1. What is alternative investment?

Question 1

Define investment:

Answer 1

investment is deferred consumption. Any net outlay of cash made with prospect of receiving future benefits might be considered an investment.

Question 2

List four major types of real assets other than land and other types of real estate.

Answer 2

1. Natural Resources
2. Commodities
3. Infrastructure
4. Intellectual property

(real estate is sometimes considered a traditional institutional-quality investment)

Question 3

List the three major types of alternative investments other than real assets in the CAIA curriculum.

Answer 3

1. Hedge funds (managed futures, 38%)
2. Private equity (including mezzanine and distressed debt, 29%)
3. Structured products (including credit derivatives, 3%)

(real assets, 30%)

Question 4

Name the five structures that differentiate traditional and alternative investments.

Answer 4

1. Regulatory structures
2. Securities strucures
3. Trading structures
4. Compensation structures
5. Institutional structures

Question 5

Which of the five structures that differentiate traditional and alternative investments relates to the taxation of an instrument?

Answer 5

regulatory structures

Question 6

Name the four return characteristics that differentiate traditional and alternative investments.

Answer 6

1. Diversification
2. Illiquidity
3. Inefficiency
4. Non-normality

Question 7

Name the four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments.

Answer 7

1. return computation methods
2. statistical methods
3. valuation methods
4. portfolio management methods

Question 8

Describe an incomplete market.

Answer 8

An incomplete market refers to the lack of investment opportunities that causes market participants to be unable to implement an investment strategy that satisfies their exact preferences such as risk preferences.

Question 9

Define active management.

Answer 9

Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return.

Question 10

What distinguishes use of the term pure arbitrage from the more general usage of the term arbitrage?

Answer 10

Pure arbitrage is risk-free, while arbitrage, as a more general term, is not risk-free. Pure arbitrage is an attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Whereas, arbitrage is used to represent efforts to earn superior returns even when risk is present because the long and short positions are not in identical assets or are not held over the same time period.

Question 11

Name 3 typical traditional investments:

Answer 11

1. publicly traded equities
2. fixed-income securities
3. Cash

Question 12

What is an institutional quality investment:

Answer 12

(focus of the CAIA curriculum when speaking of alternative investments) type of investment that financial institutions such as pension funds or endowments might include in their holding because they are expected to deliver reasonable returns at an acceptable level of risk.

Question 13

Difference between natural resources and commodities:

Answer 13

Natural resources focus on direct ownership of real assets that have received little or no alteration by humans, such as mineral and energy rights or reserves. Whereas, commodities are differentiated from natural resources by their emphasis on having been extracted or produced. Commodities are homogeneous goods available in large quantities, such as energy products, agriculture products, metals and building materials.

Question 14

What form of real assets deal mostly with futures contracts?

Answer 14

Commodities. As the futures contracts are regulated distinctly and have well-defined economic properties. For example, the analysis of futures contract typically emphasises notional amounts rather than the amount of money posted as collateral or margin to acquire positions.

Question 15

What are some examples of operationally focused real assets?

Answer 15

1. real estate
2. land
3. infrastructure
4. intellectual property

(Traditional common stocks are typically even more highly operationally focused than that of these.)

Question 16

Leveraged buyouts (LBOs):

Answer 16

refer to those transactions in which the equity of a publicly traded company is purchased using a small amount of investor capital and a large amount of borrowed funds in order to take the firm private.

Question 17

Mezzanine debt:

Answer 17

named for its position in the capital structure if a firm: between the ceiling of senior secured debt and the floor of equity. Mezzanine debt refers to a spectrum of risky claims, including preferred stock, convertible debt, and debt that includes equity kicker (i.e. options that allow investors to benefit from any upside success in the underlying business, also called hybrid securities).

Question 18

Distressed debt:

Answer 18

debt of companies that have filed or are likely to file in the near future for bankruptcy protection. They are fixed-income securities that are highly risky and highly dependent on the financial success of the distressed companies, and thus share many similarities with common stock.

Question 19

Two common forms of structured products:

Answer 19

1. collateralised debt obligation (CDOs): partition the actual or synthetic returns from a portfolio of assets (the collateral into securities with varied levels of seniority (the tranches).
2. Credit derivatives: facilitate the transfer of credit risk.

Question 20

Security structures:

Answer 20

Transforms assets ownership into potentially distinct and diverse tradable investment opportunities.

Question 21

Diversifier:

Answer 21

an investment with a primary purpose of contributing diversification benefits to its owner.

Question 22

Absolute return products:

Answer 22

investment products viewed as having little or no return correlation with traditional assets, and have investment performance that is often analysed on an absolute basis rather than relative to the performance of traditional investments.

Question 23

Illiquidity:

Answer 23

means that it trades infrequently or with low volume.

Question 24

Lumpy assets:

Answer 24

are assets that can be bought and sold only in specific quantities, such as a large real estate project.

Question 25

Efficiency vs. Inefficiency:

Answer 25

Efficiency refers to the tendency of market prices to reflect all available information. Inefficiency refers to the deviation of actual prices from valuations that would be anticipated in an efficient market. Inefficient markets are less competitive, with fewer investors, higher transaction costs, and/or an inability to take both long and short positions.

Question 26

What structures cause non-normality of returns?

Answer 26

Short-term returns on traditional investments, can be approximated as being normally distributed.

1) Securities structuring, such as with a derivative product that is nonlinearly related to its underlying security or with an equity in a highly leveraged firm.
2) trading structures, such as an active investment management strategy alternating rapidly between long and short positions.

Question 27

What method is associated with Internal Rate of Return (IRR)?

Answer 27

Return Computation Methods

Question 28

What is the statistical method of analysis include?

Answer 28

1. the mean of distribution
2. the standard deviation or variance of the distribution

non-normality is addressed through the analysis of higher moments of the return distributions, such as skewness and kurtosis.

(normally traditional investment analysis is based on the mean and standard deviation)

Question 29

What is the valuation method driven by?

Answer 29

Structures that determine the characteristics of alternative investments.

Question 30

3 other issues help form the complex differentiation between alternative and traditional investments?

Answer 30

1. Information Asymmetries: extent to which market participants possess different data and knowledge.
2. Incomplete Markets: insufficient distinct investment opportunities.
3. Innovation

Question 31

Moral hazard:

Answer 31

risk that the behavior of one or more parties will change after entering into contract.

Question 32

Benchmark:

Answer 32

is a performance standard for a portfolio that reflects the preferences of an investor with regard to risk and return.

Question 33

Goals of alternative investing:

Answer 33

1. Active management
2. Absolute and relative returns
3. Arbitrage, Return Enhancers, and Risk Diversifiers

Question 34

Absolute return standard:

Answer 34

means that returns are to be evaluated relative to zero, a fixed rate, or relative to the riskless rate, and therefore independently of performance in equity markets, debt markets, or any other markets.

Question 35

Relative return standard:

Answer 35

returns are to be evaluated relative to a benchmark.