Investments Ch 16

Question 1

INTRODUCTION

Answer 1

INTRODUCTION
* Alternative investments provide a host of potential benefits, but also expose investors to risks that may be quite different from traditional investments.

• Primary benefit of including alternatives in a portfolio is
  diversification and returns.
• Alternative investments include:
• Commodities
• Derivative securities
• Hedge funds
• Private equity
• Collectibles
• Venture capital

Question 2

BENEFITS
* Returns
* Diversification
* Tax Benefits
* Inflation Hedge

Answer 2

BENEFITS

• Returns
• Diversification
• Tax Benefits
• Inflation Hedge

Question 3

RISK

• Poor Liquidity
• High Research Costs
• Performance Appraisal Issues
• High Expenses, Fees, and Minimum Investment Requirements
• Principal Risk
• Lack of Expertise
• Volatility
• Scarcity of Regular Cash Flow Distributions

Answer 3

RISK

• Poor Liquidity
• High Research Costs
• Performance Appraisal Issues
• High Expenses, Fees, and Minimum Investment Requirements
• Principal Risk
• Lack of Expertise
• Volatility
• Scarcity of Regular Cash Flow Distributions

Question 4

COMMODITIES

Answer 4

COMMODITIES

• Commodity investing is the direct or indirect ownership in natural
  resources or agricultural output.
• Physical commodities are either primary or secondary

Question 5

TYPES OF COMMODITIES

• Agricultural
• Livestock
• Dairy
• Lumber
• Textiles
• Soft commodities

Answer 5

TYPES OF COMMODITIES

• Agricultural
• Livestock
• Dairy
• Lumber
• Textiles
• Soft commodities

Question 6

DERIVATIVE SECURITIES - OPTIONS

• Derivatives play a major role in portfolio management as they can
  be used to hedge and to speculate in an efficient manner.
• Options
• Call options
• Put options

Answer 6

DERIVATIVE SECURITIES - OPTIONS

• Derivatives play a major role in portfolio management as they can
  be used to hedge and to speculate in an efficient manner.
• Options
• Call options
• Put options

Question 7

FUTURES CONTRACTS

Answer 7

FUTURES CONTRACTS

• Futures contracts are standardized forward contracts.
• They are traded on exchanges.
• They are characterized by daily settlement.

Question 8

VENTURE CAPITAL

Answer 8

VENTURE CAPITAL

• Venture capital (VC) is a method of financing for startup companies
  or small businesses.
• Venture capital investments are more risky than traditional
  investments.

Question 9

VENTURE CAPITAL: STAGES

Answer 9

VENTURE CAPITAL: STAGES

Question 10

ANGEL INVESTING

Answer 10

ANGEL INVESTING

• Angel Investors are wealthy individuals who provide capital
• May have expertise in the field in which the business operates
• May serve on the board of directors

Question 11

ARTS AND COLLECTIBLES

• Collectibles are a fast-growing asset class due to the search for
  higher returns and diversification.
• Examples include:

Answer 11

ARTS AND COLLECTIBLES

• Collectibles are a fast-growing asset class due to the search for
  higher returns and diversification.
• Examples include:
• Artwork and sculptures
• Sports and entertainment memorabilia
• Wine
• Watches
• Classic automobiles

Question 12

HEDGE FUNDS

Answer 12

HEDGE FUNDS
* Hedge funds are investment companies that manage capital for their investors.
* The hedge fund manager acts as the general partner.
* Combine investments in traditional markets with unconventional
markets and securities.
* Use derivative securities, commodities, and other alternative
investments.
* Typically, more risk involved with hedge funds.
* Use leverage to magnify returns.

Question 13

PRIVATE EQUITY

Answer 13

PRIVATE EQUITY

• Private equity firms are organizations that raise capital and take
  ownership in businesses that are not traded on a public exchange.
• Use their expertise to locate undervalued firms
• Attempt to transform firms into successful businesses by using their
  expertise
• Perform the duties of general business partners

Question 14

RISK OF PRIVATE EQUITY

Answer 14

RISK OF PRIVATE EQUITY

• Funding Risk
• Liquidity Risk
• Market Risk
• Exit Risk

Question 15

REAL ESTATE

Answer 15

REAL ESTATE

• Real estate investors seek income, appreciation, and diversification.
• Income typically is derived from rent but may also be generated by
  commissions, fees, and ancillary assets.
• Types of real estate:
• Residential property
• Commercial property
• Industrial property
• Retail property
• Mixed-Use property
• Secondary market investing

Question 16

REAL ESTATE RISKS

• Market Risk
• Liquidity Risk
• Default Risk
• Political Risk
• Environmental Risk
• Replacement Cost Risk

Answer 16

REAL ESTATE RISKS

• Market Risk
• Liquidity Risk
• Default Risk
• Political Risk
• Environmental Risk
• Replacement Cost Risk

Question 17

NET OPERATING INCOME (1 OF 2)

Answer 17

NET OPERATING INCOME (1 OF 2)

• A common method of valuing real estate is to divide the net
  operating income (NOI) by an appropriate capitalization rate.
• Capitalization rate is based on the investor’s required rate of return.
• NOI is typically averaged over several years to account for possible
  variations in occupancy.
• Operating expenses exclude any interest associated with financing
  as well as depreciation expense.NOI EXAMPLE

Question 18

NOI EXAMPLE

Carson is considering the purchase of a rental property. The property rents for $1,500 a month, and the fee for garage parking is $85 a month. The property and garage space are expected to be rented 90% of the year.
Additional expenses associated with the property include real estatetaxes of $1,800 a year, liability insurance of $1,200 a year, advertising expense of $200 a year, maintenance costs of $1,300 a year, depreciation of $3,800 a year, and interest expense on the property loan of $5,100 a year. Carson requires a 12% rate of return on the property is 12%.

Compute the intrinsic value of the property?

Answer 18

NOI EXAMPLE

Carson is considering the purchase of a rental property. The property
rents for $1,500 a month, and the fee for garage parking is $85 a month.
The property and garage space are expected to be rented 90% of the
year. Additional expenses associated with the property include real estate taxes of $1,800 a year, liability insurance of $1,200 a year, advertising expense of $200 a year, maintenance costs of $1,300 a year, depreciation of $3,800 a year, and interest expense on the property loan of $5,100 a year.

Carson requires a 12% rate of return on the property is 12%.
Compute the intrinsic value of the property?

NOI EXAMPLE: SOLUTION

Question 19

The use of futures contracts for a farmer who grows a variety of fruits and grains is most likely to be limited by:

The lack of availability of fruit contracts on the exchanges.
The standardization of all contracts.
Federal regulations of the futures markets.
The daily settlement requirement for futures trading.

Answer 19

the lack of availability of fruit contracts on the exchanges.

Rationale

Farmers and other hedgers can use futures markets to manage their commodity price risk but only if there is a contract traded that matches their harvest.
There are many grain contracts on the exchanges but no contracts for fruit.
This farmer will be forced to choose a contract that has a high correlation with the returns on fruit, but this is likely to raise additional risks.

Question 20

A hedge fund manager believes the price of oil will fall over the next three months. The position most likely to result in a profit if the manager is accurate is:

A long call option on a barrel of oil.
A long put option on a barrel of oil.
A long position in an oil futures contract.
A short put option on a barrel of oil.

Answer 20

A long put option on a barrel of oil.

Rationale

Put options pay off if the price of the underlying asset falls. A put option on oil will benefit the hedge fund manager as the price of oil falls.

The other three positions will suffer losses in the event of a decline in oil prices

Question 21

The best hedge against inflation is most likely:

Buying call options on gold mining stocks.
Owning cases of vintage wine.
Investing in a hedge fund that uses interest rate swaps.
A private equity investment in farming equipment suppliers.

Answer 21

Owning cases of vintage wine.

Rationale

Wine has been shown to be one of the better collectible hedges against inflation, much better than call options, hedge funds, and private equity investments.

Investors must guard against consuming their valuable wine and reducing the value of their investments.

Question 22

Which of the following is the most suitable addition to the retirement income portfolio for a moderate risk tolerance, moderate net worth investor seeking diversification and current income?

Private equity.
Collectibles.
Venture capital.
Publicly traded mortgage REIT.

Answer 22

Publicly traded mortgage REIT.

Rationale

Mortgage REITS invest primarily in mortgages and construction loans or, in mortgage-backed securities, such as GNMAs, with a focus on generating income. Publicly traded REITs are suitable for investors with conservative-to-moderate risk tolerance. Non-traded REITs, however, are risky, illiquid, high fee investments that should only be considered by knowledgeable investors after extensive due diligence. Non-traded REITs are not appropriate for the conservative -to- moderate risk tolerance, or moderate net worth investor. Private equity and venture capital have high risk, high minimum investments, and lack liquidity, making them unsuitable for a moderate risk tolerant, modest net worth investor focused on producing current income. Collectibles do not produce current income and often lack liquidity.

Question 23

Which of the following statements regarding hedge funds is NOT correct?

Hedge fund managers act as general partners in managing capital for the fund’s limited partners.

Hedge fund managers are compensated via carried interest.

Hedge fund managers have leeway to pursue investment opportunities that is equivalent to that of mutual fund managers.

Hedge fund investors may be subject to lock-out periods in which they have little access to their capital.

Answer 23

Hedge fund managers have leeway to pursue investment opportunities that is equivalent to that of mutual fund managers.

Rationale

Hedge fund managers have far more leeway to pursue investment opportunities that are unavailable to mutual fund managers, including the use of derivative securities, commodities, and other alternative investments. Hedge fund managers use leverage to magnify returns for the limited partners and can do it in ways prevented by the significant regulation imposed on mutual fund managers.

Question 24

The net gain on buying a call option for $10 when the stock price is $28, the exercise price is $20, and the expiration date stock price is $40 is closest to:

$0.
$10.
$20.
$40.

Answer 24

10.

Rationale

The option expires with an intrinsic value of $20
(the owner has the right to buy at 20 when the stock trades at 40).

The owner of the option paid $10, so the net gain is $10 (20 – 10).

Question 25

Primary commodities most likely include:

Oil extracted from wells.
Refined gasoline.
Steel produced from iron ore.
‘2 by 4s’ made in a lumber yard.

Answer 25

Oil extracted from wells.

Rationale

Primary commodities are those that are considered natural resources that can be mined or extracted and used without much processing needed for consumption.

Examples include oil, gold, and wheat.

When a commodity must undergo a significant process to be able to be consumed, it is known as a secondary commodity, which includes refined gas, lumber, and steel.

Question 26

Motives for including alternative investments in a portfolio most likely include:

A desire to hold leverage-free investments.

A need to increase the level of protection against inflation during times of market stress.

A desire to increase the portfolio’s correlation with traditional securities.

A desire to reduce the weighting of publicly held stocks in the portfolio

Answer 26

A desire to reduce the weighting of publicly held stocks in the
portfolio.

Rationale

Publicly traded stocks are a traditional investment. The inclusion of alternative investments will therefore reduce the weighting of those stocks in the portfolio. Alternative investments, however, have low correlations with traditional securities, use significant leverage, and tend to be less effective against inflation during times of economic stress.

Question 27

The U.S. federal government imposes rules and regulations on corn and dairy producers in an attempt to stabilize the agricultural markets. Which of the following accurately describes the means by which this is accomplished?

The imposition of price controls.
The establishment of the government as the buyer of last resort.
Both a and b.
Neither a nor b.

Answer 27

Both a and b.

Rationale

The government can be the buyer of last resort by agreeing to purchase all unsold commodities or it can impose price controls as a means to stabilize the agricultural markets. Both are designed to make farming profitable enough to avoid bankruptcies and a collapse in food markets.

Question 28

The venture capitalist return on their investment is most likely realized during the:

Seed stage.
Emerging stage.
Expansion stage.
Bridge stage.

Answer 28

Bridge stage.

Rationale

The bridge stage occurs when the business is ready to be taken over by a larger firm or perhaps even ready for an initial public offering. The VC will generate significant profits if the business can be successfully taken over. This is known as the cash out final stage.

Question 29

A watch worn by Edmund Hillary during his first successful ascent of Mount Everest will least likely:

Have a long price history.
Contain some emotional attachment by its owner.
Be subject to the risk of forgery.
Have a limited secondary market

Answer 29

Have a long price history.
Rationale

There is likely to be almost no price history for this watch as the previous owners have most likely held on to it for extended periods of time.

Question 30

Dolan collects Russian string instruments as part of his investment portfolio. Dolan owns several violins and cellos and purchases a rare Saint Petersburg grand piano made in the 1880s. His total collectible investment now exceeds $10 million. Dolan made the investment during an international auction in which he outbid ten other collectors. The least likely result of this investment for Dolan is:
A more diversified collection.
Substantial liquidity issues.
High storage costs.
Potential loss due to theft.

Answer 30

Substantial liquidity issues.

Rationale

Although many alternative investments face severe liquidity issues, this investment does not appear to fit into that category.

A rare piano that was bid on by ten other collectors is almost certain to have significant interest in the event Dolan wants to sell the piano in the future. T

he piano will add diversification to his portfolio and Dolan will be faced with high storage and insurance costs

Question 31

.S. federal and state governments are most likely to impose regulatory price controls on:

Dairy products.
Lumber.
Textiles.
Orange juice.

Answer 31

Dairy products.

Rationale

Dairy price controls began almost a century ago and continue to this day, in which the government guarantees a price for dairy products and even agrees to purchase unsold items at a minimum price. The idea is to make certain that dairy farms do not go bankrupt and leave the country without a supply of milk, eggs, and butter. Although there is some government influence in the lumber, textile, and OJ markets, regulations in those industries are not nearly as vast as in the dairy market.

Question 32

which of the following lists of characteristics best describe alternative investments?

Illiquid, high fees, high returns, high risks, use leverage, high correlation with stocks, passive management.

Passive management, illiquid, high fees, low research costs, not for conservative investors.

Low fees, little principal risk, active management, inflation hedge.

Illiquid, high fees and risk, low correlation with equities and bonds, high research costs, not recommended for conservative investors.

Answer 32

Illiquid, high fees and risk, low correlation with equities and bonds, high research costs, not recommended for conservative investors.

Rationale

Option a is incorrect because alternative investments have low correlations with stocks and may or may not have high returns. Option b is incorrect because alternative investments employ active management and tend to have high research costs. Option c is incorrect because alternative investments generally have high fees and high principal risk. Option d is the only completely correct statement.

Question 33

The least likely reason a significant investment in an ancient European coin collection would have high research costs is because of:

An illiquid secondary market.

The threat of forgery is high.

Information on ancient coins is not readily and completely available
.
Protection from inflation is uncertain.

Answer 33

Protection from inflation is uncertain.

Rationale

Some collectibles offer protection against inflation, but not all of them.
Many investors consider coins to be an inflation hedge, but the degree of protection is not clear nor is it consistent over time. Investors tend to focus their research costs in other areas, such as verifying the authenticity of the coins. Research costs tend to be higher when there is no liquid secondary market (like that of coins) and when information is not completely available.

Question 34

The intrinsic value of an apartment complex with the following details is closest to:

Gross potential receipts $440,027
Gross potential income $460,829
Gross income before expenses $437,909
Net operating income $227,930
Capitalization rate 11.9%

Answer 34

$1,915,378.

Rationale
Net Operating Income
Intrinsic Value = ———————————–
capitalization rate

   227,930  -----------------------   = 1,915,378
  0.119

Question 35

Hedge funds are least likely known for:

Complex fee structures.
Unlimited redemptions.
Heavy reliance on leverage.
The use of short and long positions.

Answer 35

Unlimited redemptions.

Rationale

Hedge funds have limits on the amount and timing of redemptions, which is very different from the redemption polices of mutual funds. Hedge funds have complex fee structures, use complex strategies such as simultaneous long-short positions, and rely on leverage to magnify returns.

Question 36

A private equity firm has a wealthy individual shareholder who has recently declared personal bankruptcy. The likelihood the investor will be limited in her ability to make additional required contributions to the firm is known as:

Answer 36

Funding risk.

Rationale

Private equity investors agree to make regular contributions to the firm. In the event one of multiple shareholders fail to make these payments, the funding risk of the private equity firm increases, and they are at extra risk of being unable to make additional investments.

Question 37

Dale is considering the purchase of a rental property with several units. The property rents for $12,300 a month when all units are occupied. The units are expected to be rented 80% of the year. Additional expenses associated with the property include real estate taxes of $11,800 a year, liability insurance of $4,000 a year, advertising expense of $1,200 a year, maintenance costs of $11,200 a year, depreciation of $32,700 a year, and interest expense on the property loan of $25,000 a year.
If Dale’s required rate of return on the property is 10%,
what is the intrinsic value of the property?

Answer 37

$147,600 Gross potential rental receipts ($12,300 x 12)
+ 0 Other income
= $147,600 Gross potential income
- 29,520 Vacancy losses (20% x $147,600 = $29,520)
= $118,080 Gross income before expenses
- 28,200 Operating expenses (excluding interest &
depreciation)
————————————————————————
= $89,880 Net Operating Income (NOI)

$89,880 ÷ 0.10 capitalization rate = $898,800 intrinsic value

Note : that the depreciation and interest expense is not included in the NOI calculation.

Question 38

Cryptocurrencies such as Bitcoin are most suitable for investors who:
Want to hold a liquid currency which can be used to purchase goods and services.
Want to hold an electronic currency that is less volatile than other alternative investments.
Have a high risk tolerance.
Want exposure to assets that are highly correlated to the U.S. dollar.

Answer 38

Have a high risk tolerance.

Rationale

Cryptocurrencies display very high volatility levels and are therefore only suitable for investors with a high level of risk tolerance. They are not widely accepted as a form of payment for goods and services and are not highly correlated with the U.S. dollar.

Question 39

Norma, a hedge fund manager, believes the correlation coefficient between two large financial institutions is going to fall and so she shorts the higher price stock and buys the lower priced stock. Which of the following is LEAST likely to affect the profits of Norma’s long-short strategy?

Correlations remain high.

One of the institutions makes a major announcement.

The economy enters a recession.

Options exchanges experience a sudden drop in volume.

Answer 39

Options exchanges experience a sudden drop in volume.

Rationale

Correlations tend to increase during economic recessions.

A long-short position in two financial institutions is not very likely to produce a profit when their correlations remain high or if they increase.

Similarly, when the economy enters a recession, both prices will likely fall. The only event that should not influence the long-short profits is a decline in option trading volume.

Question 40

Mortgage REITS invest primarily in mortgages and construction loans or, in mortgage-backed securities, such as GNMAs, with a focus on generating income. Publicly traded REITs are suitable for investors with conservative-to-moderate risk tolerance. Private equity and venture capital have high risk, high minimum investments, and lack liquidity, making them unsuitable for a moderate risk tolerant, modest net worth investor focused on producing current income. Collectibles do not produce current income and often lack liquidity. Which of the following best describes the means by which private equity managers are compensated?

They are compensated through carried interest.

If investments are held in the fund a minimum of 3 years, they will receive long-term capital gain tax treatment on their compensation.
Both a and b.

Neither a nor b.

Answer 40

Both a and b.

Rationale

Hedge fund and private equity managers are typically compensated via carried interest, which is a distribution of profits designed to align the interests of the managers with the interests of the investors.

For years after 2017, the carried interest in private equity and hedge funds has a three-year minimum holding period to receive LTCG tax treatment, which was outlined in the Tax Cuts and Jobs Act of 2017.

Question 41

Which position produces a loss when the price of the underlying asset rises?

A long put option on a share of stock.
A long call option on an equity index.
A long position in an energy futures contract.
A pay fixed leg in an equity index swap

Answer 41

A long put option on a share of stock.

Rationale

A put option gives the holder the right to sell the stock at the exercise price. It therefore gains value if the underlying asset price falls. If the price rises, it loses value, and if the price rises above the exercise price it becomes worthless. The owner of an equity index call option has the right to buy the index at the exercise price, and therefore the call option gains value as the index rises. Long positions in energy futures contracts are obligated to buy at the future price, and therefore benefit when the price rises. They will take a loss if the spot price is below the futures price at expiry, but make a profit if the spot price higher than the futures price. The pay fixed leg in an equity swap is committed to paying a fixed rate and receiving the return on the equity index. Higher index returns therefore benefit the pay fixed leg

Question 42

JBL Equity (JBL) invested in FLUB, a technology company with $6 million of EBITDA. JBL paid $40 million. 35% of the purchase price was financed with amortizing debt, which was repaid fully in 3 equal installments of $5.04m, with the first payment occurring at the end of Year 1. Assume FLUB’s EBITDA grows by 20% each year and JBL exits after three years at a multiple of 14 times EBITDA. What answer is the closest to the IRR for the investment, without regard to any tax benefits attributable to interest or amortization.

50%.
62%.
85%.
98%

Answer 42

85%.

Rationale

Period EBITDA Cash Flow Buy/Sell EBITDA Debt Net CF
0 $6.00 0 -$26.00 -$26.00
1 $7.20 1 $7.20 ($5.04) $2.16
2 $8.64 2 $8.64 ($5.04) $3.60
3 $10.37 3 $145.18 $10.37 ($5.04)
$150.51

Question 43

A cash flow evaluation of income-producing real estate takes into account which of the following variables?

1. Taxes
2. Projected rental income
3. Depreciation

1 only.
1 and 2.
2 and 3.
1, 2, and 3

Answer 43

1, 2, and 3.

Rationale

All of these variables are included in a cash flow evaluation.