LM01 Rates and Returns 2025 Level I Notes

LM01 Rates and Returns

Introductory Note .............................................................................................................................2

1. Introduction ..................................................................................................................................2
2. Interest Rates and Time Value of Money ....................................................................................3
3. Rates of Return .............................................................................................................................5
4. Money-Weighted and Time-Weighted Return ...........................................................................9
5. Annualized Return ......................................................................................................................13
6. Other Major Return Measures and Their Applications ...........................................................17
Summary .........................................................................................................................................19

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LM01 Rates and Returns 2025 Level I Notes

Introductory Note
Financial Calculator: CFA Institute allows only two calculator models during the exam:
• Texas Instruments BA II Plus (including BA II Plus Professional) and
• Hewlett Packard 12C (including the HP 12C Platinum, 12C Platinum 25th anniversary
edition, 12C 30th anniversary edition, and HP 12C Prestige)
Unless you are already comfortable with the HP financial calculator, we recommend using
the Texas Instruments financial calculator. Explanations and keystrokes in our study
materials are based on the Texas Instruments BA II Plus calculator.
Before you start using the calculator to solve problems, we recommend that you set the
number of decimal places to ‘floating decimal’.
1. Introduction
If you have $100 today, versus an option to receive $100 after three years, what would you
prefer?

Obviously, you would prefer $100 today. Even though you have the same amount ($100) in
both cases, you prefer $100 today. This means that there has to be some value associated
with time, because you are putting more value on the $100 that you are getting today,
relative to the $100 at a later point in time. This is known as ‘time value of money.’
Let us say that you are indifferent between $100 dollars today versus $ 110 after one year.

Present value (PV): The money today or the value today is called the present value (PV =
100). This could be an investment which you make at time 0.
Future value (FV): The value at a future point in time is called the future value (FV = 110).
Interest rate (I): The relationship or the link between present value and future value is
established through an interest rate (I = 10%).
In this reading we will cover the meaning and interpretation of interest rates, and learn how
to calculate, interpret, and compare different return measures.

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LM01 Rates and Returns 2025 Level I Notes

2. Interest Rates and Time Value of Money

Let’s discuss the different interpretations of interest rates using an example. Say you lend
$900 today and receive $990 after one year (–ve sign indicates outflow).

Interest rates can be interpreted as:

1. Required rate of return: The fact that you are willing to give $900 today on the
condition that you get $990 after one year means that to engage in this transaction,
you require a return of 10%. (Simple calculation will show you that the interest rate in
this transaction is 10%).
2. Discount rate: You can discount the money that you will receive after one year i.e.
$990 at 10% to get the present value of $900 (990/1.1 = 900). Therefore, the 10% can
also be thought of as a discount rate.
3. Opportunity cost: Let’s say instead of lending the $900, you spent it on something else.
You have then forgone the opportunity to earn 10% interest. Therefore, 10% can also
be thought of as an opportunity cost.
Determinants of Interest Rates
As an investor, we can think of the interest rate as a sum of the following components:
Interest rate = Real risk-free interest rate + Inflation premium + Default risk premium +
Liquidity premium + Maturity premium
Let’s look at the different components.
• Real risk-free interest rate: This is the rate that you get on a security that has no risk
and is extremely liquid. We make an assumption here that there is no inflation.
• Inflation premium: We can then add on an inflation premium. Inflation premium is the
expected annual inflation in the upcoming period.
• Default risk premium: We can also then add a default risk premium. This is the
additional premium that investors require because of the risk of default.
Example: Let's say that you lend $100 each to person A and person B. However, B has a
high risk of default, so you are worried that he might not pay. Therefore you might
demand a higher return from B as compared to A, because of the risk of default. This
additional return that you demand is called the default risk premium.
• Liquidity premium: Liquidity premium compensates investors for the risk of receiving
less than the fair value for an investment if it must be converted to cash quickly.

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LM01 Rates and Returns 2025 Level I Notes

Example: Think of two investments C and D which are similar in all regards. The only
difference is that investment C is extremely liquid, whereas investment D is not that
liquid. Clearly as investors, we will demand a higher return on D because it is not easy
to sell. This additional return that we demand is called the liquidity premium.
• Maturity premium: Finally, we have the maturity premium. This is the premium that
investors demand on a security with long maturity. The maturity premium
compensates investors for the increased sensitivity of the market value of debt to a
change in market interest rates as maturity is extended.
Example: Let’s say we have two securities, E and F. Security E has a maturity of 1 year
and security F has a maturity of 4 years. Because of the longer maturity, F has more
risk, in terms of its price being more sensitive to changes in interest rate.
Instructor’s Note: You will understand this concept better when you study fixed
income securities. But for now, you can take it as a given that F has higher risk because
of the longer maturity.
Obviously, investors will demand some compensation for the higher level of risk. This
additional return that investors demand is called the maturity premium.
Nominal risk-free rate:
Nominal risk-free rate = Real risk-free interest rate + Inflation premium.
So if the real risk-free rate is 3% and the inflation premium is 2%, then the nominal risk-free
rate is 5%.
Instructor’s Note: On the exam if you get a term ‘risk-free rate’ with no mention of whether
the rate is real or nominal, then the assumption is that we are talking about the nominal risk-
free rate.

Example
Investments Maturity (in years) Liquidity Default risk Interest Rates(%)
A 1 High Low 2.0
B 1 Low Low 2.5
C 2 Low Low r
D 3 High Low 3.0
E 3 Low High 4.0
1. Explain the difference between the interest rates on Investment A and Investment B.
2. Estimate the default risk premium.
3. Calculate upper and lower limits for the interest rate on Investment C, r.
Solution:
1. Investments A and B have the same maturity and the same default risk. However, B has a
lower liquidity as compared to A. Hence, investors will demand a liquidity premium on B.

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LM01 Rates and Returns 2025 Level I Notes

The difference between their interest rates i.e. 2.5 – 2.0 = 0.5% is equal to the liquidity
premium.
2. Consider investments D and E, they have the same maturity, but different liquidity and
different default risk. Let’s make liquidity the same and create a new low liquidity
version of D. This version will have a higher interest rate, because now investors will
demand a liquidity premium. We have already determined that the liquidity premium is
0.5%. Therefore, the low liquidity version of D will have an interest rate of 3.0 + 0.5 =
3.5%.
Now compare this version of D with investment E. The only difference between the two is
default risk. E has a higher default risk. Therefore, the difference between their interest
rates i.e. 4.0 – 3.5 = 0.5% must be equal to the default risk premium.
3. Notice that between B and C, the only difference is that C has a longer maturity.
Therefore, interest rate of C must be higher than B (2.5%).
Also notice that between C and the low liquidity version of D, the only difference is that C
has a shorter maturity. Therefore, interest rate on C has to be lower than the low
liquidity version of D (3.5%).
So, the range for C is 2.5 < r < 3.5.
3. Rates of Return
A financial asset’s total return consists of two components: income and capital appreciation.
Holding Period Return
Holding period return (HPR) is the return that an investor earns over a specified holding
period. The holding period can range from days to years. The formula for calculating HPR for
an investment that makes one-time cash payment at the end of the holding period is given
below:
P1 – P0 + D1 ending value – beginning value + cash flow
HPR = =
P0 beginning value
where:
P0 = initial investment
P1 = price received at the end of the holding period
D1 = cash paid by the investment at the end of the holding period
Example
Assume we buy a stock for $50. Six months later, the stock price goes up to $53 and we
receive a dividend of $2. Calculate the holding period return.
Solution:
The return for the six-month holding period is given below:
53 + 2 − 50
HPR = = 0.10 = 10%
50

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LM01 Rates and Returns 2025 Level I Notes

Sometimes a holding period return can be computed for a period longer than a year. For
example, an analyst may need to calculate the holding period return from three annual
returns. In this case, the holding period return is calculated as:
R = [(1 + R1) × (1 + R2) × (1 + R3)] – 1
where:
R1, R2, and R3 are the three annual returns
Example:
The annual returns of a mutual fund for the past three years are presented below.
2020 20%
2021 -8%
2022 -1%
Calculate the fund’s holding period return over the three-year period.
Solution:
R = [(1 + R1) × (1 + R2) × (1 + R3)] – 1
R = [(1 + 0.20) (1 – 0.08) (1 – 0.01)] – 1 = 0.0929 = 9.296%
Arithmetic or Mean Return
The arithmetic mean is the sum of the observations divided by the number of observations.
It is expressed as:
∑ni=1 Xi
̅=
X
n
For example, if the annual returns of a mutual fund for the past three years are 20%, - 8%,
20−8−1
and -1%, the mean return is = 3.66%
3

A drawback of the arithmetic mean is that it is sensitive to extreme values (outliers). It can
be pulled sharply upward or downward by extremely large or small observations,
respectively.
Outliers
When data contains outliers, there are three options to deal with the extreme values:
Option 1: Do nothing; use the data without any adjustment.
Option 2: Delete all the outliers.
Option 3: Replace the outliers with another value.
Option 1 is appropriate in cases when the extreme values are genuine.

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LM01 Rates and Returns 2025 Level I Notes

Option 2 excludes extreme observations. A trimmed mean excludes a stated percentage of

the lowest and highest values and then calculates the arithmetic mean of the remaining
values.
Option 3 replaces extreme observations with observations closest to them. A winsorized
mean assigns a stated percentage of the lowest values equal to one specified low value and a
stated percentage of the highest values equal to one specified high value, and then computes
a mean from the restated data.
Geometric Mean Return
The geometric mean is calculated as the nth root of a product of n numbers. The most
common application of the geometric mean is to calculate the average return of an
investment. The formula is:
1
R G = [(1 + R1 )(1 + R 2 ) … (1 + R n )]n – 1
Example
The return over the last four periods for a given stock is: 10%, 8%, -5% and 2%. Calculate
the geometric mean.
Solution:
1
[(1 + 0.10)(1 + 0.08)(1 – 0.05)(1 + 0.02)]4 – 1 = 0.0358 = 3.58%
Given the returns shown above, $1 invested at the start of period 1 grew to:
$1.00 x 1.10 x 1.08 x 0.95 x 1.02 = $1.151. If the investment had grown at 3.58% every
period, $1.00 invested at the start of period 1 would have increased to:
$1.00 x 1.0358 x 1.0358 x 1.0358 x 1.0358 = $1.151. As expected, both scenarios give the
same answer. 3.58% is simply the average growth rate per period.
Other applications of the geometric mean involve the use of a second formula:
∑ni=1 lnXi
̅G =
lnX
n
Instructor’s Note: This formula is less testable.

Example:
The P/E ratio of a stock over the past four years has been: 10, 15, 14, 13. Calculate the
geometric mean P/E.
Solution:
∑ni=1 lnXi
̅G =
lnX
n
ln10 + ln15 + ln14 + ln13
̅G =
lnX = 2.55
4

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LM01 Rates and Returns 2025 Level I Notes

̅ G = e2.55 = 12.807
X
Using Geometric and Arithmetic Means
The geometric mean is appropriate to measure past performance over multiple periods.
Example
The portfolio returns for the past two years were 100% in year 1 and -50% in year 2. What
was the mean return?
Solution:
Past return = geometric mean = ((1+1.0) x (1-0.5))0.5 – 1 = 0%
The arithmetic mean is appropriate for forecasting single period returns.
Example
Two possible returns for the next year are 100% and -50%. What is the expected return?
Solution:
Expected return = Arithmetic mean = (100 – 50)/2 = 25%
The Harmonic Mean
The harmonic mean is a special type of weighted mean in which an observation’s weight is
inversely proportional to its magnitude. The formula for a harmonic mean is:
n
XH = 1
∑ni=1
Xi

where: Xi > 0 for i = 1, 2 … n, and n is the number of observations

The harmonic mean is used to find average purchase price for equal periodic investments.
Example
An investor purchases $1,000 of a security each month for three months. The share prices
are $10, $15 and $20 at the three purchase dates. Calculate the average purchase price per
share for the security purchased.
Solution:
The average purchase price is simply the harmonic mean of $10, $15 and $20.
The harmonic mean is:
3
1 1 1 = $13.85.
+ $15 + $20
$10

A more intuitive way of solving this is total money spent purchasing the shares divided by
the total number of shares purchased.
Total money spent purchasing the shares = $1,000 x 3 = $3,000

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LM01 Rates and Returns 2025 Level I Notes

Total shares purchased = sum of shares bought each month

$1,000 $1,000 $1,000
= + +
10 15 20
= 100 + 66.67 + 50 = 216.67
$3,000
Average purchase price per share = = $13.85
216.67
Comparison of AM, GM and HM
• Arithmetic mean × Harmonic mean = Geometric mean2
• If the returns are constant over time: AM = GM = HM.
• If the returns are variable: AM > GM > HM.
• The greater the variability of returns over time, the more the arithmetic mean will
exceed the geometric mean.
Which mean to use?
• Arithmetic mean: Should be used with single period or cross-sectional data.
• Geometric mean: Should be used with time-series data.
• Harmonic mean: Should be used to find average purchase price for equal periodic
investments.
• Trimmed mean: Should be used when the data has extreme outliers.
• Winsorized mean: Should be used when the data has extreme outliers.
4. Money-Weighted and Time-Weighted Return
Internal Rate of Return
The internal rate of return (IRR) is the discount rate that makes the net present value of an
investment equal to zero. It is ‘internal’ because it depends only on the cash flows of the
investment; no external data is needed. The formula for IRR is as follows:
CF1 CF2 CFN
NPV = CF0 + [ ] + [ ] + … + [ ]= 0
(1 + IRR)1 (1 + IRR)2 (1 + IRR)N
where:
CF0 = usually the initial investment which is a cash outflow
CFt = the expected net cash flow at time t
NPV = net present value of the investment
IRR = internal rate of return
The IRR is a single number which represents the return generated by an investment.
Consider a very simple example where the initial investment is $100. One year later the
amount received from this investment is $110. There are no other cash flows. If we apply the
formula for IRR we get:

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LM01 Rates and Returns 2025 Level I Notes

110
−100 + =0
1 + IRR
Solving this equation shows that IRR = 0.1 or 10%.
Example
Consider an initial investment of $150,000. Estimated cash flows for the following three
years from this investment are $50,000, $100,000 and $40,000 respectively. What is the
IRR?
Solution:
We can set up an equation with the initial outflow equal to the present value of future cash
flows and solve for the IRR:
CF1 CF2 CF3
CF0 = [ 1
]+ [ 2
]+ [ ]
(1 + IRR) (1 + IRR) (1 + IRR)3
Plugging in the values, we get:
$50,000 $100,000 $40,000
$150,000 = [ ] + [ ] + [ ]
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
While it is theoretically possible to solve the above equation, it is much simpler to use the
financial calculator.
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard mode 0
[CF] [2nd] [CLR WRK] Clear CF Register CF = 0
150 [+/-] [ENTER] Initial outlay (in 000’s) CF0 = -150
[↓] 50 [ENTER] Enter CF at t = 1 C01 = 50
[↓] [↓] 100 [ENTER] Enter CF at t = 2 C02 = 100
[↓] [↓] 40 [ENTER] Enter CF at t = 3 C03 = 40
[↓] [ÌRR] [CPT] Compute IRR 13.11%
Money-Weighted Rate of Return
The money-weighted rate of return is the internal rate of return (IRR) of an investment.
Let us consider a simple example to illustrate this point. At time t = 0, an investor buys a
share for $20.00. At the end of the Year 1, he receives a dividend of $0.50 and purchases
another share for $22.50. At the end of the Year 2, he sells both shares for $23.50 each after
receiving another dividend of $0.50 per share. What is the money-weighted return?
Since the money-weighted return is the IRR, we can use a financial calculator. The first step
is to determine the net cash flows for every period. This is illustrated in the table below:
Time (end Net cash
Outflow (-) Inflow (+)
of period) flow
0 -$20.00 -$20.00
To purchase the first share

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LM01 Rates and Returns 2025 Level I Notes

1 -$22.50 $0.50 -$22.00

To purchase the second share Dividend received on first share
2 Dividend received = $0.50 x 2 +48.00
shares = $1.00
From sales of 2 shares = $47
After entering these cash flows(CF0 = -20, CF1 = -22, and CF3 = 48), use the calculator’s IRR
function to find the money-weighted rate of return as 9.39%.
Time-Weighted Rate of Return
The time-weighted rate of return measures the compound growth rate of $1 initially
invested in the portfolio over a stated measurement period. The time-weighted return can
be calculated using the following steps:
1. Break the overall evaluation period into sub-periods based on the dates of cash inflows
and outflows.
2. Calculate the holding period return on the portfolio for each sub-period.
3. Link or compound holding period returns to obtain an annual rate of return for the year
(the time-weighted rate of return for the year).
4. If the investment is for more than a year, take the geometric mean of the annual returns
to obtain the time-weighted rate of return over that measurement period.

Consider the same example we discussed above with the following cash flows:
Time Outflow Inflow
0 $20.00 to purchase the first share
$22.50 to purchase the second
1 $0.50 dividend received on first share
share
2 $1.00 dividends ($0.50 x 2 shares);
$47.00 from selling 2 shares @ $23.50 per
share
Calculating the TWRR for this example is relatively simple because cash flows only occur at
the start/end of every year. We will follow the steps mentioned earlier:
Steps 1: Break into evaluation period and value the portfolio at start/end of every period.
• Value of the portfolio at the start of Year 1 (t = 0) is $20.00.
• Value of portfolio at the end of Year 1 (t = 1) before the purchase of the new share is
22.50 + 0.50 = $23.00. Note that the dividend of $0.50 on the first share is received at the
end of Year 1.
• Value of the portfolio at the start of Year 2 (t = 1) after the purchase of the second share
is 22.50 + 22.50 = $45.00. The dividend of $0.50 from the first share is paid out and is
not considered as part of the portfolio.
• Value of the portfolio at the end of Year 2 (t = 2) is 23.50 + 23.50 + 0.50 + 0.50 = $48.00.
Both shares pay a dividend of $0.50 at the end of the second year.

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LM01 Rates and Returns 2025 Level I Notes

Step 2: Calculate the holding period return on the portfolio for each sub-period.
• In this question the cash flows are taking place at the start/end of each period. Hence
there are no sub-periods. Scenarios involving sub-periods will be covered in the next
example.
Step 3: Link or compound holding period returns to obtain an annual rate of return for the
year.
• The annual rate of return is based on the portfolio value at the start and end of each
period.
• The portfolio value at the start of Year 1 was $20.00 and the value at the end of Year 1
was $23.00. Hence the holding period return was 15.00%.
• The portfolio value at the start of Year 2 was $45.00 and the value at the end of Year 2
was $48.00. Hence the holding period return was 6.67%.
Step 4: If the investment is for more than a year, take the geometric mean of the annual
returns to obtain the time-weighted rate of return over that measurement period.
1
The TWRR is calculated as: (1.15 ∗ 1.067)2 – 1 = 0.1077 = 10.77%.
Example
Consider an investment where cash flows occur at the start/end of every quarter. Here each
quarter is considered a sub-period. The return for each sub-period has already been
calculated and is shown below:

Calculate the time-weighted return.

Solution:
Step 1 (break evaluation into sub-periods) and step 2 (calculate HPR for sub-periods) have
been done for you.
Step 3: Link the quarterly returns to determine the return for Years 1 and 2 respectively.
For year 1: (1 + 0.10) (1 – 0.05) (1 + 0.15) (1 – 0.10) = 1.0816
For year 2: (1 – 0.20) (1 + 0.30) (1 + 0.20) (1 + 0) = 1.2480
Step 4: Determine the annualized return by taking the geometric mean.
TWRR = (1.0816 x 1.2480)1/2 - 1 = 0.1618 = 16.18%.
Money-weighted v/s time-weighted returns
• The money-weighted rate of return is impacted by the timing and amount of cash
flows.

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LM01 Rates and Returns 2025 Level I Notes

• The time-weighted rate of return is not impacted by the timing and amount of cash
flows.
• The time-weighted return is an appropriate performance measure if the portfolio
manager does not control the timing and amount of investment.
• On the other hand, money-weighted return is an appropriate measure if the portfolio
manager has control over the timing and amount of investment.
5. Annualized Return
Annual compounding
Let’s understand this concept with a simple example.
Say present value (PV) = $100 and interest rate (r) = 10%.
What is the future value (FV) after one year?
What is the future value (FV) after two years?

The future value of a single cash flow with annual compounding can be computed using the
following formula:
FVN = PV (1 + r)N
where:
FVN = future value of the investment
N = number of periods
PV = present value of the investment
r = rate of interest
Therefore,
FV1 = 100 (1 + 0.1)1 = $110
FV𝟐 = 100 (1 + 0.1)𝟐 = $121
Notice that with compound interest, after two years we have $121. Whereas, with simple
interest, after two years we would have $120. The difference between the two values ($1)
represents the interest on interest component. In Year 2, we not only receive interest on the
$100 principal, but we also receive interest on the $10 interest earned in Year 1 that has
been reinvested.
Example
Cyndia Rojers deposits $5 million in her savings account. The account holders are entitled to
a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash would she most likely
be able to withdraw?

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LM01 Rates and Returns 2025 Level I Notes

Solution:
FVN = PV (1 + r)N
FV2.5 = 5 (1 + 0.05)2.5 = $5.649 million
FV Calculation using a Financial Calculator
You will often use the following keys on your TI BA II Plus calculator:
N = number of periods
I/Y = rate per period
PV = present value
FV = future value
PMT = payment
CPT = compute
One important point to note is the signs used for PV and FV. If the value for PV is negative “-”,
then the value for FV is positive “+”. An inflow is often represented as a positive number,
while outflows are denoted by negative numbers.
Before you begin, set the number of decimal points on your calculator to 9 to increase
accuracy.
Keystrokes Explanation Display
[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9
Return to standard calc
[2nd] [QUIT] 0
mode
Question: You invest $100 today at 10% compounded annually. How much will you have in
5 years?
The key strokes to compute the future value of a single cash flow are illustrated below.
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0
[2nd] [CLR TVM] Clears TVM Worksheet 0
5 [N] Five years/periods N=5
10 [I/Y] Set interest rate I/Y = 10
100 [PV] Set present value PV = 100
0 [PMT] Set payment PMT = 0
[CPT] [FV] Compute future value FV = -161.05

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LM01 Rates and Returns 2025 Level I Notes

Non-annual Compounding
When our compounding frequency is not annual, we use the following formula to compute
future value:
rs mN
FVN = PV (1 + )
m
where:
rs = the stated annual interest rate in decimal format
m = the number of compounding periods per year
N = the number of years
Let’s understand this concept using an example.
You invest $80,000 in a 3-year certificate of deposit. This CD offers a stated annual interest
rate of 10% compounded quarterly. How much will you have at the end of three years?
Solution:
There are two methods to solve this question.
Formula Method
PV is $80,000.
The stated annual rate is 10%.
The number of compounding periods per year is 4. The total number of periods is 4 x 3 = 12.
Therefore, future value after 12 quarters (3 years) is
0.1 4×3
FV12 = $80,000 (1 + ) = $107,591
4
Calculator Method
You can also solve this problem using a financial calculator; the key strokes are given below:
N = 12, I/Y = 2.5%, PV = $80,000, PMT = 0, CPT FV = -$107,591
PMT is 0 because there are no intermediate payments in this example.
Example
Donald invested $3 million in an American bank that promises to pay 4% compounded daily.
Which of the following is closest to the amount Donald receives at the end of the first year?
Assume 365 days in a year.
A. $3.003 million
B. $3.122 million
C. $3.562 million
Solution
The correct answer is B.
Formula Method
r mN
FVN = PV (1 + ms )

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LM01 Rates and Returns 2025 Level I Notes

0.04 365
FV1 year = 3 million (1 + 365 ) = $3.122 million
Calculator Method
N = 365, I/Y = 4/365%, PV = $3 million, PMT = 0; CPT FV = -$3.122 million
Annualizing Returns
Annualized return converts the returns for periods that are shorter or longer than a year, to
an annualized number for easy comparison.
c
Annualized return = (1 + rperiod ) − 1
Where c = number of periods in year
Example:
(This is based on Example 13 from the curriculum.)
An investor is evaluating the returns of three ETFs.
ETF Time Since Inception Return Since Inception (%)
1 146 days 4.61
2 5 weeks 1.10
3 15 months 14.35
Which ETF has the highest annualized rate of return?
Solution:
ETF 1 annualized return = (1.0461365/146) – 1 = 11.93%
ETF 2 annualized return = (1.011052/5) – 1 = 12.05%
ETF 3 annualized return = (1.143512/15) – 1 = 11.32%
ETF 2 has the highest annualized rate of return.
Continuously Compounded Returns
We covered examples with annual compounding, quarterly compounding and daily
compounding. If we keep increasing the number of compounding periods until we have
infinite number of compounding periods per year, then we can say that we have continuous
compounding.
The continuously compounded return associated with a holding period return can be
calculated as:
• Natural logarithm of one plus that holding period return, or
• Natural logarithm of the ending price over the beginning price
i.e. Rc = ln(1 + Rt) = ln (Pt/P0)
Example:
1. If the one-week holding period return is 4%, then the equivalent continuously

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LM01 Rates and Returns 2025 Level I Notes

compounded return is: ln (1 + 0.04) = 3.922%

2. A stock was purchased at t = 0 for $30. One period later at t = 1, the stock has a value of
$34.50. The continuously compounded return over the period can be calculated as: ln
(34.50/30) = 13.976%
6. Other Major Return Measures and Their Applications
Gross Return
Gross return is the return earned by an asset manager prior to deducting management fees
and taxes. It measures the investment skill of a manager.
Net Return
Net return is the return earned by the investor on an investment after all managerial and
administrative expenses have been accounted for. This is the measure of return that should
matter to an investor.
Assume an investment manager generates $120 for every $100, and charges a 2% fee for
management and administrative expenses. The gross return, in this case, is 20% and the net
return is 18%.
Pre-tax and After-tax Nominal Return
The returns we saw till now were pre-tax nominal returns, i.e., before deducting any taxes or
any adjustments for inflation. This is the default, unless otherwise stated.
After-tax nominal return is the return after accounting for taxes. The actual return an
investor earns should consider the tax implications as well.
In the example that we saw above for gross and net return, 18% was the pre-tax nominal
return. If the tax rate for the investor is 33.33%, then the after-tax nominal return will be
18(1 - 0.3333) = 12.0006%.
Real Return
Real return is the return after deducting taxes and inflation.
(1 + r) = (1 + rreal) (1 + π)
where:
rreal = real rate
π = rate of inflation
r = nominal rate
In the previous example, the after-tax nominal return was 12%. Assume the inflation rate for
the period is 10%. What is the real rate of return?
Using the above formula, (1 + 0.12) = (1 + r) (1 + 0.1). Solving for r, we get 1.818%.

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LM01 Rates and Returns 2025 Level I Notes

Instructor’s tip: If the answer choices are close to each other, use this formula to determine
the correct answer. Else, you may use an approximation to solve for r quickly as nominal rate
= real rate + inflation.
Leveraged Return
In cases, where an investor borrows money to invest in assets like bonds or real estate, the
leveraged return is the return earned by the investor on his money after accounting for
interest paid on borrowed money.

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LM01 Rates and Returns 2025 Level I Notes

Summary
LO: Interpret interest rates as required rates of return, discount rates, or opportunity
costs and explain an interest rate as the sum of a real risk-free rate and premiums that
compensate investors for bearing distinct types of risk.
An interest rate is the required rate of return. If you invest $100 today on the condition that
you get $110 after one year, the required rate of return is 10%.
If the future value (FV) at the end of Year 1 is $110, you can discount at 10% to get the
present value (PV) of $100. Hence, 10% can also be thought of as a discount rate.
Finally, if you spent $100 on taking your spouse out for dinner you gave up the opportunity
to earn 10%. Thus, 10% can also be interpreted as an opportunity cost.
Interest rate = Real risk-free interest rate + Inflation premium + Default risk premium +
Liquidity premium + Maturity premium.
Nominal risk free rate= real risk free rate + inflation premium
LO: Calculate and interpret different approaches to return measurement over time
and describe their appropriate uses
Holding period return is the return earned on an asset during the period it was held.
PT − P0 + DT
HPR single period =
P0
Arithmetic return is a simple arithmetic average of returns.
Geometric mean return is the compounded rate of return earned on an investment.
1
GM = [(1 + R1 ) ∗ (1 + R 2 ) ∗ … . .∗ (1 + R T )]T − 1
The harmonic mean is a special type of weighted mean in which an observation’s weight is
inversely proportional to its magnitude. The harmonic mean is used to find average
purchase price for equal periodic investments.
LO: Compare the money-weighted and time-weighted rates of return and evaluate the
performance of portfolios based on these measures.
The money-weighted rate of return accounts for the timing and amount of all cash flows into
and out of a portfolio. It is simply the internal rate of return.
The time-weighted rate of return measures the compound rate of growth of $1 initially
invested in the portfolio over a stated measurement period.
Money-weighted v/s time-weighted returns
• The money-weighted rate of return is impacted by the timing and amount of cash
flows.
• The time-weighted rate of return is not impacted by the timing and amount of cash
flows.

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LM01 Rates and Returns 2025 Level I Notes

• The time-weighted return is an appropriate performance measure if the portfolio

manager does not control the timing and amount of investment.
• On the other hand, money-weighted return is an appropriate measure if the portfolio
manager has control over the timing and amount of investment.
LO: Calculate and interpret annualized return measures and continuously
compounded returns, and describe their appropriate uses.
Annualized return converts the returns for periods that are shorter or longer than a year, to
an annualized number for easy comparison.
The continuously compounded return associated with a holding period return can be
calculated as:
• Natural logarithm of one plus that holding period return, or
• Natural logarithm of the ending price over the beginning price
LO: Calculate and interpret major return measures and describe their appropriate
uses.
Gross return is the return earned by an asset manager prior to deducting management fees
and taxes. It measures investment skill.
Net return accounts for all managerial and administrative expenses is what the investor is
concerned with.
Pre-tax nominal return is the return before accounting for inflation and taxes; this is the
default, unless otherwise stated.
After-tax nominal return is the return after accounting for taxes.
Real return is the return after accounting for taxes and inflation.
Leveraged return is the return earned by the investor on his money after accounting for
interest paid on borrowed money

© IFT. All rights reserved 20