CFA Book 4 Flashcards
alt investments | 6 types
Traditional:
- real estate (including infrastructure funds)
- private equity (including buyout funds)
- commodities Modern:
- hedge funds
- managed futures
- distressed securities
alt investments | 3 roles AI can play in portfolio
- exposure to risk factors and return unavailable with stocks and bonds: real estate, long commodities
- exposure to special strats and manager skill: hedge funds, managed futures
- combo of 1 & 2: PE and distressed securities
alt investments | common features across alt investments
- low liquidity
- good diversification (low corr)
- due diligence costs
- difficult performance evaluation
alt investments | evaluation process
Assess:
- plausibility of market opportunity
- investment process / manager edge
- organization
- people
- investment terms and structure
- service providers
- review documents
- write up review results
alt investments | issues for private wealth clients
- taxes
- suitability (eg. time horizon)
- communication: many investors not sophisticated
- decision risk: emotionally abandoning a strategy at the point of maximum loss
- concentrated positions (rem: large taxable gains)
alt investment | real estate: direct and indirect investment
- direct: direct ownership of real estate; direct management of assets
- indirect: well defined middle group managing assets
alt investment | real estate: indirect investments
- companies that manage and develop real estate
- REITs: publicaly traded like stock, liquid
- CREFs: for wealth investors
- Separately managed accts: similar to CREFs
- Infrastructure funds: buy public infrastructure; stable, low return
alt investment | real estate: pros & cons
pros:
1. low corr w stocks and bonds
2. low volatility
3. inflation hedge
cons:
1. high information and trans costs
2. tax law changes
3. high op costs
4. can’t subdivide invesment
5. each asset has idiosyncratic risk
alt investment | private equity: traits
- aka PE
- ownership interest in non-public company
- limited to the wealthy or institutions
- investment: pref shares, VC, buyout funds
alt investment | private equity: 2 main types
- venture capital: startups
◎ high risk - buyout funds: buy existing public companies from shareholders
◎ middle market buyout fund: buy spin-offs
◎ mega-cap: buy whole pubic companies
◎ infrastructure: buy public infrastructure (roads, airports)
◎ less risk than VC
alt investment | private equity: return / risks
return:
1. restructure mng and ops
2. buy company for less than intrinsic
3. leverage or restructure existing debt
risk:
1. high risk, many failures
2. low liquidity
alt investment | private equity: exit from investment
- IPO
- private placement
- dividend recapitalization: company exchanges equity for debt in cap structure >> investors extract cash from company, retain ownership
alt investments | commodities: direct vs indirect
- direct: direct purchase of commodity or derivatives
- indirect: invest in business associated with commodities
- indirect has shown poor tracking with commodity prices
- most common is direct with derivatives
alt investments | commodities: pros & cons
pros:
1. uncorr with stocks and bonds
2. inflation hedge
3. fairly liquid
• business cycle sensitivity is also trait (???)
alt investments | hedge funds: traits
- funds that pool money to take non-systemic risk
- target absolute return uncorr to mkt
- initially, long-short funds
- unreg
- high fees
- “exploit arbitrage opportunities”
alt investments | hedge funds: 9 types
- equity market neutral
- convertible arbitrage
- fixed-income arbitrage
- distressed securities
- merger arbitragge
- hedged equity
- global macro
- emerging markets
- fund of funds (FOF)
alt investments | managed future funds: traits
- similar to hedge fund: structure, 2/20
- invests only derivatives
- vehicles are private commodity pools, CTAs (SMA’s), public commodity futures funds
- risk: equity > futures fund > bonds
- negative, low corr with equities, positive, low corr w bonds
alt investments | managed future funds vs hedge funds
- only derivatives (MMF) vs any asset, spot and futures (HF)
- macro (MMF) vs micro (HF)
alt investments | managed future funds: strats
- systematic trading strats
◎ trend following rules
◎ contrarian rules (rare) - discretionary
- focus on mkt (eg. financial or currency or diversified)
alt investment | real estate
- residences, commerical, raw land and associated industries
- low liquidity
- high diversification
alt investment | commodity investments
agri products, oil, metals
alt investments | distressed funds
- debt or equity
- hedge fund (more liquid) or PE (less liquid)
alt investments | real estate: benchmarks
• direct: NCREIF index
◎ value weighted
◎ annual appraisal >> downward vol bias
• indirect: NAREIT index
◎ cap-weighted
◎ live, up-to-date
• downward bias in vol, risk
• good diversification vs equity, bonds (REITs somewhat less so)
alt investments | PE: benchmarks
- Cambridge Assoc., Thompson Venture Economics, custom
- few price points >> appraisal >> downward vol bias
- vintage year corr >> comparisons by year
alt investments | commodities: benchmarks
- DJ-UBS Commodity Index, SP Commodity Index
- based on futures
- investible
- weights: world productions, relative worldwide importance
- arithmetic or geometric avging
alt investments | managed futures: benchmarks
• MLMI (mechanical, trend strat), CTA index (peer group mng’ed)
◎ dollar weighted (CTA$) or equal weighted (CTAEQ)
alt investments | distressed funds: benchmarks
- considered a sub-group of hedge funds
- benchmark similar to long-only hedge fund benchmark
alt investments | hedge funds: benchmarks
• hedge funds are very heterogeneous >> varied benchmarks
• benchmark vary by:
◎ selection criteria (AUM, track record length, investment restrictions)
◎ style of fund
◎ weighting
◎ rebalancing rules
◎ investability
• eg.: DJ, SP (both equally weighted and list funds)
alt investments | hedge funds: cons
- past data relevance
- popularity bias
- survivorship bias (big issue)
- stale price bias (small issue)
- backfill or inclusion bias
commodity futures | 4 cash and carry calculation complications
- not storable
- significant storage costs
- seasonal supply/demand price fluctuations
- ability to lease
commodity futures | forward price with lease rate
F = S * e ^ (Rf - LR)T
LR = lease rate
T = term in years
• reduces forward price
• if Rf > LR >> contango; if Rf < LR >> backwardation
commodity futures | forward price with storage costs
• F = S * e ^ (Rf * T) + lambda(0,T)
• if paid continuously and proportional to commodity:
◎ F = S * e ^ (Rf + lambda)T
lambda(0,T) = future value of storage from time 0 to T
futures | general logic
think of:
starting from 0
selling the future forward
borrowing money (and paying interest)
buying and holding the underlying to complete the hedge
commodity futures | forward price with convenience yield
S * e ^ (Rf * T) >= F >= S * e ^ (Rf - c)T
c = convenience yld
• range because c only applies if business reason to own
• if storage costs, then lease rate = convenience yld - storage costs
commodity futures | PV of gold production
PV = sum(X * (Fo,i - Ci) * e (-Rf * ti))
X = oz of gold produced in period i
C = cost of production in period i
• PV = amount produced * price that you can look in with future * discount to PV
commodity futures | commodity spread arbitrage
- buy futures of input, sell futures of output (or vice versa)
- done in ratio of inputs to outputs
- eg.: crush spread, crack spread
futures | basis
basis = F - S
• basis risk: basis may vary over the life of the contract
• larger risk with commodities vs financials
• risk eg. timing, storage, transportation, grade
futures | cross hedging
hedging one asset with a similar but not the same asset
futures | strip hedge vs stack hedge
- strip hedge: buying multiple futures that expire over a period of time to hedge a flow of assets
- when a strip hedge is not possible due to illiquid farther out futures >> stack hedge: buying more near term futures and then rolling them as they come due to hedge the farther out risk
futures | storage costs
appears that storage costs are paid at the end of each period >> one less interest multiplication
risk management | risk reduction
recognizing, reducing, eliminating, avoiding unnecessary risk (as opposed to necessary risk where investment mng’s have information or other advantage
risk management | risk management process
- top mng sets policies and procedures
- identifying risks: financial and non-financial; building investment databases to catalog
- risk tolerance for each type of risk
- measuring current risk
- adjust risk levels:
◎ execute transactions to adjust risk (often derivatives)
◎ ID most appropriate transaction
◎ consider trans cost
◎ exexcute transaction
• always ongoing; adjusting risk and risk models
risk management | risk governance
• part of corp gov system
• centralized vs decentralized
• methodologies
• needed resources
• good system:
◎ transparent
◎ clear accountability
◎ cost efficient
◎ effeective
risk management | centralized vs decentralized
• decentralized risk gov system puts control in the hands of those closest to the risk creation
• centralized (aka enterprise risk management ERM) system:
◎ one central unit
◎ view of risk across entire company
◎ view of cross impact of diff risks
◎ close to senior mng, who are ultimately responsible for risk and risk policy
◎ economies of scale
• data collection/storage must always be centralized to be tech efficient
risk management | back office vs front office
• the risk reporting side (back office) must be independent from the risk taking side (front office)
risk management | traits of effective systems
- identify every risk factor exposure for company
- quantify risk factor
- create firm-wide aggregate of every risk factor (VAR is key)
- ID how each risk factor affects firm-wide risk (advantage of VAR)
- systematically report risk and assign capital and risk to each business unit
- monitor capital and risk limits
risk management | 3 financial risks
- market risk: prices and rates; often largest risk
- credit risk: counter-party/debtor failure to pay; often second largest risk
- liquidity risk: inability to liquidate at current fail value; bid-ask width and avg trading volume are indicators of liquidity
risk managment | 7 + 3 non-financial risks
- operational: eg.: computer or human failure, weather, etc
- settlement risk: one side pays, other defaults; ‘netting’ and ‘continuously linked settlements’ reduce risk
- model risk: problems with a financial or risk model
- sovereign risk: unwillingness to pay (financial is inability to pay)
- regulatory: interpretation of or change in a regulation
- tax, accounting, legal, contract risk: unclear or change in reg or law
- political
RM | sharpe ratio
- measures excess return per until of risk
- SR = (Rp - Rf) / Std Dev(Rp)
- con: assumes normal dist
RM | risk-adjusted return on invested capital
- aka RAROC • Rp / VAR
- % or $
RM | return over maximum drawdown
- aka RoMAD
- RoMAD = avg Rp / max drawdown; taken over multiple time periods (eg. months in year)
- drawdown = within a single time period, highest value - lowest value
- max drawdown = the greatest drawdown over multiple periods
RM | sortino ratio
- sortino = Rp - MAR / downside deviation
- MAR = minimum acceptable return on portfolio
- downside deviation = std dev of returns below MAR
- doesn’t penalize for right tail returns
RM | 4 risk allocation methods for setting capital limits
- nominal position limits
◎ can be subverted using multiple securities with similar risk - VAR based position limits
◎ overestimates because does not consider corr - maximum loss limit
- internal capital requirements and regulatory capital requirements
RM | VAR vs stress tests
VAR does not capture ununsual events that stress tests do
RM | behaviorial conflicts
- portfolio mng’s often face incentives in conflict with the risk preferences of the firm
- align mng incentives to firm risk preferences
RM | insolvency probabililty should be kept between
1 - 2 %
models | models are only as good as their construction and inputs
currency RM | translation risk
- risk associated with exchanging foreign currency back into investor’s domestic currency
- translation p/l = Rd,u - Rl, Rd,u = domestic return Rl = local (foreign) return
- Rl = (Vl,t - Vl,o) / Vl,o, V = investment value
- Rd,u = (St*Vl,t - So*Vl,o) / (So*Vl,o), S = spot at time t
currency RM | total return on foreign investment and futures contract
• Rp = unhedged domestic return of foreign asset + futures return
• Rp = (St*Vl,t - So*Vl,o) / (So*Vl,o) + (Fo*Vl,o - Ft*Vl,o) / So*Vl,o
S = spot
V = value
F = futures price
l = local (foreign) mkt
• principal only hedge
currency RM | hedge the principal
in a foreign investment, hedge the fx exposure on only the principal (the return is unknown)
currency RM | minimum-variance hedge ratio: two components
- two risks: translation (fx), economic(asset corr to fx)
- min-var hedge ratio = Ht + He = 1 + cov(Rl, Rc) / VARrc; Ht = 1, Rl = asset return, Rc = currency return
fx | interest rate parity
F/S = (1 + D) / (1 + F)
currency RM | basis risk
when using futures to hedge a foreign investment, investor is taking on basis risk IF the futures maturity date does not equal the investment termination date
currency RM | trading costs vs matching futures position to currency position
more frequent future hedges >> better matching to currency position, but higher trans costs (why hedge frequently???)
currency RM | hedging multiple currencies
• use cross-hedging for illiquid currencies
• regress domestic returns against major currencies futures returns; find coefficients
◎ can use spot if futures not available
currency RM | futures vs options
- futures: obligation on both buyer/seller
- options: buyer right/seller obligation, but buyer pays premium to seller for right
- different p/l structures
- use options if expect volatility; if low vol, then futures
currency RM | delta hedging of options
- dynamic hedging strat
- delta = chg option price / chg fx rate
- 1/delta = # options / currency unit
currency RM | currency exposure
amount of translation risk required for foreign investment strat
currency RM | increasing exposure to foreign economy without increasing currency exposure
- buy higher beta stocks / longer duration bonds in foreign mkt
- use options/futures little cash outlay (aka indirect currency hedging)
currency RM | 3 currency management approaches
- strategic hedge ratio
◎ follow IPS
◎ single asset mng does everything - currency overlay
◎ follow IPS
◎ separate currency mng - currency as a separate asset allocation
◎ fx is separate asset
◎ currency mng
◎ currency play with absolute return benchmark
currency RM | minimum-variance hedge ratio
- there is a more efficient hedge than 1:1 for translation risk
- asset returns may be corr to fx movement >> change in optimal hedge
- R = a + h * (Rfut), R = unhedged, dom return, h = optimal hedge ratio, Rfut = futures return
currency RM | calc principal hedged return
- calc unhedged dom cash return
- calc futures dom cash return
- divide the sum by the original domestic principal
currency RM | what happens to a protective put hedge as the put delta increases
less puts are needed to hedge the notional
futures & forwards RM | traits
- manage interest rate (bonds) and equity risk (equity)
- zero-sum game; both sides obligated
- good way to hedge risk in which investor does not have expertise (edge)
futures vs forwards
- forwards: tailored, higher default risk (otc)
- futures: standardized, lower default risk (exchange traded)
futures & forwards RM | # contracts to increase/decrease beta in equity portfolio
contracts = (betaT - betaP)/betaF * Vp / (Pf * multiplier)
◎ beta T = target portfolio beta
◎ betaP = current portfolio beta
◎ betaF = futures beta
◎ Vp = portfolio value
◎ Pf = futures price
◎ multiplier = index multiplier (eg. SP = 250)
futures & forwards RM | synthetic cash and synthetic equity
• synthetic cash: turn equity position into cash return by reducing beta to 0
◎ syn cash = long stock - stock index futures
• synthetic equity: turning cash into equity position
◎ = syn equity = long risk free asset + stock index futures
futures & forwards RM | # contracts to equitize cash position
contracts = Tc * (1 + Rf)^t / (Pf * multiplier)
◎ Tc = current T-bill position
◎ Rf = risk free rate
◎ t = time horizon
◎ Pf = futures price
◎ multiplier = index multiplier (eg. SP = 250)
• same as reduce/increase beta w futures formula, but future value of cash and betas are 1 and 0
future & forwards RM | actual cash equitized
Te = # contracts * Pf * multiplier / (1 + Rf)^t
◎ Te = actual amount of equitized cash
◎ # contracts = rounded # contracts
◎ Pf = futures price
◎ multiplier = index multiplier (eg. SP = 250)
futures & forwards RM | equivalent # shares in equitized cash position
shares = # contracts * multiplier / (1 + div yld)^t
• derived from F = S * (1 + Rf)^t - dividends
futures & forwards RM | # contracts to synthesize cash from equity
contracts = - Vp * (1 + Rf)^t / (Pf * multiplier)
◎ Vp = equity position value
◎ Pf = futures price
• assumes betas are all 1 and 0. Otherwise use add (Btarget - Bstock)/Bfutures
the fact that futures are calced with risk free rate doesn’t mean the underlying won’t go up more, but if it does, so will the future. The risk free is just because you have to borrow the money to buy the underlying to create a full hedge (eg. buy stock, sell future). It’s not the expected return on the stock.
futures & forwards RM | # contracts to increase/decrease duration in a bond portfolio
contracts = beta_yld * (MDt - MDp) / MDf * Vp / (Pf * index_multiplier)
◎ MD = modified duration
◎ t,p,f = target, portfolio, futures
◎ Vp = portfolio value
◎ Pf = futures price
futures & forwards RM | beta of a synthetic cash position from bonds
is not 0 (eg. 6 month cash beta = .25)
futures & forwards RM | equity and bond conversion differences
- only difference is beta vs duration
- different risk measures, but same calculation
futures & forwards RM | process of converting equities to bonds and vice versa
• using equity and bond futures
• equity to bonds:
◎ convert beta >> 0
◎ convert duration >> target
• bonds to equity:
◎ convert duration >> 0
◎ convert beta >> target
futures & forwards RM | general process for converting A to B with futures
- convert A >> 0 (ie cash)
- convert 0 (ie add) >> B
• using formula: # contracts = (RiskT - RiskP) / RiskF * Vp / (Pf * index_multiplier)
◎ Risk = beta or duration
◎ T,P,F = target, portfolio, futures
◎ Vp = portfolio value
◎ Pf = futures price
futures & forwards RM | pre-investing
taking a long position in futures to create a long stock or bond position in anticipation of receiving cash (which will complete the synthetic position)
fx risk | 3 types of fx risk
1 transaction exposure: foreign currency cash flow will be received or paid
◎ most common risk to hedge
2. economic exposure: the foreign asset’s local return will be affected by (is corr to) a fx change
3. translation exposure: fx effects on converting foreign financial statements to domestic
fx | long and short a currency
- long: will be receiving a foreign currency >> sell future
- short: will be paying a foreign currency >> buy future
futures & forward RM | fx: effects of hedging foreign markets and currencies
- if foreign mkt is hedged perfectly, then return = for risk free rate
- if foreign currency is hedged perfectly, then return = domestic risk free rate
futures & forwards RM | 2 types of foreign risk hedging
- hedge foreign mkt
- hedge foreign currency
• can do one, both or neither
futures & forwards RM | futures or forwards per investment
- equities, bonds: futures
- interest payments, receipts: forwards (FRAs)
- currency: forwards
- eurodollars are mostly used by dealers and market makers to hedge
options | traits
• buyer
◎ right (not obligated)
◎ upside: large to unlimited; downside: limited to premium
◎ call: long; put: short
• seller
◎ obligated
◎ upside: limited to premium; downside: large to unlimited
◎ call: short; put: long
• zero-sum, asymmetric payoffs
options | profit, payoff and breakeven
profit: • long call = max(0, S-X) - premium
• short call = premium - max(0,S-X)
• long put = max(0,X-S) - premium
• short put = premium - max(0,X-S)
• payoff is the same except does not include the premium
breakeven
• call: S = X + premium
• put: S = X - premium
options | covered call
long a security, short a call
• goal: generate extra income when expectation of little movement
options | protective put
long a security, long a put
• aka portfolio insurance, hedged portfolio
options | contract size
remember to multiply the per unit p/l by the contract size (eg. 100) to get the final dollar amount (if asked for)
options | bull spread
buy low strike options, sell high strike option
• long delta
options | bear spread
sell low strike option, buy high strike option
• short delta
options | long butterfly spread
buy the high and low options (wings), sell 2x middle options (guts)
• long vol
options | long straddle
buy call and put on same strike
• long vol
options | collar
protective put (long put) + covered call (short call)
options | box spread
- bull call spread + bear put spread
- aka long synthetic stock on low strike, short on high strike
- p/l is always risk free rate
- way to lend/borrow money or interest play
- long box price < strike difference (PV < FV)
options | interest rate options inputs
• underlying is LIBOR
• inputs:
◎ strike rate
◎ option maturity (To)
◎ loan maturity(Tl)
◎ notional principal (NP)
• option expires around the time the loan begins
options | interest rate options calc
- calc FV of premium = prem * (1 + R * (To/360)); R = firm’s debt cost, To = days to option maturity
- calc effective principal = NP +/- FVprem; - if call, + if put
- calc interest on loan = NP * (1 + R * (Tl/360); R = firm’s debt cost at loan start, Tl = loan maturity
- calc option payoff
- calc EAR (effect annual rate) = ((NP + interest +/- option payoff) / effective principal) ^ (365/Tl); - if call, + if put
• borrower >> call; lender >> put
options | interest rate cap inputs
- reference rate (LIBOR)
- cap/floor (strike)
- aggrement length
- notional principal
- reset frequency
• only difference with options is reset frequency
options | interest rate cap traits
same as options except:
1. multiple settlements to mirror floating rate bond
2. payment at end of period is based on rate at beginning of period (again to mirror floating rate structure)
• OTC contracts
• premiums based on forward rates
options | delta
delta = chg call price / chg underlying price = % prob of in-the-money
• abs(call) + abs(put) = 1
• long call, short put: 0 to 1
• long put, short call: -1 to 0
• N(d1) is notation for delta
options | delta changes due to:
- stock movement
- time change
- volatility
- other factors
options | gamma
chg delta / chg stock price
options | gamma hedge
when gamma risk is large (near term, at the money), hedge: 2 options + underlying
swaps | purpose
swaps are used to change a floating rate cash flow to a fixed rate or vice versa
swaps | reference rate
LIBOR
swaps | payments
payments usually netted as long as both cash flows are the same currency
options and swaps | interest rate calculations
when calcing the payoff use the actual number of days to discount the rate
swaps | net payment for fixed payer
net pay = NP * (swap fixed rate +/- loan spread) * (D / 360)
• assumes same reference rate on loan and swap
swaps | net payment for floating payer
net pay = NP * (loan rate - swap rate + LIBOR) * (D / 360)
swaps | floating rate loans aka
floating rate notes (FRNs)
swaps | duration
- float has close to zero duration, fixed has a larger duration
- fixed payer >> fixed liability >> D decreases
- float payer >> fixed asset >> D increases
swaps | duration calculation
- Dswap = Dasset(receive) - Dliability(pay)
- D pay float = D fixed - D float > 0
- D pay fixed = D float - D fixed < 0
swaps | duration of a floating loan (FRN)
assumed to be 1/2 duration of reset period (eg. .25 for 6 month reset)
swaps | cash flow risk vs market value risk
- cash flow risk is associated with paying floating
- market value risk is associated with paying fixed
- firm can use a swap to offset one, but will increase the other
- market value loss may not be ‘realized’ but is a real change in value
swaps | changeing portfolio duration: calculating notional principle
- Vp * Dt = Vp * Dp + NP * Ds
- NP = Vp * (Dt - Dp) / Ds
- Vp = original portfolio value
- NP = notional principal
- D = duration
swaps | currency vs non-currency swap
- two notional principals in diff currencies that are exchanged on the effective date and returned on the maturity date
- the payments are in two diff currencies and so are not netted
swaps | plain vanilla currency swap
float CF is in dollars and fixed is in another currency
swaps | exp of fx swap purpose: lower fx borrowing costs
- companies from diff countries need to borrow in the other’s currency
- they both borrow in their own currency at lower rates that the foreign company could
- they swap these principals
- each gets to borrow at a lower rate
swaps | exp of fx swap purpose: function as a forward
• company wants to exchange foreign currency into dom
• no exchange of NP
• calc steps:
◎ foreign CF / foreign interest rate = NPfor
◎ NPfor * f/x rate (dom/for) = NPdom
◎ NPdom * dom interest rate = dom CF
◎ swap: company receives dom CF, pays foreign CF
swaps | equity swaps
- at least one side pays a return on an equity basket
- the other side may be anything: equity, bond or fixed payment
swaps | equity swaps purpose: diversify
exchange exposure:
◎ domestic for int’l
◎ concentrated equity/bond for index equity/bond
◎ equity for bonds
◎ one bond or equity mix for a diff bond or equity mix
swaps | swaption
the right to enter a swap contract
• terms are established at the outset of the swaption
swaps | swaption side
- payer swaption = pay fixed
- receiver swaption = receive fixed
- if rates go up >> payer increases in value, receiver decreases
- if rates decrease >> payer decreases, receiver increases
swaps | swaption + future CF timing
when hedging rates on a loan or some stream of CF, a swaption expires around the time that the loan begins
swaps | swaption to reverse a swap timing
- the swaption starts the same time or after the swap position and expires before or with the swap
- it can be exercised to cancel the existing swap
swaps | SFR
swap fixed rate = fixed rate in the swap contract
swaps | receiving fixed is like what in terms of duration
- removing duration risk
- remember: floating has almost no duration and the fixed side provides negative duration
swaps | swaptions and callable bonds
swaptions can be used by a borrower to add or remove callability from a bond
• receive fixed to add callability, pay fixed to remove
swaps | which side to take
- asset: pay whatever you are currently receiving
- liability: receive whatever you are currently paying
