirect taxes include taxes on spending on a variety income.
of goods and services in an economy, i.e. excise
duties on fuel, alcohol, and tobacco as well as sales
(or value-added tax).
Advantages of taxes: CFA Institute’s Curriculum.
• Taxes can be used to raise revenues for the

government to finance expenditures. The Advantages and Disadvantages of Using the
• Taxes facilitate distribution of income and wealth Different Tools of Fiscal Policy
among different segments of the population.
NOTE: Advantages:
According to supply-side economics, income taxes may • Indirect taxes are easy to adjust, can instantly
reduce the incentive to work, save and invest. affect spending behavior and have low costs of
administration and compliance.
Desirable attributes of a tax policy:
Learning Module: 5
• In addition, indirect taxes can be used to = Fraction of extra income that is saved; it is
discourage alcohol or tobacco use. estimated as
MPS = 1 – MPC.
Disadvantages:
Total increase in income and spending = Fiscal multiplier
×G
• Direct taxes, welfare and other social transfers are Example: Suppose,
relatively difficult to adjust in response to changes.
• Capital spending plans take longer period of time
• MPC = 3/4 or 0.75
to formulate and implement; this makes such
• Increase in government spending = $20 billion
plans less effective.
o AD curve will initially shift to the right by $20
billion.
NOTE:
Fiscal Multiplier = 1/(1 - 3/4) = 4 Thus,
• The announcement of future rise in income tax The total change in spending produced by our initial $20
can lead to immediate decline in consumption. billion spending increase = 4 × $20 billion = $80 billion.
• Generally, direct government spending has
relatively greater impact on aggregate spending • The multiplier effect tells us that an additional $60
and output than income tax cuts or transfer billion of consumption will occur as the initial
increases. spending increase moves through the economy.
Fiscal multiplier in the presence of taxes: When taxes are

Modeling the Impact of Taxes and Government
present,
Spending: The Fiscal Multiplier
MPC (with taxes) = MPC × (1 - t)
The net impact of the government sector on AD is: 𝟏
Fiscal multiplier = 𝟏2𝑴𝑷𝑪 (𝟏2𝒕)
G – T + B = Budget surplus OR Budget deficit
where,
Total increase in income and spending = Fiscal multiplier
G = government spending ×G
T = taxes
B = transfer benefits • The cumulative extra spending and income will
continue to spread through the economy at a
Disposable income = Income – Net taxes = (1 – t) decreasing rate because 0 < MPC × (l - t) < 1.
Income
where,
Example: Suppose,
Net taxes = taxes – transfer payments
t = net tax rate • Tax rate is 20%.
• MPC = 90%
For example, if t = 20%, then for $1 increase in national • Government increases spending (G) by $1 billion.
income,
9
Fiscal multiplier = 92:.<: (92:.=:) = 3.57
• Net tax revenue will rise by 20 cents.
• Household disposable income will rise by 80 cents.
Total increase in income and spending = 3.57 × $1 billion
= $3.57 billion.
The fiscal multiplier: Government purchases have a
multiplier effect on AD i.e. each dollar spent by the
Effects of reducing taxes:
government can increase AD for goods and services by
more than a dollar. It is used to determine the total Initial increase in consumption due to reduction in taxes
change in output that occurs as a result of exogenous = MPC × tax cut amount
changes in government spending or taxation.
The total or cumulative effect of the tax cut would be =
Fiscal Multiplier (in absence of taxes) = 1/(1 - MPC) multiplier × initial change in consumption
where,
Example: Suppose taxes are reduced by $20 billion and
MPC = Marginal propensity to consume = Fraction of MPC = 0.75, then,
extra income that a household consumes rather
than saves. Initial increase in consumption = .75 × $20 billion
= $15 billion.
MPS = Marginal propensity to save The total or cumulative effect of the tax cut would be
= 4 × $15 billion = $60 billion
Learning Module: 5
• In contrast, when government spending increases

• The total effect of the tax cut < the total effect of e.g. by $5 billion, then the AD will be increased by
Increase in government spending of the same full $5 billion.
amount because households consumption do not • Thus, the net result would be an increase in the
rise immediately with reduction in taxes i.e. a equilibrium level of GDP.
portion of the tax cut is saved.
• The higher the MPC, the lower the savings (MPS). Important to Note: The balanced budget multiplier is not
zero; rather, it is exactly equal to one i.e. when both the
Effects of increasing transfer payments: The effect of government spending and taxes increase by $X, then
increasing transfer payments is the same as the effect of the level of equilibrium GDP will increase by precisely $X.
tax cuts i.e. a portion of the transfer payment increase is
saved. NOTE:
Increase in equilibrium GDP leads to increase in induced
This implies that when MPC < 1, both increased transfer
tax revenues, thus increasing the government’s budget
payments and tax cuts are less effective than increased
surplus (or reducing its deficit).
government spending in stimulating the economy.
Government Debt, Deficits and Ricardo:

The Balanced Budget Multiplier
When the government has insufficient tax revenues to
meet expenditures, it needs to borrow from the public by
The balanced budget multiplier refers to the magnified issuing stock of IOUs.
effect of a simultaneous change in government
spending and taxes on the Aggregate Demand that Total size of the outstanding debt of government =
leaves the budget balance unchanged i.e. does not Cumulative quantity of net borrowing + Fiscal (or
result in budget deficit or surplus. This implies that: budget) deficit in the current period
• An equal increase in autonomous government • When outstanding stock of debt falls (rises),
purchases and autonomous taxes will shift the AD budget surplus rises (falls).
curve to the right and lead to an increase in the
equilibrium level of GDP. Ricardian Equivalence: Consumers are forward-looking;
• An equal decrease in autonomous government therefore, they view current debt-financed tax cut as
purchases and autonomous taxes will shift the AD equivalent to delayed taxation (i.e. increase in future
curve to the left and lead to a decrease in the taxes). Thus, the reduction in current taxation does not
equilibrium level of GDP. make consumers better off, so they do not raise
consumption. Rather, they save the full tax cut in order
Explanation: to repay the future tax liability.
Consequently, private saving rises by the amount public

• When government spending increases by ΔG, → saving falls, leaving national saving unchanged. This is
AD curve shifts to the right and leads to an known as Ricardian Equivalence.
increase in equilibrium GDP.
• When taxes increase by ΔT, → AD curve shifts to
the left and leads to decrease in equilibrium GDP.
when ΔG = ΔT, CFA Institute’s Curriculum.
a) The government’s budget deficit (or surplus) will

be initially unaffected by the policy and;
b) The expansionary effect (i.e. increase in G) will be
stronger than the contractionary effect (i.e.
increase in T). Hence, the net result will be an
increase in equilibrium GDP.
Reason:
• When taxes rises e.g. by $5 billion and MPC < 1

e.g. MPC = 0.8, → private sector’s level of desired
spending will decline by less than the full $5 billion
i.e. by $4 billion only.
Learning Module: 5
13. FISCAL POLICY IMPLEMENTATION
associated with the problem of driving with the rear

view mirror.
Deficits and Fiscal Stance
2) Action lag or Execution lag: When necessary policy
changes are decided on, it may take many months
Is increase in fiscal deficit always caused by fiscal
to implement a policy response. This is known as
policy? Answer is no. Increase in fiscal deficit (or budget action lag.
deficit) can be because of policy decision (aka
discretionary fiscal adjustments) (e.g. lowering tax rate) 3) Impact lag: Even if policy changes are implemented,
and/or because of automatic stabilizers. it may take additional time to impact the economy.
Automatic stabilizers may increase or decrease fiscal These types of policy lags are also associated with
executing discretionary Monetary Policy.
deficit without any policy decision from the government.
Fiscal policy v/s Monetary policy: Fiscal policy is less
For example, corporate tax collection by Government effective than monetary policy to deal with short-run
will decline during recessions because of lower stabilisation because:
corporate profits. This can increase fiscal deficit
(assuming other factors remain same) without any policy • Fiscal policy is often very time-consuming to
decision by Government. implement.
• It is politically easier to loosen fiscal policy than to
tighten it.
Budget deficit can be thought of as comprising two
parts. The first one is cyclical and will go away once the
Macroeconomic issues associated with Fiscal Policy:
economy returns to full employment. The second one is
structural and will not go away even when economy
• If the government is concerned with both
recovers to full employment.
unemployment and inflation in an economy, then
using expansionary fiscal policy to increase AD
Budget deficit (and changes in it) represents impacts of toward the full employment level may also lead to
policy decisions and automatic stabilizers. Structural a tightening labor market (i.e. rising wages) and
fiscal deficit indicates impacts of policy decisions only. further increase in inflation.
• When the budget deficit is already large relative
to GDP but further fiscal stimulus is required, then
Structural budget deficit is also known as cyclically
the increase in the deficit by adopting
adjusted budget deficit. expansionary fiscal policy will lead to increase in
interest rates on government debt. Consequently,
Structural budget deficit is calculated assuming government may face political pressure to deal
economy was operating at full employment this year. with the deficit.
• When resources are underutilized due to shortage
Reported budget deficit should be adjusted for nominal of supply of labor or other factors of production
rather than a shortage of demand, then
vs real interest rates and impacts of inflation.
discretionary fiscal policy will be ineffective i.e. it
will only lead to increase in inflation and will not
Difficulties in Executing Fiscal Policy increase AD.
Fiscal policy cannot completely stabilize aggregate

demand as predicted by the multiplier due to following Practice: Example 18,
time lags associated with executing and implementing CFA Institute’s Curriculum.
fiscal policy.
1) Recognition lag: Policymakers do not have complete

information on how the economy functions; hence, it
takes time to collect economic statistics and data. In
addition, data are subject to substantial revision. It is
Learning Module: 5
14. THE RELATIONSHIP BETWEEN MONETARY AND FISCAL POLICY
Both fiscal and monetary policies are used to stabilize When this expansionary fiscal policy is accompanied by
aggregate demand. However, these policies are not an expansionary monetary policy, it may lead to
interchangeable because they work through different increase in inflationary pressures.
channels.
Policy conclusions regarding the role of policy
A. Easy fiscal policy/tight monetary policy: When the interactions:
expansionary fiscal policy is accompanied by a
contractionary monetary policy, it will lead to: A. No monetary accommodation:
Increase in government spending generally has
• Higher aggregate output. greater impact (i.e. 6 times bigger) on GDP than
• Higher interest rates. similar size social transfers because the social
• Expansion of the size of the public sector relative transfers are viewed as temporary by the economic
to the private sector. agents. With no monetary accommodation (i.e.
expansionary monetary policy), increase in AD leads
to higher interest rates immediately.
B. Tight fiscal policy/easy monetary policy: When
contractionary fiscal policy is accompanied by
expansionary monetary policy, it will result in: • Targeted social transfers to the poorest citizens
have a greater effect than non-targeted transfers
(i.e. 2 times bigger).
• Low interest rates.
• Labor tax reductions have a slightly bigger impact
• Expansion of the size of the private sector relative
on GDP than the non-targeted transfers.
to the public sector.
B. Monetary accommodation (i.e. keeping interest rates

C. Easy monetary policy/easy fiscal policy: When both
unchanged in spite of rising AD):
fiscal and monetary policy are easy, then the
combined impact will be:
• Fiscal multipliers are greater when loose fiscal
policy is accompanied by loose monetary policy.
• Higher aggregate demand.
• Lower interest rates (at least if the monetary
impact is larger). Quantitative Easing
• Growing private and public sectors.
The purpose of quantitative easing – purchasing
D. Tight monetary policy/tight fiscal policy: When both
securities by central bank to reduce interest rates – is to
fiscal and monetary policies are tight, then the
combined impact will be: increase the supply of money as well as lending to the
consumers and businesses.
• Higher interest rates (at least if the monetary
impact on interest rates is larger). Central Banks have purchased large quantities of
• Lower aggregate demand from both public and government bonds under quantitative easing programs.
private sectors. This encourages bond holders (financial institutions and
others) to sell bonds to central bank and use the money
NOTE: In all the aforementioned cases, it is assumed that for spending – thus promoting consumption and money
wages and prices are rigid. supply.
Factors Influencing the Mix of Fiscal and Monetary

However, this can encourage governments to issue
Policy
more and more debt without any fear of lack of
demand for bonds (know that central bank is a buyer in
The dual objective of stabilizing the level of AD at close
big quantity). This is similar as ‘printing of money’ and
to the full employment level and increasing the growth
funding the budget.
of potential output can be best achieved by
expansionary monetary policy and a tight fiscal policy.
Cumulative multiplier =
>?@?ABCDEF FGGF>C HI JFBA KLM HEFJ CNF COH PFBJQ
When growth of an economy is slow due to shortage of % ST UVW
good quality, trained workforce or modern capital
infrastructure, the government should use expansionary
fiscal policy.
Learning Module: 5
The Importance of Credibility and Commitment
According to the IMF model, high budget deficits lead Practice: CFA Institute’s end of
to: Chapter Practice Problems and
• Higher real interest rates. Bank.
• Crowding out effects.
• Decreased productive potential of an economy.
• Increasing inflation expectations and higher
longer-term interest rates if budget deficits are
expected to persist.
ECO Introduction to Geopolitics
Learning Module: 6
1. INTRODUCTION
Curriculum Notes – 2 0 2 3
Geopolitical Risk
The international environment is constantly changing,
and this can impact companies, industries, nations, and
regional groups. Geopolitical risk is the risk that arises from tensions or
actions between actors that disrupt the normal,
peaceful flow of international relations. This can affect
Geopolitics
the circumstances of the financial markets and asset
allocation choices.
Geopolitics is the study of how geography affects
politics and international relations. Impact of Geopolitical Risk on:
o Analysts study the actors (individuals, organizations, Ø macroeconomic level: Geopolitical risks affect
governments etc.) and their interactions in order to macroeconomic growth, interest rates, and
understand key drivers of investment performance, market volatility. Changes in capital markets
such as economic growth, business performance, can affect asset allocation decisions, including
market volatility, and transaction costs. an investor's regional exposure.
Ø portfolio level: Geopolitical risk can affect a
portfolio's suitability for an investor's goals, risk
tolerance, and time horizon.
NATIONAL GOVERNMENTS AND

2.
POLITICAL COOPERATION
Actors: Actors are individuals, organizations, businesses, Political Cooperation: is the degree to which countries
and national governments that engage in political, agree on laws and standards for their operations and
economic, and financial activities. interactions.
Types of actors: 1. Cooperative country: A co-operative country is

one that engages in mutual rules standardization,
Ø State actors: parties that directly control country’s tariff harmonization, free information flow, and
national security or resources. Governments, technology transfer.
political groups, and leaders are state actors. 2. Non-cooperative country: A non-cooperative
country has inconsistent, arbitrary rules, closed
Ø Non-state actors: who participate in global borders for goods and services, retaliation, and
political, economic, or financial issues but don't limited technology exchange.
control national security or resources. Non-state
actors include NGOs, multinational enterprises,
charities, and influential figures (business leaders, Motivations for Cooperation
cultural celebs etc.).
A country may collaborate with its neighbors or other
Note: These actors are not only impacted by their nations for a variety of reasons, including military,
interaction with one another, but also by economic, or cultural interests.
circumstances affecting their allies and
opponents. 1. National Security or Military Interest - protects a
country's residents, economy, and institutions from
Features of Political Cooperation foreign threats. These threats might be military,
terrorist, criminal, cyber, or natural calamities.
Relations between nations or national governments
Geographic variables influence a country's security
(state actors) can be cooperative or competitive.
policy and degree of cooperation.
Countries cooperate to achieve a common aim. These
aims might be strategic, military, economic, or cultural. o Landlocked countries depend on neighbors for
Given the scope of country ambitions and interests, their resources, making collaboration crucial for
interconnections may be complicated, posing international access, growth, or survival.
geopolitical risk.
Copyright © FinQuiz.com. All rights reserved
Learning Module: 6
o Countries connected to trade routes, may

exploit their geographic location to exert The Role of Institutions
influence on international dynamics.
An institution is an established organization or practice in
2. Economic Interest - National security has expanded a society. NGOs, charities, religious practices, families,
beyond military to include economic factors. the media, political parties, and educational practices
are a few examples of institutions.
o Domestic security is achieved by growing
national wealth and limiting income inequality. Strong institutions
o International security is achieved by domestic
companies operating globally. o promote internal and external political
o Countries cooperate to secure essential stability.
resources through trade or level the global o strengthen a country in building cooperative
playing field through standardization. connections.
o such as those fostering government
Resource Endowment, Standardization, and Soft Power accountability, rule of law, and property
rights, allow countries to operate with more
authority and independence internationally.
1. Geophysical resource endowment includes o can lessen the risk of a country deviating from
habitable geography, climate, food, and water. its cooperative duties by integrating
cooperation at many societal levels.
These resources are unevenly distributed. This
divergence give rise to power dynamics, which can
influence the interaction between countries. When Hierarchy of Interests and Costs of Cooperation
dealing with a resource-hungry country, a resource-
rich country may have more political influence. The national interests of a country may be thought of as
a hierarchy, with survival-critical concerns at the top and
U.S., Russia, Australia, and China are resource nice-but-not-essential issues at the bottom. Governments
independent whereas western Europe, Japan, and are guided by the hierarchy of interests. When two
Turkey import a lot of fossil fuels. Saudi Arabia has concerns conflict, the one that is higher on the list is
plentiful fossil resources yet imports many essentials. given more attention.
2. Standardization is the process of making For example, tariff harmonization may help a country on
rules/protocols for how a product or service is its own, but cooperation costs more when two countries
produced, sold, transported, or used. When are at military conflict with each other. Depending on
everyone agrees to follow these rules, this is called the countries' priorities, cooperation might not be in their
standardization. best interest, even if it could help.
It supports cross-border trade and capital flows,

which boost economic growth and living standards. Power of the Decision Maker
3. Cultural Considerations and Soft Power The motivations of decision makers can affect a
country's cooperative and non-cooperative choices.
Cultural Considerations - countries may cooperate for Political parties and individual decision makers have
cultural reasons. Examples: their own influences and needs.
o cultural similarities Priority setting is significantly affected by the duration of

o historical linkages a country's political cycle. Many countries have short
o immigrant trends political cycles, making it difficult to prioritize long-term
o common experiences risks like climate change or wealth disparity.
Soft Power - involves influencing another country's One government may prioritize military buildup or
decisions without force or coercion. Countries may build healthcare differently than its predecessor. How nations
soft power over time through: assess these problems will influence cooperation.
Securing food and water may be prioritized above

o advertising supporting a cultural activity. As social demands are
o travel subsidies addressed, national interests might become more
o cultural activities subjective.
o university exchange programs
Learning Module: 6
attempt to persuade non-cooperative players to

Political Non-Cooperation
cooperate.
Countries' interests in political collaboration differ, with

some being more cooperative than others. Most Practice: Example 1, 2 and
countries cooperate to some extent, although there are Questions under ‘Knowledge
some exceptions, such as those that weight self- Check’ for this section from the
determination above collaboration. Extreme cases of CFA Institute’s Curriculum.
non-cooperation are rare, as other state actors may
NON-STATE ACTORS AND THE FORCES OF

3.
GLOBALIZATION
Globalization Motivations of Globalization
Globalization is the interaction and integration of For non-state actors, three potential gains are:
individuals, organizations, and governments on a global
scale. It is characterized by the cross-border spread of 1. Increasing profits - by increasing sales or reducing
goods, information, jobs, and culture. costs.
Cross-border trade has grown tremendously on both the a) Increasing sales: Companies globalize to access
microeconomic and macroeconomic levels during the new clients/markets to improve sales. This
last several decades. process needs considerable investment in new
markets, hiring, and training.
Globalization has had a cultural and communication b) Decreasing costs: Globalization helps firms to
impact, with nations exchanging ideas and trading access cheaper tax-operating regimes, cut
goods. It has also made it easier for people around the labor expenses, and enhance supply chain
world to collaborate. The internet has increased the efficiency.
speed and efficiency of this process.
2. Access to resources and markets: A non-state actor
may globalize to improve access to resources (such
Features of Globalization
as skilled workers or cheap raw materials), markets,
or investment opportunities. The investment can be
Globalization helps companies access new markets, done through portfolio investment or foreign direct
talent, and learning. Globalization is characterized by investment.
economic and financial cooperation including:
3. Intrinsic gain - Intrinsic gain is beyond profit. It's hard
o capital flows to measure yet promotes globalization. It increases
o currency exchange empathy among actors and reduces geopolitical
o trade of products and services risks.
o cultural and information interaction.
Intrinsic benefits include extending one's horizons,
Anti-globalization or nationalism promotes a country's experiencing new places, acquiring new concepts.
economic interests over others'. Prime focus is on All can lead to personal growth and education.
national sales and production. Anti-globalization is Learning new techniques increases productivity.
characterized by:
Costs of Globalization and Threats of Rollback
o limited currency exchange
o limited cross-border investment The following are some of the possible drawbacks of
o limited economic and financial cooperation globalization.
Important Note: 1. Unequal Accrual of Economic and Financial Gains:

Economic theory says that aggregate economic
Globalization and cooperation are related but not activity improves when all actors seek profit
always dependent, as the private sector can drive trade maximization and efficiency. However, this does not
even with little government support. mean that everyone benefits. If a factory goes
overseas, it creates employment away but reduces

Learning Module: 6
them at home. Local firms in the foreign country These tendencies might manifest themselves in the
may have to compete with the foreign firm for labor. domestic politics of many countries, reducing the
likelihood of effective political cooperation.
2. Lower Environmental, Social, and Governance
Standards: Companies in low-cost nations follow 4. Interdependence: Companies can become
local norms. While corporate profit may increase, dependent on other countries' resources for their
the aggregate effect may be negative due to lower supply chains, which can result in the nation itself
environmental protection, social benefits, or becoming dependent on other nations for certain
corporate governance standards. resources. Supply chain disruptions can force
companies to switch suppliers or cease operations.
3. Political Consequences: A third cost of globalization

Practice: Examples 3, 4 and
is the political consequences of global expansion..
Questions under the ‘Knowledge
Globalization may exacerbate income and wealth
Check’ for this section from the
disparities as well as opportunity inequalities across
nations.
4. ASSESSING GEOPOLITICAL ACTORS AND RISK
Archetypes of Globalization and Cooperation

DRV Pricing and Valuation of Forward Contracts
Learning Module: 5 and for an Underlying with Varying Maturities
The above framework shows four country behavior system provides benefits to the country itself and to the
archetypes: international system.
1. Autarky, Countries that agree with the hegemon's norms and

2. Hegemony, standards may enjoy the leader's rewards, including
3. Multilateralism, and monitoring and enforcing the standards.
4. Bilateralism.
There may be costs to a hegemonic system, including
The two axes refer to political cooperation versus non- increased geopolitical risk.
cooperation and globalization versus nationalism. Both
axis in this framework represent a spectrum.
3. Multilateralism
Each archtype has its own set of costs, benefits, and
tradeoffs. This framework can assist investment analysts in Countries that cooperate in mutually beneficial
evaluating geopolitical players and the possibility of economic agreements and broad rule harmonization
investment outcomes in terms of risks and opportunities. are characterized by multilateralism. Multiple trade
partners are completely integrated into global supply
Important: networks by private companies.
Geopolitical risk analysis - Globalization and cooperation
framework - is dynamic in nature. Therefore, countries Germany and Singapore are two examples of
can be moving targets. Successful geopolitical risk multilateral countries.
analysis considers the country's position in this framework
as well as its stability within it. 4. Bilateralism
1. Autarky Bilateralism is the cooperation between two countries,

usually involving political, economic, financial, or cultural
Autarky is characterized by little or no foreign trade or cooperation. Countries involved in bilateralism may
financing. State-owned companies govern domestic have several partners, but agreements are one-at-a-
industry. Autonomous countries are stronger politically time.
because they can control technology, products,
services, media, and political message. Countries usually exist on a spectrum between
bilateralism and multilateralism, with regionalism in
China was mostly autocratic throughout the 20th between. In regionalism, group of countries collaborate
century, with little political collaboration or globalization. with each other.
Autarky can sometimes speed up a country's economic Countries are unlikely to perfectly fit the bilateral frame,
and political growth. Autarky has disadvantages as well. as stronger political cooperation tends to lead to
North Korea and Venezuela, for example, have globalization.
experienced slower economic and political
development.
Practice: Example 5, 6, 7 and
2. Hegemony Questions under the ‘Knowledge
Check’ for this section from the
A hegemonic country is a regional or global leader and
exerts control over others' resources. State-owned
enterprises control key export markets. A hegemonic
5. THE TOOLS OF GEOPOLITICS
Three types of tools of geopolitics are: Each tool has options that can promote cooperation or
increase conflict (non-cooperation).
1. National tools
2. Economic tools
3. Financial tools

DRV Pricing and Valuation of Forward Contracts
Learning Module: 5 and for an Underlying with Varying Maturities
Exhibit:
Tools of Geopolitics
services, capital, and labor, and impact neighboring

countries and refugee-accepting countries.
1. National Security Tools
2. Economic Tools
National security tools are those that influence state
actors through direct or indirect impact on resources,
people, or borders. Economic tools are activities that support cooperative or
non-cooperative stances through economic means.
National security tools may be active, indicating they're
being utilized, or threatening, suggesting their use is • Cooperative economic tools include multilateral
probable enough to justify alarm. trade agreements, common markets, and
common currencies.
National security tools can be direct, such as armed • Economic tools can also be non-cooperative,
conflict, or indirect, such as espionage or military such as nationalization, the process of transferring
alliances. Some tools are used in a non-cooperative an activity or industry from private to state
way, while others are used cooperatively. control.
• Countries may impose:
For example, NATO is an alliance between the US, o voluntary export limits - declining to trade
Canada, UK and EU, which serves as a collective effort as much of their goods and services as is
to reduce nuclear proliferation and other common required to fulfill demand.
national security goals. o domestic content criteria - requiring a
specific amount or kind of domestic input
The most extreme example of a national security tool is to be included in an exported good.
armed conflict, which can disrupt or destroy physical
infrastructure, reshape international flows of goods,

Learning Module: 6
3. Financial Tools
The term "cabotage" refers to a foreign company's right
to transport people and products within a country.
Financial tools are activities that support cooperative or
non-cooperative stances through financial means. Note: Actors that incorporate more tools of collaboration
are less likely to initiate conflict.
Cooperative financial tools include
o encouraging foreign investments
Geopolitical Risk and Comparative Advantage
o allowing cross border currency exchanges
A country or an actor's core priorities may be shaped

Non-cooperative financial tools include both by geopolitics and by the tools of geopolitics,
o restricting foreign investments which can either shift the relative advantage in one
o limiting access to local currency markets direction or the other.
Cooperative financial tools foster security, economic Countries with certain resources and capabilities may
and financial support and as a result reduce geopolitical benefit from trade if they cooperate.
risk, but the same tools can cause international system
weaknesses. Dollar domination is an example. US Countries or regions with low geopolitical risk exposure
monetary policy can hurt countries that do not have US may attract more labor and capital, whereas those with
dollar reserves. higher geopolitical risk exposure may see a decline in
employment and capital. A sustained threat of conflict
may drive higher asset price volatility, and consequently
Multi-Tool Approach
investors may demand a higher level of risk
compensation.
Geopolitics and its tools are complex and include
political, economic, and financial systems. These systems
can be intertwined and are often multifaceted. Practice: Example 8, 9 and
Questions under the ‘Knowledge
For example, many countries, including those with Check’ for this section from the
multilateral trade agreements, restrict cabotage CFA Institute’s Curriculum.
because it is a highly complex process. Countries must
cooperate on issues like physical security and economic
cooperation to permit cabotage.
INCORPORATING GEOPOLITICAL RISK INTO THE

6.
INVESTMENT PROCESS
Geopolitical risk can have a significant impact on Note: Predictability does not affect the likelihood,
financial markets, depending on an investor's goals and speed, or magnitude of impact on investors,
risk tolerance. Some investors may consider geopolitical but it does offer them more time to prepare a
risk only if it affects their asset classes or strategies in the reaction.
long term. For other investors, geopolitical risk is key for
generating alpha. 2. Exogenous risk - is a sudden or unexpected risk
that affects either a country's cooperative
position, non-state entities' potential to globalize,
Types of Geopolitical Risk
or both.
Three types of geopolitical risks are: 3. Thematic risk – risks that evolve over time such
as climate change, pattern migration, the rise of
1. Event risk - focuses on specified dates, such as populist forces, cyber threats, and terrorism.
elections, new legislation, holidays, and political
anniversaries. Investors' expectations of a
country's cooperation are influenced by political Assessing Geopolitical Threats
changes. Therefore, risk analysts often use
political calendars as a starting point for Geopolitical risk can affect investments at
calculating event risk. macroeconomic, industry, and company levels.
Investors examine geopolitical risk in three areas:

Learning Module: 6
1. Likelihood of occurrence - is the probability that scenarios, as well as how markets are likely to recover
the risk will occur. This can be challenging to after the event.
measure as many risks are unpredictable.
Quantitative scenarios can vary in sophistication, from
Collaboration and globalization reduce simple stylized scenarios (measuring one factor) to more
geopolitical risk since partners' political, complicated ones using extreme events to test portfolio
economic, and financial costs are larger. resilience.
Other variables may include internal political Scenario analysis is a useful tool for tracking risks,
stability, economic need, and governmental deciding on valuable portfolio actions, and avoiding
motives. groupthink. It requires a consistent commitment of
investors’ time and resources.
2. Velocity of its impact - is the pace at which the
risk impacts an investor portfolio. Effective scenario analysis necessitates teams
establishing creative processes, identifying scenarios,
i. Short-term or ‘high velocity’ - impacts tracking them, and assessing the need for action on a
include market volatility and investor regular basis.
flight to quality. Such impacts may
damage whole industry or the whole Tracking risks according to signposts
market. Exogenous or ‘Black swan’
events include rare but significant
Asset managers build strategies to prioritize portfolio risks
events.
to minimize the impact of unanticipated change on
ii. Medium-term risks impact companies'
investments.
processes, costs, and investment
opportunities, resulting in lower
valuations. These risks are sector Signposts:
specific.
iii. Long-term or ‘low velocity’ risks can o are indicators, market levels, data pieces, or
impact asset allocation, but the events that signal a risk becoming more or less
immediate impact on portfolios is likely likely.
to be limited. o can be compared to traffic lights, with green
indicating no action is required, amber
indicating caution, and red indicating an action
3. Size and nature of that impact - When
plan is necessary.
evaluating a risk's relevance, investors should
evaluate its impact. High-impact risks need o identification may take trial and error. A
fundamental principle is to distinguish signal
more investigation than a low-impact risks.
from noise. E.g., policy changes are more
External variables might intensify a risk's impact.
critical than political changes.
For example, risk affects markets more during
recessions.
Economic and financial market circumstances can
The nature of the impact may be discrete or signal upcoming trouble. A pegged currency or rapidly
broad. Discrete affects only one firm or sector, declining export value can prompt a change in
whereas broad ones affect a sector, country, or exchange rate policy. Data screens should be used to
global economy. identify these red flags early for country-level portfolios.
Scenario analysis Manifestations of Geopolitical Risk
Scenario analysis, in which investment teams examine Geopolitical risks are unpredictable and can have a
their portfolios across several world scenarios, can assist wide impact on investor portfolios. They can cause
teams in prioritizing and making sound investment market volatility that can cause sudden changes in asset
decisions. prices.
Scenarios can take the form of qualitative analysis, During the COVID-19 epidemic, for example, stock
quantitative measurement, or both. prices fell while investors' "flight to safety" drove bond
prices higher.
A simple framework for qualitative scenario building
begins with developing a ‘base case’ for the risk.
Investors can then consider the upside and downside

Learning Module: 6
global investors. Changes in international cooperation

Acting on Geopolitical Risk
can affect capital markets.
Risk analysis is the process of analyzing the likelihood,

velocity, and impact of a risk to determine if and how to Practice: Example 10 and
act in the face of such threats. The asset allocator may Questions under the ‘Knowledge
consider geopolitical risk in their asset allocation Check’ for this section from the
strategy. They may consider countries with a long history CFA Institute’s Curriculum.
of using a multilateral approach to be more reliable
invest.
Portfolio managers can consider geopolitical risk in their Practice: End of Chapter Questions
models. Risk depends on investment objectives, risk ’from CFA Institute’s Curriculum
tolerance, and time horizon. and FinQuiz Question-bank.
Political, economic, and financial cooperation may

boost the stakes of geopolitical risk assessments for

ECO International Trade and Capital Flows
Learning Module: 7
1. INTRODUCTION & INTERNATIONAL TRADE-BASIC TERMINOLOGY
Investors must analyze following factors to identify have improved which implies that now the
markets that are expected to provide attractive country will be able to purchase more imports
investment opportunities: with the same amount of exports.
• Due to exports and imports of large number of
• Cross-country differences in expected GDP goods & services, the terms of trade of a country
growth rates. are usually measured as an Index number
• Cross-country differences in monetary and fiscal (normalized to 100 in some base year) i.e.
policies, trade policies, and competitiveness.
Terms of Trade (as an index number) =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭𝐬
Other factors from a longer-term perspective include
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭𝐬
Country’s
• When Terms of trade > (<) 100, it indicates that the

• Stage of economic and financial market
country or group of countries experienced better
development
(worse) terms of trade relative to the base year.
• Demographics
• Quality and quantity of physical and human
capital Net exports = Value of a country's exports - Value of
• Area of comparative advantage country's imports
• Balanced Trade: A trade is balanced when the

International Trade value of exports = value of imports.
Basic Terminology • Trade surplus: There is a trade surplus when the

value of exports > value of imports.
Difference between GDP and GNP: o When a country has a trade surplus, it lends to
foreigners or buys assets from foreigners.
• Unlike GNP, GDP includes the production of
• Trade deficit: There is a trade deficit when the
goods and services by foreigners within that
value of exports < value of imports.
country.
o When a country has a trade deficit, it borrows
• Unlike GDP, GNP includes the production of
from foreigners or sells some of its assets to
goods and services by its citizens outside of the
foreigners.
country.
A country may have large differences between GDP

Autarky: It refers to a state in which a country does not
and GNP due to the following reasons:
trade with other countries and all goods and services are
produced and consumed domestically. It is also known
• A country has a large number of citizens who work as Closed Economy.
abroad.
• A country may earn less on the capital it owns Autarkic price: The price of a good or service in an
abroad compared to what it pays for the use of autarky economy is called autarkic price.
foreign-owned capital in domestic production.
Open Economy: An economy that trades with other
NOTE: countries.
Generally, GDP is a more widely used measure of
economic activity occurring. • In the absence of any trade restrictions, the
members of an open economy can buy and sell
The terms of trade reflect the relative cost of imports in goods and services at the prevailing world market
terms of exports. price (called world price).
Terms of trade =
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭𝐬 Benefits of an Open Economy:
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭𝐬
• Provides domestic households with a greater

• If prices of exports increase relative to the prices variety of goods and services.
of imports, it indicates that the terms of trade

Learning Module: 7
• Provides domestic companies access to global

markets and customers. B. The world price is P2. At P2,
• Offers goods and services that are more
competitively priced. • Quantity demanded = QC
• Provides domestic investors access to foreign • Quantity supplied = QD.
capital markets, foreign assets. o Hence, the domestic excess supply = QC × QD.
• Provides domestic investors access to greater o The quantity (QC × QD) is exported.
investment opportunities.
• Facilitates companies to take advantage of
economies of scale by providing them access to
a much larger market.
• Reduces the monopoly power of domestic firms
by increasing competition from foreign firms; also,
due to foreign competition, domestic firms are
encouraged to become more efficient as
compared to a closed economy.
Free trade: Free trade occurs when there are no

government restrictions on a country's ability to trade.
• Under free trade, the equilibrium quantity and

price of imports and exports are determined by
the world demand and supply.
Globalization: Globalization refers to the "increasing

worldwide integration of markets for goods, services,
and capital”.
In addition, it also refers to “increasing role for large

corporations (multinational corporations) in the world
economy and increasing intervention into domestic
policies and affairs by international institutions (i.e. IMF,
WTO, World Bank)”.
Reference: CFA Institute’s Curriculum, ‘International Trade and
Refer to the fig below: Capital Flows’.
With no trade:
• E represents the autarkic equilibrium with price PA

and quantity QA. At E, the quantity of cars
demanded = the quantity of cars supplied.
With trade:
A. The world price is P1. At P1,
• Quantity demanded domestically = QK

• Quantity supplied domestically = QJ.
o Hence, domestic excess demand = QJ × QK.
o The quantity (QJ × QK) is met by imports.
PATTERNS AND TRENDS IN INTERNATIONAL
2.
TRADE AND CAPITAL FLOWS
The ratio of trade-to-GDP is used to measure the company in a foreign country (host country) by the firm
importance of trade in absolute and relative terms. in one country (source country) to gain some measure of
management control.
Foreign Direct Investment (FDI): FDI refers to purchase of
physical assets or significant amount of ownership of a
Learning Module: 7
• A firm that engages in FDI becomes a affected by economic downturns and crises
multinational corporation (MNC). MNC is a occurring in other parts of the world.
corporation that operates in more than one • Trading relationships are becoming more complex
country or has subsidiary firms in more than one due to global supply chains.
country.
Foreign portfolio investment (FPI): FPI refers to shorter-
Advantages of FDI and globalization of production: term investment by individuals, firms, and institutional
investors (e.g., pension funds) in foreign financial
• Increases business investment in smaller and less instruments i.e. foreign stocks and foreign government
developed countries. bonds. Unlike FDI, FPI does not involve obtaining a
• Provides smaller and less developed countries the degree of control in a company.
opportunity to participate in international trade.
Disadvantages of FDI and globalization of production:
• Due to increasing interdependence, countries’

exposure to global competition increases.
• Due to increasing interdependence, countries’ risk
& return profiles have changed and are more
3. BENEFITS AND COSTS OF INTERNATIONAL TRADE
• Facilitates development of higher quality and

Benefits of International trade: more effective institutions and policies that
encourage domestic innovation.
• Gains from exchange i.e. a country can receive a • Enhances the positive effects of foreign research
higher price for its exports (hence, earns greater and development (R&D) because the benefits of
profit) and/or buy imported goods at a price R&D in one country accrue to its trading partners.
lower instead of producing these goods
domestically at a higher cost. NOTE:
• Facilitates economic growth (GDP) by increasing
the efficiency of resource allocation, promoting Although trade increases overall welfare, it does not
learning by doing, increasing productivity, mean that every individual consumer and producer is
knowledge spillovers etc. better off; rather, trade creates winners and losers.
• Provides domestic households with a greater However, the gains from trade are greater than losses.
variety of goods and services.
• Provides access to larger capital and product
markets. Traditional trade models, i.e. Ricardian model and the
• Greater efficiency from increased competition. Heckscher-Ohlin model, focus on specialization and
• Facilitates specialization based on comparative trade based on the concept of comparative
advantage. advantage that results due to differences in technology
• Facilitates flow of financial capital, which helps to and factor endowments, respectively.
increase liquidity and output and lower the cost
of capital. Newer models of trade focus on the gains from trade
• Increases the wages for unskilled workers (helps that result from economies of scale, greater product
poor) when exports are concentrated in labor- variety and increased competition.
intensive manufacturing.
• Promotes macroeconomic stability Intra-industry trade: It refers to a trade that occurs when
• Enhances productivity and growth by promoting a country exports and imports goods in the same
innovation, exchange of ideas, free flow of product category or classification. Intra-trade benefits
technical expertise, and factor accumulation. countries because each country can focus on the
• Facilitates companies with economies of scale production and export of one or more varieties of the
and increasing returns to scale (e.g. automobiles, good and can import other varieties of the same good.
steel) by providing them access to new markets
for their products because the average cost of NOTE:
production falls as output increases in these In industries where there is "learning by doing," the cost
industries. of production per unit falls as output increases because
• Increases awareness of changing consumer tastes of expertise and experience acquired in the process of
and preferences in global markets. production.
Learning Module: 7
Disadvantages of Free Trade: NOTE:

Besides trade, other factors that affect economic
• Trade may result in greater income inequality. growth include:
• Trade may destroy jobs in the industries that
compete against imports.
• Quality of institutions, infrastructure, and
• Unemployment increases when less-efficient firms
education
are forced to exit the industry.
• Economic systems
• The displaced workers are required to be
• Degree of development
retrained for jobs in expanding industries.
• Global market conditions
It is argued that these costs occur in the short and

medium term only; in the long run, the resources (i.e.
displaced workers) are likely to be more effectively (re-) Practice: Example 1,
employed in expanding export industries after some re- CFA Institute’s Curriculum.
training.
But the workers who remain in import-competing industry

may be permanently worse off. Thus, even in the long-
run, trade does not necessarily benefit every
stakeholder.
COMPARATIVE ADVANTAGE AND THE GAINS FROM TRADE:
4.
ABSOLUTE AND COMPARATIVE ADVANTAGE
• Can produce 16 yards of cloth a day

Gains from Trade: Absolute and Comparative • Opportunity cost of 1 machine is 8 yards of cloth
Advantage (16/2) i.e. has to forgo 8 yards of cloth to produce
1 extra machine).
Absolute Advantage: If a country is able to produce a • Opportunity cost of 1 yard of cloth is 0.125
good at a lower cost or use fewer resources in its machines (i.e. 1/8)
production than its trading partner, it is said to have an
absolute advantage in producing that good. Data shows that:
Comparative Advantage: A country has a comparative • Country A produces machines at a lower cost
advantage in producing a good if the opportunity cost than Country B, and hence has an absolute
of producing that good is lower in the country than it is in advantage in the production of machines.
trading partner’s country. • Country B produces cloth at a lower cost than
Country A, and has an absolute advantage in the
• When a country has a comparative advantage in production of cloth.
producing a good, it implies that it uses its • Country A has the lower opportunity cost than
resources most efficiently when it produces that Country B in the production of machines and thus
good compared to producing other goods. has a comparative advantage in the production
of machines.
Example: o Thus, Country A should specialize in machines.
• Country B has a lower opportunity cost than
Country A: Country A in the production of cloth and thus has
a comparative advantage in the production of
• Can produce 4 machines a day or cloth.
• Can produce 8 yards of cloth a day o Thus, Country B should specialize in cloth.
• Opportunity cost of 1 machine is 2 yards of cloth • International trade will benefit both countries even
(i.e. 8/4) if they have absolute disadvantage in producing
• Opportunity cost of 1 yard of cloth is 0.5 machines any of the goods. Because countries can benefit
(i.e. ½) by exporting the goods in which they have
comparative advantage.
Country B:
Important to understand:
• Can produce 2 machines a day or
Learning Module: 7
• If country A can sell a machine for more than 2 • Similarly, Country B consumes 160 machines and
yards of cloth and if country B can produce a 960 yards of cloth i.e. an increase of 60 machines
machine for less than 8 yards of cloth, both and 160 yards of cloth.
countries would benefit from trade. • World production and consumption is now 400
• Both countries would gain from trade as long as machines and 1600 yards of cloth. Hence, post-
the world price for a machine in terms of cloth lies trade production and consumption exceeds the
between the autarkic prices of the trading autarkic state production and consumption by
partners i.e. between 2 and 8 yards of cloth. 100 machines and 400 yards of cloth.
• The further away the world price of a good or
service is from its autarkic price in a given country,
the more that country gains from trade e.g.
o If Country A can sell a machine to Country B for Practice: Example 2,
7 yards of cloth (i.e. closer to Country’s B CFA Institute’s Curriculum.
autarkic price), it would gain 5 yards of cloth
per machine sold to Country B compared with
its own autarkic price (with no trade) of 1 Production Possibilities Frontier (PPF): The production
machine for 2 yards of cloth. possibilities frontier is a graph that shows the
o If Country A can sell a machine to Country B for combinations of output (e.g. cloth and machinery) that
3 yards of cloth (i.e. closer to Country’s A the economy can possibly produce given the available
autarkic price), it would gain only 1 yard of cloth factors of production (i.e. capital and labor) and the
per machine sold to Country B compared with available production technology.
its own autarkic price (with no trade) of 1
machine for 2 yards of cloth.
• The slope of the PPF at any point represents the
opportunity cost of one good in terms of the
Autarkic Autarkic other.
Production Consumption • The PPF is concave to the origin which indicates
Country A increasing opportunity cost e.g. in terms of
Machines 200 200 machines as more cloth is produced and vice
Cloth 400 400 versa.
Country B • The maximum (optimal) production occurs at a
Machines 100 100 point where the slope of the PPF equals the
Cloth 800 800 relative price of the goods.
• PA represents the autarkic price line.
Autarkic Autarkic • The slope of the autarkic price line represents the
Production Consumption opportunity cost before trade.
Total World • PA is tangent to the PPF at point A.
Machines 300 300 • Point A reflects the autarkic equilibrium.
Cloth 1200 1200
In autarky:
NOTE:
Without trade, consumption of each product must equal • Country A produces and consumes 60 machines
domestic production. and 60 thousand yards of cloth.
• Country A lies on indifference curve I.
• World price of 1 machine is 4 yards of cloth.

• In an open economy, Country A would specialize With trade:
in machine production and Country B would
specialize in cloth production. As a result, • Country A and B will face the world price line P*.
o Country A will produce 400 machines and no • World price line P* is tangent to the PPF at point B.
cloth. • Hence, due to the change in relative prices of the
o Country B will produce 1600 cloth and no goods, Country A is encouraged to increase the
machines. production of the good in which it has
o Country A exports 160 machines to Country B in comparative advantage (i.e. machines) and
exchange for 640 yards of cloth. produce at point B instead of point A.
• After trade, the Country A consumes 240 • At point B, Country’s A production of machines
machines and 640 yards of cloth. Consumption in has increased to 120 units and production of cloth
the country A increases by 40 machines and 240 has reduced to 30,000 yards.
yards of cloth. • Also, post-trade, Country A consumes at point E
(which lies on P*, outside the PPF), which lies on a
Learning Module: 7
higher indifference curve (III). Hence, trade • Structural shifts in the domestic economy.
increases welfare of Country A. • Shifts in the global economy.
• It exports 80 machines to Country B and imports • Accumulation of physical or human capital, new
80,000 yards of cloth from Country B. technology, the discovery of natural resources
• P* is also called the trading possibilities line (e.g. oil).
because trade occurs along this line.
• The slope of the line P* represents the opportunity
cost of a machine in terms of cloth in the world
market. Practice: Example 4,
• At price P*, trade is balanced i.e. the export of CFA Institute’s Curriculum.
cloth from Country B equals the import of cloth
into the Country A and the export of machines
from Country A equals the import of machines From an investment perspective, analysts and investors
into the Country B. must analyze the following factors:
Conclusion: • Country's comparative and absolute advantages

and changes in them.
• A country can increase its welfare by specializing • Changes in government policy and regulations.
in the good in which it has a comparative • Changes in demographics, human capital,
advantage. demand conditions.
A country's comparative advantage is not static; rather,

it can change over time as a result of following factors:
RICARDIAN AND HECKSCHER-OHLIN MODELS OF

5. COMPARATIVE ADVANTAGE
According to Adam Smith, a country can gain from Heckscher-Ohlin Model (also known as factor-
trade if it has absolute advantage in the production of a proportions theory):
good.
According to Heckscher-Ohlin Model, differences in
According to David Ricardo, a country can gain from factor endowment i.e. labor, labor skills, physical capital
trade if it has a comparative advantage in the and land between countries can cause productive
production of a good even if it does not have an differences and leads to gains from trade.
absolute advantage in the production of any good.
• Hence, under Heckscher-Ohlin model, the source
Ricardian Model: According to the Ricardian Model, of comparative advantage is the differences in
differences in productivity of labor between countries the relative factor endowments.
cause productive differences which leads to gains from • This model is based on two factors of production
trade. i.e. labor and capital.
• Hence, under Ricardian model, the source of Assumptions of the Heckscher-Ohlin Model:
comparative advantage is the differences in
labor productivity.
• Both capital and labor are variable factors of
• Differences in labor productivity are usually
production.
explained by differences in technology.
• There are homogeneous products and
• This model is based on only one factor of
homogeneous inputs.
production i.e. labor.
• Technology in each industry is the same among
countries, but it varies between industries.
Assumptions of the Ricardian model: Only labor is the
variable factor of production.
According to the Heckscher-Ohlin theory,
Criticism: Differences in technology can be a major
source of comparative advantage only at a given point • A country has a comparative advantage in
in time because the technology gap can be closed by goods that use intensively its abundant factor. It
other countries or they can gain a technological will export that good which uses intensively its
advantage. abundant factor and will import that good which
uses intensively its scarce factor.
Learning Module: 7
• A country has relatively abundant (scarce) • Trade positively affects the abundant factor and
capital if the ratio of its endowment of capital to negatively affects the scarce factor.
labor > (<) its trading partner. This implies that: • If there is free trade, then the absolute and
o A country where capital (labor) is relatively relative factor prices will be equal in both
abundant would export relatively capital (labor) countries provided that all assumptions of the
intensive goods and import relatively labor Heckscher-Ohlin hold. However, in the long-run,
(capital) intensive good. factor prices tend to converge.
• Since this model is based on two production
factors, it may allow income redistribution through NOTE:
trade i.e. when a country starts trading, the price
of the Both the differences in technology and differences in
o Export good increases. factor abundance are complementary, not mutually
o Import good decreases. exclusive.
NOTE:
As a result,
The demand for an input is called a derived demand
• Incomes received by each factor of production because it is derived from the demand for the product it
change; because demand for factors used to is used to produce.
produce export goods ↑, whereas demand for
factors used to produce the import goods ↓.
It is important to understand that:
• When trade is opened, the relatively cheap good

and the relatively cheap factor of production
both get more expensive in each country.
TRADE AND CAPITAL FLOWS: RESTRICTIONS AND AGREEMENTS
6.
– TARIFFS, QUOTAS AND EXPORT SUBSIDIES
Trade restrictions (or trade protection) are government • Domestic content requirements: Domestic content
policies that are used to impose limits on the ability of provisions are a regulation that requires that some
domestic households and firms to trade freely with other specified % of a final good be produced
countries. Examples of trade restrictions include: domestically. This % can be specified in physical
units or in value terms.
• Tariffs: Tariffs are taxes levied by a government on
imports. Rationale behind imposing Trade restrictions:
• Import quotas: Quota is a direct quantitative 1) Protecting established domestic industries from
restriction on the amount of a good that can be foreign competition.
imported into a country (generally for a specified 2) Protecting new industries from foreign
period of time). competition (a.k.a infant industry argument).
3) Protecting and increasing domestic employment.
• Voluntary export restraints (VER): It is a trade 4) Protecting strategic industries for national security
restriction under which the exporting country agrees reasons.
to limit its exports of the good to its trading partners 5) Generating revenues (i.e. through tariffs).
to a specific number of units. VER is similar to import 6) Retaliation against trade restrictions imposed by
quotas; but unlike quotas, it is imposed by the other countries.
exporting country.
• Capital restrictions: Capital restrictions are limits
• Export Subsidies: They are direct payments (or the
imposed on foreigners' ability to own domestic
granting of tax relief and subsidized loans) paid by
assets and/ or domestic residents' ability to own
the government to the domestic exporters or
foreign assets.
potential exporters.
Trade restrictions v/s Capital restrictions:
• Embargoes: Embargo is a prohibition on trade in a
particular good.
• Trade restrictions limit the openness of goods
markets.
Learning Module: 7
• Capital restrictions limit the openness of financial • Domestic production increases to Q2.
markets. • Domestic consumption declines to Q3.
• Imports reduce to Q2Q3.
1. Tariffs
As a result of these price changes:
Tariffs are taxes levied by a government on imports.

• Consumers lose in the importing country and gain
in the exporting country.
Objectives of tariffs:
• Producers gain in the importing country and lose
in the exporting country.
• To protect domestic industries that produces the • Government imposing the tariff gains revenue.
same or similar goods.
• To reduce a trade deficit.
When a small country imposes a tariff:
Disadvantages of tariffs:
• Consumer’s surplus decreases due to increase in
price.
• Tariffs increase the price of imports above the free Consumer loss = A + B + C + D
trade price; as a result, demand for imported • Producer’s surplus increases due to increase in
goods falls. price.
• Tariffs reduce the overall global welfare. Producers gain = A
• Government revenue increases i.e. the
In this context: government gains tariff revenue on imports =
Q2Q3. It is represented by area C.
Small Country: A small country refers to a country that is • Triangle B and D reflects efficiency loss because
a price taker in the world i.e. it cannot influence the tariffs distort incentives to consume and produce.
world market price. o Triangle B reflects production inefficiencies i.e.
inefficient producers with cost of production >
• Trade barriers generate a net welfare loss in a P* exist in the market and leads to inefficient
small country. allocation of resources.
o Triangle D reflects consumption inefficiencies i.e.
Large Country: A large country refers to a country that is consumers are now unable to consume the
a large importer of the product and can influence the good due to higher prices.
world market price. Trade barriers can generate a net
welfare gain in a large country provided that:
• It imposes an even larger welfare loss on its

trading partner (s).
• It does not face retaliation from its trading partner.
• The benefits of improving its terms of trade are
greater than the deadweight loss as a result of the
tariff.
Under Free trade:
• World price (free trade price) = P*.

• Domestic supply = Q1.
• Domestic consumption = Q4.
• Imports = Q1Q4.
Under Tariffs:
• Per-unit tariff imposed = t.

• Due to tariffs, domestic price = world price + per-
unit tariff = P* + t = Pt.
Reference: CFA Institute’s Curriculum, Volume 2, ‘International
Note: A tariff imposed by a small country does not Trade and Capital Flows’.
change the price in the exporting country.
The net welfare effect = consumer’s surplus loss +
producer’s surplus gain + government revenue
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• Unlike quotas, effect of tariff is uncertain.

Deadweight loss to the country's welfare =B + D
Voluntary export restraint (VER) versus Import Quota:
• Deadweight loss occurs when loss in consumer
surplus > sum of the gain in producer surplus and
• Import Quota is imposed by the importer, whereas
government revenue.
VER is imposed by the exporter.
• Under VER, all of the quota rent is captured by the
exporting country, whereas under import quota at
Practice: Example 4, least some part of the quota rent may be earned
CFA Institute’s Curriculum. by local importers.
• VER produces a greater welfare loss to the
importing country than import quota.
2. Quotas
3. Export Subsidies
A quota is used to restrict the quantity of a good that

can be imported into a country, generally for a specified Objective of export subsidies: To stimulate exports.
period of time. This restriction is usually enforced by
issuing licenses to some group of individuals or firms. Disadvantage of export subsidies: They reduce welfare
by promoting production and trade that is inconsistent
with comparative advantage.
• Due to import quota, foreign producers increase
the price of their goods. Countervailing duties: Duties that are imposed by the
• The profits received by the import license holders importing country against subsidized exports are referred
(foreign producers) are known as quota rents. to as countervailing duties.
In the fig below, Under export subsidies:

Exporter receives = International price + per-unit subsidy
• Import quota = Q2Q3. for each unit of the good exported
• Domestic price after the quota = Pt (same as the
domestic price after the tariff t was imposed).
• It incentivizes exporters to shift sales from the
• Quota rent is represented by Area C.
domestic to the export market.
Welfare loss to the importing country = B + D + C

As a result,
• Under a quota, the welfare loss > than under an

• In case of small country, the price of a good in
equivalent tariff.
the domestic market/exporting country increases
• The welfare loss will be same under quota and
(i.e. Price = Price before subsidy + subsidy). The
tariffs only when the government of the country
net welfare effect is negative.
that imposes the quota can capture the quota
rents by auctioning the import licenses for a fee • In case of large country, the world price falls as
i.e. it will be equal to areas B + D. the large country increases exports and part of
the subsidy is transferred to the foreign country
(i.e. country’s terms of trade deteriorates). The net
Tariffs v/s Import Quotas: welfare effect is negative and is larger than that
of small country case.
• The revenue generated from a tariff is collected
by the government. Under export subsidy,
• The revenue generated from quotas is collected
by the holders of import licenses.
• Consumer surplus decreases.
• Under import quotas, an increase in demand will
• Producer surplus increases.
result in a higher domestic price and greater
• Government revenue also decreases.
domestic production compared to an equivalent
import tariff.
• Under import tariffs, an increase in demand does
not change the domestic price and domestic
production; rather, it results in higher consumption
and imports compared to an equivalent import
quota.
Learning Module: 7
Panel A: Effects of Alternative Trade Policies
Tariff Import Quota Export Subsidy VER

Impact on Importing country Importing country Exporting country Importing country
Producer surplus Increases Increases Increases Increases
Consumer surplus Decreases Decreases Decreases Decreases
Government Increases Mixed (depends on Falls (government No change (rent to
Revenue whether the quota spending rises) foreigners)
rents are captured
by the importing
country through sale
of licenses or by the
exporters)
National welfare • Decreases in small • Decreases in small Decreases Decreases
country country
• Could increase in • Could increase in
large country large country
Panel B: Effects of Alternative Trade Policies on Price, Consumption, Production, and Trade
Tariff Import Quota Export Subsidy VER

Impact on Importing country Importing country Exporting country Importing country
Price Increases Increases Increases Increases
Domestic Decreases Decreases Decreases Decreases
consumption
Domestic Increases Increases Increases Increases
Production
Trade Imports decrease Imports decrease Exports increase Imports decrease
Source: CFA Institute’s Curriculum, Exhibit 13.
Practice: Example 6, • Profitability and growth of firms because changes

CFA Institute’s Curriculum. in trade policies affect:
o Goods a firm can import/export
o Demand for its products
o Pricing policies
Changes in the Government's trade policy may affect: o Production costs due to increased paperwork,
procurement of licenses, approvals etc.
• Pattern and value of trade
• Industry structure
TRADING BLOCS, COMMON MARKETS,

7.
AND ECONOMIC UNIONS
while retaining the right to set tariffs and quotas towards

Important examples of regional integration include: non-members.
Types of Regional Trading Blocs:

1) North American Free Trade Agreement (NAFTA)
2) European Union (EU) 1) Free trade areas (FTA): A free trade area allows free-
trade among members. However, each member can
Regional Trading Bloc: A group of countries that have have its own trade policy towards non-member
signed an agreement to get the benefits of free trade countries.
by removing tariffs and quotas between themselves
Learning Module: 7
Example: The North American Free Trade Agreement • Trade creation increases welfare.
(NAFTA) creates a free trade area. Its members
include United States, Canada, and Mexico.
Example: Suppose, Country A and Country B are
members of a regional trading bloc, whereas Country C
2) Customs union: A customs union allows free trade
is not.
among members and also requires a common
external trade policy against non-member countries.
• Before the RTA, Country A has in place a specific
Example: In 1947, Belgium, the Netherlands, and (per unit) tariff on imports from both B and C.
Luxemburg ("Benelux") formed a customs union. • Country B is the lower-cost producer in
comparison to Country C.
3) Common market: A common market incorporates all o Therefore Country A imports good from Country
aspects of customs union and also allows free B.
movement of factors of production (especially labor) • Once Country A joins regional integration with
among members. Country B, tariff is removed on imports from
Country B. Good continues to be imported from
Example: The Southern Cone Common Market Country B and imports increase because price
(MERCOSUR) of Argentina, Brazil, Paraguay, and has fallen due to removal of tariff.
Uruguay. • Consumer surplus in Country A increases while
producer surplus and government tariff revenue
4) Economic Union: An economic union incorporates all falls. Hence, trade creation results in net increase
aspects of a common market and also requires in welfare.
common economic institutions and coordination of
economic policies among members. 2) Trade diversion: Trade diversion occurs when regional
integration leads to the replacement of low-cost
Example: The European Union. imports from non-members with higher-cost imports
from member countries.
Monetary Union: When the members of the economic
union decide to adopt a common currency, it is • Trade diversion reduces welfare.
referred to as a monetary union.
Example: Suppose, Country A and Country B are
World Trade Organization (WTO): The WTO is a
members of a regional trading bloc, whereas Country C
negotiating forum with objectives to eliminate trade
is not.
barriers (both tariff and non-tariffs) between countries
and to settle trade disputes among countries. Under
WTO, all countries treated on most favored nation (MFN) • Before the RTA, Country A has in place a specific
basis. (per unit) tariff on imports from both Country B
and Country C.
Regional integration v/s multilateral trade negotiations • Assume Country C is now the lower-cost producer
under WTO: in comparison to B.
o Country A imports the good from Country C.
• Once Country A joins a regional trading bloc with
• Relative to multilateral trade negotiations under
Country B, however, Country A switches to
WTO, regional integration is popular and easy to
Country B as an import supplier. → Imports
implement because it is easier, politically less
expand as the domestic price falls.
conflictual, and quicker to eliminate trade and
• Consumer surplus in Country A increases while
investment barriers among a small group of
producer surplus and government revenue falls
countries.
• Whether net welfare effect is positive or negative,
• Unlike WTO, regional integration results in
is ambiguous i.e.
preferential treatment for members compared
o If trade-diverting effects > trade-creating
with non-members.
effects, then regional trading bloc will reduce
• Regional integration can change the patterns of
welfare in Country A.
trade.
Advantages of Regional Trading Blocs:

Effects of forming a Regional Trading Bloc (e.g. Custom
Union):
• By eliminating or reducing trade barriers against
1) Trade creation: Trade creation occurs when regional each other, member countries can allocate
integration leads to replacement of high-cost resources more efficiently.
domestic production by low-cost imports from other • Other advantages are the same as that of free
members. trade e.g.
o Greater specialization
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o Reduction in monopoly power and prices due phenomenon. But when workers remain
to foreign competition unemployed for a long period, they may face
o Greater choices available to consumers long-term losses.
o Economies of scale from larger market size • Differences in tastes, culture, and competitive
o Improvements in quality due to the exposure to conditions among members of a trading bloc
more competition reduce the potential benefits from investments
o Learning by doing within the bloc.
o Technology transfer, knowledge spillovers • Problems faced by individual member countries
o Encourage FDI may quickly spread to other countries in the bloc.
• Facilitates members to negotiate better trade
terms with the rest of the world than as individual
nations. Challenges in the formation of Regional Trading
• By promoting greater interdependence among Agreements (RTA):
members, it helps to reduce the potential for
conflict. There are at least two challenges in the formation of an
• Increases labor mobility and hence help reduce RTA i.e.
unemployment in member countries.
• Strong growth in any RTA country can accrue 1) It is difficult to form an RTA due to cultural differences
other RTA member countries. and historical considerations (e.g. wars and conflicts).
• Enhances the benefits of good policy and lead to 2) Countries are hesitant to form an RTA due to their
convergence in living standards. preference to pursue independent economic and
• Provides greater currency stability. social policies.
Disadvantages of Regional Trading Blocs:

• Regional integration may result in less-efficient Institute’s Curriculum.
allocation of resources and decrease in welfare
due to trade diversion.
• They may encourage mergers and takeovers
resulting in greater oligopolistic collusion.
• They create adjustment costs arising from job
losses e.g. when inefficient firms exit the market
due to import competition, unemployment
increases. However, it is viewed as a temporary
8. CAPITAL RESTRICTIONS
Inward Capital restrictions include:

Capital restrictions are used to limit or redirect capital
flows in an economy. Such restrictions include: • Restrictions imposed on foreigners to invest in the
domestic country.
• Taxes or Price controls e.g. special taxes on returns • Limits on inward investment by foreigners i.e.
to international investment, taxes on certain types amount that they can invest in the domestic
of transactions, or mandatory reserve country and/or type of industries in which capital
requirements*. can be invested.
• Quantity controls e.g. ceilings or special
authorization requirements for new or existing Restricted capital outflows refer to limits imposed on the
borrowing from foreign creditors. purchase of foreign assets or loans abroad. Outward
• Outright prohibitions on international trade in Capital restrictions include:
assets.
• Administrative controls e.g. foreign firms need
• Restrictions placed on foreigners on repatriation
approval from government agency regarding
of capital, interest, profits, royalty payments, and
transactions for certain types of assets.
license fees.
• Restrictions imposed on citizens to invest abroad
*Mandatory reserve requirements: Under mandatory particularly in foreign exchange, scarce
reserve requirements, foreign parties are required to economies.
deposit some % of the inflow with the central bank for a • Deadlines placed on citizens regarding
minimum period at zero interest rate if they want to repatriation of income earned from any
deposit money in a domestic bank account. investments abroad.
Learning Module: 7
Reasons for governments to restrict inward and outward Capital restrictions and fixed exchange rate targets:
flow of capital:
Capital restrictions and fixed exchange rate targets are
viewed as complementary instruments because under
• To meet objectives regarding employment or perfect capital mobility, governments can achieve their
regional development. domestic and external policy objectives simultaneously
• To meet strategic or defense-related objectives. using both capital restrictions and fixed exchange rate
• To exercise control over a country's external rather than using only standard monetary and fiscal
balance. policy tools.
• To exercise a degree of monetary policy
independence. If a government follows tight exchange rate peg system,
• To raise revenues for the government by keeping then capital restrictions help in two ways i.e.
capital in the domestic economy. It facilitates
taxation of wealth and generates interest income.
i. They make it easier to maintain the tight
• To maintain a low level of interest rates to reduce
exchange rate peg.
the government's borrowing costs on its liabilities.
ii. They protect domestic interest rates against
external market forces. Thus, also helps in
Benefits of Free flow of Financial Capital: managing the domestic banking and real estate
sectors.
• Free movement of financial capital allows capital iii. They allow countries to exercise a degree of
to be invested efficiently i.e. where it will earn the monetary policy independence that is difficult to
highest return. achieve under a fixed exchange rate regime
• Free Capital inflows allow countries to invest in with free capital flows.
productive capacity at a rate greater than the
domestic savings rate. NOTE:
• Free Capital inflows enable countries to achieve a
higher rate of growth. In order to have effective restrictions on capital inflows,
• Longer-term investments by foreign firms provide they should have broad coverage and should be
spillover benefits to local firms (e.g. new implemented forcefully.
technology, skills, and advanced production and
management practices), create a network of Drawbacks of Capital Restrictions:
local suppliers, and increase efficiency of
domestic firms through increased foreign • Implementing capital restrictions may involve
competition. significant administration costs.
• Capital restrictions may affect necessary
Drawbacks of Free flow of Financial Capital: domestic policy adjustments.
• Capital restrictions give negative signals regarding
the economy, resulting in high costs and difficulty
• During macroeconomic crisis, free movement of
to access foreign funds.
financial capital may result in capital flight out of
• Capital restrictions may lead to decline in trade,
the country.
employment and living standards.
• Due to increased foreign competition, domestic
industry may be hurt and are forced to exit the
market.
9. BALANCE OF PAYMENTS – ACCOUNTS AND COMPONENTS
The balance of payments (BOP) measures the payments

that flow between any individual country and the rest of Data on trade and capital flows can be used by
the world. investors to evaluate an economy’s overall level of
capital investment, profitability, and risk.
• It is used to summarize all international economic
transactions for that country during a specific time Balance of Payments Accounts
period, usually a year.
• It reflects all payments and liabilities to foreigners
The BOP is a double-entry system in which every
(debits) and all payments and obligations
received from foreigners (credits). transaction involves both a debit and credit. The overall
BOP is always in balance (i.e. equal to 0) because each
Learning Module: 7
credit transaction has a balancing debit transaction, • Income received from investments abroad
and vice versa. • Gifts received from foreign residents
• Aid received from foreign governments
Debit: A debit represents
• An increase in a country's assets (e.g. purchase of Balance of Payment Components

foreign assets or the receipt of cash from
foreigners). BOP is composed of three components.
• A decrease in a country's liabilities (e.g. amount
owed to foreigners). 1) Current account
2) Capital account
Debit entries include: 3) Financial account
• Purchases of imported goods Current Account (CA):

• Purchases of imported services e.g. transportation
and travel expenditures CA measures the flow of goods and services. It has four
• Purchases of foreign financial assets sub-accounts:
• Payments received for exports
• Interest and principal received from debtors 1. Merchandise trade includes commodities and
• Increase in debt owed by foreigners manufactured goods bought, sold, or given away.
• Debt payments owed to foreigners 2. Services include tourism, transportation, engineering,
• Income paid on investments of foreigners and business services i.e. legal services, management
• Gifts to foreign residents consulting, and accounting, fees from patents and
• Aid given by home government copyrights on new technology, software, books, and
• Overseas investments by home country residents movies.
3. Income receipts include income derived from
ownership of assets i.e. dividends & interest payments.
Credit entries include: 4. Unilateral transfers (i.e. one-way transfers of assets)
include worker remittances from abroad to their
• Payments for imported goods and services home country and foreign direct aid or gifts.
• Payments for purchased foreign financial assets
• Value of exported goods/services Capital Account:
• Debt payments by foreigners
• Increase in debt owed to foreigners It measures transfers of capital. It has two sub-accounts:
• Income received from investments abroad
1. Capital transfers include debt forgiveness, transfer of
• Gifts received from foreign residents
goods and financial assets belonging to migrants as
• Aid received from foreign governments
they leave or enter the country, transfer of title to
fixed assets, transfer of funds linked to the sale or
Debit entries include: acquisition of fixed assets, gift and inheritance taxes,
death duties, uninsured damage to fixed assets, and
• Purchases of imported goods legacies.
• Purchases of imported services e.g. transportation 2. Sales and purchases of non-produced, non-financial
and travel expenditures assets i.e. rights to natural resources, and the sale and
• Purchases of foreign financial assets purchase of intangible assets i.e. patents, copyrights,
• Payments received for exports trademarks, franchises, and leases.
• Interest and principal received from debtors
Credit: A credit represents Financial Account:
It is used to record investment flows. It has two sub-
• A decrease in assets (e.g. sale of goods and
accounts:
services to foreigners or the payment of cash to
foreigners)
1. Financial assets abroad: They include official reserve
• An increase in liabilities (e.g. amount owed to
assets, government assets, and private assets e.g.
foreigners).
gold, foreign currencies, foreign securities, and
government’s reserve position in the International
Credit entries include: Monetary Fund, FDI, and claims reported by resident
banks.
• Payments for imported goods and services 2. Foreign-owned financial assets: They include official
• Payments for purchased foreign financial assets assets and other foreign assets i.e. securities issued by
• Payments to creditors the reporting country's government and private
Learning Module: 7
sectors (e.g. bonds, equities, and mortgage-backed

securities), direct investment, and foreign liabilities
reported by the reporting country's banking sector.
10. PAIRED TRANSACTIONS IN THE BOP BOOKKEEPING SYSTEM
Example: Payment is to be made within 90 days.
Germany would record:

1. Commercial Exports: Transactions (ia) and (ib)
• The imported gas as a debit.
A German company sells technology equipment to a • The future payment obligation as a credit.
South Korean auto manufacturer for a total price =
EUR50 million.
EUR50 million includes freight charges of EUR 1 million to 3. Loans to Borrowers Abroad: Transactions (iii)
be paid within 90 days.
A German commercial bank purchases intermediate-
The merchandise will be shipped via a German cargo term bonds issued by a Ukrainian steel company worth
ship. EUR 100 million.
Hence, Germany is exporting two assets i.e. German commercial bank would make payments in
Euros (i.e., by transferring EUR demand deposits).
1) Equipment
2) Transportation services (cargo ship service) Hence,
Germany acquires a financial asset i.e. the promise by • An increase in German holdings of Ukrainian
the South Korean manufacturer to pay for the bonds will be recorded as debit.
equipment in 90 days. • An increase in demand deposits held by
Ukrainians in German banks will be recorded as
In order to make payments to German company, South credit.
Korean auto manufacturer may purchase Euros from its
local bank (i.e., a EUR demand deposit held by the
Korean bank in a German bank) and pay them to Purchases of Home country currency by
4.
German exporter. Foreign Central Banks: Transaction (iv)
Germany would record following: Suppose, the Swiss National Bank (SNB) purchased EUR20
million i.e. in form of a EUR demand deposit held with a
• To show an increase in financial asset → EUR 50 German bank, from local commercial banks in
million debit to an account named "'private short- Switzerland.
term claims”.
• To show decrease in assets: • An increase of EUR20 million in German liabilities
o EUR49 million credit to an account named will be recorded as debit.
"good”. • A decrease in short-term liabilities held by private
o EUR 1 million credit to an account named foreigners (i.e., Swiss private investors) would be
"service”. recorded as credit.
• German liabilities to South Korean residents (i.e.,
demand deposit held by the Korean bank in a It should be noted that when the SNB purchases EUR
German bank) would be debited. funds from Swiss commercial banks, it credits them the
CHF equivalent of EUR20 million; hence, reflects an
increase in SNB's liabilities to Swiss commercial banks.
2. Commercial Imports: Transactions (ii)
• These liabilities represent reserve deposits held by
Swiss banks, which can be used for lending
Suppose a German utility company imports gas from
purposes or creating new deposits.
Russia worth EUR 45 million.
Learning Module: 7
• Thus, central banks can affect money supply

through currency interventions (all else equal). Purchase of Non-financial Assets:
6.
Transaction (vi)
Suppose, a German utility company purchases the rights

Receipts of Income from Foreign Investments:
5. to exploit a uranium mine from the government of
Transaction (v)
Kazakhstan and the payment is to be made within 3
months.
Residents of Germany can receive interest and
dividends from capital invested in foreign securities and • This transaction involves a non-financial, non-
other financial claims. produced asset; thus, it is recorded in Germany's
capital account.
Similarly, foreign residents can receive interest and
dividends for their investments in Germany.
NATIONAL ECONOMIC ACCOUNTS

11.
AND THE BALANCE OF PAYMENTS
Closed economy: In a closed economy, all output (Y) is

consumed or invested by the private sector (i.e. • When a country has CA deficit, → M > X and it
domestic households and businesses) or purchased by borrows money from foreigners.
the government. • When a country has CA surplus, → X > M and it
lends money to foreigners.
Y=C+I+G
We can decompose consumption as follows:
Open economy: When an economy opens up trade,
some of the domestic output is purchased by foreigners
Consumption = Income + transfers – taxes – saving
(i.e. exports), whereas some of the domestic spending is
C=Yd - Sp =Y+R-T-Sp
used for purchases of foreign goods and services (i.e.
imports).
And,
Y=C+I+G+(X–M)
CA = Sp- I+ Government surplus (or government saving)
= Sp- I+ (T- G- R)
Current Account Balance (X – M): A country has a:
Sp + Sg = I + CA
Current account deficit if imports > exports. It pays for
where,
the deficit by
Sg = government savings
• Borrowing from other countries (↑ in foreign debt This implies that,
e.g. direct investments by foreigners), loans by
foreign banks, and the sale of domestic equities • An open economy can use its saving for:
and fixed-income securities to foreign investors. o Domestic investment
• Selling some of its assets. o Foreign investment
• Whereas, a closed economy can use its savings
Current account surplus if exports > imports. When a only for domestic investments.
country has a current account surplus, • An open economy can increase investment by
increasing foreign borrowing (i.e. decrease in CA)
without increasing domestic savings.
• It lends to other countries or buys more foreign
assets so that other countries can pay their trade
deficits e.g. granting bank loans and investing in Inter-temporal trade: When an economy has current
financial and real assets. account deficit, it is effectively importing present
consumption (borrowing to fund current expenditures)
Current Account balance (surplus/deficit) reflects the
and exporting future consumption (when it repays the
size and direction of international borrowing. It also
debt).
affects GDP and employment.
Sp = I + CA – Sg
Current Account = X – M= Y – (C+ I + G)
This reflects that an economy’s private savings can be
Interpretation of equation:
used for 3 purposes:
Learning Module: 7
• If trade deficit is due to strong investments, then

i. To invest in domestic capital (I) an economy can improve its repaying capacity
ii. To purchase foreign assets (CA) or increase its productive assets.
iii. To purchase (redeem) government debt (- Sg) • Current account deficit tends to reflect a strong
domestic economy, strong domestic credit
Current Account Imbalance can be written as: demand, high interest rates and appreciating
domestic currency.
CA = Sp + Sg – I • However, it should be noted that a persistent
current account deficit leads to a depreciating
Hence, current account deficit (surplus) tends to result currency in the long-run.
from:
i. Low (high) private savings Practice: Example 10 & 11,

ii. High (low) private investment CFA Institute’s Curriculum.
iii. Government deficit (surplus) i.e. Sg< 0 (Sg> 0)
iv. Or a combination of the three
• If trade deficit is due to scarce savings (Sp + Sg),

then economy’s capacity to repay its liabilities
from future production remains unchanged.
12. TRADE ORGANIZATIONS
International Monetary Fund (IMF), World Bank (WB), and

World Trade Organization (WTO) are the three The IMF has redefined and deepened its operations by
organizations that set the rules for the international following ways:
trade.
1. The IMF has improved its lending facilities to better
serve its members.
1. International Monetary Fund
2. The IMF has taken several steps to improve economic
and financial monitoring of global, regional, and
Objectives of IMF: country economies.
3. The IMF has taken several steps to help global
1. To promote exchange rate stability. economies to resolve global economic imbalances.
2. To help establish multilateral system of payments and 4. The IMF is devoting more resources to analyze global
eliminate foreign exchange restrictions. capital market developments and their links with
3. To ensure the stability of the international monetary macroeconomic policy. In addition, it is devoting
system. resources for the training of country officials to assist
4. To promote international monetary cooperation to them better manage their financial systems,
deal with international monetary problems. monetary and exchange regimes, and capital
5. To ensure exchange stability and orderly exchange markets.
arrangements to 5. IMF assesses financial sector vulnerabilities to alert
countries to vulnerabilities and risks in their financial
• Facilitate growth of international trade. sectors.
• Promote high employment.
• Promote sustainable economic growth and Role of IMF from an investment perspective: The IMF
poverty reduction. helps to keep country-specific market risk and global-
systemic risk under control.
6. To provide temporary financial assistance (i.e. lends
foreign exchange to member countries) to help ease 2. World Bank Group
balance of payments adjustment. These funds are
only lent under strict conditions and IMF continually
Objectives of World Bank:
monitors borrowing countries.
Sources of funds available to IMF: Member countries • To provide assistance to developing countries to
provide IMF a pool of gold and currencies that it can use reduce poverty and enhance sustainable
for lending purposes. economic growth.
Learning Module: 7
• To provide funds for development projects (i.e. Sources of funds available to IBRD for lending purposes:
highways, schools).
• To provide technical assistance in development • Funds obtain through selling AAA-rated bonds in
projects. the world's financial markets. However, it earns a
• To provide analysis, advice, and information to its small margin on this lending.
member countries for helping them achieve • Income earned from lending out its own capital
sustainable economic growth and improve i.e. reserves built up over the years and money
standard of living. paid in from its member country shareholders. It
• To increase the capabilities of its partner represents the greater proportion of its total
countries, people in developing countries, and its income.
own staff.
Role of the World Bank from an investment perspective:
Factors necessary for developing countries to grow and The World Bank helps countries to construct the basic
attract business are as follows: economic infrastructure necessary for domestic financial
markets and a well-established financial industry in
1. Strong governments developing countries.
2. Educated government officials
3. Effective legal and judicial systems that encourage
3. World Trade Organizations
business
4. Enforcement of individual and property rights and
contracts The International Trade Organization (ITO): It was
5. Developed financial systems to support both micro- founded to
credit financing and larger corporate ventures
financing. • Promote international economic cooperation
6. Absence of corruption from perspective of trade.
• Reduce and regulate customs tariffs.
Affiliated entities of the World Bank: The World Bank has
two closely affiliated entities: World Trade Organization (WTO): WTO was founded in
1995 and is a successor to General Agreement on Tariffs
i. The International Bank for Reconstruction and and Trade (GATT). It is an international organization that
Development (IBRD)
ii. The International Development Association • Regulates cross-border trade relationships among
(IDA) countries.
• Serves as the forum for trade negotiations among
• Both IBRD and IDA are non-profit organizations. countries.
• Monitors a global policy setting to promote
coherent and transparent trade policies.
Role of IBRD and IDA:
• Serves as a major source of economic research
To provide low or interest-free loans and grants to and analysis.
countries that either have no access to international
credit markets or have unfavorable access to Objectives of WTO: WTO’s goal is to expand trade and
international credit markets. improve world living standards by establishing trade
policies i.e.
IBRD:
• Promoting free trade.
• The IBRD is market-based entity and one of the • Eliminating barriers to trade (e.g. quotas, duties
most important supranational borrowers in the and tariffs).
international capital markets. • Settling trade disputes among countries.
• IBRD has strong capital position and has very • Eliminating trade discrimination through most
conservative financial, liquidity, and lending favored nation (i.e. treating every country
policies. Hence, it has high credit rating. equally).
• Because of high credit rating, IBRD can charge • Providing technical cooperation and training to
low interest rates to its borrowers (i.e. developing developing, least-developed, and poor countries.
countries). • Cooperating with the other two Briton Woods
• IBRD does not obtain funds from outside sources institutions, the IMF and the World Bank.
to fund its own operating costs (i.e. overhead
costs).
• IBRD also finances World Bank operating Examples of Rounds of Negotiations that took place
expenses, assists IDA and debt relief programs. under the GATT:
Learning Module: 7
• Tokyo round (1970s): To deal with a wide range of NOTE:

non-tariff trade barriers. The GATT still exists in the form of an updated version of
• Uruguay round (1986): To deal with agriculture 1994 and it is the WTO's principal treaty for trade in
and textiles trade issues, intellectual property goods.
rights and trade in services.
Example of Ongoing round of negotiations under WTO:

Practice: Example 12
• Doha round: Its objective is to enhance
globalization by reducing barriers and subsidies in
agriculture and to deal with a wide range of
cross-border services. Practice: End of Chapter Practice
Problems from CFA Institute’s
Role of the WTO from an investment perspective: The
Curriculum and FinQuiz Question
WTO provides the major institutional and regulatory base
Bank
to facilitate establishment of multinational corporations.
Stocks and bonds of these multinational corporations
represent the key elements in investment portfolios.
ECO Currency Exchange Rates
Learning Module: 8
1. INTRODUCTION & THE FOREIGN EXCHANGE MARKET
Foreign exchange (FX) market is a market in which nominal exchange rates would adjust so that identical
currencies are traded against each other. It facilitates goods (or baskets of goods) will have the same price in
international trade and cross-border capital flows. different markets. For example,
o It is the world’s largest market in terms of daily o If domestic price level ↑ by 10%, domestic, then
turnover. domestic currency will ↓ by 10%.
o It operates 24 hours a day, each business day. o This implies that, changes in relative prices in two
countries will change the exchange rate of their
currencies i.e. the currency of a country with the
The Foreign Exchange Market highest price inflation should depreciate.
Individual currencies are often referred to by Assumptions of PPP:

standardized three-letter codes. Individual currency is
different from exchange rate because
o Homogenous goods and services
o No barriers to trade (tariffs, import duties and
o An individual currency can be held e.g. $100 quotas.)
million deposit. o No transportation costs.
o An individual currency can be singular.
Criticism of PPP: PPP does not hold for most goods and
Exchange rate: An exchange rate refers to the price of nominal exchange rates reflect persistent deviations
one currency (price currency) in terms of another from PPP because:
currency (base currency) i.e. number of units of one
currency (called the price currency) that can be bought 1) Goods and services are not identical across countries.
by one unit of another currency (called the base 2) Baskets of goods and services produced and
currency). consumed are not identical.
3) Many goods and services are not traded
o In an exchange rate, always two currencies are internationally.
involved. 4) There are trade barriers and transaction costs (e.g.,
o This exchange rate is referred to as nominal shipping costs and import taxes).
exchange rates. 5) PPP ignores capital flows in determining nominal
exchange rates.
Example:
Hence, PPP is not a good predictor of future movements
A/ B refers to the number of units of currency A that one in nominal exchange rates.
unit of currency B will buy.
Real exchange rates: The Real exchange rate is the
USD/ EUR exchange rate of 1.356 means that 1 euro will relative price of domestic goods in terms of foreign
buy 1.356 U.S. dollars goods (e.g. Japanese Big Macs per U.S. Big Mac). Real
exchange rate can be used to compare the relative
o Euro is the base currency purchasing power between countries. It can be
o U.S. dollar is the price currency. constructed for both the domestic currency relative to a
single foreign currency or relative to a basket of foreign
If this exchange rate decreases, then it would mean that currencies.
fewer U.S. dollars will be needed to buy one euro. It
implies that: The higher the real exchange rate,
o U.S. dollar appreciates against the Euro or o The more expensive the foreign goods (in real
o Euro depreciates against the U.S. dollar. terms).
o The lower the relative purchasing power of an
individual compared with the other country.
Purchasing Power Parity (PPP): PPP is based on law of

one price, which states that in competitive markets, free
of transportation costs and official barriers to trade,
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑖𝑛 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 = 𝑆5/7 × 𝑃7
identical goods sold in different countries must sell for the
same price when their prices are expressed in terms of where,
the same currency. Hence, according to PPP, the

ECO Currency Exchange Rates FinQuiz.com
Learning Module: 8
Sd/f = Spot exchange rate (quoted in terms of the o Nominal spot exchange rate (GBP/ EUR) increases
number of units of domestic currency per one unit by 10%.
of foreign currency) o Euro-zone price level increases by 5%.
Pf = Foreign price level quoted in terms of the foreign o U.K. price level increases by 2%.
currency.
Pd = Domestic price level in terms of the domestic
The change in the real exchange rate =
currency. ∆EU
∆ST WXY E Z
U U XY]%
𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒(?/7) = (𝑆5⁄7 × 𝑃7 )/𝑃5 = 𝑆5 ⁄7 × (𝑃7 /𝑃5 ) O1 + V× ∆ET -1 = (1+ 10%) × XY_% − 1 = 10%
ST [XY \
U ET
Real exchange rate

JKL
𝑅𝑒𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒CDE = 𝑆CDE × I JKLFGHN
FGH FGH GM o Increase in the real exchange rate for the U.K.
based individual ≈ 13%.
o This implies that Euro zone goods have become
Important to note: expensive (in real terms) or U.K. based individual’s
real purchasing power relative to Euro zone goods
o Real exchange rates are not quoted or traded in has decreased by 13%.
global FX markets.
o Real exchange rate is a poor predictor of future
nominal exchange rate movements.
Example: Suppose,
2. MARKET FUNCTIONS
FX markets facilitate FX rate movements e.g. if benchmark is 100% fully

hedged position, company’s hedging position
o International trade in goods and services. can be greater than or less than 100%.
o Capital market transactions (i.e. moving funds into o The performance of the company hedging
(or out of) foreign assets) e.g. decision is compared with a benchmark.
o Direct investments (purchase of fixed assets e.g.
factories) Foreign Exchange hedging Instruments:
o Portfolio investment (purchase of stocks, bonds,
and other financial assets denominated in 1) Spot transactions involve the exchange of currencies
foreign currencies). for immediate delivery.
Foreign exchange risk refers to risk that the exchange o Immediate delivery refers to "T + 2" delivery i.e. the
rate may move in an unfavorable direction. exchange of currencies is settled two business
days after the trade is agreed by both the parties
involved.
o Foreign exchange rate risk can be hedged using
o The exchange rate used for spot transactions is
a variety of FX instruments.
called the spot exchange rate.
o Market participants may assume speculative FX
o Spot transactions represent only a minority of total
risk exposures through a variety of FX instruments in
daily turnover in the global FX market.
order to profit from their views.
NOTE:
Suppose a company sells products to foreigners.
For Canadian dollar, spot settlement against the U.S.
o Since, the company needs to convert its revenue dollar is on a T + 1 basis.
from foreign sales into its home (domestic)
currency, the company is exposed to foreign 2) Currency futures contracts: Currency futures contracts
exchange risk. represent an obligation to buy or sell a certain
o The company can hedge this risk; however, it is amount of a specified currency at a future date at an
difficult to precisely predict the amount and exchange rate determined today. Hence, they
timing of foreign revenue. involve settlement period longer than the usual “T + 2”
o Hence, a company can under-hedge or over- settlement for spot delivery.
hedge according to its opinions regarding future
Learning Module: 8
o The exchange rate used for futures transactions is Characteristic Foreign Currency Foreign
called futures exchange rate. Futures Currency
o Futures rates are quoted for a variety of standard Forwards
futures settlement dates (e.g. one week, one Liquidity Huge daily Relatively less
month, or 90 days). turnover; highly liquid.
liquid
3) Currency forward contracts: Currency forward Counterparty No counterparty or Have
contracts represent an obligation to buy or sell a or default risk default risk. counterparty or
certain amount of a specified currency at a future default risk.
date at an exchange rate determined today. Hence,
they involve settlement period longer than the usual Forwards and futures contracts have limited maturity (i.e.
“T + 2” settlement for spot delivery. they expire on pre-specified future date). Hence, in
order to extend the hedge or speculative position, these
contracts need to be rolled over prior to their settlement
o The exchange rate used for forward transactions is dates i.e.
called the forward exchange rate.
o Forward rates can be quoted at any future date.
In addition, the size of the forward contracts can o Existing forward contract is settled through a spot
be different than that the two counter-parties transaction.
agreed upon. o Enter into a new forward contract with a new,
o The longer the term to maturity and the larger the more distant settlement date.
trade size, the lower the liquidity of a forward
contract. 4) FX swap: FX swap is a combination of an offsetting
spot transaction and a new forward contract. When
Example: a forward position is rolled over into future, it results in
a cash flow on settlement day (referred to as a mark-
Suppose, today is 16 November. to-market on the forward position).
Spot settlement is for 18 November. Then,

o FX swaps can be used for funding purposes
(called swap funding).
Three-month forward settlement would be 18 February of
o It can be used to eliminate FX (foreign exchange)
the following year.
risk.
o It is different from currency swap because unlike
NOTE: FX swaps that involve only two settlement dates, a
The standard forward settlement dates may be a currency swap is generally used for multiple
weekend or a holiday. In that case, the forward periods and payments.
settlement date is set to the closest good business day.
Example:
Characteristic Foreign Currency Foreign
Futures Currency Suppose a German based company needs to borrow
Forwards EUR100 million for 90 days (starting 2 days from today). It
can be done in two ways:
Size of the Available for Fixed Available for
contract contract amount any contract
only. amount. i. Borrow EUR100 million money in Euro-
Settlement Available for Fixed Available for denominated funds starting at T + 2
dates settlement dates any settlement ii. Borrow in U.S. dollars and exchange these for
only. date. Euros in the spot FX market (both with T + 2
Location Trade on Trade over-the- settlement) and then sell Euros 90 days forward
exchanges (i.e. counter (OTC). against the U.S. dollar.
CME).
Collateral/Mar A fixed amount of No explicit 5) Options on currencies: Options on currencies
gin collateral must be collateral represent the right (not obligation) to buy or sell a
posted against the requirement. specified amount of foreign currency at a specified
futures contract price at any time up to a specified expiration date.
trade. This right is obtained by paying an upfront
Marked-to- The collateral is No explicit premium/fee. Options can be used to hedge FX
market marked-to-market marked-to- exposures, or implement speculative FX positions.
on a daily basis. market
requirement. It is important to note that spot, forward, swap, and
Flexibility Less flexible More flexible option instruments are often used together.
compared to compared to
forwards. futures.
Learning Module: 8
3. MARKET PARTICIPANTS, SIZE AND COMPOSITION
represent a large and growing proportion of daily FX

market turnover. These accounts are managed by:
Market Participants
o Hedge funds
A. Sell side: The sell side consists of the FX dealing banks o Proprietary trading shops
that sell FX products to the buy side. They include o Commodity trading advisers (CTAs)
o High-frequency algorithmic traders
1) Large FX trading banks e.g. Citigroup, UBS, and o Proprietary trading desks at banks
Deutsche Bank. o Any active trading account that accepts and
manages FX risk for profit.
o These banks have economies of scale, broad
These accounts can be classified into different trading
global client base, IT expertise that is needed to
styles i.e.
offer competitive pricing across a wide range of
currencies and FX products.
o These banks account for a large and growing o Macro-hedge funds: These funds are based on
proportion of the daily FX turnover. underlying economic fundamentals of a currency
o Sell side banks are also known as interbank and take longer term FX positions.
market. o High-frequency algorithmic trading: It involves
using technical trading strategies (i.e. moving
averages or Fibonacci levels) and trading
2) Small FX trading banks that fall into the second and
strategies with trading cycles and investment
third tier of the FX market sell side e.g. regional or horizons measured in milliseconds.
local banks.
4) Retail accounts: It refers to an account managed by

o These banks have well-developed business an individual e.g. foreign tourist exchanging currency
relationships. at an airport kiosk.
o However, they lack economies of scale, broad
global client base, IT expertise etc. 5) Governments: Public entities manage FX accounts for
o Therefore, these banks outsource FX services from various purposes e.g.
large banks or depend on the largest FX market
participants to obtain deep and competitive
liquidity. o To maintain consulates in foreign countries
o To purchase military equipment
o To maintain overseas military bases.
B. Buy side: They include clients of sell-side banks. The
buy side can be further classified into following
categories: In addition, many governments both at the federal and
provincial/state levels issue debt in foreign currencies,
1) Corporate accounts: They refer to foreign exchange resulting in FX flows.
transactions (i.e. cross-border purchases and sales of
goods and services) undertaken by corporations. 6) Central banks: Central banks manage FX accounts to
intervene in FX markets in order to influence
2) Real money accounts: These refer to investment funds exchange rate of the domestic currency and/or to
that have restrictions on the use of leverage or manage their home country's FX reserves (i.e. like real
financial derivatives. These accounts are managed money investment fund). Central banks intervene in
by: FX markets when;
o Insurance companies o Domestic currency is considered to be too weak

o Mutual funds by the central bank, or
o Pension funds o The FX market has become so erratic and
o Endowments dysfunctional, or
o Exchange-traded funds (ETFs) o Domestic currency is considered to be too strong
o Other institutional investors by the central bank.
3) Leveraged accounts: They are referred to as the 7) Sovereign wealth funds (SWFs): SWFs are used by
professional trading community accounts. They countries with large current account surpluses. These
surpluses are deposited into SWFs rather than into
Learning Module: 8
foreign exchange reserves managed by central

banks. SWFs are government (public) entities. o The proportion of average daily FX flow
However, it is managed purely for investment accounted for by financial clients is much larger
purposes rather than public policy purposes. than that for nonfinancial clients.
o The proportion of average daily FX flow
o SWFs are similar to real money accounts. accounted for by corporations and individuals
o But, unlike real money accounts, SWFs are allowed buying and selling foreign goods and services is
to use leverage, derivatives, and aggressive much smaller.
trading strategies. o The largest proportion of average daily trade in FX
is accounted for by the FX swap market.
NOTE: o The top 5 currency pairs in terms of their % share of
average daily global FX turnover are:
i. USD/EUR
o Electronic trading technology has reduced the
ii. JPY/USD
barriers to entry into FX markets and the costs of FX
iii. USD/GBP
trading.
iv. USD/AUD
o Globally, U.S. dollar is the most widely held
v. CAD/USD
currency while the Euro is the second most widely
o The largest proportion of global FX trading occurs
held currency in central bank foreign exchange
in London,
reserves.
o The 2nd largest proportion of global FX trading
o Non-bank financial entities include real money
occurs in New York.
and leveraged accounts, SWFs, and central
o The 3rd largest proportion of global FX trading
banks.
occurs in Tokyo.
o Non-financial customers include corporations,
retail accounts, and governments.
Market Size and Composition
The Bank for International Settlements (BIS): It is an

umbrella organization for the world's central banks.
According to the survey conducted by BIS,
4. EXCHANGE RATE QUOTATIONS
Bid rate: The price at which the bank (dealer) is willing to

Exchange Rate Quotations
buy the currency i.e. number of units of price currency
that the client will receive by selling 1 unit of base
Direct Quote: Direct Quote is a home (domestic) currency to a dealer.
currency price for a unit of foreign currency i.e. FC: DC.
Ask or offer rate: The price at which the bank (dealer) is
o DC is the price currency or quote currency. willing to sell the currency i.e. number of units of price
o FC is the base currency. currency that the client must sell to the dealer to buy 1
unit of base currency.
For example, $0.989986/€ is a direct quote of about
$0.99 for one Euro in the U.S. it means that 1 Euro costs Bid is always < Offer.
0.99 USD.
o Dealers generate profits by buying at low rate and
Indirect Quote: Indirect Quote is a foreign currency price selling at higher rate. Hence, the wider the bid-
for a unit of home currency. For example, ¥122.481/$ is ask spread, the higher the profit for a dealer.
an indirect quote of 122.481 Yen for one US dollar. o Electronic dealing systems and growing worldwide
competition for business have resulted in tighter
o The base currency is the home currency. bid-ask spreads.
Direct Quote = 1 / Indirect Quote Example:
Two-sided Price: Two-sided Price is the price of a base (US$/SFr) Bid Ask
currency quoted by a dealer. It involves bid and ask Spot 0.3968 0.3978
price.
Learning Module: 8
o Typically, exchange rates are quoted to four To calculate depreciation of USD against Euro, convert
decimal places; except for yen, for which the quote from USD/EUR to EUR/USD i.e. euro is now the
exchange rate is quoted to two decimal places. price currency.
e
I N X._]dd
Percentage appreciation and depreciation of a e.fggg
e − 1 = X.cddd − 1 = -3.85%
I N
currency against the other currency: e.higg
o It shows that USD depreciated against Euro by

Suppose, the exchange rate for the euro i.e. USD/EUR
3.85%.
increases from 1.2500 to 1.3000.
X.cddd
% change in exchange rate (un-annualized) = X._]dd − 1
= 4%. Practice: Example 4,
o It shows that euro appreciated against USD by 4%.
5. CROSS-RATE CALCULATIONS
Suppose,
Triangular arbitrage:
Exchange rate for CAD/USD = 1.0460
Exchange rate for USD/EUR = 1.2880 Market participants can receive both a cross-rate quote
as well as the component underlying exchange rate
The exchange rate for CAD/EUR is determined as follows: quotes. Hence, these cross-rate quotes must be
jkl mnl jkl consistent with the above equation. If they are not
mnl
× omp = omp consistent with the above equation, then arbitrage
opportunities exist.
1.0460 × 1.2880 = 1.3472 CAD per EUR
Suppose, a misguided dealer quotes JPY / CAD rate of
Now Suppose, 82.00. Hence, profit can be earned by:
Exchange rate for CAD/USD = 1.0460
Exchange rate for JPY/USD = 85.50 o Buying CAD1 at the lower price of JPY81.74.
o Selling CAD1 at JPY82.00.
The exchange rate for JPY/CAD is determined as follows: o A riskless arbitrage profit that can be earned by a
jkl qrs X qrs mnl qrs qrs
trader = JPY0.26 per CAD1.
× = tuv × mnl = jkl × mnl = jkl
mnl mnl
wxv
This arbitrage is known as triangular arbitrage because it
(1/ 1.0460) × 85.50 = 81.74 JPY per CAD involves three currencies.
NOTE:
o Bid Rate (CAD per USD) = 1 / Ask Rate (USD per CFA Institute’s Curriculum.
CAD)
o Ask Rate (CAD per USD) = 1 / Bid Rate (USD per
CAD)
6. FORWARD CALCULATIONS
Typically, forward exchange rates are quoted in terms of i. These points are scaled to relate them to the last
points (called pips). decimal in the spot quote.
ii. Points are typically quoted to one (or more)
Points on a forward rate quote = forward exchange rate decimal places. Thus, the forward rate will typically
quote – spot exchange be quoted to five or more decimal places; except
rate quote yen, which is typically quoted to two decimal
places for spot rates and forward points are scaled
Learning Module: 8
up by two decimal places by multiplying the o This amount will grow to (1 + id) at the end on of
forward point by 100. investment horizon.
o Point is positive when the forward rate > spot rate. b) Convert 1 unit of domestic currency into foreign
o It implies that the base currency is trading at a currency using the spot rate = Sf/d. (direct quote)
forward premium and price currency is trading o Invest this amount for one period at foreign risk-
at a forward discount. free rate i.e. if.
o Point is negative when the forward rate < spot o The amount invested will grow to Sf/d (1 + if) at the
rate. end on of investment horizon.
o It implies that the base currency is trading at a o Then, convert this amount to domestic currency
forward discount and price currency is trading using the forward rate i.e. for each unit of foreign
at a forward premium. currency, investor would obtain 1/Ff/d units of
domestic currency.
Example: o Hence, converting at the forward rate has
eliminated FX risk.
Spot exchange rate USD/ EUR =1.2875
One year forward rate USD/ EUR = 1.28485
Both of these alternatives are risk-free and have same
risk characteristics. Since risk characteristics are same,
One year forward point = 1.28485 – 1.2875 = –0.00265
they must have same return; otherwise, riskless arbitrage
opportunity exists e.g.
o It is scaled up by four decimal places by
multiplying it by 10,000 i.e. - 0.00265 × 10,000 = -
o Investment that generates lower return can be
26.5 points.
short sold.
o Amount can be invested in an investment that
Swap points: Forward rates quotes are shown as the generates higher return.
number of forward points at each maturity. These
forward points are referred to as swap points.
Arbitrage relationship is stated as follows:
Term to maturity and forward points are directly related 1
(1 + 𝑖5 ) = 𝑆7/5 œ1 + 𝑖7 • W Z
(all else equal) i.e. given the interest rate differential, the 𝐹7/5
longer the term to maturity, the greater the absolute
number of forward points. In case of indirect quote, Arbitrage relationship is:
Interest rate differential and forward points are directly (1 + 𝑖5 ) = œ1/𝑆7/5 •œ1 + 𝑖7 •𝐹7/5
related (all else equal) i.e. given the term to maturity,
the wider the interest rate differential, the greater the 1 + 𝑖7
𝐹7/5 = 𝑆7/5 [ \
absolute number of forward points. 1 + 𝑖5
Converting forward points into forward quotes: Forward rate as a % of spot rate can be stated as
follows:
To convert the forward points into forward rate quote, 𝐹7/5 1 + 𝑖7
forward points are scaled down to the fourth decimal =[ \
𝑆7/5 1 + 𝑖5
place in the following manner:
𝐅𝐨𝐫𝐰𝐚𝐫𝐝𝐩𝐨𝐢𝐧𝐭𝐬 Given an f /d quoting convention (direct quote),

Forward rate = Spot exchange rate + 𝟏𝟎,𝟎𝟎𝟎
o The forward rate will be higher than (be at a

𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝒑𝒓𝒆𝒎𝒊𝒖𝒎/𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 (𝒊𝒏 %) premium to) the spot rate if foreign interest rates
𝐬𝐩𝐨𝐭 𝐞𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐫𝐚𝐭𝐞 + (𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐩𝐨𝐢𝐧𝐭𝐬/𝟏𝟎, 𝟎𝟎𝟎)
= −𝟏 are > domestic interest rates.
𝐬𝐩𝐨𝐭 𝐞𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐫𝐚𝐭𝐞 o Currency with the higher (lower) interest rate will
always trade at a discount (premium) in the
To convert spot rate into a forward quote when points forward market.
are represented as %,
Example:
Spot exchange rate × (1 + % premium or discount)
Relationship between spot rates, forward rates and o Spot exchange rate (Sf/d) = 1.6535
interest rates: o Domestic 12-month risk-free rate = 3.50%
o Foreign 12-month risk-free rate = 5.00%
An investor has two alternatives available i.e.
The 12-month forward rate (F f/d) must then be equal to:
a) Invest for one period at the domestic risk-free rate X.d]dd
1.6535 × = 1.6775
i.e. id; X.dc]d
Learning Module: 8
Now, suppose, 12-month forward rate (F f/d) quoted by a

dealer = 1.6900. Hence, a riskless arbitrage opportunity This equation shows that forward points are proportional
exists. to:
o Return on domestic-only investment = 3.50%. o Spot exchange rate

o Return on hedged foreign investment (with a o Interest rate differential
quoted forward rate) is calculated as follows: o Only approximately proportional to forward
1 contract horizon.
𝑆7/5 œ1 + 𝑖7 • W Z
𝐹7/5
Example:
Determining 30-day forward exchange rate:
Return on hedged foreign investment =
X
1.6535 (1.05) × X.žŸdd o 30-day domestic risk-free rate = 2%.
= 1.0273 – 1 = 2.73% o 30-day foreign risk-free rate = 3%.
o Spot exchange rate (direct quote) = 1.6555
Hence, this implies that an investor can generate riskless o The risk-free assets used in this arbitrage
arbitrage profit (without any upfront capital invested) relationship are typically bank deposits quoted
by: using the London Interbank Offered Rate (LIBOR)
for the currencies involved.
o Borrowing at high foreign risk-free rate. o The day count convention for LIBOR deposits =
o Selling the foreign currency at spot exchange Actual days/360.
rate.
o Hedging the currency risk at the misquoted 30-day forward rate is:
forward rate and
o Investing the funds at the lower domestic risk-free cd
1 + 0.0300 IcždN
1 + 𝑖7 𝜏
rate. 𝐹7/5 = 𝑆7/5 [ \ = 1.6555 ¨ = 1.6569
1 + 𝑖5 𝜏 cd «
1 + 0.0200 I N
cžd
Riskless arbitrage profit = 3.50% – 2.73% = 0.77%
Hence,
It should be noted that despite of borrowing at a higher
Forward rates premium = 1.6569 – 1.6555 = 14 pips.
interest rates, investor earned profit because the foreign
Or
currency is underpriced in the forward market. 𝑖7 − 𝑖5
𝐹7/5 − 𝑆7/5 = 𝑆7/5 W Z𝜏
Expected % change in the spot rate is stated as follows: 1 + 𝑖7 𝜏
0.0300 − 0.0200 30
𝑆¡YX 𝑖7 − 𝑖5 = 1.6555 ¨ cd «
[ \ = 0.0014
− 1 = %∆𝑆¡YX = [ \ 1 + 0.0200 IcždN 360
𝑆¡ 1 + 𝑖5
Important to understand:
o This shows that expected % change in the spot
rate is proportional to the interest rate differential.
o Forward rates are unbiased predictors of future o The forward points are directly proportional to the
spot rates. term of the forward contract i.e. the longer the
o However, forward rates are poor predictors of term of the forward contract (i.e. 180 days, 270
future spot rates because relationship between days etc.), the greater the forward points.
forward rates and expected change in spot rates o The forward points are directly proportional to the
is counter-intuitive e.g. (all else constant), if spread between foreign and domestic interest
domestic interest rate ↑, it is expected to result in rates i.e. the greater the interest rate differential,
domestic currency appreciation. But, it may also the greater the forward points.
indicate slower expected domestic currency
appreciation.
o Factors that affect the level and shape of the
yield curve in either domestic or foreign currency CFA Institute’s Curriculum.
also affect the relationship between spot and
forward exchange rates.
Forward points can be stated as follows:
𝒊𝒇 − 𝒊𝒅
𝑭𝒇/𝒅 − 𝑺𝒇/𝒅 = 𝑺𝒇/𝒅 W Z𝝉
𝟏 + 𝒊𝒅 𝝉
Learning Module: 8
EXCHANGE RATE REGIMES – IDEALS AND HISTORICAL

7.
PERSPECTIVE
Exchange rate Regime: The exchange rate regime is the value. Consequently, exports would rise (fall) and imports
way through which a country manages its currency with would fall (rise).
respect to foreign currencies and the foreign exchange
market. Advantage:
Under floating exchange rate regime, poor domestic

The Ideal Currency Regime
monetary policy and trade barriers do not exist.
The ideal currency regime would have the following Limitations:

three properties.
When exchange rates are highly volatile, they
1) The value of the currency would be fixed in
relationship to other currencies. o Decrease the efficiency of real economic activity.
o It facilitates to eliminate currency-related o Decrease the efficiency of financial transactions.
uncertainty with respect to the prices of o Result in inefficient allocation of financial capital.
goods/services, real and financial assets. o Increase the exchange rate risk.
2) All currencies can be freely exchanged for any In addition, selecting appropriate hedging strategies for
purpose and in any amount (fully convertible) foreign currency exposures depend on exchange rate
o It facilitates free flow of capital. volatility.
3) Each country would be able to undertake fully Limitations of Fixed exchange rates regime:
independent monetary policy to meet domestic
objectives (i.e. growth and inflation targets). Under a fixed exchange rates system, central bank is not
able to undertake independent monetary policy.
Limitations:
Historical Perspective on Currency Regimes
The aforementioned three conditions are not mutually
consistent and cannot be achieved simultaneously e.g.,
if first two conditions are met, there would only be one Gold standard:
currency in the world.
A classical gold system refers to a system of fixed
As a result, country will not be able to undertake exchange rates in which the value of currencies was
independent monetary policy. For example, fixed relative to the value of gold and gold was used as
the primary reserve asset. Hence, the official value of
o If 1st condition is met (i.e. exchange rate are each currency was expressed in ounces of gold.
credibly fixed) and capital is perfectly mobile,
then, if a central bank decreases default-free o This system was operated through “price-specie-
interest rate, → there would be outflow of capital flow” mechanism. The gold-specie-flow
to seek higher return, → central bank would start mechanism was the long-run mechanism that
selling foreign currency & buying domestic used to maintain the gold standard i.e.
currency to maintain fixed exchange rate, → o When a country had BOP deficit (surplus), gold
foreign currency reserves will fall, → domestic flowed out of (into) the country.
supply ↓, → as a result, domestic interest rates ↑, o When gold flowed into (out of) the country, the
resulting in offsetting effect on the initial domestic money supply increases (decreases),
expansionary monetary policy. prices rise (fall) and exports fall (rise).
o Opposite would occur in case of contractionary o Thus, under a classical gold standard, expansion
monetary policy (higher interest rates). and contraction of monetary base directly
o Generally, the more freely the exchange rate is depends on trade and capital flows.
allowed to float and the tightly the convertibility is o Since the value of each currency was fixed in
controlled, the more effectively a central bank terms of gold, the exchange rates were therefore
can meet domestic macroeconomic objectives. fixed.
o The amount of money a country issued was
Floating exchange rate regime: directly backed by gold.
o Although the system was limited by the amount of
Under a floating exchange rate system, if a central bank gold, gold acted as an automatic adjustment.
decreases (increases) domestic interest rate, the
domestic currency would depreciate (appreciate) in
Learning Module: 8
o Gold reserves can be increased through new gold o Facilitates more efficient allocation of resources.
discoveries as well as more efficient methods of
refining gold. Drawbacks of using a common currency e.g. Euro:
Benefits of using a common currency e.g. Euro: The member countries are not able to manage their
exchange rate and undertake independent monetary
Using a common currency policy.
o Increases transparency of prices across countries.

o Increases market competition
8. A TAXONOMY OF CURRENCY REGIMES
dollars in a dollarized economy are not necessarily

Different exchange rate regimes are adopted by equal to interest rates on dollar deposits in the U.S.
different countries for various reasons e.g.
Disadvantages:
o A fixed exchange rate regime can be adopted
by a country with a persistent hyperinflation.
o The central bank is not able to undertake
o A specific exchange rate regime can be adopted
independent monetary policy.
due to a political reason e.g. using common
o The central bank of the country no longer can
currency to enhance political union.
serve as lender of last resort.
o The benefits (profit) accruing to a government
It should be noted that exchange rates are affected by from the ability to print its own money are lost.
various factors i.e. These benefits (profits) are referred to as
Seigniorage. It is earned by the country whose
o Private sector market forces currency is used.
o Currency regimes i.e. legal and regulatory
framework of an economy. b. Currency Union: Under currency union, a country
o Policies of a government e.g., fiscal, monetary, belongs to a monetary or currency union and shares
and intervention. same currency with other union members.
Exchange rate arrangements of IMF members include:

Currency Board System (CBS)
Arrangements with No Separate Legal Tender

Under currency board system, a country promises to
exchange the domestic currency for a specified foreign
There are two types of arrangements in which a country currency at a fixed exchange rate.
does not have its own legal tender.
This implies that a country is required to issue domestic
a. Dollarization: Under dollarization, a country uses currency only against foreign currency (i.e. domestic
another country’s currency as sole legal tender i.e. as currency is backed by foreign currency).
its medium of exchange and unit of account. For
example, the use of the US dollar as the official o Like classical gold standard, money supply under
currency of the country. CBS depends on trade and capital flows.
o Like classical gold standard, CBS is successful in
Advantages: countries:
i. With flexible domestic prices and wages,
o It eliminates the risk of sharp exchange rate ii. With relatively small non-traded sectors, and
fluctuations. iii. Global reserve asset supply grows at a stable &
o It imposes fiscal discipline on the economy’s steady growth rate consistent with long-run real
central bank so that government debt is not growth with stable prices. This condition
financed by printing money. depends on monetary policy of the foreign
o It increases economic & financial stability, which currency.
facilitates the growth of international trade and
capital flows. Advantages:
o It increases the credibility of the country. However,
it does not affect the credit-worthiness of a
o Unlike dollarization, under CBS, a central bank can
country. This implies that interest rates on U.S.
earn (seigniorage) profit by paying little or no
Learning Module: 8
interest on its liability (i.e. monetary base) and can o It may involve additional risk i.e. uncertainty
earn a market interest rate on its assets (i.e. regarding the country’s ability or willingness to
foreign currency reserves). maintain the parity.
Disadvantages: Differences between Fixed parity and CBS:
o Monetary policy independence is lost. 1. Unlike CBS, fixed parity does not involve any legal
o The central bank loses its ability to perform as commitment to maintain the specified parity.
lender of last resort. However, it can provide short- Thus, a country has a flexibility to either adjust or
term liquidity to banks by lending foreign currency abandon the parity e.g. devalue or revalue its
collateral. currency or allow its currency to float.
2. Unlike CBS, a country has discretion to set any
NOTE: target level of foreign currency reserves. Thus,
under fixed parity, the level of foreign currency
Generally, Seigniorage is the profit which is earned when reserves is not related to domestic monetary
value of money issued > cost of producing it. aggregates.
3. Unlike CBS, under fixed parity, a central bank can
Fixed Parity (i.e. Conventional pegged (fixed) perform as lender of last resort.
exchange rates):
Under fixed parity regime, a country pegs its currency Target Zone
(formal or de facto) at a fixed rate to a major currency
or a basket of currencies where exchange rate It is a type of fixed parity regime where the value of the
fluctuates within a narrow margin i.e. a band of up to ± currency is maintained within fixed horizontal margins
1% around the parity level. The monetary authority is (bands) of fluctuation around a formal or de facto fixed
obligated to maintain the rate within these bands. peg that are wider than ± 1% around the parity e.g. ±
2%.
o The credibility of fixed parity depends on the
ability & willingness of a country to maintain the o Due to wider bands, it provides relatively higher
exchange rate within these bands and the level of discretion to monetary authority to undertake its
reserves maintained by a country. policy than fixed parity.
Effect of excess private demand for domestic currency:

Active and Passive Crawling Pegs
When private demand for domestic currency ↑, →
foreign currency reserves grow rapidly, → as a result,
domestic money supply ↑ and inflation accelerates. a. Passive crawling peg: The exchange rate is adjusted
frequently (i.e. weekly or daily) to account for inflation
Effect of deficient private demand for domestic or other factors.
currency:
o Frequent unannounced changes in exchange
When private demand for domestic currency ↓, → rate peg provide protection against speculative
foreign currency reserves depletes, → as a result, attacks.
domestic money supply ↓ and deflation accelerates.
b. Active crawling peg: The exchange rate is adjusted
Advantage: Fixed parity system provides periodically in small amounts at a fixed,
macroeconomic discipline and stability to a preannounced rate in response to changes in certain
country by maintaining prices of tradable quantitative measures e.g. inflation.
goods and facilitates internationals trade.
o The exchange rate is only allowed to fluctuate
Disadvantages: within a narrow range.
o Central bank has limited ability to adopt Advantages:

independent monetary policy as long as parity is
maintained.
o If there are weak institutional constraints (e.g. o In case of high inflation, crawling peg helps to
insufficient reserves to maintain the parity), the avoid overvaluation of real exchange rate.
fixed parity system is subject to speculative o Pre-announced adjustments help to guide public
attacks, resulting in immediate devaluation of the expectations.
domestic currency.
Fixed Parity with Crawling Bands
Learning Module: 8
o The effects of intervention by monetary authority

In this regime, exchange rate is maintained within are typically short-lived and may result in
certain fluctuation bands around a fixed parity that is decrease in stability in foreign exchange markets.
adjusted periodically over time i.e. it involves pre-
announced widening band around the central parity.
Independently floating exchange rates
Advantage: Due to pre-announced widening band, it
provides some degree of flexibility to Under this regime, exchange rate is determined by the
monetary authority, resulting in an market forces (i.e. demand & supply of currency). The
enhanced credibility. country's central bank does not influence the value of
the currency by intervening in the foreign exchange
Managed Float: market.
Advantages:
Under managed float regime, the value of a currency is
determined by market forces but a monetary authority
actively intervenes in the foreign exchange markets to o The monetary authority can exercise independent
influence the changes in the exchange rate if necessary. monetary policy to meet its domestic objectives
e.g. price stability, full employment etc.
However, the monetary authority does not pre- o The monetary authority can act as a lender of last
announce the desired path for the exchange rate to resort.
avoid any speculative attacks.
Disadvantages: It introduces exchange rates volatility,
o Dirty float is the same as managed float; but, which leads to:
unlike managed float, it does not involve explicit
intervention. o Decrease in the efficiency of real economic
activity.
Advantage: o Decrease in the efficiency of financial
transactions.
o Inefficient allocation of financial capital.
o It helps to reduce excessive exchange rate
o Increase the exchange rate risk.
fluctuations.
Disadvantages:
o It requires a monetary authority to maintain high CFA Institute’s Curriculum.
foreign reserves.
o It creates uncertainty due to lack of transparency
regarding monetary authority intervention.
9. EXCHANGE RATES AND THE TRADE BALANCE: INTRODUCTION
When imports > exports, a country has trade deficit. Thus, M = imports
it needs to borrow from foreigners or sell assets to S = private savings
foreigners to finance the trade deficit. I = investment in plant and equipment
T = taxes net of transfers
When imports < exports, a country has trade surplus. G = government expenditure
Thus, it needs to invest the excess either by lending to
foreigners or by buying assets from foreigners. This exhibits that:
This implies that a trade deficit (surplus) must be exactly o Trade surplus (deficit) occurs when:
matched by an offsetting capital account surplus i. A fiscal surplus i.e. T > G (deficit i.e. T < G) exists.
(deficit). Fiscal surplus represents government savings.
ii. Private savings > (<) investment.
Relationship between the trade balance and iii. Or both
expenditure/ saving decisions: It can be expressed as
It must be noted that this relationship does not provide
follows:
any information regarding the type of financial assets
X – M = (S – I) + (T – G)
that will be exchanged or the currency in which they will
where,
be denominated.
X = exports
Learning Module: 8
o In case of expectations of significant change in

an exchange rate, investors start to sell the Impact of changes in exchange rates on the trade
currency that is expected to depreciate and buy balance: The impact of changes in exchange rates on
the currency that is expected to appreciate. As a the trade balance can be analyzed through two
result, capital flows out of the country and capital different approaches.
deficit occurs. It must be offset by a simultaneous
shift in the trade balance or by changes in asset 1) Elasticities approach: It focuses on the effect of
prices and exchange rates. changing the relative price of domestic and foreign
o Generally, the adjustment usually takes place goods. Thus, it exhibits a microeconomic view of the
within the financial markets (i.e. through financial relationship between exchange rates and trade
investment decisions and asset prices) because balance.
expenditure/ saving decisions and prices of goods 2) Absorption approach: It focuses on the impact of
change much more slowly. This implies that exchange rates on aggregate expenditure/saving
o In the short-to-intermediate term, the major decisions.
determinant of changes in exchange rate is
capital flows (both potential and actual).
o Whereas in the long-term, the important
determinant of changes in exchange rate is
trade flows.
Exchange Rates and the Trade Balance: The Elasticities

10.
Approach
Marshall-Lerner condition: It is a condition that ensures where,

that trade balances improves (deteriorates) if the
ɷx = share of exports
currency is devalued/depreciated
ԐX = price elasticity of foreign demand for domestic
(revalued/appreciated).
country exports
ɷM = share of imports
Assumption of Marshall-Lerner condition: Initially, trade is
ԐM = price elasticity of domestic country demand for
balanced.
imports
We know that,
o When this condition is met, a country can improve
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 % ∆ 𝐐
Price elasticity of demand = Ԑ = − = – % ∆ 𝐏 its trade balance towards surplus through
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞
devaluation/depreciation of the domestic
currency.
o When Ԑ> 1, demand is elastic.
o When Ԑ< 1, demand is inelastic.
o When Ԑ = 1, demand is unit elastic. Note that,
ɷX + ɷM = 1
E.g. demand elasticity of 0.8 means that quantity
demanded increases by 8% if price falls by 10%.
o When ɷM> (<) ɷX,,→there is a trade deficit
Expenditure (R) = Price × Quantity = P × Q (surplus).
Thus,
ɷXԐX= change in export receipts assuming the domestic
% change in expenditure = % ∆ R = % ∆ P + % ∆ Q = (1- Ԑ)
currency price of exports unchanged.
%∆P
o Change will be positive as long as export demand

o When Ԑ > 1, increase in price will lead to decrease
is not perfectly inelastic.
in expenditure.
o When a domestic currency depreciates/devalues,
o When Ԑ < 1, increase in price will lead to increase
exports become relatively cheaper in foreign
in expenditure.
currency, resulting in an increase in export
demand by foreigners.
Basic idea of Marshall-Lerner condition: Demand for o Since the domestic currency price of exports is
both imports and exports must be sufficiently price assumed to be unchanged, price does not have
sensitive so that increase in relative prices of imports will any direct effect on domestic currency export
lead to increase in the difference between export revenue. This implies that %∆ export revenue with
receipts and import expenditures. It can be stated as respect to 1% currency depreciation = Ԑx.
follows:
𝝎𝒙 𝜺𝒙 + 𝝎𝑴 (𝜺𝑴 − 𝟏) > 0
ɷM (ԐM – 1) reflects impact on import expenditures.
Learning Module: 8
A market with a few sellers: In market with only a few

o When a domestic currency depreciates/devalues, sellers, the product demand faced by each producer
imports become relatively expensive (assuming significantly depends on reactions of its competitors i.e.
imports payments are made in foreign currency),
resulting in a decrease in imports. o If decrease in price is matched by its competitors,
o Price effect: Due to increase in price of imports, then the producer fails to gain market share by
import expenditures increase. reducing his price.
o Quantity demanded effect: As imports become o If decrease in price is not matched by its
expensive, quantity demanded of imports competitors, then the producer loses market share
decreases and results in decrease in import by raising his price.
expenditures.
o Net effect depends on ԐM.
o Import expenditures will decrease and trade Effect of changes in price on demand:
balance will improve only when import demand is 1) Substitution effect: If a product becomes more
elastic i.e. ԐM > 1. expensive (cheaper) relative to other product, then
o It must be noted that as initial trade deficit gets demand of expensive product falls and the demand
larger (ɷM increases), then ԐM becomes of cheaper product rises.
increasingly more important than ԐX.
2) Income effect: When the price of a good rises (falls),
When trade is balanced initially i.e. ɷM= ɷX, the Marshall- purchasing power of consumers is reduced
Lerner condition becomes: (increased). Therefore, consumers demand less
(more) of it.
ԐM + ԐX >1
o The greater the share of a product in consumers’
o Marshall-Lerner condition states that a budgets (i.e. the more important the product), the
depreciation of domestic currency can improve a stronger the income effect.
country’s balance of payments only when the o The income effect also depends on the nature of
sum of the demand elasticity of exports and the the product i.e. the demand for luxury goods
demand elasticity of imports exceeds unity. have high income elasticity, whereas the demand
for necessities is insensitive to income.
Source: CFA Institute’s Curriculum, Example of Marshall-Lerner
condition. Hence, it implies that Marshall-Lerner condition is more
likely to hold (i.e. trade balance can be adjusted
Determinants of Elasticity of demand for any good or through changes in exchange rate) if a country imports
service: and exports goods with higher demand elasticities i.e.
1) Time period: The longer the time interval considered

a) Country imports and exports goods with greater
(i.e. in the long run), the more elastic is the good’s
number of good substitutes available.
demand curve.
b) Country imports and exports goods that trade in
a highly competitive markets (i.e. greater number
2) Number and closeness of substitutes: The greater the
of sellers).
number of substitutes a good has, the more elastic is
c) Country imports and exports luxury goods rather
its demand.
than necessities.
3) The proportion of income taken up by the product: d) Country imports and exports goods that
The larger (smaller) the proportion of one's budget represent a greater portion of consumers’ total
budget or a greater portion of input costs for final
represented by a good, the more (less) elastic its
producers.
demand will be.
4) The nature of the product and its role in the economy Important to understand: Since demand elasticities are
(i.e. Luxury or Necessity): Demand for necessities is lower in the short run and higher in the long run, it implies
less elastic whereas demand for luxury goods is more that Marshall-Lerner condition is more likely to hold in the
elastic. long run than in the short run.
5) The nature and level of competition among producers J-Curve Effect: The J-curve shows that a currency
of that product: The greater (smaller) the competition depreciation or devaluation will first worsen a trade
(i.e. many sellers) and the more (less) identical the deficit in the very short-term due to inelastic imports and
product is, the more (less) elastic demand of the exports. Over time, imports and exports will become
product even if global demand for that product is more elastic and the trade balance will improve.
perfectly inelastic.
Reasons for J-Curve Effect: In the short-run, J-curve effect
exists due to
Learning Module: 8
o Delivery lags i.e. difference between the time

when new orders are placed and the time when
their impact on trade and payment flows is felt.
o If long-term price elasticities meet Marshall-Lerner
condition but short-term price elasticities do not
meet it. Elasticities are low in a short run and
higher in a longer run, because:
o There are long term supply contracts.
o Consumers need time for substitution. Time
o Producers keeping foreign prices constant in
order to keep market share.
EXCHANGE RATES AND THE TRADE BALANCE: THE ABSORPTION

11.
APPROACH
Trade balance can also be stated as follows: balance unless domestic expenditure decreases. Thus,
to improve trade balance, currency depreciation must
Trade balance = Income (GDP) – Domestic expenditure
decrease domestic expenditure i.e. through a
= Absorption
mechanism called wealth effect.
Thus, it shows that to increase trade surplus, a
devaluation/depreciation of domestic currency must: Wealth effect: When domestic currency depreciates, Þ
the purchasing power of domestic-currency
denominated assets (including the PV of current & future
o Increase income relative to expenditure or,
o Increase national saving relative to investment in earned income) decreases Þ to rebuild wealth,
physical capital. households increase savings and decrease expenditure.
o Result in changes in foreign & domestic asset
prices such that foreign assets become relatively However, in this case, currency depreciation will improve
more attractive than domestic assets for both trade balance only for a short-term. For a long-term
foreign and domestic investors. change in trade balance, a country may need to adopt
a policy that improves fiscal balance or have to increase
real interest rates in order to increase savings.
In other words, improvements in trade balance require a
corresponding change in the capital account.
When an economy operates at above full employment Practice: Example 8,

level, then depreciation of the currency can increase CFA Institute’s Curriculum.
income/GDP by increasing demand for domestic goods
and services.
o When income ↑, and MPC < 1, savings ↑ → Practice: CFA Institute’s end of
income rises relative to expenditure and Chapter Practice Problems and
consequently, trade balance improves. FinQuiz Questions.
When an economy operates at full employment level,

then depreciation of the currency cannot improve trade
FSA1 Introduction to Financial Statement Analysis
Learning Module: 1
2. SCOPE OF FINANCIAL STATEMENT ANALYSIS
Financial statements provide information about • assess credit risk of a company
company’s: • perform due diligence in an acquisition
• Performance • evaluate subsidiary’s performance relative to
• Financial position other business units
• Changes in financial position
Primary users of Financial Statements are outside parties
Role of Financial Reporting: i.e.
The role of financial reporting is to provide information
about a company to facilitate both external and • Creditors → mainly interested in evaluating
internal parties in assessing company’s performance and company’s assets and liquidity position.
financial position. • Analysts → mainly interested to evaluate the past
and current performance and financial position of
Role of financial Statement Analysis: a company in order to form expectations about
its future performance and financial position.
The role of financial statement analysis is to evaluate • Equity Investors → mainly interested in evaluating
company’s past, current and prospective financial company’s long-term earning power.
position i.e. its ability to generate profits and cash flow,
and the ability to generate future growth in profits and
cash flows that facilitate decision making of analysts.
Uses of Financial Analysis: CFA Institute’s Curriculum.
An analyst may perform financial analysis to:
• do valuation of equity securities
3. MAJOR FINANCIAL STATEMENTS - BALANCE SHEET
statements an income statement and a statement of

Financial Statements & Supplementary Information
comprehensive income)
• Financial statements. (Financial statements are 4. Statement of changes in equity→ provides information
prepared at regular intervals i.e. annually, regarding the amounts and sources of changes in
semiannually and / or quarterly according to the equity investor’s investment.
applicable regulatory requirements).
• Notes to Financial Statements 5. Statement of cash flows→ provides information about
• Management’s commentary i.e. Management a company’s cash receipts and cash payments
Discussion & Analysis (MD&A) during a period.
• An external auditor’s report
• A Corporate governance report that describes NOTE:
structure of the company’s board of directors These statements are generally provided to shareholders
• A corporate responsibility report
at least annually.
Basic Financial Statements:

Balance sheet (a.k.a. statement of financial
1. Balance Sheet (Statement of financial position) → position or statement of financial condition):
provides a snapshot of the company’s current
financial position. Balance sheet provides a snapshot of the company’s
financial position at a specific point in time. The balance
2. Income statement→ provides information regarding sheet consists of three parts i.e. assets, liabilities and
company’s revenues and expenses over a period of owners’ equity.
time.
• Assets: They represent economic resources of a
3. Statement of comprehensive income (i.e. a single firm obtained through the firm’s operations or
statement of comprehensive income or two separate acquisitions.

FSA1 Financial Statement Analysis: An Introduction FinQuiz.com
Learning Module: 1
• Liabilities: They represent current or estimated Order of line items:

obligations of the firm. Under U.S. GAAP, items in assets and liabilities are
• Owners’ equity: It represents the amount of assets presented in decreasing order of liquidity (i.e. cash is
that would remain once all creditors are paid i.e. typically the first asset shown and equity is presented
owners’ residual interest. It is also known as net after liabilities), whereas under IFRS (if Current* and Non-
assets, net worth of the firm, and depending on Current order is followed) line items are presented in
form of organization, also known as “partners’ increasing order of liquidity i.e. Non-current assets before
capital or shareholders’ equity”. Current Assets, Owners’ equity before Liabilities and
within Liabilities, Non-Current Liabilities before Current
Owners’ Equity = Assets – Liabilities Liabilities.
Accounting equation or balance sheet equation:
*Current assets are defined as “those that are cash or
Assets = liabilities + owners’ equity cash equivalents; are held for trading or are expected to
be converted to cash (realized), sold, and consumed
Format Specifications for Balance Sheet: within 12 months or the company’s normal operating
cycle. All other assets are classified as non-current”.
• Generally, the most recent year is presented in
*Current liabilities are defined as “those that are
the first column and previous year is presented in
expected to be settled within 12 months or company’s
the second column. However, this is not always
normal operating cycle. All other liabilities are classified
the case.
as non-current”.
Format: Scope of Balance Sheet → To Evaluate Financial

Position of a Company:
• International Financial Reporting Standards (IFRS)
Financials of a company can be evaluated by
require companies to present classified balance
comparing the resources controlled/owned by the
sheet that follow current and non-current assets
company i.e. assets (e.g. cash) in relation to the claims
and current and non-current liabilities as separate
against those resources (i.e. liabilities and equity).
classifications.
Financial position of a company is critically important in
• However, IFRS and U.S. GAAP do not prescribe
credit analysis.
any particular format.
4. STATEMENT OF COMPREHENSIVE INCOME
Under IFRS, the statement of comprehensive income Revenue: It refers to amounts that are charged for the
can be presented in two ways: delivery of goods or services in the ordinary activities of
a business.
• As a single statement of comprehensive income
or Other Income: For example, gains refer to income that
• As two statements i.e. an income statement and may or may not be generated from the ordinary
a statement of comprehensive income that starts activities of the business.
with profit or loss from income statement.
Expenses: Expenses refer to company’s outflows,
depletions of assets (e.g. depreciation) and incurrence
Income Statement of liabilities that lead to decrease in equity.
Income Statement (a.k.a a statement of Examples:

operations or profit and loss (P&L statement): Cost of sales (cost of goods sold), administrative
expenses, and income tax expenses and may include
Income statement reports financial results of a losses.
company’s business activities over a period of time. It
provides information regarding the revenues of the Net income: It is calculated as follows:
company as well as the expenses incurred to generate Net Income = Revenue + Other income –
those revenues and transform them into net income. The Expenses = Income – Expenses
objective of this statement is to show the firm’s gains or
losses for the period.
Learning Module: 1
• It is often referred to as the “bottom line”, “net NOTE:

earnings”, “net profit” or “profit or loss” in the Analysts also use Earnings for valuation purposes e.g.
Income Statement. valuing shares of a company by comparing its price-to-
• When expenses > (revenues + other income) it is earnings ratio (P/E) to the P/Es of peer companies.
referred to as “net loss”.
Profit v/s Cash flow: Profit is different from cash flow. The
Operating profit or Operating income: It represents the profit is recognized independent of when cash is
results of the company’s usual business activities before received or paid.
paying interest expense or taxes. It is often referred to as
earnings before interest and taxes (EBIT). Other Comprehensive Income
Income statements are reported on a consolidated basis

which means that they include the income and Comprehensive income includes all items that affect
expenses of subsidiary companies that are under the owner’s equity; however, these items are not the
control* of the parent (reporting) company. outcome of transactions with shareowners.
• In the consolidated I/S (income statement), each • Some items are reported in Income statement to
line item includes the total amount from the calculate net income.
relevant line item on the subsidiary’s income • Some items are reported in Other Comprehensive
statement (excluding any intercompany Income (OCI).
transactions).
• When the parent company owns < 100% of the Format under IFRS: When Comprehensive income is
subsidiary, the parent company is required to presented in two statements:
report share of net income attributable to the
minority interests at the bottom of I/S along with • Statement of comprehensive income begins with
the net income attributable to shareholders of the profit or loss from I/S and then components of
parent company. Minority interests (a.k.a non- other comprehensive income are reported.
controlling interests) indicate owners of the
remaining shares of the subsidiary that are not
owned by the parent. Format under U.S. GAAP:
When Comprehensive income is presented in two
*control refers to a situation when a parent company owns > 50% statements,
of the voting shares of a subsidiary company.
• Statement of comprehensive income begins with

Scope of income Statement → To Evaluate Financial
profit or loss from I/S and then components of
Performance:
other comprehensive income are reported.
Financial performance of a company can be evaluated • However, companies are allowed to report
by assessing company’s profitability i.e. the ability of a components of other comprehensive income in
company to earn a profit from delivering goods and the statement of changes in equity.
services and its ability to generate positive cash flows
(cash receipts > cash disbursements).
STATEMENT OF CHANGES IN EQUITY AND

5.
CASH FLOW STATEMENT
• Reserves: They represent accumulated other

Statement of changes in equity reports the sources and comprehensive income items. They can be
amounts of changes in owners’ equity over the period of reported separately or can be reported as part of
time being reported. Basic components of owners’ retained earnings.
equity include:
The statement of changes in equity reports the following
• Paid-in capital details for each component of equity:
• Retained earnings: Retained earnings include the
cumulative amount of the company’s profits that • Beginning balance,
have been retained in the company over time. • Any increases during the period,
• Non-controlling or minority interests. They can be • Any decreases during the period, and
reported separately or can be reported as part of • Ending balance
retained earnings.
Learning Module: 1
Example: • A company that generates positive cash flow

Paid-in capital: from its operations:
o Has more flexibility in funding needed for
investments
• Increase in paid-in capital occurs when new
o Able to take advantage of attractive business
equity is issued.
opportunities
• Decrease in paid-in capital occurs when
• Company’s long-term success and sustainability
previously issued stock is repurchased by the
depends on positive cash flow position (ideally
company.
cash from operations).
• Cash flow statement facilitates creditors, investors,
Retained Earnings (R/E): and other statement users to evaluate the
company’s liability, solvency, and financial
• Increase in R/E occurs when income (profit) is flexibility (i.e. ability to respond and react to
reported i.e. both net income and other financial difficulties and opportunities efficiently
comprehensive income. and in a timely manner), as it separately disclose
• Decrease in R/E occurs when dividend is paid. the sources and uses of cash.
NOTE: where,
Notes to the consolidated financial statements contain Liquidity: It refers to the ability of a company to meet its
explanatory notes on equity. short-term obligations.
Cash Flow Statement Solvency: It refers to the ability of a company to meet its
long-term obligations.
Statement of cash flows reconciles the firm’s net income Flaw: Cash flow (in any given period) does not represent
to its cash inflows and outflows. It reflects effect of complete measure of performance of a company in
changes in balance sheet accounts and income on that period. Whereas, profits may provide useful
cash and cash equivalents. It is further categorized as information to analysts regarding company’s past and
follows: future cash flows.
• Operating cash flows→ cash flows generated Methods of Reporting Cash Flows from Operating
from/used in day-to-day operations of the
company. Activities: There are two methods of reporting cash flows
• Investing cash flows→ cash flows from company’s from operating which are discussed in detail in the next
activities associated with acquisition and disposal Study session.
of long-term assets i.e. sale or purchase of
property and equipment. • Indirect method of reporting Cash Flows from
• Financing cash flows→ cash flows from Operating Activities: It begins with profit before
company’s activities associated with obtaining or tax (or net income) less actual income tax
repaying capital to be used in business operations payments and then it is adjusted for effects of
i.e. dividends, interest payments etc. non-cash transactions, accruals, deferrals and
transactions of an investing and financing nature.
NOTE: • Direct method of reporting Cash Flows from

IFRS is more flexible than U.S. GAAP in classifying Operating Activities: It reports sources and uses of
dividend and interest receipts and payments within cash i.e. discloses major classes of gross cash
these categories. receipts (e.g. cash received from customers) and
gross cash payments (e.g. cash paid to suppliers
Net change in cash during the fiscal year = Net cash and employees).
flows from operating activities + Net cash flows from
investing activities + Net cash flows from financing Income Statement v/s Cash Flow Statement: On the
activities + Effect of exchange rates on cash income statement, income is reported when earned
(not necessarily when cash is received) and expenses
Importance of Cash Flows: are reported when incurred (not necessarily when paid)
whereas Cash flow statement reflects ability of a
• The company needs cash to pay employees, company to generate cash flow from running its
suppliers and others in order to continue as a business.
going concern.
• The company needs cash to pay its debt
obligations i.e. interest and pay returns i.e.
dividends.
Learning Module: 1
FINANCIAL NOTES AND SUPPLEMENTARY SCHEDULES AND

6.
MANAGEMENT COMMENTARY
Financial notes represent an integral and important part Management Commentary or Management’s
of the financial statements. They provide following Discussion and Analysis
additional information about the company being
evaluated:
MD&A is also known as Management report(ing),
Management commentary, Operating and Financial
• Accounting methods and policies used by review. It must provide following information:
management to prepare financial statements i.e.
revenue recognition method, depreciation
• Description about the primary business segments
method and rates etc.
and future trends of a company.
• Assumptions and estimates used by management
• Information regarding specific issues of a
in developing financial statements.
company or significant balance sheet items and
• Breakdown and information about every line item
future trends i.e. deferred tax liabilities etc.
(or almost every line item) of the balance sheet
• Assessment of the company’s current financial
and income statement.
position i.e. a review of company’s revenues and
expenses.
Footnotes also include information about the following • Information regarding the effects of inflation,
(this is not an exhaustive list): changing prices or other material events and
uncertainties that can have adverse impact on
• Financial instruments and risks arising from the future operating results and financial
financial instruments conditions of a company.
• Commitments and contingencies • Review of liquidity position of a company i.e.
• Legal proceedings current and future cash flow needs.
• Related-party transactions • Company’s current and planned future capital
• Subsequent events i.e. events that occur after the expenditures.
balance sheet date. • Description and review of major transactions e.g.
• Business acquisitions and disposals acquisitions, divestitures etc.
• Operating segments’ performance. • Discussion and review regarding discontinued
operations, extraordinary items and other unusual
or infrequent events.
Uses of Financial Statement Footnotes: They facilitate • Must provide information about off-balance sheet
users of financial statements to understand the amounts, obligations and about contractual commitments
timing and uncertainty of the estimates reported in the i.e. purchase obligations.
consolidated financial statements. • MD&A must also include disclosure regarding the
critical accounting policies that are based on
An analyst must know and understand different subjective judgments of management and that
have significant impact on reported financial
accounting methods used by companies even when
results.
companies using the same set of accounting standards
are being compared, in order to make appropriate
NOTE:
adjustments.
SEC and U.K. Financial Services Authority require this
NOTE: section to be reported with the financial statements.
Companies are required to present these financial

statement footnotes in their financial statements. • Typically, information included in the MD&A is
unaudited; therefore, analyst should be aware of
Supplementary Schedules: whether the information provided in MD&A is
audited or unaudited.
It provides additional information & details regarding • Framework (guidelines not requirements) proposed
assets and liabilities of a company e.g. information by International Accounting Standards Board (IASB)
regarding natural resources reserves, an overview of for the preparation and presentation of
specific business lines, or the segmentation of income or management commentary is based on following
other line items by geographical area or customer five elements.
distribution. o The nature of the business
o Management’s objectives and strategies
Learning Module: 1
o The company’s significant resources, risks and

relationships
o Results of operations
o Critical performance measures.
7. AUDITOR’S REPORTS
Generally, Financial statements of a company regarding the fairness of the audited financial
presented in annual reports are required to be audited statements.
by an independent accounting firm in accordance with
specified auditing standards.
Types of Auditor’s Report:
After auditing the company, the independent auditor 1) Unqualified Opinion: An unqualified opinion indicates
provides a written opinion on the financial statements. that according to auditor, the financial statements
This opinion is called the audit report. are free of any material misstatements and are
prepared in accordance with the generally
NOTE: accepted accounting principles. It is also referred to
Audits of Financial statements by an independent as clean opinion.
auditor may be required by contractual arrangement,
law, regulation (i.e. stock exchanges). • Under IFRS, it states that financial statements give
a “true and fair view” and are “fairly presented” in
Objective of Audit: Under international standards for accordance with applicable accounting
auditing (ISAs), the objectives of an auditor in standards.
conducting an audit of financial statements are as • Under U.S. GAAP, it states that financial
follows: statements are “fairly presented” in accordance
with applicable accounting standards.
• Audit is performed to provide an opinion on the
fairness and reliability of the financial statements 2) Qualified Opinion: A qualified opinion is one in which
(i.e. financial statements as a whole are free from there are some exceptions or limitations to
material misstatement whether due to fraud or accounting standards used.
error) prepared by the management of a
company and whether they are prepared and Reasons to issue qualified opinion:
presented in accordance with specified,
applicable set of accounting standards and • Auditor has concerns regarding the going-
principles. concern assumption of the company.
• To perform an audit in accordance with the • Auditor has concerns regarding the valuation of
generally accepted auditing procedures and to certain items on the balance sheet or some
report an opinion as required by the ISAs in unreported pending contingent liabilities.
accordance with the auditor’s findings.
3) Adverse opinion: An adverse opinion is issued if the

Auditor’s report should contain the following main statements are not presented fairly, are materially
paragraphs (under both International and U.S. Auditing misstated or are not prepared in accordance with the
Standards): generally accepted accounting principles.
• First or Introductory paragraph: This paragraph 4) Disclaimer of Opinion: It occurs when an auditor is
states that the preparation of Financial unable to issue an opinion for some reason such as
statements is the management’s responsibility scope limitation.
and independent review of the financial
statements has been performed by the auditor. NOTE:
• Second or Scope paragraph: This paragraph
describes the nature of the audit process i.e. audit Independent auditors cannot provide an absolute
has been performed in accordance with the assurance about the accuracy or precision of the
generally accepted auditing procedures and financial statements; rather they can only provide
provides reasonable assurance that the financial reasonable assurance about the fairness and reliability
statements are free from any material errors. of the financial statements because financial statements
• Third or Opinion paragraph: In the third are based on assumptions & estimates and auditors use
paragraph, auditor expresses his/her opinion audit sampling techniques to audit them.
Internal Controls:
Learning Module: 1
According to U.S. Sarbanes-Oxley Act, auditors are • A description of the internal control system and
required to provide opinion* on the company’s internal how it is evaluated.
control system (i.e. the processes used by the company • An analysis and assessment of the effectiveness of
to ensure accurate financial statements) in the auditor’s the internal controls over the last year.
opinion/ report. Under the Sarbanes-Oxley act, • A statement stating that the auditors have
management of a company has a duty to assess its reviewed management’s report on its internal
internal controls and provide the following information: controls.
• A statement stating that the financial statements NOTE:

are presented fairly.
• A statement stating that it is the management’s *This opinion can be reported separately or
responsibility to maintain and execute effective incorporated as a paragraph in the opinion related to
internal controls. the financial statements.
8. OTHER SOURCES OF INFORMATION
o Press release includes periodic earnings

• Interim Reports e.g. quarterly or semi-annually announcements.
reports are used to provide updated information o Conference calls are held after press release in
regarding company financial position and which the company’s senior executives
performance. These reports are not audited. describe the company’s performance and
• Proxy Statements: These statements are issued in respond to questions of the conference call
case of important issues i.e. participants.
o Matters that require Shareholders’ voting. o Afterwards, company may provide information
o Board elections regarding press release and conference call on
• Corporate reports its website.
• Companies’ websites, press releases and
conference calls
9. FINANCIAL STATEMENT ANALYSIS FRAMEWORK
Financial statement analysis framework consists of 6 to understand company’s financial performance

steps: and position.
• Other sources may include economic and
industry data, which can be used to evaluate the
Articulate the Purpose and Context of the environment in which the company operates.
1.
Analysis
• The purpose of the analysis e.g. analysis can be 3. Process Data

performed to do a periodic credit review of an
investment-grade debt portfolio, to evaluate
• Computing ratios, forecasting growth rates etc. to
performance of a subsidiary company, to
evaluate a company’s relative profitability,
evaluate whether the company stock is
liquidity, leverage, efficiency, and valuation in
undervalued or overvalued etc.
relation to past results and/or peers’ results.
• The form/format in which information needs to be
• Preparing common-size financial statements for
presented and procedures and/or sources of
comparison purposes.
information available to perform the analysis.
• Creating charts, performing statistical analysis
• Time period available to perform the analysis.
(e.g. regression), equity valuation etc.
• Making appropriate adjustments to financial
2. Collect Input Data statements for comparison purposes.
• Collecting and assembling company’s financial 4. Analyze / Interpret the processed data
data from financial statements and other sources
Learning Module: 1
• Interpreting the data processed and output

obtained in step 3 to support a conclusion.
Develop and Communicate Conclusions and

5.
Recommendations
Reporting answers to questions posed in phase 1 and

communicate conclusions and recommendations in an
appropriate format. According to CFA code &
standards,
• The analysts must disclose the limitations and risks

associated with the investment.
• The report must include all necessary information
& conclusions so that readers can evaluate the
conclusions themselves.
6. Follow-Up
Perform periodic review to evaluate validity of the

original conclusions and recommendations. In this
phase, all the previous steps in the process may be
repeated on a periodic basis.
(See the table Financial Statement Analysis on the next

page)
Financial Statement Analysis Framework
Phase Sources of Information Output

1. Articulate the purpose and • The nature of the analyst’s • Statement of the purpose or
context of the analysis. function i.e. evaluating an objective of analysis.
equity or debt investment or • A list (written or unwritten) of
issuing a credit rating. specific questions to be
• Communication with client or answered by the analysis.
supervisor on needs and • Nature and content of report to
concerns. be provided.
• Institutional guidelines related • Timetable and budged
to developing specific work resources for completion.
product.
2. Collect input data • Financial statements, other • Organized financial statements.
financial data, questionnaires, • Financial data tables.
and industry/ economic data. • Completed questionnaires, if
• Discussions with management, applicable.
suppliers, customers, and
competitors.
• Company site visits e.g. to
production facilities or retail
stores.
3. Process data • Data from the previous phase. • Adjusted financial statements.
• Common-size statements.
• Ratios and graphs.
• Forecasts.
4. Analyze/interpret the • Input data as well as • Analytical results.
processed data. processed data.
Learning Module: 1
Phase Sources of Information Output

5. Develop and • Analytical results and previous • Analytical report answering
communicate conclusions reports. questions posed in phase 1.
and recommendations e.g. • Institutional guidelines for • Recommendation regarding
with an analysis report. published reports. the purpose of the analysis i.e.
whether to make an investment
or grant credit.
6. Follow-up • Information gathered by • Updated reports and
periodically repeating above recommendations.
steps as necessary to
determine whether changes
to holdings or
recommendations are
necessary.
Source: Exhibit 11, CFA Institute’s Curriculum.
Practice: CFA Institute’s end of

bank.
FAS1 Financial Reporting Standards
Learning Module: 2
1. INTRODUCTION
The framework of financial reporting standard is a An understanding of framework of financial reporting
broader concept compared to specific accounting standards facilitates analysts to do financial analysis.
rules.
2. THE OBJECTIVE OF FINANCIAL REPORTING
The financial reports of a company are composed of Increased globalization of capital markets has
financial statements and other supplemental disclosures augmented the need for uniform, high quality global
that are necessary to assess a company’s financial financial reporting standards.
position and periodic financial performance.
As economic reality is hard to understand therefore
establishing financial reporting standards is strenuous.
According to International Accounting Standards Presenting economic reality in financial reports is not
Board (IASB) simple and requires judgement due to the involvement
Conceptual Framework: of estimates & accruals. Financial reporting standards try
to increase consistency in financial reports.
“The objective of financial reporting is to provide
financial information that is useful to users in making Understanding accounting choices and financial
decisions about providing resources to the reporting reporting framework facilitate analysts to compare
entity, where those decisions relate to entity and debt financial statements of different companies and to
instruments, or loans and other forms of credit that affect assess financial performance of a company.
the use of the entity’s economic resources”.
3. ACCOUNTING STANDARD BOARDS
manner. IASB promotes convergence of national

Accounting Standard Boards accounting standards.
Financial Accounting Standards Board (IFASB):

• are standard setters
• are typically independent, private, not-for-profit FASB issues financial reporting standards in the United
organizations States to improve standards of financial reporting and
• exist in almost every country provide decision-useful information to the users.
Two standard boards IASB (international) and FASB (U.S.) Note: Both IASB and FASB issue new and revised
are discussed below. standards to improve standards of financial reporting.
International Accounting Standards Board (IASB):
1) U.S. GAAP, issued by the FASB
They develop and issue international financial reporting
2) International Financial Reporting Standards
standards and specify the overall objective and qualities
(IFRS), issued by the IASB.
of information and provide guidelines regarding how
information should be presented in the financial reports
in a transparent, comparable and decision-useful
4. REGULATORY AUTHORITIES
Their responsibility is to ensure that companies prepare For example,

financial reports in accordance with specified
accounting standards and to enforce financial reporting • Securities & Exchange Commission (SEC): Its
requirements. responsibility is to regulate securities markets.

FAS1 Financial Reporting Standards FinQuiz.com
Learning Module: 2
The major responsibility of U.S. SEC is to regulate securities

An analyst should have understanding regarding the and capital markets in the U.S. It is an ordinary member
regulations and reporting standards that affect the of IOSCO.
company and/or industry being analyzed.
Any company issuing securities within U.S., or otherwise
Difference between Standard-Setting Bodies and involved in U.S. capital markets is subject to the rules and
Regulatory Authorities regulations of the SEC. To satisfy reporting requirements
there are more than 50 SEC forms. Most SEC filings are
required to be made electronically.
Standard-Setting Bodies Regulatory Authorities
• Their responsibility is to set • Their responsibility is Common sources of information used by analysts
accounting standards. to recognize and include:
enforce the
1. Securities Offerings Registration Statement:
accounting
standards. According to the 1993 Act, companies offering securities
to the public (both new issuers and new securities issued
• They are typically: • They are by previously registered companies) are required to file
§ Private governmental a registration statement. Typically, required information
§ Independent/self- entities. includes:
regulated
organizations
§ Not-for-profit • Disclosures about the securities being offered for
organizations sale
• The relationship of these new securities to the
issuer’s other capital securities
NOTE:
• Recent audited financial statements
Regulators often have the legal authority to develop • Risk factors involved in the business.
financial reporting standards in their jurisdiction and
these standards can overrule the private sector 2. Forms 10-K, 20-F and 40-F:
standard-setting bodies.
These are forms that are required to be filed annually by
International Organization of Securities companies.
Commissions (IOSCO)
• U.S. companies file forms 10-K and 10-Q.
• Foreign companies file forms 20-F and 6-K (filed
Objectives of IOSCO include
semi-annually).
• Certain Canadian companies file Form 40-F.
1) To protect investors
2) To ensure that markets are fair, efficient and
In these forms, the required information includes:
transparent
3) To reduce systematic risk
• Information about the business and its
management.
The role of IOSCO is to provide guidelines and set up
• Audited financial statements and disclosures (e.g.
principles regarding financial reporting. IOSCO’s
historical summary of financials, MD&A etc.).
principles are classified into nine categories e.g.
• Legal proceedings.
principles for regulators, for enforcement, for auditing
and for issuers etc. Two principles for issuers that are
directly related to financial reporting are as follows: 3. Annual Report:
Besides the SEC’s annual filings (e.g. Form 10-K), most
• Issuers should timely, fully, and accurately disclose companies prepare an annual report for shareholders.
financial results, risk and other material information SEC does not require companies to prepare Annual
to investors. report. Unlike annual report, Form 10-K is a more legal
• Issuers should prepare their financial statements type of document with minimal marketing emphasis.
using internationally acceptable accounting
standards. 4. Proxy Statement Form DEF-14A:
When a firm prepares a proxy statement prior to a vote,
Due to increasing globalization of financial markets, the SEC requires the firm to file Form DEF-14A.
there is a need to develop comparable financial
reporting standards internationally. • A proxy refers to a right given to another party to
cast a vote (authorized by a shareholder). Proxies
The Securities and Exchange Commission (U.S.) (particularly annual meeting proxies) contain
useful information for financial analysts.
Learning Module: 2
Information included in proxy statements include disposals, changes in management, or corporate

proposals that require a shareholder vote, details governance.
of security ownership by management and
principal owners, biographical information on 2. Form 144:
directors, and disclosure of executive Companies are required to file this form when issuing
compensation. securities to qualified buyers without registering the
securities with the SEC. However, Rule 144 allows only
5. Forms 10-Q and 6-K: limited sales of restricted securities without registration.
• 10-Q: Companies are required to file Form 10-Q 3. Form 3, 4 and 5:

quarterly. It provides updated financial
Companies are required to file these forms to report
statements. Unlike Form 10-K, it is not audited and
beneficial ownership of securities i.e. greater than 10% of
includes accounting, MD&A and legal disclosures.
a class of registered equity securities. These forms along
In addition, it also includes information regarding
with Form 144 can be used by analysts to determine
non-recurring events i.e. adoption of a significant
purchases and sales of company securities by corporate
accounting policy, commencement of significant
insiders.
litigation etc.
• Form 6-K: Non-U.S. companies are required to file • Form 3 is the initial statement.
this form on semi-annual basis. • Form 4 reports changes.
• Form 5 is the annual report.
Following forms are filed by a company either
periodically or if significant events or transactions have
occurred in between the periodic reports noted above. 4. Form 11-K:
These forms provide useful and timely information to
It represents an annual report of employee stock
analysts and may have significant valuation implications.
purchases, savings and similar plans.
1. Form 8-K (6-K for non-U.S. registrants):
Practice: Example 2
In addition to filing annual and interim reports,
companies are required to file this form to disclose
material events including asset acquisitions and
THE INTERNATIONAL FINANCIAL REPORTING

5.
STANDARDS FRAMEWORK
Objectives of IFRS Framework: confirmatory value), present, and must be useful in

The objective of IFRS is “to provide information about the making future forecasts (i.e. predictive value), must be
financial position, performance, and changes in useful to confirm or correct past evaluations, is timely (i.e.
financial position of an entity; this information should be must be available to make decisions) and is detailed
useful and understandable to a wide range of users for enough to help asses risks and opportunities.
the purpose of making economic decisions e.g. rational
investment, credit, and similar decisions ”. • Materiality: Information is considered to be
material if omission or misstatement of the
The primary users of financial reports include: information could have large influence on the
decision of a user of information. Materiality
• Investors depends on the nature and/or magnitude of the
• Lenders information.
• Other creditors
2. Faithful Representation:
Qualitative Characteristics of Financial Reports The information provided must be:
The two fundamental qualitative characteristics that • Complete: It means that all necessary information
make financial information useful are as follows: is provided.
• Neutral: It means that the information is selected
1. Relevance: and presented without any bias. It is similar to the
concept of fairness.
Information is said to be relevant when it helps users in
• Free from errors: It means that there are no errors
making economic decisions. In order to be relevant, the
or omissions in the information provided.
information must help to evaluate past (i.e. have
Learning Module: 2
is enhanced by clear and concise presentation of

Characteristics that help to enhance the usefulness of information.
relevant and faithfully represented financial
information:
Constraints on Financial Reports
There are four enhancing qualitative characteristics i.e.
Constraints in preparing Financial Statements include:
1. Comparability:
Comparability means that the information must be • Non-quantifiable & intangible information cannot
relatable to a benchmark or standard and must be be fully captured in financial statements e.g.
presented in a consistent manner over time and across creativity, innovation, competence of a
entities so that users can identify and understand company’s work force, customer loyalty, a
similarities and differences of items. positive corporate culture, environmental
responsibility etc.
2. Verifiability: • Verifiability v/s Timeliness: The information
It implies consensus i.e. different knowledgeable and provided to users must be balanced between
independent observers would agree that the being error free and timely i.e. providing timely
information is presented faithfully. information implies a shorter time period whereas
a fully verified information may require a longer
time period.
3. Timeliness:
• Cost-benefit: Benefits must be greater than costs
It means that timely information is available to decision i.e. the information provided must be worth more
makers prior to their decision making. than the cost of producing that information.
4. Understandability:
Practice: Example 2
It means that information should be easily CFA Institute’s Curriculum.
understandable by users with a basic understanding of
business, economics, and accounting. Understandability
6. THE ELEMENTS OF FINANCIAL STATEMENTS
Elements directly related to measurement of Financial company received cash before delivering the product,
Position are: after delivering the product, or at the time of delivery.
1. Assets 2. Going concern:

2. Liabilities
3. Equity Going concern refers to the assumption that the
company will continue its business for the foreseeable
future. It implies that a business will survive long enough
Elements directly related to measurement of Financial to meet its current obligations.
Performance are:
• When a company is assumed to be a going
1. Income concern, assets should be reported at current
2. Expenses value based upon normal market conditions.
3. Capital Maintenance Adjustments • When a company is expected to be liquidated,
assets should be reported at their appropriate
Underlying Assumptions underlying Financial liquidation value.
Statements
Recognition of Financial Statement Elements
These assumptions are used to determine how financial
statement elements are recognized and measured. Recognition refers to including an item in balance sheet
Assumptions include: or income statement.
1. Accrual basis:
Recognition Criteria:
Under accrual accounting, a company reports revenues
when they are earned irrespective of whether the For an item to be formally recognized, it must
Learning Module: 2
present relevant information and faithful representation • For Assets: Realizable value is the amount of cash
of items such assets, liabilities, expenses, income etc. or cash equivalents that could currently be
received by selling the asset in an orderly disposal.
Measurement of Financial Statement Elements • For Liabilities: Realizable value is called
“settlement value” i.e. the undiscounted amount
of cash or cash equivalents expected to be paid
Measurement is the process to determine the monetary to satisfy the liabilities in the normal course of
amounts at which the elements of the financial business.
statements are to be recognized and carried on the
balance sheet and the income statement. Following are
5. Present value:
alternative bases of measurement:
1. Historical cost: • For Assets: Present value is the present discounted

value of the future net cash inflows that the asset
Historical cost refers to the amount of cash or cash is expected to generate in the normal course of
equivalents paid to purchase an asset, including any business.
costs of acquisition and/or preparation. • For Liabilities: Present value is the present
discounted value of the future net cash outflows
• When the asset was not bought for cash, historical that are expected to be needed to satisfy the
cost represents the fair value of whatever was liabilities in the normal course of business.
given in order to buy the asset.
• For liabilities, the historical cost refers to the 6. Fair Value:
amount of proceeds received in exchange for
Fair value refers to the amount at which an asset could
the obligation.
be exchanged or a liability could be satisfied, between
knowledgeable, willing parties in an arm’s length
2. Amortized cost: transaction. It can be based on either market measures
or present value measures according to the available
It refers to historical cost adjusted for amortization,
information.
depreciation or depletion and/or impairment.
Fair Value under FASB:
3. Current cost:
Under FASB, Fair value refers to “an exit price i.e. the
• For Assets: Current cost is the amount of cash or price that would be received to sell an asset or paid to
cash equivalents that would have to be paid to transfer a liability in an orderly transaction between
buy the same or an equivalent asset today. market participants at the measurement date”.
• For Liabilities: Current cost is the undiscounted
amount of cash or cash equivalents that would NOTE:
be needed to settle the obligation today.
Framework refers to guiding principles whereas
standards refer to laws.
4. Realizable (settlement) value:
7. GENERAL REQUIREMENTS FOR FINANCIAL STATEMENTS
• Statement of cash flows

Required Financial Statements • Notes, summarizing accounting policies and
disclosing other items
• In certain cases, statement of financial position
• Statement of financial position (balance sheet)
from earliest comparative period.
• Statement of comprehensive income (single
statement or income statement + statement of
comprehensive income) General Features of Financial Statements
• Statement of changes in equity: Shows changes in
equity resulting from profit or loss, each item of • Fair representation: It refers to faithful
other comprehensive income, and transactions representation of the effects of transactions, other
with owners (e.g. sale of equity securities to events and conditions in accordance with the
investors, distributions of earnings to investors and definitions and recognition criteria for assets,
repurchases of equity securities from investors). liabilities, income and expenses.
Learning Module: 2
• Going concern: Financial statements are

prepared on a going concern basis unless Structure and Content Requirements
management intends to liquidate the entity.
When financial statements are not presented on a
going concern basis, then a company should • Classified balance sheet: Balance sheet must be
disclose the fact and rationale behind it. presented in classified form i.e. in which current
• Accrual basis: Financial statements (except for and non-current assets, and current and non-
cash flow information) must be prepared on the current liabilities are presented separately unless a
basis of accrual accounting. presentation based on liquidity provides more
• Materiality and aggregation: Each material class relevant and reliable information e.g. in the case
of similar items must be presented separately; of a bank or similar financial institution.
whereas dissimilar items are presented separately • Minimum specified information on face: e.g.
unless they are immaterial. companies must disclose the amount of their
• No offsetting: Assets and liabilities, income and plant, property, and equipment as a line item on
expenses are not offset unless required or the face of the balance sheet.
permitted by IFRS. • Minimum specified note disclosures: (see exhibit
• Frequency of reporting: Financial statements must 5)
be prepared at least annually. • Comparative information: It is recommended that
• Comparative information: Comparative comparative information should be provided for
information from the previous period must be the previous period.
included in Financial Statements. The
comparative information of prior periods is
disclosed for all amounts reported in the financial
statements, unless IFRS requires or permits See: Exhibit 1 & 2,
otherwise. CFA Institute’s Curriculum.
• Consistency of presentation: The presentation and
classification of items in the financial statement NOTE:
must be consistent from one period to the next.
A company that applies IFRS is required to explicitly state
in the notes to its financial statements that it is in
compliance with the standards (only when a company is
in compliance with all requirements of IFRS).
8. COMPARISON OF IFRS WITH ALTERNATIVE REPORTING SYSTEM
Development cost expensed Capitalized (if

Key differences between IFRS and US GAAP treatment certain
Basis for US GAAP IFRS conditions are
Comparison met)
Developed by FASB IASB Reversal of Not allowed Allowed (if
Based on Rules Principles Inventory certain
Inventory LIFO is LIFO is conditions are
Valuation allowed prohibited met)
difference
Extraordinary Items Segregated Not segregated Reference: https://keydiffrences.com/diffrence-between-
in the income (shown gap-and-ifrs-html
statement below)
MONITORING DEVELOPMENTS IN FINANCIAL REPORTING

9.
STANDARDS
• An analyst must be careful enough in interpreting

New Products or Type of Transactions comparative financial measures presented under
different accounting standards.
Learning Module: 2
• Also, an analyst must monitor significant

developments in financial reporting standards,
must be aware of new products and innovations Evolving Standards and the Role of CFA Institute
in the financial markets that result in new types of
transactions and their impact on the financial The model proposed by CFA Institute prefers:
statements.
• New products and/or transactions can be • Using current fair value for valuing assets and
evaluated by using financial reporting framework liabilities
as a guide. • Neutrality in financial reporting.
• Providing detailed information on cash flows to
investors by using direct-method for the cash flow
NOTE: Investors demand timeliness, transparency, statement.
comparability and consistency in financial reporting.
And for investors, decision relevance is more important
Practice: CFA Institute’s end of
than reliability.
Bank.

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QM The Time Value of Money

Interest rates can be interpreted in three ways.

3. FUTURE VALUE OF A SINGLE CASH FLOW

The future value of cash flows can be computed using Example:

Simple interest = Interest rate × Principal

𝐹𝑉. = 100(1 + 0.10)(1 + 0.10) = 121 Important to note:

or Both the interest rate (r) and number of compounding

4. NON-ANNUAL COMPOUNDING (FUTURE VALUE)

The more frequent the compounding, the greater will be

Periodic interest rate = rs / m = Stated annual interest

For example, EAR% for 10% semiannual investment will

EAR with continuous compounding:

Example: • Given the EAR, periodic interest rate can be

E.g. m = 4 for quarterly, m = 2 for semi-annually NOTE:

EAR (%) = (1 + Periodic interest rate) m– 1

• Given the EAR, periodic interest rate can be

FUTURE VALUE OF A SERIES OF CASH FLOWS, FUTURE VALUE

Annuity: • Ordinary Annuity: Annuities whose payments begin

• It is important to note that PV of annuity due > PV of

= 10; FV=0; CPTèPV

Using a Financial Calculator: N= 5; PMT = -100; I/Y = 10;

Annuity Due: An annuity due can be viewed as = $100

Calculating Future value for Annuity Due:

7. PRESENT VALUE OF A SINGLE CASH FLOW

The present value of cash flows can be computed using

• The PV factor = 1 / (1 + r) N; It is the reciprocal of the

• For a given discount rate, the greater the number of

8. NON-ANNUAL COMPOUNDING (PRESENT VALUE)

With more than one compounding period per year,

PRESENT VALUE OF A SERIES OF EQUAL CASH FLOWS

Enter I/YR = 5, è press NPVèNPV or PV = $15,036.46

Suppose cash flows for Year 1 = $1000, Year 2 = $2000,

A. Using the calculator’s “CFLO” register, enter the cash

PRESENT VALUE OF A PERPETUITY AND PRESENT VALUES

Suppose, a stock pays constant dividend of $10 per

Perpetuity: It is a set of infinite periodic outflows/ inflows PV = $10 / 0.20 = $50

PV = Pmt / r Present Values Indexed at Times Other than t =0

This formula is valid only for perpetuity with level

• It represents a seven-year Ordinary Annuity.

b) Then, the PV at t = 3 is again discounted to t = 0. i. PV0 of Perpetuity 1 = $100 / 0.05 = $2000

Source: CFA Institute’s Curriculum, Example 16.

• An annuity can be viewed as the difference

• Perpetuity 1: $100 per year starting in Year 1 (i.e. 1st

4-year Ordinary annuity = Perpetuity 1 – Perpetuity 2

Solving for the Number of Periods

SOLVING FOR THE SIZE OF ANNUITY PAYMENTS (COMBINING

• The amount borrowed = $100,000

+ i. We would first estimate PV of the annuity of

PRESENT AND FUTURE VALUE EQUIVALENCE AND THE

FV of annuity at t = 5 is calculated as: FV of (A + B) can be calculated by adding the cash

The Cash Flow Additivity Principle Example:

t=0è0 N = 2, I/Y = 6, Pmt = 4, FV = 0,

Practice: Questions from FinQuiz

as dividend-paying versus non-

are readily searchable and readable by

E.g., monthly returns (the variables) of

3. ORGANIZING DATA FOR QUANTITATIVE ANALYSIS

Two-dimensional rectangular array (a.k.a. data

4. SUMMARIZING DATA USING FREQUENCY DISTRIBUTIONS