Chapter 3 CAIA Flashcards
Continuous Compounding
Continuous compounding assumes that earnings can be instantaneously reinvested to generate additional earnings.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 45). Wiley. Edición de Kindle.
Discrete Compounding
Discrete compounding includes any compounding interval other than continuous compounding such as daily, monthly, or annual.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 45). Wiley. Edición de Kindle.
Log Returns
A log return is a continuously compounded return that can be formed by taking the natural logarithm of a wealth ratio
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 46). Wiley. Edición de Kindle.
Return Computation Interval
The return computation interval for a particular analysis is the smallest time interval for which returns are calculated, such as daily, monthly, or even annually.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 46). Wiley. Edición de Kindle.
Notional Principal
Notional principal or notional value of a contract is the value of the asset underlying, or used as a reference to, the contract or derivative position.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 48). Wiley. Edición de Kindle.
Return on Notional Principal
The return on notional principal divides economic gain or loss by the notional principal of the contract.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 48). Wiley. Edición de Kindle.
Fully Collateralised
Fully collateralized means that a position (such as a forward contract) is assumed to be paired with a quantity of capital equal in value to the notional principal of the contract.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 49). Wiley. Edición de Kindle.
What are the two components of return for a fully collateralised position
A fully collateralized position has two components of return:
(1) the change in the value of the derivative, and
(2) any return on the collateral.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 49). Wiley. Edición de Kindle.
Partially Collateralised Rates of Return
A partially collateralized position has collateral lower in value than the notional value.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 49). Wiley. Edición de Kindle.
Internal Rate of Return
The internal rate of return (IRR) can be defined as the discount rate that equates the present value of the costs (cash outflows) of an investment with the present value of the benefits (cash inflows) from the investment. Using the terminology and methods of finance, the IRR is the discount rate that makes the net present value (NPV) of an investment equal to zero.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 51). Wiley. Edición de Kindle.
The four types of IRR based on when cash flows are available
Lifetime IRR
Since Inception IRR
Interim IRR
Point to Point IRR
Lifetime IRR
A lifetime IRR contains all of the cash flows, realized or anticipated, occurring over the investment’s entire life, from period 0 to period T. In other words, if in the context of Equation 3.9, time period 0 is the inception of the investment and time period T is the termination of the investment, then the IRR is a lifetime IRR.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 53). Wiley. Edición de Kindle.
Since Inception IRRS
SINCE-INCEPTION IRRS: A since-inception IRR is commonly used as a measure of fund performance rather than the performance of an individual investment. The cash flows that would then be used in Equation 3.9 are aggregate cash flows of a fund rather than a single portfolio company. The terminal (time period T) cash flow in this case is the appraised value of the fund’s portfolio at time T rather than a liquidation cash flow. Interim cash flows represent actual fund-level cash flows from liquidated investments.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 53). Wiley. Edición de Kindle.
Interim IRRS
INTERIM IRRS: The interim IRR is a computation of IRR based on realized cash flows from an investment and its current estimated residual value. The key to an interim IRR is that generally T would not be the termination of the investment; thus, CFT is an estimated value rather than a realized cash flow. The interim IRR can be calculated on an investment purchased subsequent to its inception.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 53). Wiley. Edición de Kindle.
Point to Point IRRS
POINT-TO-POINT IRRS: A point-to-point IRR is a calculation of performance over part of an investment’s life. All cash flows are based on realized or appraised values rather than expected cash flow over the investment’s projected life. Although any IRR is calculated from one point in time to another, a point-to-point IRR would typically not be used to refer to a lifetime IRR.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 53). Wiley. Edición de Kindle.
Complex cash flow pattern
complex cash flow pattern is an investment involving either borrowing or multiple sign changes.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 54). Wiley. Edición de Kindle.
Borrowing type cash flow pattern
A borrowing type cash flow pattern begins with one or more cash inflows and is followed only by cash outflows.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 54). Wiley. Edición de Kindle.
Multiple sign change cash flow pattern
A multiple sign change cash flow pattern is an investment where the cash flows switch over time from inflows to outflows, or from outflows to inflows, more than once.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (pp. 54-55). Wiley. Edición de Kindle.
Scale Differences
Scale differences are when investments have unequal sizes and/or timing of their cash flows. When comparing investments with different scales, an investment with a higher IRR may be inferior to an investment with a lower IRR.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 57). Wiley. Edición de Kindle.
Aggregation of IRRs
Aggregation of IRRs refers to the relationship between the IRRs of individual investments and the IRR of the combined cash flows of the investments.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 57). Wiley. Edición de Kindle.
Reinvestment Rate Assumption
The reinvestment rate assumption refers to the assumption of the rate at which any cash flows not invested in a particular investment or received during the investment’s life can be reinvested during the investment’s lifetime. If the assumed reinvestment rate is the same rate of return as the investment’s IRR, then no ranking problem exists.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 59). Wiley. Edición de Kindle.
Modified IRR
- The modified IRR approach discounts all cash outflows into a present value using a financing rate,
- compounds all cash inflows into a future value using an assumed reinvestment rate, and
- calculates the modified IRR as the discount rate that sets the absolute values of the future value and the present value equal to each other.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 59). Wiley. Edición de Kindle.
Time Weighted Returns
Time-weighted returns are averaged returns that assume that no cash was contributed or withdrawn during the averaging period, meaning after the initial investment.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 59). Wiley. Edición de Kindle.
Dollar Weighted Returns
Dollar-weighted returns are averaged returns that are adjusted for and therefore reflect when cash has been contributed or withdrawn during the averaging period. The IRR is the primary method of computing a dollar-weighted return.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 59). Wiley. Edición de Kindle.
Cash Waterfall
Limited partnerships, including private equity funds and hedge funds, have provisions for the allocation of cash inflows between general partners (GPs) and limited partners (LPs). Provisions related to the distribution waterfall are often the most complex parts of the limited partnership agreement. The waterfall is a provision of the limited partnership agreement that specifies how distributions from a fund will be split and how the payouts will be prioritized. Specifically, the waterfall details what amount must be distributed to the LPs before the fund manager or GPs can take a share from the fund’s profits.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (pp. 60-61). Wiley. Edición de Kindle.
Hurdle Rate
A hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 61). Wiley. Edición de Kindle.
Catch up Provision
A catch-up provision permits the fund manager to receive a large share of profits once the hurdle rate of return has been achieved and passed. A catch-up provision gives the fund manager a chance to earn incentive fees on all profits, not just the profits in excess of the hurdle rate. A catch-up provision contains a catch-up rate, which is the percentage of the profits used to catch up the incentive fee once the hurdle is met. A full catch-up rate is 100%. To be effective, the catch-up rate must exceed the rate of carried interest.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 61). Wiley. Edición de Kindle.
Clawback Clause
A clawback clause, clawback provision, or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses. A clawback provision requires the GP to return cash to the LPs to the extent that the GP has received more than the agreed profit split. A GP clawback option ensures that if a fund experiences strong performance early in its life and weaker performance at the end, the LPs get back any incentive fees until their capital contributions, expenses, and any preferred return promised in the partnership agreement have been paid.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 62). Wiley. Edición de Kindle.
Compensation Scheme
The compensation scheme is the set of provisions and procedures governing management fees, general partner investment in the fund, carried-interest allocations, vesting, and distribution.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 62). Wiley. Edición de Kindle.
Fund as a whole carried interest
Carried interest can be fund-as-a-whole carried interest, which is carried interest based on aggregated profits and losses across all the investments,
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 64). Wiley. Edición de Kindle.
Deal by Deal Carried Interest
Deal-by-deal carried interest is when incentive fees are awarded separately based on the performance of each individual investment.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 64). Wiley. Edición de Kindle.
Hard Hurdle Rate
A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 66). Wiley. Edición de Kindle.
Sequence of Distributions with a hard hurdle rate
Capital is returned to the limited partners until their investment has been repaid. Profits are distributed only to the limited partners until the hurdle rate is reached. Additional profits are split such that the fund manager receives an incentive fee only on the profits in excess of the hurdle rate.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 67). Wiley. Edición de Kindle.
Soft Hurdle Rate
A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 67). Wiley. Edición de Kindle.
Sequence of distribution with a soft hurdle rate
Capital is returned to the limited partners until their investment has been repaid.
Profits are distributed only to the limited partners until the hurdle rate is reached.
Additional profits are split, with a high proportion going to the fund manager until the fund manager receives an incentive fee on all of the profits.
Chambers, Donald R.. Alternative Investments: CAIA Level I (Wiley Finance) (p. 67). Wiley. Edición de Kindle.
What are some of the main challenges in determining rates of return for alternative investments?
A main challenge with the analysis of some alternative investments is the lack of regularly observable market prices. Some alternative investments, such as private equity and private real estate, are analyzed using an internal rate of return approach. This approach has numerous potential complications and shortcomings.
Chambers, Donald R.; Anson, Mark J. P.; Black, Keith H.; Kazemi, Hossein. Alternative Investments: CAIA Level I (Wiley Finance) (p. 50). Wiley. Edición de Kindle.
