Reading Flash Cards
Endowments
perrmanent pools of capital owned by institutions such as colleges, universities, hospitals, museums, and religious institutions
Corpus
the nominal value of the initial gift
Operating foundations
the income generated by the endowment is used to fund the operations of the charitable organization
Community foundations
based in a specific geographical area, concentrating the charitable giving of a regions residents. The gifts and investment returns received by the community foundation are distributed in the form of grants to other charities in the community
Corporate foundations
sponsored by corporations and their employees. Similar distribution to community foundations.
Independent foundations
funded by an individual or family
Intergenerational equity
balancing the need for spending on the current generation of beneficiaries with the goal of maintaining a perpetual pool of assets. 50% = value of maintaining inflation adjusted value in perpetuity. 50
Foundation Spending Limits
Us law requires foundations to spend 5% per year on expenses and charitable activities
Endowment Model
aggressive return targets as well as the perpetual life of endowments has led to an aggressive asset allocation (which often incudes substantial alternative investments).
Return Attribution
contributions from strategic asset allocation + security selection + market timing/allocation
strategic asset allocation return
multiplying weightd by benchmark returns to each asset class
Tail risk
a large drawdown in portfolio value during times of increased systemic risk
Real Assets
include inflation linked bnds, both direct and private equity fund investments in mining, oil and gas, timber, farmland and infrastructure. Ideally a real-asset portfolio would earn long term returns smilair to equity markets, with yields similar to fixed
Inflation beta
a positive inflation beta represents an inflation hedge.
Pension Plans (pension schemes or superannuation plans)
manage assets that are used t provide workers with a low of income during their retirement years
Mortality risk
the age at which someone dies
Longetivity risk
the risk that an individual lives longer than anticipated
Defined Benefit (DB) Pension Plans
a type of pension plan in which an employer/sponsor promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending directly on individual investment returns.
Retirement Income Replacement ratio
the pension benefit as a portion of final salary
Non-Portable Benefits
benefits earned at one employer do not continue to accrue at another employer
Accumulated Benefit Obligation
the present value of the amount of benefits currently accumulated by workers and retirees
Projected benefit obligation
the present value of the amount of benefits assumed to be paid to all future retirees of the firm
Funded status (pension plan)
the amount of the plan’s current assets compared to its projected benefit obligation (PBO)
Surplus of a pension plan
the amount of assets in excess of the projected benefit obligation (PBO)
Surplus risk
the tracking error of the assets relative to the present value of the liabilities
Frozen pension plan
a pension plan where employees scheduled to receive DB pension benefits will no longer continue to accrue additional years of service in the plan
Liability-driven investing (LDI)
seeks to reduce surplus volatility by building a portfolio of assets that produces returns that are highly correlated with the change of the plan’s liabilities
Government Social Security Plans
providing retirement income to all previously employed citizens of a specific country
Defined Contribution Plans
The employed makes a stated contribution to each covered employee on a regular basis. There is no surplus risk to the employee (assets always match liabilities).
Venture Capital
equity co-invested with entrepreneurs to fund their young and potentially fast-growing companies and is often active in technology sectors.
Early Stage VC
Split into the seed and startup stages
Seed Stage
takes place before a company is set up and any new product is sold
Startup Stage
Once the seed stage is successful the startup stage is used to establish the company and begin to market its new product
Expansion Stage (developmental capital stage)
company has already established the technology and market for its new product.
Buyout
capital provided as a mix of debt and equity to acquire from current shareholders an established business
5 Types of Buyout
MBO – management buyout, MBI – management buy-in, P2P – public-to-private, LBO – Leveraged buyout
Mezzanine
capital provided through the issuance of subordinated debt. Mezzanine financing is halfway between equity and secured debt
Rescue (turnaround) strategy
capital is provided to help established companies recover profitability after experiencing trading, financial, operational or other difficulties
Replacement capital (secondary purchase) strategy
capital provided to acquire existing shares in a company from another PE org.
Limited partnership structure
PE Fund Investment program buys units of a PE fund GP which in turn purchases units of a PE fund
Co-investment
the PE fund has an additional investment in a certain portfolio company typically at a preferential manager and fee terms
Going direct
eschew PE funds altogether – makes direct investments in to the portfolio company
Vintage year
the year in which the first capital is drawn down
J-curve – (hockey stick)
curve generated by plotting the returns generated by a PE fund against time
Net Asset Value (NAV) J-Curve
the evolution of NAV versus the net paid in (NPI)
Limited Partnership Agreement (LPA)
defines the legal framework of the fund and its terms and conditions. Divided up into two main categories (1) investor protection clauses and (2) economics terms and clauses.
Distribution waterfall
defines how returns are split between LP and GP and how fees are calculated
Moral Hazard
cheating
adverse selection
Lying
holdup problem
In economics this is a situation in which two parties refrain from cooperating due to concerns that they might give the other party increased bargaining power and therefore reduce their own profits
Qualified majority
75% of the limited partners (as opposed to 50% for a simple majority)
Carried interest (carry)
the share in the funds profits received by the fund manager. This can be calculated on either fund as a whole or a deal by deal basis
Preferred return (hurdle rate)
the minimum return the manager must make before they acquire the carry
Key person provision
allows the limited partners to suspend investment/divestment activities until a replacement is found
Bad-leaver cause
allows for a for-cause removal of the GP. Normally requires a simple majority, but is hard to prove cause/conditions for a for cause removal
Good-leaver termination
requires a qualified majority (75%) but requires no cause
Clawback
a liability triggered when at the end of a funds life, the limited partners have received less than the sum of contributed capital and a certain amount of the funds profits. Can go both ways (GPLP)
Type 1 Conflict of Interest
conflict between a firms own economic interests and the interests of its own clients
Type 2 Conflict of Interest
conflict between the firms clients, or between types of clients and forces the firm to pick between the two.
PE Performance Drivers
portfolio design, management of liquidity, and fund manager selection
Bottom up approach
based on fund manager research, emphasis is on screening all investment opportunities in the targeted PE markets and picking the perceived best fund managers.
Top down approach
analyzes the macroeconomic conditions surrounding the targeted PE markets and then determines the strategic asset allocation
Core-satellite approach
is a way of allocating assets to protect and grow wealth. The portfolio is structured into various sub portfolio.
Core portfolio
the safe/base portfolio.
Satellite portfolio
the bet on radical changes
Naïve diversification
the optimal strategy when there is no information that allows differentiation among assets
Interim Internal Rate of Return (IIRR)
cash weighted IRR and the since-inception IRR. The most appropriate return measure for VC and PE funds. [(Dt / (1 + IIRRt)^t) – (Ct / (1 + IRRt)^t) + (NAVt / (1 + IIRRt)^t) = 0]; where Dt = fund distribution in period t, Ct = capital contribution or drawd
Internal Rate of Return (IRR)
the implied discount rate that makes the NPV of all cash flows equal to 0. [(Dt / (1 + IRRt)^t) – (Ct / (1 + IRRt)^t) = 0]; where Dt = fund distribution in period t, Ct = capital contribution or drawdown in period t.
Modified IRR (MIRR)
assumes a given reinvestment rate, instead of using the IRR rate.
Total Value to paid in ratio (TVPI or total return)
a measure of the cumulative distribution to investors plus the total value of the unrealized investments to the total capital drawn from investors
Distribution to paid-in ratio (DPI or realized return)
a measure of the cumulative distribution to investors relative to the total capital drawn from investors
Residual value to paid-in ratio (RVPI on unrealized return)
a measure of the total value of the unrealized investments relative to the total capital drawn from investors
Benchmarking
aims to evaluate the performance of a specific entity by comparison to a standard or a point of reference.
Important aspects of a benchmark:
Unambiguous/knowable, Investable, Measurable, Specified in advance, Appropriate
Survivorship bias
the bias that managers or funds that perform poorly tend to go out of business and drop out of the peer universe
Style drift
the tendency of investment managers to deviate over time from their initially stated and agreed-on investment style
Two main exit routes to PE investments –
secondary transactions and securization
Secondary transactions
there is a secondary market for limited partnership shares. Transactions take place at a negotiated price, often at a significant discount to NAV
Securitization
involves the transfer of a partnership share to a SPV for a collateralized fund obligation.
Economic value approach
used to forecast cash flows
Bottom up cash flow projection
analyzing a funds main drivers and aggregating these individual components
Modified bottom up approach
this is used when it is difficult or too costly to determine to determine specific exit scenarios. In this case, alternative inputs are used at the fund manager or market level, including fund manager track record or broad VC market insight
Modified comparable approach (Top down cash flow projection)
this method does not rely on the projection of individual portfolio company exit values, but rather on a high level evaluation of the overall private equity fund and on information on the pas performance of cash flows of comparable funds
CAPM
defines the relationship between risk and return. E(Ra) = Rf + Ba [ E(Rm) – Rf ]
Relative volatility
measures the volatility of an asset relative to the average volatility across all assets in the market
Bottom-up beta approach
estimating risk parameters using the financial characteristics of the portfolio companies
Unleveraged Beta
B(u) = B(l) / [ 1 + (1-Tc) x (D/E) ]; where Tc = corporate tax rate and D/E = debt to equity ration
Advantages to real estate
Absolute returns, Inflation hedge, Diversification with stocks and bonds, Cash inflows, Income tax advantages
Disadvantages
Heterogeneity (uniqueness, every property is very different and hard to analyze), Lumpiness (assets cannot easily be bought and sold), Illiquidity
Mortgage
a debt instrument collateralized by real estate. Mortgages with high credit risk can behave like equity and long term leases can behave like debt
Private Real Estate Equity
involves the direct or indirect acquisition and management of actual physical properties that are not traded on an exchange
Public Real Estate Investment
the buying of shares of real estate investment companies and investing in other indirect forms of real estate
REITs
securitized pools of real estate. Advantages are liquidity, investor access, low transaction costs, better corporate governance and transparency
2 Main Restrictions to REITS
(1) 75% of income must be derived from real estate activities – (2) 90% of taxable income must be paid out in the form of dividends
Fisher effect
states that nominal interest rates will incorporate both real interest rates and a premium for anticipated inflation. The net result is every asset in an informationally efficient market provides identical protection from anticipated inflation
Smooth
the extent that a price or return series demonstrates a delayed response to price movement
Unsmoothing
the process of removing the effects of smoothing from a data series
Causes of RE smoothing
Appraisals and transaction costs cause smoothing
First order autocorrelation
when the first data point correlates to the data point prior
Anchoring
the disproportionate weight given to previous observations
Core Real Estate
assets that achieve a relatively high percentage f their return from income and are expected to have low volatility. Core properties are the most liquid, most developed, least leveraged, and most recognizable properties in a real estate portfolio. Most of
Value-Added Real Estate
exhibit one or more of the following attributes: (1) achieving a substantial portion of their return from appreciation in value, (2) exhibiting moderate volatility, (3) not having the reliability of core properties
Opportunistic Real Estate
properties expected to derive a substantial part of their return from property appreciation and may exhibit substantial volatility in value and returns.
Real estate style boxes
use 2 categorizations of real estate to generate a box or matrix that can be used to characterize properties or portfolios
Cap Rate
the cap rate of a real estate investment is the net operating income (NOI) of the investment divided by some measure of the real estate’s total value: Cap Rate = NOI / Value
Real Estate Value
NOI / Cap Rate
Cap Rate Spread
the excess of the cap rate over the yield of a default-free 10 Yr bond.
Risk Premium Approach
expresses a risky assets return as the sum of a riskless return and a premium for bearing the risk of that asset
NCREIF NPI (National Property Index)
appraisal based index. Value weighted. Calculated on an unleveraged basis and pre-tax. Property values are reported every quarter
Real estate price discovery
the process by which the opinions of market participants about the value of an asset are combined together into a single statistic.
Hedonic price index
involves using observed real estate transaction of some properties to estimate the prices of all properties.
Pooling of securities
a collection of tradable securities into a single tradable entity
Securitization
a collection of non-tradeable securities into a single tradable entity
Open Ended vs. Closed End Funds
Closed end funds have a fixed amount of shares, so it will be trading at a premium/discount to NAV. Open ended funds should trade close to NAV
Income Taxation
investors in high income brackets should concentrate on real estate investments that offer substantial income taxation advantages, and investors in low or zero income tax brackets should generally avoid investments that offer tax advantages
2 Primary Tax Advantages to Investing in RE
(1) Deferral of gains (real estate can offer the advantage of deferred taxation of investment gains until the assets are liquidated) and (2) Leverage (generally offers tax deductible financing costs for income tax purposes)
Leveraged Return Formula
R(lev) = R (asset) * L; where L = leverage factor
Leveraged Volatility
Vol(lev) = Vol(asset) * L
Rational for Farmland as an investment
Inflation hedge, A diversifying source of return, and As an asset positioned for a food and energy scarcity theme
Biofuels
the use of agriculture products for producing fuels
Advantages of direct ownership of land
Yield enhancing technologies, Insulation from systemic failure or disruption of financial system
Crop Yield Formula
Y = S * I * E * * H; Y = Yield, S = total solar radiation per period, I = fraction of total solar radiation captured by the crop canopy, E = photosynthetic efficiency of the crop, H = harvest index (fraction of total dry matter that is havestable
Row Cropland
annual cropland – land used to grow plants that are replanted each year
Permanent Cropland
used to grow crops that do not need to be replanted annually
Intellectual property
intangible asset, broken into 3 categories; film production and distribution, artwork, and research and development.
Unbundled intellectual property
IP that may be owned or traded on a standalone basis
Mature intellectual property
IP that has developed and established a reliable usefulness
Spillover effects
can elevate the estimated return substantially. The spillover effects (externalities) represent the effects on other entities such as benefits realized by other firms and consumers
Film production and distribution Life Cycle
(1) Story rights acquisition (2) Preproduction (3) Principal photography/production (4) Postproduction
Types of equity financing in film
(1) Slate equity financing – an outside investor funds a set of films to be produced by a studio. This allows financial risk to be spread across a series of films that typically have tight guidelines (2) Corporate equity – equity fund raising to fund the
Investment properties of Art
the newly wealthy (emerging markets) have a demand for art that is driving up auction prices
Hedonic price estimators
use a regression based methodology to synthetically develop continuous price series by controlling for the unique characteristics of each transaction
Repeat sales estimators
focusing on returns of artwork with one or more sales and applying those returns to the group
Hammer prices
final auction prices, do not include commissions to the auction house
Masterpiece effect
returns to the most expensive artworks are qualitatively different from the market as a whole
Negative pickup deal
film distributor agrees to purchase a film for a specific fixed sum upon delivery
sale license-back patent strategy
patent holder sells one or more patents to a buyer who then licenses those patents back to the original holder. The holder benefits by monetizing a portion of the asset and the buyer can place the patent in a pool and license it out to a broader group
Durable Assets
employed in the production of wealth, but not consumed in the process
Non-Durable Assets
assets that are used up in the production process
Financial Assets
claims on the income that is derived from the use of real assets
Speculation
the purchase (or sale) of goods with a view to re-sale (or repurchase) at a later date, where the motive behind such action is the expectation of a change in the price
Convenience yield
the benefit that comes from physical possession of an asset
Consumer surplus
the difference between the highest price a buyer would be willing to pay and the actual market price
Cost of carry
the cost of storing a commodity; this includes (1) financing costs, (2) storage costs, and (3) spoilage
Cash and carry arbitrage
when the forward cost is higher than the current cost + cost of carry and a buyer could profit by buying the commodity and storing it while simultaneously selling the future.
Contango
when the forward curve is upward sloping. When the future price is higher than the spot price
Backwardation
when the forward curve is downward sloping. When the future price is below the spot price
Rational Expectation Hypothesis
the price of an asset for delivery in the future must be the same as the markets current forecast of the spot price of the asset on the future delivery date
Normal Backwardation
the tendency of commodity futures contracts to trade at prices below the rational expectations price.
Preferred habitat hypothesis
the producers of bonds (borrowers) prefer long maturities, wheras consumers of bonds (lenders) prefer short maturities. Producers offer attractive yields (low bond prices) to entice borrowers to extend their maturity, or to induce speculators to borrower
Stock-out
when storage is 0 and consumption is fully dependent on production
Liquidity preference hypothesis
occurs when there is an insufficient natural commercial long position in the futures market, so some long positions must be taken by speculators in order to balance the market
Normal contango
the relationship between futures prices and expected spot prices
Arithmetic Mean Return
R(Arithmetic) = 1/T * (R1 + R2 + . . . . RT); T = years
Geometric Mean Return
R(Geometric) = ((1 + R1) + (1 + R2) . . . (1 + RT) – 1)) ^ (1/t)
Relationship between arithmetic mean and geometric mean
R(geo) = R(arith) – (1/2)*(STDEVport)^2
Income return (collateral yield)
return that results from the return of the cash collateral (which is usually a treasury)
Roll return
the portion of return of a futures contract that is due to a change in the basis
Spot returns
result from the changes in the value of the underlying cash commodity
Scarcity
when the forward curve is downward sloping. People are willing to pay a premium for the commodity at spot
Relative Value Strategies
attempt to identify mispriced assets or securities and to hedge away some or all of the market exposure
Fundamental directional strategies
based on an analysis of supply and demand factors for commodities. Can be based on macroeconomic factors.
Quantitative directional strategies
use technical or quant models to identify overpriced and underpriced commodities
Commodity spreads
strategies that take advantage of trading opportunities that can be executed entirely in derivatives markets.
Calendar spread
taking opposing positions in the futures market for delivery at different times in the future.
Bull spread
where an investor is long the near contact and short the distant contract. In a backwardated market they are hoping that the spread widens and in a contango market they are hoping the spread narrows
Bear spread
where an investor is long the farther contract and short the near contract. In a backwardated market they are hoping that the spread narrows and in a contango market they are hoping the spread widens
Processing spreads
seek to take advantage of the relative price difference between a commodity and the products producing the same commodity
Crack spreads
typically used by oil refineries to lock in the margin. Long oil futures and short gasoline
Crush spreads
typically used by soybean processors – long soybean futures and short soybean oil/meal futures. Protects from rising costs of inputs and decreasing outputs
Substitution spreads
trades between commodities that can be substituted for one another.
Quality spreads
spread is across the different grades of the same commodity
Location spreads
trades across the same commodity but different delivery locations
Storage strategies
utilizing storage facilities to buy and hold physical commodities for delivery at a future time
Transportation strategies
utilize spot commodity markets to execute location trades. Involves leasing transportation to take commodities from one location to another
Commodity index swap
an exchange of cash flows in which one of the cash flows is based on the price of a specific commodity index while the other cash flow is based on an interest rate
principal guaranteed notes
notes that offer investors the opportunity to profit if commodity prices rise, combined with a guarantee that the principal amount will be returned at the maturity of the structure
Cash and call strategy
the principal guaranty comes from an investment in zero coupon notes, while the commodity linked returns comes through call options.
Dynamic strategy
varies the size of the commodity investment based on the cost of insuring the principal guaranty
Commodity index
a group of commodity futures contracts
Commodity beta
the return to holding the active futures contract until the contract roll date and then rolling to the next active futures contract. This is the simplest way to hold commodities
Roll return (roll yield)
the profit or loss from holding a futures contract due to the change in the basis. Positive when in backwardation and negative in contango.
Spot return
the difference between the excess return of an index and the roll return.
Unexpected inflation
inflations minus the short term interest rate
Front month equivalent – FME
a statistical measure that defines the entire position of a commodity in an equivalent to the front month contract
Market impact cost
the percentage loss incurred by a portfolio during the unwind of a large position
Managed futures
sector of the investment management industry in which professional money managers actively manage client assets using global futures and other derivatives as investment instruments
CTA
commodity trading advisor
CPO
Commodity pool operators
Commodity pool
a comingled investment vehicle that is managed by a commodity pool operator (CPO).
Commodity Futures Trading Commission (CFTC)
created in 1974 as a fed regulatory agency for all futures and derivatives trading
National Futures Association (NFA)
an independent industry supported self regulatory body created in 1982.
Sing currency margining
the trading client can post the full margin in the form of dollars. Under this arrangement the client can post the full margin in one currency and the clearing firm is responsible for converting into the base currency for the respective trades
Variation margin
daily cash settlements of gains and losses
Margin to equity ratio
the proportion of client assets required for margin deposits.
Efficient market hypothesis `
investors should not be able to earn abnormally high returns in perfect financial markets, because prices incorporate all available information
Weak form efficiency
past prices cannot be used to predict future price changes
Semistrong form efficiency
past prices as well as currently available public information cannot be used to create profitable trading opportunities
Strong form efficiency
even private information cannot be sued to create profitable trading strategies
Data mining
researchers may have examined hundreds of strategies to discover what would have worked in the past, but there is no reason this will work in the future
Data snooping
researchers are influenced by past findings and therefore sample selections are not truly “random”
Anchoring
causes market participants to use the initial price as an anchor. As a result, they are slow or can under react to new information
Disposition effect
leads market participants to close their profitable positions to quickly and hold their losing positions for a longer period.
Herding
a group of investors who after observing a price trend decide to come to the market to take advantage of the trend. This effect can feed on itself leading the price trend to continue
Confirmation bias
leads an investor to favor info that confirms their initial beliefs
Representativeness bias
participants tend to look at past prices to form their beliefs
Margin requirement
amount of collateral or margin that a party to a futures contract must put up
Initial margin requirement
the amount of cash (or treasuries) that must be in an acct at the broker for FCM (futures commission merchant) in order to initiate a trade
Maintenance margin
the amount of margin required to carry previously initiated positions
Margin to equity
the amount of initial margin as a percentage of the NAV of the investment account
Capital at Risk (CaR)
the total loss that each position would hit its stop-loss price level on that day.
Value at Risk (VaR)
a method of measuring potential loss in an investment portfolio given a particular holding period, with no changes to the portfolio during the period and a particular confidence level
VaR Formula
VaR = Alpha (Critical value at X confidence level) * Daily Volatility * Daily Mean Return
Parametric approach to calculating VaR
one assumes that return on the investment follows a known distribution (typical normal).
Maximum Drawdown
the relative value of the last peak price to the all-time low price since the peak was reached
Omega Ratio
a more general measure of risk that takes the entire distribution of an investment
Omega
Upper Partial Moment / Lower Partial Moment; Upper Partial Moment = average realized return in excess of a given target return; Lower Partial Moment = average realized loss in excess of a given target return
Backfill bias (instant history bias)
occurs when a funds decides to start providing its performance to an index and also provides its historical performance.
Survivorship bias
occurs when a funds performance data is remove from the database as a result of the fund shutting down
Access bias
arises because some managers may not wish to be part of an investable index due to restrictions that such indices may impose on them.
Straddle
the trader takes long positions in both call and put options on the same underlying asset. Investor will profit if the asset makes large moves in either direction
Gamma
gamma measures the rate of change in the delta of an option as the price of the options underlying asset changes
CTA Fund
a separate legal corporation with a board of directors that assigns trading authority to the single manager CTA’s investment management company
Master feeder structure
two funds feed into a single master account. One feeder for US investors and one for overseas investors. This allows the fund to serve both investor groups with the ease
Multi CTA Funds
CTA Fund of Funds
Hedge fund replication products
(clones or trackers) – are created to capture the traditional and alternative betas underlying the expected return and risk of a hedge fund benchmark
Alternative betas
those sources of return that are not normally available through investments in traditional assets (or are commonly bundled with other risks).
Fund bubble hypothesis
assumes that successful hedge fund managers can earn substantially greater incomes than successful fund managers in the traditional space. As investment bubbles expand in certain assets classes, more investors will come, with that, more bad managers
Capacity constraint hypothesis
argues that most alpha is a zero sum game.
Increased allocation to active funds hypothesis
as hedge fund investment becomes more popular, the performance of hedge funds will be adversely affected by the trading decisions of investors who have allocations to these funds as well as traditional assets
Three approaches to hedge fund replication
(1) factor based (2) payoff distribution (3) bottom up algorithmic
Factor based approach to hedge fund replication
a significant portion of a funds returns can be explained by a set of asset based factors
View commonality
when individual hedge funds managers’ views are aggregated in an index they tend to cluster into common themes that drive the overall performance of the index
Exposure inertia
attempts to explain why the overall weights of an index consisting of actively managed portfolios can be empirically estimated
Nonlinear approach to replication
this idea is based on the approach that hedge fund managers have the skill to time the market, and therefore will increase their exposure to a factor when return is expected to be positive and vice versa.
Payoff distribution approach to hedge fund replication
aims to produce a return distribution that matches that of the benchmark
Bottom up (algorithmic approach) to hedge fund replication
involves implementing a simple version of the actual trading strategy employed by funds that follow that particular strategy.
Convertible Arbitrage
buying cheap convertible bonds and hedging the market risk by selling short the underlying stock
Conversion ratio
the number of shares obtained if one converts 100% of the face value of the bond
Conversion price
the price at which shares are indirectly purchased via the convertible security
Call protections
grants the issuer the right to call back the convertible bond before its maturity. This can either be a (1) hard call, where the issuer can call the bond at a pre-fixed price or a (2) soft call, where the issuer can call the bond only if the equity price
Convertible price
the quoted price of the convertible bond, usually expressed as a percentage of the nominal value
Parity
the total market value of the shares into which the bond can be converted. It is calculated as the shares per bond * the $ per share. For a convertible bond to be “in-the-money” parity needs to be over 100%
Conversion premium
the difference between the convertible bond price and parity
Component Approach to Valuing a Convertible Security
Convertible Bond = Straight Bond + Call Option on the underlying stock
Four Possible States for a Convertible Bond
(1) Junk or Distressed – when the stock price is so low that it indicates substantial doubt about the issuers ability to meet debt obligations, (2) Busted – when the stock price is low enough that conversion is unlikely. The value of the call option is ne
Delta
measures sensitivity of the value of a derivative security to changes in its underlying asset (or in other words, the Delta measures the sensitivity of the bond to the changes in parity value. Delta = Derivative Price / Stock Price
Modified Delta Formula
½ * [ (Change on Convertible Value/Positive Change in Stock Price) + (Change on Convertible Value/Negative Change in Stock Price)]
Gamma
measures the rate of change of the delta as the stock price changes. Gamma = Convertible Value / Stock Price = Delta / Stock Price
Vega
measures the sensitivity of the convertible bond value to changes in the volatility of the underlying stock. Vega = Convertible Value / Volatility
Theta
time decay – the change in the convertible price due to the passage of time. Theta = Convertible Value / Time
Rho
the sensitivity of a convertible value to movements in interest rates. Rho + Convertible Value / Interest Rates
Chi
estimate of the rate of change of a convertible’s value to changes in the spot exchange rate
Omicron
an estimate of the rate of change of a convertibles value to changes in the credit spread
Upsilon
an estimate of the rate of change of a convertibles value to changes in the credit recovery rate
Phi
an estimate of the rate of change of a convertibles value to changes in the underlying stocks dividend rate
Carry trade
borrowing in a low interest rate currency and lending in a high interest rate currency without hedging the exchange rate risk. The goal of the trade is to capture the interest rate differential
Covered interest rate parity formula
(1 + risk free(foreign)) * Forward Domestic/ Spot Domestic = (1 + risk free (domestic))
Uncovered interest rate parity formula
(1 + risk free(foreign)) * Expected Future Spot Domestic/ Spot Domestic = (1 + risk free (domestic))
Law of one price
absent transaction costs, the same item should have the same cost in all countries adjusted using current exchange rates
Absolute PPP
compares the price of a basket of goods across countries
Relative PPP
provides a one to one link between inflation differential and exchange rate changes. Relative PPP = Exchange Rate@t0/Exchange Rate@t1 = 1 + InflationDomestic / 1 + InflationForeign
Short squeeze
a situation where the stock price rises rapidly and the short sellers are forced to cover their positions for risk management purposes.
Form 13F Filings
required of institutional investment managers having discretion over $100mm in 13F securities. 13F filings disclose holdings information
Short stock rebate
an institutional short seller will receive this. The rebate is typically an index linked variable interest rate minus the borrowing costs that the borrower earns on the proceeds of the short sale.
Mean reversion
the tendency to return to typical historical relationships or levels
Co-integration
the relationship between a drunken person and that persons dog, both walking aimlessly. Though they both appear to meander randomly, they move less wildly and widely as they continually adjust their positions closer to each other as they try to reunited.
Z-scoring
A common technique that transforms the original data into standardized dimensionless quantities
Price momentum
exists when the market prices of companies or sectors that have performed well in the past continue to perform well in the future
latency arbitrage
a manager who has a deep understanding of the technology infrastructure of the exchanges can identify trading opportunities
Hedge Funds of funds serve the following purpose
portfolio construction, manager selection, risk management and monitoring and due diligence
concentrated FoF
typically allocates assets to a small number of hedge fund managers (5-15)
balanced FoF
invests in a large number of hedge fund managers
Advantages of FoF
diversification, accessibility to economies of scales, information advantage, liquidity, access to certain managers, negotiated fees, regulation, currency hedging, leverage, educational, role
Disadvantages of FoF
double layer of fees, performance fees on portions of the portfolio, taxation, lack of transparency, exposure to other investors cash flows, lack of control, lack f customization
Private Adviser Exemption (Advisers Act)
allowed investment advisers to claim an exemption from registration if they (1) had fewer than 15 clients during the previous 12 months, (2) did not publicly hold themselves out as investment advisers, and (3) did not advise registered investment companie
Accredited Investor
a natural person who has a net worth exceeding $1mm. Dodd-Frank removed a persons primary residence from this calculation
Dodd-Frank changes
private adviser exemption, accredited investors, 13F filers must report short sales, increased liability for aiding and abetting
13(d)
requires an adviser who owns more than 5% of a publicly traded security to file disclosure within 10 days of the acquisition
13(f)
requires a fund manager with investment discretion of $100mmm to file quarterly reports
Section 16
apples to fund managers who, investing for their own accounts or for the purposes of changing or influencing control of the issuer, own more than 10% of a class of a publicly traded company’s outstanding equity securities
Form PF
required by Dodd-Frank – Registered investment advisers with at least $150mm of AUM are required to file.
Alternative Investment Fund Managers Directive (AIFMD)
created to regulat3e the marketing of alternative investment funds in the European Union
Operational Risk
losses caused by problems with people, processes, technology, or external events
Hard lockup provisions
do not allow redemptions for any reason during the lockup period
Soft lockup provision
the hedge fund will allow withdrawals during the lockup period if the investor pays a penalty to the fund to compensate other investors for the trading costs caused by the liquidation of the existing investors holdings
Gating provision
a restriction placed by the hedge fund that limits the amount of withdrawals during a redemption period
Fund administrators
maintain the hedge fund’s books and records and facilitate any subscription/redemption requests
Prime brokers – services they add
(1) introducing hedge funds to investors, (2) securities lending, (3) facilitating leverage, (4) portfolio reporting and risk reports, (5) specific operational support, (6) office leasing and servicing, (7) capital (human capital) introduction, (8) consul
Naked short selling
short sales by persons who, at the time of selling, have no plan in place to meet their obligations
Covered short selling
first securing the borrowing of the stock before selling it.
Gross exposure
the absolute level of investment bets, measured as the total of long and short positions
Net exposure
the implicit amount of directional market risk that resides unhedged in the portfolio
Static returns
the gains of the portfolio in the absence of change in the price of underlying stocks
Market linked returns
coming from the residual net long or net short market exposure
Manager alpha
can arise because of stock picking or market timing activities
Reverse merger
taking the inverse of the usual position (buying the acquirer and selling short the target). Regular merger play involves buying the target and shorting the acquirer
Swap spread arbitrage
enter into a received fix swap, short the treasury and invest the proceeds into a margin account earning the repo rate.
