CAIA Level 1

real estate investment styles

1) core real estate generates a majority of returns from income rather than price appreciation (least risky) 2) value-added real estate generates a majority of returns from price appreciation, with some returns from income 3) opportunistic real estate derives almost all returns from price appreciation (most risky)

categories of LBOs

1) efficiency buyouts - improve operating efficiency; LBO firm takes on active overseer role 2) entrepreneurship stimulators - frees management from daily operational duties to concentrate on innovation; can also free divisions by giving it operational autonomy to implement a separate business plan 3) conglomerates - focuses on bloated businesses with numerous divisions or subsidiaries; LBO sells off non-core assets and focuses on undervalued core business 4) buy-and-build strategies - LBO firm combines several operating firms or divisions; based on strategic alignment and anticipated synergies 5) turnaround strategies - seek out underperforming firms with excessive leverage and weak management

five major CAIA classifications of hedge fund strategies

1) macro and managed futures 2) event-driven 3) relative value 4) equity 5) funds of funds

characteristics of investable infrastructure

1. Public use of the asset or service 2. Monopolistic pricing power 3. Government related 4. Provides an essential good/service 5. Generates cash 6. Conducive to privatization 7. Capital intensive and long-term typically have high current yields due to high dividend payments, steady cash flows due to monopolistic nature, long duration, possibility of built-in inflation protection

hypothesis testing

1. State the hypothesis - the null hypothesis (the statement the analyst attempts to reject) and the alternative hypothesis (the statement the analyst is attempting to prove) are usually mutually exclusive and complements 2. Form an analysis plan - the null hypothesis is examined using a test statistic: large values of the test statistic indicate the sampled data are significantly far from expected, providing evidence against the null hypothesis a significance level (alpha) must be established for the test; denotes the probability that a significant result may be due to random chance i.e. a type 1 error (1%, 5%, 10% typically used); the confidence level is 1 minus the significance level 3. Analyze the sample data - the test statistic is calculated from the data and is compared against the predetermined critical value test statistic = (estimated value - hypothesized value) / standard error of statistic 4. Interpret the results - reject the null hypothesis if the calculated test statistic exceeds its critical value or if the p-value is less than the significance level (identical decisions are reached by both rules) if evidence isn't sufficient to reject the null hypothesis we DON'T accept the null hypothesis we fail to reject the null hypothesis two major errors in hypothesis testing are type 1 and type 2 errors a type 1 error is made when the null hypothesis is rejected when it is in fact true; the probability of making a type 1 error is equivalent to the significance level alpha; a type I error is known as a FALSE POSITIVE a type 2 error is made when the null hypothesis is not rejected when it is in fact untrue; denoted by beta; the statistical power of a test is 1 minus beta; a type II error is known as a FALSE NEGATIVE the probabilities of making either a type 1 or type 2 error are reduced when the sample size is increased

primary goals of investing in alternative investments

1. active management - create better risk and return combinations not found in passive investing 2. generate absolute and relative returns 3. arbitrage, return enhancement, and diversification

HFR classification of funds of hedge funds

1. composite/diversified indices - represent the broad hedge fund universe e.g. equity, event-driven, macro, RV 2. conservative index - funds that exhibit lower standard deviations (typically market neutral); objective is consistent returns with low risk 3. market-defensive index - funds with little downside risk and low correlation to bonds and equities; overall objective is to hedge market risk 4. strategic index - includes directional strategies; emphasis is return enhancement

alternative investments risk and return characteristics

1. diversification - seen as diversifiers 2. illiquidity - liquidity risk premia 3. inefficiency - not all information is incorporated into prices 4. non-normal returns

CAPM limitations

CAPM's application to alternative asset performance benchmarking is limited due to: 1) over multiple periods CAPM assumes return non-stationarity - alternative investment returns are heteroskedastic 2) CAPM assumes returns are normally distributed - alternative investment returns are not 3) CAPM assumes perfect liquidity (generally, frictionless trading) - alternative assets are illiquid

liquid alternatives

Liquid alternatives typically have (1) constraints on permissible investments strategies (for example, liquidity and leverage limits), (2) no incentive fees, (3) less skilled managers as a result of less attractive compensation and limited strategies, and (4) an inability to earn substantial illiquidity premiums. constrained clone - A liquid investment fund that seeks to replicate the strategy of an existing alternative investment but imposes some constraint (e.g., liquidity, leverage, diversification) is categorized as a constrained clone. unconstrained clone - a near-identical strategy that mimics an existing alternative investment strategy that is itself relatively liquid (and therefore doesn't need much modification) liquidity-based replication products - ensures liquidity is present by selecting liquid investments that have similar characteristics to illiquid securities used in alternative funds diversified/absolute return products - focuses on creating returns that have low correlation with traditional assets; does not attempt to mimic an alternative investment strategy

return on a fully collateralized derivatives position

R(fcoll) = collateral yield + excess return R(fcoll) = collateral yield + spot return + roll yield spot return - results from changes in the spot price of a commodity owing to supply and demand forces collateral yield - interest earned on the risk-free rate excess return is a function of spot returns and changes in the basis owing to fluctuations in the term structure of forward prices roll yield is the return that results from changes in the basis owing to passage of time (as the time to maturity shortens, the futures price and basis converges to the spot price thereby producing a return) and changes in the cost of carry (fluctuations in the term structure) if the cost of carry is constant, an efficient market with a backwardated forward curve will produce positive roll return and a market with a contangoed forward curve will produce a negative roll return

Federal Reserve leverage rule

The standard Federal Reserve leverage rule requires a deposit of at least 50% of the purchase cost/short sale proceeds of a trade, or margin transaction. Alternative investment managers that seek higher levels of leverage must avoid falling under this rule by registering as a broker-dealer, using a joint back office account, or relying on a broker-dealer that is located offshore.

fund legal documents

The subscription agreement determines if a potential investor meets the legal requirements to invest in a fund by asking the investor a set of questions. The offering documents explain the potential trading strategies and associated risks of a fund. The partnership agreement describes the legal framework of the partnership and the terms and conditions for all parties in a fund. The management company operating agreement defines the responsibilities of the limited partnership members and of the fund.

leverage and total fund risk

a fund with a leverage ratio of L has short-run returns with volatility of L times the asset volatility when compared to a fund without leverage, the probability of a given percentage loss is greater than L times the probability of the same loss for the unleveraged fund for an N-sigma event, the probability of experiencing a loss is much higher for a leveraged fund

goodness of fit statistic (R-squared)

a measure of a regression's overall explanatory power; it is equal to the percent of the variation in the dependent variables explained by the independent variables; ranges from 0 to 1

put-call parity

a no arbitrage relationship between two sets of positions with identical payoffs: owning a risky underlying asset (e.g. stock) versus being long a call and a risk-free bond and being short a put: call + risk-free bond - put = underlying risky asset the call and put both have identical strike prices and expiration dates the risk-free bond indicates the initial cash investment and the risk-free rate that investment must earn, upside exposure is provided by the long call and downside risk is provided by the short put it is possible to value a firm's capital structure using a structural model based on put-call parity: we assume the assets of the firm are the underlying, the strike price is the face value of debt, and the expiration date of the option is the debt's maturity; the value of equity (residual stake after debt is paid) is the value of the call option on the underlying i.e. the firm's assets: firm's debt = assets - call = risk-free bond - put firm's equity = call = assets + put - risk-free bond i) firm's risky debt valued via call option view of capital structure: risky debt is equivalent to short a call and long the asset i.e. covered call ii) firm's risky debt valued via put option view of capital structure i.e. Merton's structural model: risky debt is equivalent to owning risk-free debt and writing a put option on the firm's assets, the premium of which is based on the riskiness of those assets put-call parity can be used to create a riskless cash flow i.e. a hedge inf the form of a riskless bond: the result is a riskless cash flow equal to the strike price at expiration (option strike prices and expiration dates must be equal)

activist strategy

an event-driven strategy that aims to influence shareholder voting rights to impact corporate governance in a way that maximizes shareholder value active initiators, active followers, and passive followers three common agendas for activist investors to maximize shareholder wealth: - change management compensation and reduce interlocking boards - alter capital structure or dividend policy - execute mergers and/or divestitures of non-core assets

intellectual property

an intangible asset that can be owned; some are excludable goods (others are prevented from accessing them) e.g. copyrights, patents; some gain value over time e.g. art while some are wasting assets e.g. patents; discounted cash flow model like constant growth model applied to stock valuation is the best way to value IP

exchange option

an option to exchange one risky asset for another risky asset; in the parlance of real assets, the strike price is determined by the costs of deliverables (costs incurred by the option buyer to convert one real asset to another e.g. natural resources to commodities) and the resulting output is known as the receivables value of the option varies over time based on: 1) correlation between deliverables price and receivables price 2) volatility of the deliverables' prices 3) volatility of the receivables' price moneyness of option is based on the ratio of the receivables price relative to the deliverables cost (must be greater than 1) intrinsic value of option is the maximum of zero and the amount by which the option is in the money prior to expiration, an option has time value in addition to any intrinsic value; the time value of an option is the amount by which the option price exceeds the intrinsic value option price = intrinsic value + time value this value in excess of intrinsic value comes from the value of being able to wait to exercise the option

barrier option

an option with a range of payoffs (path dependent) such that a change in payoff occurs if the underlying asset reaches a specific level during a specific time; barrier options have two components: the barrier - the price and time at which the option is activated - and the strike price or terms of the underlying option a knock-in option becomes active if the underlying asset reaches a specific level (the barrier) at any point before expiration - known as being knocked "in"; once activate, payoff is determined by strike price; can either be a put or call a knock-out option terminates if the underlying asset reaches a specific level (the barrier) - referred to as being knocked ""out"; can either be a put or call "up" and "down" refers to the direction the underlying asset price must move to reach the barrier and become active e.g. an up and in call option is a knock-in option where the call becomes active ("in") once the underlying price moves "up" and passes the barrier

volatility arbitrage

attempt to capitalize on differences in the implied volatility between option prices on a particular stock manager compares anticipated volatility (based on historical observations) to implied volatility; if anticipated volatility is greater than implied volatility, option is undervalued and manager takes a long position; conversely if anticipated volatility is less than implied volatility, option is overvalued and manager takes a short position traders take long positions in options to place directional bets on underlying assets: have limited downside risk, have positive skew, and provide leverage traders short options when they perceive that volatility is mispriced (implied volatility is not in-line with expected volatility making the option premium either too high or too low)

relative value strategy

attempt to predict changes in spreads between related prices or rates; establish hedged positions i.e. long and short therefore contains little market risk and tends to profit during normal market conditions when valuations converge to their equilibrium levels and volatility is low --> relative value is a convergence strategy; price and rates convergence tends to be small so managers use leverage to magnify returns large losses occur during market crises when investors seek safe-haven assets and volatility increases and spreads widen

dispersion trade (short correlation trade)

built on the assumption that realized correlations in market aggregates such as indices will be lower than implied correlations --> because correlation is a component of variance, this is the same as saying that realized vol will be lower than implied vol --> bet that options on market aggregates are overvalued --> take long positions in options of individual equities and a short position in option of related index such that the combined positions are market neutral profits are associated with LOW levels of realized correlation and losses are associated with HIGH levels of realized correlation

cash and carry

commodity derivatives arbitrage strategy in a cash and carry, the trader perceives the basis to be overly priced (basis is too wide i.e. forward is overpriced) and wants to short the basis --> sell the forward contract short, borrow at the risk-free rate to buy the spot, once at forward maturity deliver against short position using spot in a reverse cash and carry, the trader perceives the basis to be under priced (basis is too thin i.e. forward is underpriced) and wants to buy the basis --> buy the forward contract, sell the spot short and use the proceeds to earn the risk-free rate, and once at forward maturity take delivery of the asset to cover short position

cost of carry model of forward contract pricing

cost of carry refers to the cost involved with holding an asset until expiration of the forward contract and includes both the cost of storing the asset and the opportunity costs associated with using capital to purchase the asset any difference between the spot and forward price is due to the cost of carry, which causes the term structure of forward prices to have a slope (arbitrage ensures this) the costs and benefits of direct ownership today versus derivatives ownership (in the future via a forward) determines the arbitrage-free pricing relationships between underlying assets and their associated forward contracts: costs of direct ownership today (opportunity cost of capital and storage costs of a commodity) are added to the spot price (because these are costs not borne by the investor when asset is purchased forward) and benefits of direct ownership (dividends or convenience yield) are subtracted from the spot price (because these are benefits not enjoyed by purchasing asset forward)

market types

primary - relate to the sale of newly issued securities (including secondary issues and securitizations) secondary - where securities trade after their initial issuance; consist of both physical exchanges and OTC markets third - a subset of the OTC market where participants make markets in and trade exchange-listed securities fourth - describe the direct exchange of securities between investors without using the services of a broker/intermediary; facilitated by electronic communication network (ECN)

option greeks

delta - first derivative of an option's price with respect to the price of the underlying --> the change in the value of the option with respect to a change in the underlying asset; for a far-out-of-the-money option, deltas are close to 0, for options deep-in-the-money delta is close to 1; delta is the hedge ratio - the number of shares an investor long a call option must be short in order to delta-neutralize the option position i.e. make the option position's value insensitive to small changes in the underlying gamma - the second derivative of an option's price with respect to the underlying asset --> the change in value of the option with respect to changes in delta; gamma determines the curvature (convexity) of the option-underlying relationship theta - the first derivative of an option's price with respect to the time to expiration --> the sensitivity of the option's price with respect to changes in time (the passage of time); theta is NEGATIVE for a long option position because the passage of time decreases option's value; theta captures the loss of value in hedged options positions i.e. positions that are delta and vega neutral; theta is greater for short-dated options given the negative convexity of the option value-time relationship delta-neutralization only holds for small changes in the underlying because of positive gamma (increases in the stock price increase delta) --> as stock price increases (decreases) the number of shares that need to be sold short as a hedge increases (decreases); this is is known as dynamic delta hedging price changes for convertible bonds (for options) are nonlinear due to convexity i.e. changes in the underlying result in greater changes in the convertible bond/option price --> essential to determine the gamma and theta if a delta-neutral position will produce a profit: in order for a delta-neutral option to profit, the position MUST MAKE MORE MONEY ON GAMMA THAN WHAT IS LOST BY THETA

option Greeks

delta - sensitivity of the option price to changes in the price of the underlying security gamma - sensitivity of the option price to changes in the rate of delta (second derivative) vega - measures the sensitivity of the option price to changes in the price volatility of the underlying theta - measures the sensitivity of the option price to changes in the time to expiration (passage of time) rho - measures sensitivity of the option price to changes in the risk-free rate

multifactor asset pricing model

describes the relationship between expected returns of assets and the assets' exposures to multiple risk factors, and therefore better explain systematic risk than single factor models risk factors are derived theoretically (logic that captures behavior) or empirically (historically observed) application to non-equity alternative investments has been limited e.g. CAPM cannot explain alternative asset pricing because alternatives have large idiosyncratic risks that are not easily diversified away

Fama French

empirical multifactor model based on three factors: market beta, market capitalization (SMB), and book-to-market ratio (HML) subsequently added the Carhart momentum factor (UMD)

event-driven strategy

event-driven hedge fund managers speculate on security price movements related to events (event risk) associated with asymmetric information in the markets; have payoffs similar to selling insurance or writing out of the money options; thus, return distributions are negatively skewed and leptokurtic; most event-driven strategies have high correlation with traditional assets and therefore have limited diversification benefits; the two most common strategies are merger arbitrage and distressed securities insurance selling perspective: event-driven managers seek the the risk premium associated with selling insurance against event risk e.g. failed merger binary option perspective: 1) long binary call option - gains if merger takes place and loses if the option expires worthless if the merger doesn't take plae 2) short a binary put option - event-driven funds write put options have payouts consistent with writing out-of-the money options: modest gains and large losses

calendar spread

ex ante apha strategy that combines a long forward position and a short forward position on the same underlying asset but with different expiration dates; an implicit bet on the shape and slope of the forward term structure and an attempt to earn profits from the relative mispricing between related contracts; slope changes in the forward price term structure and carrying cost changes drive returns on calendar spreads; similar to a curve steepener or flattener calendar spread = F(T + t) - F(T) spot price change causes parallel term structure shift while cost of carry changes cause slope changes in the term structure

variance swap

forward contracts based on the variance of a price or rate; bets on volatility variance swap buyer agrees to pay variance swap seller a cash price known as the strike variance (determined at the outset) in exchange for receiving realized variance; long swap position (swap buyer) believes volatility is underpriced: betting that future realized variance is greater than current expected variance i.e. implied volatility (opposite view for the swap seller) the difference between realized variance and strike variance is multiplied by the variance notional value to determine the cash payment; variance notional value can be imputed from vega notional value

conditional heteroskedasticity

heteroskedasticity (non-constant variance) related to the level of (conditional on) the independent variables --> exists if the variance of the dependent variables changes as the value of the independent variables changes

term structure of forwards

in a simple scenario with no interest costs and dividends (r and d = 0) or if interest costs equal dividends (r = d) forward prices equal spot prices and the term structure is flat when interest rates exceed the dividend rate (r > d, or generally when costs of direct ownership exceed the benefits) forward prices are greater than spot prices and the term structure is upward sloping (referred to as contango) when the dividend rate exceeds the interest rate (r < d, or generally when benefits of direct ownership exceed costs) forward prices are lower than spot prices and the term structure is downward sloping (referred to as backwardation)

margin terminology

initial margin - collateral that must be deposited to trade derivatives; generally, less than 10% of the full contract price (leverage) maintenance margin requirement is the amount of margin that must be maintained in a futures account for open positions; if the margin balance falls below the maintenance margin, cash mush be deposited to bring the margin balance back up to the INITIAL MARGIN REQUIREMENT increases or decreases in the trader's margin account are called the variation margin; positive (negative) variation margin adds to (reduces) the equity in the margin account

portable alpha

involves exploiting opportunities to increase alpha while simultaneously managing beta exposure to a target level (because pursuing alpha opportunities unhedged results in unwanted exposure to systematic risk) Example: Portfolio manager has the S&P 500 as the benchmark for its strategic allocation; invests in small-cap stocks to generate alpha 1) Invest cash in the small-cap strategy to generate positive alpha 2) Take a short position in a small-cap index using futures contracts to offset small-cap risk 3) Take a long position in the S&P 500 via futures and bring systematic risk exposure back in line with the benchmark (S&P 500) The long and short futures position ensure that the alpha portfolio's returns are purely a result of managerial skill and not unwanted exposure to small cap beta or mis-alignment of systematic exposure --> the idea is to earn alpha while hedging away the risk of the alpha generating strategy; the net result is the systematic risk of the portfolio's benchmark with the return of the benchmark plus the alpha generated by active management

convertible bond arbitrage

involves purchasing a company's convertible bonds with the simultaneous short sale of the company's common stock; the short sale of the stock eliminates some or all of the equity exposure in the convertible bond convertible bond contains an embedded call option giving the bondholder the right to receive common stock convertible bond value = straight bond value + call option value convertible bonds can be valued using the unbundled approach, which divides the convertible bond into its debt security and equity call option components the key to traditional convertible bond arbitrage is to buy convertible bonds with underpriced conversion options (implied volatility too low compared to realized volatility) and short sell convertible bonds with overpriced conversion options (implied vol is too high compared to realized vol) and maintain delta hedges to neutralize market risk

four categories of institutional-quality alternative assets

real assets, hedge funds, private equity, structured products

single option strategy payoffs

long call: unlimited upside, limited downside (premium paid) short call: limited upside (premium earned), unlimited downside long put: limited upside (difference between strike and 0), limited downside (premium paid) short put: limited upside (premium earned), limited downside (difference between strike and 0) covered call: long underlying security, short call option; obligation to deliver covered by long security, limited upside, limited downside --> similar payoff to short put protective put: long underlying security and long put option; unlimited upside, limited downside --> similary payoff to long call

smoothing

lower volatility of prices and returns due to real assets being valued on an appraisal basis (they are not traded on an exchange i.e. no daily mark to market); this makes real assets look less risky than they might be smoothing also makes correlations to unsmoothed returns lower, making the benefits f diversification greater than they actually are because appraisals are infrequent appraised values lag true market values which results in lower reported correlations which increases the perceived diversification benefits

MLPs

master limited partnership allows for publicly traded investments in operationally intensive assets; most are concentrated in the energy sector not subject to taxes at the partnership level

commodities exposure to event risk

most asset classes tend to have negative exposure to event risk, but commodities generally have positive exposure, thereby providing investors with defensive properties - shock events that hurt growth and equities (droughts, floods, wars, political instability) tend to reduce commodity supply and increase prices, thereby benefiting investors (long positions) - events that decrease commodity prices occur infrequently and are relatively less severe --> return distribution for commodities is positively skewed - events tend to affect specific commodity groups not the whole asset class --> commodities have low correlation to one another - events that benefit commodities tend to hurt stock and bonds --> commodities have low to negative correlation to traditional assets Correlation between stocks and bonds and commodities should be negative because long-term expectations of cash flows drive the former while short-term supply-demand interactions determine the latter. Also, inflation tends to hurt financial assets (erodes cash flows) but helps commodities. Because long-term expectations drive stocks and bonds while short-term expectations drive commodities, stocks and bonds tend to lead/anticipate shifts in the economic cycle while commodities reflect current conditions.

nonlinearity of returns

nonlinear relationships among asset returns and factros might arise from the market timing skills of fund managers dynamic risk exposure models examine nonlinear relationships caused by factor risk exposures that change over time (presumably because managers change them to take advantage of given market conditions) three dynamic risk exposure models: 1) dummy variable regression model - fund beta takes one of two values: an up-market beta and a down-market beta; if the difference between the up-market beta and down-market beta is significantly positive, we can conclude that the manager can time the market with skill 2) separate regressions model - analyst runs separate non-overlapping regressions to estimate betas for each regression period (each period corresponding to different market conditions) 3) quadratic curve regression model - excess returns are regressed against the square of the market excess returns, resulting in a quadratic curve regression --> a positive beta means the manager continually (hence the convexity) adjusted the beta higher as the market return increased and adjusted the beta lower as the market return fell, indicative of good timing; a negative beta is indicative of poor timing

types of asset pricing models

normative models explain how investors should behave e.g. Markowitz, positive models explain how investors actually behave theoretical models are based on logic that captures behavior vs. empirical models which are based on historical observations applied models are designed to address real world problems vs. abstract models are theoretical models designed to describe behavior, often undrealistic circumstances cross-sectional asset pricing models identify risk factors that explain differences in returns across assets vs. time series asset pricing models which are used to identify factors driving returns over time for a single security

strategies with two option positions

option spreads involve both long and short positions in either call or puts (but not both) vertical spreads utilize both long and short positions in either two calls or two puts, with each option differing in strike price: 1) bull spread combines a long position in a lower strike price call option with a short position in a higher strike price call option, creating bullish exposure bounded by the two strike prices; result is a capped gain from underlying increasing in price 2) bearish spread combines a long position in a higher strike price put option with a short position in a lower strike price put option, creating a bearish exposure bounded by the two strike prices; result is capped gain from underlying falling in price option combinations involve positions in both calls and puts; they are known as volatility strategies as the investor anticipates large swings in a security's price but does now know the direction 1) option straddle is a position in a call and a put (either both long or both short) with the same expiration date and strike price (v payoff shape) 2) option strangle is a position in a call and a put (either both long or short) with the same expiration date BUT different strike prices (hitched U payoff shape) 3) an option straddle with different signs e.g long call and short put, creates a synthetic long position in the underlying position with a straight line payoff; long put and short call would result in a synthetic short position 4) a risk reversal is an option strangle with different signs and is similar to a synthetic long position (straddle with different sign options) except the options have different strike prices, creating a break in the payoff line 5) a collar includes a long position in the underlying, a long position in a put, and a short position in a call --> investor expects minimum volatility and protects against downside but is willing to forego upside potential 6) an option collar is a long position in an out of the money put and short in an out of the money call; the short position of a risk reversal and has the payoff of a bull spread

term structure of forward prices

refers to the relationship between forward prices and time contango refers to a price pattern where forward prices are above the spot price and converge to the spot price from above over time; upward sloping forward curve backwardation refers to a price pattern where forward prices are less than the spot price and converge to the spot price from below; downward sloping forward curve differences between the spot price and forward price are due to the cost of carry (cost of financing, storage costs, convenience yield) all else equal, if the cost of carry increases (financing cost, storage cost) the futures price increases costs of carry fluctuate e.g. storage costs fluctuate throughout the season, commodity shortages may increase individual convenience yields --> due to the fluctuating nature of carry costs, term structure likely takes wave form not a monotonically increasing/decreasing curve normal backwardation refers to a price pattern where the forward price is below the EXPECTED future spot price and converges to that price from below over time --> thus a long forward contract in a backwardated market is expected to earn a positive return normal contango refers to a price pattern where the forward price is above the expected future spot price and converges to that price from above over time --> a short forward contract is expected to produce a positive return (long forward contract a loss) in a normally backwardated market, hedgers tend to hold more short contracts than long contracts --> hedgers are willing to accept a lower forward price (they are sellers of commodities e.g. farmers) and provide a discount to speculators that is required for them to be short in a normally contango market, hedgers are net long forward contracts and must pay a premium above the expected future spot price (they are buyers of commodities e.g. fuel sellers) to attract speculators on the short side

moneyness

refers to the relationship between the conversion option (the strike price) and the current price of the underlying stock - busted convertible is bond with a very high conversion premium, indicating the embedded stock options are far out of the money; value of the convertible bond is similar to straight debt - hybrid convertibles have moderately sized conversion premiums, indicating that the embedded options are close to being in the money; have asymmetric payoff profiles (convexity) - equity-like convertibles have a very small conversion premium as the embedded options are in the money; trade more like the underlying stock

abnormal return persistence

refers to the tendency for idiosyncratic performance (alpha) to be positively correlated over time i.e. if the slope coefficient for a regression of current fund returns on past fund returns is positive, then good performance in the past is indicative of good performance in the future; helps dislodge the skill and luck attributes of ex post alpha: hypothesis of performance persistence is supported if the correlation between ex post alpha for period t and for period t+1 is statistically significant i.e. if evidence of serial correlation is present --> we can conclude that returns are attributable mostly to skill if evidence of return persistence is present

five structures that describe alternative assets

regulatory, securities, trading, compensation, and institutional

Black forward option pricing model

replaces the underlying security in the Black-Scholes option pricing model with the PV of the forward contract and assumes no dividends

prepayment speed

speed of prepayments is measured by the conditional prepayment rate (CPR); the PSA benchmark assumes the CPR of a 30-year mortgage is 0.2% per month, and increases by 0.2% per month until month 30, at which point it reaches a maximum of 6%

Fundamental Law of Active Management (FLOAM)

states that active management involves a tradeoff between focusing on securities with higher return opportunities and maintaining a diversified portfolio i.e. alpha versus diversification links the breadth (number of active trades) and the skill (information coefficient) of the manager to the information ratio IR = information coefficient x std.dev(breadth) IR is positively related to both skill (information coefficient) and number of active bets taken fundamental tradeoff betweeen IC and breadth: as breadth increases, IC falls; this holds because managers employ their best ranking opportunities first and as the number of active bets increases, less attractive bets are used, causing the IC to decrease inclusion of non-active bets are designed to reduce tracking error rather than to increase returns

ordinary least squares (OLS)

statistical method that derives estimates (of dependent variables) that minimize the sum of squared residuals; estimates a linear relationship between a dependent variable and independent variables most likely to generate accurate, unbiased estimates if the regression residuals are normally distributed (no significant outliers), uncorrelated, and homoskedastic (variance of the residuals is constant)

two major categories of credit models

structural credit model - values debt securities by incorporating factors including the corporate structure and the volatility of the firm's assets e.g. Merton's structural model using put-call parity reduced-form credit models use market prices for liquid securities to infer the implied default probability which is used to price illiquid securities; the reduced-form model is a risk-neutral model under a risk-neutral approach, investors are assumed to not have a preference for the amount of risk taken given a level of return - risk aversion is disregarded --> systematic risk and idiosyncratic risk are indistinguishable - risky assets can be discounted using the risk-free rate - risk-neutral probabilities of default are higher than real-life probabilities to reduce expected debt payoffs to compensate for the low discount rate used i.e. the risk-free rate

structuring, CMO / CDOs

structuring is a process of creating new securities with differing risk/return characteristics from a single investment or number of investments; structured products were made in part to meet investor demand for securities that have characteristics that cannot be met with traditional assets --> this is known as market completion CMOs differ from mortgage pools because mortgage pools usually only have one type of payout for all investors. sequential pay CMO: cash flows first go to pay coupon yields for each tranche in order of seniority - that order is known as the cash flow waterfall; any remaining cash flows are applied to the principal of each tranche in order of seniority; when principal is paid off for a tranche, it is no longer entitled to any cash flows; if there are losses/defaults, those accrue to the tranches in the opposite order of the waterfall i.e. the most junior tranches absorb the losses first in a CDO, the equity tranche receives all residual CFs after the senior and mezzanine tranches have received their coupon payments attachment and detachment points give an indication of a tranche's relative size t other tranches and its loss position e.g. a 5%/20% mezzanine tranche indicates that a loss of 5% (the lower attachment point) to the CDO collateral is necessary to begin eroding the value of that tranche and a 20% (the upper attachment point) collateral loss is necessary to wipe out the tranche's value completely tranches of a CDO can be modeled using options: the senior tranche cane be seen as the debt of a firm: covered call position i.e. a risk-free bond and a short put the equity tranche is seen as equity of a firm: a long call option position i.e. a financed long position (long asset, short risk-free asset) in the underlying combined with a long put the mezzanine tranche can be seen as either a bull call spread, bull put spread, or a collar interest-only tranches (IO) are most sensitive to interest rate changes; the value of the tranche will increase as interest rates rise and prepayments slow as this extends the longevity of the coupon payment stream principal-only tranches are less sensitive to interest rate changes; the value of the tranche will decrease as interest rates rise and prepayments slow as principal cash flows are pushed further out into the future, decreasing their values

depreciation tax shield

tax savings that results from depreciation is known as the depreciation tax shield, calculated as the present value of the tax savings from depreciation First principle of depreciation: when depreciation is not allowed as a tax-deductible expense (or if the accounting rate is less than the economic rate), the after-tax IRR will be less than the pre-tax IRR reduced by the tax rate --> intuition is that investor is paying taxes earlier than they are due , providing an interest-free loan to the government Second principle of depreciation: when depreciation is allowed as a tax-deductible expense and the accounting rate is equal to the economic rate, the after-tax IRR will be equal to the pre-tax IRR reduced by the tax rate Third principle of depreciation: when depreciation is allowed and the accounting rate is higher than the economic rate, the after-tax IRR will be higher than the pre-tax IRR reduced by the tax rate --> intuition is that investor is deferring taxes, government is providing an interest-free loan to the investor Fourth principle of depreciation: if the entire capital expenditure can be expensed upfront i.e. asset is fully depreciated, the after-tax IRR will be approximately equal to the post-tax IRR --> intuition is that fully expensing provides the same benefit to the investor as not paying taxes General principle: depreciation for tax accounting does not change the total taxes paid, just the timing; given the TVM the sooner the firm depreciates (accelerated depreciation, tax rate > economic rate), the earlier the tax savings and the higher the after-tax IRR

alpha

the return earned in excess of the risk-adjusted benchmark; can be categorized into two types: 1) ex ante alpha is a forecast of incremental return after adjusting for TMV and systematic effects; the return attributable to manager skill 2) ex post alpha measures the realized (actual) excess return; may be attributable to skill, luck, or both ex post alpha is observable, ex ante alpha is not alpha attributable to manager skill = ex ante alpha - ex post alpha in most cases, performance is attributable to a commingling of alpha and beta

real estate investment trusts (REITS)

trade on stock exchanges; at least 75% of income must be real estate derived and 90% of income paid to investors as dividends to be considered a REIT and be eligible for no corporate taxation three types: 1) equity REITs - own equity of underlying properties and often add value by developing properties; returns are derived from rental and lease payments 2) mortgage REITs - invests in loans used to finance property purchases and is essentially a mortgage lender; returns derived from loan interest 3) hybrid REITs - combination of both

currency option pricing model

two risk-free rates for each of the two currencies being exchanged; model prices an option that exchanges one currency (and its associated risk free rate) for x units of another currency (and its associated risk free rate)

global macro strategy

typically a discretionary strategy, are opportunistic in nature, and use a top-down approach to analyze and invest in global macroeconomic themes are most profitable when market events/macro variables are volatile and markets exhibit uncertainty three primary risks are market risk, event risk, and leverage risk

managed futures/CTAs strategy

typically systematic in nature, based on technical analysis of asset prices, and employ trend-following techniques common strategies are: 1) trend-following - attempt to exploit predictable price patterns after the trend has begun; employs moving averages and channel breakouts 2) non-trend following strategies - attempt to exploit perceived inconsistencies in futures prices e.g. market anomalies and countertrend strategies (uses RSI) 3) relative value - exploits pricing inefficiencies between two related futures contracts (can employ RSI but price differences are based on two contracts not on one security or index as in countertrend strategies) conceptual rationale for excess returns for CTAs is that they play a valuable role as speculators in futures markets and provide a service to natural hedgers

gearing

use of leverage in in a real estate fund; will magnify the returns and losses common ratio used to measure the amount of gearing employed is the LTV ratio, often referred to as the debt-to-assets ratio, which is used to impute debt-to-equity

Black-Scholes call option pricing model

values a call option as a function of the security price, the option strike price, the volatility of the security returns, the option's time to expiration, and the risk-free rate

general option pricing model

values an option on a portfolio that contains both long and short positions

forms of market efficiency

weak form efficiency - asset prices reflect all available historical data on prices and volumes; cannot earn superior returns using technical analysis semistrong form efficiency - asset prices reflect all publicly available information; cannot earn superior returns with either technical or fundamental analysis strong from efficiency - asset prices reflect all publicly and privately available information; no investor can earn superior returns market efficiency affected by: asset size, trade frequency, trading frictions, regulations, information access, valuation accuracy