Last Revised: 09/16/2024

2025 Level 2 - Alternative Investments

Learning Modules Page

Introduction to Commodities and Commodity Derivatives 2

Overview of Types of Real Estate Investment 20

Investments in Real Estate through Publicly Traded Securities 43

Hedge Fund Strategies 50

Review 61

M.M152248032.

This document should be used in conjunction with the corresponding learning modules in the 2025 Level 2 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2024, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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Institute.

© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.

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 Last Revised: 09/16/2024

Introduction to Commodities and Commodity Derivatives

a. compare characteristics of commodity sectors

b. compare the life cycle of commodity sectors from production through trading
or consumption

c. contrast the valuation of commodities with the valuation of equities and bonds

d. describe types of participants in commodity futures markets

e. analyze the relationship between spot prices and futures prices in markets in
contango and markets in backwardation

f. compare theories of commodity futures returns

g. describe, calculate, and interpret the components of total return for a fully
collateralized commodity futures contract

h. contrast roll return in markets in contango and markets in backwardation

i. describe how commodity swaps are used to obtain or modify exposure to

commodities

j. describe how the construction of commodity indexes affects index returns

M.M152248032.

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 Last Revised: 09/16/2024

Commodities

⇒ Commodity – a physical good attributable to a Page 1

LOS a
natural resource that is tradeable and supplied
- compare
without substantial differentiation by the general public
- trade in physical (spot) & futures/forward markets

- potential for diversification benefits in a Page 2

multi-asset class portfolio due to low (historically) LOS a
- compare
correlation w/ bonds & stocks (some possible inflation
hedging benefits)
from use as a consumable
- derive their value
as inputs to the production process
Sectors/ as per Thompson Reuters/Core Commodity CRB Index
· Energy · Industrial (base) metals · Livestock
· Grains · Precious Metals · Softs (cash crops)
M.M152248032.
1. Energy – most economically valuable sector
1) Crude Oil – must be refined to be useful
Brent – North Sea
- different grades
WTI – US
(trade at
varied prices) Bonny Light – Nigeria
Mayan Crude – Mexico

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 Last Revised: 09/16/2024

Page 3
1. Energy LOS a
1) Crude Oil – low in density & flows freely at - compare
room temperature ⇒ Light
- easier to process, yielding more valuable gasoline & diesel
- low in sulfur content ⇒ Sweet
- weather ➞ temporary impact (e.g. hurricane)
· as economies grow, oil demand increases (availability of
oil at affordable prices also facilitates growth)
extraction
· drivers of supply & demand technology
politics refining
business cycle usage
e.g./ shale oil – supply availability due to extraction technology
electric vehicles, solar – reduce demand for oil products
US & Canada – ban offshore drilling in Artic waters

1. Energy Page 4
LOS a
2) Natural Gas – can be used directly
- compare
(heavier compounds – NGLs – are also extracted

liquids
- categorized as either:
a) associated gas – coming from an oil well (a co-product of oil)
can be: - sold in spot markets
- burned off
- re-injected into the oil field to maintain
pressure (keeps extraction costs low)
b) unassociated gas – on its own (where oil is not present)
- Storage/transportation cost high ➞ need to keep gas under
M.M152248032.
pressure
- liquified natural gas (LNG) – for transport by ships
- must be cooled to -260℉
- primary demand – electric generation
cooling
- also weather dependent
heating

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Page 5
1. Energy LOS a
3) Refined products – heating oil, gasoline, - compare
jet fuel, propane, etc…
- refined products typically have a short shelf life (availability
measured in days)
- refineries typically located on major coastlines & ports
(that is where the oil is delivered)
- planned refinery maintenance ➞ switch over from summer gas
(typically low demand periods) to winter gas

2. Grains/ · Corn · Soybean · Wheat · Rice

- can be stored season over season (sometimes multiple
seasons)
- some crops can be grown multiple times/yr.
- levels of heat & precipitation determine yields & acreage
(droughts kill, floods drown)

Page 6
3. Industrial (base) Metals/ can be stored for years
LOS a
- mined ore that is processed into
- compare
copper, aluminum, nickel, zinc, lead, tin & iron

used in production, construction, infrastructure

- supply is weather insensitive, but demand may be affected

- tied very closely with GDP growth
- political issues ➞ strikes, development approval, environmental
concerns, regulation

feeder
4. Livestock/ · hogs · cattle M.M152248032. · sheep · poultry
live
- depends on low cost inputs (feed) i.e. grains
- high grain costs lead to short-term oversupply
as herds are slaughtered (mid-term price increases)
- tied to GDP growth (especially in emerging/developing
economies)

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Page 7
4. Livestock/ LOS a
Weather – affects health & weight - compare
- winters tough for cattle, heat & humidity tough for hogs
- limits weight gain
avian flu
- disease
mad cow disease
porcine epidemic diarrhea virus (PEDv)

fear of consumption can drive prices down

price effect uncertain
lost supply can increase prices
5. Precious Metals
- straddle monetary & industrial world
gold, silver, platinum ⇒ act as stores of value
- also used in jewelry, auto parts, electronics
(makes up about 50% of demand, other than gold)
- high storability

Page 8
6. Softs (cash crops) · cotton, coffee, sugar, LOS a
cocoa - compare
- called ‘cash crops’ since they are grown to be sold,
not consumed for subsistence

- primary source – countries close to the equator

- weather is an important supply factor, global growth

is an important demand factor

M.M152248032.

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Commodity Production Life Cycle

- will reflect (and amplify) changes in storage, Page 9

LOS b
weather political/economic events that shift demand & supply
- compare
- Short life cycle ⇒ rapid adjustment
- long life cycle ⇒ limits ability of market to react
⇒ Energy/ crude futures
reflect both demand for crude

Extraction Transportation Storage Refining Transportation

50-100 days 1-10 days days to 3-5 days 5-20 days
a few
months
natural gas can be consumption of crude
consumed at this stage oil products begin
- trading in futures will reflect - futures reflect pricing
pricing just prior to this point at this point

Page 10
⇒ Energy/
LOS b
· Refineries – affect demand for crude - compare
& supply of oil products

costly to build - long lead times – built to a specific

oil grade
· Pipelines – affect supply of oil & market reach

costly to build, long lead times

· Exploration – affects supply of crude

- over 120 different grades of oilM.M152248032. - both 1000

Brent barrels
- 2 most traded futures contracts
West Texas Intermediate
(CL)
- contracts for gasoline – RB – 42,000 gallons
nat. gas – NG – 10,000 MBTU
heating oil – HO – 42,000 gallons

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Page 11
⇒ Industrial/Precious Metals
LOS b
- ore & finished products can be stored - compare
for years (but storage costs, risks of ownership, financing
costs)
e.g./ Copper

extracting ➞ grinding ➞ concentrating ➞ roasting ➞ smelting

ore ～ 2% into metal content removes heated to 1200℃

metal content powder reaches 25% sulfur to melt calcine
- powder now - metal content
called calcine reaches 60%

➞ converting ➞ electro-refining ➞ storage/logistics

air blown into purified to typically held in a bonded

the liquid 99.99% warehouse until shipped
- 99% pure copper to end user

Page 12
⇒ Industrial/Precious Metals
LOS b
- smelting/processing relies on economies of scale - compare
- large facilities with high utilization rates
∴ when supply > demand, difficult to cut production
- overproduction continues until smaller players
drop out
- long lead times + large costs to add extraction or processing
capacity
- monthly futures contracts with no seasonality (unlike energy)

⇒ Livestock/ - all year round M.M152248032.

- good weather, high quality pasture & feed accelerate

weight gain
- timing to maturity increases with size

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⇒ Livestock/ poultry – a few weeks Page 13

hogs – a few months LOS b
- compare
cattle – a few years
HE
sow gives birth 6 mos. to get slaughter weight
after summer heat (soymeal & cornmeal)

1-2 years – feeder cattle ⇒ 6-12 months LE

(grass fed) GF (feed lot ➞ corn-based diet)
～ 1200 lbs.
⇒ Grains/
hard
northern winter
hemisphere wheat
(North Am.)

Page 14
⇒ Grains/ - demand for grains is year round
LOS b
- storage facilities supply year round
- compare
⇒ need to understand old crop vs. new crop
(inventory) (coming harvest)
for futures trading
⇒ Softs/ commodities in this sector differ significantly
e.g./ coffee

M.M152248032.

- harvested somewhere all year round (best are from

high-altitude plantations, picked in middle of harvest)

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 Last Revised: 09/16/2024

⇒ Softs/ - newly planted trees take about Page 15

LOS b
3-4 years to produce
- compare
- once picked, laid out in sun for 2-3 weeks to dry
(dry method ～ 50%)

or/ soaked in water to remove pulp, bean then fermented

12-48 hours, then dried 24-36 hours
- then shipped – roasting done by buyer before shipping to sales
points
robusta – lower quality, less flavour
2 main varieties futures traded in London
arabica
futures traded in New York

Valuation

Page 16
estimation of
FV LOS c
future profitability
- contrast
CF CF CF TV and cash flows

PV = DCF Stocks
bonds

financial assets

no cash inflows

future possible ➞ based on

price supply & demand
-CF -CF -CF of the item
PV= M.M152248032.
discounted
potential cash outflows
commodities - transportation
- storage
- physical assets
- tangible items with intrinsic value affects the forward
price curve

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Participants
Page 17
1) Hedgers – eliminate price risk
LOS d
- may be a registration requirement - describe
(hedgers face different margin requirements
since they make/take delivery)

2) Traders/Investors 1) informed investors

2) liquidity providers
3) arbitrageurs

3) Exchanges – standardized contracts

4) Analysts – perform research, conduct policy

5) Regulators

Spot vs. Futures Price

- spot ➞ current price for immediate delivery Page 18

LOS e
- futures ➞ price today for some future delivery
- analyze
· difference between spot & futures price called the ‘basis’

futures futures
price price
spot - price difference
between one
contract & another
is called the
calendar
spread
M.M152248032.
spot
Backwardation Contango
𝒕 𝒕
- bearish indicator - bullish indicator
- expected future spot - expected future spot price
price = lower = higher
Note: for commodities

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Page 19
Contango LOS e
$ (negative $ - analyze
spot
calendar
spread)
Backwardation
(positive
calendar spread)

spot

𝒕 𝒕
Trading strategy 1. Trading strategy 3.
Buy long-dated contract Sell long-dated contract
Sell short-dated contract Buy short-dated contract

roll over short position roll over long position

each month each month

Trading strategy 2. short long-dated Trading strategy #4 Buy

contract long-dated contract

Theories of Futures Returns

Page 20
⇒ theories to explain the shape of the futures LOS f
curve - compare
1) Insurance Theory (Keynes) – a.k.a. ‘Theory of Normal Backwardation’
- producers will use commodity futures for insurance
by locking-in prices, thereby having more predictable revenue
- this selling forward pushes down prices in the future
⇒ further, prices would have to be lower in the future to
induce a buyer to take price risk (remuneration for the
M.M152248032.

speculator)
∴ such a resulting price curve would be ‘normal’
⇒ not backed by observation however:
i.e. backwardation does not generate positive returns
contango does not generate negative returns
(statistically significant that is)

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2) Hedging Pressure Hypothesis/ Page 21

LOS f
- producers will want to sell to hedge
- compare
- end users will want to buy to hedge

- if hedging demand from producers & end users is in balance,

then a flat futures curve should develop

- if hedging demand from producers > hedging demand from end users
then futures prices would have to be lower to induce
speculators to fill the gap ⇒ Backwardation

- if hedging demand from producers < hedging demand from end users
then the futures prices will be higher ⇒ Contango
Problem: producers tend to be more persistently exposed to
price risk than end-users/consumers

Page 22
3) Theory of Storage/
LOS f
- compare
Futures price = spot price + direct storage costs – convenience yield

- high when - low when stocks - low when stocks

demand > supply are low are high
- low when - high when stocks - high when stocks
supply > demand are high are low

M.M152248032.

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Components of Futures Returns

- total return with futures is different from Page 23

LOS g
total return on the physical asset
- describe
- futures price return (spot yield) - calculate
roll return (roll yield) - interpret
collateral return (collateral yield)

Price Return/ - change in price in the front month contract

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
𝐩𝐫𝐢𝐜𝐞 𝐫𝐞𝐭𝐮𝐫𝐧 =
𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

Roll/ - as investors move from contract to contract, must sell

the current contract on/near expiration and buy
the next dated contract
- likely a price difference depending on the shape of
the futures curve

Page 24
e.g./
LOS g
- 11 Jan contracts = $110 exposure - describe
10 - rolling forward to Feb, need - calculate
12 contracts = $108 exposure - interpret
(opposite for contango)
9

Jan Feb
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
. 9 %′𝐚𝐠𝐞 𝐨𝐟 𝐭𝐡𝐞
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐑𝐨𝐥𝐥 𝐫𝐞𝐭𝐮𝐫𝐧 = × 𝐩𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐛𝐞𝐢𝐧𝐠
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐫𝐨𝐥𝐥𝐞𝐝
e.g./ 𝟏𝟎 − 𝟗
= . 𝟏 𝐨𝐫 𝟏𝟎% M.M152248032.
𝟏𝟎

- the amount of return generated in a backwardated futures

market and profiting from the convergence towards a
higher spot price

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 Last Revised: 09/16/2024

Page 25
3) Collateral Return/ yield from bonds/cash
LOS g
used to maintain the position - describe
- when calculating E(R), most indices will use S.t. T-Bills - calculate
- interpret
Notes/ price return on front month contracts typically different
from the price change of the physical commodity
contract–standardized (quality, delivery)
physical markets – not to the same degree

- roll at T, 𝚫spot at T, 𝚫spot at T, 𝚫spot > 𝚫futures

= 𝚫futures spot < 𝚫futures
futures

spot 𝚫𝐟𝐮𝐭𝐮𝐫𝐞𝐬
− 𝚫𝐬𝐩𝐨𝐭
= 𝐫𝐨𝐥𝐥
futures
futures spot neg. roll
no roll yield pos. roll
T T T

Roll Return – More Detail

- periods of either backwardation or contango Page 26

LOS h
do not persist indefinitely
- contrast
- roll return is also not very indicative of price return
(i.e. pos. roll does not necessarily imply pos. price return)
- roll return is very sector dependent

(statistically strong neg. roll return)

M.M152248032.

longer storage periods

minimal
storage

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Commodity Swaps

- commodity swap – a legal contract involving Page 27

LOS i
the exchange of payments over multiple
- describe
dates as determined by specified reference prices or
indexes relating to commodities
often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts

2) may want a specific

grade/quality of oil
hedged

3) may want to maintain

flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months
pays $25/barrel
for the 9-month period
· called an ‘excess return swap’

M.M152248032.

overall (-9)
+ 16

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Page 29
- OTC, customizable LOS i
· Total return swap – one party receives payment based - describe
on the change in the level of an index (multiplied
by some notional amount)

· Basis swap – periodic payments are exchanged based on the

values of 2 related commodity reference prices
that are not perfectly correlated
- often used between a highly liquid futures contract
as an illiquid but related material

· variance swaps – for a specific commodity

· volatility swaps – relative to the volatility of a reference

commodity

Commodity Index
used as a benchmark to evaluate Page 30
⇒ Index LOS j
broader moves in commodity pricing
- describe
for macroeconomic or forecasting purposes
the basis for an investment vehicle

- differ based on:

a) the breadth of coverage - # of commodities & sectors
b) relative weighting – assigned to each component & how
those weights are determined
c) the rolling methodology – has a direct impact on the roll return
d) methodology & frequency of rebalancing the weights
of the individual commodities,M.M152248032.
sectors & contracts - potential
for positive rebalancing return (assuming mean reversion
of prices)

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 Last Revised: 09/16/2024

- differ based on: Page 31

LOS j
e) governance – rules-based ⇒ quantitative
- describe
methodology for a-d above
- selection-based – an index committee selects
the commodities

- the Index should be replicable to be useful – must be

investable (i.e. translated into a representation of the
asset class)
- use of exchanges vs. physical trading
- contracts/markets with liquidity
- care used in selecting long-dated contracts
⇒ S&P GSCI – based on 24 commodities
- uses only contracts with a minimum level of
trading volume

⇒ S&P GSCI/ Page 32

LOS j
- uses a world-production weighting scheme
- describe
- largest weight to the most valuable commodity
of the basis of physical trade value
(crude oil highest single weight, energy highest sector
weight)
- rolling methodology ⇒ owning the front contracts
- highest liquidity
- supply/demand shocks have most impact

⇒ Bloomberg Commodity Index/ (BCOM – formerly DJ–USB)

- 22 commodities, selection-based
- 33% cap on size of sectors,
M.M152248032.
2% minimum floor
- results in very different index composition &
weights
- same rolling methodology as S&P GSCI

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Page 33
⇒ Deutsche Bank Liquid Commodity Index/
LOS j
- uses a fixed weighting scheme - describe
- rolling a bit complicated ⇒ attempts to maximize
backwardation & minimize contango

more e.g./ June contract 1% backwardated to May

active July contract 3% 3%/2 months = 1.5%/month
roll
mgmt. ∴ roll May into July

⇒ Thompson Reuters/Core Commodity CRB Index

- 19 commodities, fixed weights, selection committee
- rolling ⇒ own front or second front month

Page 34
⇒ Rogers International Commodity Index (RICI)/ LOS j
- 37 commodities, fixed weights, selection committee - describe
- not all components are denominated in USD

- Rebalancing Frequency/
- rebalancing is more important if a market is
frequently mean reverting (more peaks to sell, more
valleys to buy)
- can lead to underperformance in a trending market

- TR/CC CRB & RICI – monthly rebalancing

- Other – annual
- S&P GSCI & BCOM ➞ typically have lower rebalancing costs
(production weights) M.M152248032.

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Overview of Types of Real Estate Investment

a. compare important real estate investment features for valuation purposes

b. explain economic value drivers of real estate investments and their role in a
portfolio

c. discuss the distinctive investment characteristics of commercial property types

d. explain the due diligence process and valuation approaches for real estate
investments

e. discuss real estate investment indexes, including their construction and

potential biases

M.M152248032.

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Types of Real Estate Investment

Page 1/
Characteristics & Key Features
Heterogeneous assets
Fragmented local markets
Range from core to opportunistic
Economic use (residential / commercial)
Property-specific (location, size, age, amenities)

Page 2/
Net Operating Income = Effective gross income - opex - Maint. allowance
(NOI)
Effective gross income = Gross rent + other rev. - vacancies - concessions
Operating expenses (opex) = Fixed costs (prop. taxes, insurance, services, repairs)
+ variable costs (utilities, etc.)
Property maint. allowance = maintenance CAPEX to maintain property’s
current level of income generation

M.M152248032.

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Page 3/

Page 4/

Capital Structure
Loan to value (LTV) ratio = Mortgage Debt / Property value

Debt service coverage (DSC) = NOI / Debt service

Equity dividend rate = (NOI - Debt service) / Initial equity

M.M152248032.

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Page 5/

Page 6/

Depreciable base = original cost

+ improvements
* does not include land ( infinite
life
)
After-tax cash flow = Pretax CF – taxes
M.M152248032.

Taxes = 𝐭 × (NOI - interest expense - depreciation expense)

tax rate

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Page 7/

RE Classifications
REITs
RE mgmt. + development
(REOCs)

Property classes
Age, local income levels,
property condition, amenities

Debt based RE investments (mortgages)

are typically classified as fixed income
investments.

Page 8/

Basic Forms
NOI ➞ income-based return at
property level

FFO ➞ common measure of

REIT performance

FFO = NI + D & A - Net gains

from property sales

Risks
M.M152248032.
Economic ➞ activity levels, demographics, supply, capital costs
Property specific ➞ management, obsolescence, environmental, tech changes
Level of leverage

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Page 9/

Page 10/

Economic value drivers

Macro factors ➞ GDP growth, job creation, wage growth
RE sector sensitivity ➞ interest rates, credit cycles
RE cycle ➞ recovery, expansion, oversupply, recession

M.M152248032.

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Page 11/

Portfolio Characteristics of RE
Sources of return ➞ Income and Capital appreciation
Characteristics ➞ Bond-like CFs or Equity-like speculative
step-up clauses, indexed rents, overage rent

Lease terms vs. investment horizon ➞ rollover risk

Role of RE in Portfolios
Inflation hedge ➞ rents rise, property value increases
Diversification benefits ➞ low correlation with stocks, bonds
Tax benefits ➞ depreciation, REIT structure

Page 12/

M.M152248032.

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Page 13/

Page 14/
Commercial Property Types
Residential ➞ multi-family
Non-residential ➞ office, industrial/warehouse, retail, hospitality
Mixed use ➞ combine residential, office, retail
Specialty ➞ student housing, senior living, self storage, data centers,
parking, cell towers, etc.

Residential Property Investment Characteristics

Single family and multi-family
Multi-family categorization ➞ location (urban, suburban), structure
(high rise, garden, townhouse), amenities
Demand ➞ local economic conditions, job growth, affordability
Shorter lease terms compared to non-residential
M.M152248032.

CF analysis ➞ Gross Potential Rental Income (GPRI)

GPRI = Market rent × Rentable space

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Page 15/

Page 16/

M.M152248032.

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Page 17/

Office Property Investment Characteristics

Range from single-tenant facilities to multi-tenant buildings
Demand ➞ service industry employment, work from home

Industrial / Warehouse Investment Characteristics

Wholesale / retail distribution, manufacturing, storage
Properties may be purpose built & difficult to repurpose
E-commerce driving demand for warehouse space

Retail Property Investment Characteristics

Shopping centers, malls, standalone properties, grocery, restaurants
Impacted by shift to e-commerce, changing consumer behaviors
Proximity to workers and residents influences rents, occupancy

Page 18/

Hospitality Property Investment Characteristics

Hotels and resorts with varied business models
Business hotels affected by economic cycles
Leisure hotels rely on consumer confidence, disposable income
Destination hotels ➞ luxurious, lots of amenities, mgmt.-intensive

Mixed-Use Development Investment Characteristics

Combined residential, office, and retail space
Income generated from different activities, linked to local econ.

Specialty Property Investment Characteristics

Student housing, senior living, self storage, data centers, etc.
Each subsegment has different investment risks and returns
M.M152248032.

Ex: self-storage has low capital requirements and opex with

flexible pricing

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Page 19/

Page 20/

M.M152248032.

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Page 21/

Real Estate Due Diligence

public
RE lacks transparency and standardization compared to markets
Detailed due diligence ➞ essential to estimate income & appreciation
Helps ensure accurate valuations and legal compliance

Page 22/
Market Review and Outlook
Assess current prices, economic uses, demand/supply changes, macro factors
Current Lease Review
Current tenant rents/creditworthiness, market rents, vacancies, lease length
Future Lease Outlook
Costs/incentives for renewals, re-leasing challenges, zoning/legal changes
Financial Review
Analyze historical financials, Is current NOI sustainable?
Documentation Review
Ensure property is free of liens, tax obligations, compliant w/zoning & environ. regs.
Property Inspection and Service Agreements
Comprehensive property survey: physical, engineering, environ. inspections
Review of all building systems, foundation,
M.M152248032.
utilities, service agreements
Evaluate property management if not owner-managed
Address any discrepancies through remediation or price adjustments

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Page 23/

Real Estate Valuation Approaches

Income Approach ➞ Estimate future NOI, discount to PV
Direct Capitalization Method ➞ value based on single year’s NOI
DCF Method ➞ Project series of NOI with terminal value
Cost Approach ➞ Estimate cost to reproduce or replace
adjust for depreciation and other factors
Sales Comparison Approach ➞ compare recent sales prices of
similar properties, adjust for differences

Income Approach Direct Capitalization Method

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐍𝐎𝐈
Property value =
𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐳𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐞

Capitalization rate (cap rate) = r - g

Page 24/

M.M152248032.

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Page 25/

Income Approach Direct Capitalization Method (con’t.)

Most appropriate for properties that generate consistent NOI
If not, project a normalized or stabilized NOI instead

Income Approach DCF Method

𝐧
𝐍𝐎𝐈𝐭"𝐢 𝐓𝐞𝐫𝐦𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞
Property value = O +
𝐢%𝟏 (𝟏 + 𝐫)𝐢 (𝟏 + 𝐫)𝐧

𝐍𝐎𝐈𝐧 (𝟏 + 𝐠)
Terminal value =
𝐫−𝐠

Page 26/

M.M152248032.

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Page 27/

Going-in cap rate

Cap rate based on first year
of ownership used for
initial annual cash flow

Terminal cap rate

based on expected income
for the period after the
anticipated sale of property

Page 28/
Cost Approach
Replacement cost ➞ expense of buying land and constructing
a new property that has same economic use as
subject property, then make necessary adjustments
Investors should not pay more than cost of vacant land
+ development of comparable property

M.M152248032.

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Page 29/

Sales Comparison Approach

Relative valuation approach similar to multiples
used in equity valuation
Must identify units of comparison

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Application of Real Estate Valuation Methods
Income Approach ➞ Best for income-producing properties
with consistent NOI
Cost Approach ➞ useful when comparing cost of new
construction to market value
Sales comparison approach ➞ Most reliable in markets
with frequent transactions of similar
properties

Consider multiple valuation methods for a

comprehensive analysis

M.M152248032.

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Real Estate Investment Indexes

Track market performance
Provide benchmarks for investments and managers
Measure property income and total return performance,
fund performance, and listed security returns

Private Market Indexes

Appraisal-Based or Transaction-Based
Not investable

Public Market Indexes

comprised of listed equity or debt securities
often investable through mutual funds, ETFs, UCITS

Page 35/

Appraisal-Based Indexes
Rely of professional estimates of property values
Examples: Global Real Estate Fund Index (GREFI),
National Council of Real Estate Investment
Fiduciaries (NCREIF)

NOI - CAPEX + (END Mkt. value -

Holding period return = Beg. Mkt. value
Beg. Market value

Equivalent to single period IRR if property was

purchased at beginning M.M152248032.
of period and sold at end of
period.

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Page 36/

Page 37/

Transaction-Based Indexes
Based on actual transactions rather than appraisals
Infrequency of transactions an issue, addressed through
econometrics techniques such as regression analysis
Repeat sales index
Relies on multiple sales of the same property
When same property sells twice, change in value between
sales dates indicates how market conditions have changed
Hedonic index
Does not require repeat sales of same property
Controls for property differences using regression
analysis on characteristics like size, age, and location
M.M152248032.

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Advantages and Disadvantages of Index Type

Appraisal-Based Indexes
Useful to compare investment managers if all are using
appraisal values to measure returns
Less reliable for comparisons with other asset classes
that are publicly traded
Suffer from appraisal lags, causing delays in reflecting
market changes
Infrequent appraisals can cause smoothed returns,
which underestimate volatility
Transaction-Based Indexes
Tend to lead appraisal-based indexes, more timely
and responsive to market changes
May introduce noise due to statistical estimation

Page 39/

Adjusting for Appraisal Lag

Appraisal lag can lead to underestimated volatility
and overestimated Sharpe ratios
Unsmoothing requires an assumption on how smoothing occurs
Reverse smoothing process to estimate true returns
Model current observed price

𝐑∗𝐭 = 𝐚𝐑 𝐭 + (𝟏 − 𝐚) 𝐑∗𝐭$𝟏

Then reverse smoothing process by solving for 𝐑 𝐭

𝐑∗𝐭 𝟏−𝐚
𝐑𝐭 = +, - 𝐑∗𝐭$𝟏
𝐚 𝐚
M.M152248032.

𝐑∗𝐭 = observed return at time 𝐭 𝐑∗𝐭#𝟏 = observed return at 𝐭 − 𝟏

𝐚 = coefficient that reflects speed that actual returns
are reflected in index, (0 ≤ 𝐚 ≤ 1), higher 𝐚 ➞ more rapid adj.

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Public Real Estate Equity Indexes

Most common type track public equity REITs
typically categorized by industry classification or region

Real Estate Fixed Income Indexes

Include MBS and covered bonds
risks include prepayment risk ➞ risk that some or all
of principal is repaid at a different speed than expected
extension risk ➞ repaid later than expected
contraction risk ➞ repaid earlier than expected
M.M152248032.

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M.M152248032.

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Investments in Real Estate through Publicly Traded Securities

a. discuss types of publicly traded real estate securities

b. justify the use of net asset value per share (NAVPS) in valuation of publicly
traded real estate securities and estimate NAVPS based on forecasted cash net
operating income

c. describe the use of funds from operations (FFO) and adjusted funds from
operations (AFFO) in REIT valuation

d. calculate and interpret the value of a REIT share using the net asset value,
relative value (price-to-FFO and price-to-AFFO), and discounted cash flow
approaches

e. explain advantages and disadvantages of investing in real estate through

publicly traded securities compared to private vehicles

M.M152248032.

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Real Estate Investments

Page 1/
➞ Types of Publicly Traded Real Estate Securities/

a) Real Estate Investment Trusts (REITs)

a) equity REIT - own, operate (maybe develop)

income-producing real estate
b) mortgage REITs - make loans, or hold mortgage securities,
backed by real estate

b) Real Estate Operating Companies (REOCs)

- taxable
- REOC structure used when a jurisdiction does not have a
tax advantaged REIT regime in place
or/ engage to a large extent in the development of properties
(with the intent to sell)
or/ if they offer other non-qualifying services ➞ brokerage, 3rd party
property management

Page 2/
➞ Types of Publicly Traded Real Estate Securities/

b) Real Estate Operating Companies (REOCs)

- primary cash flows from the sale of properties
- reinvest cash flow rather than distribute large dividends

c) Mortgage-back securities (debt) - covered in fixed income

➞ REIT structures/ corporations or trusts

- tax-advantaged, required to distribute 90%-100% of taxable
earnings
> 75% of assetsM.M152248032.
in real estate
> 75% of income from rental or interest income

- may have min. number of shareholders, max. share ownership,

min. number of properties, maximum asset concentration,
maximum level of non-rental income
- most US REITs are self-managed and self-advised
- externally managed relies on property management companies

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Page 3/
➞ Advantages/

1/ greater liquidity - publicly traded

2/ transparency - share price, quarterly financials, annual audit
3/ diversification - geography, property type
4/ high-quality portfolios
5/ active professional management
6/ high, stable income - predictable, recurring, contractual revenue
7/ tax efficiency - at corporate/trust level

➞ Disadvantages/
- lack of retained earnings - more frequent secondary offerings
- constrained in the types of assets the own

- will own taxable REIT subsidiaries (TRS)

- concentrate non-qualifying revenue there

Page 4/
+ premium = potential overvaluation
➞ Net Asset Value per share
- discount = potential undervaluation
(NAVPS)
key word - over/under valuation may
largest component of be justified
intrinsic value

IFRS - Investment Property - owned for the purpose of earning either

rental income or price appreciation
- valued with cost model or fair value model
- method must be disclosed all changes affect net income
cost ➞ dep. method, useful life, + FV - must be able to reliably determine
M.M152248032.
FV on a continuing basis
FV ➞ how determined, reconcile
beg. + end. FV balances

U.S. GAAP - cost model only tends to - overstate dep.

- understate carrying values

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Page 5/
NAVPS - difference between assets and liabilities all
taken at market value, divided by the number of
shares outstanding

MV assets ➞ appraised value of properties (if available)

or 𝐍𝐎𝐈Q𝐜𝐚𝐩 − 𝐫𝐚𝐭𝐞 (comparables)

(- goodwill, DTA,
deferred financing exp.) + other assets
- MV liabilities
(-DTL)

# of shares outstanding

Page 6/

result of straight-lining rent

(may be pos. or neg.)

reflect a full year’s impact of

acquisitions

value of other tangible assets

M.M152248032.
$𝟐, 𝟗𝟏𝟒, 𝟏𝟗𝟖
= $𝟓𝟐. 𝟑𝟑 𝐍𝐀𝐕𝐏𝐒
𝟓𝟓, 𝟔𝟖𝟗

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Page 7/
- since comparables are from the private market,
so are cap-rates and values per square foot
- NAV reflects the value of a REITs/REOCs assets
to a private market buyer

- may or may not be the same as the value that a

REIT/REOC investor may use
- helps account for some of the discount/premium range
- NAV also does not reflect value that a mgmt. team can add
(or subtract) from NAV
- other NAV issues
NAV can become subjective in illiquid markets
undeveloped land, very large properties with few/no comparables,
specific use properties ➞ all complicate NAV
- since REITs/REOCs offer liquidity, r should be lower, ∴ should trade
at a premium (can also attract better mgmt.)

Page 8/
➞ FFO/AFFO: widely accepted and reported measure of
the operating performance of a REIT

FFO = Net Income

+ Dep. ➞ since RE often appreciates over the long-term, Dep.

does not reflect economic reality
+ Amort. ➞ leasing commissions, tenant
improvements/allowances

+ losses
➞ on sale of properties - do not represent sustainable
- gains
normal income
+ impairments
+ writedowns M.M152248032.

AFFO (FAD - funds available for distribution)

= FFO
+/- non-cash rent
- maintenance-related CAPEX and leasing commissions

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Page 9/
➞ FFO/AFFO: AFFO is superior to FFO as a measure of
economic income since it takes into consideration
the CAPEX needed to maintain the economic
income of the property
- also more reflective of dividend-paying ability ex. # 30/31

- open to more variation and error in estimation than FFO

Relative valuation measures

h versus historical multiples
versus other REITs or
𝐏1
𝐅𝐅𝐎
𝐏1 - based on net income available to equity, thus
𝐀𝐅𝐅𝐎 represent levered income
𝐄𝐕1
𝐄𝐁𝐈𝐓𝐃𝐀 - measures income before the leveraging effects of debt
- facilitates like-for-like valuation comparisons

drivers of multiples 1/ expectations for growth of FFO/AFFO

- higher expectations, higher multiple

Page 10/
drivers of multiples
2/ risk associated with the underlying real estate
- cash flow volatility associated with asset type,
quality, age, market conditions, etc…

e.g. apartments less risky CF vs. hotels

higher multiples

3/ risks associated with the company’s capital structure and access

h to capital
- as leverage ↑, multiples ↓ since r ↑ as risk ↑
- investors anticipate equity offering

+/ widely accepted P/FFO ➞ most frequently used multiple

M.M152248032.

readily available through market data providers (FF0)

-/ may not capture the intrinsic value of all real estate assets
(esp. non-income producing assets, e.g. undeveloped land)
P/FFO ignores cap. reinvestment necessary to maintain income levels
- P/AFFO does, wide variations in assumptions exist

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Page 11/
LOS n - calculate/interpret - mini case study
LOS o - explain

M.M152248032.

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Hedge Fund Strategies

a. discuss how hedge fund strategies may be classified

b. discuss investment characteristics, strategy implementation, and role in a

portfolio of equity-related hedge fund strategies

c. discuss investment characteristics, strategy implementation, and role in a

portfolio of event-driven hedge fund strategies

d. discuss investment characteristics, strategy implementation, and role in a

portfolio of relative value hedge fund strategies

e. discuss investment characteristics, strategy implementation, and role in a

portfolio of opportunistic hedge fund strategies

f. discuss investment characteristics, strategy implementation, and role in a

portfolio of specialist hedge fund strategies

g. discuss investment characteristics, strategy implementation, and role in a

portfolio of multi-manager hedge fund strategies

h. describe how factor models may be used to understand hedge fund risk
exposures

i. evaluate the impact of an allocation to a hedge fund strategy in a traditional

investment portfolio

M.M152248032.

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Hedge Fund Strategies

Page 1
- The Investment Thesis: additional alpha + diversification LOS a
benefits - discuss
Common Characteristics
1/ Legal/Regulatory – accredited investors only (min. income/net worth)
- liquid alts. ➞ MF/ETF structures for the more liquid HF
strategies, retail investors
2/ Flexible mandates – Few Investment constraints
3/ Large Investment Universe – traditional assets + private securities, HY debt,
distressed securities, derivatives
4/ Aggressive Investment Style – shorting, concentration, leverage
5/ Liberal use of Leverage – loans and derivatives
6/ Liquidity Constraints – lock-up periods, liquidity gates, exit windows
7/ Relatively high fee structure – mgmt. + incentive fees
1-2% 10-30%

Page 2
➞ Classification/ LOS a
- discuss

single manager funds (i.e. one strategy or style)

Equity - equity market return and risk characteristics
Event-Driven – corporate events (governance, M&A, bankruptcy)
Relative-Value – relative valuation between two or more securities,
exposed to credit & liquidity risk
Opportunistic – top-down approach, multi-asset opportunity set
M.M152248032.

Specialist - strategies that require specialized skill or knowledge of

a specific market

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Page 3
➞ Equity Strategies/ Long-Short Equity LOS b
- discuss
- reliance on fundamental
research
- most managers specialize in a
specific geography, sector or style
- some are more generalist
and avoid complex sectors

➞ strategy is a mix of extracting alpha

on long and short side from single-
name stock selection combined with
some net long embedded beta

the less risk factor exposure, the

more leverage risk exposure

Page 4
➞ Equity Strategies/ Dedicated Short/Bias LOS b
- discuss
+ activist short
selling
➞ take a short position then
present research publicly
➞ reputation effect may help

increasing returns when the

market declines, 𝐫𝐟 or decreasing
returns when the market rises
- bottom-up approach (deep-dive)
- difficult to get mgmt. cooperation
M.M152248032.
- flawed business models, high &
unsustainable debt levels, poor
governance, questionable actg.
etc.

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Page 5
➞ Equity Strategies/ Equity Market Neutral LOS b
- discuss
➞ 𝐄(𝛃𝐏 ) = 𝟎
➞ typically try to be sector and
industry neutral as well
(pairs trading, stub trading, multi-class
➞ more diverse holdings trading)
- adjusted often (daily, hourly)
must balance
neutrality with the costs
of rebalancing
often seen as preferred
replacements for FI during
low return periods or YC is
flat
➞ since 𝛃 = 𝟎, require leverage to
generate meaningful returns

Equity Strategies
Page 6
Short bias L/S
LOS b
Dedicated Market long-only - discuss
Short neutral (100% +)
(60%-120%)
Leverage low high low
Volatility high low high
𝛃 exposure negative neutral positive
Return Correlation negative zero positive
Orientation deep. fund. quantitative fundamental
Valuation approach absolute relative absolute
Position sizing concentrated diverse concentrated
M.M152248032.

Long/Short ➞ 𝛂 – stock picking, market timing (factor tilts)

➞ return – equivalent to long only
➞ risk – ½ of long only

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Page 7
Dedicated Short/Short Bias LOS b
𝛂 – stock picking, some market timing - discuss
return – lower than other HFs, but negative correlation
risk – more volatile than typical L/S benefit

Market Neutral
𝛂 – security selection, market timing
return – steadier than other equity hedge strategies
risk – less volatility, but leverage risk creates tail
risk

Page 8
Event-Driven Strategies/ Merger Arbitrage LOS c
- discuss
- soft-catalyst ED approach
- trade in anticipation of an
event
- hard-catalyst ED approach - trade
in reaction to an event
(less volatile/risky)
- cash-for-stock deal, buy target
stock
- Stock-for-stock deal, buy T and sell
A in same ratio as the offer
(contrarian approach - sell T, buy A)
uncorrelated source of alpha
- trades typically done using common
stock, but may include preferred,
M.M152248032.

or junior/senior debt

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Page 9
Event-Driven Strategies/ Distressed Securities LOS c
- in bankruptcy, potential bankruptcy, - discuss
or financial distress

may take several years

to resolve

➞ long lock-up periods

➞ liquidation - assets are

sold and paid out
based on capital structure
priority
best context for
or/ reorganization
reorganization
(capital structure arb.)
i.e. buy senior debt
may be
sell junior debt
a fulcrum
or equity
security

Event-Driven Strategies
Page 10
Merger Arbitrage: LOS c
𝛂 – specific deal selection - discuss
return – 7 - 12% range, low correlation to market return
risk – low, single digit s.d.
- market sensitivity in times of market stress
∴ left-tail risk
Distressed Securities
𝛂 – deal selection, capital structure decisions
return – higher end of event-driven strategies
risk – higher volatility M.M152248032.
than other event-driven strategies

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Page 11
Relative Value Strategies/ Fixed-Income Arbitrage LOS d
- discuss

- valuation differences
between securities due to
credit quality, and/or implied
volatility spreads

- pricing inefficiencies are

quite small, but high
correlations between securities
∴ high levels of
leverage

Page 12
Relative Value Strategies/ Convertible Bond Arbitrage LOS d
- discuss

➞ embedded option trades at

relatively low implied vol.
levels compared to the
underlying - makes the call
cheap
- must accept or hedge away
interest rate, credit and
market risk
- if realized equity vol. is
M.M152248032.
greater than the IV of
the convertible’s option - overall
gain is achieved

56
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Opportunistic Strategies
Page 13
- wide range of markets and securities LOS e
- discuss
region and asset-class level (vs. individual securities)
- broad themes, global relationships, market trends, cycles
- generally divided by:
technical fundamental
relies on mgr. skill, subject
discretionary to behavioral biases
rules-based algorithms, may
systematic fail in new contexts
(subject to herding effects)
use statistical methods use economic data and focus
to predict relative price on fair valuation of securities,
movements based on past sectors, markets
price trends

Page 14
➞ Global Macro ➞ wide range of asset classes LOS e
➞ focus on themes or regions - discuss
➞ top-down, typically fundamental

- tend to be anticipatory, often contrarian, but some follow momentum

- fairly heterogeneous as a group
∴ not as consistent a source of alpha compared
to systematic, trend-following managed futures
- common theme ➞ use of leverage (6 - 7x)
- mean-reverting, low volatility markets offer few opportunities
𝛂 – correctly discerning and capitalizing on trends in global markets
return – produce lumpier and more uneven return streams than other
hedge fund strategies
M.M152248032.

risk – higher levels of volatility

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Page 15
➞ Managed Futures LOS e
uncorrelated with stocks and bonds - discuss
returns tend to be positively skewed
- since funds only acquire asset exposure (not assets), the
majority of capital (85% - 90%) is invested in short-term
government debt
- tend more towards systematic trading with a quantitative
driven approach to trend identification

① TSM – time series momentum trend following

(long assets that are rising in price, short
assets that are falling in price)
② CSM – cross-sectional momentum
- same as TSM, but a group of long
positions against a group of short positions

Page 16
Opportunistic Strategies/ Global Macro LOS e
Managed Futures - discuss

M.M152248032.

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Page 17
Specialist Strategies/ Volatility Trading LOS f
- discuss

Relative Value
volatility arbitrage
- buy cheap vol. and
sell more expensive vol.
Long/Short vol.
- VIX futures
- options
- swaps
(watch term structure
of vol., skew & smile)

Specialist Strategies Page 18

LOS f
- Reinsurance/Life Settlement: - discuss

catastrophe rather than policyholders surrendering their

insurance policies to the insurer when no longer wanted,
uncorrelated they often realize more by selling the policy
with other to a fund
asset classes - fund continues to pay the premiums, collects
payout upon death
catastrophe bonds
catastrophe risk futures uncorrelated with other HF strategies
and with other asset classes

M.M152248032.

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Page 19
Multi-Manager Strategies/ FoF, Multi-Strategy HF
LOS g
- discuss
FoF ➞ fees
fees

fund 1 … … … fund n
FoF manager allocates to
uncorrelated strategies
- more diversification
- less extreme risk exposure
- lower realized volatility
fees
Multi-strategy

strategy 1 … … … strategy n

fee netting at fund level

Hedge Fund Strategies

Page 20
Conditional Factor Risk Model LOS h, i
One factor ➞ CAPM dummy variable = 1 in - describe
c𝐑 𝐇𝐅𝐢 d𝐭 = 𝛂𝐢 + 𝛃𝐢 (𝐄𝐑𝐏)𝐭 + 𝐃𝐭 𝛃𝐢 (𝐄𝐑𝐏)𝐭 period 𝐭 - evaluate

factor risk model conditional

Multi-factor: exposure to 𝐅𝟏 for 𝐇𝐅𝐢 in period 𝐭 (normal times)

c𝐑 𝐇𝐅𝐢 d𝐭 = 𝛂𝐢 + 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ 𝐃𝐭 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝐃𝐭 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ (𝐞𝐫𝐫𝐨𝐫)𝐢,𝐭 incremental exposure to 𝐅𝐤 for 𝐇𝐅𝐢
in period 𝐭 (financial crisis period)
M.M152248032.
factors: SNP500 - monthly return to index USD - monthly return on USD index
CREDIT - (Baa - Aaa) bond yields VIX - (𝐕𝐈𝐗 𝐭 − 𝐕𝐈𝐗 𝐭$𝟏 )𝐄𝐎𝐌

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REVIEW

M.M152248032.

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Commodities
Review - 1
⇒ commodity – a physical good that is tradable and supplied
without substantial differentiation (spot & future/forward
markets)
- potential for diversification – low 𝐫 with stocks
and bonds
- possible inflation hedging benefits
⇒ Energy/ – most economically valuable sector
1) Crude Oil - different grades (Brent, WTI)
– low in density ⇒ Light - low sulfur content ⇒ Sweet
- drivers of supply & demand technology extraction
politics refining
usage
2) Natural Gas business cycle
· associated gas – coming from an oil well
· unassociated gas – no oil present
- storage/transportation costs high - markets tend to be
- primary demand – electric generation regional
(heating/cooling)

⇒ Energy/ Review - 2
3) Refined products – heating oil, gasoline, jet fuel etc…
- shut down for planned maintenance 2x/yr. during low
demand periods
⇒ Grains/ · Corn · Soybean · Wheat · Rice - can be stored season
- heat/precipitation determine yield over season
⇒ Industrial (base) Metals/ - copper, aluminum, zinc, lead, tin, iron etc…
· demand tied very closely to GDP
feeder
⇒ Livestock/ · hogs · cattle · sheep · poultry
live
- depend on price of grains (input)
M.M152248032.

- tied to GDP growth (esp. in emerging/developing markets)

- weather – can affect health & weight
- disease
⇒ Precious Metals/ · gold · silver · platinum · palladium
- act as stores of value
- also used as an input in other items

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Review - 3
⇒ Softs/ cash crops · cotton, coffee, sugar, cocoa
- weather affects supply, GDP growth affects demand

⇒ Commodity Production Life Cycle/

Extraction Transport. Storage Refining Transport.
➀ Energy
50-100d. 1-10d. days to a 3-5d. 5-20d.
few months
nat. gas can be consumed here oil products
futures reflect
Refineries – affect demand for crude pricing here
- costly to build - long lead times
Pipelines
affect supply of oil
Exploration
➁ Industrial/Precious Metals - can be stored for yrs.
- requires storage, risks of ownership, financing costs
· smelting/processing relies of economies of scale
· long lead times + large costs to add extraction/processing
· monthly futures contracts w/ no seasonality capacity

⇒ Commodity Production Life Cycle/ Review - 4

poultry – a few weeks
4) Livestock – all yr./
hogs – a few months
cattle – a few years
5) Grains ➞ 5-6 mos. (Planting to Harvest)
- demand year round, storage facilities supply yr. round
6) Softs - each commodity differs significantly
⇒ Participants/
· Hedgers – eliminate price risk · Exchanges – standardized
· Traders/Investors informed investors · Analysts contracts
liquidity providers · Regulators
arbitrageurs
M.M152248032.
⇒ Spot vs. Futures Price/ - difference between spot & futures price
negative Contango called ‘basis’
Backwardation
calendar limited by positive spot
spread arbitrage calendar
bullish
spread
spot indicator
bearish indicator
𝐭 𝐭

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⇒ Spot vs. Futures Price/ Review - 5

Contango - buy long dated contracts

sell short dated contracts

roll over short pos. each

Backwardation – opposite month

⇒ Theories of Futures Returns/

1) Insurance Theory (Keynes) (Theory of Normal Backwardation)
- produces reduce risk by selling futures, prices ↓
2) Hedging Pressure Hypothesis - producers sell to hedge
but users buy to hedge
producers = users - flat curve
producers > users - backwardation, else Contango
3) Theory of Storage
direct storage convenience
Futures price = spot price + -
costs yield
low is stocks - low when
D > S, then
low stocks
high
high

⇒ Components of Futures Returns/ Review - 6

· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

=
· change in price in the return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
front month contract
· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergenceM.M152248032.
to a convergence to a higher spot price
higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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Components of Futures Returns

e.g./ Page 24
- 11 Jan. contracts = $110 exposure LOS g
10 - rolling forward to Feb., need - describe
12 contracts = $108 exposure - calculate
- interpret
(opposite for contango)
9

Jan. Feb.

Roll return = > 𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞

F %’age of the
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position being
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝟏𝟎 − 𝟗 rolled
e.g./ = . 𝟏 𝐨𝐫 𝟏𝟎%
𝟏𝟎
- the amount of return generated in a backwardated futures
market and profiting from the convergence towards a
higher spot price

Commodities
Review - 6
⇒ Components of Futures Returns/
· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
=
· change in price in the return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
front month contract
· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergence to a
M.M152248032.

convergence to a higher spot price

higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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 Last Revised: 09/16/2024

Commodity Swaps

- commodity swap – a legal contract involving Page 27

the exchange of payments over multiple LOS i
- describe
dates as determined by specified reference prices or
indexes relating to commodities often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts
2) may want a specific
grade/quality of oil
hedged
3) may want to maintain
flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months
pays $25/barrel
for the 9-month period called an ‘excess return swap’

M.M152248032.

overall (-9) +16

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 Last Revised: 09/16/2024

Commodities

⇒ Commodity Index/ a benchmark Review - 7

macro forecasting purposes
investment vehicle
Differ based on:
· breadth of coverage - # of commodities/sectors
· relative weighting
· rolling methodology
· rebalancing methodology/frequency
· governance – rules based quantitative methodology
- selection based – index committee selects

M.M152248032.

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 Last Revised: 09/16/2024

Investment Characteristics
Review - 1
Equity:
1/ Long/short: specialize by region/sector/style (some generalists)
typically net long (pos. market factor exposures) (40 - 60%)
heterogeneity in exposures to various equity factors
alpha through stock picking (market timing poor)
𝐄(𝐑) ~ long only, 𝐄(𝛔) = 𝟏Q𝟐 long only
liquid, average leverage
df
2/ Dedicated Short:
negatively correlated returns vs. equities and other HF
alpha through stock picking (market timing poor) strategies
60% - 120% short
𝛔𝐒 > 𝛔𝐋'
𝐒
liquid, low leverage

Review - 2
Equity:
3/ Equity Market Neutral:
high leverage, quantitative approach
steadier returns, less volatile
highly diversified, high liquidity
short IH, mean-reverting trades, higher turnover, tax
no/low beta risk issues

Event Driven:
df
4/ Merger-Arb.:
cash-for-stock ➞ long target
stock-for-stock ➞ long target, short acquirer (𝟕+ %)
cross-border M/A, vertical M/A ➞ wider spreads, more risk
friendly M/A, horizontal M/A, domestic deals ➞ smaller spreads
M.M152248032.

(3-7%)
left-tail risk due to M/A failures, market sensitivity (more deals
alpha from deal selection fail with
high leverage, 𝐄(𝐑) ~ low double digits, 𝐄(𝛔) < 𝟏𝟎% market stress)

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Review - 3
Event Driven:
5/ Distressed Securities:
very illiquid, long IH, longer lock-up periods
𝐄(𝐑) highest for event driven strategies, but higher 𝛔
typically long-biased (returns are
low diversification, concentrated positions lumpy and
best in early recovery period cyclical)
df
moderate to low leverage (1.2x – 1.7x NAV)

Relative Value:
6/ Fixed Income Arbitrage: - credit quality, liquidity, volatility premiums
reversion to the mean
net positive carry (as well)
high levels of leverage (4x – 5x)
liquidity varies by security type

Review - 4
Relative Value:
7/ Convertible Bond Arbitrage
tend to be volatility related trades
more illiquid (small issues sizes) ➞ low investment
high levels of leverage (3x) capacity
may/may not hedge credit, interest rate risk
diversification benefit, small return, risk reduction effect
df
Opportunistic:
8/ Global Macro
fundamental/technical, discretionary, some systematic
strong trends or themes (mean reverting, low vol. markets
risk factor exposure very heterogeneous, dynamic poor)
high leverage, 6x – 7x
M.M152248032.

lumpier return series, higher vol.

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Review - 5
Opportunistic:
9/ Managed Futures:
uncorrelated with stocks/bonds
cyclical return profile, range-bound, mean-reverting
markets poor
highly liquid, systematic, trend following, wide range
of risk factor exp.
positively skewed returns in stressed markets
higher volatility than most
df HFs
high leverage

Specialist:
10/ Volatility Trading - long vol. ➞ positive convexity, short equity bet
- short vol. ➞ premium income, long equity bet
- low leverage
11/ Reinsurance/Life Settlement – no asset class correlation
- very specialized skills
- low investment capacity

Review - 6
Multi-Strategy:
F-o-F: - diversification, investment access
- liquidity, manager selection expertise
- strategic, tactical, style allocation
- lower realized 𝛔, less single mgr. risk
- netting risk, added layer of fees, less transparency
- steady, low vol. returns
df
Multi-Strategy – faster tactical allocations
- GP absorbs netting risk, one layer of fees
- concentration of M.M152248032.
operational risks
- steady, low vol. returns > FoF, but more variance
- less investor liquidity than FoF
- more leverage than FoF

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 Last Revised: 09/16/2024

Hedge Funds
Review - 7
LOS h/
Conditional Factor Risk Model
𝐑 𝐇𝐅𝐢 = 𝛂𝐢 + 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝛃𝐢,𝐧 𝐅𝐧
+ 𝐃𝐭 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐧 𝐅𝐧
df
dummy var. ➞ incremental exposure

e.g. 𝛃𝟏 = . 𝟕𝟏 or 𝛃𝟐 = . 𝟔𝟒
𝐃𝛃𝟏 = . 𝟎𝟑 𝐃𝛃𝟐 = −. 𝟎𝟖
. 𝟕𝟒 . 𝟓𝟔

Review - 8
LOS i/
- when added to a 60/40 eq./fx-inc. port.

df

vs. 6.96 8.66 .62 1.13 14.42

M.M152248032.

71