Alternative Investments, Risk Management, and the Application of Derivatives

private equity fund characteristics

1. illiquid 2. long term commitments required 3. higher risk than seasoned public equity 4. higher expected IRR required 5. limited information (for venture capital) (PE is less of a diversifier and more of a long term return enhancer)

PE fund characteristics

1. illiquidity 2. required long term commitments 3. higher risk than seasoned public equity 4. higher expected IRR required 5. limited information (for VC)

why reporting and compounding frequency can affect apparent hedge fund performance

1. hedge funds allow entry or exit quarterly or even less often 2. no compounding is typically applied to the loss in calculating drawdowns

disadvantages of real estate

1. high information and transaction costs 2. political risk related to tax law changes 3. high operating expenses 4. inability to subdivide investments 5. large idiosyncratic risk

steps in an effective enterprise risk management system

1. identify each risk exposure of the company 2. quantify exposures in measurable terms 3. include each risk in aggregate measure of firm risk 4. report the risks and allocate capital and risk to units of the firm 5. monitor compliance with allocated limits of capital and risk

reasons for illiquidity in direct real estate investment

1. lack of availability and timeliness of information 2. high transaction costs 3. large transaction sizes when buying/selling versus the flexibility of trading small sizes of a REIT

gain-to-loss ratio

(# mos. pos. ret./# mos. neg. ret.) x (avg. up mo. ret./avg down mo. ret.)

disadvantages of VaR based position limits

1. limit regime will only be as effective as the VaR calculation itself 2. relationship between overall VaR and VaR of individual positions can be complex and counter-intuitive

ways to manage credit risk

1. limiting exposure (primary way) 2. marking to market 3. collateral 4. netting 5. minimum credit standards

financial risks

1. liquidity 2. credit 3. commodity 4. equity 5. exchange rate 6. interest rate

why hedge with futures rather than the underlying

1. liquidity and transaction costs 2. tax consequences 3. institutional constraints

advantages of real estate

1. low correlation to stocks and bonds 2. inflation hedge 3. low volatility of return 4. may also offer tax advantages and opportunities to leverage

issues that must be addressed in formulating a private equity investment strategy

1. low liquidity (plan to keep money invested 7 to 10 years) 2. diversification through the number of positions 3. diversification strategy (knowing the characteristics of PE relative to the rest of the portfolio) 4. plans for meeting capital calls

credit risk of swaps

actual current credit risk on multiple dates of payments. potential credit risk is the value of the swap to the party with a gain. credit risk is highest in the middle of the swap's life.

advantage of VaR based position limits

allocates capital in units of estimated exposure (in harmony with risk control)

current credit risk

amount of a payment currently due (0 on any day that one isn't due - american style options have current credit risk while european style do not)

earnings at risk (EaR)

analogous to CFAR but from an accounting earnings perspective (substitutes earnings for value in VaR)

stressing models

apply shocks to model inputs in a mechanical way to glean some idea of the likelihood of scenarios happening (has disadvantage of being computationally demanding)

advantage of factor push stress models

appropriate for a wide range of models

political risk

associated with changes in the political environment

potential credit risk

associated with payments due in the future and exists even if there is no current credit risk

disadvantages of the historical approach to calculating VaR

assumes that the historical pattern of returns will repeat in the future

credit risk of forwards

at any one point credit risk is with the party that has a gain (party with a gain faces current credit risk at settlement). potential credit risk will be highest in the middle to later periods of the contract.

return over maximum drawdown (RoMAD)

average return in a given year that a portfolio generates as a % of the largest difference btween a high water mark and a subsequent low (willing to accept occasional drawdown of X for average return Y?)

what rolling returns can show

how consistent returns are over the investment period and whether there is any cyclicality in the returns

cross default provisions

if a borrower defaults on any outstanding credit obligations, the borrower is considered to be in default on all obligations

positive event risk

in periods of financial, economic, or political distress, and sometimes after natural disasters, short term commodity prices tend to rise due to shocks that reduce current supply

credit risk of options

only the long position faces potential credit risk so the credit risk is unilateral (the buyer will have potential credit risk equal to the current market value of the option)

credit spread option

option on the yield spread of a reference obligation over a referenced benchmark

direct real estate

ownership of residencies, commercial real estate, agricultural land

hypothetical events

scenario analysis based on events that never happened or market outcomes with a small probability (has the disadvantage of being difficult to analyze and possibly generating confusing outcomes)

characteristics of VaR

1. VaR for individual positions cannot be aggregated into portfolio VaR (have to take correlations into account) 2. VaR increases as the time period is extended 3. VaR at 1% will be bigger than VaR at 5%

disadvantages of the analytical method to computing VaR

1. assumes a normal distribution of returns 2. many assets demonstrate leptokurtosis (fat tails), in which case VaR will underestimate the possible loss 3. can be difficult to estimate the standard deviation of large portfolios (difficult to calculate covariance between options or options and another security)

other tools that should be used with VaR

1. back testing 2. incremental VaR (IVaR) 3. cash flow at risk (CFAR) 4. earnings at risk (EAR) 5. tail value at risk (TVAR) 6. credit VaR 7. stress testing

determinants of commodity returns

1. business cycle supply and demand 2. convenience yield 3. real options under uncertainty

disadvantages of VaR

1. can be difficult to estimate in complex organizations/portfolios (and different methods of calculating it can give different results) 2. can lull one into a false sense of security 3. often underestimates the magnitude of the worst returns (often due to erroneous assumptions) 4. does not account for liquidity risk (assumes positions can be liquidated)

advantages of VaR

1. can quantify potential loss in simple terms that can be understood by management 2. it is versatile (can be used in many different types of businesses and portfolios/used in capital allocation)

disadvantages of direct equity investments in real estate

1. cannot subdivide 2. political risk of changing tax regimes 3. idiosyncratic and geographic risk 4. high information costs 5. high commissions and transaction costs 6. relative illiquidity 7. high operating costs

differences between venture capital funds and buyout funds

1. cash flows to buyout investors come earlier and are more steady 2. returns to VC investors are subject to greater error in measurement 3. buyout funds can be highly levered 4. buyout funds have less frequent losses but less upside potential

market risks

1. commodity 2. equity 3. exchange rate 4. interest rate

style classifications of hedge funds

1. convertible arbitrage (exploit mispricings in convertible securities - have low market exposure but high credit risk from leverage in the derivatives used to hedge) 2. distressed securities 3. emerging markets 4. equity market neutral (eliminates systematic risk to capitalize only on mispricings) 5. hedged equity (does not seek to remove systematic risk) 6. fixed income arbitrage 7. global macro 8. merger arbitrage 9. fund of funds

credit derivatives

1. credit default swap (protection buyer pays seller in return for the right to receive a payment in the event of a specified credit event) 2. total return swap (protection buyer pays the total return on a reference obligation in return for floating rate payments) 3. credit spread option (option on the yield spread of a reference obligation over a referenced benchmark) 4. credit spread forward (forward contract on a yield spread)

hedge fund index biases

1. databases are self reported 2. survivorship bias 3. stale price bias (securities with infrequent trading may have correlations lower than expected and standard deviations lower than if frequently traded) 4. backfill bias (filling in missing past reutnr data is supplied by the HF when it joins the index - only HFs with good past performance will want to supply it) 5. relevance of past data may be questionable as HF indices frequently change composition 6. size, age, and weighting requirements that differ can make similar strategy indices have a low correlation

commodities' role in portfolios

1. diversification 2. inflation hedge

advantages of the analytical method to computing VaR

1. easily calculated and easily understood as a single number 2. allows modeling of the correlation of risks 3. can be applied to shorter or longer time periods

advantages of scenario analysis

1. enables identifying and analyzing specific exposures that might affect a portfolio 2. is a natural complement to VaR with different scenarios having attached probabilities

types of stressing models

1. factor push (push prices and risk factors of an underlying model in the most disadvantagous way to work out the combined effect on portfolio value) 2. maximum loss optimization (try to optimize mathematically the risk variable that will produce the maximum loss) 3. worst case scenario analysis (examine the worst case that we actually expect to occur)

characteristics of commodities

1. fairly liquid compared to other alts 2. low correlation to stocks and bonds (diversifier) 3. positive correlation with inflation

type of companies that demand venture capital

1. formative stage companies 2. expansion stage companies

risk management process

1. management sets risk management policies and procedures 2. define risk tolerance to various risks in terms of what firm is willing and able to bear 3. identify risks faced by the organization (financial and nonfinancial) 4. measure current levels of risk 5. adjust the levels of risk using derivatives or other things

advantages of direct equity investments in real estate

1. many expenses are tax deductible 2. can diversify geographically 3. can use more leverage 4. low volatility 5. have control of the property

major due diligence check points involved in selecting alts active managers

1. market opportunity (identify inefficiencies and their causes) 2. investment process (what's the edge, best practices, competitive advantage) 3. organization 4. people (trustworthy and experienced?) 5. terms and structure 6. service providers (lawyers, brokers, auditors) 7. documents (prospectus and private placement memos) 8. write up (formal manager recommendation)

issues with private equity indices

1. might present dated values 2. repricing occurs frequently 3. lack of pricing data causes reliance on appraisal values that understate vol and correlations

non financial risks

1. operational 2. model 3. settlement (Herstatt) 4. legal/contract 5. tax 6. accounting 7. sovereign 8. political

disadvantages of the monte carlo approach to calculating VaR

1. output is only as good as the analysts' inputs 2. data and computer intensive (costly to use in complex situations)

how buyout funds can exit an investment

1. private placement 2. IPO 3. recapitalization (company issues substantial debt to pay large special dividend to buyout fund)

inputs to projecting credit risk

1. probability of default 2. recovery rate

alts' roles in portfolios

1. provide exposure to risk factors not easily accessible through stocks and bonds 2. provide exposure to specialized strategies 3. combine features of prior two groups

groups of alts

1. real estate (ownership interests in land or structures attached to land) 2. private equity (ownership interests in non publically traded companies) 3. commodities (articles of commerce such as metals, grains) 4. hedge funds (loosely regulated, pooled investment vehicles) 5. manage futures (pooled investment vehicles in futures or options on futures)

common features of alts

1. relative illiquidity 2. diversifying potential 3. high due diligence costs (structures and strategies may be complex, require expertise and reporting lacks transparency) 4. unusually difficult performance appraisal due to lack of valid benchmarks

how buyout funds add value

1. restructuring company operations and management 2. buying companies for less than intrinsic value 3. adding leverage or restructuring debt

considerations for hedge fund performance evaluation

1. returns achieved 2. volatility 3. what performance appraisal measures to use 4. correlations 5. skewness and kurtosis 6. consistency

factors that affect how much of a hedge a commodity is to unexpected inflation

1. storability (primary determinate - storable commodities are more highly correlated to unexpected inflation) 2. economic activity (those with a more constant level of demand provide little hedge against unexpected inflation)

issues that alts raise for advisers of private wealth clients

1. suitability 2. tax issues 3. communication with client (can be hard to describe the role of complex investments to individuals) 4. decision risk (risk of changing strategies at the point of maximum loss) 5. concentrated client equity position (affects risk and liquidity needs)

limitations of sharpe for hedge fund performance

1. time dependency (increases proportionately with the square root of time) 2. not appropriate when returns are asymmetric (hedge fund returns have high kurtosis - fat tails - and/or are skewed) 3. illiquid holdings bias it up 4. does not take into account correlations to other assets in the portfolio 5. overestimated when returns are serially correlated 6. has not been found to have predictive ability for hedge funds 7. can be gamed by (1) lengthening the measurement interval (2) compounding monthly returns but calculating standard deviation from the not compounded returns (3) using options to receive premium but not paying them off until after measurement period (4) smoothing of returns (5) getting rid of extreme returns

characteristics of good risk governance

1. transparent 2. establishes clear accountability 3. cost efficient 4. achieves desired outcomes

reasons for basis risk

1. underlying and hedge are not based on the same vehicle (cross hedge) 2. betas and durations used in hedge calculation do not reflect future actual market changes 3. hedge results are measured prior to contract expiration 4. number of contracts is rounded 5. future and spot price are not fairly priced based on cash and carry arb. model 6. nonparallel shifts in the yield curve (immunization risk remains)

advantages of the historical approach to calculating VaR

1. very easy to calculate and understand 2. does not assume a normal distribution 3. can be applied to different time periods

tail value at risk (TVaR)

VaR plus the average of the outcomes in the tail (gives insight into what happens if VaR is exceeded)

historical approach to calculating VaR

accumulate a number of past daily returns, rank the returns from highest to lowest, and identify the lowest % of returns. the highest of the lowest % of these returns in the VaR (multiply by the value of the portfolio to get the dollar amount). it is appropriate for portfolios with more complexity (options, time sensitive bonds, etc.)

private equity investing in distressed debt

acquire position in distressed company and then use control to improve things and create own opportunities (done by vulture funds)

analytical method to computing VaR

based on the normal distribution and the concept of one tailed confidence intervals (should be used with portfolios that have linear return characteristics and a limited budget for computing and analytical personnel)

centralized risk governance (enterprise risk management)

brings risk control closer to key decision makers and enables better controlling of risks based on recognizing diversification across units (manages exposures in the context of the exposures of the overall firm)

indirect investment in commodities

buy company whose principal business is associated with a commodity

distressed debt arbitrage

buy company's distressed debt while shorting the equity (the equity should fall more in value than the debt because the debt is senior - the return from bonds should be greater when things improve). this is passive compared to private equity distressed debt investing.

direct investment in commodities

buying physical commodity or derivatives on those assets

advantages of the monte marlo approach to calculating VaR

can incorporate any assumptions regarding return patterns, correlations, and other factors

commodity roll yield

change in the futures contract price for the period minus the change in the spot price for the period. backwardation predicts positive roll yield while contango predicts negative roll yield.

unsmoothed NCREIF

corrects NCREIF for biases such as infrequent appraisal based valuations, reflecting the true characteristics of the underlying (higher volatility and higher correlation to other assets)

why credit risk is difficult to estimate

credit events happen infrequently

prepackaged bankruptcy

creditors agree in advance with the debtor company on a plan or reorganization before bankruptcy is filed (creditors may make concessions in return for equity in the reorganized company). shareholders do not have as strong a stake prebankruptcy as creditors and may lose everything. vulture funds seek to become majority owner of the new company.

drawdown (for hedge funds)

difference between maximum NAV and any low point thereafter

risk adjusted return on capital (RAROC)

divides expected return on investment by a measure of capital at risk (may require investment RAROC to exceed a benchmark RAROC to invest)

closeout netting

during bankruptcy, multiple obligations owed between parties are combined into a single overall value owed by one party (reduces cherry picking where a bankrupt company only meets obligations that are favorable to it)

when potential credit risk will be highest during the life of a swap

during the middle period of the swap life (the number of remaining payments decreases towards maturity). credit risk of a currency swap is highest towards the end of the swap because the return of notional is made at the end.

when potential credit risk will be highest during a forward contract

during the middle to later periods of the contract

advantage of nominal, notional, or monetary position limits

easy to understand and easy to calculate

vintage year effect

economic conditions of the year a private equity fund was launched has a large impact on performance (and PE indices)

incremental VaR (IVaR)

effect of an individual item on an overall portfolio risk (difference in VaR before and after an item is added)

high water mark (for hedge funds)

employed to avoid incentive fee double dipping (incentive fee cannot be levied until fund value reaches previous high value if fund value declines)

disadvantage of factor push stress models

enormous model risk in assuming models will hold up in extreme scenarios

orphan equities

equities of firms emerging from reorganization

risk budgeting

establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk (comprehensive methodology that empowers management to allocate capital and risk in an optimal way to the most profitable areas of the business. limits are constantly monitored and corrective action taken immediately. diversification allows the sum of risk buckets for each unit to exceed the risk budget of the overall firm. you can compare the efficiency of unit profits based on VaR allocated.

VaR

estimate of the loss (in money terms) expected to be exceeded with a certain probability over a specified time period (actual loss can be much worse)

sovereign risk

form of credit risk in which the borrower is a country (magnitude determined by likelihood of default and the estimated recovery rate)

credit spread forward

forward contract on a yield spread

lock up period

limits withdrawals by requiring minimum investment period and designating exit windows (if an investor's lock up period is the as as his time horizon, it is actually better than a shorter lock up period because it prevents others from redeeming and forcing unwinds during time horizon)

market liquidity risk (distressed debt)

low liquidity and can be cyclical supply and demand for distressed securities

hedge fund strategy most similar to managed futures

macro (both try to take advantage of systematic moves in financial and nonfinancial markets). macro also extensively uses futures and options and has increased leverage and credit risk in addition to a large amount of market risk.

why it's sometimes hard to determine the alpha of a hedge fund

many are absolute return vehicles without an appropriate benchmark

disadvantage of nominal, notional, or monetary position limits

may not effectively capture the effects of correlations or offsetting risks (seldom a sufficient means of capital allocation from a risk control perspective)

cash flow at risk (CFaR)

measures risk of company's cash flows by substituting cash flow for value in VaR

commodity collateral return

periodic risk free return (assuming cash equivalents to the price of the contract are held). this is not a part of the price change. assumes that the full value of the underlying futures are invested at the risk free rate as the invest posts 100% margin with t-bills.

decentralized risk governance

places risk control responsibility in the hands of the business units and nearer in proximity to the sources of risk but does not account for portfolio effects across units

commingled real estate funds (CREFs)

pooled investments in real estate that are professionally managed and privately held (have more flexibilty than REITs but are restricted to wealthy investors and institutions)

legal/contract risk

possibility of a loss from the legal system failing to enforce a contract in which the company is a party (can happen to dealers in derivative transactions)

performance netting risk

potential for a loss stemming from a contractual obligation to pay a manager an incentive fee for positive performance when another manager has offsetting negative performance

NCREIF Property Index

principal index for direct investments. value weighted index of commercial properties sampled across geographies and type. its volatility is downward biased based on annual appraisals and the index being published quarterly. its biased also by the use of leverage in real estate investments (returns and sharpe ratios would be lower excluding leverage)

scenario analysis

process of evaluating a portfolio under different states of the world (should be used as a complement to VaR)

credit VaR

projects risk due to credit events

credit default swap

protection buyer pays seller in return for the right to receive a payment in the event of a specified credit event

total return swap

protection buyer pays the total return on a reference obligation in return for floating rate payments

venture capital

provides funding to start or grow a private company

middle market buyout fund

provides funds divisions spun out from larger publically traded companies and small companies that cannot efficiently obtain capital

buyout fund

provides funds to buy existing companies that are public and take them private

real estate investment trust (REITs)

publically traded equity shares in a portfolio of real estate (can be purchased in small sizes and liquid)

factor push stress model

push prices and risk factors of an underlying model in the most disadvantagous way to work out the combined effect on portfolio value (appropriate for a wide range of models but has enormous model risk in assuming models will hold up in extreme scenarios)

stress testing

putting through an extreme scenario

netting (credit risk management)

reduction of all obligations owed between parties into a single cash transaction that eliminates these liabilities (netting decreases the total amount at risk of credit loss because negative values of the amount owed reduces the positive value of the amount due to you that can be lost in the event of a default)

use of convertible preferred stock in direct venture capital investment

requires preferred stockholders to be paid a specified amount before common shareholders can receive cash in dividends or other distributions. buyout or acquisition of the common equity at a favorable price will trigger conversion of the preferred into the common shares of the company.

disadvantages of scenario analysis

results only as good as implied by the accuracy of the scenarios devised and user specification

event risk (distressed debt)

return in this space typically depends on an event for the company not associated with the company (can provide diversification)

market risk (distressed debt)

risk from macroeconomic changes (usually less important than other risks)

operational risk

risk of loss from failures in a company's systems and procedures or from external events (computers, human error, acts of god)

liquidity risk

risk that a financial instrument cannot be bought or sold without a significant concession in price because the market cannot efficiently accommodate the size of the trade

settlement netting risk

risk that a liquidator of a counterparty in default could challenge a netting agreement so that profitable transactions are realized to the benefit of the creditor

model risk

risk that a model is incorrect or mispecified (mispricing of options/valuation)

settlement (Herstatt) risk

risk that one party could be int he process of paying the counterparty while the counterparty is declaring bankruptcy (swaps and forwards in the OTC market)

j-factor risk (distressed debt)

role that courts and judges play in the return/an unpredictable human element (significant during bankruptcy)

distressed securities

securities of companies at or near bankruptcy. investment is often categorized by liquidity. a distressed hedge fund will be more liquid than a distressed private equity fund. have high returns because not all investors can hold them and there is little analyst coverage. large negative skew.

stale price bias

securities with infrequent trading may have correlations lower than expected and standard deviations lower than if frequently traded

enhanced derivatives product companies

separate from parent company and not liable for parent debts. highly capitalized and hedge positions. almost always receive highest credit rating. used by derivative dealers to control exposure to downgrades that could affect business.

stylized scenarios

simulating a movement in at least one interest rate, FX rate, stock price, or commodity price affecting the portfolio (disadvantage is that shocks tend to affect different variables simultaneously)

managed futures

sometimes classified as hedge funds because of same limited partnership legal structure and base fee + performance fee structure. tend to trade only derivatives markets and take positions based on indices. trading strategies can be systematic (trend following) or discretionary (based on fundamental econ data or trader beliefs). often have low or negative correlation to equities.

sortino ratio

sortino and sharpe tell more together than either can in isolation

internal capital requirements

specifies level of capital that management believes is appropriate. it is often specified heuristically or by regulations. can use VaR to determine a capital requirement.

hedge funds

structured to avoid regulation which also allows them to charge large incentive fees (designed to exploit a perceived market opportunity)

indirect real estate

there is a well defined middle group managing the property (REITs, CREFs, infrastructure funds, real estate companies)

purpose of hedge fund fund of funds

they are hedge funds that typically consist of 10-30 hedge funds (achieves diversification and greater liquidity but with a cost drag - there is also a cash drag of manager keeping extra cash to meet other investors' withdrawals). fund of funds can suffer from style drift and are more highly correlated to equities than an individual HF

why a fund of funds may be a better indicator of aggregate hedge fund performance

they keep defunct funds in their historical performance while an index may drop the failed fund

commodity total return

total return = spot return + collateral return + roll yield

maximum loss optimization stress model

try to optimize mathematically the risk variable that will produce the maximum loss

actual extreme events

type of scenario analysis involving putting portfolios through actual price movements of events like the GFC (has the advantage of being useful given the occurrence of extreme breaks has a higher probability than that given by the probability model and historical time period estimate used in VaR)

accounting risk

uncertainty about how a transaction should be recorded and the potential for accounting rules and regulations to change

tax risk

uncertainty associate with tax laws (something appears to be exempt but is later determined to be taxable - affected by priorities of politicians and regulators)

monte carlo approach to calculating VaR

uses computer software to generate hundreds or thousands of possible outcomes from the distributions of inputs provided by the user (not a wise choice unless managed by organizations with complex derivatives and capital to cover high technology and human capital costs)

when is good to invest in distressed securities

when the economy is faltering and may be going into recession (there are more bankruptcies, increasing supply)