CFP 3 Unit 5 Alternative Investments and Derivatives

developed markets

DM is associated with countries that have highly developed economies with stable political and social institutions. These are characterized by --large levels of equity capitalization; --few, if any, currency conversion restrictions; --highly liquid markets with many brokerage institutions and market makers; --many large capitalization securities; and --well-defined regulatory schemes leading to transparency similar to that enjoyed by those investing in U.S. securities.

Example: NOI Capitalization approach

If the cap rate for determining the value of Aspen Leaf Apartments is 9%, did the investor make a good purchase? V = NOI / cap rate = $65,490 / .09 = $727,667 The investor paid $700,000 for a property valued at greater than $727,000. The cost was approximately equal to the computed fair market value. Therefore, the investor did not overpay for the property.

tranches

In the traditional mortgage-backed pass-through certificate, each investor receives a pro rata share of principal and interest each month, no matter the repayment period. This is not the case with CMOs; instead, each of the tranches receives regular interest payments, with the investors of the first tranche (Tranche A) receiving all principal payments until they are completely repaid. Once all of the obligations of Tranche A are satisfied, all principal payments are made to the second tranche (Tranche B) and so on, until all of the tranches are repaid. As a result, the holders of Tranche A have less interest rate risk than do the holders of all the other tranches, because the maturity date (or repayment period) of the mortgage principal obligation is the shortest. Tranche Z, on the other hand, has the longest repayment period, subjecting its investors to the most interest rate risk. Tranche Z bondholders do not receive any interest or principal payments until all other tranches are repaid. The interest due on Tranche Z bonds accrues in a similar fashion to that of zero-coupon bonds and is taxable in the year earned.

collateralized mortgage obligation (CMO)

One of the most common forms of REMIC is the collateralized mortgage obligation (CMO). CMOs, which are mortgage derivatives created by private investment firms, are similar to mortgage-backed securities in that they are both backed by large pools of mortgages. However, CMOs, also referred to as multiclass securities, differ from mortgage-backed securities in that the cash flows associated with the pool of underlying mortgages are divided into repayment periods known as tranches.

real estate limited partnership (RELP)

A popular form of indirect ownership of real estate is to invest as a limited partner, usually through a nonpublicly traded real estate limited partnership (RELP) or syndication. A syndicated limited partnership consists of two owners: one is the syndicator or promoter of the partnership, who usually also serves as the general partner, and the second is the investor or limited partner. The syndicator will typically acquire a tract or tracts of real property and then attempt to sell it (or them) to the limited partner investors. In addition to charging fees for management of the real property tracts, the syndicator will retain an ownership interest and will be liable for all acts of the partnership. Investors will have no management responsibilities, and their liability will be limited to the extent of investment. RELPs may provide capital growth through appreciation of property. They may also distribute income, which can be sheltered from taxes by deductions of mortgage interest and depreciation.

zero-cost collar

A zero-cost collar is a strategy used to protect a gain in a long position of a stock. This strategy consists of 1. a long (or buy) position in the underlying stock, 2. a long put option, and 3. a short (or writing of a) call option. Specifically, the investor purchases a put option to protect against a decline in the value of the underlying stock and sells a call option to generate premium income to cover the cost of the premium for the put option. As a result, the premium received on the call option pays for the premium paid on the put option (thus, the term zero-cost or cashless).

natural resources

An investment in natural resources includes an investment in oil and gas properties or timberlands. Investors may participate in this market in the following three ways: 1. Investing in properties or lands via (typically) limited partnerships 2. Investing in the stock of companies that develop the natural resources 3. Investing in mutual funds that specialize in natural resources (a type of sector fund) A major advantage of investing in natural resources is the pass-through of certain tax benefits, such as deductions for depletion or intangible drilling costs. The returns from natural resources often happen when supply cannot keep pace with demand. At any given time, there is a fixed amount of a natural resource, such as oil, copper, or timber, available. Discovering and extracting more oil or copper, or growing more timber, takes time and expense. Also, natural resources have historically exhibited some negative correlation with other financial assets (stocks and bonds). However, a major disadvantage of such an investment is the higher degree of risk, particularly if the activity involves exploratory drilling for oil wells. Another major influence on the price of commodities in general is the times of rapid growth of the emerging markets, and the demand they have for various commodities and resources to fuel their growth. With this rapid growth comes demand for the resources necessary to continue growing, which includes making products and building infrastructure.

at the money

An option is at the money when the exercise price of the option equals the market price of the underlying stock.

in the money

An option is in the money when its intrinsic value is positive. A profitable put (in the money) would occur when the market price of the stock is lower than the strike price less the amount of the premium paid; a profitable call (in the money) would occur when the market price of the stock is higher than the strike price plus the amount of the premium paid.

out of the money

An option is out of the money when its intrinsic value is zero and the exercise price does not equal the market price of the underlying security. An unprofitable put (out of the money) would occur when the market price of the stock is higher than the strike price; an unprofitable call (out of the money) would occur when the market price of the stock is lower than the strike price. Intrinsic value is always zero when an option is out of the money or at the money.

Example: GIM

Based on the following information, calculate the GIM for the two properties. Comparable 1: 20 units @ $500 per month Sales price = $1,026,000 Comparable 2: 30 units @ $525 per month Sales price = $1,669,815 Answer: Comparable 1: 20 × $500 × 12 = $120,000 $1,026,000 ÷ $120,000 = 8.55 times (GIM) Comparable 2: 30 × $525 × 12 = $189,000 $1,669,815 ÷ $189,000 = 8.84 times (GIM) Calculating the value of real estate property is an important element in investment decision-making. Unless the intrinsic value of an investment is known, investors have no way of knowing if they are paying a fair value for the investment or if they are overpaying.

Options Positions - Possible Gains and Losses

Buy Call -> Max Gain: Unlimited Max Loss: Amount of premium paid Write Call -> Max Gain: Amount of premium paid Max Loss: Unlimited (if naked) Buy Put -> Max Gain: Exercise price less amount of premium paid Max Loss: Amount of premium paid Write Put -> Max Gain: Amount of premium paid Max Loss: Exercise price less amount of premium received

EXAMPLE: Exchange rate calculation

Calculate how many U.S. dollars you would receive for one euro if dealing with the exchange rates of 0.6600 euros per U.S. dollar, and 0.6800 euros per U.S. dollar. HP 10bII+: 0.66, SHIFT, 1/x = 1.5152 HP 10bII+: 0.68, SHIFT, 1/x = 1.4706

country risk

Country risk is a composite of all the risks of investing in a particular country. These may include political risks, such as revolutions or military coups, and structural risks, such as confiscatory policies toward profits, capital gains, and dividends.

real estate investment trust (REIT)

REITs serve as a source of long-term financing for real estate projects by investing in real estate, short-term construction loans, and mortgages. A REIT pools capital in a manner similar to an investment company. Some REITs are publicly traded on stock exchanges and may sell at a premium or discount to net asset value (NAV). As a result, the REIT investor achieves diversification and marketability that is generally lacking with the RELP form. A REIT entity is not subject to federal income taxation as long as it distributes at least 90% of its net annual earnings to shareholders each year. Another requirement is that at least 75% of an entity's gross income must be derived from real estate. For the shareholders, income received is considered investment (not passive) income. This means that losses from the REIT are considered capital losses and are not restricted by the passive income activity rules that apply to RELPs. Dividends received from a REIT are taxed as ordinary income. However, they may be classified as qualified dividends for purposes of the 0%/15%/20% capital gain tax rates. Types: Mortgage REITS, Hybrid REITs, and Equity REITs (90% of REITs) These acquire real estate for the purpose of renting the space to other companies. Income is generated from the rents and sales of the real estate properties. Equity REITs make up over 90% of the REIT market (by capitalization). REITs can be justified on many investor need factors, including the need for a high level of income, diversification benefits, and portfolio risk reduction due to low correlations with financial assets (stocks and bonds). Reasons to invest include: Inflation hedge, Diversification, Global reach, and Investment management philosophy. Differences between RELP and REIT includes liquidity, organizational structure, risk (RElPs have liquidity and marketability risk).

frontier markets

Smaller economies and markets in the emerging market sector are often referred to as frontier markets. Frontier markets include countries such as Bulgaria, Croatia, Romania, Ukraine, Serbia, Kenya, Nigeria, Lebanon, and Vietnam. There is increased risk and volatility when investing in these frontier markets. A major risk when investing in any emerging market is political risk. Dictatorships, regime changes, military takeovers, fixed elections, and nationalization of foreign holdings are examples of the risks that investors may encounter in less stable countries.

tangible assets

Tangible assets take the form of either collectibles or, sometimes, precious metals (e.g., gold or silver). Collectibles (e.g., baseball cards) may provide the dual benefit to the investor of pleasure in maintaining a collection and possible capital appreciation. However, the collectibles market is usually characterized by an inefficient market and inherent lack of liquidity. Alternatively, precious metals derive their value from factors that are external to the financial markets (e.g., with the purchase of gold, an investor's fear of inflation). As a result, the price of precious metals often moves inversely (i.e., has a negative correlation) with the market prices of stocks. An advisor may recommend a maximum allocation of 5%-10% gold, or gold mutual funds or ETFs, as part of a diversified portfolio. Funds often involve metals other than gold, such as platinum, palladium, silver, and copper.

Example: NOI

The following information pertains to Seven Oaks Apartments. Gross rental receipts = $150,000 Other income (laundry, parking, etc.) = $3,000 Average vacancy rate = 8% Operating expenses = $48,000 Mortgage payments = $120,00 Depreciation expense = $15,000 Gross rents (GRR) $150,000 Other income +$3,000 PGI =$153,000 Vacancy etc (8% of PGI) -$12,240 Effective Gross Income =$140,760 Operating Expenses. -$48,000 NOI =$92,760

intrinsic value

The intrinsic value of an option is the minimum price at which the option will trade on an exchange. The trading value of the option consists of two parts: the intrinsic value of the option and the time value of the option. These two parts make up the option premium. *Options will never have a negative intrinsic value. IV of a call option: the greater of zero and the market price less the exercise price of the underlying stock. Ex. Stock ABC is trading at $45. A call option on ABC with an exercise price of $40 would have an intrinsic value of $5. If ABC was trading at $35, the call option would have an intrinsic value of $0. An investor would not exercise the call option in this case because the investor could purchase the stock for less. IV of a put option: the greater of zero and the exercise price less the market price of the underlying stock. Ex. Stock XYZ is trading at $50. A put option on XYZ with an exercise price of $48 would have an intrinsic value of $0. The investor could sell her XYZ stock at $50 in the market and thus would not exercise her put option. However, if XYZ was trading at $42, the intrinsic value of the put option would be $6.

Options strategies

The three most widely used options strategies are as follows: 1. Buying options for speculation 2. Writing covered calls for income 3. Hedging a portfolio or position by buying protective puts

time value

The time value of the option is the amount by which the trading value of the option exceeds its intrinsic value. For example, MNO stock is trading at $80. An MNO $76 call is trading at $5. The intrinsic value of the call option is $4, and the time value is $1.

Hedging with futures

When you own something and want to hedge, you must short; when you are short something and want to hedge, you must buy. The most popular stock index futures is the S&P 500 Index future. Settlement takes place in cash and is based on a multiplier of 250; therefore, the value of a contract is 250 times the level of the index stated in the contract. With an index level of 2,000, the value of each contract is $500,000. Each index point in the futures price represents a gain or loss of $250 per contract. A long stock index futures position on S&P 500 Index futures at 2,051 would show a gain of $1,750 in the trader's account if the index were 2,058 at the settlement date ($250 × 7 = $1,750). Futures contracts covering several other popular indices are traded, and the pricing and contract valuation are the same—though the multiplier can vary from contract to contract. Long-term bond portfolios can be hedged using U.S. Treasury bond futures on the Chicago Board of Trade. Futures trade on 2-, 5-, and 10-year Treasury notes, as well as 30-year Treasury bonds. Be careful with fixed-income futures—remember that you are in effect buying (or selling) a bond, which has an inverse relationship with interest rates. So, if you believe interest rates are going to increase (meaning bonds will decrease in price), you would then sell a bond futures contract. Conversely, if you believe interest rates are going to decrease (meaning bonds will increase in price), you would then buy a bond futures contract. Foreign currencies can also be hedged, and there are appropriate contracts traded on the CME (www .cmegroup .com). Short hedge. When you are long an asset, you would enter into a short hedge (e.g., a wheat farmer is long the wheat, so he would then short wheat). With a short hedge, you are hedging against prices going down. If they do go down, you will make money on the short position, and this would offset any losses on having to sell the long position (the wheat you are growing, in this example) at lower prices. Long hedge. When you are short an asset, you would enter into a long hedge (e.g., a baker uses wheat for bread, so he would then go long wheat). With a long hedge, you are hedging against prices going up. If they do go up, you will make money on the long position, and this would offset any losses on having to buy the asset at higher prices in the cash market. Hedgers are not speculators—they are "locking" in a price, and will neither profit nor lose money going forward. Whatever they make or lose on one side of the equation will be offset by the other side.

undeveloped land

a passive investment, and it produces negative cash flows (in the form of ongoing expenses) while generating no income. Therefore, this asset is held by an investor strictly for the possibility of significant capital appreciation. Undeveloped land does not usually produce significant income or cash flow to the owner; accordingly, current taxation is of little consequence. The primary tax advantage to the owner is that appreciation in the value of the land is not recognized as income until the owner disposes of the land in a taxable transaction. At such time, the appreciation is taxed as capital gain income unless the owner is treated as a dealer in real estate by the IRS, in which case ordinary income treatment will result. In addition, the real estate taxes are normally tax deductible by the owner of the undeveloped land during the entire period of ownership. The risks associated with undeveloped land include the following: ---The land may be adversely rezoned (e.g., property bought for residential development purposes may be rezoned as commercial use only). ---The investor may not be able to obtain permits to build on the land. ---Access to the investor's land may be restricted by adjacent landowners. ---The population growth anticipated by the investor may not occur. As a result, an investment in undeveloped land is extremely risky. Therefore, the investor should expect a significant, future capital return—or the investment will likely not be made.

real estate mortgage investment conduit (REMIC)

a self-liquidating, flow-through entity (similar to a partnership) that invests exclusively in real estate mortgages or mortgage-backed securities and terminates when the mortgages that constitute the investment of the REMIC are repaid. Typically, a REMIC issues debt securities to investors in the form of publicly traded REMIC bonds. However, some issue residual interests, which are privately placed and not available to the general public. Most REMICs provide for monthly payments to the investor and are offered in denominations ranging from $1,000 to $25,000, depending on the issuer. Investors who own either a REMIC bond or residual interest receive a specified cash flow from the underlying pool of mortgages. REMICs often are structured to offer classes of bonds that mature over a period of 3-30 years. Accordingly, investors may invest in a bond class that matches their investment time horizon, thereby avoiding the uncertainty of bond principal repayment. As evident from the word conduit in its name, a REMIC is a pass-through entity that is wholly exempt from federal income tax. Thus, it acts as a conduit, and holders of REMIC bonds (not the entity itself) must report any taxable income from the underlying mortgages.

American depositary receipt (ADR)

a trust receipt issued by a U.S. bank for shares of a foreign company purchased and held by a foreign branch of the bank. ADRs are an alternative to direct investing in foreign companies or mutual funds, and they provide several benefits: --ADRs are denominated and pay dividends in U.S. dollars, not foreign currencies, thus saving the investor transaction costs with respect to converting currencies. Such dividends, however, are declared in the local currency and converted into U.S. dollars. Therefore, exchange rate risk is not completely eliminated. --Information about the foreign company is often more easily attainable with ADRs because the U.S. bank (or its foreign branch) holding the security generally has ready access to that information. --Because ADRs are traded on exchanges, they are relatively liquid and marketable investments. An ADR's price corresponds to the foreign stock's price in its home market. Dividends paid by ADRs are taxed to the investor as ordinary income in the year earned. However, corporations whose stock of ADRs is readily tradable on an established U.S. securities market qualify for the same 0%/15%/20% rates as do long-term capital gains. Before dividends are passed through to the shareholder on ADRs, the entity may withhold foreign taxes due.

futures contract

an agreement between two parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price. In addition to commodities (e.g., corn, wheat), futures contracts are written on financial assets, such as U.S. Treasury securities, indices, and foreign currencies. Using commodity futures is the easiest and most common way to gain economic exposure to commodities. To complete the futures contract, delivery of the commodity or asset may be made, but more often, the buyer (or holder) simply purchases an offsetting contract and cancels the original position. Only about 1% of all futures contract positions involve the delivery of the underlying commodity. Futures contracts, which are standardized as to size, quality, and delivery, are traded on exchanges such as the New York Mercantile Exchange (NYMEX) or Chicago Mercantile Exchange (CME). As with options, investors can take a long or short position in a futures contract. Purchasing a contract for future delivery is a long position (i.e., to take delivery of the commodity). Selling a contract for future delivery is a short position (i.e., to make delivery of the commodity). As with stocks, a long position will increase in value if the underlying commodity or asset increases in value, whereas a short position will increase in value if the underlying commodity or asset declines in value. Unlike purchasing options, where the most investors can lose is the premium paid, there is much more risk when entering into a futures contract because of the high degree of leverage. If investors purchase an option, the most they can lose is the premium paid. If investors enter into a futures contract, they can potentially lose substantially more than the initial deposit. Investors are usually required to have strong balance sheets and deposited funds with the broker—in addition to sufficient knowledge of the risks—before they are permitted to trade futures. Of greater interest to financial advisors are futures contracts on stock market indices and on interest rates. An investor in stocks and bonds is similar to the cattle rancher in that he owns an inventory of assets that can be protected against market corrections. Just like cattle ranchers, many stock and bond investors have a feel for when stock and bond prices are high and when they are low. When prices are perceived to be low, these investors may want to buy stocks and bonds; when prices are perceived as high, they may want to hold onto their positions and hedge against a market correction (that is, if they feel confident that the long-term direction of their portfolios is up). Numerous stock indices futures contracts are available to hedge a long position in a stock portfolio. For example, the CME has contracts on the S&P 500 Index, the Russell 2000 Index, the Nasdaq 100 Index, and the S&P Midcap 400 Index, among others.

straddle

an options strategy combining the use of a call option and a put option with the same exercise price and expiration date. For example, a long straddle is the simultaneous purchase of a call option and a put option with the same exercise price and expiration date. A short straddle occurs when both options are sold or written. An investor can profit from a long straddle if the underlying stock price increases or decreases by more than the premiums paid for the two options. Therefore, the investor will enter into a long straddle if she is expecting significant volatility in the price of the underlying stock, but is hedging against a risk of loss in the event that the stock's price moves either up or down. Conversely, an investor who writes a short straddle expects that the underlying stock's price will not change or change very little.

binomial option pricing model

attempts to estimate the price of a call option. This model assumes the price of the option will change in discrete increments (up or down) on the basis of movements in the price of the underlying stock. Therefore, the model is sometimes referred to as the two-state option pricing model because the underlying security's price may always be simplified to either an up or down movement. This model starts with looking at two possible outcomes over a certain time period (such as three months), one with the price increasing in value, and the other with the price decreasing in value. From there, an increasing number of possible outcomes and time periods can be extrapolated. As the number of time periods and outcomes increases, the binominal option pricing model approaches the Black-Scholes option valuation model. The model also assumes that the call option being valued has an exercise price of $100. ***The computation of the estimated price of the option under the binomial model is much too complex to be reproduced. Rather, you need to know only the assumptions upon which the model is based and that the analysis leads to the more popular method of valuing options—the Black-Scholes option valuation model

put-call parity

based on the premise that the premium of a call option implies a certain fair price for the corresponding put option having the same exercise price and expiration date, and vice versa. Put and call option pricing must be in parity to prevent arbitrage opportunities. An arbitrage opportunity is the ability to earn a riskless return without any investment of personal funds. Put-call parity is the difference between the call price and the put price and equals the difference between the market price of the stock and the present value of the exercise price continuously discounted at the risk-free rate.

exchange rate risk

currency risk; the risk related to having international operations in a world where relative currency values vary.

Black-Scholes option valuation model

designed to determine the estimated price of a European CALL option. However, unlike the binomial model, Black-Scholes assumes that the price of the option will change constantly (i.e., geometric Brownian motion) because the market price of the underlying security also changes constantly. Ultimately, this process is summarized by a volatility factor ascribed to the underlying security represented by the Greek symbol "σ" like with the reference in the standard deviation formula. Functionally, Black-Scholes holds that the value of the option is dependent on five factors: 1. The current underlying stock price on which the option is written 2. The option's exercise price 3. The time to expiration of the option 4. The risk-free rate of return 5. The volatility (standard deviation) of the security's returns All of these factors are directly related to the price of the option (i.e., the price of the option will move in the same direction as the numerical factor) except the option's exercise price, which moves inversely to that of the value of the option. ***For CFP® exam purposes, you will not be required to calculate the estimated price of the option using Black-Scholes. Instead, you should understand 1. the difference in assumptions used for Black-Scholes versus the binomial model; and 2. that, for any call option, an increase in the option's exercise price leads to a decrease in the value of the option because the price of the underlying stock has to increase further before the option has intrinsic value.

emerging markets

found in less developed countries. They are generally associated with --low levels of income, as measured by the country's gross domestic product (GDP); --low levels of equity capitalization; --questionable market liquidity; --potential restrictions on currency conversion; --high volatility; --prospects for economic growth and development; --stabilizing political and social institutions; --high taxes and commission costs for foreign investors; --restrictions on foreign ownership and on foreign currency conversion; and --lower regulatory standards, resulting in a lack of transparency. Despite their relatively primitive market infrastructures, many emerging markets have rapid growth rates that make their securities attractive to foreign investors whose local markets experience more modest growth.

call option

gives the buyer the right to purchase the underlying security for a specified price within a specified period. If the investor is bullish (i.e., thinks that market prices will increase), he will either purchase a call or write a put. If the investor is bearish (i.e., thinks that market prices will decline), he will either write a call or purchase a put.

put option

gives the buyer the right to sell the underlying security for a specified price within a specified period. If the investor is bullish (i.e., thinks that market prices will increase), he will either purchase a call or write a put. If the investor is bearish (i.e., thinks that market prices will decline), he will either write a call or purchase a put.

long-term equity anticipation securities (LEAPS)

have expiration dates that can run more than 3 years compared to the 9 months for standard option contracts. Because time value is a direct function of the length of the option, the longer the time until expiry, the greater the potential time value.

derivatives

investment vehicles whose value is based on that of another security, such as a listed stock. The most common of these are options and futures contracts. For each of these investments, an investor may take a long position (i.e., buying or owning the underlying security or commodity) or a short position (i.e., selling or wanting to own the underlying security or commodity). Institutional investors have historically used derivatives to increase portfolio return or to limit portfolio risk. However, individual investors also use derivatives to generate income from an otherwise flat or extremely volatile stock market.

gross income multiplier (GIM) approach

involves multiplying the gross rental receipts, the PGI, or the effective gross income by a multiplier. The multiplier is determined by comparing the multipliers used for recent comparable sales of similar properties, in much the same manner as the cap rate is determined. This approach is similar to the price/sales ratio used to calculate the value of a stock when the company has no dividends or earnings. Before applying the multiplier, the analyst should be certain which of the three revenue numbers from comparable properties is used to determine the multiplier. The GIM approach can be used to obtain a reasonably quick rough estimate of a property's fair market value. The computed value can then be compared with other properties' values (provided the properties being analyzed are similar) to determine if the asking price is low, reasonable, or high.

net operating income (NOI)

one of several methods to determine the proper, or intrinsic, fair market value of property. NOI is computed using the following steps: Gross rental receipts from the property + nonrental or other income (e.g., laundry receipts) = potential gross income (PGI) - vacancy and collection losses = effective gross income (EGI) - operating expenses (excluding interest and depreciation) = NOI *Operating expenses only includes cash expenses. It doesn't include debt service (interest expense for the mortgage) or depreciation (tax adjustment). *The focus of the NOI computation is the property's cash flow, not the investor's cash flow. Once the NOI from the real property is calculated, we can then determine the intrinsic value of the property. Technically, intrinsic value is the discounted present value of the real property based on its future cash flows—but for most investors, it simply serves as the benchmark amount above which the property is not a prudent investment. To determine the intrinsic value of the real property, divide its NOI by an estimated capitalization (discount) rate for the market and location of the property.