Chapter 4: Specialist Asset Classes 2 Flashcards
Define securitisation and list the main classes of assets that have been securitised in practice
Securitisation
+Issue of securities, usually bonds, service and repaid exclusively out of a defined element of future cashflow owned by issuer
+often used to convert a bundle of highly unmarketable assets into negotiable structure financial instrument
Main classes of assets that have been securitised
+Residential and commerical mortgages (with mortgage-backed securities and coolateralised debt obligations)
+Credit card receivables
+Bank loans(within collateralised loan and debt obligations)
+Corporate bonds (within collaterallised bond and debt obligations)
+Credit derivatives (within collateralised debt obligations)
State the two main risks facing the investor in asset backed seurities
Default risks - risk that cashflows from underlying assets insufficient to cover interest and capital payments on asset backed securities
Prepayment risk - risk that loan repaid earlier than originally anticipated because underlying assets redeemed
Describe the role of the special purpose vehicle in a typical securitisation
+Original owner of assets sells them to special purpose vehicle
+SPV raises funds to purchase assets by issuing securities to investors
+receivables transferred into SPV meet principal and interest liabilities on debt
+SPV may grant security over receivables
+SPV structured to be bankruptcy remote, so that in event of default by SPV, investor has no recourse to assets of the original owner and vice versa
Describe how the asset backed securities are typically structured and explain why the securities are typically structured in this way
Normally issued in multi-tranche format, with different ranking tranches, eg senior, mezzanine and equity
credit ratings and or credit default protection obtained for (at least major tranches)
Tranches repaid in order of rating, with actual timing of amortisation/repayments and any default losses and recoveries
any excess remaining collateralisation return to original asset owner or kept by bond holders
Asset backed securities structured this way so as to package up risks and returns in way that most appeals to different types of investor. This minimises cost of borrowing
Explain why a company might raise money via a complex and expensive securitisation as opposed to a straightforward bond issue
Gives way of crystallising future profits, which can then be invested now to generate greater profits in future
Bankruptcy remote seuritised bonds don’t appear on balance sheet of issuer so gearing is increased
securitised bonds may appeal to investors who want exposure to particular subset of issuer’s assets
muti-tranche format enables default and prepayment risks to be structured in a way that most appeals to range of different investors
securitised bonds may obtain better credit rating than straight bonds secured on general assets of issuer
These factors may enable the issuer to borrow more cheaply than via normal bond issue
Define the term private equity adn describe its two main forms
Private equity
Investment in unquoted companies not listed on stock exchange. Instead shares used and traded privately
No immediate exit route via secondary market
Two main forms
Venture capital - capital for businesses in conceptual stage or where products are not developed and revenues and or profits not achieved
Leveraged buyouts - equity capital for acquisition or refinancing of larger company. Typically this involves buying out shareholders of an existing public company and de-listing it. Acquisition often funded largely by borrowing if buyers have insufficient personal funds
The other two form of leveraged buyouts are management buyout and management buy-ins
Describe 2 other situations where equity finance may be raised privately
Developmental Capital
Where private company requires development capital in order to fund growth or expansion of business in need of product extension and or market expansion
Development capital may be provided en-route to public issue once company sufficiently large and profitable. Can be used to fund organic growth, ie expansion of existing lines of production or new projects in different markets
Restructuring Capital
Where a financially or operationally distressed company requires restructuring capital, in order to carry out restructuring of its finances (liabilities) or assets
What s meant by a private equity fund
Collective investment vehicle that brings together private equity investors
Fund then invests in unlisted investments on behalf of its investors
Unlikely to have quoted price and no easy way to sell investment even in small amounts
Maybe restricted on when how investment may be sold to which investors agree on entry
State three circumstances in which might a company choose to issue shares privately rather than publicly
Cost of capital lower under private ownership
Company too risky for public ownership
Valuation is difficult in public arena perhaps because of lack of information or past history
State with reason the two main potential advantages of private equity investment
Private equity investment may offer
Higher investment returns
+As compensation for high default risk and low marketability
+due to inefficient pricing
+due to highly incentivised management
because returns are +highly leveraged
Low correlation with existing investments (and so be good for diversification) eg becuase private companies operate in new industries
List 6 potential disadvantages of investing in private equity
\+High default risk \+Lack of marketability \+Lack of information \+Difficult to value \+May be constrained by regulation \+High gearing in LBOS
Summarize the life cycle of a typical private equity fund
3 to 6 months fund raising period, prior to launch of fund
Series of further fund raising periods with closing dates of 12 months since start of the fund.
Monies committed in fund raising periods and called on invested in tranches usually 5-10% of commitment amount
All purchases will be made by the end of the investment period (3 years from the closing date)
fund may start to make cash distributions to investors after about 3 years
Fund typically wound up after 8 to 12 years
Define the term hedge fund and explain how they have less restrictions than more regulated vehicles such as mutal funds
A hedge fund can be defined as an investment fund that is to meet high or absolute returns by investing across a number of asset classes of financial instruments
Hedge funds typically have less restrictions on
Borrowing
Short selling
use of derivatives
Than more regulated vehicles such as mutual funds
This allows for investment strategies that differ significantly from the long only non leveraged strategies traditionally followed by investors
List five other features that originally characterised hedge funds
The placing of many aggresive position on different assets
a high level of borrowing given the limited size
of the capital of the funds
compared to the size of the individual investments
a mix of investments for which the price movements would be expected mostly to cancel each other out, except for the positive effect the hedge fund is looking for
A willingness to trade in derivatives, commodities and non - income bearing securities
a higher risk tolerance than other funds
Describe the four main classes of hedge funds
Global macro funds - concentrate on macroeconomic changes around the world
event driven funds - trade either distressed securities or securities of companies involve in mergers and acquisitions (risk arbitrage)
Market neutral funds enter simultaneously into long and short positions, while trying to exploit individual price movements
Multi-strategy funds - a combination of the above
Describe the three biases that influence hedge fund performance data
Survivor ship bias - arises when data doesn’t realistically reflect survivors and failures. Means and average returns overestimated and volatility underestimated
selection bias - arises because funds with good history more likely to apply for inclusion in databases, and may reflect back filling of good past performance. Means average returns overestimated and volatility underestimated
Marking to market bias - since underlying securities may be relatively illiquid, funds typically use either latest report price or own estimate of current market price for valuation. Use of stale prices can lead to underestimation of true variances and correlation
Explain why claims of hedge fund superior performance can be questioned
Claims of hedge fund superior performance can be questioned since return distribution are far from normal - many of them tend to be negatively skewed
As a result, standard measures of performances such as a portfolio’s alpha (excess return that cannot be explained by the fund’s beta) and its Sharpe Ratio will be biased upwards
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Outline the typical level and structure of a hedge fund’s management fees
Most hedge funds charge fixed annual fee of 1 - 2%, plus incentive fee of 15% - 25% of annual return over some benchmark
Funds of hedge funds charge similar fees and, although they generally obtain rebates from managers they invest in, extra layer of fees puts substantial pressure on funds of funds performance
List 2 potential advantages and five potential disadvantages of investing in hedge funds
Advantages of investing in hedge funds
Possibility of high returns
Low correlation with other investments
Potential disadvantages of investing hedge funds
\+High levels of fees \+lock-in and or notice periods \+limited regulation means lack of protection \+lack of information/transparency \+maximum/minimum investment size
Give four headings under which the key features of hedge funds can be summarised
Management
Operations
Past performance
Strategies
Explain what is meant by the FX market and outline the 2 types of transaction in this market
The FX market exists whenever once currency is traded for another.
It is by far the largest market in the world, in terms of cash value traded, with trillions of dollars changing hands daily between large banks, central banks, currency speculators, multinational corporations, governments and other financial markets and institutions
Currency transactions are either spot transactions of forward transactions.
Spot FX deals are delivered in 2 working day’s time, with settlement actually taking place in the 2 separate countries
Forward transactions involve agreeing the guaranteed price today at which the buyer will take delivery of the currency on a specific future date
Explain infrastructure in the context of investment and give examples of the 2 main forms
The financing of long term infrastructure where project debt and equity used to finance the project is paid back from the cash flow generated by the project.
It tends to be separated into 2 broad subsets
Economic
Eg highways, water and sewerage facilities, energy distribution, telecommunication networks
Social
Eg schools & universities, hospitals, public, prisons
Describe the characteristics that infrastructure assets display that distinguish them from more traditional equity or debt investments
Assets tend be single purpose in nature, such as a gas pipeline, toll road or hospital
investor’s participation in the asset is often for a finite period (due to agreement with government)
The initial development involves high upfront capital costs with payback occurring over the asset’s generally lengthy life
tend to be, of exhibit the characteristics of, natural monopolies
tend to be subject to varying degree of government regulation, depending largely on the degree of natural monopoly
Define the term commodity and explain how institutional investors usually invest in commodities
Commodities can be defined as any products that can be used in commerce ie any goods that are traded
The term refers to internationally traded agricultural goods such as coffee, fuels such as oil and raw materials such as copper
Institutional commodity investment in derivatives based on the price of the underlying commodity (rather than direct investment in the goods themselves, such as the purchase of a warehouse full of coffee)
Describe the commodities futures market, giving a formula for the price of a commodity future
Commoedities derivatives are traded on various markets around the world, primarily in the Chicago and London.
Commodity futures are based on the price of the underlying commodities including agricultural produce, energy and metals
commodity futures and forward contracts are used by producers and consumers who wish to reduce the uncertainty in the amount they will pay or receive for the product
Commodity futures are priced as:
Future Price = Spot price + cost of carry - convenience yield
Explain how the specification of a future contract for a commodity differs from that of a futures contract based on an investment index
The specification of a commodity futures contract is considerably more complex than that of a contract for a future based on an investment index. It will be necessary to specify:
\+Contract size \+Delivery dates \+quality of the product \+Method of packaging \+package size \+delivery site \+method of resolving disputes about quality
Discuss the suitability of commodities as an investment class for institutional investors
Advantages
Commodities offer significant real returns that are produced by doing real economic work within the economy
returns accrue to the long only investor without the need for active management in periods of poor returns, commodities have produced higher returns than any other asset class used by institutional investors'
unlike other asset classes, commodities are concerned with short term supply and demand and short term risk
Disadvantages
No strong historical evidence for a real return from commodities
the market are volatile, being driven by a number of factors unrelated to the underlying economic factors that affect institutional liabilities
Explain what insurance linked securities are and why an insurer might find them useful
Insurance linked securities (ILS) - securities whose return depends on the occurrence of a specific insurance event, which can be either related to non- life (eg catastrophe bonds) or life risks
From an insurer’s perspective, ILS offer the ability to transfer risks from its balance sheet to investors in return for payment of a risk premium
Outline the process for creating a catastrophe bonds
The ceding insurance company establishes a special purpose vehicle in a tax efficient jurisdiction
The SPV establishes a reinsurance agreement with the sponsoring insurance company
The SPV issues a note to investors; this note has default provisions that mirror the terms of the reinsurance agreement
The proceeds from the note sale are invested in money market instruments with a segregated collateral account
if no trigger event occur during the risk period, the SPV returns the principal to investors with the final coupon payment,
If trigger events occur, the assets of the SPV are first used to meet the inssurer’s losses, beofre any return of principal (if any)
Explain what is meant by a structured products in the context of investment
A structured product is a pre-packaged investment strategy in the form of a a single investment.
A typical structured product will consist of two components:
A note - essentially a zero coupon debt security that provides capital protection
A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates
Discuss the suitability of structured products as an investment class for institutional investors over direct investment in the underlying derivatives
Advantages
Practical - investors may be unable to invest themselves in the underlying derivatives
legal - designed to satisfy legal or regulatory requirements
tax - tax treatment maybe more favourable
accounting - may be structured to avoid income statement volatility from the underlying derivatives
Disadvantage
Pricing - difficult to assess whether a quoted price is competitive
Costs - distribution costs are generally not explicit and are normally implicit in the quoted price
Explain how index funds, exchanged traded funds and contracts for differences can be used to gain access to traditional asset classes
Index funds - “Open ended” unitised collective investment scheme that attempts to mimic the performance of a particular index. As such, it is passive management in action
Exchange - traded funds (ETF) - the listed investment trust equivalents of (mutual) index funds. An ETF represents shares of ownership of a unit investment trust (UIT) which holds portfolios of stocks, bonds, currencies or commodities.
The investor purchases the shares on a stock exchange in a process identical to the purchase or sale of any other listed stock
Contracts for differences (CFD) - A contract stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at a specific time
Explain why the price of an ETF stays close to its net asset value
The actions of arbitrageurs result in ETF prices that are kept very close to the NAV of the underlying securities
when the ETF price starts to deviate from the underlying net asset value (NAV) of the component stocks, market participants can step in and take profit on the different
List the popular types of CFD
Popular ETFs
SPDRs - which tract the S&P 500 major sectors of this index
iShare which covers broad based US, international, industry sectors, fixed income and commodities
VIPERs - which range from broad based to industry sector as well as international and bond ETFs
PowerSHares including the QQQQ Nasdaq 100 ETF
Popular CFD
Major global indices (Dow Jones, NASDAQ,
