Ch 4 - Specialist Asset Classes (2) Flashcards
Securitisation
Issue of securities, usually bonds, where the bonds are serviced and repaid exclusively out of a defined element of future cashflow owned by the issuer
Therefore converts a portfolio of often unmarketable assets into a structured financial instrument which is then negotiable
The key requirement for an asset to be used as the basis of a securitisation is that it generates a reasonably predictable income stream
The bondholders have no claim on any other cashflows or assets of the issuer (due to SPV)
Classes of Securitised Assets:
MBS CCABS CLS CLO CDO Insurance securitisations
Risks with securitisation
Prepayment risk
Credit risk
SPV
Original owner of the assets sells those assets that are to be the basis of the securitisation to a corporate entity called a SPV
SPV raises funds to purchase the assets by issuing debt securities (ABS) to investors
The cashflows received on the secured assets (the receivables) are transferred into the SPV and used to meet the principle and interest payments on the debt
SPV is a separate legal entity – usually a company in its own right
SPV structured to be “bankruptcy remote” in the vent of the failure of the borrower (or in event of default of SPV)
Structure of CLOs, CBOs and CDOs + 2 advantages
Pool of securitised assets are used to back several different tranches of ABS
Cashflows from the portfolio are divided up into tranches and assigned to the different new securities created
Thus the cashflows from the underlying portfolio might be used to create:
- Bond with a fixed coupon. Most senior security and its coupons are paid first. It is termed senior debt and might carry a AAA rating
- Bond whose coupons are paid as long as there is enough left after the payments to the senior debt is made. BB rating. Known as the mezzanine piece or tranche
- Claim on the residual cashflows.
Thus new securities have different credit risk features by construction and appeal to a wider range of investors
This could thus reduce the overall cost of borrowing
Private Equity
Is investment in unquoted companies that are not listed on a stock exchange (thus, there is no immediate exit route via the secondary market )
Forms of Private Equity
Venture capital Leveraged buy-outs -management buy-outs -management buy-ins Development capital Restructuring capital
Advantages of taking a Public Company into Private Ownership (5)
Fewer regulatory restrictions
Closer relationship with small number of sophisticated investors who may provide management input
Incurs lower costs (less reporting for example)
Lack of a quoted market share price - management takes a longer-term view
Possibly may be able to reduce cost of capital under private ownership
Advantages of Private Equity (as an asset class)
Out-perform
Loosely correlated asset - diversification
Disadvantages of PE to II
VRRIL CEP
Valuation can be difficult Regulatory constraints Risk = high Information = lack of reliable info Liquidity = lack of
Costs = high Expertise = needed Performance = past record is variable and is impacted by survivorship bias
Ways to invest in PE
Directly by purchasing shares in private companies
Pay a private equity firm to invest for you
Invest in a private equity collective vehicle – investment trust
Invest in a fund-of-funds
Cashflows of a PE fund
Prior to the fund launch there will be a 3 to 6-month initial fund raising
Initial/first closing date
Final closing date
Investment period
Typical investment is held for 3-5 years
End of funds life - distribution/extension/etc of fund
Annual fee
Performance bonus/carried interest/carry/profit share
Hedge fund definition
Investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments.
It is a type of collective investment vehicle.
Aren’t restricted to a long-only, non-leveraged investment strategy and thus typically have less restrictions on:
- Borrowing
- Short-selling
- Derivatives
General features of hedge funds (in addition to 3 obvious ones)
FFML RLS
Freedom
Fees for performance
Minimum investment amount = high
Limits on total size of fund
Risk tolerance is higher
Lock-up periods
Strategies are best executed with relatively small amounts
Classes of Hedge Funds
Global tactical asset allocation funds
Event-driven funds
Market-neutral funds
Multi-strategy funds
Global tactical asset allocation funds
Concentrate on economic changes around the world and sometimes make extensive use of leverage and derivatives
Therefore will be a combination of short and long positions that reflect the manager’s views on how macroeconomic factors such as levels of international asset markets, interest rates and currencies will move
Event-driven funds
These trade securities of companies in reorganisation and/or bankruptcy (“distressed” securities)
Or companies involved in merger or acquisition (risk arbitrage)
Market-neutral funds
Designed to be market-neutral (beta or currency)
- long portfolio beta is equal to short portfolio beta
- thus performance of the fund is not affected by general market movements
- just focus on stock selection profits by exploiting market inefficiencies
Multi-strategy funds
Invest in a range of investment strategies to provide a level of diversification and help smooth returns
E.g. Might short-sell equities, invest in more property, whilst simultaneously focusing on event driven strategies for its property portfolio
Past performance of hedge funds can be affected by 3 types of biases:
Survivorship Bias
Selection Bias
Marking to Market Bias
Other problems when looking at past performance (returns) of hedge funds:
Practical problems (lack of data/too short a time period)
Returns that are negatively skewed
- thus sharpe ration (which uses standard deviation) will be biased upwards
2 types of infrastructure
Social
Economic
Characteristics of infrastructure
High development costs (high barrier to entry)
Long lives
Non-recourse (or limited) financial structure
Single purpose in nature (assets)
Natural monopolies (usually)
Private investor’s participation in the asset is often finite
Risks of infrastructure investment can be divided into:
Asset specific risks
- Market/economic risk
- Regulatory and Political Risk
- Operating Risk
Broader risks
- Interest rate risk
- Foreign exchange risk
How to invest in Infrastructure
Be very rich
Invest directly in a company whose sole purpose is an infrastructure project
Invest in a unit trust
Invest in shares of a company that heavily invests in infrastructure
Form a syndicate to fund the investment
Benefits of Commodity Investment (5)
Real returns
Diversification
-counter-cyclical
Level of predictability to returns - returns have been based on real underlying economics
Supply squeeze - should see rising prices in future
Commodities are concerned with short-term supply and demand and short-term risk
Arguments against Commodity investment
No strong historical evidence for a real return from commodities
Markets are volatile
High level of specialist expertise required to trade profitably
Insurance-linked securities
Securities whose return depends on the occurrence of a specific insurance event, which can either be related to non-life (cat bonds) or life risks
Why would the banking and capital markets be prepared to buy a cat bond (or ILS)?
Diversify portfolio
Capital markets may have the capacity to accept the risk
May perceive the return to be adequate compensation for the risk
-but beware! need expertise to understand the underlying risks and structure can be complex
Advantages of transferring risk through an ILS
Available when reinsurance is not Cheaper Effective Tax advantages "Taylormade" solution Can reduce capital requirements Accelerated profit emergence (depends on structure)
A typical structured product will consist of two components:
A Note
+
Derivate component
Advantages of structured products
RAT PAL
Return/risk profile is favourable
Accounting
Tax
Practical (i.e. not allowed to trade derivatives by themselves, and costs may be less through this product)
Active intervention = not required by investor (saves time and costs)
Legal
Risks of structured products
CC TALL
Counterparty risk
Complexity
Tax
Accounting
Legal
Liquidity risk
Index Funds:
Is an ‘open-ended’ unitised collective investment scheme that attempt to mimic the performance of a particular index
Advantages of index funds include (4):
Low expertise
Low dealing costs
Simplicity
No “style drift”
Disadvantages of index funds include:
Tracking error
No outperformance
Reduced return due to index changes
Differences between ETFs and Unit Trusts and Investment Trusts:
Costs (annual fees)
- Lower fund management fees (or annual management fees) than the other two (usually)
- Because they are usually tracker funds, which can be run very cheaply
Costs (commission)
- ETFs incur commissions and stock exchange trading fees, similar to an investment trust
- No bid/offer spreads set by the managing company, as is the case for unit trusts
Tradability
- Traded like shares
- Whereas unit trusts, the manager will generally trade only once a day
Diversification
Contracts For Difference:
Is a contract stipulating that the seller will pay (if negative difference then receive) to the buyer the difference between the current value of an asset and its value at contract time
Risks of CFDs:
Counterparty risk
Market risk
Liquidity risk
