Chapter 5: Special asset classes (2) Flashcards
Asset-backed securities
Resulting securities issued from a securitisation. Pay coupons based on the cashflows generated by the securitised assets.
Securitisation
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
Classes of asset backed securities (ABSs)
- residential and commercial mortgage-backed securities (MBS)
- credit card receivables (CCABS)
- collateralised loan, bond and debt obligations (CLO, CBO and CDOs)
- insurance securitisations
SPV
A subsidiary created by a company to isolate financial risk. Bankrupty remote with regard to the orignal company.
Structure of asset-backed securities
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.
Private equity
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
Forms of private equity
- Venture capital
- Leveraged buy-outs (Management buy-outs and buy-ins)
- Development capital
- Restructuring capital
Venture capital
Capital for businesses in the conceptual stage or where products aren’t developed and revenues and/or profits may not have been achieved.
Leveraged buy-outs
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
Development capital
Growth or expansion working capital for mature businesses in need of product extension and/or market expansion
Restructuring capital
New equity for financially or operationally distressed companies
Private equity funds
Providers of private equity brought together
Advantages of private equity
- Out-performs over the long term
- Loosely correlated asset = enhance portfolio performance without materially increasing risk - diversification
Disadvantages of private equity to institutional investors
- 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
When are private equity funds appropriate owners of businesses?
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
Hedge fund
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
Classes of hedge funds
- Global macro funds
- Event-driven funds
- Market-neutral funds
- Multi-strategy funds
Global macro funds
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.
Event-driven funds
Trade securities of companies in reorganisation and/or bankruptcy (‘distressed’ securities) or companies involved in a merger or aquisition (‘risk arbitrage’)
Market-neutral funds
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.
Multi-strategy funds
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.
Past performance of hedge funds can be affected by 3 types of bias
- Survivorship bias
- Selection bias
- Marking to market bias
Survivorship bias
When data doesn’t realistically reflect survivors and failures. When emphasis is on survivors, average returns will be over-estimated.
Selection bias
Funds with good history are more likely to apply for inclusion. Backfilling will then cause a significant upward bias.
Marking to market bias
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.
Foreign exchange (currency or forex or FX)
When on currency is traded for another
Pricing of forward rate contracts
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
Forward points
Forward points = F - S
= Forward rate - Spot rate
Infrustructure
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.
- Social - schools, universities, hosipitals, public housing, prisons
- Economic - highways, water and sewerage facilities, energy distribution, telecommunications networks
Commodities
Any product that can be used in commerce, i.e. any goods that are traded.
Commodity indices
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.
Valuing commodity futures
- Commodities held as investment assets
Future price = spot price of underlying + cost of carry - Commodities held for commercial purposes
Future price = spot price + cost of carry - convenience yield
Cost of carry
Financing cost of holding the underlying plus storage costs.
Convenience yield
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)
Contango market
When the futures price is higher than the spot price of the commodity.
Backwardation
When the convenience yield is higher than the cost of carry = the futures price is less than the spot price
Insurance-linked securities (ILS)
Securities whose return depends on the occurence of a specific insurance event, which can be related to non-life (cat bonds) or life risks.
Process for creating a catastrophe bond
- SPV established in tax-efficient jurisdiction.
- SPV establishes a reinsurance agreement with the company
- SPV issues bond to investors with default provisions that mirror the terms of the reinsurance agreement
- Proceeds from bond sale are invested in a segregated collateral account
- If catastrophe occurs, the assets of the SPV are used to meet the insurer’s losses
Structured products
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.
Interest rate-linked notes
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
Equity-linked notes
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.
Index funds
Is an ‘open-ended’ unitised collective investment scheme that attempt to mimic the performance of a particular index. Passive management in action
Exchange Traded Funds (ETFs)
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
Contracts for Differences (CFDs)
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.
