Chapter 5: Specialist asset classes (2)

Question 1

i. Characteristics of ABS, securitisation

Define:
1. Asset backed securities
2. Securitisation
3. Main classes of assets that have been securitised in practice

Answer 1

ABS:
- result from the securisation of revenue generating assets held by the borrower.

Securitisation:
- Issue of securities, usually bonds, serviced and repaid exclusively out of a defined element of future cashflow owned by the issuer
- usually to convert a bundle of highly unmarketable assets into a negotiable, structured financial instrument

Main classes:
- residential and commercial mortgages
- credit card receivables
- bank loans
- corporate bonds
- credit derivatives
-(paid royalties to performers)
- (loans on cars and boats)

Question 2

i. Characteristics of ABS, securitisation

State the two risks facing the investor in ABS

Answer 2

1. Default risk - risk that cashflows from underlying assets insufficient to cover interest and capital payments on ABS
2. prepayment risk - risk that loan repaid earlier than originally anticipated because of underlying asset redeemed

Question 3

i. Characteristics of ABS, securitisation

Describe the role of the SPV in a typical securitisation.

Answer 3

• The SPV will be set up by the issuer in a tax-efficient jurisdiction
• SPV structured to be bankruptcy remote, so that in the event of default by SPV, investor has no recourse to assets of original owner and vice versa
• original owner of assets sells them to the SPV
• 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

Question 4

i. Characteristics of ABS, securitisation

Describe how the ABS are typically structured in a securitisation and explain why the securities are typically structured in this way.

Answer 4

• Normally issued in multi-tranche format, with different ranking tranches, e.g., senior, mezzanine and equity
• credit rating and/or credit default protection obtained for (at least) major tranches
• traches repaid in order of rating, with actual timing of amortisation/repayment dependent on underlying assets, early repayments and any defaults losses and recoveries

ABS structured this way so as to package up risks and returns in way that most appeals to different types of investors. This minimises cost of borrowing.

Question 5

i. Characteristics of ABS, securitisation

Describe the three main tranches of bonds that can be issued for ABS.

Answer 5

1. Senior debt
   - bond with fixed coupon rate
   - the most senior security
   - its coupons are paid first
   - it might carry a rating of AAA
2. Mezzanine
   - coupons are paid as long as there is enough left after payments to senior debt has been made
   - might carry a rating of BB
3. Equity claim
   - a claim on the residual cashflows from original pf after the two senior classes are paid
   - this might be a yield speculative bond

Question 6

i. Characteristics of ABS, securitisation

Explain why a company might raise money via a complex and expensive securitisation as opposed to a straight forward bond issue.

Answer 6

• Gives way of crystallising future profits, which could be invested now to generate greater profits in the future.
• Bankruptcy remote securitised bonds do not appear on the BS of issuer - so gearing isn’t increased
• Securitised bonds may appeal to investors who may want exposure to a particular subset of the issuer’s assets
• Multi-tranche format enables default and prepayment risks to be structure in a way that appeals to a range of different investors
• Securitised bonds may obtain better 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.

Question 7

i. Characteristics Private equity

Define private equity and describe two main forms.

Answer 7

Private equity:
- Investment in unquoted companies not listed on stock exchange
- instead, shares are issued and traded privately
- No immediate exit route via secondary market

Main forms
1. Venture capital
-capital in businesses in conceptual stages or where products are not developed and revenue and/or profits not achieved.
- venture capitalist not silent partners, their expertise and advice crucial for success of business
2. Leveraged buy-outs
- equity capital for acquisition or refinancing of larger company.
- Typically involves (management) buying out shareholders of an existing public company and de-listing it and obtaining a controlling interest in the company. Acquistion often funded by borrowing if buyers have insufficient funds.

(leveraged buy-in, where shareholders are bought out by external management - here there is more incentive to make company successful)

Question 8

i. Characteristics Private equity

Discuss why it is advantageous to take a public company into private ownership.

Answer 8

1. fewer regulatory restrictions on its activities, so giving it greater freedom to make profits
2. it may benefit from a closer relationship with a typically smaller number of more sophisticated investors who provide management input
3. it incurs lower costs in complying with less onerous financial reporting requirements
4. lack of quoted market share price may enable management to take longer-term view when making investment decisions

Question 9

i. Characteristics of Private equity

Describe two other situations where equity finance may be raised privately.

Answer 9

1. Where private company requires development capital
   - in order to fund growth or expansion of business in need of product extension and/or market expansion
   - this development capital may be provided en-route to public issue when the company is sufficiently large and profitble
2. ‘restructuring’ capital - Where a financially or operationally distressed company requires restructuring capital in order to carry out restructuring its finances (liabilities) and assets.

Question 10

i. Characteristics of Private equity

Explain what is meant by a private equity fund.

Answer 10

• Collective investment vehicle that brings together private equity investors.
• Fund then invests in unlisted investments on behalf of its investors.
• likely to have no quoted price and no easy way to sell investment, even in small amounts.
• May be restrictions on how and when investment may be sold, to which investor agree on entry.

Question 11

i. Characteristics of Private equity

State three circumstances in which a company may choose to issue shares privately rather than publicly.

Answer 11

1. Cost of capital lower under private ownership
2. company too risky for public ownership
3. valuation is difficult in public arena, perhaps due to lack of information or past history

Question 12

i. Characteristics of Private equity

State, with reasons, the two main potential advantages private equity investment.

Answer 12

1. High investment returns
   - as compensation for high default risk and low marketability
   - due to inefficient pricing
   - due to high incentivized management (e.g., due to own stake)
   - because returns are highly leveraged
2. low correlation with existing investments (and so good diversification) e.g., because private companies operate in new industries

However, the assessment of these claims is complicated by impact of survivorship bias.

Question 13

i. Characteristics of Private equity

List six potential disadvantages of investing private equity.

Answer 13

1. High default risk
2. Low marketability and lack of liquidity
3. lack of information/track record and/or variable past performance record
4. difficult to value
5. may be constrained by regulation, e.g., admissibility regulations
6. high gearing in LBOs
7. higher (transactional) costs
8. Need for specialist investment advice

Question 14

i. Characteristics of Private equity

Options available for investors who want to investment in private equity.

Answer 14

1. Directly purchase shares in private companies
2. pay private equity firm to invest your capital for you
3. invest in a private equity collective vehicle, e.g., investment trust
4. invest in fund of funds - which invests in a range of private equity finds (double layer of fees)

Question 15

i. Characteristics of Private equity

Summarise the life cycle of a typical private equity fund

Answer 15

Fundraising;
- first close within 3 to 6 months
- manager can call on investors to hand over cash to invest and earn fees
- further fund raising (typical 12 months after marketing start)

Investment period:
- Lasts 3 years after final closing.
- All investments are made during this period.

Holding and distribution:
- Investments held for 3-5 years.
- Distributions to investors may start within 3 years.
- Investors may not contribute their entire committed amount.

End of Investment Period:
- Unused committed capital is released to investors.

Fund Maturity:
- Remaining assets are distributed pro-rata, fund life extended, or rolled into a new fund.

Fees & Carried Interest (6.1):
- Management fee: 2% annually on committed capital.
- Carried interest: 20% of profits above a hurdle rate.

Question 16

i. Characteristics of hedge funds

Define the term hedge fund and explain how they have less restrictions than more regulated vehicles such as mutual funds.

Answer 16

Definition:
- it can be defined as an investment fund that aims to meet high or absolute returns by investing across a number asset classes or financial instruments

less restrictions on:
- borrowing
- short-selling
- the use of derivatives

This allows for investment strategies that differ significantly from long-only, non-leveraged strategies traditional followed by investors.

Question 17

i. Characteristics of hedge funds

List five other features of HF relating to how they invest.

Answer 17

Five other features:
1. Placing of many aggressive positions
2. a high level of borrowing given the limited size of the capital of the funds relative to the individual investments.
3. Mix of investments for which the price movements would be expected to mostly cancel each other out except for positive effect which the fund is looking for.
4. a willingness to trade derivatives, commodities and non-income bearing securities
5. a higher risk tolerance than other funds

Question 18

i. Characteristics of hedge funds

List five other features of HF relating to how they invest and 4 additional features

Answer 18

Additional features:
1. more investment freedom
2. fees include investment related component in addition to an annual management charge
3. High initial investment and limits on total fund size
4. lock-up periods, i.e minimum investment periods and notice periods

Question 19

i. Characteristics of hedge funds

List the four main classes of hedge funds

Answer 19

1. Event-driven funds
2. Global macro funds
3. market-neutral funds
4. Multi-strategy funds

Question 20

i. Characteristics of hedge funds

Describe global macro funds.

Answer 20

• They concentrate on macroeconomic changes around the world
• take a combination of long and short positions based on the manager’s views of how macroeconomic factors will move
• views depend on economic trends globally and international events
• And sometimes may make extensive use of leverage and derivatives

Question 21

i. Characteristics of hedge funds

Describe Event-driven funds

Answer 21

• trade either distressed securities or securities of companies involved in mergers and acquisitions (risk arbitrage)
• invest to try and profit from price movements of anticipated events
• securities of distressed companies are below par:
  -….many traditional investors unable or unwilling to buy stocks –> less demand putting pressure on prices
• …price anomalies which fund can exploit through research and expertise
• active or passive approach possible

Question 22

i. Characteristics of hedge funds

Describe market-neutral funds

Answer 22

• simultaneously enter into long and short positions, while trying to exploit individual price movements
• Aim to exploit inefficiencies in markets by making stock selection profits (take long position of under priced stocks vice versa)
• fund as a whole designed to be market neutral –> so that performance is not affect by general movements in market
• funds may be beta neutral and/or currency neutral or neutral by equity sector or size

Question 23

i. Characteristics of hedge funds

Describe three biases that influence hedge fund performance data

Answer 23

Describe the three biases that influence hedge fund performance data

1. Survivorship bias - arises when data does not realistically reflect survivors and failures. Means average returns overestimated and volatility underestimated.
2. Selection bias - arises because funds with good history more likely to apply for inclusion in the database and may reflect backfilling of good past performance.
3. Marking to market bias - since underlying securities may be relatively illiquid, funds use latest price or own estimate of current market price for valuation. Use of ‘stale’ prices can lead to underestimation of true variances and correlation.

Question 24

i. Characteristics of hedge funds

Explain why claims of HF superior performance can be questioned.

Answer 24

They can be questioned since return distributions are far from normal - many of them are negatively skewed.

As a result, standard measures of performance such as a pfs alpha (the excess return that cannot be explained by the fund’s beta) and its Sharpe ratio will be biased upwards

Question 25

i. Characteristics of hedge funds

Outline the typical level and structure of a hedge fund’s management fee

Answer 25

1. Fixed annual fee of 1 - 2%, plus incentive fee of 15 - 20% of annual return above some benchmark
2. Funds of hedge funds charge similar fees, although they get rebates from managers they invest in, extra layer of fees put substantial pressure on fund-of-funds performance

Question 26

i. Characteristics of hedge funds

List two potential advantages and five disadvantages of investing in hedge funds.

Answer 26

Advantages:
- possibility of higher returns
- low correlation with other investments

disadvantage:
- high levels of fees
- lock-in and notice periods (leading to liquidity issues)
- lack regulation mean lack of protection (fraud and mismanagement)
- lack of information/transparency (no disclosure of holdings and investment strategies –> difficult to fully understand risk)
- max/min investment sizes (limited access for small investor)

Question 27

i. Characteristics of hedge funds

Give four headings under which the key features of hedge funds can be summarised.

Answer 27

1. Mangement
2. Operations (e.g., legal structure, tax jurisdiction, fees, lock-in periods)
3. Past performance
4. strategies (e.g., short selling, gearing) and investments

Question 28

i. Characteristics of currencies

Explain what is meant by the FX market and outline the two types of transaction in this market.

Answer 28

FX market:
Exists when one currency is traded for another. it is by far the largest market in the world with trillions of dollars exchanging hands daily between:
- large banks
- central banks
- governments
- currency speculators
- other financial markets and institutions

Two types of transaction:
1. Spot market - settlement takes place in the same ‘working day’ in both countries, but because of time zone differences, settlement will take place first in the Far East, followed by Europe and the USA –> resulting settlement risk is called the ‘Herstatt risk’

2. Forward - involve agreeing the guarantee price today at which the buyer will take delivery of the currency on a specific future dat

Question 29

i. Characteristics of currencies

Describe the process of pricing a forward currency contract.

Answer 29

• The process is known as Covered Interest Parity (CIP)
  -it involves the spot rate and MM interest rates in both countries, so the synthetic forward rate is:

F = S x (1 + r_d)/(1 + r_f) - domestic per unit of foreign

• in practice. outright forward rates do not usually appear on dealer’s screens –> forward points = F - S are quoted instead
• By comparing the actual forward rate (quoted as forward points) with the synthetic forward rate, we can identify potential arbitrage opportunities.
• If the actual forward rate is higher than the synthetic forward rate, it suggests a potential for riskless profit.
• However, this may be complicated by bid-ask spreads and other transaction costs.

Question 30

i. Characteristics of infrastructure

Explain infrastructure in the context of investments and give two examples two main forms.

Answer 30

Infrastructure:
The financing of long-term infrastructure where debt and equity used to finance the project is paid back from the cashflow generated by the project.

Main forms

1. Economic, e.g.,
   - highways, water and sewerage facilities, energy generation distribution, telecoms networks.
2. Public
   - schools, universities, hospitals, public housing, prisons

Question 31

i. Characteristics of infrastructure

What are the key characteristics of infrastructure.

Answer 31

Happy People Find Real Meaningful Lives

1.High development (initial) costs with payback occurring over asset’s life
2. Single Purpose
3. Participation for Finite periods
- Depends on the agreement / useful life of the asset
4. subject to gov Regulation => more stable profits
- Result in income streams with low growth but yields higher than equity investments
- Lower price volatility => defensive asset
5. natural Monopolies => Economies of scale are such that the unit cost of a product will only be minimised if a single firm produces the entire industry output
6. Long lives

Question 32

i. Characteristics of infrastructure

Describe the asset specific risks of infrastructure as an asset.

Answer 32

These encompass risk pertaining to the design, construction, and operation of the infrastructure. The include:

1. Market risk - risk of overestimating demand and willingness to pay
2. Political risk and Regulatory risk - due to the lack of clarity in government policies
3. Operating risk
   - Underestimation of operation costs
   - pricing regulated by government –> but burden of underestimation cannot be entirely passed to consumer.
   - and exposure to large scale disasters

Question 33

i. Characteristics of infrastructure

Describe the broad risks of infrastructure as an asset.

Answer 33

1. Interest rate risk
   - Have an impact on the discount rates applied to the valuation of infrastructure investments and debt portion of the investment structure
2. Foreign exchange risk
   - if there is off-shore debt –> then exposure to foreign exchange risk. This risk arises because the project’s costs and revenues are typically denominated in the local currency.

Question 34

i. Characteristics of infrastructure

What the key risks with infrastructure funds?

Answer 34

SOVEREIGN
- Size of investments
- Opportunities limited
- Valuation issues (unlisted)
- Expertise required
- Risk and return is for more mature investors (i.e. Very long term investments)
- Existing currency risk
- It may discourage smaller investors (i.e. Bidding)
- Guidance and regulation may limit investment
- No liquidity

Question 35

i. Characteristics commodities

Define the term commodity and explain how institutional investors usually invest in commodities.

Answer 35

Commodities are any goods that can be used in commerce, e.g., any goods that are traded.

The term refers to internationally traded agricultural such as coffee, fuels such as oil and raw materials such as copper.

Institutional commodity investment is the investment in derivatives based on the price of the underlying commodity (rather than direct investment in the goods themselves, such as purchase of warehouse full of coffee)

Commodity indices produced by banks such as Goldman Sachs and other compilers are available. These contracts allow for diversification and avoid the danger of taking delivery of underlying product.

Question 36

i. Characteristics of commodities

Give an example of commodities that most futures are based on:

Answer 36

Energy –> traded on Intercontinental Exchange
- crude oil, heating oil, natural gas
Precious metals - CME
- Gold, platinum, silver
Base metals –> London Metal Exchange
-Aluminum, Al Alloy, Copper, Lead, Nickel, Tin, Zinc
Agriculture
-Cocoa, coffee, Sugar, Potatoes, Wheat, barley
Meaty and livestock
- Live cattle, lean hogs and pork bellies

Question 37

i. Characteristics of commodities

Provide a brief summary of a typical commodity contract specification.

Answer 37

• Contract size
• delivery dates
• quality of product
• method of packaging
  -package size
  -method of resolving disputes about quality

Question 38

i. Characteristics of commodities

Describe the commodities futures market.

Answer 38

Commodities are traded on various markets around the world, primarily in London and Chicago. Commodity futures are based on the prices of the underlying commodities including agricultural produce, energy and metals.

Commodity futures and forwards are used by producers or consumers who want to reduce the uncertainty of the amount they will pay or receive the product.

Question 39

i. Characteristics of commodities

Describe how futures on commodities are priced.

Answer 39

This is for commodities such as precious metals, which are held as investments:

Future price = spot price underlying + cost of carry

Cost of carry = storage cost + finance cost

F>S this is known as contango market

For this formula to be enforced the commodity must be loanable

Where the underlying is not widely held as an investment:

Cost of carry = storage cost + finance cost - convivence yield

CY ( Positive value of ownership of the physical commodity –> protection against shortages or selling at a higher price)

if CY > CC –> F<S this is backwardation

Question 40

i. Characteristics of commodities

Discuss the suitability of commodities as an investment class for institutional investors.

Answer 40

+ Significant real returns 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( (rising inflation, excessive global demand, supply disruptions), they have provided higher returns for institutional investors than any other class
+ Returns based on real underlying economics, suggesting similar pattern of returns likely to recur in future.
+ Unlike other asset classes, commodities are concerned with short-term supply and demand and short-term risk –> This can be advantageous for investors seeking high returns in a relatively short period

• no strong historical evidence for a real return from commodities
• markets are volatile, being driven by a number of factors unrelated to underlying economic factors that affect institutional liabilities
• The level of specialist expertise required to trade commodities successfully can be prohibitive.

Question 41

i. Characteristics of Insurance-linked securities

Explain what ILS are and why an insurer might find them useful.

Answer 41

ILS - securities whose return depends on the occurance of a specific insurance event, which can be either related to non-life (cat bonds) or life risks

From an insurer’s perspective, ILS - offer the ability to transfer risks from its BS to investors in return for payment of a risk premium.
Other benefits include:
- reduced capital requirements
- or acceleration of emergence of profits

Question 42

i. Characteristics of Insurance-linked securities

Outline the process for creating a cat bond

Answer 42

1. Ceding insurance company establishes an SPV in a tax-efficient jurisdiction
2. SPV establishes reinsurance agreement with sponsoring insurer.
3. The insurer pays a premium to the SPV which reflects likelihood and cost of cat being insured. (This premium is passed to bond holders as a spread)
4. SPV issues note to investors; this note has default provisions that mirror terms of the reinsurance agreement.
5. The proceeds from the note sale are invested in money market instruments within a segregated collateral account.
6. if no trigger event occurs during risk period, SPV returns the principle to investors with final coupon payment. if it occurs, asset of the SPV are first used to meet the insurer’s losses before any return of principle (if any)

Question 43

i. Characteristics of Insurance-linked securities

Why would an insurer use ILS?

Answer 43

1. Available when Re not
   - Market saturated or simply not willing to cover risks
2. Capital markets have sufficient capacity
3. Diversifies investors’ portfolios
   - May be cheaper then Re
   - Return gives adequate compensation for risk
   - Efficient risk transfer

Question 44

i. Characteristics of Structured products

Explain what is meant by a structured product in the context of investments.

Answer 44

It is a pre-packaged investment strategy in the form of a single investment. A typical SP will consist of two components:

1. A note - essentially a zero-coupon debt security that provides capital protection.
2. A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX, or interest rates.

Question 45

i. Characteristics of Structured products

Describe examples of SP.

Answer 45

1. Interest - linked notes/deposits - structured to pay one of two coupons linked to an index rate defined over a range of value over a reference period.
2. Equity - linked notes - 5-year bond with maturity payment max{ 100% initial payment, performance of FTSE 100 index return). Part of capital use to buy zero-coupon bond to return initial investment remaining call option on equities.

Question 46

i. Characteristics of Structured products

Discuss the suitability of SP as an investment class for institutional investors over direct investment in the underlying derivatives.

Answer 46

+ practical - investors may themselves not be able to invest in underlying derivatives
+ legal - design to satisfy legal or regulatory requirements
+ accounting - may be design to avoid income statement volatility from underlying derivative
- pricing - difficult to assess whether quoted price is competitive
- costs - distribution costs are generally not explicit and are normally implicit in the quoted price

Question 47

i. Characteristics of new ways of investing in old assets

Explain how index funds, ETF and contracts for difference can be used to gains access to traditional asset classes.

Answer 47

Index funds - ‘open-ended’ investment vehicles that aim to mimic the performance of a particular index. As such, it is passive management in action.

ETF:
- the listed investment trust equivalents of (mutual) index funds
- An ETF represents a share of ownership in a unit investment trust which holds stocks, bonds, currencies or commodities
- The investor purchase the shares on a stock exchange in a process identical to the purchase or sale of shares of any other listed stock.

CFD:
- contract which stipulates that the seller will pay the buyer a difference between the current value of an asset and the value at a specified time
- if the difference is negative, then the buyer pays the seller

Question 48

i. Characteristics of ETF

Explain why the price of an ETF stays close to its NAV.

Answer 48

The actions of arbitrageurs result in ETF prices that are kept close to NAV of the underlying securities.

When the price starts to deviate from the underlying NAV of the componet stock, market participants can step in and take profits on the differences.