Chapter 5: Special asset classes (2)

Question 1

Asset-backed securities

Answer 1

Resulting securities issued from a securitisation. Pay coupons based on the cashflows generated by the securitised assets.

Question 2

Securitisation

Answer 2

The 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. A way for a company to raise finance

Question 3

Classes of asset backed securities (ABSs)

Answer 3

• residential and commercial mortgage-backed securities (MBS)
• credit card receivables (CCABS)
• collateralised loan, bond and debt obligations (CLO, CBO and CDOs)
• insurance securitisations

Question 4

SPV

Answer 4

A subsidiary created by a company to isolate financial risk. Bankrupty remote with regard to the orignal company.

Question 5

Structure of asset-backed securities

Answer 5

Cashflows from the portfolio are normally made in multi-tranche format involving several differently ranking levels of debt, e.e. senior, mezzanine and equity. This is done to appeal to the various risk/return preferences of different investors, thereby reducing the overall cost of capital.

Question 6

Private equity

Answer 6

Private equity is the provision of equity capital where there is no immediate exit route via the secondary market, i.e. investment in unquoted securities

Question 7

Forms of private equity

Answer 7

• Venture capital
• Leveraged buy-outs (Management buy-outs and buy-ins)
• Development capital
• Restructuring capital

Question 8

Venture capital

Answer 8

Capital for businesses in the conceptual stage or where products aren’t developed and revenues and/or profits may not have been achieved.

Question 9

Leveraged buy-outs

Answer 9

Equity capital for acquisition or refinancing of a larger company.

• Management buy-outs - existing management buy-out the owners of the company
• Management buy-ins - when the buyer is an external management team

Question 10

Development capital

Answer 10

Growth or expansion working capital for mature businesses in need of product extension and/or market expansion

Question 11

Restructuring capital

Answer 11

New equity for financially or operationally distressed companies

Question 12

Private equity funds

Answer 12

Providers of private equity brought together

Question 13

Advantages of private equity

Answer 13

• Out-performs over the long term
• Loosely correlated asset = enhance portfolio performance without materially increasing risk - diversification

Question 14

Disadvantages of private equity to institutional investors

Answer 14

• lack of liquidity and marketability
• variable past performance record and impacted by survisorship bias
• difficulty in valuation
• need for specialist investment advice
• high costs
• lack of reliable information
• regulatory constraints
• high risk

Question 15

When are private equity funds appropriate owners of businesses?

Answer 15

May be appropriate owners of business where:

• the risk profile is unsuitable for public ownership
• the cost of capital may be reduced under private ownership (e.g. by using very high levels of financial gearing
• where valuation is difficult in the public arena for any other reason

Question 16

Hedge fund

Answer 16

Investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments.

Typically have less restriction on:

• borrowing
• short-selling
• use of derivatives

Question 17

Classes of hedge funds

Answer 17

• Global macro funds
• Event-driven funds
• Market-neutral funds
• Multi-strategy funds

Question 18

Global macro funds

Answer 18

These concentrate on economic change around the world and sometimes make extensive use of leverage and derivatives.

Combination of long and short positions that reflect the hedge fund manager’s view on how macroeconomic factors like levels of international asset markets, interest rates and currencies will move.

Question 19

Event-driven funds

Answer 19

Trade securities of companies in reorganisation and/or bankruptcy (‘distressed’ securities) or companies involved in a merger or aquisition (‘risk arbitrage’)

Question 20

Market-neutral funds

Answer 20

Simultaneously enter into long as well as short positions at a market or sector level, while trying to exploit individual security price movements

Designed to be market-neutral (beta or currency)

• long portfolio beta is equal to short portfolio beta
• thus performance of fund is not affected by general market movements
• just focus on stock selection profits by exploiting market inefficiencies.

Question 21

Multi-strategy funds

Answer 21

Invest in a range of investment strategies to provide a level of diversification (of strategy) and helps smooth profits.

• combination of strategies on the same set of assets.

Question 22

Past performance of hedge funds can be affected by 3 types of bias

Answer 22

1. Survivorship bias
2. Selection bias
3. Marking to market bias

Question 23

Survivorship bias

Answer 23

When data doesn’t realistically reflect survivors and failures. When emphasis is on survivors, average returns will be over-estimated.

Question 24

Selection bias

Answer 24

Funds with good history are more likely to apply for inclusion. Backfilling will then cause a significant upward bias.

Question 25

Marking to market bias

Answer 25

Since underlying securities relatively illiquid, funds typically use either the latest reported price or their own estimate of the current market price for valuation. Use of old prices can lead to underestimation of true variances and correlation.

Question 26

Foreign exchange (currency or forex or FX)

Answer 26

When on currency is traded for another

Question 27

Pricing of forward rate contracts

Answer 27

Known as ‘covered interest parity’ (CIP) and involves the spot rate and money market interest rates in the two countries.

F = S x (1+rd)/(1+rf)

NB: F and S should refer to the cost of one unit of the overseas currency in terms of the domestic currency

Question 28

Forward points

Answer 28

Forward points = F - S
= Forward rate - Spot rate

Question 29

Infrustructure

Answer 29

The financing of long-term infrastructure, industrial and public services projects is based upon a non-recourse (or limited recourse) financial structure where project debt and equity used to finance the project is paid back from the cashflow generated by the project.

1. Social - schools, universities, hosipitals, public housing, prisons
2. Economic - highways, water and sewerage facilities, energy distribution, telecommunications networks

Question 30

Commodities

Answer 30

Any product that can be used in commerce, i.e. any goods that are traded.

Question 31

Commodity indices

Answer 31

Indices of commodity prices are produced by major investment banks.
Contracts based on commodity indices allow diversification and avoid danger of having to take delivery of underlying product.

Question 32

Valuing commodity futures

Answer 32

1. Commodities held as investment assets
   Future price = spot price of underlying + cost of carry
2. Commodities held for commercial purposes
   Future price = spot price + cost of carry - convenience yield

Question 33

Cost of carry

Answer 33

Financing cost of holding the underlying plus storage costs.

Question 34

Convenience yield

Answer 34

The positive value to ownership of the physical commodity (e.g. as a protection against future shortages or to be able to take advantage of them and sell them at a higher price)

Question 35

Contango market

Answer 35

When the futures price is higher than the spot price of the commodity.

Question 36

Backwardation

Answer 36

When the convenience yield is higher than the cost of carry = the futures price is less than the spot price

Question 37

Insurance-linked securities (ILS)

Answer 37

Securities whose return depends on the occurence of a specific insurance event, which can be related to non-life (cat bonds) or life risks.

Question 38

Process for creating a catastrophe bond

Answer 38

1. SPV established in tax-efficient jurisdiction.
2. SPV establishes a reinsurance agreement with the company
3. SPV issues bond to investors with default provisions that mirror the terms of the reinsurance agreement
4. Proceeds from bond sale are invested in a segregated collateral account
5. If catastrophe occurs, the assets of the SPV are used to meet the insurer’s losses

Question 39

Structured products

Answer 39

A prepackaged investment strategy in the form of a single investment.

Typically consists of two components:
1. A note - essentially a zero-coupon debt security that provides capital protection
2. Derivative component - provides exposure to one/many underlying assets. Returns from derivative - paid out in form of coupons/added as proceeds at maturity.

Question 40

Interest rate-linked notes

Answer 40

Structured to pay one of two coupons linked to an index rate defined over a specific range and over a reference period:

• higher coupon - indexed rate stays within a certain range during period
• lower coupon or zero - indexed rate is outside that range during the certain period

AKA Range Accrual Notes

Question 41

Equity-linked notes

Answer 41

Investment product that combines a fixed-income investment with additional potential returns that are tied to the performance of equities

Sold to investors who are unable to buy equity options and want to benefit from upside of the equity markets.

Question 42

Index funds

Answer 42

Is an ‘open-ended’ unitised collective investment scheme that attempt to mimic the performance of a particular index. Passive management in action

Question 43

Exchange Traded Funds (ETFs)

Answer 43

Exhibit features that are like investment trusts in some ways and unit trusts in others.

• trade at NAV, and rarely at discount
• quoted on the stock market and can be traded in real time
• generally index tracking funds
• low annual management charges

Question 44

Contracts for Differences (CFDs)

Answer 44

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.

• Allow investors to take long/short positions
• Have no fixed expiry date, standardised contract or contract size.
• Initial and variation margin applies to CFD trading.