2025 | Quantitative Methods | Learning Module: 1

Rates and Returns

2. INTEREST RATES AND TIME VALUE OF MONEY

Interest Rate (r) Determinants of

Interest Rates
The Time Value
of Money
is used to compare r = Real Risk-free rate +
financial instruments with Inflation Premium + Default risk
varied payment timings. Premium + Liquidity premium +
Cash now is preferred
Maturity Premium
over future cash.
Interest Rate Interpretations Ways:
1. Real Risk-Free Rate: Interest rate in a
no-inflation, risk-free scenario.
1. Required Return: The minimum 2. Inflation Premium: Adjustment for
expected return on an investment. expected inflation.
2. Discount Rate: Used for calculating 3. Default Risk Premium: Compensates
present value from future values. for the issuer's potential default.
3. Opportunity Cost: The foregone 4. Liquidity Premium: Covers risks
return from spending rather than related to quick asset liquidation.
saving or investing. 5. Maturity Premium: Accounts for
increased risks in long-term
investments.

3. RATES OF RETURN

Two types of financial asset returns are:

1) periodic income (cash dividends or interest payments)
2) capital gain or loss (changes in the price of a financial asset).

Arithmetic Geometric Harmonic Additional Means

Holding Period for Handling Data
Return (HPR) Mean Return Mean Return Mean Return
Variability
)

Measures the return Sum of all returns Compound growth rate Sum of all returns Trimmed Mean:
over multiple periods. divided by the total Excludes a small % of
over a specific period. divided by the total
observations. the extreme values
observations. Suitable for a "buy-and- from both ends of a
Calculated as: hold" strategy. dataset before
(𝑃% − 𝑃' ) + 𝐼% Advantages: Easy to Used in cost averaging calculating the mean.
𝑅= strategies, where fixed
𝑃' compute, commonly Calculated as:
amounts are invested Winsorized Mean:
used, and facilitates 3 (1 + 𝑅,% ) × periodically.
For periods longer than standard deviation 𝑅+, = . −1 Assigns specified
… (1 + 𝑅,2 )
values to the
a year, HPR is calculations to Advantage: Harmonic extreme ends of a
compounded annually. assess variability. Advantage: Provides a mean is lower than dataset before
more accurate measure of geometric & arithmetic averaging, mitigating
long-term investment means when data is the impact of
returns. variable. outliers.

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 2025 | Quantitative Methods | Learning Module: 1

4. MONEY-WEIGHTED AND
TIME-WEIGHTED RETURN

Metric Money-Weighted Return (MWR) Time-Weighted Return (TWR)

Compound growth rate of all funds Compound rate of growth for one unit of initially
Definition
over the entire evaluation period invested money over a specified evaluation period
2
𝐶𝐹7 Time weighted return = rtwr = [(1 + 𝑟𝑡, 1) ×
Formula 4 =0
(1 + 𝐼𝑅𝑅)7 (1 + 𝑟𝑡, 2) × … × (1 + 𝑟𝑡, 𝑛)]%/B – 1
79'
Actual rate of return earned by the portfolio
Representation Internal Rate of Return (IRR)
manager
Consideration of Takes into account the timing and size Does not consider the timing and size of cash
Cash Flows of cash flows flows
Can be used to compare different
Comparative
investments with varying cash flow Cannot be used to compare different investments
Analysis
patterns
More commonly used to evaluate portfolio
Common Usage -
manager performance
Sensitivity to Sensitive to timing and size of cash
Not sensitive to timing and size of cash flows
Cash Flows flows
Comparative Can compare performance of different Cannot compare performance of different
Capability investments investments
Cannot compare returns between
Requires determining account value for each cash
Limitations different individuals or investment
flow, potentially incurring costs
opportunities

5. ANNUALIZED RETURN

Annualized Return Continuously Compounded

Rates of Return

• Return that would have been earned if a • Returns that would have been earned if an
given investment was compounded over a investment was compounded
one-year period. continuously, rather than at discrete intervals.
rannual= (1 + rperiod)c– 1 • For Single Period:
• Converts short-term returns to an annual rt, t+1= ln(1 + holding period return) or
basis, rt, t+1 = ln(price relative) = ln (St+1 / St)
• Standardizes return comparisons across • For Multiple Period:
time and investment types. R0,T= ln (ST / S0)
• Compounded differently based on the • Continuously compounded returns are always
period (monthly, quarterly, weekly, daily) lower than associated holding period returns
• Limitation: Assumes constant • Offers a refined view of returns, especially
reinvestment at similar rates. valuable in financial modeling and analysis.

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 2025 | Quantitative Methods | Learning Module: 1

6. OTHER MAJOR RETURN MEASURES

AND THEIR APPLICATIONS

Gross and Net Pre-Tax and After-Tax Real Returns Leveraged

Return Nominal Return Return

Gross Return: Total return There is different taxation Real returns: Amplifies underlying
minus direct trading for capital gains and income o accounts for inflation security returns through
expenses. It is used to returns. Long-term capital and risk premium. futures contracts or
evaluate investment skills. gains typically receive o provide a more borrowing funds.
favorable tax treatment accurate gauge of
Net Return: Gross return purchasing power Magnifies returns but
minus all managerial and After-Tax Nominal Return: is heightens risk. - Impact
administrative expenses. calculated by subtracting Real Return = (𝟏 + 𝒓) = varies based on leverage
Net return reflects the taxes on dividends, interest, (𝟏 + 𝒓𝒓𝑭 ) × (𝟏 + 𝝅) × (𝟏 + method.
actual return earned by and realized gains from the 𝑹𝑷)
investors. total return.
After-Tax Real Return are
Tax minimization strategies useful for comparing returns
include selecting tax-favored across different periods and
securities and reducing countries.
trading turnover

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