Alternative Instruments

Question 1

Categories of Alternative Investments

Answer 1

• Hedge Funds
• Private Equity
• Real Estate
• Commodities
• Others (e.g., collectibles, patents)

Question 2

Alternative vs. Traditional Investments

Answer 2

• Different types of assets held, structure of investment vehicles
• Higher fees (management, incentive)
• Less liquid
• Less regualted, less transparent
• Different tax treatments

Question 3

Benefits of Alternative Investments

Answer 3

• Potential portolio diversification benefits
  
  • Low correlation with traditional investment returns
  • Higher average returns than traditional investments
• Return measures biased upward, risk measured biased downward
  
  • Survivorship bias
  • Backfill bias

Question 4

Hedge Funds

Answer 4

• Investment companies structured as limited partnerships
• Use leverage, derivatives, short selling
• Limited to qualified investors
  
  • Lockup period: Minimum time before investors can withdraw funds
  • Notice period: Days within which a fund must fulfull a redemption request

Question 5

Hedge Fund Strategies: Event Driven

Answer 5

Event-driven strategies

• Merger arbitrage: Buy shares of firm being acquired, short shares of acquirer
• Distressed/restructuring: Buy if restructuring will increase value
• Activist shareholder: Gain board seat to influence company decisions
• Special situations: Spinoff, asset sales, securitiy issuance or repurchase

Question 6

Hedge Fund Strategies: Relative Value

Answer 6

Relative value strategies

• Covertible argibtrage: Convertible bonds versus underlying stok
• Asset-backed: ABS, MBS
• General fixed income
• Volatility: Trade options based on implied versus expected volatility
• Multi-strategy: Across asset classes

Question 7

Hedge Fund Strategies: Macro / Equity

Answer 7

• Macro strategies: Trade strategies, currencies, commodities based on global economic trends
• Equity hedge fund strategies
  
  • Market neutral: Equals values in long and short positions
  • Fundamental growth: Identiy high-growth companies
  • Fundamental value: Identify undervalued companies
  • Quantitative directional: May have net long or short exposure
  • Short bias: Net short exposure
• Fund of funds: Invest in multiple hedge funds

Question 8

Hedge Fund Valuation Issues

Answer 8

• Should use bid prices for long positions, ask prices for short positions
• Values of non-traded securities estimated with pricing models
• Illiquid securities
  
  • Reduce market price to account for illiquidity based on size of position held
  • Trading NAV is adjusted for illiquidity

Question 9

Hedge Fund Strategies - Problem

Answer 9

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Question 10

Private Equity

Answer 10

• Invest in private companies or take public companies private
• Private equity strategies:
  
  • Leveraged buyout
  • Venture capital
  • Development capital / minority equity / private investment in public equity (PIPE)
  • Distressed investing

Question 11

Leverages Buyouts

Answer 11

• Most common private equity strategy
• Funded by debt
  
  • Bank debt, high yield bonds
  • Mezzanine financing：Subordinated debt, includes warrants or conversion to equity
• Management buyout: Current managers involved in purchase, remain with company
• Management buy-in: Replace managers of acquired company

Question 12

Venture Capital

Answer 12

1. Formative stage
   
   • Angel investing: Business plan, market potential
   • Seed stage: Product development, market research
   • Early stage: Begin production and sales
2. Later stage: Company expansion
3. Mezzanine stage: Prepare for IPO

Question 13

Private Equity Structure and Fees

Answer 13

• Typically structured as limited partnership
• Investors privde committed capital which fund managers draw down to invest in portfolio companies
• Management fees typically 1% to 3% of committed capital
• Incentive fees typically 20% of profits
  
  • Fees paid periodically may exceed 20% over time: Clawback provision requires managers to return excess fees

Question 14

Private Equity Exit Strategies

Answer 14

• Trade sale: Sell portfolio company to competitor
• Secondary sale: Sell portfolio company to other private equity investors
• IPO: Sell portfolio company shares to public
• Recapitalization: Issue portfolio company debt to fund divident payment (to private equity owner)
• Write-off/liquidation: Take loss

Question 15

Private Equity Valuation

Answer 15

• Same techniques used to value publicly traded companies are used to value equity portfolio companies
  
  • Market/comparables approach
  • Discounted cash flow approach
  • Asset-based approach
• Private companies may require different discount rates or price multiples than publicly traded companies

Question 16

Real Estate

Answer 16

1. Residential property
2. Commercial property
3. Mortgages, mortgage-backed securities
4. Real Estate Investment Trusts (REITs)
5. Farmland, timberland

Question 17

Real Estate Valuation

Answer 17

• Comparable sales approach: Recent sales of similar properties
• Income approach
  
  • Present value of future cash flows from property
  • Net operating income/capitalization rate
• Cost approach: Replacement cost, including land and current costs to rebuild

Question 18

REIT Valuation

Answer 18

• Income based: Similar to direct capitalization
  
  • Funds from operations (FFO)
  • Adjusted funds from operations (AFFO)
  • Capitalization rates
• Asset-based: approach to calculating REIT’s NAV: (Market value of total assets - total liabilities) / (Number of REIT shares outstanding)

Question 19

Commodities

Answer 19

1. Commodities exposure most commonly gained through derivatives rather than outright ownershIp
2. Return comes from price changes (no income)
3. Hedge against inflation risk
4. Commodity ETFs: Available to investors who are restricted to equity shares
5. Shares of commodity producers: Less-than-perfect correlation with commodity prices
6. Managed future funds: Active management of commodity investments
7. Individual managed accounts
8. Commodity sector funds

Question 20

.Commodities Valuation

Answer 20

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Question 21

Hedge Fund Fees

Answer 21

1. “2 and 20:” 2% management fee, 20% incentive fee
2. Management fee may be calculated on beginning or ending assets
3. Incentive fee may be net of management fees or independent of management fees
4. Fund of funds typically charge “1 and 10” in addition to fees paid on underlying hedge fund investments
5. Hard hurdle rate: Incentive fees only on gains above hurdle rate
6. Soft hurdle rate: Incentive fees on all gains but only if return exceeds hurdle rate
7. High water mark: Incentive fees only on gains that increase assets abive highest previous value

Question 22

Hedge Fund Fees - Example

Answer 22

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Question 23

Risk Management

Answer 23

1. Standard deviation is not the most appropriate risk measure
   
   • Fat tails, negative skewness
   • Returns smoothed by model or appraisal asset valuation
   • Use vale-at-risk or Sortino ratio
2. Risks from use of deriatives (counterparty, liquidity, operational, financial)
3. Performance depends on manager’s skill
4. Lack of transparency
5. Illiquidity
6. Correlations with traditional investment returns vary over time, may increase during crisis period

Question 24

Risk Management - Problem

Answer 24

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Question 25

Commodities: Spot Prices and Expected Future Prices

Answer 25

• Contango

Future price is above the spot price

• Long hedgers (users of commodity) bid up the price of commodity futures - paying a premium for the hedging benefit from taking long future positions
• Backwardation

Futures price is below the sport price

• Dominant traders in a commodity future are producers hedging exposure to unexpected price declines

Question 26

Commodities: Risk

Answer 26

Risk

• Long exposure to a commodity prie can be achieved through a derivative investment in forwards or futures
• Some physical commodities cannot be effectively purchased and stored long term and for others (e.g. precious metals), derivatives may be more efficient means of gaining long exposure

Question 27

Commodities: Return

Answer 27

Return

The return on a commodity investment includes:

• Collateral yield: the return on the collateral posted to satisfy margin requirments
• Price return: the gain or loss due to changes in the spot price
• Roll yield: the gain or loss reulting from re-establishing positions as contracts expire
• Roll yield is positive if the futures market is in backwardtion and negative if the market is in contango

Question 28

Commodities: Index investing

Answer 28

Commodity Index Investing as an Active Strategy

• A commodity index strategy is considered an active investment because the manager has to decide which maturities to usefor contracts and determin when to roll them over into new constracts
• Active management is also requird to manage portfolio weights to match those of the bechmark index and to determine the best choice of securities to post as collateral and how these should be rolled over as they mature

Question 29

Commodities: Problem

Answer 29

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Question 30

Commodities: Roll Yield - Problem

Answer 30

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