Practice Questions Flashcards
Key Performance Drivers for PE Investing
(1) Selection of fund manager
(2) management of diversification
(3) management of capital commitments
Total Value to Paid in Ratio (TVPI)
a measure of the cumulative distribution to investors plus the total value of the unrealized investments relative to to the total capital drawn from investors.
TVPI = DPI + RVPI
Distribution to Paid-in Ration (DPI)
a measure of the cumulative distribution to investors relative to the total capital drawn from investors
Residual Value to Paid-in Ration (RVPI)
a measure of the total value of the unrealized investments relative to the total capital drawn from investors
CAPM Formula
CAPM = Rf + Beta*[E(Rm) - RF]
What is the most common process for selling timberland through auction?
a “sealed bid auction”. Each party submits a private offer price to the seller and the highest bidder wins
Omega Ration
A general measure of risk that takes into account the entire distribution.
Formula = Average Upper Partial Moment/Average Lower Partial Moment
Upper Partial Moment = max(R-T,0)
Lower Partial Moment = Max(T-R,0)
Portfolio Construction Using a Volatility Weighted Approach
Weight(x) = (1/x%)/[(1/x%)+(1/y%)+(1/z%)…]
Priority of Claims During a Bankruptcy
(1) Secured Creditors (2) Bankruptcy Admin Costs (3) Post-petition bankruptcy expenses (4) Owed Wages (5) Owed Benefit Plan Contributions (6) Unsecured Customer Deposits (7) Taxes (8) Unfunded Pension Liabilities (limit 30% BV) (9) unsecured claims (10) Preferred Stockholders (11) Common Shareholders
Mean Variance Asset Allocation
Allocates more weight to assets/funds with higher mean-variance efficiency (or better risk-return profiles)
Unlevered Beta
B(u) = B(l)/ [1+(1-CorpTax)(D/E)]
To qualify as a REIT, how much income (%) must a corporation generate from real estate assets?
75%
Representativeness Bias
participants look at past prices to form their beliefs
disposition effect
leads market participants to close profitable positions quickly and hold losing positions for a longer period
Fee Netting
involves netting the positive and negative returns of the managers in the fund
’40 Act fund
a pooled investment vehicle offered
by a registered investment company as defined in
the 1940 Investment Companies Act . A way fro hedge fund products to be delivered.
Over-commitment Ratio
Overcommitment ratio = Total Commitments/Resources available for commitments
overcommitment rations help to decrease the opportunity cost of less profitable srategies
TOPSCAN
(1) Team Building, (2) Operations, (3) Perspective, (4) Skill Building, (5) Customer Development, (6) Analysis, (7) Network
Crack Spread
hedges typically used by oil refineries. Would involve going long crude oil futures and short gasoline and heating oil
Commodity returns are (1)______ during contractive monetary policy regimes and (2) ______ during expansive monetary policy regimes.
(1) Higher, (2) Lower
Contango
when the forward curve is upward sloping. When the future price is higher than the spot price
Long only excess returns tend to be negative in a contango market.
Backwardation
when the forward curve is downward sloping. When the future price is below the spot price.
Long only excess returns tend to be positive in a backwardated market.
What year was the CFTC created?
1974
Defined Contribution Pension Plan
the employee makes a defined contribution each period. The employee bears longevity risk.
Relative Value Strategies are characterized as being (1) ______ Gamma. Trend-following strategies are characterized as being (2)______ gamma.
(1) Short, (2) Long
Gamma is used to measure the rate of change in an option’s delta as the underlying security (stock, ETF, index) moves. In a positional context, long gamma means your option position is such that if the stock rallies (or declines), your share equivalent position (also known as delta) gets you longer (or shorter).
Regulation Triple-X Securitization
an alternative risk transfer instrument used to transfer life risk
crush spreads
hedges typically used by soybean processors. a typical crush spread involves going long soybean futures and short soybean oil futures and soy meal futures
Fortigents 7 Step Process to Alternative Investment Strategies
(1) Idea Sourcing (2) Quantitative Screening (3) Risk Analysis (4) Quantitative Analysis (5) Operational and Compliance Analysis (6) Onsite Verification (7) Formal Approval
Unleveraged Beta Formula
B(u) = B(L) / 1 + (1-CorpTax)*(D/E)
Real Estate UnSmoothed Formula
R(t)True = R(t Reported) - R(t-1 Reported) * Auto/ (1 - Auto)
Masters Hypothesis
Michael Masters maintains that buying pressure from passive commodity indices creates a bubble in commodity futures prices which has caused commodity prices to increase above their fundamental values
Section 13(d)
requires an adviser who owns more than 5% of a publicly traded security to file disclosure within 10 days of the acquisition
What kind of strategy is a momentum strategy?
cross sectional, non-directional, long/short strategy
Normal Backwardation
Futures price is less than expected future spot price
F
David Swensen’s Endowment Model
the endowment model strives to generate high returns by allocating more to illiquid alternative assets and less to liquid traditional assets
Autocorrelation Formula
Autocorrelation = Covariance / (STDreportedRet *STDlaggedRet)
Unsmoothed Beta Formula
Beta(unsmoothed) = Beta(Smoothed) / (1 - Autocorrel)
Margin to equity ratio
the proportion of client assets required for margin deposits. The more aggressive the manager, the higher the margin-to-equity ratio
Sharpe Ratio
Excess return divided by standard deviation
Digital Call Option
digital call options default in bad economic states and pay off a fixed amount otherwise. Similar to a Senior CDO tranche.
EV (Embedded Value) Securitizations
goal is to monetize the present value of future earnings
CAT Bonds
Used for risk transfer. Bond sponsor receives a payment that is conditional on the insured event.
CPPI (Constant Proportion Portfolio Insurance) Strategy
(convex strategy) a trading strategy that allows an investor to maintain an exposure to the upside potential of a risky asset while providing a capital guarantee against downside risk.
Stock = 2 * (Asset - Floor)
Constant Mix Strategy (rebalancing of investments)
(concave strategy) brings a portfolio that has deviated from the target asset allocation back into line. Exploits reversals.
OBPI
(Option Based Portfolio Insurance)
In a commodity substitution spread, the relative performance of the commodities is typically expressed as which of the following?
national log of the ratio of commodity prices.
Hedonic Price Estimators
use a regression based methodology to synthetically develop a continuous price series by controlling for the unique characteristics of each transaction that comes to market
Capacity Constraint Hypothesis
per capita alpha is reduced as investment capital increases
fund bubble hypothesis
assumes that investment bubbles result in less skilled managers entering the industry and diluting hedge fund returns
increased allocation to active funds
increased allocations to hedge funds adversely affect their performance and increase their betas
Hurst Ratio
a measure of persistence
- Mean reverting returns = 0 - 0.5
- random returns = .5
- persistent returns = .5 - 1
D-statistic
measures downside risk. Measured between 0 and 1.
No downside risk D = 0.
No positive returns D = 1
Panageas and Westerfield Theoretical Model
managers who are compensated with an incentive fee and have a high watermark will keep a constant proportion in the risky asset (ie they will not adjust allocations)
The Dealer Rule
the dealer rule imposes additional taxes on capital gains of REITS when the holding period is short. This keeps REITS from being able to take advantage of short term price inefficiencies
Traditional IRR
the discount rate that results in a zero NPV
Interim IRR (IIRR)
the discount rate that results in a zero NPV (except or the last cash flow). The IIRR uses the NAV as the last cash flow
Price of Real Estate using Decay Factor
Price(true) = P(t-1) + (1/DecayFactor) * (P(t) - P(t-1)
Successful high frequency trading strategies typically have ____ capacity and _____ sharpe ratios
Low and High
Standard Deviation (formula)
SQRT(Variance)
Idiosyncratic Risk
Idiosyncratic risk has little or no correlation with market risk, and can therefore be substantially mitigated or eliminated from a portfolio by using adequate diversification.
40 Act Fund Regulations
(1) 5% of the fund can be invested in one issuers securities (2) daily pricing and liquiddity (3) 15% can be illiquid (4) 1.33x max leverage
Autocorrelation of Smoothed Retuns (formila)
Autocorrelation = 1 - (SmoothedCorrel/UnsmoothedCorrel)
Blend Approach
A combination of the value approach and growth approach. Used by fundamental equity hedge fund managers
winsorizing
a step used by quantiative equity hedge fund managers to remove outliers
Exchange Rate Mechanism Crisis of 92-93 (ERM)
- UK faced currency depreciation
- Bank of England attempted to defend its currency during quantum funds attack on the pound
- germany faced currency appreciation
- currencies of participating countries were bound within narrow predetermined bands
Economic Value Approach (private equity valuation)
Used for private equity fund valuation. used to overcome the issues associated with net asset value approach.
Bottom up model (private equity valuation)
used by determining exit scenarios using manager track record data
top down model (private equity valuation)
uses historical performance of a best comparable peer group
What is the standard approach to estimating private equity fund betas?
the standard way of estimating PE fund betas is based on quoted comparable. Betas obtained using this approach are regression based
What commodity index has the largest energy allocation
S&P Goldman Sachs Commodity Index
Mount Lucas Management Index (MLMI)
a passive benchmark that uses long and short futures positions and follows a trend following strategy
Insurance Linked Securities (ILS) Payment Triggers
(1) Indemnity based - based on actual losses (2) modelled loss (3) industry loss index - determined in the uSA by the Property Claim Services (PCS) (4) Parametric Index - based on physical characteristics of a loss event.
Front Month Equivalents (FME)
FMEs take a portfolio of forward contracts and convert it into an equivalent exposure in terms of a near term futures contract
Concave Strategy
a strategy where you buy as stocks fall and sell as they go up.
Convex Strategy
a strategy where you sell as stocks fall and buy as they go up.
Leveraged Beta Formula
B(U) = B(L) / 1 + (1 - Tax) * (D / E)
European inflation is ______ correlated with energy returns and Asian inflation is ________ correlated with energy returns
(1) Positive, (2) Negative
Positive Kurtosis
Fat tails
Positively Skewed
more weight in the right tail. Average negative returns.
Exponential Smoothing Model (Formula)
Exponentially Smoothed Volatility = SQRT( (1 - SmoothingFactor) * volatility^2 + SmoothingFactor * (LatestRet - AvgRet)^2 )
3 Stages of PE Fund Manager Life Cycle
(1) Entry and Establish
(2) Build and Harvest
(3) Decline or Exit
Hedging Pressure Hypothesis
commodities in which hedgers are net short have positive excess returns and commodities in which hedgers are net long and negative excess return.
VAR Formula
VAR = (Confidence level factor * Volatility ) + Return
What is the difference between trend following and momentum strategies?
trend following - market timing with one asset at a time. A time series strategy. hedge against tail risk.
Momentum strategy - typically a long/short strategy, cross sectional strategy
World stocks and bonds are ______ correlated with inflation
negatively
Z-Scoring
subtracting the average P/E ration from each firms P/E ration and dividing the result by the standard deviation of P/E ratios. This results in values that have a mean of zero and a standard deviation of one.
Payment Triggers Ranked by hedging effectiveness (highest to lowest)
(1) Indemnity
(2) modeled loss
(3) industry loss
(4) Parametric
Payment triggers ranked by transparency (highest to lowest)
(4) Indemnity
(3) modeled loss
(2) industry loss
(1) Parametric
Explain the algorithm for risk budgeting created by DeSouza and Golkcan
capital is allocated to each fund based on its standard deviation. The base principal is that each risk class has equal amount of capital at risk. Returns and correlations are not brought into this method at all.
Clare and Motson’s findings on moneyness
managers adjust their risk levels based on both relative returns and moneyness. For at the money incentive options, they increase risk significantly, at in/out of the money options, they reduce risky behavior.
Managers make larger risk adjustments based on poor relative returns.
Brownfield vs. greenfield infrastructure assets
brownfield is a seasoned already set up asset wheras greenfield is something new.
Fama french carhart model
Fama French = 3 factors - excess returns, size, value
Carhart - adds momentum
RSI
-a counter-trend following strategy. used to determine when a security is overbought or oversold.RSI can be used as a relative value indicator.
Moneyness of an incentive call option (formula)
Moneyness = NAV / HighWater
What are Tier 1, 2 and 3 assets
Tier 1 - short term FI
Tier 2- risky liquid assets (stocks)
Tier 3 - risky illiquid assets
Ilmanen’s sources of return
(1) Value, (2) carry, (3) trendfollowing and momentum, (4) volatility, (5) liquidity
Geometric return formula
Rg = Ra - VARport/2
Covenants in capital markets are similar to _______ loan covenants
negative
Capital Market Theory Model
Assumes all investors have the same horizon. Assumes only the mean and variance are important.
What did Erb and Harvey find?
diversification return is high when correlations are low and asset variances are high
Hurricane Katrina caused spark spreads to _____ and crack spreads to _____.
(1) Widen (2) widen
Spark spreads are the correlation between natural gas and power.
What is the basis of a futures position
the difference between the futures price and current spot price.
trend following CTAs behave most like _______ that increase their _____ positions in up markets
(1) in the money straddles
(2) long
Conditions favorable to a convertible strategy
high game, low conversion premium, high stock volatility and enough stock to be shorted.
Convertible Delta Formula
Change in price / change in parity
Interest Rate Parity Formula
F/S = (1 + Dom / 1 + Foreign)
Requirements of Hedge Funds in Hong Kong
1 - starting capital of $5mm
2 - liquidity of $3mm
3 - officer with 3 years experience
4 - be authorizaed by the SFC before offering shares to the public
Section 363 Sale
distressed companies can sell assets free of liens of liabilities without regard to creditor objections.
40 Act fund requirements
(1) redemptions in 7 days (2) 15% of assets in illiquid securities (3) no performance fees (4)max 5% one issuer, 10% issuers voting securities, 25% given industry (5) at most 10% of income generated from non-securities (6) leverage limited to 33%.
S&P Case Schiller Home Price Index
residential property index based on repeated sales
How does inflation correlate with:
- stocks
- bonds
- Real Estate
- Energy
- Commodities
- stocks - negative
- bonds - negative
- Real Estate - negative
- Energy - positive
- Commodities - positive
Parity
The total market value of the shares into which a convertible bond can be converted. (often quoted as a %)
How do interest rates correlate with:
- stocks
- bonds
- Real Estate
- Energy
- Commodities
- stocks - positive
- bonds - positive
- Real Estate - positive
- Energy - negative
- Commodities - negative
Surplus Risk
the tracking error of the assets relative to the present value of the liabilities
Straddle
long positions in both a call and put on the same asset. The trader will profit with large asset moves in either direction. The delta of the position grows as it moves in the same directions.
Explain Diff CTA investment options
1) CTA Fund - similar to a hedge fund.
2) Multi CTA Fund - similar to FoF
3) Managed Account - investor gets complete control and transparency. heavy oversight and costs of entrance.
4) Platform - operates like a multi-fund except investors can choose their own leverage and invest in the funds f their choice that the platform carries.
Beta
(Volatility(portfolio) * Correlation) / Volatility(market)
Standard Portfolio Analysis of Risk (SPAN)
used to determine margin requirements for futures contracts. SPAN takes into account benefits of diversification by determining overall portfolio risk by calculating the maximum loss of a portfolio.
Variance of portfolio (formula)
Variance = Variance(fx) + Variance (re) + 2*cov
Overcommitment Ratio
Total Commitments / Resources available for commitments
Information Ratio
Port Return - Index Return / Tracking Error
Tracking Error = difference between return of portfolio and return of index.
Purchasing Power Parity
the change in the exchange rate between two currencies should reflect the difference in the countries exchange rates.
Carry Trade
Borrowing in a low interest currency and lending in a high interest currency
Diversification Return
the difference between a portfolios geometric average return and the weighted geometric average of the returns associated with the portfolio
Geometric Return
SQRT( (1+r1)(1+r2)…..)
40 Act Trust Structure
Series Trust - setup is outsourced
Stand alone trust - product sponsor creates the trust
Convertible Bond Conversion Premium
Conversion Premium = (Convertible Price - Parity) / Parity
How to find the stock price at a node of the binomial tree
U = exp(vol * sqrt(T) )
Define UCITS
Undertakings for Collective Investment in Transferable Securities
Objectives - establish a regulatory framework and provide investors protection by a single regulator across the EU
10% Trash Ration is an exemption that permits UCITS funds to hold 10% in non-eligible assets
Var may not exceed 20% of the NAV of the fund
UCITS III
led to the construction of Newcits funds (UCITS funds that invest in alternative investment strategies
Sophisticated vs. Non Sophisticated UCITS funds
Non-Sophisticated - long only, only stocks and bonds, can use derivatives for hedging, leverage limit is 200% of the funds NAV
Sophisticated - can use derivatives for investment, must use VAR to establish leverage levels, leverage limits are 99% monthly relative VAR cannot exceed twice the reference portfolios VAR or 99% of monthly absolute VAR cannot exceed 20% of the funds NAV
Economic Characteristics of Infrastructure
- high barriers to entry
- economies of scale
- inelastic demand for services
- low operating costs and high operating margins
- long duration
Describe the 2 step process financial institutions use to create securities that achieve a given credit rating
1- pooling - involves assembling a portfolio containing a large set of credit sensitive assets
2- tranching - involves dividing the claims on cash flows generated by the collateral into several classes/trances
Overcollateralization
the maximum loss to the collateral pool before impairment of the senior bonds
Depreciation Tax Shield
Depreciation Tax Shield = Depreciation * Tax Rate
Bad Leaver vs. Good Leaver Clause
Bad Leaver - for cause removal of GP. Needs a simple majority. Hard to prove
Good Leaver - allows the LPs to cease funding with a qualified majority
Insurance Perspective of Commodity Futures Returns
under normal backwardation hedgers are assumed to sell short commodity futures to cover their long positions. They therefore offer an insurance premium to investors in long only commodity futures. (ie a risk premium)
Hedge Pressure Hypothesis (for commodity futures returns)
hedgers can be long or short. Therefore risk premiums can be positive or negative depending on the net position of the hedger
Diversification Return
Diversification Return = Port Geometric Return - Weighted Avg Geometric Returns
Discuss evidence surrounding persistence of performance in private equity funds. Also indicate a consequence of this?
- Evidence indicates top quartile PE funds that performed well in the past will continue to perform well in the future.
- A consequence is that top quartile funds tend to be oversubscribed. Therfore new investors face a barrier to entry to access top tier funds.
Bailey Criteria
An ideal benchmark should have the following characteristics
(1)unambiguous(2)investable (3)measurable(4)specified in advance(5)appropriate
For each convertible bond, how much stock do you short?
delta * conversaion ratio
How can a hedge fund investment add value?
Strategic allocation, tactical allocation and manager selection.
Alpha Decay Formula
P(t True) = P(t-1 Reported) + [(1/AlphaDecay)*(P(t Reported) - P(t-1 Reported))]
Define Weak form, semistron form and strong form
Weak - past prices cannot be used to predict future prices
Semistrong - past prices as well as currently available public info cannot be used to generate returns
strong form - private info cannot be used to create profitable strategies
works bottom up.
Approach to risk management for PE funds
(1) risk measurement
(2) risk control
(3) risk mitigation
What constitutes a tender offer?
1- a limited time offer to purchase a large % of a companies debt securities at a premium
2- active solicitation of holders of public securities
3- firm terms
4- purch contingent on acquisition of securities
5- pressure for security holders to sell stock
De Souza and Gokcan - pre screening model identifies what as being associated with surving hedge funds
better performance, higher aum, old, high watermarks, longer lockups, required redemption periods
Which alternative strategies are most adoptable to mutual funds
Long short equity, long short credit and managed futures
Steps of unsmoothing a return series that contains first order autocorrelation.
1- specify the form of autocorrelation
2- estimate the parameter of the assumed autocorrelation process
3- use the estimated autocorrelation coefficient to generate the unsmoothed return series
In film higher budgets lead to (1) _______ revenues and (2) ______profitability
(1) Higher (2) lower
The fischer effect states that….
nominal interest rates incorporate real interest rates and a premium for anticipated inflation
Roll Return Formula
Excess Return - Spot Return = Roll Return
Formula for up and down multipliers in a binomial model
U = exp ( vol *SQRT(T) )
D = 1/U
Formula for up probability in a binomial model
Prob = (Exp(Rf) - D) / (U - D)
Describe the types of FoFs
- Balanced - an FoF that invests in a large number of hedge fund managers (30-40)
- Concentrated- a FoF that invests in a few strategies
- Single strategy
- multi-strategy
Spot to future commodity price formula
Future - Spot = Spot * (Funding + Storage - Convenience)* (T - t)
Rational Expectations Model
The price of an asset for delivery in the future must be the same as the markets current spot price in the future
Pension Benefit Obligation (PBO) change in yields formula
PBO = -1 * change in yields * duration
Intergenerational Equity Formula
intergenerational equity can be expressed by a 50% probability of maintaining the inflation adjusted value of the endowment in perpetuity
Describe the 3 primary sources that cause returns to go to extremes during tail risk events
1- increased risk to individual stocks due to higher fundamanetal and flow related risk at the company level.
2- high levels of short term corellation caused by deleveraging and derisking across large groups of securities
3- higher price for providing liquidity
Modified Delta
- used for discrete-time hedging. Modified delta provides a measure for the average change in the convertible price for a given change in the stock price
Exchange Traded Note (ETN)
- Exchange trades commodity index linked notes that are economically equivalent to fully collateralized forward contracts.
- Advantage - taxes - becasue they are an index they can qualify for long term capital gains
Disadvantage - credit risk (risk of issuing bank defaulting)
Total Return of one commodity futures contract vs. a portfolio of commodity futures contracts
Total Return of a cash collateralized commodity futures contract = cash return + excess return (excess return = spot + roll)
Total Ret Portfolio = cash ret + weighted avg exces ret + diversification ret
Theoretical Frameworks that explain commodity returns
- CAPM
- Insurance perspective (normal backwardation
- hedging pressure hypothesis
- thoery of storage
Affects of Smoothing on Real Estate
- reduced volatility
- lower correlations
- lower betas
- Consequences -inflated sharpe ratios, overallocation to real estate, inflated diversification potential, inaccurate hedge ratios
What is the argument from Jensen and Meckling and Myers on why financiers include covenants in their contracts with entrepreneurs?
to reduce agency costs
Hurt Money
Money the GP is required to commit to a fund
Explain the tenors for estimates, forecasts and scenarios
- estimates - short term
- forecasts - medium term (1-2 years)
- scenario analysis is used for future long term projections
Maximum Drawdown
[(Nav(small) / Nav(big)) - 1] *100
The _____ measure gives the true return of the portfolio.
pooled
the pooled measure gives the true return of the portfolio. It combines the individual funds cash flows and residual values together as if they came from a single fund
According to Gorton and Rouwenhorst how to commodities and equities perform through expansions and recessions
- Commodities and equities perform similarly through expansions and recessions
- commodity futures perform well in early stages of recession
commoditiy futures tend to perform poorly in later stages of a recession - commodity futures outperform stocks in later stages of an expansion
Define Commodity Beta
Commodity beta is the return associated with holding the active futures contract until its roll date and then rolling to the next active futures contract
- IE Roll return
Drawback of payoff distribution approach
it assumes that the return on the clone portfolio is the same as the return on the hedge fund if they have the same probability distribution.
Investors are not indifferent between two portfolios even if they have the same distriubtion
to reduce equity allocations after a 10% price increase what would you do?
Sell equity index call options 10% above the market
To buy equities after a 10% price decrease what would you do?
sell equity index put options with a strike price 10% below the current market
The most important components of IRR or PE are?
past present and future cash flows
What was Indersts conclsion regarding infrastructure as an asset class?
No emprical evidence or financial theory supports classifying infrastructure as a distinct asset class.
Master Limited Partnerships are most similar to?
MLPS are most similar to REITs. They avoid corporate taxation by distributing income to their investors
Factor Based Approach to hedge fund replication
- the most logical way to address hedge fund replication
- it assumes that the return on the clone portfolio is equivalent to the return on the hedge fund if there values agree with probability one
Investable hedge fund indices ______ perform non-investable indices
Under
- it is easier to replicate investible hedge fund indices because they have more transparent disclosure about component hedge funds
Which private equity investment typically yields the lowest returns
mezzanine funds
What part of a commodities return provides diversification benefit
Spot return
Spot Return Formula
Spot Return = [Spot Index(t)/Spot Index (t-1) ] - 1
Define Principal Guaranteed Notes
Cash and Call Strategy - principal guaranteed notes consist of 2 parts, an investment in a 0 coupon band and a call option linked to a commodity return
Define Capital at risk
the ratio of total loss if positions hit the stop loss price to net asset value and it can be part of a stop loss rule
According to Preqin, what do most investors allocate to infrastructure?
most investors have target allocations of 1-10% but actual allocations are generally lower
