Quantitative Foundations Flashcards
What does compounding recognize?
That interest on interest creates more wealth than simple compounding.
What is discrete compounding?
Any compounding interval other than continuous compounding such as daily, monthly, annually.
What is continuous compounding?
Continuous compounding uses a natural log-based formula to calculate and add back accrued interest at the smallest possible intervals.
What is a return computation interval?
The smallest time interval for which returns are calculated. (ie daily, monthly, even annually)
What are other names for return computation intervals?
Granularity, time resolution, or frequency of return ratio
What are two common tasks in return analysis?
- Aggregating a number of returns from a smaller sub period into one large sum.
- Determining an average return.
What is the mathematical difference between simple returns and log returns?
Simple returns require multiplication and log returns use addition.
What is a forward contract?
An agreement to make an exchange at some date in the future.
What is the typical starting value of a forward contract?
0
What is notional principal?
The value of the asset underlying or used as reference to the contract or the derivative position.
What does it mean to be fully collateralized?
The position has been paired with a quantity of capital equal in value to the notional principal of the contract.
What are the two components of return for a fully collateralized position?
- The change in value of the derivative.
2. Any return on the collateral.
How is the rate of return for traditional investments calculated?
rate of return= (change in price + cash flows)/initial price
What is the internal rate of return or IRR?
This equates the present value of costs (cash outflow) with the present value of benefits (cash inflow). It also acts as the discount rate that makes the net present value (NPV) equal to 0.
What are the four types of IRRs?
- Lifetime IRR
- Since Inception IRR
- Interim IRR
- Point to Point IRR
What is a lifetime IRR?
A lifetime IRR contains all the cash flows, realized and anticipated, of the investments life. You would have periods 0 to termination.
What is a since inception IRR?
Used as a measure of fund performance rather than individual performance. In this case there is no liquidation, rather T indicates the date through to which you are analyzing.
What is interim IRR?
IRR based on the realized cash flow and its current estimated residual value rather than realized cash flow.
What is a point to point IRR?
Only analyzes a certain period of an investments life. This is based on realized gains/losses rather than anticipated gains/losses.
What are the problems with the Internal Rate of Return?
- Complex cash flow pattern
- Borrowing type cash flow pattern
- Multiple sign change cash flow pattern
What is a complex cash flow pattern?
An investment involving borrowing or multiple sign changes.
What is a borrowing type cash flow pattern?
Begins with one or more cash inflows and then is followed only by cash outflows.
What is a multiple sign change cash flow pattern?
Fluctuates between inflows to outflows then outflows to inflows.
((Here the maximum number of IRRs is equal to the maximum number of sign changes.))
What are scale differences?
When investments have unequal sizes and/or timing of their cash flows.
What is reinvestment rate assumption?
Refers to the assumption of the rate at which any cash flows not invested in a particular investment or reccieved during the investment’s life can be reinvested during the investment’s lifetime.
What are time weighted returns?
Assumes no additional cash was contributed over the time period.
What are dollar rated returns?
Returns that have been adjusted for when cash has been invested or withdrawn.
What weighting are investment managers best evaluated on?
Time weighted.
What weighting are individual investors returns best evaluated on?
Dollar weighted.
What is a waterfall?
The provision that lays out the agreement of how the distributions from the fund will be split and payouts prioritized. ie what funds must be given to the LPs before the GP or fund manager can take part.
Why is the waterfall important?
It is one of the only ways LPs can manage risk.
What is cash flow?
Profit minus management fees.
What is carried interest?
The portion paid to the GP as compensation for services (above the management fee)
What are other names for carried interest?
Incentive fee, performance based fee
What percentage can carried interest go up to?
20%
When does the carried interest become payable?
Once LPs have achieved repayment and hurdle rate.
What is the hurdle rate?
The return threshold that the funds must pay to their investors also known as preferred return.
What is a catch-up provision?
Contains a catch-up rate (% of profits used to catch up incentive fee once hurdle is achieved)
What is vesting?
The process of granting full ownership of conferred rights.
What is a clawback?
Ensures that if a fund does well early in its life then weakens, the LP gets back the inventive fees until their capital contribution, expenses and any preferred return promised have been paid.
What does the compensation scheme outline?
Governing management fees, GP investment in the fund, carried-interest allocations, vesting, and distributions.
What is the goal of the compensation scheme outline?
To align the interests of the LP and GPs.
What are the management fees based on?
The size of the fund, not the performance.
What two methods does private equity use to determine profits and fees?
Fund as a whole carried interest and deal by deal carried interest
What is fund as a whole carried interest?
Based on aggregate profits and losses across all investments.
What is a deal by deal carried interest?
It is awarded seperately based on each individual investment.
