CAIA Book 2 Flashcards
What do advanced versions of the CAPM such as multi beta CAPM capture?
Multi beta CAPM captures risk exposures not explained by the market portfolio
Why are traditional asset pricing models like CAPM not easily applied to commodities?
According to the CAPM risks can be segmented into systematic (market) risk and unsystematic (firm specific) risk. MPT tells us that unsystematic risk can be diversified away so the investor is only compensated for systematic risk in the form of a market risk premium. For commodities it is difficult to differentiate between systematic and unsystematic risk using the CAPM because it’s application is commonly used on a portfolio of financial assets.
Why is the concept of international diversification irrelevant with regards to commodities?
Commodity prices are determined by international supply and demand, making the concept of international diversification irrelevant
How does one gain access to the commodities market via a pure play investment?
Investing in a firm with all or a significant portion of its revenue tied to a specific commodity
Three Advantages of investing in commodities futures markets
Commodity futures are traded on an organized exchange
Delivery of the commodity is not required to close the futures position
Futures contracts can be purchased without paying the full commodity price
Differences between commodity swaps and forward contracts and futures contracts
Swaps and forwards are customized privately negotiated instruments between two parties
Swaps and forward contracts trade OTC
Swaps and forwards trade out of the view of the public
Commodity Linked Notes
Combines a standard interest paying debt instrument with either a commodity futures contract or an option on commodity prices. The bond investor accepts a lower coupon payment on the debt instrument in exchange for receiving the upside potential from commodity prices.
Advantages of investing in Commodity Linked Notes
Investor does not have to worry about rolling futures contracts to maintain long term exposure
Since a commodity linked note is effectively a bond, it can be a means to avoid violating any restrictions an investor may have against investing in commodities
Any tracking error issues with a specific commodity are the responsibility of the note issuer, not the investor
Commodity Exchange Traded Funds
Investment funds that trade over an exchange and seek to replicate the returns on a commodity, a basket of commodities, or an index. An example of an EFT that follows a single commodity is UNG, which replicates the returns on US natural gas.
Futures prices
Futures prices are a function of the current price of an asset today (spot price), and the carrying costs involved with holding the asset until expiration of the futures contract
Under what conditions could a trader make a profit by using a reverse cash and carry arbitrage strategy?
If the price of a futures contract is greater than the price implied by the futures pricing relationship, a trader could make a risk free profit by using a cash and carry arbitrage strategy
Steps in the cash and carry arbitrage strategy when a futures contract is greater than the price implied by the futures pricing relationship
Sell a futures contract at the current futures price
Borrow cash at the risk free rate for the term of the futures contract
Use the borrowed funds to buy the underlying asset at the current spot price
Deliver the underlying asset to settle the futures contract and receive the futures price
Repay the interest and principal on the loan
If the price of a futures contract is lower than the price implied by the futures trading relationship, a trader could make a risk free profit by using the following steps to execute a reverse cash and carry arbitrage strategy.
Buy a futures contract at the current futures price
Sell the underlying asset short at the current spot price
Lend cash received from the short sale at the risk free rate
Collect loan proceeds, plus interest
Use the collected loan proceeds to take delivery of the asset at the futures price and cover the short sale commitment
Interest Rate Parity Theorem
The forward exchange rate measured in domestic currency per unit of foreign currency, must be related to the spot exchange rate and the interest rate differential between the domestic and foreign currency.
The difference in interest rates between two countries determines the difference in the countries’ exchange rates.
Convenience Yield
Reflects a return from holding the physical asset. The convenience yield reduces the cost of ownership for a physical asset the same way receiving a dividend reduces the cost of ownership for a financial asset.
Mispriced arbitrage opportunities in the commodity markets
Overpriced commodity futures can create a cash and carry arbitrage opportunity
Underpriced commodity futures are generally difficult to exploit through reverse cash and carry arbitrage
Normal Backwardation
A price pattern where the futures price is below the expected future spot price and converges so that price from below over time
Contango Market
A price pattern where the futures price is above the expected future spot price and converges to that price from above over time
How are futures contracts commonly used to hedge the risk of loss that commodity producers face
To reduce the risk of declining commodity prices, a firm could sell futures contracts
Backwardated commodity markets
Backwardated commodity markets are based on the relationship between hedgers and speculators. The theory suggests that hedgers will tend to hold more short contracts than long contracts. Since hedgers are risk averse they are willing to accept a lower futures price.
Contango markets
Assumes that hedgers are net long futures contracts rather than net short. A contango market suggests that when hedgers are net long futures contracts, they must pay a premium above the expected future spot price in order to coax speculators to take the corresponding short positions.
Commodity prices should be negatively correlated to the prices of stocks and bonds for the following reasons:
Inflation is positively related to commodities prices but negatively related to the prices of stocks and bonds
The time period for expectations is different for commodity futures (short term), than for stocks and bonds (long term).
The production process can result in a trade off between the cost of capital and the cost of raw materials. When the cost of capital rises, the cost of raw materials falls and vice versa.
What is the impact of rising commodity prices on inflation and short term interest rates?
As the prices of commodities increases, inflation also increases, which will cause short term interest rates to rise. Higher levels of short term interest rates result in higher interest rates on margin deposits and, therefore lower returns to investors in stocks and bonds.
In general, how are the returns on commodities distributed?
Commodities in general have positively skewed distributions as a result of price increases caused by unexpected supply reductions.
Of what impact is an event that decreases the supply of a commodity?
An event that decreases the supply of a commodity that rapidly increases the commodity’s price will decrease stock and bond prices because the cost of production has increased. As an example, a rapid increase in the cost of raw materials will decrease expected returns to stockholders
Characteristics of a desirable commodity index
The index should represent the total return from only long positions (investable)
The index should be unleveraged (no margin purchases)
The index should exclude financial futures because of their linkage to underlying financial assets (linkage means there are no diversification benefits to a portfolio of financial assets).
For commodity indices, define an unleveraged index
The face values of the commodities contracts in an unleveraged index are assumed to be fully collateralized by the purchase of an equal dollar amount of US T-Bills.
What are managed futures accounts
Actively managed portfolios of futures contracts that include long and short positions in financial and commodity futures contracts. MFA ‘s are highly leveraged because of the low initial margins on most futures contracts. They stand in sharp contrast to commodity indices, which are passive investments, unleveraged, and invest only in long commodity futures.
Sources of return for commodity indices
Commodity price changes
Collateral yield
Roll yield
What is a collateral yield and how does it serve as an inflation hedge?
Collateral yield is the interest earned on the US T-bills purchased to collateralise the face amount of the futures index. The collateral yield serves as an inflation hedge as the T-bill is adjusted, in part, based on inflation rate changes.
Roll Yield
The holding period return that results from the commodity futures term structure. With the passage of time, futures prices for a given commodity will approach the spot price and at maturity will converge. The roll yield is thus the change in the futures price less the change in the spot price of the commodity.
Positive Roll Yield
A positive roll yield is earned in a backwardated market. In backwardated markets, futures prices are lower than spot prices. A backwardated market structure implies that investors who are long in the commodity are willing to pay a premium to hedge their price risk in the future by selling their future production today at a discount. Speculators in these markets are receiving a discount on the commodity price for taking on the uncertainty related to the future spot price. As time passes this risk will decline and the discount will decrease.
Negative Roll Yields
A negative roll yield is earned in a contango market. In a contango market, futures prices are higher than spot prices. A contango market structure implies that investors who are short in the commodity are willing to pay a premium to hedge their price risk in the future by buying he commodity in the future at a premium
Characteristics of the Goldman Sachs Commodities Index (GSCI).
Long only tradeable index for physical commodity futures contracts
Index comprised of the shortest maturity contract for each of the 24 physical commodities contracts included in the index.
The weighting methodology of the GSCI
GSCI is a production value weighted using 5 year averages of exogenous economic data to reflect the importance of each component of the global economy. The asset weights of the index are set at the beginning of each year and change throughout the year based on commodity price fluctuations. Commodities with price gains will become a part of the index as the year progresses.
The five groups of real assets represented in the GSCI
Precious metals Industrial metals Livestock Agriculture Energy Energy makes up over 70% of the index
What does the negative skew in the GSCI an indication of?
The distribution of returns for the GSCI is described as being slightly negatively skewed and leptokurtic (fat tails), therefore indicating an exposure to event risk. It is expected that there would be a positive skew reflecting the benefit that supply shocks have on commodity prices. The negative skew found for the GSCI may indicate that it is not a completely passive index.
Components of the DJ AIG Commodity Index, identify the components.
The physical commodities in the DJ-AIGCI are from the following groups: energy, precious metals, industrial metals, grains, livestock, and soft commodities (which include coffee, cotton, and sugar).
For the DJ-AIG Commodity Index, describe the weighting methodology.
The DJ-AIGCI is weighted primarily by the trading volume of the futures contracts and secondarily on production. The index also requires that no group comprise more than 33% of the index and that each commodity must represent at least 2% of the index. Although the index weights are rebalanced each January, the commodity weights in the index vary based on each commodity’s value. Thus the index is momentum based because of its reliance on the liquidity as indicated by the trading volume.
For the DJ-AIG commodity Index, identify the main characteristics of the historical return distributions.
The distributions of returns is described as being slightly negatively skewed and leptokurtic, therefore indicating an exposure to event risk.
Why are TIPS not the best alternative to protect a portfolio against inflation as compared to the use of commodity futures. Explain
The use of commodity futures in a portfolio context provides a better hedge against inflation because their values will actually increase during periods of high inflation.
Why are international stocks not considered an inflationary protection device for a US portfolio of stocks and bonds
Similar to US stocks, international stocks are also negatively correlated with US inflation. This relationship indicates that higher raw materials prices affect foreign securities in the same way as US securities.
Define and explain the Efficient Frontier
The efficient frontier is a graph in risk/return space of the most efficient combinations of risky assets. Each point on the efficient frontier represents the combination of risky assets that produces the highest level of return for a given level of risk for a given return
How can adding a passive commodity index to a portfolio of stocks and bonds change the efficient frontier
Adding a commodity futures index to a portfolio will produce a more efficient portfolio. That is for each level of risk, the portfolio’s returns are higher, and for each level of return, the portfolio’s risk is lower.
Why is it said that global equity markets are more integrated and more correlated?
- Int’l efforts and treaties between countries to coordinate their fiscal and monetary policies
- An increase in multi national companies with operations in numerous countries
- Increases in capital flows between countries
- Greater individual investor access to foreign investors
What are commodity pools?
A collection of investors who combine their funds to invest in the commodity futures market
Public Commodity Pools
Public commodity pools are available to the general public and are required to register with the SEC and file reports with the commodity Futures Trading Commission (CFTC).. Public commodity pools have low initial minimum levels of investment and are considered liquid investments.
Private Commodity Pools
Private Commodity Pools avoid SEC registration requirements by selling to institutional investors and to high net worth individuals
What is the relationship between the CPO & CTA
CPO’s are the general partners in a commodity pool. Both public and private CPO’s typically hire professional money managers called CTA’s to manage the funds in the commodity pool. However in some cases the CPO and CTA are the same entity
What are the standard fees charged by CTA’s and CPO’s?
2% management fee & 20% incentive fee. Mgmt fees can range from 0% to 3% and incentive fees can range from 10% to 35%.
What is meant by a naive passive benchmark to evaluate the skill of a CTA?
To evaluate the skill of a CTA, a naive passive benchmark that uses a trend-following strategy can be employed. In this strategy, if the price of an asset is trending upward, the trend following investor buys the asset. If the asset is trending downward, the investor sells.
List the four distinct terms emcompassed by the term Private Equity
Venture Capital
LBO’s
Mezzanine Financing
Distressed Debt Investing
Define the terms venture capital
Involves equity investments in start-up ventures that are unable to attract capital from more traditional sources
Define the term venture capitalists
VC’s are in the business of financing immature cash flow negative firms. They are willing to take significant risks, and lose their entire investment in several ventures, in the hopes of cashing in on a few highly profitable ventures by taking equity stakes in the firms in which they invest.
What are three factors that contributed to the strong growth of VC investing in the 1990’S
strong US stock market
robust IPO market
low inflation
When viewed over an entire economic life cycle, what is the return on VC’s as compared to the overall stock market
VC returns generally earn between a 5% and 7% return above the overall market when viewed over an entire economic cycle.
What is the generally accepted legal structure of VC’s
Limited Partnership with the venture capitalist as the general partner and the other investors as limited partners
What are the two roles of VC’s in the PE industry
Raising Capital from investors
Investing the capital in start up firms
List and explain the three main categories of VC Covenants
Covenants regarding fund management
Covenants relating to the general partner
Covenants that define allowable investments
What is the fee structure of VC’s
mgmt fees between 1% - 3.5%
incentive fees 20%
What are some of the covenants that VC’s have to combat the issue of VC managers incentive to increase the volatility of the fund
Clawback Provisions granting LP’s to reclaim incentive fees at liquidation if they experienced a loss of capital
An escrow agreement that requires a portion of the VC’s incentive fees to be held in a separate account until all LP’s have earned a profit
A prohibition on the distribution of profit sharing fees to VC’s until all capital is returned to the LP’s ensures that the capital is returned to the LP’s before fees are paid to the VC’s
What are some of the various VC investing vehicles
Limited Partnerships
Limited Liability Companies
Corporate Venture Capital Funds
Venture Capital Fund of Funds
Limited Partnerships
LP’s are not taxed. All income and capital gains flow through to the Limited Partners who pay taxes individually. In the US the IRS helped to facilitate the growth of LP by allowing entities to determine their tax status by simply checking the box on their tax return. The expected life of a LP is generally seven to ten years, but can be extended up to an additional five years. The VC is the general partner and contributes capital along wit the Limited Partnes
Limited Liability Companies
LLC preferred if the VC is dealing with a smaller group of knowledgeable investors. LLC’s typically have more definite rights and privileges, and an LLC format permits the sale of additional shares in the LLC to new investors or shareholders.
Corporate Venture Capital Funds
Formed with a corporation’s excess cash and outside investors are not allowed. The purpose may be to supplement research and development budgets or to gain important insights into new technologies. This can be beneficial to start-ups, since a large company can provide needed technological expertise. Potential problems with these funds include possible conflicting goals between the corporate parent and the VC fund. In addition the longer term time frame of the fund may be at odds with a corporation’s shorter term focus.
Venture capital fund of funds
Instead of investing directly in start up firms, a VC fund of funds invests in other VC funds. This gives investors broad exposure to many different VC firms and strategies. A fund of funds manager permits better access to more popular venture capitalists that have funds which may be closed. There is typically a 0.5-2% management fee.
Stages of VC Financing
Seed Financing Early Stage Mid or Late Stage Rounds Mezzanine Stage Balanced VC Funds
Seed Financing
Firms participating in seed financing are usually smaller as larger VC firms typically do not invest at this stage as it can be very time consuming and risky
Early Stage
Involves testing of later generation prototypes, marketing the product and establishing distribution channels
Mid or Late Stage Rounds
Most VC firms prefer to invest in the mid or late stage financing rounds. Returns are lower, but so is the risk, and there is a more rapid return of capital invested
Mezzanine Stage
Final stage before the VC before the firm is sold through either IPO or private investors. By this stage, the company has matured with respect to the product design, company management, marketing, and distribution.
Balanced VC Funds
Invest in both early and late stage companies
Five Stages of the VC Fund
Fund Raising Investment Sourcing Investment Commitment Investment Management Fund Liquidation
List the five stages of financing a start-up company
Angel Financing Seed Financing Early Stage Financing Mid or Late Stage Rounds Mezzanine Stage
Angel Financing
Financing from family, friends, and wealthy individuals. Financing in the range of $50k - $500k. Less formal documentation in place for investors
Seed Financing
A management team is assembled as well as a business plan. Also includes beta testing of any prototypes. Firms participating in seed financing are usually smaller and only provide $1m - $2m in capital
Early Stage Financing
At this stage a product has successfully made it through beta testing. During this stage, the product moves into alpha testing. Alpha testing is the second stage of testing later generation prototypes by potential customers. The business begins making sales during this stage and attempting to create a market for its product. Financing during this stage is generally $2m+
Mid or late stage rounds
The product has penetrated the market and is established in the marketplace. The business will either be profitable or breaking even at this point. Financing during this stage is in the $5m - $25m and is needed to get the business through the cash crunch
Mezzanine Financing
Final stage of VC before the firm is sold through either the IPO or private investors. The firm has a proven track record. Financing is required to bridge the firm to the point where the firm can be sold. Financing at this stage is generally in the $5m - $25m range and may take the form of convertible debt. In addition to VC, the business may be able to obtain a traditional loan.
What is a leveraged buyout?
A means of taking a public company private by purchasing all of the outstanding stock. LBO’s ate typically financed by using the firms assets and cash flows to secure debt financing.
Management Buyout
When the investor or group of investors is the firm’s current management team, the transaction is referred to as a management buyout.
What is meant by the term merchant banking
The purchase of non financial firms by financial institutions. Many large investment banks have merchant banking divisions, which is a way for financial institutions to participate in the upside of firms they finance
Define EBITDA
A measure of free cash flow from operations available for distribution to debtors and equity owners of the firm
List and explain the three primary sources of funding for LBO’s
senior debt
mezzanine debt
equity
Senior Debt
Provided by commercial banks, finance companies, and insurance companies and represents 40%-60% of LBO transaction value. Senior debt investors expect a return of 400-500 bps above LIBOR and a payback of two to three times EBITDA over a 4-6 year period.
Mezzanine Debt
Provided by mezzanine debt funds, institutional investors, insurance companies, and investment banks and represents 20% - 30% of the LBO transaction value. Mezzanine debt investors expect a total return of 17% - 20% and a payback of one to two times EBITDA over a A 5-7 year period. Returns are boosted through an equity component (stock warrants).
Equity
Provided by the LBO firm taking the target private, the target firm’s management and the equity component (an equity kicker) of mezzanine debt and represents 20% to 40% of the LBO transaction value. Equity investors require a return of 25% to 40% with a 5-7 year investment horizon.
List the five general categories of value creation through LBO’s
LBO's that improve operating efficiency Unlocking the entrepreneurial mindset The overstuffed corporation Buy and build strategies LBO turnaround strategies
What is the purpose of a Material Adverse Clause in a contract
A contract clause between a LBO fund and the firm being acquired. A MAC clause allows the LBO fund to withdraw from the buyout if there is a material change to the company being acquired.
Compare and contrast the structure of LBO funds, VC, and Hedge Funds
An LBO fund has general partner, which typically is the LBO firm itself, but it also has limited partners who are passive investors. Sometimes an advisory board consisting of a small number of limited partners is set up to advise on issues related to acquiring companies, collecting fees, making valuation decisions, and determining dividend payment methods for its acquired companies.
List some of the revenue streams for an LBO
Management Fees Profit Sharing Fees Privatisation Fees Breakup Fees Divestiture Fees
Vintage Year
The year in which the LBO fund was created.
What are some of the risks that are associated with LBO’s
An LBO target company has an established track record with proven products and/or services
Management of the LBO target also has an established track record
The products and or/ services and a profit track record for the LBO target company are already established - the LBO simply unlocks the management so that the operations can be improved.
An IPO exit strategy is much more realistic for an LBO versus a venture capital deal since the LBO target had public stock outstanding previously
What are three types of Agency Costs that are associated with LBO transactions
Costs to align management’s goals with shareholders goals
Cost of monitoring management
Deterioration of Shareholder Value
Define mezzanine debt
A hybrid of debt and equity. This form of private equity is termed mezzanine debt because it falls between senior secured debt and equity in a company’s capital structure
Story Credits
Loans made to a company with a good story, rather than a strong credit history
List the three broad purposes of mezzanine financing
Mezzanine Financing to bridge a gap in time
Mezzanine Financing to bridge a gap in capital structure
Mezzanine Financing to bridge a gap in an LBO
Characteristics of Leveraged Loans
Most senior debt Has first claim on borrowers assets Term of five years Principal is paid in installments No equity kicker Recovery rate in default 60-100%
Characterstics of High Yield Bonds
Contractural and structural subordination
Requires borrower to have a credit rating
Term 7-10 years
Principal is paid as a bullet payment
Recovery Rate in default 40-50%
Characteristics of Mezzanine Debt
Lowest seniority Unsecured debt Term 4-6 years Usually has an equity kicker Recovery rate in default 20-30%
The types of financing typically used in mezzanine financing
Management Buyouts Growth &/or expansion Acquisitions Recapitalisation Real Estate Financing LBO Bridge Financing
Chapter 11 bankruptcy
The debtor firm is reorganised but remains a going concern
Steps in Chapter 11 bankruptcy
- Debtor firm files for chapter 11 of the US Bankruptcy Code
- Bankruptcy court freezes all default notices from lenders
- If the firm has a “pre packaged plan” (i.e. a reorganisation plan approved by the lenders in advance of the filing), the firm will seek bankruptcy court approval upon Chapter 11 filing.
- If not, the debtor firm must creat and file a reorganisation plan within 120 days
- After filing, the debtor firm has 60 days to convince creditors to accept the plan
Steps in Chapter 11 bankruptcy (II)
- If 1/2 of the number and 2/3 of the value of each class of claimants accept the plan, then the firm seeks bankruptcy court approval of the plan
- If the 120 day plus 60 day period lapses without an approved plan, any “party of interest” (the firm’s creditors) may submit a reorganisation plan to the bankruptcy court
8 If the debtor firm accepts the alternative plan, bankruptcy court approval is sought - If the debtor firm rejects the alternative plan, the debtor firm submits a new plan and again begins the negotiation process with creditors, or alternatively, the bankruptcy court can force a “cram down” (the court confirms a reorganisation plan in spite of claimant objections).
Debtor in Possession Financing
When a lender extends additional credit to a debtor to prevent the debtor from ceasing operations.
Two reasons why an lender will grant DIP financing
It allows the borrower to continue operations
DIP loans have first priority in bankruptcy
Chapter 7 Bankruptcy
Will occur if a plan of reorganisation is not accepted by the creditors of the company and the company is forced to liquidate its assets. If this occurs, the company is no longer a going concern, and the assets are liquidated to repay the debtors in order of priority
What is meant by the term “Club Deal”?
A Club Deal occurs when multiple private equity firms work together on the details of a single deal
Advantages of Club Deals
Larger Capital Pool
Investment Restrictions
Pooled Resources
Disadvantages of Club Deals
Lack of opportunity in the marketplace
Lack of defined leadership for the business plan
Weak firms piggybacking on deals
What is a Secondary Buyout
When one private equity firm sells to another private equity firm as an exit strategy
Advantages of a Secondary Private Equity Market
- Greater level of liquidity
- More effective diversification
3 Faster profit realisation
4 Greater access to future PE funds
Disadvantages of a Secondary PE market
- Lack of opportunity in the marketplace
- Incentive fees reduce value for investors
- Reduced return for investors
List some of the deal term advantages of hedge funds over private equity
Hedge funds can receive incentive fees at any time, while PE funds receive incentive fees only after returning capital to investors
Hedge fund incentive fees are based on changes in NAV, while PE fund incentive fees are based on realised profits
Hedge fund incentive fees are collected on a regular basis (i.e. quarterly)
List some of the deal term advantages of hedge funds over private equity (II)
A hedge fund does not need to recoup management fees before paying incentive fees, while a private equity fund does
Hedge funds typically do not have provisions for the clawback of management or incentive fees while a private equity fund does
Hedge funds typically target a return in excess of cash (e.g. LIBOR +5%), while PE firms try to achieve returns of greater than 20%. Having a lower target return allows hedge funds to be more aggressive in the bidding process
What are leveraged loans?
Loans made to borrowers who do not carry an investment grade credit rating.
A leveraged loans typically meets one or more of the following conditions
Borrowers debt carries a non investment grade credit rating, which is defined as a rating lower than BBB
The loan carries a spread greater than 150 bp over LIBOR
The loan is subordinated to other senior secured loans
What are the for major types of PIPE’s
- Registered Common Stock
- Privately Placed Common Stock
- Convertible Preferred Stock or Convertible Debt
- Equity Line of Credit
List the four major reasons a company would be willing to use a PIPE and sell its equity at a discount
Wall Street
What are the three ways we can differentiate commodities from capital assets?
Valuation
The application of asset pricing models
The global structure of commodity markets
