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CAIA Notes
September 2009 Exam Level II Book 2 Topics 7-11
Book 2 (Topics 7-11)
September 2009 Exam
CAIA Notes
Level II
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CAIA Notes
CAIA Level II Book 2 (Topics 7-11) September 2009 Exam
Copyright 2009 Institutional Investor, Inc. (ISBN #0-9800485-4-0 978-0-9800485-4-4) POSTMASTER: Send address changes for CAIA Notes to Circulation Department, Institutional Investor, Inc., 225 Park Avenue South, New York, NY 10003. Phone (212) 224-3800. Institutional Investor ExamPrep products should be used together with the original reading materials recommended in the CAIA Study Guide. Institutional Investor, Inc. is not responsible for the accuracy, completeness, or timeliness of the information contained in the articles herein. Printed in the United States of America. Reproduction in whole or in part without written permission is prohibited. No part of this publication may be reproduced or distributed in any form of by any means, or stored in a database or retrieval system, without prior written consent from Institutional Investor ExamPrep. While Institutional Investor ExamPrep has attempted to provide accurate information in CAIA Notes, the company cannot guarantee the accuracy thereof. CAIA Notes is provided without warranty of any kind, either expressed or implied. Any significant changes necessary and/ or identified corrections will be communicated to all purchasers. No statement in this book is to be construed as a recommendation to buy or sell securities. Product names mentioned may be trademarks or service marks of their respective owners.
About the ExamPrep Faculty
ERIK BENRUD, CAIA, CFA, FRM

Curriculum Director Erik Benrud is an associate clinical professor of finance at Drexel Universitys LeBow College of Business, Philadelphia. His research interests are hedge funds, swaps and options, and competition in financial services. Dr. Benrud has earned the CAIA, CFA and FRM designations. He has extensive experience in teaching and writing exam preparatory material. He has authored several papers in derivatives, financial services, and financial forecasting. Dr. Benrud received his Ph.D. from the University of Virginia.
VIKAS AGARWAL
Topic Author Vikas Agarwal, who was Curriculum Director of IIExamPrep for two exam cycles in 2008-09, is an assistant professor of finance at Georgia State University in Atlanta. He is widely published on hedge fund strategy and performance, and has been teaching courses on asset pricing and the financial system at Georgia State University since 2001. He has a Ph.D. in finance from the London Business School
DONALD R. CHAMBERS, CAIA

Topic Author Don Chambers, who was Curriculum Director of IIExamPrep until March 2008, is the Walter E. Hanson/KPMG Peat Marwick Professor of Business and Finance at Lafayette College in Easton, Penn. He is widely published on investments, corporate finance, risk management, and alternative investments. Dr. Chambers was one of the first candidates to earn the CAIA designation, and has played a leading role in designing learning materials for those taking the CAIA examination.
HENRY A. DAVIS
Topic Author Henry (Hal) Davis, an independent consultant, is editor of The Journal of Structured Finance and The Journal of Investment Compliance. He has written and co-authored 15 books and numerous articles in the areas of corporate finance and the financial markets.
URBI GARAY
Topic Author Urbi Garay is a professor of finance at the IESA Business School in Caracas, Venezuela, and is currently a visiting professor and researcher at the Isenberg School of Management and the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts, Amherst. He teaches both MBA and undergraduate courses in investments, derivatives products, corporate finance and international finance.
RAJ GUPTA
Topic Author Raj Gupta is research director of the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts, Amherst. He supervises the CISDM Hedge Funds and Managed Futures Database. He is also a visiting faculty at Clark University. Dr. Gupta is assistant editor for The Journal of Alternative Investments, and has published widely in leading financial journals and alternative investment books.
SANJAY K. NAWALKHA
Topic Author Sanjay Nawalkha is an associate professor of finance at the Isenberg School of Management, University of Massachusetts, Amherst, where he teaches fixed income, asset pricing, and finance theory. He has published several books and articles on interest rate risk and fixed income valuation. His most recent book series The Fixed Income Valuation Course, includes Dynamic Term Structure Modeling and the forthcoming Credit Risk Modeling.
TABLE OF CONTENTS
PART 5: CURRENT AND INTEGRATED TOPICS
Topic 7: Structured Products, New Products and New Strategies ........................................................ 1 Topic 8: Asset Allocation .............................................................................................................................. 19 Topic 9: Current Topics .............................................................................................................................. 47 Topic 10: Portfolio and Risk Management .............................................................................................. 73 Topic 11: Research Issues in Alternative Investments .......................................................................... 81
GLOSSARY .............................................................................................................................................................................................................. 105 INDEX............................................................................................................................................................................................................................ 117
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Navigating the CAIA Notes

CAIA Notes are comprehensive study materials organized to prepare you for the forthcoming CAIA Exam. The CAIA Notes are most effective when used in conjunction with the CAIA Study Guide and original reading materials, and Institutional Investors CAIA Prep software. CAIA Notes Level 2, Book 2 (Topics 7-12) is organized around the CAIA Study Guides Learning Objectives: it gives you summaries and explanations of what our experienced authors believe are the most important issues in the curriculum. That is, it provides you with the material that is most likely needed to correctly respond to the CAIA exam questions. CAIA Notes begins by listing the CAIA Association Course Outline by Topic and Learning Objective. You can quickly reference a particular Learning Objective by turning to the page number against each Learning Objective. Each Topic starts by listing the Main Points from the CAIA Study Guide. Within that Topic, it then goes through the explanations for each Learning Objective and its sub-parts. The Learning Objectives are summarized using various explanations, examples, and calculations, where appropriate. Keywords are highlighted within each Topic to remind you of these important terms as you read. Each Topic also lists the original source references. The Glossary aims to provide useful information directly related to the Keywords. Each entry in the Glossary refers back to its relevant Topic. The Index at the end also highlights the Keywords. In the Index, the page numbers in bold are the pages on which a Keyword is found in its respective Topic. Various icons are placed throughout the books to point out calculations, references, and note-worthy items. We have also boxed out important equations for quick reference (you can also find a separate Formula Sheet at www.iiexamprep.com). All of these features should assist you with your navigation through the various Topics as you study. For your convenience, we have produced both a digital and paper version of CAIA Notes. This allows you to download CAIA Notes onto your laptop, or bring the book with you in your briefcase, so that you can study anytime, anywhere.
CAIA Study Guide Learning Objectives

This CAIA Association listing is by Topic and Learning Objective. Each Learning Objective within a Topic has a page number (in brackets) for this CAIA Notes book. PART 5: CURRENT AND INTEGRATED TOPICS TOPIC 7: Structured Products, New Products and New Strategies 7.1 Describe the characteristics of a special purpose vehicle (SPV) in the context of collateralized obligations. (1) 7.2 Describe the key characteristics of a collateralized fund obligation (CFO). (2) 7.3 Explain the benefits and risks of investing in CFOs. (2) 7.4 Describe the structure of a collateralized commodity obligation (CCO). (3) 7.5 Describe the conceptual characteristics of infrastructure sectors. (3) 7.6 Compare infrastructure with other traditional and alternative assets. (4) 7.7 Critique the evidence on the performance history for infrastructure investments. (5) 7.8 Explain how the composition and construction of the following indices impact their relative performance: (5) a. RREEF Hypothetical Infrastructure Index b. UBS Global Infrastructure & Utilities Index c. Moodys Economy.com Infrastructure Index 7.9 Identify risks involved with infrastructure investments.(6) 7.10 Explain the economic implications of climate change in terms of its impacts on existing assets, future economic activity, increased regulation, and consumer behavior. (7) 7.11 Describe the role of financial markets in reducing the economic cost of climate change through (7) a. markets for catastrophe and weather risks. b. emissions trading. c. climate-related investments. 7.12 Explain the economics rationale for using financial instruments to transfer risk. (9) 7.13 Discuss the criteria that need to be fulfilled by instruments employed for risk transfer. (9) 7.14 Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of these instruments. (10) 7.15 Describe both exchange traded as well as over-the-counter weather derivatives. (11) 7.16 Describe emissions trading, its project based mechanism, and its potential market participants. (11) 7.17 Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge fund replication, in terms of their: (12) a. goals. b. methodology. c. ability to replicate hedge fund returns. d. benefits. e. drawbacks. 7.18 Discuss the term convergence as it is applied to the alternative investments industry. (14) 7.19 Compare and contrast the historical objectives of private equity funds with that of hedge funds. (14) 7.20 Contrast recent hedge fund participation in traditional private equity activities with recent private equity participation in traditional hedge funds activities. (15) 7.21 Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund and private equity strategies. (16) 7.22 Describe the emergence of the hybrid hedge fund/private equity fund. (16) 7.23 Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing recent trends in the area. (17) 7.24 Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund strategies. (18) TOPIC 8: Asset Allocation 8.1 Calculate the portfolios asset values after a given change in the equity value, using: (19) a. buy-and-hold. b. constant mix. c. constant-proportion portfolio insurance. 8.2 Compare the payoff and exposure diagrams of the buy-and-hold, constant mix, constant-proportion portfolio insurance, and option-based portfolio insurance strategies. (23) 8.3 Determine the expected performance and cost of implementing strategies with concave payoff curves relative to those with convex payoff curves under: (26) a. trending markets. b. flat (but oscillating) markets. 8.4 Discuss the motivations for and impact of resetting the parameters of dynamic strategies. (28) 8.5 Describe examples of undiversified strategies that have allowed individuals to become wealthy. (28)
Copyright 2009 CAIA Association. All Rights Reserved.
Topics and Learning Objectives 8.6 8.7 8.8 Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth management and asset allocation. (28) Explain and apply the concept of personal risk and its various components to the asset allocation problem faced by individuals. (29) Explain and apply the wealth allocation framework that accounts for various dimensions of risk and leads to an ideal portfolio that provides: (29) a. the certainty of protection from anxiety. b. the high probability of maintaining ones standard of living. c. the possibility of substantially moving upward in the wealth spectrum. Develop and justify an asset and risk allocation for an individual using the information provided to the candidate during the examination. (30) Understand the impact of alternative investments, including real estate, executive stock options and human capital on asset allocation of individual investors. (31) Describe and apply barbell and option based strategies in the context of asset allocation. (31) Discuss reasons why the performance of rebalanced equally weighted commodity futures portfolio should not be used to represent the return of commodity futures asset class. (32) Explain why the three most commonly used commodity futures indices (GSCI, DJ-AIGCI, CRB) show different levels of return and volatility over a common time period. (32) Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized commodity futures can be decomposed into various sources of return. (33) Discuss the four theoretical frameworks (CAPM, the insurance perspective, hedging pressure hypothesis, theory of storage) used to explain the source of commodity futures excess returns. (34) Explain the concepts of contango, normal backwardation and market backwardation. (35) Calculate the roll yield of a commodity futures contract in backwardation or contango. (35) Note: The 12th line from bottom of the left column should read if inventories are high, the convenience yield may be low. Discuss the importance of roll return in explaining the long-run cross-sectional variation of commodity futures returns and the implication for investors. (36) Describe the relative importance of volatility of spot return and roll return in determining the volatility of futures returns. (36) Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity contracts, sectors, and diversified commodity portfolios and indices. (36) Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison to its arithmetic rate of return. (38) Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on momentum and term structure of futures prices. (38) Argue against the use of nave extrapolation of past commodities returns to forecast future performance and discuss the importance of formulating forward-looking expectations. (39) Discuss the role of global commercial real estate in a strategic asset allocation setting. (40) Identify the components of the commercial real estate asset class and the relative advantages of direct real estate investment and real estate investment trusts (REITs). (41) Explain the historical performance and diversification benefits of select asset classes. (41) Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when determining forward-looking asset allocations. (42) Explain the seven caveats identified by the author as considerations for strategic asset allocation to global commercial real estate. (43)
8.9 8.10 8.11 8.12 8.13 8.14 8.15 8.16 8.17 8.18 8.19 8.20 8.21 8.22 8.23 8.24 8.25 8.26 8.27 8.28
TOPIC 9: Current Topics 9.1 Understand what is meant by the term structure of a commodity futures curve and the terms backwardation and contango. (47) 9.2 Understand the derivation of the futures curve for natural gas and the association between the curve and potential determinants including anticipated production, consumption and seasonal factors. (47) 9.3 Explain a futures calendar-spread strategy and the sources of potential profits, potential losses and risk from this type of strategy. (48) 9.4. Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it relates to natural gas pricing. (48) 9.5 Discuss the magnitude of Amaranths calendar-spread positions: explain how this hedge fund was able to accumulate such large positions (including the role of position limits) and describe the effects of the magnitude of the positions on daily profits and losses. (49) 9.6 Discuss the causes for increased volatility on the natural gas commodity futures market prior to Amaranths liquidation in September 2006. (52) 9.7 Discuss how sophisticated storage operators can manage their storage facilities as a set of options on calendar spreads. (52) 9.8 Describe how daily volatility as measured by standard deviation can underestimate potential risk (where risk is defined as the likelihood of experiencing severe loss), and explain how scenario analysis can be used to better indicate the risk of a funds structural position in such circumstances. (53)
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Topics and Learning Objectives 9.9 9.10 9.11 9.12 9.13 Describe what is meant by nodal or one-way liquidity in the commodity markets and how the lack of twoway liquidity adversely affected Amaranth. (55) Understand how forced liquidations can affect market prices and why changes in market prices can be correlated with the size and direction of the liquidation. (55) Discuss eight hypotheses explaining the market events of August 2007. (56) Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall under the broad heading of long/short equity. (57) Describe the anatomy of the long/short equity strategy. Explain how it is simulated in the paper, how the strategy provides liquidity to the market place, how leveraged portfolio returns are constructed, the relationship between market capitalization and the strategys profitability, and the practical implications of transactions costs. (58) Explain the return pattern of the main simulated strategy during the second week of August 2007. (60) Compare and contrast market events in August 2007 with August 1998. (60) Explain how the increase in total assets under management and the number of long/short funds over the 1998 to 2007 time period likely impacted expected returns and the use of leverage. (60) Describe the set of hypotheses that are collectively referred to as the unwind hypothesis. (61) Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over the past decade. (61) Describe a method for approximating a network view of the hedge-fund industry and what such a view indicates. (62) Evaluate the statement: Quant failed in August 2007. (62) Critique the methodology of the article. (63) Evaluate the current outlook for systemic risk in the hedge fund industry. (64) Describe a subprime loan and discuss the four principal reasons for the recent increase in sub-prime loan delinquencies. (64) Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the securities they issued and the resulting contribution to the credit crisis. (65) Explain the role of rating agencies in the credit crisis. (66) Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the duediligence efforts at the firms. (66) Explain the factors affecting the rating of a special investment vehicle (SIV). (66) Describe the role of monolines. (67) Explain the lack of incentives for banks to perform due diligence on the collateral pool. (67) Explain the role and actions of central banks in 2007 and early 2008. (67) Explain the role of valuation methods. (67) Describe the lack of transparency in the credit markets. (68) Describe how systemic risk arose in 2007. (68) Argue how increased transparency in the rating process is necessary. (69) Argue how standardization can simplify valuation issues. (69) Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased transparency can provide investors with information regarding financial institutions exposure. (69) Describe how new product design can dampen market disruptions. (70) Discuss possible regulatory responses. (70) Describe sound risk management practices. (71) Describe nonlinearities in the risk of subprime CDO tranches. (71)
9.14 9.15 9.16 9.17 9.18 9.19 9.20 9.21 9.22 9.23 9.24 9.25 9.26 9.27 9.28 9.29 9.30 9.31 9.32 9.33 9.34 9.35 9.36 9.37 9.38 9.39 9.40
TOPIC 10: Portfolio and Risk Management 10.1 Assess the long-run and short-run benefits of hedging the tail risk of a portfolio. (73) 10.2 Explain the relationship between systemic risk, liquidity risk, monetary policy and other macro events. (73) 10.3 Explain why increased correlation among various asset returns during periods of stress could provide opportunities for free insurance against tail risk. (74) 10.4 Describe the four approaches to hedging or insuring a portfolio against tail risk. (74) 10.5 Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk. (74) 10.6 Describe the three factors that impact the construction of a tail hedge. (75) 10.7 Explain why long-dated options may provide an inexpensive method for hedging tail risk. (75) 10.8 Evaluate the factors that lead to the underpricing of risk by investors. (75) 10.9 Explain the relationship between the real economy and capital markets and discuss the factors that have made the real economy less volatile through time. (76) 10.10 Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for models of risk measurement. (76) 10.11 Compare and contrast the terms risk and uncertainty. (77) 10.12 Explain the role of shadow banking system as a source of liquidity and discuss why during periods of market stress this source of liquidity may disappear. (77) 10.13 Demonstrate how cognitive biases can lead to errors in judgment by financial market participants. (78)
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Topics and Learning Objectives 10.14 Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes. (78) 10.15 Explain the role of Monte-Carlo simulation to achieve stable (steady-state) allocation in this study. (79) 10.16 Illustrate the total impact of several individual risk factors on private equity allocation drift. (79) TOPIC 11: Research Issues in Alternative Investments 11.1 Illustrate how an investment in commodity futures can earn a positive return when spot commodity prices are falling. (81) 11.2 Compare commodity spot returns and commodity futures returns. (82) 11.3 Compare commodity futures returns with stock returns and bond returns. (83) 11.4 Compare commodity futures risk with equity risk. (83) 11.5 Discuss the use of commodity futures as a hedge against inflation. (84) 11.6 Explain the diversification benefits of commodity futures. (84) 11.7 Describe the performance of commodity futures from a non-US investors perspective. (85) 11.8 Describe the difference between normal backwardation and a market that is in backwardation. (85) 11.9 Describe a trading strategy that uses basis in futures markets as an indication of risk premium in futures markets. (86) 11.10 Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions. (86) 11.11 Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on allocations to real estate. (87) 11.12 Compare four approaches to generating an unsmoothed total real estate return series. (87) 11.13 Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations to real estate. (92) 11.14 In the Marcato and Key (2007) study, compare and contrast the results of using UK data with those employing US and Australia real estate return data. (92) 11.15 Argue the best method of adjusting a real estate return series when conducting an asset allocation study. (93) 11.16 Describe the hedge fund business model presented by the authors. (93) 11.17 Analyze the issues in measuring the growth of the hedge fund industry. (94) 11.18 Evaluate the potential biases in hedge fund databases. (95) 11.19 Review the approach and describe the main findings of bottom-up research on hedge fund risk factors. (96) 11.20 Describe and assess the adequacy of the asset-based style (ABS) risk factor model used by Fung and Hsieh to analyze hedge fund returns. (98) 11.21 Discuss the broader risks associated with hedge funds and describe the regulatory concerns. (99) 11.22 Describe the role of manager selection in the experience of a private equity investor. (99) 11.23 Discuss the challenges that an investor would face in measuring the risk-adjusted performance of private equity. (100) 11.24 Explain the implication of the observation that mean and median returns on private equity databases are significantly different. (101) 11.25 Explain and identify the potential bias in using the performance of liquidated funds to represent the overall performance of private equity funds. (101) 11.26 Compare the performance of companies in which private equity firms invest with small cap firms listed on NASDAQ. (101) 11.27 Explain the liquidity characteristics of listed private equity securities. (102) 11.28 Discuss the impacts of adjustment for stale prices on risk, return, and diversification benefits of private equity (candidates do need to memorize exact figures). (102) 11.29 Identify the impact of IPO under-pricing on the performance of the PVCI. (103) 11.30 Explain how the following issues pose a challenge to private equity investors: (103) a. Illiquidity. b. Parameter uncertainty. c. Absence of an investible index. d. Cross-sectional differences in private equity managers.
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TOPIC
Structured Products, New Products and New Strategies

Main Points
Explaining the structure, characteristics, benefits and risks of investing in CFOs Explaining the characteristics of infrastructure investments and the practical use of infrastructure indices Explaining the potential for financial markets and instruments to play a role in alleviating negative climate change consequences Comparing factor-based and pay-off distribution approaches to hedge fund replication Describing factors that contributed to convergence between private equity and hedge fund strategies as well as concerns and risks regarding the past trend 1. Describe the characteristics of a special purpose vehicle (SPV) in the context of collateralized obligations. Special purpose vehicles (SPVs) are used as the legal entities (e.g., trusts) that form the center of every collateralized obligation (CO) structure. Collateralized obligations is the umbrella term for a spectrum of asset-backed structures (e.g., collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs)) that hold debt obligations as collateral and are financed with tranches or securities that typically have diverse seniority and/or longevity. The SPV is the entity that legally owns (holds) the collateral (the underlying debt, credit, or other instruments), and is the entity that issues the various tranches that have claims to the cash flows (senior, mezzanine and equity). The SPVs are usually Delaware based business trusts or special purpose corporations. They are referred to as bankruptcy remote. This means that a bankruptcy of the sponsoring bank or the money manager will not affect the functioning of the CO structure. The SPVs hold the collateral and distribute the cash flows from the collateral to the tranche holders. SPVs typically hold asset backed securities (ABS), which are bonds that are securitized or collateralized by the cash flows from an underlying pool of assetssuch as credit cards, home loans, auto loans, equipment leases, or other non-mortgage related assets.
Copyright 2009 Institutional Investor, Inc. All Rights Reserved.
Topic 7: Structured Products, New Products and New Strategies
2.
Describe the key characteristics of a collateralized fund obligation (CFO). Collateralized fund obligations (CFOs) are the application of the collateralized obligation (CO) concept to investing in hedge funds and started in 2002. CFOs hold portfolios of hedge funds and repackage the ownership of the portfolio into securities or tranches with different levels of seniority and/or longevity. CFOs allow investors to participate in alternative investment opportunities (typically with diversification) through a spectrum of CFO tranches with various maturities and risk levels that are potentially more tailored to the preferences of the investor and more easily understood due to standardization and comparability to other similar programs. The debt tranches may offer credit ratings and the equity tranches offer leverage. For example, a CFO might be formed that requires that the portfolio of hedge funds owned inside the CFO meet a number of minimum diversification requirements (e.g., 25 or more funds, 20 or more managers, no more than 10% with one fund, no more than 15% with one manager, etc.). The level of diversification is an important issue in determining the relative value (and credit ratings) of the tranches or securities that have claim to the cash flows generated by the portfolio. Tranches are securities sold to investors that represent claims to the cash flows from the portfolio. The tranches are usually denoted with letter names and vary in seniority from very low risk senior tranches to an equity tranche with high risk. For example, tranche A might represent half of the value of the CFO, might offer a low coupon (e.g., LIBOR plus 60 basis points), have semi-annual coupon payments and have first priority to the cash flows from the portfolio of hedge funds. Given this high priority and substantial diversification of the portfolio's holdings, the tranche might receive a credit rating from a major agency of AAA. Less senior tranches would have higher coupons and lower credit ratings. Finally, the equity tranche would be unrated and would receive the residual cash flows, if any, after the debt tranches have been satisfied. Certain requirements such as a total net value might be imposed which, if not met, trigger a liquidation (along with potential diversification and liquidity requirements). These liquidation triggers are designed, along with the diversification, to provide protection to the senior tranches so that they can be sold with high credit ratings.
3.
Explain the benefits and risks of investing in CFOs. Benefits to CFOs (collateralized fund obligation) to investment company managers that manage the CFOs can include management fees, incentive fees and gains through ownership of the equity tranche. Benefits to CFOs (collateralized fund obligation) to hedge fund managers who view the CFOs as investors in their hedge fund are that the money is less likely to be withdrawn. Hedge fund managers prefer investors that are relatively unlikely to withdraw funds (sticky money rather than hot money). Using the CFO structure, investors in a tranche wishing to liquidate can sell their tranche without it affecting the CFO portfolio and requiring a liquidation of a portfolio holding.
Benefits of CFOs (collateralized fund obligations) to investors include the ability of institutions such as pension funds, insurance companies and others to diversify into the hedge fund arena through ownership of tranches rated by a major rating agency. Often, such institutions are prohibited from direct ownership of unrated investments such as a hedge fund. Further, CFOs have been shown to have lower systematic risk exposures (due to their absolute return strategies) than other similarly rated investments (such as pools of corporate bonds) and so are less subject to general credit market events or other market wide events. Anson reports the correlation of fund of funds returns with leveraged loans and high yield returns of only .35 and .43. Thus, investors can receive the benefits of somewhat diversified risk exposures that contain less systematic risk (and perhaps more idiosyncratic risk related to funds manager skill). Risks of CFO investing are generated from the risks of the assets (hedge funds) that comprise the portfolio. Anson analyzes historic returns to funds of funds and compares the return distributions to the distributions of high yield portfolios and leveraged loan portfolios. Anson concludes that the past return distributions have been roughly similar. The hedge fund of fund returns have moderate volatility and a good Sharpe ratio but have a slight negative skew and slightly high kurtosis. Therefore, CFO investors are exposed to a relatively substantial risk of large negative returns. However, as noted in the previous paragraph, the correlations of the returns with large credit market events may be reasonably low and therefore CFOs provide diversification benefits. 4. Describe the structure of a collateralized commodity obligation (CCO). The concept of collateralized obligations (COs) has been extended into commodities with a collateralized commodity obligation (CCO) being issued with rated tranches in 2005. The idea is to utilize a CO structure to facilitate exposure to commodity price risk. The commodity price risk is accomplished in the CCO using commodity trigger swaps (CTSs). A commodity trigger swap is similar to a credit default swap except that the risk to the principal is generated by falling commodity prices (rather than a credit event). The CCO receives fixed coupons (much like insurance premiums) up to the maturity of the CTS at which time the CCO either receives the full principal of the CTS (if the triggering event has not occurred) or nothing from that CTS if the triggering event has occurred. The triggering event is prespecified. For example, a triggering event might be if a ten day average of a particular commodity price has declined more than 35% from the commodity price when the swap is set. The CCO contains a diversified portfolio of CTSs and must adhere to prespecified diversification standards. The result is a set of tranches that offer a spectrum of probabilities for full payment and an exposure to various commodity prices such that severe declines in one or more commodity prices could cause tranches to lose principal (starting with the least senior tranches). 5. Describe the conceptual characteristics of infrastructure sectors. Mansour and Nadji describe six conceptual characteristics of infrastructure sectors. Note that the set of characteristics of infrastructure investments is a main point of CAIAs
curriculum. Of particular interest here is the fact that infrastructure assets are highly heterogeneous, with no two infrastructure assets having identical attributes. Another crucial aspect is that the lifecycle of the infrastructure asset is a key determinant of the assets performance. 1. Monopoly: Infrastructure assets generally have very high initial fixed costs. As a result, they are typically large-scale investments that can act as a barrier to entry for new entrants. A consequence of this is that infrastructure assets have monopolistic or quasi-monopolistic characteristics. The article also notes that these assets have traditionally been funded by the government through general taxes or the municipal bond market that also indicates a barrier to entry for new entrants. 2. Inelastic demand: Infrastructure assets provide essential services to the community and demand does not fluctuate with price movements or the business cycle. Since infrastructure assets have few substitutes, they contribute to the inelastic nature of demand. 3. Stable cash returns: The previous two characteristics monopoly and the inelastic nature of demand ensure that infrastructure assets have stable cash returns. This is generally because infrastructure assets render essential services, the demand for which does not change with consumer sentiment. 4. Long duration: As is the case with real estate, infrastructure assets last for a long time, often over 50 years. The long lasting nature of infrastructure asset returns makes these assets very attractive to institutional investors. Most public and corporate pension plans face long-term liabilities and the long lasting nature of these assets makes them very attractive to plan sponsors. 5. Inflation hedge: Infrastructure assets can be classified as tangible, real assets and provide an inflation hedge. The replacement costs of real assets increase in an inflationary environment, which preserves the value of existing infrastructure assets. Rent escalations on infrastructure assets that are usually CPI-linked are permitted. 6. Hybrid asset: Infrastructure assets share many common features with a variety of other assets such as real estate, fixed income, and private equity. If the infrastructure asset is government regulated, the income streams are analogous to fixed income investments with the additional advantage of having inflation protection. Developing infrastructure assets in India share common risk and return characteristics with opportunistic real estate development. An infrastructure investment in an operating company that runs an airport is a common private equity strategy. 6. Compare infrastructure with other traditional and alternative assets. Many institutional investors new to this asset class view it as a subset of commercial real estate with physical, real, tangible assets generating cash flows. But others view it as a substitute for long duration bonds with an embedded inflation hedge. More generally, infrastructure is a hybrid asset class and shares common features with many traditional and alternative assets. However, the bond-like, equity-like, and real estate-like features of
any infrastructure investment depends on the individual asset and the stage of the assets maturity. See the exhibit below.
Opportunistic/Private Equity
Expected Return
Value-Added
Core Real Estate/Fixed Income
Risk
Core Real Estate/Fixed Income Gas/Electricity/Transmission (Mature) Mature Toll Roads Mature Telecom Water Value-Added Airports Seaports Mature Toll Roads (with Expansion) Opportunistic/Private Equity Greenfield Toll Roads New Telecommunications Power Generation/Transmission
Source: Mansour and Nadji (2007)
7.
Critique the evidence on the performance history for infrastructure investments. The performance history for infrastructure investments has several limitations. These limitations include: 1. Limited Performance History. 2. Expensive and often proprietary data collection. 3. Lack of Appropriate Benchmarks. 4. Significant variation within infrastructure investments given its hybrid nature.
8.
Explain how the composition and construction of the following indices impact their relative performance: Note that the bulk of the material focuses on the UBS Index and Moodys Economy.com Infrastructure Index. Also note that benchmarking infrastructure investments is listed as a main point for this Learning Objective, and such investments can be: listed infrastructure investments and unlisted infrastructure investments. The major indexes use listed companies in their construction. The article also notes a study by Peng and Graeme (2007) that examined the performance of 19 major unlisted Australian funds.
a.
RREEF Hypothetical Infrastructure Index
The RREEF was constructed based on the UBS index because the UBS index was not widely available on a global or U.S.-basis. RREEF used the UBS-Europe Index as the base, stripping out companies that did not focus on direct infrastructure such as airlines and logistics. Hence, the RREEF index has focused primarily on pure infrastructure plays or infrastructure operating companies. Since only listed companies were used, the volatility of this series was increased but could be directly compared to publicly-traded assets such as equities and securitized real estate. It returned 12.5% per year with a 13.2% volatility, placing it between European bonds and equities. b. UBS Global Infrastructure & Utilities Index
The UBS indices exist for the global and major regions of the world, including the U.S. The Global series is based on a group of 85 companies. The UBS index is about 4.6% of the S&P Global Universe. Integrated Utilities make up 52% of the index, Integrated Regulated Utilities make up 25% and Energy Transmission and Distribution make up 13%. The remaining subsets are Power Generation (5%), Water (1%) and Other Infrastructure (including communication and transport) that make up 4%. On a 10-year basis, the UBS index averaged 12.7% less than private equity and public real estate but more than hedge funds, public equity, and fixed income returns. The volatility at 18.3% has exceeded fixed income and hedge funds but trails public real estate and public equity. The index has showed low correlations with traditional and alternative assets. c. Moodys Economy.com Infrastructure Index
Five infrastructure sectors are included: Electricity (Distribution and Generation), Water (Treatment and Distribution), Communications, Transport, and Gas (storage and distribution). The Electricity, Water, and Gas sectors are under Energy and Utility. Companies are market-cap weighted. The Economy.com Index has a lower return than the UBS Index since its inception (5.3% for Economy.com versus 9.4% for UBS). It also has a lower volatility than the UBS Index (13.1% for Economy.com versus 19.3% for UBS). 9. Identify risks involved with infrastructure investments. Mansour and Nadji find six types of risks associated with infrastructure projects, including: 1. Construction Risk: Construction may be delayed or abandoned due to unforeseen risks related to weather.
2. Operational Risk: Infrastructure projects may fail operationally if a chain of command does not exist and is not properly supervised. 3. Leverage/Interest Rate Risk: Infrastructure investments may require additional borrowing of capital which subjects itself to interest rate risk. 4. Regulatory Risk: Infrastructure projects may be exposed to regulatory risk if new laws inadvertently create new restrictions. 5. Legal Risk: Infrastructure investments may be exposed to legal risk if, for example, they are to require land not yet acquired. 6. Political Risk: International infrastructure investments may be exposed to the whims of the government. Other considerations include liquidity, pricing and benchmarking. 10. Explain the economic implications of climate change in terms of its impacts on existing assets, future economic activity, increased regulation, and consumer behavior. According to the latest Intergovernmental Panel on Climate Change (IPCC), global warming is a reality, and there will be an increase in the severity of weather around the globe. Emerging and developing economies will be hit hard. Initially, the human toll will probably be highest in countries such as India, Bangladesh, South and Central America. In developed countries, meanwhile, the economic toll will be higher. The changes in climate will have many impacts: higher cost of capital, higher insurance costs, higher regulatory costs, and changes in consumer behavior that may have positive or negative effects. The increased uncertainty associated with the weather changes will affect the planning of future economic activity. This will increase the risk premiums from the investments. Companies that plan to build and invest in an area where the weather effects are higher can expect a higher cost of capital. Furthermore, people planning to move to such areas can expect higher insurance premiums for homes and property. Regulations associated with the weather will increase costs. However, certain industries are likely to benefit: e.g. construction, renewable energies, and mechanical and electric engineering as companies attempt to meet the new regulations. Climate change can also have an economic impact on consumer behavior. Evidence suggests that consumers are conserving energy and cutting back on climate harming activities and supporting compensation measures. 11. Describe the role of financial markets in reducing the economic cost of climate change through: There are two basic approaches for dealing with climate change: abatement strategies and adjustment strategies. Abatement strategies attempt to prevent climate change. Adjustment strategies react rationally to the unavoidable consequences of climate change.
Financial markets and suitable financial instruments can help finance climate-related technology and distribute weather risks efficiently. The following list summarizes the roles of financial markets. a. markets for catastrophe and weather risks.
The market for catastrophe risks and weather risks offers adjustment strategies. These are instruments that provide compensation for certain events. Such instruments include catastrophe risk transfer instruments such as catastrophe bonds and weather derivatives, which involve a cash flow when a certain event occurs. There are also risksharing arrangements for unavoidable natural catastrophes and weather risk, which can reduce the individual cost of coverage. The effect of these instruments is an efficient sharing of the risks that come from unavoidable natural catastrophe and weather risks. This lowers the cost of covering individuals. The markets also provide information such as price signals concerning environmental threats. b. emissions trading.
Emissions trading is part of an abatement strategy. The strategy sets a limit on the amount of pollution across the economy by issuing a limited supply of emission certificates. These certificates can be traded, which gives each corporation an incentive to produce less pollution because it can sell unused emission certificates. Additional benefits may result from derivatives on those certificates and the existence of funds and other investment vehicles that invest in emission certificates. The goal of emission trading is to minimize the costs associated with greenhouse gas emission reduction. However, there is an ongoing debate concerning the potential benefits and functioning of the emissions trading market. c. climate-related investments.
Climate-related investments are part of both abatement strategies and adjustment strategies. Climate-related investments include public investment funds and private equity funds that invest in assets that could profit from climate change. Such investments would include simply investing in the equity of companies that are developing environmentally friendly products. Making loans to such companies would also be a part of this strategy. There are a wide variety of companies in which to invest, e.g., those in the energy industry, those that are developing and producing climate protection-relevant technologies, those that are applying climate protection-relevant technologies, and those that offer solutions for adapting to climate change. This strategy would be enhanced by a political and regulatory framework that reduces the cost of debt and equity financing for the companies. Increased investor awareness would lower perceived risk and the cost of capital.
12. Explain the economic rationale for using financial instruments to transfer risk. The general economic rationale for having financial instruments to transfer risk is that risk sharing by agents in the economy can reduce shocks to the overall economy. For one thing, a decline in business for any sector will reduce tax revenues, and there will be a drain on government funds in repairing the infrastructure. The following list provides more details. Coverage of large volumes: Natural catastrophes and extreme weather events can cover large areas so that the potential losses are above the levels that a single firm or even government can afford. The financial instruments would provide payoffs to help supply capital to cover losses. Efficiency and transparency: The market can break down the risk into small pieces and distribute them among qualified investors. This would reduce the concentration of risk among a few insurers, and the risk levels would be more transparent. Market participants would price risk to include all relevant information, which would increase efficiency. Uncorrelated asset class: The new instruments would provide a new tool for increasing diversification of investment portfolios. This is especially true because weather-related events typically have a low correlation with market returns. Macroeconomic benefits: Firms can hedge risks and increase output, which helps the overall economy. Market efficiencies should lower the cost of hedging and increase macroeconomic benefits further. 13. Discuss the criteria that need to be fulfilled by instruments employed for risk transfer. There are five basic criteria for instruments to be effective in transferring risk. 1. Measurable and calculable risk: There must be estimates of both losses and probabilities in order to price the instruments, which would most likely come from historical data. 2. Affordable risk premium: For the party seeking protection, the risk premium must be affordable while still covering the potential losses. 3. Reliable payment trigger: To minimize conflicts of interest, there should be a precise definition of the event that triggers payment. The payment trigger must be transparent, reliable, and difficult to manipulate. 4. Avoidance of moral hazard and adverse selection: There should be information symmetry. This would lower the adverse selection problem where high-risk firms seek coverage at the average market price. Information symmetry would lower the potential for the moral hazard problem in that the covered firm would want to inflate losses. 5. Development of adequate pricing models: Traditional pricing models would require modification to price catastrophe risks and weather risks. Weather data is very different from traditional market data, for e.g., weather data has a seasonal element.
Furthermore, catastrophe data is sparse, and all the outcomes are not known. These and other considerations would have to be included in the pricing models. 14. Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of these instruments. The following list describes the existing instruments that can be used to transfer catastrophe and weather risks. Catastrophe bonds and exchange-traded contracts are fairly liquid, and the other instruments are tailored to meet the needs of certain entities and are usually held until maturity. Catastrophe bonds (cat bonds): The coupons are usually based on LIBOR plus an appropriate risk premium, and when a predefined loss occurs, the investor forfeits the capital invested. Special purpose vehicles (SPVs) usually issue the bonds and invest the proceeds in traditional fixed income securities to cover contingent claims by the sponsor. Cat-risk CDO (Collateralized Debt Obligation): The various catastrophe risks are bundled and sold in individual risk tranches. One or more events must occur before the investor suffers a loss. Capital market-financed quota share reinsurance, known as sidecars: In this contract, the investors share proportionally in a loss according to a predetermined quota. This uses tranches as well, and there is at least one debt and equity tranche. Industry loss warrants (ILW): This market, that has been around for a while, is usually in the form of private placements. It is a type of capital market-financed loss (re-)insurance, which is linked to an industry loss index. Event loss swaps (ELS): These are a variant of conventional ILWs. They are more tradable because they are more highly standardized. Catastrophe swaps (cat swaps): These are contracts where two insurers can swap generally uncorrelated risks, such as those between different regions or industries. Contingent capital arrangements: This category is composed of types of put options. The option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs. One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss. They were popular in the 1990s, but because they are difficult to price, they are not used much today. Exchange-traded contracts in catastrophe risks: Some cat futures and cat options trade on an exchange. They started in the early 1990s, but turnover was small. There have been moves to modify the contracts to generate more interest. Since they trade on an exchange, they offer more liquidity, and they would be used by entities where liquidity is important. The investors in these instruments must be knowledgeable, which limits potential investors to insurers and reinsurers, institutional investors, and hedge funds. Insurers and reinsurers use the contracts as part of their overall portfolio strategy. Hedge funds make investments to earn the premiums. Mutual funds using these instruments are being developed so that more investors can participate.
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The sponsors are those that issue the contracts for protection. The largest sponsors are insurers and reinsurers, corporations with a high exposure, and government insurance and development funds. Insurance companies that have taken on the risks of companies with insurance contracts are a large group of sponsors that use the contracts to manage their risk. Corporations with high-risk exposure naturally hedge risk so they can focus on their business. There are government insurance and development funds in many countries that are sponsors, e.g., Mexicos natural catastrophe fund (FONDEN) recently transferred large amounts of earthquake risks to the capital markets using catastrophe bonds. 15. Describe both exchange traded as well as over-the-counter weather derivatives. The market for weather derivatives is concerned with relatively low-cost high probability events. This is in contrast to the market for catastrophe risks that covers high-cost low probability events. Weather derivatives pay off when there are unusually low or high temperatures. A natural gas company may wish to hedge against a warm winter, for example, which lowers the quantity demanded of natural gas used for heating. In the OTC market, the contracts are negotiated individually and with properties specified by the counterparties. These contracts began in the mid-1990s. Tradable weather-related futures and options have been on the Chicago Mercantile Exchange (CME) since 1998. Other exchanges have offered these products, but have discontinued them for now, through some are planning to introduce new products. As of now, however, the CME is the only exchange where weather-related futures and options trade, and the exchange plans to expand its offering. Market participants find that the exchange-traded products have a lower cost and higher liquidity. There has been an increase in the turnover in exchange-traded contracts at the CME relative to that of the OTC market. 16. Describe emissions trading, its project-based mechanism, and its potential market participants. The biggest market for greenhouse gas emissions is the EU Emission Trading System (EU-ETS). The EU-ETS uses targets proposed by the Kyoto Protocol, which defines a number of different emission certificates. There is a distinction, for example, between emission rights and emission credits. There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. This is referred to as cap and trade, in that there is a limit or cap to the emissions and the right to emit can be traded. The limited number includes the EU Allowances (EUAs), traded in the EU-ETS, and includes the assigned amount units (AAUs) that trade internationally. With respect to emission credits, on the other hand, investors can have credits from additional climate protection projects that are in other countries credited to their own reduction target (baseline and credit). Also, with respect to emission credits, there is a difference when the reductions take place in an industrial country or in an emerging market. For the industrial country, the resulting certificates are called emission reduction
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units (ERUs). For emerging markets, they are called certified emission reductions (CERs). The Kyoto Protocol also allows for the realization of carbon-sink projects at home such as afforestation. This is done with the use of removal units (RMUs). Also, it is possible to generate tradable project-based credits called verified emission reductions (VERs). They differ from CERs and ERUs in that VERs can only be used for voluntary CO2 compensation. The CERs and ERUs are useful for the exceptions the Kyoto Protocol extends to emerging markets. This is because emerging markets are exempt from greenhouse gases quantitative reduction commitments. The Kyoto Protocols project-based mechanisms allow the CERs and ERUs from additional climate protection projects in third countries to be credited to the owners reduction target within certain limits, e.g., down to 50% of the initial target. The Clean Development Mechanism (CDM) of the Kyoto Protocol allows for investment to be made in a project that promises to yield future income in the form of CERs. A wide variety of projects qualify, and the CERs can be generated from a portfolio of projects. The rights to future CERs are traded at a discount, which is a function of the projects stage of progress. A less advanced project would have a higher discount. Potential market participants include carbon funds, which include government purchasing programs and private commercial funds. The Prototype Carbon Fund (PCF), launched by the World Bank, was one of the earliest funds. It gathered experience with the new emissions trading instruments and prepared the market for later funds. An increasing number of investment banks, brokers and institutional investors are buying and selling certificates for their own or third-party accounts; however, companies that have to meet reduction commitments within the EU-ETS framework are still the biggest group of end buyers (compliance buyers). Investors who have no direct involvement with emissions can attempt to earn a positive return in the market for these types of instruments. Carbon funds offer advantages over a direct investment because the funds have an expertise in the area, offer diversification, and can allow the investors to take on a particular level of risk via the number of shares purchased in the fund. There has been increasing product differentiation, and new possibilities are opening up for investors. Investors can place bets on rising prices through derivative instruments on emission certificates or participate in the realization of CDM projects. 17. Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge fund replication, in terms of their: a. goals. The ultimate goal of both the factor-replication approach (or the factor-based approach) and the payoff distribution approach is to create a portfolio with
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characteristics similar to a particular hedge fund, for e.g., to have the same risk profile, and earn returns similar to those of the hedge fund at a lower cost. To achieve that ultimate goal, the factor-based approach has the goal of replicating the hedge funds returns using hedge fund risk factors. The payoff distribution approach attempts to replicate the hedge funds returns by matching the unconditional higher moments, which should then give the same first moment, i.e., the same average return. b. methodology.
The factor-based approach focuses on the conditional distribution to earn the conditional mean of a hedge fund, given values of the underlying risk factors. This requires a two-step approach. Step 1 requires the calibration of a satisfactory factor model for hedge fund returns. This is essentially estimating a factor model: Hedge Fund k Returnt = B0 + B1F1,t + B2F2,t + . . . + BNFN,t + et where each Fi,t is the value of factor i at time t, and each Bi is the corresponding factor sensitivity. A stepwise regression is often used in this process, but it does not allow for the researcher to make inferences. A stepwise regression is a regression technique that allows for forward selection of relevant factors or backward elimination of irrelevant factors. Forward selection starts with no factors and, at each step, the most significant factor is added to the model. Backward elimination starts with a set of factors and, at each stage, the least significant factor is removed. Another approach is to use a conditional factor model which allows the coefficients, Bi, to be time varying, too. The goal is to capture time varying factor exposures. Another approach is to use non-linear factor models that may also be able to better capture the relationship and make better out-of-sample forecasts. There is also return-based style (RBS) analysis, which examines the exposure of hedge funds to certain style factors. While this approach allows for lower specification risk, the key issue is the efficacy of the factors in building mimicking portfolios. Once having chosen a particular methodology in Step 1, Step 2 requires the identification of the replicating factor strategy (RFS), which is creating a clone of the hedge fund return using the estimated coefficients and the out-of-sample values of the factors. The payoff distribution approach focuses on creating a clone portfolio where, for all x, Pr(Clone return<x) = Pr(Hedge Fund return < x). This also requires a two-step process: Step 1 consists of estimating a payoff function that maps an index return onto a hedge fund return. Step 2 consists of pricing the payoffs and deriving the replicating factor strategy, which is done using the Merton (1973) replicating portfolio interpretation of the Black and Scholes (1973) formula.
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c.
ability to replicate hedge fund returns.
The factor-based approach, while the most natural and straightforward way to approach the replication problem, has failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis. The payoff distribution approach produces satisfying results for long-run out-of-sample returns but cannot capture short-run time-series properties. Also, the approach does not attempt to match the first moment (the mean), which is crucial to any investment analysis. d. benefits.
The factor-based model addresses the essence of the problem, which is to find details of the risk exposures. The payoff distribution approach has the benefit of doing a better job of replicating return, at least, in the long run. e. drawbacks.
Neither approach has produced satisfactory results. With the factor-based approach, there is a difficulty in identifying the correct factors and replicating the dynamic exposure to the factors. We should recall that simple regression techniques only capture the past average exposures of the managers. Also, any factor analysis can suffer from specification risk. This is the result of not using an accurate mix of factors. Either the omission of factors or including too many factors can lower the accuracy of the model. The payoff distribution property has some success in replicating long-run returns. However, it fails to replicate the short-run time-series characteristics. 18. Discuss the term convergence as it is applied to the alternative investments industry. The term convergence is used to define the blurring of the lines between hedge fund and private equity investing. In this context, the authors refer to actual transactions pursed by both hedge fund managers as well as private equity managers. The objective of both hedge fund and private equity investors is to pursue manager skill or alpha rather than market exposure. 19. Compare and contrast the historical objectives of private equity funds with that of hedge funds. There are several distinctions in the historical objectives of hedge fund managers versus private equity managers, as noted by the authors. The exhibit below classifies these objectives into three categories (Securities employed, Strategy pursued and Sources of returns) and compares these objectives.
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Distinction
Securities Strategy
Hedge Fund
Listed Long or Short 1. Arbitrage Opportunities,
Private Equity
Unregistered, Private Ownership to obtain voting control 1. Control of the Underlying Business Strategy and Management Composition 2. Alignment of Economic Interests of Management and Shareholders and 3. Access to types of Non-public information that listed share investments cannot provide.
Sources of Return
2. Superior Security Selection
3. Provision of Liquidity not generally available to the Market Source: Gonzalez-Heres and Beinkampen (2006)
20. Contrast recent hedge fund participation in traditional private equity activities with recent private equity participation in traditional hedge funds activities. Gonzalez-Heres and Beinkampen note that hedge funds use side pockets within existing hedge fund vehicles to participate in private equity activities. Hedge funds also establish direct lending businesses that function much like a bank or mezzanine fund. In contrast, private equity funds set up units under the same roof to pursue hedge fund investing. The authors mention five examples. Some have detailed information on their websites. These include: 1. Blackstone Group (http://www.blackstone.com/company/index.html): A private equity specialist, with five general private equity funds and one specialized fund focusing on media and communications-related investments. Blackstone also manages hedge funds such as Blackstone Kailix Advisors that invests primarily in equity investments on a long and short basis. 2. Texas Pacific Group (http://www.texaspacificgroup.com/): A global private investment firm with over $30 billion of capital under management. It manages a family of funds including private equity, venture capital and public equity and debt investing. 3. Fortress Investment Group (http://www.fortressinv.com/): A private equity specialist that makes significant, control-oriented investments in North America and Western Europe, with a focus on acquiring and building asset-based businesses with significant cash flows. It also runs hedge funds: hybrid hedge funds and liquid hedge funds. 4. Bain Capital (http://www.baincapital.com): A private investment firm whose affiliates manage over $50 billion in assets. It has investments in private equity and venture capital as well as long/short public equity, credit products, and global macro hedge funds.
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5. H.I.G. (http://www.higcapital.com/): A private investment specialist that manages private equity, venture capital, distressed debt, and public equities products. 21. Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund and private equity strategies. The distressed space provides an excellent example of recent convergence because both hedge fund investors and private equity investors have expanded their mandates. A typical distressed hedge fund manager evaluated investment opportunities more like a debt investor and invested in publicly traded securities. He/she may or may not have played a significant role in negotiating a restructuring of the issuing company. The objective was to identify securities of companies at various stages of the bankruptcy process (including companies on the verge of filing for bankruptcy or just emerging from bankruptcy), that are publicly traded at a discount to their intrinsic values. Exit generally came through selling the appreciated security in the public market or to a strategic acquirer. Capital was in lock-up status for one or two years. Private equity managers, on the other hand, are active investors that typically acquire a majority interest in a company in order to get operating control and run the business. The key difference is that they play a significant role in the operational turnaround and restructuring of the issuing company. They often sell the company at a much later date for a profit via an initial public offering (IPO) or sale to strategic investors. However in recent times, hedge fund managers have expanded from passive investing to buy-to-own investing. They are now acquiring sizable stakes with the mindset of owning the business rather than trading the securities. They have also taken a lend-toown debt financing approach. This entails providing debt financing, usually to highly levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults. Private equity fund managers, on the other hand, are increasingly taking toehold positions in order to identify opportunities. Even if they are ultimately unsuccessful in gaining control, they recognize that material gains can be realized from these toehold positions. In other words, they are poaching each others strategies. 22. Describe the emergence of the hybrid hedge fund/private equity fund. While Gonzalez-Heres and Beinkampen offer some general observations, they specifically describe a multi-billion-dollar hedge fund manager that their team has had a longstanding relationship with since the mid-1990s. This manager is a multi-strategy manager. The manager started out as a convertible arbitrage manager but transformed into a passive distressed manager by the end of 2001 and then morphed into a hybrid fund over the last 18 months. The authors note that this was done by investing away from liquid distressed debt situations and toward more illiquid private assets, ranging from small- and mid-sized companies to physical aircrafts. Currently, the fund is approximately one-third private equity and two-thirds hedge fund.
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During the 2001-2002 period, there was a large wave of corporate bankruptcies. The manager took advantage of these opportunities by focusing on passive (non-operational) hedge fund-style distressed investing. By mid-2004, when these opportunities vanished, this manager felt that there were gaps that were overlooked by both hedge fund and private equity managers. These situations, however, required three to five years to produce attractive returns. After conferring with investors and getting their consent, the manager shifted towards a more private equity-oriented approach. In the situations above, the ability of the manager to adapt and migrate quickly to where the opportunities lay, led to strong returns. The ability to offer both hedge fund and private equity products are referred to as hybrid funds. The authors note that in late 2005 and early 2006, several private equity managers that they had longstanding relationships with indicated a desire to launch sister hedge fund products. Research conducted by private equity managers as they seek opportunities often led them to uncover opportunities in public markets. Alternatively, large positions in private companies often may lead managers to discover unique insights into the health and stability of other companies or industries. 23. Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing recent trends in the area. There are several factors that have contributed to the convergence of private equity and hedge fund strategies. First, the surge of capital that has flowed into hedge funds and away from private equity has put downward pressure on returns. It has also forced managers to look into private equity opportunities where venture capital slowed significantly after the Internet bubble burst in 2001. Second, because corporate defaults since 2004 have been at near historical lows, opportunities for distressed and private equity managers have been limited. Third, the limited opportunities have led distressed hedge fund managers to pursue other opportunities such as leveraged buyouts. A record $149 billion was raised for leveraged buyouts in 2005. Hedge fund managers watching these capital flows have been encouraged by some of the enthusiasm in this space. Fourth, private equity funds have been able to persuade corporate boards to back their transactions using the allure of stable capital, significant savings in time and money, and the avoidance of scrutiny that comes with going private. This is because the corporate board of a private company is no longer compelled to comply with the Sarbanes-Oxley Act, nor does it have to answer to a multitude of shareholder constituencies. Fifth, the compensation structure of many hedge funds provides incentives for the fund to invest in higher yielding, illiquid securities traditionally purchased by private equity firms over the short term. Unlike private equity firms where the manager is typically paid a performance fee only after all invested capital is returned to investors, hedge funds have traditionally been compensated on an annual basis.
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The authors also describe a sixth factor regarding SEC registration that is now mute. The CAIA Level 1 Study Guide includes the following study tip (under Topic 23: Regulation of Hedge Funds): in December 2004, the Securities and Exchange Commission (SEC), by a vote of 3-2, promulgated regulations 203(b)(3)-2, an amendment to the Investment Advisers Act of 1940 (Advisers Act), which required many hedge fund managers to register with the SEC for the first time. However on June 23, 2006, the United States Court of Appeals for the District of Columbia overturned this regulation... 24. Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund strategies. There are several risks related to the trend toward convergence. These include 1. Mismatch of liquidity provisions and investment skill sets, 2. Diversification (so that investors do not find themselves with one or two illiquid investments), and 3. Appropriate staffing to trade, finance, restructure and, if necessary, operate underlying investments. The authors note that as hedge funds realize the impact that their capital can have on the management of public companies, excesses could arise but few high profile conflicts are anticipated. Hedge funds need to have appropriate staffing to operate underlying investments, if necessary, duties that have not traditionally fallen on a hedge fund managers modus operandi.
References Anson, M.J.P. Collateralized Fund Obligations: Intersection of Credit Derivative Market and Hedge Fund World. Chapter 25 in Handbook of Alternative Assets, 2nd edition. Edited by Frank J. Fabozzi. John Wiley & Sons, 2006. Mansour, A., and H. Nadji. Performance Characteristics of Infrastructure Investments. RREEF Research A Member of the Deutsche Bank Group. August 2007. Weistroffer, C. Coping with Climate Change. Deutsche Bank Research. November 15, 2007. Amenc, N., W. Gehin, L. Martellini, and J.C. Meyfredi. The Myths and Limits of Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques. Journal of Alternative Investments. Fall 2008. Gonzalez-Heres, J., and K. Beinkampen. The Convergence of Private Equity and Hedge Funds. Morgan Stanleys Investment Management Journal. Vol. 2, No. 1, 2006.
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TOPIC
Asset Allocation
Main Points
Comparing and contrasting buy-and-hold, constant mix, and constantproportion portfolio insurance strategies Applying a wealth allocation framework that accounts for various dimensions of risk and deriving an ideal asset allocation for an individual Interpreting the term structure of futures prices, the components of futures returns for individual contracts, returns for portfolios constructed and rebalanced with various methods, and the implications of tactical asset allocation strategies using commodity futures contracts Critically examining the methods of including global commercial real estate in a strategic asset allocation
1. Calculate the portfolios asset values after a given change in the equity value, using: a. buy-and-hold.
Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity). There are three primary strategies discussed as summarized below: Strategy Name Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance Rebalancing in Up Market None Sell Stock Buy Stock Rebalancing in Down Market None Buy Stock Sell Stock Shape of Payoff v. Stock Market Linear Concave Convex
Consider for example an investor with $100 starting value allocating all of the funds between two choices: risk free bonds (interest rate equals zero for simplicity) and a single risky portfolio (the stock market). Assume that the investors initial allocation is to put $70 in stock and $30 in bonds. The stock market is indexed to 100.0 Under a buy-and-hold strategy there is no rebalancing. The Up panel below shows the value of the portfolio in an up market with the market index rising
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Topic 8: Asset Allocation
10 points each period for three consecutive periods. The Down panel below shows the value of the portfolio in an analogous down market. Any funds used to purchase stocks come from bonds and vice versa. Up Market Panel: Buy-and-hold: Before Balance Time 0 1 2 3 Stock Level 100.0 110.0 120.0 130.0 Bonds 30 30 30 30 Stocks 70 77 84 91 After Balance Stock Bought(+) Bonds or Sold (-) 0 30 0 30 0 30 0 30 Stocks 70 77 84 91 Total 100 107 114 121
Down Market Panel: Buy-and-Hold: Before Balance Time 0 1 2 3 Stock Level 100.0 90.0 80.0 70.0 Bonds 30 30 30 30 Stocks 70 63 56 49 Stock Bought(+) or Sold (-) 0 0 0 0 30 30 30 30 After Balance Bonds Stocks 70 63 56 49 Total 100 93 86 79
Note that there are no transactions since the strategy is buy and hold. Further note that the total value is linear it changes by the same dollar amount for each equal dollar movement in the stock market. The value of the portfolio (last column on right) changes $7 for each 10 point change in the stock market index when it is 70% initially invested in the stock market and there is no rebalancing. b. constant mix.
Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity). There are three primary strategies discussed as summarized below:
Strategy Name
Rebalancing in Up Market None Sell Stock Buy Stock
Rebalancing in Down Market None Buy Stock Sell Stock
Shape of Payoff v. Stock Market Linear Concave Convex
Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance
Under a Constant Mix strategy there is periodic rebalancing such that the portfolio is returned to being, in this case, 70% stocks and 30% bonds. The Up panel below shows the value of the portfolio in an up market with the market index rising 10 points each period for three consecutive periods. The Down panel below shows the value of the portfolio in an analogous down market. Any funds used to purchase stocks come from bonds and vice versa.
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Up Market Panel: Constant Mix:

Before Balance Time 0 1 2 3 Stock Level 100.0 110.0 120.0 130.0 Bonds 30 30 32.10 34.14 Stocks 70 77 81.71 86.31 Stock Bought(+) or Sold (-) 0 -2.10 -2.04 -1.99 Bonds 30 32.10 34.14 36.13 After Balance Stocks 70 74.90 79.67 84.31 Total 100 107.00 113.81 120.45
Down Market Panel: Constant Mix:

Before Balance Time 0 1 2 3 Stock Level 100.0 90.0 80.0 70.0 Bonds 30 30 27.90 25.73 Stocks 70 63 57.87 52.54 Stock Bought(+) or Sold (-) 0 +2.10 +2.17 +2.25 Bonds 30 27.90 25.73 23.48 After Balance Stocks 70 65.10 60.04 54.78 Total 100 93.00 85.77 78.26
The $2.10 sale of stocks (and purchase of bonds) in time period 1 of the Up panel is a rebalancing such that the new value of the portfolio ($107) remains 70% allocated to stocks. Stocks are sold as the stock market trends up to prevent underweighting in bonds. In the downward panel, stocks are purchased as the stock market trends down to prevent underweighting of stock. Very importantly, note that the total value is non-linear it changes by smaller dollar amounts for each equal upward dollar movement in the stock market. The value of the portfolio rises $7 for the first upward 10-point change in the stock market index but rises by only $6.81 for the second 10-point change (the rebalanced stock holding does not rise by $7 because the 10-point stock rise is a smaller percentage stock price rise than it was when the stock level was lower). Conversely, rebalancing to the stock market while it is falling produces larger losses than in previous periods or in the buy-and-hold strategy (note that each 10-point decline in the market index represents a higher percentage decline). Viewed on a graph with total portfolio value on the vertical axis and stock market index values on the horizontal level, the Constant Mix strategy forms a concave shape. The buy-and-hold strategy forms a straight line. c. constant-proportion portfolio insurance.
Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity). There are three primary strategies discussed as summarized below:
Strategy Name Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance Rebalancing in Up Market None Sell Stock Buy Stock Rebalancing in Down Market None Buy Stock Sell Stock Shape of Payoff v. Stock Market Linear Concave Convex
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Under a Constant-Proportion Portfolio Insurance (CPPI) strategy the investor sets a floor value at which all risky investing terminates. Further, the investor increases risky assets holding when the market rises and decreases risky asset holdings when the market falls. For example, consider that the investor sets a floor value of $50 but invests 150% of the total portfolio value in excess of this floor in stock. Thus, the investor starts with a total value of $100 allocated $25 to bonds and $75 to stock. At the end of each period, the investor resets the stock allocation so that it is 150% of the excess, if any, by which the total portfolio exceeds the floor ($50). Any funds used to purchase stocks come from bonds and vice versa. Up Market Panel: CPPI:
Before Balance Time 0 1 2 3 Stock Level 100.0 110.0 120.0 130.0 Bonds 25 25 21.25 17.33 Stocks 75 82.50 94.09 106.18 Stock Bought(+) or Sold (-) 0 +3.75 +3.92 +4.08 Bonds 25 21.25 17.33 13.25 After Balance Stocks 75 86.25 98.01 110.26 Total 100 107.50 115.34 123.51
Down Market Panel: CPPI:

Before Balance Time 0 1 2 3 Stock Level 100.0 90.0 80.0 70.0 Bonds 25 25 28.75 32.29 Stocks 75 67.50 56.67 46.49 Stock Bought(+) or Sold (-) 0 -3.75 -3.54 -3.32 Bonds 25 28.75 32.29 35.61 After Balance Stocks 75 63.75 53.13 43.16 Total 100 92.50 85.42 78.78
The $3.75 purchase of stocks (and sale of bonds) in time period 1 of the Up panel is a rebalancing such that the new allocation increases its bet on stocks. Stocks are bought as the stock market trends up to try to achieve massive gains. In the downward panel, stocks are aggressively sold as the stock market trends down to prevent larger losses and to insure that the floor value ($75) is protected. Very importantly, note that the total value is non-linear it changes by larger dollar amounts for each equal upward dollar movement in the stock market. The value of the portfolio rises $7.50 for the first upward 10-point change in the stock market index and rises $7.84 for the second 10-point change (since the strategy placed 150% of profits in stock). Conversely, rebalancing away from the stock market while it is falling produces smaller losses than in previous periods. Over the long-term, the floor should increase, so that the relationship between the initial floor and a floor at time t is Ft =F0ert where Ft, F0, r, and t are are the floor value of the portfolio at time t, the floor value at initiation of the strategy (t=0), the risk-free rate, and a time index. At a given point in time, viewed on a graph with total portfolio value on the vertical axis and stock market index values on the horizontal level, the CPPI strategy forms a convex
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shape. The buy-and-hold strategy forms a straight line and the constant mix strategy forms a concave shape. 2. Compare the payoff and exposure diagrams of the buy-and-hold, constant mix, constant-proportion portfolio insurance, and optionbased portfolio insurance strategies. A payoff diagram in the context of the article by Period and Sharpe, is a graph of the relationship between total portfolio (asset) value on the vertical axis and stock market index value (performance of the risky asset class) on the horizontal axis. Simply put, it tells the investor the profit and loss of his or her entire portfolio in relationship to movement in the stock market. For example, consider a buy-and-hold strategy that purchases a particular combination (e.g., 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds). The bond values are assumed constant and for simplicity do not even pay interest. The buy-andhold strategy does not rebalance, so the stock position simply grows and shrinks linearly with the stock market as depicted below. The slope of the line depends on the original mix, but the relationship is linear regardless of initial mix Buy & Hold | | X | X | X | X | X | X | X | X |_X_____________________________________________________ Value of the Stock Market
Total Portfolio Value
Now consider a constant proportion strategy that sells stock in a rising market to maintain the desired mix and buys stock in a declining market similarly to maintain a desired mix. The payoff diagram will demonstrate a concave relationship as indicated below: Constant Mix | | | X | X | X | X | X | X | X |_______________________________________________________ Value of the Stock Market
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Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value). The payoff diagram will demonstrate a convex relationship as indicated below: CPPI strategy | | | | | |
| X
X X X X X X X
|X |_______________________________________________________ Value of the Stock Market Finally, consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value). The payoff diagram will demonstrate a kinked but otherwise linear relationship similar to the traditional diagram of a call options and as indicated below: Option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market | | X | X | X | X |X X X X | | | |_______________________________________________________ Value of the Stock Market
In summary, the key to the payoff diagrams is that they show the linearity, concavity, convexity and call-option-like relationships of the four strategies as reviewed above. These shapes are important in understanding behavior in trending versus reverting markets. An exposure diagram in the context of the article by Period and Sharpe, is a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolios cumulative performance.
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For example, consider a buy-and-hold strategy that purchases a particular combination (e.g., 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds). The bond values are assumes constant and for simplicity do not even pay interest. The buy-andhold strategy does not rebalance, so the stock position simply grows and shrinks linearly with the stock market with a lower bound equal to the bond position as depicted below. The location of the line on the horizontal axis depends on the original mix and bond position but is linear regardless of initial mix. The key to the diagram is that it has a moderate slope. Buy & Hold | X | X | X | X | X | X | X | X | X |_____________________________________________________ Value of the Total Portfolio
Portfolios Stock Value
Now consider a constant proportion strategy that sells stock in a rising market to maintain the desired mix and buys stock in a declining market similarly to maintain a desired mix. The key to the diagram is that it has a moderate slope. Constant proportion strategy | | | | | X | X | X | X | X |_X___________________________________________________ Value of the Total Portfolio
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Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value). The exposure diagram will demonstrate a steeply sloped relationship as indicated below: CPPI strategy | X | X | X | X | X | X | X | X X | |______________ X__________________________________ Value of the Total Portfolio
Finally, consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value). The exposure diagram will demonstrate a steep and curved relationship as indicated below: Option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market | | | X | X | X | X | X | X | X |__________________ __________X________________________ Value of the Total Portfolio
3.
Determine the expected performance and cost of implementing strategies with concave payoff curves relative to those with convex payoff curves under: a. trending markets b. flat (but oscillating) markets. Concavity in the context of the Perold and Sharpe study refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises and to increase equity exposure as the equity market falls. An example is a constant mix strategy that sells stock in a rising stock market to keep the stocks value a constant proportion of the portfolio. Convexity refers to the tendency of a strategy to increase equity
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exposure (risk) as the equity market rises and to decrease equity exposure as the equity market falls. An example is a CPPI (Constant-Proportion Portfolio Insurance strategy) that is highly aggressive with profits, but is quick to reduce stock exposure when nearing a lower bound floor value. The expected performance of a strategy is directly associated with the strategies payoff curves. A linear (buy-and-hold) strategy simply makes or loses money based on the terminal performance of the underlying stocks. However, concave strategies perform relatively well in flat (but oscillating) markets while convex strategies perform well in trending markets. a. trending markets.
A trending market works in favor of a convex strategy because as markets rise the stock exposure is greatly increase, producing high relative profits if the up trend is substantial and sustained. Conversely, in a downtrend the stocks are sold off, mitigating the losses. A concave strategys relative performance is the opposite. A concave strategy such as a constant mix strategy liquidates stocks into a rally and buys additional stock throughout a long decline. b. flat (but oscillating) markets.
A flat but oscillating market favors concave strategies and hurts convex strategies. A concave strategy will buy after a decline (e.g., to keep a target mix) and then profit in a reversal. A convex strategy will get whipsawed selling after the decline and buying after the rise. Thus, the curvature explains the expected performance and costs of the strategy due to the subsequent nature of the market in the sense of whether the market will tend to trend more, or oscillate more. The following equations can help in describing the payoffs and equity weights for the various strategies. The role of the variance in the constant proportion strategy is evident from the payoff equation for that strategy: Vt = Ft + (V0 - F0) [(It/I0) m]e(1-m)(r+0.5*m*variance)t where Vt, Ft, It, m and r are are the value of the portfolio, the floor value of the portfolio, the value of the market index, the multiplier, and the risk-free rate, respectively. The subscripts 0 and t stand for the beginning value and the value at time t respectively. The amount of equity (risky assets) held in the CPPI strategy is: Equity = m (At Ft), or Equity = MIN(A, m( At Ft)) if no leverage is allowed. For the buy-and-hold strategy, the payoff equation reduces to Vt = Ft + (V0 F0)(It/I0), and the amount of the equity held is Equity = (At Ft).
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4.
Discuss the motivations for and impact of resetting the parameters of dynamic strategies. Parameters of dynamic asset allocation strategies can adjust exposures to risky assets at various levels, can adjust minimum desired asset levels (cushions and floor values) and so forth. Some dynamic strategies, such as option-based portfolio insurance, require resetting of parameters at horizon points. Other dynamic strategies such as constant mix require transactions but not resetting of parameters. By adjusting the parameters, the risk exposures and payoffs of the strategies can be altered. For example, the option based portfolio insurance strategy may be viewed as a special case of the Constant-Proportion Portfolio Insurance in which parameters change with levels of the cushion. Further, the CPPI strategy can be transformed into a constant mix strategy by constantly adjusting the floor to a specified percentage of the asset values. Resetting of parameters can allow the portfolio allocator to make substantial changes in the exposures and payoffs of the strategy potentially changing the entire character of the strategy as illustrated above by the ability to transform one strategy into another through constant parameter adjustment. In particular, parameter resetting can be appropriate for horizon points or after major market movements.
5.
Describe examples of undiversified strategies that have allowed individuals to become wealthy. Undiversified strategies that have worked for a minority of investors include: 1. using leverage in real estate by assuming a mortgage; 2. accumulation of low-basis stock and stock options and not diversifying; and 3. starting a small business. In each case, there is the potential for large returns if the conditions are favorable, for e.g., a 20% down payment on a home provides a 50% return if the home increases in value by only 10%. It should be noted that a large portion of those that have become wealthy have used these strategies, but this can be misleading, because there are many investors that used these strategies and did very poorly.
6.
Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth management and asset allocation. The primary change that has thrust more responsibility upon individuals is the movement from defined benefit to defined contribution plans. This means that market risk has moved from the sponsoring firm to the individual. The following factors have also increased the level of responsibility that individuals have for their own retirement: 1. estimating life expectancy and the general increase in life expectancy (with a defined benefit plan, the sponsor pays as long as the individual is alive); 2. achieving diversification from funds whose returns tend to have higher levels of correlation; and
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3. choosing among a wider range of possible products, for e.g., derivatives, structured products. 7. Explain and apply the concept of personal risk and its various components to the asset allocation problem faced by individuals. Personal risk comes from the unique characteristics of the investor that can amplify the level of risk well above that implied by the basic market statistics. For example, the historical market standard deviation can imply a much higher level of risk for an older individual or a person with less job security. The components of personal risk are listed below. 1. Cash flows: the estimated net inflows and savings and the variability of those cash flows. 2. Lifecycle stage: the stage of earning power and the desire to leave a legacy. 3. Ability to weather shortfalls: ability to adjust to unexpected declines in assets and/or living longer than expected. 4. Event risk: ability to adjust to events like the loss of a job, health problems, market crashes, etc. One way to think of personal risk in contrast to a traditional risk measure is to consider how well an individual can endure under extreme shocks, e.g., a move three or more standard deviations from the mean, which could reduce a portfolio to zero. More generally, the investor might have a target minimum level of wealth, and a shock could lower the portfolios value below that number, which could be devastating to the investor on either a real or psychological level or both. With respect to such a shock, one application of the personal risk approach is to use Roys Safety First criterion when addressing the ability to weather shortfalls. With respect to cash flows, an application of the personal risk approach is to allow the outflows of cash to vary directly with the changing value of the portfolio. That is, the investor should not take the same amount out each period, especially in a down-trending market. Taking out insurance policies is an application of the personal risk approach to address event risk. 8. Explain and apply the wealth allocation framework that accounts for various dimensions of risk and leads to an ideal portfolio that provides: Note: By analyzing actual human behavior, Kahneman and Tversky (1979) found that investors attempt to compose a portfolio that protects from anxiety, that has a high probability of maintaining ones standard of living, and provides for the possibility of increasing wealth. The three dimensions of risk that the ideal portfolio must address are: one, personal risk that can lower the level of lifestyle; two, market risk to increase returns, and three, aspirational risk associated with enhancing ones lifestyle. a. the certainty of protection from anxiety. Personal risk refers to the possibility of a fall in the investors lifestyle and the resulting anxiety associated with that possibility. The investor can address this risk by applying a
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variety of strategies. Those strategies include incurring expenses that limit downside risk, e.g., purchasing puts. Another type of strategy is to simply make an allocation of wealth to a very safe asset such as Treasury Bills. Such portfolio decisions are said to be making an allocation to the investors personal risk bucket. b. the high probability of maintaining ones standard of living. Market risk refers to the possibility of the investor being able to at least maintain a certain standard of living or even improve it moderately with the market returns. Addressing this issue is referred to as making an allocation to the investors market risk bucket. In most cases, this would be the largest allocation and would be made to standard market assets such as stocks and bonds. c. the possibility of substantially moving upward in the wealth spectrum. Aspirational risk is associated with the possibility of significantly enhancing ones lifestyle. Allocations in this area are called allocations to the aspirational risk bucket. They would include purchasing call options on market assets or purchasing assets with large risk but also the high possibility of returns such as small capitalization stocks. Allocations to the aspirational risk bucket would be relatively small compared to the market risk bucket. In summary, a wealth allocation framework that accounts for these three dimensions would provide a safety net on the downside, a large exposure to market risk with its commensurate returns, and an investment in a high-risk asset that can provide very high returns in a positive market environment. 9. Develop and justify an asset and risk allocation for an individual using information provided to the candidate during the examination. The following are examples of the types of investments that an individual would make to address the three dimensions of risk. 1. Personal risk bucket: make an allocation to the risk free asset or buy put options. Both of these will lower return under average market conditions, but will provide benefits if the market falls below certain thresholds. 2. Market risk bucket: after making allocations to the personal and aspirational risk bucket, investing the remainder in a well diversified portfolio of conventional assets that provide a return commensurate with market risk and low idiosyncratic risk. 3. Aspirational risk bucket: investing in high risk/return assets such as hedge funds and/or private equity, or buying call options that will pay off if the market takes off. A representative allocation might be to invest 2% in protective puts and 3% in long call positions, with the rest in a diversified portfolio of market assets. The justification is that the 2% allocation to protective puts lowers the risk of extreme losses, and the 3% allocation to long calls can achieve high returns if the market increases. An alternative might be to invest 30% in the risk free asset and 5% in a high-risk alternative asset such as a hedge fund and the rest in a portfolio of market assets. Once again, the 30% in the
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risk-free asset will minimize losses, and the 5% in the hedge fund provides high upside potential under the right conditions. 10. Understand the impact of alternative investments, including real estate, executive stock options and human capital, on the asset allocation of individual investors. Alternative investments, real estate, executive stock options and human capital will have an impact on the asset allocation of individual investors. Alternative investments such as private equity, hedge funds, futures, commodities, and foreign exchange have become a basic ingredient in the portfolios of wealthy individuals. Each has a particular set of impacts on the portfolio, and some can fit into more than one risk bucket. 1. Private equity and hedge funds would be allocations to the aspirational risk bucket. These investments have idiosyncratic risk, high fees, and low transparency. 2. Commodities would best fit into the personal risk bucket as a protection against inflation. 3. Futures could fit into all three buckets as a means to reduce risk, diversify with managed futures, or enhance risk. 4. Foreign exchange would fit into the personal risk budget as a protection against the declines in currency and as a diversifier. It could be a means to address aspirational risk if there is the expectation of an increase in a given currency. Real estate can also fit into various risk buckets. A sensible home for personal use would be an allocation to the personal risk bucket. Modest rental units would be an allocation to the market risk bucket and serve as a good diversifier. Speculative real estate purchased for resale at a higher price would be an allocation to the aspirational risk bucket. Executive stock options would fit into the aspirational risk bucket. This is because they are high risk and undiversified assets. Furthermore, they would be highly correlated with the human capital of the individual. Human capital would generally fit into the aspirational risk bucket. As education and skills become more specialized, and therefore undiversified, investments in this area are designed to increase the standard of living of the individual. 11. Describe and apply barbell and option based strategies in the context of asset allocation. The barbell strategy is one where an investor allocates a given amount to a safe position that provides a cushion. The rest would be allocated to a risky portion known as the aspirational part. Thus, the portfolio has two extreme positions to meet the desired risk allocations. An application of the barbell strategy would be to have a relatively high weight in the personal risk bucket, a relatively low weight in the market risk bucket, and a relatively high weight in the aspirational risk bucket. Relatively high would be in comparison to
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a more standard allocation. A more standard application might be 40% in the personal risk bucket, 55% in the market risk bucket, and 5% in the aspirational risk bucket. The application of the barbell strategy would produce an allocation more like 65%, 10%, and 25% respectively. Various tools could be used to achieve this for the three buckets. The personal risk bucket could have bonds, the market risk bucket could have a broad-based equity market portfolio, and the aspirational risk bucket could be a hedge fund; i.e., a barbell portfolio would be 65% in high-grade bonds, 10% in a market ETF, and 25% in a hedge fund. One particular barbell strategy is an option-based strategy that invests in TIPS for the safe portion and then purchasing call options for the aspirational part. If the market performs poorly, the investor has some credit and inflation risk. If the market performs well, the calls will provide a high level of return. Option-based investing strategies can include certain dynamic asset allocation strategies that can be approximated using simple buy-and-hold strategies that include options. Incorporating options may help the sustainability of pension funds. An application of this strategy would be 90% in TIPS and 10% in a call option on a market ETF. There is no need to make an allocation to the market risk bucket because the option on the ETF has exposure to the market. 12. Discuss reasons why the performance of a rebalanced equally weighted commodity futures portfolio should not be used to represent the return of the commodity futures asset class. There has been a significant difference in the average returns of individual futures contracts and the returns of a rebalanced equally weighted commodity futures portfolio. The Goldman Sachs Commodity Index (GSCI) earned an average annual return equal to 12.2% over the time period 1969-2004, with a standard deviation of 18.35%, but the annual return of individual commodity futures has been close to zero. Of 36 commodity contracts, for the period 1959-2004, only one had a positive return statistically different from zero. These differences are the obvious reason that the performance of a rebalanced equally weighted commodity futures portfolio should not be used to represent the return of the commodity futures asset class. The underlying reason comes from the fact that a portfolio of uncorrelated securities with high standard deviations that is rebalanced can have a higher return than the individual assets in the portfolio. 13. Explain why the three most commonly used commodity futures indices (GSCI, DJ-AIGCI, CRB) show different levels of return and volatility over a common time period. The three most commonly used commodity futures indices are the Goldman Sachs Commodity Index (GSCI), traded on the Chicago Mercantile Exchange; the Dow JonesAIG Commodity Index (DJ-AIGCI), traded on the Chicago Board of Trade; and what used to be the Reuters-CRB Futures Price Index (CRB), traded on the New York Board of Trade.
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Each index is designed to be a broad representation of investment opportunities in the aggregate commodity futures market. The GSCI is the most representative with 86% of open interest, the DJ-AIGCI accounted for 10%, and the CRB made up the remaining 4% of open interest (figures as of 2004). Over the period 1991-2004, the three commodity indices experienced different levels of return and volatility. The GSCI had twice the volatility of the CRB during the period. The DJ-AIGCI and the GSCI had average returns similar to that of the Lehman Aggregate, and the CRB had a return about equal to that of the T-bill return. The return of an index is a function of two factors: the returns of the components of the index and the weights of the components. In the case of the indices, the most important factor that can explain the differences is the differing weights of individual commodity futures contracts in the indices. The use of different portfolio weights implies that each index defines the aggregate commodity futures market differently. The GSCI uses weights based on the level of worldwide production for each commodity, and it has a high weight in energy commodities. The annually rebalanced DJ-AIGCI uses weights based on contract liquidity and production data. The monthly rebalanced CRB had been a geometrically averaged and equally weighted index; however, it has now changed to be similar to the DJ-AIGCI. 14. Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized commodity futures can be decomposed into various sources of return. Two components make up the annualized total return of a cash-collateralized commodity futures contract: the return on the cash position used as collateral and the change in the futures price. The equation is Individual cash-collateralized commodity futures return = Cash return + Excess return The excess return is simply the percent change in the price of a futures contract. If, for instance, an investor purchases a corn futures contract for $2 a bushel and later sells the contract for $2.1 a bushel, the excess return on this position is 5%. Example: An investor goes long a gold contract at $800/oz. If the cash return over the horizon is 2% and the price of the contract changes to $820/oz., what is the total cashcollateralized commodity futures return? Return = 2% + ($820-$800)/$800 = 2% + 2.5% = 4.5% The annualized total return of a diversified cash-collateralized commodity futures portfolio can be decomposed into three components: Cash-collateralized commodity futures portfolio total return = Cash return + weighted-average excess return + diversification return
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The diversification return is usually a benefit from the synergies of combining two or more assets and rebalancing the portfolio. The geometric average return of a portfolio will be positively affected by the reduction in variance. A positive diversification return means that the compound return of the portfolio will be greater than the weighted-average compound return of the individual portfolio constituents. The diversification return is enhanced by rebalancing but will usually be lower if the portfolio is not rebalanced. 15. Discuss the four theoretical frameworks (CAPM, the insurance perspective, hedging pressure hypothesis, theory of storage) used to explain the source of commodity futures excess returns. The four theoretical frameworks for understanding the source of commodity futures excess returns are the capital asset pricing model (CAPM), the insurance perspective, the hedging pressure hypothesis, and the theory of storage. None of these is the definitive model, but they all represent work being done to understand commodity returns. The CAPM would predict that commodities futures would have a zero excess return. This is because commodities futures are uncorrelated with equities and have a zero beta. There are at least two faults with this argument. First, the CAPM is for capital markets, and commodities are not included in the market index. Second, the CAPM has low explanatory power even for equities; therefore, it would not be surprising that it would not have much explanatory power for non-equity assets. The insurance perspective proposes a return is earned by speculators who take long positions from normal backwardation. If todays futures price is below the spot price in the future, then as the futures price converges toward the spot price at maturity, excess returns should be positive. The excess return from a long commodity futures investment should be viewed as an insurance risk premium. Under normal backwardation, investors who go long commodity futures should receive a positive risk premium; therefore, normal backwardation provides a rationale that a long-only portfolio of commodity futures can represent an effective allocation of capital. The hedging pressure hypothesis says that commodities can produce positive returns for either normal backwardation markets or contango markets. In normal backwardation markets, the agents who are long the commodity itself, for e.g., oil producers, are willing to short futures at a lower price, and the speculators can be long and earn a profit as the futures price rises. In contango markets, the agents who are short the commodity, for e.g., airlines needing fuel, are willing to go long futures at a higher price, and the speculators can be short and earn a profit as the futures price rises. The bottom line is that returns can be positive for either the long or short position, and it depends upon whether there is more hedging pressure on the long or short side. The theory of storage focuses on the role that inventories of commodities play in the determination of commodity futures prices. The theory is that inventories allow producers to avoid shortages and production disruptions. The more plentiful inventories are, the less the likelihood is that a production disruption will affect prices. The less plentiful inventories are, the more likely it is that a production disruption will affect prices. As a result, having a level of inventories that will reduce the impact of production disruptions is beneficial. The convenience yield is a type of risk premium that is determined by inventory levels.
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Inventories may be low for difficult-to-store commodities; as a result, those commodities may have high convenience yields. Conversely, for easy-to-store commodities, inventories should be plentiful and they should have low convenience yields. In the theory of storage, storage costs determine the price of a commodity futures contract. We should recall the basic futures pricing formula when there are not storage costs and a convenience yield: the futures price equals the spot price times the future value interest factor. For example, if the spot price = $800 and the interest rate = 5%, for a one-year contract, the futures price = $840. There could be a convenience yield, however, if inventories are low. In the above example, if the convenience yield is 1%, the futures price = $832. Example: A commodity has a convenience yield of 10%, and the interest rate is 6%. If the spot price is $50, compute the futures price for a six-month contract. Answer: The net effect will be a futures price that is 2% lower than the spot price: for an annual contract, the computation is 6% - 10% = -4%, but for a six-month contract, the effect is one half of this. The futures price = $50*(1 - 4%/2) = $49. 16. Explain the concepts of contango, normal backwardation and market backwardation. Contango is the condition of the futures price being above the expected future spot price. The term contangoed commodities refers to contracts where the futures price is greater than the spot price. One explanation for contango is that hedgers are net long futures. Normal backwardation describes the case where the futures price for a commodity is less than the expected spot price in the future. If todays futures price is below the spot price in the future, then as the futures price converges toward the spot price at maturity, excess returns should be positive. Normal backwardation cannot be observed, because the expected spot price is not truly known. Market backwardation can be observed, and its two components are the market consensus expected future spot price and a possible risk premium. 17. Calculate the roll yield of a commodity futures contract in backwardation or contango. Roll yield or roll return generated in a backwardated futures market is achieved by rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price. The short-term contract will have a higher price and the return will be positive: Roll yield = (Fshort-term/Flong-term) -1. When backwardation exits, the roll yield is positive. For example, if the futures price for a May 2009 contract is $45 and the futures price is $40 for the June 2010 contract, and assuming the term structure remains the same, Roll yield = ($45/$40) -1 = 12.5%
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When contango exits, the roll yield is negative. If the futures price for a May 2009 contract is $48 and the futures price is $50 for the June 2010 contract, and assuming the term structure remains the same, Roll yield = ($48/$50)-1 = -4% Example: If the futures price for a January 2010 contract is $100 and the futures price is $80 for the January 2011 contract, and assuming the term structure remains the same, calculate the roll yield and comment on whether the market is in backwardation or contango. Answer: Roll yield = ($100/$80)-1 = 25%. Since the roll yield is positive, the market is in backwardation. 18. Discuss the importance of roll return in explaining the long-run crosssectional variation of commodity futures returns and the implication for investors. Roll returns are important in explaining the cross-section of individual commodity futures excess returns from December 1982 through May 2004. In a regression, the coefficient of determination (R2) indicates that the roll returns explained 91.6% of the long-run cross-sectional variation of commodity futures returns over the period. There was a lot of variation ranging from positive roll returns to negative roll returns. The implications are that investing in commodity futures with relatively high roll may be rewarding, but it is not a guarantee. Potential investors should be cautious. The results do not suggest that roll returns will explain 91.6% of the cross-sectional variation of commodity futures returns over any particular future time horizon. It is convenient to extrapolate, but it is not scientific. For a broadly diversified portfolio of commodity futures, it may be the best for a risk averse investor to assume a future roll return of zero or even below zero. 19. Describe the relative importance of the volatility of spot return and roll return in determining the volatility of futures returns. For the period December 1982 through May 2004, roll returns have been highly correlated with excess returns. However, there was not a significant average excess or spot return for any given individual commodity futures or commodity futures sector. The importance of the high volatility of spot returns is evident because it made even the highest roll return an insignificant excess return. Given the conflicting results, the bottom line is that it is not clear if any of the average spot and excess returns were statistically different from zero in this time period. 20. Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity contracts, sectors, and diversified commodity portfolios and indices. Inflation is usually considered an important factor in determining commodity prices and, therefore, would probably play a role in determining return volatility. Two studies are representative of research in this area.
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Greer (2000): Over the 197099 period, the Chase Physical Commodity Index had a time-series correlation of 0.25 with the annual rate of inflation and a time series correlation of 0.59 with the change in the annual rate of inflation. Strongin and Petsch (1996): The GSCI performs well relative to stocks and nominal bonds during periods of rising inflation. We must be careful about how we define inflation, however, because commodities have only about a 40% weight in the U.S. Consumer Price Index (CPI), and a broad-based commodity futures index excludes many items measured in the CPI. One notable example is the housing component of the CPI, which is the biggest single CPI component and is not in a commodity futures index. Inflation consists of two components: expected inflation and unexpected changes in inflation. Unexpected inflation appears to be correlated with excess returns of the GSCI. Assuming changes in inflation cannot be forecast means that changes in inflation can serve as a proxy for unexpected inflation. Using this proxy, it is found that for the period 1969 to 2003, unexpected inflation explained 43% of the time-series variation in the GSCIs annual excess returns. The GSCI has a positive (but statistically insignificant) actual inflation beta and a positive (and significant) unexpected inflation beta. This result requires a closer look for two reasons: first, the GSCIs composition has changed over time and, second, the returns of many commodity futures seem to be uncorrelated with one another. We should recall that the inflation beta of a commodity futures portfolio is simply a weighted average of the portfolios constituent inflation betas. Thus, it is important to understand the behavior of a broad-based commodity futures investment by looking at the inflation sensitivity of individual commodity futures. The following is a summary of statistical tests. The sectors energy, livestock, and industrial metals have significant unexpected inflation betas. The individual commodity futures heating oil, cattle, and copper have significant unexpected inflation betas. The precious metals sector has a statistically significant negative inflation beta. No other sectors or individual commodities have significant inflation betas. Average roll returns explain 67% of the cross-sectional variation of commodity futures unexpected inflation betas. Some commodities (e.g., copper, heating oil, and live cattle) had positive roll returns for the period and high unexpected inflation betas. Other commodities (e.g., wheat) had negative roll returns and negative unexpected inflation betas. Thus, one explanation for why some commodity futures might be better inflation hedges than others is that average roll returns are highly correlated with unexpected inflation betas. The wide dispersion of relationships probably explains why the equally weighted average of the 12 commodities has a positive (but insignificant) inflation beta. Finally, neither the magnitude nor the sign of the inflation coefficients is guaranteed to remain constant in the future.
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21. Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison to its arithmetic rate of return. The diversification return is the difference between a portfolios geometric return and the weighted-average geometric return of the portfolios constituents. The diversification return can, under certain circumstances, appreciably raise the geometric return of a fixedweight, rebalanced, commodity futures portfolio. The arithmetic return is the simple average of period-to-period returns. The geometric return is the return that takes into account the compounding across periods. The geometric return is always less than the arithmetic return, but there can be a positive incremental return from variance reduction. Illustrating this begins with the approximation: geometric return = (arithmetic return) (asset or portfolios variance)/2. By reducing the variance, the geometric return increases. A fairly simple formula defines the diversification return of an equally weighted, rebalanced portfolio: portfolio diversification return = (average variance)*(1-average correlation)*(N-1)/(2*N), where N is the number of assets in the portfolio. This equation illustrates that there is a positive relationship between the diversification return and the average variance of the securities in the portfolio, a negative return between the diversification return and the average correlation and the number of securities in the portfolio. For example, for an equally weighted portfolio of 30 securities with average individual security standard deviations of 30% a year and average security correlations ranging from 0.0 to 0.3, the diversification return ranges from 3.05% to 4.35%. This indicates how investors can boost a geometric return with some certainty by rebalancing a portfolio. The important point to remember is that when asset variances are high and correlations are low (as they are with commodities), the diversification return can be high. 22. Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on momentum and the term structure of futures prices. Many investors find the possibility of earning returns from both time-series and crosssectional analysis attractive. The two basic strategies are: Momentum or trend following. Fung and Hsieh (2001) found that most active managers of commodity futures portfolios are trend followers who rely on the assumption that past price moves predict future price moves; and Term structure or cross-sectional analysis focuses on the idea that the term structure of commodity futures explains a significant portion of the long-run cross-section of commodity futures returns.
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Momentum/Trend following Evidence suggests that commodity futures returns are predictable. Jensen et al. (2000, 2002) found that the GSCI outperformed stocks and bonds when their measure of U.S. Federal Reserve monetary policy rose. Strongin and Petsch (1996) found that GSCI returns were tied to current economic conditions. Nijman and Swinkels (2003) found that nominal and real portfolio efficient frontiers can be improved by timing allocation to the GSCI in response changes in some macroeconomic variables (bond yield, the rate of inflation, the term spread, and the default spread). Vrugt, Bauer, Molenaar, and Steenkamp (2004) found that GSCI return variation is affected by measures of the business cycle, the monetary environment, and market sentiment. Furthermore, for the period 1969-2004 and subperiods within that sample, Erb and Harvey (2006) found a positive and significant return from a simple trend following strategy of going long the GSCI for one month when the previous month had had positive returns. Erb and Harvey also found the returns increased by a long-the-winners and a short-the-loser strategy, and the Sharpe ratio was more than twice that of a long-only strategy. Term structure or Cross-sectional analysis When the GSCI is backwardated, i.e., the price of the nearby GSCI futures contract is greater than the price of the next-nearby futures contract, this could provide long-only positive excess returns. Nash and Smyk (2003) found that GSCI total returns are positive when the GSCI is backwardated. Based upon this, it would be natural to extrapolate that when the GSCI is in contango, i.e., the price of the nearby GSCI futures contract is less than the price of the next nearby futures contract, the long-only strategy would produce negative returns. The historical evidence suggests that the term structure seems to have been an effective tactical indicator of when to go long or go short a broadly diversified commodity futures portfolio. Erb and Harvey measured the return to be 8.2% for a strategy of going long the GSCI when backwardated and short when contangoed. That return is more than twice that of a long-only strategy. They also found positive results for similar strategies on individual futures contracts. 23. Argue against the use of naive extrapolation of past commodity returns to forecast future performance and discuss the importance of formulating forward-looking expectations. Nave extrapolation is the practice of using past performance as a forecast of future performance. Research suggests this can be hazardous. Arnott and Bernstein (2002) found that past high excess returns for U.S. equities do not mean that forward looking equity risk premiums are high. They argued that forward-looking returns should be based on an understanding of the fundamental drivers of equity returns, such as earnings growth, dividend yield, and the change in valuation levels. Only if the future return drivers are the same as in the past will past returns be a guide to the future.
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In commodity futures, historically, the long-only GSCI has had an excess return of about 6% a year; however, it has been declining in recent years. One explanation is that increased institutional investment in commodity futures has driven up prices and driven down prospective returns, and another explanation is that the decline is from changes in the composition of the GSCI. Furthermore, there is no guarantee that the yield curve in the future will be such that positive roll returns are possible. It is also important to note that, historically, individual commodity futures excess and spot returns have not been statistically significant. This would infer that any longterm forecast of positive excess return or positive spot return for an individual commodity futures contract is unlikely to be statistically supported by historical experience. In conclusion, there is no one best estimate of the expected return of a commodity futures portfolio, although the diversification return is the easiest return driver to estimate. 24. Discuss the role of global commercial real estate in a strategic asset allocation setting. Modern portfolio theory suggests that assets such as commercial real estate, which have low correlations with the current opportunity set of traditional asset classes (stocks, bonds, and cash), tend to provide the greatest diversification benefits. Unfortunately, there exists ample disagreement on the role of these other asset classes (e.g. commercial real estate) in a strategic asset allocation, even though commercial real estate represents a large portion of the investable universe and should be included in all investors opportunity sets. Hudson-Wilson, et al., who are cited by Idzorek et al., argue that real estate and the other assets should be incorporated in the portfolio at their market weights and that, as a second step, these weights should be adjusted in order to best attain investment objectives. Idzorek et al. argue that the largest investors target allocations will be more heavily weighted in direct commercial real estate investments (acquiring and managing actual physical properties), while smaller investors will likely do it more with real estate investment trusts (REITs) and stocks of listed companies that belong to the real estate industry, as well as direct investments in commercial real estate, as they work towards a strategic asset allocation to global commercial real estate (for more on the components of the commercial real estate asset class, see Learning Objective 25). Relative weightings should be very close to market capitalization-based weights. For the average investor, however, REITs and real estate stocks are the only practical and efficient means to obtain exposure to the commercial real estate equity asset class. Idzorek et al. document that a shift is in progress within global commercial real estate as the advantages of REITs and stocks of listed real estate companies (for more on this, see Learning Objective 25) produce a likely inclination for these securities among investors, and eventually a considerable portion of direct real estate is prone to be securitized. They predict that the size of REITs and stocks of listed real estate companies and their proportion in the total commercial real estate market will continue to grow in the coming years.
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25. Identify the components of the commercial real estate asset class and the relative advantages of direct real estate investment and real estate investment trusts (REITs). The four components (or segments) of the commercial real estate asset class are: 1) Private (direct) commercial real estate: debt. This segment is accessible only to large investors, which can purchase issued whole loans directly. Small investors may gain exposure to this component of commercial real estate through the purchase of stocks of commercial banks, stocks of mortgage REITs, and other specialty finance companies. 2) Public (indirect) commercial real estate: debt. This component is constituted primarily by commercial mortgage-backed securities (CMBS). 3) Private (direct) commercial real estate: equity. It involves the acquisition and management of actual physical properties. 4) Public (indirect) commercial real estate: equity. This segment involves buying shares of real estate investment companies (REITs) and other listed real estate companies. The relative advantages of direct real estate as an investment include: 1) direct control, 2) the ability to choose specific properties, 3) greater capacity, and 4) potential tax-timing benefits. The relative advantages of REITs include: 1) liquidity, 2) investor access, 3) lower costs, 4) potential for better corporate governance structures, 5) independent analysis, and 6) pricing in public capital markets. 26. Explain the historical performance and diversification benefits of select asset classes. Instructor note: There are ten different asset classes to compare in this section. The learning objective does not specify on which assets the student should concentrate. We believe focus should be mainly on real estate assets. Idzorek et al. analyze the historical performance of the following four geographically segmented indirect real estate investments (REITs): Global, North America, Europe and Asia, and also compare them to the performance of traditional assets (cash, U.S. and Non-U.S. bonds, U.S. large and U.S. small caps, and Non-U.S. stocks).
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During the period 1990-2005, North American real estate was the highest-returning asset class (with an average annual arithmetic return of around 17%). Furthermore, North American real estate, U.S. bonds, and U.S. large-cap stocks showed the highest Sharpe ratios, while non-U.S. stocks, European real estate, and Asian real estate exhibited the lowest Sharpe ratios. Asian real estate was the most volatile asset class, reflecting the fact that Asian currency markets were highly volatile over the period. Idzorek, et al. also conclude that, at least over short periods of time, it is almost impossible to predict which asset class (among the traditional assets and the previous four real estate investments) will be the best performer. The data illustrates that global real estate has generally had low, or negative, correlation coefficients with traditional assets (U.S. large-cap stocks, U.S. small-cap stocks, and U.S. bonds). European real estate has had negative, or very low, correlations with all U.S. asset classes. These weak to negative correlations between real estate and traditional asset classes suggest that additional diversification benefits can be attained by including real estate investments in a portfolio. Also, the three sub-asset classes of global real estate considered (American, European, and Asian) exhibit relatively high intra-equity correlations. Finally, global real estate tends to have lower correlations with the four traditional U.S. assets when compared to North American real estate. On the other hand, North American real estate has lower correlations with non-U.S. bonds and stocks when compared to global, European, or Asian real estate. 27. Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when determining forward-looking asset allocations. Two forward-looking asset allocations models are analyzed in Idzorek, et al.: the CAPM approach and the Bayesian Black-Litterman asset allocation approach. In a forwardlooking context, as opposed to the traditional mean-variance optimization approach, the capital market assumptions are forecasts and, therefore, they are not known with complete certainty. Idzorek, et al. estimate forward-looking efficient asset allocations based on expected return estimates drawn from the CAPM using a reverse optimization procedure. They find a large difference between the CAPM return and the historical arithmetic return for North American real estate and offer two possible explanations. First, the historical average annual return may be the result of an abnormally optimistic but temporary period for North American real estate. Second, past research has suggested that several return anomalies can not be explained by the CAPM (e.g. small firm effect, momentum, etc.). It may be that North American real estate represents an anomaly analogous to these. Idzorek et al. then also use the Black-Litterman model to produce a set of forwardlooking expected returns that blends expected returns arising from the CAPM with the historical returns. The Black-Litterman asset allocation gives a greater weight to worldwide commercial real estate equities and smaller weights to non-U.S. stocks than the CAPM. Furthermore, these forward-looking efficient asset allocations support North
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American and European real estate more than the CAPM-based allocations (see the exhibit). The Bayesian Black-Litterman asset allocation procedure provides market-based asset allocations that are improved with information available from the historical returns. As in the CAPM-based allocations, another description of the market portfolio will generate a different set of asset allocations. The Black-Litterman-based approach is largely influenced by the short-term returns that are mixed with the CAPM returns, although the resulting suggested asset allocations are influenced far less than most other models. Exhibit: CAPM and Black-Litterman Forward-Looking Asset Allocations for Real Estate Classes CAPM Forward-Looking A. A.
Asset Class North Am. RE European RE Asian RE Conservative 2.9% 3.9% 1.7% Moderate 5.0% 6.7% 4.1%
Black-Litterman Forward-Looking A. A.
Aggressive 4.8% 8.5% 8.6% Conservative 5.9% 4.5% 1.1% Moderate 12.1% 7.8% 3.4% Aggressive 15.4% 11.1% 8.2%
Source: Idzorek, et al. (2007)
28. Explain the seven caveats identified by the author as considerations for strategic asset allocation to global commercial real estate. Idzorek et al.s first caveat is that the two forward-looking asset allocations sets they present represent only two of the many possible asset allocations that can be derived from analytically based forward-looking expected returns. Second, it may questionable to use global REITs and stocks of real estate companies to embody the long-term performance of the universe of commercial real estate equity investments. However, considering REITs and listed real estate stock returns as a proxy for all commercial real estate investments has become more suitable in the last few years as these investments have been growing fast and represent a larger proportion of the market. In the end, we are confronted with an empirical question. Third, investors who have a separate strategic asset allocation to REITs and listed real estate stocks may not need to own these indirect real estate investments. However, all other investors should own REITs and listed real estate stocks. Idzorek et al. note that this caveat is relevant only to a small group of the largest investors. Fourth, the CAPM-based asset allocations presented are market-based and assume that investors do not suffer from a U.S. or home bias (i.e. the tendency to invest in a large proportion of domestic assets, despite the supposed benefits of diversifying into foreign assets). Another definition of the market portfolio (one that includes, for example, commercial real estate) will produce another asset allocation. More work on this topic is needed. Fifth, if investors would be able to increase their opportunity set so as to include all the most important assets that are part of the unobservable market portfolio (assets such
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as TIPS, convertible bonds, commodities, emerging market bonds, high-yield bonds and emerging market stocks), the end result will be a reduction in the allocation to the asset classes considered in Idzorek et al.s study. The sixth caveat, which is related to the fifth, is that a different composition of the market portfolio will yield a different set of Black-Litterman-based asset allocations. Finally, actual asset allocations should be tailored to the investors unique situation. Example: Let us use these insights on real estate asset allocation in a hypothetical example. Peter Gray, an investment analyst at YHG Investments, is analyzing whether to include real estate as an asset class in a client portfolio that is currently constituted only in U.S. stocks and U.S. bonds. To that end, he collects the following historical information on U.S. real estate, U.S. stocks, U.S. bonds and U.S. inflation. YEAR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average St. Deviation REITS 35.68% 12.18% 18.55% 0.81% 18.31% 35.75% 18.86% -18.82% -6.48% 25.89% 15.50% 5.22% 38.47% 30.41% 8.29% 34.35% 17.06% 16.46% Stocks 30.47% 7.62% 10.08% 1.32% 37.58% 22.96% 33.37% 28.58% 21.04% -9.10% -11.89% -22.10% 28.68% 10.88% 4.91% 15.79% 13.14% 17.45%
Stocks 0.17 1.00
Bonds 16.00% 7.40% 9.75% -2.92% 18.47% 3.63% 9.65% 8.69% -0.82% 11.63% 8.44% 10.26% 4.10% 4.34% 2.43% 4.33% 7.21% 5.64%
Bonds 0.22 0.18 1.00
CPI 2.98% 2.97% 2.81% 2.60% 2.53% 3.38% 1.70% 1.61% 2.68% 3.44% 1.60% 2.48% 1.87% 3.29% 3.40% 2.53% 2.62% 0.64%
CPI 0.31 -0.19 -0.09 1.00
CORRELATION MATRIX REITS 1.00 REITS Stocks Bonds CPI
Note: REITS returns were measured from the total return index REITs calculated by NAREIT, Stock returns were measured from the Standard and Poors 500 total return index, Bonds returns where measured from the Lehman Aggregate U.S. Bond total return index, and CPI is the percentage changes in the U.S. Consumer Price Index.
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Part A: Peter notices that real estate provided the highest return of the three asset classes, but he is concerned that the standard deviation of real estate is almost as high as the standard deviation of stocks. This leads him to question whether to add real estate to the traditional portfolio at all. Do you agree with Peter? Modern portfolio theory suggests that asset classes such as real estate, which have low correlations with the current opportunity set of traditional asset classes (we can see in the table that it has correlations of 0.17 and 0.22 with stocks and bonds, respectively), may well provide substantial diversification benefits. Therefore, even though real estate exhibited one of the highest standard deviations, its low correlation to traditional assets, combined with the high returns it offered, makes this alternative investment a good potential candidate to be added to a traditional portfolio. Part B: Based on the information presented in the tables, Peter is assessing whether real estate offers a better hedge than stocks or bonds against the risk of inflation. What would you say to him? You could say that real estate investments exhibited a positive correlation with inflation (0.31), as opposed to stocks and bonds, which showed a slightly negative correlation with inflation (-0.19 and -0.09, respectively). Therefore, it appears that real estate investments offered a better hedge against the risk of inflation than stocks or bonds did during the period 1991-2006. A more rigorous study would attempt to see the correlation of real estate returns with inflation using a measure of unexpected inflation (what is shown in the table, CPI inflation, is simply the observed inflation, whether it was expected or not).
References Perold, A. F., and W.F. Sharpe. Dynamic Strategies for Asset Allocation. Financial Analysts Journal. January/February 1988. Chhabra, A. Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors. The Journal of Wealth Management, Spring 2005. Erb. C., and C. Harvey. The Strategic and Tactical Value of Commodity Futures. Financial Analysts Journal. Vol. 62, No. 2, March/April 2006. Idzorek, T.M., M. Barad, and S.L. Meier. Global Commercial Real Estate. The Journal of Portfolio Management. Special Issue, 2007
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TOPIC
Current Topics
Main Points
Explaining what happened in the Amaranth debacle, how it happened and how it could have been avoided Applying the market events of August 2007 to the concept of systemic risk Describing factors contributing to the subprime credit crisis and recommending policies and practices to address them 1. Understand what is meant by the term structure of a commodity futures curve and the terms backwardation and contango. The term structure of a commodity futures market is a curve that is constructed by plotting each delivery-month contract on the x-axis and its respective price on the y-axis.
As noted on page 326, the author says: When the near-month futures contracts trade at a discount to further-delivery contracts, one says that the futures curve is in contango. When the near-month futures contracts instead trade at a premium to further-delivery contracts, one says the futures curve is in backwardation. 2. Understand the derivation of the futures curve for natural gas and the association between the curve and potential determinants including anticipated production, consumption and seasonal factors. The prices of summer and fall natural gas contracts typically trade at a discount to the winter contracts. The markets, therefore, provide a return for storing natural gas. An
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Topic 9: Current Topics
owner of a storage facility can buy summer natural gas contracts and, simultaneously, sell winter natural gas contracts. The difference will be the operators return for storage. When the summer contracts expire, the owner takes delivery and injects it into storage. When the winter contracts expire, the owner makes delivery of the natural gas. U.S. natural gas storage capacity has actually declined since 1989 and domestic production has not kept up with demand. If there are hurricanes during the summer in the U.S., concerns arise as to whether natural gas production will be sufficient for winter consumption needs. In such scenarios, the front months contract price can increase dramatically to discourage current demand and the futures curve would trade in steeper contango to provide a further enhanced return for storage. This occurred after Hurricane Katrina in 2005. 3. Explain a futures calendar-spread strategy and the sources of potential profits, potential losses and risk from this type of strategy. Trades that exploit the spreads between two delivery months are referred to as calendarspread trading strategies. As noted by the author, sophisticated storage operators can potentially value their storage facilities as a set of complex options on calendar spreads. Potential profits: In general, if the calendar spreads are volatile, storage is worth more. The strategy is profitable as long as the operators financing and physical outlay costs are under the spread locked in through the futures market. If spreads tighten, traders (operators) can trade out of the spread at a profit and reinitiate a trade later. If traders (operators) cannot trade out of the spread, they can take physical delivery and realize the value of their storage facility. Potential losses and risk: If the winter months are unexpectedly mild and there are massive amounts of natural gas in storage, the near month contracts price plummets to encourage its current use. 4. Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it relates to natural gas pricing. As described by Till, Amaranths spread trading strategy involved taking long positions in winter contract deliveries and short positions in non-winter contract deliveries. These positions would have been profitable if adverse weather events such as hurricanes and cold shocks occurred during the period 2006-2010. However, by August 2006, Amaranth faced a major dilemma how to trade out of its large, high-priced spread positions without causing the price of those spreads to fall. In prior months, Amaranth had rolled its short positions into the next month, hoping that market conditions would change and enable it to unload its positions. As summer was now ending, there were no more summer months into which it could roll these positions. By late August, with the hurricane season almost over and with natural gas supplies remaining plentiful, it appeared likely there would be adequate supplies for the winter. The market fundamentals were strongly indicating that the winter/summer price spreads
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should fall. This would be particularly disastrous for Amaranth, which was still holding large positions that it had obtained when these spread prices were high (See the US Senate PSI Staff Report Excessive Speculation in the Natural Gas Market, that is summarized in Tills article.) The key economic function for natural gas is to provide for heating demand during the winter in the northern states in the U.S. and air-conditioning demand during the summer months. There is a long injection season during spring through fall when natural gas is stored in caverns for later use during the long winter season. Till makes several points regarding the natural gas market: Domestic production has not kept up with demand. U.S. natural gas markets are largely insulated, in the short-term, from global energy factors. There is insufficient storage capacity, particularly if there is a severe winter. Inventories need to be recycled to maintain integrity. All these factors have a major impact on the pricing relationships for different delivery months. 5. Discuss the magnitude of Amaranths calendar-spread positions: explain how this hedge fund was able to accumulate such large positions (including the role of position limits) and describe the effects of the magnitude of the positions on daily profits and losses. Given below is an excerpt from the US Senate Permanent Subcommittee on Investigations (PSI) Report that sheds some light on position limits and actions by NYMEX. The key item to consider here is that Amaranth was easily able to move to ICE from NYMEX because ICE did not have the same constraints as NYMEX. By the end of July, Amaranth was short nearly 60,000 contracts for September, 42,000 contracts for October, and 80,000 contracts for April 2007; it was long 80,000 contracts for January 2007, 60,000 contracts for March 2007, and 29,000 contracts for December 2007. Amaranth held about 40% of the total open interest in the NYMEX natural gas market for all of the winter months (October 2006 through March 2007). During 2006, NYMEX repeatedly reviewed Amaranths natural gas holdings to determine whether they exceeded NYMEXs established position limits or accountability levels. On several occasions, Amaranth traded large numbers of contracts near their expiration date, triggering NYMEX notices that the firm had violated NYMEX position limits; a CFTC investigation of one of these instances is still ongoing. In August 2006, NYMEX took more forceful action to limit Amaranths trading, directing Amaranth to reduce its positions in the NYMEX futures contracts not just for the September contracts that were about to expire, but also for its contracts in the following month of October. In response, Amaranth reduced its positions in those contracts on NYMEX, but at the same time, it increased its positions in the corresponding contracts on ICE. The end result was that Amaranth maintained and even increased its positions in contracts for September and October, and it preserved its ability to engage in
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large-scale trading as the September contract neared expiration. In fact, Amaranths move enhanced its ability to conduct large-scale trading near the contract expiration because, under current law, no market surveillance or position limits apply to trading on ICE. The US Senate PSI Report found, for example, in late July 2006, that Amaranths natural gas positions for delivery in January 2007 represented a volume of natural gas that equaled the entire amount of natural gas eventually used in that month by U.S. residential consumers nationwide. The scale of Amaranths trades is shown in Exhibit 2, reproduced from Tills article, below. Exhibit 3 shows graphically Amaranths forward curve. The key again is the magnitude of the positions when NYMEX and ICE positions are combined.
Source: Till (2007)
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Tills Exhibits 4 and 5 indicate that the changes for various spread relationships across the natural gas curve were extremely large on September 15 and September 18 which signaled, at the time to market participants, that a distressed liquidation was occurring given that these moves were very large standard deviation moves compared to recent history. Exhibits 4 and 5 also show that the prices of the winter-month contracts fell dramatically as compared to the non-winter-month contracts in the near-month through 2011 forward maturities for natural gas. While NYMEX had position limits, ICE did not at the time. (The US Senate PSI Report provides details.)
Source: Till (2007)
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Source: Till (2007)
6.
Discuss the causes for increased volatility on the natural gas commodity futures market prior to Amaranths liquidation in September 2006. As noted by Till, if the winter is unexpectedly mild and there are still massive amounts of natural gas in storage, the near month price of natural gas plummets in order to encourage its current use and the curve trades in contango in order to provide a return to any storage operator who can still store gas. This scenario occurred during the end of the winter in early 2006. As indicated in Learning Objective 4 above (See the US Senate PSI Report), with hurricane season almost over and with natural gas supplies remaining plentiful, it appeared likely there would be adequate supplies for the winter. The market fundamentals were strongly indicating that the winter/summer price spreads should fall.
7.
Discuss how sophisticated storage operators can manage their storage facilities as a set of options on calendar spreads. Storage is worth more if the calendar spreads in natural gas are volatile. As a calendar spread trades in steep contango, storage operators can buy the near month contract and sell the far month contract, knowing that they can ultimately realize the value of this spread through storage. Another preferable scenario would occur if the spread tightens. Under this scenario, the trader could trade out of the spread at a profit. If the spreads were to be in wide contango again, the position could be reinitiated. The key consideration here again is the volatility of the spreads. If the volatility of the spreads remained high, the storage operator/trader
52
can continually lock in profits. If conditions are such that the operator/trader cannot trade out of the spread with a profit, they can take delivery of the natural gas in anticipation of making delivery at a later date. The storage operator/trader is thus realizing the value of the storage facility. Alternatively, if the winter is unexpectedly mild with an abundance of natural gas in storage, the near month price plummets and current consumption is encouraged. If storage operators can still store gas, they can realize a return. 8. Describe how daily volatility as measured by standard deviation can underestimate potential risk (where risk is defined as the likelihood of experiencing severe loss), and explain how scenario analysis can be used to better indicate the risk of a funds structural position in such circumstances. The daily P/L of Amaranths August 31 positions is shown in Exhibit 12 from Tills article. The daily standard deviation based on three months of data was about $105 million far lower than the actual losses that occurred in September. See below an excerpt from the Senate Report on the losses suffered by Amaranth. If scenario analysis had been conducted, the riskiness of the funds structural position would have been more evident. As noted by Till, as of August 31, 2006, winter natural gas futures prices were trading at an extreme relative to non-winter-month contracts. A scenario analysis could have examined over the past six years what the level of the funds spreads had been. Using the Senate report, Till finds two spreads that were 93% correlated to Amaranths natural gas book: the November 2006 versus October 2006 (NGX-V6) spread and the March 2007 versus April 2007 (NGH-J7) spread. Exhibit 14 shows that if these two spreads had reverted to the levels that had prevailed at the end of August during the previous six years, up to -36% could have been lost under normal conditions.
Source: Till (2007)
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Source: Till (2007)
Excerpt from the US Senate PSI Report: The 60-cent increase in the price of the September contract and the associated drop in the price of the October/September spread caused a huge loss for Amaranth. On August 29, its daily profit and loss statements recorded a loss in the value of its natural gas holdings of nearly $600 million. Despite this enormous one-day loss, Amaranth still finished August with a net gain of $631 million for the month. More ominous for Amaranths long-term survival, however, were the increased margin calls and requirements that followed. Because its natural gas holdings had lost value, on August 30, Amaranths margin requirements increased by $944 million. According to an internal memorandum from J.P.Morgan Chase, Amaranths clearing firm, this margin call resulted from Amaranths activity on the ICE yesterday. On August 31, Amaranths margin requirements on ICE and NYMEX exceeded $2.5 billion; by September 8 they had surpassed $3 billion. During the first week of September, from Amaranths perspective, more bad news arrived. Other natural gas prices began falling. Two spreads of particular concern to Amaranth were the March/April 2007 price spread and the January2007/October 2006 price spread. The March/April spread had begun a free fall, dropping nearly 25%, from $2.49 on August 25 to $2.05 on September 1. The falling March/April spread increased Amaranths margin woes. During the first two weeks in September, the January/October spread also went into a steep decline, falling from $4.68 on September 1 to $4.15 on September 11, to $3.52 on September 15. By September 15, as Amaranths natural gas positions continued to deteriorate and its cash position weakened considerably, Amaranth began to seek a counterparty to buy its energy book. One of the counterparties Amaranth approached was Centaurus. Late on Saturday, September 16, Amaranths senior energy trader Brian Hunter asked John Arnold, Centaurus CEO, whether the hedge fund would like to make a bid for some of Amaranths positions. Early the next morning, Mr. Arnold offered a bid after making the following observations: I was not in the office on Friday but I understand you were selling h/j [March/April]. The market is now loaded up on recent, bad purchases that they will probably try to be spitting out on Monday if there is a lower opening given that spread
54
has been in free fall. In my opinion, fundamentally, that spread is still a long way from fundamental value. Over the past couple years the market has put a big risk premium into that spread yet it has paid out on expiry once in ten years. Well be at all time high storage levels with mediocre s/d [supply and demand] and an el nino. Even though that spread has collapsed over the past 2 weeks, the only reason its still $1 is because of your position. Historically, that spread would be well below $1 at this point given the scenario. Mr. Arnold gave Mr. Hunter two price quotes for the March/April spread: 45-60 cents for the March/April 2007 spread which had closed the previous trading day at $1.15; and $1.00-$1.20 for the March/April spread in 2008 and beyond, which had closed the previous day at between $2.10 and $2.20. Mr. Hunter declined Mr. Arnolds offer. Mr. Arnolds prediction of the behavior of these spreads, however, turned out to be remarkably accurate. On September 21, the last day of Amaranths trading in the natural gas market, the March/April 2007 spread stood at 58 cents, and the March/April spreads for 2008 and beyond ranged from $1.18 to $1.25. After several days of frantic negotiations with several brokerages and banks, on September 20th, Amaranth formally sold its energy book to its clearing firm, JPMorgan Chase, and Citadel, another hedge fund. To meet its margin calls and satisfy client requests, Amaranth liquidated the remainder of its $8 billion portfolio. 9. Describe what is meant by nodal or one-way liquidity in the commodity markets and how the lack of two-way liquidity adversely affected Amaranth. Commodity markets have nodal liquidity. This implies that as a commercial market participant needs to initiate or lift hedges, there will be flow but these transactions do not occur on demand. That is, there is no ready and willing counterparty available to take the opposite positions. Hence a key focus of experienced commodity traders is an exit strategy. What flow or catalyst will allow a trader to exit a position? In the case of Amaranth, there was no natural (financial) counterparty that could take on its positions in under a week (or, specifically, during the weekend of September 16-17, 2006). The natural counterparties to Amaranths trades were the physical market participants who had already locked in the value of forward production or storage, so they would not be interested in taking counterparty positions to Amaranth. 10. Understand how forced liquidations can affect market prices and why changes in market prices can be correlated with the size and direction of the liquidation. Exhibit 15 shows the critical liquidation cycle. By Friday September 15, 2006, Amaranth had lost more than $2 billion of its $8 billion portfolio. According to Davis et al. (2007), at this point, the fund was bleeding cash and facing demands from its prime broker for additional funds that it did not have. The critical liquidation cycle began at this point. Once a threshold of losses is crossed, the cycle of investor redemptions occurs and prime brokers demand a reduction of leverage.
55
The funds NAV declines precipitously as the fund sells holdings in a distressed fashion. The distressed sale of assets negatively impacts market prices.
Source: Till (2007)
11. Discuss eight hypotheses explaining the market events of August 2007. After reviewing a number of empirical results, Khandani and Lo developed the following eight tentative hypotheses (based exclusively on indirect evidence) about August 2007: 1. The losses to quant funds in the second week of August 2007 were started by a short-term price impact that was the consequence of a rapid unwinding" of one or more large quantitative equity market-neutral portfolios. The price impact of the unwind between Tuesday, August 7, and Wednesday, August 8, forced a number of other types of equity funds to drastically reduce their risk exposures, thus aggravating the losses of the majority of these funds on August 8-9. Most of the unwinding and de-leveraging took place on August 7-9. The losses stopped after Thursday, August 9, and a significant turnaround took place on Friday, August 10. This price-impact pattern led the authors to hint that the losses were the short-term side-effects of an abrupt liquidation on August 7-8. In other words, the losses did not arise as a result of a hypothetical fundamental collapse in the primary economic forces that affect long/short equity strategies. The authors point to the following likely factors as contributors to the scale of the losses resulting from the unwind: (a) the massive recent growth in assets dedicated to long/short equity strategies; (b) the trending decline in the effectiveness of quantitative equity market-neutral strategies; (c) the bigger leverage required to
2.
3.
4.
5.
56
preserve expected returns levels demanded by hedge fund investors; (d) the lack of realization about how popular the long/short equity category had become; and (e) the unknown magnitude and timing of the mortgage-related problems surfacing in the credit markets. 6. The presumed unexpected liquidation of one or more large quantitative equity market-neutral portfolios occurred. Given that these portfolios are composed mainly of exchange-traded instruments, the price shock of the quick unwind was swiftly spread to other funds. The authors find it reasonable to deduce that the systemic risk in the hedge fund industry may have increased in recent years because of the following: the differences between the behavior of their test strategies in August 2007 and August 1998, the increase in average absolute correlations among hedge fund indices, the boost in the number of funds and the average assets under management per fund, and the expansion of credit-related styles among hedge funds. The authors suggest that the continuing troubles in the subprime mortgage market may activate more liquidity shocks in the more liquid hedge fund styles (e.g. long/short equity, managed futures, and global macro). However, they hypothesize that the harshness of the shock to the long/short equity style is likely to be subdued in the short-term because market participants now possess more information regarding the magnitude of this sector and the possible price-impact of another potential liquidation of a long/short equity portfolio.
7.
8.
12. Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall under the broad heading of long/short equity. Khandani and Lo refer to the following four seemingly dissimilar categories of fund strategies as long/short equity: 1. Statistical arbitrage. This refers to highly technical short-term mean-reversion strategies concerning large numbers of securities. They use very short holding periods and substantial computational, trading, and IT infrastructure. Quantitative equity market-neutral. This is a more general category, concerning broader types of quantitative models, some with lower turnover, fewer securities, and inputs other than past prices such as accounting variables, earnings forecasts, and economic indicators. Long/short equity strategies. The third category is the broadest. Khandani and Lo characterize long/short equity strategies as those that comprise any equity portfolios that employ short-selling, that may or may not be quantitative, that may or may not be market-neutral (for e.g., many long/short equity funds are net long), and where technology does not necessarily play a significant role. Long/short equity strategies usually represent the single largest category in most hedge fund databases in terms of number of funds and assets. 130/30. This group, also called active extension strategy, is a relatively new category in which a fund or managed account of, say $10MM, invests $13MM in
2.
3.
4.
57
long positions in one group of securities and $3MM in short positions in another group of securities. Khandani and Lo argue that this strategy can be considered a logical addition of a long-only fund, assuming that the long-only constraint has been relaxed to a limited extent. 13. Describe the anatomy of the long/short equity strategy. Explain how it is simulated in the paper, how the strategy provides liquidity to the market place, how leveraged portfolio returns are constructed, the relationship between market capitalization and the strategys profitability, and the practical implications of transactions costs. We explain this learning objective by dissecting its parts. Anatomy of the long/short equity strategy and how it is simulated: Khandani and Lo estimate the effects of the events of August 6-10, 2007, on long/short equity portfolios simulating a specific strategy originally proposed by Lehmann (1990) and Lo and MacKinlay (1990). The strategy works as follows. Suppose there are N securities, and consider a long/short market-neutral equity strategy that consists of allocating an equal dollar amount to long and short positions. At each rebalancing date, the long positions are made up of what might be called the losers (stocks that have been underperforming relative to a given market average m), and the short positions are invested in what might be called the winners (stocks that have been outperforming relative to the same market average m). In terms of an equation, if we denote it as the portfolio weight of security i at date t, then we have:
it =
1 ( Rit k Rmt k ) N 1 N
Rmt k
R
i =1
it k
(1)
for some k > 0. Notice that the portfolio weights are equal to the negative of the degree of outperformance k periods ago. Therefore, each value of k generates, to some extent, a special strategy. Khandani and Lo set k=1 to represent a day. By buying yesterday's losers and selling yesterday's winners at each date, the proposed strategy is dynamically betting on the existence of a mean reversion across all N securities, thus profiting from turnarounds that take place within the rebalancing time interval. As a result, equation (1) can be considered a contrarian trading strategy that is capable of profiting from a market overreaction, that is, when underperformance (outperformance) is followed by positive (negative) returns.
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How the strategy provides liquidity to the market place: Contrarian trading strategies increase the demand for losers (by buying losers) and add to the supply of winners (by selling winners), thus providing liquidity to the marketplace and helping stabilize any imbalances that may exist between supply and demand. In offering liquidity to the marketplace, contrarian trading strategies also achieve a reduction in market volatility as they help mitigate price fluctuations by buying stocks for which there is excess supply and selling stocks for which there is excess demand. How leveraged portfolio returns are constructed: The portfolios return of an arbitrage or market-neutral portfolio (where long and short positions exactly offset each other) cannot be calculated in the usual way because there is no net investment. In practice, however, the return of these strategies can be calculated as the profit-and-loss of that strategys positions divided by the initial investment that was required to support those positions. More specifically, the gross dollar investment It of the portfolio presented in equation (1) and its unleveraged portfolio return Rpt can be computed by the following equation:
It 1 N | it |, 2 i =1
R pt
N i =1
it Rit
It
(2)
Then, to construct leveraged portfolio returns Lpt() employing a regulatory leverage factor of :1, Khandani and Lo multiply equation (2) by /2:
( / 2) i =1 it Rit
N
L pt ( )
It
(3)
Relationship between market capitalization and the strategys profitability: Khandani and Lo find that the average daily return of the strategy in the smallest decile is considerably larger than the corresponding return for the largest decile. This finding is consistent with the smaller-cap pattern that has been long known by long/short equity managers. The reason behind this finding may lie in the fact that smaller-cap stocks generally exhibit more inefficiencies and, hence, the profitability of the contrarian strategy in the smaller deciles is significantly higher than in the larger-cap portfolios. Practical implications of transactions costs: A caveat of these findings relating to smaller-cap stocks is that the transaction costs inherent to trading smaller-cap stocks are typically very high. Therefore, in the real world, the previous results may not be as attractive as the data might imply. This trade-off
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between apparent profitability and transaction costs suggests that the intermediate deciles may be the most suitable from a realistic point of view. 14. Explain the return pattern of the main simulated strategy during the second week of August 2007. Khandani and Lo simulate an unlevered contrarian return strategy applied on August 7, 8, and 9, 2007, and find that the strategy yielded a cumulative three-day loss of -6.85%, which represents a staggering loss of 7.6 standard deviations, assuming independently and identically distributed daily returns. Actual losses were probably magnified severalfold as many long/short equity managers were employing leverage. Interestingly, a good portion of the losses was reversed on Friday, August 10, when the contrarian strategy yielded a return of 5.92%. Khandani and Lo argue that this dramatic reversal is a revealing sign of a liquidity trade. The extraordinary return patterns observed in the second week of August 2007 can be explained as the result of broad-based momentum induced by a major strategy liquidation. Once the liquidation had ended, the liquidation-based momentum reversed into a strong mean reversion that caused Fridays extraordinarily positive returns. 15. Compare and contrast market events in August 2007 with August 1998. Khandani and Lo argue that there exists one important difference between August 1998 (around the time of the Long Term Capital Management (LTCM) debacle), and August 2007. They say: In contrast to August 2007, where an apparent demand for liquidity caused a re-sale liquidation that is easily observed in the contrarian strategy's daily returns, the well-documented demand for liquidity in the fixed-income arbitrage space of August 1998 had no discernible impact on the very same strategy. This is a very significant difference that is consistent with a greater degree of financial integration, including the possibility of contagion among markets, in 2007 than in 1998. According to Khandani and Lo, the differences between August 1998 and August 2007 are the result of several possible interpretations. One explanation is that in 1998, there were less multistrategy funds and proprietary trading desks participating in both fixed income arbitrage and long/short equity. As a result, the demand for liquidity caused by failing fixed income arbitrage strategies did not spread out as willingly to long/short equity portfolios. A second possibility is that the magnitude of the capital invested in long/short equity strategies was not sufficiently large to cause any major disruption, even if such strategies were unwound rapidly in August 1998. Finally, a third possible explanation is that in 1998, long/short equity funds were not as leveraged as it appears they were in 2007. The authors argue that all three of these explanations may be at least partially valid. 16. Explain how the increase in total assets under management and the number of long/short funds over the 1998 to 2007 time period likely impacted expected returns and the use of leverage. Khandani and Lo estimate that, excluding strategies such as 130/30 funds, the total number of long/short funds and the average assets per fund grew exponentially since
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1994 (beginning at $62MM in January 1994 and ending at $229MM in July 2007). This implies greater competition and, consequently, a diminishing profitability arising from the strategies used by such funds. The authors speculate that, as these strategies began to yield decreasing returns, hedge fund managers started to increase leverage in order to preserve the expected returns that investors anticipate. However, even though leverage offers the potential to magnify small profit opportunities into larger profits, it also has the potential risk of escalating small losses into larger ones. More leverage also implies that the magnitude of the positions is often significantly larger than the size of collateral placed to hold up those positions. This situation can be very precarious because when unfavorable market fluctuations shrink the market value of collateral, credit is withdrawn rapidly. This can lead to an abrupt liquidation of large positions over very short time periods and can wreak havoc in financial markets, in a way similar to what happened in August 1998 and in August 2007. 17. Describe the set of hypotheses that are collectively referred to as the unwind hypothesis. Khandani and Lo argue that the fact that the leveraged contrarian strategy that they simulate lost -4.64% on Tuesday, August 7, and then -11.33% on Wednesday, August 8, points to an abrupt liquidation by one or more equity market-neutral portfolios of large size. They also note that the timing of these losses was just a few days after the end of July, which was a very difficult month for many hedge funds, and propose that the events of August 7-9 may well had been the first time that hedge funds were strained to deal with the astonishing credit-related losses they had experienced in July. This realization may, in turn, have activated the first unwind of their more liquid positions (basically their equity portfolios) during this period. Another significant pattern that the authors uncovered is the fact that the losses on August 7 and 8 were most dramatic for some of the intermediate-decile portfolios, a finding that is consistent with a statistical arbitrage unwind. Confronted with the large losses of August 7-8, most of the affected hedge funds would probably have been forced to cut their risk prior to Thursdays market open by deleveraging (either on a voluntary basis or because they had surpassed borrowing limits established by their creditors). As the authors point out, this was a sensible practice that, unfortunately, also proved to be disastrous. Fridays enormous turnaround seemed to confirm that the losses of the preceding three days were caused by an abrupt liquidation, and not by any structural change in the equilibrium returns of long/short equity strategies. Structural changes would probably have had a more enduring effect on prices. 18. Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over the past decade. Khandani and Lo argue that a significant decrease in liquidity of long/short equity strategies over the past decade has probably occurred because the number of long/short equity funds, the level of assets per fund, and the leverage that each fund uses have all increased throughout that period. They then propose to measure the illiquidity of
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long/short equity funds using the first-order autocorrelation coefficient of their monthly returns, as originally put forward by Lo (1999) and Getmansky, Lo, and Makarov (2004). Results using the proposed measure of illiquidity for the period from December 1994 to June 2007 imply that, apart from for a short-lived increase in late 2004, a significant decline in the liquidity of long/short equity funds occurred over the past six years as suggested by an ever increasing autocorrelation (i.e. the correlation between the return for a hedge fund and its lagged return from the previous month) since 2000. More importantly, they argue that the fact that the autocorrelations have risen at all in the most crowded, and among the most liquid, of all hedge fund sectors represents yet another clue that systemic risk in the hedge fund industry has risen in recent years. 19. Describe a method for approximating a network view of the hedge fund industry and what such a view indicates. Although credit and liquidity are separate sources of risk exposure for hedge funds and their investors, the two have been generally perceived as being inevitably entangled since the LTCM collapse in August 1998. In spite of recent progress achieved in modeling credit and liquidity risk, the intricate network of creditor/obligor interactions still needs to be correctly mapped. In this regard, Khandani and Lo present an approximation of the use of some of the techniques developed in the theory of networks to design systemic measures for liquidity and credit risk exposures and improve the strength of the worlds financial system to idiosyncratic shocks. Khandani and Lo caution that the opaqueness of the hedge fund industry does not allow them to collect the data needed to approximate the network topology that is the initial point of these procedures. In spite of this, they proceed to calculate the changes in the absolute values of correlations between hedge fund indices over time as an indirect and rudimentary estimation of the change in the degree of connectedness in the hedge fund industry. Khandani and Lo find that the hedge fund industry has undoubtedly become more closely connected. This is because the multi-strategy category exhibits now a higher correlation with almost every other index. This higher correlation also yields support to the hypothesis that factors outside the long/short equity segment may have produced an unwinding of arbitrage strategies in August of 2007. The authors caution that it is possible that the variation in correlations may have been due to volatility shifts and not due to changes in the covariances of returns. They also warn that it may not be possible to gather the required data to draw the network topology without resorting to additional regulatory supervision, given the fact that the hedge fund industry protects its intellectual property by being secretive about its trades. 20. Evaluate the statement: Quant failed in August 2007. Khandani and Lo comment that it would be easy to conclude that the losses resulting from the events of August 2007 were the result of a fire-sale liquidation of quantitatively constructed portfolios, rather than the particular limitations inherent to the quantitative methods they use. If this was the case, the fire sale would have come about as a result of an underestimation of risk on the part of hedge funds.
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The authors also contend that while market participants will most likely advance their strategies and risk management practices as a result of the events of August 2007, it is implausible that the likelihood of potential disruptions can be entirely eradicated by such improvements. This is because events such as this may merely be an inevitable aspect of equity market-neutral strategies. Furthermore, the risk/reward profiles of these strategies can be thought of as providing small but stable positive returns nearly all of the time, tied with sporadic short-lived considerable losses. Such profit-and-loss pattern can be fairly attractive to those investors that are aware of the meaning of tail risk and whose individual risk preferences allow them to endure the unavoidable rare event. Khandani and Lo leave open the answer to the question Did Quant fail? when they conclude that: Quantitative models may have failed in August 2007 by not adequately capturing the endogeneity of their risk exposures. Given the size and interconnectedness of the hedge fund industry, we may require more sophisticated analytics to model the feedback implicit in current market dynamics... (However) If all three sets of stakeholders - managers, investors, and creditors - were aware of the risks and willing to bear them, then August 2007 is merely the cost of doing business. If not, then August 2007 signaled another kind of failure in this industry. 21. Critique the methodology of the article. Khandani and Lo caution that, even though their unwind hypothesis is consistent with the events that occurred during the week of August 6-10, 2007, all of their inferences should be taken as tentative, indirect, and too recent to be pondered correctly. This is because of the following five reasons: 1. The authors did not have access to inside information about the hedge funds that were impacted by the crisis in August 2007, nor to information on prime trading or brokerage records, or industry leverage statistics. Their empirical results were based on only one simple trading strategy applied to U.S. stocks. This strategy may or may not be representative of certain short-term market-neutral mean reversion strategies. The outsiders perspective of the methodology used by Khandani and Lo does not allow them to determine whether or not the early losses on August 7 were the result of a forced liquidation or of a deliberate risk reduction by hedge funds. Results were based on information that was available in the TASS hedge fund database, which only has data for hedge funds that have voluntarily decided to be included in the database. The authors admit that they had no means to ensure that the funds in the database were representative of the industry or of a particular style. In fact, many of the hedge funds that made headlines in August 2007 were not available in the TASS database. Finally, the authors were not able to test the hypothesis that liquidations of various investment strategies and asset classes may have started before the week of August 6-10, 2007.
2.
3.
4.
5.
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22. Evaluate the current outlook for systemic risk in the hedge fund industry. Khandani and Lo argue that by providing liquidity, facilitating the transfer of risk, engaging in price discovery, and discerning new sources of returns, the hedge fund industry has, on the aggregate, facilitated economic growth and provided social benefits. They also argue that hedge funds have evolved to become more similar to banks, an industry that is vastly regulated due to the negative externalities banks cause when they fail, and in spite of the positive externalities banks generate when they do well. However, unlike banks, hedge funds can withdraw liquidity at any time, and a synchronized liquidity withdrawal among a large group or a whole segment of funds could have potentially devastating effects on the basic functioning and viability of the global financial system. If hedge funds have amplified systemic risk, then Khandani and Lo argue that we would need to know by how much? and do the benefits outweigh the risks? Although nobody would argue that the systemic risk for the financial system would completely disappear, we still need to know the optimal or acceptable level. Khandani and Lo suggest that the first step needed to tackle this problem consists in making efforts to understand the probability and causes of systemic risk in the financial system and how to measure it. One possibility is the suggestion made by Getmansky, Lo, and Mei (2004) to create a National Transportation Safety Board-like organization for capital markets to supervise different features of systemic risk, and by creating procedures for improving models and methods that are typically used. A Capital Markets Safety Board may be a more direct way to deal with the systemic risks inherent to hedge funds than registration, as some have suggested, because the latter would not tackle the systemic risks that the hedge fund industry may create in the financial system. 23. Describe a subprime loan and discuss the four principal reasons for the recent increase in subprime loan delinquencies. Subprime mortgages typically have a 200- to 300-basis point interest premium above prevailing conventional or prime mortgage rates. Alt-A mortgages are issued to borrowers who have better credit scores than subprime borrowers but fail to provide sufficient documentation with respect to all sources of income and/or assets. In terms of credit risk, an Alt-A mortgage falls between prime and subprime borrowers. Four principal reasons for the recent increase in subprime loan delinquencies are: 1. The subprime borrowers were not creditworthy. They were highly levered with high debt-to-income ratios. The loans had high loan-to-value ratios. Furthermore, many of the mortgages allowed the borrower to borrow the down payment for the home. The use of short reset loans. These would have low teaser rates for the first two or three years, referred to as 2/28 and 3/27 hybrid subprime ARMs. The rates would increase after the initial period.
2.
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3. 4.
The slowing in the rise in home values, which made it more difficult for subprime borrowers to refinance. A decline in credit standards by mortgage originators in underwriting to meet the demand for high-yield assets.
24. Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the securities they issued and the resulting contribution to the credit crisis. Asset backed security (ABS) trusts became the owners of the loans securitized by the originators. They generated net present value from the repackaging of the cash flows and could absorb some losses. The managers would perform simulations to obtain a loss distribution that allowed the determination of the credit enhancement (CE), which is the amount of loss on the underlying collateral that can be absorbed before the tranche absorbs any loss. The ABS trust or CDO would run the collaterals cash flows through a waterfall payment structure. In a waterfall payment structure, the cash flows are assigned to a range of low grade to high grade tranches. The high grade or senior bonds are paid first, and the junior tranches do not get paid if the collateral pool becomes stressed in certain ways, e.g., a change in the collateral/liability or cash-flow/bond-payment ratios. Furthermore, insurance purchased from a monoline insurer called a surety wrap could increase the credit status of the senior tranches, despite that fact that the underlying collateral was subprime mortgages. There were many economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating. Those economic motivations include: 1. 2. the desire to lower costs and rely on the ratings so that pension funds and insurance companies had a disincentive to perform their own due diligence; rating agencies would get paid fees for monitoring assets that were given an investment grade rating, and this would incent the agency to issue more investment grade ratings; the CDO trusts being rated knew the procedures and had a fixed target to meet to get an investment grade rating, mortgage originators had no incentive to perform due diligence and monitor borrowers creditworthiness, special investment vehicles (SIVs) had to achieve investment grade status in order to survive and did whatever it took to meet that goal, monolines were perceived to have low risk and therefore had an incentive to increase leverage, and Basel II allowed banks to hold AAA assets as collateral so there was an increased demand for such assets.
3. 4. 5. 6. 7.
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25. Explain the role of rating agencies in the credit crisis. The actions of ratings agencies played a huge role in the credit crisis. Many investors relied on the ratings for a diverse set of products such as asset-backed commercial paper (ABCP), mortgage bonds, derivative product companies (DPCs), and monolines which insure municipal bonds, and structured credit products such as tranches of CDOs. Many institutional investors are restricted to only investing in assets with a high credit rating. These investors rely heavily on the risk assessment of credit agencies. As long as the asset has an adequate credit rating, the other characteristics and complexities would be overlooked by these institutions. The institutions overlooked the fact that these assets rated AAA had higher returns than comparable corporate assets, which should have been a signal that there was an error in the rating. Finally, the rating agencies had an incentive to issue AAA ratings because they were paid for the rating, and they were also paid fees for monitoring the entities to which they had given such ratings. 26. Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the due-diligence efforts at the firms. The basic problem with the system was that brokers and lenders had little or no incentive to perform due diligence and monitor borrowers creditworthiness. This was because most of the subprime loans originated by brokers were securitized after the origination of the loan. Securitization is the packaging of loans and selling them to other firms to get them off the loan originators balance sheet. The loan originator, e.g., a bank, got paid from the origination of the loan and suffered few, if any, negative consequences if the loan defaulted. 27. Explain the factors affecting the rating of a special investment vehicle (SIV). The acronym SIV refers to either a special investment vehicle or structured investment vehicle. An SIV is a limited-purpose, bankruptcy-remote company that purchases mainly high-rated medium- and long-term assets from its parent company. The SIV funds these purchases with short-term asset-backed commercial paper (ABCP), medium-term notes (MTNs), and subordinated debt capital. The factors that affect the rating of SIVs are the usual set of risks: credit, liquidity, market, interest rate, foreign currency, and managerial and operational risk. i) ii) Credit risk addresses the creditworthiness of each obligor and the risk during what is called the wind down period associated with credit deterioration. Liquidity risk is the result of the need to refinance because of a maturity mismatch between assets and liabilities.
iii) Market risk is the change in prices from changes in the market, which managers must address by marking-to-market and marking-to-model the liquid and illiquid assets respectively.
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iv) Interest rate risk is the risk the present value will change from a change in interest rates. v) Foreign currency risk is the risk of a change in value from changes in the value of currencies in which investments have been made.
vi) Managerial and operational risks refer to losses from errors and/or criminal acts of employees. 28. Describe the role of monolines. Monoline insurers guarantee the payments from certain types of assets. They are highly leveraged, and yet they carried a AAA rating which, in turn, gave a AAA rating to the assets they backed. They began in the 1970s as entities to insure the debt of hospitals and nonprofit groups. In recent years, much of their growth has been from backing structured ABS and CDOs. The monolines contributed to the financial crisis because the when they were downgraded, the assets they backed were downgraded. 29. Explain the lack of incentives for banks to perform due diligence on the collateral pool. The banks invested in AAA rated securities, as the Basel II regulations allowed such assets to serve as bank regulatory capital. Structured securities that had AAA rated tranches were thought to be acceptable. The rating lowered the incentive of the bank to perform due diligence. Another issue was managers short-term horizons. They generally focused on their yearon-year bonuses, and this further lowered the incentives to do due diligence. The worse that could happen to managers is that they could lose their jobs. This was not a very big disincentive because the market environment was such that there were plenty of other jobs to be had, and even a failed manager could get rehired at another institution. Thus, the managers had little incentive to consider the risk exposure from the possible write down of the monolines which would, in turn, lower the rating of the assets they held. 30. Explain the role and actions of central banks in 2007 and early 2008. In mid 2007, the Federal Reserve indicated that the spillovers from the subprime market should not affect the overall economy. Central banks around the world provided capital to banks. For example, the Russian Central Bank injected the ruble equivalent of $1.7 billion into the banking system. Also, the European Central Bank pumped money into Europes money markets, and the Fed did the same in the U.S. In the spring of 2008, the Fed introduced a new lending facility: the Primary Dealer Credit Facility (PDCF). The PDCF allowed investment banks and securities dealers to use a wide range of securities as collateral for loans from the Fed. 31. Explain the role of valuation methods. The fair value accounting framework has three levels of evaluation: 1) market prices, 2) prices of related assets, and 3) model valuation for illiquid assets. The valuation methods
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allow for the estimation of fair value of a wide range of assets from liquid assets to illiquid assets. The valuation methods contributed to the crisis because the models had uncertain parameters, especially in turbulent markets. Furthermore, the uncertainty about which valuation methods to use could lead to disagreements between borrowers and lenders, which in turn could lead to the selling of assets and cause funds to close. This would increase market turbulence further. 32. Describe the lack of transparency in the credit markets. Lack of transparency has been endemic on many levels. Here is a list of reasons for the low level of transparency. 1. 2. 3. Methods of valuation are often not known, which leads to price uncertainty. The basic information concerning the percentage of CDOs and subprime mortgages in a fund is rarely readily available. For institutions, there is lack of transparency as to the total magnitude of commitments given in terms of backstop lines of credit or loan commitments to private equity buyouts. Banks may hold or warehouse sub-prime assets with the intention of securitizing and selling them, and the extent of these holdings are unknown to outside investors. The general level of complexity of the assets leads to a low level of transparency.
4. 5.
33. Describe how systemic risk arose in 2007. Systemic risk is the degree to which events in one market will affect other markets. It arose in 2007 when money market managers who normally purchased Asset Backed Commercial Paper (ABCP) switched to Treasury bills and drove up the Treasury yields. This increased the perceived risk of subprime mortgages and the general level of risk aversion. The ABCP market basically closed. This in turn led to some borrowers not being able to roll over debt even when they were not involved in the sub-prime market. Hedge funds had to sell assets to raise cash, and this depressed prices of various types of assets. Many SIVs have backstop lines of credit from banks. The uncertainty led to banks hoarding cash and restricting loans to other banks. The LIBOR rate increased. The reluctance to lend and the tightening of credit standards affected hedge funds, the availability of residential and commercial mortgages, bond auction markets, and lending to businesses. Regulators failed to recognize the existence of positive feedback mechanisms and to understand their implications for the financial system. One reason for the systemic nature of the crisis was from the widespread ownership of structures containing subprime mortgages and the circular dependence between refinancing and collateral valuation. If asset values decline, ability to refinance declines, valuation of counterparty collateral declines, value of monoline assets declines, and the value of the guarantees given by monolines declines.
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34. Argue how increased transparency in the rating process is necessary. Most of the recommendations for dampening the effect of future crises require an increase in transparency. It is necessary to know, or have, transparency with respect to what a rating means, how the rating was calculated, and the nature of the data used in the calculation. This is the only way investors can have confidence in the ratings. Some of the needs for transparency are specific for certain assets. For collateralized structures, there is the need for more transparency concerning the types of models, the assumptions used to rate a particular structure, and the accuracy and robustness of the methodologies and assumptions. For SIVs, there also needs to be transparency with respect to the backstop lines of support in the case of disruptions so investors know the risks. There are four basic recommendations that could dampen the impact of future crises: 1) There should be a clear definition of the meaning of a rating. It should be known what a rating implies with respect to the probability of timely payment and expected loss. If a rating is through-the-cycle, then the length of the cycle should be known. The method of calculating a rating should be known and reproducible by an independent third party. The government should create an agency that collects and makes available information on collateralized pools. There should be transparency with respect to the source and nature of the data used in the calculations.
2) 3) 4)
35. Argue how standardization can simplify valuation issues. The standardization of instruments has already proved valuable in the market for swaps. There are standardized maturities of 1, 3, 5, 7, and 10 years. This standardization means that models have very reliable prices as inputs. This has simplified valuation in this market because the models can be calibrated to match these current prices. Such moves towards standardizing issues in other markets would likewise improve the valuation methodologies in those markets. 36. Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased transparency can provide investors with information regarding financial institutions exposure. Banks had a variety of hidden risks on their balance sheet. Current 10-K statements of financial institutions offer little information about the level of the total off balance sheet commitments of banks, and an increase in transparency would provide investors with information regarding financial institutions exposure. One type of explicit commitment occurs when providing financing for a levered buyout without the protection of an adverse market, which can provide an escape from a bad deal. Another explicit commitment comes about when banks gave backstop lines of credit to their sponsored SIVs without specifying the total level of these commitments. Increased transparency would alert the investors of the level of risk concerning these commitments.
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Another type of implicit commitment arose when banks would bring back assets from their SIVs to protect the reputation of the SIV. Another implicit commitment is in enhanced money market funds that invested in subprime mortgages, and banks would step in to support such funds to keep the value from falling below zero, i.e., to prevent the funds from breaking the buck. Increased transparency would alert investors that these commitments exist and the type of events that banks have committed themselves to covering. An increased level of transparency can provide investors with information concerning these exposures. Any increase would be an improvement, and 10-K statements should offer information about assets being warehoused and the level of the total off balance sheet commitments of banks. 37. Describe how new product design can dampen market disruptions. New indices, like the CDS indices introduced in 2002, can improve transparency. These indices increase the availability of information on bid-ask spreads and pricing. To improve transparency, sub-indices in some areas are recommended. The development of new options can allow institutions to protect against risk. Commercial paper can be designed, for example, to allow an SIV to convert it into a oneor two-year note if certain market conditions exist. This would make SIVs less sensitive to market disruptions, albeit at the cost of the option. 38. Discuss possible regulatory responses. The Group of 7 finance ministers and Central Bank governors has been presented with 67 recommendations by the Basel-based Financial Stability Forum. Many of the recommendations address improvements in transparency and an increase in regulatory oversight. In general, the recommendations advise increased capital requirements for structured products, transparency of the risk exposures on the trading book, faster disclosure of losses by banks, clearing houses for OTC trades, and increased cross-border monitoring. The following list provides more details: 1) 2) 3) 4) 5) 6) There should be consistent regulations and oversight and a lower degree of fragmentation of regulations. At the Federal level, there should be minimal lending standards to avoid local lobbyists from lowering standards in certain areas. There should be random sampling of loan applications for approved loans to make sure standards are met. Banks must hold a randomly selected number of mortgages and a specified portion of the equity tranche of ABS composed of their mortgages. Regulators need to address the effects of wrong-way counterparty credit exposure in determining capital requirements and the effects of procyclicality in stress testing. There should be regulations against cherry-picking the placement of assets on either the bank book or the trading book at the time of purchase.
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7) 8)
Rating agency methods need to be improved and made more transparent. Also, there needs to be a lowering of the conflict of interest of these agencies. Centralized clearing houses (CCHs) for OTC transactions should be established that would monitor the risk exposure of participants, to make sure they have sufficient collateral, and stand ready to back defaults.
39. Describe sound risk management practices. According to Crouhy, Jarrow, and Turnbull (2008), a proven set of risk management practices includes: 1) 2) 3) 4) adopting a comprehensive view of exposures with the sharing of quantitative and qualitative information across the organization, establishing processes to value complex and illiquid securities, enforcing active controls over the consolidated organizations balance sheet, liquidity and capital positions, and relying on a wide range of risk measures.
Other practices would include integrating liquidity, credit market, and finance control structures. Managers should take a more active role in balancing the need to develop new business and the level of risk the firm can assume. This would also mean better aligning the compensation of managers to the quality, and not just the quantity, of loans issued. 40. Describe nonlinearities in the risk of subprime CDO tranches. Limited liquidity and other complexities introduce nonlinearities in the risk of the subprime CDO tranches. One reason is that a typical subprime CDO has a pool of assets composed of MBS bonds, rated BB to AA, with an average BBB rating, but the BBB group is relatively small. A relatively small default rate could hit and wipe out the BBB group fairly quickly. This would mean the super senior tranches would soon be hit. There is essentially a binary situation where either the cumulative default rate of the sub-prime mortgages remains below the threshold that keeps the MBS bonds untouched and the super senior tranches do not incur any losses, or the cumulative default rate exceeds the threshold and the senior tranches are dramatically affected or even wiped out. References
Till, H. Amaranth Lessons Thus Far. The Journal of Alternative Investments. Spring 2008. Khandani, A.E., and A.W. Lo. What Happened to the Quants in August 2007? Journal of Investment Management. Vol. 5, No. 4, 2007. Crouhy, M., R. Jarrow and S. Turnbull, The Subprime Credit Crisis of 2007. The Journal of Derivatives, Fall 2008.
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TOPIC
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Portfolio and Risk Management

Main Points
Comparing methods of hedging against tail risk and their relative merits Explaining the implications of complex and adaptive capital markets for risk management methods Evaluating factors leading to portfolio allocation drift
1.
Assess the long-run and short-run benefits of hedging the tail risk of a portfolio. Tail risk refers to extreme and rare events that can produce large losses. Hedging tail risk is defensive in the short term, but is offensive in the long term. In the short-term, it lowers risk, which increases the chance of survival. In the long term, it allows those that were defensive to be offensive because they can take advantage of the reduced liquidity that accompanies tail events and position themselves for attractive prospective returns.
2.
Explain the relationship between systemic risk, liquidity risk, monetary policy and other macro events. Systemic risks are characterized by periods where there is an increase in the demand for liquidity, but few, if any, entities are willing to provide it. It puts pressure on the ability to fund levered holdings. Liquidity is a macro risk, which must be measured using macro models. Tail risk is macro risk, which includes risks associated with monetary policy. Early and late periods of Federal Reserve monetary easing and tightening are correlated with early and late expansions. Macro instruments that respond to Fed activity can hedge the tail events in these periods. Deleveraging risk, for example, is a monetary policy risk, i.e., it is a tail event that is the result of macro events. Modeling this type of macro risk involves addressing improbable, high-severity scenarios. However, relating tail risk to macro risk simplifies the construction of the hedges. Macro markets are the bond, stock, foreign exchange, credit, commodity markets. Since these markets are typically liquid and deep, some forms of insurance is usually available at an attractive price.
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Topic 10: Portfolio and Risk Management
3.
Explain why increased correlation among various asset returns during periods of stress could provide opportunities for free insurance against tail risk. When systemic risk increases, the macro markets become more correlated. Although this is bad in general, it is beneficial from a hedging strategy perspective. It means that a hedge in one market, e.g., the bond market, can be a hedge for all the others as the correlation increases in all the markets.
4.
Describe the four approaches to hedging or insuring a portfolio against tail risk. The four approaches to hedging or insuring a portfolio against tail risk are buying insurance securities, buying options, investing in assets negatively correlated with tail risk, and moving the portfolio off the optimal frontier. Each is described in more detail below. 1. Buy high quality insurance securities. The best example of these are short-term U.S. Treasury instruments. In times of crisis, the flight to quality will increase the value of these assets. The hedger must be careful to make sure the assets are not already overpriced. 2. Buy contingent claims, or option-like securities. In some cases, there are mispricings that allow the portfolio manager to get a significant amount of protection against systemic risk at a very low cost. 3. Invest in strategies that are negatively correlated to tail risk. One such strategy is the trend-following managed futures strategy, which has exhibited positive correlation to tail risk indicators, e.g., the CBOE Volatility Index (VIX). As an added benefit, as a strategy, managed futures are uncorrelated with the stock market. 4. Move the portfolio off the optimal frontier. Although this seems counterintuitive, the reasoning is that the optimal frontier is only optimal with respect to the second moment, i.e., the variance. Also, the efficient frontier assumes the manager has perfect forecasting ability concerning the mean and variance, which is hardly true. Some assets such as spread products that have large higher moments can move a portfolio out into the optimal frontier while adding tail risk. Such spread products include corporate bonds and low-quality mortgages, which have higher yields because of embedded default and illiquidity options. Although each of these strategies insure the portfolio against tail risk to some level, they are not what would be termed portfolio insurance strategies that the manager would dynamically adjust in response to changing market conditions.
5.
Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk. Dynamic strategies cannot be used to hedge tail risk because they require the ability to trade the assets used to hedge, and the liquidity of these assets typically declines in a crisis. Thus, the ability to engage in a dynamic strategy when a tail event or crisis occurs will be greatly reduced. That is why the four strategies mentioned above (buying insurance securities,
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buying options, investing in assets negatively correlated with tail risk, and moving the portfolio off the efficient frontier) have advantages in hedging tail risk. 6. Describe the three factors that impact the construction of a tail hedge. The three factors that affect the construction of a tail hedge are: 1. the scenario behavior of the portfolio; 2. the scenario behavior of the hedges after deducting costs; and 3. the probability of the scenario occurring. In order to find the best combination of the three factors, the manager must know how the portfolio behaves under certain extreme scenarios where shocks occur. The manager would then examine the stress scenarios where the shocks occur and find the combination of hedges that controls the risk of the factors that produced the stress scenario. By having a hedged portfolio when stress scenarios occur, the manager will have liquidity relative to other portfolios and survive the stressful period, which allows the manager to plan over multiple periods. 7. Explain why long-dated options may provide an inexpensive method for hedging tail risk. Mispricing can exist for long-dated options, which is why they can provide an inexpensive method for hedging. One reason for this is that there is also a natural habitat formation of option market participants. Another reason is that models used by participants generally focus only on the short term. The model must compute the various Greeks, e.g., the deltas, gammas, vegas, etc. Without the available reference information, the calculations of these will have higher error, which leads to a greater amount of mispricing. Another source of mispricing is the error in estimating the probabilities. Simulations based upon past observations are generally unsatisfactory in estimating probabilities for the pricing of tail options. Furthermore, the probability calculation is less important than the knowledge that the potential hedges exist at the right price. Thus, tail hedges are usually cheap for long-lived portfolios. 8. Evaluate the factors that lead to the underpricing of risk by investors. The main factor that leads to the underpricing of risk is the focus on getting higher returns. By focusing only on how to get higher returns, two other factors begin to play a role: i) investors find themselves more accepting of new and riskier product structures, and ii) there is a tendency not to recognize the uncertainty of outcomes. Examining the recent credit crises provides better insight into these two factors. i) Investors find themselves more accepting of new and riskier product structures: As yields on high-yield bonds fell in the years leading up to 2007, there were developments such as more questionable loan guarantees and fewer loan convents. There was also an increase in the use of leverage to try to enhance already falling returns.
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ii) A tendency not to recognize the uncertainty of outcomes: The pursuit of higher returns also makes investors more open to investing in risky products. Many financial innovations were constantly introduced in the financial market, but the complexities of these products were not fully understood. Investors did not know or fully understand the outcomes of these products. 9. Explain the relationship between the real economy and capital markets and discuss the factors that have made the real economy less volatile through time. According to the Capital Asset Pricing Model (CAPM), assets only earn a return based upon their exposure to systematic risk. Systematic risk is caused by undiversified movements in the macro real economy, and ultimately, it is the real economy that determines the return and risk that cannot be diversified away. Over the long term, sustainable aggregate GDP growth sets an upper limit on the growth of earnings in the corporate sector. Although there is a link between the levels of growth of GDP and earnings, there is a weak link between the volatility of corporate earnings growth and the volatility of the growth of the overall economy. Corporate earnings growth and stock market prices have been much more volatile than the growth of the overall economy. Since 1947, for example, the standard deviation of real equity returns and earnings growth have been 13.6% and 10.6%, respectively. The standard deviation of GDP growth has only been 2.3%. Furthermore, the variability in stock returns and variability in earnings growth have remained constant, while the variability in the growth of the real economy has declined. Four factors are behind the downward trend in the volatility of growth rates in the real economy: i) increased diversification of industries with the development of new technologies; ii) increased importance of the emerging markets, which has also had a diversification effect, as does the increased number of industries; iii) increased understanding of the workings of the economy by the central banks around the world; and iv) safety-net government programs. In summary, there has been an increase in the diversification of the real economy from the emergence of new industries and new markets. Furthermore, there has been an increase in the effectiveness of monetary authorities to stabilize growth, and of governments providing programs to prevent the economy from declining too quickly. 10. Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for models of risk measurement. Capital markets are complex adaptive systems. They are complex because the economic system is made up of many interactive agents, and their decisions relate to and influence each other in nonlinear and unanticipated ways. Capital markets are adaptive because the agents in the markets can change their behavior when confronted with new situations and allow the system to evolve and benefit from the
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changing environment. Furthermore, the agents are not purely quantitative and emotionless entities. Although rational to some extent, there are behavioral aspects to markets, and they essentially evolve similar to living creatures. The behavioral and evolutionary aspects of markets are why standard, traditional statistics with smooth quantitative functions fail to describe financial activity. New methods such as jump diffusion, GARCH, copulas, and other advances have led to the development of sophisticated models that can better predict the risk-return tradeoff in markets. However, even these models cannot predict all outcomes, and the models may make unrealistic assumptions concerning the way individuals and markets act. 11. Compare and contrast the terms risk and uncertainty. Frank Knight (Risk, Uncertainty, and Profit, 1921) cautioned that there is a difference between risk and uncertainty. Specifically, we are able to quantify risk because there are distinct outcomes, and the probabilities of risk are also distinct. A bet or investment based upon the flip of a fair coin or the roll of a fair die would be based on risk. The outcomes are known and so are the probabilities. Uncertainty, however, is not deterministic. Uncertainty means that the outcomes and probabilities are not known. To the extent that some outcomes and probabilities are known but many are not, financial markets have both risk and uncertainty. Exposure is another factor when dealing with risk and uncertainty, and it is the degree to which an investor should be concerned about possible outcomes. 12. Explain the role of the shadow banking system as a source of liquidity and discuss why during periods of market stress this source of liquidity may disappear. The shadow banking system consists of levered intermediaries that are largely unregulated. They seek profit, which comes with risk. The shadow banking system consists of intermediaries that provide liquidity and includes hedge funds and structured conduits provided by SIVs (special investment vehicles). The structured conduits are collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). This shadow banking system is important for the financial markets as it provides liquidity by taking on risk. The pool of capital is directly linked to the changing level of liquidity. Thus, a decrease in risk aversion (an increase in the desire for risk and its corresponding profit) will increase the availability of liquidity. In other words, an increase in the desire for profit and the willingness to take on more risk increases leverage and liquidity through vehicles like CDOs and SIVs. The shadow banking system is not backed by a central bank and is largely unregulated. This is the reason why liquidity can dry up when the publics risk tolerance declines. Liquidity can literally disappear from the shadow banking system in a very short period of time simply from a change in the mood of investors. The liquidity withdrawal can lead to the forced selling of assets, which increases systemic risk and creates a downward Minsky-type spiral of de-levering and collateral-related liquidity-seeking by levered investors. This increases risk aversion and reduces liquidity further, producing a liquidity conundrum.
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In summary, liquidity is dependent upon the risk aversion (appetite) of investors. If risk aversion increases (appetite for risk decreases), liquidity will decline. This will create market stress from the forced sale of assets, which increases risk aversion further, lowers liquidity and asset prices further and continues the decline. This relationship between liquidity and risk, and that liquidity is not only determined by monetary factors, is the liquidity conundrum. 13. Demonstrate how cognitive biases can lead to errors in judgment by financial market participants. Investors can suffer from several cognitive biases: confirmation bias, overconfidence in models, group think, short-term thinking bias, and hindsight and recent memory bias. Confirmation bias: the investor seeks evidence that his theories are correct, ignores evidence that contradicts his/her beliefs, and continues patterns of behavior that may be detrimental. Overconfidence in models: investors rely too heavily on models to measure risk and predict the future, and they confuse measurable risk with uncertainty, which cannot be measured. Group think: investors look to what others are doing to form opinions and ignore the evidence. Short-term thinking or short-termism: related to group think, the investor gets caught up in the current market mood and ignores the long-term view. Hindsight and recent memory bias: forecasting the future based upon the recent past. All of these biases can lead to errors in judgment. In cognitive bias, the investor will continue to engage in the same activity despite it repeatedly failing because the investor thinks that sooner or later it has to work. One example would be buying more and more stock of a failing company. In overconfidence in models, the investor will make a prediction based upon a model. The investor may make an over-allocation to the investment thinking that all the risks are known. Group think can lead to errors as an investor joins the herd in either buying or selling stocks. As all investors buy, for example, the prices continue to rise. This increases the cognitive bias and investors buy more. Short-term thinking and hindsight bias also come into play here as investors only see the recent past increases in value and only look ahead to the short-term possible gains. 14. Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes. Non-traded assets, such as private equity and real estate, have traditionally exhibited attractive performance. However, establishing and preserving a target allocation of illiquid asset classes is a complex task. More specifically, Meredith, et al. describe the following four reasons why it is difficult to establish and maintain target allocations to illiquid assets: 1. Illiquidity: An asset is considered illiquid when it can not be sold, either quickly, with insignificant loss of value, or at anytime. Secondary markets for illiquid investments
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are limited. As a result, investors cannot easily rebalance their asset allocation when they deviate from their target allocation. 2. Uncertainty concerning the timing and size of capital calls: When the general partner of a private equity fund identifies an appropriate investment opportunity, he/she can call the required equity capital, at which time each partner will typically support a pro rata share of its commitment (i.e. the pledge made by an investor to a private equity fund). Unfortunately, it is impossible to know exactly what investment opportunities will arise when investing in a private equity or private real estate fund. As a result, there exists considerable uncertainty regarding the timing and size of capital calls made by the funds general partner. This point highlights the importance of having a commitment strategy because an investor may eventually invest less than was expected or committed if a private equity fund cannot find appropriate investment prospects. 3. Uncertainty about the timing and size of distributions: Since the timing of investment realizations cannot be predicted with complete certainty, the timing and size of fund distributions (i.e. the cash payments investors receive as compensation for investing in private equity) are also uncertain. 4. Valuation subjectivity: It is very difficult to value a private equity or a private real estate fund at any point in time. This is because: a) these investments trade infrequently, b) accounting rules tend to push general partners to account these assets at book value, and c) there is always uncertainty regarding the precision of asset valuations. 15. Explain the role of Monte-Carlo simulation to achieve stable (steadystate) allocation in this study. Meredith, et al. create a model portfolio formed by the following assets and allocations: private equity (0%), public equity (65%), and fixed income (35%), which they seek to migrate to a steady state (or stable) allocation of private equity (25%), public equity (50%), and fixed income (25%) over time. They then make assumptions regarding the performance of their private equity, public equity, and fixed-income investments. They use Monte-Carlo analysis to simulate the performance of this portfolio for thousands of scenarios entailing various levels of asset class returns and cash flow patterns. MonteCarlo analysis consists of a class of computational algorithms that relies on repeated random sampling to calculate its results. Meredith, et al. found that they could not reach their 25% private equity allocation target until the 5th year, and that it took 25 years to achieve a steady-state 25% allocation. They acknowledged that it may be possible to arrive at the steady-state faster if the magnitude of the transition had been lower (instead of the 0% to 25% shift that they used) or if the asset would have produced cash flows, such as in the case of private real estate. 16. Illustrate the total impact of several individual risk factors on private equity allocation drift. Instructor note: Allocation drift occurs when one asset class becomes overweighted while another becomes underweighted in the portfolio. In the short run, allocation drift may not be an important problem. However, in the long run, allocation drift can change the portfolios risk level to a point where it might become misaligned with the investors objectives.
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Meredith, et al. analyzed the extent to which five specific individual risk factors, when considered in isolation, influence private equity allocation drift (or volatility of the private equity exposure). The individual factors are: 1. volatility in the performance on public equity and fixed income, 2. volatility in the performance of the private equity investments, 3. uncertainty regarding capital calls, 4. uncertainty in distributions, and 5. uncertainty regarding private equity valuations. The authors perform this experiment once their model portfolio has achieved a steady-state (or stable) allocation of 25% to private equity. Results show that, on a stand-alone basis: 1. Volatility in the performance on public equity and fixed income (the other two asset classes in the portfolio) generates a +/- 2.8% volatility in the portfolios private equity exposure, 2. Volatility in the performance of the private equity investments leads to a +/- 4.6% volatility in the allocation to private equity, 3. Uncertainty regarding capital calls generates a +/- 1.8% volatility in the private equity allocation, 4. Uncertainty in distributions leads to a +/- 2.7% volatility in the private equity allocation, and 5. Uncertainty regarding private equity valuations leads to a +/- 2.7% volatility in the portfolios private equity exposure. It would appear that the combined effect of these individual risk factors would have a significant impact on the volatility of the allocation. Simply summing the effects would give a possible range of +/-14.6%. However, this level of risk is not realistic because these sources of uncertainty are not perfectly correlated; therefore some of the potential risk is diversified away. In other words, the possible total effect of uncertain investment returns (stock and bond returns), cash flows (capital calls and distributions), and valuation on the volatility of the private equity allocation is lowered from low correlations of the risk factors and some of the potential total risk being diversified away.
This result is evident from the findings of Meredith, et al. That study estimates the total potential volatility from the five individual sources of risk was equal to about 6%, which is less than half of the total of the volatilities at 14.6%. They argue that this percentage is not an unreasonable magnitude since institutional investors tend to allow their target asset class allocations to drift within a range of about 5% (to minimize transaction and administrative costs) before they begin to rebalance their portfolios.
References Bhansali, V. Tail Risk Management. The Journal of Portfolio Management. Summer 2008. Sullivan, R. Taming Global Village Risk. The Journal of Portfolio Management. Summer 2008. Meredith, R., N. De Brito, and R. De Figueiredo. Portfolio Management with Illiquid Investments. Citi Alternative Investments. June 2006.
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TOPIC
11
Research Issues in Alternative Investments

Main Points
Evaluating the risk and return components of commodity futures returns from various perspectives Comparing approaches to evaluate smoothing effects in the real estate market Assessing research on hedge fund risk factors and biases in hedge fund databases Describing the impact of unique characteristics of private equity returns on investor decision-making 1. Illustrate how an investment in commodity futures can earn a positive return when spot commodity prices are falling. This learning objective covers an interesting and important point on how expected spot price changes are embedded into commodity futures prices and what the implications are for the changes in futures prices. Long positions in commodity futures earn higher than expected returns when commodity prices are higher than expected. The key is that profits and losses are driven by changes in commodity prices relative to expectations. The following diagram illustrates the concept. Assume that the current spot price of oil is $70 but that over the next year it is expected to decline to $60. The commodity futures contract for one year is priced at $55. A holder of a long position in the contract expects to earn $5 per contract as the current futures price ($55) rises to the expected spot price at the end of the year ($60). However, the spot price of the commodity is expected to fall by $10 over this year. Note that this example exactly addresses the learning objective's point: how a long position in a futures contract can earn a positive return when a commodity price is falling. The key is that the commodity price is expected to fall.
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Topic 11: Research Issues in Alternative Investments
Futures contract holders also can earn a risk premium. Thus, even in an example where commodity prices are not expected, on average, to rise or fall, the holder of a long position might still earn a positive return while commodity prices fall if the anticipated risk premium exceeds the losses caused by a small unexpected decline in the spot price. In the above example, the long position expects to receive a $5 profitwhich could be a normal profit from bearing risk (a risk premium for bearing risk or it could include an expected abnormal profit from superior forecasting abilities). The expected profit (loss) to a futures contract is the risk premium earned (paid) for bearing (hedging) risk. Unexpected, rather than expected commodity price changes, drive returns. When spot prices fall they do not cause futures prices to fall unless the spot prices fall more than expected. 2. Compare commodity spot returns and commodity futures returns. The returns from physically holding commodities can be substantially different from the returns of long positions in (collateralized) commodity futures contracts. One explanation is that positions in collateralized commodity futures earn interest (e.g., the T-Bill yield) on the collateral. For example, having $1,000,000 in T-Bills and long positions in $1,000,000 of gold futures should be expected to outperform having $1 of gold. Actual physical possession of commodities can have storage and convenience yield costs. Also, spot commodity price changes can differ from commodity contract price changes because commodity futures prices are based on expected commodity prices. According to Gorton and Rouwenhorst, inflation adjusted over the period 1959 to 2004, collateralized commodity futures vastly outperformed commodity spot prices (perhaps having double the total inflation adjusted return). Many spot commodity prices exhibit seasonal price fluctuations (for example, heating oil prices tend to be higher during the winter). As a result, temporary price movements can be very prominent in commodity spot prices. In spite of this, seasonality in spot prices should not have an influence on futures prices because seasonality is a predictable oscillation that market participants take into account when they establish futures prices.
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3.
Compare commodity futures returns with stock returns and bond returns. In a nutshell, collateralized commodity futures contracts (long positions in commodity futures combined with interest bearing collateral deposits) have performed well, especially adjusted for risk. Gorton and Rouwenhorst compare collateralized commodity futures returns with stock returns (measured using the returns on the S&P 500) and corporate bond returns (measured using the returns on a corporate bond index) return for the period July 1959 through 2004. All the series were deflated by the U.S. CPI (Consumer Price Index) and, thus, provide a measure of real return (i.e. inflation-adjusted) performance. According to Gorton and Rouwenhorst's analysis of inflation adjusted returns from 1959-2004: Average annual returns of collateralized commodities and US common stocks have been roughly equal (with both earning a risk premium of about 5%) Both commodities and stocks had higher average returns than bonds (bonds earned a risk premium about half as much as stocks and commodities) Commodities outperformed stocks in the 1970's and for a few years after 1999, but stocks performed better in the 1990's (and perhaps a little better in the 1980's).
4.
Compare commodity futures risk with equity risk. In a nutshell, collateralized commodity futures contracts (long positions in commodity futures combined with interest bearing collateral deposits) have generated high average returns (roughly in line with US common stocks) and have done so with favorable risk attributes and correlations. According to Gorton and Rouwenhorsts analysis of inflation adjusted returns from 19592004: Standard deviations were higher for stocks (4.27% per month) than for collateralized commodity futures (3.47%). Stock distributions were negatively skewed (which is bad), while collateralized commodity futures returns were positively skewed. Therefore, stocks have relatively more weight in the left tail of the return distribution and commodity futures have relatively more weight in the right tail. Collateralized commodity futures and stocks both had positive kurtosis (which means they are fat-tailed relative to the normal distribution), but the kurtosis for futures was more than double that of stocks. Equities had substantially higher down side risk as would be measured by Value at Risk. The worst 5% of months for equities lost more than 6.34% while the worst 5% of months for commodities lost more than 4.10%. Commodity futures returns were negatively correlated with equities and bonds over long-term time horizons (but not over shorter intervals). This finding implies that commodity futures may provide diversification benefits when added to a portfolio of stocks and bonds.
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The negative correlation of commodity futures returns with stocks and bonds tends to increase as the horizon lengthens, thus implying that the diversification benefits of adding commodities to a traditional portfolio are larger at longer horizons. During the worst 5% of monthly equity market returns, stocks lost an average of 9% per month while collateralized commodity futures actually earned positive monthly returns averaging about 1%. 5. Discuss the use of commodity futures as a hedge against inflation. In a nutshell, collateralized commodity futures contracts have provided superior inflation hedges compared to stocks and, in particular, bonds. Inflation hedging is the idea that an investment at least keeps up with, and better yet outpaces, bouts of unexpected inflation. Gorton and Rouwenhorst demonstrate that unlike stocks and bonds, collateralized commodity returns have had positive correlations with inflation, especially over longer term time horizons such as one or five years. The positive correlation means that collateralized commodity returns tend to be highest when inflation is highest. Gorton and Rouwenhorst then formulate a measure of unexpected inflation (which they define as the actual inflation rate minus the nominal interest rate) and show that even collateralized commodity quarterly returns have had positive correlations with unexpected inflation while stocks and bonds have had negative correlations. Commodities can be expected to be positively correlated with inflation through the direct link that commodity prices are part of inflation. However, it is also noted that shocks that increase inflation (e.g., oil price spikes) often tend to cause negative shocks in general economic output. Therefore, the empirical results (1959-2004) of excellent inflation hedging with collateralized commodities and terrible inflation hedging with stocks and bonds are not surprising. 6. Explain the diversification benefits of commodity futures. While diversification benefits are typically discussed in the context of return correlations, this particular learning objective is focused on the relationship between returns and business cycles. Gorton and Rouwenhorst analyze the performance of stocks, bonds and collateralized commodity futures relative to the last seven US business cycles. The major conclusions were: 1. 2. In the early part of a recession, stocks on average lost almost 20% and collateralized commodity futures gained almost 20%! In the late part of a recession, stocks on average gained almost 20% and collateralized commodity futures lost a few percent.
They also found that bonds, somewhat like stocks, did very well near the end of a recession and somewhat poorly at the start. The important conclusion being that this is further indication of the potential of collateralized commodity futures to provide diversification during recessions.
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However, there were no strong behavior differences during the expansion side of the cycle. 7. Describe the performance of commodity futures from a non-US investors perspective. Gorton and Rouwenhorst empirically analyzed relative inflation adjusted performance of US stocks, US bonds and collateralized commodity futures. They then analyzed whether these empirical findings for commodity futures (which are traded mostly in the US, denominated mostly in US dollars and settled mostly in the US) were similar from the perspective of a British or Japanese based investor. In other words, if one used British stocks, bonds and currency, would the major results change (and similarly from a Japanese perspective) The general finding of Gorton and Rouwenhorst was that their empirical findings for US investors held for British or Japanese investors considering collateralized commodity futures. Specifically, the overall performance and performance rankings of stocks, bonds and commodities did not change substantially based on whether the analysis was performed with US, United Kingdom or Japanese markets. Overall, the authors found that: The average performance of commodity futures and equities was similar in both the U.K. and Japan, and that commodity futures outperformed government bonds. Commodity futures returns were positive in real terms in both the U.K. and Japan. The relative rankings of the real return performance of commodity futures, stocks, and bonds were fairly similar in Japan, the U.K., and the U.S. 8. Describe the difference between normal backwardation and a market that is in backwardation Normal backwardation describes a relationship between the current futures price and the expected spot price at the maturity of the option. Normal backwardation occurs when the futures price is below the expected spot price, and the usual explanation for this is that hedgers outnumber speculators. Hedgers desire to lock in a selling price for their product. Speculators are willing to take on price risk and go long the futures contract. When hedgers outnumber speculators, this places downward pressure on the futures price to a level below the expected price in the future. A market in backwardation describes a condition associated with the current futures price and the current spot price. When the current futures price is below the current spot price, then the market in backwardation. A market is in contango when the current futures price is above the current spot price. The difference between normal backwardation and a market in backwardation becomes more obvious when it is realized that normal backwardation and contango are not mutually exclusive. The following illustrates an example. If, the futures price is $10, the spot price is $9, and the expected spot price in the future is $11, then the market exhibits contango, but normal backwardation exits.
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Example: The six-month gold futures contract has a price equal to $899. The current spot price for gold is $922, and the expected spot price in six months is $911. Does this market exhibit normal backwardation? Is the market backwardated or in contango? Answer: Since the futures price is below both the spot and expected spot price, normal backwardation exists, and the market is in backwardation. 9. Describe a trading strategy that uses basis in futures markets as an indication of risk premium in futures markets. Basis refers to the difference between the futures price and the spot price. A market in backwardation has a negative basis, i.e., futures price spot price < 0. A market in contango has a positive basis, i.e., futures price spot price > 0. The basis will change from either a change in expectations about the future spot price or variation in the expected risk premium. If markets are efficient, then trading strategies based upon changes in expectations will not earn excess returns. However, if changes in basis are a function of the differences in required risk premiums across commodities or the changing risk of a given commodity over time, then a trading strategy that selects commodities according to the size of their basis can be expected to earn positive profits. There is evidence that the futures basis includes important information about the risk premium of individual commodities. The following steps outline a trading strategy that uses the basis in futures markets as in indication of risk premium in futures markets: 1) Calculate the basis of a futures position as the slope of the futures curve between the contract in our index and the next available expiration; 2) Rank the available commodity futures by their basis; 3) Compose two equally weighted portfolios: a high basis and a low basis group; 4) Take a long position in the low-basis portfolio and a short position in the high-basis portfolio. At the end of each period, recalculate the basis of each contract and adjust the portfolio accordingly. The intuition behind the strategy is that high-basis futures are overpriced and low-basis futures are underpriced. The strategy essentially goes long underpriced, low-basis contracts and goes short over-priced, high-basis contracts. 10. Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions. Marcato and Key define smoothing as a phenomenon that produces a lag effect and reduced volatility in valuation-based indices when compared to the underlying market, which is measured by more precise transaction-based indices. An important consequence of smoothing is that it causes risk to be underestimated. The following three main factors may cause smoothing: 1. The aggregation process behind the index construction.
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2.
Valuations spread over time. This is also known as temporal aggregation and would most likely be present when several spot valuations taking place over a period of time are used to construct a real estate index. Inertia in individual valuations can arise from anchoring to past values when conclusive current market evidence is lacking. An example of this is the use of thresholds by values (e.g. 1% of capital value) prior to the reporting of a change in value.
3.
Smoothing has an impact on asset allocation decisions because the estimation of riskreturn profiles of various assets is critical to the design of efficient portfolios. For example, the mean-variance framework of Markowitz would assign an optimally high weight to the real estate asset class because valuation-based real estate indices exhibit low risk levels. Contrary to this, portfolios of institutional investors typically have a real estate weight of only between 5% and 10%. The difference between the two is often attributed to the underestimation of risk in available real estate indices. 11. Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on allocations to real estate. Stevenson (2004) analyzes the effects of including real estate to an international portfolio composed of various assets. He finds an improvement in performance when real estate is added to this portfolio. Stevenson also finds, contrary to previous studies, that the use of different unsmoothing models does not suggest different allocation weights. Marcato and Key examine this issue by applying different unsmoothing techniques to identify the reasons why Stevenson and previous studies reached different results. In fact, Marcato and Key reinforce Stevensons findings and highlight that calibration of the unsmoothing parameter, rather than model selection, is the most important aspect when unsmoothing real estate data. 12. Compare four approaches to generating an unsmoothed total real estate return series. Using a series of historical market rents and cap rates, Marcato and Key create an income return assumed to be equal to the cap rate. They then estimate the capital growth rate at time t (cgt) of investing in real estate as:
cgt =
valuet 1 valuet 1 rentt capratet
where valuet is the value of a property at time t and is calculated as:
valuet =
Marcato and Key then use four different approaches to generate an unsmoothed total real estate return series and test whether optimal real estate weights are caused by unsmoothing model selection or by the choice of parameter levels (calibration).
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The first unsmoothing procedure is the First Order Autoregressive Reverse Filter (FOARF). Unsmoothed capital rates of growth for real estate investment (ucgt) are estimated as:
ucgt = [cgt 1 * cgt 1 ] (1 1 )
where cgt is the capital growth of the valuation-based index at time t, and 1 is the unsmoothing parameter. Three main assumptions are underlying this model. First, adjusted and unadjusted values of the mean for the series are equal. Second, the model holds over time (stationarity assumption). Third, random errors are left out of the index (the assumption that there is no noise). The second unsmoothing method is the Second Order Autoregressive Reverse Filter (AR2), that is shown in this equation:
ucgt =
cgt (1 * cgt 1 + 2 * cgt 2 ) (1 1 2 )
As can be seen in the AR2 equation, this autoregressive process has more than one lag and thus gives a more generalized model. However, Marcato and Key argue that there is no ex-ante motivation to assume the existence of an autoregressive process of an order higher than two when using annual returns. Therefore, they restrict their analysis to an AR2. The third approach that Marcato and Key use applies a procedure suggested by Fisher, Geltner and Webb (1994) with a First Order Autoregressive specification. Following this procedure, they obtain a Full Information Value Index (FIVI) (also known as FIVI unsmoothing method). Residuals are computed from (cgt-1*cgt-1), and their volatility is used to compute the weight (w0):
2 * resid w0 = equity
The weight (w0) is needed to find the unsmoothed rate of capital appreciation from the next equation:
ucgt =
(cgt 1 * cgt 1 ) w0
The fourth method known as STATES assumes that different phases of the market cycle will tend to produce changes to the unsmoothing parameter. For instance, the unsmoothing parameter will be higher in falling markets versus rising markets because valuers will be inclined to resist downward adjustments more than upward adjustments.
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This method also assumes that the stronger the capital appreciation, the higher the unsmoothing parameter, and the stronger the capital depreciation, the lower the unsmoothing parameter. Different unsmoothing parameters are then applied for different market growth states (hence the name STATES for this method). First, the parameter is fixed for returns ranging between the mean and the mean plus its standard deviation. For returns falling outside this range, new parameters are estimated by adding a varying coefficient to the fixed parameter following the next schedule: 0.10 for returns lying between the mean plus 1 standard deviation and the mean plus 2 standard deviations; 0.20 for returns falling above the mean plus 2 standard deviations. 0.05 for returns lying between the mean and the mean minus 1 standard deviation; 0.15 for returns included between the mean minus 1 standard deviation and minus 2 standard deviations; and 0.25 for returns falling below the mean minus 2 standard deviations. The STATES method uses the same equation as in the First Order Autoregressive Reverse Filter to unsmoothed capital growth rates. In this case however, unsmoothing parameters vary, which are then employed for different market growth states.
ucgt = [cgt 1 * cgt 1 ] (1 1 )
After the computation of unsmoothed capital growth rates (ucgt) using the four different models just presented (FOARF, AR2, FIVI, and STATES), the next step consists in obtaining an income return (uirt) recalibrated for the unsmoothed capital value index (ucgit) as follows:s
uirt = inct ucgit 1
where inct is the income (at time t) and ucgt-1 represents the unsmoothed capital growth index (at time t1). Finally, the unsmoothed total return for real estate at time t (utrt) is calculated as the sum of the unsmoothed capital growth and the unsmoothed income return at time t: utrt = ucg t + uirt This formula reminds us that the unsmoothed total return for real estate has two components. The first is the unsmoothed capital growth (property price appreciation), which is analogous to the capital gains component when investing in stocks. The second is the unsmoothed income return (rents collected from real estate), which is analogous to dividend returns in the case of stocks.
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Example: We illustrate the use of these equations in a numerical example. Suppose you would like to analyze the time series behavior of the real estate returns for a certain city. After searching for information, you find a real estate time series of capital growth rates that was calculated using the formula [(valuet/valuet-1) 1], where valuet = rentt / capratet. The corresponding last 16 quarters of real estate capital growth rates were:
Quarter Real Estate Returns 2.05% 1.75% 1.38% 1.52% 0.84% -1.43% 0.05% 0.01% -0.33% -5.33% -0.03% -1.03% -0.44% -2.81% 0.77% -0.24%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
However, you are concerned that this time series may have been the subject of smoothing as it was calculated from an appraisal-based index. To get a clearer picture from the data, you decide to unsmooth the time series using the First Order Autoregressive Reverse Filter (FOARF). What would the unsmoothed real estate return be for the third quarter using the FOARF? (Note: The value of the unsmoothing parameter 1 was estimated to be equal to 0.5).
ucgt =
cgt 1 * cgt 1 1.38 0.5 *1.75 = = 1.01% (1 1 ) (1 0.5)
Now, suppose that you suspect that the autoregressive process might actually have two lags. What would the unsmoothed real estate return be for the third quarter using the Second Order Autoregressive Reverse Filter (AR2)? (Note: The unsmoothing parameters were estimated to have the following values: 1 = 0.4, and 2 = 0.3).
ucgt =
cgt (1 * cgt 1 + 2 * cgt 2 ) 1.38 (0.4 *1.75 + 0.3 * 2.05) = = 0.22% (1 1 2 ) (1 0.4 0.3)
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In this example, what would need to happen for the unsmoothing method known as FIVI to yield the same results as the FOARF? (Note: Assume that the value of the unsmoothing parameter 1 was estimated to be equal to 0.5). We know the equations for FOARF and FIVI, and how to compute for weight (w0). Then, we can compute the following:
(cgt 1 * cgt 1 ) (cgt 1 * cgt 1 ) = (1 1 ) w0

From this equation, we can see that the term (cgt-1*cgt-1) will simplify since it is in both numerators. Therefore, we have: (1 1 ) = w0 Now, since we know that in the case of FIVI w0 is equal to:
w0 =
2 * resid
equity
We will have, substituting this formula in the previous equation, that:

2 * resid
(1 1 ) =
equity
Now, since a1 = 0.5, then, substituting a1 above by 0.5, we obtain:

w0 = 2 * resid
equity
= 0.5
We find that:
equity = 4 resid
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That is, the standard deviation of the residuals computed from (cgt-1*cgt-1) will need to be four times larger than the standard deviation of equity returns for FIVI to yield the same results as FOARF.
13. Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations to real estate.
Marcato and Key use data for the U.K. for the period 1921-2005 and compare the suggested allocations to real estate arising from the four methods presented in Learning Objective 10. They also calculate the four models for the following three sub-periods: 1921-2005, 1921-1970, and 1971-2005. The First Order Autoregressive Reverse Filter (FOARF) suggests a very high weight for real estate in the mixed asset portfolio. Allocation choices are also found to be very sensitive to the value of the unsmoothing coefficient. For instance, results suggest that real estate should have a weight of 60% in the original data. As the unsmoothing parameter increases in value, the real estate weight decreases, disappearing when the parameter is greater than 0.60. When a coefficient ranging between 0.50 and 0.60 is used, as some authors have previously done, the calculated weights tend to be similar to those currently held by institutional funds in the U.K. (between 5% and 10%). The Second Order Autoregressive Reverse Filter (AR2) also points to a decreasing real estate weight in the mixed asset portfolio as the unsmoothing parameter increases. However, the minimum coefficient that will produce a zero real estate weight is lower (0.40) than the one generated by the FOARF. This is due to the inclusion of a secondorder parameter. The third unsmoothing method, the Full Information Value Index (FIVI), yields portfolio compositions that are comparable to the first method. However, this model shows even more sensitivity to the value of the unsmoothing coefficient. For example, real estate weights fall rapidly (from 40% to 1%) when the unsmoothing parameter is increased slightly, from 0.40 to just 0.45. Finally, the fourth method, the STATES model, yields a relationship between weights and the unsmoothing coefficient that is comparable to the one suggested by FOARF. However, in this fourth method, smaller unsmoothing parameters are necessary to suggest the same asset allocations. Summarizing, the results for the U.K. point to larger differences between minimum and maximum values of the unsmoothing parameter than between unsmoothing methods. This finding supports the hypothesis that calibration in smoothing techniques (i.e., choice of the parameter) is much more important than model selection.
14. In the Marcato and Key (2007) study, compare and contrast the results of using UK data with those employing US and Australia real estate return data.
Using a FOARF unsmoothing model for the U.S. and Australia, Marcato and Key reinforce the findings arising from the analysis of the U.K. market for the period 1971-
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2005, with real estate weights diminishing as the value of the unsmoothing parameter increases. In spite of this, the authors point out three differences: 1. For the U.S. and Australia, the unsmoothing parameter has a significant (and much larger than for the U.K) impact on the overall portfolio weighting. This is because there exists a much higher first order serial correlation coefficient in the U.S. and Australia compared to the case of the U.K. This result also suggests the presence of more serious inefficiencies in the valuation-based indexes used in the U.S. and Australia when compared to those used in the U.K. The maximum suggested portfolio weights of equities in both the U.S. and Australia never reach the 80% level of the U.K. when the unsmoothing coefficient is 1. This is caused by the relative risk-return profile of bonds, which is appreciably more attractive in the U.S. and Australia than in the U.K. There exists a substitution effect between real estate and cash in both the U.S. and Australia that is due to a correlation coefficient that is near 0.50.
2.
3.
15. Argue the best method of adjusting a real estate return series when conducting an asset allocation study.
Marcato and Key calculate and compare the Sharpe ratio obtained for four portfolios (using different unsmoothing methods) and three benchmarks. Results suggest that an implicit unsmoothing parameter exists and that its value ranges between 0.40 and 0.60. This range is similar to the values found for this parameter in previous research. For practical use, Marcato and Key suggest using the simplest form of unsmoothing method, the First Order Autoregressive Reverse Filter (FOARF), with a coefficient whose value is included in the mentioned range. The authors conduct a series of portfolio simulations and arrive at the very important conclusion that all unsmoothing methods are highly sensitive to the choice of the parameter (calibration). On the other hand, unsmoothing model specification has little impact on asset allocation. This finding is consistent and supports Stevensons conclusion that calibration, rather than model specification, is the most important concern when unsmoothing real estate data. As a result, Marcato and Key argue that previous research that proclaimed the significance of model specification may be biased due to the selection of different (and not necessarily comparable) parameters for alternative models.
16. Describe the hedge fund business model presented by the authors.
Fung and Hsieh propose a hedge fund business model that is based on the following economic rationale. Assume that a money manager has a limited amount of personal wealth and believes that he/she could earn risk-adjusted returns that would be above average. To start a trading operation, the manager ought to leverage his/her skills by drawing external capital so that he/she can meet the resulting fixed costs. Fung and Hsieh compared this business model to the financing of a new venture. This external capital could be either equity financing or debt financing. However, typically, the managers personal wealth would not be enough to attract significant debt financing. As a result, the creation of a hedge fund arises as the only realistic financing alternative.
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Hedge fund managers attempt to maximize the enterprise value of their funds subject to a number of constraints, such as diminishing return to scale or the possibility that, for reasons external to the fund manager, the investment strategies they follow may become more or less popular among investors. The compensation contract design between the hedge fund manager and investors (e.g. the fee structure) will, in turn, determine the characteristics of the business model (e.g. degree of leverage, the allocation of capital to factor-related bets, etc.). In the end, optimal contracting between hedge fund managers and investors must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. Some authors have argued that the co-investing by the hedge fund manager and the investors may improve the alignment of interests on the downside but can also produce excessive conservatism by the funds manager on the upside.
17. Analyze the issues in measuring the growth of the hedge fund industry.
Fung and Hsieh offer an overview of the following five issues related to recent developments in the growth of the hedge fund industry: 1. Increasing institutional investments in hedge funds. Demand for hedge funds by institutional investors in the U.S. has been increasing in recent years. While the lead was initially taken by university endowments, pension plans are also growing their hedge funds investments. Growth in the supply of funds and in assets under management. Although the number of hedge funds has increased in recent years, in spite of the high attrition rate inherent to the industry, the actual size of the hedge fund industry is very difficult to measure. This is because, unlike mutual funds, hedge funds provide information to one or more databases on a voluntary basis. The three most important hedge fund databases are: (i) Center for International Securities and Derivatives Markets (CISDM), (ii) Hedge Fund Research (HFR), and (iii) Lipper TASS (TASS). Changes in styles and strategies. Hedge funds constitute a heterogeneous group that employs many diverse investment strategies. Databases usually classify hedge funds according to self-described styles. For example, TASS classifies hedge funds into the following ten styles: (i) Convertible arbitrage: Hedge funds attempt to generate alpha by buying securities while hedging the equity, interest rate, and credit risks with short positions of the equity of the issuing firm or other fixed-income derivatives . Dedicated shorts: Hedge funds that short sell securities (typically equities) that are estimated to be overpriced. Equity market neutral: Hedge funds trade long-short portfolios of stocks while keeping a neutral exposure to the general stock market. Macro funds: Hedge funds that invest money on directional movements in stocks, bonds, commodity prices and foreign exchange rates.
2.
3.
(ii) (iii) (iv)
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(v) (vi)
Fixed-income arbitrage: Hedge funds trade long-short portfolios of bonds. Long/short equity: hedge funds are invested in a long-short portfolio of stocks with a long bias.
(vii) Managed futures: Hedge funds specialize in futures trading. (viii) Event driven: Hedge funds focus on corporate events (typically merger transactions or corporate restructurings). (ix) (x) 4. Emerging market: Hedge funds invest in securities of developing economies. Others: All other hedge fund strategies.
Management fees and performance fees. Similar to the case of mutual funds, hedge funds charge a fixed management fee that is calculated as a percent of net assets under management. Most hedge funds charge a management fee that ranges between 1% and 2%. However, unlike mutual funds, hedge funds also charge an incentive fee or a performance fee. Roughly 80% of hedge funds charge a 20% incentive fee. Style evolution and changing investor clientele. A growing recent trend has been for hedge funds to progress from single-strategy specialists into multi-strategy hedge funds.
5.
Fung and Hsieh comment on the increasing research on synthetic hedge funds. These are defined as the replication of hedge-fund-like returns, available at a lower cost to investors, using mathematical models. However, the authors are not convinced that synthetic hedge funds represent a reasonable solution to the current imbalance between supply (alpha producers) and demand (alpha buyers).
18. Evaluate the potential biases in hedge fund databases.
Hedge fund databases CISDM, TASS, and HFR all suffer from the following four potential biases: 1.
Selection bias. This bias arises because inclusion in a database is voluntary (i.e., it is at the discretion of a hedge fund manager). On the one hand, one might expect that hedge funds having superior performance would go into a database to seize the interest of investors. On the other, many successful hedge funds that are closed to new investors decide not to be included in a database as they do not have an incentive to be there. Therefore, it is very difficult to estimate the magnitude of this important bias. The existence of this bias implies that hedge funds in a database may not be representative of the industry universe. Survivorship bias. A hedge fund may become defunct when investors are dissatisfied by the funds performance and vote to redeem their capital, or when the fund-raising attempts of the hedge fund manager fall short to draw the critical mass required for the hedge fund to remain a feasible business proposition. Empirical evidence suggests that surviving funds have had better returns than dead funds. The survivorship bias can be measured as the average return of surviving (or live) funds in excess of the average return of all funds, both surviving and defunct. Fung and Hsieh argue that, as the hedge fund industry matures, the importance of the
2.
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survivorship bias will diminish. Survivorship bias amounts to roughly 2.5% a year.
3.
Incubation bias (backfill or instant history bias). New hedge funds typically undergo an incubation period to accumulate a track record. This incubation period typically lasts at most a few years, as the opportunity costs related to a funds incubation period can be significant. If the track record is decent, the manager usually registers the hedge fund into a database hoping to draw the interest of prospective investors. Since the incubation history of the hedge fund before the entry date is backfilled, it is logical to speculate that the early part of a hedge funds history will be upwardly biased. Incubation bias has been estimated to be around 1.5% per annum. A related concept is the hazard rate, which is the proportion of hedge funds that drop out of a database at a given age. For example, Fung and Hsieh find that the highest dropout rate tends to happen when a hedge fund is 14 months old. Liquidation bias. This bias refers to the finding that fund managers discontinue reporting their returns to a database before the final liquidation value of a hedge fund, thus causing an upward bias in the observed returns of dead funds. Fung and Hsieh mention that during the Russian debt crisis of August 1998, several hedge funds (including the famous Long Term Capital Management) lost all their capital and became defunct. However, managers stopped reporting their hedge funds returns in July of that year. Had they reported the corresponding -100% returns in August of 1998, observed hedge fund returns would have been lower during that month.
4.
Finally, past research has also shown that hedge fund indexes have serial correlation of hedge fund returns (autocorrelation) and that the returns are correlated to past returns of market factors (such as the S&P 500). It is still not clear whether this correlation arises as a result of infrequent trading of illiquid securities by hedge funds in their portfolios or whether it is a reflection of manipulation by hedge funds managers to smooth or massage their returns.
19. Review the approach and describe the main findings of bottom-up research on hedge fund risk factors.
The bottom-up approach to hedge fund risk factors, as opposed to the top-down approach, is an approach in which risk factors inherent in specific styles are identified. 1. Managed futures. The majority of managed futures funds employ a trend-following strategy. A market timer who switches between Treasury bills and stocks creates a return profile that is similar to that of a call option on the stock market. It has also been shown that the resulting return profile is similar to that of lookback straddles. A lookback straddle is a derivative that pays the holder the difference between the maximum and minimum prices of the underlying security over a certain time period. Merger arbitrage. It has been shown that merger arbitrage returns are comparable to those of merger arbitrage hedge funds. Merger arbitrageurs tend to be long deal risk as they bet on the success of a merger. Fung and Hsieh argue that merger arbitrage returns can be considered an insurance premium arising from selling a
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policy against the risk that the merger is not completed. Mergers bear a significant idiosyncratic risk that is usually mitigated by the hedge fund by holding a portfolio of merger transactions. 3. Fixed-income hedge funds. Convertible bond funds are strongly correlated to a convertible bond index and high-yield funds are strongly correlated to a high-yield bond index. Furthermore, all styles have correlations to changes in default spreads. Past research has shown that the returns arising from fixed-income hedge funds can be created using different fixed-income arbitrage trades that are often used by hedge funds, such as:
Swap spreads A bet that the fixed side of the spread will remain higher than the floating side of the spread. Credit spread: A bet on the difference in the prices or interest rates of two fixed-income securities, where the value of the position is determined by fluctuations in the differentials between the prices or interest rates.
Mortgage spreads: A bet on prepayment rates. Yield-curve spreads: A bet that bond prices deviate from the overall yield curve only in the short-run due to liquidity issues, which disappear over time.
Capital structure arbitrage (spread): These are credit arbitrage spreads on mispricing among different securities (typically bonds and stocks) issued by the same company. Fixed-income volatility trade: A bet that the implied volatility of interest rate caps will be higher than the realized (observed) volatility of the Eurodollar futures contract.
4.
Long/short equity hedge funds. Long/short equity hedge funds have been found to have a positive exposure to the stock market and to long small-cap/short large-cap positions. The performance of this type of hedge funds is highly idiosyncratic, as hedge fund managers in this style are stock pickers possessing diverse opinions and abilities. Convertible arbitrage. Empirical results suggest that convertible arbitrage hedge funds offer liquidity to the convertible bond market trading mostly from the long side while hedging the underlying risk factors of the bond. Past research suggests that the following three strategies are commonly used by convertible arbitrage hedge funds: volatility arbitrage strategy, which is a bet that the option embedded in the convertible bond is not correctly priced, credit arbitrage strategy, which is a bet that the convertible bonds credit risk is not correctly priced, and carry strategy, which is a combination of the volatility arbitrage and the credit arbitrage strategy.
5.
6.
Niche styles. Past research suggests that emerging market hedge funds returns are strongly correlated with an emerging market stock index; distressed securities hedge
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funds returns are strongly correlated with a high-yield bond index; equity non-hedge (hedge funds that usually trade from the long side, leaving their market risk essentially unhedged) returns are strongly correlated with a small growth stock index; and dedicated short-sellers returns are strongly negatively correlated with a small growth stock Index. In the case of equity market neutral, the difficulty in correctly classifying the strategies that fall into this style has made this category challenging to analyze. 7. Macro hedge funds. Disentangling the risk of macro funds has been a difficult task to researchers because of the dynamics of risk in these hedge funds. A seven-factor model proposed by Fung and Hsieh (2004) does a reasonable job in capturing the risk of macro funds (see Learning Objective 21).
20. Describe and assess the adequacy of the asset-based style risk factor model used by Fung and Hsieh to analyze hedge fund returns.
Fung and Hsieh stress that investors should try to understand the most important risk factors in hedge fund portfolios so that they can evaluate their effect on their overall asset allocation profile. Furthermore, counterparties to hedge funds and regulators need to recognize the key sources of hedge fund risk so that they are able to assess capital at risk. Fung and Hsieh propose an asset-based style (ABS) factor model consisting of seven risk factors to capture the risk of diversified portfolios of hedge funds. The term assetbased used to describe these sources of uncertainty arises because these top-down risk factors are all based on tradable securities and their derivatives. The seven factors are: 1. 2. 3. 4. 5. 6. 7. The excess return of the S&P 500 (i.e. the return of the S&P 500 above the risk-free return), Small-cap stocks minus large-cap stock returns, The return of the 10-year Treasury bond above the risk-free return, The return of Baa bonds above the return of the 10-year Treasury bond, A lookback portfolio in bonds, A lookback portfolio in currencies, and A lookback portfolio in commodities.
The importance of the asset-based style (ABS) risk factor model to analyze hedge fund returns resides in that the identification of these observable risk factors based on tradable assets allows us to indirectly get around the opaqueness of hedge fund operations. Thus, the ABS risk factor model allows us to indirectly measure the systematic risk of hedge fund investing. Another important feature of the ABS risk factor model is that it provides a more natural way of defining hedge fund alphas and hedge fund betas, or alternative alphas and alternative betas. The ABS risk factor model provides investors in search of alpha with a way to assess the value of their hedge fund investment. Beta buyers, on the other hand, can evaluate whether their investments have exposure to the right risk. And finally, both types of investors can assess whether the fees they paid are reasonable.
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21. Discuss the broader risks associated with hedge funds and describe the regulatory concerns.
Fung and Hsieh describe the following three primary regulatory concerns associated with hedge funds: 1. Investor protection. In general, regulatorsmainly the Securities and Exchange Commission (SEC) and, to a lesser degree, the Commodity Futures Trading Commission (CFTC)maintain that hedge fund investors can fend for themselves, given that these investment vehicles are accessible only to sophisticated wealthy individuals and institutional investors. These accredited investors are assumed to have the knowledge and the sufficient wealth to hold out the risk of suffering potentially substantial losses from hedge fund investing.
Systemic risk. This is the risk that large losses from one or more hedge funds can wreak havoc to their counterparties, thus creating a domino effect to other market participants and institutions. Regulators generally consider that systemic risk should be dealt with by existing regulation of banks and other counterparties rather than by new laws. Market integrity. Some regulators are concerned about the potential impact that hedge funds may have on the markets, given that a number of these funds are large enough to exert a major impact on the markets. A case in point was the effects of the near bankruptcy of Long Term Capital Management (1998). Others, however, argue that hedge funds are too small to be able to manipulate particular markets. Fung and Hsieh argue that the potential impact that hedge funds may have on market integrity has shifted from the failure of a mega hedge fund (such as LTCM) to that of a convergence of leveraged opinions among funds that individually may function unnoticed. A convergence of leveraged opinions can be defined as an event in which the opinions of a large group of hedge funds converge onto the same set of bets, thus potentially threatening markets and creating systemic risk. Fung and Hsieh recommend that risk monitoring of the hedge fund industry should reorient its focal point away from megafund collapses to the convergence of factor bets.
2.
3.
22. Describe the role of manager selection in the experience of a private equity investor.
Research on the returns of private equity firms has shown that risks are often understated and returns overstated. The key to successful private equity investing is to select the best private equity firms in which to invest, but this is not easy because of the lack of transparency concerning the valuation and disclosure of the assets in each private equity firm. This emphasizes the importance of the private equity investor somehow being able to recognize and have access to the managers with the best record in order to earn the best returns. David Swensen, chief investment officer of Yales endowment, indicated that passive investment in private equity is bound to provide disappointing results. The superior performance is only the result of selecting top-quality managers who pursue value-added strategies with appropriate deal structures.
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Simply recognizing the top managers is not enough, however, because the top managers may not be open to new investments. An investor must be able to invest with the top managers, e.g., by already having a relationship with them. The conclusion is that successful investors in private equity must have both the ability to identify, as well as have access to, superior private equity firms and their funds. Typically, the manager of a private equity firm is the general partner. He/she obtains capital commitments from limited partners that are qualified investors such as financial institutions, university endowments, pension funds, and wealthy individuals. The general partner looks for good investments, and when finding one, calls the limited partners for investment capital. The general partner generally receives a fee of about 2% of assets and 20% of the gross profits on invested capital.
23. Discuss the challenges that an investor would face in measuring the riskadjusted performance of private equity.
The three basic challenges when measuring the risk-adjusted performance of private equity are: 1. 2. Making adjustments for stale prices and illiquidity. Recognizing that earning the returns indicated by summary market measures, e.g., a private equity index, requires identifying and having access to the managers that earn the higher returns. The limitations of data availability.
3.
Stale prices and illiquidity complicate measuring the returns to private equity funds. Stale prices refer to when a firm does not change reported prices frequently. Measures of performance using such data are unreliable. Some private equity firms have been known to not update the values of some of their investments for years. The fact that the firms are illiquid means that the potential returns are not accurately represented by the returns estimated using reported prices. There are two layers to this illiquidity: the shares of the private equity firms do not actively trade and the investments of the firms are illiquid. These two layers compound the problem.
The second challenge influencing returns is to be able to identify and have access to topperforming managers. Some managers outperform others on a consistent basis. Furthermore, there is asymmetry of information in this market, and investors in private equity firms have different abilities with respect to both identifying the best managers and having access to them. For this reason, the average investor in private equity firms cannot expect to earn the returns reported for the industry. Thirdly, when analyzing the data of private equity, it is important to recognize the history of private equity and the limitations of the data when compared to more conventional publicly-traded investments such as stocks and bonds. Private equity has grown dramatically in the U.S. in the last 30 years, and has recently spread around the world. The relatively short history, combined with the irregularities associated with the growth of this sector, presents challenges when analyzing the data. Investors should be less confident with respect to measures of risk and return. There is also parameter
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uncertainty with respect to the models. The challenges are greater for the data of firms outside the US.
24. Explain the implication of the observation that mean and median returns on private equity databases are significantly different.
A study by Kaplan and Schoar (2005) for the period 1980-2001 found that the mean return of venture funds and buyout funds were 17% and 18% respectively. This is far greater than the reported median returns of 12% across all funds. The median is the value below and above which 50% of the values fall. The differences between the mean and median returns indicate that the best private equity firms do outperform the market on a fairly consistent basis. One implication is that the ability to recognize top managers and have access to their funds plays a significant role in the realized returns. There are certain types of institutional investors, notably endowments, that have a documented record of higher returns with private equity relative to the general returns of private equity, and they probably do this by focusing their investment in the best-performing private equity firms. A very important overall implication of these observations is that, when looking at the industrys aggregate reported returns, the attractiveness of private equity as a general asset class of investments is overstated.
25. Explain and identify the potential bias in using the performance of liquidated funds to represent the overall performance of private equity funds.
Phalippou and Zollo (2005) put forward the hypothesis that the returns of liquidated funds may not be a representative sample of the returns offered by all funds. Liquidated funds may represent a biased sample because the more successful funds are more likely to liquidate. Funds that are not performing well may not be as likely to liquidate to avoid having to recognize poor performance from unsuccessful results concerning their Initial Public Offerings (IPOs) and asset sales. By keeping the assets on the books, i.e., not liquidating them, they can keep the assets at unrealistically high values. Phalippou and Zollo examined 981 funds that had officially liquidated or were inactive in the two years prior to when they took their sample. They compared the performance of these funds to 1,391 funds that were still active. The returns of the liquidated funds had a higher proportion of good outcomes, e.g., successful IPOs, and a lower proportion of bad outcomes, e.g., bankruptcies. When adjusting the sample for the bias, the authors found that investments in private equity from 1980 to 1996 had an annual return lower than the S&P 500 by as much as 3.3%.
26. Compare the performance of companies in which private equity firms invest with small cap firms listed on NASDAQ.
Both the assets in which private equity firms invest and the smallest stocks on the NASDAQ have payoffs that are similar to those of options. Both have the potential for huge payoffs along with a high probability of a complete loss of capital.
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In statistical terms, both the investments made by private equity firms and small NASDAQ stocks have large means and volatilities. After adjusting for biases, Cochran (2005) estimated the mean arithmetic return for early rounds of private equity investments to be 59% with a standard deviation of 109%. The returns for later rounds of investments decline as a firm becomes more established over time. Also, given the similarities, small stock indices (e.g. NASDAQ) are sometimes used by practitioners to help gauge success in private equity.
27. Explain the liquidity characteristics of Listed Private Equity securities. Listed Private Equity (LPE) securities are traded securities that have the properties of private equity but also trade on an exchange. Zimmerman et al. (2005) classified listed private equity securities (LPEs) into one of three categories:
(1) public companies whose core business is private equity; (2) quoted investment funds that co-invest with specific private equity funds, (3) specially structured vehicles that invest directly in private companies and/or indirectly through various private equity funds. Zimmerman et al. (2005) examined 287 Listed Private Equity securities (LPEs) during the period 1986-2003. The LPEs represented the gamut of financing stages, e.g., early, later expansion, buyouts, and turnarounds. The sample included listings in North America, Europe and Asia. Although the firms often sought listing to increase liquidity, the liquidity was still very limited when compared to other public stocks. The bid ask spread exceeded 20% for over 40% of the LPEs. Liquidity issues tended to influence the characteristics of the returns of LPEs. The estimates of returns drop significantly when adjustments for the bid ask spread are made. Also, adjusting for the biases of thin trading increases risk measures, and the beta of the LPEs increase from 0.60 to 0.99. In summary, the studies suggest that private equity has not produced returns that are competitive with the returns of public equity. This is the case for both LPEs and unlisted private equity, and it is certainly the case given the relative low liquidity and high risks of investments in private equity.
28. Discuss the impacts of adjustment for stale prices on risk, return, and diversification benefits of private equity (candidates do need to memorize exact figures).
Adjusting for stale prices increases risk and lowers diversification benefits, but does not affect returns. It is true that without the adjustments, including a 20% allocation of private equity to a traditional stock and bond portfolio would shift out the efficient frontier significantly; however, after the adjustments, the benefits are much lower. Using quarterly data, Conroy and Harris 2007 study shows that the risks of private equity investments increases dramatically after an adjustment for stale prices. Specifically, the standard deviation of the private equity quarterly index (PEQR) almost doubles; and the standard deviation of the Sand Hill Econometrics index of venture capital (Sand Hill) increases by more than half again as much. The correlations and betas of the indexes with the S&P 500 also increase.
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The table below summarizes the results found in Conroy and Harris. It gives the actual numbers for the quarterly results for two private equity indexes and the monthly results for one index. The adjustment employed was Dimsons approach, which includes both contemporaneous and lagged risk values in the risk measures. The reported Dimson beta, for example, is the sum of regression coefficients on the S&P 500 and its lagged values. The adjustment attempts to correct for the smoothing that is usually observed with the stale prices associated with illiquid assets.
Index (Quarterly Returns) PEQR Sand Hill (quarterly) LPX America (monthly) Std. Dev. before/after adjustment 13% / 25% 18% / 31% 26% / 32% Corr. w/S&P 500 before/after adjustment 0.63 / 0.74 0.76 / 0.84 0.68 / 0.69 Beta before/after adjustment 0.53 / 1.17 0.90 / 1.71 1.15 / 1.41 Mean Return before/after adjustment 16.00% / 16.00% 15.97% / 15.97% 16.59% / 16.59%
An increase in the standard deviation means that there is an increase in stand-alone risk. The increases in correlation and beta means there is a lower benefit from diversification.
29. Identify the impact of IPO under-pricing on the performance of the PVCI.
The Post-Venture Capital Index (PVCI) is a measure composed by Venture Economics. As a representative investment in private equity, the performance of the PVCI would be biased because of the effect of IPO underpricing. A company becomes part of the index at the offering price when it goes public. If the IPO was underpriced and the price of the stock subsequently increases in value, the return of the PVCI will increase from that effect. Thus, the initial impact is the tendency for the PVCI to increase when it includes an underpriced IPO stock at its issue price, and the stock subsequently increases in value. This has an impact on investors who attempt to replicate the PVCI. They will find that they cannot achieve the level of the returns of the index because they cannot participate in the IPOs. Any strategy attempting to replicate the returns from PVCI would usually result in lower returns than those reported by PVCI. By the estimates of some researchers, the return of a strategy that attempts to replicate the PVCI by buying stocks in the aftermarket will be about 2% lower than the PVCI itself. Furthermore, adjusting the PVCI to remove the impact of IPO underpricing reduces the attractiveness of private equity. In fact, the Sharpe ratio falls to such a degree that some models suggest that private equity should have a zero allocation in an efficient portfolio.
30. Explain how the following issues pose a challenge to private equity investors:
Private equity investors have several issues that complicate their analysis of private equity. Four such issues are illiquidity, parameter uncertainty, absence of an investible index, and cross-sectional differences in private equity managers.
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a.
Illiquidity.
Historical returns generally do not have built in any return premium required for illiquidity. Such a premium would reduce the effective return from private equity and make it less desirable. Adjusting for liquidity by reducing the expected return of PEQR by 1% per year, for instance, would reduce the recommended allocation to private equity in an efficient portfolio significantly
b. Parameter uncertainty.
Parameter uncertainty about estimates of risk and return is larger for private equity than for conventional assets, e.g., stocks and bonds. Estimates made based upon historical data may not indicate future performance.
c. Absence of an investible index.
No index is readily available for purchase, and access to some funds may be impossible. Thus, investors in private equity are unlikely to be able to invest in assets with the properties of the indexes or the properties indicated by the private equity industrys summary statistics.
d. Cross-sectional differences in private equity managers.
There is a large cross-sectional difference in private equity managers. One indication is the dispersion of their internal rates of return (IRR). Recent data indicates the mean IRR is 11.9%, which is much higher than the median of 5.6%. The dispersion is indicated by the three quartile boundaries: -2.6%, 5.6%, and 15.9%. (These results represent 1,747 funds for the period 1969-2005. The data was from Venture Economics.) A random draw of a private equity fund has an equal chance of being below 5.6% as above 5.6%, which would not be desirable. As mentioned earlier, only investors with the ability to recognize and have access to top managers can expect the higher returns.
References
Gorton, G. and K. G. Rouwenhorst. Facts and Fantasies about Commodity Futures. Financial Analysts Journal. Vol. 62, No. 2, 2006. Marcato, G., and T. Key. Smoothing and Implications for Asset Allocation Choices. The Journal of Portfolio Management. Special Issue 2007. Fung, W.K.H., and D.A. Hsieh. Hedge Funds: An Industry in Its Adolescence. Federal Reserve Bank of Atlanta, Economic Review. Fourth Quarter 2006. Conroy, R. and R. Harris. How Good are Private Equity Returns? Journal of Applied Corporate Finance, Vol. 19, No. 3, Summer 2007.
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GLOSSARY: Level 2, Topics 711 Please note that this Glossary is to be used exclusively in preparation for the CAIA Exam. The aim of this Glossary is to provide useful information, in context, that is directly related to the CAIA Study Guide Keywords. 130/30: active extension strategies that invest 130% in long positions in one group of strategies and 30% in short positions in another group of securities. (Topic 9) Abatement Strategies: An approach to dealing with climate change that attempts to prevent climate change. It contrasts with adjustment strategies that are reactions to the unavoidable consequences of climate change. (Topic 7) Adjustment Strategies: An approach to dealing with climate change that is a rational reaction to the unavoidable consequences of climate change. It contrasts with abatement strategies that attempt to prevent climate change. (Topic 7) Alignment of interests: The idea that optimal contracting between hedge fund managers and investors must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. (Topic 11) Allocation drift: The situation in which one asset class in the portfolio becomes overweighted while another becomes underweighted. Over the long run, allocation drift can change the portfolios risk level to a point where it might become misaligned with the investors objectives. (Topic 10) Alt-A mortgage loans: Loans issued to borrowers who have better credit scores than subprime borrowers but fail to provide sufficient documentation with respect to all sources of income and/or assets. (Topic 9) Alternative alphas: Alpha that is derived from the asset-based style (ABS) model of Fung and Hsieh, a risk factor model which provides investors in search of alpha with a way to assess the value of their hedge fund investment. (Topic 11) Alternative betas: Beta that is derived from the asset-based style (ABS) model of Fung and Hsieh, a risk factor model where beta buyers can evaluate whether their investments have exposure to the right risk. (Topic 11) Arithmetic return: The simple average of period-to-period returns. (Topic 8) Aspirational risk: One of the three dimensions of risk, according to Kahneman and Tversky (1979), that the ideal portfolio must address; aspirational risk is associated with enhancing ones lifestyle. (Topic 8) Asset-backed securities (ABS): Bonds that are securitized or collateralized by the cash flows from an underlying pool of assetssuch as credit cards, home loans, auto loans, equipment
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Glossary: Level 2, Topics 711
leases, or other non-mortgage related assets. They are often issued by special investment vehicles with several tranches of senior and subordinate securities, with the tranches being paid in order of seniority (Topic 7) Asset backed security (ABS) trust: The owner of securitized loans acquired from the originators of the loans. They generate NPV from repackaging the cash flows in a way that can absorb some losses. They typically use a waterfall payment structure for the collaterals cash flows. (Topic 9) Asset-based style (ABS) factors: Top-down risk factors representing tradable securities and their derivatives. Fung and Hsieh use seven such risk factors to capture the risk of diversified portfolios of hedge funds. (Topic 11) Backfill: The process in which the incubation history of a hedge fund before the entry date in an index is typically backfilled. (Topic 11) Backwardation: The condition of the futures curve when near-month futures contracts trade at a premium to further-out-month futures delivery contracts, i.e., the term-structure of futures prices has a negative slope. In contrast to contango, backwardation means that the price of a commodity for future delivery is below the spot price. (Topic 9 and 11) Bankruptcy remote: The attribute, related to the use of SPVs, that a bankruptcy of an affiliated entity (e.g., a sponsoring bank or money manager) will not affect the functioning of the structure (e.g., SPV) that is bankruptcy remote. (Topic 7) Barbell strategies: The strategies that allocate a relatively high weight to the personal (lowrisk cushion) and aspirational (high-risk/return) risk buckets and a smaller weight to the market (middle-risk/return) risk buckets. (Topic 8) Basis: The cash price minus the futures price (i.e., the spread between the spot price of a commodity and the price of, usually, a short term futures contract). (Topic 11) Black-Litterman asset allocation: A model where the investment manager begins with the equilibrium expected returns computed from the CAPM, which is called the neutral reference point. Then, the manager combines his/her own expectations about the market with the expectations from the CAPM. (Topic 8) Bottom-up approach: An approach to identifying hedge fund risk factors based upon investment styles such as managed futures, merger arbitrage, and fixed-income arbitrage. It is in contrast to a top-down approach, which identifies factors based upon investable portfolios. (Topic 11) Buy-and-hold: A portfolio strategy in which there is no rebalancing even when market prices move. (Topic 8) Buy to own investing: Acquiring sizable stakes in companies with the goal of having control or ownership rather than trading the securities. (Topic 7)
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Calendar spread strategy: A futures trading strategy that exploits the spreads between two delivery months. It is typically used by sophisticated storage operators who recognize that their storage facilities are essentially a set of complex options on calendar spreads. (Topic 9) Capital calls: When the general partner of a private equity fund recognizes a suitable investment prospect, he/she is allowed to call the necessary equity capital at which time each partner typically funds a pro rata share of its commitment. (Topic 10) Capital-structure arbitrage: This is an arbitrage consisting of credit arbitrage spreads on mispricing among different securities (typically debt and equity) issued by the same company. (Topic 11) Carbon funds: Funds that participate in the market for certified emission reductions (CERs), as created by the Kyoto Protocol. They may be government purchasing programs and private commercial funds. (Topic 7) Catastrophe bonds: Catastrophe risk-transfer instruments, which provide a cash flow when a certain unavoidable event occurs. Coupons are usually based on LIBOR plus an appropriate risk premium, and when a predefined loss occurs, the investor forfeits the capital invested. (Topic 7) Catastrophe risks: Unavoidable natural catastrophe and weather risks that are used in risk transfer instruments such as catastrophe bonds and weather derivatives, that provide compensation for certain events. The market for catastrophe risks offer adjustment strategies. (Topic 7) Cat-risk CDOs: Securitized products that bundle various catastrophe risks and sell them in individual risk tranches. Typically issued by a special purpose vehicle (SPV) that purchases the underlying pool for a CDO. (Topic 7) Centralized Clearing House (CCH): clearing house for OTC transactions recommended by the Basel-based Financial Stability Forum to the G-7. CCHs would monitor the risk exposure of participants, to make sure they have sufficient collateral, and stand ready to back defaults. (Topic 9) Claw-back: When fees paid to the general partner by limited partners for profitable investments may be subject to reclaim if significant losses from later investments occur. (Topic 7) Clean Development Mechanism: Part of the Kyoto Protocol that allows for investment to be made in a project that promises to yield future income in the form of certified emission reductions (CERs) in the emerging markets. (Topic 9) Climate-related investments: Public investment funds and private equity funds that invest in assets that could profit from climate change. Examples are investing in the equity of companies that are developing environmentally friendly products and making loans to such companies. (Topic 7)
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Collateralized commodity obligation (CCO): The concept of collateralized obligations (COs) extended into commodities. The CO structure facilitates exposure to commodity price risk through the use of CTSs (commodity trigger swaps). (Topic 7) Collateralized fund obligation (CFOs): The application of the CDO concept to investing in hedge funds and private equity. (Topic 7) Commitment strategy: The pledge made by an investor to a private equity fund. If a private equity fund cannot find appropriate investment prospects, it will not draw on an investor's commitment. In this case, the investor may eventually invest less than was expected or committed. (Topic 10) Commodity trigger swaps (CTS): A derivative that is similar in concept to a credit default swap and used by CCOs. In this case, the trigger event is a specified decline in commodity prices, e.g., a 35% decline. At the initiation of the CTS, the CCO would give a certain amount of money (the principal) to the counterparty and receive coupons over a specified time. If, during the life of the CTS, a trigger event occurs, then the CCO would not receive the principal back at the maturity of the CTS. (Topic 7) Compensation contract design: The fee structure design between the hedge fund manager and the investors. Optimal compensation design must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. (Topic 11) Complex adaptive systems: Term to describe the capital markets that are made up of many interactive agents whose decisions impact each other in nonlinear and unanticipated ways, and whose behavior changes when confronted with new situations, thereby allowing the system to evolve and benefit from the changing environment. (Topic 10) Concave payoff curves: In the context of the Perold and Sharpe study, refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises. (Topic 8) Conditional factor models: Either rule-based approaches or econometric approaches that model the time-varying factor exposures of hedge fund returns. (Topic 7) Constant mix: A portfolio rebalancing strategy wherein there is periodic rebalancing such that the portfolio is adjusted back to being a specified percentage mix of securities or security classes. (Topic 8) Constant-proportion portfolio insurance: A portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates. Furthermore, the investor increases risky asset holdings when the market rises and decreases risky asset holdings when the market falls. (Topic 8) Contango: The condition when near-month delivery futures contracts trade at a discount to further-out-month futures delivery contracts, i.e., the futures curve has a positive slope. In contrast to backwardation, the futures price is greater than the spot price. (Topic 8 and 9)
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Contingent capital arrangements: Types of put options where option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs. One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss. Due to pricing difficulties, they are not used much today. (Topic 7) Contrarian: trading strategies that increase the demand for losers (by buying losers) and add to the supply of winners (by selling winners), thus providing market liquidity and helping stabilize supply-demand imbalances. (Topic 9) Convergence: The broadening of goals of hedge fund managers and private equity managers that has led to the two types of funds becoming more similar. Specifically, hedge funds have moved from just making short-term debt-type investments to some longer-term equity-type investments with the goal of having some control in companies in which they invest. Private equity funds are making more shorter-term investments without the goal of control. (Topic 7) Convergence of leveraged opinions: The event where the opinions of a large group of hedge funds (which are highly levered investment vehicles that, individually, may function unnoticed) converge onto the same set of bets, thus potentially destabilizing markets and creating systemic risk. (Topic 11) Convex payoff curves: In the context of the Perold and Sharpe study, refers to the tendency of a strategy to increase equity exposure (risk) as the equity market rises. (Topic 8) Credit Enhancement: In an ABS trust, the amount of loss on the underlying collateral that can be absorbed before the tranche absorbs any loss. (Topic 9) Credit spread: The difference in the prices or interest rates of two fixed-income securities based upon risk; it is used in fixed income strategies where the investor takes positions based upon the disparity between the prices or interest rates. (Topic 11) Decision rule: In the context of the Perold and Sharpe study, refers to the exact determination procedure for a portfolio reallocation strategy such as the amount of dollars that will be invested in a risky asset as the prices of the risky assets change. (Topic 8) Dimson Beta: the sum of regression coefficients on the S&P 500 and its lagged values. It attempts to correct for the smoothing that is usually observed with the stale prices associated with illiquid assets. (Topic 11) Distributions: Cash payments investors receive as compensation for investing in private equity. (Topic 10) Emission credits: While the EU Emission Trading System (EU-ETS) has a limit to tradable emission rights for all companies, emission credits can be won by companies from additional climate protection projects that are in other countries and that can be credited to their own reduction target (baseline and credit). (Topic 7) Emission rights: The EU Emission Trading System (EU-ETS) makes a distinction between greenhouse gas emission rights and emission credits. There are a limited number of emission
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rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) EU Allowances (EUAs): The limited number of greenhouse gas emission rights that are traded among companies in the EU Emission Trading System (EU-ETS). There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) EU Emission Trading System (EU-ETS): The biggest market for greenhouse gas emissions. It uses targets proposed by the Kyoto Protocol, which defines a number of different emission certificates. There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) Event loss swaps: A variant of conventional industry loss warrants (ILWs). They are more tradable because they are more highly standardized. (Topic 7) Event risk: One of the components of personal risk of an individual investor, which refers to his or her ability to adjust to events such as the loss of a job, health problems, market crashes, etc. (Topic 8) Exposure: the degree to which an investor should be concerned about possible outcomes. It is another factor when dealing with risk and uncertainty. (Topic 10) Exposure diagram: In the context of the article by Period and Sharpe, a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolios cumulative performance. (Topic 8) Factor-replication approach: attempt to replicate hedge fund returns using hedge fund risk factors. (Topic 7) First Order Autoregressive Reverse Filter (FOARF): An approach to generate an unsmoothed total real estate return series, with three assumptions underlying this model: adjusted and unadjusted values of the mean for the series are equal; the model holds over time; and random errors are left out of the index. (Topic 11) Fixed income volatility: A bet that the implied volatility of interest rate caps will be higher than the realized (observed) volatility of the Eurodollar futures contract. (Topic 11) Floor: In the context of the Perold and Sharpe study, refers to a total portfolio value that, if reached via a decline in portfolio value, causes a portfolio reallocation such as the termination of investment in risky assets. (Topic 8) Full Information Value Index (FIVI): An approach to generate an unsmoothed total real estate return series, with a first-order autoregressive specification, without the need to assume that the underlying property market is informationally efficient. (Topic 11) Geometric return: return that takes into account compounding across periods, versus arithmetic returns which is the simple average of period-to-period returns. (Topic 8)
110
Hazard rate: The proportion of hedge funds that drop out of a database at a given age. For example, Fung and Hsieh find that the highest dropout rate tends to happen when a hedge fund is 14 months old. (Topic 11) Hybrid asset: An asset that shares common characteristics with two or more other assets. (Topic 7) Hybrid funds: Funds that utilize both hedge fund and private equity strategies. (Topic 7) Illiquidity: The property where an asset cannot be sold, either rapidly, with negligible loss of value, or at anytime during market hours. Secondary markets for illiquid investments (such as private equity) are limited. (Topic 10) Incentive fee: A performance fee charged by hedge funds on top of the management fee. Most hedge funds charge a 20% performance fee. (Topic 11) Incubation bias: (Also known as backfill or instant history bias) refers to the bias in hedge funds returns caused when the incubation history of a fund before the entry date in an index is backfilled, potentially causing that the early part of a hedge funds history will be upwardly biased. Incubation bias has been estimated to be around 1.5% per annum. (Topic 11) Incubation period: A period that new hedge funds typically undergo in order to accumulate a track record. It lasts at most a few years because the opportunity costs related to a funds incubation period can be quite significant. (Topic 11) Industry loss warrants: A type of capital market-financed loss (re-)insurance, which is linked to an industry loss index. It is usually in the form of private placements. (Topic 7) Infrastructure funds: Funds that invest in companies that usually provide an essential service to the community and have some monopoly power, e.g., a bridge, utility, or road. They typically provide relatively steady income and provide a hedge against inflation. (Topic 7) Lend to own debt financing: Providing debt financing, usually to highly levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults. (Topic 7) Lifecycle: refers to the various stages of the infrastructure asset from inception to maturity. (Topic 7) Lifecycle stage: One of the components of personal risk of an individual investor, which refers to his or her earning power and the desire to leave a legacy. (Topic 8) Liquidation bias: The finding that fund managers discontinue reporting their returns to a database before the final liquidation value of a hedge fund, thus causing an upward bias in the observed returns of dead funds. (Topic 11) Liquidity conundrum: The relationship between liquidity and risk where liquidity is dependent upon the risk aversion of investors and not just determined by monetary
111
factors. The conundrum is that the increase in risk aversion lowers liquidity, which in turn increases risk aversion and further lowers liquidity. (Topic 10) Listed infrastructure funds: Infrastructure funds trading on exchanges (e.g. NYSE). (Topic 7) Listed Private Equity: Traded securities that have the properties of private equity but also trade on an exchange. These can be: public companies whose core business is private equity; quoted investment funds that co-invest with specific private equity funds; and specially structured vehicles that invest directly in private companies and/or indirectly through various private equity funds (Topic 11) Lock-up: Period when the investors capital is committed to the fund and cannot be withdrawn. (Topic 7) Long/short equity: Strategies that employ a broad range of short-selling, that may or may not be quantitative, that may or may not be market-neutral, and where technology does not necessarily play a significant role. (Topic 9) Lookback straddles: A derivative that pays the holder the difference between the maximum and the minimum prices of the underlying security over a certain period of time. (Topic 11) Market integrity: A concept to describe the potentially major impact that a large hedge fund(s) may have on the markets, given that a number of these funds are large enough to exert a major impact on the markets, and was made evident by the near bankruptcy of LTCM (1998). (Topic 11) Market risk: One of the three dimensions of risk, according to Kahneman and Tversky (1979), that the ideal portfolio must address; increasing market risk should increase returns. (Topic 8) Market risk factors: Risk factors that affect hedge fund returns. Fung and Hsieh have proposed a risk-factor model consisting of seven risk factors to capture the risk of diversified portfolios of hedge funds. (Topic 11) Monoline Insurers: insurers that guarantee payments from certain types of structured credit products. They often issued a surety wrap to increase credit status for senior tranches of an ABS trust or CDO structure, despite the fact that the underlying collateral was subprime mortgages. They are highly leveraged, yet carry a AAA rating. (Topic 9) Mortgage spread: A trade that is a bet on prepayment rates, with a long position on a pool of GNMA mortgages which is financed using a dollar roll. The position is delta-hedged with a five-year interest rate swap. (Topic 11) Multiplier: Within a portfolio reallocation strategy such as constant proportion portfolio insurance, it is the parameter that indicates how much an investor increases risky asset holdings when the market rises and decreases risky asset holdings when the market falls. (Topic 8)
112
Multistrategy hedge funds: Hedge funds that invest opportunistically among different hedge fund strategies applied to global markets. A growing recent trend has been for hedge funds to progress from single-strategy specialists into multi-strategy investments. (Topic 11) Normal backwardation: This term describes the case where the futures price for a commodity is less than the expected spot price in the future, i.e., the expected price at the maturity of the contract, and suggests that futures prices generally trend up as they approach maturity. This condition allows for positive excess returns as an investor takes long-term futures positions and then rolls them over as they approach maturity. (Topic 8) Option-based portfolio insurance: A portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates and increases risky asset holdings at values above that floor value such that the ultimate risk exposure of the strategy mirrors that of a portfolio comprised of risk free bills and call options on a risky asset. (Topic 8) Payoff distribution approach: It attempts to replicate hedge fund returns by matching higher moments but not the first moment. The approach is based on the premise that two random variables can be equal almost surely or equal in distribution. (Topic 7) Personal risk: One of the three dimensions of risk, according to Kahneman and Tversky (1979), that the ideal portfolio must address; personal risk refers to the possibility of a fall in the investors lifestyle and the resulting anxiety associated with that possibility. (Topic 8) Positive Feedback Mechanisms: The term for the circular dependence between refinancing and collateral valuation. If asset values decline, the ability to refinance declines, valuation of counterparty collateral declines, value of monoline assets declines, and the value of the guarantees given by monolines declines. This contributes to systemic risk. Post-Venture Capital Index (PVCI): measure composed by Venture Economics as a representative investment in private equity. The performance of the PVCI is biased because of the effect of IPO underpricing. (Topic 11) Private (direct) commercial real estate - debt: The direct purchase of issued whole loans. This component of commercial real estate is accessible only to large investors, given the large amounts of capital needed to participate in it. (Topic 8) Private (direct) commercial real estate equity: This segment of commercial real estate involves the acquisition and management of actual physical properties. (Topic 8) Public (indirect) commercial real estate - debt: This component of commercial real estate is constituted primarily by commercial mortgage-backed securities (CMBS). (Topic 8) Public (indirect) commercial real estate - equity: This segment of commercial real estate involves buying shares of real estate investment companies (REITs) and other listed real estate companies. (Topic 8)
113
Quantitative equity market-neutral: Investment strategies using broad types of quantitative models, some with lower turnover, fewer securities and inputs other than past prices, such as accounting variables, earnings forecasts, and economic indicators (Topic 9) Resampled mean-variance optimization: An improved adaptation of the Markowitz framework that explicitly recognizes that there is uncertainty in the future regarding the capital market assumptions driving the asset allocation model. (Topic 8) Risk premium: The increased expected return (usually expressed as an annual percentage rate) for bearing risk, typically defined as the expected return of a risky asset minus the risk free rate. In the futures market, it is the difference between the expected spot price and the futures price. (Topic 11) Roll Return: Also known as roll yield generated in a backwardated futures market is achieved by rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price. (Topic 8) Second order autoregressive reverse filter: It is an approach to generate an unsmoothed total real estate return series. This autoregressive process has more than one lag and thus gives a more generalized model than the first order autoregressive model (FOARF). (Topic 11) Selection bias: This bias arises because inclusion in a database is voluntary (i.e. it is at the discretion of a hedge fund manager). The existence of this bias implies that hedge funds in a database may not be representative of the universe of the industry. (Topic 11) Serial correlation of hedge fund returns: Research has shown that hedge fund index returns have serial correlation (autocorrelation), which implies that hedge fund current returns tend to be correlated to past returns. (Topic 11) Shadow banking system: Levered intermediaries such as hedge funds and structured conduits provided by SIVs that are largely unregulated and that provide liquidity to the financial markets by taking on risk. (Topic 10) Short reset loans: Loans with low teaser rates for the first two or three years, referred to as 2/28 and 3/27 hybrid sub-prime ARMs. The rates increase after the initial period. (Topic 9) Short-termism: Short-term thinking, related to group think, where an investor gets caught up in the current market mood and ignores the long-term view or fundamentals. (Topic 10) Side pockets: Separate accounts within hedge funds designed to hold investments that differ from the primary strategy of the funds. These investments may be more illiquid and treated separately as far as fees and redemptions are concerned. (Topic 7) Smoothing: A phenomenon that produces a lag effect and reduced volatility in valuationbased indices when compared to the underlying market, which is measured by more precise transaction-based indices. An important consequence of smoothing is that it causes risk to be underestimated. (Topic 11)
114
Special Investment Vehicle (SIV): A limited-purpose, bankruptcy-remote company that purchases mainly high-rated medium- and long-term assets from its parent company. The SIV funds these purchases with short-term ABCP, MTNs, and subordinated debt capital. (Topic 9) Special purpose vehicle (SPV): The legal entity (e.g., trust) that forms the core of collateralized obligation (CO) structures. The SPV is the entity that legally owns the collateral (e.g., funds, securities or other assets) and is the entity that issues the various tranches that have claims to the cash flows (senior, mezzanine and equity). (Topic 7) Stale prices: A term to describe prices when a firm does not change reported prices frequently, which makes it challenging for investors who want to measure the risk-adjusted performance of private equity, (Topic 11) Statistical arbitrage: Mean-reversion strategies which are short-term and highly technical; they use large numbers of securities, very short holding periods, as well as substantial computational, trading and IT infrastructure (Topic 9) Survivorship bias: In a hedge fund database, the average return of surviving (or live) funds in excess of the average return of all funds, both surviving and defunct. This bias amounts to roughly 2.5% a year. (Topic 11) Swap spread: A bet that the fixed side of the spread will remain higher than the floating side of the spread. (Topic 11) Synthetic hedge funds: Replication of hedge-fund-like returns using mathematical models. The idea is that these returns can then made available to investors at a lower cost than that arising from directly investing in hedge funds. (Topic 11) Systemic risk: The risk to the entire financial system as opposed to just one area. A general lowering of liquidity and an increase in risk aversion can affect all financial markets and the collapse of the system. (Topics 10 and 11) Tail risk: This is the possibility of extreme and rare events that can produce large losses. It is higher when the distribution of returns has fat tails, i.e., is leptokurtic. (Topic 10) Time varying factor exposure: Hedge fund managers may change their exposures as positions are closed out and new positions are opened. Depending on the duration of the trade, the effects of these changes will be evident in the factor exposures. (Topic 7) Toehold positions: Positions taken by private equity companies in the distressed securities of public companies in order to identify opportunities in distressed companies that they intend to take private. (Topic 7) Top-down approach: An approach in which the risk factors affecting diversified hedge fund portfolios are modeled. Fung and Hsieh propose a risk-factor model using seven factors to encompass the risk of diversified portfolios of hedge funds. (Topic 11)
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Uncertainty: Describes a situation where outcomes and probabilities are not known. According to Knight (1921), it is different from risk where the probabilities and outcomes are known. (Topic 10) Unlisted infrastructure funds: infrastructure funds not trading on exchanges. (Topic 7) Valuation: In the context of illiquid investments, it is one of the challenges associated with private equity or a private real estate fund. This is because: a) these investments trade infrequently, b) accounting rules tend to push general partners to account these assets at book value, and c) there is always uncertainty regarding the precision of asset valuations. (Topic 10) Waterfall Payment Structure: A payout scheme where cash flows are assigned to a range of low-grade to high-grade tranches. The high-grade or senior bonds are paid first, and the junior tranches do not get paid if the collateral pool becomes stressed in certain ways, e.g., there is a change in the collateral/liability or cash-flow/bond-payment ratios. (Topic 9)
116
Index: Level 2, Topics 711

A
Abatement Strategies, 78 Adjustment Strategies, 78 Alignment of interests, 94 Allocation drift, 7980 Alt-A mortgage loans, 64 Alternative alphas, 98 Alternative betas, 98 Arithmetic return, 38 Aspirational risk, 2932 Asset-backed securities, 1 Asset-backed security trust, 65 Asset-based style factors, 98 Constant mix, 1928 Constant-proportion portfolio insurance, 2128 Contango, 3435, 39, 4748, 52, 8586 Contingent capital arrangements, 10 Contrarian, 5961 Convergence, 14, 1618 Convergence of leveraged opinions, 99 Convex payoff curves, 1921, 2627 Credit enhancement, 65 Credit spread, 97
D
Dimson beta, 103 Distributions, 79
B
Backfill, 96 Backwardation, 47, 8586 Bankruptcy remote, 1 Barbell strategies, 3132 Basis, 86 Black-Litterman asset allocation, 4243 Bottom-up approach, 96 Buy-and-hold, 1927 Buy-to-own investing, 16
E
Emission credits, 11 Emission rights, 11 EU Allowances, 11 EU Emission Trading System, 11 Event loss swaps, 10 Exposure, 77 Exposure diagram, 24
C
Calendar spread strategy, 4849 Capital calls, 79 Capital-structure arbitrage, 97 Carbon funds, 12 Catastrophe bonds, 811 Catastrophe risks, 811 Cat-risk CDOs, 10 Centralized Clearing House, 71 Clean Development Mechanism, 12 Climate-related investments, 8 Collateralized commodity obligation, 3 Collateralized fund obligation, 23 Commitment strategy, 79 Commodity trigger swaps, 3 Compensation contract design, 94 Complex adaptive systems, 76 Concave payoff curves, 1921, 2627 Conditional factor models, 13
F
Factor-replication approach, 1213 First Order Autoregressive Reverse Filter (FOARF), 8893 Fixed income volatility, 97 Floor, 22, 2728 Full Information Value Index (FIVI), 8892
G
Geometric return, 38
H
Hazard rate, 96 Hybrid asset, 4 Hybrid funds, 1617
I
Illiquidity, 78, 104 Incentive fee, 95
117
Index: Level 2, Topics 711
Incubation bias, 96 Incubation period, 96 Industry loss warrants, 10
L
Lend to own debt financing, 16 Lifecycle, 4 Lifecycle stage, 4 Liquidation bias, 96 Liquidity conundrum, 7778 Listed infrastructure funds, 5 Listed private equity, 102 Lock-up, 16 Long/short equity, 5763 Lookback straddles, 96
Selection bias, 95 Serial correlation of hedge fund returns, 96 Shadow banking system, 77 Short reset loans, 64 Short-termism, 78 Side pocket, 15 Smoothing, 8687 Special Investment Vehicle, 6566, 6870, 77 Special Purpose Vehicle, 1 Stale prices, 100, 102103 Statistical arbitrage, 57, 61 Survivorship bias, 9596 Swap spread, 97 Synthetic hedge funds, 95 Systemic risk, 64, 73, 77, 99
M
Market integrity, 99 Market risk, 2932 Monoline insurers, 6567 Mortgage spread, 97 Multistrategy hedge funds, 95
T
Tail risk, 63, 73 Time varying factor exposure, 13 Toehold position, 16 Top-down approach, 96
U
Uncertainty, 7578 Unlisted infrastructure funds, 5
N
Normal backwardation, 3435
O
Option-based portfolio insurance, 2325 Valuation, 79
V W
Waterfall payment structure, 65
P
Payoff distribution approach, 1213 Personal risk, 2932 Positive feedback mechanisms, 68 Post-Venture Capital Index, 103 Private (direct) commercial real estate, 41 Public (indirect) commercial real estate, 41
Q
Quantitative equity market-neutral, 57
R
Risk premium, 8283 Roll return, 3537, 40
S
Second order autoregressive reverse filter, 88, 92
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CAIA Notes

September 2009 Exam Level II Book 2 Topics 7-11

Book 2 (Topics 7-11)

September 2009 Exam

About the ExamPrep Faculty

ERIK BENRUD, CAIA, CFA, FRM

DONALD R. CHAMBERS, CAIA

Navigating the CAIA Notes

CAIA Study Guide Learning Objectives

Copyright 2009 CAIA Association. All Rights Reserved.

Copyright 2009 CAIA Association. All Rights Reserved.

Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

Core Real Estate/Fixed Income

Source: Mansour and Nadji (2007)

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

RREEF Hypothetical Infrastructure Index

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 7: Structured Products, New Products and New Strategies

ability to replicate hedge fund returns.

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Topic 7: Structured Products, New Products and New Strategies

2. Superior Security Selection

Topic 7: Structured Products, New Products and New Strategies

Topic 7: Structured Products, New Products and New Strategies

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Topic 7: Structured Products, New Products and New Strategies

Copyright 2009 Institutional Investor, Inc. All Rights Reserved.

Topic 8: Asset Allocation

Rebalancing in Up Market None Sell Stock Buy Stock

Rebalancing in Down Market None Buy Stock Sell Stock

Shape of Payoff v. Stock Market Linear Concave Convex

Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance

Topic 8: Asset Allocation

Up Market Panel: Constant Mix:

Down Market Panel: Constant Mix:

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Topic 8: Asset Allocation

Down Market Panel: CPPI:

Topic 8: Asset Allocation

Total Portfolio Value

Total Portfolio Value

Topic 8: Asset Allocation

Total Portfolio Value

Total Portfolio Value

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Topic 8: Asset Allocation

Portfolios Stock Value