CFA Derivatives & Alternative Investments

Contemporary Hedge Fund Characteristics

1. It is an aggressively managed portfolio of investments across asset classes and regions that is leveraged, takes long and short positions, and/or uses derivatives. 2. It has a goal of generating high returns, either in an absolute sense or over a specified market benchmark, and it has few, if any, investment restrictions. 3. It is set up as a private investment partnership open to a limited number of investors willing and able to make a large initial investment. 4. It imposes restrictions on redemptions. Investors may be required to keep their money in the hedge fund for a minimum period (referred to as a lockup period) before they are allowed to make withdrawals or redeem shares. Investors may be required to give notice of their intent to redeem; the notice period is typically 30 to 90 days in length. Also, investors may be charged a fee to redeem shares.

Foward & Future Same Price When

1. The interest rate is constant 2. When futures prices and interest rates are uncorrelated

The Lower Limits for Put & Call Options

1. The lowest value of a European call is the greater of zero or the value of the underlying minus the present value of the exercise price. 2. The lowest value of a European put is the greater of zero or the present value of the exercise price minus the value of the underlying.

Effect of Rƒ on Option

1. The value of a European call is directly related to the risk-free interest rate. 2. The value of a European put is inversely related to the risk-free interest rate.

Effect of the Value of the Underlying

1. The value of a European call option is directly related to the value of the underlying. 2. The value of a European put option is inversely related to the value of the underlying.

Futures: Limit Down

A limit move in the futures market in which the price at which a transaction would be made is at or below the lower limit.

Real Estate: Key Reasons for Investing

1. Potential for competitive long-term total returns driven by both income generation and capital appreciation. 2. Prospect that multiple-year leases with fixed rents for some property types may lessen cash flow effects from economic shocks. 3. Likelihood that less-than-perfect correlation with other asset classes may provide diversification benefits. 4. Potential to provide an inflation hedge if rents can be adjusted quickly for inflation.

PE Investments & Due Diligence

Look at the refinancing risk. Should also be a liquidity premium.

Private Equity Strategies: Leveraged Buyout

Management buyouts (MB): mgmt part of the LBO Management buy-in (MBI): current mgmt team is being replaced and the acquiring team will be involved in managing the company.

American Style

May be exercised early

Put Call Forward Parity

A fiduciary call is equivalent to a protective put with a foward contract

Hedge Fund Failure Rate

1/4 of all hedge funds fail w/in first 3 years.

Some Characteristics of Alternative Investments

1. Illiquidity of underlying investments 2. Narrow manager specialization 3. Low correlation of returns switch those of traditional investments 4. Less regulation and less transparency than traditional investments 5. Limited and potentially problematic historical risk and return data 6. Unique legal and tax considerations

Categorization of Active Management Strategies

1. Absolute return. Absolute return strategies seek to generate returns that are independent of market returns; theoretically, betas of funds using absolute return strategies should be close to zero.11 As a result, with an absolute return strategy, there is typically no market index specified to beat. Instead, the formal performance objective tends to be stated relative to either a cash rate such as Libor, a return exceeding the inflation rate (a real return target), or an absolute, nominal return target such as 10%. 2. Market segmentation. Market segmentation exists when capital cannot migrate effortlessly from lower expected return areas to higher ones. Segmentation typically results from institutional, contractual, or regulatory restrictions on traditional asset managers or from differences across investors in investment objectives or liabilities. Segmentation brought on by investment constraints includes portfolios managed relative to published market indexes, limitations on the use of derivatives, and restrictions on the proportion of low-quality or non-domestic securities. Portfolios may also be subject to environmental, social, and governance constraints and mandates. Restrictions on some portfolios may provide an opportunity for managers with more flexibility to move into higher-returning segments more quickly than managers with more-restricted or more-conservative portfolios. 3. Concentrated portfolios. This strategy entails concentrating assets among fewer securities, strategies, and/or managers, which results in less diversification but may enable an investor to achieve higher returns if these concentrated positions outperform the market.

Real Estate Valuation

1. Comparable sales approach. This approach involves determining an approximate value based on recent sales of similar properties. Adjustments are made for differences in key characteristics of the property being appraised and the sold properties identified as similar. Key characteristics include condition, age, location, and size. Adjustments are also made for price changes in the relevant real estate market between dates of sales. 2. Income approach. Direct capitalization and discounted cash flow approaches are two income-based approaches to appraising an income-producing property. — The direct capitalization approach estimates the value of an income-producing property based on the level and quality of its net operating income (NOI). Similar to EBITDA, NOI represents the income to the property after deducting operating expenses, including property taxes, insurance, maintenance, utilities, and repairs but before depreciation, financing costs, and income taxes. NOI is a proxy for property-level operating cash flow. The expected annual NOI is divided by a capitalization rate (cap rate) to estimate the property's value. A cap rate is a discount rate less a growth rate. The reciprocal of the cap rate is a multiple that can be applied to NOI. The cap rate is estimated for a given property based on relevant information, including cap rates on sales of comparable properties, general business conditions, property quality, and assessment of management. The analysis might include assessing the strength of tenants, the level of landlord involvement, the extent and adequacy of repairs and improvements, the vacancy rate, management and operating costs, and expected inflation of costs and rent. — The discounted cash flow approach discounts future projected cash flows to arrive at a present value for the property. Typically, the analysis involves projections of annual operating cash flows for a finite number of periods and a resale or reversion value at the end of that total period. The projected resale value is often estimated using a direct capitalization approach. 3. Cost approach. This approach evaluates the property's replacement cost by estimating the market value of the land and the costs of rebuilding using current construction costs and standards. Costs include building materials, labor to build, tenant improvements, and various "soft" costs, including architectural, engineering, and construction supervision costs; legal, insurance, and brokerage fees; and environmental assessment costs. The cost of rebuilding is the replacement cost of the building(s) in new condition and is adjusted to take into account the location and condition of the existing building(s).

Infrastructure: Categories

1. Economic and social infrastructure assets: include transportation, utility, educational, and health care. 2. By underlying assets state of development: — brownfield: existing infrastructure investment — greenfield: new projects 3. May be categorized by geography

Other Commodity Investment Vehicles

1. Exchange-traded funds may be suitable for investors who can buy only equity shares or seek the simplicity of trading them. ETFs may invest in commodities or futures of commodities (often, specializing in a particular sector) seeking to track the performance of the commodities. For example, the SPDR Gold Shares ETF attempts to track the price of gold. It owned more than $50 billion in gold bullion as of November 2010 and more than $38 billion in gold bullion as of October 2016. There are also commodity index-linked ETFs. ETFs may use leverage. Similar to mutual funds or unit trusts, ETFs charge fees that are included in their expense ratios, although the ETF expense ratios are generally lower than those of most mutual funds. 2. Common stock of companies exposed to a particular commodity—such as Royal Dutch Shell, which is exposed to oil—may be purchased. Investors may consider owning shares in a few commodity-exposed companies in order to have a small exposure to commodities. It is unclear, however, whether the performance of these stocks closely tracks the performance of the underlying commodity(ies). 3. Managed futures funds are actively managed investment funds. Professional money managers invest in the futures market (and forward market sometimes) on behalf of the funds. These funds historically focused on commodity futures, but today they may invest in other futures contracts as well. Managed futures funds may concentrate on specific commodity sectors or may be broadly diversified. They are similar to hedge funds in that each fund has a GP, and fees typically follow a 2-and-20 structure. The funds may operate similarly to mutual funds with shares that are available to the general public, or they may operate like hedge funds and restrict sales to high-net-worth and institutional investors. The former may appeal to retail investors because of the professional management, low minimum investment, and relatively high liquidity. 4. Individual managed accounts are managed by chosen professional money managers with expertise in commodities and futures on behalf of high-net-worth individuals or institutional investors. 5. Funds exist that specialize in specific commodity sectors. For example, private energy partnerships, similar to private equity funds, are a popular way for institutions to gain exposure to the energy sector. Management fees can range from 1% to 3% of committed capital with a lockup period of 10 years and extensions of 1- and 2-year periods. Publicly available energy mutual funds and unit trusts typically focus on the oil and gas sector. They may focus on upstream (drilling), midstream (refineries), or downstream (chemicals). Management fees for these funds are in line with those of other public equity managers and range from 0.4% to 1%.

Hedge Fund Strategies: Relative Value

1. Fixed-income convertible arbitrage. These market-neutral (a zero-beta portfolio, at least in theory) investment strategies seek to exploit a perceived mispricing between a convertible bond and its component parts (the underlying bond and the embedded stock option). The strategy typically involves buying convertible debt securities and simultaneously selling the same issuer's common stock. 2. Fixed-income asset backed. These strategies focus on the relative value between a variety of asset-backed securities (ABS) and mortgage-backed securities (MBS) and seek to take advantage of mispricing across different ABS. 3. Fixed-income general. These strategies focus on the relative value within the fixed-income markets. Strategies may incorporate trades between two corporate issuers, between corporate and government issuers, between different parts of the same issuer's capital structure, or between different parts of an issuer's yield curve. Currency dynamics and government yield curve considerations may also come into play when managing these fixed-income instruments. 4. Volatility. These strategies typically use options to go long or short market volatility either in a specific asset class or across asset classes. Option prices reflect implied volatility, and an increase in market volatility leads to an increase in option prices. 5. Multi-strategy. These strategies trade relative value within and across asset classes or instruments. Rather than focusing on one type of trade (e.g., convertible arbitrage), a single basis for trade (e.g., volatility), or a particular asset class (e.g., fixed income), this strategy instead looks for investment opportunities wherever they might exist.

Commodity Derivatives & Indexes

1. Futures and forward contracts are obligations to buy or sell a specific amount of a given commodity at a fixed price, location, and date in the future. Futures contracts are ETPs, marked to market daily, and generally are not settled with delivery or receipt of the physical commodity. Forward contracts trade OTC, and the expectation is that delivery and receipt of the physical commodity will occur. Counterparty risk is higher for forward contracts. 2. Option contracts for commodities give their holders the right, but not the obligation, to buy or sell a specific amount of a given commodity at a specified price and delivery location on or before a specified date in the future. Options can be ETPs or OTC traded. 3. Swap contracts are agreements to exchange streams of cash flows between two parties based on future commodity or commodity index prices. One party typically makes fixed payments in exchange for payments that depend on a specified commodity or commodity index price.

Categories of Alternative Investments

1. Hedge funds. Hedge funds are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. They may use long and short positions, may be highly leveraged, and aim to deliver investment performance that is independent of broad market performance. 2. Private equity funds. Private equity funds generally invest in companies (either start-up or established) that are not listed on a public exchange, or they invest in public companies with the intent to take them private. The majority of private equity activity involves leveraged buyouts of established profitable and cash-generative companies with solid customer bases, proven products, and high-quality management. Venture capital, which typically involves investing in or providing financing to start-up or young companies with high growth potential, is a small portion of the private equity market. 3. Real estate. Real estate investments may be in buildings and/or land, including timberland and farmland, either directly or indirectly. The growing popularity of securitizations broadened the definition of real estate investing. It now includes private commercial real estate equity (e.g., ownership of an office building), private commercial real estate debt (e.g., directly issued loans or mortgages on commercial property), public real estate equity (e.g., REITs), and public real estate debt (e.g., mortgage-backed securities) investments. 4. Commodities. Commodities investments may be in physical commodity products such as grains, metals, and crude oil, either through owning cash instruments, using derivative products, or investing in businesses engaged in the production of physical commodities. The main vehicles investors use to gain exposure to commodities are commodity futures contracts and funds benchmarked to commodity indexes. Commodity indexes are typically based on various underlying commodity futures. 5. Infrastructure. Infrastructure assets are capital-intensive, long-lived, real assets, such as roads, dams, and schools, which are intended for public use and provide essential services. Infrastructure assets may be financed, owned, and operated by governments, but increasingly the private sector is investing in infrastructure assets. Investors may gain exposure to these assets directly or indirectly. Indirect investment vehicles include shares of companies, ETFs, private equity funds, listed funds, and unlisted funds that invest in infrastructure. 6. Other. Other alternative investments may include tangible assets (such as fine wine, art, antique furniture and automobiles, stamps, coins, and other collectibles) and intangible assets (such as patents).

Private Equity

1. Leveraged buyouts (LBOs) or highly leveraged transactions refer to private equity firms establishing buyout funds (or LBO funds) that acquire public companies or established private companies with a significant percentage of the purchase price financed through debt. The target company's assets typically serve as collateral for the debt, and the target company's cash flows are expected to be sufficient to service the debt. The debt becomes part of the target company's capital structure if the buyout goes through. After the buyout, the target company becomes or remains a privately owned company. 2. Venture capital entails investing in or providing financing to private companies with high growth potential. Typically, these are start-up or young companies, but venture capital can be provided at a variety of stages. In contrast, development capital generally refers to minority equity investments in more-mature companies that are looking for capital to expand or restructure operations, enter new markets, or finance major acquisitions. 3. Distressed investing typically entails buying the debt of mature companies in financial difficulties. These companies may be in bankruptcy proceedings, have defaulted on debt, or seem likely to default on debt. Some investors attempt to identify companies with a temporary cash flow problem but a good business plan that will help the company survive and, in the end, flourish. These investors buy the company's debt in expectation of both the company and its debt increasing in value. Turnaround investors buy debt and plan to be more active in the management and direction of the company. They seek distressed companies to restructure and revive.

Effect of Lower Strike on Puts

1. Lower strike, harder to be in the money 2. Lower strike, less return when the value of underlying falls below it 3. Excercise forms lower bound for European put. Best you can hope for is zero value for the underlying, which would give 100% of the put. Thus, max value of put is the present value of X

Hedge Fund Strategies: Equity Hedge Strategies

1. Market neutral. These strategies use quantitative (technical) and/or fundamental analysis to identify under- and over-valued equity securities. The hedge fund takes long positions in securities it has identified as undervalued and short positions in securities it has identified as overvalued. The hedge fund tries to maintain a net position that is neutral with respect to market risk. Ideally, the portfolio should have a beta of approximately zero. The intent is to profit from individual securities movements while hedging against market risk. 2. Fundamental growth. These strategies use fundamental analysis to identify companies expected to exhibit high growth and capital appreciation. The hedge fund takes long positions in identified companies. Fundamental value. These strategies use fundamental analysis to identify companies that are undervalued. The hedge fund takes long positions in identified companies. 3. Quantitative directional. These strategies use technical analysis to identify companies that are under- and overvalued and to ascertain relationships between securities. The hedge fund takes long positions in securities identified as undervalued and short positions in securities identified as overvalued. The hedge fund typically varies levels of net long or short exposure depending on the anticipated market direction and stage in the market cycle. Similar long-short approaches exist that are based on fundamental analysis. 4. Short bias. These strategies use quantitative (technical) and/or fundamental analysis to identify overvalued equity securities. The hedge fund takes short positions in securities identified as overvalued. The fund typically varies its net short exposure based on market expectations, going fully short in declining markets. 5. Sector specific. These strategies exploit expertise in a particular sector and use quantitative (technical) and fundamental analysis to identify opportunities in the sector.

Hedge Fund Strategies: Event Driven

1. Merger arbitrage. Generally, these strategies involve going long (buying) the stock of the company being acquired and going short (selling) the stock of the acquiring company when the merger or acquisition is announced. The manager may expect to profit from the deal spread, which reflects the uncertainty of the deal closing, or may expect the acquirer to ultimately overpay for the acquisition and perhaps suffer from an increased debt load. The primary risk in this strategy is that the announced merger or acquisition does not occur, and the hedge fund has not closed its positions on a timely basis. 2. Distressed/restructuring. These strategies focus on the securities of companies either in bankruptcy or perceived to be near to bankruptcy. Hedge funds attempt to profit from distressed securities in a variety of ways. The hedge fund may simply purchase fixed-income securities trading at a significant discount to par. This transaction takes place in anticipation of the company restructuring and the fund earning a profit from the subsequent sale of the securities. The hedge fund may also use a more complicated approach, for example, buying senior debt and shorting junior debt or buying preferred stock and shorting common stock. These transactions take place in expectation of a profit as the spread between the securities widens. The fund may also short sell the company's stock, but this transaction involves considerable risk given the potential for loss if the company's prospects improve. 3. Activist. The term "activist" is short for "activist shareholder." These strategies focus on the purchase of sufficient equity in order to influence a company's policies or direction. For example, the activist hedge fund may advocate for divestitures, restructuring, capital distributions to shareholders, and/or changes in management and company strategy. These hedge funds are distinct from private equity because they operate in the public equity market. 4. Special situations. These strategies focus on opportunities in the equity of companies that are currently engaged in restructuring activities other than mergers, acquisitions, or bankruptcy. These activities include security issuance or repurchase, special capital distributions, and asset sales/spin-offs.

Effect of Lower Strike on Calls

1. More values of in the money expirations 2. The option is more valuable the lower the excercise price 3. Underlying creates upper boundary for value of option

Three Sources of Return for Commodity Futures Contracts

1. Roll yield: The term "roll yield" refers to the difference between a commodity's spot price and the price specified by its futures contract (or the difference between two futures contracts with different expiration dates). The formula shows that, with a convenience yield high enough to position the futures price below the spot price, the price of the futures contract generally rolls up to the spot price as the expiry date of the futures contract approaches. This price convergence earns the bearer of the futures contract a positive roll yield. This explanation is called the theory of storage. An alternative theory, called the hedging pressure hypothesis, suggests the difference between the spot and futures price is determined by user preferences and risk premiums. 2. Collateral yield: The collateral yield component of commodity index returns is the interest earned on the collateral (plus invested cash up to the value of the underlying asset) posted as a good-faith deposit for the futures contracts. In measuring this return component, index managers typically assume that futures contracts are fully collateralized and that the collateral is invested in risk-free assets. Thus, the returns on a passive investment in commodity futures are expected to equal the return on the collateral plus a risk premium (i.e., the hedging pressure hypothesis) or the convenience yield net of storage costs (i.e., the theory of storage). 3. ∆ in spot prices for the underlying commodity: primary determinant of spot (or current) prices is the relationship b/t current supply & demand

Effect of Time

1. The value of a European call option is directly related to the time to expiration. 2. The value of a European put option can be either directly or inversely related to the time to expiration. The direct effect is more common, but the inverse effect can prevail with a put the longer the time to expiration, the higher the risk-free rate, and the deeper it is in-the-money.

Characteristics of Attractive Target Companies for LBOs

1. Undervalued/depressed stock price. The private equity firm perceives the company's intrinsic value to exceed its market price. Private equity firms are therefore willing to pay a premium to the market price to secure shareholder approval. Firms try to buy assets or companies cheaply, and they may focus on companies that are out of favor in the public markets and have stock prices that reflect this perception. 2. Willing management and shareholders. Existing management is looking for a deal. Management may have identified opportunities but does not have access to the resources to make substantial investments in new processes, personnel, equipment, and so on to drive long-term growth. Current shareholders may have insufficient access to capital and welcome a private equity partner. Family business owners may want to cash out. Private equity firms can provide management and owners with the time and capital to expand a company or turn it around. 3. Inefficient companies. Private equity firms seek to generate attractive returns on equity by creating value in the companies they buy. They achieve this goal by identifying companies that are inefficiently managed and that have the potential to perform well if managed better. 4. Strong and sustainable cash flow. Companies that generate strong cash flow are attractive because in an LBO transaction, the target company will be taking on a significant portion of debt. Cash flow is necessary to make interest payments on the increased debt load. 5. Low leverage. Private equity firms focus on target companies that currently have no significant debt on their balance sheets. This characteristic makes it easier to use debt to finance a large portion of the purchase price. 6. Assets. Private equity managers like companies that have a significant amount of unencumbered physical assets. These physical assets can be used as security, and secured debt is cheaper than unsecured debt.

Insight from Binomial Model

1. the volatility of the underlying, which is reflected in the difference between S₁⁺ and S₁⁻ and affects ᥴ₁⁺ and ᥴ₁⁻, is an important factor in determining the price of the option 2. probabilities of the up and down moves do not appear in the formula, q and (1-q) 3. the values π and (1-π) are similar to probabilities and are often called synthetic or pseudo probabilities. they produce a weighted average of the next two possible call values 4. the formula takes the form of an expected future value, the numerator, discounted at the risk free rate

Fiduciary Call

A combination of a European call and a risk-free bond that matures on the option expiration day and has a face value equal to the exercise price of the call.

Futures: Locked Limit

A condition in the futures markets in which a transaction cannot take place because the price would be beyond the limits.

Foward Rate Agreement (FRA)

A forward contract calling for one party to make a fixed interest payment and the other to make an interest payment at a rate to be determined at the contract expiration.

Off Market Forward

A foward contract that starts with a nonzero value

Binomial Model

A model for pricing options in which the underlying may move to one one of two new prices, up or down. u = S₁⁺/S₀, d = S₁⁻/S₀ u = up movement d = down movement

Put Call Pairity

A protective put is equal to a fiduciary call, which means, Sₒ + Þₒ = ᥴₒ + X/(1+Rƒ)т where, Þₒ = premium for put ᥴₒ = premium for call

Swap to Forward Equivalence

A swap is equivalent to a series of forward contracts, each created at the swap price

Asset-Backed Securities

ABSs typically divide the payments into slices, called tranches, in which the priority of claims has been changed from equivalent to preferential. For example, in a bond mutual fund or an ETF, all investors in the fund have equal claims, and so the rate of return earned by each investor is exactly the same. If a portfolio of the same bonds were assembled into an ABS, some investors in the ABS would have claims that would supersede those of other investors. The differential nature of these claims becomes relevant when either prepayments or defaults occur.

Collateralized Bond Obligations (CBO) or Collateralized Loan Obligations (CLO) and collectively known as Collateralized Debt Obligations (CDO)

All are a structured asset-backed security that is collateralized by a pool of bonds.

Law of One Price

Assets that produce identical results can thus have only one true market price. This rule is called the "law of one price."

Alternative Investments Risk Issues

Alt investments may be susceptible to bubbles, economic cycles, and business cycles. Additionally, historical correlations, standard deviations, and returns may change. Investors typically require managers to follow Diversification concentration guidelines.

Hedge Fund Regulation

Although hedge funds are not subject to extensive regulation globally, there have been calls for more oversight. In the United States, hedge funds larger than $100 million are registered with the SEC (Securities and Exchange Commission). Additional regulation has been established in recent years. Under the Alternative Investment Fund Managers Directive (AIFMD), hedge funds that operate or market themselves in the European Union must be authorized. The AIFMD was implemented in the European Union (EU) in 2013, and in the United States, regular submission of the risk disclosure form "Form PF" to the Financial Stability Oversight Council has been required since 2012. Regulation may not require hedge funds to be transparent to outsiders or proactive in communicating their strategies and reporting their returns.

Swap: Notional Principal

An imputed principal amount. The actual loan will have a real balance, but the swap will only have a notional principal that matches the loan balance.

Protective Put

An option strategy in which a long position in an asset is combined with a long position in a put.

ETF & Mutual Funds

Are not derivatives despite the fact that they derive their value from the values of underlying securities they hold.

American Option Pricing

B/c American options have all the rights of European Options plus the additional right of being exercised early, C₀ ≥ c₀ P₀ ≥ p₀ thus the minimum value of American options, C₀ = Max(0, S₀-X) P₀ = Max(0, X-S₀) remember minimum value of European call is, ᥴ₀ ≥ Max[0,S₀-(X/(1+Rƒ)ᵀ)] Means the European option is equal or greater than the American option. However, the American call price may not be less than the European, thus the new American call minimum must be, C₀ = Max[0,S₀-(X/(1+Rƒ)ᵀ)]

Binomial Option Pricing

B/c the option payoff is determined by the underlying, if the underlying is known, the payoff of the option is known. All one needs to know is if the option expires in or out of the money.

Residential Properties

Before offering a mortgage, the due diligence process should include the following: 1. ensuring that the borrower is making an appropriate equity investment in the home (in other words, paying an adequate proportion of the purchase price), 2. conducting a credit review of the borrower, 3. establishing that the borrower has sufficient cash flows to make the required payments on the mortgage and to maintain the home, 4. appraising (estimating the value of) the home, and 5. ensuring that adequate and appropriate insurance is in place on the home and, in some cases, on the borrower.

CMO Traches: A,B,C

C is the most senior tranche and A and B get paid after C

Real Estate Performance & Diversification Benefits

Categories of real estate indexes: 1. Appraisal index 2. Repeat sales (transaction-based) 3. REIT index Investors must be aware of how the index is constructed and the inherent limitations resulting from the construction method. Investors should also be aware the apparent low volatility and low correlation of real estate w/ other asset classes may be a result of limitations in the real estate index construction.

Minimum Value for American Options

C₀ ≥ Max[0,S₀-(X/(1+Rƒ)ᵀ)] P₀ ≥ Max(0,X-S₀)

Other Private Equity Strategies

Development capital: minority equity investing which earns profits from funding business growth or restructuring PIPEs (private investment in public equities) Distressed investing by a private equity firm involves the purchase of troubled company debt.

Hedge Fund Redemptions & Drawdowns

Drawdown: percentage peak to trough reduction in NAV

LBO Financing

Firm may use only 30% equity and a combination of bank loans (leveraged loans) and high-yield debt. Mezzanine financing, an alternative to high yield loans, may be used. Mezzanine financing refers to debt or preferred shares with a relationship to common equity resulting from a feature such as attached warrants or conversion options. Being subordinate to both senior and high yield debt, mezzanine financing typically pays a higher coupon rate. In addition to interest or dividends, this type of financing offers a potential return based on increases in the value of common equity.

Credit Derivative: Credit Linked Note

Fixed income security in which the holder of the security has the right to withhold payment of the full amount due at maturity if the credit event occurs. With this derivative, the credit protection buyer holds a bond or loan that is subject to default risk (the underlying reference security) and issues its own security (the credit-linked note) with the condition that if the bond or loan it holds defaults, the principal payoff on the credit-linked note is reduced accordingly. Thus, the buyer of the credit-linked note effectively insures the credit risk of the underlying reference security.

Excercise Price (Strike Price)

Fixed price at which the underlying asset maybe purchased.

Effect of Payments & Cost of Carry on Options

For call holders, the value is lowered by payments and convience yield. For put holder the value is increased Carrying costs have the opposite effect 1. A European call option is worth less the more benefits that are paid by the underlying and worth more the more costs that are incurred in holding the underlying. 2. A European put option is worth more the more benefits that are paid by the underlying and worth less the more costs that are incurred in holding the underlying.

Swap vs. Forward

Foward price is determined by the spot price and the net cost of carry.

Funds of Hedge Funds

Funds that hold a portfolio of hedge funds.

Derivatives: Information Discovery

Futures markets allow for price discovery. It is not 100% accurate but they do a decent job of predicting spot prices. Derivative markets can, however, convey information not impounded in spot markets. By virtue of the fact that derivative markets require less capital, information can flow into the derivative markets before it gets into the spot market. The difference may well be only a matter of minutes or possibly seconds, but it can provide the edge to astute traders. Finally, futures also reveal the price one would pay to avoid uncertainty. The price should be the price that guarantees the risk-free rate minus whatever dividends would be paid on the stock. Derivatives—specifically, futures, forwards, and swaps—reveal the price that the holder of an asset could take and avoid the risk.

Formula for Futures Contract Price of Commodity

Futures price ≈ Spot price*(1+r) + Storage costs - Convenience yield

Contango vs. Backwardation

Futures prices may be higher or lower than spot prices depending on the convenience yield. When futures prices are higher than the spot price, the commodity forward curve is upward sloping, and the prices are referred to as being in contango. Contango occurs when there is little or no convenience yield. When futures prices are lower than the spot price, the commodity forward curve is downward sloping, and the prices are referred to as being in backwardation. Backwardation occurs when the convenience yield is high.

Put Call Forward Parity Formula

Fₒ(T)/(1+Rƒ)ᵀ + Þₒ = ᥴₒ + X/(1+Rƒ)ᵀ

Private Equity Fund Fee Structure

Generally 1-3% of committed capital Committed capital: capital that limited partners have agreed to provide to the PE fund Until committed capital is deployed, management fee is based on the committed capital and not invested capital. After the committed capital is fully invested, the fees are paid only on the funds remaining in the investment vehicle; as investments are exited, capital is paid back to the investors, and investors no longer pay fees on that portion of their investment. For most private equity funds, the GP does not earn an incentive fee until the LPs have received back their initial investment. The GP typically receives 20% of the total profit, net of any hard hurdle rate, of the private equity fund as an incentive or profit sharing fee.25 The LPs receive 80% of the total profit of the equity fund plus the return of their initial investment. If distributions are made based on profits earned over time rather than at exit from investments of the fund, the distributions may result in receipts by the GP of more than 20% of the total profit. Most private equity partnership agreements include policies that protect the LPs from this contingency. These policies include prohibiting distributions of incentive fees to the GP until the LPs have received back their invested capital, setting up an escrow account for a portion of the incentive fees, and incorporating a clawback provision that requires the GP to return any funds distributed as incentive fees until the LPs have received back their initial investment and 80% of the total profit.

Hedge Funds Prime Brokers

Hedge funds normally trade through prime brokers. Brokers that provide services including custody, administration, lending, short borrowing, and trading. The prime broker lends the hedge fund money to make investments, and the hedge fund puts money or other collateral into a margin account with the prime broker.

Futures & Fowards w/ Different Interst Rate Correlation

If futures prices are positively correlated with interest rates, futures contracts are more desirable to holders of long positions than are forwards. The reason is because rising prices lead to futures profits that are reinvested in periods of rising interest rates, and falling prices leads to losses that occur in periods of falling interest rates. It is far better to receive cash flows in the interim than all at expiration under such conditions. This condition makes futures more attractive than forwards, and therefore their prices will be higher than forward prices. A negative correlation between futures prices and interest rates leads to the opposite interpretation, with forwards being more desirable than futures to the long position. The more desirable contract will tend to have the higher price.

Pricing & Valuation during the Life of the Contract

In general, the value of a forward contract is the spot price of the underlying asset minus the present value of the forward price. Equation 6. Vߪ(T) = Sߪ - Fₒ(T)*(1+Rƒ)¯⁽ᵀ־ ᵗ⁾ With cost of carry, Equation 7. Vߪ(T) = Sߪ - Fₒ(T)*(1+Rƒ)¯⁽ᵀ־ ᵗ⁾

Commercial Real Estate

In order to provide direct debt financing, the lender (investor) will conduct financial analyses to establish the borrower's creditworthiness, to ensure that the property will generate cash flows sufficient to service the debt, to estimate the value of the property, and to evaluate economic conditions. The estimate of the property value is critical because the loan-to-value ratio is a critical factor in the lending decision. The borrower's equity in the property is an indicator of commitment to the success of the project and provides a cushion to the lender because the property is generally used as collateral for the loan. Indirect investment vehicles provide individual investors with the opportunity to invest in real estate. For example, shares of REITs provide indirect, equity investment opportunities in real estate, and commercial mortgage-backed securities (CMBS) provide indirect, debt investment opportunities in real estate.

REIT Valuations

Income-based approaches for REITs are typically similar to the direct capitalization approach. A measure of income, which is a cash flow proxy, is capitalized into a value indication by using a cap rate (an alternative calculation could multiply the income measure by the reciprocal of the cap rate). Two common measures used are funds from operations (FFO) and adjusted funds from operations (AFFO). FFO, in its most basic form, equals net income plus depreciation charges on real estate property less gains from sales of real estate property plus losses on sales of real estate property. These adjustments to net income effectively exclude depreciation and the gains and losses from sales of real estate property from the FFO. Depreciation is excluded because it represents a non-cash charge and is often unrelated to changes in the value of the property. Gains and losses from sales are excluded because these are assumed to be non-recurring. AFFO adjusts the FFO for recurring capital expenditures. It is similar to a free cash flow measure. The cap rate and its reciprocal multiple are estimated based on a variety of factors, including market cap rates and current market and economic conditions, expectations for growth in the relevant measure, risks associated with the REIT's underlying properties, the financial leverage of the REIT, and multiples of recent transactions. Asset-based approaches calculate a REIT's NAV. Generally, a REIT's NAV is calculated as the estimated market value, based on appraisals, of a REIT's total assets minus the value of its total liabilities. REIT shares frequently trade at prices that differ from NAV per share. Both premiums and discounts to the NAV are observed in the market.

Alt Investments Due Diligence

Independent valuation of illiquid underlying assets should be performed regularly. Often, this analysis is done in conjunction with a portfolio review explaining the performance of every transaction in detail, its status, and future strategy for the portfolio. Limits on security type, leverage, sector, geography, and individual positions should be well defined in the offering memorandum, and the positions should be carefully monitored by the manager and regularly reported to clients.

Pricing of Commodity Futures Contracts

It is important to understand futures contracts and the sources of return for each commodity futures contract because commodity investments often involve the use of futures contracts. These contracts trade on exchanges. The buyer (i.e., the long side) of a futures contract is obligated to take delivery of the commodity or its cash equivalent based on the spot price at expiration and will pay a settlement price. The settlement price is an amount specified in the contract or the previous mark-to-market price if the contract has been marked to market. In other words, the long side is obligated to buy the commodity at the settlement price. The long side of a futures contract increases in value when the underlying commodity increases in value. The seller of a futures contract (i.e., the short side) is obligated to deliver the commodity or its cash equivalent based on the spot price at expiration and will receive the settlement price.

PE: Diversification Benefits, Performance, & Risk

It shows the mean annual returns for the Cambridge Associates US Private Equity Index, the NASDAQ and S&P 500 indexes, and the Cambridge Associates mPME (Modified Public Market Equivalent) S&P 500 Index for a variety of periods ending 31 December 2014. Public market equivalent (PME) index returns use internal rate of return (IRR) calculations to simulate investment of private equity cash flows in a market index, such as the S&P 500. The technique involves recording the timing of cash flows for the fund and computing period returns, assuming the flows are invested in a market index instead of the fund. Based on the returns shown in Exhibit 8, US private equity funds, based on the Cambridge Associates' estimates, on average outperformed stocks based on the NASDAQ and S&P 500 indexes only in the 10- and 20-year periods ending 31 December 2014. The returns to US private equity underperformed these indexes' returns for the 1- and 3--year periods and were similar for the 5-year period ending 31 December 2014. The mPME index returns were more similar to the S&P 500 index returns than returns on private equity.

Key Factor When Considering Hedge Funds

Key factors to consider include investment strategy, investment process, competitive advantage, track record, size and longevity, management style, key person risk, reputation, investor relations, plans for growth, and risk management systems. It should be possible, however, to identify in which markets the hedge fund invests, the general investment strategy (for example, long-short, relative arbitrage, and so on) and the basic process to implement this strategy, and the benchmark against which the fund gauges its performance. Investors should determine how the returns are calculated (e.g., based on estimates of value or market prices) and reported (e.g., before or after fees) and how the returns and risks compare with some benchmark. The investor should inquire about the fee structure because this information will affect, as demonstrated earlier, the return to the investor. The hedge fund due diligence process also focuses on many qualitative factors, including management style, key person risk, reputation, investor relations, and plans for growth In addition to gathering information about the fund's prime broker and custody arrangements for securities, the investor should identify the auditor of the hedge fund and ensure that the auditor is independent and known for conducting competent audits.

Risk Return Measures

Many alternative investments do not exhibit close-to-normal distributions of returns, which is a crucial assumption for standard deviation's validity as a comprehensive risk measure. Alternative investment returns tend to be leptokurtic, or negatively skewed (in other words, they have fat tails characterized by positive average returns and long-tails downside characterized by potential extreme losses). For this reason, a measure of downside risk, ideally non-normal, would be useful. Downside risk measures focus on the left side of the return distribution curve where losses occur. For example, value at risk (VaR) is a measure of the minimum amount of loss expected for a given period at a given level of probability. In other words, this measure answers a question such as, "What is the minimum amount expected to be lost in a year with a 5% probability?" This measure, however, if it is calculated using standard deviation, will underestimate the VaR for a negatively skewed distribution. Shortfall or safety-first risk measures the probability that the portfolio value will fall below some minimum acceptable level over a given period. In other words, this measure answers a question such as, "What is the probability of losing 20% of principal in any given year?" Shortfall risk also uses standard deviation as the measure of risk. The Sortino ratio, another risk-return measure, uses downside deviation rather than standard deviation as a measure of risk. Assuming normal probability distributions when calculating these measures will lead to underestimating downside risk for a negatively skewed distribution. Understanding and evaluating "tail events"—low-probability, high-severity instances of stress—is an important yet extraordinarily difficult aspect of the risk management process. Stress testing/scenario analysis is often used as a complement to VaR to develop a better understanding of a portfolio's potential loss under both normal and stressed market conditions. Stress testing involves estimating losses under extremely unfavorable conditions.

Investment Structures

Most common structure is a partnership where the fund is the General Partner and the investors are Limited Partners. Funds generally structured with a management fee based on assets under management plus an incentive fee. Fee calculations take on high water marks. General partner: the partner that runs the business and theoretically bears unlimited liability Limited patterns: partners with limited liability. Limited partnerships in hedge and private equity funds are typically restricted to investors who are expected to understand and to be able to assume the risks associated with the investments. Fees include management fees, incentive fees and high water marks. Hurdle rate: a rate of return that must be achieved before a funds incentive fee is paid. High water mark: highest value, net of fees, the fund has reached in history. It reflects the highest cumulative return used to calculate an incentive fee. The use of high-water marks protects clients from paying twice for the same performance. Many alternative investment funds, including hedge funds, use this basic partnership and fee structure. Fee structures are discussed in more detail later in the reading.

Options vs. Foward/Futures/Swaps

Options, due to arbitrage pricing, may ultimately lead to the convergence of fundemental value of an asset. Forwards, futures, and swaps do not. The fixed price is embedded in the contract while the underlying value will fluctuate and thus the value and price are not at all comparable.

Hedge Fund Valuation Issues

Often use Bid-Ask/2 average for valuation. May use bid prices for longs and ask for shorts. May also give liquidity haircut.

Pricing Futures

Perhaps the most important distinction is that they are marked to market on a daily basis, meaning that the accumulated gains and losses from the previous day's trading session are deducted from the accounts of those holding losing positions and transferred to the accounts of those holding winning positions.

Portfolio Company Valuation

Popular valuation methods in PE include 1. Market comp — EBITDA multiples are common. May be found by looking at the MV of equity plus debt (enterprise value) of a similar publicly traded company or the price recently paid for a comparable business, divided by EBITDA. — NI and revenue multiples may be based on the multiples from transactions in comparable companies 2. DCF — Free cash flow to the firm discounted at the weighted average cost of capital may be used to estimate the company's value. Free cash flow to equity may be used to estimate the value of the company's equity. 3. Asset based

Private Equity: Venture Capital

Portfolio company: in private equity, it is the fund in which the PE firm is investing. The VC fund may also provide some debt financing. 1. Formative-stage financing occurs when the company is still in the process of being formed and encompasses several financing steps, described as follows: — Angel investing is capital provided at the idea stage. Funds may be used to transform the idea into a business plan and to assess market potential. The amount of financing at this stage is typically small and provided by individuals (often friends and family) rather than by VC funds. — Seed-stage financing or seed capital generally supports product development and/or marketing efforts, including market research. This point is generally the first stage at which VC funds invest. — Early-stage financing (early-stage VC) is provided to companies moving toward operation but before commercial production and sales have occurred. Early-stage financing may be provided to initiate commercial production and sales. 2. Later-stage financing (expansion VC) is provided after commercial production and sales have begun but before any IPO. Funds may be used for initial expansion of a company already producing and selling a product or for major expansion, such as physical plant expansion, product improvement, or a major marketing campaign. 3. Mezzanine-stage financing27 (mezzanine venture capital) is provided to prepare a company to go public. It represents the bridge financing needed to fund a private firm until it can complete an IPO.

Determine Put or Call Premium

Put will exceed the call by the sum of the right side of the equation, Þₒ - ᥴₒ = X/(1+Rƒ)т - Sₒ

Arbitrage & Replication

Replication is the creation of an asset or portfolio from another asset, portfolio, and/or derivative

Highwater Mark

Reported net of fees. High-water marks reflect the highest cumulative return used to calculate an incentive fee. In other words, the hedge fund must recover its past losses and return to its high-water mark before any additional incentive fee is earned. Clients are not charged an incentive fee if the latest cumulative return does not exceed the prior high-water mark. This use of a high-water mark protects clients from paying twice for the same performance. Although poorly performing hedge funds may not receive an incentive fee, the management fee is earned irrespective of returns.\

Put Option

Right to sell an option

Derivative Pricing

Risk neutral pricing. Risk-neutral pricing uses the fact that arbitrage opportunities guarantee that a risk-free portfolio consisting of the underlying and the derivative must earn the risk-free rate.

European Style

Said of an option contract that can only be exercised on the option's expiration date.

Arbitrage & Put Call Parity

Short the over priced side of the equation and go long the underpriced side.

Infrastructure: Forms of Investment

Some investors invest directly, but most invest indirectly. Indirect investment includes shares of companies, ETFs, listed funds, private equity funds a and unlisted mutual funds. MLPs are a popular way to invest

Value of Futures Contract

The accumulated gain or loss on a futures contract since its previous day's settlement. When that value is paid out in the daily settlement, the future price is effectively reset to the settlement price and the value goes to 0.

REIT Investing

The business strategy for equity REITs is simple: Maximize property occupancy rates and rents in order to maximize income and dividends. Equity REITs, like other public companies, must report earnings per share based on net income as defined by generally accepted accounting principles (GAAP).

Long vs. Short

The buyer is referred to as the long and the seller is the short.

Time Value of Options

The difference b/t the market price of the option and its intrinsic price. It represents the potential for higher excercise value relative to the potential for lower excercise value given the volatility of the underlying. Time value of decay: options lose value as time to expiration gets closer

Foward Future Price From Sₒ

The foward price of an asset w/ benefits and/or costs is the spot price compounded at the risk free rate over the life of the contract minus the future value of those benefits & costs. The foward price is reduced by the future value of any benefits and increased by the costs.

Alternative Investments Historical Returns & Volatilities

The links between this quote and the expected characteristics of alternative investments are clear: diversifying power (low correlations among returns), higher expected returns (positive absolute return), and illiquid and potentially less efficient markets

Arbitrage Free Pricing

The overall process of pricing derivatives by arbitrage and risk neutrality. Also called the principle of no arbitrage.

Swaps

The term, FSₒ(n,T) = a fixed payment established at time 0 for a swap consisting of n payments w/ the last payment at time T

Call Options & Underlying Move Together

Thus, one may buy the underlying and sell the call which will create a hedge. If we sell one call and hold h units of the underlying that value of the h units of the underlying and one short call is V₀ = hS₀ - ᥴ₀ @ T = 0 @ T = 1, V₁⁺ = hS₁⁺ - ᥴ₁⁺ or V₁⁻ = hS₁⁻ - ᥴ₁⁻ c = call price, not premium

Timberland & Farmland

Timberland offers an income stream based on the sale of timber products as a component of total return and has historically provided a return that is not highly correlated with other asset classes. Timberland functions as both a factory and a warehouse Timber can be grown and easily stored by not harvesting. This feature offers the flexibility of harvesting more trees when timber prices are up and delaying harvests when prices are down. Timberland has three primary return drivers: biological growth, commodity price changes, and land price changes. Farmland is often perceived to provide a hedge against inflation. Its returns include an income component related to harvest quantities and agricultural commodity prices. Farmland consists of two main property types: row crops that are planted and harvested annually (i.e., more than one planting and harvesting can occur in a year depending on the crop and the climate) and permanent crops that grow on trees or vines. Unlike with timberland, farm products must be harvested when ripe, so there is little flexibility in harvesting. Farmland may also be used as pastureland for livestock. Similar to timberland, farmland has three primary return drivers: harvest quantities, commodity prices, and land price changes.

Hedge Fund Strategies: Macro Strategies

Trades made based on expected movements in economic variables. Use long and/or short positions to potentially profit from a view on overall market direction.

Private Equity: Exit Strategies

Typical holding time is 5 years. Common exit strategies of PE companies: 1. Trade sale. This strategy refers to the sale of a company to a strategic buyer such as a competitor. A trade sale can be conducted through an auction process or by private negotiation. Benefits of a trade sale include (a) an immediate cash exit for the private equity fund; (b) potential for high valuation of the asset because strategic buyers may be willing and able to pay more than other potential buyers as a result of anticipated synergies; (c) fast and simple execution; (d) lower transaction costs than an IPO; and (e) lower levels of disclosure and higher confidentiality than an IPO because the private equity firm is generally dealing with only one other party. Disadvantages of trade sales include (a) possible opposition by management; (b) lower attractiveness to employees of the portfolio company than an IPO; (c) a limited number of potential trade buyers; and (d) a possible lower price than in an IPO. 2. IPO. This approach involves the portfolio company selling its shares, including some or all of those held by the private equity firm, to public investors through an IPO. Advantages for an IPO exit include (a) potential for the highest price; (b) management approval, because management will be retained; (c) publicity for the private equity firm; and (d) potential ability to retain future upside potential, because the private equity firm may choose to remain a large shareholder. Disadvantages for an IPO exit include (a) high transaction costs paid to investment banks and lawyers; (b) long lead times; (c) risk of stock market volatility; (d) high disclosure requirements; (e) potential lock-up period, which requires the private equity firm to retain an equity position for a specified period after the IPO; and (f) the fact that an IPO is usually appropriate only for larger companies with attractive growth profiles. 3. Recapitalization. A recapitalization is not a true exit strategy, because the private equity firm typically maintains control; however, it does allow the private equity investor to extract money from the company. Recapitalization is a very popular strategy when interest rates are low, as the private equity firm re-leverages or introduces leverage to the company and pays itself a dividend. A recapitalization is often a prelude to a later exit. 4. Secondary sales. This approach represents a sale to another private equity firm or other group of investors. 5. Write-off/liquidation. A write-off occurs when a transaction has not gone well, and the private equity firm is updating its value of the investment or liquidating the portfolio company to move on to other projects.

Foward, Futures, & Swaps vs Options

Unlike FFS, an option is an asset to the buyer and a liability to the seller.

Value of Foward Contract at Intiation

Value at intiation is 0 and foward is not an asset. Thus, Vₒ(T) = 0 Equation 3. Fₒ(T)/Sₒ) = (1+Rƒ)ᵀ which means the foward price is, Fₒ(T) = Sₒ(1+Rƒ)ᵀ which means the foward price is the spot price compounded over the life of the contract. Equation 5. (1+Rƒ)ᵀ = [Fₒ(T) + (ץ-φ) * (1+Rƒ)ᵀ]/Sₒ which is, Fₒ(T) = Sₒ(1+Rƒ)ᵀ + [(ץ-φ) * (1+Rƒ)ᵀ]

Value of Call vs. Leveraged Transaction

Value of call strategy must be at least worth Sₒ - X/(1+Rƒ)ᵀ thus, cₒ ≥ Max[0,Sₒ-X/(1+Rƒ)ᵀ]

Value of European Option at Expiration

Value of call, cт = Max(0,Sт-X) Intrinsic value or exercise value Value of put, pт = Max(0,X-Sт)

Forward Contract Pricing

Value of foward to long, Vт(T) = Sт - Fₒ(T) Vт(T) = value at expiration of the forward contract The value of a foward contract at expiration is the spot price of the underlying minus the foward price agreed in the contract Value to short, Vт(T) = -1*[Sт - Fₒ(T)]

Volatility & Options

Volatility is universally desired. 1. The value of a European call is directly related to the volatility of the underlying. 2. The value of a European put is directly related to the volatility of the underlying.

Portfolio Hedging & Binomial Pricing

V₁⁺ = V₁⁻ ==> hS₁⁺ - ᥴ₁⁺ = hS₁⁻ - ᥴ₁⁻ ==> h = [ᥴ₁⁺ - ᥴ₁⁻]/[S₁⁺ - S₁⁻] h = units of the underlying A perfectly hedged instrument should earn the risk free rate, V₁⁺ (or V₁⁻) = V₀*(1+Rƒ) Substitue V₀ = hS₀ - ᥴ₀ into the above to get, ᥴ₀ = [πᥴ₁⁺ + (1-π)ᥴ₁⁻]/(1+Rƒ) ᥴ = the call price at expiration and initial, not premium where, π = [1+Rƒ-d]/(u-d) π = the weight of the possible call prices, given by π & (1-π)

Symbols for Pricing an Option

We start by assuming that today is time 0, and the option expires at time T. The underlying is an asset currently priced at Sₒ, and at time T, its price is Sт. Of course, we do not know Sт until we get to the expiration. The option has an exercise or strike price of X. The symbols we use are as follows: For calls, cₒ = value (price) of European call today cт = value (price of European call at expiration Cₒ = value (price) of American call today Cт = value (price) of American call at expiration for puts, pₒ = value (price) of European put today pт = value (price) of European put at expiration Pₒ = value (price) of American put at today Pт = value (price) of American put at expiration

Risk Neutral Probabilities

Weights that are used to compute a binomial option price. They are the probabilities that would apply if a risk-neutral investor valued an option. They are represented as π and (1-π)

Futures: Offset

When a long sells its position before expiration or when a short buys a previously open contract. The clearinghouse marks the contract to the current price relative to the previous settlement price and closes out the participants position

Lowest Prices of Calls & Puts

When the call expires out of the money, its call value is 0 but the leveraged transaction is almost surely a loss. If the call expires in the money, both transactions have the same payoff

Derivatives: Speculation & Gambling

Why is it bad? Its not.

Formula for Option

cʈ = Max(0,Sʈ-X) cʈ = value of option at expiration Sʈ = price of underlying at expiration X = strike price

Commodities

economic goods or products before they are processed and/or given a brand name, such as a product of agriculture Derivative contracts specify terms such as quantity, quality, maturity date, and delivery location

Binomial Pricing Formula for Puts

p₀ = [πp₁⁺ + (1-π)p₁⁻]/1+Rƒ where π is, π = [1+Rƒ-d]/(u-d)

Value of Put vs. Leveraged Transaction

pₒ ≥ Max[0,X/(1+Rƒ)ᵀ - Sₒ]

Risk Premium Symbol

λ

Swap: Fixed for Floating Interest Rate Swap (Plain Vanilla Swap)

An interest rate swap in which one party pays a fixed rate and the other pays a floating rate, with both sets of payments in the same currency. Also called plain vanilla swap or vanilla swap.

Futures: Open Interest

The number of outstanding contracts in a clearinghouse at any given time. The open interest figure changes daily as some parties open up new positions, while other parties offset their old positions. Delivery ensures the futures price converges to the spot price at expiration.

Index Swaps

More often called equity swaps, are quite popular and permit investors to pay the return on one stock index and receive the return on another index or a fixed rate. They can be very useful in asset allocation strategies by allowing an equity manager to increase or reduce exposure to an equity market or sector without trading the individual securities.

Warrant

A type of equity option sold to the public direct from a company.

ABS & Options

An ABS is a type of put option.

In, Out, At the Money

In the money = Sʈ > X Out of the money = Sʈ < X At the money = Sʈ = X

Derivative: Arbitrage

1) The simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a riskless profit on the price differential. Taking advantage of a market inefficiency in a risk-free manner. 2) The condition in a financial market in which equivalent assets or combinations of assets sell for two different prices, creating an opportunity to profit at no risk with no commitment of money. In a well-functioning financial market, few arbitrage opportunities are possible. 3) A risk-free operation that earns an expected positive net profit but requires no net investment of money.

Standardization: Clearing & Settlement

1. Clearing: refers to the process by which the exchange verifies the execution of a transaction and records the participants identities. 2. Settlement: refers to the related process in which the exchange transfers money from one participant to the other or from one participant to the exchange or vice versa.

4 Main Types of Underlyings

1. Fixed income 2. Securities/interest rates 3. Currencies 4. Commodities

Two Types of Derivatives

1. Forward commitments: locks in a price that will be transacted at some future date 2. Contingent claims: provides the right but not the obligation to buy or sell the underlying at a pre-determined price. Primary contingent claim is called the option.

3 Types of Forward Commitments

1. Forward contract: an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree upon when the contract is signed. 2. Futures contract: a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a price agreed upon by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse. 3. Swaps contract: an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either 1) a variable series determined by a different underlying asset or rate or 2) a fixed series.

Derivatives: Operational Advantages

1. Lower transaction costs 2. Greater liquidity 3. Ease of going short

Contingent Claim

1. Options 2. Credit derivatives 3. Asset backed securities

Derivatives

A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Ex: corn futures contracts, put options, and forward agreements.

Limits to Arbitrage

1. Transaction costs 2. Volatility of underlying asset may prevent risk free aribtrage 3. Arbitrage that requires short selling of non-shortable assets

Credit derivative: Credit Default Swap

A credit default swap is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the default of a third party. Most common method is the payout to be determined by an auction to estimate the market value of the defaulting debt

Credit Derivative (CD)

A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and a credit protection seller, in which the latter provides protection to the former against a specific credit loss.

Contingent Claim

A derivative in which the outcome or payoff is dependent on the outcome or payoff of an underlying asset Difference b/t it and a forward is the RIGHT and not the OBLIGATION to make a final payment on the underlying.

Forward Contract

A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed. The two parties also agree upon the specific identity of the underlying, the number of units of the underlying that will be delivered, and where the future delivery will occur. The short's payoff is the negative of the long: -[Sʈ - Fₒ(ʈ)], which is a consolidation of the formula. Note the derivative transforms the gain from the underlying. Without derivative, the return would be Sʈ-Sₒ, but with the derivative it become S(ʈ)-Fₒ(ʈ)

Futures

A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.

Hedge Portfolio

A hypothetical combination of the derivative and its underlying that eliminates risk. With risk eliminated it follows the hedge portfolio should earn a risk-free rate.

Futures: Limit Up

A limit move in the futures market in which the price at which a transaction would be made is at or above the upper limit.

Benefits of Holding an Asset: Convenience Yield

A non-monetary advantage of holding an asset. Convenience yields are primarily associated with commodities and generally exist as a result of difficulty in either shorting the commodity or unusually tight supplies

Collateralized Mortgage Obligation (CMO)

A security created through the securitization of a pool of mortgage-related products (mortgage pass-through securities or pools of loans).

CD: Total Return Swap

A swap in which one party agrees to pay the total return on a security. Often used as a credit derivative, in which the underlying is a bond. The total return consists of all interest and principal paid by the borrower plus any changes in the bond's market value.

Swaps

A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed series. Swaps also contain the identity of the underlying, the relevant payment dates, and the payment procedure that are negotiated b/t parties. Swaps are relatively young derivatives, yet they are the most popular

Derivative: Underlying

An asset that trades in a market in which buyers and sellers meet, decide on a price, and the seller then delivers the asset to the buyer and receives payment. The underlying is the asset or other derivative on which a particular derivative is based. The market for the underlying is also referred to as the spot market. Components of the underlying may be equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets.

Asset Backed Secuity Formal Definition

An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and the most-senior tranches last.

Option

An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date. Options may be created in the OTC and customized, or created and traded on options exchanges and standardized. As with forward contracts and swaps, customized options are subject to default, are less regulated, and are less transparent than exchange-traded derivatives. As with forward contracts and swaps, customized options are subject to default, are less regulated, and are less transparent than exchange-traded derivatives

OTC Derivatives Market

Backbone of the market are the dealers, which are typically banks. Most of the banks are part of the International Swaps and Derivatives Association (ISDA) Typically risk is mitigated via hedging by engaging in alternative but similar transactions.

Risk Neutral & Arbitrage

Because the risk free rate may be created with a derivative, the investor is assumed to be risk neutral instead of risk averse, and the discount applied to derive expected payoff of the derivative is the risk free rate. Risk aversion is relevant to pricing assets, but not to pricing derivatives.

Derivative: Storage

Cost of carry: risk free rate minus the dividend yield.

Swap: Credit Risk

Credit risk is higher than with a future, but lower than a forward b/c the only money passing around is the difference b/t the fixed and floating rates.

Future Market Settlement

Daily settlement of gains and losses and the associated credit guarantee provided by the exchange via its clearinghouse. At the end of the day the prices are settled and the long or short will receive or pay to settle.

Exchange Traded Derivatives Markets

Derivatives are traded on an exchange or OTC derivatives. Exchange traded derivatives are standardized while OTC derivatives are customized.

Risk Allocation w/ Derivatives

Derivatives improve the allocation of risk and facilitate more effective risk management for both companies and economies

Derivatives & Arbitrage

Derivatives may be used to hedge the underlying and vice versa

What is the Point of Derivatives

Derivatives provide strategies that otherwise would not exist in the market. For example, going short. Derivatives involve large amounts of leverage meaning participants need invest but a small sum of money relative to the underlying value. Derivatives generally trade at lower transaction costs than comparable spot market transactions, are often more liquid than their underlyings, and offer a simple, effective, and low-cost way to transfer risk.

Derivative Definition Cont.

Derivatives usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast mutual funds and ETF pass through the returns from their underlying securities. Derivatives provide for the transfer of risk from one party to another.

Default: Only the Short May Default

For a call option with physical delivery, upon exercise the underlying asset is delivered to the call buyer, who pays the call seller the exercise price. For a put option with physical delivery, upon exercise the put buyer delivers the underlying asset to the put seller and receives the strike price. For a cash settlement option, exercise results in the seller paying the buyer the cash equivalent value as if the asset were delivered and paid for.

Forwards & Exchanges

Forwards are not traded on an exchange due to their vast customization.

Derivatives: Market Efficiency

Fundemental value is restored to the derivatives markets before the underlying market

What Inforamtion Do Options Hold

Given the underlying and the type of option (call or put), an option price reflects two characteristics of the option (exercise price and time to expiration), three characteristics of the underlying (price, volatility, and cash flows it might pay), and one general macroeconomic factor (risk-free rate). Only one of these factors, volatility, is not relatively easy to identify.

Futures Exchanges

Highly regulated at the national level and specificy what contracts are authorized for trading. These contracts have specific underlying assets, times to expiration, delivery and settlement conditions, and quantities. The exchange offers a facility in the form of a physical location and/or an electronic system as well as liquidity provided by authorized market makers.

Futures Margin: Margin Call

In a futures margin call, the party with the call must deposit enough funds to return back to the initial margin, not the maintainence margin. If a party chooses not to deposit funds, the party would be required to close the contract ASAP and is responsible for any additional losses until the position is closed.

Futures: Price Limits

Limits imposed by a futures exchange on the price change that can occur from one day to the next.

Future Margin: Insurance Fund

Maintained by the clearinghouse in the event of a catastrophic loss of one party

Cash Market (Spot Market)

Markets in which assets are traded for immediate delivery

Costs of Holding an Asset: Storage

May be high for commodities but low for financials

Derivatives: Destabilization & Systemic Risk

May happen? But is it that pronounced?

OTC Market Liquidity

OTC market can be very liquid and often OTC instruments can easily be created and then essentially offset by doing the exact opposite transaction, often with the same party.

Credit Derivative: Credit Spread Option

Option on the yeild spread on the bond. The spread is the difference b/t the bond's yield and the yield on a benchmark default free bond. This is essentially a call option with the underlying being the credit spread.

Payoff to Put Holder

Payoff to put buyer: pʈ = Max(0,X-Sʈ) If put buyer paid pₒ at time 0, the profit to the put buyer is, ∏ = Max(0,X-Sʈ) - pₒ And for the seller the payoff is: -pʈ = -Max(0,X-Sʈ) And profit to the seller is, ∏ = -Max(0,X-Sʈ) + pₒ Note: Put buyer has limited loss, and gain is limited by the fact that the underlying value cannot go below 0

Profit from Call Option Strategy

Payoff to the call buyer: cʈ = Max(o, Sʈ-X) Profit to the call buyer: ∏ = Max(0,Sʈ-X) - cₒ Payoff to the call seller: -cʈ = -Max(0,Sʈ-X) Profit to the call seller: ∏ = -Max(0,Sʈ-X) + cₒ where, ∏ = profit from the strategy Note, the buyer of a call has unlimited upside, but downside is limited to Premium. The seller of the call has limited upside, but limited gains in the form of the premium

Option Settlement

Physical delivery or cash settlement. For a call option with physical delivery, upon exercise the underlying asset is delivered to the call buyer, who pays the call seller the exercise price. For a put option with physical delivery, upon exercise the put buyer delivers the underlying asset to the put seller and receives the strike price. For a cash settlement option, exercise results in the seller paying the buyer the cash equivalent value as if the asset were delivered and paid for.

Derivatives Exchanges & Default Risk

Provide credit guarantee via clearing houses to provide to the winning party if the loser does not pay. Does this via the margin or performance bond from the contract participants.

Call Option

Right to buy an option

Risk Averse, Risk Seeking, Risk Neutral

Risk-neutral investors are willing to engage in risky investments for which they expect to earn only the risk-free rate. Thus, they do not expect to earn a premium for bearing risk. For risk-averse investors, however, risk is undesirable, so they do not consider the risk-free rate an adequate return to compensate them for the risk. Thus, risk-averse investors require a risk premium, which is an increase in the expected return that is sufficient to justify the acceptance of risk. All things being equal, an investment with a higher risk premium will have a lower price. It is very important to understand, however, that risk premiums are not automatically earned. They are merely expectations. Actual outcomes can differ. Clearly stocks that decline in value did not earn risk premiums, even though someone obviously bought them with the expectation that they would. Nonetheless, risk premiums must exist in the long run or risk-averse investors would not accept the risk. The third type of investor is one we must mention but do not treat as realistic.

Futures Margin Account

The amount of money that a trader deposits in a margin account. The term is derived from the stock market practice in which an investor borrows a portion of the money required to purchase a certain amount of stock. In futures markets, there is no borrowing so the margin is more of a down payment or performance bond. There is no formal loan created as in equity markets. A futures margin is more of a performance bond or good faith deposit, terms that were previously mentioned. It is simply an amount of money put into an account that covers possible future losses.

Futures Margin Account: Initial Margin

The amount that must be deposited in a clearinghouse account when entering into a futures contract.

Market Makers & Dealers

The cornerstones of the exchange-traded derivatives market are the market makers (or dealers) and the speculators, both of whom typically own memberships on the exchange The market makers stand ready to buy at one price and sell at a higher price. With standardization of terms and an active market, market makers are often able to buy and sell almost simultaneously at different prices, locking in small, short-term profits—a process commonly known as scalping. In some cases, however, they are unable to do so, thereby forcing them to either hold exposed positions or find other parties with whom they can trade and thus lay off (get rid of) the risk. Speculators will take risk from market makers but do it wisely.

Cost of Holding an Asset: Opportunity Costs of Holding an Asset

The forgone interest on the money

Futures Margin: Maintenance Margin

The maintenance margin is the amount of money that each participant must maintain in the account after the trade is initiated, and it is always significantly lower than the initial margin

Price an Asset

The price of a financial asset is often determined using a present value of future cash flows approach. The value of the financial asset is the expected future price plus any interim payments such as dividends or coupon interest discounted at a rate appropriate for the risk assumed. Such a definition presumes a period of time over which an investor anticipates holding an asset, known as the holding period. The investor forecasts the price expected to prevail at the end of the holding period as well as any cash flows that are expected to be earned over the holding period. He then takes that predicted future price and expected cash flows and finds their current value by discounting them to the present. Thereby, the investor arrives at a fundamental value for the asset and will compare that value with its current market price. Based on any differential relative to the cost of trading and his confidence in his valuation model, he will make a decision about whether to trade.

Option Premium

The price you pay to buy an option

Risk Management

The process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former. Risk management never offers a guarantee that large losses will not occur, and it does not eliminate the possibility of total failure.

Standardized Derivatives

The terms and conditions are precisely specified by the exchange and there is li,mired ability to alter the terms This facilitates liquidity

What Inforamtion Do Options Hold: Implied Volatility

The volatility that option traders use to price an option, implied by the price of the option and a particular option-pricing model and measures the expected risk of the underlying. Options allow investors to infer what volatility people are using from the actual market prices at which they execute trades.

Non-deliverable Forwards (NDF), Cash Settled Forwards, or Contracts for Differences

These contracts are settled in cash but have same economic effect as delivery based counterparts. In this case the short delivers Sʈ-Fₒ(ʈ) in cash. Because the long received cash, they may go out and purchase the asset at S(ʈ). In which case the long woul dpay Sʈ- [Sʈ-Fₒ(ʈ)]

Derivative: Arbitrage

This is a relative valuation methodology and not a absolute model

Required Rate of Return on the Underlying Asset

Ƙ = unknown discount rate or required rate of return and includes the risk free rate, Rƒ

Futures: Pricing

ʄʈ(T) - ʄₒ(T) on day T, Which means, ʄʈ(T) - ʄₒ(T) = Sʈ - Fₒ(T) ʄ = futures Futures contracts realize profits/losses daily and give the clearinghouse the ability to insure transactions and manage credit risk

Formula for Pricing an Asset w/ Both Costs & Benefits

φ = present value of costs γ = present value of benefits (includes dividends, interest, and convienence yield) Thus, Sₒ = [E(Sт)/(1-Rƒ+λ)ᵀ] -φ + γ