Compounding
Interest being added to the balance so that it earns interest itself in later periods. It makes growth exponential rather than linear, and more frequent compounding raises the effective annual rate.
Where you will meet it
Compounding appears in 16 learning outcomes on the CFA syllabus. A few of them:
- Work out an equity's price return and its total return
“Over several periods the returns are linked by compounding, multiplying (1 + r) for each period and subtracting one, not by adding them, and an annualised figure is the geometric mean of those period returns.”
- Restate a yield at a different compounding frequency
“A yield's periodicity is the number of compounding periods a year it assumes, and a yield can only be compared with another once you know it.”
- Work out what a cash flow will be worth in future
“Compounding is what makes the relationship exponential rather than linear: interest earns interest.”
- Show how the absence of arbitrage fixes a forward price
“Buying the asset today with borrowed money and holding it to the delivery date produces exactly what the forward delivers, so the forward price must equal the spot price compounded at the financing rate, adjusted for anything the asset pays or costs while held.”
Learn it properly
- Effective annual rate and compounding: comparing rates properly
- Time value of money explained: present value, future value and annuities
- How to memorise CFA formulas: understand them first, then make them automatic
- Effective annual rate calculator
Practise it
Practise compounding until it is automatic: questions that explain every wrong option.
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