Derivatives & Alternative Investments

Consider a call option selling for $4 in which the exercise price is $50 Determine the value at expiration and the profit for a seller if the price of the underling at expiration is $49. $4 $0 -$1

A is correct. -CT = -Max(0,ST − X) = -Max(0,49 − 50) = 0 Π = -CT + C0 = −0 + 4 = 4

Credit default swap (CDS)

A type of credit derivative in which one party, the credit protection buyer who is seeking credit protection against a third party, makes a series of regularly scheduled payments to the other party, the credit protection seller. The seller makes no payments until a credit event occurs.

Which of the following statements most accurately describes exchange-traded derivatives relative to over-the-counter derivatives? Exchange-traded derivatives are more likely to have: greater credit risk. standardized contract terms. greater risk management uses.

B is correct. Standardization of contract terms is a characteristic of exchange-traded derivatives. A is incorrect because credit risk is well-controlled in exchange markets. C is incorrect because the risk management uses are not limited by being traded over the counter.

Consider a call option selling for $4 in which the exercise price is $50 Determine the value at expiration and the profit for a seller if the price of the underling at expiration is $52. -$2 $5 $2

C is correct. -CT = -Max(0,ST − X) = -Max(0,52 − 50) = −2 Π = -CT + C0 = −2 + 4 = 2

Forward commitments subject to default are: forwards and futures. futures and interest rate swaps. interest rate swaps and forwards.

C is correct. Interest rate swaps and forwards are over-the-counter contracts that are privately negotiated and are both subject to default. Futures contracts are traded on an exchange, which provides a credit guarantee and protection against default. A is incorrect because futures are exchange-traded contracts which provide daily settlement of gains and losses and a credit guarantee by the exchange through its clearinghouse. B is incorrect because futures are exchange-traded contracts which provide daily settlement of gains and losses and a credit guarantee by the exchange through its clearinghouse.

Which of the following statements is true about contingent claims? Either party can default to the other. The payoffs are linearly related to the performance of the underlying. The most the long can lose is the amount paid for the contingent claim.

C is correct. The maximum loss to the long is the premium. The payoffs of contingent claims are not linearly related to the underlying, and only one party, the short, can default.

Out of the money

Options that, if exercised, would require the payment of more money than the value received and therefore would not be currently exercised.

Option premium

The amount of money a buyer pays and seller receives to engage in an option transaction. It represents a fair price of the option, and in a well-functioning market, it would be the value of the option. Consistent with everything we know about finance, it is the present value of the cash flows that are expected to be received by the holder of the option during the life of the option.

Maintenance margin

The minimum amount that is required by a futures clearinghouse to maintain a margin account and to protect against default. Participants whose margin balances drop below the required maintenance margin must replenish their accounts.

Settlement

The process that occurs after a trade is completed, the securities are passed to the buyer, and payment is received by the seller.

Which of the following statements about derivatives is not true? They are created in the spot market. They are used in the practice of risk management. They take their values from the value of something else.

A is correct. Derivatives are used to practice risk management and they take (derive) their values from the value of something else, the underlying. They are not created in the spot market, which is where the underlying trades.

Which of the following statements regarding commodity derivatives is correct? The primary commodity derivatives are futures. Commodities are subject to a set of well-defined risk factors. Commodity traders and financial traders today are distinct groups within the financial world.

A is correct. The primary commodity derivatives are futures, but forwards, swaps, and options are also used. B is incorrect because the commodity market is extremely large and subject to an almost unimaginable array of risks. C is incorrect because commodity and financial traders have become relatively homogeneous since the creation of financial futures. Historically, commodity traders and financial traders were quite different groups, and there used to be a tendency to think of the commodity world as somewhat separate from the financial world.

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.

Margin call

A request for the short to deposit additional funds to bring their balance up to the initial margin.

Which of the following derivatives is classified as a contingent claim? Futures contracts Interest rate swaps Credit default swaps

C is correct. A credit default swap (CDS) is a derivative in which the credit protection seller provides protection to the credit protection buyer against the credit risk of a separate party. CDS are classified as a contingent claim. A is incorrect because futures contracts are classified as forward commitments. B is incorrect because interest rate swaps are classified as forward commitments.

Exchange-traded derivatives are: largely unregulated. traded through an informal network. guaranteed by a clearinghouse against default.

C is correct. Exchanged-traded derivatives are guaranteed by a clearinghouse against default. A is incorrect because traded derivatives are characterized by a relatively high degree of regulation. B is incorrect because the terms of exchange-traded derivatives terms are specified by the exchange.

Contingency claims

Derivatives in which the payoffs occur if a specific event occurs; generally referred to as options.

In the money

Options that, if exercised, would result in the value received being worth more than the payment required to exercise.

Mark to market

The revaluation of a financial asset or liability to its current market value or fair value. aka Daily Settlement

Margin

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.

Credit-linked note (CLN)

Fixed-income security in which the holder of the security has the right to withhold payment of the full amount due at maturity if a 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.

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. Commitment!! Forwards are customized, less transparent, less regulated, and subject to higher counterparty default risk. The value of a forward contract is the spot price of the underlying asset minus the present value of the forward price.

Compared with the underlying spot market, derivative markets are more likely to have: greater liquidity. higher transaction costs. higher capital requirements.

A is correct. Derivative markets typically have greater liquidity than the underlying spot market as a result of the lower capital required to trade derivatives compared with the underlying. Derivatives also have lower transaction costs and lower capital requirements than the underlying.

A credit derivative is a derivative contract in which the: clearinghouse provides a credit guarantee to both the buyer and the seller. seller provides protection to the buyer against the credit risk of a third party. the buyer and seller provide a performance bond at initiation of the contract.

B is correct. A credit derivative is a derivative contract in which the credit protection seller provides protection to the credit protection buyer against the credit risk of a third party. A is incorrect because the clearinghouse provides a credit guarantee to both the buyer and the seller of a futures contract, whereas a credit derivative is between two parties, in which the credit protection seller provides a credit guarantee to the credit protection buyer. C is incorrect because futures contracts require that both the buyer and the seller of the futures contract provide a cash deposit for a portion of the futures transaction into a margin account, often referred to as a performance bond or good faith deposit.

A derivative is best described as a financial instrument that derives its performance by: passing through the returns of the underlying. replicating the performance of the underlying. transforming the performance of the underlying.

C is correct. A derivative is a financial instrument that transforms the performance of the underlying. The transformation of performance function of derivatives is what distinguishes it from mutual funds and exchange traded funds that pass through the returns of the underlying. A is incorrect because derivatives, in contrast to mutual funds and exchange traded funds, do not simply pass through the returns of the underlying at payout. B is incorrect because a derivative transforms rather than replicates the performance of the underlying.

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.

Risk management

The process of identifying the level of risk an organization wants, measuring the level of risk the organization currently has, taking actions that bring the actual level of risk to the desired level of risk, and monitoring the new actual level of risk so that it continues to be aligned with the desired level of risk.

hedge portfolio

A hypothetical combination of the derivative and its underlying that eliminates risk.

Relative to traditional investments, alternative investments are least likely to be characterized by: high levels of transparency. limited historical return data. significant restrictions on redemptions.

A is correct. Alternative investments are characterized as typically having low levels of transparency.

Risks in infrastructure investing are most likely greatest when the project involves: construction of infrastructure assets. investment in existing infrastructure assets. investing in assets that will be leased back to a government.

A is correct. Infrastructure projects involving construction have more risk than investments in existing assets with a demonstrated cash flow or investments in assets that are expected to generate regular cash flows.

Holding other factors constant, the value of a European put option will most likely decrease as the: risk-free interest rate increases. volatility of the underlying increases. value of the underlying decreases.

A is correct. The value of a European put option will decrease as the risk-free interest rate increases.

When the price of the underlying is below the exercise price, a put option is: in-the-money. at-the-money. out-of-the-money.

A is correct. When the price of the underlying is below the exercise price for a put, the option is said to be in-the-money. If the price of the underlying is the same as the exercise price, the put is at-the-money and if it is above the exercise price, the put is out-of-the-money.

drawdown

A percentage peak-to-trough reduction in net asset value.

Notional principal

An imputed principal amount. principal amount used to calculate swap payments, ordinarily matches the loan balance

Which approach is most commonly used by equity hedge strategies? Top down Bottom up Market timing

B is correct. Most equity hedge strategies use a bottom-up strategy.

Which of the following pieces of information is not conveyed by at least one type of derivative? The volatility of the underlying The most widely used strategy of the underlying The price at which uncertainty in the underlying can be eliminated

B is correct. Options do convey the volatility of the underlying, and futures, forwards, and swaps convey the price at which uncertainty in the underlying can be eliminated. Derivatives do not convey any information about the use of the underlying in strategies.

The price of a forward contract most likely: decreases as the price of the underlying goes up. is constant and set as part of the contract specifications. increases as market risk increases.

B is correct. The price of a forward contract remains constant throughout the life of the contract. It is set as part of the contract specifications.

The underlying in a forward rate agreement is most likely a(n): growth rate of an equity index. interest rate. exchange rate.

B is correct. The underlying in a forward rate agreement is an interest rate.

An investor who requires no premium to compensate for the assumption of risk is said to be which of the following? Risk seeking Risk averse Risk neutral

C is correct. Risk-seeking investors give away a risk premium because they enjoy taking risk. Risk-averse investors expect a risk premium to compensate for the risk. Risk-neutral investors neither give nor receive a risk premium because they have no feelings about risk.

If the present value of the payments in a forward contract or swap is not zero, which of the following is most likely to be true? The contract cannot legally be created. The contract must be replicated by another contract with zero value. The party whose stream of payments to be received is greater has to pay the other party the present value difference.

C is correct. The party whose stream of payments to be received is greater has to pay the other party the present value difference. Such a contract can legally be created, but the party receiving the greater present value must compensate the other party with a cash payment at the start. Replication is never required.

portfolio company

In private equity, the company in which the private equity fund is investing.

Later-stage financing

(expansion VC) is provided after commercial production and sales have begun but before an IPO takes place. Funds may be used to support initial growth, a major expansion (such as a physical plant upgrade), product improvements, or a major marketing campaign.

Catch-up clause

A clause in an agreement that favors the GP. For a GP who earns a 20% performance fee, a catch-up clause allows the GP to receive 100% of the distributions above the hurdle rate until she receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP.

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.

Public-private partnership (PPP)

An agreement between the public sector and the private sector to finance, build, and operate public infrastructure, such as hospitals and toll roads.

Put-call parity

An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices. S0 + p0 = c0 + X / (1+r)^T

In efficient financial markets, risk-free arbitrage opportunities: will not exist. may persist in the long run. may exist temporarily.

C is correct. In efficient financial markets, risk-free arbitrage opportunities may exist temporarily, but their continuous exploitation will eliminate these arbitrage opportunities in the long run.

Funds of hedge funds

Funds that hold a portfolio of hedge funds, more commonly shortened to funds of funds.

Co-investing

In co-investing, the investor invests in assets indirectly through the fund but also possesses rights (known as co-investment rights) to invest directly in the same assets. Through co-investing, an investor is able to make an investment alongside a fund when the fund identifies deals.

Fund investing

In fund investing, the investor invests in assets indirectly by contributing capital to a fund as part of a group of investors. Fund investing is available for all major alternative investment types.

Brownfield investment

Investing in existing infrastructure assets.

Greenfield investment

Investing in infrastructure assets that are to be constructed. Greenfield investors typically invest alongside strategic investors or developers who specialize in developing the underlying assets.

Fill in the blank: The goal of hedge fund redemption restrictions is typically to ___________ manager flexibility.

The goal of hedge fund redemption restrictions is typically to increase hedge fund manager flexibility.

Notice periods

The length of time (typically 30 to 90 days) in advance that investors may be required to notify a fund of their intent to redeem some or all of their investment.

Carry

The net of the costs and benefits of holding, storing, or "carrying" an asset.

Describe a risk of farmland that distinguishes it from real estate investment in raw land.

There are two significant risks differentiating farmland from raw land investment: Weather is a more unique and exogenous risk for farmland, with drought or flooding dramatically decreasing many crop yields and thus the expected income stream. Productive land generates globally traded and consumed commodities. This international competitive landscape can result in interruptions in world trade, growing foreign agricultural competition, and resulting declines in crop prices.

Secondary sales

This approach represents a sale of the company to another private equity firm or another group of investors. With the growth of "dry powder", we have seen an increase in the proportion of secondary sales exits.

Venture capital funds

a specialized form of private equity that typically involves investing in or providing financing to startup or early-stage companies with high growth potential, represent a small portion of the private equity market.

Sortino Ratio

excess return divided by lower partial standard deviation The Sortino ratio uses downside deviation, and therefore will capture the effects of negative skewness better than measures that use standard deviation. However, the Sharpe and Sortino risk measures alone still do not take into account the correlation of alternative assets with the traditional assets that their inclusion in the portfolio may be intended to hedge.

Fill in the blank: Fund offering documents typically offer terms that include a ___________, whereby incentive fees will accrue, and subsequently be paid, only on new earnings above and beyond the recoupment of any prior losses.

high-water mark

Sharpe ratio

ratio of portfolio risk premium to standard deviation The Sharpe ratio is probably the first basic intuitive metric that some people use to evaluate an alternative investment.. The single biggest flaw, however, in a dependence on the Sharpe ratio is probably the underlying assumption of normally distributed returns. Given that caveat and taken by itself as a simple starting point, an attractive Sharpe ratio for an alternative strategy might be deemed to be anywhere between 1.0 and 2.0. Getting twice the return per unit of risk is generally quite attractive and hard to achieve; getting only a single unit of return for a unit of risk (a Sharpe ratio of 1.0) might be deemed acceptable but not overwhelmingly compelling, unless the strategy in question also has negative correlation attributes compared with other strategy areas in a portfolio, as with macro or CTA managers.

put-call-forward parity

the cost of the fiduciary call must equal the cost of the synthetic protective put F0(T) / (1+r)^T + p0 = c0 + X/(1+r)^T

Is the following statement true or false? The Sharpe and Sortino ratios share the same denominator

the statement is false. The Sharpe and Sortino ratios share the same numerator—average annualized return net of the risk free-rate. Their denominators are different. The denominator for the Sharpe ratio is standard deviation of returns, and the denominator for the Sortino ratio is downside deviation of returns—a semi-deviation measure of volatility only during periods of loss for an alternative investment.

Consider a put option selling for $4 in which the exercise price is $60 and the price of the underlying is $62. Determine the value at expiration and the profit for a put buyer under the following outcomes: 1. The price of the underlying at expiration is $62. 2. The price of the underlying at expiration is $55.

1. If the price of the underlying at expiration is $62, The put buyer's value at expiration = pT = Max(0,X − ST) = Max(0,60 − 62) = $0. The put buyer's profit = Π = pT − p0 = 0 − 4 = -$4. 2. If the price of the underlying at expiration is $55, The put buyer's value at expiration = pT = Max(0,X - ST) = Max(0,60 − 55) = $5. The put buyer's profit = Π = pT − p0 = 5 − 4 = $1.

Margin bond (performance bond)

A cash deposit required by the clearinghouse from the participants to a contract to provide a credit guarantee. Also called a performance bond. Derivatives clearinghouses manage these deposits, occasionally requiring additional deposits, so effectively that they have never failed to pay in the nearly 100 years they have existed.

Credit derivatives

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.

Which of the following characterizes forward contracts and swaps but not futures? They are customized. They are subject to daily price limits. Their payoffs are received on a daily basis.

A is correct. Forwards and swaps are OTC contracts and, therefore, are customized. Futures are exchange traded and, therefore, are standardized. Some futures contracts are subject to daily price limits and their payoffs are received daily, but these characteristics are not true for forwards and swaps.

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. Unfortunately, even that definition does not cover every unique aspect of options. For example, options can be created in the OTC market and customized to the terms of each party, or they can be 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. Exchange-traded options are protected against default by the clearinghouse of the options exchange and are relatively transparent and regulated at the national level. As noted in the definition above, options can be terminated early or at their expirations. When an option is terminated, either early or at expiration, the holder of the option chooses whether to exercise it. If he exercises it, he either buys or sells the underlying asset, but he does not have both rights.

A plain vanilla interest rate swap is also known as: a basis swap. a fixed-for-floating swap. an overnight indexed swap.

B is correct. A plain vanilla swap is a fixed-for-floating interest rate swap, which is the most common type of swap. A is incorrect because a basis swap is a transaction based on the TED spread (T-bills versus Eurodollars) and is not the same as a plain vanilla swap. C is incorrect because an overnight indexed swap is a swap that is tied to a federal funds type of rate, reflecting the rate at which banks borrow overnight, and is not the same as a plain vanilla swap.

Which of the following statements best portrays the full implementation of post-financial-crisis regulations in the OTC derivatives market? Transactions are no longer private. Most transactions need to be reported to regulators. All transactions must be cleared through central clearing agencies.

B is correct. With full implementation of these regulations in the OTC derivatives market, most OTC transactions need to be reported to regulators. A is incorrect because although under full implementation of the regulations information on most OTC transactions needs to be reported to regulators, many transactions retain a degree of privacy with lower transparency. C is incorrect because although under full implementation of new regulations a number of OTC transactions have to be cleared through central clearing agencies, there are exemptions that cover a significant percentage of derivative transactions.

Suppose you believe that the price of a particular underlying, currently selling at $99, is going to decrease substantially in the next six months. You decide to purchase a put option expiring in six months on this underlying. The put option has an exercise price of $95 and sells for $5. Determine the profit for you if the price of the underlying six months from now is $100. $0 $5 -$5

C is correct. PT = Max(0, X − ST) = Max(0,95 − 100) = 0 Π = PT − P0 = 0 − 5 = −5

Which of the following options grants the holder the right to purchase the underlying prior to expiration? American-style put option European-style call option American-style call option

C is correct. The right to buy the underlying is referred to as a call option. Furthermore, options that can be exercised prior to the expiration date are referred to as American-style options. A is incorrect because a put option grants the holder the right to sell, as opposed to buy, the underlying. B is incorrect because European-style options can only be exercised at expiration.

Benefits of derivatives

Derivative markets create beneficial opportunities that do not exist in their absence. Derivatives can be used to create strategies that cannot be implemented with the underlyings alone. For example, derivatives make it easier to go short, thereby benefiting from a decline in the value of the underlying. In addition, derivatives, in and of themselves, are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative. 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. For example, a shareholder of a company can reduce or even completely eliminate the market exposure by trading a derivative on the equity. Holders of fixed-income securities can use derivatives to reduce or completely eliminate interest rate risk, allowing them to focus on the credit risk. Alternatively, holders of fixed-income securities can reduce or eliminate the credit risk, focusing more on the interest rate risk. Derivatives permit such adjustments easily and quickly. The types of performance transformations facilitated by derivatives allow market participants to practice more effective risk management.

Mezzanine-stage financing

(mezzanine venture capital) prepares a company to go public. It represents the bridge financing needed to fund a private firm until it can complete an IPO or be sold. The term mezzanine-stage financing is used because this financing is provided at the stage between being a private company and being a public company. The focus is on when the financing occurs rather than the financing mechanism itself.

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.

Steps in Formative-stage financing

1. Pre-seed capital, or 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. 2. Seed-stage financing, or seed capital, generally supports product development and marketing efforts, including market research. This is the first stage at which VC funds usually invest. 3. Early-stage financing (early-stage VC), or start-up stage financing, is provided to companies that are moving toward operation but have not yet started commercial production or sales, both of which early-stage financing may be injected to initiate.

United Capital is a hedge fund with $250 million of initial capital. United charges a 2% management fee based on assets under management at year end and a 20% incentive fee based on returns in excess of an 8% hurdle rate. In its first year, United appreciates 16%. Assume management fees are calculated using end-of-period valuation. The investor's net return assuming the performance fee is calculated net of the management fee is closest to: (2020 Q26) 11.58%. 12.54%. 12.80%.

12.54%

Clawback

A requirement that the general partner return any funds distributed as incentive fees until the limited partners have received back their initial investment and a percentage of the total profit.

Multiple on Invested Capital (MOIC)

A simplified calculation that measures the total value of all distributions and residual asset values relative to an initial total investment; also known as a money multiple.

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.

Calmar ratio

A comparison of the average annual compounded rate of return and the maximum drawdown risk of commodity trading advisors and hedge funds. The lower the Calmar Ratio, the worse the investment performed on a risk-adjusted basis over the specified time period; the higher the Calmar Ratio, the better it performed. Generally speaking, the time period used is three years, but this can be higher or lower based on the investment in question. I: Developed by Terry W. Young in 1991, the Calmar Ratio is short for California Managed Account Reports. The ratio is very similar to the MAR Ratio, which was formulated much earlier. The only difference is that the MAR Ratio is based on data produced from the inception of the investment, whereas the Calmar Ratio is typically based on more recent and shorter-term data. Regardless of which ratio is used, investors gain better insight as to the risk of various investments.

Backwardation

A condition in the futures markets in which the spot price exceeds the futures price, the forward curve is downward sloping, and the convenience yield is high.

Contango

A condition in the futures markets in which the spot price is lower than the futures price, the forward curve is upward sloping, and there is little or no convenience yield.

Management fee

A fee based on assets under management or committed capital, as applicable—also called a base fee. typically ranging from 1% to 2% of assets under management (e.g., for hedge funds) or committed capital (e.g., for private equity funds)

Forward rate agreements (FRAs)

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. These instruments differ slightly from most other forward contracts in that the underlying is not an asset. Changes in interest rates, such as the value of an asset, are unpredictable. Moreover, virtually every company and organization is affected by the uncertainty of interest rates. Hence, FRAs are very useful devices for many companies. FRAs are forward contracts that allow participants to make a known interest payment at a later date and receive in return an unknown interest payment. In that way, a participant whose business will involve borrowing at a future date can hedge against an increase in interest rates by buying an FRA (the long side) and locking in a fixed payment and receiving a random payment that offsets the unknown interest payment it will make on its loan. Note that the FRA seller (the short side) is hedging against a decrease in interest rates. Also, consider that the FRA seller could be a lender wishing to lock in a fixed rate on a loan it will make at a future date.

Which of the following best describes the value of the forward contract at expiration? The value is the price of the underlying: minus the forward price. divided by the forward price. minus the compounded forward price.

A is correct because the holder of the contract gains the difference between the price of the underlying and the forward price. That value can, of course, be negative, which will occur if the holder is forced to buy the underlying at a price higher than the market price.

Capricorn Fund of Funds invests GBP100 million in each of Alpha Hedge Fund and ABC Hedge Fund. Capricorn Fund of Funds has a "1 and 10" fee structure. Management fees and incentive fees are calculated independently at the end of each year. After one year, net of their respective management and incentive fees, Capricorn's investment in Alpha is valued at GBP80 million and Capricorn's investment in ABC is valued at GBP140 million. The annual return to an investor in Capricorn Fund of Funds, net of fees assessed at the fund-of-funds level, is closest to: (2020 Q27) 7.9%. 8.0%. 8.1%.

A is correct because the net investor return is 7.9%, calculated as follows: First, note that "1 and 10" refers to a 1% management fee and a 10% incentive fee. End-of-year capital = GBP140 million + GBP80 million = GBP220 million. Management fee = GBP220 million × 1% = GBP2.2 million. Incentive fee = (GBP220 − GBP200) million × 10% = GBP2 million. Total fees to Capricorn = (GBP2.2 + GBP2) million = GBP4.2 million. Investor net return: (GBP220 − GBP200 − GBP4.2)/GBP200 = 7.9%.

Which of the following best describes how derivatives are priced? A hedge portfolio is used that eliminates arbitrage opportunities. The payoff of the underlying is adjusted downward by the derivative value. The expected future payoff of the derivative is discounted at the risk-free rate plus a risk premium.

A is correct. A hedge portfolio is formed that eliminates arbitrage opportunities and implies a unique price for the derivative. The other answers are incorrect because the underlying payoff is not adjusted by the derivative value and the discount rate of the derivative does not include a risk premium.

Which of the following most likely belongs in an alternative asset category? A limited partnership that takes long and short positions in publicly traded equity. Equity in an emerging market company that is traded over-the-counter. Securitized commercial real estate debt.

A is correct. A limited partnership that takes long and short positions in publicly traded equity is one type of hedge fund, a category of alternative assets. B is incorrect because traded equity, even equity that is traded over the counter, is a part of the traditional equity asset category. C is incorrect because securitized real estate debt (i.e., CMBS and RMBS) are part of the publicly traded debt universe, which is not an alternative asset.

Based on put-call parity, a trader who combines a long asset, a long put, and a short call will create a synthetic: long bond. fiduciary call. protective put

A is correct. A long bond can be synthetically created by combining a long asset, a long put, and a short call. A fiduciary call is created by combining a long call with a risk free bond. A protective put is created by combining a long asset with a long put.

What is the most significant drawback of a repeat sales index to measure returns to real estate? (2020 Q14) Sample selection bias Understatement of volatility Reliance on subjective appraisals

A is correct. A repeat sales index uses the changes in price of repeat sales properties to construct the index. Sample selection bias is a significant drawback because the properties that sell in each period vary and may not be representative of the overall market the index is meant to cover. The properties that transact are not a random sample and may be biased toward properties that changed in value. Understated volatility and reliance on subjective appraisals by experts are drawbacks of an appraisal index.

The distribution method by which profits generated by a fund are allocated between LPs and the GP is called: a waterfall. an 80/20 split. a fair division.

A is correct. Although profits are typically split 80/20 between LPs and the GP, the distribution method of profits is not called an "80/20 split." "Fair division" is not a real term that exists in the industry.

The following information applies to Rotunda Advisers, a hedge fund: $288 million in AUM as of prior year end 2% management fee (based on year-end AUM) 20% incentive fee calculated: - net of management fee - using a 5% soft hurdle rate - using a high-water mark (high-water mark is $357 million) Current-year fund gross return is 25%. Q. The total fee earned by Rotunda in the current year is closest to: (2020 Q28) $7.20 million. $20.16 million. $21.60 million.

A is correct. Although the gross return of Rotunda results in a $360 million gross NAV, the deduction of the $7.2 million incentive fee brings NAV to $352.8 million, which is below the prior high-water mark. Rotunda earns a management fee of $7.20 million but does not earn an incentive fee because the year-end fund value net of management fee does not exceed the prior high-water mark of $357 million. Since Rotunda is still also below the prior-year high-water mark, the hurdle rate of return is also basically irrelevant in this fee calculation. The specifics of this calculation are as follows: End-of-year AUM = Prior year-end AUM × (1 + Fund return) = $288 million × 1.25 = $360 million. $360 million × 2% = $7.20 million management fee. $360 million − $7.2 million = $352.8 million AUM net of management fee. The year-end AUM net of fees do not exceed the $357 million high-water mark. Therefore, no incentive fee is earned.

Why might a European put be worth less the longer the time to expiration? The cost of waiting to receive the exercise price is higher. The risk of the underlying is lower over a longer period of time. The longer time to expiration means that the put is more likely to expire out-of-the-money.

A is correct. Although the longer time benefits the holder of the option, it also has a cost in that exercise of a longer-term put comes much later. Therefore, the receipt of the exercise price is delayed. Longer time to expiration does not lower the risk of the underlying. The longer time also does not increase the likelihood of the option expiring out-of-the-money.

If the net cost of carry of an asset is positive, then the price of a forward contract on that asset is most likely: lower than if the net cost of carry was zero. the same as if the net cost of carry was zero. higher than if the net cost of carry was zero.

A is correct. An asset's forward price is increased by the future value of any costs and decreased by the future value of any benefits: F0(T) = S0(1 + r)^T − (γ − θ)(1 + r)^T. If the net cost of carry (benefits less costs) is positive, the forward price is lower than if the net cost of carry was zero.

An arbitrage opportunity is least likely to be exploited when: one position is illiquid. the price differential between assets is large. the investor can execute a transaction in large volumes.

A is correct. An illiquid position is a limit to arbitrage because it may be difficult to realize gains of an illiquid offsetting position. A significant opportunity arises from a sufficiently large price differential or a small price differential that can be employed on a very large scale.

If the risk-free rate increases, the value of an in-the-money European put option will most likely: decrease. remain the same. increase.

A is correct. An in-the-money European put option decreases in value with an increase in the risk-free rate. A higher risk-free rate reduces the present value of any proceeds received on exercise.

The loss in value of an option as it moves closer to expiration is called what? Time value decay Volatility diminution Time value of money

A is correct. An option has time value that decays as the expiration approaches. There is no such concept as volatility diminution. Time value of money relates only to the value of money at one point in time versus another.

Which of the following is a result of arbitrage? The law of one price The law of similar prices The law of limited profitability

A is correct. Arbitrage forces equivalent assets to have a single price. There is nothing called the law of similar prices or the law of limited profitability.

Arbitrage opportunities exist when: two identical assets or derivatives sell for different prices. combinations of the underlying asset and a derivative earn the risk-free rate. arbitrageurs simultaneously buy takeover targets and sell takeover acquirers.

A is correct. Arbitrage opportunities exist when the same asset or two equivalent combinations of assets that produce the same results sell for different prices. When this situation occurs, market participants would buy the asset in the cheaper market and simultaneously sell it in the more expensive market, thus earning a riskless arbitrage profit without committing any capital.

With regard to commodities, it is most likely true that: exposure is most commonly achieved via commodity derivatives. their returns are based on an income stream such as interest or dividends. they are physical products so most investors prefer to trade the actual commodity.

A is correct. Commodity exposure is most commonly accessed via commodity derivatives. B is incorrect because commodities returns are based on changes in price rather than income streams. C is incorrect because holding commodities (i.e., the physical products) incurs costs for transportation and storage. Thus, most commodity investors do not trade actual physical commodities, but rather trade commodity derivatives.

Cap rate

A metric by which real estate managers are often judged; the annual rent actually earned (net of any vacancies) divided by the price originally paid for the property.

Which of the following is not an advantage of derivative markets? They are less volatile than spot markets. They facilitate the allocation of risk in the market. They incur lower transaction costs than spot markets.

A is correct. Derivative markets are not by nature more or less volatile than spot markets. They facilitate risk allocation by making it easier and less costly to transfer risk, and their transaction costs are lower than those of spot markets.

Knowledge about the degree of risk aversion of investors is most likely needed for: the pricing of assets, but not for the pricing of derivatives. both the pricing of assets and of derivatives. the pricing of derivatives, but not for the pricing of assets.

A is correct. Derivatives pricing makes use of the fact that arbitrage opportunities guarantee that a risk-free portfolio that combines the underlying with a derivative must earn the risk-free rate. As such, no knowledge about the degree of risk aversion of investors is needed. In contrast, the pricing of assets requires knowledge of the degree of risk aversion to adequately assess risk premia.

Which of the following responds to the criticism that derivatives can be destabilizing to the underlying market? Market crashes and panics have occurred since long before derivatives existed. Derivatives are sufficiently regulated that they cannot destabilize the spot market. The transaction costs of derivatives are high enough to keep their use at a minimum level.

A is correct. Derivatives regulation is not more and is arguably less than spot market regulation, and the transaction costs of derivatives are not a deterrent to their use; in fact, derivatives are widely used. Market crashes and panics have a very long history, much longer than that of derivatives.

The effect of dividends on a stock on early exercise of a put is to: make early exercise less likely. have no effect on early exercise. make early exercise more likely.

A is correct. Dividends drive down the stock price when the dividend is paid. Thus, all else being equal, a stock paying dividends has a built-in force that drives down the stock price. This characteristic discourages early exercise, because stock price declines are beneficial to holders of puts.

A swap is equivalent to a series of: forward contracts, each created at the swap price. long forward contracts, matched with short futures contracts. forward contracts, each created at their appropriate forward prices.

A is correct. Each implicit forward contract is said to be off-market, because it is created at the swap price, not the appropriate forward price, which would be the price created in the forward market.

Conceptually, a forward rate agreement most likely allows a company that wants to invest money in the future to lock in a rate by making a: variable payment and receiving a fixed payment. fixed payment and receiving a different fixed payment. fixed payment and receiving a variable payment.

A is correct. Forward rate agreements are forward contracts that conceptually allow lenders to lock in a fixed payment on a future investment by receiving a known payment and making an unknown payment that offsets the unknown future interest payment.

Binomial model

A model for pricing options in which the underlying price can move to only one of two possible new prices.

A perfectly hedged position consisting of a derivative and its underlying asset will most likely yield a return that is: equal to the risk-free rate. smaller than the risk-free rate. greater than the risk-free rate.

A is correct. If a risk-free position earns a return that is different from the risk-free return, arbitrage will lead to the elimination of the mispricing.

To the holder of a long position, it is more desirable to own a forward contract than a futures contract when interest rates and futures prices are: negatively correlated. uncorrelated. positively correlated.

A is correct. If futures prices and interest rates are negatively correlated, forwards are more desirable to holders of long positions than are futures. This is because rising prices lead to futures profits that are reinvested in periods of falling interest rates. It is better to receive all of the cash at expiration under such conditions. If futures prices and interest rates are uncorrelated, forward and futures prices will be the same. If futures prices are positively correlated with interest rates, futures contracts are more desirable to holders of long positions than are forwards.

If the exercise price of a European put option at expiration is below the price of the underlying, the value of the option is most likely: equal to zero. less than zero. greater than zero.

A is correct. If the exercise price of a European put option is below the underlying price at expiration, the option is worthless and has a value of zero.

A hedge fund limited partnership agreement describes the general partner's total fees for each year as follows: The general partner will measure the fair value of the fund's assets at the beginning of the year (net of fees from the previous year) and the fair value of the fund's assets at the end of the year. The general partner will receive 15% of any increase in fair value in excess of the 1-year US Treasury yield at the beginning of the year. This fee structure most likely includes a: hard hurdle rate. management fee. high-water mark provision.

A is correct. In order for the general partner to earn its incentive fee, the return on the fund must exceed the Treasury yield (which is a hurdle rate), and the incentive fee is based only on the return in excess of the hurdle rate, so it is a hard hurdle rate. The general partner doesn't earn any fee regardless of performance, so there is no management fee. There is no mention of the fund's value needing to exceed its historical maximum value, so there is no high-water mark. B is incorrect because there is no fixed management fee (one that does not depend on performance). C is incorrect because there is no requirement that the fund's value exceed its previous maximum.

Compared with traditional investments, alternative investments are more likely to have: greater use of leverage. long-only positions in liquid assets. more transparent and reliable risk and return data.

A is correct. Investing in alternative investments is often pursued through such special vehicles as hedge funds and private equity funds, which have flexibility to use leverage. Alternative investments include investments in such assets as real estate, which is an illiquid asset, and investments in such special vehicles as private equity and hedge funds, which may make investments in illiquid assets and take short positions. Obtaining information on strategies used and identifying reliable measures of risk and return are challenges of investing in alternatives.

Both event-driven and macro hedge fund strategies use: long-short positions. a top-down approach. long-term market cycles.

A is correct. Long-short positions are used by both types of hedge funds to potentially profit from anticipated market or security moves. Event-driven strategies use a bottom-up approach and seek to profit from a catalyst event typically involving a corporate action, such as an acquisition or a restructuring. Macro strategies seek to profit from expected movements in evolving economic variables.

A hedge fund that implements trades based on a top-down analysis of expected movements in economic variables most likely uses a(n): macro strategy. relative value strategy. event-driven strategy.

A is correct. Macro strategies emphasize a top-down approach, and trades are made based on expected movements of economic variables.

Based on the historical record, adding alternative investments to a traditional investment portfolio consisting of publicly traded debt and equity will most likely decrease the portfolio's: liquidity. downside risk. risk-adjusted return.

A is correct. Many categories of alternative assets have low liquidity because of the fund structures used (e.g., limited partnerships for hedge funds and private equity) or high transactions costs for underlying assets (e.g., real estate). Alternative assets have generally had high downside risks. However, low correlations with traditional asset classes suggest strong diversifying potential, and high returns result in relatively strong Sharpe ratios (high risk-adjusted returns). B is incorrect because many alternative investments have exhibited high downside risks. C is incorrect because many alternative investments have exhibited strong risk-adjusted returns and low correlations with traditional asset classes.

Hedge fund losses are most likely to be magnified by a: margin call. lockup period. redemption notice period.

A is correct. Margin calls can magnify losses. To meet the margin call, the hedge fund manager may be forced to liquidate a losing position in a security, which, depending on the position size, could exert further price pressure on the security, resulting in further losses. Restrictions on redemptions, such as lockup and notice periods, may allow the manager to close positions in a more orderly manner and minimize forced-sale liquidations of losing positions.

When an arbitrage opportunity exists, what happens in the market? The combined actions of all arbitrageurs force the prices to converge. The combined actions of arbitrageurs result in a locked-limit situation. The combined actions of all arbitrageurs result in sustained profits to all.

A is correct. Prices converge because of the heavy demand for the cheaper asset and the heavy supply of the more expensive asset. Profits are not sustained, and, in fact, they are eradicated as prices converge. Locked-limit is a condition in the futures market and has nothing to do with arbitrage.

Hedge funds are similar to private equity funds in that both: are typically structured as partnerships. assess management fees based on assets under management. do not earn an incentive fee until the initial investment is repaid.

A is correct. Private equity funds and hedge funds are typically structured as partnerships where investors are limited partners and the fund is the general partner. The management fee for private equity funds is based on committed capital, whereas for hedge funds, the management fees are based on assets under management. For most private equity funds, the general partner does not earn an incentive fee until the limited partners have received their initial investment back.

Which of the following is most likely a private real estate investment vehicle? Real estate limited partnership Real estate investment trust Collateralized mortgage obligation

A is correct. Real estate limited partnerships are a form of private real estate investment. B is incorrect. Real estate investment trusts are a form of public real estate investment. C is incorrect. Collateralized mortgage obligations are a form of public real estate investment.

An arbitrageur will most likely execute a trade when: transaction costs are low. costs of short-selling are high. prices are consistent with the law of one price.

A is correct. Some arbitrage opportunities represent such small price discrepancies that they are only worth exploiting if the transaction costs are low. An arbitrage opportunity may require short-selling assets at costs that eliminate any profit potential. If the law of one price holds, there is no arbitrage opportunity.

Which of the following is most likely to be a destabilizing consequence of speculation using derivatives? Increased defaults by speculators and creditors Market price swings resulting from arbitrage activities The creation of trading strategies that result in asymmetric performance

A is correct. The benefits of derivatives, such as low transaction costs, low capital requirements, use of leverage, and the ease in which participants can go short, also can result in excessive speculative trading. These activities can lead to defaults on the part of speculators and creditors. B is incorrect because arbitrage activities tend to bring about a convergence of prices to intrinsic value. C is incorrect because asymmetric performance is not itself destabilizing.

From put-call parity, which of the following transactions is risk-free? Long asset, long put, short call Long call, long put, short asset Long asset, long call, short bond

A is correct. The combination of a long asset, long put, and short call is risk free because its payoffs produce a known cash flow of the value of the exercise price. The other two combinations do not produce risk-free positions. You should work through the payoffs of these three combinations in the form of Exhibit 12.

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. The holder of the commodity has the ability to sell it when market conditions suggest that selling is advisable and short selling is difficult.

What most likely happens when an arbitrage opportunity exists? Investors trade quickly and prices adjust to eliminate the opportunity. Risk premiums increase to compensate traders for the additional risk. Markets cease operations to eliminate the possibility of profit at no risk.

A is correct. The combined actions of traders push prices back in line to a level at which no arbitrage opportunities exist. Markets certainly do not shut down, and risk premiums do not adjust and, in fact, have no relevance to arbitrage profits.

Which of the following best describes the difference between the price of a forward contract and its value? The forward price is fixed at the start, and the value starts at zero and then changes. The price determines the profit to the buyer, and the value determines the profit to the seller. The forward contract value is a benchmark against which the price is compared for the purposes of determining whether a trade is advisable.

A is correct. The forward price is fixed at the start, whereas the value starts at zero and then changes. Both price and value are relevant in determining the profit for both parties. The forward contract value is not a benchmark for comparison with the price.

Stocks BWQ and ZER are each currently priced at $100 per share. Over the next year, stock BWQ is expected to generate significant benefits whereas stock ZER is not expected to generate any benefits. There are no carrying costs associated with holding either stock over the next year. Compared with ZER, the one-year forward price of BWQ is most likely: lower. the same. higher.

A is correct. The forward price of each stock is found by compounding the spot price by the risk-free rate for the period and then subtracting the future value of any benefits and adding the future value of any costs. In the absence of any benefits or costs, the one-year forward prices of BWQ and ZER should be equal. After subtracting the benefits related to BWQ, the one-year forward price of BWQ is lower than the one-year forward price of ZER.

A hedge fund with a market-neutral strategy restricts its investment universe to domestic publicly traded equity securities that are actively traded on an exchange or between over-the-counter brokers. In calculating net asset value, the fund is most likely to use which of the following to value underlying positions? Exchange last-trade pricing and/or averaged quotes of any available over-the-counter bid-offer spreads Average quotes adjusted for liquidity Bid price for shorts and ask price for longs

A is correct. The fund is most likely to use exchange-traded last-trade pricing (Level 1 pricing) or averaged quotes of publicly available bid-offer spreads (Level 2 pricing). The securities are actively traded, so no liquidity adjustment is required. If the fund uses bid-ask prices, it will use ask prices for shorts and bid prices for longs; these are the prices at which the positions are closed.

How does the minimum value of a call or put option differ from its exercise value? The exercise price is adjusted for the time value of money. The minimum value reflects the volatility of the underlying. The underlying price is adjusted for the time value of money.

A is correct. The minimum value formula is the greater of zero or the difference between the underlying price and the present value of the exercise price, whereas the exercise value is the maximum of zero and the appropriate difference between the underlying price and the exercise price. Volatility does not affect the minimum price. It does not make sense to adjust the underlying price for the time value of money for the simple reason that it is already adjusted for the time value of money.

A hedge fund with $98 million of initial capital charges a management fee of 2% and an incentive fee of 20%. The management fee is based on assets under management at year end and the incentive fee is calculated independently from the management fee. The fee structure has a high-water mark provision. The fund value is $112 million at the end of Year 1, $100 million at the end of Year, and $116 million at the end of Year 3. The net-of-fees return earned by the fund in Year 3 is closest to: 14.15%. 12.33%. 11.87%.

A is correct. The net-of-fees return to the fund in Year 3 is closest to 14.15%, calculated as follows: Year 1: Portfolio gain = Year-end value - Beginning value = $112 million − $98 million = $14 million Management fee = Year-end value × Management fee % = $112 million × 2% = $2.24 million Incentive fee = Portfolio gain × Incentive fee % = $14 million × 20% = $2.8 million Total fees = Management fee + Incentive fee = $2.24 million + $2.8 million = $5.04 million Ending Capital Position = Year-end value - Total fees = $112 million − $5.04 million = $106.96 million High water mark = Ending capital position = $106.96 million Year 2: No incentive fee is earned as the fund declines in value; the high water mark established in Year 1 is not exceeded. Management fee = Year-end value × Management fee % = $100 million × 2% = $2 million Ending Capital Position = Year-end value - Management fee = $100 million − $2 million = $98 million High water mark = Highest ending capital position = $106.96 million Year 3: Net-of-fee returns are affected by the Year 1 high water mark and the Year 2 net capital position (i.e. Year 3 beginning capital position). Management fee = Year-end value × Management fee % = $116 million × 2% = $2.32 million Incentive fee = (Year-end value - High water mark) × Incentive fee % = ($116 million - $106.96 million) × 20% = $1.81 million. Total fees = Management fee + Incentive fee = $2.32 million + $1.81 million = $4.13 million Net-of-fees return = (Year-end value - Total fees - Beginning capital position)/Beginning capital position = ($116 million - $4.13 million - $98 million)/$98 million = 14.15%.

The first stage of financing at which a venture capital fund most likely invests is the: (2020 Q13) seed stage. mezzanine stage. angel investing stage.

A is correct. The seed stage supports market research and product development and is generally the first stage at which venture capital funds invest. The seed stage follows the angel investing stage. In the angel investing stage, funds are typically provided by individuals (often friends or family), rather than a venture capital fund, to assess an idea's potential and to transform the idea into a plan. Mezzanine-stage financing is provided by venture capital funds to prepare the portfolio company for its IPO.

Alternative investment funds are typically managed: actively. to generate positive beta return. assuming that markets are efficient.

A is correct. There are many approaches to managing alternative investment funds, but typically these funds are actively managed.

An investor seeks a current income stream as a component of total return and desires an investment that historically has low correlation with other asset classes. The investment most likely to achieve the investor's goals is: (2020 Q10) timberland. collectibles. commodities.

A is correct. Timberland offers an income stream based on the sale of timber products as a component of total return and has historically generated returns not highly correlated with other asset classes.

A hedge fund with $225 million of initial capital charges a management fee of 1% and an incentive fee of 10%. The management fee is based on assets under management at year-end, and the incentive fee is calculated independently from the management fee. Assuming the fund earns a 15% return at year-end, total fees earned by the hedge fund during the year are closest to: $5.96 million. $5.70 million. $5.63 million.

A is correct. Total fees earned by the hedge fund are closest to $5.96 million: Year-end value = $225 million × 1.15 = $258.75 million Management fee = Year-end value × Management fee % = $258.75 million × 1% = $2.5875 million Incentive fee = (Year-end value - Beginning value) × Incentive fee % = ($258.75 million - $225 million) × 10% = $3.375 million Total fees = Management fee + Incentive fee = $2.5875 million + $3.375 million = $5.9625 million = $5.96 million

Which of the following circumstances will most likely affect the value of an American call option relative to a European call option? Dividends are declared Expiration date occurs The risk-free rate changes

A is correct. When a dividend is declared, an American call option will have a higher value than a European call option because an American call option holder can exercise early to capture the value of the dividend. At expiration, both types of call options are worth the greater of zero and the exercise value. A change in the risk-free rate does not affect the relative values of American and European call options.

The value of a forward contract at expiration is: positive to the long party if the spot price is higher than the forward price. negative to the short party if the forward price is higher than the spot price. positive to the short party if the spot price is higher than the forward price.

A is correct. When a forward contract expires, if the spot price is higher than the forward price, the long party profits from paying the lower forward price for the underlying. Therefore, the forward contract has a positive value to the long party and a negative value to the short party. However, if the forward price is higher than the spot price, the short party profits from receiving the higher forward price (the contract value is positive to the short party and negative to the long party).

Which of the following relates to a benefit when owning real estate directly? Taxes Capital requirements Portfolio concentration

A is correct. When owning real estate directly, there is a benefit related to taxes. The owner can use property non-cash depreciation expenses to reduce taxable income and lower the current income tax bill. In fact, accelerated depreciation and interest expense can reduce taxable income below zero in the early years of asset ownership, and losses can be carried forward to offset future income. Thus, a property investment can be cash-flow positive while generating accounting losses and deferring tax payments. If the tax losses do not reverse during the life of the asset, depreciation-recapture taxes can be triggered when the property is sold.

___________ is an infrastructure investment characteristic most likely valuable to investors aiming to sell newly constructed assets to the government. "Strategically important" "Monopolistic and regulated" "Significant capital investment"

A is the correct answer because the related priority will probably increase the demand of the public buyer to effectively provide essential services to its citizens. B would be more advantageous for investors holding and operating an asset and charging fees to the buyer, with the inelastic demand supporting pricing and regulations increasing the barriers to entry that improve the competitive position. C is more of a challenge than a benefit to the investor, requiring greater funding capability and potentially higher financial risks.

Limited partnership agreement (LPA)

A legal document that outlines the rules of the partnership and establishes the framework that ultimately guides the fund's operations throughout its life.

Treynor ratio

A measure of the excess average return of an investment relative to its beta to a relevant benchmark, such as a broad equity index. The lower the beta of the alternative asset, the higher the Treynor ratio will be, and all else being equal, when comparing alternative investment possibilities, an asset with a higher Treynor ratio will be deemed more attractive than an asset with a low Treynor ratio. The main limitation of the Treynor ratio is that it is based on historical beta data that may change in the future. The ratio also becomes less meaningful if the beta of the alternative asset to its systematic benchmark is negative, which is certainly possible for some alternative assets.

Collateralized loan obligations (CLOs)

A structured asset-backed security that is collateralized by a pool of loans. A CLO manager extends several loans to corporations—usually to firms involved in LBOs, corporate acquisitions, or similar transactions—pools these loans together, and then divides that pool into various tranches of debt and equity that differ in seniority and security. The CLO manager then sells each tranche to different investors according to their risk profile; the most senior portion of the CLO will be the least risky, and the most junior portion of the CLO (i.e., equity) will be the riskiest.

Leveraged buyouts (LBOs)

A transaction whereby the target company's management team converts the target to a privately held company by using heavy borrowing to finance the purchase of the target company's outstanding shares.

MAR Ratio

A variation of the Calmar ratio that uses a full investment history and the average drawdown.

Write-off/liquidation

A write-off occurs when a transaction has not gone well: The private equity firm revises the value of its investment downward or liquidates the portfolio company before moving on to other projects.

The value of a European call option is inversely related to the: exercise price. time to expiration. volatility of the underlying.

A. exercise price The value of a European call option is inversely related to the exercise price and directly related to the time to expiration.

Protective Put

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

High Plains Capital is a hedge fund with a portfolio valued at $475,000,000 at the beginning of the year. One year later, the value of assets under management is $541,500,000. The hedge fund charges a 1.5% management fee based on the end-of-year portfolio value as well as a 10% incentive fee. If the incentive fee and management fee are calculated independently, the effective return for a hedge fund investor is closest to: 12.29%. 10.89%. 11.06%.

B is correct. Management fee = $541,500,000 × 0.015 = $8,122,500 Incentive fee = ($541,500,000 - $475,000,000) × 0.10 = $6,650,000 Total fees = $14,772,500 Return = ($541,500,000 - $475,000,000 - $14,772,500)/$475,000,000 = 0.1089 or 10.89%

Initial investment capital $100 million Return at the end of one year 12% Management fee based on assets under management 1% Incentive fee based on the return net of the management fee 10% Assume management fees are calculated using end-of-period valuation. The investor's net return given this fee structure is closest to: 10.88%. 9.79%. 9.68%.

B is correct. Management fee: 1% of $112 million = $1.12 million Incentive fee: 10% of ($12 million - $ 1.12 million) = $1.088 million Fund value after fees: $112 million - $1.12 million - $1.088 million = $109.792 million Investor return: ($109.792 million/$100 million) - 1 = 9.79%

For a European call option with two months until expiration, if the spot price is below the exercise price, the call option will most likely have: zero time value. positive time value. positive exercise value.

B is correct. A European call option with two months until expiration will typically have positive time value, where time value reflects the value of the uncertainty that arises from the volatility in the underlying. The call option has a zero exercise value if the spot price is below the exercise price. The exercise value of a European call option is Max(0,St - X), where St is the current spot price at time t and X is the exercise price.

An investor chooses to invest in a brownfield, rather than a greenfield, infrastructure project. The investor is most likely motivated by: growth opportunities. predictable cash flows. higher expected returns.

B is correct. A brownfield investment is an investment in an existing infrastructure asset, which is more likely to have a history of steady cash flows compared with that of a greenfield investment. Growth opportunities and returns are expected to be lower for brownfield investments, which are less risky than greenfield investments.

An investor in a private equity fund is concerned that the general partner can receive incentive fees in excess of the agreed-on incentive fees by making distributions over time based on profits earned rather than making distributions only at exit from investments of the fund. Which of the following is most likely to protect the investor from the general partner receiving excess fees? (2020 Q32) A high hurdle rate A clawback provision A lower capital commitment

B is correct. A clawback provision requires the general partner in a private equity fund to return any funds distributed (to the general partner) as incentive fees until the limited partners have received their initial investments and the contracted portion of the total profits. A high hurdle rate will result in distributions occurring only after the fund achieves a specified return. A high hurdle rate decreases the likelihood of, but does not prevent, excess distributions. Management fees, not incentive fees, are based on committed capital.

The minimum rate of return that a GP must exceed in order to earn an incentive or performance fee is called the: high-water mark. hurdle rate. performance threshold.

B is correct. A high-water mark is the highest value used to calculate an incentive fee. "Performance threshold" is not a term that is generally used in the industry.

Which of the following combinations replicates a long derivative position? A short derivative and a long asset A long asset and a short risk-free bond A short derivative and a short risk-free bond

B is correct. A long asset and a short risk-free asset (meaning to borrow at the risk-free rate) can be combined to produce a long derivative position. A is incorrect because a short derivative and a long asset combine to produce a position equivalent to a long risk-free bond, not a long derivative. C is incorrect because a short derivative and a short risk-free bond combine to produce a position equivalent to a short asset, not a long derivative.

A significant challenge to investing in timber is most likely its: high correlation with other asset classes. dependence on an international competitive context. return volatility compounded by financial market exposure.

B is correct. A primary risk of timber is the international competitive landscape. Timber is a globally sold and consumed commodity subject to world trade interruptions. So the international context can be considered one of its major risk factors. A is incorrect because timberland offers an income stream based on the sale of trees, wood, and other timber products that has not been highly correlated with other asset classes. C is incorrect because investors are interested in timber because of its global nature (everyone requires shelter), the current income generated from the sale of the crop, inflation protection from holding the land, and its safe haven characteristics (it offers some insulation from financial market volatility)

The potential benefits of allocating a portion of a portfolio to alternative investments include: ease of manager selection. improvement in the portfolio's risk-return relationship. accessible and reliable measures of risk and return.

B is correct. Adding alternative investments to a portfolio may provide diversification benefits because of these investments' less-than-perfect correlation with other assets in the portfolio. As a result, allocating a portion of one's funds to alternatives could potentially result in an improved risk-return relationship. Challenges to allocating a portion of a portfolio to alternative investments include obtaining reliable measures of risk and return and selecting portfolio managers for the alternative investments.

True or false: Alternative investments focus solely on the private markets. True False

B is correct. Although many alternative investments are focused on private markets, there are alternative investments, such as hedge funds, that focus on the public markets.

Which of the following accurately defines arbitrage? An opportunity to make a profit at no risk An opportunity to make a profit at no risk and with the investment of no capital An opportunity to earn a return in excess of the return appropriate for the risk assumed

B is correct. An opportunity to profit at no risk could merely describe the purchase of a risk-free asset. An opportunity to earn a return in excess of the return appropriate for the risk assumed is a concept studied in portfolio management and is often referred to as an abnormal return. It is certainly desirable but is hardly an arbitrage because it requires the assumption of risk and the investment of capital. Arbitrage is risk free and requires no capital because selling the overpriced asset produces the funds to buy the underpriced asset.

Which of the following does not represent a benefit of holding an asset? The convenience yield An optimistic expected outlook for the asset Dividends if the asset is a stock or interest if the asset is a bond

B is correct. An optimistic forecast for the asset is not a benefit of holding the asset, but it does appear in the valuation of the asset as a high expected price at the horizon date. Convenience yields and dividends and interest are benefits of holding the asset.

___________ is the type of private debt expected to have the greatest excess return potential. Unitranche Mezzanine Infrastructure

B is correct. As a junior form of subordinated debt, mezzanine private debt private debt offers higher growth potential, equity upside, and higher risk, with the comparatively highest returns. Infrastructure debt is senior and poses the lowest risk. Unitranche debt is less risky than subordinated debt but riskier than infrastructure debt and is a blend of secured and unsecured debt; its interest rate generally falls in between the interest rates often demanded on secured and unsecured debt, and the loan itself is usually structured between senior and subordinated debt.

At expiration, an option that is in the money will most likely have: time value, but no exercise value. exercise value, but no time value. both time value and exercise value.

B is correct. At expiration, options have no time value; if they are in the money, they have exercise value.

At expiration, American call options are worth: less than European call options. the same as European call options. more than European call options.

B is correct. At expiration, the values of American and European call options are effectively the same; both are worth the greater of zero and the exercise value.

At the initiation of a forward contract on an asset that neither receives benefits nor incurs carrying costs during the term of the contract, the forward price is equal to the: spot price. future value of the spot price. present value of the spot price.

B is correct. At initiation, the forward price is the future value of the spot price (spot price compounded at the risk-free rate over the life of the contract). If the forward price were set to the spot price or the present value of the spot price, it would be possible for one side to earn an arbitrage profit by selling the asset and investing the proceeds until contract expiration.

The return on a commodity index is likely to be different from returns on the underlying commodities because: data are subject to survivorship bias. indices are constructed using futures contracts. assets are not marked to market.

B is correct. Because commodity indices are constructed using commodity futures and not the underlying commodities, there can be differences between commodity index returns and the returns of the underlying commodities. A is incorrect. There are no survivorship bias concerns with commodity index returns (that is a concern with hedge fund and private equity returns). C is incorrect. Commodity index returns reflect market values, but private equity returns may not.

In comparison to other alternative investment approaches, co-investing is most likely: more expensive. subject to adverse selection bias. the most flexible approach for the investor.

B is correct. Co-investing may be subject to adverse selection bias. For example, the fund manager may make less attractive investment opportunities available to the co-investor while allocating its own capital to more appealing deals. A is incorrect because co-investing is likely not more expensive than fund investing since co-investors can co-invest an additional amount alongside the fund directly in a fund investment without paying management fees on the capital that has been directly invested. C is incorrect because direct investing, not co-investing, provides the greatest amount of flexibility for the investor.

If a commodity's forward curve is upward sloping and there is little or no convenience yield, the market is said to be in: backwardation. contango. equilibrium.

B is correct. Contango is a condition in the futures markets in which the spot price is lower than the futures price, the forward curve is upward sloping, and there is little or no convenience yield. Backwardation is the opposite condition in the futures markets, where the spot price exceeds the futures price, the forward curve is downward sloping, and the convenience yield is high. Equilibrium is an economic term where supply is equal to demand.

Relative to co-investing, direct investing due diligence is most likely: harder to control. more independent. equally thorough.

B is correct. Direct investing due diligence may be more independent than that of co-investing because the direct investing team is typically introduced to opportunities by third parties rather than fund managers, as is customary in co-investing. A is incorrect because the direct investing team has more control over the due diligence process compared with co-investing. C is incorrect because due diligence for direct investing requires the investor to conduct a thorough investigation into the important aspects of a target asset or business, whereas in co-investing, fund managers typically provide investors with access to a data room so they can view the due diligence completed by the fund managers.

Which of the following best describes the forward rate of an FRA? The spot rate implied by the term structure The forward rate implied by the term structure The rate on a zero-coupon bond of maturity equal to that of the forward contract

B is correct. FRAs are based on Libor, and they represent forward rates, not spot rates. Spot rates are needed to determine forward rates, but they are not equal to forward rates. The rate on a zero-coupon bond of maturity equal to that of the forward contract describes a spot rate.

Angel investing capital is typically provided in which stage of financing? (2020 Q24) Later stage Formative stage Mezzanine stage

B is correct. Formative-stage financing occurs when the company is still in the process of being formed and encompasses several financing steps. Angel investing capital is typically raised in this early stage of financing.

Which of the following best describes how futures contract payoffs differ from forward contract payoffs? Forward contract payoffs are larger. They are equal, ignoring the time value of money. Futures contract payoffs are larger if the underlying is a commodity.

B is correct. Forward payoffs occur all at expiration, whereas futures payoffs occur on a day-to-day basis but would equal forward payoffs ignoring interest. Payoffs could differ, so forward payoffs are not always larger. The type of underlying is not relevant to the point of which payoff is large

A disadvantage of a fund of hedge funds as compared to a large multi-strategy fund is: due diligence expertise. higher management fees. diversified exposure to various hedge fund strategies.

B is correct. Funds of hedge funds will add an extra layer of fees because each hedge fund in which such fund of hedge funds invests will charge a management fee plus an incentive fee. Such a layer of fees comes on top of the fees that the fund of hedge funds charges investors., including management fees, to the costs for investors.

An alternative investments fund that uses leverage and takes long and short positions in securities is most likely a: leveraged buyout fund. hedge fund. venture capital fund.

B is correct. Hedge funds invest in securities and may take long and short positions. They may also use leverage. A is incorrect. Leveraged buyout funds make equity investments in established companies C is incorrect. Venture capital funds provide capital to start-up firms with high growth potential.

An investor is seeking an investment that can take long and short positions, may use multi-strategies, and historically exhibits low correlation with a traditional investment portfolio. The investor's goals will be best satisfied with an investment in: real estate. a hedge fund. a private equity fund.

B is correct. Hedge funds may use a variety of strategies, generally have a low correlation with traditional investments, and may take long and short positions.

Which of the following statements is least accurate concerning differences in the pricing of forwards and futures? Differences in the pattern of cash flows of forwards and futures can explain pricing differences. Pricing differences can arise if futures prices and interest rates are uncorrelated. Interest rate volatility can explain pricing differences.

B is correct. If futures prices and interest rates are uncorrelated, the prices of forwards and futures will be identical.

A European call option and a European put option are written on the same underlying, and both options have the same expiration date and exercise price. At expiration, it is possible that both options will have: negative values. the same value. positive values.

B is correct. If the underlying has a value equal to the exercise price at expiration, both options will have zero value since they both have the same exercise price. For example, if the exercise price is $25 and at expiration the underlying price is $25, both the call option and the put option will have a value of zero. The value of an option cannot fall below zero. The holder of an option is not obligated to exercise the option; therefore, the options each have a minimum value of zero. If the call has a positive value, the put, by definition, must have a zero value and vice versa. Both cannot have a positive value.

The privatization of an existing hospital is best described as: a greenfield investment. a brownfield investment. an economic infrastructure investment.

B is correct. Investing in an existing infrastructure asset with the intent to privatize, lease, or sell and lease back the asset is referred to as a brownfield investment. An economic infrastructure asset supports economic activity and includes such assets as transportation and utility assets. Hospitals are social infrastructure assets, which are focused on human activities

Private capital is: accurately described by the generic term "private equity." a source of diversification benefits from both debt and equity. predisposed to invest in both the debt and equity of a client's firm.

B is correct. Investments in private capital funds can add diversity to a portfolio composed of publicly traded stocks and bonds because they have less-than-perfect correlation with those investments. There is also the potential to offer further diversification within the private capital asset class. For example, private equity investments may also offer vintage diversification since capital is not deployed at a single point in time but is invested over several years. Private debt provides investors with the opportunity to diversify the fixed-income portion of their portfolios since private debt investments offer more options than bonds and other public forms of traditional fixed income.

Illiquidity is most likely a major concern when investing in: real estate investment trusts. private equity. commodities

B is correct. Once a commitment in a private equity fund has been made, the investor has very limited liquidity options. C is incorrect. The majority of commodity investments are implemented through derivatives, so liquidity is not a major concern. A is incorrect. Real estate investment trusts are publicly listed, so liquidity is not a major concern.

If the implied volatility for options on a broad-based equity market index goes up, then it is most likely that: the broad-based equity market index has gone up in value. the general level of market uncertainty has gone up. market interest rates have gone up.

B is correct. One benefit of derivatives markets is information discovery. Implied volatility reveals information about the risk of the underlying. Increases in implied volatility are an implication of increased market uncertainty. A is incorrect. Implied volatility does not provide information about the level of the equity market. C is incorrect. Implied volatility does not provide information about the level of market interest rates.

Which of the following characteristics is least likely to be a benefit associated with using derivatives? More effective management of risk Payoffs similar to those associated with the underlying Greater opportunities to go short compared with the spot market

B is correct. One of the benefits of derivative markets is that derivatives create trading strategies not otherwise possible in the underlying spot market, thus providing opportunities for more effective risk management than simply replicating the payoff of the underlying. A is incorrect because effective risk management is one of the primary purposes associated with derivative markets. C is incorrect because one of the operational advantages associated with derivatives is that it is easier to go short compared to the underlying spot market.

Which of the following statements most likely contributes to the view that derivatives have some role in causing financial crashes? Derivatives are the primary means by which leverage and related excessive risk is brought into financial markets. Growth in the number of investors willing to speculate in derivatives markets leads to excessive speculative trading. Restrictions on derivatives, such as enhanced collateral requirements and credit mitigation measures, in the years leading up to crashes introduce market rigidity.

B is correct. Opponents of derivatives claim that excessive speculative trading brings instability to the markets. Defaults by speculators can lead to defaults by their creditors, their creditors' creditors, and so on. A is incorrect because derivatives are one of many mechanisms through which excessive risk can be taken. There are many ways to take on leverage that look far less harmful but can be just as risky. C is incorrect because responses to crashes and crises typically call for more rules and regulations restricting the use of derivatives, such as requiring more collateral and credit mitigation measures. Such rules and regulations are generally implemented after a crash and are directed at limiting government bailouts of the costs from derivatives risks.

Prior to expiration, the lowest value of a European put option is the greater of zero or the: exercise price minus the value of the underlying. present value of the exercise price minus the value of the underlying. value of the underlying minus the present value of the exercise price.

B is correct. Prior to expiration, 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.

A private equity fund desiring to realize an immediate and complete cash exit from a portfolio company is most likely to pursue: (2020 Q18) an IPO. a trade sale. a recapitalization.

B is correct. Private equity funds can realize an immediate cash exit in a trade sale. Using this strategy, the portfolio company is typically sold to a strategic buyer.

Compared with direct investment in infrastructure, publicly traded infrastructure securities are characterized by: higher concentration risk. more transparent governance. greater control over the infrastructure assets.

B is correct. Publicly traded infrastructure securities, which include shares of companies, exchange-traded funds, and listed funds that invest in infrastructure, provide the benefits of transparent governance, liquidity, reasonable fees, market prices, and the ability to diversify among underlying assets. Direct investment in infrastructure involves a large capital investment in any single project, resulting in high concentration risks. Direct investment in infrastructure provides control over the assets and the opportunity to capture the assets' full value.

Which of the following statements is true for REITs? According to GAAP, equity REITs are exempt from reporting earnings per share. Though equity REIT correlations with other asset classes are typically moderate, they are highest during steep market downturns. The REIT corporation pays taxes on income, and the REIT shareholder pays taxes on the REIT's dividend distribution of after-tax earnings.

B is correct. Real estate investments, including REITs, provide important portfolio benefits due to moderate correlation with other asset classes. However, there are periods when equity REIT correlations with other securities are high, and their correlations are highest during steep market downturns. A is incorrect because equity REITs, like other public companies, must report earnings per share based on net income as defined by GAAP or IFRS. C is incorrect because REITs can avoid this double taxation. A REIT can avoid corporate income taxation by distributing dividends equal to 90%-100% of its taxable net rental income. This ability to avoid double taxation is the main appeal of the REIT structure.

Which of the following is not considered a strategy in private debt investing? Direct lending Recapitalization Mezzanine debt

B is correct. Recapitalization is when a private equity firm increases leverage or introduces it to the company and pays itself a dividend.

A real estate investor looking for equity exposure in the public market is most likely to invest in: real estate limited partnerships. shares of real estate investment trusts. collateralized mortgage obligations.

B is correct. Shares in real estate investment trusts are publicly traded and represent an equity investment in real estate. A is incorrect. Real estate limited partnerships are an example of a private real estate investment. C is incorrect. A collateralized mortgage obligation is an example of debt-based exposure to real estate.

The Sharpe ratio is a less-than-ideal performance measure for alternative investments because: it uses a semi-deviation measure of volatility. returns of alternative assets are not normally distributed. alternative assets exhibit low correlation with traditional asset classes.

B is correct. The Sharpe ratio assumes normally distributed returns. However, alternative assets tend to have non-normal return distributions with significant skewness (fat tails in one direction or the other) and kurtosis (sharper peak than a normal distribution has, with fatter tails). Therefore, the Sharpe ratio may not be a good risk-adjusted performance measure to rely on for alternative investments. A is incorrect because the Sharpe ratio does not use a semi-deviation measure of volatility; it uses standard deviation. The Sortino ratio uses a semi-deviation measure of volatility. Further, the use of semi-deviation instead of standard deviation actually makes the Sortino ratio a more attractive measure of alternative asset performance than the Sharpe ratio. C is incorrect because correlation does not enter into the calculation of the Sharpe ratio. However, it is true that alternative assets can have low correlations with other asset classes. In contrast to the Sharpe ratio, the Treynor ratio incorporates the beta of the alternative asset relative to a benchmark, which is conceptually similar to correlation.

Which of the following is true regarding private equity performance calculations? The money multiple calculation relies on the amount and timing of cash flows. The IRR calculation involves the assumption of two rates. Because private equity funds have low volatility, accounting conventions allow them to use a lagged mark-to-market process.

B is correct. The determination of an IRR involves certain assumptions about a financing rate to use for outgoing cash flows (typically a weighted average cost of capital) and a reinvestment rate assumption to make on incoming cash flows (which must be assumed and may or may not actually be earned). A is incorrect because the money multiple calculation completely ignores the timing of cash flows. C is incorrect because it is somewhat of a reversal of cause and effect: Private equity (PE) funds can appear to have low volatility because of the lag in their mark-to-market process. It's not that PE investments don't actually rise and fall behind the scenes with economic influences, but accounting conventions may simply leave longer-lived investments marked at their initial cost for some time or with only modest adjustments to such carrying value until known impairments or realization events begin to transpire. Also, because PE funds are not easily marked to market, their returns can appear somewhat smoothed, making them appear more resilient and less correlated with other assets than they really are. The slowness to re-mark them can unfortunately be confused by investors as an overall lack of volatility.

The price of a forward contract: is the amount paid at initiation. is the amount paid at expiration. fluctuates over the term of the contract.

B is correct. The forward price is agreed upon at the start of the contract and is the fixed price at which the underlying will be purchased (or sold) at expiration. Payment is made at expiration. The value of the forward contract may change over time, but the forward price does not change.

There are two forward contracts, contract 1 and contract 2, on the same underlying. The underlying makes no cash payments, does not yield any nonfinancial benefits, and does not incur any storage costs. Contract 1 expires in one year, and contract 2 expires in two years. It is most likely that the price of contract 1: is equal to the price of contract 2. is less than the price of contract 2. exceeds the price of contract 2.

B is correct. The forward price is the spot price compounded at the risk-free rate over the life of the contract. Because contract 2 has the longer life, compounding will lead to a larger value.

Which of the following statements imply that a European call on a stock is worth more? Less time to expiration A higher stock price relative to the exercise price Larger dividends paid by the stock during the life of the option

B is correct. The higher the stock price and the lower the exercise price, the more valuable is the call. Less time to expiration and larger dividends reduce the value of the call.

Private equity funds are most likely to use: merger arbitrage strategies. leveraged buyouts. market-neutral strategies.

B is correct. The majority of private equity activity involves leveraged buyouts. Merger arbitrage and market neutral are strategies used by hedge funds.

The majority of real estate property may be classified as either: debt or equity. commercial or residential. direct ownership or indirect ownership.

B is correct. The majority of real estate property may be classified as either commercial or residential.

The pricing of forwards and futures will most likely differ if: interest rates exhibit zero volatility. futures prices and interest rates are negatively correlated. futures prices and interest rates are uncorrelated.

B is correct. The pricing of forwards and futures will differ if futures prices and interest rates are negatively correlated. A negative correlation between futures prices and interest rates makes forwards more desirable than futures in the long position.

The value of a swap is equal to the present value of the: fixed payments from the swap. net cash flow payments from the swap. underlying at the end of the contract.

B is correct. The principal of replication articulates that the valuation of a swap is the present value of all the net cash flow payments from the swap, not simply the present value of the fixed payments of the swap or the present value of the underlying at the end of the contract.

Which of the following terms directly represents the volatility of the underlying in the binomial model? The standard deviation of the underlying The difference between the up and down factors The ratio of the underlying value to the exercise price.

B is correct. The up and down factors express how high and how low the underlying can go. Standard deviation does not appear directly in the binomial model, although it is implicit. The ratio of the underlying value to the exercise price expresses the moneyness of the option.

The value of a European call option at expiration is the greater of zero or the: value of the underlying. value of the underlying minus the exercise price. exercise price minus the value of the underlying.

B is correct. The value of a European call option at expiration is the greater of zero or the value of the underlying minus the exercise price.

The value of a European put option can be either directly or inversely related to the: exercise price. time to expiration. volatility of the underlying.

B is correct. The value of a European put option can be either directly or indirectly related to time to expiration. The direct effect is more common, but the inverse effect can prevail the longer the time to expiration, the higher the risk-free rate, and the deeper in-the-money is the put. The value of a European put option is directly related to the exercise price and the volatility of the underlying.

What is the most likely reason why arbitrage will not completely eliminate all pricing discrepancies for derivatives? Differences in risk aversion Transaction costs Inaccurate forecasts

B is correct. Transaction costs may render an arbitrage strategy unprofitable and can therefore prevent precise convergence of prices. A is incorrect. Differences in risk aversion are irrelevant for arbitrage because arbitrage transactions are riskless. C is incorrect. No forecasts are needed in implementing an arbitrage position.

A characteristic of farmland strongly distinguishing it from timberland is its: commodity price-driven returns. inherent rigidity of production for output. value as an offset to other human activities.

B is correct. Unlike timberland products, farm products must be harvested when ripe, so there is little flexibility in the production process. In contrast, timber (trees) can be grown and easily "stored" by simply not harvesting. This feature offers the flexibility of harvesting more trees when timber prices are up and delaying harvests when prices are down. A is incorrect because just as a primary return driver for timberland is change in commodity price (of lumber from cut wood) in either the spot or futures price, farmland's returns are driven by agricultural commodity prices, with commodity futures contracts potentially combined with farmland holdings to generate an overall hedged return. C is incorrect because for both farmland and timberland owned or leased for the benefit of the bounty each generates in the form of crops and more broadly timber, since these resources consume carbon as part of the plant life cycle, the considered value comes not just from the harvest but also from the offset to other human activities.

Until the committed capital is fully drawn down and invested, the management fee for a private equity fund is based on: (2022 Q33) invested capital. committed capital. assets under management.

B is correct. Until the committed capital is fully drawn down and invested, the management fee for a private equity fund is based on committed capital, not invested capital.

The value of a swap typically: is non-zero at initiation. is obtained through replication. does not fluctuate over the life of the contract.

B is correct. Valuation of the swap during its life appeals to replication and the principle of arbitrage. Valuation consists of reproducing the remaining payments on the swap with other transactions. The value of that replication strategy is the value of the swap. The swap price is typically set such that the swap contract has a value of zero at initiation. The value of a swap contract will change during the life of the contract as the value of the underlying changes in value.

Most derivatives are priced by: assuming that the market offers arbitrage opportunities. discounting the expected payoff of the derivative at the risk-free rate. applying a risk premium to the expected payoff of the derivative and its risk.

B is correct. Virtually all derivative pricing models discount the expected payoff of the derivative at the risk-free rate. A is incorrect because derivatives are priced by assuming that the market is free of arbitrage opportunities via the principle of no arbitrage, not by assuming that the market offers them. C is incorrect because the application of a risk premium to the expected payoff of the derivative and its risk is not appropriate in the pricing of derivatives. An investor's risk premium is not relevant to pricing a derivative.

When interest rates are constant, futures prices are most likely: less than forward prices. equal to forward prices. greater than forward prices.

B is correct. When interest rates are constant, forwards and futures will likely have the same prices. The price differential will vary with the volatility of interest rates. In addition, if futures prices and interest rates are uncorrelated, forward and futures prices will be the same. If futures prices are positively correlated with interest rates, futures contracts are more desirable to holders of long positions than are forwards. This is because rising prices lead to future profits that are reinvested in periods of rising interest rates, and falling prices lead to losses that occur in periods of falling interest rates. If futures prices are negatively correlated with interest rates, futures contracts are less desirable to holders of long positions than are forwards. The more desirable contract will tend to have the higher price.

If no cash is initially exchanged, a swap is comparable to a series of forward contracts when: the swap payments are variable. the combined value of all the forward contracts is zero. all the forward contracts have the same agreed-on price.

B is correct. When two parties engage in a series of forward contracts and initially agree on a price of FS0(T), some of the forward contracts have positive values and some have negative values, but their combined value equals zero.

True or false: Advantages of funds-of-hedge funds include: due diligence in selecting individual hedge funds, access to hedge funds that may be closed to direct investments, and dilution of returns to the investor.

B is correct; the statement is false. Although these three attributes are indeed true of funds of hedge funds, the dilution of returns to the investor is a disadvantage for the investor, not an advantage. The "due diligence" and "access" attributes are advantages.

True or false: The largest sector of the real estate market by value and size is commercial real estate. True False

B is correct; the statement is false. Residential real estate is by far the largest sector of the real estate market by value and size. The residential debt market greatly exceeds commercial property debt because of the larger total value of residential properties combined with property owners' greater ability to use leverage—up to 80% of the property's value or more in some cases. In addition, home mortgages are subsidized in some markets, including government guarantees.

Is the following statement true or false? For the most appropriate instrument to invest in natural resources today, retail investors should focus on the stocks and bonds of companies producing in this sector. True False

B is correct; the statement is false. Up to about 20 years ago, the only commonly available investment vehicles related to this asset class were indeed financial instruments (stocks and bonds). Rather than investing in the physical land and the products that come from it, investors concentrated on the companies that produced natural resources. Nowadays, however, the wide variety of direct investments via ETFs, limited partnerships, REITS, swaps, and futures opens the door for almost everyone to participate in these assets directly.

Large institutional investors consider timberland investments because: The small parcel sizes permit fine tuning of their holdings across geography and wood types. The optionality around harvesting gives investors the choice between cutting trees for lumber and current income or letting them grow another year for future gain. The short return history allows for many alpha opportunities by knowledgeable active managers. Clear-cutting trees and destroying nature is appreciated by ESG investors, which are becoming a larger portion of the investment universe.

B is the correct answer. A is incorrect because the parcel sizes are generally large, especially compared with farmland. C is incorrect because the return history is relatively long, not short. D states the opposite reason why ESG investors may be interested in timberland investments—for the opportunity to create "conservation zones."

Prime brokers

Brokers that provide services that commonly include custody, administration, lending, short borrowing, and trading.

Which of the following best describes an arbitrage opportunity? It is an opportunity to: earn a risk premium in the short run. buy an asset at less than its fundamental value. make a profit at no risk with no capital invested.

C is correct because it is the only answer that is based on the notion of when an arbitrage opportunity exists: when two identical assets or portfolios sell for different prices. A risk premium earned in the short run can easily have occurred through luck. Buying an asset at less than fair value might not even produce a profit.

A collateralized loan obligation specialist is most likely to: sell its debt at a single interest rate. cater to niche borrowers in specific situations. rely on diverse risk profiles to complete deals.

C is correct. A CLO manager will extend several loans to corporations (usually to firms involved in LBOs, corporate acquisitions, or other similar types of transactions), pool these loans, and then divide that pool into various tranches of debt and equity that range in seniority and security. The CLO manager will then sell each tranche to different investors according to their risk profiles; the most senior portion of the CLO will be the least risky, and the most junior portion of the CLO (i.e., equity) will be the riskiest.

If dividends paid by the underlying increase, the value of a European call option will most likely: not change. increase. decrease.

C is correct. A European call option is worth less the more dividends are paid by the underlying.

At expiration, a European put option will be valuable if the exercise price is: less than the underlying price. equal to the underlying price. greater than the underlying price.

C is correct. A European put option will be valuable at expiration if the exercise price is greater than the underlying price. The holder can put (deliver) the underlying and receive the exercise price which is higher than the spot price. A European put option would be worthless if the exercise price was equal to or less than the underlying price.

Which of the following forms of infrastructure investment is the most liquid? An unlisted infrastructure mutual fund A direct investment in a greenfield project An exchange-traded MLP

C is correct. A publicly traded infrastructure security, such as an exchange-traded MLP, provides the benefit of liquidity.

From the perspective of the investor, the most active approach to investing in alternative investments is: co-investing. fund investing. direct investing.

C is correct. From the perspective of the investor, direct investing is the most active approach to investing because of the absence of fund managers and the services and expertise they generally provide.

An investor notices that the price of an American call option is above the price of a European call option with otherwise identical features. What is the most likely reason for this difference? The options are close to expiration. The options are deep in the money. The underlying will go ex-dividend.

C is correct. American call prices can differ from European call prices only if there are cash flows on the underlying. A is incorrect. Early expiration of the option is not a reason for pricing differences between American and European call options. American call prices can differ from European call prices only if there are cash flows on the underlying. B is incorrect. The fact that the option is deep in the money is not a reason for pricing differences between American and European call options. American call prices can differ from European call prices only if there are cash flows on the underlying.

Fill in the blanks with the correct words: An American waterfall distributes performance fees on a(n) _____ basis and is more advantageous to the _____. deal-by-deal; LPs aggregate fund; LPs deal-by-deal; GP

C is correct. American waterfalls, also known as deal-by-deal waterfalls, pay performance fees after every deal is completed and are more advantageous to the GP because they get paid sooner (compared with European, or whole-of-fund, waterfalls).

An alternative investment fund's hurdle rate is a: rate unrelated to a catch-up clause. tool to protect clients from paying twice for the same performance. minimum rate of return the GP must exceed in order to earn a performance fee.

C is correct. An alternative investment fund's hurdle rate is a minimum rate of return the GP must exceed in order to earn a performance fee.

For a risk-averse investor, the price of a risky asset, assuming no additional costs and benefits of holding the asset, is: unrelated to the risk-free rate. directly related to its level of risk. inversely related to its level of risk.

C is correct. An asset's current price, S0, is determined by discounting the expected future price of the asset by r (the risk free rate) plus λ (the risk premium) over the period from 0 to T, as illustrated in the following equation: S0=E(ST) / (1+r+λ)^T. Thus, an asset's current price inversely relates to its level of risk via the related risk premium, λ.

Which of the following ways best describes how arbitrage contributes to market efficiency? Arbitrage penalizes those who trade too rapidly. Arbitrage equalizes the risks taken by all market participants. Arbitrage improves the rate at which prices converge to their relative fair values.

C is correct. Arbitrage imposes no penalties on rapid trading; in fact, it tends to reward those who trade rapidly to take advantage of arbitrage opportunities. Arbitrage has no effect of equalizing risk among market participants. Arbitrage does result in an acceleration of price convergence to fair values relative to instruments with equivalent payoffs.

An arbitrage transaction generates a net inflow of funds: throughout the holding period. at the end of the holding period. at the start of the holding period.

C is correct. Arbitrage is a type of transaction undertaken when two assets or portfolios produce identical results but sell for different prices. A trader buys the asset or portfolio with the lower price and sells the asset or portfolio with the higher price, generating a net inflow of funds at the start of the holding period. Because the two assets or portfolios produce identical results, a long position in one and short position in the other means that at the end of the holding period, the payoffs offset. Therefore, there is no money gained or lost at the end of the holding period, so there is no risk.

Which of the following forms of debt are likely to have additional features, such as warrants or conversion rights? Mezzanine debt Venture debt Both A and B

C is correct. Both mezzanine and venture debt are likely to have additional features, such as warrants and conversion rights, to compensate debt holders for increased risk, including the risk of default.

With respect to American calls, which of the following statements is most accurate? American calls should be exercised early if the underlying has reached its expected maximum price. American calls should be exercised early if the underlying has a lower expected return than the risk-free rate. American calls should be exercised early only if there is a dividend or other cash payment on the underlying.

C is correct. Cash payments on the underlying are the only reason to exercise American calls early. Interest rates, the expected return on the underlying, and any notion of a maximum price is irrelevant. But note that a dividend does not mean that early exercise should automatically be conducted. A dividend is only a necessary condition to justify early exercise for calls.

Which of the following statements about commodity investing is invalid? Few commodity investors trade actual physical commodities. Commodity producers and consumers both hedge and speculate. Commodity indexes are based on the price of physical commodities.

C is correct. Commodity indexes typically use the price of futures contracts on the commodities included in them rather than the prices of the physical commodities themselves in order to be transparent, investable, and replicable. A is incorrect because trading in physical commodities is primarily limited to a smaller group of entities that are part of the physical supply chain. Thus, most commodity investors do not trade actual physical commodities but, rather, trade commodity derivatives. B is incorrect because although supply chain participants use futures to hedge their forward purchases and sales of the physical commodities, those commodity producers and consumers nonetheless both hedge and speculate on commodity prices.

Which of the following conditions will not make futures and forward prices equivalent? Interest rates are constant. Futures prices are uncorrelated with interest rates. The volatility of the forward price is different from the volatility of the futures price.

C is correct. Constant interest rates or the condition that futures prices are uncorrelated with interest rates will make forward and futures prices equivalent. The volatility of forward and futures prices has no relationship to any difference.

In contrast to gambling, derivatives speculation: has a positive public image. is a form of financial risk taking. benefits the financial markets and thus society.

C is correct. Derivatives trading brings extensive benefits to financial markets (low costs, low capital requirements, ease of going short, etc.) and thus benefits society as a whole. Gambling, on the other hand, typically benefits only a limited number of participants. A is incorrect because the general image of speculators is not a good one. Speculators are often thought to be short-term traders who attempt to exploit temporary inefficiencies, caring little about long-term fundamental values. B is incorrect because speculation and gambling are both forms of financial risk taking.

In direct investing, an investor puts capital in an asset or business: using a special purpose vehicle, such as a fund. using a separate business entity, such as a joint venture. without the use of an intermediary.

C is correct. Direct investing occurs when an investor makes a direct investment in an asset without the use of an intermediary.

An analyst wanting to assess the downside risk of an alternative investment is least likely to use the investment's: (2020 Q34) Sortino ratio. value at risk (VaR). standard deviation of returns.

C is correct. Downside risk measures focus on the left side of the return distribution curve, where losses occur. The standard deviation of returns assumes that returns are normally distributed. Many alternative investments do not exhibit close-to-normal distributions of returns, which is a crucial assumption for the validity of a standard deviation as a comprehensive risk measure. Assuming normal probability distributions when calculating these measures will lead to an underestimation of downside risk for a negatively skewed distribution. Both the Sortino ratio and the VaR measure are measures of downside risk.

Capital provided for companies moving toward operation but before commercial manufacturing and sales have occurred best describes which stage in venture capital investing? Later stage Seed stage Early stage

C is correct. Early-stage financing is capital provided for companies moving toward operation but before commercial manufacturing and sales have occurred. A is incorrect. Later-stage financing is provided after commercial manufacturing and sales have begun but before any initial public offering. B is incorrect. Seed-stage financing is capital provided for a business idea.

Which of the following statements best describes a feature of an American option? Early exercise of an American: put option is optimal only if the underlying is dividend paying. call option is never optimal if the underlying is dividend paying. put option that is deep in the money may be optimal.

C is correct. For a deep-in-the-money put option, early exercise may be optimal because the additional upside is limited. A is incorrect. The fact that the underlying is dividend paying does not justify early exercise in the case of a put option. B is incorrect. Early exercise of a call option may be beneficial if a sufficiently high dividend can be captured.

A forward rate agreement most likely differs from most other forward contracts because: positions cannot be closed out prior to maturity. it involves an option component. its underlying is not an asset.

C is correct. Forward rate agreements, unlike most other forward contracts, do not have an asset as an underlying. Instead, the underlying is an interest rate

An equity hedge fund following a fundamental growth strategy uses fundamental analysis to identify companies that are most likely to: (2022 Q16) be undervalued. be either undervalued or overvalued. experience high growth and capital appreciation.

C is correct. Fundamental growth strategies take long positions in companies identified, using fundamental analysis, to have high growth and capital appreciation. Fundamental value strategies use fundamental analysis to identify undervalued companies. Market-neutral strategies use quantitative and fundamental analysis to identify under- and overvalued companies.

In contrast to a forward contract, a futures contract: trades over-the-counter. is initiated at a zero value. is marked-to-market daily.

C is correct. Futures contracts are marked-to-market on a daily basis. 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. Futures contracts trade on an exchange, forward contracts are over-the-counter transactions. Typically both forward and futures contracts are initiated at a zero value.

An investor may prefer a single hedge fund to a fund of funds if she seeks: (2022 Q8) due diligence expertise. better redemption terms. a less complex fee structure.

C is correct. Hedge funds of funds have multi-layered fee structures, whereas the fee structure for a single hedge fund is less complex. Funds of funds presumably have some expertise in conducting due diligence on hedge funds and may be able to negotiate more favorable redemption terms than an individual investor in a single hedge fund could.

For a forward contract with a value of zero, a situation where the spot price is above the forward price is best explained by high: interest rates. storage costs. convenience yield.

C is correct. If the convenience yield is high, holding the underlying confers large benefits, thus the spot price can exceed the forward price for a forward contract with a value of zero. Based on the formula Vt(T) = St - (γ - θ)(1 + r)^t - F0(T)(1 + r)^[-(T-t)] and an initial value Vt(0) of zero, large benefits γ explain why the spot price can exceed the forward price.

Which is not true of mark-to-model valuations? Return volatility may be understated. Returns may be smooth and overstated. A calibrated model will produce a reliable liquidation value

C is correct. It is not true that a calibrated model will produce a reliable liquidation value in a mark-to-model valuation. The need to use a model for valuation arises when an asset is so illiquid that there are not reliable market values available. A model may reflect only an imperfect theoretical valuation, not a true liquidation value, should liquidation become necessary. The illiquid nature of alternative assets means that estimates, rather than observable transaction prices, may have been used for valuation purposes.

Which of the following is a limit to arbitrage? Clearinghouses restrict the transactions that can be arbitraged. Pricing models do not show whether to buy or sell the derivative. It may not always be possible to raise sufficient capital to engage in arbitrage.

C is correct. It may not always be possible to raise sufficient capital to engage in arbitrage. Clearinghouses do not restrict arbitrage. Pricing models show what the price of the derivative should be. Thus, comparison with the market price will indicate if the derivative is overpriced and should be sold or if it is underpriced and should be purchased.

Which of the following is least likely to be considered an alternative investment? Real estate Commodities Long-only equity funds

C is correct. Long-only equity funds are typically considered traditional investments, and real estate and commodities are typically classified as alternative investments.

The complex nature of derivatives has led to: reliable financial models of derivatives markets. widespread trust in applying scientific principles to derivatives. financial industry employment of mathematicians and physicists.

C is correct. Many derivatives are extremely complex and require a high-level understanding of mathematics. As a result, the financial industry employs many mathematicians, physicists, and computer scientists. A is incorrect because scientists create models of markets by using scientific principles that often fail. For example, to a physicist modeling the movements of celestial bodies, the science is reliable and the physicist is unlikely to misapply the science. The same science applied to financial markets is far less reliable. Financial markets are driven by the actions of people who are not as consistent as the movements of celestial bodies. B is incorrect because the complex nature of derivatives has made many distrust, as opposed to trust, derivatives, the people who work with them, and the scientific methods they use.

The price of a swap typically: is zero at initiation. fluctuates over the life of the contract. is obtained through a process of replication.

C is correct. Replication is the key to pricing a swap. The swap price is determined at initiation by replication. The value (not the price) of the swap is typically zero at initiation and the fixed swap price is typically determined such that the value of the swap will be zero at initiation.

For a swap in which a series of fixed payments is exchanged for a series of floating payments, the parties to the transaction: designate the value of the underlying at contract initiation. value the underlying solely on the basis of its market value at the end of the swap. value the underlying sequentially at the time of each payment to determine the floating payment.

C is correct. On each payment date, the swap owner receives a payment based on the value of the underlying at the time of each respective payment. A is incorrect because in a swap involving a series of fixed payments exchanged for a series of floating payments, each floating payment reflects the value of the underlying at the time of payment, not a designated value at contract initiation. B is incorrect because in a swap involving a series of fixed payments exchanged for a series of floating payments, each floating payment is based on the value of the underlying at the time of each respective payment, not on the market value at the end of the swap.

A European credit hedge fund has a very short redemption notice period—one week—because the fund's managers believe it invests in highly liquid asset classes and is market neutral. The fund has a small number of holdings that represent a significant portion of the outstanding issue of each holding. The fund's lockup period has expired. Unfortunately, in one particular month, because of the downgrades of two large holdings, the hedge fund has a drawdown (decline in NAV) of more than 10%. The declines in value of the two holdings result in margin calls from their prime broker, and the drawdown results in requests to redeem 50% of total partnership interests. The combined requests are most likely to: force the hedge fund to liquidate or unwind 50% of its positions in an orderly fashion throughout the week. have little effect on the prices received when liquidating the positions because the hedge fund has a week before the partnership interests are redeemed. result in a forced liquidation, which is likely to further drive down prices and result in ongoing pressures on the hedge fund as it tries to convince nervous investors to remain in the fund.

C is correct. One week may not be enough time to unwind such a large portion of the fund's positions in an orderly fashion that also does not further drive down prices. A downgrade is not likely to have a temporary effect, so even if other non-losing positions are liquidated to meet the redemption requests, it is unlikely that the two large holdings will return to previous or higher values in short order. Also, the hedge fund may have a week to satisfy the requests for redemptions, but the margin call must be met immediately. Overall, sudden redemptions at the fund level can have a cascading negative impact on a fund.

Derivatives may contribute to financial contagion because of the: centrally cleared nature of OTC derivatives. associated significant costs and high capital requirements. reliance by derivatives speculators on large amounts of leverage.

C is correct. Opponents argue that speculators use large amounts of leverage, thereby subjecting themselves and their creditors to substantial risk if markets do not move in their hoped-for direction. Defaults by speculators can then lead to defaults by their creditors, their creditors' creditors, and so on. These effects can, therefore, be systemic and reflect an epidemic contagion whereby instability can spread throughout markets and an economy, if not the entire world. A is incorrect because central clearing of OTC derivatives, similar to how exchange-traded derivatives are cleared, is intended to lessen the risk of contagion. B is incorrect because it is derivatives' low cost and low capital requirements, not high cost and high capital requirements, that opponents point to as contributing to an excessive amount of speculative trading that brings instability to the markets.

The most likely impact of adding commodities to a portfolio of equities and bonds is to: increase risk. provide higher current income. reduce exposure to inflation.

C is correct. Over the long term, commodity prices are closely related to inflation, so including commodities in a portfolio of equities and bonds will reduce its exposure to inflation. A is incorrect because commodities have low correlations with traditional securities and therefore reduce overall risk. B is incorrect because commodity investments tend to produce no current income.

A European put option on a dividend-paying stock is most likely to increase if there is an increase in: carrying costs. the risk-free rate. dividend payments.

C is correct. Payments, such as dividends, reduce the value of the underlying which increases the value of a European put option. Carrying costs reduce the value of a European put option. An increase in the risk-free interest rate may decrease the value of a European put option.

An at-the-money American call option on a stock that pays no dividends has three months remaining until expiration. The market value of the option will most likely be: less than its exercise value. equal to its exercise value. greater than its exercise value.

C is correct. Prior to expiration, an American call option will typically have a value in the market that is greater than its exercise value. Although the American option is at-the-money and therefore has an exercise value of zero, the time value of the call option would likely lead to the option having a positive market value.

Valuation of a swap during its life will least likely involve the: application of the principle of no arbitrage. use of replication. investor's risk aversion.

C is correct. Risk neutrality, not risk aversion, is a key element of derivatives pricing, including swaps. A is incorrect. The statement is true because the principle of no arbitrage is applied in pricing swaps. B is incorrect. The statement is true because replication is used in pricing swaps.

Which of the following best describes the binomial option pricing formula? The expected payoff is discounted at the risk-free rate plus a risk premium. The spot price is compounded at the risk-free rate minus the volatility premium. The expected payoff based on risk-neutral probabilities is discounted at the risk-free rate.

C is correct. Risk-neutral probabilities are used, and discounting is at the risk-free rate. There is no risk premium incorporated into option pricing because of the use of arbitrage.

Which of the following is not a factor in pricing a call option in the binomial model? The risk-free rate The exercise price The probability that the underlying will go up

C is correct. The actual probabilities of the up and down moves are irrelevant to pricing options. The risk-free and exercise price are, of course, highly relevant.

Which of the following factors most likely explains why the spot price of a commodity in short supply can be greater than its forward price? Opportunity cost Lack of dividends Convenience yield

C is correct. The convenience yield is a benefit of holding the asset and generally exists when a commodity is in short supply. The future value of the convenience yield is subtracted from the compounded spot price and reduces the commodity's forward price relative to it spot price. The opportunity cost is the risk-free rate. In the absence of carry costs, the forward price is the spot price compounded at the risk-free rate and will exceed the spot price. Dividends are benefits that reduce the forward price but the lack of dividends has no effect on the spot price relative to the forward price of a commodity in short supply.

Which of the following factors does not affect the forward price? The costs of holding the underlying Dividends or interest paid by the underlying Whether the investor is risk averse, risk seeking, or risk neutral

C is correct. The costs of holding the underlying, known as carrying costs, and the dividends and interest paid by the underlying are extremely relevant to the forward price. How the investor feels about risk is irrelevant, because the forward price is determined by arbitrage.

Which of the following statements best represents information discovery in the futures market? The futures price is predictive. Information flows more slowly into the futures market than into the spot market. The futures market reveals the price that the holder of the asset can take to avoid uncertainty.

C is correct. The futures market reveals the price that the holder of an asset could take and avoid the risk of uncertainty. A is incorrect because although the futures price is sometimes thought of as predictive, it provides only a little more information than does a spot price and is not really a forecast of the futures spot price. B is incorrect because by virtue of the fact that the futures market requires less capital, information can flow into the futures market before it gets into the spot market.

As the loan-to-value ratio increases for a real estate investment, risk most likely increases for: (2020 Q19) debt investors only. equity investors only. both debt and equity investors.

C is correct. The higher the loan-to-value ratio, the higher leverage is for a real estate investment, which increases the risk to both debt and equity investors.

Which of the following factors does not affect the value of a European option? The volatility of the underlying Dividends or interest paid by the underlying The percentage of the investor's assets invested in the option

C is correct. The investor's exposure to the option is not relevant to the price one should pay to buy or ask to sell the option. Volatility and dividends or interest paid by the underlying are highly relevant to the value of the option.

The law of one price is best described as: the true fundamental value of an asset. earning a risk-free profit without committing any capital. two assets that will produce the same cash flows in the future must sell for equivalent prices.

C is correct. The law of one price occurs when market participants engage in arbitrage activities so that identical assets sell for the same price in different markets. A is incorrect because the law of one price refers to identical assets. B is incorrect because it refers to arbitrage not the law of one price.

A hedge fund has the following fee structure: Annual management fee based on year-end AUM 2% Incentive fee 20% Hurdle rate before incentive fee collection starts 4% Current high-water mark $610 million Q. The fund has a value of $583.1 million at the beginning of the year. After one year, it has a value of $642 million before fees. The net percentage return to an investor for this year is closest to: (2020 Q29) 6.72%. 6.80%. 7.64%.

C is correct. The management fee for the year is $642 × 0.02 = $12.84 million. Because the ending gross value of the fund of $642 million exceeds the high-water mark of $610 million, the hedge fund can collect an incentive fee on gains above this high-water mark but net of the hurdle rate of return. The incentive fee calculation becomes {$642 − [$610 × (1 + 0.04)]} × 0.20 = $1.52 million. The net return to the investor for the year is [($642 − $12.84 − $1.52)/$583.1] − 1 ≈ 0.07638 ≈ 7.64%.

Assume an asset pays no dividends or interest, and also assume that the asset does not yield any non-financial benefits or incur any carrying cost. At initiation, the price of a forward contract on that asset is: lower than the value of the contract. equal to the value of the contract. greater than the value of the contract.

C is correct. The price of a forward contract is a contractually fixed price, established at initiation, at which the underlying will be purchased (or sold) at expiration. The value of a forward contract at initiation is zero; therefore, the forward price is greater than the value of the forward contract at initiation.

Which of the following factors does not affect the spot price of an asset that has no interim costs or benefits? The time value of money The risk aversion of investors The price recently paid by other investors

C is correct. The price recently paid by other investors is past information and does not affect the spot price. The time value of money and the risk aversion of investors determine the discount rate. Only current information is relevant as investors look ahead, not back.

Which of the following statements best describes put-call parity? The put price always equals the call price. The put price equals the call price if the volatility is known. The put price plus the underlying price equals the call price plus the present value of the exercise price.

C is correct. The put and underlying make up a protective put, while the call and present value of the exercise price make up a fiduciary call. The put price equals the call price for certain combinations of interest rates, times to expiration, and option moneyness, but these are special cases. Volatility has no effect on put-call parity.

The following information is available about a hedge fund: Initial fund assets $100 million Fund assets at the end of the period (before fees) $110 million Management fee based on assets under management 2% Incentive fee based on the return 20% Soft hurdle rate 8% No deposits to the fund or withdrawals from the fund occurred during the year. Management fees are calculated using end-of-period valuation. Management fees and incentive fees are calculated independently. The net-of-fees return of the investor is closest to: 7.8%. 7.4%. 5.8%.

C is correct. The soft hurdle rate is surpassed because the return of the fund is 10%. For that reason, the full fee, based on the full performance, is due. Management fee: 2% of $110 million = $2.2 million Incentive fee: 20% of $10 million = $2 million Total fees: $4.2 million Therefore, the fund assets at the end of the period after fees are $105.8 million. The return for the investor is 5.8%.

With respect to the value of a futures contract, which of the following statements is most accurate? The value is the: futures price minus the spot price. present value of the expected payoff at expiration. accumulated gain since the previous settlement, which resets to zero upon settlement.

C is correct. Value accumulates from the previous settlement and goes to zero when distributed

If the present value of storage costs exceeds the present value of its convenience yield, then the commodity's forward price is most likely: less than the spot price compounded at the risk-free rate. the same as the spot price compounded at the risk-free rate. higher than the spot price compounded at the risk-free rate.

C is correct. When a commodity's storage costs exceed its convenience yield benefits, the net cost of carry (benefits less costs) is negative. Subtracting this negative amount from the spot price compounded at the risk-free rate results in an addition to the compounded spot price. The result is a commodity forward price which is higher than the spot price compounded. The commodity's forward price is less than the spot price compounded when the convenience yield benefits exceed the storage costs and the commodity's forward price is the same as the spot price compounded when the costs equal the benefits.

Which of the following statements is true regarding mortgage-backed securities? Insurance companies prefer the first-loss tranche. When interest rates rise, prepayments will likely accelerate. When interest rates fall, the low-risk senior tranche will amortize more quickly.

C is correct. When interest rates decline, borrowers are likely to refinance their loans at a faster pace than before, resulting in faster amortization of each MBS tranche, including the senior tranche, which is the lowest-risk tranche. A is incorrect because risk-averse investors, primarily insurance companies, prefer the lowest-risk tranches, which are the first to receive interest and principal. The junior-most tranche is referred to as the first-loss tranche. It is the highest-risk tranche and is the last to receive interest and principal distributions. B is incorrect because when interest rates rise, prepayments will likely slow down, lengthening the duration of most MBS tranches. Prepayments will likely increase when interest rates decline, because borrowers are likely to refinance their loans at a faster pace.

The derivative markets tend to: transfer liquidity from the broader financial markets. not reflect fundamental value after it is restored in the underlying market. offer a less costly way to exploit mispricing in comparison to other free and competitive financial markets.

C is correct. When prices deviate from fundamental values, derivative markets offer a less costly way to exploit mispricing in comparison to other free and competitive financial markets. A is incorrect because derivative markets tend to transfer liquidity to (not from) the broader financial markets, because investors are far more willing to trade if they can more easily manage their risk, trade at lower cost and with less capital, and go short more easily. An increased willingness to trade leads to a more liquid market. B is incorrect because it is likely (not unlikely) that fundamental value will be reflected in the derivative markets both before and after it is restored in the underlying market owing to lower capital requirements and transaction costs in the derivative markets.

Fill in the blank: Compared with private real estate investing, publicly traded real estate investment trusts provide much greater ___________, lower ___________, and better ___________. Choices of words: transparency, liquidity, trading costs, variety, happiness

Compared with private real estate investing, publicly traded real estate investment trusts provide much greater liquidity, lower trading costs, and better transparency.

Unitranche debt

Consists of a hybrid or blended loan structure that combines different tranches of secured and unsecured debt into a single loan with a single, blended interest rate.

Which of the following can be considered as an investment in the commodities asset class? A set of rare antique coins, some of which are made of silver and gold A lease on an oil tanker shipping oil between Saudi Arabia and China Ownership of a battery factory that uses industrial metals A metric tonne of coffee packed in jute bags in a warehouse in Brazil

D is correct, assuming the investor owns the commodity directly, not via a derivatives contract. A describes an investment in collectables (whose value has more to do with the rarity of the collectible rather than the actual value of the silver or gold). B describes a financial contract—effectively, a lease or bond. C is also a financial contract that pays on the use of commodities but depends on many other factors (technology, marketing, rent, and employees) for returns.

Forward price

F0(T) = S0(1 + r)^T Or, in words, The forward price is the spot price compounded at the risk-free rate over the life of the contract. F0(T) = (S0−γ+θ) x (1+r)^T or F0(T) = S0(1+r)^T − (γ−θ) x (1+r)^T The forward price of an asset with 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 and costs.

Performance fee

Fees paid to the general partner from the limited partner(s) based on realized net profits.

Define funds of hedge funds, and identify their primary purpose.

Funds of hedge funds are funds that hold a portfolio of hedge funds. Their primary purpose is to add value in manager selection and due diligence and create a diversified portfolio of hedge funds accessible to smaller investors.

Futures price for commodities

Futures price ≈ Spot price(1 + r) + Storage costs − Convenience yield, where r is the period's short-term risk-free interest rate

Hedge fund strategies

HFR classifies hedge funds under four broad strategy categories: event-driven, relative value, macro, and equity hedge.

A PE fund invests $15 million in a nascent luxury yacht manufacturer and $17 million in a new casino venture. The yacht manufacturer generates a $9 million profit when the company is acquired by a larger competitor, but the casino venture turns out to be a flop when its state licensing is eventually denied and it generates a $10 million loss. If the manager's carried interest incentive fee is 20% of the profits, what would this incentive be with a European-style waterfall whole-of-fund approach, and what would it be if the incentive is paid on an American-style waterfall deal-by-deal basis (assuming no clawback applies)?

In aggregate, the fund lost money (+$9 million − $10 million = -$1 million), so with a European-style whole-of-fund waterfall and assuming the time period for the gain and the loss are the same, there is no incentive fee. With an American-style waterfall, the GP could still earn 20% × $9 million = $1.8 million on the yacht company, thereby further compounding the loss to the ultimate investor to -$2.8 million net of fees. If the gain and loss in this example transpired sequentially over different years, perhaps with the yacht company gain occurring first and then the Casino venture loss later on, the outcome for a European-style waterfall would typically result in an initial accrued incentive fee for the yacht manufacturer gain, but if there is a clawback provision in place, then there would be a clawback of that fee for the investor in the subsequent year when the casino venture loss is eventually realized, still resulting in no overall incentive fee. Waterfall language and clawback provisions on fees are very important to study and understand in offering memorandums, and these terms can vary widely.

Categories of infrastructure investments

Infrastructure assets are frequently characterized on the basis of (1) underlying assets, (2) the underlying asset's state of development, and (3) the geographic location on the underlying assets. The first category comprises economic assets supporting economic activity, such as transportation and energy/utility assets. It also includes social infrastructure assets, which enable public services directed toward human activities, such as education, health care, and housing. The second category refers to the relevant stages of the infrastructure asset's life cycle. These include a greenfield investment for a newly created asset and a brownfield investment for an established asset. The third category highlights the specific place (local, regional, national) associated with the government entity directly involved with the assets.

Venture Capital

Investments that provide "seed" or startup capital, early-stage financing, or later-stage financing (including mezzanine-stage financing) to companies that are in early development stages and require additional capital for expansion or preparation for an initial public offering.

Direct investing

Occurs when an investor makes a direct investment in an asset without the use of an intermediary.

Private equity funds

Private equity funds generally invest in companies, whether startups or established firms, 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-generating companies with solid customer bases, proven products, and high-quality management.

Recapitalization in the context of private equity

Recapitalization in the context of private equity describes the steps a firm takes to increase or introduce leverage to its portfolio company and pay itself a dividend out of the new capital structure. 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 to pay its investors and improve IRR. A recapitalization may be a prelude to a later exit. However, LP investors should be aware that a recapitalization can be used as a method for the GP to manipulate fund IRRs.

Waterfall

Represents the distribution method that defines the order in which allocations are made to LPs and GPs. There are two major types of waterfall: deal by deal (or American) and whole of fund (or European).

Time value decay

Said of an option when, at expiration, no time value remains and the option is worth only its exercise value.

Side letters

Side agreements created between the GP and specific LPs. These agreements exist outside the LPA. These agreements provide additional terms and conditions related to the investment agreement.

Risk-neutral pricing

Sometimes said of derivatives 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. There is only one derivative price that meets that condition. Any mispricing of the derivative will lead to arbitrage transactions that drive the derivative price back to where it should be, the price that eliminates arbitrage opportunities.

Committed capital

The amount that the limited partners have agreed to provide to the private equity fund.

Alexandra is considering buying a tract of farmland for long-term capital appreciation and current income. Which of the following factors play a role in evaluating the attractiveness of the investment? The land's rights to preferential water access The land's proximity to a large, privately held nature reserve The land's soil chemical composition allowing the growth of a variety of crops All of the above

The answer is D. A is important to ensure that crops can be grown with a reasonable chance of success. B allows for the land to be rented to the stewards of the nature reserve and to lay fallow instead of growing food for human consumption. Nature preserve foundations are interested in the land around them because (1) runoff and pesticide use affect the plants and animals in the preserve, (2) migration of animals in the preserve may incur onto the farmland, and (3) foundations often look to add to their holdings, allowing for a future sale of the land. C allows for the possibility of being able to react to market preferences and more stable productivity and thus more reliable income.

Law of one price

The condition in a financial market in which two equivalent financial instruments or combinations of financial instruments can sell for only one price. Equivalent to the principle that no arbitrage opportunities are possible.

Which of the following performance measures uses beta as the risk measure? Sharpe ratio Treynor ratio Sortino ratio

The correct answer is B. Both Sharpe Ratio and Sortino Ratio use standard deviation as a risk measure. Treynor ratio uses beta as a risk measure.

Replication

The creation of an asset or portfolio from another asset, portfolio, and/or derivative.

Time value

The difference between the market price of the option and its intrinsic value.

Pricing and Valuation of Forward Contracts at Expiration

The forward price, established at the initiation date of contract is F0(T). Let us denote the value at expiration of the forward contract as VT(T). This value is formally stated as VT(T) = ST − F0(T) In words, The value of a forward contract at expiration is the spot price of the underlying minus the forward price agreed to in the contract. In the financial world, we generally define value as the value to the long position, so the above definition is generally correct but would be adjusted if we look at the transaction from the point of view of the short party. In that case, we would multiply the value to the long party by −1 to calculate the value to the short party. Alternatively, the value to the short party is the forward price minus the spot price at expiration.

High-water mark

The highest value, net of fees, which a fund has reached in history. It reflects the highest cumulative return used to calculate an incentive fee. A high-water mark clause states that a hedge fund manager must recuperate declines in value from the high-water mark before performance fees can be charged on newly generated profits. The use of high-water marks protects clients from paying twice for the same performance.

Lower limits for prices of European options

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. 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.

Lockup periods

The minimum holding period before investors are allowed to make withdrawals or redeem shares from a fund.

Hurdle rate

The minimum rate of return on investment that a fund must reach before a GP receives carried interest. The hurdle rate is a minimum rate of return, typically 8%, that the GP must exceed in order to earn the performance fee. GPs typically receive 20% of the total profit of the private equity fund net of any hard hurdle rate, in which case the GP earns fees on annual returns in excess of the hurdle rate, or net of the soft hurdle rate, in which case the fee is calculated on the entire annual gross return as long as the set hurdle is exceeded. Hurdle rates are less common for hedge funds but do appear from time to time.

Arbitrage-free pricing

The overall process of pricing derivatives by arbitrage and risk neutrality. Also called the principle of no arbitrage. We are effectively determining the price of a derivative by assuming that the market is free of arbitrage opportunities. If there are no arbitrage opportunities, combinations of assets and/or derivatives that produce the same results must sell for the same price. The correct derivative price assures us that the market is free of arbitrage opportunities.

Capital loss ratio

The percentage of capital in deals that have been realized below cost, net of any recovered proceeds, divided by total invested capital.

Identify the four stages of the private equity continuum and the company growth stage each finances.

The stages of the entire PE continuum and their associated growth stage financing are as follows: Venture capital focuses on start-up and seed-stage businesses. Growth equity focuses on more established businesses. Recapitalizations focus on more mature businesses, either healthy or distressed. Buyouts/LBOs focuses on mature businesses.

True or false: The Sharpe ratio measures the amount of risk per unit of return.

The statement is false. The Sharpe, Sortino, and Treynor ratios are risk-adjusted performance measurements. They are measures of return per unit of risk.

Value of European calls and puts at expiration

The value of a European call at expiration is the exercise value, which is the greater of zero or the value of the underlying minus the exercise price. The value of a European put at expiration is the exercise value, which is the greater of zero or the exercise price minus the value of the underlying. The value of a European call option is directly related to the value of the underlying. The value of a European put option is inversely related to the value of the underlying. The value of a European call option is inversely related to the exercise price. The value of a European put option is directly related to the exercise price. The value of a European call option is directly related to the time to expiration. 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. The value of a European call is directly related to the risk-free interest rate. The value of a European put is inversely related to the risk-free interest rate. 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. 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. The value of a call option cannot exceed the value of the underlying.

Trade sale

This refers to the sale of a company to a strategic buyer, such as a competitor. A trade sale can be conducted by auction or by private negotiation. Benefits include (a) an immediate cash exit for the private equity fund, (b) the potential willingness of strategic buyers to pay more because they anticipate synergies with their own business, (c) fast and simple execution, (d) lower transaction costs than for an IPO, and (e) lower levels of disclosure and higher confidentiality than for an IPO because private equity firms generally deal with only one other party. Disadvantages of trade sales include (a) possible opposition by management (management may wish to avoid being purchased by a competitor for job security reasons), (b) lower attractiveness to employees of the portfolio company than for an IPO (an IPO allows for the monetizing of shares), (c) a limited universe of potential trade buyers, and (d) a potentially lower price for the sale than would be achieved from an IPO.

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. π and 1 − π Thus, the option is valued as though investors are risk neutral. As we discussed extensively earlier, that is not the same as assuming that investors are risk neutral.

Pricing and Valuation at Initiation Date

When a forward contract is initiated, neither party pays anything to the other. It is a valueless contract, neither an asset nor a liability. Therefore, its value at initiation is zero: V0(T) = 0 Although a forward contract has zero value at the start, it will not have zero value during its life.

American style vs European style options

Options that can be exercised early are referred to as American-style. Options that can be exercised only at expiration are referred to as European-style. It is extremely important that you do not associate these terms with where these options are traded. Both types of options trade on all continents.

Consider a call option selling for $7 in which the exercise price is $100 and the price of the underlying is $98. Determine the value at expiration and the profit for a call buyer under the following outcomes: 1. The price of the underlying at expiration is $102. 2. The price of the underlying at expiration is $94.

1. If the price of the underlying at expiration is $102, The call buyer's value at expiration = cT = Max(0,ST − X) = Max(0,102 − 100) = $2. The call buyer's profit = Π = cT − c0 = 2 − 7 = -$5. 2. If the price of the underlying at expiration is $94, The call buyer's value at expiration = cT = Max(0,ST − X) = Max(0,94 − 100) = $0. The call buyer's profit = Π = cT − c0 = 0 − 7 = -$7.

Locked limit

A condition in the futures markets in which a transaction cannot take place because the price would be beyond the limits. These price limits, which may be somewhat objectionable to proponents of free markets, are important in helping the clearinghouse manage its credit exposure.

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. In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are 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.

Fixed-for-floating interest rate 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.

At the money

An option in which the underlying's price equals the exercise price. When ST = X, the call option is said to be at the money, although at the money is, for all practical purposes, out of the money because the value is still zero.

Credit spread option

An option on the yield spread on a bond. credit / yield spread = the difference between the bond's yield and the yield on a benchmark default-free bond Because a credit spread option requires a credit spread as the underlying, this type of derivative works only with a traded bond that has a quoted price. The credit protection buyer selects the strike spread it desires and pays the option premium to the credit protection seller. At expiration, the parties determine whether the option is in the money by comparing the bond's yield spread with the strike chosen, and if it is, the credit protection seller pays the credit protection buyer the established payoff. Thus, this instrument is essentially a call option in which the underlying is the credit spread.

Which of the following is not a characteristic of a derivative? An underlying A low degree of leverage Two parties—a buyer and a seller

B is correct. All derivatives have an underlying and must have a buyer and a seller. More importantly, derivatives have high degrees of leverage, not low degrees of leverage.

Which of these is best classified as a forward commitment? A convertible bond A call option A swap agreement

C is correct. A swap agreement is equivalent to a series of forward agreements, which can be described as forward commitments. A is incorrect. A convertible bond does not meet the definition of a forward commitment. B is incorrect. A call option is an example of a contingent claim.

Non-deliverable forwards (NDFs)

Cash-settled forward contracts, used predominately with respect to foreign exchange forwards. Also called contracts for differences.

Forward commitments

Class of derivatives that provides the ability to lock in a price to transact in the future at a previously agreed-upon price. The various types of forward commitments are called forward contracts, futures contracts, and swaps MUST transact!

Derivative contracts

Derivatives are created in the form of legal contracts. They involve two parties—the buyer and the seller (sometimes known as the writer)—each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.1 A derivative contract always defines the rights and obligations of each party. These contracts are intended to be, and almost always are, recognized by the legal system as commercial contracts that each party expects to be upheld and supported in the legal system.

Price limits

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

Cash Markets (spot markets)

Markets in which assets are traded for immediate delivery. stocks, bonds, commodities, etc (not derivatives)

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.

Consider a call option selling for $7 in which the exercise price is $100 and the price of the underlying is $98. Determine the value at expiration and the profit for a call seller under the following outcomes: 1. The price of the underlying at expiration is $91. 2. The price of the underlying at expiration is $101.

1. If the price of the underlying at expiration is $91, The call seller's value at expiration = -cT = -Max(0,ST − X) = -Max(0,91 − 100) = $0. The call seller's profit = Π = -cT + c0 = 0 + 7 = $7 If the price of the underlying at expiration is $101, 2. The call seller's value at expiration = -cT = -Max(0,ST − X) = -Max(0,101 − 100) = -$1. The call seller's profit = Π = -cT + c0 = −1 + 7 = $6.

Derivatives

A financial instrument whose value depends on the value of some underlying asset or factor (e.g., a stock price, an interest rate, or exchange rate). Perhaps the distinction that best characterizes derivatives is that they usually transform the performance of the underlying asset before paying it out in the derivatives transaction. In contrast, with the exception of expense deductions, mutual funds and exchange-traded funds simply pass through the returns of their underlying securities. This transformation of performance is typically understood or implicit in references to derivatives but rarely makes its way into the formal definition. In keeping with customary industry practice, this characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives from mutual funds and exchange-traded funds and some other straight pass-through instruments.

Futures contract

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. Futures are standardized, more transparent, more regulated, and generally immune to counterparty default than forwards are.

A characteristic of forward commitments is that they: provide linear payoffs. do not depend on the outcome or payoff of an underlying asset. provide one party the right to engage in future transactions on terms agreed on in advance.

A is correct because forward commitments provide linear payoffs. B is incorrect because forward commitments depend on the outcome or payoff of an underlying asset. C is incorrect because forward commitments obligate parties to make (not provide the right to engage) a final payment contingent on the performance of the underlying.

Which of the following is not a characteristic of a call option on a stock? A guarantee that the stock will increase A specified date on which the right to buy expires A fixed price at which the call holder can buy the stock

A is correct. A call option on a stock provides no guarantee of any change in the stock price. It has an expiration date, and it provides for a fixed price at which the holder can exercise the option, thereby purchasing the stock.

The buyer of an option has a contingent claim in the sense that the option creates: a right. an obligation. a linear payoff with respect to gains and losses of the underlying.

A is correct. A contingent claim, a derivative in which the outcome or payoff depends on the outcome or payoff of an underlying asset, has come to be associated with a right, but not an obligation, to make a final payment contingent on the performance of the underlying. B is incorrect because an option, as a contingent claim, grants the right but not the obligation to buy or sell the underlying at a later date. C is incorrect because the holder of an option has a choice of whether to exercise the option. This choice creates a payoff that transforms the underlying payoff in a more pronounced manner than does a forward, futures, or swap, which provide linear payoffs. Options are different in that they limit losses in one direction.

A futures contract is best described as a contract that is: standardized. subject to credit risk. marked to market throughout the trading day.

A is correct. A futures contract is a standardized derivative contract. B is incorrect because through its clearinghouse the futures exchange provides a credit guarantee that it will make up a loss in the event a losing party cannot pay. C is incorrect because a futures contract is marked to market at the end of each day, a process in which the futures clearinghouse determines an average of the final futures trade of the day and designates that price as the settlement price.

A swap is: more like a forward than a futures contract. subject to simultaneous default by both parties. based on an exchange of two series of fixed cash flows.

A is correct. A swap is a bit more like a forward contract than a futures contract in that it is an OTC contract, so it is privately negotiated and subject to default. B is incorrect because in a swap, although either party can default, only one party can do so at a particular time. Money owed is based on the net owed by one party to the other, and only the party owing the greater amount can default to the counterparty owing the lesser amount. C is incorrect because a swap involves an exchange between parties in which at least one party pays a variable series of cash flows determined by an underlying asset or rate.

An interest rate swap is a derivative contract in which: two parties agree to exchange a series of cash flows. the credit seller provides protection to the credit buyer. the buyer has the right to purchase the underlying from the seller.

A is correct. An interest rate swap is defined as a derivative in which two parties agree to exchange a series of cash flows: One set of cash flows is variable, and the other set can be variable or fixed. B is incorrect because a credit derivative is a derivative contract in which the credit protection seller provides protection to the credit protection buyer. C is incorrect because a call option gives the buyer the right to purchase the underlying from the seller.

An option provides which of the following? Either the right to buy or the right to sell an underlying The right to buy and sell, with the choice made at expiration The obligation to buy or sell, which can be converted into the right to buy or sell

A is correct. An option is strictly the right to buy (a call) or the right to sell (a put). It does not provide both choices or the right to convert an obligation into a right.

Consider a call option selling for $4 in which the exercise price is $50 Determine the value at expiration and the profit for a buyer if the price of the underlying at expiration is $48. -$4 $0 $2

A is correct. CT = Max(0,ST − X) = Max(0,48 − 50) = 0 Π = CT − C0 = 0 − 4 = −4

A beneficial opportunity created by the derivatives market is the ability to: adjust risk exposures to desired levels. generate returns proportional to movements in the underlying. simultaneously take long positions in multiple highly liquid fixed-income securities.

A is correct. Derivatives allow market participants to practice more effective risk management, a 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. B is incorrect because derivatives are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount, as opposed to a large amount, of their own capital relative to the value of the underlying. This allows participants to generate returns that are disproportional, as opposed to proportional, to movements in the underlying. C is incorrect because derivatives are not needed to copy strategies that can be implemented with the underlying on a standalone basis. Rather, derivatives can be used to create strategies that cannot be implemented with the underlying alone. Simultaneously taking long positions in multiple highly liquid fixed-income securities is a strategy that can be implemented with the underlying securities on a standalone basis.

Which of the following derivatives allows an investor to pay the return on a stock index and receive a fixed rate? Equity swap Stock warrant Index futures contract

A is correct. Equity swaps, also known as index 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. B is incorrect because warrants are options that are sold directly to the public, allowing holders to exercise and buy shares directly from the company as opposed to using stock indexes to determine returns. C is incorrect because although index derivatives in the form of options, forwards, futures, and swaps are very popular, paying the return on a stock index and receiving a fixed rate describes an equity swap (or index swap), not a futures contract.

Which of the following is most likely the underlying of a plain vanilla interest rate swap? 180-day Libor 10-year US Treasury bond Bloomberg Barclay's US Aggregate Bond Index

A is correct. In a plain vanilla interest rate swap, an interest rate, such as Libor, serves as the underlying. A plain vanilla interest rate swap is one of many derivatives in which a rate, not the instrument that pays the rate, is the underlying. B is incorrect because a plain vanilla interest rate swap is one of many derivatives in which a rate, not an instrument that pays a rate, is the underlying. C is incorrect because a plain vanilla interest rate swap is one of many derivatives in which a rate, not an instrument (or index) that pays a rate, is the underlying.

In a declining interest rate environment, compared with a CMO's Class A tranche, its Class C tranche will be repaid: earlier. at the same pace. later.

A is correct. Lower interest rates entice homeowners to pay off their mortgages early because they can refinance at lower rates. The most junior tranche in a CMO will bear the first wave of prepayments until that tranche has been completely repaid its full principal investment. At that point, the next tranche will bear prepayments until that tranche has been fully repaid. Therefore, the Class C tranche of a CMO will be repaid before the more senior Class A tranche. B is incorrect because the tranches, which have different priorities of claims on the principal payments made by the underlying mortgages, will see prepayments allocated to the most junior tranches first and the most senior tranches last. C is incorrect because the most junior tranche in a CMO will bear the first wave of prepayments until that tranche has been completely repaid its full principal investment. At that point, the next tranche will bear prepayments until that tranche has been fully repaid. Therefore, the Class C tranche will be repaid prior to, not after, the Class A tranche.

Which of the following derivatives provide payoffs that are non-linearly related to the payoffs of the underlying? Options Forwards Interest-rate swaps

A is correct. Options are classified as a contingent claim which provides payoffs that are non-linearly related to the performance of the underlying. B is incorrect because forwards are classified as a forward commitment, which provides payoffs that are linearly related to the performance of the underlying. C is incorrect because interest-rate swaps are classified as a forward commitment, which provides payoffs that are linearly related to the performance of the underlying.

In contrast to over-the-counter options, futures contracts most likely: are not exposed to default risk. represent a right rather than a commitment. are private, customized transactions.

A is correct. Over-the-counter options are exposed to default risk, but futures contracts are standardized transactions that take place on futures exchanges and are not exposed to default risk. B is incorrect. Futures contracts are commitments, but options represent a right. C is incorrect. Futures contracts are not private; they are standardized instruments that trade on organized exchanges.

Which of the following statements explains a characteristic of futures price limits? Price limits: help the clearinghouse manage its credit exposure. can typically be expanded intra-day by willing traders. establish a band around the final trade of the previous day.

A is correct. Price limits are important in helping the clearinghouse manage its credit exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from parties losing money. B is incorrect because typically the exchange rules allow for an expansion of price limits the next day (not intra-day) if traders are willing. C is incorrect because price limits establish a band relative to the previous day's settlement price (not final trade).

The clearing and settlement process of an exchange-traded derivatives market: provides a credit guarantee. provides transparency and flexibility. takes longer than that of most securities exchanges.

A is correct. The clearing and settlement process of derivative transactions provides a credit guarantee. B is incorrect because although the exchange markets are said to have transparency, they also involve standardization. That entails a loss of flexibility, with participants limited to only those transactions permitted on the exchange. C is incorrect because derivatives exchanges clear and settle all contracts overnight, which is faster than most securities exchanges, which require two business days.

For a given CDO, which of the following tranches is most likely to have the highest expected return? Equity Senior Mezzanine

A is correct. The expected returns of the tranches vary according to the perceived credit risk, with the senior tranches having the highest credit quality and the junior tranches the lowest. Thus, the senior tranches have the lowest expected returns and the junior tranches have the highest. The most junior tranche is sometimes called the "equity tranche."

Which of the following statements describes an aspect of margin accounts for futures? The maintenance margin is always less than the initial margin. The initial margin required is typically at least 10% of the futures price. A margin call requires a deposit sufficient to raise the account balance to the maintenance margin.

A is correct. The maintenance margin is always significantly lower than the initial margin. B is incorrect because the initial margin required is typically at most (not at least) 10% of the futures price. C is incorrect because a margin call requires a deposit large enough to bring the balance up to the initial (not maintenance) margin.

The notional principal of a swap is: not exchanged in the case of an interest rate swap. a fixed amount whenever it is matched with a loan. equal to the amount owed by one swap party to the other.

A is correct. The notional principal of a swap is not exchanged in the case of an interest rate swap. B is incorrect because an amortizing loan will be matched with a swap with a pre-specified declining (not fixed) notional principal that matches the loan balance. C is incorrect because the notional principal is equal to the loan balance. Although the loan has an actual balance (the amount owed by the borrower to the creditor), the swap does not have such a balance owed by one swap party to the other.

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 credit protection buyer offers to pay the credit protection seller the total return on the underlying bond. This total return consists of all interest and principal paid by the borrower plus any changes in the bond's market value. In return, the credit protection seller typically pays the credit protection buyer either a fixed or a floating rate of interest. Thus, if the bond defaults, the credit protection seller must continue to make its promised payments, while receiving a very small return or virtually no return from the credit protection buyer. If the bond incurs a loss, as it surely will if it defaults, the credit protection seller effectively pays the credit protection buyer.

Swap

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. The most widely used derivative Because swaps, forwards, and futures are forward commitments, they can all accomplish the same thing. One could create a series of forwards or futures expiring at a set of dates that would serve the same purpose as a swap. Although swaps are better suited for risks that involve multiple payments, at its most fundamental level, a swap is more or less just a series of forwards and, acknowledging the slight differences discussed above, more or less just a series of futures.

Currency swaps are: rarely used. commonly used to manage interest rate risk. executed by two parties making a series of interest rate payments in the same currency.

B is correct. Because interest rates and currencies are both subject to change, a currency swap has two sources of risk. Furthermore, companies operating across borders are subject to both interest rate risk and currency risk, and currency swaps are commonly used to manage these risks. A is incorrect because currency risk is a major factor in global financial markets, and the currency derivatives market is extremely large, as opposed to small. C is incorrect because a currency swap is executed by two parties making a series of interest rate payments to each other in different currencies, as opposed to the same currency.

Which of the following is not a forward commitment? An agreement to take out a loan at a future date at a specific rate An offer of employment that must be accepted or rejected in two weeks An agreement to lease a piece of machinery for one year with a series of fixed monthly payments

B is correct. Both A and C are commitments to engage in transactions at future dates. In fact, C is like a swap because the party agrees to make a series of future payments and in return receives temporary use of an asset whose value could vary. B is a contingent claim. The party receiving the employment offer can accept it or reject it if there is a better alternative.

Suppose you believe that the price of a particular underlying, currently selling at $99, is going to increase substantially in the next six months. You decide to purchase a call option expiring in six months on this underlying. The call option has an exercise price of $105 and sells for $7. Determine the profit if the price of the underlying six months from now is $112. $7 $0 -$3

B is correct. CT = Max(0,ST − X) = Max(0,112 − 105) = 7 Π = CT − C0 = 7 − 7 = 0 Note: $112 is the breakeven price

In contrast to contingent claims, forward commitments provide the: right to buy or sell the underlying asset in the future. obligation to buy or sell the underlying asset in the future. promise to provide credit protection in the event of default.

B is correct. Forward commitments represent an obligation to buy or sell the underlying asset at an agreed upon price at a future date. A is incorrect because the right to buy or sell the underlying asset is a characteristic of contingent claims, not forward commitments. C is incorrect because a credit default swap provides a promise to provide credit protection to the credit protection buyer in the event of a credit event such as a default or credit downgrade and is classified as a contingent claim.

In contrast to contingent claims, forward contracts: have their prices chosen by the participants. could end in default by either party. can be exercised by physical or cash delivery.

B is correct. In a forward contract, either party could default, whereas in a contingent claim, default is possible only from the short to the long. A is incorrect because the forward price is set in the pricing of the contract such that the starting contract value is zero, unlike contingent claims, under which parties can select any starting value. C is incorrect because both forward contracts and contingent claims can be settled by either physical or cash delivery.

Derivatives are similar to insurance in that both: have an indefinite life span. allow for the transfer of risk from one party to another. allow for the transformation of the underlying risk itself.

B is correct. Insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of risk transfer. A is incorrect because derivatives, like insurance, have a definite, as opposed to indefinite, life span and expire on a specified date. C is incorrect because both derivatives and insurance allow for the transfer of risk from one party (the purchaser of the insurance policy or of a derivative) to another party (the insurer or a derivative seller), for a specified period of time. The risk itself does not change, but the party bearing it does.

Which of the following statements best describes the payoff from a forward contract? The buyer has more to gain going long than the seller has to lose going short. The buyer profits if the price of the underlying at expiration exceeds the forward price. The gains from owning the underlying versus owning the forward contract are equivalent.

B is correct. The buyer is obligated to pay the forward price F0(T) at expiration and receives an asset worth ST, the price of the underlying. The contract effectively pays off ST − F0(T), the value of the contract at expiration. The buyer therefore profits if ST > F0(T). A is incorrect because the long and the short are engaged in a zero-sum game. This is a type of competition in which one participant's gains are the other's losses, with their payoffs effectively being mirror images. C is incorrect because although the gain from owning the underlying and the gain from owning the forward are both driven by ST, the price of the underlying at expiration, they are not the same value. The gain from owning the underlying would be ST − S0, the change in its price, whereas the gain from owning the forward would be ST − F0(T), the value of the forward at expiration.

Which of the following derivatives is least likely to have a value of zero at initiation of the contract? Futures Options Forwards

B is correct. The buyer of the option pays the option premium to the seller of the option at the initiation of the contract. The option premium represents the value of the option, whereas futures and forwards have a value of zero at the initiation of the contract. A is incorrect because no money changes hands between parties at the initiation of the futures contract, thus the value of the futures contract is zero at initiation. C is incorrect because no money changes hands between parties at the initiation of the forward contract, thus the value of the forward contract is zero at initiation.

A corporation issues five-year fixed-rate bonds. Its treasurer expects interest rates to decline for all maturities for at least the next year. She enters into a one-year agreement with a bank to receive quarterly fixed-rate payments and to make payments based on floating rates benchmarked on three-month Libor. This agreement is best described as a: futures contract. forward contract. swap.

C is correct. A swap is a series of forward payments. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows. The corporation receives fixed interest rate payments and makes variable interest rate payments. Given that the contract is for one year and the floating rate is based on three-month Libor, at least four payments will be made during the year.

Suppose you believe that the price of a particular underlying, currently selling at $99, is going to increase substantially in the next six months. You decide to purchase a call option expiring in six months on this underlying. The call option has an exercise price of $105 and sells for $7. Determine the profit if the price of the underlying six months from now is $99. $6 $0 -$7

C is correct. CT = Max(0,ST − X) = Max(0,99 − 105) = 0 Π = CT − C0 = 0 − 7 = −7

Which of the following factors is shared by forwards and futures contracts? Timing of profits Flexible settlement arrangements Nearly equivalent profits by expiration

C is correct. Comparing the derivatives, forward and futures contracts have nearly equivalent profits by the time of expiration of the forward. A is incorrect because the timing of profits for a futures contract is different from that of forwards. Forwards realize the full amount at expiration, whereas futures contracts realize their profit in parts on a day-to-day basis. B is incorrect because the settlement arrangements for the forwards can be agreed on at initiation and written in the contract based on the desires of the engaged parties. However, in the case of a futures contract, the exchange (not the engaged parties) specifies whether physical delivery or cash settlement applies.

A credit derivative is which of the following? A derivative in which the premium is obtained on credit A derivative in which the payoff is borrowed by the seller A derivative in which the seller provides protection to the buyer against credit loss from a third party

C is correct. Credit derivatives provide a guarantee against loss caused by a third party's default. They do not involve borrowing the premium or the payoff.

Which of the following characteristics is not associated with exchange-traded derivatives? Margin or performance bonds are required. The exchange guarantees all payments in the event of default. All terms except the price are customized to the parties' individual needs.

C is correct. Exchange-traded contracts are standardized, meaning that the exchange determines the terms of the contract except the price. The exchange guarantees against default and requires margins or performance bonds.

Which of the following distinguishes forwards from swaps? Forwards are OTC instruments, whereas swaps are exchange traded. Forwards are regulated as futures, whereas swaps are regulated as securities. Swaps have multiple payments, whereas forwards have only a single payment.

C is correct. Forwards and swaps are OTC instruments and both are regulated as such. Neither is regulated as a futures contract or a security. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment, made at its expiration date.

Which of the following statements regarding the settlement of forward contracts is correct? Contract settlement by cash has different economic effects from those of a settlement by delivery. Non-deliverable forwards and contracts for differences have distinct settlement procedures. At cash settlement, when the long party acquires the asset in the market, it effectively pays the forward price.

C is correct. In the case of cash settlement, the long can acquire the asset, effectively paying the forward price, F0(T). A is incorrect because forward contracts settled by cash or by delivery have the same economic effect. B is incorrect because both non-deliverable forwards and contracts for differences can settle by an exchange of cash.

Which of the following occurs in the daily settlement of futures contracts? Initial margin deposits are refunded to the two parties. Gains and losses are reported to other market participants. Losses are charged to one party and gains credited to the other.

C is correct. Losses and gains are collected and distributed to the respective parties. There is no specific reporting of these gains and losses to anyone else. Initial margin deposits are not refunded and, in fact, additional deposits may be required.

Market makers earn a profit in both exchange and over-the-counter derivatives markets by: charging a commission on each trade. a combination of commissions and markups. buying at one price, selling at a higher price, and hedging any risk.

C is correct. Market makers buy at one price (the bid), sell at a higher price (the ask), and hedge whatever risk they otherwise assume. Market makers do not charge a commission. Hence, A and B are both incorrect.

Which of the following is the best example of a derivative? A global equity mutual fund A non-callable government bond A contract to purchase Apple Computer at a fixed price

C is correct. Mutual funds and government bonds are not derivatives. A government bond is a fundamental asset on which derivatives might be created, but it is not a derivative itself. A mutual fund can technically meet the definition of a derivative, but as noted in the reading, derivatives transform the value of a payoff of an underlying asset. Mutual funds merely pass those payoffs through to their holders.

Which of the following characteristics is associated with over-the-counter derivatives? Trading occurs in a central location. They are more regulated than exchange-listed derivatives. They are less transparent than exchange-listed derivatives.

C is correct. OTC derivatives have a lower degree of transparency than exchange-listed derivatives. Trading does not occur in a central location but, rather, is quite dispersed. Although new national securities laws are tightening the regulation of OTC derivatives, the degree of regulation is less than that of exchange-listed derivatives.

Exercise price

The fixed price at which an option holder can buy or sell the underlying. Also called strike price, striking price, or strike. This price is somewhat analogous to the forward price because it represents the price at which the underlying will be purchased or sold if the option is exercised. The forward price, however, is set in the pricing of the contract such that the contract value at the start is zero. The strike price of the option is chosen by the participants. The actual price or value of the option is an altogether different concept.

Settlement price

The official price, designated by the clearinghouse, from which daily gains and losses will be determined and marked to market. The clearinghouse determines an average of the final futures trades of the day and designates that price as the settlement price. All contracts are then said to be marked to the settlement price. For example, if the long purchases the contract during the day at a futures price of £120 and the settlement price at the end of the day is £122, the long's account would be marked for a gain of £2. In other words, the long has made a profit of £2 and that amount is credited to his account, with the money coming from the account of the short, who has lost £2. Naturally, if the futures price decreases, the long loses money and is charged with that loss, and the money is transferred to the account of the short.

Clearing

The process by which the exchange verifies the execution of a transaction and records the participants' identities.