vocab Flashcards
glossary
absolute return products
Absolute return products are investment products viewed as having little or no return correlation with traditional assets, and have investment performance that is often analyzed on an absolute basis rather than relative to the performance of traditional investments.
absolute return standard
An absolute return standard means that returns are to be evaluated relative to zero, a fixed rate, or relative to the riskless rate, and therefore independently of performance in equity markets, debt markets, or any other markets.
active management
Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return.
active return
Active return is the difference between the return of a portfolio and its benchmark that is due to active management.
active risk
Active risk is that risk that causes a portfolio’s return to deviate from the return of a benchmark due to active management.
alternative investments
Alternative investments are sometimes viewed as including any investment that is not simply a long position in traditional investments.
benchmark
A benchmark is a performance standard for a portfolio that reflects the preferences of an investor with regard to risk and return.
benchmark return
A benchmark return is the return of the benchmark index or benchmark portfolio
commodities
Commodities are homogeneous goods available in large quantities, such as energy products, agricultural products, metals, and building materials.
compensation structure
Compensation structure refers to the ways that organizational issues, especially compensation schemes, influence particular investments.
distressed debt
Distressed debt refers to the debt of companies that have filed or are likely to file in the near future for bankruptcy protection.
diversifier
A diversifier is an investment with a primary purpose of contributing diversification benefits to its owner.
efficiency
Efficiency refers to the tendency of market prices to reflect all available information.
farmland
Farmland consists of land cultivated for row crops (e.g., vegetables and grains) and permanent crops (e.g., orchards and vineyards).
financial asset
A financial asset is not a real asset—it is a claim on cash flows, such as a share of stock or a bond.
hedge fund
A hedge fund as a privately organized investment vehicle that uses its less regulated nature to generate investment opportunities that are substantially distinct from those offered by traditional investment vehicles, which are subject to regulations such as those restricting their use of derivatives and leverage.
illiquidity
Illiquidity means that the investment trades infrequently or with low volume (i.e., thinly).
incomplete markets
Incomplete markets refer to markets with insufficient distinct investment opportunities
inefficiency
Inefficiency refers to the deviation of actual prices from valuations that would be anticipated in an efficient market.
information asymmetries
Information asymmetries refer to the extent to which market participants possess different data and knowledge.
infrastructure investments
Infrastructure investments are claims on the income of toll roads, regulated utilities, ports, airports, and other real assets that are traditionally held and controlled by the public sector (i.e., various levels of government).
institutional structure
Institutional structure refers to the financial markets and financial institutions related to a particular investment, such as whether the investment is publicly traded.
institutional-quality investment
An institutional-quality investment is the type of investment that financial institutions such as pension funds or endowments might include in their holdings because they are expected to deliver reasonable returns at an acceptable level of risk.
investment
An investment is that it is deferred consumption. Any net outlay of cash made with the prospect of receiving future benefits might be considered an investment.
land
Land comprises a variety of forms, including undeveloped land, timberland, and farmland.
lumpy assets
Lumpy assets are assets that can be bought and sold only in specific quantities, such as a large real estate project.
mezzanine debt
Mezzanine debt derives its name from its position in the capital structure of a firm: between the ceilings of senior secured debt and the floor of equity.
moral hazard
Moral hazard is risk that the behavior of one or more parties will change after entering into a contract.
operationally focused real assets
Operationally focused real assets include real estate, land, infrastructure, and intellectual property.
passive investing
Passive investing tends to focus on buying and holding securities in an effort to match the risk and return of a target, such as a highly diversified index.
private equity
The term private equity is used in the CAIA curriculum to include both equity and debt positions that, among other things, are not publicly traded.
pure arbitrage
Pure arbitrage is the attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets.
real assets
Real assets are investments in which the underlying assets involve direct ownership of nonfinancial assets rather than ownership through financial assets, such as the securities of manufacturing or service enterprises.
real estate
Real estate focuses on land and improvements that are permanently affixed, like buildings
regulatory structure
Regulatory structure refers to the role of government, including both regulation and taxation, in influencing the nature of an investment.
relative return standard
A relative return standard means that returns are to be evaluated relative to a benchmark.
return diversifier
If the primary objective of including the product is the reduction in the portfolio’s risk that it is believed to offer through its lack of correlation with the portfolio’s other assets, then that product is often referred to as a return diversifier.
return enhancer
If the primary objective of including an investment product in a portfolio is the superior average returns that it is believed to offer, then that product is often referred to as a return enhancer.
securities structure
Securities structure refers to the structuring of cash flows through leverage and securitization.
structured products
Structured products are instruments created to exhibit particular return, risk, taxation, or other attributes.
timberland
Timberland includes both the land and the timber of forests of tree species typically used in the forest products industry.
trading structure
Trading structure refers to the role of an investment vehicle’s investment managers in developing and implementing trading strategies.
traditional investments
Traditional investments include publicly traded equities, fixed-income securities, and cash.
40 Act funds
Mutual funds, or ’40 Act funds, are registered investment pools offering their shareholders pro rata claims on the fund’s portfolio of assets.
back office operations
Back office operations play a supportive role in the maintenance of accounts and information systems used to transmit important market and trader information in all trading transactions, as well as in the clearance and settlement of the trades.
bid-ask spread
The price difference between the highest bid price (the best bid price) and the lowest offer (the best ask price) is the bid-ask spread.
buy side
Buy side refers to the institutions and entities that buy large quantities of securities for the portfolios they manage.
closed-end mutual fund
Closed-end mutual fund structures provide investors with relatively liquid access to the returns of underlying assets even when the underlying assets are illiquid.
commercial bank
A commercial bank focuses on the business of accepting deposits and making loans, with modest investment-related services.
custodians
Depositories and custodians are very similar entities that are responsible for holding their clients’ cash and securities and settling clients’ trades, both of which maintain the integrity of clients’ assets while ensuring that trades are settled quickly.
dark pool
A dark pool refers to non-exchange trading by large market participants that is hidden from the view of most market participants.
depositories
Depositories and custodians are very similar entities that are responsible for holding their clients’ cash and securities and settling clients’ trades, both of which maintain the integrity of clients’ assets while ensuring that trades are settled quickly.
Depository Trust Company (DTC)
The Depository Trust Company (DTC) is the principal holding body of securities for traders all over the world and is part of the Depository Trust and Clearing Corporation (DTCC), which provides clearing, settlement, and information services.
endowment
An endowment is a fund bestowed on an individual or institution (e.g., a museum, university, hospital, or foundation) to be used by that entity for specific purposes and with principal preservation in mind.
family office
A family office is a group of investors joined by familial or other ties who manage their personal investments as a single entity, usually hiring professionals to manage money for members of the office.
financial data providers
Financial data providers supply funds primarily with raw financial market data, including security prices, trading information, and indices.
financial platforms
Financial platforms are systems that provide access to financial markets, portfolio management systems, accounting and reporting systems, and risk management systems.
financial software
Financial software may consist of prepackaged software programs and computer languages tailored to the needs of financial organizations. Some funds use open-source software, and others pay licensing fees for proprietary software.
foundation
A foundation is a not-for-profit organization that donates funds and support to other organizations for its own charitable purposes.
fourth markets
Fourth markets are electronic exchanges that allow traders to quickly buy and sell exchange-listed stocks via the electronic communications systems offered by these markets.
front office operations
Front office operations involve investment decision-making and, in the case of brokerage firms, contact with clients.
fund administrator
The fund administrator maintains a general ledger account, marks the fund’s books, maintains its records, carries out monthly accounting, supplies its monthly profit and loss (P&L) statements, calculates its returns, verifies asset existence, independently calculates fees, and provides an unbiased, third-party resource for price confirmation on security positions.
hedge fund replication
Hedge fund replication is the attempt to mimic the returns of an illiquid or highly sophisticated hedge fund strategy using liquid assets and simplified trading rules.
investment bank
An investment bank focuses on providing sophisticated investment services, including underwriting and raising capital, as well as other activities such as brokerage services, mergers, and acquisitions.
large dealer banks
Large dealer banks are major financial institutions, such as Goldman Sachs, Deutsche Bank, and the Barclays Group, that deal in securities and derivatives.
liquid alternatives
Liquid alternatives are investment vehicles that offer alternative strategies in a form that provides investors with liquidity through opportunities to sell their positions in a market.
management company operating agreement
A management company operating agreement is an agreement between members related to a limited liability company and the conduct of its business as it pertains to the law.
market making
market making
market orders
Market participants that wish to have transactions executed without delay may place market orders, which cause immediate execution at the best available price.
market takers
Participants that place market orders are market takers, which buy at ask prices and sell at bid prices, generally paying the bid-ask spread for taking liquidity.
Markets in Financial Instruments Directive (MiFID)
The Markets in Financial Instruments Directive (MiFID) is an EU law that establishes uniform regulation for investment managers in the European Economic Area (the EU plus Iceland, Norway, and Liechtenstein).
master limited partnerships (MLPs)
Master limited partnerships (MLPs) are publicly traded investment pools that are structured as limited partnerships and that offer their owners pro rata claims.
middle office operations
Middle office operations form the interface between the front office and the back office, with a focus on risk management.
mutual funds
Mutual funds, or ’40 Act funds, are registered investment pools offering their shareholders pro rata claims on the fund’s portfolio of assets.
partnership agreement
A partnership agreement is a formal written contract creating a partnership.
plan sponsor
A plan sponsor is a designated party, such as a company or an employer, that establishes a health care or retirement plan (pension) that has special legal or taxation status, such as a 401(k) retirement plan in the United States for employees.
primary market
A primary market refers to the methods, institutions, and mechanisms involved in the placement of new securities to investors.
prime broker
The prime broker has the following primary functions: clearing and financing trades for its client, providing research, arranging financing, and producing portfolio accounting.
private limited partnerships
Private limited partnerships are a form of business organization that potentially offers the benefit of limited liability to the organization’s limited partners (similar to that enjoyed by shareholders of corporations) but not to its general partner.
private-placement memoranda
Private-placement memoranda (a.k.a. offering documents) are formal descriptions of an investment opportunity that comply with federal securities regulations.
progressive taxation
Progressive taxation places higher-percentage taxation on individuals and corporations with higher incomes.
proprietary trading
Proprietary trading occurs when a firm trades securities with its own money in order to make a profit.
Regulation T margin rule
Federal Reserve Board leverage rules include the Regulation T margin rule, which currently requires a deposit of at least 50% of the purchase cost or short sale proceeds of a trade (margin).
secondary market
A secondary market facilitates trading among investors of previously existing securities.
Section 1256 contracts
Section 1256 contracts include many futures and options contracts; have potentially enormous tax advantages in the United States. including having their income treated as 60% long-term capital gain and 40% short-term capital gain regardless of holding period.
securitization
Securitization involves bundling assets, especially unlisted assets, and issuing claims on the bundled assets.
sell side
Sell-side institutions, such as large dealer banks, act as agents for investors when they trade securities.
separately managed accounts
Separately managed accounts (SMAs) are individual investment accounts offered by a brokerage firm and managed by independent investment management firms.
soft dollar arrangement
A soft dollar arrangement generally refers to an agreement or an understanding by which an investment adviser receives research services from a broker-dealer in exchange for a fee (such as a commission) paid out of the fund or client account.
sovereign wealth funds
Sovereign wealth funds are state-owned investment funds held by that state’s central bank for the purpose of future generations and/or to stabilize the state currency.
subscription agreement
A subscription agreement is an application submitted by an investor who desires to join a limited partnership.
systemic risk
Systemic risk is the potential for economy-wide losses attributable to failures or concerns over potential failures in financial markets, financial institutions, or major participants.
third markets
Third markets are regional exchanges where stocks listed in primary secondary markets can also be traded. In the United States, third markets allow brokers and dealers to set up trades away from an exchange by listing their prices on the NASDAQ Intermarket.
Undertakings for Collective Investment in Transferable Securities (UCITS)
Regulation of hedge funds in Europe centers on the concept of
Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS are carefully regulated European fund vehicles that allow retail access and marketing of hedge- fund-like investment pools.
universal banking
Germany uses universal banking, which means that German banks can engage in both commercial and investment banking.
aggregation of IRRs
Aggregation of IRRs refers to the relationship between the IRRs of individual investments and the IRR of the combined cash flows of the investments.
borrowing type cash flow pattern
A borrowing type cash flow pattern begins with one or more cash inflows and is followed only by cash outflows.
carried interest
Carried interest is synonymous with an incentive fee or a performance-based fee and is the portion of the profit paid to the GPs as compensation for their services, above and beyond management fees.
catch-up provision
A catch-up provision permits the fund manager to receive a large share of profits once the hurdle rate of return has been achieved and passed.
catch-up rate
A catch-up provision contains a catch-up rate, which is the percentage of the profits used to catch up the incentive fee once the hurdle is met.
claw back
A claw back clause, claw back provision, or claw back option is designed to return incentive fees to LPs when early profits are followed by subsequent losses.
compensation scheme
The compensation scheme is the set of provisions and procedures governing management fees, general partner investment in the fund, carried-interest allocations, vesting, and distribution.
complex cash flow pattern
A complex cash flow pattern is an investment involving either borrowing or multiple sign changes.
continuous compounding
Continuous compounding assumes that earnings can be instantaneously reinvested to generate additional earnings.
deal-by-deal carried interest
Deal-by-deal carried interest is when incentive fees are awarded separately based on the performance of each individual investment.
discrete compounding
Discrete compounding includes any compounding interval other than continuous compounding such as daily, monthly, or annual.
dollar-weighted returns
Dollar-weighted returns are averaged returns that are adjusted for and therefore reflect when cash has been contributed or withdrawn during the averaging period.
fully collateralized
Fully collateralized means that a position (such as a forward contract) is assumed to be paired with a quantity of capital equal in value to the notional principal of the contract.
fund-as-a-whole carried interest
Carried interest can be fund-as-a-whole carried interest, which is carried interest based on aggregated profits and losses across all the investments, or can be structured as deal-by-deal carried interest.
hard hurdle rate
A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate.
hurdle rate
A hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees.
incentive fee
Carried interest is synonymous with an incentive fee or a performance-based fee and is the portion of the profit paid to the GPs as compensation for their services, above and beyond management fees.
interim IRR
The interim IRR is a computation of IRR based on realized cash flows from an investment and its current estimated residual value.
internal rate of return (IRR)
The internal rate of return (IRR) can be defined as the discount rate that equates the present value of the costs (cash outflows) of an investment with the present value of the benefits (cash inflows) from the investment.
lifetime IRR
A lifetime IRR contains all of the cash flows, realized or anticipated, occurring over the investment’s entire life, from period 0 to period T.
log return
A log return is a continuously compounded return that can be formed by taking the natural logarithm of a wealth ratio: Rm=∞ = ln(1 + R) where ln( ) is the natural logarithm function, Rm=∞ is the log return, or continuously compounded return, and m is the number of compounding intervals per year.
management fees
Management fees are regular fees that are paid from the fund to the fund managers based on the size of the fund rather than the profitability of the fund.
modified IRR
The modified IRR approach discounts all cash outflows into a present value using a financing rate, compounds all cash inflows into a future value using an assumed reinvestment rate, and calculates the modified IRR as the discount rate that sets the absolute values of the future value and the present value equal to each other.
multiple sign change cash flow pattern
A multiple sign change cash flow pattern is an investment where the cash flows switch over time from inflows to outflows, or from outflows to inflows, more than once.
notional principal
Notional principal or notional value of a contract is the value of the asset underlying, or used as a reference to, the contract or derivative position.
partially collateralized
A partially collateralized position has collateral lower in value than the notional value.
performance-based fee
Carried interest is synonymous with an incentive fee or a performance-based fee and is the portion of the profit paid to the GPs as compensation for their services, above and beyond management fees.
point-to-point IRR
A point-to-point IRR is a calculation of performance over part of an investment’s life.
preferred return
The term preferred return is often used synonymously with hurdle rate—a return level that LPs must receive before GPs begin to receive incentive fees.
reinvestment rate assumption
The reinvestment rate assumption refers to the assumption of the rate at which any cash flows not invested in a particular investment or received during the investment’s life can be reinvested during the investment’s lifetime.
return computation interval
The return computation interval for a particular analysis is the smallest time interval for which returns are calculated, such as daily, monthly, or even annually.
return on notional principal
The return on notional principal divides economic gain or loss by the notional principal of the contract.
scale differences
Scale differences are when investments have unequal sizes and/or timing of their cash flows.
simple interest
Simple interest is an interest rate computation approach that does not incorporate compounding.
since-inception IRR
A since-inception IRR is commonly used as a measure of fund performance rather than the performance of an individual investment.
soft hurdle rate
A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved.
time-weighted returns
Time-weighted returns are averaged returns that assume that no cash was contributed or withdrawn during the averaging period, meaning after the initial investment.
vesting
Vesting is the process of granting full ownership of conferred rights, such as incentive fees.
waterfall
The waterfall is a provision of the limited partnership agreement that specifies how distributions from a fund will be split and how the payouts will be prioritized.
ARCH
ARCH (autoregressive conditional heteroscedasticity) is a special case of GARCH that allows future variances to rely only on past disturbances, whereas GARCH allows future variances to depend on past variances as well.
autocorrelation
The autocorrelation of a time series of returns from an investment refers to the possible correlation of the returns with one another through time.
autoregressive
Autoregressive refers to when subsequent values to a variable are explained by past values of the same variable.
beta
The beta of an asset is defined as the covariance between the asset’s returns and a return such as the market index, divided by the variance of the index’s return, or, equivalently, as the correlation coefficient multiplied by the ratio of the asset volatility to market volatility: βi = Cov(R m,R i)∕Var(R m) = σim∕σ2 where βi is the beta of the returns of asset i (Ri) with respect to a market index of returns, Rm.
conditionally heteroskedastic
Conditionally heteroskedastic financial market prices have different levels of return variation even when specified conditions are similar (e.g., when they are viewed at similar price levels).
correlation coefficient
The correlation coefficient (also called the Pearson correlation coefficient) measures the degree of association between two variables, but unlike the covariance, the correlation coefficient can be easily interpreted.
covariance
The covariance of the return of two assets is a measure of the degree or tendency of two variables to move in relationship with each other.
ex ante returns
Future possible returns and their probabilities are referred to as expectational or ex ante returns.
ex post returns
Ex post returns are realized outcomes rather than anticipated outcomes.
excess kurtosis
Excess kurtosis provides a more intuitive measure of kurtosis relative to the normal distribution because it has a value of zero in the case of the normal distribution: Excess Kurtosis = {E[(R − μ)4 ]∕σ4 } − 3
first-order autocorrelation
First-order autocorrelation refers to the correlation between the return in time period t and the return in the immediately previous time period, t − 1.
GARCH
GARCH (generalized autoregressive conditional heteroskedasticity) is an example of a time-series method that adjusts for varying volatility.
heteroskedasticity
Heteroskedasticity is when the variance of a variable changes with respect to a variable, such as itself or time.
homoskedasticity
Homoskedasticity is when the variance of a variable is constant.
Jarque-Bera test
The Jarque-Bera test involves a statistic that is a function of the skewness and excess kurtosis of the sample: JB = (n∕6)[S2 + (K2 ∕4)] where JB is the Jarque-Bera test statistic, n is the number of observations, S is the skewness of the sample, and K is the excess kurtosis of the sample.
kurtosis
Kurtosis serves as an indicator of the peaks and tails of a distribution. Kurtosis = E[(R − μ)4 ]∕σ4
leptokurtosis
If a return distribution has positive excess kurtosis, meaning it has more kurtosis than the normal distribution, it is said to be leptokurtic, leptokurtotic, or fat tailed, and to exhibit leptokurtosis.
lognormal distribution
A variable has a lognormal distribution if the distribution of the logarithm of the variable is normally distributed.
mean
The most common raw moment is the first raw moment and is known as the mean, or expected value, and is an indication of the central tendency of the variable.
mesokurtosis
If a return distribution has no excess kurtosis, meaning it has the same kurtosis as the normal distribution, it is said to be mesokurtic, mesokurtotic, or normal tailed, and to exhibit mesokurtosis.
normal distribution
The normal distribution is the familiar bell-shaped distribution, also known as the Gaussian distribution.
perfect linear negative correlation
A correlation coefficient of −1 indicates that the two assets move in the exact opposite direction and in the same proportion, a result known as perfect linear negative correlation.
perfect linear positive correlation
A correlation coefficient of +1 indicates that the two assets move in the exact same direction and in the same proportion, a result known as perfect linear positive correlation.
platykurtosis
If a return distribution has negative excess kurtosis, meaning less kurtosis than the normal distribution, it is said to be platykurtic, platykurtotic, or thin tailed, and to exhibit platykurtosis.
skewness
The skewness is equal to the third central moment divided by the standard deviation of the variable cubed and serves as a measure of asymmetry: Skewness = E[(R − μ)3 ]∕σ3
Spearman rank correlation
The Spearman rank correlation is a correlation designed to adjust for outliers by measuring the relationship between variable ranks rather than variable values.
standard deviation
The square root of the variance is an extremely popular and useful measure of dispersion known as the standard deviation: Standard Deviation = √σ2 = σ
variance
The variance is the second central moment and is the expected value of the deviations squared,
volatility
In investment terminology, volatility is a popular term that is used synonymously with the standard deviation of returns.
average tracking error
Average tracking error refers to the excess of an investment’s return relative to its benchmark. In other words, it is the numerator of the information ratio.
conditional value-at-risk
Conditional value-at-risk (CVaR), also known as expected tail loss, is the expected loss of the investor given that the VaR has been equaled or exceeded.
drawdown
Drawdown is defined as the maximum loss in the value of an asset over a specified time interval and is usually expressed in percentage-return form rather than currency.
information ratio
The information ratio has a numerator formed by the difference between the average return of a portfolio (or other asset) and its benchmark, and a denominator equal to its tracking error: Information Ratio = [E(Rp) − RBenchmark]∕TE where E(Rp) is the expected or mean return for portfolio p, RBenchmark is the expected or mean return of the benchmark, and TE is the tracking error of the portfolio relative to its benchmark return.
Jensen’s alpha
Jensen’s alpha may be expressed as the difference between its expected return and the expected return of efficiently priced assets of similar risk.
M2 approach
The M2 approach, or M-squared approach, expresses the excess return of an investment after its risk has been normalized to equal the risk of the market portfolio.
maximum drawdown
Maximum drawdown is defined as the largest decline over any time interval within the entire observation period.
Monte Carlo analysis
Monte Carlo analysis is a type of simulation in which many potential paths of the future are projected using an assumed model, the results of which are analyzed as an approximation to the future probability distributions.
parametric V aR
A VaR computation assuming normality and using the statistics of the normal distribution is known as parametric VaR.
return on VaR (RoVaR)
Return on VaR (RoVaR) is simply the expected or average return of an asset divided by a specified VaR (expressing VaR as a positive number): RoVaR = E(Rp)∕VaR.
semistandard deviation
Semistandard deviation, sometimes called semideviation, is the square root of semivariance.
semivariance
The semivariance uses a formula otherwise identical to the variance formula except that it considers only the negative deviations. Semivariance is therefore expressed as:
Semivariance = 1/∑[Rt E(R)]2 For all Rt< E(R) where T∗ is the number of negative deviations.
Sharpe ratio
The Sharpe ratio has excess return as its numerator and volatility as its denominator: SR = [E(Rp) − Rf ]∕σp where SR is the Sharpe ratio for portfolio p,E (Rp) is the expected return for portfolio p, Rf is the riskless rate, and σp is the standard deviation of the returns of portfolio p.
shortfall risk
Shortfall risk is simply the probability that the return will be less than the investor’s target rate of return.
Sortino ratio
The Sortino ratio subtracts a benchmark return, rather than the riskless rate, from the asset’s return in its numerator and uses downside standard deviation as the measure of risk in its denominator: Sortino Ratio = [E(Rp) − RTarget ]∕TSSD where E(Rp) is the expected return, or mean return in practice, for portfolio p; RTarget is the user’s target rate of return; and TSSD is the target semistandard deviation (or downside deviation).
target semistandard deviation
Target semistandard deviation (TSSD) is simply the square root of the target semivariance.
target semivariance
Target semivariance is similar to semivariance except that target semivariance substitutes the investor’s target rate of return in place of the mean return.
tracking error
Tracking error indicates the dispersion of the returns of an investment relative to a benchmark return, where a benchmark return is the contemporaneous realized return on an index or peer group of comparable risk.
Treynor ratio
The Treynor ratio has excess return as its numerator and beta as the measure of risk as its denominator: TR = [E(Rp) − Rf ]∕βp where TR is the Treynor ratio for portfolio p; E(Rp) is the expected return, or mean return, for portfolio p; Rf is the riskless rate; and βpis the beta of the returns of portfolio p.
value at risk
Value at risk (VaR) is the loss figure associated with a particular percentile of a cumulative loss function.
well-diversified portfolio
In the field of investments, the term well-diversified portfolio is traditionally interpreted as any portfolio containing only trivial amounts of diversifiable risk.
absolute pricing model
An absolute pricing model attempts to describe a price level based on its underlying economic factors.
arbitrage
Arbitrage is the attempt to earn riskless profits (in excess of the risk-free rate) by identifying and trading relatively mispriced assets.
arbitrage-free model
An arbitrage-free model is a financial model with relationships derived by the assumption that arbitrage opportunities do not exist, or at least do not persist.
asset pricing model
An asset pricing model is a framework for specifying the return or price of an asset based on its risk, as well as future cash flows and payoffs.
bear spread
An option combination in which the long option position is at the higher of two strike prices is a bear spread, which offers bearish exposure to the underlying asset that begins at the higher strike price and ends at the lower strike price.
binomial tree model
A binomial tree model projects possible outcomes in a variable by modeling uncertainty as two movements: an upward movement and a downward movement.
Black-Scholes call option formula
Black-Scholes call option formula expresses the price of a call option as a function of five variables: the price of the underlying asset, the strike price, the return volatility of the underlying asset, the time to the option’s expiration, and the riskless rate.
bull spread
An option combination in which the long option position is at the lower of two strike prices is a bull spread, which offers bullish exposure to the underlying asset that begins at the lower strike price and ends at the higher strike price.
capital asset pricing model (CAPM)
The capital asset pricing model (CAPM) provides one of the easiest and most widely understood examples of single-factor asset pricing by demonstrating that the risk of the overall market index is the only risk that offers a risk premium.
carrying cost
The carrying cost is the cost of maintaining a position through time and includes direct costs, such as storage or custody costs, as well as opportunity costs, such as forgone cash flows.
cash market
The spot market or cash market is any market in which transactions involve immediate payment and delivery: The buyer immediately pays the price, and the seller immediately delivers the product.
collar
A collar generally refers to a long position in an asset combined with a short call option and a long put option on that asset, in which the call option has a higher strike price than the put option.
cost-of-carry model
A cost-of-carry model specifies a relationship between two positions that must exist if the only difference between the positions involves the expense of maintaining the positions.
covered call
A covered call combines being long an asset with being short a call option on the same asset.
elasticity
An elasticity is the percentage change in a value with respect to a percentage change in another value.
empirical model
An empirical model is derived from observation. An example would be a model that recognizes that the returns of some traditional assets are correlated with their market-to-book ratios.
ex ante models
Ex ante models, such as ex ante asset pricing models, explain expected relationships, such as expected returns. Ex ante means “from before.”
ex post model
An ex post model describes realized returns and provides an understanding of risk and how it relates to the deviations of realized returns from expected returns.
excess return
The excess return of an asset refers to the excess or deficiency of the asset’s return relative to the periodic risk-free rate.
Fama-French model
The Fama-French model links the returns of assets to three factors: (1) the market portfolio, (2) a factor representing a value versus growth effect, and (3) a factor representing a small-cap versus large-cap effect.
Fama-French-Carhart model
The Fama-French-Carhart model adds a fourth factor to the Fama-French model: momentum.
financed positions
Financed positions enable economic ownership of an asset without the posting of the purchase price.
forward contract
A forward contract is simply an agreement calling for deferred delivery of an asset or a payoff.
idiosyncratic return
Idiosyncratic return is the portion of an asset’s return that is unique to an investment and not driven by a common association.
idiosyncratic risk
Idiosyncratic risk is the dispersion in economic outcomes caused by investment-specific effects. This section focuses on realized returns and the modeling of risk.
informational market efficiency
Informational market efficiency refers to the extent to which asset prices reflect available information.
lambda
Lambda or omega for a call option is the elasticity of an option price with respect to the price of the underlying asset and is equal to delta multiplied times the quantity (S/c).
market portfolio
The market portfolio is a hypothetical portfolio containing all tradable assets in the world.
market weight
The market weight of an asset is the proportion of the total value of that asset to the total value of all assets in the market portfolio.
multifactor models
Multifactor models of asset pricing express systematic risk using multiple factors and are extremely popular throughout traditional and alternative investing.
naked option
A short option position that is unhedged is often referred to as a naked option.
omega
Lambda or omega for a call option is the elasticity of an option price with respect to the price of the underlying asset and is equal to delta multiplied times the quantity (S/c).
omicron
Omicron is the partial derivative of an option or a position containing an option to a change in the credit spread and is useful for analyzing option positions on credit-risky assets.
option collar
An option collar generally refers only to the long position in a put and a short position in a call.
option combination
An option combination contains both calls and puts on the same underlying asset.
option spread
An option spread (1) contains either call options or put options (not both), and (2) contains both long and short positions in options with the same underlying asset.
option straddle
An option straddle is a position in a call and put with the same sign (i.e., long or short), the same underlying asset, the same expiration date, and the same strike price.
option strangle
An option strangle is a position in a call and put with the same sign, the same underlying asset, the same expiration date, but different strike prices.
protective put
A protective put combines being long an asset with a long position in a put option on the same asset.
put-call parity
Put-call parity is an arbitrage-free relationship among the values of an asset, a riskless bond, a call option, and a put option.
relative pricing model
relative pricing model
rho
Rho is the sensitivity of an option price with respect to changes in the riskless interest rate.
risk reversal
A long out-of-the-money call combined with a short out-of- the-money put on the same asset and with the same expiration date is termed a risk reversal.
semistrong form informational market efficiency
The concept of semistrong form informational market efficiency (or semistrong level) refers to market prices reflecting all publicly available information (including not only past prices and volumes but also any publicly available information such as financial statements and other underlying economic data).
single-factor asset pricing model
A single-factor asset pricing model explains returns and systematic risk using a single risk factor.
spot market
The spot market or cash market is any market in which transactions involve immediate payment and delivery: The buyer immediately pays the price, and the seller immediately delivers the product.
strong form informational market efficiency
The concept of strong form informational market efficiency (or strong level) refers to market prices reflecting all publicly and privately available information.
systematic return
Systematic return is the portion of an asset’s return driven by a common association.
systematic risk
Systematic risk is the dispersion in economic outcomes caused by variation in systematic return
term structure of forward contracts
The term structure of forward contracts is the relationship between forward prices (or forward rates) and the time to delivery of the forward contract.
theoretical model
In a theoretical model, the factors are derived from reasoning based on known facts and relationships.
tradable asset
A tradable asset is a position that can be readily established and liquidated in the financial market, such as a stock position, a bond position, or a portfolio of liquid positions.
weak form informational market efficiency
Weak form informational market efficiency (or weak level) refers to market prices reflecting available data on past prices and volumes.
abstract models
Abstract models, also called basic models, tend to have applicability only in solving real-world challenges of the future.
applied models
Applied models are designed to address immediate real- world challenges and opportunities.
benchmarking
Benchmarking, often referred to as performance benchmarking, is the process of selecting an investment index, an investment portfolio, or any other source of return as a standard (or benchmark) for comparison during performance analysis
cross-sectional models
Cross-sectional models analyze behavior at a single point in time across various subjects, such as investors or investments.
normative model
A normative model attempts to describe how people and prices ought to behave.
panel data sets
Panel data sets combine the two approaches by tracking multiple subjects through time and can also be referred to as longitudinal data sets and cross-sectional time-series data sets.
peer group
The peer group is typically a group of funds with similar objectives, strategies, or portfolio holdings.
performance attribution
Performance attribution, also known as return attribution, is the process of identifying the components of an asset’s return or performance.
positive model
A positive model attempts to describe how people and prices actually behave.
return attribution
Performance attribution, also known as return attribution, is the process of identifying the components of an asset’s return or performance.
time-series models
Time-series models analyze behavior of a single subject or a set of subjects through time.
abnormal return persistence
Abnormal return persistence is the tendency of idiosyncratic performance in one time period to be correlated with idiosyncratic performance in a subsequent time period.
alpha
Alpha refers to any excess or deficient investment return after the return has been adjusted for the time value of money (the risk-free rate) and for the effects of bearing systematic risk (beta).
alpha driver
An investment that seeks high returns independent of the market is an alpha driver.
alternative hypothesis
The alternative hypothesis is the behavior that the analyst assumes would be true if the null hypothesis were rejected.
asset gatherers
Asset gatherers are managers striving to deliver beta as cheaply and efficiently as possible, and include the large- scale index trackers that produce passive products tied to well-recognized financial market benchmarks.
backfill bias
Backfill bias fun, or instant history bias, is when the funds, returns, and strategies being added to a data set are not representative of the universe of fund managers, fund returns, and fund strategies.
backfilling
Backfilling typically refers to the insertion of an actual trading record of an investment into a database when that trading record predates the entry of the investment into the database.
backtesting
Backtesting is the use of historical data to test a strategy that was developed subsequent to the observation of the data.
beta creep
Beta creep is when hedge fund strategies pick up more systematic market risk over time.
beta driver
An investment that moves in tandem with the overall market or a particular risk factor is a beta driver.
beta expansion
Beta expansion is the perceived tendency of the systematic risk exposures of a fund or asset to increase due to changes in general economic conditions.
beta nonstationarity
Beta nonstationarity is a general term that refers to the tendency of the systematic risk of a security, strategy, or fund to shift through time.
causality
The difference between true correlation and causality is that causality reflects when one variable’s correlation with another variable is determined by or due to the value or change in value of the other variable.
cherry-picking
Cherry-picking is the concept of extracting or publicizing only those results that support a particular viewpoint.
chumming
Chumming is a fishing term used to describe scattering pieces of cheap fish into the water as bait to attract larger fish to catch.
confidence interval
A confidence interval is a range of values within which a parameter estimate is expected to lie with a given probability.
data dredging
Data dredging, or data snooping, refers to the overuse and misuse of statistical tests to identify historical patterns.
data mining
Data mining typically refers to the vigorous use of data to uncover valid relationships.
economic significance
Economic significance describes the extent to which a variable in an economic model has a meaningful impact on another variable in a practical sense.
equity risk premium
The equity risk premium (ERP) is the expected return of the equity market in excess of the risk-free rate.
equity risk premium puzzle
The equity risk premium puzzle is the enigma that equities have historically performed much better than can be explained purely by risk aversion, yet many investors continue to invest heavily in low-risk assets.
ex ante alpha
Ex ante alpha is the expected superior return if positive (or inferior return if negative) offered by an investment on a forward-looking basis after adjusting for the riskless rate and for the effects of systematic risks (beta) on expected returns.
ex post alpha
Ex post alpha is the return, observed or estimated in retrospect, of an investment above or below the risk-free rate and after adjusting for the effects of beta (systematic risks).
full market cycle
A full market cycle is a period of time containing a large representation of market conditions, especially up (bull) markets and down (bear) markets.
hypotheses
Hypotheses are propositions that underlie the analysis of an issue.
linear risk exposure
A linear risk exposure means that when the returns to such a strategy are graphed against the returns of the market index or another appropriate standard, the result tends to be a straight line.
model misspecification
Model misspecification is any error in the identification of the variables in a model or any error in identification of the relationships between the variables.
null hypothesis
The null hypothesis is usually a statement that the analyst is attempting to reject, typically that a particular variable has no effect or that a parameter’s true value is equal to zero.
outlier
An outlier is an observation that is markedly further from the mean than almost all other observations.
overfitting
Overfitting is using too many parameters to fit a model very closely to data over some past time frame.
passive beta driver
A passive beta driver strategy generates returns that follow the up-and-down movement of the market on a one-to-one basis.
process drivers
Process drivers are beta drivers that focus on providing beta that is fine-tuned or differentiated.
product innovators
At one end of the spectrum are product innovators, which are alpha drivers that seek new investment strategies offering superior rates of risk-adjusted return.
p-value
The p-value is a result generated by the statistical test that indicates the probability of obtaining a test statistic by chance that is equal to or more extreme than the one that was actually observed (under the condition that the null hypothesis is true).
return driver
The term return driver represents the investments, the investment products, the investment strategies, or the underlying factors that generate the risk and return of a portfolio.
selection bias
Selection bias is a distortion in relevant sample characteristics from the characteristics of the population, caused by the sampling method of selection or inclusion.
self-selection bias
If the selection bias originates from the decision of fund managers to report or not to report their returns, then the bias is referred to as a self-selection bias.
significance level
The term significance level is used in hypothesis testing to denote a small number, such as 1%, 5%, or 10%, that reflects the probability that a researcher will tolerate of the null hypothesis being rejected when in fact it is true.
spurious correlation
The difference between spurious correlation and true correlation is that spurious correlation is idiosyncratic in nature, coincidental, and limited to a specific set of observations.
survivorship bias
Survivorship bias is a common problem in investment databases in which the sample is limited to those observations that continue to exist through the end of the period of study.
test statistic
The test statistic is the variable that is analyzed to make an inference with regard to rejecting or failing to reject a null hypothesis.
type I error
A type I error, also known as a false positive, is when an analyst makes the mistake of falsely rejecting a true null hypothesis.
type II error
A type II error, also known as a false negative, is failing to reject the null hypothesis when it is false.
conditional correlation
A conditional correlation is a correlation between two variables under specified circumstances.
dependent variable
The dependent variable is the variable supplied by the researcher that is the focus of the analysis and is determined at least in part by other (independent or explanatory) variables.
down market beta
The down market beta, bi,d, is the responsiveness of the fund’s return to the market return when the market return is less than the riskless rate (i.e., when the market’s excess return is negative, or down).
goodness of fit
The goodness of fit of a regression is the extent to which the model appears to explain the variation in the dependent variable.
independent variable
Independent variables are those explanatory variables that are inputs to the regression and are viewed as causing the observed values of the dependent variable.
intercept
The intercept is the value of the dependent variable when all independent variables are zero.
look-back option
A look-back option has a payoff that is based on the value of the underlying asset over a reference period rather than simply the value of the underlying asset at the option’s expiration date.
multicollinearity
Multicollinearity is when two or more independent variables in a regression model have high correlation to each other.
multiple regression model
A multiple regression model is a regression model with more than one independent variable.
negative conditional correlation
When the correlation in the down sample is higher than the correlation in the up sample, it is termed negative conditional correlation.
nonlinear exposure
A nonlinear exposure of a position to a market factor is when the sensitivity of the position’s value varies based on the magnitude of the level of change in the market factor’s value.
nonstationary
The return distributions of hedge funds and hedge fund indices are nonstationary, meaning that return volatilities and correlations vary through time.
positive conditional correlation
Positive conditional correlation of investment returns to market returns is when the correlation in the up sample is higher than the correlation in the down sample. Investors prefer investment strategies with positive conditional correlation, since the strategies offer higher participation in profits during bull markets and lower participation in losses during bear markets.
principal components analysis
Principal components analysis is a statistical technique that groups the observations in a large data set into smaller sets of similar types based on commonalities in the data.
regression
A regression is a statistical analysis of the relationship that explains the values of a dependent variable as a function of the values of one or more independent variables based on a specified model.
residuals
The residuals of the regression, eit, reflect the regression’s estimate of the idiosyncratic portion of asset i’s realized returns above or below its mean idiosyncratic return (i.e., the regression’s estimates of the error term).
rolling window analysis
Rolling window analysis is a relatively advanced technique for analyzing statistical behavior over time, using overlapping subsamples that move evenly through time.
r-squared
The r-squared value of the regression, which is also called the coefficient of determination, is often used to assess goodness of fit, especially when comparing models. In a simple linear regression, the r-squared is simply the squared value of the estimated correlation coefficient between the dependent variable and the independent variable.
serial correlation
Serial correlation is the same as autocorrelation: It is the correlation of a variable, such as return, in one time period (e.g., year) to the same variable in another time period.
simple linear regression
A simple linear regression is a linear regression in which the model has only one independent variable.
slope coefficient
The slope coefficient is a measure of the change in a dependent variable with respect to a change in an independent variable.
stepwise regression
Stepwise regression is an iterative technique in which variables are added or deleted from the regression equation based on their statistical significance.
style analysis
Style analysis is the process of understanding an investment strategy, especially using a statistical approach, based on grouping funds by their investment strategies or styles.
t-statistic
The t-statistic of a parameter is formed by taking the estimated absolute value of the parameter and dividing by its standard error.
t-test
A t-test is a statistical test that rejects or fails to reject a hypothesis by comparing a t-statistic to a critical value.
up market beta
The up market beta, bi,u, is the responsiveness of the fund’s return to the market return when the excess market return is positive, and is estimated as the sum of bi,d and bi,diff.
agency risk
Agency risk is the economic dispersion resulting from the consequences of having another party (the agent) making decisions contrary to the preferences of the owner (the principal).
binomial option pricing
Binomial option pricing is a technique for pricing options that assumes that the price of the underlying asset can experience only a specified upward movement or downward movement during each period.
blue top lots
Blue top lots are at an interim stage of lot completion. In this case, the owner has completed the rough grading of the property and the lots, including the undercutting of the street section, interim drainage, and erosion control facilities, and has paid all applicable fees required.
cap rate
In real estate, the cap rate (capitalization rate) or yield is a common term for the return on assets (7.33% in this example).
contagion
Contagion is the general term used in finance to indicate any tendency of major market movements—especially declines in prices or increases in volatility—to be transmitted from one financial market to other financial markets.
exchange option
An exchange option is an option to exchange one risky asset for another rather than to buy or sell one asset at a fixed exercise or strike price.
favorable mark
A favorable mark is a biased indication of the value of a position that is intentionally provided by a subjective source.
finished lots
Finished lots are fully completed and ready for home construction and occupancy.
intrinsic option value
An intrinsic option value is the greater of $0 and the value of an option if exercised immediately.
land banking
Land banking is the practice of buying vacant lots for the purpose of development or disposition at a future date.
low-hanging-fruit principle
The low-hanging-fruit principle states that the first action that should be taken is the one that reaps the highest benefits over costs.
managed returns
Managed returns are returns based on values that are reported with an element of managerial discretion.
market manipulation
Market manipulation refers to engaging in trading activity designed to cause the markets to produce favorable prices for thinly traded listed securities.
model manipulation
Model manipulation is the process of altering model assumptions and inputs to generate desired values and returns.
natural resources
Natural resources are real assets that have received no or almost no human alteration.
negative survivorship bias
A negative survivorship bias is a downward bias caused by excluding the positive returns of the properties or other assets that successfully left the database.
paper lots
Paper lots refers to sites that are vacant and approved for development by the local zoning authority but for which construction on streets, utilities, and other infrastructure has not yet commenced.
perpetual option
A perpetual option is an option with no expiration date.
political risk
Political risk is economic uncertainty caused by changes in government policy that may affect returns, perhaps dramatically.
pure play
A pure play on an investment is an investment vehicle that offers direct exposure to the risks and returns of a specific type of investment without the inclusion of other exposures.
risk-neutral probability
A risk-neutral probability is a probability that values assets correctly if, everything else being equal, all market participants were risk neutral.
rotation
Rotation is the length of time from the start of the timber (typically the planting) until the harvest of the timber.
selective appraisals
Selective appraisals refers to the opportunity for investment managers to choose how many, and which, illiquid assets should have their values appraised during a given quarter or some other reporting period.
smoothing
Smoothing is reduction in the reported dispersion in a price or return series.
split estate
A split estate is when surface rights and mineral rights are separately owned.
timberland investment management organizations (TIMOs)
Timberland investment management organizations (TIMOs) provide management services to timberland owned by institutional investors, such as pension plans, endowments, foundations, and insurance companies.
time value of an option
The time value of an option is the excess of an option’s price above its intrinsic value.
backwardation
When the slope of the term structure of forward prices is negative, the market is in backwardation, or is backwardated.
basis
The basis in a forward contract is the difference between the spot (or cash) price of the referenced asset, S, and the price (F) of a forward contract with delivery T.
calendar spread
A calendar spread can be viewed as the difference between futures or forward prices on the same underlying asset but with different settlement dates.
contango
When the term structure of forward prices is upward sloping (i.e., when more distant forward contracts have higher prices than contracts that are nearby), the market is said to be in contango.
convenience yield
Convenience yield, y, is the economic benefit that the holder of an inventory in the commodity receives from directly holding the inventory rather than having a long position in a forward contract on the commodity.
cost of carry
In the context of futures and forward contracts, a cost of carry (or carrying cost) is any financial difference between maintaining a position in the cash market and maintaining a position in the forward market.
crisis at maturity
A crisis at maturity is when the party owing a payment is forced at the last moment to reveal that it cannot afford to make the payment or when the party obligated to deliver the asset at the original price is forced to reveal that it cannot deliver the asset.
distant contracts
Contracts with longer times to settlement are often called distant contracts, deferred contracts, or back contracts.
front month contract
On an exchange, the futures contract with the shortest time to settlement is often referred to as the front month contract.
inelastic supply
Inelastic supply is when supplies change slowly in response to market prices or when large changes in market prices are necessary to effect supply changes.
informationally inefficient term structure
An informationally inefficient term structure has pricing relationships that do not properly reflect available information.
initial margin
The collateral deposit made at the initiation of a long or short futures position is called the initial margin.
law of one price
The law of one price states that in the absence of trading restrictions, two identical assets will not persist in trading at different prices in different markets because arbitrageurs will buy the relatively underpriced asset and sell the relatively overpriced asset until the discrepancy disappears.
maintenance margin requirement
A maintenance margin requirement is a minimum collateral requirement imposed on an ongoing basis until a position is closed.
margin call
A margin call is a demand for the posting of additional collateral to meet the initial margin requirement.
marginal market participant
The marginal market participant to a derivative contract is any entity with individual costs and benefits that make the entity indifferent between physical positions and synthetic positions.
marked-to-market
The term marked-to-market means that the side of a futures contract that benefits from a price change receives cash from the other side of the contract (and vice versa) throughout the contract’s life.
normal backwardation
In normal backwardation, the forward price is believed to be below the expected spot price.
normal contango
In normal contango, the forward price is believed to be above the expected spot price.
open interest
The outstanding quantity of unclosed contracts is known as open interest.
perfectly elastic supply
With regard to supply, on one end of the spectrum is a perfectly elastic supply, in which any quantity demanded of a commodity can be instantaneously and limitlessly supplied without changes in the market price.
rolling contracts
Rolling contracts refers to the process of closing positions in short-term futures contracts and simultaneously replacing the exposure by establishing similar positions with longer terms.
storage costs
Storage costs of physical commodities involve such expenditures as warehouse fees, insurance, transportation, and spoilage.
swap
A swap is a string of forward contracts grouped together that vary by time to settlement.
basis risk
Basis risk is the dispersion in economic returns associated with changes in the relationship between spot prices and futures prices.
Bloomberg Commodity Index (BCOM)
The Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, is a long-only index composed of futures contracts on 22 physical commodities.
collateral yield
Collateral yield, is the interest earned from the riskless bonds or other money market assets used to collateralize the futures contract.
commodity-linked note
A commodity-linked note (CLN) is an intermediate-term debt instrument whose value at maturity is a function of the value of an underlying commodity or basket of commodities.
convergence at settlement
Convergence at settlement is the process of the futures price nearing the spot price as settlement approaches, and the two prices matching each other at settlement.
excess return of a futures contract
The return generated exclusively from changes in futures prices is known as the excess return of a futures contract.
fully collateralized position
A fully collateralized position is a position in which the cash necessary to settle the contract has been posted in the form of short-term, riskless bonds.
heterogeneous
A heterogeneous value differs across one or more dimensions.
inflation
Inflation is the decline in the value of money relative to the
value of a general bundle of goods and services.
inflation risk
Inflation risk is the dispersion in economic outcomes caused by uncertainty regarding the value of a currency.
investable index
An investable index has returns that an investor can match in practice by maintaining the same positions that constitute the index.
nominal price
A nominal price refers to the stated price of an asset measured using the contemporaneous values of a currency.
production-weighted index
A production-weighted index weights each underlying commodity using estimates of the quantity of each commodity produced.
real price
A real price refers to the price of an asset that is adjusted for inflation through being expressed in the value of currency from a different time period.
Reuters/Jefferies Commodity Research Bureau (CRB) Index
The Reuters/Jefferies Commodity Research Bureau (CRB) Index is the oldest major commodity index and is currently made up of 19 commodities traded on various exchanges.
roll return
Roll yield or roll return is properly defined as the portion of the return of a futures position from the change in the contract’s basis through time.
roll yield
Roll yield or roll return is properly defined as the portion of the return of a futures position from the change in the contract’s basis through time.
spot return
Spot return is the return on the underlying asset in the spot market.
Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI)
The Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI) is a longonly index of physical commodity futures.
brownfield project
Investable infrastructure can also be an existing project, or brownfield project, that has a history of operations and may have converted from a government asset into something privately investable.
double taxation
Double taxation is the application of income taxes twice: taxation of profits at the corporate income tax level and taxation of distributions at the individual income tax level.
downstream operations
Downstream operations focus on refining, distributing, and marketing the oil and gas.
evergreen funds
Unlisted open-end funds, also called evergreen funds, allow investors to subscribe to or redeem from these funds on a regular basis.
excludable good
An excludable good is a good others can be prevented from enjoying.
gates
Gates are fund restrictions on investor withdrawals.
greenfield project
Investable infrastructure can originate as a new, yet-to-be- constructed project, referred to as a greenfield project, which was designed to be investable.
intangible assets
Intangible assets are economic resources that do not have a physical form.
intellectual property
Intellectual property (IP) is an intangible asset that can be owned, such as copyrighted artwork.
investable infrastructure
Investable infrastructure is typically differentiated from other assets with seven primary characteristics: (1) public use, (2) monopolistic power, (3) government related, (4) essential, (5) cash generating, (6) conducive to privatization of control, and (7) capital intensive with long-term horizons.
midstream operations
Midstream operations and midstream MLPs—the largest of the three segments—process, store, and transport energy and tend to have little or no commodity price risk.
negative costs
Negative costs refer not to the sign of the values but to the fact that these are costs required to produce what was, in the predigital era, the film’s negative image.
present value of growth opportunities (PVGO)
In corporate finance, present value of growth opportunities (PVGO) describes a high value assigned to an investment based on the idea that the underlying assets offer exceptional future income.
privatization
When a governmental entity sells a public asset to a private operator, this is termed privatization.
public-private partnership
A public-private partnership (PPP) occurs when a private sector party is retained to design, build, operate, or maintain a public building (e.g., a hospital), often for a lease payment for a prespecified period of time.
regulatory risk
Regulatory risk is the economic dispersion to an investor from uncertainty regarding governmental regulatory actions.
unbundling
In recent years, there has been an increased interest in unbundling IP from corporations and permitting it to be purchased as a stand-alone investment.
upstream operations
Upstream operations focus on exploration and production; midstream operations focus on storing and transporting the oil and gas.
amortization
. Reduction in principal due to payments is known as amortization.
balloon payment
A balloon payment is a large scheduled future payment.
collateralized mortgage obligations (CMOs)
Collateralized mortgage obligations (CMOs) extend this MBS mechanism to create different security classes, called tranches, which have different priorities to receiving cash flows and therefore different risks.
commercial mortgage loans
Commercial mortgage loans are loans backed by commercial real estate (multifamily apartments, hotels, offices, retail and industrial properties) rather than owner-occupied residential properties.
commercial mortgage-backed securities
Commercial mortgage-backed securities (CMBS) are mortgage-backed securities with underlying collateral pools of commercial property loans.
conditional prepayment rate
The annualized percentage of a mortgage’s remaining principal value that is prepaid in a particular month is known as the conditional prepayment rate (CPR).
core real estate
Core real estate includes assets that achieve a relatively high percentage of their returns from income and are expected to have low volatility.
covenants
Covenants are promises made by the borrower to the lender, such as requirements that the borrower maintain the property in good repair and continue to meet specified financial conditions.
cross-collateral provision
In order to mitigate the risk to which they are exposed, lenders commonly use a cross-collateral provision, wherein the collateral for one loan is used as collateral for another loan.
debt service coverage ratio
A related measure is the debt service coverage ratio (DSCR), which is the ratio of the property’s net operating income to all loan payments, including the amortization of the loan.
equity REITs
Equity REITs invest predominantly in equity ownership within the private real estate market.
fixed charges ratio
The fixed charges ratio is the ratio of the property’s net operating income to all fixed charges that the borrower pays annually.
fixed-rate mortgage
A fixed-rate mortgage has interest charges and interest payments based on a single rate established at the initiation of the mortgage.
fully amortized
An asset is fully amortized when its principal is reduced to zero.
idiosyncratic prepayment factors
Factors affecting prepayment decisions other than interest rates or other systematic factors are known as idiosyncratic prepayment factors.
index rate
An index rate is a variable interest rate used in the determination of the mortgage’s stated interest rate.
interest coverage ratio
Lenders typically examine the interest coverage ratio, which can be defined as the property’s net operating income divided by the loan’s interest payments.
interest rate cap
An interest rate cap is a limit on interest rate adjustments used in mortgages and derivatives with variable interest rates.
loan-to-value ratio (LTV ratio)
The loan-to-value ratio (LTV ratio) is the ratio of the amount of the loan to the value (either market or appraised) of the property.
lumpiness
Lumpiness describes when assets cannot be easily and inexpensively bought and sold in sizes or quantities that meet the preferences of the buyers and sellers.
margin rate
A margin rate is the spread by which the stated mortgage rate is set above the index rate. (This should not be confused with the same term used to describe a rate associated with margin debt in a brokerage account.)
mortgage
A mortgage loan can be simply defined as a loan secured by property.
mortgage REITs
Mortgage REITs invest predominantly in real estate–based debt.
mortgage-backed securities (MBS)
Mortgage-backed securities (MBS) are a type of asset- backed security that is secured by a mortgage or pool of mortgages.
negative amortization
Negative amortization occurs when the interest owed is greater than the payments being made such that the deficit is added to the principal balance on the loan, causing the principal balance to increase through time.
opportunistic real estate
Opportunistic real estate properties are expected to derive most or all of their returns from property appreciation and may exhibit substantial volatility in value and returns.
option adjustable-rate mortgage (option ARM)
An option adjustable-rate mortgage (option ARM) is an adjustable-rate mortgage that provides borrowers with the flexibility to make one of several possible payments on their mortgage every month.
pass-through MBS
A pass-through MBS is perhaps the simplest MBS and consists of the issuance of a homogeneous class of securities with pro rata rights to the cash flows of the underlying pool of mortgage loans
prepayment option
The ability of the borrower to make or not make unscheduled principal payments is an option to the borrower: the borrower’s prepayment option.
PSA benchmark
The Public Securities Association (PSA) established the PSA benchmark, a benchmark of prepayment speed that is based on the CPR and that has become the standard approach used by market participants.
real estate investment trust (REIT)
A real estate investment trust (REIT) is an entity structured much like a traditional operating corporation, except that the assets of the entity are almost entirely real estate.
recourse
Recourse is the set of rights or means that an entity such as a lender has in order to protect its investment.
refinancing burnout
Reduced refinancing speeds due to high levels of previous refinancing activity is known as refinancing burnout.
residential mortgage loans
Residential mortgage loans are typically taken out by individual households on properties that generate no explicit rental income, since the houses are usually owner occupied.
residential mortgage-backed securities
The residential mortgage-backed securities (RMBS) market is backed by residential mortgage loans.
styles of real estate investing
Styles of real estate investing refer to the categorization of real estate property characteristics into core, value added, and opportunistic.
subprime mortgages
Uninsured mortgages with borrowers of relatively high credit risk are generally known as subprime mortgages.
unscheduled principal payments
If the borrower makes unscheduled principal payments, which are payments above and beyond the scheduled mortgage payments, the mortgage’s balance will decline more quickly than illustrated in Exhibit 14.1, and the mortgage will terminate early. In traditional mortgages, payments that exceed the required payment reduce the principal payment but do not lower required subsequent payments until the mortgage is paid off.
value-added real estate
Value-added real estate includes assets that exhibit one or more of the following characteristics: (1) achieving a substantial portion of their anticipated returns from appreciation in value, (2) exhibiting moderate volatility, and (3) not having the financial reliability of core properties.
variable-rate mortgage
A variable-rate mortgage has interest charges and interest payments based on a rate that is allowed to vary over the life of the mortgage based on terms established at the initiation of the mortgage.
after-tax discounting approach
In an after-tax discounting approach, the estimated after-tax cash flows (e.g., after-tax bond payments) are discounted using a rate that has been reduced to reflect the net rate received by an investor with a specified marginal tax rate.
appraisals
Appraisals are professional opinions with regard to the value of an asset, such as a real estate property.
backward induction
Backward induction is the process of solving a decision tree by working from the final nodes toward the first node, based on valuation analysis at each node.
closed-end real estate mutual fund
A closed-end real estate mutual fund is an investment pool that has real estate as its underlying asset and a relatively fixed number of outstanding shares.
commingled real state funds
Commingled real estate funds (CREFs) are a type of private equity real estate fund that is a pool of investment capital raised from private placements that are commingled to purchase commercial properties.
comparable sale prices approach
The comparable sale prices approach values real estate based on transaction values of similar real estate, with adjustments made for differences in characteristics.
data smoothing
Data smoothing occurs in a return series when the prices used in computing the return series have been dampened relative to the volatility of the true but unobservable underlying prices.
decision node
A decision node is a point in a decision tree at which the holder of the option must make a decision.
decision tree
A decision tree shows the various pathways that a decision maker can select as well as the points at which uncertainty is resolved.
depreciation
Depreciation is a noncash expense that is deducted from revenues in computing accounting income to indicate the decline of an asset’s value.
depreciation tax shield
A depreciation tax shield is a taxable entity’s ability to reduce taxes by deducting depreciation in the computation of taxable income.
discounted cash flow (DCF) method
The income approach is also known as the discounted cash flow (DCF) method when cash flows are discounted rather than accounting estimates of income.
effective gross income
The effective gross income is the potential gross income reduced for the vacancy loss rate
effective tax rate
The effective tax rate is the actual reduction in value that occurs in practice when other aspects of taxation are included in the analysis, such as exemptions, penalties, and timing of cash flows.
equity residual approach
An alternative approach, often termed the equity residual approach, focuses on the perspective of the equity investor by subtracting the interest expense and other cash outflows due to mortgage holders (in the numerator) and by discounting the remaining cash flows using an interest rate reflective of the required rate of return on the equity of a leveraged real estate investment (in the denominator).
exchange-traded funds (ETFs)
Exchange-traded funds (ETFs) represent a tradable investment vehicle that tracks a particular index or portfolio by holding its constituent assets or a subsample of them.
fixed expenses
Fixed expenses, examples of which are property taxes and property insurance, do not change directly with the level of occupancy of the property.
FTSE NAREIT US Real Estate Index Series
The FTSE NAREIT US Real Estate Index Series is a family of REIT-based performance indices that covers the different sectors of the U.S. commercial real estate space.
gearing
Gearing is the use of leverage.
hedonic price index
A hedonic price index estimates value changes based on an analysis of observed transaction prices that have been adjusted to reflect the differing characteristics of the assets underlying each transaction.
income approach
The income approach values real estate by projecting expected income or cash flows, discounting for time and risk, and summing them to form the total value.
information node
An information node denotes a point in a decision tree at which new information arrives.
NCREIF Property Index (NPI)
The NCREIF Property Index (NPI) is the primary example of an appraisal-based real estate index in the United States and is published by the National Council of Real Estate Investment Fiduciaries (NCREIF), a not-for-profit industry association that collects data regarding property values from its members.
net lease
In a net lease, the tenant is responsible for almost all of the operating expenses.
net operating income (NOI)
Net operating income (NOI) is a measure of periodic earnings that is calculated as the property’s rental income minus all expenses associated with maintaining and operating the property.
net sale proceeds
The net sale proceeds (NSP) is the expected selling price minus any expected selling expenses arising from the sale of the property at time T.
open-end real estate mutual funds
Open-end real estate mutual funds are public investments that offer a non-exchange traded means of obtaining access to the private real estate market.
operating expenses
Operating expenses are non-capital outlays that support rental of the property and can be classified as fixed or variable.
potential gross income
The potential gross income is the gross income that could potentially be received if all offices in the building were occupied.
pre-tax discounting approach
The pre-tax discounting approach is commonly used in finance, where pre-tax cash flows are used in the numerator of the present value analysis (as the cash flows to be received), and the pre-tax discount rate is used in the denominator.
private equity real estate funds
Private equity real estate funds are privately organized funds that are similar to other alternative investment funds, such as private equity funds and hedge funds, yet have real estate as their underlying asset.
profit approach
The profit approach to real estate valuation is typically used for properties with a value driven by the actual business use of the premises; it is effectively a valuation of the business rather than a valuation of the property itself.
real estate development projects
Real estate development projects can include one or more stages of creating or improving a real estate project, including the acquisition of raw land, the construction of improvements, and the renovation of existing facilities.
real estate joint ventures
Real estate joint ventures are private equity real estate funds that consist of the combination of two or more parties, typically represented by a small number of individual or institutional investors, embarking on a business enterprise such as the development of real estate properties.
real estate valuation
Real estate valuation is the process of estimating the market value of a property and should be reflective of the price at which informed investors would be willing to both buy and sell that property.
real option
A real option is an option on a real asset rather than a financial security.
risk premium approach
The risk premium approach to estimation of a discount rate for an investment uses the sum of a riskless interest rate and one or more expected rewards—expressed as rates—for bearing the risks of the investment.
stale pricing
The use of prices that lag changes in true market prices is known as stale pricing.
syndications
Syndications are private equity real estate funds formed by a group of investors who retain a real estate expert with the intention of undertaking a particular real estate project.
vacancy loss rate
The vacancy loss rate is the observed or anticipated rate at which potential gross income is reduced for space that is not generating rental income.
variable expenses
Variable expenses, examples of which are maintenance, repairs, utilities, garbage removal, and supplies, change as the level of occupancy of the property varies.
absolute return strategies
Absolute return strategies are hedge fund strategies that seek to minimize market risk and total risk.
annuity view of hedge fund fees
The annuity view of hedge fund fees represents the prospective stream of cash flows from fees available to a hedge fund manager.
asymmetric incentive fees
Asymmetric incentive fees, in which managers earn a portion of investment gains without compensating investors for investment losses, are generally prohibited for stock and bond funds offered as ’40 Act mutual funds in the United States.
at-the-money incentive fee approximation
The at-the-money incentive fee approximation expresses the value of a managerial incentive fee as the product of 40%, the fund’s NAV, the incentive fee percentage, and the volatility of the assets (σ1 ) over the option’s life.
capacity
Capacity is the limit on the quantity of capital that can be deployed without substantially diminished performance.
classification of hedge fund strategies
A classification of hedge fund strategies is an organized grouping and labeling of hedge fund strategies.
closet indexer
A closet indexer is a manager who attempts to generate returns that mimic an index while claiming to be an active manager.
consolidation
Consolidation is an increase in the proportion of a market represented by a relatively small number of participants (i.e., the industry concentration).
convergent strategies
Convergent strategies profit when relative value spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate.
diversified strategies
Diversified strategies are hedge fund strategies that seek to diversify across a number of different investment themes.
equity strategies
Equity strategies are hedge fund strategies that exhibit substantial market risk.
event-driven strategies
Event-driven strategies are hedge fund strategies that seek to earn returns by taking on event risk, such as failed mergers, that other investors are not willing or prepared to take.
excessive conservatism
Excessive conservatism is inappropriately high risk aversion by the manager, since the manager’s total income and total wealth may be highly sensitive to fund performance.
fee bias
Fee bias is when index returns overstate what a new investor can obtain in the hedge fund marketplace because the fees used to estimate index returns are lower than the typical fees that a new investor would pay.
fund mortality
Fund mortality, the liquidation or cessation of operations of funds, illustrates the risk of individual hedge funds and is an important issue in hedge fund analysis.
fund of funds
A fund of funds in this context is a hedge fund with underlying investments that are predominantly investments in other hedge funds.
headline risk
Headline risk is dispersion in economic value from events so important, unexpected, or controversial that they are the center of major news stories.
hedge fund program
A hedge fund program refers to the processes and procedures for the construction, monitoring, and maintenance of a portfolio of hedge funds.
high-water mark
The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid.
incentive fee option value
The incentive fee option value is the risk-adjusted present value of the incentive fees to a manager that have been adjusted for its optionality.
instant history bias
Instant history bias or backfill bias occurs when an index contains histories of returns that predate the entry date of the corresponding funds into a database and thereby cause the index to disproportionately reflect the characteristics of funds that are added to a database.
investability
The investability of an index is the extent to which market participants can invest to actually achieve the returns of the index.
liquidation bias
Liquidation bias occurs when an index disproportionately reflects the characteristics of funds that are not near liquidation.
lock-in effect
The lock-in effect in this context refers to the pressure exerted on managers to avoid further risks once high profitability and a high incentive fee have been achieved.
managerial coinvesting
Managerial coinvesting in this context is an agreement between fund managers and fund investors that the managers will invest their own money in the fund.
managing returns
The terms managing returns and massaging returns refer to efforts by managers to alter reported investment returns toward preferred targets through accounting decisions or investment changes.
massaging returns
The terms managing returns and massaging returns refer to efforts by managers to alter reported investment returns toward preferred targets through accounting decisions or investment changes.
multistrategy fund
A multistrategy fund deploys its underlying investments with a variety of strategies and sub-managers, much as a corporation would use its divisions.
off-balance-sheet risk
Event risk is effectively an off-balance-sheet risk—that is, a risk exposure that is not explicitly reflected in the statement of financial positions.
opportunistic
An investment strategy is referred to as opportunistic when a major goal is to seek attractive returns through locating superior underlying investments.
optimal contracting
Optimal contracting between investors and hedge fund managers attempts to align the interests of both parties to the extent that the interests can be aligned cost-effectively, with marginal benefits that exceed marginal costs.
option view of incentive fees
The option view of incentive fees uses option theory to demonstrate the ability of managers to increase the present value of their fees by increasing the volatility of the fund’s assets.
participation bias
Participation bias may occur for a successful hedge fund manager who closes a fund and stops reporting results because the fund no longer needs to attract new capital.
perverse incentive
A perverse incentive is an incentive that motivates the receiver of the incentive to work in opposition to the interests of the provider of the incentive.
pure asset gatherer
A pure asset gatherer is a manager focused primarily on increasing the AUM of the fund. A pure asset gatherer is likely to take very little risk in a portfolio and, like mutual fund managers, become a closet indexer.
relative return product
A relative return product is an investment with returns that are substantially driven by broad market returns and that should therefore be evaluated on the basis of how the investment’s return compares with broad market returns.
relative value strategies
Relative value strategies are hedge fund strategies that seek to earn returns by taking risks regarding the convergence of values between securities.
representativeness
The representativeness of a sample is the extent to which the characteristics of that sample are similar to the characteristics of the universe.
safe harbor
In investments, a safe harbor denotes an area that is explicitly protected by one set of regulations from another set of regulations.
short volatility exposure
Short volatility exposure is any risk exposure that causes losses when underlying asset return volatilities increase.
single-manager hedge fund
A single-manager hedge fund, or single hedge fund, has underlying investments that are not allocations to other hedge funds.
strategy definitions
Strategy definitions, the method of grouping similar funds, raise two problems: (1) definitions of strategies can be very difficult for index providers to establish and specify, and (2) some funds can be difficult to classify in the process of applying the definition.
synthetic hedge funds
Synthetic hedge funds attempt to mimic hedge fund returns using listed securities and mathematical models.
black-box model trading
Systematic fund trading, often referred to as black-box model trading because the details are hidden in complex software, occurs when the ongoing trading decisions of the investment process are automatically generated by computer programs.
breakout strategies
Breakout strategies focus on identifying the commencement of a new trend by observing the range of recent market prices (e.g., looking back at the range of prices over a specific time period).
capacity risk
Capacity risk arises when a managed futures trader concentrates trades in a market that lacks sufficient depth (i.e., liquidity).
commodity pools
Commodity pools are investment funds that combine the money of several investors for the purpose of investing in the futures markets.
commodity trading advisers (CTAs)
Commodity trading advisers (CTAs) are professional money managers who specialize in the futures markets.
conditional correlation coefficient
A conditional correlation coefficient is a correlation coefficient calculated on a subset of observations that is selected using a condition.
counterparty risk
Counterparty risk is the uncertainty associated with the economic outcomes of one party to a contract due to potential failure of the other side of the contract to fulfill its obligations, presumably due to insolvency or illiquidity.
countertrend strategies
Countertrend strategies use various statistical measures, such as price oscillation or a relative strength index, to identify range-trading opportunities rather than price- trending opportunities.
degradation
Degradation is the tendency and process through time by which a trading rule or trading system declines in effectiveness.
discretionary fund trading
Discretionary fund trading occurs when the decisions of the investment process are made according to the judgment of human traders.
event risk
Event risk refers to sudden and unexpected changes in market conditions resulting from a specific event (e.g., Lehman Brothers bankruptcy).
exponential moving average
The exponential moving average is a geometrically declining moving average based on a weighted parameter, λ, with 0 < λ < 1.
fundamental analysis
Fundamental analysis uses underlying financial and economic information to ascertain intrinsic values based on economic modeling.
global macro funds
Global macro funds have the broadest investment universe: They are not limited by market segment, industry sector, geographic region, financial market, or currency, and therefore tend to offer high diversification.
in-sample data
In-sample data are those observations directly used in the backtesting process.
lack of trends risk
Lack of trends risk, which comes into play when the trader continues allocating capital to trendless markets, leading to substantial losses.
leverage
Leverage refers to the use of financing to acquire and maintain market positions larger than the assets under management (AUM) of the fund.
liquidity risk
Liquidity risk, is somewhat related to capacity risk in that it refers to how a large fund that is trading in a thinly traded market will affect the price should it decide to increase or decrease its allocation.
managed account
A managed account (or separately managed account) is created when money is placed directly with a CTA in an individual account rather than being pooled with other investors.
managed futures
The term managed futures refers to the active trading of futures and forward contracts on physical commodities, financial assets, and exchange rates.
market microstructure
Market microstructure is the study of how transactions take place, including the costs involved and the behavior of bid and ask prices.
market risk
Market risk refers to exposure to directional moves in general market price levels.
mean-reverting
Mean-reverting refers to the situation in which returns show negative autocorrelation—the opposite tendency of momentum or trending.
model risk
Model risk is economic dispersion caused by the failure of models to perform as intended.
momentum
Momentum is the extent to which a movement in a security price tends to be followed by subsequent movements of the same security price in the same direction.
Mount Lucas Management (MLM) Index
The Mount Lucas Management (MLM) Index is a passive, transparent, and investable index designed to capture the returns to active futures investing.
moving average
A moving average is a series of averages that is recalculated through time based on a window of observations.
natural hedger
A natural hedger is a market participant who seeks to hedge a risk that springs from its fundamental business activities.
out-of-sample data
Out-of-sample data are observations that were not directly used to develop a trading rule or even indirectly used as a basis for knowledge in the research.
pattern recognition system
A pattern recognition system looks to capture non-trend- based predictable abnormal market behavior in prices or volatilities.
private commodity pools
Private commodity pools are funds that invest in the futures markets and are sold privately to high-net-worth investors and institutional investors.
public commodity pools
Public commodity pools are open to the general public for investing in much the same way that a mutual fund sells its shares to the public.
random walk
A price series with changes in its prices that are independent from current and past prices is a random walk.
relative strength index (RSI)
The relative strength index (RSI), sometimes called the relative strength indicator, is a signal that examines average up and down price changes and is designed to identify trading signals such as the price level at which a trend reverses.
robustness
Robustness refers to the reliability with which a model or system developed for a particular application or with a particular data set can be successfully extended into other applications or data sets.
sideways market
A sideways market exhibits volatility without a persistent direction.
simple moving average
The most basic approach uses a simple moving average, a simple arithmetic average of previous prices.
slippage
Slippage is the unfavorable difference between assumed entry and exit prices and the entry and exit prices experienced in practice.
systematic fund trading
Systematic fund trading, often referred to as black-box model trading because the details are hidden in complex software, occurs when the ongoing trading decisions of the investment process are automatically generated by computer programs.
technical analysis
Technical analysis relies on data from trading activity, including past prices and volume data.
thematic investing
Thematic investing is a trading strategy that is not based on a particular instrument or market; rather, it is based on secular and long-term changes in some fundamental economic variables or relationships—for example, trends in population, the need for alternative sources of energy, or changes in a particular region of the world economy.
transparency
Transparency is the ability to understand the detail within an investment strategy or portfolio.
transparency risk
Transparency risk is dispersion in economic outcomes caused by the lack of detailed information regarding an investment portfolio or strategy.
trend-following strategies
Trend-following strategies are designed to identify and take advantage of momentum in price direction (i.e., trends in prices).
validation
Validation of a trading rule refers to the use of new data or new methodologies to test a trading rule developed on another set of data or with another methodology.
weighted moving average
A weighted moving average is usually formed as an unequal average, with weights arithmetically declining from most recent to most distant prices.
whipsawing
Whipsawing is when a trader alternates between establishing long positions immediately before price declines and establishing short positions immediately before price increases and, in so doing, experiences a sequence of losses. In trend following strategies, whipsawing results from a sideways market.
activist investment strategy
The activist investment strategy involves efforts by shareholders to use their rights, such as voting power or the threat of such power, to influence corporate governance to their financial benefit as shareholders.
agency costs
Agency costs are any costs, explicit (e.g., monitoring and auditing costs) or implicit (e.g., excessive corporate perks), resulting from inherent conflicts of interest between shareholders as principals and managers as agents.
agency theory
Agency theory studies the relationship between principals and agents.
agent compensation scheme
An agent compensation scheme is all agreements and procedures specifying payments to an agent for services, or any other treatment of an agent with regard to employment.
antitrust review
An antitrust review is a government analysis of whether a corporate merger or some other action is in violation of regulations through its potential to reduce competition.
bankruptcy process
The bankruptcy process is the series of actions taken from the filing for bankruptcy through its resolution.
bidding contest
A bidding contest or bidding war is when two or more firms compete to acquire the same target.
capital structure arbitrage
Capital structure arbitrage involves offsetting positions within a company’s capital structure with the goal of being long relatively underpriced securities, being short overpriced securities, and being hedged against risk.
corporate event risk
Corporate event risk is dispersion in economic outcomes due to uncertainty regarding corporate events.
corporate governance
Corporate governance describes the processes and people that control the decisions of a corporation.
distressed debt hedge funds
Distressed debt hedge funds invest in the securities of a corporation that is in bankruptcy or is likely to fall into bankruptcy.
event-driven
The event-driven category of hedge funds includes activist hedge funds, merger arbitrage funds, and distressed securities funds, as well as special situation funds and multistrategy funds that combine a variety of event-driven strategies.
event-driven multistrategy funds
Event-driven multistrategy funds diversify across a wide variety of event-driven strategies, participating in opportunities in both corporate debt and equity securities.
financial market segmentation
Financial market segmentation occurs when two or more markets use different valuations for similar assets due to the lack of participants who trade in both markets or who perform arbitrage between the markets.
financing risk
Financing risk is the economic dispersion caused by failure or potential failure of an entity, such as an acquiring firm, to secure the funding necessary to consummate a plan.
Form 13D
In the United States, Form 13D is required to be filed with the Securities and Exchange Commission (SEC) within 10 days, publicizing an activist’s stake in a firm once the activist owns more than 5% of the firm and has a strategic plan for the firm.
Form 13F
In the United States, Form 13F is a required quarterly filing of all long positions by all U.S. asset managers with over $100 million in assets under management, including hedge funds and mutual funds, among other investors.
Form 13G
In the United States, Form 13G is required of passive shareholders who buy a 5% stake in a firm, but this filing may be delayed until 45 days after year-end.
free rider
A free rider is a person or entity that allows others to pay initial costs and then benefits from those expenditures.
interlocking boards
Interlocking boards occur when board members from multiple firms—especially managers—simultaneously serve on each other’s boards and may lead to a reduced responsiveness to the interests of shareholders.
liquidation process
In a liquidation process (chapter 7 in U.S. bankruptcy laws), all of the assets of the firm are sold, and the cash proceeds are distributed to creditors.
long binary call option
A long binary call option makes one payout when the referenced price exceeds the strike price at expiration and a lower payout or no payout in all other cases.
long binary put option
A long binary put option makes one payout when the referenced price is lower than the strike price at expiration and a lower payout or no payout in all other cases.
merger arbitrage
Merger arbitrage attempts to benefit from merger activity with minimal risk and is perhaps the best-known event-driven strategy.
one-off transaction
A one-off transaction has one or more unique characteristics that cause the transaction to require specialized skill, knowledge, or effort.
principal-agent relationship
A principal-agent relationship is any relationship in which one person or group, the principal(s), hires another person or group, the agent(s), to perform decision-making tasks.
proxy battle
A proxy battle is a fight between the firm’s current management and one or more shareholder activists to obtain proxies (i.e., favorable votes) from shareholders.
recovery value
The recovery value of the firm and its securities is the value of each security in the firm and is based on the time it will take the firm to emerge from the bankruptcy process and the condition in which it will emerge.
reorganization process
In a reorganization process (chapter 11 in U.S. bankruptcy laws), the firm’s activities are preserved.
selling insurance
Selling insurance in this context refers to the economic process of earning relatively small returns for providing protection against risks, not the literal process of offering traditional insurance policies.
shareholder activism
Shareholder activism refers to efforts by one or more shareholders to influence the decisions of a firm in a direction contrary to the initial recommendations of the firm’s senior management.
special situation funds
Special situation funds also invest across a number of event styles are typically focused on equity securities, especially those with a spin-off or recent emergence from bankruptcy.
spin-off
A spin-off occurs when a publicly traded firm splits into two publicly traded firms, with shareholders in the original firm becoming shareholders in both firms.
split-off
A split-off occurs when investors have a choice to own Company A or B, as they are required to exchange their shares in the parent firm if they would like to own shares in the newly created firm.
staggered board seats
Staggered board seats exist when instead of having all members of a board elected at a single point in time, portions of the board are elected at regular intervals.
stock-for-stock mergers
Stock-for-stock mergers acquire stock in the target firm using the stock of the acquirer and typically generate large initial increases in the share price of the target firm.
toehold
A toehold is a stake in a potential merger target that is accumulated by a potential acquirer prior to the news of the merger attempt becoming widely known.
traditional merger arbitrage
Traditional merger arbitrage generally uses leverage to buy the stock of the firm that is to be acquired and to sell short the stock of the firm that is the acquirer.
wolf pack
A wolf pack is a group of investors who may take similar positions to benefit from an activists’ engagement with corporate management.
anticipated volatility
Anticipated volatility is the future level of volatility expected by a market participant.
asset-backed securities
Still another subset of fixed-income arbitrage trades is asset- backed securities (ABS), which are securitized products created from pools of underlying loans or other assets.
busted convertibles
Bonds with very high conversion premiums are often called busted convertibles, as the embedded stock options are far out-of-the-money.
carry trades
Carry trades attempt to earn profits from carrying or maintaining long positions in higher-yielding assets and short positions in lower-yielding assets without suffering from adverse price movements.
classic convertible bond arbitrage trade
The classic convertible bond arbitrage trade is to purchase a convertible bond that is believed to be undervalued and to hedge its risk using a short position in the underlying equity.
classic dispersion trade
The classic dispersion trade is a market-neutral short correlation trade, popular among volatility arbitrage practitioners, that typically takes long positions in options listed on the equities of single companies and short positions in a related index option.
classic relative value strategy trade
The classic relative value strategy trade is based on the premise that a particular relationship or spread between two prices or rates has reached an abnormal level and will therefore tend to return to its normal level.
complexity premium
A complexity premium is a higher expected return offered by a security to an investor to compensate for analyzing and managing a position that requires added time and expertise.
components of convertible arbitrage returns
The components of convertible arbitrage returns include interest, dividends, rebates, and capital gains and losses.
convergence
Convergence is the return of prices or rates to relative values that are deemed normal.
convertible bonds
Convertible bonds are hybrid corporate securities, mixing fixed-income and equity characteristics into one security.
correlation risk
Correlation risk is dispersion in economic outcomes attributable to changes in realized or anticipated levels of correlation between market prices or rates.
correlations go to one
The term correlations go to one means that during periods of enormous stress, stocks and bonds with credit risk decline simultaneously and with somewhat similar magnitudes.
delta
Delta is the change in the value of an option (or a security with an implicit option) with respect to a change in the value of the underlying asset (i.e., it measures the sensitivity of the option price to small changes in the price of its underlying asset).
delta-neutral
A delta-neutral position is a position in which the value- weighted sum of all deltas of all positions equals zero.
dilution
Dilution takes place when additional equity is issued at below- market values, and the per-share value of the holdings of existing shareholders is diminished.
duration
Duration is a measure of the sensitivity of a fixed-income security to a change in the general level of interest rates.
duration-neutral
A duration-neutral position is a portfolio in which the aggregated durations of the short positions equal the aggregated durations of the long positions weighted by value.
dynamic delta hedging
Dynamic delta hedging is the process of frequently adjusting positions in order to maintain a target exposure to delta, often delta neutrality.
effective duration
Effective duration is a measure of the interest rate sensitivity of a position that includes the effects of embedded option characteristics.
equity-like convertible
An equity-like convertible is a convertible bond that is far in- the-money and therefore has a price that tracks its underlying equity very closely.
fixed-income arbitrage
Fixed-income arbitrage involves simultaneous long and short positions in fixed income securities with the expectation that over the investment holding period, the security prices will converge toward a similar valuation standard.
gamma
Gamma is the second derivative of an option’s price with respect to the price of the underlying asset—or, equivalently, the first derivative of delta with respect to the price of the underlying asset.
general collateral stocks
General collateral stocks, which are stocks not facing heavy borrowing demand, may earn a 2% rebate when Treasury bill rates are at 2%, whereas stocks on special may earn zero rebates or even negative rebates, wherein borrowers must pay the lenders money in addition to the interest that the lender is earning on the collateral.
hybrid convertibles
Convertible bonds with moderately sized conversion ratios have stock options closer to being at-the-money and are called hybrid convertibles.
implied volatility
The implied volatility of an option or an option-like position— in this case, the implied volatility of a convertible bond—is the standard deviation of returns that is viewed as being consistent with an observed market price for the option.
intercurve arbitrage positions
There are also intercurve arbitrage positions, which means arbitrage (hedged positions) using securities related to different yield curves.
interest rate immunization
Interest rate immunization is the process of eliminating all interest rate risk exposures.
intracurve arbitrage positions
These are examples of intracurve arbitrage positions because they are based on hedged positions within the same yield curve.
marking-to-market
Marking-to-market refers to the use of current market prices to value instruments, positions, portfolios, and even the balance sheets of firms.
marking-to-model
Marking-to-model refers to valuation based on prices generated by pricing models. The pricing models generally involve two components.
modified duration
Modified duration is equal to traditional duration divided by the quantity [1 + (y/m)], where y is the stated annual yield, m is the number of compounding periods per year, and y/m is the periodic yield.
moneyness
Moneyness is the extent to which an option is in-the-money, at-the-money, or out-of-the-money.
mortgage-backed securities arbitrage
Mortgage-backed securities arbitrage attempts to generate low-risk profits through the relative mispricing among MBS or between MBS and other fixed-income securities.
net delta
The net delta of a position is the delta of long positions minus the delta of short positions.
option-adjusted spread
A key concept in pricing fixed income securities with embedded prepayment options is the option-adjusted spread (OAS), which is a measure of the excess of the return of a fixed-income security containing an option over the yield of an otherwise comparable fixed-income security without an option after the return of the fixed-income security containing the option has been adjusted to remove the effects of the option.
parallel shift
A parallel shift in the yield curve happens when yields of all maturities shift up or down by equal (additive) amounts.
portfolio insurance
Portfolio insurance is any financial method, arrangement, or program for limiting losses from large adverse price movements.
price transparency
Price transparency is information on the prices and quantities at which participants are offering to buy (bid) and sell (offer) an instrument.
pricing risk
Pricing risk is the economic uncertainty caused by actual or potential mispricing of positions.
realized volatility
Realized volatility is the actual observed volatility (i.e., the standard deviation of returns) experienced by an asset—in this case, the underlying stock.
rebate
A rebate is a payment of interest to the securities’ borrower on the collateral posted.
riding the yield curve
The process of holding a bond as its yield moves up or down the yield curve due to the passage of time is known as riding the yield curve.
rolling down
Rolling down the yield curve is the process of experiencing decreasing yields to maturity as an asset’s maturity declines through time in an upward-sloping yield curve environment.
short correlation
The classic dispersion trade is referred to as a short correlation trade because the trade generates profits from low levels of realized correlation and losses from high levels of realized correlation.
short squeeze
A short squeeze occurs when holders of short positions are compelled to purchase shares at increasing prices to cover their positions due to limited liquidity.
sovereign debt
Sovereign debt is debt issued by national governments.
special stock
A special stock is a stock for which higher net fees are demanded when it is borrowed.
tail risk
Tail risk is the potential for very large loss exposures due to very unusual events, especially those associated with widespread market price declines.
term structure of interest rates
Sometimes the term structure of interest rates is distinguished from the yield curve because the yield curve plots yields to maturity of coupon bonds, whereas the term structure of interest rates plots actual or hypothetical yields of zero-coupon bonds.
theta
Theta is the first derivative of an option’s price with respect to the time to expiration of the option.
variance notional value
The variance notional value of the contract simply scales the size of the cash flows in a variance swap.
variance swaps
Variance swaps are forward contracts in which one party agrees to make a cash payment to the other party based on the realized variance of a price or rate in exchange for receiving a predetermined cash flow.
vega
Vega is a measure of the risk of a position or an asset due to changes in the volatility of a price or rate that helps determine the value of that position or asset.
vega notional value
The vega notional value of a contract serves to scale the contract and determine the size of the payoff in a volatility swap.
vega risk
Vega risk is the economic dispersion caused by changes in the volatility of a price, return, or rate.
volatility arbitrage
Volatility arbitrage is any strategy that attempts to earn a superior and riskless profit based on prices that explicitly depend on volatility.
volatility risk
Volatility risk is dispersion in economic outcomes attributable to changes in realized or anticipated levels of volatility in a market price or rate.
volatility swap
A volatility swap mirrors a variance swap except that the payoff of the contract is linearly based on the standard deviation of a return series rather than the variance.
yield curve
A yield curve is the relationship between the yields of various securities, usually depicted on the vertical axis, and the term to maturity, usually depicted on the horizontal axis.
accounting accrual
An accounting accrual is the recognition of a value based on anticipation of a transaction.
asynchronous trading
Asynchronous trading is an example of market inefficiency in which news affecting more than one stock may be assimilated into the price of the stocks at different speeds.
breadth
The breadth of a strategy is the number of independent active bets placed into an active portfolio.
earnings momentum
Earnings momentum is the tendency of earnings changes to be positively correlated.
earnings surprise
Earnings surprise is the concept and measure of the unexpectedness of an earnings announcement.
equity long/short funds
Equity long/short funds tend to have net positive systematic risk exposure from taking a net long position, with the long positions beinglarger than the short positions.
equity market-neutral funds
Equity market-neutral funds attempt to balance short and long positions, ideally matching the beta exposure of the long and short positions and leaving the fund relatively insensitive to changes in the underlying stock market index.
Fundamental Law of Active Management (FLOAM)
Richard Grinold in 1989 proposed the Fundamental Law of Active Management (FLOAM), which identifies two key components of actively managed investment strategies: breadth and skill.
illegal insider trading
Illegal insider trading varies by jurisdiction but may involve using material nonpublic information, such as an impending merger, for trading without required disclosure.
information coefficient
The information coefficient (IC) measures managerial skill as the correlation between managerial return predictions and realized returns.
informationally efficient
Markets are said to be informationally efficient when security prices reflect available information.
issuance of new stock
Issuance of new stock is a firm’s creation of new shares of common stock in that firm and may occur as a result of a stock-for-stock merger transaction or through a secondary offering.
legal insider trading
Trading by insiders can be legal insider trading when it is performed subject to legal restrictions.
limits to arbitrage
The limits to arbitrage refer to the potential inability or unwillingness of speculators, such as equity hedge fund managers, to hold their positions without time constraints or to increase their positions without size constraints.
liquidity
Liquidity in this context is the extent to which transactions can be executed with minimal disruption to prices.
market anomalies
Investment strategies that can be identified based on available information and that offer higher expected returns after adjustment for risk are known as market anomalies, and they are violations of informational market efficiency.
market impact
Market impact is the degree of the short-term effect of trades on the sizes and levels of bid prices and offer prices.
market maker
A market maker is a market participant that offers liquidity, typically both on the buy side by placing bid orders and on the sell side by placing offer orders.
mean neutrality
Mean neutrality is when a fund is shown to have zero beta exposure or correlation to the underlying market index
multiple-factor scoring models
Multiple-factor scoring models combine the factor scores of a number of independent anomaly signals into a single trading signal.
net stock issuance
Net stock issuance is issuance of new stock minus share repurchases.
nonactive bets
Nonactive bets are positions held to reduce tracking error rather than to serve as return-enhancing active bets.
overreacting
Another potential source of abnormal profits for hedge funds is overreacting in which short-term price changes are too large relative to the value changes that should occur in a market
with perfect informational efficiency.
pairs trading
Pairs trading is a strategy of constructing a portfolio with matching stocks in terms of systematic risks but with a long position in the stock perceived to be relatively underpriced and a short position in the stock perceived to be relatively overpriced.
post-earnings-announcement drift
A post-earnings-announcement drift anomaly has been documented, in which investors can profit from positive surprises by buying immediately after the earnings announcement or selling short immediately after a negative earnings surprise.
price momentum
Price momentum is trending in prices such that an upward price movement indicates a higher expected price and a downward price movement indicates a lower expected price
providing liquidity
Providing liquidity refers to the placement of limit orders or other actions that increase the number of shares available to be bought or sold near the current best bid and offer prices.
share buyback program
When a company chooses to reduce its shares outstanding, a share buyback program is initiated, and the company purchases its own shares from investors in the open market or through a tender offer.
short interest
Short interest is the percentage of outstanding shares that are currently held short.
short-bias funds
Short-bias funds have larger short positions than long positions, leaving a persistent net short position relative to the market index that allows these funds to profit during times of declining equity prices.
speculation
Speculation is defined as bearing abnormal risk in anticipation of abnormally high expected returns.
standardized unexpected earnings
Standardized unexpected earnings (SUE) is a measure of earnings surprise
taking liquidity
More generally, taking liquidity refers to the execution of market orders by a market participant to meet portfolio preferences that cause a decrease in the supply of limit orders immediately near the current best bid and offer prices.
test of joint hypotheses
An empirical test of market efficiency is a test of joint hypotheses, because the test assumes the validity of a model of the risk-return relationship to test whether a given trading strategy earns consistent risk-adjusted profits.
underreacting
Another potential source of abnormal profits for hedge funds is underreacting in which short-term price changes are too small relative to the value changes that should occur in a market with perfect informational efficiency
uptick rule
An uptick rule permits short sellers to enter a short sale only at a price that is equal to or higher than the previous transaction price of the stock.
variance neutrality
Variance neutrality is when fund returns are uncorrelated to changes in market risk, including extreme risks in crisis market scenarios.
access
Access is an investor’s ability to place new or increased money in a particular fund.
conservative funds of funds
Conservative funds of funds have underlying hedged positions.
diversified funds of funds
Diversified funds of funds represent a broad mix of funds.
fee netting
Fee netting in the case of a multistrategy fund is when the investor pays incentive fees based only on net profits of the combined strategies, rather than on all profitable strategies.
liquidity facility
A liquidity facility is a standby agreement with a major bank to provide temporary cash for specified needs with pre- specified conditions.
market-defensive funds of funds
Market-defensive funds of funds tend to have underlying and unhedged short positions.
nontraditional bond funds
Nontraditional or unconstrained bond funds do not simply take long positions in investment-grade sovereign and credit securities, but may also invest in high-yield or emerging markets debt, often including leverage and short positions.
operational due diligence
Operational due diligence is the process of evaluating the policies, procedures, and internal controls of an asset management organization.
seeding funds
Seeding funds, or seeders, are funds of funds that invest in newly created individual hedge funds, often taking an equity stake in the management companies of the newly minted hedge funds.
strategic funds of funds
Strategic funds of funds tend to have underlying directional bets.
unconstrained bond funds
Nontraditional or unconstrained bond funds do not simply take long positions in investment-grade sovereign and credit securities, but may also invest in high-yield or emerging markets debt, often including leverage and short positions.
burn rate
The burn rate of young businesses describes the speed with which cash is being depleted through time and can be used to project when the organization will again require outside funding.
business development companies (BDCs)
Business development companies (BDCs) are publicly traded funds with underlying assets typically consisting of equity or equity-like positions in small, private companies. BDCs use a closed-end structure and trade on major stock exchanges, especially the NASDAQ.
buyouts
In the context of private equity, buyouts are the purchase of a public company by an entity that has a private ownership structure.
call option view of private equity
This call option view of private equity from the perspective of the investor reflects the frequent total losses and occasional huge gains of private equity investments, especially venture capital.
charge-off loans
Charge-off loans are the loans of a financial institution or other lender that have been sold to investors and written off the books of the lender at a loss.
conversion price
The conversion price is the price per share at which the convertible security can be exchanged into shares of common stock, expressed in terms of the principal value of the convertible security.
conversion ratio
The conversion ratio is the number of shares of common stock into which each convertible security can be exchanged.
covenant-lite loans
Covenant-lite loans are loans that place minimal restrictions on the debtor in terms of loan covenants.
distressed debt investing
Distressed debt investing is the practice of purchasing the debt of troubled companies, requiring special expertise and subjecting the investor to substantial risk.
equity kicker
An equity kicker is an option for some type of equity participation in the firm (e.g., options to buy shares of common stock) that is packaged with a debt financing transaction.
equity line of credit
An equity line of credit (ELC) is a contractual agreement between an issuer and an investor that enables the issuer to sell a formula-based quantity of stock at set intervals of time.
haircut
In finance, the term haircut usually refers to a percentage reduction applied to the value of securities in determining their value as collateral.
incurrence covenants
Incurrence covenants typically require a borrower to take or not take a specific action once a specified event occurs.
junk bond
Junk bonds are debt instruments with high credit risk, also referred to as high-yield, noninvestment-grade, or speculative- grade debt.
leveraged loans
Leveraged loans are syndicated bank loans to non-investment grade borrowers.
maintenance covenants
Maintenance covenants are stricter than incurrence covenants in that they require that a standard be regularly met to avoid default.
merchant banking
Merchant banking is the practice whereby financial institutions purchase nonfinancial companies as opposed to merging with or acquiring other financial institutions.
middle market
The middle market refers to companies that are not as large as those companies that have ready access to the financial markets but are larger than companies seeking venture capital.
negative covenants
Negative covenants are promises by the debtor not to engage in particular activities, such as paying dividends or issuing new debt.
positive covenants
Positive covenants are promises to do particular things, such as maintain a specified cash level.
private equity firms
Private equity firms invest in private equity and serve as managers to private equity funds.
private equity funds
Private equity funds are investment pools created to hold portfolios of private equity securities.
private investments in public equity (PIPE)
Private investments in public equity (PIPE) transactions are privately issued equity or equity-linked securities that are placed outside of a public offering and are exempt from registration.
prudent person standard
The prudent person standard is a requirement that specifies levels of care that should be exercised in particular decision- making roles, such as investment decisions made by a fiduciary.
segmentation
Segmentation in this context denotes the grouping of market participants into clienteles that focus their activities within specific areas of the market, rather than varying their range of activities more broadly throughout all available opportunities.
story credit
A story credit is a debt issue with credit risk based on unusual circumstances, and may involve special aspects, such as corporate reorganizations, that distinguish their analysis from more traditional circumstances and as such involve a story.
structured PIPEs
Structured PIPEs include more exotic securities, like floating-rate convertible preferred stock, convertible resets, and common stock resets.
syndicated
The term syndicated refers to the use of a group of entities, often investment banks, in underwriting a security offering or, more generally, jointly engaging in other financial activities.
toxic PIPE
A toxic PIPE is a PIPE with adjustable conversion terms that can generate high levels of shareholder dilution in the event of deteriorating prices in the firm’s common stock.
traditional PIPEs
The large majority of PIPE transactions are traditional PIPEs, in which investors can buy common stock at a fixed price.
underlying business enterprises
Underlying business enterprises in private equity are the unlisted, typically small businesses seeking to grow through investment from private equity funds or private equity firms.
venture capital (VC)
Venture capital (VC), the best known of the private equity categories, is early-stage financing for young firms with high potential growth that do not have a sufficient track record to attract investment capital from traditional sources, like public markets or lending institutions.
venture capital securities
Venture capital securities are the privately held stock, or equity-linked securities, that venture capitalists obtain when investing in business ventures that are striving to become larger and to go public.
vintage year
The year a particular private equity fund commences operations is known as its vintage year.
20-bagger
The terminology 20-bagger indicates a company that appreciates in value 20-fold compared to the cost of the VC investment.
angel investing
Angel investing refers to the earliest stage of venture capital, in which investors fund the first cash needs of an entrepreneurial idea.
auction process
An auction process involves bidding among several private equity firms, with the deal going to the highest bidder.
business plan
The business plan should clearly state the business strategy, identify the niche that the new company will fill, and describe the resources needed to fill that niche, including the expenses, personnel, and assets.
buy-and-build strategy
A buy-and-build strategy is an LBO value-creation strategy involving the synergistic combination of several operating companies or divisions through additional buyouts.
buy-in management buyout
A buy-in management buyout is a hybrid between an MBI and an MBO in which the new management team is a combination of new managers and incumbent managers.
buyout-to-buyout deal
A buyout-to-buyout deal takes place when a private equity firm sells one of its portfolio companies to another buyout firm.
capital calls
Capital calls are options for the manager to demand, according to the subscription agreement, that investors contribute additional capital.
club deal
In a club deal, two or more LBO firms work together to share costs, present a business plan, and contribute capital to the deal.
committed capital
Committed capital is the cash investment that has been promised by an investor but not yet delivered to the fund.
compound option
A compound option is an option on an option. In other words, a compound option allows its owner the right but not the obligation to pay additional money at some point in the future to obtain an option.
conglomerates
Conglomerates have many different divisions or subsidiaries, often operating in completely different industries.
early-stage venture capital
First or early-stage venture capital denotes the funding after seed capital but before commercial viability has been established.
efficiency buyouts
Efficiency buyouts are LBOs that improve operating efficiency.
entrepreneurship stimulators
Entrepreneurship stimulators are LBOs that create value by helping to free management to concentrate on innovations.
escrow agreement
There is often an escrow agreement, in which a portion of the manager’s incentive fees are held in a segregated account until the entire fund is liquidated.
exit plan
The exit plan describes how venture capitalists can liquidate their investment in the start-up company to realize a gain for themselves and their investors.
expansion stage venture capital
Expansion stage (i.e., Second or late-stage) venture capital fills the cash flow deficiency once commercial viability is established.
first stage venture capital
First or early-stage venture capital denotes the funding after seed capital but before commercial viability has been established.
golden parachute
A generous compensation scheme, known as a golden parachute, is often given to top managers whose careers are being negatively affected by a corporate reorganization.
J-curve
The J-curve is the classic illustration of the early losses and later likely profitability of venture capital.
leveraged buyout (LBO)
A leveraged buyout (LBO) is distinguished from a traditionalinvestment bythreeprimaryaspects:(1)anLBO buys out control of the assets, (2) an LBO uses leverage, and (3) an LBO itself is not publicly traded.
limited liability
Limited liability is the protection of investors from losses that exceed their investment.
management buy-in (MBI)
A management buy-in (MBI) is a type of LBO in which the buyout is led by an outside management team.
management buyout (MBO)
A management buyout (MBO) is a buyout that is led by the target firm’s current management.
mezzanine venture capital
Mezzanine venture capital, or pre-IPO financing, is the last funding stage before a start-up company goes public or is sold to a strategic buyer.
milestone
A milestone is a set of goals that must be met to complete a phase and usually denotes when the entrepreneur will be eligible for the next round of financing.
second or late-stage venture capital
Second or late-stage (i.e., expansion stage) venture capital
fills the cash flow deficiency once commercial viability is established.
secondary buyout
In a secondary buyout, one private equity firm typically sells a private company to another private equity firm.
seed capital stage
The seed capital stage is the first stage where VC firms invest their capital into a venture and is typically prior to having established the viability of the product.
sourcing investments
Sourcing investments is the process of locating possible investments (i.e., generating deal flow), reading business plans, preparing intense due diligence on start-up companies, and determining the attractiveness of each start-up company.
turnaround strategy
A turnaround strategy is an approach used by LBO funds that look for underperforming companies with excessive leverage or poor management.
venture capital fund
A venture capital fund is a private equity fund that pools the capital of large sophisticated investors to fund new and start-up companies.
absolute priority rule
An absolute priority rule is a specification of which claims in a liquidation process are satisfied first, second, third, and so forth in receiving distributions.
acceleration
Acceleration is a requirement that debt be repaid sooner than originally scheduled, such as when the senior lender can declare the senior debt due and payable immediately.
blanket subordination
A blanket subordination prevents any payment of principal or interest to the mezzanine investor until after the senior debt has been fully repaid.
bridge financing
Bridge financing is a form of gap financing—a method of debt financing that is used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of cash.
Chapter 11 bankruptcy
Chapter 11 bankruptcy attempts to maintain operations of a distressed corporation that may be viable as a going concern.
Chapter 7 bankruptcy
Chapter 7 bankruptcy is entered into when a company is no longer viewed as a viable business and the assets of the firm are liquidated. Essentially, the firm shuts down its operations and parcels out its assets to various claimants and creditors.
cramdown
A cramdown is when a bankruptcy court judge implements a plan of reorganization over the objections of an impaired class of security holders.
debtor-in-possession financing
When secured lenders extend additional credit to the debtor company, it is commonly known as debtor-in-possession financing (DIP financing).
fulcrum securities
Fulcrum securities are the more junior debt securities that are most likely to be converted into the equity of the reorganized company.
intercreditor agreement
An intercreditor agreement is an agreement with the company’s existing creditors that places restrictions on both the senior creditor and the mezzanine investor.
PIK toggle
A PIK toggle allows the underlying company to choose whether it will make required coupon payments in the form of cash or in kind, meaning with more mezzanine bonds.
plan of reorganization
A plan of reorganization is a business plan for emerging from bankruptcy protection as a viable concern, including operational changes.
springing subordination
A springing subordination allows the mezzanine investor to receive interest payments while the senior debt is still outstanding.
stretch financing
In stretch financing, a bank lends more money than it believes would be prudent with traditional lending standards and traditional lending terms.
takeout provision
A takeout provision allows the mezzanine investor to purchase the senior debt once it has been repaid to a specified level.
weighted average cost of capital
The weighted average cost of capital for a firm is the sum of the products of the percentages of each type of capital used to finance a firm times its annual cost to the firm.
attachment point
The first percentage loss in the collateral pool that begins to cause reduction in a tranche is known as the lower attachment point, or simply the attachment point.
bull call spread
A bull call spread has two calls that differ only by strike price, in which the long position is in the lower strike price and the short position is in the higher strike price.
bull put spread
A bull put spread has two puts that differ only by strike price, in which the long position is in the lower strike price and the short position is in the higher strike price.
call option view of capital structure
The call option view of capital structure views the equity of a levered firm as a call option on the assets of the firm.
collateralized debt obligation (CDO)
A collateralized debt obligation (CDO) applies the concept of structuring to cash flows from a portfolio of debt securities into multiple claims; these claims are securities and are referred to as tranches.
complete market
A complete market is a financial market in which enough different types of distinct securities exist to meet the needs and preferences of all participants.
contraction risk
Contraction risk is dispersion in economic outcomes caused by uncertainty in the longevity—especially decreased longevity—of cash flow streams.
detachment point
The higher percentage loss point at which the given tranche is completely wiped out is known as the upper attachment point, or the detachment point.
equity tranche
The equity tranche has lowest priority and serves as the residual claimant.
extension risk
Extension risk is dispersion in economic outcomes caused by uncertainty in the longevity—especially increased longevity—of cash flow streams.
floating-rate tranches
Floating-rate tranches earn interest rates that are linked to an interest rate index, such as the London Interbank Offered Rate (LIBOR), and are usually used to finance collateral pools of adjustable-rate mortgages.
interest-only (IO)
Interest-only (IO) tranches receive only interest payments from the collateral pool.
inverse floater tranche
An inverse floater tranche offers a coupon that increases when interest rates fall and decreases when interest rates rise.
lower attachment point
The first percentage loss in the collateral pool that begins to cause reduction in a tranche is known as the lower attachment point, or simply the attachment point.
mezzanine tranche
A mezzanine tranche is a tranche with a moderate priority to cash flows in the structured product and with lower priority than the senior tranche.
planned amortization class (PAC) tranches
Planned amortization class (PAC) tranches receive principal payments in a more complex manner than do sequential pay CMOs.
principal-only (PO)
Principal-only (PO) tranches receive only principal payments from the collateral pool.
put option view of capital structure
The put option view of capital structure views the equity holders of a levered firm as owning the firm’s assets through riskless financing and having a put option to deliver those assets to the debt holders.
senior tranche
The senior tranche is a tranche with the first or highest priority to cash flows in the structured product.
sequential-pay collateralized mortgage obligation
The sequential-pay collateralized mortgage obligation is the simplest form of CMO.
state of the world
A state of the world, or state of nature (or state), is a precisely defined and comprehensive description of an outcome of the economy that specifies the realized values of all economically important variables.
structural credit risk models
Structural credit risk models use option theory to explicitly take into account credit risk and the various underlying factors that drive the default process, such as (1) the behavior of the underlying assets, and (2) the structuring of the cash flows (i.e., debt levels).
structuring
In the context of alternative investments, structuring is the process of engineering unique financial opportunities from existing asset exposures.
targeted amortization class (TAC) tranches
Targeted amortization class (TAC) tranches receive principal payments in a manner similar to PAC tranches but generally with an even narrower and more complex set of ranges.
tranche
A tranche is a distinct claim on assets that differs substantially from other claims in such aspects as seniority, risk, and maturity.
upper attachment point
The higher percentage loss point at which the given tranche is completely wiped out is known as the upper attachment point, or the detachment point.
American credit options
American credit options are credit options that can be exercised prior to or at expiration.
assignment
A novation or an assignment is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.
binary options
Binary options (sometimes termed digital options) offer only two possible payouts, usually zero and some other fixed value.
calibrate a model
To calibrate a model means to establish values for the key parameters in a model, such as a default probability or an asset volatility, typically using an analysis of market prices of highly liquid assets.
cash settlement
In a cash settlement, the credit protection seller makes the credit protection buyer whole by transferring to the buyer an amount of cash based on the contract.
CDS indices
CDS indices are indices or portfolios of single-name CDSs.
CDS premium
The CDS spread or CDS premium is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.
CDS spread
The CDS spread or CDS premium is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.
credit default swap (CDS)
A credit default swap (CDS) is an insurance-like bilateral contract in which the buyer pays a periodic fee (analogous to an insurance premium) to the seller in exchange for a contingent payment from the seller if a credit event occurs with respect to an underlying credit-risky asset.
credit derivatives
Credit derivatives transfer credit risk from one party to another such that both parties view themselves as having an improved position as a result of the derivative.
credit protection buyer
In a CDS, the credit protection buyer pays a periodic premium on a predetermined amount (the notional amount) in exchange for a contingent payment from the credit protection seller if a specified credit event occurs.
credit protection seller
The credit protection seller receives a periodic premium in exchange for delivering a contingent payment to the credit protection buyer if a specified credit event occurs.
credit risk
Credit risk is dispersion in financial outcomes associated with the failure or potential failure of a counterparty to fulfill its financial obligations.
credit-linked notes (CLNs)
Credit-linked notes (CLNs) are bonds issued by one entity with an embedded credit option on one or more other entities.
default risk
Default risk is the risk that the issuer of a bond or the debtor on a loan will not repay the interest and principal payments of the outstanding debt in full.
derivatives
Derivatives are cost-effective vehicles for the transfer of risk, with values driven by an underlying asset.
European credit options
European credit options are credit options exercisable only at expiration.
exposure at default
Exposure at default (EAD) specifies the nominal value of the position that is exposed to default at the time of default.
funded credit derivatives
Funded credit derivatives require cash outlays and create exposures similar to those gained from traditional investing in corporate bonds through the cash market.
hazard rate
Hazard rate is a term often used in the context of reduced- form models to denote the default rate.
loss given default
Loss given default (LGD) specifies the economic loss in case of default.
mark-to-market adjustment
The process of altering the value of a CDS in the accounting and financial systems of the CDS parties is known as a mark- to-market adjustment.
multiname instruments
Multiname instruments, in contrast to single-name instruments, make payoffs that are contingent on one or more credit events (e.g., defaults) affecting two or more reference entities.
novation
A novation or an assignment is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.
physical settlement
Under physical settlement, the credit protection seller purchases the impaired loan or bond from the credit protection buyer at par value.
price revelation
Price revelation, or price discovery, is the process of providing observable prices being used or offered by informed buyers and sellers.
probability of default
Probability of default (PD) specifies the probability that the counterparty fails to meet its obligations.
recovery rate
The recovery rate is the percentage of the credit exposure that the lender ultimately receives through the bankruptcy process and all available remedies.
reduced-form credit models
Reduced-form credit models focus on default probabilities based on observations of market data of similar-risk securities.
referenced asset
The referenced asset (also called the referenced bond, referenced obligation, or referenced credit) is the underlying security on which the credit protection is provided.
risk-neutral approach
A risk-neutral approach models financial characteristics, such as asset prices, within a framework that assumes that investors are risk neutral.
risk-neutral investor
A risk-neutral investor is an investor that requires the same rate of return on all investments, regardless of levels and types of risk, because the investor is indifferent with regard to how much risk is borne.
single-name credit derivatives
Single-name credit derivatives transfer the credit risk associated with a single entity. This is the most common type of credit derivative and can be used to build more complex credit derivatives.
standard ISDA agreement
The standard ISDA agreement serves as a template to negotiated credit agreements that contains commonly used provisions used by market participants.
total return swap
In a total return swap, the credit protection buyer, typically the owner of the credit risky asset, passes on the total return of the asset to the credit protection seller in return for a certain payment.
unfunded credit derivatives
Unfunded credit derivatives involve exchanges of payments that are tied to a notional amount, but the notional amount does not change hands until a default occurs.
arbitrage CDOs
Arbitrage CDOs are created to attempt to exploit perceived opportunities to earn superior profits through money management.
balance sheet CDOs
Balance sheet CDOs are created to assist a financial institution in divesting assets from its balance sheet.
bankruptcy remote
Bankruptcy remote means that if the sponsoring bank or money manager goes bankrupt, the CDO trust is not affected.
cash flow CDO
In a cash flow CDO, the proceeds of the issuance and sale of securities (tranches) are used to purchase a portfolio of underlying credit-risky assets, with attention paid to matching the maturities of the assets and liabilities.
cash-funded CDO
A cash-funded CDO involves the actual purchase of the portfolio of securities serving as the collateral for the trust and to be held in the trust.
collateralized fund obligation (CFO)
A collateralized fund obligation (CFO) applies the CDO structure concept to the ownership of hedge funds as the collateral pool.
copula approach
A copula approach to analyzing the credit risk of a CDO may be viewed like a simulation analysis of the effects of possible default rates on the cash flows to the CDO’s tranches and the values of the CDO’s tranches.
distressed debt CDO
A distressed debt CDO uses the CDO structure to securitize and structure the risks and returns of a portfolio of distressed debt securities, in which the primary collateral component is distressed debt.
diversity score
A diversity score is a numerical estimation of the extent to which a portfolio is diversified.
external credit enhancement
An external credit enhancement is a protection to tranche investors that is provided by an outside third party, such as a form of insurance against defaults in the loan portfolio.
financial engineering risk
Financial engineering risk is potential loss attributable to securitization, structuring of cash flows, option exposures, and other applications of innovative financing devices.
internal credit enhancement
An internal credit enhancement is a mechanism that protects tranche investors and is made or exists within the CDO structure, such as a large cash position.
market value CDO
In a market value CDO, the underlying portfolio is actively traded without a focus on cash flow matching of assets and liabilities.
overcollateralization
Overcollateralization refers to the excess of assets over a given liability or group of liabilities.
ramp-up period
The ramp-up period, is the first period in a CDO life cycle, during which the CDO trust issues securities (tranches) and uses the proceeds from the CDO note sale to acquire the initial collateral pool (the assets).
reference portfolio
The underlying portfolio or pool of assets (and/or derivatives) held in the SPV within the CDO structure is also known as the collateral or reference portfolio.
reserve account
A reserve account holds excess cash in highly rated instruments,suchasU.S.Treasurysecurities orhigh-grade commercial paper, to provide security to the debt holders of the CDO trust.
revolving period
The second phase in the CDO life cycle is normally called the revolving period, during which the manager of the CDO trust may actively manage the collateral pool for the CDO, potentially buying and selling securities and reinvesting the excess cash flows received from the CDO collateral pool.
risk shifting
Risk shifting is the process of altering the risk of an asset or a portfolio in a manner that differentially affects the risks and values of related securities and the investors who own those securities.
single-tranche CDO
In a single-tranche CDO, the CDO may have multiple tranches, but the sponsor issues (sells) only one tranche from the capital structure to an outside investor.
special purpose vehicle (SPV)
A special purpose vehicle (SPV) is a legal entity at the heart of a CDO structure that is established to accomplish a specific transaction, such as holding the collateral portfolio.
sponsor of the trust
The sponsor of the trust establishes the trust and bears the associated administrative and legal costs.
subordination
Subordination is the most common form of credit enhancement in a CDO transaction, and it flows from the structure of the CDO trust.
synthetic CDO
In a synthetic CDO, the CDO obtains risk exposure for the collateral pool through the use of a credit derivative, such as a total return swap or a CDS.
tranche width
The tranche width is the percentage of the CDO’s capital structure that is attributable to a particular tranche.
weighted average rating factor (WARF)
The weighted average rating factor (WARF), as described by Moody’s Investors Service, is a numerical scale ranging from 1 (for AAA-rated credit risks) to 10,000 (for the worst credit risks) that reflects the estimated probability of default.
weighted average spread (WAS)
The weighted average spread (WAS) of a portfolio is a weighted average of the return spreads of the portfolio’s securities in which the weights are based on market values.
absolute return structured product
An absolute return structured product offers payouts over some or all underlying asset returns that are equal to the absolute value of the underlying asset’s returns.
active option
An active option in a barrier option is an option for which the underlying asset has reached the barrier.
analytical
The solution is analytical because the model can be exactly solved using a finite set of common mathematical operations.
Asian option
An Asian option is an option with a payoff that depends on the average price of an underlying asset through time.
barrier option
A barrier option is an option in which a change in the payoff is triggered if the underlying asset reaches a prespecified level during a prespecified time period.
boundary condition
A boundary condition of a derivative is a known relationship regarding the value of that derivative at some future point in time that can be used to generate a solution to the derivative’s current price.
building blocks approach
The building blocks approach (i.e., portfolio approach) models a structured product or other derivative by replicating the investment as the sum of two or more simplified assets, such as underlying cash-market securities and simple options.
cash-and-call strategy
A cash-and-call strategy is a long position in cash, or a zero- coupon bond, combined with a long position in a call option.
dynamic hedging
Dynamic hedging is when the portfolio weights must be altered through time to maintain a desired risk exposure, such as zero risk.
equity-linked structured products
Equity-linked structured products are distinguished from structured products by one or more of the following three aspects: (1) They are tailored to meet the preferences of the investors and to generate fee revenue for the issuer; (2) they are not usually collateralized with risky assets; and (3) they rarely serve as a pass-through or simple tranching of the risks of a long-only exposure to an asset, such as a risky bond or a loan portfolio.
exotic option
Although there is no universally accepted definition of an exotic option, a useful definition is that an exotic option is an option that has one or more features that prevent it from being classified as a simple option, including payoffs based on values prior to the expiration date, and/or payoffs that are nonlinear or discontinuous functions of the underlying asset.
knock-in option
A knock-in option is an option that becomes active if and only if the underlying asset reaches a prespecified barrier.
knock-out option
A knock-out option is an option that becomes inactive (i.e., terminates) if and only if the underlying asset reaches a prespecified barrier.
numerical methods
Numerical methods for derivative pricing are potentially complex sets of procedures to approximate derivative values when analytical solutions are unavailable.
overconfidence bias
An overconfidence bias is a tendency to overestimate the true accuracy of one’s beliefs and predictions.
partial differential equation approach (PDE approach)
The partial differential equation approach (PDE approach)
finds the value to a financial derivative based on the assumption that the underlying asset follows a specified stochastic process and that a hedged portfolio can be constructed using a combination of the derivative and its underlying asset(s).
participation rate
The participation rate indicates the ratio of the product’s payout to the value of the underlying asset.
path-dependent option
A path-dependent option is any option with a payoff that depends on the value of the underlying asset at points prior to the option’s expiration date.
payoff diagram level
The payoff diagram level determines the amount of money or the percentage return that an investor can anticipate in exchange for paying the price of the product.
payoff diagram shape
The payoff diagram shape indicates the risk exposure of a product relative to an underlier.
power reverse dual-currency note
At its core, in a power reverse dual-currency note (PRDC), an investor pays a fixed interest rate in one currency in exchange for receiving a payment based on a fixed interest rate in another currency.
principal protected absolute return barrier note
A principal protected absolute return barrier note offers to pay absolute returns to the investor if the underlying asset stays within both an upper barrier and a lower barrier over the life of the product.
principal-protected structured product
A principal-protected structured product is an investment that is engineered to provide a minimum payout guaranteed by the product’s issuer (counterparty).
quanto option
A quanto option is an option with a payoff based in one currency using the numerical value of the underlying asset expressed in a different currency.
simple option
A simple option has (1) payoffs based only on the value of a single underlying asset observed at the expiration date, and (2) linear payoffs to the long position of the calls and puts based on the distance between the option’s strike price and the value of the underlying asset.
spread option
A spread option has a payoff that depends on the difference between two prices or two rates.
static hedge
A static hedge is when the positions in the portfolio do not need to be adjusted through time in response to stochastic price changes to maintain a hedge.
tax deduction
Tax deduction of an item is the ability of a taxpayer to reduce taxable income by the value of the item.
tax deferral
Tax deferral refers to the delay between when income or gains on an investment occur and when they are taxed.
wrapper
A wrapper is the legal vehicle or construct within which an investment product is offered.
affinity fraud
Affinity fraud is the commission of fraud against people or entities with which the perpetrator of the fraud shares a common bond, such as race, ethnicity, or religious affiliation.
anchoring
Anchoring may be viewed in this context as a tendency to rely too heavily on previous beliefs.
behavioral biases
Behavioral biases are tendencies or patterns exhibited by humans that conflict with prescriptions based on rationality and empiricism.
behavioral finance
Behavioral finance studies the potential impacts of cognitive, emotional, and social factors on financing decision-making.
circuit breaker
A circuit breaker is a decision rule and procedure wherein exchange authorities invoke trading restrictions (even exchange closures) in an attempt to mute market fluctuations and to give market participants time to digest information and formulate their trading responses.
confirmation bias
Confirmation bias is the tendency to disproportionately interpret results that confirm a previously held opinion as being true.
crowded trade
When large investors hold substantial positions in the same asset or similar assets, it is known as a crowded trade.
fraud
Fraud is intentional deception typically for the purpose of financial gain.
painting the tape
Placing transactions to record high or low prices on the transaction records of public markets is a fraudulent activity often termed painting the tape, in reference to the historical use of ticker tape to broadcast prices.
Ponzi scheme
A Ponzi scheme is a fraudulent program that returns deposits to investors and identifies the returned capital as a distribution of profit in order to overstate the profitability of the enterprise and to attract additional and larger deposits.
restitution
Restitution is the restoration of lost funds.
return on assets (ROA)
Return on assets (ROA) is profit before financing costs (and taxes), expressed as a percentage of assets. ROE can be expressed as a function of ROA, leverage (L, which is defined here as the ratio of assets to equity), and interest costs on the financing (r): ROE = (ROA × L) − [r × (L − 1)]
return on equity (ROE)
Return on equity (ROE) is profit after financing costs, expressed as a percentage of equity.
spoofing
Spoofing is the placing of large orders to influence market prices with no intention of honoring the orders if executed.
unwind hypothesis
The unwind hypothesis suggests that hedge fund losses began with the forced liquidation of one or more large equity market-neutral portfolios, primarily to raise cash or reduce leverage.
window dressing
Window dressing is a term used in the investment industry to denote a variety of legal and illegal strategies to improve the outward appearance of an investment vehicle.
actual investment strategy
The actual investment strategy of a fund at a particular point in time is the investment strategy being implemented by the fund.
business activities
Business activities include the indirect support of the investment activities of the fund, including all of the normal activities of running any similarly sized organization, such as human resources management, technology, infrastructure, and facility maintenance.
business risk
Business risk is the added economic dispersion caused by unexpected performance of the business team and business activities.
custody
Custody refers to the safekeeping of the cash and securities of a fund.
fund culture
A fund culture is a generally shared set of priorities and values within the fund’s organization.
gaming
Gaming refers to strategic behavior to gain benefits from circumventing the intention of the rules of a particular system.
investment activities
Investment activities span the investment process, involving all aspects of determining and implementing investment decisions.
investment management governance process
The investment process in discretionary cases centers on the investment management governance process, which is the explicit or implicit set of procedures through which investment decisions are made.
investment mandate
An investment mandate is an explicit or implicit statement of the allowable and intended strategy, goals, and/or risks of an investment program.
investment process
The investment process includes the methods a manager uses to formulate, execute, and monitor investment decisions, and spans the range of investment activities, from the design of the investment strategy, through the implementation of the ideas into decisions, and ultimately to the placing and execution of trading orders.
investment process risk
Investment process risk is economic dispersion caused by imperfect application of the stated investment strategy by the investment team.
investment strategy
A fund’s investment strategy refers to the sets of objectives, principles, techniques, and procedures used to construct and modify the fund’s portfolio.
market risk in the investment process
In discussions of investment process, the market risk in the investment process describes any systematic or idiosyncratic dispersion in economic outcomes attributable to changes in market prices and rates.
operational activities
Operational activities include the direct support of investment activities, often described as middle office and back office operations.
operational errors
Operational errors are inadvertent mistakes made in the process of executing a fund’s investment strategy.
operational fraud
Operational fraud from the perspective of an investor is any intentional, self-serving, deceptive behavior in the operational activities of a fund that is generally harmful to the investor.
operational risk
A broad interpretation of operational risk is that it is any economic dispersion caused by investment, operational, or business activities.
permitted investment strategies
The permitted investment strategies of a fund delineate the range of investment strategies that the fund’s managers have communicated and are mandated as allowable for the fund to implement.
position limit
A position limit is a specific restriction on the size of the holdings of a particular security or combination of securities.
risk limits
Risk limits are the maximum levels of measured risk that are allowed in a portfolio, in terms of both individual risks and aggregated risks.
rogue trader
A rogue trader intentionally establishes substantial positions well outside the investment mandate.
slack variable
A slack variable is the variable in an optimization problem that takes on whatever value is necessary to allow an optimum to be feasible but, while doing so, does not directly alter the value of the objective function.
stated investment strategy
The stated investment strategy of a fund is the investment strategy that a diligent investor would expect the fund to pursue, based on a reasonable analysis of information made available by the fund.
style drift
Style drift (or strategy drift) is the change through time of a fund’s investment strategy based on purposeful decisions by the fund manager in an attempt to improve risk-adjusted performance in light of changing market conditions
synergistic risk effect
A synergistic risk effect is the potential for the combination of two or more risks to have a greater total risk than the sum of the individual risks.
annual volatility
Thus, annual volatility is only about 16 times larger than daily volatility based on 256 trading days per year and zero autocorrelation.
bias blind spot
The bias blind spot is people’s tendency to underestimate the extent to which they possess biases.
chief risk officer
The chief risk officer (CRO) oversees the fund manager’s program for identifying, measuring, monitoring, and managing risk.
daily volatility
Annual volatility is only about 16 times larger than daily volatility based on 256 trading days per year and zero autocorrelation.
due diligence
Due diligence is the process of performing a review of an investment with an appropriate level of competence, care, and thoroughness.
expectation bias
Expectation bias is synonymous with confirmation bias and is a tendency to overweight those findings that most agree with one’s prior beliefs.
feeder fund
A feeder fund is a legal structure through which investors have access to the investment performance of the master trust.
financial firewall
A limited liability shield or financial firewall is a legal construct that prevents creditors from pursuing restitution from investors or other participants involved in an economic activity beyond the amount of capital that they have contributed.
fund style index
A fund style index is a collection of fund managers operating with a similar strategy to the fund manager in question that can be used as a benchmark.
hard lockup period
In a hard lockup period, withdrawals are contractually not allowed for the entire duration of the lockup period.
herd behavior
Herd behavior is the extent to which people are overly eager to adopt beliefs that conform to those of their peers.
information filtering
Information filtering is the fund manager’s ability to use data available to others but to be better able to glean tradable insights from it.
information gathering
Information gathering indicates the ability of the manager to create access to information or to have access to better information than do other managers.
investment objective
The investment objective of a fund specifies the goals, nature, and strategies of the fund’s investment program.
key personnel clause
A key personnel clause is a provision that allows investors to withdraw their assets from the fund, immediately and without penalty, when the identified key personnel are no longer making investment decisions for the fund.
league table
Common in many industries, a league table is a listing of organizations, generated by a research or media firm, that ranks organizations by size, volume, or other indicators of activity.
level 1 assets
Level 1 assets are those assets that can be valued based on an unadjusted market price quote from an actively traded market of identical assets.
level 2 assets
Level 2 assets are best valued based on nonactive market price quotes, active market price quotes for similar assets, or non-quoted values based on observable inputs that can be corroborated.
level 3 assets
Level 3 assets must be valued substantially on the basis of unobservable inputs, critical assumptions, and/or imprecise valuation techniques.
limited liability shield
A limited liability shield or financial firewall is a legal construct that prevents creditors from pursuing restitution from investors or other participants involved in an economic activity beyond the amount of capital that they have contributed.
lockup period
A lockup period is a provision preventing, or providing financial disincentives for, redemption or withdrawal of an investor’s funds for a designated period, typically one to three years for hedge funds, and up to ten years or more for real estate and private equity funds.
master trust
The master trust is the legal structure used to invest the assets of both onshore investors and offshore investors in a consistent if not identical manner, so that both funds share the benefit of the fund manager’s insights.
master-feeder structure
Together, the master trust and feeder funds are referred to as a master-feeder structure.
N-sigma event
An N-sigma event is an event that is N standard deviations from the mean.
omega-score
The omega-score is a measure of future risk that is computed as a function of a fund’s age, size, past performance, volatility, and fee structure.
shorting volatility
Shorting volatility is a strategy whereby a fund manager sells call or put options, especially out-of-the-money options, without an offsetting position.
side pocket arrangement
In a side pocket arrangement, illiquid investments held by a hedge fund are segregated from the rest of the portfolio.
soft lockup period
In a soft lockup period, investors may be allowed to withdraw capital from the fund before the expiration of the lockup period but only after the payment of a redemption fee, which is frequently 1% to 5% of the withdrawal amount.
trade allocation
Trade allocation, in this context, refers to the process by which—and priorities with which—an attractive investment opportunity is distributed among the manager’s various funds and accounts.
actively managed portfolio
An actively managed portfolio involves trading with the intent of generating improved performance.
distinguishing alpha and beta
Distinguishing alpha and beta involves measurement and attribution and the process of identifying how much of an asset’s return is generated by alpha and how much is generated by beta.
enhanced index products
Enhanced index products are designed to take slightly more risk than the index within tightly controlled parameters and offer a little extra return, usually on a large pool of capital.
index products
Index products take little or no active risk, extract no added value, and are not expected to generate active return.
new investment model
In the new investment model, investments are allocated with flexibility and in the explicit context of alpha and beta management.
passively managed portfolio
A passively managed portfolio, such as an indexed buy-and- hold portfolio, seeks to match the return of an index or a benchmark without engaging in active trading that attempts to generate improved performance.
portable alpha
Portable alpha is the ability of a particular investment product or strategy to be used in the separation of alpha and beta.
separating alpha and beta
Separating alpha and beta involves portfolio management and refers to attempts to independently manage a portfolio’s alpha and its exposure to beta, each toward desired levels.
smart beta
Smart beta is the strategy of implementing a rules-based portfolio weighting scheme based on one or more characteristics in the underlying assets that generates portfolio weights that differ from a market-capitalization weighting scheme.
strategic asset allocation decision
The strategic asset allocation decision is the long-term target asset allocation based on investor objectives and long-term expectations of returns and risk.
tactical asset allocation
Tactical asset allocation is the process of making portfolio decisions to alter the systematic risks of the portfolio through time in an attempt to earn superior risk adjusted returns.
traditional approach to portfolio allocation
In the traditional approach to portfolio allocation, the top- level decision is a long-term target allocation decision, known as the strategic asset allocation decision.
zero-sum game
A zero-sum game is a market, environment, or situation in which any gains to one party must be equally offset by losses to one or more other parties.
