LEVEL I SCHWESER’S QuickSheet

Critical Concepts for the 2024 CAIA® Exam

PROFESSIONAL STANDARDS • Forms of hedge fund regulation: marketing • Dollar-weighted return: investment’s IRR,
and distribution, establishment, operational, considering all cash inflows and outflows.
AND ETHICS management, and reporting. • Time-weighted return: averaged return that
I. Professionalism • U.S. hedge fund regulation: funds are typically ignores the timing of cash inflows and outflows.
(A) Knowledge of the Law. exempt from regulation due to restrictions on • Performance measures for illiquid investments:
(B) Independence and Objectivity. total investors and investor qualifications. distribution to paid-in ratio (DPI), residual value
(C) Misrepresentation. • Short sale: borrow the security, sell it on the open to paid-in ratio (RVPI), and total value to paid-in
(D) Misconduct. market, and buy it back later. ratio (TVPI).
II. Integrity of Capital Markets Accessing Alternative Investments • Cash waterfall: provision describing how capital is
(A) Material Nonpublic Information. distributed to the fund’s investors.
• Types of alternative investment funds: fund
(B) Market Manipulation. structures are segmented by strategies that involve • Hurdle rate: rate of return that must be
III. Duties to Clients either public (liquid) or private (illiquid) securities. distributed to the limited partners before general
(A) Loyalty, Prudence, and Care. Public securities typically use open-end (evergreen) partners can earn any incentive fees.
(B) Fair Dealing. funds while private securities typically use closed-end
(C) Suitability.
Statistical Foundations
funds, drawdown funds, or PE-style funds.
(D) Performance Presentation. • Ex ante return distributions: use future, or
• Types of liquid alternative investments: skill- before-the-fact, returns.
(E) Preservation of Confidentiality. based replication, liquidity-based replication,
IV. Duties to Employers constrained clones, unconstrained clones, and • Ex post return distributions: use historical, or
(A) Loyalty. diversified/absolute return. after-the-fact, returns.
(B) Additional Compensation Arrangements. • Mean: The first moment of the distribution;
• Direct investing examples include solo investing,
(C) Responsibilities of Supervisors. measures the expected value of the returns.
partnership investing, and co-investing. Demand
V. Investment Analysis, Recommendations, and for direct investing is driven by ability to target
Actions • Variance: The second central moment of the
specific risks and exposures. distribution; measures the dispersion of the data.
(A) Diligence and Reasonable Basis.
(B) Communication with Clients and Prospective • Co-investing is detailed in side letter between GP • Skewness: The standardized third central moment
and co-investing LPs. Lock-step provisions keep of the distribution; measures the departure from
Clients.
the GP-LP relationship unchanged relative to symmetry in the distribution. If the skewness
(C) Record Retention.
general fund investors. exceeds 0, the distribution is positively skewed. In a
VI. Conflicts of Interest
(A) Disclosure of Conflicts. • Co-investing fee structures vary and include zero positively skewed distribution, mean > median. In
(B) Priority of Transactions. annual management fees and zero carried interest. a negatively skewed distribution, median > mean.
Carried interest can be replaced with promote, • Kurtosis: The standardized fourth central
(C) Referral Fees.
which is a performance-based fee for specific services. moment of the distribution; measures the degree
• Co-investing advantages: reduced fees, superior of peakedness in the distribution.
INTRODUCTION TO returns, targeted investing, diversification • Excess kurtosis: equals kurtosis – 3.
ALTERNATIVE INVESTMENTS management, dilution mitigation, dual layer
of deal review, improved monitoring, access to • Correlation coefficient: measures the strength of
invitation-only funds, and reduced J-curve. the linear relationship between the returns of two
What Is an Alternative Investment? assets. The correlation equals the covariance of
• Co-investing disadvantages: potentially
• Real assets: directly control rights to consumption returns for the two assets divided by the product
unbalanced portfolios, increased fiduciary risk,
rather than indirect financial claims to cash flows of their standard deviations.
conflicts of interest, disagreement between LPs,
generated by a firm. Real asset types include real and challenges with allocation of fees. • Spearman rank correlation: correlation of the
estate, infrastructure, intangible assets, natural rankings of the asset returns; preferred correlation
• Co-investing performance produced mixed
resources, and commodities. measure when a data series contains outliers.
results when compared to general fund investing.
• Hedge funds: private investment vehicles that
use investments that are available as a result of
• LPs competencies to pursue co-investing should
ρs = 1 −
6 ∑ di2
include: (1) internal expertise, (2) deal sourcing n(n2 − 1)
minimal regulatory restrictions. network, (3) ability to approve (or deny) deals
• Private equity (PE): includes equity securities quickly and efficiently, and (4) eye for risk • Autocorrelation: refers to the correlation over
that are not publicly traded. Categories include management. time for an asset.
venture capital and leveraged buyouts (LBOs). • Co-investing influences shape of J-curve: E[(R t − µ )(R t−k − µ )]
(1) lower (or zero) fees shorten J-curve, (2) k-order autocorrelation =
• Private debt: includes direct lending strategies, σt σt−k
distressed debt, and structured products. Structured immediate capital deployment shortens J-curve,
products segment cash flows of traditional (3) return dispersion is wider for co-investing, • Durbin-Watson statistic: tests for serial correlation
investments or link returns to market values to which amplifies J-curve, and (4) co-investing and will be close to 4 in the presence of strong
achieve risk, return, tax, or other objectives. follow-on investments lengthen the J-curve. negative serial correlation, close to 0 in the presence
• Primary goals of alternative investments: Quantitative Foundations of strong positive serial correlation, and close to 2
active management, absolute or relative returns, in the presence of no serial correlation.
• Converting simple interest rates to continuously
arbitrage, return enhancement, and return T
compounded rates:
diversification.
ln(1 + R) = =e
R ln( R m→∞ ) = R m→∞
-1
∑ (et − et−1 )2
The Environment of Alternative DW = t=2 T
Investments • Return on notional principal: equals the gain or
• Alternative investment structures: limited liability
loss on the derivative instrument divided by the ∑ et2
notional principal and can be expressed on a fully t =1
companies (LLCs), special purpose vehicles (SPVs),
or partially collateralized basis.
and special purpose entities (SPEs). • Jarque-Bera statistic: used to test data for
• Fully collateralized return: departures from the normal distribution by testing
• Fund structure documents: private placement
memoranda, partnership agreement, subscription Rfcoll = ln(1 + R) + Rf if the skewness and excess kurtosis jointly equal 0.
agreement, and management company operating • Partially collateralized return: n K 2 
JB = S2 + 
agreement. Rpcoll = [l × ln(1 + R)] + Rf 6  4  continued on next page...
INTRODUCTION TO ALTERNATIVE INVESTMENTS continued... • Ex ante asset pricing models: describe expected
• Forward price on stock: FT = P0e(r−q )T
future returns.
Financial Economics Foundations • Ex post asset pricing models: describe historical
• Cost of carry: financial difference between forward
market position and cash market position.
• Informational market efficiency: speed and extent returns.
to which security prices adjust to new market • Commodity forward price: FT ≤ P0e( r +c−y )T
• Simple linear regression: statistical method
information. that estimates a linear relationship between a • Rolling contracts: closing one contract near
Š Weak form efficiency: security prices fully dependent variable and a single independent settlement and opening another position on same
reflect all available security data on past prices variable. underlying asset with longer settlement time.
and volumes. • Ordinary least squares: method used to generate • Put-call parity: call + risk-free bond – put =
Š Semistrong form efficiency: security prices accurate estimates of regression residuals. This underlying asset.
fully reflect all publicly available information. relationship might encounter some data integrity • Option spreads: (1) calls or puts and (2) both
Š Strong form efficiency: security prices fully challenges in the presence of leptokurtosis, long and short positions on the underlying asset
reflect all publicly and privately available autocorrelation, or heteroskedasticity. (e.g., bull spread).
information. • Single-factor market-model-based regression • Option combinations: calls and puts on the
• Six factors affecting market efficiency: (1) asset equation: Rit - Rf = ai + bi(Rmt - Rf) + eit underlying asset (e.g., straddle).
size, (2) trade frequency, (3) trading frictions, • Hypothesis testing steps: • Option on portfolio:
(4) regulations, (5) information access, and Step 1: State the hypothesis.
(6) valuation accuracy. Poption = PlongN(d) – PshortN(d – v)
Step 2: Design the statistical test. • Black-Scholes call option model:
• Bootstrap the term structure of interest rates:
Step 3: Calculate the test statistic.
recursively estimate spot rates using zero-coupon c = SN(d1 ) − e−rT KN(d 2 )
and coupon bonds. Step 4: Reject or fail to reject the null hypothesis.
 ln(S / e−rT K )   v 
• Term structure of interest rate theories: unbiased • Null hypothesis: statement that the analyst d1 =   +  
v   2 
expectations theory, liquidity preference theory, attempts to reject. The null hypothesis is examined  
and market segmentation theory. using a test statistic such as the t-statistic. d 2 = d1 − v
• Implied forward rate: interest rate differential • Large test statistics indicate sampled data are far v = σs T
implied by current term structure of interest rates from expected, in which case the null hypothesis
between two dates. is rejected. If the test statistic is not large, then we • Black-Scholes forward option pricing model:
fail to reject the null hypothesis. Statistical tests
• Arbitrage-free models: calculate asset prices by are designed to disprove rather than to prove the c = e−rT  FN (d1 ) − KN (d 2 )
assuming that no arbitrage opportunities exist. null hypothesis.  F 
• Binomial trees: represent possible outcomes in  ln  
• Alternative hypothesis: represents the behavior   K    v 
a variable and can be used to price outcomes in d1 =  + 
equities, interest rates, and derivatives.
that exists if the null hypothesis is false.  v   2 
 
• P-value: equals the probability of observing a  
• Duration: a measure of a bond’s price elasticity sample estimate as extreme as the one observed,
relative to changes in its yield. d2 = d1 – v
assuming the null hypothesis is true. It does not
• Structural credit models: value debt securities indicate the strength of a relationship. • Currency option pricing model:
by incorporating factors including the corporate • Significance level: denotes the probability that a option price = e−r *S* N (d1 ) − e−rT SN (d 2 )
structure (e.g., debt-to-asset ratio) and the significant result may be due to random chance.
volatility of the firm’s assets. • Option sensitivities related to a call option:
• Confidence level: equals 100% – the significance Š Delta (first derivative of option sensitivity to
• Reduced-form credit models: use market prices level.
for liquid securities to infer the implied default underlying asset price): ∂c / ∂S
probability. Once calibrated, reduced-form • Type I error: occurs when a true null hypothesis Š Gamma (second derivative of option price
models can be used to price illiquid securities. is rejected. sensitivity to underlying asset price): ∂ 2 c / ∂S2
• Expected credit loss: • Type II error: occurs when an untrue null Š Vega (option price sensitivity to changes in
hypothesis is not rejected. volatility of underlying asset): ∂c / ∂σS
PD × EAD × LGD = PD × EAD × (1 - RR)
• Selection bias: refers to exclusion of certain Š Theta (option price decline relative to passage
where: of time): ∂c / ∂T
observations from sample, causing distortions in
PD = probability of default relevant characteristics of the population. Š Rho (option price sensitivity to changes in
EAD = exposure at default riskless interest rate): ∂c / ∂r
• Survivorship bias: a type of selection bias that
LGD = loss given default occurs when funds or companies no longer in Measures of Risk and Performance
RR = recovery rate existence are excluded from sample. • Semivariance: measures downside risk. Use
• Advantages of reduced-form models: ability • Self-selection bias: fund managers decide to T – 1 as denominator if calculating sample
to extract information from market prices and report or not report performance. As a result, semivariance.
flexibility. affected databases likely exhibit an upward bias. ∑  R t − E (R ) 2
 
• Disadvantages of reduced-form models: • Data mining: vigorously testing data until valid for R t <E(R )
semivariance =
potential lack of adequate market data needed relationships are found. T
to calibrate the model, sensitivity to key • Data dredging: practice of overusing statistical
assumptions, limited historical default rates, and • Value at risk (VaR): interpreted as the worst
tests to identify significant relationships with little possible loss under normal conditions over a
no guarantee that historical default rates represent regard for underlying economic rationale.
future default rates. specified period at a given confidence level.
Derivatives and Risk-Neutral Valuation • Parametric VaR:
• Risk-neutral approach to bond pricing:
• Forward contract: bilateral contract that obligates
K × RR K one party to buy and one party to sell specific
parametric VaR = z × σ × days × value
B (0,1)= λ × + (1 − λ )×
(1 + r ) (1 + r ) quantity of asset, at set price, on specific date.
K • Conditional VaR (CVaR): expected loss given
= (λ × RR + (1 − λ)) • Futures contract: forward contract that is that the portfolio return already lies below the
(1 + r ) standardized and exchange traded. prespecified worst-case quantile return.
• Approximate probability of bond default: • Forward rate agreement (FRA): contract settled • Monte Carlo VaR: involves developing a model
credit spread in cash where one side of transaction offers that simulates risk factor values and estimates how
λ ≈ specific, fixed rate (FRA rate) over period of time changes in risk factors affect the fund’s returns.
1 − RR and other side agrees to pay that rate.
• Historical VaR: data are simulated from realized
historical returns.
 Š Two-asset portfolio VaR: VaR assuming perfect REAL ASSETS Other Real Assets
positive correlation.
Natural Resources and Land • Equity prices of commodity producing firms:
VaRp = VaR1 + VaR2 driven by commodity price changes, equity
• Pure play: direct investment that contains only
Š VaR assuming perfect negative correlation: market conditions, and internal operations.
the risks and returns of the underlying asset.
VaR p = VaR1 − VaR 2 • Master limited partnership (MLP): publicly
• Binomial option pricing model: can be used traded investment that provides access to
Š VaR assuming zero correlation: to value undeveloped land as a call option. The operationally intensive real assets. LPs are direct
components of the call option are as follows: strike owners of the MLP and are not subject to taxes at
VaR p = VaR12 + VaR 22 price, time to expiration, underlying asset, option the partnership level; investors can benefit from
payoff, exercising the option, and option moneyness. tax-free distributions.
• Index benchmarking: used to isolate variables • Land banking: purchase undeveloped land for • Investable infrastructure has seven key
including asset allocation, security selection, and development. characteristics:
market timing. Š Paper lots: vacant lots with zoning approval for 1. Public use of the asset or service.
• Ratio-based performance measures: development. 2. Monopolistic power to set prices.
Š Sharpe ratio: appropriate if the portfolio is the Š Blue top lots: lots where development has 3. Government related.
investor’s total stand-alone portfolio. begun including rough grading. 4. Provides an essential service.
E(R p ) − R f Š Finished lots: lots ready for construction with 5. Generates cash.
SR = all development fees paid. 6. Conducive to privatization.
σp 7. Capital intensive long-term projects.
• Return management methods for real assets:
Š Treynor ratio: appropriate when comparing 1. Market manipulation via trading activity. • A discounted cash flow approach is the best way
components of a well-diversified portfolio. 2. Valuation model manipulation. to value an intellectual property (IP) investment.
E(R p ) − R f 3. Selective appraisals. p × CF1
TR = VIP,0 =
4. Favorable marking. r−g
βp
• Advantages of investing in timberland: • Negative costs: the all-in costs from shooting and
Š Sortino ratio: portfolio’s expected return (1) low correlation with stock and bond returns, producing a film.
in excess of the target return scaled to the (2) investment serves as inflation hedge, (3) real
portfolio’s target semistandard deviation. • Visual works of art: have poor risk-adjusted
asset investment, (4) flexible harvesting schedule,
returns and are an unattractive asset class for
E(R p )− R τ and (5) multiple uses for timber products.
institutional portfolios.
Sortino ratio = • Disadvantages of investing in timberland:
TSSD • Patent investors: gain exposure to R&D without
(1) natural disasters can destroy investment, bearing operational risks associated with operating
Š Information ratio: portfolio’s expected return in
(2) investment values are tied to cyclical industries, companies.
excess of the benchmark return (alpha) scaled
(3) timber supplies are not fixed, (4) technology
to the portfolio’s tracking error. • Risks associated patent investments:
and recycling may diminish demand for timber,
E(R p ) − R benchmark and (5) long investment horizon. (1) illiquidity, (2) operational/technological
IR = risks, (3) obsolescence risk, (4) expiration risk,
TE p Commodities (5) macroeconomic/sector risks, (6) regulatory
Š Return on VaR: • Hotelling theory: exhaustible commodities’ real risk, and (7) legal risks.
E(R p ) prices will increase at the real interest rate. Real Estate Assets
RoVaR = • Cost of carry: measure of holding costs for a
VaR • Potential advantages of real estate:
commodity. (1) diversification with other investments,
• Risk-adjusted return measures: • Returns to a fully collateralized future position: (2) hedge against unexpected inflation, (3) achieve
Š Jensen’s alpha: Rfcoll = collateral yield + spot return + roll yield. absolute returns, (4) earn cash inflows, (5) provide
tangible assets, (6) portfolio targets investment
α p = R p −  R f + βp (R m − R f ) • Normal backwardation: current forward price is
  less than the expected future spot price. strategy, and (7) portfolio is diversified with REITs.
Š M 2 approach: • Normal contango: current forward price is greater • Potential disadvantages of real estate:
σ than the expected future spot price. (1) heterogeneity, (2) lumpiness, (3) illiquidity, and
M2 = R f + m  E(R p ) − R f  (4) market inefficiency.
σp   • Four reasons commodities have low correlation
with traditional assets: (1) supply and demand, • Real estate styles (from least risky to most risky):
Š Average tracking error: equals the average Š Core real estate: generates most returns from
(2) correlation with inflation, (3) correlation with
difference between the portfolio return and the income rather than price appreciation.
the business cycle, and (4) commodities are a cost
benchmark return. Š Value-added real estate: generates most returns
to producers.
• Smoothing: illiquid assets falsely appear less risky from price appreciation, with some returns
• Lower expected commodity returns in the future:
than they actually are due to appraisal process. from income.
(1) technology improves commodity extraction,
Alpha, Beta, and Hypothesis Testing (2) less demand due to more efficient use of Š Opportunistic real estate: derives almost all
commodities, and (3) financial institutions have returns from price appreciation.
• Beta: measure of systematic (market) risk.
no convenience yield and are unlikely to hold • Private market real estate capital stack: Real
• Alpha: measure of investment return in excess of physical commodities. estate capital ranges from the most senior position
the risk-adjusted benchmark. (usually the first mortgage) to the least senior
• Commodity futures indices are different position (common equity). Mezzanine debt
• Beta nonstationarity: tendency for beta to shift from traditional indices: they are unleveraged,
over time. Examples of beta nonstationarity include occurs after the first and second mortgages, but
collateralized, and long only. before preferred and common equity in the stack.
beta creep, beta expansion, and market timing.
• Commodities tend to be negatively correlated with • Ratios used to measure the risk of a commercial
• Beta drivers: exposures to nondiversifiable traditional assets: act as a defensive investment.
systematic risk (e.g., process drivers). real estate loan:
• Historical returns of commodities (2000–2022): balance of the loan
• Alpha drivers: provide exposures to active return LTV =
factors (e.g., product innovators). Most alternative Š Sharpe ratio: 0.1. market value of the property
assets are alpha drivers. Š 3.8% average return vs. 5.7% global equities
return. NOI
• Spurious correlation: correlation that does not interest coverage ratio =
Š 23.3% standard deviation of returns greater annual interest payment
result from a true or direct relationship. than global equities return of 15.7%. NOI
• Causality: exists when one variable at least partly Š Negatively skewed (–0.6) and have positive DSCR =
determines the value of another variable. excess kurtosis (1.8). total loan payment
• Correlation: measure of the strength of linear Š Extremely large maximum drawdown (–87.2%). NOI
fixed charges ratio =
relationship between variables. all fixed payments
• Commercial mortgage types: (1) construction • Compound options in VC: at each stage of PRIVATE DEBT
mortgages (i.e., property development), (2) financing, an investor may be given the option to
mini-permanent construction mortgages, (3) invest additional money in the start-up business Private Credit and Distressed Debt
transitional mortgages (i.e., acquiring existing or let the option expire.
property), and (4) permanent mortgages. • Private credit: collection of nonpublic loans with
• Characteristics of growth equity investments: higher yields than traditional bonds.
• Commercial real estate investment: (1) pooled (1) minority shares and unlikely to controlling
private market real estate funds, which are stakes, (2) investment firms focus on improving • Distressed debt: debt of firms in financial distress
open-end funds, closed-end funds, club deals, margin and profits from launch of new products or going through the bankruptcy process.
co-investments, or syndications, (2) separately or business lines, (3) financing is often to fund • Default risk: risk that the issuer of a bond will not
managed accounts (SMAs), which are discretionary working capital and expanding production but meet required interest or principal payments.
or non-discretionary, and (3) direct investments, can also include investing in assets that will
provide greater cost control or efficiency, and • Loans: privately traded securities that often have
which involve direct acquisitions or joint ventures.
(4) free cash flow (if any) is reinvested. less liquidity relative to bonds, but also have less
Real Estate Methods default risk and less interest rate risk.
• Objectives of buyouts: (1) deleverage, (2) margin
• Development yield: stabilized annual NOI / total improvement, and (3) multiple expansion. • Leveraged loans: second-lien senior loans that
development costs. reside near the top of the capital stack.
• Management buyout (MBO): LBO led by the
• Expected sales price: projected stabilized NOI / current management team. • Direct lending: nonbank lenders loan money
market cap rate. to businesses. Underwriting is focused more on
• LBO firms: earn fees through (1) management
Š Market cap rate > development yield results in collateral than on cash flows.
fees, (2) profit-sharing fees, (3) privatization fees,
a loss on sale. (4) break-up fees, and (5) divestiture fees. • Mezzanine debt: hybrid of debt and equity and
Š Market cap rate < development yield results in • Management buy-in (MBI): LBO led by a falls between senior secured debt and equity in
a gain on sale management team from outside the firm. a company’s capital structure. Used by middle
• Comparable sales approach: uses recent market companies to bridge financing gaps.
• Compound annual return on an LBO:
transaction values of similar properties, adjusted  
• Mezzanine transactions:
for subject property differences.   Š Management buyouts.
 1 
• Discounted cash flow approach: involves  firm value at the end of  debt paydown 
 Š Growth and/or expansion.
   
estimating revenues and expenses over the life of  the debt paydown period  period
  Š Acquisitions.
 −1
a project and then discounting the cash flows to  equity porttion of  Š Recapitalizations.
time 0 at the required rate of return.  LBO transaction 
Š Real estate financing.
NOI1 NOI2 Š Leveraged buyouts.
V0 = + +… • LBO categories:
(1 + k )1 (1 + k )2 Š Efficiency buyouts.
Š Bridge financing.
NOIi NSP • Unique characteristics of mezzanine debt:
+ + Š Entrepreneurship stimulators.
i i Š Board representation.
(1 + k ) (1 + k ) Š Conglomerates.
Š Borrower restrictions.
• Public real estate investment: includes open-end Š Buy-and-build strategies.
Š Flexibility.
real estate mutual funds, options and futures on Š Turnaround strategies.
real estate indices, exchange-traded funds, closed- Š Negotiations with senior creditors.
• LBO exit strategies: sale to a strategic buyer, buyout- Š Subordination.
end investment funds, and equity real estate to-buyout, sale via IPO, new LBO, or refinancing.
investment trusts (REITs). Š Acceleration.
• Merchant banking: the purchase of nonfinancial
• REIT performance: from 2000–2022, relative to Š Assignment.
firms by financial institutions.
global equities, equity REITs had higher returns, Š Takeout provisions.
higher volatility, a higher Sharpe ratio, a more • Internal rate of return (IRR): geometric average
of returns over the holding period; IRR is main • Mezzanine debt investors: mezzanine funds,
negative skew, a higher positive excess kurtosis, insurance companies, traditional senior lenders,
and a larger maximum drawdown. measure of success for private equity investments.
and traditional venture capital firms.
• SPAC mergers: are regulated as mergers and not
as IPOs, which avoids SEC scrutiny in the U.S. • Variable-rate mortgage: interest rate fluctuates up
SPACs avoid the long lead time of an IPO. or down during loan term based on movement of
PRIVATE EQUITY Private Equity Funds
a published index. The sum of the index rate plus
the margin rate determines the rate on mortgage.
Private Equity Assets • Venture capital life cycle stages: • Interest rate caps and floors: limit amount the
• Primary forms of private equity: 1. Fundraising. interest rate may increase or decrease in any one
Š Venture capital: financing for start-up 2. Sourcing investments. adjustment period and over the life of the loan.
companies that can’t get funding from 3. Investment commitment.
4. Investment management. Introduction to Structuring
traditional sources.
Š Growth equity: provides private companies 5. Fund liquidation. • Collateralized mortgage obligation (CMO): a
with working capital and financing for growth. • Keys to successful VC investing: selecting top pool of mortgages that have been structured into
managers and maintaining adequate vintage year various tranches.
Š Buyouts: taking private company public or
public company private. diversification. • Advantages of structural models: (1) uses
• VC investors expect a return 4%–8% higher than equity market data, which is reliable and easily
• Stages of financing for a start-up: obtainable, and (2) flexible enough to price
that of the stock market due to increased business
1. Angel investing: $50,000–$500,000; friends, risk, liquidity risk, and idiosyncratic risk. related fixed-income securities.
family, wealthy individuals; developing a
prototype and writing a business plan. • Leveraged buyout (LBO): designed to take a public • Disadvantages of structural models:
company private by purchasing all outstanding (1) distortions in equity prices will misprice debt
2. Seed capital: $1 million–$5 million; venture
stock using a large quantity of borrowed capital. securities, (2) data on firm liabilities may be
capital source; alpha testing, beta testing, and
• Club deal: occurs when multiple LBO firms work unavailable, and (3) computed values from simple
finishing the prototype.
together on the details of a single deal. models are too low for short-term debt, high-
3. First or early capital stage: $2 million or more; quality debt, and severely distressed debt.
second-generation customer testing and initial • Long-hold fund benefits: (1) reduced transaction
sales. costs, (2) fully invested capital over longer • Collateralized debt obligations (CDOs):
4. Second or late expansion stage: $5 periods, (3) deferred capital gains taxes, and approximately same as CMOs in terms of
million–$25 million; profitable or breaking (4) flexible exit timing. structure, but include various debt instruments in
even; high growth. • Long-hold funds drawbacks: (1) higher illiquidity, addition to mortgages.
5. Mezzanine stage: $5 million–$25 million; final (2) lower IRRs, (3) less attractive to some
stage before IPO or sale to private. managers, and (4) more difficult to add value. continued on next page...
PRIVATE DEBT continued... Š Obligation acceleration. Macro and Managed Futures Funds
• Waterfall of cash flows: way in which cash flows Š Obligation default. • Global macro funds: opportunistic in nature,
are prioritized through tranches. Equity tranche Š Repudiation/moratorium. use a top-down approach to analyzing global
gets whatever is left. Š Government intervention. macroeconomic events, and can invest anywhere
• CDO life cycle: in the world based on forecasts of economic
• Motivations for entering into CDSs: growth, currency movements, and changes in
1. Ramp-up period—CDO manager builds the Š Isolation of credit risk. interest rates.
collateral portfolio.
Š Efficient shorting of credit risk. • Primary risks of global macro funds: market risk,
2. Revolving period—CDO manager reinvests cash
Š Ease of establishing synthetic positions. event risk, and leverage risk.
flows and manages the portfolio.
Š Linking of markets. • Discretionary strategies: use a subjective
3. Amortization period—principal payments are
made to CDO security holders. Š Liquidity during periods of market stress. approach to trade using fundamental data.
• Balance sheet CDO: used to manage assets and • Risks of credit derivatives: excess risk taking, • Systematic strategies: rely on a consistent,
their credit risk exposure on the balance sheet. liquidity risk, pricing/model risk, counterparty objective adherence to trading rules using technical
risk, and basis risk. data. Trading rules must be tested for degradation.
• Arbitrage CDO: used to earn arbitrage profit
between the collateral return and the CDO • Trend-following strategies: exploit predictable
funding cost. price patterns after a trend has begun. It is
• Synthetic CDO: uses credit derivatives to gain
HEDGE FUNDS common practice for trend-following analysts to
use moving averages to identify trends and price
exposure to the assets underlying the CDO. Structure of the Hedge Fund Industry patterns. Trading rule is to buy (sell) when the
• Cash flow CDO: purchases and holds underlying price is above (below) moving average.
• Total annual management fees: percentage of
assets to maturity; generally has a fixed maturity. Š Simple moving average (SMA): the arithmetic
assets under management.
• Market value CDO: trades underlying securities; average (i.e., equally weighted average) of the
mgt fee %(NAVbeg) + {max[0,(incentive fee %) closing prices.
does not have a fixed maturity.
× (GR – mgt fee – hurdle)]}
• Cash-funded CDO: referenced assets are sold to Š Weighted moving average (WMA): an
• Annuity view of hedge fund fees: demonstrates arithmetically declining average of more
SPV. This reduces required regulatory capital and
management’s incentive to earn large returns over distant prices.
credit exposure concentration. Proceeds can be
a long period of time. Š Exponential moving average (EMA): uses a
used to make other loans or reduce liabilities.
• Option view of incentive fees: suggests that smoothing factor, λ, to determine the influence
• Distressed debt CDO: uses distressed debt as
increasing the volatility of the fund will increase of recent prices relative to prior moving averages.
the primary collateral component; some tranches
can be investment grade even though collateral is the present value of future management fees. EMAt(λ) = λPt–1 + λ(1 – λ)Pt–2 + λ(1 – λ)2Pt–3 +
speculative grade. incentive fee payout = max[i(NAVend – NAVbeg),0] ...
• Hedge fund CDO: backed by hedge funds of • Incentive fee option: expressed using the Black- • Non-trend-following strategies: attempt to profit
various strategies. Scholes option pricing model. from inconsistencies in market prices. Often use
• Single-tranche CDO: synthetic CDO; one tranche i × 40% × NAV × σ1 the Relative Strength Index (RSI):
sold to investors with remainder retained by issuer. 100
• Empirical studies find evidence suggesting RSI = 100 −
U
Credit Risk and Credit Derivatives managers take less risk to preserve their incentive 1+
fees when the incentive option is far in the money; D
• Key risks of CDOs: this behavior is referred to as the lock-in effect. • Countertrend strategies: attempt to profit by
Š Underlying collateral risk (most important). There is also evidence of managing returns and trading against the current trend.
Š Financial engineering risk. massaging returns. • Commodity pool operators (CPOs): general
Š Differences in interest payment receipt • Categories of hedge fund strategies: partners in a commodity pool who typically hire
periodicity and interest payment dates. Š Equity strategies: have some degree of professional money managers called commodity
Š Basis risk. systematic exposure. This strategy historically trading advisors (CTAs) to manage the funds.
Š Compression of credit spreads. had the highest absolute value of correlation • Managed futures risks: transparency risk, model
Š Changes in the shape of the yield curve. with equity markets. risk, capacity risk, liquidity risk, regulatory risk,
Š Event-driven and relative value strategies: and lack of trends risk.
Š Correlation risk.
take positions based on some event that has Event-Driven and Relative Value
Š Risk shifting. occurred or is likely to occur. Historical return Hedge Funds
• Copula approach: commonly used to model patterns are similar to the insurance industry,
CDOs because it incorporates interdependencies with small profits for most time periods with • Event-driven strategies: similar payoffs to binary
in the credit risk of the underlying assets. occasional large losses. options and selling insurance.
Š Absolute return strategies: attempt to earn Š Under the insurance view, the fund earns
• Major categories of credit derivatives:
positive returns regardless of the direction of relatively small risk premiums for providing
Š Single-name vs. multi-name instruments: protection against large losses associated with
the financial markets. Absolute return programs
single-name instruments reference a single unfavorable events.
allow investors to achieve improved risk-return
entity, while multi-name instruments reference Š Under the binary call option view, the fund
performance by capturing the benefits of fund
multiple entities. gains if the event takes place and the option
diversification.
Š Funded vs. unfunded: only funded credit is in the money and loses if the event fails to
Š Diversified strategies: strategies like global
instruments involve the transfer of notional occur, and the option expires worthless.
macro funds, systematic diversified funds,
principal. Š Under the binary put option view, the fund
multistrategy funds, and FoFs diversify across
Š Nonsovereign entities vs. sovereign entities. different investment themes. An FoF program writes put options and has payouts consistent
• Credit default swap (CDS): only makes a combines individual hedge funds in an effort to with writing out-of-the-money options.
payment if a credit event occurs. diversify away idiosyncratic risk. • An activist investment strategy involves:
• Total return swap (TRS): credit protection seller • Representativeness: extent to which the Š Identifying corporations that do not maximize
receives the reference asset total return in exchange characteristics of the sample are similar to the shareholder wealth.
for a fixed payment, and assumes credit risk of the characteristics of the entire hedge fund universe. Š Investing in positions that benefit from
asset; credit protection buyer retains ownership of There are numerous biases that impact a sample’s changes in corporate governance.
asset, pays total return, and receives a fixed payment. representativeness (e.g., survivorship bias,
Š Executing favorable corporate governance
selection bias, instant history bias, liquidation
• ISDA payment trigger events: bankruptcy. changes.
bias, participation bias, style drift, and
Š Failure to pay. investability). Š Key players in financial activism: active
Š Restructuring. initiators, active followers, and passive followers.
 Š Traditional merger arbitrageurs: use leverage • Multiple-factor scoring models: generate a single ADDITIONAL STRATEGIES
to buy stock of the target firm and short sell trading signal based on combining scores from
stock in the acquiring firm. numerous anomalies. Funds of Funds (FoFs)
Š Distressed debt hedge funds: invest in • Pairs trading strategies: match stocks based on • Benefits of FoFs: diversification, low minimum
securities of corporations in bankruptcy or systematic risk. A long position is established in investments, economies of scale, informational
corporations with a high risk of bankruptcy. the undervalued stock, and a short position is advantages, liquidity, access to closed funds,
Š Capital structure arbitrage: refers to holding held in the overpriced stock. ability to negotiate reduced fees, regulatory
a long position in relatively undervalued protection, currency hedging, leverage, and an
• Limits to arbitrage: related to time and size educational role.
securities (senior debt or preferred stock) and a constraints of hedge fund managers, market
short position in relatively overpriced securities structures, and inability to establish short • Disadvantages of FoFs: double layer of fees,
(junior debt or common stock), resulting in a positions due to market restrictions or lack of performance fees are not netted, adverse tax
hedged position. supply of shares. consequences, lack of transparency, effects of
Š Event-driven multistrategy funds: combine investor cash flows, and less control.
countercyclical event-driven strategies to gain • Primary risks for equity hedge funds: (1) equity
market risks, (2) quantitative vs. fundamental • Phases of private equity portfolio investing:
diversification benefits. (1) portfolio construction, (2) fund selection
strategies, (3) concentrated positions and liquidity,
• Relative value strategies: establish hedged and (4) regulatory changes. (15–50 funds), and (3) ongoing monitoring.
positions with a long position in one security and • Advantages of PE FoF investing: (1) diversification,
a short position in a related security. Strategy has (2) professional management, (3) enhanced access,
very little market risk and tends to profit during
normal market conditions. DIGITAL ASSETS and (4) lower capital commitments.
• Disadvantages of PE FoFs: (1) additional layer
• Classic relative value strategy trade: identifies
abnormal spreads between two related prices or
Distributed Ledger Technology (DLT) of fees, (2) loss of direct connection with GPs,
(3) less transparency, and (4) lack of liquidity.
rates and establishes a position that anticipates • DLT: shared dataset that records which entities
convergence to normal levels. own which assets; exists in decentralized networks, • Factors driving interest in the PE FoF market: (1)
which are operated by many users rather than one ease of accessing PE funds, (2) better opportunities
• Classic convertible bond arbitrage trade: involves for smaller PE programs, (3) complement
the purchase of a company’s convertible bonds. central entity.
to existing PE programs, and (4) increasing
• Classic dispersion trade: takes long positions in • Blockchain: digital ledger where a series of data complexity of PE operational due diligence.
options on individual equities and short positions blocks are linked chronologically together using
cryptography. Verifying and adding new blocks • PE FoF approach will reduce return dispersion
in options on a related index.
uses a consensus mechanism: relative to owning individual PE funds. VC FoFs
• Volatility arbitrage strategies: capitalize on have the highest reduction in dispersion.
differences in the implied volatility that exists Š Proof of work (PoW): requires miners (with
large computing power) to generate many • Theoretical diversification estimation approach
between option prices on a particular stock.
random guesses until the correct hash is found. for a portfolio of hedge funds is based on the
• Variance swap: variance buyer agrees to pay the assumption that all assets in the portfolio have
variance seller a cash price (known as the swap Š Proof of stake (PoS): randomly selects
validators based on assets staked. equal weights, volatility, and systematic risk.
strike price or strike variance) in exchange for σ
receiving realized variance. Variance swap payoff • Decentralized finance (DeFi): new area of finance σportfolio = f
n
equals: that offers financial services using DLT and
(
vega notional value × strike variance )
realized variance − blockchain technology.
Š DeFi applications: (1) decentralized exchanges,
Equity-Linked Structured Products
• Six types of wrappers: (1) OTC contracts,
2 × strike variance (2) oracles, (3), lending and borrowing, (2) medium-term notes/certificates/warrants,
• Volatility swap: similar to variance swap but uses (4) insurance, (5) yield farming, and (3) funds, (4) life insurance policies, (5) structured
volatility rather than variance. Volatility swap (6) derivatives. deposits, and (6) Islamic wrappers.
payoff equals: • Bitcoin: cryptocurrency that relies on a global • Types of exotic options: binary options, Asian
vega notional value × (realized volatility – strike decentralized network of miners to verify options, barrier options (including knock-in and
volatility) transactions through a PoW system. knock-out options), active options, lookback
• Fixed-income arbitrage strategy: manager buys • Ethereum: public blockchain like Bitcoin, but options, spread options, and quanto options.
one fixed-income security and sells a similar fixed- instead uses a PoS system; also uses decentralized • Methods for pricing structured products:
income security in an attempt to profit as the applications (dApps) and heavily relies on smart
Š Partial differential equation (PDE) approach:
spread between their prices declines over time. contracts.
assumes structured product’s value can be
• Relative value multistrategy funds: contain a • Smart contracts: third-party code/programs on determined by predicting movement of
combination of multiple arbitrage strategies. They a blockchain that automatically execute when underlying asset and then formulating a hedge.
are formed to increase fund capacity, increase predefined conditions are met. Š Simulation approach: hypothetical paths for
diversification, and increase opportunities for • Stablecoins: digital assets whose values are pegged underlying asset’s value are used to estimate
investment due to the cyclical nature of markets. to another digital asset or fiat currency (e.g., how structured product would pay out under
Equity Hedge Funds US dollar). each situation.
• Central bank digital currencies (CBDCs): digital Š Building blocks approach: breaks down structured
• Equity hedge funds: establish long positions product into easy-to-analyze assets, estimates value
in undervalued equities and short positions in cash issued by central banks; generally pegged to
the country’s own fiat currency. of each piece, and then sums the values.
overvalued equities. Common strategies include
long/short funds, equity market-neutral funds, • Tokens: digital assets that can be transacted • Eight investor motivations for structured products:
and short-bias funds. between two parties on the blockchain; can be (1) enhanced returns, (2) enhanced liquidity,
fungible (each asset worth exactly the same) or (3) improved risk management, (4) improved
• Accounting accruals: noncash transactions that diversification, (5) improved access to top managers,
can cause an imbalance between net income nonfungible (each asset is unique).
(6) regulatory advantages, (7) reduced income taxes,
and cash flows of a firm can be used to identify • Digital asset valuation models: (1) stock-to-flow and (8) reduced transaction taxes.
mispriced stocks. model, (2) addressable market model, (3) cost
total accruals = ΔCA – ΔCL – Δcash – of production model, (4) discounted cash flow
ΔSTdebt – D&A model (DCF) model and price multiples, and ISBN: 978-1-0788-4129-0
(5) Metcalfe’s law.
• Standardized Unexpected Earnings (SUE): used
to measure earnings surprises. • Digital asset risks: (1) financial and investment
SUE = (EPS – average EPS estimate) / standard risks, (2) technology risks, (3) blockchain
deviation of earnings misses protocol-related risks, and (4) other risks, such as
fraud and regulation. 9 781078 841290

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