Alternative Investments Flashcards
Real Assets
Associated with investments that directly control non financial assets & represent actual rights to consumption. May invest in real estate, timberland, infrastructure & intangible assets.
Hedge Funds
Private investment vehicles subject to minimal regulation & able to pursue unique investment opportunities using derivatives, leverage, short positions, & others.
Commodities
Investments include physical commodity ownership, forward or futures contracts, securities of commodity producers & exchange-traded funds.
Private Equity
Investments include debt & equities securities not publicly traded. May invest in venture capital, leveraged buyouts, mezzanine debt & distressed debt.
Structured Products
Create a specific risk, return, tax or other profile buy segmenting cash flows of traditional investments or linking returns to one or more market values. Ex. collateralized debt obligations & credit derivatives
Alternative Investments
- Real Assets
- Hedge Funds
- Commodities
- Private Equity
- Structured Products
Regulatory structures
Government regulation & taxation
Securities structres
Methods of cash flow securitization & the resulting tradable units
Trading structures
Development & execution of trading strategies utilized by investment managers the resulting performance impact of the strategies
Compensation structures
Arrangements that impact a manager’s fees, exposure to investment’s performance & conflicts of interest with investors.
Institutional structures
Financial institutions and markets that affect the ownership and trading of a particular investment.
Return Characteristics
- Diversifiers b/c low or no correlation with traditional assets
- Illiquid & lumpy b/c immediate transactions occur at lower prices than for an equivalent liquid asset
- Abnormal return distributions b/c infrequent trading, nonlinear payoffs & leverage
Alternative Investing Goals
- Active management
- Absolute & relative return generation
- Arbitrage
- Return enhancement
- Return diverisfication
Absolute Returns
Evaluated against a standard of zero or the risk-free rate
Relative Returns
Evaluated against a risky benchmark return
Buy-side Institutions
Asset managers that focus on acquiring appropriate securities for their investment portfolios
Plan Sponsors
Organizations that fund a health care or retirement plan for qualified members. Manages plan assets to meet obligations & determines membership requirements & plan structure.
Foundations
Nonprofit funds established to support specific charitable activities on a continuing basis while maintaining real value of portfolio assets. Typically have long investment horizons, high-risk tolerance & low liquidity needs.
Endowments
Funds dedicated to providing financial support on an ongoing basis for a specific purpose. Typically have long investment horizons, high-risk tolerance & low liquidity needs.
Family Office/Private Wealth Institutions
Investment firms whose client base consists of high net worth families
Sovereign/Non-federal Wealth Funds
Pools of assets owned by a government & typically managed by central bank. Purpose is to stabilize economy, provide potential resource for future crises & provide future goods & services to citizens.
Alternative Investment Fund
Includes hedge funds, fund of funds, private equity funds & commodity trading advisers. Typically structured as limited partnerships & utilize sophisticated trading strategies. Performance-based fees reward top-performing general partners.
Separately Managed Accont
Portfolio owned by a single investor & managed according to their preferences. No shares are issued b/c single investors owns the entire account.
Sell-Side Institutions
Focus on selling investment research & transaction execution services rather than managing accounts.
Dealer Banks
Underwrite & trade securities & derivatives. Often operate their own hedge funds & private equity funds. Engage in proprietary trading, off-balance sheet financing & over-the-counter derivatives trading. May offer account management services or serve as prime brokers. Large dealer banks have the potential to influence overall health of financial markets.
Retail Brokers
Generate investment research & execute securities traders for customers. Engage in proprietary trading.
Front office responsibilities: client meetings to decide investment strategy.
Middle office: managing risk & linking front & back office communication.
Back office: account maintenance, information technology & clearing/settling all trades.
Outside Service Providers
Provide professional services vital to the formation & continued operation of alternative investment funds.
Prime Brokers
Executes trades on behalf of investment managers, lend securities to short, provide research, provide account statements & other documentation & provide financing. Allow managers to transact with multiple broker dealers & transact in multiple investment types within a single account.
Auditors/Accountants
Review all documentation for accounting issues & provide tax advice to managers creating funds. Audits fund records, provides tax & compensation advice & prepares financial statements once fund is operational.
Attorneys
Provide legal advice regarding optimal fund structure. Maintain regulatory registrations. Prepare documents (private-placement memoranda, offering documents, partnership agreements, subscription agreements & management company operating agreements).
Fund Administrators
Verify operation controls, assets under management & performance figures. May also be key figure with regard to tax issues & audit preparation.
Hedge Fund Infrastructure
Reduce complexity of operating a hedge fund by providing platforms, software & data.
Consultants
Provide portfolio allocation & investment manager selection advice. May also help identify client investment objectives & provide ongoing monitoring of portfolios and managers.
Depositories/Custodians
Hold client assets & provide information services, trade clearance & trade settlement.
Commercial Banks
Assist with capital management & provide loans, lines of credit & external credit enhancement.
Financial Markets
- Primary markets
- Secondary markets
- Third markets
- Fourth markets
- Private markets
Primary Markets
Relate to the sale of new security issues. New equity issues involve initial public offerings & seasoned issues or secondary issues.For traditional securities, an investment bank serves as the underwriter, taking on responsibility for origination, risk bearing & distribution. Role = often an exit strategy for alternative investments. Global primary market securities include American Depository Receipts & Global Depository Receipts.
Secondary Markets
Where securities trade after initial issuance. Provide liquidity and price/value information. This market lowers costs of capital for firms raising external capital in the primary market. Consist of both physical exchanges & over the counter markets.
Securitization
Process of pooling assets & then issuing new securities that derive cash flows from the pool. May be publicly listed or unlisted & vary in terms of liquidity.
Call Markets
Only allow securities to trade at specific times. All trades, bids & asks are declared. One negotiated price is set that clears the market.
Continuous Markets
Allows securities to trade at any time the market is open. Prices are set by the auction process or dealer bid-ask quotes.
Bid-Ask Spread
In secondary markets, dealer banks serve as intermediaries & trade for their own accounts with other dealer banks & brokers/dealers. Generally do not charge commissions on transactions & instead make profit from bid-ask spread.
Third Markets
Over the counter markets where nonmember firms can both make markets in & trade exchange-listed securities without the exchange, reducing transaction costs.
Fourth Markets
Allow private electronic exchange of securities between investors WITHOUT using a broker as intermediary. Members avoid bid-ask spread by submitting orders that are matched to other outstanding orders through CROSSING. Used by institutions that trade very large volumes of securities.
Private Markets
Do not involve exchange trading or over the counter trading. Alternative assets are commonly traded here. Flexible, low cost & fast. Lack transparency & regulation.
Over-the-counter Markets
Terms are not specified by exchange, allowing participants more flexibility to negotiate the mutually agreeable trades.
American Depository Receipts
Claims to foreign stocks in US dollars & traded on US markets.
Global Depository Receipts
Issued outside US in issuer’s home country but usually in US dollars.
Financial Services Authority (FSA)
UK Regulatory Institution - 80% of European HF assets are located in the UK. Must maintain minimum levels of capital and receive periodic reviews.
Swiss Financial Market Supervisory Authority (FINMA)
Switzerland Regulatory Institution - 33% of a Funds of Hedge Funds are located here.
Forms of Taxation
Income tax, real estate tax, wealth tax, estate tax, transaction tax, and foreign investment income tax
What type of locales do hedge funds seek?
Those which offer income tax relief at the corporate level
Ex Post Distributions
Summarize historical or realized values of the random variable. Can be used to approximate ex ante distributions if the distribution has a constant mean and variance and a large number of historical data points available.
Ex Ante Distributions
Summarize possible future values of the random variable.
Normal Distribution
Bell-shaped symmetrical curve. Mean, median, and mode are all equal. The two halves are identical. 69% of data lie within one standard deviation of the mean. 95% of data lie within two standard deviation of the mean.
Compounding
The growth in value realized on a reinvested assets. Recognizes interest earned on reinvested interest.
Continuous Compounding
The continuous reinvestment of interest.
Logarithms
Can be used to calculate continuously compounded rate.
Geometric Mean Return
Facilitated through log returns. = eM - 1
If monthly log returns are normally distributed…
then quarterly log returns are also normally distributed.
Main Causes of Non-Normality
Autocorrelation, illiquidity, and non-linearity
Autocorrelation
Occurs when the return in one period is directly related to the return from the prior period. Will cause more extreme outcomes than predicted by normal distribution.
Illiquidity
Transactions do not take place on a regular basis and require appraisal valuations. Appraisals often exhibit positive autocorrelation that produces non-normal returns.
Shapes of probability distributions
Described by the moments of distribution, including both raw (mean) and central moments (variance, skewness, and kurtosis).
Mean
First raw moment of probability distributions
Variance
Second central moment of probability distributions
Standard Deviation
o, square root of the variance. Often used to measure volatility.
Skewness Statistic
Third central moment of probability distributions. Measures the departure from symmetry.
Positively Skewed Distribution
Tails are elongated to the right. More outliers to the right of the mean.
Negatively Skewed Distribution
Tails are elongated to the left. More outliers to the left of the mean.
Kurtosis Statistic
Standardized fourth moment of probability distributions. Refers to the degree of peakedness and, for normal distribution, equals 3.
Mesokurtic Distribution
Has zero excess kurtosis
Leptokurtic Distribution
Has a peak that extends above a normal distribution and tails that are fatter than those of a normal distribution. Greater percentage of small deviations from the mean and a greater percentage of extremely large deviations from the mean.
Platykurtic Distribution
Has a peak that lies beneath a normal distribution. Smaller percentage of small deviations from the mean.
To find the boundary of a portfolio
Calculate the portfolio mean and variance.
If log returns are uncorrelated over time…
…the variance of a multi-period log-return equals the sum of the inter-period log-return variances.
If the variances of daily log-returns are identical & if returns are independent…
then the T-period log-return variance is simply T times the variance of daily log-return where T is the number of days.
Jarque-Bera Statistic
Used to test data for departures from the normal distribution. Follows a chi-square distribution with 2 degrees of freedom. The hypothesis of normality is rejected if the Jarque-Bera statistic for the sampled data extends the critical value.
Target Semi-Standard Deviation
Differs from volatility risk by focusing solely on returns that fall below a pre-specified target return, T.
Semi-Standard Deviation / Downside Standard Deviation
If T is set equal to the mean return
Tracking Error
Measures the extent to which the investment returns deviate from the benchmark returns over time.
Maximum Drawdown
The worst percent loss experienced from peak to trough over a specified period of time.
Value at Risk (VaR)
Measure of potential loss. Interpreted as the worst possible loss under normal conditions over a specified period for a given confidence level.
Strengths of VaR
Simply to apply, can be applied across segments within a fund or across funds, useful when it makes no sense to examine the worst-case scenario.
Weakness of VaR
Misleading for non-normal distributions.
Conditional VaR (CVaR)
Also known as expected shortfall or expected tail loss. The expected loss given that the portfolio return already lies below the pre-specified worst-case quantile return.
Parametric VaR
Common method of calculating VaR. Assumes returns are normally distributed.
Factor Model VaR
VaR is calculated as a function of variances and covariances of the factors and of the exposures of the security returns to the factors.
Autoregressive Conditional Heteroskedasticity (ARCH) & Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models
Estimate volatility by placing greater weight on more recent data than older data.
The only case in which the portfolio VaR equals the sum of the individual asset VaRs
If the individual asset outcomes are perfectly and positively correlated.
ARCH Models
Used to forecast variances based on recent volatility in prior periods.
GARCH Models
Used to forecast vairances based on recent unexpected returns and past variances. Allows volatility to change based on the past history, even if the price level for the variable has not changed.
3 Primary Components of Asset Pricing Models
- the risk free rate of return, 2. factor risk premiums, 3. factor sensitivities for the asset.
Asset Pricing Models
Can be used to separate risks and returns into diversifiable (idiosyncratic) and non-diversifiable (systematic) components and to quantify the compensation expected to be received for risk.
Ex Ante Asset Pricing Models
Important for developing frameworks to analyze investment performance.
According to Capital Asset Pricing Model,
- The expected return on any asset is solely determined by systematic risk (beta).
- No additional expected return will be earned by bearing-non-systematic or idiosyncratic risk.
Ex Post Asset Pricing Model
After-the-fact historical returns.
Single Factor Asset Pricing Model
Single risk factor model. The Capital Asset Pricing Model is an example.
Systematic Rsiks
Driven by non-diversifiable market factors.
Idiosyncratic risks
Driven by diversifiable investment-specific factors that cfan be offset by combining assets within a portfolio.
