103-4 Alternative Investments & Derivatives Flashcards
Primary motivation for holding alternative investments
Low correlation of returns w/ those of traditional investments
Undeveloped land
A passive investment and produces negative cash flows (in the form of ongoing expenses), while generating no income
Appreciation not recognized until owner disposes of the land in a taxable transaction
Real estate taxes normally tax deductible
Net operating income (NOI)
Used by appraiser to value the the proper/intrinsic value of the property
NOI = Gross rental receipts + nonrental or other items - Vacancy and collection losses - Operating expenses
For most investors, this serves as the benchmark above which the the property is not a prudent investment
Real Estate Limited Partnerships (RELPs)
Popular form of indirect ownership of real estate
Non-publicly traded
1) Syndicator/General Partner
2) Investors/Limited Partners
Real Estate Investment Trusts (REITs)
Serves as a source of long-term financing for real estate projects by investing in real estate, short-term construction loans, and mortgages
A REIT pools capital in a manner similar to an investment company
REIT entity not subject to federal income taxation as long as it distributes 90% of its net annual earnings to shareholders each year
At least 75% of an entity’s gross income must be derived from real estate
1) Equity REITs
2) Mortgage REITs
3) Hybrid REITs
Invest in REITs for portfolio diversification or current income
Real Estate Mortgage Investment Conduits (REMICs)
A self-liquidating, flow-through entity (similar to a partnership) that invests exclusively in real estate mortgages or mortgage-backed securities and terminates when the mortgages that constitute the investment of the REMIC are paid
Typically, a REMIC issues debt securities to investors in the form of publicly traded REMIC bonds
One of most common forms of a REMIC: Collateralized Mortgage Obligation (CMO)
Collateralized Mortgage Obligation (CMO)
Mortgage derivatives created by private investment firms
The cash flows associated w/ the pool of underlying mortgages are divided into repayment periods known as tranches
Tranche A bondholders receive all dividend + interest until completely repaid. Then moves onto the same for Tranche B. Tranche Z bondholders do not receive any interest or principal payments until all other tranches are repaid
Guaranteed investment contracts (GICs)
Similar to certificates of deposit (CDs) but are issued by insurance companies, not commercial banks
Not federally insured
Major purchasers: institutions
Derivatives
Investment vehicles whose value is based on that of another security, such as a listed stock
Option Contract
A 2-party contract that allows the holder the right, but not the obligation, to buy (call) or sell (put) shares of an underlying security at a specified price on or before the expiration date
Option contracts typically issued w/ expiration dates no longer than 9 months
Exception: Long-term Equity Anticipation Securities (LEAPS)
Option contract = 100 shares
Long-term Equity Anticipation Securities (LEAPS)
Options that can have expiration dates extending beyond 2 years
Bullish calls/puts
Buy call
Sell put
Bearish calls/puts
Sell call
Buy put
Intrinsic value of an option
The minimum price at which the option will trade on an exchange
Time value of an option
The amount by which the trading value of an option exceeds its intrinsic value
Example: MNO stock is trading at $80
An MNO $76 call is trading at $5
The intrinsic value of the call option is $4, and the time value is $1
In-the-money option
When its intrinsic value is positive
Out-of-the-money option
When its intrinsic value is zero and the exercise price does not equal the market price of the underlying security
At-the-money option
When the exercise price of the option equals the market price of the underlying stock
Binomial option pricing model
Attempts to estimate the price of a call option
Assumes the price of the option will change in discrete increments (up or down) on the basis of movements in the price of the underlying stock
Black-Scholes Option Valuation Model
Designed to determine the estimated price of a European call option
Assumes the price of the option will change constantly because the market price of the underlying security also changes constantly
Five factors to determine the value:
1) The current underlying stock price of which the option is written
2) The option’s exercise price
3) The time to expiration of the option
4) The risk-free rate of return
5) The volatility (standard deviation) of the security’s returns
Difference between a European and an American option
A European option may be exercised only at the expiration date of the option, i.e. at a single pre-defined point in time. An American option on the other hand may be exercised at any time before the expiration date.
Put-call parity
Based on the premise that the premium of a call option implies a certain fair price for the corresponding put option having the same exercise price and expiration date, and vice versa
Hedging
Considered any transaction involving derivatives (including options) in which the investor attempts to minimize investment risk
Straddle
Options strategy combining the use of a call option and put option with the same exercise price and expiration date
Long straddle - investor thinks stock will be volatile
Short straddle - investor thinks stock will be flat
Protective put
aka portfolio insurance
Because the put will increase in value as the stock portfolio decreases in value, the portfolio is protected and the investor’s loss on the option is limited to the amount of the premium paid for the put
Zero-cost collar
A strategy used to protect a gain in a long position of a stock. Consists of:
1) Long position in the stock
2) Long put option
3) Short call option
zero collar = cashless
Futures Contract
An agreement between 2 parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price
Tax characteristics: at the end of the calendar year, net gains or losses on the contract are treated as 60% long-term and 40% short-term regardless of the actual breakdown of the gain or loss
Tangible Assets
Take the form of either collectibles or, sometimes, precious metals (e.g. gold or silver)
The price of precious metals often moves inversely (i.e., has a negative correlation) w/ the market prices of stocks
Investment in Natural Resources
Includes an investment in oil and gas properties or timber lands
Major advantage: the pass-through of certain tax benefits, such as deductions for depletion or intangible drilling costs
Major disadvantage: the higher degree of risk, particularly if the activity involves exploratory drilling for oil wells
