CAIA Book 2 Flashcards

Question

Of what impact is an event that decreases the supply of a commodity?

Answer 1

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

Answer 2

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).

Answer 3

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.

Answer 4

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.

Answer 5

Commodity price changes Collateral yield Roll yield

Answer 6

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.

Answer 7

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.

Answer 8

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.

Answer 9

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

Answer 10

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.

Answer 11

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.

Answer 12

``` Precious metals Industrial metals Livestock Agriculture Energy Energy makes up over 70% of the index ```

Answer 13

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.

Answer 14

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).

Answer 15

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.

Answer 16

The distributions of returns is described as being slightly negatively skewed and leptokurtic, therefore indicating an exposure to event risk.

Answer 17

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.

Answer 18

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.

Answer 19

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

Answer 20

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.

Answer 21

1. Int'l efforts and treaties between countries to coordinate their fiscal and monetary policies 2. An increase in multi national companies with operations in numerous countries 3. Increases in capital flows between countries 4. Greater individual investor access to foreign investors

Answer 22

A collection of investors who combine their funds to invest in the commodity futures market

Answer 23

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.

Answer 24

Private Commodity Pools avoid SEC registration requirements by selling to institutional investors and to high net worth individuals

Answer 25

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

Answer 26

2% management fee & 20% incentive fee. Mgmt fees can range from 0% to 3% and incentive fees can range from 10% to 35%.

Answer 27

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.

Answer 28

Venture Capital LBO's Mezzanine Financing Distressed Debt Investing

Answer 29

Involves equity investments in start-up ventures that are unable to attract capital from more traditional sources

Answer 30

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.

Answer 31

strong US stock market robust IPO market low inflation

Answer 32

VC returns generally earn between a 5% and 7% return above the overall market when viewed over an entire economic cycle.

Answer 33

Limited Partnership with the venture capitalist as the general partner and the other investors as limited partners

Answer 34

Raising Capital from investors | Investing the capital in start up firms

Answer 35

Covenants regarding fund management Covenants relating to the general partner Covenants that define allowable investments

Answer 36

mgmt fees between 1% - 3.5% | incentive fees 20%

Answer 37

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

Answer 38

Limited Partnerships Limited Liability Companies Corporate Venture Capital Funds Venture Capital Fund of Funds

Answer 39

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

Answer 40

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.

Answer 41

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.

Answer 42

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.

Answer 43

``` Seed Financing Early Stage Mid or Late Stage Rounds Mezzanine Stage Balanced VC Funds ```

Answer 44

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

Answer 45

Involves testing of later generation prototypes, marketing the product and establishing distribution channels

Answer 46

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

Answer 47

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.

Answer 48

Invest in both early and late stage companies

Answer 49

``` Fund Raising Investment Sourcing Investment Commitment Investment Management Fund Liquidation ```

Answer 50

``` Angel Financing Seed Financing Early Stage Financing Mid or Late Stage Rounds Mezzanine Stage ```

Answer 51

Financing from family, friends, and wealthy individuals. Financing in the range of $50k - $500k. Less formal documentation in place for investors

Answer 52

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

Answer 53

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+

Answer 54

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

Answer 55

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.

Answer 56

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.

Answer 57

When the investor or group of investors is the firm's current management team, the transaction is referred to as a management buyout.

Answer 58

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

Answer 59

A measure of free cash flow from operations available for distribution to debtors and equity owners of the firm

Answer 60

senior debt mezzanine debt equity

Answer 61

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.

Answer 62

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).

Answer 63

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.

Answer 64

``` LBO's that improve operating efficiency Unlocking the entrepreneurial mindset The overstuffed corporation Buy and build strategies LBO turnaround strategies ```

Answer 65

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.

Answer 66

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.

Answer 67

``` Management Fees Profit Sharing Fees Privatisation Fees Breakup Fees Divestiture Fees ```

Answer 68

The year in which the LBO fund was created.

Answer 69

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

Answer 70

Costs to align management's goals with shareholders goals Cost of monitoring management Deterioration of Shareholder Value

Answer 71

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

Answer 72

Loans made to a company with a good story, rather than a strong credit history

Answer 73

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

Answer 74

``` 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% ```

Answer 75

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%

Answer 76

``` Lowest seniority Unsecured debt Term 4-6 years Usually has an equity kicker Recovery rate in default 20-30% ```

Answer 77

``` Management Buyouts Growth &/or expansion Acquisitions Recapitalisation Real Estate Financing LBO Bridge Financing ```

Answer 78

The debtor firm is reorganised but remains a going concern

Answer 79

1. Debtor firm files for chapter 11 of the US Bankruptcy Code 2. Bankruptcy court freezes all default notices from lenders 3. 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. 4. If not, the debtor firm must creat and file a reorganisation plan within 120 days 5. After filing, the debtor firm has 60 days to convince creditors to accept the plan

Answer 80

6. 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 7. 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 9. 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).

Answer 81

When a lender extends additional credit to a debtor to prevent the debtor from ceasing operations.

Answer 82

It allows the borrower to continue operations | DIP loans have first priority in bankruptcy

Answer 83

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

Answer 84

A Club Deal occurs when multiple private equity firms work together on the details of a single deal

Answer 85

Larger Capital Pool Investment Restrictions Pooled Resources

Answer 86

Lack of opportunity in the marketplace Lack of defined leadership for the business plan Weak firms piggybacking on deals

Answer 87

When one private equity firm sells to another private equity firm as an exit strategy

Answer 88

1. Greater level of liquidity 2. More effective diversification 3 Faster profit realisation 4 Greater access to future PE funds

Answer 89

1. Lack of opportunity in the marketplace 2. Incentive fees reduce value for investors 3. Reduced return for investors

Answer 90

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)

Answer 91

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

Answer 92

Loans made to borrowers who do not carry an investment grade credit rating.

Answer 93

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

Answer 94

1. Registered Common Stock 2. Privately Placed Common Stock 3. Convertible Preferred Stock or Convertible Debt 4. Equity Line of Credit

Answer 95

Wall Street

Answer 96

Valuation The application of asset pricing models The global structure of commodity markets