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CAIA > 6: Structured Finance > Flashcards

6: Structured Finance Flashcards

0
Q

Catastrophe (cat) bonds

A
  • used to transfer risk (ie epidemic)
  • investors receive interest in the bond’s principal and a premium for bearing risk
  • payment only triggered by an event
  • usually rates below investment grade
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1
Q

Over-collaterization

A

Largest loss to the collateral pool before the senior tranche is impaired

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2
Q

CDO-squared

A

CDOs created from the tranches of other CDOs

Increases the amount of highly rated notional that may be issued

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3
Q

Embedded value (EV) or Value in force (VF)

A

Types of ILS transactions used by life insurance companies to monetize future earnings from insurance policies. Insurance company receives a down payment at the outset of the contract’s duration.

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4
Q

2 objectives of EV securitization

A
  • monetize the PV of future earnings from insurance policies
  • insure against possible losses
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5
Q

Regulation Triple-X

A

Requires US life insurers to increase reserves on their policies (against underlying mortality risk) to ensure adequate coverage

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6
Q

Longevity risk

A

Risk that the insured lives longer than expected

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7
Q

Mortality risk

A

Risk that the insured died earlier than expected

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8
Q

Insured perils

A

Damage due to wind, earthquakes and typhoons. Cat bonds can be used

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9
Q

4 types of payment triggers

A
  1. Indemnity based
  2. Modeled loss index
  3. Industry loss index
  4. Parametric index

While insurers using ILS prefer indemnity based triggers, non indemnity triggers are more commonly used

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10
Q

Indemnity based trigger

A
  • Based on the sponsor’s actual losses

- have greatest hedging effectiveness but the lowest transparency

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11
Q

Modeled loss index trigger

A

Based on losses modeled for a specific reference portfolio based on a catastrophic event

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12
Q

Industry loss index trigger

A

Based on an industry loss index. This is determined in the US by information services provider - property claim services. Europe does not have a broadly accepted loss index

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13
Q

Parametric index trigger

A
  • Based on a loss event’s physical characteristics (eg a hurricane’s location and wind speed)
  • least effective hedges but offer the greatest transparency
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14
Q

Basis risk (for non indemnity triggers)

A

There will be a difference between the risk traced by a trigger and the actual risk covered by the portfolio being insured

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15
Q

Solvency 2

A
  • New regulatory framework for insurance industry in Europe.
  • primary goal is to enhance protection of policyholders and provide a level playing field for the insurance industry.
  • similar to Basel 2 for banks
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17
Q

3 pillars of solvency 2

A
  1. Capital adequacy and reserve requirements
  2. Risk management and supervision
  3. Disclosure and transparency
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18
Q

Pass through securitization

A

SPV issues non prioritized claims to pool

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19
Q

What played a role in rise and fall of structured finance market?

A
  1. investors outsourced due diligence
  2. low yields on senior tranches encouraged purchase of toxic junior tranches
  3. ratings agencies made significant mistakes
  4. conflict of interest (issuer pays for rating)
  5. regulators allowed banks to satisfy capital requirements by holding AAA-rated tranches
  6. investment banks acted as both investors and dealers (perverse incentives)
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20
Q

Insurance-linked securities (ILS)

A

protect insurers from unexpected losses

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21
Q

Key advantages of ILS

A
  1. insurers can manage risks more efficiently

2. investors benefit from additional diversification and attractive yields

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22
Q

Motivation for using ILS (sponsor view)

A
  1. Transfer peak risk to capital markets (cat bonds)
  2. Transfer insurance risks and provide financing (EV)
  3. Fund regulatory reserves in excess of that considered economically necessary (XXX)
23
Q

Non-life risk securitization examples

A
  1. Cat bonds
  2. Sidecars
  3. Industry loss warranties
  4. OTC swaps
24
Q

Sidecars

A

share proportionally in insurance risk according to a preset quota
Allows insurer to offer more coverage that it could bear based on it own capital

25
Q

Industry loss warranties

A

capital market financed loss insurance linked to industry loss index

26
Q

ILS correlations

A
  • not correlated to financial assets

- performance is linked to other asset classes via liquidity risk, collateral risk and third-party guarantees

27
Q

Life ILS correlations

A

life insurance products are exposed to non-insurance risk (eg. credit risk), policy lapse risk, and life risk

28
Q

Factors affecting potential ILS growth

A
  1. increasing demand for risk coverage (due to increased wealth, extreme weather, longer life expectancy, more buy side investors)
  2. ILS pricing (investors demand premium for pricing uncertainty)
  3. Lessons from financial crisis (use higher quality collateral and less complex structures
29
Q

Demand drivers for ‘40 Act Alts

A
  1. more understanding of Alts
  2. Using Alts for diversification & downside protection
  3. Need for liquidity, transparency, and more regulation
  4. Cannot access 2/20 products or dislike higher minimum investments
30
Q

Supply drivers for ‘40 Act Alts

A
  1. Perceived improved quality
  2. Regulation not additional burden
  3. New revenue source
31
Q

Players/Functions Needed for ‘40 Act Funds

A
  1. Investment manager - fund advisor to fund
  2. Product sponsor - product setup & compliance
  3. Distributor (needs experience with retail investors)
32
Q

Series trust, for 40 Act HFs

A
  • setup can be outsourced
  • Pros: lower costs, operational complexity, time to market
  • Con: lack of customization; (operates for several funds)
33
Q

Stand-alone trust, for 40 Act HFs

A
  • sponsor establishes the fund (set up board etc.)
  • Pro: greater flexibility/customization; cost disadvantage relative to series trust disappears over time
  • Cons: more upfront costs and complexity; longer time to market
34
Q

Main Players in ‘40 Act Market

A
  1. HFs (sub-advise; sponsor/distribute own product)
  2. FoHFs (sponsor/distribute; team up with distribution partner)
  3. Asset managers (manage product in-house; team up with HF sub adviser)
35
Q

Reasons for launching ‘40 Act Products

A
  1. Growth and diversification (e.g. access to retail investors, consistent revenue)
  2. Higher earnings multiples
  3. First mover advantage
36
Q

Risks of Launching ‘40 Act Products

A

(mitigating factors in parentheses)
1. Poor performance
(manage expenses)
2. Cannibalization
(differentiate product from existing HFs)
3. Investment team compensation/distractions
(pay managers for specific assets, manage product pari passu with HF)
4. Conflicts of interest
(write rules on allocation between HF and ‘40 products)
5. Risk of re-regulation
(no mitigation)

37
Q

Value proposition for alts

A
  • Pre mid 2000s: alts were return enhancers
  • After: HFs are volatility reducers/capital preservers –> value of alts is now enhanced risk-adjusted returns and improved diversification
38
Q

Alternative MFs: Regulator Risks

A
  1. regulatory changes
  2. liquidity (must pay redemptions within 7 days; may breach 15% illiquidity threshold if assets become illiquid)
  3. multi manager solution (most do not have operations & infrastructure to manage multi manager funds)
39
Q

Alternative MFs: Investment Risks

A
  1. performance dispersion (may not benefit if weak manager is selected - even with good strategy)
  2. style drift (monitoring is challenging due to complexity & opacity of alt MFs
  3. asset constraints (some firms do not apply capacity constraints - so returns decline)
40
Q

Structured finace, CDOs and risk

A

SF creates “safe” assets from risky assets via pooling and tranching. a large number of credit sensitive assets are pooled via an SPV.

Claims on the pool are sold in tranches with prioritized claims. The senior tranche is the last to incur losses and has a lower likelihood of suffering losses than the average loan in the collateral pool. The senior tranche pays a fixed amount or it totally defaults, it resembles a “digital call option”.

The senior tranche of a CDO should have a higher required return than a similar senior corporate bond, due to the tranche’s systematic exposure. Thru diversification, the senior tranche has no exposure to idiosyncratic risk and instead has exposure to systematic risk, which it experiences in the worst economic states, when investors are most averse to default.

41
Q

Solvency II

A

new reg framework for European insurance industry, 3 pillars:

  1. Capital adequacy
  2. Risk Management
  3. Disclosure/transperancy
42
Q

40 Act HF’s regulatory items

Leverage, Shorting, Liquidity, Diversification, Transparency and Investment Mandate

A
  1. Max 1.33 leverage, i.e 300% asset coverage
  2. Only short selling with assets segregated to cover short positions
  3. NAVs struck daily, daily redemption
  4. Max of 5% of fund invested in one issuer’s securities, so, at least 50% of the fund must be diversified
  5. File reports with SEC
  6. Cannot change investment mandate without shareholder approval
43
Q

Risks of ‘40 products (4)

A

Poor performance
Cannibalization risk
Compensation/distraction of the investment managers
Conflicts of interest (with 2/20 hedge fund products)
Re-regulation risk

44
Q

Series Trust (part 2)

A

A series trust outsources the fund sponsorship to a third party with the required infrastructure, vendors, and board of directors.

Advantages of this structure (vs. a stand-alone trust):

  • less expensive, labor-intensive, and time-consuming;
  • shorter time-to-market;
  • no manager compliance liability (assumed by third party);
  • no mutual fund expertise needed.
45
Q

Regulatory risk of alternative strategy mutual funds

A
  1. Regulatory constraints: esp related to illiquidity and leverage, regulation is always changing
  2. Liquidity: 15% of a MF can be invested in illiquid assets and during crisis the 15% threshold can be easily breached
  3. Multi-managers need to be looked at more deeply with an eye on operational and infrastructure capabilities
46
Q

Investment risk of alternative strategy mutual funds

A
  1. Performance Dispersion: given wide performance gap between top-tier and bottom-tier managers
  2. Style Drift: tough given opacity of alternative strategies
  3. Asset constraints given market size/nature and inherent limitations of trading complexities, esp for emerging markets
47
Q

Operational consideration of alternative strategy mutual funds

A
  1. Tax considerations: high turnover leads to lower tax efficiency
  2. Transparency: understanding filings is not easy, esp given derivative holdings
  3. Fee hurdle: alt products demand premium due to higher costs but we know that traditional MFs have undergone fee compression
48
Q

‘40 Act Funds regulatory requirements

A
  1. Redemptions must be paid within 7 days.
  2. At most 15% of assets invested in illiquid securities.
  3. No performance fees (unless use fulcrum fee: varies based on performance).
  4. For at least 75% of diversified MFs: max. 5% invested with one issuer, max. 10% invested in an issuer’s outstanding voting securities, and max. 25% invested in a given industry.
  5. At most 10% of income may be generated from non-securities (e.g., commodity futures).
  6. Leverage limited to 33% (i.e., need 300% asset coverage).
49
Q

Evolution of value proposition for alternative investments

A

Until mid-2000s, alternative investments were return enhancers.
Since then, hedge funds became volatility dampeners and capital preservers (as institutional investors allocated more to alternatives), and the value of alternatives became enhanced risk-adjusted returns and improved diversification.

50
Q

Trend of expense ratios in the financial services industry over the past decade?

A

Expense ratios of both alternative mutual funds and traditional portfolios have decreased.

However, compared to traditional portfolios, expense ratios of alternative mutual funds are higher (due to the complexity premium).

51
Q

Most adoptable alternative strategy in the mutual fund structure

A

long/short equity; other adoptable strategies are long/short credit (e.g. managed futures and global macro); these strategies trade in liquid assets, thus can meet the daily requirements of alternative mutual funds.

Sidey: Strategies that need significant leverage and/or use illiquid assets are less adoptable into the MF structure.

52
Q

Key challenges of HFs associated with distributing ‘40 Act Funds

A
  1. Inexperience of HF marketing teams with retail investors
  2. significant resources needed to distribute to retail investors (large numbers/diverse geographic locations)
  3. not being able to easily leverage their brand due to their being relatively unknown in retail markets
53
Q

Reasons DC pension plans have shown little interest in ‘40 Act Alternatives

A
  1. fee sensitivity (large users of passive index products)

2. conservative attitude (advisors to DC plans are conservative investors)

54
Q

Alternative investment strategies used by limited partnerships and mutual funds

A

Multi-strategy
Long/short equity
Event driven (e.g., merger arbitrage)
Market neutral/relative value
Diversified credit (e.g., distressed debt)
Trading strategies (e.g., global macro and managed futures)

CAIA (9 decks)

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