CFA Points and Ethics Study Notes

Instructor: Varun
Subject Overview: Introduction to fundamentals of finance relevant in CFA including concepts such as time value of money, risks associated with different asset classes, and the basic principles of return calculation.
Importance of the Subject: Understanding these core concepts is essential as they form the foundation for more complex topics discussed in higher CFA levels.

Discussion Format: Mixed group of students from different academic backgrounds and levels, some new and others who have completed portions of the CFA curriculum.
Engagement: Encouragement of participation by asking student preferences and understanding of the previous topics.

Core Principle: Money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
- Example: Preference for receiving 10,000 rupees today versus receiving 10,700 rupees after one year due to interest accumulation.
Cash Preference: Cash received today is always preferred over cash promised in the future, emphasizing the principle of opportunity cost.

Definition: The return that investors require to compensate for the risks associated with investing in a particular asset class.
Comparison of Different Assets: Higher potential returns generally correspond to higher risks. For example, stocks typically offer greater returns than fixed deposits (FDs) but come with a higher risk of capital loss.

Risk-Free Rate:
- Definition: The return on investment with no risk of financial loss. In finance, often represented by the yield on government bonds, specifically U.S. treasury bonds.
- Importance of U.S. Treasury Bonds: They are considered risk-free because of the U.S. government’s ability to pay back its debts using its currency.
Real and Nominal Rates:
- Nominal Rate: Includes inflation and reflects the reported interest rate on bonds, loans, and deposits.
- Real Rate: The actual increase in purchasing power after accounting for inflation; defined as the return investors require to forgo consumption today for more consumption in the future.

Inflation Impact: If the nominal rate of return is equal to the inflation rate, investors do not increase their purchasing power. Example: A 6% return with 6% inflation results in no real gain.
Real Risk-Free Rate: The minimum return required by investors above inflation to maintain purchasing power.
Treasury Inflation-Protected Securities (TIPS): The only investment that provides a real risk-free rate as the principal is adjusted based on inflation.

Components of Total Return:
- Inflation Premium: Compensation for anticipated inflation rates for investment returns.
- Default Risk Premium: The extra return demanded by investors to compensate for the risk that a borrower might default on a loan.
- Liquidity Premium: Compensation for the difficulty associated with converting an investment into cash quickly without sacrificing value.
- Maturity Premium: Higher returns required for long-term investments due to uncertainty over longer periods.

Discussion of real-world scenarios where varying returns across asset classes must compensate for risks, using bonds, equities, and alternative investments as examples.

Default Risk: The risk of loss due to the borrower's failure to repay a loan or meet contractual obligations. High default risk results in higher required yields from investors.
Liquidity Risk: The risk of not being able to quickly convert an asset into cash without a loss in value. Illiquid investments require higher yields due to this risk.
Maturity Risk: Longer-duration investments carry higher risks, which must be compensated with higher returns.

Holding Period Return: The total return earned on an investment over a holding period, typically expressed as a percentage.
Average Return: The simple average of returns over several periods:
- Example: If the returns over five years are 7%, 8%, 6%, 4%, and 8%, the average return is calculated as (7+8+6+4+8)/5 = 6.6%.
Geometric Mean Return: Used for data that are multiplicative rather than additive. The geometric mean gives a more accurate reflection of investment performance over time by accounting for compounding.

Example problems related to different return calculations with practical illustrations.
Importance of using calculators in determining returns accurately, especially under exam conditions.

Arithmetic Mean: The average calculated by summing up values and dividing by their count.
Harmonic Mean: Used mainly when assessing rates and ratios, particularly when the data set includes outliers that skew the average. Good for financial ratios where rates are involved (like price-to-earnings ratios).
Trimmed Mean: Averages that remove a portion of the extreme values before presenting the mean to reduce the impact of outliers.
Winsorized Mean: Similar to trimmed mean but replaces extreme values with the highest or lowest value still in the data set to minimize their influence.

Money Weighted Rate of Return (MWRR): Calculated considering all contributions and withdrawals. It accounts for cash flows and is influenced by the timing of those flows, thus reflecting actual performance more accurately.
Time Weighted Rate of Return (TWRR): Useful for comparing fund managers, as it eliminates the impact of cash flows occurring at different times, focusing solely on the assets' performance.

Review of key concepts and principles regarding money management, different types of calculations involving returns, and the importance of understanding risk and valuation in investments.
Encouragement for practice and familiarity with calculators for succeeding in CFA examinations, especially in level two and three.