CAIA Notes

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September 2009 Exam Level II Book 2 —Topics 7-11

Book 2 (Topics 7-11)

September 2009 Exam

CAIA Notes

Level II

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CAIA® Notes
CAIA Level II Book 2 (Topics 7-11) September 2009 Exam

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

Benrud has earned the CAIA. is editor of The Journal of Structured Finance and The Journal of Investment Compliance. He teaches both MBA and undergraduate courses in investments. He has a Ph. Dr.D. CAIA Topic Author Don Chambers. He has written and co-authored 15 books and numerous articles in the areas of corporate finance and the financial markets. Dr. CFA. an independent consultant. in finance from the London Business School DONALD R. from the University of Virginia. HENRY A. financial services. who was Curriculum Director of IIExamPrep for two exam cycles in 2008-09. CHAMBERS. Benrud received his Ph. CFA and FRM designations. and alternative investments.About the ExamPrep Faculty ERIK BENRUD. Venezuela. He has extensive experience in teaching and writing exam preparatory material. corporate finance. and is currently a visiting professor and researcher at the Isenberg School of Management and the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts. Dr. derivatives products. and competition in financial services. corporate finance and international finance. He is widely published on investments. risk management. swaps and options. Chambers was one of the first candidates to earn the CAIA® designation. VIKAS AGARWAL Topic Author Vikas Agarwal. Philadelphia.D. He is widely published on hedge fund strategy and performance. Penn. DAVIS Topic Author Henry (Hal) Davis. is an assistant professor of finance at Georgia State University in Atlanta. CAIA. . His research interests are hedge funds. and has been teaching courses on asset pricing and the financial system at Georgia State University since 2001. and has played a leading role in designing learning materials for those taking the CAIA® examination. is the Walter E. and financial forecasting. He has authored several papers in derivatives. Amherst. who was Curriculum Director of IIExamPrep until March 2008. Hanson/KPMG Peat Marwick Professor of Business and Finance at Lafayette College in Easton. FRM Curriculum Director Erik Benrud is an associate clinical professor of finance at Drexel University’s LeBow College of Business. URBI GARAY Topic Author Urbi Garay is a professor of finance at the IESA Business School in Caracas.

where he teaches fixed income. Dr. asset pricing. He has published several books and articles on interest rate risk and fixed income valuation. . His most recent book series The Fixed Income Valuation Course.RAJ GUPTA Topic Author Raj Gupta is research director of the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts. Amherst. and finance theory. SANJAY K. NAWALKHA Topic Author Sanjay Nawalkha is an associate professor of finance at the Isenberg School of Management. and has published widely in leading financial journals and alternative investment books. He is also a visiting faculty at Clark University. Gupta is assistant editor for The Journal of Alternative Investments. University of Massachusetts. He supervises the CISDM Hedge Funds and Managed Futures Database. Amherst. includes Dynamic Term Structure Modeling and the forthcoming Credit Risk Modeling.

................................................................................................. 81 GLOSSARY ..........TABLE OF CONTENTS PART 5: CURRENT AND INTEGRATED TOPICS Topic 7: Structured Products................ and Chartered Alternative Investment Analyst Association .... CAIA Association ........................................... Chartered Alternative Investment Analyst .................... a Massachusetts non-profit organization with its principal place of business at Amherst....................... INC........................... New Products and New Strategies ....................... CAIA ............................ are service marks and trademarks owned by CHARTERED ALTERNATIVE INVESTMENT ANALYST ASSOCIATION....... promote......................................... review or warrant the accuracy of the products or services offered by Institutional Investor ExamPrep (“II”)................. CAIAA is not responsible for any fees or costs paid by the user to II nor is CAIAA responsible for any fees or costs of any person or entity providing any services to II................................................................... 47 Topic 10: Portfolio and Risk Management .............. 117 CAIAA does not endorse................................................................................................... SM ® ® ® ..................................... and are used by permission................ 1 Topic 8: Asset Allocation ............ 73 Topic 11: Research Issues in Alternative Investments ........................................... 105 INDEX ........................................................................ Massachusetts............................................................................................ nor does it endorse any pass rates claimed by the provider... 19 Topic 9: Current Topics ............................................................................................................

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

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c. and consumer behavior. trending markets. b. flat (but oscillating) markets.10 Explain the economic implications of climate change in terms of its impacts on existing assets. Each Learning Objective within a Topic has a page number (in brackets) for this CAIA® Notes book. 8. (15) 7. (16) 7. b.23 Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing recent trends in the area. ability to replicate hedge fund returns. (11) 7.11 Describe the role of financial markets in reducing the economic cost of climate change through (7) a.1 Describe the characteristics of a special purpose vehicle (SPV) in the context of collateralized obligations. (28) Copyright © 2009 CAIA Association.19 Compare and contrast the historical objectives of private equity funds with that of hedge funds.2 Describe the key characteristics of a collateralized fund obligation (CFO). (2) 7. constant-proportion portfolio insurance. increased regulation. (11) 7.CAIA® Study Guide Learning Objectives This CAIA Association® listing is by Topic and Learning Objective.24 Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund strategies. e. (9) 7.9 Identify risks involved with infrastructure investments.5 Describe examples of undiversified “strategies” that have allowed individuals to become wealthy. d.6 Compare infrastructure with other traditional and alternative assets. (14) 7. UBS Global Infrastructure & Utilities Index c. PART 5: CURRENT AND INTEGRATED TOPICS TOPIC 7: Structured Products. (1) 7.3 Explain the benefits and risks of investing in CFOs. methodology. drawbacks.3 Determine the expected performance and cost of implementing strategies with concave payoff curves relative to those with convex payoff curves under: (26) a. markets for catastrophe and weather risks. future economic activity. (3) 7. and its potential market participants. 7. emissions trading.21 Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund and private equity strategies. Moody’s Economy. in terms of their: (12) a. climate-related investments. (16) 7. RREEF Hypothetical Infrastructure Index b. (9) 7.2 Compare the payoff and exposure diagrams of the buy-and-hold.4 Discuss the motivations for and impact of resetting the parameters of dynamic strategies. c. constant mix. c. (4) 7. (5) 7. (18) TOPIC 8: Asset Allocation 8.17 Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge fund replication.14 Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of these instruments.5 Describe the conceptual characteristics of infrastructure sectors. and option-based portfolio insurance strategies. buy-and-hold. (2) 7. constant-proportion portfolio insurance.(6) 7.18 Discuss the term convergence as it is applied to the alternative investments industry. (3) 7.15 Describe both exchange traded as well as over-the-counter weather derivatives. (10) 7. using: (19) a.1 Calculate the portfolio’s asset values after a given change in the equity value. b.20 Contrast recent hedge fund participation in traditional private equity activities with recent private equity participation in traditional hedge funds activities. 8.22 Describe the emergence of the hybrid hedge fund/private equity fund.7 Critique the evidence on the performance history for infrastructure investments.4 Describe the structure of a collateralized commodity obligation (CCO). b. New Products and New Strategies 7. constant mix. (28) 8. (14) 7.com Infrastructure Index 7.12 Explain the economics rationale for using financial instruments to transfer risk. 7. benefits.16 Describe emissions trading.13 Discuss the criteria that need to be fulfilled by instruments employed for risk transfer.® All Rights Reserved. i . goals. (17) 7.8 Explain how the composition and construction of the following indices impact their relative performance: (5) a. its project based mechanism. (23) 8. (7) 7.

26 8. and explain how scenario analysis can be used to better indicate the risk of a fund’s structural position in such circumstances. b.22 8. including real estate. consumption and seasonal factors. (40) Identify the components of the commercial real estate asset class and the relative advantages of direct real estate investment and real estate investment trusts (REITs). (34) Explain the concepts of contango. (29) Explain and apply the wealth allocation framework that accounts for various dimensions of risk and leads to an ideal portfolio that provides: (29) a. the certainty of protection from anxiety. (36) Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity contracts.14 8.20 8.6 8. potential losses and risk from this type of strategy. (52) 9.10 8. Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it relates to natural gas pricing.15 8.12 8. (39) Discuss the role of global commercial real estate in a strategic asset allocation setting. the convenience yield may be low. (42) Explain the seven caveats identified by the author as considerations for strategic asset allocation to global commercial real estate. executive stock options and human capital on asset allocation of individual investors. ii . (28) Explain and apply the concept of personal risk and its various components to the asset allocation problem faced by individuals.28 TOPIC 9: Current Topics 9.17 8. (38) Argue against the use of naïve extrapolation of past commodities returns to forecast future performance and discuss the importance of formulating forward-looking expectations. (52) 9. (49) 9. (33) Discuss the four theoretical frameworks (CAPM. (30) Understand the impact of alternative investments.11 8. the possibility of substantially moving upward in the wealth spectrum. (48) 9. theory of storage) used to explain the source of commodity futures excess returns.9 8. (32) Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized commodity futures can be decomposed into various sources of return. (32) Explain why the three most commonly used commodity futures indices (GSCI.27 8. and diversified commodity portfolios and indices. (36) Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison to its arithmetic rate of return.4.Topics and Learning Objectives 8.23 8. (41) Explain the historical performance and diversification benefits of select asset classes. (43) 8.24 8.2 Understand the derivation of the futures curve for natural gas and the association between the curve and potential determinants including anticipated production. (48) 9. sectors. (35) Note: The 12th line from bottom of the left column should read “if inventories are high.8 Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth management and asset allocation. (53) Copyright © 2009 CAIA Association. (38) Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on momentum and term structure of futures prices.1 Understand what is meant by the “term structure of a commodity futures curve” and the terms “backwardation” and “contango.18 8.3 Explain a futures calendar-spread strategy and the sources of potential profits.7 8. the high probability of maintaining one’s standard of living.16 8. (41) Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when determining forward-looking asset allocations. CRB) show different levels of return and volatility over a common time period. Develop and justify an asset and risk allocation for an individual using the information provided to the candidate during the examination.7 Discuss how sophisticated storage operators can manage their storage facilities as a set of options on calendar spreads. (31) Describe and apply barbell and option based strategies in the context of asset allocation.21 8. (36) Describe the relative importance of volatility of spot return and roll return in determining the volatility of futures returns.25 8.” Discuss the importance of roll return in explaining the long-run cross-sectional variation of commodity futures returns and the implication for investors.13 8. the insurance perspective.5 Discuss the magnitude of Amaranth’s calendar-spread positions: explain how this hedge fund was able to accumulate such large positions (including the role of position limits) and describe the effects of the magnitude of the positions on daily profits and losses. (35) Calculate the roll yield of a commodity futures contract in backwardation or contango. normal backwardation and market backwardation. c.® All Rights Reserved.” (47) 9. DJ-AIGCI. hedging pressure hypothesis.8 Describe how daily volatility as measured by standard deviation can underestimate potential risk (where risk is defined as the likelihood of experiencing severe loss). (31) Discuss reasons why the performance of rebalanced equally weighted commodity futures portfolio should not be used to represent the return of commodity futures asset class.6 Discuss the causes for increased volatility on the natural gas commodity futures market prior to Amaranth’s liquidation in September 2006.19 8. (47) 9.

(71) Describe nonlinearities in the risk of subprime CDO tranches.23 9. (69) Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased transparency can provide investors with information regarding financial institutions’ exposure. (75) 10.36 9. (74) 10. (76) 10.” (61) Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over the past decade. (68) Argue how increased transparency in the rating process is necessary.1 Assess the long-run and short-run benefits of hedging the tail risk of a portfolio. (62) Evaluate the statement: Quant failed in August 2007. (60) Describe the set of hypotheses that are collectively referred to as the “unwind hypothesis.10 Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for models of risk measurement.30 9.Topics and Learning Objectives 9.28 9.37 9. (66) Explain the factors affecting the rating of a special investment vehicle (SIV).10 9.13 Demonstrate how cognitive biases can lead to errors in judgment by financial market participants. (70) Discuss possible regulatory responses.12 9.11 9. (77) 10. (78) Copyright © 2009 CAIA Association.18 9. and the practical implications of transactions costs.40 TOPIC 10: Portfolio and Risk Management 10. how leveraged portfolio returns are constructed.6 Describe the three factors that impact the construction of a tail hedge.39 9. Explain how it is simulated in the paper. (65) Explain the role of rating agencies in the credit crisis.33 9. (67) Explain the lack of incentives for banks to perform due diligence on the collateral pool. (70) Describe sound risk management practices. iii .20 9.22 9. (64) Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the securities they issued and the resulting contribution to the credit crisis.12 Explain the role of shadow banking system as a source of liquidity and discuss why during periods of market stress this source of liquidity may disappear. (58) Explain the return pattern of the main simulated strategy during the second week of August 2007.13 Describe what is meant by “nodal” or “one-way” liquidity in the commodity markets and how the lack of “twoway” liquidity adversely affected Amaranth. (61) Describe a method for approximating a network view of the hedge-fund industry and what such a view indicates. (62) Critique the methodology of the article.29 9. (77) 10.35 9. (66) Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the duediligence efforts at the firms. (67) Explain the role and actions of central banks in 2007 and early 2008. liquidity risk. (74) 10.3 Explain why increased correlation among various asset returns during periods of stress could provide opportunities for free insurance against tail risk.9 9. (66) Describe the role of monolines. (55) Understand how forced liquidations can affect market prices and why changes in market prices can be correlated with the size and direction of the liquidation.9 Explain the relationship between the real economy and capital markets and discuss the factors that have made the real economy less volatile through time. the relationship between market capitalization and the strategy’s profitability.17 9. (64) Describe a subprime loan and discuss the four principal reasons for the recent increase in sub-prime loan delinquencies. (73) 10. (76) 10.38 9.32 9.8 Evaluate the factors that lead to the underpricing of risk by investors.26 9. (69) Argue how standardization can simplify valuation issues. (75) 10.7 Explain why long-dated options may provide an inexpensive method for hedging tail risk.21 9.15 9. (74) 10. (69) Describe how new product design can dampen market disruptions.” (57) Describe the anatomy of the long/short equity strategy. (60) Compare and contrast market events in August 2007 with August 1998.34 9. (56) Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall under the broad heading of “long/short equity. monetary policy and other macro events.24 9.11 Compare and contrast the terms risk and uncertainty.14 9.2 Explain the relationship between systemic risk.31 9.16 9. (75) 10. (63) Evaluate the current outlook for systemic risk in the hedge fund industry.25 9.5 Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk.19 9. (68) Describe how systemic risk arose in 2007.® All Rights Reserved.27 9. (67) Describe the lack of transparency in the credit markets. how the strategy provides liquidity to the market place. (55) Discuss eight hypotheses explaining the market events of August 2007.4 Describe the four approaches to hedging or insuring a portfolio against tail risk. (71) 9. (67) Explain the role of valuation methods. (60) Explain how the increase in total assets under management and the number of long/short funds over the 1998 to 2007 time period likely impacted expected returns and the use of leverage. (73) 10.

b. iv .19 Review the approach and describe the main findings of bottom-up research on hedge fund risk factors. (101) 11.9 Describe a trading strategy that uses basis in futures markets as an indication of risk premium in futures markets. (83) 11. (96) 11. (92) 11.26 Compare the performance of companies in which private equity firms invest with small cap firms listed on NASDAQ. (86) 11. (93) 11. (85) 11. (87) 11. d. (81) 11. (94) 11. (100) 11.27 Explain the liquidity characteristics of listed private equity securities.6 Explain the diversification benefits of commodity futures. (95) 11.Topics and Learning Objectives 10.4 Compare commodity futures risk with equity risk.2 Compare commodity spot returns and commodity futures returns. (103) 11.13 Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations to real estate.23 Discuss the challenges that an investor would face in measuring the risk-adjusted performance of private equity. return. (83) 11. (101) 11.21 Discuss the broader risks associated with hedge funds and describe the regulatory concerns. (87) 11.11 Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on allocations to real estate.14 Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes.18 Evaluate the potential biases in hedge fund databases. (78) 10. compare and contrast the results of using UK data with those employing US and Australia real estate return data.28 Discuss the impacts of adjustment for stale prices on risk.20 Describe and assess the adequacy of the asset-based style (ABS) risk factor model used by Fung and Hsieh to analyze hedge fund returns.17 Analyze the issues in measuring the growth of the hedge fund industry.25 Explain and identify the potential bias in using the performance of liquidated funds to represent the overall performance of private equity funds. c. (82) 11. (79) TOPIC 11: Research Issues in Alternative Investments 11. Cross-sectional differences in private equity managers.1 Illustrate how an investment in commodity futures can earn a positive return when spot commodity prices are falling. (98) 11. Copyright © 2009 CAIA Association.7 Describe the performance of commodity futures from a non-US investor’s perspective.16 Describe the hedge fund business model presented by the authors. Parameter uncertainty.29 Identify the impact of IPO under-pricing on the performance of the PVCI. Illiquidity.3 Compare commodity futures returns with stock returns and bond returns. (93) 11.30 Explain how the following issues pose a challenge to private equity investors: (103) a.15 Argue the best method of adjusting a real estate return series when conducting an asset allocation study. (84) 11. Absence of an investible index. (86) 11.24 Explain the implication of the observation that mean and median returns on private equity databases are significantly different.16 Illustrate the total impact of several individual risk factors on private equity allocation drift. (79) 10. (102) 11.15 Explain the role of Monte-Carlo simulation to achieve stable (steady-state) allocation in this study. and diversification benefits of private equity (candidates do need to memorize exact figures).® All Rights Reserved.5 Discuss the use of commodity futures as a hedge against inflation. (85) 11. (102) 11.10 Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions. (84) 11. (92) 11.8 Describe the difference between normal backwardation and a market that is in backwardation.22 Describe the role of manager selection in the experience of a private equity investor. (99) 11. (101) 11. (99) 11.14 In the Marcato and Key (2007) study.12 Compare four approaches to generating an unsmoothed total real estate return series.

or other non-mortgage related assets. and is the entity that issues the various tranches that have claims to the cash flows (senior. 1 . auto loans. This means that a bankruptcy of the sponsoring bank or the money manager will not affect the functioning of the CO structure. collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs)) that hold debt obligations as collateral and are financed with “tranches” or securities that typically have diverse seniority and/or longevity. Inc.. All Rights Reserved. Special purpose vehicles (SPVs) are used as the legal entities (e. “Collateralized obligations” is the umbrella term for a spectrum of asset-backed structures (e. trusts) that form the center of every collateralized obligation (CO) structure. The SPVs hold the collateral and distribute the cash flows from the collateral to the tranche holders. Copyright © 2009 Institutional Investor. They are referred to as “bankruptcy remote”.TOPIC 7 Structured Products. home loans. Describe the characteristics of a special purpose vehicle (SPV) in the context of collateralized obligations.g. credit.g. characteristics. or other instruments). The SPV is the entity that legally owns (holds) the collateral (the underlying debt. mezzanine and equity). equipment leases. New Products and New Strategies  Main Points  Explaining the structure. which are bonds that are securitized or collateralized by the cash flows from an underlying pool of assets—such as credit cards. SPVs typically hold asset backed securities (ABS). benefits and risks of investing in CFOs  Explaining the characteristics of infrastructure investments and the practical use of infrastructure indices  Explaining the potential for financial markets and instruments to play a role in alleviating negative climate change consequences  Comparing factor-based and pay-off distribution approaches to hedge fund replication  Describing factors that contributed to convergence between private equity and hedge fund strategies as well as concerns and risks regarding the past trend 1. The SPVs are usually Delaware based business trusts or special purpose corporations..

CFOs hold portfolios of hedge funds and “repackage” the ownership of the portfolio into securities or tranches with different levels of seniority and/or longevity. no more than 10% with one fund. investors in a tranche wishing to liquidate can sell their tranche without it affecting the CFO portfolio and requiring a liquidation of a portfolio holding. the equity tranche would be unrated and would receive the residual cash flows. Using the CFO structure. Benefits to CFOs (collateralized fund obligation) to investment company managers that manage the CFOs can include management fees. 25 or more funds. to provide protection to the senior tranches so that they can be sold with high credit ratings. along with the diversification. The tranches are usually denoted with letter names and vary in seniority from very low risk senior tranches to an equity tranche with high risk. 2 . Inc. For example. The debt tranches may offer credit ratings and the equity tranches offer leverage. New Products and New Strategies 2. trigger a liquidation (along with potential diversification and liquidity requirements). Describe the key characteristics of a collateralized fund obligation (CFO). might offer a low coupon (e. Hedge fund managers prefer investors that are relatively unlikely to withdraw funds (“sticky” money rather than “hot” money).. 3. All Rights Reserved. Tranches are securities sold to investors that represent claims to the cash flows from the portfolio. have semi-annual coupon payments and have first priority to the cash flows from the portfolio of hedge funds. etc..Topic 7: Structured Products. Certain requirements such as a total net value might be imposed which. Copyright © 2009 Institutional Investor.). Collateralized fund obligations (CFOs) are the application of the collateralized obligation (CO) concept to investing in hedge funds and started in 2002. no more than 15% with one manager. LIBOR plus 60 basis points). tranche “A” might represent half of the value of the CFO. 20 or more managers.g. Less senior tranches would have higher coupons and lower credit ratings. after the debt tranches have been satisfied. if any. Finally. incentive fees and gains through ownership of the equity tranche. These liquidation triggers are designed. a CFO might be formed that requires that the portfolio of hedge funds owned inside the CFO meet a number of minimum diversification requirements (e. CFOs allow investors to participate in alternative investment opportunities (typically with diversification) through a spectrum of CFO tranches with various maturities and risk levels that are potentially more tailored to the preferences of the investor and more easily understood due to standardization and comparability to other similar programs. Explain the benefits and risks of investing in CFOs. Benefits to CFOs (collateralized fund obligation) to hedge fund managers who view the CFOs as investors in their hedge fund are that the money is less likely to be withdrawn. if not met. Given this high priority and substantial diversification of the portfolio's holdings. the tranche might receive a credit rating from a major agency of AAA. The level of diversification is an important issue in determining the relative value (and credit ratings) of the tranches or securities that have claim to the cash flows generated by the portfolio.g. For example.

The commodity price risk is accomplished in the CCO using commodity trigger swaps (CTSs). Risks of CFO investing are generated from the risks of the assets (hedge funds) that comprise the portfolio.35 and . Anson reports the correlation of fund of funds returns with leveraged loans and high yield returns of only . as noted in the previous paragraph. 5. Further. CFOs have been shown to have lower systematic risk exposures (due to their absolute return strategies) than other similarly rated investments (such as pools of corporate bonds) and so are less subject to general credit market events or other market wide events. All Rights Reserved. Describe the conceptual characteristics of infrastructure sectors. a triggering event might be if a ten day average of a particular commodity price has declined more than 35% from the commodity price when the swap is set. The CCO contains a diversified portfolio of CTSs and must adhere to prespecified diversification standards. investors can receive the benefits of somewhat diversified risk exposures that contain less systematic risk (and perhaps more idiosyncratic risk related to funds manager skill). Inc. Often. CFO investors are exposed to a relatively substantial risk of large negative returns. The result is a set of tranches that offer a spectrum of probabilities for full payment and an exposure to various commodity prices such that severe declines in one or more commodity prices could cause tranches to lose principal (starting with the least senior tranches). Anson analyzes historic returns to funds of funds and compares the return distributions to the distributions of high yield portfolios and leveraged loan portfolios. Thus. The hedge fund of fund returns have moderate volatility and a good Sharpe ratio but have a slight negative skew and slightly high kurtosis. Mansour and Nadji describe six conceptual characteristics of infrastructure sectors. Therefore. Anson concludes that the past return distributions have been roughly similar. the correlations of the returns with large credit market events may be reasonably low and therefore CFOs provide diversification benefits. The idea is to utilize a CO structure to facilitate exposure to commodity price risk. 3 . insurance companies and others to diversify into the hedge fund arena through ownership of tranches rated by a major rating agency. The concept of collateralized obligations (COs) has been extended into commodities with a collateralized commodity obligation (CCO) being issued with rated tranches in 2005. For example.43. The CCO receives fixed coupons (much like insurance premiums) up to the maturity of the CTS at which time the CCO either receives the full principal of the CTS (if the triggering event has not occurred) or nothing from that CTS if the triggering event has occurred. such institutions are prohibited from direct ownership of unrated investments such as a hedge fund. A commodity trigger swap is similar to a credit default swap except that the risk to the principal is generated by falling commodity prices (rather than a credit event). New Products and New Strategies Benefits of CFOs (collateralized fund obligations) to investors include the ability of institutions such as pension funds. However.Topic 7: Structured Products. Describe the structure of a collateralized commodity obligation (CCO). Note that the set of characteristics of infrastructure investments is a main point of CAIA’s Copyright © 2009 Institutional Investor. The triggering event is prespecified. 4.

The article also notes that these assets have traditionally been funded by the government through general taxes or the municipal bond market that also indicates a barrier to entry for new entrants. the income streams are analogous to fixed income investments with the additional advantage of having inflation protection. 5. 1. Rent escalations on infrastructure assets that are usually CPI-linked are permitted. 3. Inflation hedge: Infrastructure assets can be classified as tangible. Stable cash returns: The previous two characteristics – monopoly and the inelastic nature of demand – ensure that infrastructure assets have stable cash returns. But others view it as a substitute for long duration bonds with an embedded inflation hedge. Long duration: As is the case with real estate. Developing infrastructure assets in India share common risk and return characteristics with opportunistic real estate development. and private equity. tangible assets generating cash flows. often over 50 years. If the infrastructure asset is government regulated. The long lasting nature of infrastructure asset returns makes these assets very attractive to institutional investors. However. 4. infrastructure is a hybrid asset class and shares common features with many traditional and alternative assets. infrastructure assets last for a long time. Inc. Many institutional investors new to this asset class view it as a subset of commercial real estate – with physical. 2. they contribute to the inelastic nature of demand. fixed income. equity-like. they are typically large-scale investments that can act as a barrier to entry for new entrants. All Rights Reserved. A consequence of this is that infrastructure assets have monopolistic or “quasi-monopolistic” characteristics. This is generally because infrastructure assets render essential services. and real estate-like features of Copyright © 2009 Institutional Investor. 6. Monopoly: Infrastructure assets generally have very high initial fixed costs. As a result. 6. the demand for which does not change with consumer sentiment. An infrastructure investment in an operating company that runs an airport is a common private equity strategy. Another crucial aspect is that the lifecycle of the infrastructure asset is a key determinant of the asset’s performance. 4 . Compare infrastructure with other traditional and alternative assets. New Products and New Strategies curriculum. real. More generally. Since infrastructure assets have few substitutes. Inelastic demand: Infrastructure assets provide essential services to the community and demand does not fluctuate with price movements or the business cycle. Hybrid asset: Infrastructure assets share many common features with a variety of other assets such as real estate. Of particular interest here is the fact that infrastructure assets are highly heterogeneous. with no two infrastructure assets having identical attributes.Topic 7: Structured Products. real assets and provide an inflation hedge. the bond-like. Most public and corporate pension plans face long-term liabilities and the long lasting nature of these assets makes them very attractive to plan sponsors. The replacement costs of real assets increase in an inflationary environment. which preserves the value of existing infrastructure assets.

Opportunistic/Private Equity Expected Return Value-Added Core Real Estate/Fixed Income Risk Core Real Estate/Fixed Income Gas/Electricity/Transmission (Mature) Mature Toll Roads Mature Telecom Water Value-Added Airports Seaports Mature Toll Roads (with Expansion) Opportunistic/Private Equity Greenfield Toll Roads New Telecommunications Power Generation/Transmission Source: Mansour and Nadji (2007) 7. Explain how the composition and construction of the following indices impact their relative performance: Note that the bulk of the material focuses on the UBS Index and Moody’s Economy. New Products and New Strategies any infrastructure investment depends on the individual asset and the stage of the asset’s maturity. The major indexes use listed companies in their construction. 8. 2. Also note that benchmarking infrastructure investments is listed as a main point for this Learning Objective. The article also notes a study by Peng and Graeme (2007) that examined the performance of 19 major unlisted Australian funds. Copyright © 2009 Institutional Investor. Significant variation within infrastructure investments given its hybrid nature. Limited Performance History. and such investments can be: listed infrastructure investments and unlisted infrastructure investments. Lack of Appropriate Benchmarks. All Rights Reserved. Expensive and often proprietary data collection. See the exhibit below. These limitations include: 1. Critique the evidence on the performance history for infrastructure investments. 5 . 3.com Infrastructure Index.Topic 7: Structured Products. Inc. 4. The performance history for infrastructure investments has several limitations.

b. All Rights Reserved.Topic 7: Structured Products.6% of the S&P Global Universe. Mansour and Nadji find six types of risks associated with infrastructure projects. c. Moody’s Economy.7% less than private equity and public real estate but more than hedge funds. The Economy. UBS Global Infrastructure & Utilities Index The UBS indices exist for the global and major regions of the world. Water. It also has a lower volatility than the UBS Index (13. Transport.-basis.S. Copyright © 2009 Institutional Investor. Integrated Utilities make up 52% of the index. Construction Risk: Construction may be delayed or abandoned due to unforeseen risks related to weather.1% for Economy.5% per year with a 13. Companies are market-cap weighted. RREEF Hypothetical Infrastructure Index The RREEF was constructed based on the UBS index because the UBS index was not widely available on a global or U. the RREEF index has focused primarily on pure infrastructure plays or “infrastructure operating companies. the volatility of this series was increased but could be directly compared to publicly-traded assets such as equities and securitized real estate. Hence. and Gas sectors are under Energy and Utility. The remaining subsets are Power Generation (5%). including the U. The volatility at 18. The UBS index is about 4.S. including: 1. It returned 12. The index has showed low correlations with traditional and alternative assets.3% for Economy. placing it between European bonds and equities. and fixed income returns. and Gas (storage and distribution).com Index has a lower return than the UBS Index since its inception (5.4% for UBS). 9. Water (Treatment and Distribution). Inc. Identify risks involved with infrastructure investments.3% for UBS). Integrated Regulated Utilities make up 25% and Energy Transmission and Distribution make up 13%.3% has exceeded fixed income and hedge funds but trails public real estate and public equity.com versus 9. public equity. Water (1%) and Other Infrastructure (including communication and transport) that make up 4%. the UBS index averaged 12.com versus 19.” Since only listed companies were used. 6 . RREEF used the UBS-Europe Index as the base. New Products and New Strategies a. The Electricity. Communications.2% volatility. stripping out companies that did not focus on direct infrastructure such as airlines and logistics. On a 10-year basis. The Global series is based on a group of 85 companies.com Infrastructure Index Five infrastructure sectors are included: Electricity (Distribution and Generation).

future economic activity. and there will be an increase in the severity of weather around the globe. Furthermore. Regulations associated with the weather will increase costs. Adjustment strategies react rationally to the unavoidable consequences of climate change. Initially. The changes in climate will have many impacts: higher cost of capital. renewable energies. 11. Political Risk: International infrastructure investments may be exposed to the whims of the government. they are to require land not yet acquired. 7 . for example. Abatement strategies attempt to prevent climate change. The increased uncertainty associated with the weather changes will affect the planning of future economic activity. and changes in consumer behavior that may have positive or negative effects. 5. Copyright © 2009 Institutional Investor. New Products and New Strategies 2. people planning to move to such areas can expect higher insurance premiums for homes and property. Legal Risk: Infrastructure investments may be exposed to legal risk if. Inc. Companies that plan to build and invest in an area where the weather effects are higher can expect a higher cost of capital. meanwhile.Topic 7: Structured Products. Bangladesh. South and Central America. Evidence suggests that consumers are conserving energy and cutting back on climate harming activities and supporting compensation measures. All Rights Reserved. the human toll will probably be highest in countries such as India. the economic toll will be higher. higher insurance costs. 6. In developed countries. According to the latest Intergovernmental Panel on Climate Change (IPCC). Operational Risk: Infrastructure projects may fail operationally if a chain of command does not exist and is not properly supervised. global warming is a reality. construction.g. 3. pricing and benchmarking. Describe the role of financial markets in reducing the economic cost of climate change through: There are two basic approaches for dealing with climate change: abatement strategies and adjustment strategies. This will increase the risk premiums from the investments. Other considerations include liquidity. 10. However. higher regulatory costs. Emerging and developing economies will be hit hard. and mechanical and electric engineering as companies attempt to meet the new regulations. Climate change can also have an economic impact on consumer behavior. Leverage/Interest Rate Risk: Infrastructure investments may require additional borrowing of capital which subjects itself to interest rate risk. Regulatory Risk: Infrastructure projects may be exposed to regulatory risk if new laws inadvertently create new restrictions. certain industries are likely to benefit: e. Explain the economic implications of climate change in terms of its impacts on existing assets. and consumer behavior. 4. increased regulation.

Such investments would include simply investing in the equity of companies that are developing environmentally friendly products. This strategy would be enhanced by a political and regulatory framework that reduces the cost of debt and equity financing for the companies. Such instruments include catastrophe risk transfer instruments such as catastrophe bonds and weather derivatives.Topic 7: Structured Products. The following list summarizes the roles of financial markets. The strategy sets a limit on the amount of pollution across the economy by issuing a limited supply of emission certificates. emissions trading. These certificates can be traded. 8 . Inc. those that are developing and producing climate protection-relevant technologies. which can reduce the individual cost of coverage. There are also risksharing arrangements for unavoidable natural catastrophes and weather risk. there is an ongoing debate concerning the potential benefits and functioning of the emissions trading market.g.. those that are applying climate protection-relevant technologies. which involve a cash flow when a certain event occurs. Increased investor awareness would lower perceived risk and the cost of capital. The market for catastrophe risks and weather risks offers adjustment strategies. The goal of emission trading is to minimize the costs associated with greenhouse gas emission reduction. b. e. Climate-related investments are part of both abatement strategies and adjustment strategies. climate-related investments. and those that offer solutions for adapting to climate change. a. All Rights Reserved. These are instruments that provide compensation for certain events. Emissions trading is part of an abatement strategy. Making loans to such companies would also be a part of this strategy. The effect of these instruments is an efficient sharing of the risks that come from unavoidable natural catastrophe and weather risks. The markets also provide information such as price signals concerning environmental threats. Copyright © 2009 Institutional Investor. This lowers the cost of covering individuals. Climate-related investments include public investment funds and private equity funds that invest in assets that could profit from climate change. There are a wide variety of companies in which to invest. Additional benefits may result from derivatives on those certificates and the existence of funds and other investment vehicles that invest in emission certificates. However. markets for catastrophe and weather risks. which gives each corporation an incentive to produce less pollution because it can sell unused emission certificates. New Products and New Strategies Financial markets and suitable financial instruments can help finance climate-related technology and distribute weather risks efficiently. c. those in the energy industry.

Market efficiencies should lower the cost of hedging and increase macroeconomic benefits further. 5. Measurable and calculable risk: There must be estimates of both losses and probabilities in order to price the instruments. The following list provides more details. and the risk levels would be more transparent. 4. This would reduce the concentration of risk among a few insurers. reliable. Copyright © 2009 Institutional Investor. For one thing. Explain the economic rationale for using financial instruments to transfer risk. the risk premium must be affordable while still covering the potential losses. New Products and New Strategies 12. This is especially true because weather-related events typically have a low correlation with market returns. This would lower the adverse selection problem where high-risk firms seek coverage at the average market price. Avoidance of moral hazard and adverse selection: There should be information symmetry. Discuss the criteria that need to be fulfilled by instruments employed for risk transfer. 3.. a decline in business for any sector will reduce tax revenues. and there will be a drain on government funds in repairing the infrastructure. 9 . Market participants would price risk to include all relevant information.Topic 7: Structured Products. Reliable payment trigger: To minimize conflicts of interest. which would most likely come from historical data. Development of adequate pricing models: Traditional pricing models would require modification to price catastrophe risks and weather risks. 2. there should be a precise definition of the event that triggers payment. There are five basic criteria for instruments to be effective in transferring risk. 13. Inc. ● Uncorrelated asset class: The new instruments would provide a new tool for increasing diversification of investment portfolios. All Rights Reserved. for e.g. Affordable risk premium: For the party seeking protection. Weather data is very different from traditional market data. weather data has a seasonal element. The payment trigger must be transparent. The general economic rationale for having financial instruments to transfer risk is that risk sharing by agents in the economy can reduce shocks to the overall economy. ● Macroeconomic benefits: Firms can hedge risks and increase output. ● Coverage of large volumes: Natural catastrophes and extreme weather events can cover large areas so that the potential losses are above the levels that a single firm or even government can afford. which helps the overall economy. The financial instruments would provide payoffs to help supply capital to cover losses. and difficult to manipulate. ● Efficiency and transparency: The market can break down the risk into small pieces and distribute them among qualified investors. which would increase efficiency. 1. Information symmetry would lower the potential for the moral hazard problem in that the covered firm would want to inflate losses.

but because they are difficult to price. Capital market-financed quota share reinsurance. These and other considerations would have to be included in the pricing models. they offer more liquidity. There have been moves to modify the contracts to generate more interest. Mutual funds using these instruments are being developed so that more investors can participate. One or more events must occur before the investor suffers a loss. The investors in these instruments must be knowledgeable. One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss. Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of these instruments. Cat-risk CDO (Collateralized Debt Obligation): The various catastrophe risks are bundled and sold in individual risk tranches. Catastrophe bonds and exchange-traded contracts are fairly liquid. but turnover was small. Contingent capital arrangements: This category is composed of types of put options. Hedge funds make investments to earn the premiums. they are not used much today. The following list describes the existing instruments that can be used to transfer catastrophe and weather risks. is usually in the form of private placements. They were popular in the 1990s. 10 . The option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs. and when a predefined loss occurs. the investors share proportionally in a loss according to a predetermined quota. catastrophe data is sparse. which is linked to an industry loss index. and all the outcomes are not known. Industry loss warrants (ILW): This market. All Rights Reserved. and the other instruments are tailored to meet the needs of certain entities and are usually held until maturity. known as sidecars: In this contract. Copyright © 2009 Institutional Investor.Topic 7: Structured Products. and hedge funds. that has been around for a while. the investor forfeits the capital invested. Exchange-traded contracts in catastrophe risks: Some cat futures and cat options trade on an exchange. Event loss swaps (ELS): These are a variant of conventional ILWs. Insurers and reinsurers use the contracts as part of their overall portfolio strategy. New Products and New Strategies Furthermore. They started in the early 1990s. and they would be used by entities where liquidity is important. and there is at least one debt and equity tranche. It is a type of capital market-financed loss (re-)insurance. Since they trade on an exchange. Catastrophe bonds (cat bonds): The coupons are usually based on LIBOR plus an appropriate risk premium. such as those between different regions or industries. which limits potential investors to insurers and reinsurers. Inc. Special purpose vehicles (SPVs) usually issue the bonds and invest the proceeds in traditional fixed income securities to cover contingent claims by the sponsor. This uses tranches as well. Catastrophe swaps (cat swaps): These are contracts where two insurers can swap generally uncorrelated risks. They are more tradable because they are more highly standardized. 14. institutional investors.

Weather derivatives pay off when there are unusually low or high temperatures. through some are planning to introduce new products. the CME is the only exchange where weather-related futures and options trade. the contracts are negotiated individually and with properties specified by the counterparties. and includes the assigned amount units (AAUs) that trade internationally. on the other hand. All Rights Reserved. Describe both exchange traded as well as over-the-counter weather derivatives. A natural gas company may wish to hedge against a warm winter. and the exchange plans to expand its offering. The market for weather derivatives is concerned with relatively low-cost high probability events. its project-based mechanism.. Tradable weather-related futures and options have been on the Chicago Mercantile Exchange (CME) since 1998. there is a difference when the reductions take place in an industrial country or in an emerging market.g. traded in the EU-ETS. With respect to emission credits. Market participants find that the exchange-traded products have a lower cost and higher liquidity. Corporations with high-risk exposure naturally hedge risk so they can focus on their business. Inc. but have discontinued them for now. As of now. The largest sponsors are insurers and reinsurers. for example. and its potential market participants. 11 . the resulting certificates are called emission reduction Copyright © 2009 Institutional Investor. There has been an increase in the turnover in exchange-traded contracts at the CME relative to that of the OTC market. with respect to emission credits. Other exchanges have offered these products. Describe emissions trading. 15. There are government insurance and development funds in many countries that are sponsors. 16.Topic 7: Structured Products. investors can have credits from additional climate protection projects that are in other countries credited to their own reduction target (baseline and credit). For the industrial country. and government insurance and development funds. Insurance companies that have taken on the risks of companies with insurance contracts are a large group of sponsors that use the contracts to manage their risk. This is in contrast to the market for catastrophe risks that covers high-cost low probability events. In the OTC market. The limited number includes the EU Allowances (EUAs). There are a limited number of emission rights for all companies. which defines a number of different emission certificates. There is a distinction. These contracts began in the mid-1990s. This is referred to as cap and trade. however. New Products and New Strategies The “sponsors” are those that issue the contracts for protection. The biggest market for greenhouse gas emissions is the EU Emission Trading System (EU-ETS). and these rights can be traded among companies that emit the greenhouse gases. The EU-ETS uses targets proposed by the Kyoto Protocol. corporations with a high exposure. for example. Mexico’s natural catastrophe fund (FONDEN) recently transferred large amounts of earthquake risks to the capital markets using catastrophe bonds. e. between emission rights and emission credits. Also. in that there is a limit or cap to the emissions and the right to emit can be traded. which lowers the quantity demanded of natural gas used for heating.

The Clean Development Mechanism (CDM) of the Kyoto Protocol allows for investment to be made in a project that promises to yield future income in the form of CERs. down to 50% of the initial target. it is possible to generate tradable project-based credits called verified emission reductions (VERs). Investors can place bets on rising prices through derivative instruments on emission certificates or participate in the realization of CDM projects. offer diversification. Potential market participants include carbon funds. they are called certified emission reductions (CERs). The Prototype Carbon Fund (PCF). This is done with the use of removal units (RMUs). They differ from CERs and ERUs in that VERs can only be used for voluntary CO2 compensation. Investors who have no direct involvement with emissions can attempt to earn a positive return in the market for these types of instruments. All Rights Reserved. An increasing number of investment banks.. The ultimate goal of both the factor-replication approach (or the factor-based approach) and the payoff distribution approach is to create a portfolio with Copyright © 2009 Institutional Investor. and the CERs can be generated from a portfolio of projects. This is because emerging markets are exempt from greenhouse gases quantitative reduction commitments. 17. brokers and institutional investors are buying and selling certificates for their own or third-party accounts.g. There has been increasing product differentiation. The rights to future CERs are traded at a discount. e. in terms of their: a. The CERs and ERUs are useful for the exceptions the Kyoto Protocol extends to emerging markets. Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge fund replication. which is a function of the project’s stage of progress. Carbon funds offer advantages over a direct investment because the funds have an expertise in the area. 12 . was one of the earliest funds. companies that have to meet reduction commitments within the EU-ETS framework are still the biggest group of end buyers (compliance buyers). launched by the World Bank. The Kyoto Protocol also allows for the realization of carbon-sink projects at home such as afforestation. and new possibilities are opening up for investors.Topic 7: Structured Products. goals. The Kyoto Protocol’s project-based mechanisms allow the CERs and ERUs from additional climate protection projects in third countries to be credited to the owner’s reduction target within certain limits. and can allow the investors to take on a particular level of risk via the number of shares purchased in the fund. A less advanced project would have a higher discount. A wide variety of projects qualify. For emerging markets. however. which include government purchasing programs and private commercial funds. It gathered experience with the new emissions trading instruments and prepared the market for later funds. Inc. Also. New Products and New Strategies units (ERUs).

the same average return. A stepwise regression is often used in this process. which is creating a clone of the hedge fund return using the estimated coefficients and the out-of-sample values of the factors. To achieve that ultimate goal. + BNFN. This also requires a two-step process: Step 1 consists of estimating a payoff function that maps an index return onto a hedge fund return. This is essentially estimating a factor model: Hedge Fund “k” Returnt = B0 + B1F1. given values of the underlying risk factors. to be time varying. A stepwise regression is a regression technique that allows for forward selection of relevant factors or backward elimination of irrelevant factors. Inc. for e. and earn returns similar to those of the hedge fund at a lower cost. All Rights Reserved. Bi.t + et where each Fi. The payoff distribution approach focuses on creating a clone portfolio where. Step 2 consists of pricing the payoffs and deriving the replicating factor strategy.Topic 7: Structured Products. to have the same risk profile. Step 2 requires the identification of the replicating factor strategy (RFS). .g. but it does not allow for the researcher to make inferences. at each step. at each stage. i. the most significant factor is added to the model. for all x. New Products and New Strategies characteristics similar to a particular hedge fund. and each Bi is the corresponding factor sensitivity. too.. The payoff distribution approach attempts to replicate the hedge fund’s returns by matching the unconditional higher moments. Another approach is to use non-linear factor models that may also be able to better capture the relationship and make better out-of-sample forecasts. Copyright © 2009 Institutional Investor. There is also return-based style (RBS) analysis. This requires a two-step approach. the least significant factor is removed. Another approach is to use a conditional factor model which allows the coefficients. which examines the exposure of hedge funds to certain style factors. the factor-based approach has the goal of replicating the hedge fund’s returns using hedge fund risk factors. The goal is to capture time varying factor exposures. The factor-based approach focuses on the conditional distribution to earn the conditional mean of a hedge fund. 13 . which is done using the Merton (1973) replicating portfolio interpretation of the Black and Scholes (1973) formula.t + .. Once having chosen a particular methodology in Step 1. the key issue is the efficacy of the factors in building mimicking portfolios. which should then give the same first moment. .t + B2F2. Backward elimination starts with a set of factors and. methodology. While this approach allows for lower specification risk. b. Pr(Clone return<x) = Pr(Hedge Fund return < x).t is the value of factor “i” at time “t”. Forward selection starts with no factors and. Step 1 requires the calibration of a satisfactory factor model for hedge fund returns.e.

The factor-based approach. The exhibit below classifies these objectives into three categories (Securities employed. The payoff distribution approach produces satisfying results for long-run out-of-sample returns but cannot capture short-run time-series properties. Discuss the term convergence as it is applied to the alternative investments industry. the authors refer to actual transactions pursed by both hedge fund managers as well as private equity managers. 14 . as noted by the authors. while the most natural and straightforward way to approach the replication problem. The factor-based model addresses the essence of the problem. Also. which is to find details of the risk exposures. d. 19. The term convergence is used to define the blurring of the lines between hedge fund and private equity investing. With the factor-based approach. it fails to replicate the short-run time-series characteristics. any factor analysis can suffer from specification risk. Copyright © 2009 Institutional Investor. There are several distinctions in the historical objectives of hedge fund managers versus private equity managers. We should recall that simple regression techniques only capture the past average exposures of the managers. benefits. Strategy pursued and Sources of returns) and compares these objectives. The payoff distribution property has some success in replicating long-run returns. drawbacks. Compare and contrast the historical objectives of private equity funds with that of hedge funds. Either the omission of factors or including too many factors can lower the accuracy of the model. The payoff distribution approach has the benefit of doing a better job of replicating return.Topic 7: Structured Products. This is the result of not using an accurate mix of factors. e. All Rights Reserved. New Products and New Strategies c. Neither approach has produced satisfactory results. there is a difficulty in identifying the correct factors and replicating the dynamic exposure to the factors. at least. the approach does not attempt to match the first moment (the mean). which is crucial to any investment analysis. 18. In this context. in the long run. Also. Inc. The objective of both hedge fund and private equity investors is to pursue “manager skill” or “alpha” rather than market exposure. has failed in thorough empirical tests to produce satisfactory results on an out-of-sample basis. However. ability to replicate hedge fund returns.

venture capital and public equity and debt investing. Hedge funds also establish direct lending businesses that function much like a bank or mezzanine fund. Blackstone also manages hedge funds such as Blackstone Kailix Advisors that invests primarily in equity investments on a long and short basis. with five general private equity funds and one specialized fund focusing on media and communications-related investments. and global macro hedge funds. 15 . Blackstone Group (http://www. All Rights Reserved. 4. control-oriented investments in North America and Western Europe.com/): A global private investment firm with over $30 billion of capital under management. private equity funds set up units under the same roof to pursue hedge fund investing. with a focus on acquiring and building asset-based businesses with significant cash flows.blackstone. 3. Private Ownership to obtain voting control 1. It manages a family of funds including private equity. Bain Capital (http://www.html): A private equity specialist. Gonzalez-Heres and Beinkampen note that hedge funds use side pockets within existing hedge fund vehicles to participate in private equity activities.Topic 7: Structured Products. It also runs hedge funds: hybrid hedge funds and liquid hedge funds. Arbitrage Opportunities. Copyright © 2009 Institutional Investor. Some have detailed information on their websites. Alignment of Economic Interests of Management and Shareholders and 3. Fortress Investment Group (http://www. Texas Pacific Group (http://www. credit products. Superior Security Selection 3. Contrast recent hedge fund participation in traditional private equity activities with recent private equity participation in traditional hedge funds activities.com/company/index. Private Equity Unregistered.texaspacificgroup. In contrast. New Products and New Strategies Distinction Securities Strategy Hedge Fund Listed Long or Short 1.com/): A private equity specialist that makes significant. It has investments in private equity and venture capital as well as long/short public equity. Access to types of Non-public information that listed share investments cannot provide.com): A private investment firm whose affiliates manage over $50 billion in assets.fortressinv. These include: 1. Inc.baincapital. The authors mention five examples. 2. Provision of Liquidity not generally available to the Market Source: Gonzalez-Heres and Beinkampen (2006) 20. Sources of Return 2. Control of the Underlying Business Strategy and Management Composition 2.

Topic 7: Structured Products. ranging from small. The objective was to identify securities of companies at various stages of the bankruptcy process (including companies on the verge of filing for bankruptcy or just emerging from bankruptcy). A typical distressed hedge fund manager evaluated investment opportunities more like a debt investor and invested in publicly traded securities. they specifically describe a multi-billion-dollar hedge fund manager that their team has had a longstanding relationship with since the mid-1990s. Private equity managers. This entails providing debt financing. This manager is a multi-strategy manager. The manager started out as a convertible arbitrage manager but transformed into a passive distressed manager by the end of 2001 and then morphed into a hybrid fund over the last 18 months. However in recent times. and public equities products.I. Private equity fund managers. The authors note that this was done by investing away from liquid distressed debt situations and toward more illiquid private assets. They have also taken a “lend-toown” debt financing approach. The distressed space provides an excellent example of recent convergence because both hedge fund investors and private equity investors have expanded their mandates. New Products and New Strategies 5. venture capital.G. Exit generally came through selling the appreciated security in the public market or to a strategic acquirer. usually to highly levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults.com/): A private investment specialist that manages private equity. distressed debt. on the other hand. While Gonzalez-Heres and Beinkampen offer some general observations. they are poaching each other’s strategies.and mid-sized companies to physical aircrafts. on the other hand. they recognize that material gains can be realized from these toehold positions. They are now acquiring sizable stakes with the mindset of owning the business rather than trading the securities. All Rights Reserved. 21. Copyright © 2009 Institutional Investor. He/she may or may not have played a significant role in negotiating a restructuring of the issuing company. that are publicly traded at a discount to their intrinsic values. are “active” investors that typically acquire a majority interest in a company in order to get operating control and run the business. hedge fund managers have expanded from “passive investing” to “buy-to-own” investing. 16 . Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund and private equity strategies. (http://www. the fund is approximately one-third private equity and two-thirds hedge fund. 22. In other words. are increasingly taking “toehold positions” in order to identify opportunities. Even if they are ultimately unsuccessful in gaining control. They often sell the company at a much later date for a profit via an initial public offering (IPO) or sale to strategic investors. Currently.higcapital. H. Capital was in lock-up status for one or two years. The key difference is that they play a significant role in the operational turnaround and restructuring of the issuing company. Describe the emergence of the hybrid hedge fund/private equity fund. Inc.

Topic 7: Structured Products, New Products and New Strategies

During the 2001-2002 period, there was a large wave of corporate bankruptcies. The manager took advantage of these opportunities by focusing on passive (non-operational) hedge fund-style distressed investing. By mid-2004, when these opportunities vanished, this manager felt that there were “gaps” that were overlooked by both hedge fund and private equity managers. These situations, however, required three to five years to produce attractive returns. After conferring with investors and getting their consent, the manager shifted towards a more private equity-oriented approach. In the situations above, the ability of the manager to adapt and migrate quickly to where the opportunities lay, led to strong returns. The ability to offer both hedge fund and private equity products are referred to as hybrid funds. The authors note that in late 2005 and early 2006, several private equity managers that they had longstanding relationships with indicated a desire to launch “sister” hedge fund products. Research conducted by private equity managers as they seek opportunities often led them to uncover opportunities in public markets. Alternatively, large positions in private companies often may lead managers to discover unique insights into the health and stability of other companies or industries. 23. Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing recent trends in the area. There are several factors that have contributed to the convergence of private equity and hedge fund strategies. First, the surge of capital that has flowed into hedge funds and away from private equity has put downward pressure on returns. It has also forced managers to look into private equity opportunities where venture capital slowed significantly after the Internet bubble burst in 2001. Second, because corporate defaults since 2004 have been at near historical lows, opportunities for distressed and private equity managers have been limited. Third, the limited opportunities have led distressed hedge fund managers to pursue other opportunities such as leveraged buyouts. A record $149 billion was raised for leveraged buyouts in 2005. Hedge fund managers watching these capital flows have been encouraged by some of the enthusiasm in this space. Fourth, private equity funds have been able to persuade corporate boards to back their transactions using the allure of stable capital, significant savings in time and money, and the avoidance of scrutiny that comes with going private. This is because the corporate board of a private company is no longer compelled to comply with the Sarbanes-Oxley Act, nor does it have to answer to a multitude of shareholder constituencies. Fifth, the compensation structure of many hedge funds provides incentives for the fund to invest in higher yielding, illiquid securities traditionally purchased by private equity firms over the short term. Unlike private equity firms where the manager is typically paid a performance fee only after all invested capital is returned to investors, hedge funds have traditionally been compensated on an annual basis.

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Topic 7: Structured Products, New Products and New Strategies

The authors also describe a sixth factor regarding SEC registration that is now mute. The CAIA® Level 1 Study Guide includes the following study tip (under Topic 23: Regulation of Hedge Funds): “…in December 2004, the Securities and Exchange Commission (SEC), by a vote of 3-2, promulgated regulations 203(b)(3)-2, an amendment to the Investment Advisers Act of 1940 (Advisers Act), which required many hedge fund managers to register with the SEC for the first time. However… on June 23, 2006, the United States Court of Appeals for the District of Columbia overturned this regulation...” 24. Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund strategies. There are several risks related to the trend toward convergence. These include 1. Mismatch of liquidity provisions and investment skill sets, 2. Diversification (so that investors do not find themselves with one or two illiquid investments), and 3. Appropriate staffing to trade, finance, restructure and, if necessary, operate underlying investments. The authors note that as hedge funds realize the impact that their capital can have on the management of public companies, excesses could arise but few high profile conflicts are anticipated. Hedge funds need to have appropriate staffing to operate underlying investments, if necessary, duties that have not traditionally fallen on a hedge fund manager’s modus operandi.

Š

References Anson, M.J.P. “Collateralized Fund Obligations: Intersection of Credit Derivative Market and Hedge Fund World.” Chapter 25 in Handbook of Alternative Assets, 2nd edition. Edited by Frank J. Fabozzi. John Wiley & Sons, 2006. Mansour, A., and H. Nadji. “Performance Characteristics of Infrastructure Investments.” RREEF Research – A Member of the Deutsche Bank Group. August 2007. Weistroffer, C. “Coping with Climate Change.” Deutsche Bank Research. November 15, 2007. Amenc, N., W. Gehin, L. Martellini, and J.C. Meyfredi. “The Myths and Limits of Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques.” Journal of Alternative Investments. Fall 2008. Gonzalez-Heres, J., and K. Beinkampen. “The Convergence of Private Equity and Hedge Funds.” Morgan Stanley’s Investment Management Journal. Vol. 2, No. 1, 2006.

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TOPIC

8

Asset Allocation 

Main

Points 

Comparing and contrasting buy-and-hold, constant mix, and constantproportion portfolio insurance strategies  Applying a wealth allocation framework that accounts for various dimensions of risk and deriving an ideal asset allocation for an individual  Interpreting the term structure of futures prices, the components of futures returns for individual contracts, returns for portfolios constructed and rebalanced with various methods, and the implications of tactical asset allocation strategies using commodity futures contracts  Critically examining the methods of including global commercial real estate in a strategic asset allocation

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1. Calculate the portfolio’s asset values after a given change in the equity value, using: a. buy-and-hold.

Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity). There are three primary strategies discussed as summarized below: Strategy Name Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance Rebalancing in Up Market None Sell Stock Buy Stock Rebalancing in Down Market None Buy Stock Sell Stock Shape of Payoff v. Stock Market Linear Concave Convex 

Consider for example an investor with $100 starting value allocating all of the funds

between two choices: risk free bonds (interest rate equals zero for simplicity) and a single risky portfolio (the stock market). Assume that the investor’s initial allocation is to put $70 in stock and $30 in bonds. The stock market is indexed to 100.0

Under a buy-and-hold strategy there is no rebalancing. The “Up” panel below shows the value of the portfolio in an up market with the market index rising
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19

in this case. The “Up” panel below shows the value of the portfolio in an up market with the market index rising 10 points each period for three consecutive periods.0 70. Inc.Topic 8: Asset Allocation 10 points each period for three consecutive periods. There are three primary strategies discussed as summarized below: Strategy Name Rebalancing in Up Market None Sell Stock Buy Stock Rebalancing in Down Market None Buy Stock Sell Stock Shape of Payoff v.0 80. 20 . Copyright © 2009 Institutional Investor. Any funds used to purchase stocks come from bonds and vice versa. Stock Market Linear Concave Convex Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance Under a “Constant Mix” strategy there is periodic rebalancing such that the portfolio is returned to being.0 120.0 Bonds 30 30 30 30 Stocks 70 77 84 91 After Balance Stock Bought(+) Bonds or Sold (-) 0 30 0 30 0 30 0 30 Stocks 70 77 84 91 Total 100 107 114 121 “Down” Market Panel: Buy-and-Hold: Before Balance Time 0 1 2 3 Stock Level 100. constant mix. b. All Rights Reserved. “Up” Market Panel: Buy-and-hold: Before Balance Time 0 1 2 3 Stock Level 100. The “Down” panel below shows the value of the portfolio in an analogous down market.0 130. Any funds used to purchase stocks come from bonds and vice versa. 70% stocks and 30% bonds. The “Down” panel below shows the value of the portfolio in an analogous down market. Further note that the total value is linear – it changes by the same dollar amount for each equal dollar movement in the stock market. Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity).0 90.0 Bonds 30 30 30 30 Stocks 70 63 56 49 Stock Bought(+) or Sold (-) 0 0 0 0 30 30 30 30 After Balance Bonds Stocks 70 63 56 49 Total 100 93 86 79  Note that there are no transactions since the strategy is buy and hold. The value of the portfolio (last column on right) changes $7 for each 10 point change in the stock market index when it is 70% initially invested in the stock market and there is no rebalancing.0 110.

Topic 8: Asset Allocation

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

“Down” Market Panel: Constant Mix:
Before Balance Time 0 1 2 3 Stock Level 100.0 90.0 80.0 70.0 Bonds 30 30 27.90 25.73 Stocks 70 63 57.87 52.54 Stock Bought(+) or Sold (-) 0 +2.10 +2.17 +2.25 Bonds 30 27.90 25.73 23.48 After Balance Stocks 70 65.10 60.04 54.78 Total 100 93.00 85.77 78.26

The $2.10 sale of stocks (and purchase of bonds) in time period 1 of the “Up panel” is a rebalancing such that the new value of the portfolio ($107) remains 70% allocated to stocks. Stocks are sold as the stock market trends up to prevent “underweighting” in bonds. In the downward panel, stocks are purchased as the stock market trends down to prevent “underweighting” of stock. Very importantly, note that the total value is non-linear – it changes by smaller dollar amounts for each equal upward dollar movement in the stock market. The value of the portfolio rises $7 for the first upward 10-point change in the stock market index but rises by only $6.81 for the second 10-point change (the rebalanced stock holding does not rise by $7 because the 10-point stock rise is a smaller percentage stock price rise than it was when the stock level was lower). Conversely, rebalancing to the stock market while it is falling produces larger losses than in previous periods or in the buy-and-hold strategy (note that each 10-point decline in the market index represents a higher percentage decline). Viewed on a graph with total portfolio value on the vertical axis and stock market index values on the horizontal level, the Constant Mix strategy forms a concave shape. The buy-and-hold strategy forms a straight line. c. constant-proportion portfolio insurance.

Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity). There are three primary strategies discussed as summarized below:
Strategy Name Buy-and-hold Constant Mix Constant Proportion Portfolio Insurance Rebalancing in Up Market None Sell Stock Buy Stock Rebalancing in Down Market None Buy Stock Sell Stock Shape of Payoff v. Stock Market Linear Concave Convex

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21

Topic 8: Asset Allocation

Under a “Constant-Proportion Portfolio Insurance” (CPPI) strategy the investor sets a floor value at which all risky investing terminates. Further, the investor increases risky assets holding when the market rises and decreases risky asset holdings when the market falls. 

For example, consider that the investor sets a floor value of $50 but invests 150% of the total

portfolio value in excess of this floor in stock. Thus, the investor starts with a total value of $100 allocated $25 to bonds and $75 to stock. At the end of each period, the investor resets the stock allocation so that it is 150% of the excess, if any, by which the total portfolio exceeds the floor ($50). Any funds used to purchase stocks come from bonds and vice versa.
Before Balance Time 0 1 2 3 Stock Level 100.0 110.0 120.0 130.0 Bonds 25 25 21.25 17.33 Stocks 75 82.50 94.09 106.18 Stock Bought(+) or Sold (-) 0 +3.75 +3.92 +4.08 Bonds 25 21.25 17.33 13.25 After Balance Stocks 75 86.25 98.01 110.26 Total 100 107.50 115.34 123.51

“Up” Market Panel: CPPI:

“Down” Market Panel: CPPI:
Before Balance Time 0 1 2 3 Stock Level 100.0 90.0 80.0 70.0 Bonds 25 25 28.75 32.29 Stocks 75 67.50 56.67 46.49 Stock Bought(+) or Sold (-) 0 -3.75 -3.54 -3.32 Bonds 25 28.75 32.29 35.61 After Balance Stocks 75 63.75 53.13 43.16 Total 100 92.50 85.42 78.78

The $3.75 purchase of stocks (and sale of bonds) in time period 1 of the “Up panel” is a rebalancing such that the new allocation increases its “bet” on stocks. Stocks are bought as the stock market trends up to try to achieve massive gains. In the downward panel, stocks are aggressively sold as the stock market trends down to prevent larger losses and to insure that the floor value ($75) is protected. Very importantly, note that the total value is non-linear – it changes by larger dollar amounts for each equal upward dollar movement in the stock market. The value of the portfolio rises $7.50 for the first upward 10-point change in the stock market index and rises $7.84 for the second 10-point change (since the strategy placed 150% of “profits” in stock). Conversely, rebalancing away from the stock market while it is falling produces smaller losses than in previous periods. Over the long-term, the floor should increase, so that the relationship between the initial floor and a floor at time “t” is Ft =F0ert where Ft, F0, r, and t are are the floor value of the portfolio at time t, the floor value at initiation of the strategy (t=0), the risk-free rate, and a time index. At a given point in time, viewed on a graph with total portfolio value on the vertical axis and stock market index values on the horizontal level, the CPPI strategy forms a convex
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Topic 8: Asset Allocation

shape. The buy-and-hold strategy forms a straight line and the constant mix strategy forms a concave shape. 2. Compare the payoff and exposure diagrams of the buy-and-hold, constant mix, constant-proportion portfolio insurance, and optionbased portfolio insurance strategies. A payoff diagram in the context of the article by Period and Sharpe, is a graph of the relationship between total portfolio (asset) value on the vertical axis and stock market index value (performance of the risky asset class) on the horizontal axis. Simply put, it tells the investor the profit and loss of his or her entire portfolio in relationship to movement in the stock market. 

For example, consider a buy-and-hold strategy that purchases a particular combination

(e.g., 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds). The bond values are assumed constant and for simplicity do not even pay interest. The buy-andhold strategy does not rebalance, so the stock position simply grows and shrinks linearly with the stock market as depicted below. The slope of the line depends on the original mix, but the relationship is linear regardless of initial mix Buy & Hold | | X | X | X | X | X | X | X | X |_X_____________________________________________________ Value of the Stock Market

Total Portfolio Value

Now consider a constant proportion strategy that sells stock in a rising market to maintain the desired mix and buys stock in a declining market similarly to maintain a desired mix. The payoff diagram will demonstrate a concave relationship as indicated below: Constant Mix | | | X | X | X | X | X | X | X |_______________________________________________________ Value of the Stock Market
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

X

Total Portfolio Value

23

convexity and call-option-like relationships of the four strategies as reviewed above. These shapes are important in understanding behavior in trending versus reverting markets. consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value). it tells the investor the risk exposure of the portfolio in relationship to the total portfolio’s cumulative performance.Topic 8: Asset Allocation Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value). Simply put. 24 . concavity. The payoff diagram will demonstrate a kinked but otherwise linear relationship similar to the traditional diagram of a call options and as indicated below: Option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market | | X | X | X | X |X X X X | | | |_______________________________________________________ Value of the Stock Market Total Portfolio Value  In summary. The payoff diagram will demonstrate a convex relationship as indicated below: CPPI strategy | | | | | | | X X X X X X X X Total Portfolio Value | |X |_______________________________________________________ Value of the Stock Market Finally. An exposure diagram in the context of the article by Period and Sharpe. is a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Copyright © 2009 Institutional Investor. All Rights Reserved. Inc. the key to the payoff diagrams is that they show the linearity.

Topic 8: Asset Allocation  For example. The bond values are assumes constant and for simplicity do not even pay interest. consider a buy-and-hold strategy that purchases a particular combination (e. Inc. so the stock position simply grows and shrinks linearly with the stock market with a lower bound equal to the bond position as depicted below. The key to the diagram is that it has a moderate slope. Buy & Hold | X | X | X | X | X | X | X | X | X |_____________________________________________________ Value of the Total Portfolio Portfolio’s Stock Value Now consider a constant proportion strategy that sells stock in a rising market to maintain the desired mix and buys stock in a declining market similarly to maintain a desired mix. The key to the diagram is that it has a moderate slope. The buy-andhold strategy does not rebalance.g. Constant proportion strategy | | | | | X | X | X | X | X |_X___________________________________________________ Value of the Total Portfolio Portfolio’s Stock Value Copyright © 2009 Institutional Investor. All Rights Reserved.. 25 . The location of the line on the horizontal axis depends on the original mix and bond position but is linear regardless of initial mix. 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds).

The exposure diagram will demonstrate a steep and curved relationship as indicated below: Option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market | | | X | X | X | X | X | X | X |__________________ __________X________________________ Value of the Total Portfolio Portfolio’s Stock Value 3. 26 .Topic 8: Asset Allocation Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value). All Rights Reserved. Concavity in the context of the Perold and Sharpe study refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises and to increase equity exposure as the equity market falls. flat (but oscillating) markets. The exposure diagram will demonstrate a steeply sloped relationship as indicated below: CPPI strategy | X | X | X | X | X | X | X | X X | |______________ X__________________________________ Value of the Total Portfolio Portfolio’s Stock Value Finally. An example is a constant mix strategy that sells stock in a rising stock market to keep the stock’s value a constant proportion of the portfolio. Determine the expected performance and cost of implementing strategies with concave payoff curves relative to those with convex payoff curves under: a. trending markets b. Convexity refers to the tendency of a strategy to increase equity Copyright © 2009 Institutional Investor. Inc. consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value).

and the risk-free rate. All Rights Reserved. trending markets.F0) [(It/I0) m]e(1-m)(r+0. A concave strategy such as a constant mix strategy liquidates stocks into a rally and buys additional stock throughout a long decline. The expected performance of a strategy is directly associated with the strategies’ payoff curves. b.. The subscripts 0 and t stand for the beginning value and the value at time t respectively. Conversely. or oscillate more. For the buy-and-hold strategy. the multiplier. to keep a target mix) and then profit in a reversal. but is quick to reduce stock exposure when nearing a lower bound “floor” value. A concave strategy’s relative performance is the opposite. the floor value of the portfolio. The amount of equity (risky assets) held in the CPPI strategy is: Equity = m (At – Ft). mitigating the losses. m( At – Ft)) if no leverage is allowed. The following equations can help in describing the payoffs and equity weights for the various strategies. or Equity = MIN(A. Inc.Topic 8: Asset Allocation exposure (risk) as the equity market rises and to decrease equity exposure as the equity market falls. Thus. A trending market works in favor of a convex strategy because as markets rise the stock exposure is greatly increase. the value of the market index. Ft. A flat but oscillating market favors concave strategies and hurts convex strategies. The role of the variance in the constant proportion strategy is evident from the payoff equation for that strategy: Vt = Ft + (V0 . A linear (buy-and-hold) strategy simply makes or loses money based on the terminal performance of the underlying stocks. An example is a CPPI (Constant-Proportion Portfolio Insurance strategy) that is highly aggressive with profits. concave strategies perform relatively well in flat (but oscillating) markets while convex strategies perform well in trending markets. flat (but oscillating) markets. the payoff equation reduces to Vt = Ft + (V0 – F0)(It/I0). A convex strategy will get whipsawed – selling after the decline and buying after the rise. the curvature explains the expected performance and costs of the strategy due to the subsequent nature of the market in the sense of whether the market will tend to trend more. Copyright © 2009 Institutional Investor. It. in a downtrend the stocks are sold off. A concave strategy will buy after a decline (e. a.5*m*variance)t where Vt. respectively. producing high relative profits if the up trend is substantial and sustained.g. and the amount of the equity held is Equity = (At – Ft). m and r are are the value of the portfolio. However. 27 .

28 . The following factors have also increased the level of responsibility that individuals have for their own retirement: 1. By adjusting the parameters. In particular. achieving diversification from funds whose returns tend to have higher levels of correlation. Resetting of parameters can allow the portfolio allocator to make substantial changes in the exposures and payoffs of the strategy – potentially changing the entire character of the strategy as illustrated above by the ability to transform one strategy into another through constant parameter adjustment. can adjust minimum desired asset levels (cushions and floor values) and so forth. Inc. 6. the risk exposures and payoffs of the strategies can be altered. such as option-based portfolio insurance. and 3.g. a 20% down payment on a home provides a 50% return if the home increases in value by only 10%. for e. The primary change that has thrust more responsibility upon individuals is the movement from defined benefit to defined contribution plans. but this can be misleading. Further. Other dynamic strategies such as constant mix require transactions but not resetting of parameters. the CPPI strategy can be transformed into a constant mix strategy by constantly adjusting the floor to a specified percentage of the asset values. Parameters of dynamic asset allocation strategies can adjust exposures to risky assets at various levels. 2. It should be noted that a large portion of those that have become wealthy have used these strategies. This means that market risk has moved from the sponsoring firm to the individual. using leverage in real estate by assuming a mortgage. Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth management and asset allocation. parameter resetting can be appropriate for horizon points or after major market movements. Some dynamic strategies. the option based portfolio insurance strategy may be viewed as a special case of the Constant-Proportion Portfolio Insurance in which parameters change with levels of the cushion.Topic 8: Asset Allocation 4. because there are many investors that used these strategies and did very poorly.  In each case. For example. All Rights Reserved. estimating life expectancy and the general increase in life expectancy (with a defined benefit plan. 5. and Copyright © 2009 Institutional Investor. starting a small business. 2. the sponsor pays as long as the individual is alive).. accumulation of low-basis stock and stock options and not diversifying. Discuss the motivations for and impact of resetting the parameters of dynamic strategies. require resetting of parameters at horizon points. Undiversified strategies that have worked for a minority of investors include: 1. there is the potential for large returns if the conditions are favorable. Describe examples of undiversified “strategies” that have allowed individuals to become wealthy.

For example. the investor should not take the same amount out each period.g. Personal risk refers to the possibility of a fall in the investor’s lifestyle and the resulting anxiety associated with that possibility. Explain and apply the wealth allocation framework that accounts for various dimensions of risk and leads to an ideal portfolio that provides: Note: By analyzing actual human behavior. Lifecycle stage: the stage of earning power and the desire to leave a legacy. that has a high probability of maintaining one’s standard of living. 8. 2. etc. the investor might have a target minimum level of wealth. health problems. Kahneman and Tversky (1979) found that investors attempt to compose a portfolio that protects from anxiety. and provides for the possibility of increasing wealth. derivatives. All Rights Reserved. and a shock could lower the portfolio’s value below that number. market risk to increase returns. Ability to weather shortfalls: ability to adjust to unexpected declines in assets and/or living longer than expected. More generally. an application of the personal risk approach is to allow the outflows of cash to vary directly with the changing value of the portfolio. the certainty of protection from anxiety. Event risk: ability to adjust to events like the loss of a job.. Explain and apply the concept of personal risk and its various components to the asset allocation problem faced by individuals. personal risk that can lower the level of lifestyle. structured products. market crashes. That is. one application of the personal risk approach is to use Roy’s Safety First criterion when addressing the ability to weather shortfalls. and three. a move three or more standard deviations from the mean. two. the historical market standard deviation can imply a much higher level of risk for an older individual or a person with less job security. especially in a down-trending market.. 3. Personal risk comes from the unique characteristics of the investor that can amplify the level of risk well above that implied by the basic market statistics. which could be devastating to the investor on either a real or psychological level or both. Inc. The three dimensions of risk that the ideal portfolio must address are: one. 7. 1. The investor can address this risk by applying a Copyright © 2009 Institutional Investor. Cash flows: the estimated net inflows and savings and the variability of those cash flows. With respect to cash flows. a.Topic 8: Asset Allocation 3. 29 . e. With respect to such a shock. Taking out insurance policies is an application of the personal risk approach to address event risk.g. for e. The components of personal risk are listed below. choosing among a wider range of possible products. One way to think of personal risk in contrast to a traditional risk measure is to consider how well an individual can endure under extreme shocks. aspirational risk associated with enhancing one’s lifestyle. 4. which could reduce a portfolio to zero.

and the 3% allocation to long calls can achieve high returns if the market increases. Another type of strategy is to simply make an allocation of wealth to a very safe asset such as Treasury Bills. Both of these will lower return under average market conditions. with the rest in a diversified portfolio of market assets. investing the remainder in a well diversified portfolio of conventional assets that provide a return commensurate with market risk and low idiosyncratic risk. a large exposure to market risk with its commensurate returns. Market risk bucket: after making allocations to the personal and aspirational risk bucket. 9. All Rights Reserved. this would be the largest allocation and would be made to standard market assets such as stocks and bonds. Market risk refers to the possibility of the investor being able to at least maintain a certain standard of living or even improve it moderately with the market returns. Those strategies include incurring expenses that limit downside risk. Inc. Allocations in this area are called allocations to the aspirational risk bucket. Aspirational risk bucket: investing in high risk/return assets such as hedge funds and/or private equity. 30 . the 30% in the Copyright © 2009 Institutional Investor. Addressing this issue is referred to as making an allocation to the investor’s market risk bucket. The following are examples of the types of investments that an individual would make to address the three dimensions of risk. In most cases. Such portfolio decisions are said to be making an allocation to the investor’s personal risk bucket. The justification is that the 2% allocation to protective puts lowers the risk of extreme losses.Topic 8: Asset Allocation variety of strategies.  A representative allocation might be to invest 2% in protective puts and 3% in long call positions. and an investment in a high-risk asset that can provide very high returns in a positive market environment. 1. 3. They would include purchasing call options on market assets or purchasing assets with large risk but also the high possibility of returns such as small capitalization stocks. e. 2. the possibility of substantially moving upward in the wealth spectrum. or buying call options that will pay off if the market takes off. Develop and justify an asset and risk allocation for an individual using information provided to the candidate during the examination. the high probability of maintaining one’s standard of living. Aspirational risk is associated with the possibility of significantly enhancing one’s lifestyle. purchasing puts. An alternative might be to invest 30% in the risk free asset and 5% in a high-risk alternative asset such as a hedge fund and the rest in a portfolio of market assets.g. In summary.. Once again. c. Allocations to the aspirational risk bucket would be relatively small compared to the market risk bucket. b. but will provide benefits if the market falls below certain thresholds. Personal risk bucket: make an allocation to the risk free asset or buy put options. a wealth allocation framework that accounts for these three dimensions would provide a safety net on the downside.

a relatively low weight in the market risk bucket. or enhance risk. including real estate. and the 5% in the hedge fund provides high upside potential under the right conditions. the portfolio has two extreme positions to meet the desired risk allocations. 11. on the asset allocation of individual investors. ‘Relatively high’ would be in comparison to Copyright © 2009 Institutional Investor. futures. Describe and apply barbell and option based strategies in the context of asset allocation. Futures could fit into all three buckets as a means to reduce risk. 1. Alternative investments such as private equity. diversify with managed futures. Modest rental units would be an allocation to the market risk bucket and serve as a good diversifier. Each has a particular set of impacts on the portfolio. executive stock options and human capital.Topic 8: Asset Allocation risk-free asset will minimize losses. It could be a means to address aspirational risk if there is the expectation of an increase in a given currency. hedge funds. 4. they would be highly correlated with the human capital of the individual. and therefore undiversified. Speculative real estate purchased for resale at a higher price would be an allocation to the aspirational risk bucket. Executive stock options would fit into the aspirational risk bucket. high fees. real estate. Foreign exchange would fit into the personal risk budget as a protection against the declines in currency and as a diversifier. The barbell strategy is one where an investor allocates a given amount to a safe position that provides a cushion. Inc. Human capital would generally fit into the aspirational risk bucket. Private equity and hedge funds would be allocations to the aspirational risk bucket. Understand the impact of alternative investments. A sensible home for personal use would be an allocation to the personal risk bucket. As education and skills become more specialized. executive stock options and human capital will have an impact on the asset allocation of individual investors. 3. 31 . 2. and low transparency. and some can fit into more than one risk bucket. 10. and a relatively high weight in the aspirational risk bucket. All Rights Reserved. Real estate can also fit into various risk buckets. commodities. Furthermore. The rest would be allocated to a risky portion known as the aspirational part. This is because they are high risk and undiversified assets. investments in this area are designed to increase the standard of living of the individual. An application of the barbell strategy would be to have a relatively high weight in the personal risk bucket. and foreign exchange have become a basic ingredient in the portfolios of wealthy individuals. Thus. Alternative investments. These investments have idiosyncratic risk. Commodities would best fit into the personal risk bucket as a protection against inflation.

with a standard deviation of 18. 10%. Inc. The underlying reason comes from the fact that a portfolio of uncorrelated securities with high standard deviations that is rebalanced can have a higher return than the individual assets in the portfolio. and what used to be the Reuters-CRB Futures Price Index (CRB). the market risk bucket could have a broad-based equity market portfolio. Copyright © 2009 Institutional Investor. CRB) show different levels of return and volatility over a common time period. traded on the Chicago Board of Trade. The three most commonly used commodity futures indices are the Goldman Sachs Commodity Index (GSCI). 55% in the market risk bucket.Topic 8: Asset Allocation a more standard allocation. traded on the Chicago Mercantile Exchange. Explain why the three most commonly used commodity futures indices (GSCI. and 5% in the aspirational risk bucket. 10% in a market ETF. If the market performs poorly. These differences are the obvious reason that the performance of a rebalanced equally weighted commodity futures portfolio should not be used to represent the return of the commodity futures asset class. and 25% in a hedge fund. Discuss reasons why the performance of a rebalanced equally weighted commodity futures portfolio should not be used to represent the return of the commodity futures asset class.e. DJ-AIGCI. A more standard application might be 40% in the personal risk bucket. The personal risk bucket could have bonds.35%. and the aspirational risk bucket could be a hedge fund.  The application of the barbell strategy would produce an allocation more like 65%. 13..2% over the time period 1969-2004. and 25% respectively. There has been a significant difference in the average returns of individual futures contracts and the returns of a rebalanced equally weighted commodity futures portfolio. If the market performs well. 12. for the period 1959-2004. Various tools could be used to achieve this for the three buckets. the Dow JonesAIG Commodity Index (DJ-AIGCI). i. traded on the New York Board of Trade. the calls will provide a high level of return. Option-based investing strategies can include certain dynamic asset allocation strategies that can be approximated using simple buy-and-hold strategies that include options. Of 36 commodity contracts. All Rights Reserved. a barbell portfolio would be 65% in high-grade bonds. One particular barbell strategy is an option-based strategy that invests in TIPS for the safe portion and then purchasing call options for the aspirational part. An application of this strategy would be 90% in TIPS and 10% in a call option on a market ETF. but the annual return of individual commodity futures has been close to zero. Incorporating options may help the sustainability of pension funds. the investor has some credit and inflation risk. There is no need to make an allocation to the market risk bucket because the option on the ETF has exposure to the market. only one had a positive return statistically different from zero. The Goldman Sachs Commodity Index (GSCI) earned an average annual return equal to 12. 32 .

14. the three commodity indices experienced different levels of return and volatility. the excess return on this position is 5%. ● The monthly rebalanced CRB had been a geometrically averaged and equally weighted index. the DJ-AIGCI accounted for 10%. it has now changed to be similar to the DJ-AIGCI. and the CRB had a return about equal to that of the T-bill return. however. The GSCI is the most representative with 86% of open interest.5% The annualized total return of a diversified cash-collateralized commodity futures portfolio can be decomposed into three components: Cash-collateralized commodity futures portfolio total return = Cash return + weighted-average excess return + diversification return Copyright © 2009 Institutional Investor. If the cash return over the horizon is 2% and the price of the contract changes to $820/oz. for instance. The use of different portfolio weights implies that each index defines the aggregate commodity futures market differently. Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized commodity futures can be decomposed into various sources of return.1 a bushel. The GSCI had twice the volatility of the CRB during the period. The DJ-AIGCI and the GSCI had average returns similar to that of the Lehman Aggregate. The equation is Individual cash-collateralized commodity futures return = Cash return + Excess return The excess return is simply the percent change in the price of a futures contract. Two components make up the annualized total return of a cash-collateralized commodity futures contract: the return on the cash position used as collateral and the change in the futures price. the most important factor that can explain the differences is the differing weights of individual commodity futures contracts in the indices. and the CRB made up the remaining 4% of open interest (figures as of 2004). an investor purchases a corn futures contract for $2 a bushel and later sells the contract for $2. Over the period 1991-2004. In the case of the indices. The return of an index is a function of two factors: the returns of the components of the index and the weights of the components. All Rights Reserved.5% = 4. and it has a high weight in energy commodities.Topic 8: Asset Allocation Each index is designed to be a broad representation of investment opportunities in the aggregate commodity futures market. ● The GSCI uses weights based on the level of worldwide production for each commodity. 33 .  Example: An investor goes long a gold contract at $800/oz. If. Inc. ● The annually rebalanced DJ-AIGCI uses weights based on contract liquidity and production data.. what is the total cashcollateralized commodity futures return? Return = 2% + ($820-$800)/$800 = 2% + 2.

The bottom line is that returns can be positive for either the long or short position. The theory is that inventories allow producers to avoid shortages and production disruptions. the insurance perspective. investors who go long commodity futures should receive a positive risk premium. Discuss the four theoretical frameworks (CAPM. In contango markets. excess returns should be positive. for e.. The diversification return is enhanced by rebalancing but will usually be lower if the portfolio is not rebalanced.” If today’s futures price is below the spot price in the future. As a result. In normal backwardation markets. 15. then as the futures price converges toward the spot price at maturity. airlines needing fuel. are willing to short futures at a lower price. Copyright © 2009 Institutional Investor. None of these is the definitive model. and the speculators can be short and earn a profit as the futures price rises. The geometric average return of a portfolio will be positively affected by the reduction in variance. theory of storage) used to explain the source of commodity futures excess returns. having a level of inventories that will reduce the impact of production disruptions is beneficial. are willing to go long futures at a higher price. but they all represent work being done to understand commodity returns. The more plentiful inventories are. for e. There are at least two faults with this argument. it would not be surprising that it would not have much explanatory power for non-equity assets. The theory of storage focuses on the role that inventories of commodities play in the determination of commodity futures prices. normal backwardation provides a rationale that a long-only portfolio of commodity futures can represent an effective allocation of capital. therefore. The less plentiful inventories are.g. the agents who are short the commodity. Under normal backwardation. The insurance perspective proposes a return is earned by speculators who take long positions from “normal backwardation. This is because commodities futures are uncorrelated with equities and have a zero beta..g. the insurance perspective. Inc. A positive diversification return means that the compound return of the portfolio will be greater than the weighted-average compound return of the individual portfolio constituents. The hedging pressure hypothesis says that commodities can produce positive returns for either normal backwardation markets or contango markets. First. and commodities are not included in the market index. hedging pressure hypothesis. and it depends upon whether there is more hedging pressure on the long or short side. All Rights Reserved. The excess return from a long commodity futures investment should be viewed as an insurance risk premium. and the theory of storage. The convenience yield is a type of risk premium that is determined by inventory levels. oil producers. the less the likelihood is that a production disruption will affect prices. the more likely it is that a production disruption will affect prices. The CAPM would predict that commodities futures would have a zero excess return. therefore. 34 .Topic 8: Asset Allocation The diversification return is usually a benefit from the synergies of combining two or more assets and rebalancing the portfolio. the agents who are long the commodity itself. the CAPM has low explanatory power even for equities. Second. the hedging pressure hypothesis. and the speculators can be long and earn a profit as the futures price rises. The four theoretical frameworks for understanding the source of commodity futures excess returns are the capital asset pricing model (CAPM). the CAPM is for capital markets.

In the theory of storage. If the spot price is $50. Answer: The net effect will be a futures price that is 2% lower than the spot price: for an annual contract. 17. If today’s futures price is below the spot price in the future. for a one-year contract. compute the futures price for a six-month contract. In the above example. if the convenience yield is 1%. then as the futures price converges toward the spot price at maturity.  Example: the futures price = $840. Explain the concepts of contango.10% = -4%. if the futures price for a May 2009 contract is $45 and the futures price is $40 for the June 2010 contract. 35 . All Rights Reserved. inventories should be plentiful and they should have low convenience yields.5% Copyright © 2009 Institutional Investor. as a result. For example.4%/2) = $49. the computation is 6% . Inc.  For example. The futures price = $50*(1 . Calculate the roll yield of a commodity futures contract in backwardation or contango. normal backwardation and market backwardation. but for a six-month contract. Contango is the condition of the futures price being above the expected future spot price. the effect is one half of this. if the spot price = $800 and the interest rate = 5%. Market backwardation can be observed. We should recall the basic futures pricing formula when there are not storage costs and a convenience yield: the futures price equals the spot price times the future value interest factor. however. Normal backwardation cannot be observed. and its two components are the market consensus expected future spot price and a possible risk premium. and the interest rate is 6%. The term “contangoed commodities” refers to contracts where the futures price is greater than the spot price. Conversely. A commodity has a convenience yield of 10%. if inventories are low. excess returns should be positive. One explanation for contango is that hedgers are net long futures. those commodities may have high convenience yields. The short-term contract will have a higher price and the return will be positive: Roll yield = (Fshort-term/Flong-term) -1. for easy-to-store commodities. Roll yield = ($45/$40) -1 = 12. 16. the roll yield is positive. and assuming the term structure remains the same. the futures price = $832. There could be a convenience yield. because the expected spot price is not truly known. Normal backwardation describes the case where the futures price for a commodity is less than the expected spot price in the future. Roll yield or roll return generated in a backwardated futures market is achieved by rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price.  When backwardation exits. storage costs determine the price of a commodity futures contract.Topic 8: Asset Allocation Inventories may be low for difficult-to-store commodities.

the bottom line is that it is not clear if any of the average spot and excess returns were statistically different from zero in this time period. If the futures price for a May 2009 contract is $48 and the futures price is $50 for the June 2010 contract. Inc.Topic 8: Asset Allocation When contango exits. Since the roll yield is positive. it may be the best for a risk averse investor to assume a future roll return of zero or even below zero. there was not a significant average excess or spot return for any given individual commodity futures or commodity futures sector. and assuming the term structure remains the same. There was a lot of variation ranging from positive roll returns to negative roll returns. 36 . The implications are that investing in commodity futures with relatively high roll may be rewarding. the roll yield is negative. Two studies are representative of research in this area. However. therefore. The importance of the high volatility of spot returns is evident because it made even the highest roll return an insignificant excess return. Answer: Roll yield = ($100/$80)-1 = 25%. Roll returns are important in explaining the cross-section of individual commodity futures’ excess returns from December 1982 through May 2004. For the period December 1982 through May 2004. and assuming the term structure remains the same. All Rights Reserved. Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity contracts. and diversified commodity portfolios and indices. Describe the relative importance of the volatility of spot return and roll return in determining the volatility of futures returns. calculate the roll yield and comment on whether the market is in backwardation or contango. 19. but it is not a guarantee. but it is not scientific. It is convenient to extrapolate. 20. Given the conflicting results.6% of the long-run cross-sectional variation of commodity futures returns over the period. 18. the coefficient of determination (R2) indicates that the roll returns explained 91. Inflation is usually considered an important factor in determining commodity prices and. For a broadly diversified portfolio of commodity futures.6% of the cross-sectional variation of commodity futures returns over any particular future time horizon. Roll yield = ($48/$50)-1 = -4%  Example: If the futures price for a January 2010 contract is $100 and the futures price is $80 for the January 2011 contract. would probably play a role in determining return volatility. The results do not suggest that roll returns will explain 91. In a regression. sectors. Potential investors should be cautious. roll returns have been highly correlated with excess returns. the market is in backwardation. Discuss the importance of roll return in explaining the long-run crosssectional variation of commodity futures returns and the implication for investors. Copyright © 2009 Institutional Investor.

it is found that for the period 1969 to 2003. because commodities have only about a 40% weight in the U. Thus. This result requires a closer look for two reasons: first. it is important to understand the behavior of a broad-based commodity futures investment by looking at the inflation sensitivity of individual commodity futures. Finally. One notable example is the housing component of the CPI. unexpected inflation explained 43% of the time-series variation in the GSCI’s annual excess returns. ● The sectors energy. wheat) had negative roll returns and negative unexpected inflation betas. Other commodities (e. Some commodities (e. Using this proxy. Inc.g. the returns of many commodity futures seem to be uncorrelated with one another. The wide dispersion of relationships probably explains why the equally weighted average of the 12 commodities has a positive (but insignificant) inflation beta. We should recall that the inflation beta of a commodity futures portfolio is simply a weighted average of the portfolio’s constituent inflation betas. Assuming changes in inflation cannot be forecast means that changes in inflation can serve as a proxy for unexpected inflation.59 with the change in the annual rate of inflation.g.S. Inflation consists of two components: expected inflation and unexpected changes in inflation. Thus. and copper have significant unexpected inflation betas. ● The individual commodity futures heating oil. Consumer Price Index (CPI). Copyright © 2009 Institutional Investor. which is the biggest single CPI component and is not in a commodity futures index. ● No other sectors or individual commodities have significant inflation betas. and live cattle) had positive roll returns for the period and high unexpected inflation betas.. ● Strongin and Petsch (1996): The GSCI performs well relative to stocks and nominal bonds during periods of rising inflation. livestock. the GSCI’s composition has changed over time and. All Rights Reserved. one explanation for why some commodity futures might be better inflation hedges than others is that average roll returns are highly correlated with unexpected inflation betas..25 with the annual rate of inflation and a time series correlation of 0. copper. and a broad-based commodity futures index excludes many items measured in the CPI. second. heating oil. The GSCI has a positive (but statistically insignificant) actual inflation beta and a positive (and significant) unexpected inflation beta. and industrial metals have significant unexpected inflation betas. however. Unexpected inflation appears to be correlated with excess returns of the GSCI. cattle. 37 . the Chase Physical Commodity Index had a time-series correlation of 0. We must be careful about how we define inflation.Topic 8: Asset Allocation ● Greer (2000): Over the 1970–99 period. The following is a summary of statistical tests. ● The precious metals sector has a statistically significant negative inflation beta. Average roll returns explain 67% of the cross-sectional variation of commodity futures unexpected inflation betas. neither the magnitude nor the sign of the inflation coefficients is guaranteed to remain constant in the future.

This indicates how investors can boost a geometric return with some certainty by rebalancing a portfolio. appreciably raise the geometric return of a fixedweight. a negative return between the diversification return and the average correlation and the number of securities in the portfolio. Illustrating this begins with the approximation: geometric return = (arithmetic return) – (asset or portfolio’s variance)/2. Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on momentum and the term structure of futures prices. The arithmetic return is the simple average of period-to-period returns. 38 . rebalanced portfolio: portfolio diversification return = (average variance)*(1-average correlation)*(N-1)/(2*N). the diversification return can be high. for an equally weighted portfolio of 30 securities with average individual security standard deviations of 30% a year and average security correlations ranging from 0. the geometric return increases. Many investors find the possibility of earning returns from both time-series and crosssectional analysis attractive. Fung and Hsieh (2001) found that most active managers of commodity futures portfolios are trend followers who rely on the assumption that past price moves predict future price moves. where N is the number of assets in the portfolio.  For example. commodity futures portfolio.Topic 8: Asset Allocation 21. and ● Term structure or cross-sectional analysis focuses on the idea that the term structure of commodity futures explains a significant portion of the long-run cross-section of commodity futures returns. The important point to remember is that when asset variances are high and correlations are low (as they are with commodities). The diversification return is the difference between a portfolio’s geometric return and the weighted-average geometric return of the portfolio’s constituents. This equation illustrates that there is a positive relationship between the diversification return and the average variance of the securities in the portfolio. The geometric return is the return that takes into account the compounding across periods.35%. A fairly simple formula defines the diversification return of an equally weighted. Inc. By reducing the variance. but there can be a positive incremental return from variance reduction. under certain circumstances.05% to 4.3. The diversification return can. Copyright © 2009 Institutional Investor. 22. The two basic strategies are: ● Momentum or trend following. The geometric return is always less than the arithmetic return.0 to 0. the diversification return ranges from 3. Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison to its arithmetic rate of return. rebalanced. All Rights Reserved.

. 39 . and the change in valuation levels.2% for a strategy of going long the GSCI when backwardated and short when contangoed.e. dividend yield. the monetary environment. Erb and Harvey (2006) found a positive and significant return from a simple trend following strategy of going long the GSCI for one month when the previous month had had positive returns. Bauer. (2000. Research suggests this can be hazardous. and market sentiment. Only if the future return drivers are the same as in the past will past returns be a guide to the future. The historical evidence suggests that the term structure seems to have been an effective tactical indicator of when to go long or go short a broadly diversified commodity futures portfolio. and Steenkamp (2004) found that GSCI return variation is affected by measures of the business cycle. Argue against the use of naive extrapolation of past commodity returns to forecast future performance and discuss the importance of formulating forward-looking expectations. the rate of inflation. Jensen et al. the price of the nearby GSCI futures contract is greater than the price of the next-nearby futures contract. All Rights Reserved. Vrugt. Inc. and the default spread). Molenaar. the term spread. Nijman and Swinkels (2003) found that nominal and real portfolio efficient frontiers can be improved by timing allocation to the GSCI in response changes in some macroeconomic variables (bond yield. They argued that forward-looking returns should be based on an understanding of the fundamental drivers of equity returns. 23. Based upon this. 2002) found that the GSCI outperformed stocks and bonds when their measure of U. Furthermore. the long-only strategy would produce negative returns. such as earnings growth. That return is more than twice that of a long-only strategy. equities do not mean that forward looking equity risk premiums are high.S. Naïve extrapolation is the practice of using past performance as a forecast of future performance. for the period 1969-2004 and subperiods within that sample. They also found positive results for similar strategies on individual futures contracts. i. Erb and Harvey measured the return to be 8. Copyright © 2009 Institutional Investor. Federal Reserve monetary policy rose.e.S. Nash and Smyk (2003) found that GSCI total returns are positive when the GSCI is backwardated. Strongin and Petsch (1996) found that GSCI returns were tied to current economic conditions.Topic 8: Asset Allocation Momentum/Trend following Evidence suggests that commodity futures returns are predictable. i. Arnott and Bernstein (2002) found that past high excess returns for U. it would be natural to extrapolate that when the GSCI is in contango. and the Sharpe ratio was more than twice that of a long-only strategy. Erb and Harvey also found the returns increased by a long-the-winners and a short-the-loser strategy. this could provide long-only positive excess returns.. the price of the nearby GSCI futures contract is less than the price of the next nearby futures contract. Term structure or Cross-sectional analysis When the GSCI is backwardated.

g. there is no guarantee that the yield curve in the future will be such that positive roll returns are possible.. Furthermore. and cash). these weights should be adjusted in order to best attain investment objectives. They predict that the size of REITs and stocks of listed real estate companies and their proportion in the total commercial real estate market will continue to grow in the coming years. Modern portfolio theory suggests that assets such as commercial real estate. even though commercial real estate represents a large portion of the investable universe and should be included in all investors’ opportunity sets.Topic 8: Asset Allocation In commodity futures. individual commodity futures’ excess and spot returns have not been statistically significant. there is no one best estimate of the expected return of a commodity futures portfolio. as well as direct investments in commercial real estate. and another explanation is that the decline is from changes in the composition of the GSCI. historically. et al. Idzorek et al. as they work towards a strategic asset allocation to global commercial real estate (for more on the components of the commercial real estate asset class. historically. which have low correlations with the current opportunity set of traditional asset classes (stocks. however. however. commercial real estate) in a strategic asset allocation. Copyright © 2009 Institutional Investor. One explanation is that increased institutional investment in commodity futures has driven up prices and driven down prospective returns. document that a shift is in progress within global commercial real estate as the advantages of REITs and stocks of listed real estate companies (for more on this. who are cited by Idzorek et al. while smaller investors will likely do it more with real estate investment trusts (REITs) and stocks of listed companies that belong to the real estate industry. argue that the largest investors’ target allocations will be more heavily weighted in direct commercial real estate investments (acquiring and managing actual physical properties). Hudson-Wilson. REITs and real estate stocks are the only practical and efficient means to obtain exposure to the commercial real estate equity asset class. For the average investor. All Rights Reserved. Unfortunately. bonds. Relative weightings should be very close to market capitalization-based weights. It is also important to note that. the long-only GSCI has had an excess return of about 6% a year. and eventually a considerable portion of direct real estate is prone to be securitized. see Learning Objective 25). Idzorek et al. although the diversification return is the easiest return driver to estimate.. This would infer that any longterm forecast of positive excess return or positive spot return for an individual commodity futures contract is unlikely to be statistically supported by historical experience. there exists ample disagreement on the role of these other asset classes (e. it has been declining in recent years. see Learning Objective 25) produce a likely inclination for these securities among investors. argue that real estate and the other assets should be incorporated in the portfolio at their market weights and that. as a second step. Inc. 40 . 24. tend to provide the greatest diversification benefits. Discuss the role of global commercial real estate in a strategic asset allocation setting. In conclusion.

and other specialty finance companies. The relative advantages of REITs include: 1) liquidity. 41 . Identify the components of the commercial real estate asset class and the relative advantages of direct real estate investment and real estate investment trusts (REITs). stocks of mortgage REITs. U.S. We believe focus should be mainly on real estate assets. This component is constituted primarily by commercial mortgage-backed securities (CMBS). and 6) pricing in public capital markets. small caps. 3) Private (direct) commercial real estate: equity. The learning objective does not specify on which assets the student should concentrate. It involves the acquisition and management of actual physical properties. 2) Public (indirect) commercial real estate: debt.S. 2) the ability to choose specific properties. Small investors may gain exposure to this component of commercial real estate through the purchase of stocks of commercial banks.S. 3) greater capacity. and Non-U. Instructor note: There are ten different asset classes to compare in this section. and Non-U. 3) lower costs. All Rights Reserved. bonds. The relative advantages of direct real estate as an investment include: 1) direct control. U. The four components (or segments) of the commercial real estate asset class are: 1) Private (direct) commercial real estate: debt.S. North America. and 4) potential tax-timing benefits. 26. 5) independent analysis. stocks). 4) potential for better corporate governance structures. 2) investor access. This segment is accessible only to large investors.S. This segment involves buying shares of real estate investment companies (REITs) and other listed real estate companies. Copyright © 2009 Institutional Investor. which can purchase issued whole loans directly.Topic 8: Asset Allocation 25. Europe and Asia. large and U. and also compare them to the performance of traditional assets (cash. Explain the historical performance and diversification benefits of select asset classes. Idzorek et al. Inc. analyze the historical performance of the following four geographically segmented indirect real estate investments (REITs): Global. 4) Public (indirect) commercial real estate: equity.

North American real estate has lower correlations with non-U.S. the historical average annual return may be the result of an abnormally optimistic but temporary period for North American real estate. The Black-Litterman asset allocation gives a greater weight to worldwide commercial real estate equities and smaller weights to non-U. Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when determining forward-looking asset allocations. Two forward-looking asset allocations models are analyzed in Idzorek. or negative. bonds and stocks when compared to global. Idzorek et al. the three sub-asset classes of global real estate considered (American. They find a large difference between the CAPM return and the historical arithmetic return for North American real estate and offer two possible explanations.S.S. or Asian real estate. Second. U. European real estate.S. et al.Topic 8: Asset Allocation During the period 1990-2005. and Asian) exhibit relatively high intra-equity correlations. It may be that North American real estate represents an anomaly analogous to these. large-cap stocks showed the highest Sharpe ratios. Finally. at least over short periods of time. or very low. as opposed to the traditional mean-variance optimization approach. global real estate tends to have lower correlations with the four traditional U. Furthermore. assets when compared to North American real estate. correlations with all U. also conclude that. Asian real estate was the most volatile asset class. large-cap stocks. past research has suggested that several return anomalies can not be explained by the CAPM (e. et al. small-cap stocks.: the CAPM approach and the Bayesian Black-Litterman asset allocation approach. bonds). Inc. North American real estate. European real estate has had negative.S. stocks. et al. and U. Idzorek. bonds. Also. then also use the Black-Litterman model to produce a set of forwardlooking expected returns that blends expected returns arising from the CAPM with the historical returns. The data illustrates that global real estate has generally had low. the capital market assumptions are forecasts and. North American real estate was the highest-returning asset class (with an average annual arithmetic return of around 17%). U. Furthermore. 27. Idzorek.S. First. All Rights Reserved.S. asset classes. In a forwardlooking context. small firm effect.g.S.). stocks than the CAPM. European.S. reflecting the fact that Asian currency markets were highly volatile over the period. and Asian real estate exhibited the lowest Sharpe ratios. etc. while non-U. these forward-looking efficient asset allocations support North Copyright © 2009 Institutional Investor. European. momentum. and U. 42 . These weak to negative correlations between real estate and traditional asset classes suggest that additional diversification benefits can be attained by including real estate investments in a portfolio. estimate forward-looking efficient asset allocations based on expected return estimates drawn from the CAPM using a reverse optimization procedure. On the other hand.S. correlation coefficients with traditional assets (U. they are not known with complete certainty. therefore. it is almost impossible to predict which asset class (among the traditional assets and the previous four real estate investments) will be the best performer.

for example.1% 8.Topic 8: Asset Allocation American and European real estate more than the CAPM-based allocations (see the exhibit). Exhibit: CAPM and Black-Litterman Forward-Looking Asset Allocations for Real Estate Classes CAPM Forward-Looking A. if investors would be able to increase their opportunity set so as to include all the most important assets that are part of the – unobservable – market portfolio (assets such Copyright © 2009 Institutional Investor.5% 1.9% 3.2% Source: Idzorek. Aggressive 4. As in the CAPM-based allocations. Asset Class North Am.’s first caveat is that the two forward-looking asset allocations sets they present represent only two of the many possible asset allocations that can be derived from analytically based forward-looking expected returns. the CAPM-based asset allocations presented are market-based and assume that investors do not suffer from a U. note that this caveat is relevant only to a small group of the largest investors. Idzorek et al. Third.1% Moderate 12. et al. The Black-Litterman-based approach is largely influenced by the short-term returns that are mixed with the CAPM returns.8% 8. investors who have a separate strategic asset allocation to REITs and listed real estate stocks may not need to own these indirect real estate investments.9% 4.1% 7.S. (2007) 28. Inc. A. despite the supposed benefits of diversifying into foreign assets). Idzorek et al. it may questionable to use global REITs and stocks of real estate companies to embody the long-term performance of the universe of commercial real estate equity investments. More work on this topic is needed. or home bias (i.4% 11. all other investors should own REITs and listed real estate stocks.8% 3. Another definition of the market portfolio (one that includes. Fourth. The Bayesian Black-Litterman asset allocation procedure provides market-based asset allocations that are improved with information available from the historical returns. RE European RE Asian RE Conservative 2. Explain the seven caveats identified by the author as considerations for strategic asset allocation to global commercial real estate. In the end. However. commercial real estate) will produce another asset allocation.4% Aggressive 15.e.6% Conservative 5.1% Black-Litterman Forward-Looking A. 43 .9% 1. All Rights Reserved.7% Moderate 5.0% 6. considering REITs and listed real estate stock returns as a proxy for all commercial real estate investments has become more suitable in the last few years as these investments have been growing fast and represent a larger proportion of the market. we are confronted with an empirical question. the tendency to invest in a large proportion of domestic assets. However. although the resulting suggested asset allocations are influenced far less than most other models.7% 4. Fifth.5% 8. Second. another description of the market portfolio will generate a different set of asset allocations. A.

44% 1.89% 15. “Stock” returns were measured from the Standard and Poor’s 500 total return index. bonds.62% 0. is that a different composition of the market portfolio will yield a different set of Black-Litterman-based asset allocations. Consumer Price Index.S.68% 3. and “CPI” is the percentage changes in the U.29% 34. The sixth caveat.00 Bonds 16.00 CORRELATION MATRIX REITS 1. Deviation REITS 35.  Example: Let us use these insights on real estate asset allocation in a hypothetical example.88% 4.S.22% 38.31 -0.75% -2.62% 10. inflation.75% 18.60% 2.17 1. actual asset allocations should be tailored to the investor’s unique situation.53% 3. U.10% -11.64% Bonds 0. which is related to the fifth.S.S.91% 15. bonds and U.44% 10.04% -9.37% 28. high-yield bonds and emerging market stocks).40% 2.47% 3.09 1.22 0.10% 28. the end result will be a reduction in the allocation to the asset classes considered in Idzorek et al.35% 17.41% 8. Copyright © 2009 Institutional Investor.40% 9. stocks. commodities.58% 21.61% 2.53% 2. convertible bonds.50% 5.89% -22.43% 4. he collects the following historical information on U.70% 1.14% 17.18% 18.65% 8.68% 12.S.98% 2.31% 35.18 1. an investment analyst at YHG Investments.79% 13.96% 33.33% 7.00 REITS Stocks Bonds CPI Note: “REITS” returns were measured from the total return index REITs calculated by NAREIT. “Bonds” returns where measured from the Lehman Aggregate U.10% 4. YEAR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average St.82% -6.06% 16.87% 3.63% 9.68% 10.’s study.48% 1. U.29% 3.81% 2.32% 37. Finally.Topic 8: Asset Allocation as TIPS.48% 25. emerging market bonds.47% 7.19 -0.21% 5.34% 2.S. is analyzing whether to include real estate as an asset class in a client portfolio that is currently constituted only in U. Peter Gray. Inc.26% 4.58% 22.64% CPI 0.46% Stocks 30.S.92% 18. 44 .97% 2. stocks and U.00 CPI 2.00% 7. All Rights Reserved.45% Stocks 0.69% -0. To that end.86% -18.47% 30.63% 8.08% 1. Bond total return index.S.81% 18.55% 0.38% 1.60% 2. real estate.82% 11.

“Global Commercial Real Estate. Do you agree with Peter? Modern portfolio theory suggests that asset classes such as real estate.F. its low correlation to traditional assets. Therefore.L. 62. and C.. makes this alternative investment a good potential candidate to be added to a traditional portfolio. All Rights Reserved. it appears that real estate investments offered a better hedge against the risk of inflation than stocks or bonds did during the period 1991-2006. Meier. Special Issue.22 with stocks and bonds. “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors. F. Š References Perold. Idzorek. as opposed to stocks and bonds.” Financial Analysts Journal. and W.19 and -0. “The Strategic and Tactical Value of Commodity Futures. “Dynamic Strategies for Asset Allocation. Harvey.09. 2007 Copyright © 2009 Institutional Investor.. What would you say to him? You could say that real estate investments exhibited a positive correlation with inflation (0. Inc. even though real estate exhibited one of the highest standard deviations. Erb.” Financial Analysts Journal. Chhabra.M. respectively). M. A. C.” The Journal of Wealth Management.17 and 0. which have low correlations with the current opportunity set of traditional asset classes (we can see in the table that it has correlations of 0. This leads him to question whether to add real estate to the traditional portfolio at all. January/February 1988. may well provide substantial diversification benefits. Vol. CPI inflation. Peter is assessing whether real estate offers a better hedge than stocks or bonds against the risk of inflation. whether it was expected or not). No. A more rigorous study would attempt to see the correlation of real estate returns with inflation using a measure of unexpected inflation (what is shown in the table. Part B: Based on the information presented in the tables. but he is concerned that the standard deviation of real estate is almost as high as the standard deviation of stocks. respectively). Therefore. A. T. and S. combined with the high returns it offered.31). Sharpe. which showed a slightly negative correlation with inflation (-0.Topic 8: Asset Allocation Part A: Peter notices that real estate provided the highest return of the three asset classes. 45 ..” The Journal of Portfolio Management. is simply the observed inflation. Spring 2005. March/April 2006. Barad. 2.

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one says that the futures curve is in contango. one says the futures curve is in backwardation. therefore. provide a return for storing natural gas. Inc. 47 . Understand what is meant by the “term structure of a commodity futures curve” and the terms “backwardation” and “contango”. The term structure of a commodity futures market is a curve that is constructed by plotting each delivery-month contract on the x-axis and its respective price on the y-axis.” 2. When the near-month futures contracts instead trade at a premium to further-delivery contracts.TOPIC 9 Points Current Topics  Main  Explaining what happened in the Amaranth debacle. An Copyright © 2009 Institutional Investor. how it happened and how it could have been avoided  Applying the market events of August 2007 to the concept of systemic risk  Describing factors contributing to the subprime credit crisis and recommending policies and practices to address them 1. All Rights Reserved. The markets. consumption and seasonal factors. the author says: “When the near-month futures contracts trade at a discount to further-delivery contracts. The prices of summer and fall natural gas contracts typically trade at a discount to the winter contracts. Understand the derivation of the futures curve for natural gas and the association between the curve and potential determinants including anticipated production. As noted on page 326.

If traders (operators) cannot trade out of the spread. 4. sell winter natural gas contracts. Amaranth faced a major dilemma – how to trade out of its large. potential losses and risk from this type of strategy. hoping that market conditions would change and enable it to unload its positions. simultaneously. the owner takes delivery and injects it into storage. it appeared likely there would be adequate supplies for the winter. high-priced spread positions without causing the price of those spreads to fall. These positions would have been profitable if adverse weather events such as hurricanes and cold shocks occurred during the period 2006-2010. there were no more summer months into which it could roll these positions.S. natural gas storage capacity has actually declined since 1989 and domestic production has not kept up with demand. In such scenarios.S. If spreads tighten. they can take physical delivery and realize the value of their storage facility.Topic 9: Current Topics owner of a storage facility can buy summer natural gas contracts and. storage is worth more. Trades that exploit the spreads between two delivery months are referred to as calendarspread trading strategies. concerns arise as to whether natural gas production will be sufficient for winter consumption needs. Amaranth had rolled its short positions into the next month. As noted by the author. Explain a futures calendar-spread strategy and the sources of potential profits. Amaranth’s spread trading strategy involved taking long positions in winter contract deliveries and short positions in non-winter contract deliveries. By late August. traders (operators) can trade out of the spread at a profit and reinitiate a trade later. However. When the winter contracts expire. Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it relates to natural gas pricing.. Potential profits: In general. 48 . As summer was now ending. 3. with the hurricane season almost over and with natural gas supplies remaining plentiful. U. the near month contract’s price plummets to encourage its current use. The difference will be the operator’s return for storage. sophisticated storage operators can potentially value their storage facilities as a set of complex options on calendar spreads. by August 2006. Potential losses and risk: If the winter months are unexpectedly mild and there are massive amounts of natural gas in storage. if the calendar spreads are volatile. As described by Till. If there are hurricanes during the summer in the U. The market fundamentals were strongly indicating that the winter/summer price spreads Copyright © 2009 Institutional Investor. This occurred after Hurricane Katrina in 2005. the owner makes delivery of the natural gas. All Rights Reserved. In prior months. the front month’s contract price can increase dramatically to discourage current demand and the futures curve would trade in steeper contango to provide a further enhanced return for storage. The strategy is profitable as long as the operator’s financing and physical outlay costs are under the spread locked in through the futures market. Inc. When the summer contracts expire.

and air-conditioning demand during the summer months.000 contracts for April 2007. natural gas markets are largely insulated. 60.000 contracts for September. but also for its contracts in the following month of October. By the end of July. it increased its positions in the corresponding contracts on ICE. Given below is an excerpt from the US Senate Permanent Subcommittee on Investigations (PSI) Report that sheds some light on position limits and actions by NYMEX.S. In August 2006. and it preserved its ability to engage in Copyright © 2009 Institutional Investor. it was long 80. and 29.” that is summarized in Till’s article. In response. On several occasions. 49 . 5. Till makes several points regarding the natural gas market: Q Q Domestic production has not kept up with demand. 42. from global energy factors. particularly if there is a severe winter. NYMEX repeatedly reviewed Amaranth’s natural gas holdings to determine whether they exceeded NYMEX’s established position limits or accountability levels. During 2006. There is a long injection season during spring through fall when natural gas is stored in caverns for later use during the long winter season. Amaranth held about 40% of the total open interest in the NYMEX natural gas market for all of the winter months (October 2006 through March 2007). Amaranth traded large numbers of contracts near their expiration date.) The key economic function for natural gas is to provide for heating demand during the winter in the northern states in the U.S.000 contracts for March 2007. This would be particularly disastrous for Amaranth. directing Amaranth to reduce its positions in the NYMEX futures contracts not just for the September contracts that were about to expire. Inc. which was still holding large positions that it had obtained when these spread prices were high (See the US Senate PSI Staff Report “Excessive Speculation in the Natural Gas Market. Q Q All these factors have a major impact on the pricing relationships for different delivery months. There is insufficient storage capacity. and 80. Amaranth was short nearly 60.000 contracts for October. The key item to consider here is that Amaranth was easily able to move to ICE from NYMEX because ICE did not have the same constraints as NYMEX.000 contracts for December 2007. a CFTC investigation of one of these instances is still ongoing. but at the same time. All Rights Reserved. The end result was that Amaranth maintained and even increased its positions in contracts for September and October. triggering NYMEX notices that the firm had violated NYMEX position limits. Amaranth reduced its positions in those contracts on NYMEX. Discuss the magnitude of Amaranth’s calendar-spread positions: explain how this hedge fund was able to accumulate such large positions (including the role of position limits) and describe the effects of the magnitude of the positions on daily profits and losses. Inventories need to be recycled to maintain integrity.Topic 9: Current Topics should fall. in the short-term.000 contracts for January 2007. U. NYMEX took more forceful action to limit Amaranth’s trading.

below. under current law. reproduced from Till’s article. for example. Inc. Exhibit 3 shows graphically Amaranth’s forward curve. no market surveillance or position limits apply to trading on ICE. in late July 2006.Topic 9: Current Topics large-scale trading as the September contract neared expiration. In fact. that Amaranth’s natural gas positions for delivery in January 2007 represented a volume of natural gas that equaled the entire amount of natural gas eventually used in that month by U. Amaranth’s move enhanced its ability to conduct large-scale trading near the contract expiration because. All Rights Reserved.S. residential consumers nationwide. Source: Till (2007) Copyright © 2009 Institutional Investor. 50 . The scale of Amaranth’s trades is shown in Exhibit 2. The US Senate PSI Report found. The key again is the magnitude of the positions when NYMEX and ICE positions are combined.

Inc. Exhibits 4 and 5 also show that the prices of the winter-month contracts fell dramatically as compared to the non-winter-month contracts in the near-month through 2011 forward maturities for natural gas. While NYMEX had position limits. 51 . (The US Senate PSI Report provides details. that a distressed liquidation was occurring given that these moves were very large standard deviation moves compared to recent history. All Rights Reserved. ICE did not at the time. at the time to market participants.Topic 9: Current Topics Till’s Exhibits 4 and 5 indicate that the changes for various spread relationships across the natural gas curve were extremely large on September 15 and September 18 which signaled.) Source: Till (2007) Copyright © 2009 Institutional Investor.

the near month price of natural gas plummets in order to encourage its current use and the curve trades in contango in order to provide a return to any storage operator who can still store gas. As indicated in Learning Objective 4 above (See the US Senate PSI Report). Storage is worth more if the calendar spreads in natural gas are volatile. 52 . All Rights Reserved. If the spreads were to be in wide contango again. 7. with hurricane season almost over and with natural gas supplies remaining plentiful. Inc. If the volatility of the spreads remained high. Discuss the causes for increased volatility on the natural gas commodity futures market prior to Amaranth’s liquidation in September 2006. knowing that they can ultimately realize the value of this spread through storage. As a calendar spread trades in steep contango. Another preferable scenario would occur if the spread tightens. the storage operator/trader Copyright © 2009 Institutional Investor. the trader could trade out of the spread at a profit. Discuss how sophisticated storage operators can manage their storage facilities as a set of options on calendar spreads. storage operators can buy the near month contract and sell the far month contract. The key consideration here again is the volatility of the spreads. As noted by Till. the position could be reinitiated. Under this scenario. it appeared likely there would be adequate supplies for the winter. if the winter is unexpectedly mild and there are still massive amounts of natural gas in storage. This scenario occurred during the end of the winter in early 2006.Topic 9: Current Topics Source: Till (2007) 6. The market fundamentals were strongly indicating that the winter/summer price spreads should fall.

Till finds two spreads that were 93% correlated to Amaranth’s natural gas book: the November 2006 versus October 2006 (NGX-V6) spread and the March 2007 versus April 2007 (NGH-J7) spread. If scenario analysis had been conducted. Describe how daily volatility as measured by standard deviation can underestimate potential risk (where risk is defined as the likelihood of experiencing severe loss). as of August 31. If conditions are such that the operator/trader cannot trade out of the spread with a profit. All Rights Reserved. up to -36% could have been lost under normal conditions. As noted by Till. Inc. and explain how scenario analysis can be used to better indicate the risk of a fund’s structural position in such circumstances. 2006. Alternatively. See below an excerpt from the Senate Report on the losses suffered by Amaranth. Source: Till (2007) Copyright © 2009 Institutional Investor. If storage operators can still store gas. if the winter is unexpectedly mild with an abundance of natural gas in storage. they can take delivery of the natural gas in anticipation of making delivery at a later date. winter natural gas futures prices were trading at an extreme relative to non-winter-month contracts. 53 . they can realize a return. Using the Senate report. A scenario analysis could have examined over the past six years what the level of the fund’s spreads had been. the near month price plummets and current consumption is encouraged. Exhibit 14 shows that if these two spreads had reverted to the levels that had prevailed at the end of August during the previous six years. The daily standard deviation based on three months of data was about $105 million – far lower than the actual losses that occurred in September. the riskiness of the fund’s structural position would have been more evident. 8. The daily P/L of Amaranth’s August 31 positions is shown in Exhibit 12 from Till’s article. The storage operator/trader is thus realizing the value of the storage facility.Topic 9: Current Topics can continually lock in profits.

by September 8 they had surpassed $3 billion. One of the counterparties Amaranth approached was Centaurus. Early the next morning. on August 30. During the first two weeks in September.68 on September 1 to $4. dropping nearly 25%.49 on August 25 to $2. By September 15.Morgan Chase. Amaranth began to seek a counterparty to buy its energy book. Amaranth’s clearing firm. On August 29. Arnold offered a bid after making the following observations: ‘I was not in the office on Friday but I understand you were selling h/j [March/April]. its daily profit and loss statements recorded a loss in the value of its natural gas holdings of nearly $600 million. The March/April spread had begun a free fall. During the first week of September.52 on September 15. Two spreads of particular concern to Amaranth were the March/April 2007 price spread and the January2007/October 2006 price spread. this margin call “resulted from Amaranth’s activity on the ICE yesterday. Mr. According to an internal memorandum from J. the January/October spread also went into a steep decline. 54 . from $2. as Amaranth’s natural gas positions continued to deteriorate and its cash position weakened considerably. More ominous for Amaranth’s long-term survival. September 16. The market is now loaded up on recent. bad purchases that they will probably try to be spitting out on Monday if there is a lower opening given that spread Copyright © 2009 Institutional Investor. whether the hedge fund would like to make a bid for some of Amaranth’s positions. falling from $4.5 billion.” On August 31. were the increased margin calls and requirements that followed. Other natural gas prices began falling. Amaranth’s margin requirements increased by $944 million. Despite this enormous one-day loss. Centaurus CEO. The falling March/April spread increased Amaranth’s margin woes. All Rights Reserved.15 on September 11. more bad news arrived.P. to $3. however. Amaranth’s senior energy trader Brian Hunter asked John Arnold.Topic 9: Current Topics Source: Till (2007) Excerpt from the US Senate PSI Report: “The 60-cent increase in the price of the September contract and the associated drop in the price of the October/September spread caused a huge loss for Amaranth. Late on Saturday. Because its natural gas holdings had lost value. Inc. from Amaranth’s perspective. Amaranth still finished August with a net gain of $631 million for the month. Amaranth’s margin requirements on ICE and NYMEX exceeded $2.05 on September 1.

10 and $2. Hunter declined Mr. the cycle of investor redemptions occurs and prime brokers demand a reduction of leverage. Hunter two price quotes for the March/April spread: 45-60 cents for the March/April 2007 spread which had closed the previous trading day at $1. at this point. the only reason it’s still $1 is because of your position. Once a threshold of losses is crossed. Inc. there was no natural (financial) counterparty that could take on its positions in under a week (or.20. Hence a key focus of experienced commodity traders is an exit strategy. there is no ready and willing counterparty available to take the opposite positions. which had closed the previous day at between $2. Arnold gave Mr. What flow or catalyst will allow a trader to exit a position? In the case of Amaranth. and Citadel. however. specifically. Even though that spread has collapsed over the past 2 weeks. After several days of frantic negotiations with several brokerages and banks. that spread would be well below $1 at this point given the scenario. The critical liquidation cycle began at this point. there will be flow but these transactions do not occur on demand. JPMorgan Chase. Arnold’s prediction of the behavior of these spreads. Copyright © 2009 Institutional Investor.25. Commodity markets have “nodal liquidity”. Amaranth liquidated the remainder of its $8 billion portfolio. the fund was bleeding cash and facing demands from its prime broker for additional funds that it did not have. According to Davis et al. another hedge fund. 10. Mr.’ Mr. On September 21. Amaranth had lost more than $2 billion of its $8 billion portfolio. the March/April 2007 spread stood at 58 cents. turned out to be remarkably accurate. that spread is still a long way from fundamental value. Over the past couple years the market has put a big risk premium into that spread yet it has paid out on expiry once in ten years. fundamentally. Arnold’s offer. In my opinion. The natural counterparties to Amaranth’s trades were the physical market participants who had already locked in the value of forward production or storage. and the March/April spreads for 2008 and beyond ranged from $1. We’ll be at all time high storage levels with mediocre s/d [supply and demand] and an el nino.Topic 9: Current Topics has been in free fall. and $1. the last day of Amaranth’s trading in the natural gas market.” 9. This implies that as a commercial market participant needs to initiate or lift hedges. 55 . 2006). (2007).15. Exhibit 15 shows the critical liquidation cycle. on September 20th. during the weekend of September 16-17. By Friday September 15. That is. To meet its margin calls and satisfy client requests. Describe what is meant by “nodal” or “one-way” liquidity in the commodity markets and how the lack of “two-way” liquidity adversely affected Amaranth. Historically. All Rights Reserved. Understand how forced liquidations can affect market prices and why changes in market prices can be correlated with the size and direction of the liquidation. 2006. Mr.00-$1. Amaranth formally sold its energy book to its clearing firm. so they would not be interested in taking counterparty positions to Amaranth.18 to $1.20 for the March/April spread in 2008 and beyond.

The distressed sale of assets negatively impacts market prices. Most of the unwinding and “de-leveraging” took place on August 7-9. In other words. This price-impact pattern led the authors to hint that the losses were the short-term side-effects of an abrupt liquidation on August 7-8. (b) the trending decline in the effectiveness of quantitative equity market-neutral strategies. forced a number of other types of equity funds to drastically reduce their risk exposures. After reviewing a number of empirical results. thus aggravating the losses of the majority of these funds on August 8-9. Inc. August 7. 5. the losses did not arise as a result of a hypothetical fundamental collapse in the primary economic forces that affect long/short equity strategies.Topic 9: Current Topics The fund’s NAV declines precipitously as the fund sells holdings in a distressed fashion. Discuss eight hypotheses explaining the market events of August 2007. August 8. Khandani and Lo developed the following eight tentative hypotheses (based exclusively on indirect evidence) about August 2007: 1. (c) the bigger leverage required to Copyright © 2009 Institutional Investor. 4. August 10. The losses to quant funds in the second week of August 2007 were started by a short-term price impact that was the consequence of a rapid “unwinding" of one or more large quantitative equity market-neutral portfolios. August 9. 3. The losses stopped after Thursday. All Rights Reserved. and a significant turnaround took place on Friday. The authors point to the following likely factors as contributors to the scale of the losses resulting from the unwind: (a) the massive recent growth in assets dedicated to long/short equity strategies. and Wednesday. 2. Source: Till (2007) 11. The price impact of the “unwind” between Tuesday. 56 .

Quantitative equity market-neutral. Inc. the price shock of the quick unwind was swiftly spread to other funds. 57 . they hypothesize that the harshness of the shock to the long/short equity style is likely to be subdued in the short-term because market participants now possess more information regarding the magnitude of this sector and the possible price-impact of another potential liquidation of a long/short equity portfolio. The authors suggest that the continuing troubles in the subprime mortgage market may activate more liquidity shocks in the more liquid hedge fund styles (e. and economic indicators.g. and where technology does not necessarily play a significant role. and the expansion of credit-related styles among hedge funds. the increase in average absolute correlations among hedge fund indices. Given that these portfolios are composed mainly of exchange-traded instruments. 130/30. and (e) the unknown magnitude and timing of the mortgage-related problems surfacing in the credit markets. However. This is a more general category. earnings forecasts. and inputs other than past prices such as accounting variables. 7. managed futures. They use very short holding periods and substantial computational.g. The authors find it reasonable to deduce that the systemic risk in the hedge fund industry may have increased in recent years because of the following: the differences between the behavior of their test strategies in August 2007 and August 1998. concerning broader types of quantitative models. (d) the lack of realization about how popular the long/short equity category had become. This group. All Rights Reserved. trading.. that may or may not be market-neutral (for e. some with lower turnover. that may or may not be quantitative. Long/short equity strategies.” Khandani and Lo refer to the following four seemingly dissimilar categories of fund strategies as “long/short equity”: 1. many long/short equity funds are net long). say $10MM. 4. and IT infrastructure. Khandani and Lo characterize long/short equity strategies as those that comprise any equity portfolios that employ short-selling. invests $13MM in Copyright © 2009 Institutional Investor. 12.Topic 9: Current Topics preserve expected returns levels demanded by hedge fund investors. The presumed unexpected liquidation of one or more large quantitative equity market-neutral portfolios occurred. Statistical arbitrage. 2. and global macro). 8. also called “active extension” strategy. 6. 3. Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall under the broad heading of “long/short equity. The third category is the broadest. fewer securities. the boost in the number of funds and the average assets under management per fund. is a relatively new category in which a fund or managed account of. long/short equity. Long/short equity strategies usually represent the single largest category in most hedge fund databases in terms of number of funds and assets. This refers to “highly technical short-term mean-reversion strategies” concerning large numbers of securities.

Topic 9: Current Topics long positions in one group of securities and $3MM in short positions in another group of securities. and the short positions are invested in what might be called the “winners” (stocks that have been outperforming relative to the same market average m). how leveraged portfolio returns are constructed. when underperformance (outperformance) is followed by positive (negative) returns. 13. the relationship between market capitalization and the strategy’s profitability. that is. on long/short equity portfolios simulating a specific strategy originally proposed by Lehmann (1990) and Lo and MacKinlay (1990). Explain how it is simulated in the paper. the long positions are made up of what might be called the “losers” (stocks that have been underperforming relative to a given market average m). Anatomy of the long/short equity strategy and how it is simulated: Khandani and Lo estimate the effects of the events of August 6-10. Copyright © 2009 Institutional Investor. if we denote ωit as the portfolio weight of security i at date t. assuming that the long-only constraint has been relaxed to a limited extent. then we have: ωit = − 1 ( Rit − k − Rmt − k ) N 1 N Rmt − k ≡ ∑R i =1 N it − k (1) for some k > 0. equation (1) can be considered a “contrarian” trading strategy that is capable of profiting from a market “overreaction”. thus profiting from turnarounds that take place within the rebalancing time interval. 58 . Suppose there are N securities. As a result. All Rights Reserved. Describe the anatomy of the long/short equity strategy. Khandani and Lo argue that this strategy can be considered a logical addition of a long-only fund. the proposed strategy is dynamically betting on the existence of a mean reversion across all N securities. how the strategy provides liquidity to the market place. In terms of an equation. each value of k generates. By buying yesterday's “losers” and selling yesterday's “winners” at each date. Notice that the portfolio weights are equal to the negative of the degree of outperformance k periods ago. Khandani and Lo set k=1 to represent a day. to some extent. Therefore. and the practical implications of transactions costs. 2007. At each rebalancing date. and consider a long/short market-neutral equity strategy that consists of allocating an equal dollar amount to long and short positions. a special strategy. We explain this learning objective by dissecting its parts. Inc. The strategy works as follows.

Khandani and Lo multiply equation (2) by θ/2: (θ / 2)∑ i =1 ωit Rit N L pt (θ ) ≡ It (3) Relationship between market capitalization and the strategy’s profitability: Khandani and Lo find that the average daily return of the strategy in the smallest decile is considerably larger than the corresponding return for the largest decile. Practical implications of transactions costs: A caveat of these findings relating to smaller-cap stocks is that the transaction costs inherent to trading smaller-cap stocks are typically very high. 2 i =1 R pt ∑ ≡ N i =1 ωit Rit It (2) Then. Inc. Therefore. The reason behind this finding may lie in the fact that smaller-cap stocks generally exhibit more “inefficiencies” and. This trade-off Copyright © 2009 Institutional Investor. How leveraged portfolio returns are constructed: The portfolio’s return of an “arbitrage” or “market-neutral” portfolio (where long and short positions exactly offset each other) cannot be calculated in the usual way because there is no net investment. the gross dollar investment It of the portfolio presented in equation (1) and its unleveraged portfolio return Rpt can be computed by the following equation: It ≡ 1 N ∑ | ωit |. the profitability of the contrarian strategy in the smaller deciles is significantly higher than in the larger-cap portfolios. In offering liquidity to the marketplace. in the real world. More specifically. the previous results may not be as attractive as the data might imply. thus providing liquidity to the marketplace and helping stabilize any imbalances that may exist between supply and demand.Topic 9: Current Topics How the strategy provides liquidity to the market place: Contrarian trading strategies increase the demand for losers (by buying losers) and add to the supply of winners (by selling winners). In practice. to construct leveraged portfolio returns Lpt(θ) employing a regulatory leverage factor of θ:1. hence. This finding is consistent with the smaller-cap pattern that has been long known by long/short equity managers. the return of these strategies can be calculated as the profit-and-loss of that strategy’s positions divided by the initial investment that was required to support those positions. All Rights Reserved. contrarian trading strategies also achieve a reduction in market volatility as they help mitigate price fluctuations by buying stocks for which there is excess supply and selling stocks for which there is excess demand. however. 59 .

8. a third possible explanation is that in 1998. All Rights Reserved. 15. The extraordinary return patterns observed in the second week of August 2007 can be explained as the result of broad-based momentum induced by a major strategy liquidation. Finally. Khandani and Lo argue that there exists one important difference between August 1998 (around the time of the Long Term Capital Management (LTCM) debacle). 2007. As a result. The authors argue that all three of these explanations may be at least partially valid. long/short equity funds were not as leveraged as it appears they were in 2007. the well-documented demand for liquidity in the fixed-income arbitrage space of August 1998 had no discernible impact on the very same strategy. Once the liquidation had ended. 16. A second possibility is that the magnitude of the capital invested in long/short equity strategies was not sufficiently large to cause any major disruption. even if such strategies were unwound rapidly in August 1998. Compare and contrast market events in August 2007 with August 1998.85%. Interestingly. They say: “In contrast to August 2007. Khandani and Lo argue that this dramatic reversal is a revealing sign of a liquidity trade. the differences between August 1998 and August 2007 are the result of several possible interpretations. and find that the strategy yielded a cumulative three-day loss of -6. 14.Topic 9: Current Topics between apparent profitability and transaction costs suggests that the intermediate deciles may be the most suitable from a realistic point of view. there were less multistrategy funds and proprietary trading desks participating in both fixed income arbitrage and long/short equity.” This is a very significant difference that is consistent with a greater degree of financial integration. where an apparent demand for liquidity caused a re-sale liquidation that is easily observed in the contrarian strategy's daily returns. in 2007 than in 1998. when the contrarian strategy yielded a return of 5. assuming independently and identically distributed daily returns. Explain how the increase in total assets under management and the number of long/short funds over the 1998 to 2007 time period likely impacted expected returns and the use of leverage.92%. Actual losses were probably magnified severalfold as many long/short equity managers were employing leverage. the liquidation-based momentum reversed into a strong mean reversion that caused Friday’s extraordinarily positive returns. August 10. which represents a staggering loss of 7. and August 2007. and 9. the demand for liquidity caused by failing fixed income arbitrage strategies did not spread out as willingly to long/short equity portfolios. 60 . Inc. One explanation is that in 1998. Explain the return pattern of the main simulated strategy during the second week of August 2007. including the possibility of contagion among markets.6 standard deviations. Khandani and Lo simulate an unlevered contrarian return strategy applied on August 7. the total number of long/short funds and the average assets per fund grew exponentially since Copyright © 2009 Institutional Investor. Khandani and Lo estimate that. excluding strategies such as 130/30 funds. a good portion of the losses was reversed on Friday. According to Khandani and Lo.

have activated the first unwind of their more liquid positions (basically their equity portfolios) during this period. However.64% on Tuesday. unfortunately. 17. August 7. More leverage also implies that the magnitude of the positions is often significantly larger than the size of collateral placed to hold up those positions. Khandani and Lo argue that a significant decrease in liquidity of long/short equity strategies over the past decade has probably occurred because the number of long/short equity funds. and the leverage that each fund uses have all increased throughout that period. Another significant pattern that the authors uncovered is the fact that the losses on August 7 and 8 were most dramatic for some of the intermediate-decile portfolios. credit is withdrawn rapidly. Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over the past decade. a finding that is consistent with a statistical arbitrage unwind. hedge fund managers started to increase leverage in order to preserve the expected returns that investors anticipate. in a way similar to what happened in August 1998 and in August 2007. even though leverage offers the potential to magnify small profit opportunities into larger profits. Friday’s enormous turnaround seemed to confirm that the losses of the preceding three days were caused by an abrupt liquidation. it also has the potential risk of escalating small losses into larger ones. points to an abrupt liquidation by one or more equity market-neutral portfolios of large size. the level of assets per fund. 61 . most of the affected hedge funds would probably have been forced to cut their risk prior to Thursday’s market open by “deleveraging” (either on a voluntary basis or because they had surpassed borrowing limits established by their creditors). This situation can be very precarious because when unfavorable market fluctuations shrink the market value of collateral. this was a sensible practice that. As the authors point out. They then propose to measure the illiquidity of Copyright © 2009 Institutional Investor. consequently. This implies greater competition and. August 8. All Rights Reserved. Inc. Describe the set of hypotheses that are collectively referred to as the “unwind hypothesis. This can lead to an abrupt liquidation of large positions over very short time periods and can wreak havoc in financial markets. and propose that the events of August 7-9 may well had been the first time that hedge funds were strained to deal with the astonishing credit-related losses they had experienced in July. which was a very difficult month for many hedge funds. Confronted with the large losses of August 7-8.33% on Wednesday. 18. as these strategies began to yield decreasing returns. a diminishing profitability arising from the strategies used by such funds. They also note that the timing of these losses was just a few days after the end of July. This realization may. in turn.Topic 9: Current Topics 1994 (beginning at $62MM in January 1994 and ending at $229MM in July 2007). and then -11. also proved to be disastrous. and not by any structural change in the equilibrium returns of long/short equity strategies. Structural changes would probably have had a more enduring effect on prices.” Khandani and Lo argue that the fact that the leveraged contrarian strategy that they simulate lost -4. The authors speculate that.

This higher correlation also yields support to the hypothesis that factors outside the long/short equity segment may have produced an unwinding of arbitrage strategies in August of 2007. Khandani and Lo find that the hedge fund industry has undoubtedly become more closely connected. In this regard. 62 . Khandani and Lo present an approximation of the use of some of the techniques developed in the theory of networks to design systemic measures for liquidity and credit risk exposures and improve the strength of the world’s financial system to idiosyncratic shocks. rather than the particular limitations inherent to the quantitative methods they use. and Makarov (2004). the correlation between the return for a hedge fund and its lagged return from the previous month) since 2000. Khandani and Lo comment that it would be easy to conclude that the losses resulting from the events of August 2007 were the result of a “fire-sale liquidation” of quantitatively constructed portfolios.e. Khandani and Lo caution that the opaqueness of the hedge fund industry does not allow them to collect the data needed to approximate the “network topology” that is the initial point of these procedures. Evaluate the statement: Quant failed in August 2007. Lo. Although credit and liquidity are separate sources of risk exposure for hedge funds and their investors. Inc. given the fact that the hedge fund industry protects its intellectual property by being secretive about its trades. The authors caution that it is possible that the variation in correlations may have been due to volatility shifts and not due to changes in the covariances of returns. In spite of this. as originally put forward by Lo (1999) and Getmansky. 19. the intricate network of creditor/obligor interactions still needs to be correctly mapped. they argue that the fact that the autocorrelations have risen at all in the most crowded. a significant decline in the liquidity of long/short equity funds occurred over the past six years as suggested by an ever increasing autocorrelation (i.Topic 9: Current Topics long/short equity funds using the first-order autocorrelation coefficient of their monthly returns. If this was the case. Copyright © 2009 Institutional Investor. In spite of recent progress achieved in modeling credit and liquidity risk. Results using the proposed measure of illiquidity for the period from December 1994 to June 2007 imply that. Describe a method for approximating a network view of the hedge fund industry and what such a view indicates. the fire sale would have come about as a result of an underestimation of risk on the part of hedge funds. the two have been generally perceived as being inevitably entangled since the LTCM collapse in August 1998. of all hedge fund sectors represents yet another clue that systemic risk in the hedge fund industry has risen in recent years. they proceed to calculate the changes in the absolute values of correlations between hedge fund indices over time as an indirect and rudimentary estimation of the change in the “degree of connectedness” in the hedge fund industry. This is because the multi-strategy category exhibits now a higher correlation with almost every other index. All Rights Reserved. More importantly. They also warn that it may not be possible to gather the required data to draw the network topology without resorting to additional regulatory supervision. and among the most liquid. 20. apart from for a short-lived increase in late 2004.

Given the size and interconnectedness of the hedge fund industry. 2007. Critique the methodology of the article. tied with sporadic short-lived considerable losses. Their empirical results were based on only one simple trading strategy applied to U.S. 5. and creditors . stocks. and too recent to be pondered correctly. we may require more sophisticated analytics to model the feedback implicit in current market dynamics. investors. This is because events such as this may merely be an inevitable aspect of equity market-neutral strategies. 63 . which only has data for hedge funds that have voluntarily decided to be included in the database. 3. 2007. many of the hedge funds that made headlines in August 2007 were not available in the TASS database. Inc.. even though their unwind hypothesis is consistent with the events that occurred during the week of August 6-10. Such profit-and-loss pattern can be fairly attractive to those investors that are aware of the meaning of “tail risk” and whose individual risk preferences allow them to endure the unavoidable “rare event”. the authors were not able to test the hypothesis that liquidations of various investment strategies and asset classes may have started before the week of August 6-10. then August 2007 is merely the cost of doing business.” 21. 4. Finally. then August 2007 signaled another kind of failure in this industry. Results were based on information that was available in the TASS hedge fund database. This strategy may or may not be representative of certain short-term market-neutral mean reversion strategies. The “outsider’s perspective” of the methodology used by Khandani and Lo does not allow them to determine whether or not the early losses on August 7 were the result of a forced liquidation or of a deliberate risk reduction by hedge funds. In fact. Khandani and Lo leave open the answer to the question “Did ‘Quant’ fail?” when they conclude that: “Quantitative models may have failed in August 2007 by not adequately capturing the endogeneity of their risk exposures.Topic 9: Current Topics The authors also contend that while market participants will most likely advance their strategies and risk management practices as a result of the events of August 2007. The authors admit that they had no means to ensure that the funds in the database were representative of the industry or of a particular style. nor to information on prime trading or brokerage records.were aware of the risks and willing to bear them. The authors did not have access to inside information about the hedge funds that were impacted by the crisis in August 2007. Furthermore. the risk/reward profiles of these strategies can be thought of as providing small but stable positive returns nearly all of the time. If not. Copyright © 2009 Institutional Investor. indirect. it is implausible that the likelihood of potential disruptions can be entirely eradicated by such improvements. All Rights Reserved. Khandani and Lo caution that. This is because of the following five reasons: 1.. 2.managers. all of their inferences should be taken as tentative. (However) If all three sets of stakeholders . or industry leverage statistics.

we still need to know the optimal or acceptable level. Furthermore. Khandani and Lo argue that by providing liquidity. and by creating procedures for improving models and methods that are typically used. and discerning new sources of returns. hedge funds can withdraw liquidity at any time. on the aggregate. The rates would increase after the initial period. the hedge fund industry has.Topic 9: Current Topics 22. as some have suggested. Inc. Describe a subprime loan and discuss the four principal reasons for the recent increase in subprime loan delinquencies. Subprime mortgages typically have a 200. and Mei (2004) to create a National Transportation Safety Board-like organization for capital markets to supervise different features of systemic risk. Lo. A “Capital Markets Safety Board” may be a more direct way to deal with the systemic risks inherent to hedge funds than registration. 64 . The use of short reset loans. In terms of credit risk. facilitating the transfer of risk. One possibility is the suggestion made by Getmansky. unlike banks. Evaluate the current outlook for systemic risk in the hedge fund industry. Khandani and Lo suggest that the first step needed to tackle this problem consists in making efforts to understand the probability and causes of systemic risk in the financial system and how to measure it. engaging in price discovery. They were highly levered with high debt-to-income ratios. These would have low teaser rates for the first two or three years. and in spite of the positive externalities banks generate when they do well. Alt-A mortgages are issued to borrowers who have better credit scores than subprime borrowers but fail to provide sufficient documentation with respect to all sources of income and/or assets.to 300-basis point interest premium above prevailing conventional or prime mortgage rates. and a synchronized liquidity withdrawal among a large group or a whole segment of funds could have potentially devastating effects on the basic functioning and viability of the global financial system. then Khandani and Lo argue that we would need to know “by how much?” and “do the benefits outweigh the risks?” Although nobody would argue that the systemic risk for the financial system would completely disappear. All Rights Reserved. The subprime borrowers were not creditworthy. Four principal reasons for the recent increase in subprime loan delinquencies are: 1. an industry that is vastly regulated due to the negative externalities banks cause when they fail. facilitated economic growth and provided social benefits. because the latter would not tackle the systemic risks that the hedge fund industry may create in the financial system. 23. They also argue that hedge funds have evolved to become more similar to banks. 2. However. many of the mortgages allowed the borrower to borrow the down payment for the home. Copyright © 2009 Institutional Investor. an Alt-A mortgage falls between prime and subprime borrowers. If hedge funds have amplified systemic risk. The loans had high loan-to-value ratios. referred to as 2/28 and 3/27 hybrid subprime ARMs.

All Rights Reserved.. which is the amount of loss on the underlying collateral that can be absorbed before the tranche absorbs any loss. 65 . special investment vehicles (SIVs) had to achieve investment grade status in order to survive and did whatever it took to meet that goal.Topic 9: Current Topics 3. and Basel II allowed banks to hold AAA assets as collateral so there was an increased demand for such assets. The slowing in the rise in home values. Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the securities they issued and the resulting contribution to the credit crisis. A decline in credit standards by mortgage originators in underwriting to meet the demand for high-yield assets. the cash flows are assigned to a range of low grade to high grade tranches.g. 3. despite that fact that the underlying collateral was subprime mortgages. monolines were perceived to have low risk and therefore had an incentive to increase leverage. The managers would perform simulations to obtain a loss distribution that allowed the determination of the credit enhancement (CE). Those economic motivations include: 1. Asset backed security (ABS) trusts became the owners of the loans securitized by the originators. the CDO trusts being rated knew the procedures and had a fixed target to meet to get an investment grade rating. a change in the collateral/liability or cash-flow/bond-payment ratios. 5. e. The ABS trust or CDO would run the collateral’s cash flows through a waterfall payment structure. They generated net present value from the repackaging of the cash flows and could absorb some losses. the desire to lower costs and rely on the ratings so that pension funds and insurance companies had a disincentive to perform their own due diligence. 24. which made it more difficult for subprime borrowers to refinance. 4. mortgage originators had no incentive to perform due diligence and monitor borrower’s creditworthiness. and this would incent the agency to issue more investment grade ratings. There were many economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating. In a waterfall payment structure. 7. rating agencies would get paid fees for monitoring assets that were given an investment grade rating. Inc. 4. and the junior tranches do not get paid if the collateral pool becomes stressed in certain ways. insurance purchased from a monoline insurer called a “surety wrap” could increase the credit status of the senior tranches. Furthermore. 2. 6. Copyright © 2009 Institutional Investor. The high grade or “senior bonds” are paid first.

medium-term notes (MTNs). Many investors relied on the ratings for a diverse set of products such as asset-backed commercial paper (ABCP). These investors rely heavily on the risk assessment of credit agencies. the other characteristics and complexities would be overlooked by these institutions. The basic problem with the system was that brokers and lenders had little or no incentive to perform due diligence and monitor borrowers’ creditworthiness. The SIV funds these purchases with short-term asset-backed commercial paper (ABCP). The acronym SIV refers to either a special investment vehicle or structured investment vehicle. negative consequences if the loan defaulted. An SIV is a limited-purpose. the rating agencies had an incentive to issue AAA ratings because they were paid for the rating. Liquidity risk is the result of the need to refinance because of a maturity mismatch between assets and liabilities. Finally. liquidity. got paid from the origination of the loan and suffered few. Many institutional investors are restricted to only investing in assets with a high credit rating. if any. Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the due-diligence efforts at the firms. i) ii) Credit risk addresses the creditworthiness of each obligor and the risk during what is called the wind down period associated with credit deterioration. market. 27. The institutions overlooked the fact that these assets rated AAA had higher returns than comparable corporate assets. and subordinated debt capital. The factors that affect the rating of SIVs are the usual set of risks: credit. As long as the asset has an adequate credit rating. Securitization is the packaging of loans and selling them to other firms to get them off the loan originator’s balance sheet. e. Explain the factors affecting the rating of a special investment vehicle (SIV). Copyright © 2009 Institutional Investor. a bank. 26. and managerial and operational risk. Explain the role of rating agencies in the credit crisis. and they were also paid fees for monitoring the entities to which they had given such ratings. which should have been a signal that there was an error in the rating.and long-term assets from its parent company.. 66 .g. and monolines which insure municipal bonds. Inc. foreign currency. and structured credit products such as tranches of CDOs.Topic 9: Current Topics 25. The loan originator. iii) Market risk is the change in prices from changes in the market. bankruptcy-remote company that purchases mainly high-rated medium. All Rights Reserved. This was because most of the subprime loans originated by brokers were securitized after the origination of the loan. which managers must address by marking-to-market and marking-to-model the liquid and illiquid assets respectively. The actions of ratings agencies played a huge role in the credit crisis. interest rate. mortgage bonds. derivative product companies (DPCs).

the managers had little incentive to consider the risk exposure from the possible write down of the monolines which would. the Fed introduced a new lending facility: the Primary Dealer Credit Facility (PDCF). All Rights Reserved.S. The monolines contributed to the financial crisis because the when they were downgraded. 29. Another issue was managers’ short-term horizons. The PDCF allowed investment banks and securities dealers to use a wide range of securities as collateral for loans from the Fed. The fair value accounting framework has three levels of evaluation: 1) market prices. the assets they backed were downgraded. The rating lowered the incentive of the bank to perform due diligence. Monoline insurers guarantee the payments from certain types of assets. 28. In recent years. They are highly leveraged. This was not a very big disincentive because the market environment was such that there were plenty of other jobs to be had. v) Foreign currency risk is the risk of a change in value from changes in the value of currencies in which investments have been made. Structured securities that had AAA rated tranches were thought to be acceptable. lower the rating of the assets they held. Central banks around the world provided capital to banks. The banks invested in AAA rated securities. and the Fed did the same in the U. vi) Managerial and operational risks refer to losses from errors and/or criminal acts of employees. 67 . 2) prices of related assets. the European Central Bank pumped money into Europe’s money markets. in turn. Explain the role of valuation methods. and even a failed manager could get rehired at another institution. Explain the role and actions of central banks in 2007 and early 2008. the Russian Central Bank injected the ruble equivalent of $1. The worse that could happen to managers is that they could lose their jobs. and 3) model valuation for illiquid assets.Topic 9: Current Topics iv) Interest rate risk is the risk the present value will change from a change in interest rates. 30. Explain the lack of incentives for banks to perform due diligence on the collateral pool. and this further lowered the incentives to do due diligence. gave a AAA rating to the assets they backed.7 billion into the banking system. In mid 2007. Describe the role of monolines. and yet they carried a AAA rating which. The valuation methods Copyright © 2009 Institutional Investor. Inc. as the Basel II regulations allowed such assets to serve as bank regulatory capital. much of their growth has been from backing structured ABS and CDOs. in turn. the Federal Reserve indicated that the spillovers from the subprime market should not affect the overall economy. For example. 31. They generally focused on their yearon-year bonuses. They began in the 1970s as entities to insure the debt of hospitals and nonprofit groups. In the spring of 2008. Also. Thus.

It arose in 2007 when money market managers who normally purchased Asset Backed Commercial Paper (ABCP) switched to Treasury bills and drove up the Treasury yields. Describe the lack of transparency in the credit markets. Many SIVs have backstop lines of credit from banks. there is lack of transparency as to the total magnitude of commitments given in terms of backstop lines of credit or loan commitments to private equity buyouts. ability to refinance declines. This in turn led to some borrowers not being able to roll over debt even when they were not involved in the sub-prime market. If asset values decline.Topic 9: Current Topics allow for the estimation of fair value of a wide range of assets from liquid assets to illiquid assets. and this depressed prices of various types of assets. The reluctance to lend and the tightening of credit standards affected hedge funds. 4. 68 . Systemic risk is the degree to which events in one market will affect other markets. One reason for the systemic nature of the crisis was from the widespread ownership of structures containing subprime mortgages and the circular dependence between refinancing and collateral valuation. and the extent of these holdings are unknown to outside investors. Regulators failed to recognize the existence of positive feedback mechanisms and to understand their implications for the financial system. Inc. 5. 2. The basic information concerning the percentage of CDOs and subprime mortgages in a fund is rarely readily available. 3. which leads to price uncertainty. the availability of residential and commercial mortgages. 1. Here is a list of reasons for the low level of transparency. All Rights Reserved. 33. and the value of the guarantees given by monolines declines. Lack of transparency has been endemic on many levels. Copyright © 2009 Institutional Investor. The LIBOR rate increased. The uncertainty led to banks hoarding cash and restricting loans to other banks. Furthermore. Hedge funds had to sell assets to raise cash. 32. bond auction markets. The valuation methods contributed to the crisis because the models had uncertain parameters. valuation of counterparty collateral declines. For institutions. the uncertainty about which valuation methods to use could lead to disagreements between borrowers and lenders. Banks may hold or “warehouse” sub-prime assets with the intention of securitizing and selling them. This increased the perceived risk of subprime mortgages and the general level of risk aversion. This would increase market turbulence further. The general level of complexity of the assets leads to a low level of transparency. value of monoline assets declines. Methods of valuation are often not known. The ABCP market basically closed. Describe how systemic risk arose in 2007. and lending to businesses. which in turn could lead to the selling of assets and cause funds to close. especially in turbulent markets.

There are standardized maturities of 1. there is the need for more transparency concerning the types of models. All Rights Reserved. Current 10-K statements of financial institutions offer little information about the level of the total off balance sheet commitments of banks. The standardization of instruments has already proved valuable in the market for swaps. and the accuracy and robustness of the methodologies and assumptions. Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased transparency can provide investors with information regarding financial institutions’ exposure. It should be known what a rating implies with respect to the probability of timely payment and expected loss. This has simplified valuation in this market because the models can be calibrated to match these current prices. The method of calculating a rating should be known and reproducible by an independent third party. then the length of the cycle should be known. transparency with respect to what a rating means. If a rating is through-the-cycle. and the nature of the data used in the calculation. 2) 3) 4) 35. This standardization means that models have very reliable prices as inputs. Argue how standardization can simplify valuation issues. 69 . Inc. or have. and 10 years. This is the only way investors can have confidence in the ratings. There are four basic recommendations that could dampen the impact of future crises: 1) There should be a clear definition of the meaning of a rating. and an increase in transparency would provide investors with information regarding financial institutions’ exposure. 36. there also needs to be transparency with respect to the backstop lines of support in the case of disruptions so investors know the risks. the assumptions used to rate a particular structure. Banks had a variety of hidden risks on their balance sheet. The government should create an agency that collects and makes available information on collateralized pools. One type of explicit commitment occurs when providing financing for a levered buyout without the protection of an “adverse market. It is necessary to know. For collateralized structures. how the rating was calculated. Increased transparency would alert the investors of the level of risk concerning these commitments. For SIVs. Another explicit commitment comes about when banks gave backstop lines of credit to their sponsored SIVs without specifying the total level of these commitments. Such moves towards standardizing issues in other markets would likewise improve the valuation methodologies in those markets. 3. Some of the needs for transparency are specific for certain assets. Copyright © 2009 Institutional Investor. Argue how increased transparency in the rating process is necessary. There should be transparency with respect to the source and nature of the data used in the calculations. Most of the recommendations for dampening the effect of future crises require an increase in transparency.” which can provide an escape from a bad deal. 5. 7.Topic 9: Current Topics 34.

The following list provides more details: 1) 2) 3) 4) 5) 6) There should be consistent regulations and oversight and a lower degree of fragmentation of regulations. can improve transparency. There should be regulations against cherry-picking the placement of assets on either the bank book or the trading book at the time of purchase. the recommendations advise increased capital requirements for structured products. At the Federal level. Commercial paper can be designed. There should be random sampling of loan applications for approved loans to make sure standards are met. Banks must hold a randomly selected number of mortgages and a specified portion of the equity tranche of ABS composed of their mortgages. The development of new options can allow institutions to protect against risk. sub-indices in some areas are recommended.Topic 9: Current Topics Another type of implicit commitment arose when banks would bring back assets from their SIVs to protect the reputation of the SIV. All Rights Reserved. albeit at the cost of the option. To improve transparency. Any increase would be an improvement. Many of the recommendations address improvements in transparency and an increase in regulatory oversight. clearing houses for OTC trades.e. These indices increase the availability of information on bid-ask spreads and pricing. The Group of 7 finance ministers and Central Bank governors has been presented with 67 recommendations by the Basel-based Financial Stability Forum. Regulators need to address the effects of wrong-way counterparty credit exposure in determining capital requirements and the effects of procyclicality in stress testing. to prevent the funds from breaking the buck. faster disclosure of losses by banks. to allow an SIV to convert it into a oneor two-year note if certain market conditions exist. An increased level of transparency can provide investors with information concerning these exposures. i. This would make SIVs less sensitive to market disruptions. like the CDS indices introduced in 2002. 37.. Increased transparency would alert investors that these commitments exist and the type of events that banks have committed themselves to covering. 38. 70 . for example. Discuss possible regulatory responses. and 10-K statements should offer information about assets being warehoused and the level of the total off balance sheet commitments of banks. there should be minimal lending standards to avoid local lobbyists from lowering standards in certain areas. Another implicit commitment is in enhanced money market funds that invested in subprime mortgages. and banks would step in to support such funds to keep the value from falling below zero. Describe how new product design can dampen market disruptions. New indices. In general. Inc. transparency of the risk exposures on the trading book. and increased cross-border monitoring. Copyright © 2009 Institutional Investor.

and relying on a wide range of risk measures. There is essentially a binary situation where either the cumulative default rate of the sub-prime mortgages remains below the threshold that keeps the MBS bonds untouched and the super senior tranches do not incur any losses. Managers should take a more active role in balancing the need to develop new business and the level of risk the firm can assume. 5. Jarrow and S. 71 . 40.Topic 9: Current Topics 7) 8) Rating agency methods need to be improved and made more transparent.” The Journal of Derivatives. Vol. but the BBB group is relatively small. credit market. establishing processes to value complex and illiquid securities. “What Happened to the Quants in August 2007?” Journal of Investment Management. No. 4. 2007. Spring 2008.E. “The Subprime Credit Crisis of 2007. M. Lo. a proven set of risk management practices includes: 1) 2) 3) 4) adopting a comprehensive view of exposures with the sharing of quantitative and qualitative information across the organization. Centralized clearing houses (CCHs) for OTC transactions should be established that would monitor the risk exposure of participants. R. Turnbull. Crouhy. and A. This would also mean better aligning the compensation of managers to the quality. Š References Till. rated BB to AA. A relatively small default rate could hit and wipe out the BBB group fairly quickly. Limited liquidity and other complexities introduce nonlinearities in the risk of the subprime CDO tranches. Fall 2008. and not just the quantity.. liquidity and capital positions. and stand ready to back defaults. of loans issued. enforcing active controls over the consolidated organizations balance sheet.W. One reason is that a typical subprime CDO has a pool of assets composed of MBS bonds. 39. Copyright © 2009 Institutional Investor. there needs to be a lowering of the conflict of interest of these agencies. Describe nonlinearities in the risk of subprime CDO tranches. A. “Amaranth Lessons Thus Far. or the cumulative default rate exceeds the threshold and the senior tranches are dramatically affected or even wiped out. Inc. to make sure they have sufficient collateral. Describe sound risk management practices. Khandani. All Rights Reserved. H. and Turnbull (2008). with an average BBB rating.. According to Crouhy. Other practices would include integrating liquidity. This would mean the super senior tranches would soon be hit. Also. Jarrow. and finance control structures.” The Journal of Alternative Investments.

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for example. 73 . which includes risks associated with monetary policy. it lowers risk. Since these markets are typically liquid and deep. Explain the relationship between systemic risk. if any. Macro instruments that respond to Fed activity can hedge the tail events in these periods. Hedging tail risk is defensive in the short term. i. high-severity scenarios. Assess the long-run and short-run benefits of hedging the tail risk of a portfolio. credit. commodity markets. liquidity risk. entities are willing to provide it. Macro markets are the bond. which must be measured using macro models.. Copyright © 2009 Institutional Investor. Deleveraging risk. monetary policy and other macro events. Tail risk is macro risk. it is a tail event that is the result of macro events. foreign exchange. is a monetary policy risk. Inc.TOPIC 10 Portfolio and Risk Management  Main Points  Comparing methods of hedging against tail risk and their relative merits  Explaining the implications of complex and adaptive capital markets for risk management methods  Evaluating factors leading to portfolio allocation drift 1. but is offensive in the long term. Modeling this type of macro risk involves addressing improbable.e. All Rights Reserved. relating tail risk to macro risk simplifies the construction of the hedges. In the short-term. stock. Liquidity is a macro risk. Early and late periods of Federal Reserve monetary easing and tightening are correlated with early and late expansions. In the long term. However. which increases the chance of survival. Systemic risks are characterized by periods where there is an increase in the demand for liquidity. but few. it allows those that were defensive to be offensive because they can take advantage of the reduced liquidity that accompanies tail events and position themselves for attractive prospective returns. 2. Tail risk refers to extreme and rare events that can produce large losses. some forms of insurance is usually available at an attractive price. It puts pressure on the ability to fund levered holdings.

The best example of these are short-term U. 2.e. they are not what would be termed portfolio insurance strategies that the manager would dynamically adjust in response to changing market conditions. When systemic risk increases. the bond market. 4. Dynamic strategies cannot be used to hedge tail risk because they require the ability to trade the assets used to hedge.g. The four approaches to hedging or insuring a portfolio against tail risk are buying insurance securities. 74 . it is beneficial from a hedging strategy perspective. and moving the portfolio off the optimal frontier. 5. Inc. and the liquidity of these assets typically declines in a crisis. One such strategy is the trend-following managed futures strategy. can be a hedge for all the others as the correlation increases in all the markets.. e. the flight to quality will increase the value of these assets.g. It means that a hedge in one market. Invest in strategies that are negatively correlated to tail risk. e. Treasury instruments. the efficient frontier assumes the manager has perfect forecasting ability concerning the mean and variance. Buy contingent claims. Some assets such as spread products that have large higher moments can move a portfolio out into the optimal frontier while adding tail risk. there are mispricings that allow the portfolio manager to get a significant amount of protection against systemic risk at a very low cost. the variance. the CBOE Volatility Index (VIX). Although this is bad in general. The hedger must be careful to make sure the assets are not already overpriced. All Rights Reserved. Thus. or “option-like” securities. Although each of these strategies insure the portfolio against tail risk to some level. Although this seems counterintuitive. managed futures are uncorrelated with the stock market. In times of crisis. buying options. Explain why increased correlation among various asset returns during periods of stress could provide opportunities for free insurance against tail risk. the ability to engage in a dynamic strategy when a tail event or crisis occurs will be greatly reduced. 3. Such spread products include corporate bonds and low-quality mortgages.S. Each is described in more detail below. which has exhibited positive correlation to tail risk indicators. which is hardly true. Describe the four approaches to hedging or insuring a portfolio against tail risk.. Also. the reasoning is that the optimal frontier is only optimal with respect to the second moment. Move the portfolio off the optimal frontier. Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk. Copyright © 2009 Institutional Investor. as a strategy. the macro markets become more correlated. 4..Topic 10: Portfolio and Risk Management 3. That is why the four strategies mentioned above (buying insurance securities. As an added benefit. In some cases. i. Buy high quality “insurance securities”. which have higher yields because of embedded default and illiquidity options. investing in assets negatively correlated with tail risk. 1.

All Rights Reserved. 6. the probability calculation is less important than the knowledge that the potential hedges exist at the right price. two other factors begin to play a role: i) investors find themselves more accepting of new and riskier product structures. By focusing only on how to get higher returns. gammas. Thus. Another reason is that models used by participants generally focus only on the short term. investing in assets negatively correlated with tail risk. the scenario behavior of the hedges after deducting costs. Examining the recent credit crises provides better insight into these two factors. Furthermore. Evaluate the factors that lead to the underpricing of risk by investors. Describe the three factors that impact the construction of a tail hedge. One reason for this is that there is also a natural habitat formation of option market participants. e. In order to find the best combination of the three factors. The model must compute the various “Greeks”. the probability of the scenario occurring.g. 75 . which allows the manager to plan over multiple periods. The three factors that affect the construction of a tail hedge are: 1. The main factor that leads to the underpricing of risk is the focus on getting higher returns. tail hedges are usually cheap for long-lived portfolios. and ii) there is a tendency not to recognize the uncertainty of outcomes. etc. 7.Topic 10: Portfolio and Risk Management buying options. Another source of mispricing is the error in estimating the probabilities. Mispricing can exist for long-dated options.. 2. Explain why long-dated options may provide an inexpensive method for hedging tail risk. the calculations of these will have higher error. the manager will have liquidity relative to other portfolios and survive the stressful period. the manager must know how the portfolio behaves under certain extreme scenarios where shocks occur. 8. the deltas. Simulations based upon past observations are generally unsatisfactory in estimating probabilities for the pricing of tail options. i) Investors find themselves more accepting of new and riskier product structures: As yields on high-yield bonds fell in the years leading up to 2007. vegas. and 3. The manager would then examine the stress scenarios where the shocks occur and find the combination of hedges that controls the risk of the factors that produced the stress scenario. the scenario behavior of the portfolio. Copyright © 2009 Institutional Investor. Without the available reference information. Inc. There was also an increase in the use of leverage to try to enhance already falling returns. which leads to a greater amount of mispricing. which is why they can provide an inexpensive method for hedging. there were developments such as more questionable loan guarantees and fewer loan convents. and moving the portfolio off the efficient frontier) have advantages in hedging tail risk. By having a hedged portfolio when stress scenarios occur.

6% and 10. respectively. In summary. Since 1947. there is a weak link between the volatility of corporate earnings growth and the volatility of the growth of the overall economy. Furthermore. Systematic risk is caused by undiversified movements in the macro “real economy. and their decisions relate to and influence each other in nonlinear and unanticipated ways. Many financial innovations were constantly introduced in the financial market.3%. there has been an increase in the effectiveness of monetary authorities to stabilize growth. Corporate earnings growth and stock market prices have been much more volatile than the growth of the overall economy. assets only earn a return based upon their exposure to systematic risk. for example. Four factors are behind the downward trend in the volatility of growth rates in the real economy: i) increased diversification of industries with the development of new technologies. Furthermore. They are complex because the economic system is made up of many interactive agents. 76 . The standard deviation of GDP growth has only been 2. According to the Capital Asset Pricing Model (CAPM). Capital markets are adaptive because the agents in the markets can change their behavior when confronted with new situations and allow the system to evolve and benefit from the Copyright © 2009 Institutional Investor. sustainable aggregate GDP growth sets an upper limit on the growth of earnings in the corporate sector. Explain the relationship between the real economy and capital markets and discuss the factors that have made the real economy less volatile through time.6%. 10. Inc. Over the long term. it is the real economy that determines the return and risk that cannot be diversified away. while the variability in the growth of the real economy has declined. as does the increased number of industries. ii) increased importance of the emerging markets. the standard deviation of real equity returns and earnings growth have been 13. Although there is a link between the levels of growth of GDP and earnings. Capital markets are complex adaptive systems. Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for models of risk measurement. and iv) safety-net government programs. 9. and of governments providing programs to prevent the economy from declining too quickly. the variability in stock returns and variability in earnings growth have remained constant. which has also had a diversification effect.Topic 10: Portfolio and Risk Management ii) A tendency not to recognize the uncertainty of outcomes: The pursuit of higher returns also makes investors more open to investing in risky products. but the complexities of these products were not fully understood. iii) increased understanding of the workings of the economy by the central banks around the world. there has been an increase in the diversification of the real economy from the emergence of new industries and new markets.” and ultimately. All Rights Reserved. Investors did not know or fully understand the outcomes of these products.

GARCH. copulas. which comes with risk. and the models may make unrealistic assumptions concerning the way individuals and markets act. They seek profit. Specifically. The pool of capital is directly linked to the changing level of liquidity. and it is the degree to which an investor should be concerned about possible outcomes. This is the reason why liquidity can dry up when the public’s risk tolerance declines. producing a liquidity conundrum. In other words. even these models cannot predict all outcomes. Uncertainty. The shadow banking system consists of intermediaries that provide liquidity and includes hedge funds and structured conduits provided by SIVs (special investment vehicles). 77 . Furthermore. The structured conduits are collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). This increases risk aversion and reduces liquidity further. Frank Knight (Risk. A bet or “investment” based upon the flip of a fair coin or the roll of a fair die would be based on risk. The shadow banking system is not backed by a central bank and is largely unregulated. This shadow banking system is important for the financial markets as it provides liquidity by taking on risk. Although rational to some extent. Liquidity can literally disappear from the shadow banking system in a very short period of time simply from a change in the mood of investors. The outcomes are known and so are the probabilities. 1921) cautioned that there is a difference between risk and uncertainty. and other advances have led to the development of sophisticated models that can better predict the risk-return tradeoff in markets. Thus. and Profit. 11. a decrease in risk aversion (an increase in the desire for risk and its corresponding profit) will increase the availability of liquidity. which increases systemic risk and creates a downward Minsky-type spiral of de-levering and collateral-related liquidity-seeking by levered investors. and the probabilities of risk are also distinct. there are behavioral aspects to markets. However. Explain the role of the shadow banking system as a source of liquidity and discuss why during periods of market stress this source of liquidity may disappear.Topic 10: Portfolio and Risk Management changing environment. Compare and contrast the terms risk and uncertainty. an increase in the desire for profit and the willingness to take on more risk increases leverage and liquidity through vehicles like CDOs and SIVs. the agents are not purely quantitative and emotionless entities. Copyright © 2009 Institutional Investor. To the extent that some outcomes and probabilities are known but many are not. Exposure is another factor when dealing with risk and uncertainty. Uncertainty means that the outcomes and probabilities are not known. is not deterministic. however. The behavioral and evolutionary aspects of markets are why standard. New methods such as jump diffusion. 12. Uncertainty. The liquidity withdrawal can lead to the forced selling of assets. and they essentially evolve similar to living creatures. Inc. All Rights Reserved. financial markets have both risk and uncertainty. The shadow banking system consists of levered intermediaries that are largely unregulated. we are able to quantify risk because there are distinct outcomes. traditional statistics with smooth quantitative functions fail to describe financial activity.

This will create market stress from the forced sale of assets. ● Hindsight and recent memory bias: forecasting the future based upon the recent past. One example would be buying more and more stock of a failing company. More specifically. Group think can lead to errors as an investor “joins the herd” in either buying or selling stocks. or at anytime. short-term thinking bias. with insignificant loss of value. This increases the cognitive bias and investors buy more. 78 . and hindsight and recent memory bias. which cannot be measured. Meredith. and they confuse measurable risk with uncertainty. Inc. is the liquidity conundrum. describe the following four reasons why it is difficult to establish and maintain target allocations to illiquid assets: 1. Non-traded assets. the investor will make a prediction based upon a model. the investor gets caught up in the current market mood and ignores the long-term view. This relationship between liquidity and risk. et al. the investor will continue to engage in the same activity despite it repeatedly failing because the investor thinks that sooner or later it has to work. and that liquidity is not only determined by monetary factors. Demonstrate how cognitive biases can lead to errors in judgment by financial market participants. Short-term thinking and hindsight bias also come into play here as investors only see the recent past increases in value and only look ahead to the short-term possible gains. ● Group think: investors look to what others are doing to form opinions and ignore the evidence. ● Overconfidence in models: investors rely too heavily on models to measure risk and predict the future.Topic 10: Portfolio and Risk Management In summary. which increases risk aversion further. 13. and continues patterns of behavior that may be detrimental. As all investors buy. either quickly. have traditionally exhibited attractive performance. In cognitive bias. liquidity will decline. Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes. establishing and preserving a target allocation of illiquid asset classes is a complex task. Secondary markets for illiquid investments Copyright © 2009 Institutional Investor. All of these biases can lead to errors in judgment. ● Confirmation bias: the investor seeks evidence that his theories are correct. The investor may make an over-allocation to the investment thinking that all the risks are known. lowers liquidity and asset prices further and continues the decline. ignores evidence that contradicts his/her beliefs. Investors can suffer from several cognitive biases: confirmation bias. overconfidence in models. ● Short-term thinking or short-termism: related to group think. In overconfidence in models. liquidity is dependent upon the risk aversion (appetite) of investors. However. 14. group think. such as private equity and real estate. Illiquidity: An asset is considered illiquid when it can not be sold. for example. All Rights Reserved. If risk aversion increases (appetite for risk decreases). the prices continue to rise.

Topic 10: Portfolio and Risk Management are limited. such as in the case of private real estate. In the short run. create a model portfolio formed by the following assets and allocations: private equity (0%). As a result. This point highlights the importance of having a commitment strategy because an investor may eventually invest less than was expected or committed if a private equity fund cannot find appropriate investment prospects. They use Monte-Carlo analysis to simulate the performance of this portfolio for thousands of scenarios entailing various levels of asset class returns and cash flow patterns. the timing and size of fund distributions (i. Uncertainty concerning the timing and size of capital calls: When the general partner of a private equity fund identifies an appropriate investment opportunity. which they seek to migrate to a “steady state” (or stable) allocation of private equity (25%). However. public equity. Instructor note: Allocation “drift” occurs when one asset class becomes overweighted while another becomes underweighted in the portfolio.e. MonteCarlo analysis consists of a class of computational algorithms that relies on repeated random sampling to calculate its results. investors cannot easily rebalance their asset allocation when they deviate from their target allocation. 2. They acknowledged that it may be possible to arrive at the steady-state faster if the magnitude of the transition had been lower (instead of the 0% to 25% shift that they used) or if the asset would have produced cash flows. public equity (65%). They then make assumptions regarding the performance of their private equity. and fixed-income investments. Illustrate the total impact of several individual risk factors on private equity allocation drift. at which time each partner will typically support a pro rata share of its commitment (i. in the long run. Copyright © 2009 Institutional Investor. the pledge made by an investor to a private equity fund). b) accounting rules tend to push general partners to account these assets at book value. Inc. et al. found that they could not reach their 25% private equity allocation target until the 5th year. Unfortunately. the cash payments investors receive as compensation for investing in private equity) are also uncertain. allocation drift may not be an important problem. 79 . This is because: a) these investments trade infrequently. public equity (50%). Meredith. 16. and fixed income (35%). he/she can “call” the required equity capital. Uncertainty about the timing and size of distributions: Since the timing of investment realizations cannot be predicted with complete certainty. Valuation subjectivity: It is very difficult to value a private equity or a private real estate fund at any point in time. 15. et al. there exists considerable uncertainty regarding the timing and size of capital calls made by the fund’s general partner. 3. allocation drift can change the portfolio’s risk level to a point where it might become misaligned with the investor’s objectives. Meredith. and fixed income (25%) over time. All Rights Reserved. it is impossible to know exactly what investment opportunities will arise when investing in a private equity or private real estate fund.e. 4. and that it took 25 years to achieve a steady-state 25% allocation. Explain the role of Monte-Carlo simulation to achieve stable (steadystate) allocation in this study. and c) there is always uncertainty regarding the precision of asset valuations. As a result.

Uncertainty regarding capital calls generates a +/.” The Journal of Portfolio Management. et al. the possible total effect of uncertain investment returns (stock and bond returns). and 5. and R. It would appear that the combined effect of these individual risk factors would have a significant impact on the volatility of the allocation. which is less than half of the total of the volatilities at 14.2.1. therefore some of the potential risk is diversified away. Summer 2008. Volatility in the performance of the private equity investments leads to a +/.” The Journal of Portfolio Management. 3. when considered in isolation. influence private equity allocation drift (or volatility of the private equity exposure). 80 . uncertainty regarding private equity valuations. In other words. volatility in the performance of the private equity investments. The authors perform this experiment once their model portfolio has achieved a steady-state (or stable) allocation of 25% to private equity. Results show that. That study estimates the total potential volatility from the five individual sources of risk was equal to about 6%. Inc. V. Simply summing the effects would give a possible range of +/-14.2. Š References Bhansali.6%. uncertainty in distributions. N.7% volatility in the private equity allocation. volatility in the performance on public equity and fixed income.6%. et al. uncertainty regarding capital calls. this level of risk is not realistic because these sources of uncertainty are not perfectly correlated. analyzed the extent to which five specific individual risk factors. 2. 3. and 5.7% volatility in the portfolio’s private equity exposure.Topic 10: Portfolio and Risk Management Meredith. The individual factors are: 1. Sullivan. Uncertainty in distributions leads to a +/. cash flows (capital calls and distributions). However. R. and valuation on the volatility of the private equity allocation is lowered from low correlations of the risk factors and some of the potential total risk being diversified away. Summer 2008. Volatility in the performance on public equity and fixed income (the other two asset classes in the portfolio) generates a +/. They argue that this percentage is not an unreasonable magnitude since institutional investors tend to allow their target asset class allocations to drift within a range of about 5% (to minimize transaction and administrative costs) before they begin to rebalance their portfolios. Meredith. All Rights Reserved. on a stand-alone basis: 1. R. “Tail Risk Management. 4. “Portfolio Management with Illiquid Investments. 4.8% volatility in the private equity allocation. 2. This result is evident from the findings of Meredith.. Copyright © 2009 Institutional Investor.” Citi Alternative Investments.6% volatility in the allocation to private equity.2. June 2006. De Figueiredo.4.8% volatility in the portfolio’s private equity exposure. “Taming Global Village Risk. De Brito. Uncertainty regarding private equity valuations leads to a +/.

 The following diagram illustrates the concept. the spot price of the commodity is expected to fall by $10 over this year.TOPIC 11 Research Issues in Alternative Investments  Main Points  Evaluating the risk and return components of commodity futures returns from various perspectives  Comparing approaches to evaluate smoothing effects in the real estate market  Assessing research on hedge fund risk factors and biases in hedge fund databases  Describing the impact of unique characteristics of private equity returns on investor decision-making 1. Copyright © 2009 Institutional Investor. Inc. This learning objective covers an interesting and important point on how expected spot price changes are embedded into commodity futures prices and what the implications are for the changes in futures prices. Note that this example exactly addresses the learning objective's point: how a long position in a futures contract can earn a positive return when a commodity price is falling. A holder of a long position in the contract expects to earn $5 per contract as the current futures price ($55) rises to the expected spot price at the end of the year ($60). However. The key is that the commodity price is expected to fall. Long positions in commodity futures earn higher than expected returns when commodity prices are higher than expected. Illustrate how an investment in commodity futures can earn a positive return when spot commodity prices are falling. The key is that profits and losses are driven by changes in commodity prices relative to expectations. All Rights Reserved. The commodity futures contract for one year is priced at $55. Assume that the current spot price of oil is $70 but that over the next year it is expected to decline to $60. 81 .

Many spot commodity prices exhibit seasonal price fluctuations (for example. In the above example. collateralized commodity futures vastly outperformed commodity spot prices (perhaps having double the total inflation adjusted return).000 in T-Bills and long positions in $1. The expected profit (loss) to a futures contract is the risk premium earned (paid) for bearing (hedging) risk. Inc.000. the long position expects to receive a $5 profit—which could be a normal profit from bearing risk (a risk premium for bearing risk or it could include an expected abnormal profit from superior forecasting abilities).Topic 11: Research Issues in Alternative Investments Futures contract holders also can earn a risk premium. Thus. In spite of this. drive returns. One explanation is that positions in collateralized commodity futures earn interest (e. on average. the T-Bill yield) on the collateral. even in an example where commodity prices are not expected. Copyright © 2009 Institutional Investor. spot commodity price changes can differ from commodity contract price changes because commodity futures prices are based on expected commodity prices. All Rights Reserved. to rise or fall. temporary price movements can be very prominent in commodity spot prices. Also. having $1. heating oil prices tend to be higher during the winter). As a result.000 of gold futures should be expected to outperform having $1 of gold. For example.g. According to Gorton and Rouwenhorst. Actual physical possession of commodities can have storage and convenience yield costs. When spot prices fall they do not cause futures prices to fall unless the spot prices fall more than expected.000. 2. Unexpected. inflation adjusted over the period 1959 to 2004. the holder of a long position might still earn a positive return while commodity prices fall if the anticipated risk premium exceeds the losses caused by a small unexpected decline in the spot price. seasonality in spot prices should not have an influence on futures prices because seasonality is a predictable oscillation that market participants take into account when they establish futures prices. Compare commodity spot returns and commodity futures returns. The returns from physically holding commodities can be substantially different from the returns of long positions in (collateralized) commodity futures contracts.. rather than expected commodity price changes. 82 .

CPI (Consumer Price Index) and.” ● Collateralized commodity futures and stocks both had positive kurtosis (which means they are fat-tailed relative to the normal distribution). collateralized commodity futures contracts (long positions in commodity futures combined with interest bearing collateral deposits) have generated high average returns (roughly in line with US common stocks) and have done so with favorable risk attributes and correlations. while collateralized commodity futures returns were positively skewed.S. Therefore. ● Commodity futures returns were negatively correlated with equities and bonds over long-term time horizons (but not over shorter intervals). According to Gorton and Rouwenhorst’s analysis of inflation adjusted returns from 19592004: ● Standard deviations were higher for stocks (4. The worst 5% of months for equities lost more than 6. Compare commodity futures returns with stock returns and bond returns. but stocks performed better in the 1990's (and perhaps a little better in the 1980's). especially adjusted for risk. This finding implies that commodity futures may provide diversification benefits when added to a portfolio of stocks and bonds. In a nutshell. thus.27% per month) than for collateralized commodity futures (3. stocks have relatively more weight in the “left tail” of the return distribution and commodity futures have relatively more weight in the “right tail. Compare commodity futures risk with equity risk.47%).e. Gorton and Rouwenhorst compare collateralized commodity futures returns with stock returns (measured using the returns on the S&P 500) and corporate bond returns (measured using the returns on a corporate bond index) return for the period July 1959 through 2004. All the series were deflated by the U. Copyright © 2009 Institutional Investor. 4.Topic 11: Research Issues in Alternative Investments 3. provide a measure of real return (i. ● Stock distributions were negatively skewed (which is bad).34% while the worst 5% of months for commodities lost more than 4. All Rights Reserved. ● Equities had substantially higher down side risk as would be measured by Value at Risk.10%. In a nutshell. inflation-adjusted) performance. Inc. According to Gorton and Rouwenhorst's analysis of inflation adjusted returns from 1959-2004: ● Average annual returns of collateralized commodities and US common stocks have been roughly equal (with both earning a risk premium of about 5%) ● Both commodities and stocks had higher average returns than bonds (bonds earned a risk premium about half as much as stocks and commodities) ● Commodities outperformed stocks in the 1970's and for a few years after 1999. but the kurtosis for futures was more than double that of stocks. collateralized commodity futures contracts (long positions in commodity futures combined with interest bearing collateral deposits) have performed well. 83 .

They also found that bonds. Gorton and Rouwenhorst analyze the performance of stocks. the empirical results (1959-2004) of excellent inflation hedging with collateralized commodities and terrible inflation hedging with stocks and bonds are not surprising.. collateralized commodity returns have had positive correlations with inflation. this particular learning objective is focused on the relationship between returns and business cycles. Inc. did very well near the end of a recession and somewhat poorly at the start. bouts of unexpected inflation. in particular. ● During the worst 5% of monthly equity market returns.g. The major conclusions were: 1. stocks on average lost almost 20% and collateralized commodity futures gained almost 20%! In the late part of a recession. The important conclusion being that this is further indication of the potential of collateralized commodity futures to provide diversification during recessions. bonds and collateralized commodity futures relative to the last seven US business cycles. 5. All Rights Reserved. Explain the diversification benefits of commodity futures. Gorton and Rouwenhorst then formulate a measure of unexpected inflation (which they define as the actual inflation rate minus the nominal interest rate) and show that even collateralized commodity quarterly returns have had positive correlations with unexpected inflation while stocks and bonds have had negative correlations. However. While diversification benefits are typically discussed in the context of return correlations. Gorton and Rouwenhorst demonstrate that unlike stocks and bonds. collateralized commodity futures contracts have provided superior inflation hedges compared to stocks and.Topic 11: Research Issues in Alternative Investments ● The negative correlation of commodity futures returns with stocks and bonds tends to increase as the horizon lengthens. The positive correlation means that collateralized commodity returns tend to be highest when inflation is highest. oil price spikes) often tend to cause negative shocks in general economic output. it is also noted that shocks that increase inflation (e. especially over longer term time horizons such as one or five years. stocks on average gained almost 20% and collateralized commodity futures lost a few percent. Inflation hedging is the idea that an investment at least keeps up with. 6. 84 . Therefore. stocks lost an average of 9% per month while collateralized commodity futures actually earned positive monthly returns averaging about 1%. In the early part of a recession. 2. and better yet outpaces. In a nutshell. Discuss the use of commodity futures as a hedge against inflation. Copyright © 2009 Institutional Investor. thus implying that the diversification benefits of adding commodities to a traditional portfolio are larger at longer horizons. Commodities can be expected to be positively correlated with inflation through the direct link that commodity prices are part of inflation. bonds. somewhat like stocks.

this places downward pressure on the futures price to a level below the expected price in the future. stocks. there were no strong behavior differences during the expansion side of the cycle. Overall. Normal backwardation occurs when the futures price is below the expected spot price. Speculators are willing to take on price risk and go long the futures contract. 8. and that commodity futures outperformed government bonds. the authors found that: ● The average performance of commodity futures and equities was similar in both the U. Describe the performance of commodity futures from a non-US investor’s perspective. They then analyzed whether these empirical findings for commodity futures (which are traded mostly in the US.  The difference between normal backwardation and a market in backwardation becomes more obvious when it is realized that normal backwardation and contango are not mutually exclusive. US bonds and collateralized commodity futures. ● The relative rankings of the real return performance of commodity futures. Hedgers desire to lock in a selling price for their product. the spot price is $9. the overall performance and performance rankings of stocks. then the market exhibits contango. and bonds were fairly similar in Japan. Copyright © 2009 Institutional Investor. bonds and commodities did not change substantially based on whether the analysis was performed with US.Topic 11: Research Issues in Alternative Investments However. A market in backwardation describes a condition associated with the current futures price and the current spot price. Gorton and Rouwenhorst empirically analyzed relative inflation adjusted performance of US stocks. The following illustrates an example. ● Commodity futures returns were positive in real terms in both the U.K. then the market in backwardation. the futures price is $10. but normal backwardation exits. bonds and currency. United Kingdom or Japanese markets. and the U. 85 . and the expected spot price in the future is $11.. would the major results change (and similarly from a Japanese perspective) The general finding of Gorton and Rouwenhorst was that their empirical findings for US investors held for British or Japanese investors considering collateralized commodity futures. 7. and the usual explanation for this is that hedgers outnumber speculators. If. and Japan. if one used British stocks. All Rights Reserved. When hedgers outnumber speculators.K. Describe the difference between normal backwardation and a market that is in backwardation Normal backwardation describes a relationship between the current futures price and the expected spot price at the maturity of the option. denominated mostly in US dollars and settled mostly in the US) were similar from the perspective of a British or Japanese based investor. When the current futures price is below the current spot price. and Japan. Specifically. Inc. A market is in contango when the current futures price is above the current spot price. In other words. the U.S.K.

2) Rank the available commodity futures by their basis. Marcato and Key define smoothing as a phenomenon that produces a lag effect and reduced volatility in valuation-based indices when compared to the underlying market. recalculate the basis of each contract and adjust the portfolio accordingly. futures price – spot price > 0.e. futures price – spot price < 0. which is measured by more precise transaction-based indices.e. If markets are efficient.. if changes in basis are a function of the differences in required risk premiums across commodities or the changing risk of a given commodity over time. then trading strategies based upon changes in expectations will not earn excess returns. Inc. normal backwardation exists. 86 . The following steps outline a trading strategy that uses the basis in futures markets as in indication of risk premium in futures markets: 1) Calculate the basis of a futures position as the slope of the futures curve between the contract in our index and the next available expiration. The aggregation process behind the index construction. 4) Take a long position in the low-basis portfolio and a short position in the high-basis portfolio.Topic 11: Research Issues in Alternative Investments  Example: The six-month gold futures contract has a price equal to $899. At the end of each period. 3) Compose two equally weighted portfolios: a high basis and a low basis group. Does this market exhibit normal backwardation? Is the market backwardated or in contango? Answer: Since the futures price is below both the spot and expected spot price. ● A market in backwardation has a negative basis. i. Copyright © 2009 Institutional Investor. and the expected spot price in six months is $911. 9. ● A market in contango has a positive basis. There is evidence that the futures basis includes important information about the risk premium of individual commodities. The current spot price for gold is $922. All Rights Reserved. The following three main factors may cause smoothing: 1. An important consequence of smoothing is that it causes risk to be underestimated. However. The intuition behind the strategy is that high-basis futures are overpriced and low-basis futures are underpriced. Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions. The basis will change from either a change in expectations about the future spot price or variation in the expected risk premium. low-basis contracts and goes short over-priced. high-basis contracts.. then a trading strategy that selects commodities according to the size of their basis can be expected to earn positive profits. i. The strategy essentially goes long underpriced. and the market is in backwardation. Basis refers to the difference between the futures price and the spot price. Describe a trading strategy that uses basis in futures markets as an indication of risk premium in futures markets. 10.

Compare four approaches to generating an unsmoothed total real estate return series. 87 . the mean-variance framework of Markowitz would assign an optimally high weight to the real estate asset class because valuation-based real estate indices exhibit low risk levels. Smoothing has an impact on asset allocation decisions because the estimation of riskreturn profiles of various assets is critical to the design of efficient portfolios. This is also known as temporal aggregation and would most likely be present when several spot valuations – taking place over a period of time – are used to construct a real estate index. He finds an improvement in performance when real estate is added to this portfolio. Valuations spread over time. is the most important aspect when unsmoothing real estate data. An example of this is the use of thresholds by values (e. Contrary to this. 3.g. All Rights Reserved. Marcato and Key examine this issue by applying different unsmoothing techniques to identify the reasons why Stevenson and previous studies reached different results. In fact. contrary to previous studies. Using a series of historical market rents and cap rates. that the use of different unsmoothing models does not suggest different allocation weights. Marcato and Key reinforce Stevenson’s findings and highlight that calibration of the unsmoothing parameter. Stevenson also finds. Stevenson (2004) analyzes the effects of including real estate to an international portfolio composed of various assets. 12. Inc.Topic 11: Research Issues in Alternative Investments 2. 1% of capital value) prior to the reporting of a change in value. Marcato and Key create an income return assumed to be equal to the cap rate. rather than model selection. The difference between the two is often attributed to the underestimation of risk in available real estate indices. They then estimate the capital growth rate at time t (cgt) of investing in real estate as: cgt = valuet −1 valuet −1 rentt capratet where valuet is the value of a property at time t and is calculated as: valuet = Marcato and Key then use four different approaches to generate an unsmoothed total real estate return series and test whether optimal real estate weights are caused by unsmoothing model selection or by the choice of parameter levels (calibration). Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on allocations to real estate. Copyright © 2009 Institutional Investor. portfolios of institutional investors typically have a real estate weight of only between 5% and 10%. Inertia in individual valuations can arise from “anchoring” to past values when conclusive current market evidence is lacking. 11. For example.

Three main assumptions are underlying this model. 88 . Marcato and Key argue that there is no ex-ante motivation to assume the existence of an autoregressive process of an order higher than two when using annual returns. Residuals are computed from (cgt-α1*cgt-1). Geltner and Webb (1994) with a First Order Autoregressive specification. they restrict their analysis to an AR2. Third. Unsmoothed capital rates of growth for real estate investment (ucgt) are estimated as: ucgt = [cgt − α1 * cgt −1 ] (1 − α 1 ) where cgt is the capital growth of the valuation-based index at time t. The third approach that Marcato and Key use applies a procedure suggested by Fisher. Therefore. random errors are left out of the index (the assumption that there is no noise). and α1 is the unsmoothing parameter. The second unsmoothing method is the Second Order Autoregressive Reverse Filter (AR2). the model holds over time (stationarity assumption). they obtain a Full Information Value Index (FIVI) (also known as FIVI unsmoothing method). First. this autoregressive process has more than one lag and thus gives a more generalized model. the unsmoothing parameter will be higher in falling markets versus rising markets because “valuers” will be inclined to resist downward adjustments more than upward adjustments.Topic 11: Research Issues in Alternative Investments The first unsmoothing procedure is the First Order Autoregressive Reverse Filter (FOARF). However. Following this procedure. Second. and their volatility is used to compute the weight (w0):  2 * σ resid  w0 =    σ equity  The weight (w0) is needed to find the unsmoothed rate of capital appreciation from the next equation: ucgt = (cgt − α1 * cgt −1 ) w0 The fourth method – known as STATES – assumes that different phases of the market cycle will tend to produce changes to the unsmoothing parameter. For instance. adjusted and unadjusted values of the mean for the series are equal. Copyright © 2009 Institutional Investor. that is shown in this equation: ucgt = cgt − (α1 * cgt −1 + α 2 * cgt − 2 ) (1 − α1 − α 2 ) As can be seen in the AR2 equation. Inc. All Rights Reserved.

● 0.25 for returns falling below the mean minus 2 standard deviations. Inc. the next step consists in obtaining an income return (uirt) recalibrated for the unsmoothed capital value index (ucgit) as follows:s uirt = inct ucgit −1 where inct is the income (at time t) and ucgt-1 represents the unsmoothed capital growth index (at time t−1). ucgt = [cgt − α1 * cgt −1 ] (1 − α 1 ) After the computation of unsmoothed capital growth rates (ucgt) using the four different models just presented (FOARF.10 for returns lying between the mean plus 1 standard deviation and the mean plus 2 standard deviations. Different unsmoothing parameters are then applied for different market growth states (hence the name STATES for this method). Copyright © 2009 Institutional Investor.05 for returns lying between the mean and the mean minus 1 standard deviation. First. The STATES method uses the same equation as in the First Order Autoregressive Reverse Filter to unsmoothed capital growth rates. new parameters are estimated by adding a varying coefficient to the fixed parameter following the next schedule: ● 0. In this case however. and STATES). Finally. the lower the unsmoothing parameter. For returns falling outside this range. which is analogous to dividend returns in the case of stocks. The first is the unsmoothed capital growth (property price appreciation). ● 0.20 for returns falling above the mean plus 2 standard deviations. FIVI. 89 . which are then employed for different market growth states. and the stronger the capital depreciation. the unsmoothed total return for real estate at time t (utrt) is calculated as the sum of the unsmoothed capital growth and the unsmoothed income return at time t: utrt = ucg t + uirt This formula reminds us that the unsmoothed total return for real estate has two components.Topic 11: Research Issues in Alternative Investments This method also assumes that the stronger the capital appreciation. which is analogous to the capital gains component when investing in stocks. AR2. ● 0. The second is the unsmoothed income return (rents collected from real estate). All Rights Reserved. and ● 0. unsmoothing parameters vary. the parameter is fixed for returns ranging between the mean and the mean plus its standard deviation. the higher the unsmoothing parameter.15 for returns included between the mean minus 1 standard deviation and minus 2 standard deviations.

38 − 0.5). Inc.3) Copyright © 2009 Institutional Investor. where valuet = rentt / capratet.33% -5.75% 1.03% -0.Topic 11: Research Issues in Alternative Investments  Example: We illustrate the use of these equations in a numerical example.05) = = 0.03% -1.4. Suppose you would like to analyze the time series behavior of the real estate returns for a certain city. you are concerned that this time series may have been the subject of smoothing as it was calculated from an appraisal-based index.52% 0. All Rights Reserved.01% -0. The corresponding last 16 quarters of real estate capital growth rates were: Quarter Real Estate Returns 2. and α2 = 0.81% 0.4 − 0.38 − (0.3 * 2.3).4 *1.05% 0.05% 1.75 = = 1. ucgt = cgt − (α1 * cgt −1 + α 2 * cgt − 2 ) 1.77% -0. suppose that you suspect that the autoregressive process might actually have two lags. What would the unsmoothed real estate return be for the third quarter using the Second Order Autoregressive Reverse Filter (AR2)? (Note: The unsmoothing parameters were estimated to have the following values: α1 = 0.5) Now. What would the unsmoothed real estate return be for the third quarter using the FOARF? (Note: The value of the unsmoothing parameter α1 was estimated to be equal to 0.5 *1.75 + 0. ucgt = cgt − α1 * cgt −1 1.33% -0.24% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 However.01% (1 − α1 ) (1 − 0. After searching for information.22% (1 − α1 − α 2 ) (1 − 0.84% -1. you find a real estate time series of capital growth rates that was calculated using the formula [(valuet/valuet-1) – 1]. 90 . To get a clearer picture from the data.44% -2. you decide to unsmooth the time series using the First Order Autoregressive Reverse Filter (FOARF).38% 1.43% 0.

we obtain: w0 = 2 * σ resid σ equity = 0. and how to compute for weight (w0). that: 2 * σ resid (1 − α 1 ) = σ equity Now. Then. substituting a1 above by 0. All Rights Reserved.Topic 11: Research Issues in Alternative Investments In this example.5 We find that: σ equity = 4σ resid Copyright © 2009 Institutional Investor. then. Inc. since we know that in the case of FIVI w0 is equal to: w0 = 2 * σ resid σ equity We will have.5. substituting this formula in the previous equation. 91 . what would need to happen for the unsmoothing method known as FIVI to yield the same results as the FOARF? (Note: Assume that the value of the unsmoothing parameter α1 was estimated to be equal to 0. we can see that the term (cgt-α1*cgt-1) will simplify since it is in both numerators. Therefore. since a1 = 0. we have: (1 − α1 ) = w0 Now. we can compute the following: (cgt − α1 * cgt −1 ) (cgt − α1 * cgt −1 ) = (1 − α1 ) w0 From this equation.5). We know the equations for FOARF and FIVI.5.

60.K. in this fourth method. the standard deviation of the residuals computed from (cgt-α1*cgt-1) will need to be four times larger than the standard deviation of equity returns for FIVI to yield the same results as FOARF. 92 . Finally. However. market for the period 1971- Copyright © 2009 Institutional Investor. real estate weights fall rapidly (from 40% to 1%) when the unsmoothing parameter is increased slightly.K. Inc. the STATES model.e. 1921-1970. yields portfolio compositions that are comparable to the first method. the Full Information Value Index (FIVI).40 to just 0. this model shows even more sensitivity to the value of the unsmoothing coefficient. and Australia.45. the fourth method. However. This is due to the inclusion of a secondorder parameter. This finding supports the hypothesis that calibration in smoothing techniques (i. All Rights Reserved.50 and 0. disappearing when the parameter is greater than 0. The Second Order Autoregressive Reverse Filter (AR2) also points to a decreasing real estate weight in the mixed asset portfolio as the unsmoothing parameter increases. Marcato and Key use data for the U. Using a FOARF unsmoothing model for the U. compare and contrast the results of using UK data with those employing US and Australia real estate return data. For example. choice of the parameter) is much more important than model selection. (between 5% and 10%).60 is used.S. As the unsmoothing parameter increases in value. Summarizing. the calculated weights tend to be similar to those currently held by institutional funds in the U. Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations to real estate. the minimum coefficient that will produce a zero real estate weight is lower (0. 14. However. for the period 1921-2005 and compare the suggested allocations to real estate arising from the four methods presented in Learning Objective 10. smaller unsmoothing parameters are necessary to suggest the same asset allocations..40) than the one generated by the FOARF. 13. When a coefficient ranging between 0.K. The third unsmoothing method. from 0. The First Order Autoregressive Reverse Filter (FOARF) suggests a very high weight for real estate in the mixed asset portfolio. results suggest that real estate should have a weight of 60% in the original data. and 1971-2005. point to larger differences between minimum and maximum values of the unsmoothing parameter than between unsmoothing methods. the real estate weight decreases. Marcato and Key reinforce the findings arising from the analysis of the U. the results for the U.K. as some authors have previously done. yields a relationship between weights and the unsmoothing coefficient that is comparable to the one suggested by FOARF. For instance. Allocation choices are also found to be very sensitive to the value of the unsmoothing coefficient. In the Marcato and Key (2007) study. They also calculate the four models for the following three sub-periods: 1921-2005.Topic 11: Research Issues in Alternative Investments That is.

Marcato and Key suggest using the simplest form of unsmoothing method. To start a trading operation. when the unsmoothing coefficient is 1.K) impact on the overall portfolio weighting. and Australia. 93 . the manager ought to leverage his/her skills by drawing external capital so that he/she can meet the resulting fixed costs.S.S. 16. In spite of this. and Australia than in the U. the manager’s personal wealth would not be enough to attract significant debt financing.60. which is appreciably more attractive in the U. Fung and Hsieh propose a hedge fund business model that is based on the following economic rationale. unsmoothing model specification has little impact on asset allocation. 15. This is because there exists a much higher first order serial correlation coefficient in the U.S.S. the unsmoothing parameter has a significant (and much larger than for the U. The authors conduct a series of portfolio simulations and arrive at the very important conclusion that all unsmoothing methods are highly sensitive to the choice of the parameter (calibration). and Australia when compared to those used in the U. This is caused by the relative risk-return profile of bonds. with real estate weights diminishing as the value of the unsmoothing parameter increases.S. Results suggest that an implicit unsmoothing parameter exists and that its value ranges between 0. the First Order Autoregressive Reverse Filter (FOARF). and Australia that is due to a correlation coefficient that is near 0. All Rights Reserved. Marcato and Key argue that previous research that proclaimed the significance of model specification may be biased due to the selection of different (and not necessarily comparable) parameters for alternative models. with a coefficient whose value is included in the mentioned range. For the U. is the most important concern when unsmoothing real estate data.50. There exists a substitution effect between real estate and cash in both the U. Marcato and Key calculate and compare the Sharpe ratio obtained for four portfolios (using different unsmoothing methods) and three benchmarks.S. This external capital could be either equity financing or debt financing.K. As a result. Inc. However. Assume that a money manager has a limited amount of personal wealth and believes that he/she could earn risk-adjusted returns that would be above average. This result also suggests the presence of more serious inefficiencies in the valuation-based indexes used in the U.K. 3. the authors point out three differences: 1. rather than model specification.K. Copyright © 2009 Institutional Investor. This range is similar to the values found for this parameter in previous research. Fung and Hsieh compared this business model to the financing of a new venture. typically. The maximum suggested portfolio weights of equities in both the U. As a result. This finding is consistent and supports Stevenson’s conclusion that calibration. For practical use. and Australia compared to the case of the U. the creation of a hedge fund arises as the only realistic financing alternative.Topic 11: Research Issues in Alternative Investments 2005. 2.K. Describe the hedge fund business model presented by the authors. Argue the best method of adjusting a real estate return series when conducting an asset allocation study.40 and 0. and Australia never reach the 80% level of the U. On the other hand.

pension plans are also growing their hedge funds investments. determine the characteristics of the business model (e. Hedge funds constitute a heterogeneous group that employs many diverse investment strategies. This is because. Macro funds: Hedge funds that invest money on directional movements in stocks. Although the number of hedge funds has increased in recent years. Copyright © 2009 Institutional Investor. etc. the actual size of the hedge fund industry is very difficult to measure.). the fee structure) will. (ii) (iii) (iv) 94 . such as diminishing return to scale or the possibility that. and credit risks with short positions of the equity of the issuing firm or other fixed-income derivatives . For example. Changes in styles and strategies. (ii) Hedge Fund Research (HFR). 3. 2. interest rate. While the lead was initially taken by university endowments. commodity prices and foreign exchange rates. Equity market neutral: Hedge funds trade long-short portfolios of stocks while keeping a neutral exposure to the general stock market. Increasing institutional investments in hedge funds. Analyze the issues in measuring the growth of the hedge fund industry. Fung and Hsieh offer an overview of the following five “issues” related to recent developments in the growth of the hedge fund industry: 1. Dedicated shorts: Hedge funds that short sell securities (typically equities) that are estimated to be overpriced. hedge funds provide information to one or more databases on a voluntary basis. optimal contracting between hedge fund managers and investors must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. in turn. Some authors have argued that the co-investing by the hedge fund manager and the investors may improve the alignment of interests on the downside but can also produce excessive conservatism by the fund’s manager on the upside. In the end. 17. TASS classifies hedge funds into the following ten styles: (i) Convertible arbitrage: Hedge funds attempt to generate alpha by buying securities while hedging the equity. Growth in the supply of funds and in assets under management. unlike mutual funds. for reasons external to the fund manager. degree of leverage. Demand for hedge funds by institutional investors in the U. has been increasing in recent years. and (iii) Lipper TASS (TASS).g. in spite of the high attrition rate inherent to the industry. The compensation contract design between the hedge fund manager and investors (e.S. Inc. All Rights Reserved. The three most important hedge fund databases are: (i) Center for International Securities and Derivatives Markets (CISDM).g. the allocation of capital to factor-related bets. Databases usually classify hedge funds according to self-described styles. bonds.Topic 11: Research Issues in Alternative Investments Hedge fund managers attempt to maximize the enterprise value of their funds subject to a number of constraints. the investment strategies they follow may become more or less popular among investors.

95 . Emerging market: Hedge funds invest in securities of developing economies. (viii) Event driven: Hedge funds focus on corporate events (typically merger transactions or corporate restructurings). Empirical evidence suggests that surviving funds have had better returns than dead funds. Fung and Hsieh argue that. However. Style evolution and changing investor clientele. Others: All other hedge fund strategies. All Rights Reserved. as the hedge fund industry matures. A hedge fund may become defunct when investors are dissatisfied by the fund’s performance and vote to redeem their capital. unlike mutual funds. The existence of this bias implies that hedge funds in a database may not be representative of the industry universe. using mathematical models. or when the fund-raising attempts of the hedge fund manager fall short to draw the critical mass required for the hedge fund to remain a feasible business proposition. Therefore. Fung and Hsieh comment on the increasing research on synthetic hedge funds. the importance of the Copyright © 2009 Institutional Investor. it is at the discretion of a hedge fund manager). A growing recent trend has been for hedge funds to progress from single-strategy specialists into multi-strategy hedge funds. (ix) (x) 4. both surviving and defunct. This bias arises because inclusion in a database is voluntary (i. Evaluate the potential biases in hedge fund databases. Inc. Roughly 80% of hedge funds charge a 20% incentive fee. The survivorship bias can be measured as the average return of surviving (or live) funds in excess of the average return of all funds. 18.. Survivorship bias. Management fees and performance fees. On the one hand. Hedge fund databases – CISDM. and HFR – all suffer from the following four potential biases: 1. one might expect that hedge funds having superior performance would go into a database to seize the interest of investors. Similar to the case of mutual funds. These are defined as the replication of hedge-fund-like returns. it is very difficult to estimate the magnitude of this important bias. Long/short equity: hedge funds are invested in a long-short portfolio of stocks with a long bias. hedge funds also charge an incentive fee or a performance fee. (vii) Managed futures: Hedge funds specialize in futures trading.Topic 11: Research Issues in Alternative Investments (v) (vi) Fixed-income arbitrage: Hedge funds trade long-short portfolios of bonds. TASS. available at a lower cost to investors. However. many successful hedge funds that are closed to new investors decide not to be included in a database as they do not have an incentive to be there.e. On the other. hedge funds charge a fixed management fee that is calculated as a percent of net assets under management. Selection bias. 5. 2. the authors are not convinced that synthetic hedge funds represent a reasonable solution to the current imbalance between supply (alpha producers) and demand (alpha buyers). Most hedge funds charge a management fee that ranges between 1% and 2%.

Liquidation bias. However. The majority of managed futures funds employ a trend-following strategy. observed hedge fund returns would have been lower during that month. 1. A market timer who switches between Treasury bills and stocks creates a return profile that is similar to that of a call option on the stock market. Finally. New hedge funds typically undergo an incubation period to accumulate a track record. A lookback straddle is a derivative that pays the holder the difference between the maximum and minimum prices of the underlying security over a certain time period. This incubation period typically lasts at most a few years. past research has also shown that hedge fund indexes have serial correlation of hedge fund returns (autocorrelation) and that the returns are correlated to past returns of market factors (such as the S&P 500). Fung and Hsieh argue that merger arbitrage returns can be considered an insurance premium arising from selling a Copyright © 2009 Institutional Investor. which is the proportion of hedge funds that drop out of a database at a given age. All Rights Reserved. the manager usually registers the hedge fund into a database hoping to draw the interest of prospective investors. Managed futures. 2. Since the incubation history of the hedge fund before the entry date is backfilled. Incubation bias (backfill or instant history bias). is an approach in which risk factors inherent in specific styles are identified.5% per annum. Fung and Hsieh mention that during the Russian debt crisis of August 1998. 4. Fung and Hsieh find that the highest dropout rate tends to happen when a hedge fund is 14 months old. 19. thus causing an upward bias in the observed returns of dead funds. It has also been shown that the resulting return profile is similar to that of lookback straddles. Survivorship bias amounts to roughly 2. several hedge funds (including the famous Long Term Capital Management) lost all their capital and became defunct. It is still not clear whether this correlation arises as a result of infrequent trading of illiquid securities by hedge funds in their portfolios or whether it is a reflection of manipulation by hedge funds managers to smooth or “massage” their returns. Inc. 96 . Review the approach and describe the main findings of bottom-up research on hedge fund risk factors. It has been shown that merger arbitrage returns are comparable to those of merger arbitrage hedge funds. Incubation bias has been estimated to be around 1. This bias refers to the finding that fund managers discontinue reporting their returns to a database before the final liquidation value of a hedge fund. For example. managers stopped reporting their hedge fund’s returns in July of that year. Merger arbitrage. The bottom-up approach to hedge fund risk factors. Merger arbitrageurs tend to be long “deal risk” as they bet on the success of a merger.Topic 11: Research Issues in Alternative Investments survivorship bias will diminish. it is logical to speculate that the early part of a hedge fund’s history will be upwardly biased. as the opportunity costs related to a fund’s incubation period can be significant. as opposed to the top-down approach. 3. Had they reported the corresponding -100% returns in August of 1998. If the track record is decent.5% a year. A related concept is the hazard rate.

5. Past research suggests that the following three strategies are commonly used by convertible arbitrage hedge funds: ● ● ● volatility arbitrage strategy. Past research suggests that emerging market hedge funds returns are strongly correlated with an emerging market stock index. Inc. which disappear over time. Convertible bond funds are strongly correlated to a convertible bond index and high-yield funds are strongly correlated to a high-yield bond index. where the value of the position is determined by fluctuations in the differentials between the prices or interest rates. Niche styles. 3. and carry strategy. Past research has shown that the returns arising from fixed-income hedge funds can be “created” using different fixed-income arbitrage trades that are often used by hedge funds. The performance of this type of hedge funds is highly idiosyncratic. ● ● ● Mortgage spreads: A bet on prepayment rates. Credit spread: A bet on the difference in the prices or interest rates of two fixed-income securities. Mergers bear a significant idiosyncratic risk that is usually mitigated by the hedge fund by holding a portfolio of merger transactions. as hedge fund managers in this style are stock pickers possessing diverse opinions and abilities. such as: ● ● Swap spreads A bet that the fixed side of the spread will remain higher than the floating side of the spread. Fixed-income hedge funds. Capital structure arbitrage (spread): These are credit arbitrage spreads on mispricing among different securities (typically bonds and stocks) issued by the same company. 97 . distressed securities hedge Copyright © 2009 Institutional Investor. All Rights Reserved. Long/short equity hedge funds. Fixed-income volatility trade: A bet that the implied volatility of interest rate caps will be higher than the realized (observed) volatility of the Eurodollar futures contract.Topic 11: Research Issues in Alternative Investments policy against the risk that the merger is not completed. Empirical results suggest that convertible arbitrage hedge funds offer liquidity to the convertible bond market trading mostly from the long side while hedging the underlying risk factors of the bond. which is a combination of the volatility arbitrage and the credit arbitrage strategy. credit arbitrage strategy. Furthermore. 6. Yield-curve spreads: A bet that bond prices deviate from the overall yield curve only in the short-run due to liquidity issues. ● 4. which is a bet that the option embedded in the convertible bond is not correctly priced. Long/short equity hedge funds have been found to have a positive exposure to the stock market and to long small-cap/short large-cap positions. which is a bet that the convertible bond’s credit risk is not correctly priced. Convertible arbitrage. all styles have correlations to changes in default spreads.

Thus. the return of the S&P 500 above the risk-free return). 98 . Disentangling the risk of macro funds has been a difficult task to researchers because of the dynamics of risk in these hedge funds. A lookback portfolio in currencies. the difficulty in correctly classifying the strategies that fall into this style has made this category challenging to analyze. both types of investors can assess whether the fees they paid are reasonable. All Rights Reserved. or “alternative alphas” and “alternative betas”. 7. The return of the 10-year Treasury bond above the risk-free return. and dedicated short-sellers’ returns are strongly negatively correlated with a small growth stock Index. 6.e.Topic 11: Research Issues in Alternative Investments funds returns are strongly correlated with a high-yield bond index. Describe and assess the adequacy of the asset-based style risk factor model used by Fung and Hsieh to analyze hedge fund returns. Fung and Hsieh stress that investors should try to understand the most important risk factors in hedge fund portfolios so that they can evaluate their effect on their overall asset allocation profile. A lookback portfolio in bonds. equity non-hedge (hedge funds that usually trade from the long side. Inc. Macro hedge funds. The ABS risk factor model provides investors in search of alpha with a way to assess the value of their hedge fund investment. Beta buyers. 5. Fung and Hsieh propose an asset-based style (ABS) factor model consisting of seven risk factors to capture the risk of diversified portfolios of hedge funds. And finally. 4. 7. on the other hand. 20. leaving their market risk essentially unhedged) returns are strongly correlated with a small growth stock index. Copyright © 2009 Institutional Investor. The term assetbased used to describe these sources of uncertainty arises because these top-down risk factors are all based on tradable securities and their derivatives. The return of Baa bonds above the return of the 10-year Treasury bond. Small-cap stocks minus large-cap stock returns. A seven-factor model proposed by Fung and Hsieh (2004) does a reasonable job in capturing the risk of macro funds (see Learning Objective 21). counterparties to hedge funds and regulators need to recognize the key sources of hedge fund risk so that they are able to assess capital at risk. The excess return of the S&P 500 (i. The seven factors are: 1. The importance of the asset-based style (ABS) risk factor model to analyze hedge fund returns resides in that the identification of these observable risk factors based on tradable assets allows us to indirectly get around the opaqueness of hedge fund operations. Another important feature of the ABS risk factor model is that it provides a more natural way of defining hedge fund alphas and hedge fund betas. 2. and A lookback portfolio in commodities. can evaluate whether their investments have exposure to the right risk. the ABS risk factor model allows us to indirectly measure the systematic risk of hedge fund investing. In the case of equity market neutral. 3. Furthermore.

22. This emphasizes the importance of the private equity investor somehow being able to recognize and have access to the managers with the best record in order to earn the best returns. In general. thus creating a domino effect to other market participants and institutions. Fung and Hsieh argue that the potential impact that hedge funds may have on market integrity has shifted from the failure of a mega hedge fund (such as LTCM) to that of a convergence of leveraged opinions among funds that individually may function unnoticed. 3. Copyright © 2009 Institutional Investor. argue that hedge funds are too small to be able to manipulate particular markets.Topic 11: Research Issues in Alternative Investments 21. given that these investment vehicles are accessible only to sophisticated wealthy individuals and institutional investors. Investor protection. All Rights Reserved. David Swensen. Fung and Hsieh describe the following three primary regulatory concerns associated with hedge funds: 1. however. chief investment officer of Yale’s endowment. Research on the returns of private equity firms has shown that risks are often understated and returns overstated. 99 . regulators—mainly the Securities and Exchange Commission (SEC) and. The superior performance is only the result of selecting top-quality managers who pursue value-added strategies with appropriate deal structures. Some regulators are concerned about the potential impact that hedge funds may have on the markets. This is the risk that large losses from one or more hedge funds can wreak havoc to their counterparties. A case in point was the effects of the near bankruptcy of Long Term Capital Management (1998). These “accredited investors” are assumed to have the knowledge and the sufficient wealth to hold out the risk of suffering potentially substantial losses from hedge fund investing. Market integrity. A convergence of leveraged opinions can be defined as an event in which the opinions of a large group of hedge funds converge onto the same set of bets. Describe the role of manager selection in the experience of a private equity investor. Discuss the broader risks associated with hedge funds and describe the regulatory concerns. indicated that passive investment in private equity is bound to provide disappointing results. The key to successful private equity investing is to select the best private equity firms in which to invest. to a lesser degree. thus potentially threatening markets and creating systemic risk. Inc. Others. Regulators generally consider that systemic risk should be dealt with by existing regulation of banks and other counterparties rather than by new laws. 2. Systemic risk. given that a number of these funds are large enough to exert a major impact on the markets. but this is not easy because of the lack of transparency concerning the valuation and disclosure of the assets in each private equity firm. Fung and Hsieh recommend that risk monitoring of the hedge fund industry should reorient its focal point away from megafund collapses to the convergence of factor bets. the Commodity Futures Trading Commission (CFTC)—maintain that hedge fund investors can “fend for themselves”.

Inc. Private equity has grown dramatically in the U. Furthermore. Making adjustments for stale prices and illiquidity. Some private equity firms have been known to not update the values of some of their investments for years. and when finding one. e. All Rights Reserved.g. it is important to recognize the history of private equity and the limitations of the data when compared to more conventional publicly-traded investments such as stocks and bonds. the manager of a private equity firm is the general partner. and wealthy individuals. requires identifying and having access to the managers that earn the higher returns. 100 . there is asymmetry of information in this market. 2. superior private equity firms and their funds. pension funds. however. An investor must be able to invest with the top managers. The fact that the firms are illiquid means that the potential returns are not accurately represented by the returns estimated using reported prices.. The three basic challenges when measuring the risk-adjusted performance of private equity are: 1. The general partner looks for good investments. a private equity index. Some managers outperform others on a consistent basis.S.. Discuss the challenges that an investor would face in measuring the riskadjusted performance of private equity. presents challenges when analyzing the data. by already having a relationship with them.g. 23. The conclusion is that successful investors in private equity must have both the ability to identify. university endowments.Topic 11: Research Issues in Alternative Investments Simply recognizing the top managers is not enough. The general partner generally receives a fee of about 2% of assets and 20% of the gross profits on invested capital. The relatively short history. in the last 30 years. There are two layers to this illiquidity: the shares of the private equity firms do not actively trade and the investments of the firms are illiquid. and has recently spread around the world. These two layers compound the problem. Stale prices and illiquidity complicate measuring the returns to private equity funds. Thirdly. combined with the irregularities associated with the growth of this sector. Investors should be less confident with respect to measures of risk and return. He/she obtains capital commitments from limited partners that are qualified investors such as financial institutions. and investors in private equity firms have different abilities with respect to both identifying the best managers and having access to them. because the top managers may not be open to new investments. For this reason. There is also “parameter Copyright © 2009 Institutional Investor. e. 3. The second challenge influencing returns is to be able to identify and have access to topperforming managers. as well as have access to. when analyzing the data of private equity. “calls” the limited partners for investment capital. The limitations of data availability. Typically. Measures of performance using such data are unreliable. the “average” investor in private equity firms cannot expect to earn the returns reported for the industry. Recognizing that earning the returns indicated by summary market measures. Stale prices refer to when a firm does not change reported prices frequently.

A very important overall implication of these observations is that. 25. Both the assets in which private equity firms invest and the smallest stocks on the NASDAQ have payoffs that are similar to those of options. By keeping the assets on the books. 101 .g. the authors found that investments in private equity from 1980 to 1996 had an annual return lower than the S&P 500 by as much as 3. Explain and identify the potential bias in using the performance of liquidated funds to represent the overall performance of private equity funds.Topic 11: Research Issues in Alternative Investments uncertainty” with respect to the models. The median is the value below and above which 50% of the values fall. This is far greater than the reported median returns of 12% across all funds. 24. They compared the performance of these funds to 1.g.. The challenges are greater for the data of firms outside the US. and a lower proportion of bad outcomes.3%. Inc.. that have a documented record of higher returns with private equity relative to the general returns of private equity. and they probably do this by focusing their investment in the best-performing private equity firms. When adjusting the sample for the bias.391 funds that were still active. Compare the performance of companies in which private equity firms invest with small cap firms listed on NASDAQ. Explain the implication of the observation that mean and median returns on private equity databases are significantly different. e. successful IPOs. There are certain types of institutional investors. bankruptcies. One implication is that the ability to recognize top managers and have access to their funds plays a significant role in the realized returns. the attractiveness of private equity as a general asset class of investments is overstated. they can keep the assets at unrealistically high values. i. e. Funds that are not performing well may not be as likely to liquidate to avoid having to recognize poor performance from unsuccessful results concerning their Initial Public Offerings (IPOs) and asset sales.e. Liquidated funds may represent a biased sample because the more successful funds are more likely to liquidate. 26. when looking at the industry’s aggregate reported returns. All Rights Reserved. not liquidating them. Both have the potential for huge payoffs along with a high probability of a complete loss of capital. A study by Kaplan and Schoar (2005) for the period 1980-2001 found that the mean return of venture funds and buyout funds were 17% and 18% respectively.. The differences between the mean and median returns indicate that the best private equity firms do outperform the market on a fairly consistent basis. notably endowments. The returns of the liquidated funds had a higher proportion of good outcomes. Phalippou and Zollo examined 981 funds that had officially liquidated or were inactive in the two years prior to when they took their sample. Copyright © 2009 Institutional Investor. Phalippou and Zollo (2005) put forward the hypothesis that the returns of liquidated funds may not be a representative sample of the returns offered by all funds.

NASDAQ) are sometimes used by practitioners to help gauge success in private equity. the standard deviation of the private equity quarterly index (PEQR) almost doubles. both the investments made by private equity firms and small NASDAQ stocks have large means and volatilities. including a 20% allocation of private equity to a traditional stock and bond portfolio would shift out the efficient frontier significantly. Explain the liquidity characteristics of Listed Private Equity securities. (2005) classified listed private equity securities (LPEs) into one of three categories: (1) public companies whose core business is private equity. The sample included listings in North America.g. Discuss the impacts of adjustment for stale prices on risk. Although the firms often sought listing to increase liquidity. given the similarities. the liquidity was still very limited when compared to other public stocks. buyouts. Adjusting for stale prices increases risk and lowers diversification benefits. Specifically. however. 27. the studies suggest that private equity has not produced returns that are competitive with the returns of public equity. adjusting for the biases of thin trading increases risk measures.99.Topic 11: Research Issues in Alternative Investments In statistical terms. The returns for later rounds of investments decline as a firm becomes more established over time. The estimates of returns drop significantly when adjustments for the bid ask spread are made. Europe and Asia. Listed Private Equity (LPE) securities are traded securities that have the properties of private equity but also trade on an exchange. Zimmerman et al. Copyright © 2009 Institutional Investor. (3) specially structured vehicles that invest directly in private companies and/or indirectly through various private equity funds. This is the case for both LPEs and unlisted private equity. small stock indices (e. Inc. (2) quoted investment funds that co-invest with specific private equity funds. In summary. Using quarterly data. Also. e. (2005) examined 287 Listed Private Equity securities (LPEs) during the period 1986-2003. after the adjustments. Also. later expansion.60 to 0. and the standard deviation of the Sand Hill Econometrics index of venture capital (Sand Hill) increases by more than half again as much. and it is certainly the case given the relative low liquidity and high risks of investments in private equity. 102 . Conroy and Harris’ 2007 study shows that the risks of private equity investments increases dramatically after an adjustment for stale prices. 28. the benefits are much lower. but does not affect returns. Zimmerman et al. The correlations and betas of the indexes with the S&P 500 also increase. Cochran (2005) estimated the mean arithmetic return for early rounds of private equity investments to be 59% with a standard deviation of 109%. and the beta of the LPEs increase from 0.. The LPEs represented the gamut of financing stages.g. It is true that without the adjustments. All Rights Reserved. and diversification benefits of private equity (candidates do need to memorize exact figures). early. and turnarounds. The bid ask spread exceeded 20% for over 40% of the LPEs. After adjusting for biases. Liquidity issues tended to influence the characteristics of the returns of LPEs. return.

59% / 16.Topic 11: Research Issues in Alternative Investments The table below summarizes the results found in Conroy and Harris. It gives the actual numbers for the quarterly results for two private equity indexes and the monthly results for one index. Thus. The reported Dimson beta. for example. and the stock subsequently increases in value. Dev. The adjustment attempts to correct for the smoothing that is usually observed with the stale prices associated with illiquid assets. The Post-Venture Capital Index (PVCI) is a measure composed by Venture Economics. Furthermore. All Rights Reserved. If the IPO was underpriced and the price of the stock subsequently increases in value. 30. Identify the impact of IPO under-pricing on the performance of the PVCI. 29. the return of a strategy that attempts to replicate the PVCI by buying stocks in the aftermarket will be about 2% lower than the PVCI itself. adjusting the PVCI to remove the impact of IPO underpricing reduces the attractiveness of private equity.97% / 15. absence of an investible index. before/after adjustment 13% / 25% 18% / 31% 26% / 32% Corr.71 1. is the sum of regression coefficients on the S&P 500 and its lagged values. Copyright © 2009 Institutional Investor. w/S&P 500 before/after adjustment 0. They will find that they cannot achieve the level of the returns of the index because they cannot participate in the IPOs.74 0.68 / 0. which includes both contemporaneous and lagged risk values in the risk measures. Index (Quarterly Returns) PEQR Sand Hill (quarterly) LPX America (monthly) Std.53 / 1. As a representative investment in private equity. A company becomes part of the index at the offering price when it goes public. In fact. Inc.90 / 1.17 0.69 Beta before/after adjustment 0. the return of the PVCI will increase from that effect. Any strategy attempting to replicate the returns from PVCI would usually result in lower returns than those reported by PVCI.84 0. This has an impact on investors who attempt to replicate the PVCI.63 / 0. the initial impact is the tendency for the PVCI to increase when it includes an underpriced IPO stock at its issue price.76 / 0.41 Mean Return before/after adjustment 16. the performance of the PVCI would be biased because of the effect of IPO underpricing. By the estimates of some researchers.15 / 1. and cross-sectional differences in private equity managers.00% 15. The increases in correlation and beta means there is a lower benefit from diversification. Explain how the following issues pose a challenge to private equity investors: Private equity investors have several issues that complicate their analysis of private equity.00% / 16. parameter uncertainty.59% An increase in the standard deviation means that there is an increase in stand-alone risk.97% 16. The adjustment employed was Dimson’s approach. the Sharpe ratio falls to such a degree that some models suggest that private equity should have a zero allocation in an efficient portfolio. 103 . Four such issues are illiquidity.

9%.H. Rouwenhorst.. All Rights Reserved. The dispersion is indicated by the three quartile boundaries: -2. and K. only investors with the ability to recognize and have access to top managers can expect the higher returns. 5. “Facts and Fantasies about Commodity Futures. which would not be desirable. “Smoothing and Implications for Asset Allocation Choices. R.g.6%.K. Hsieh. G. Special Issue 2007. Such a premium would reduce the effective return from private equity and make it less desirable.A.” Financial Analysts Journal. and R.747 funds for the period 1969-2005. Copyright © 2009 Institutional Investor. Parameter uncertainty about estimates of risk and return is larger for private equity than for conventional assets.” The Journal of Portfolio Management. Vol.6%. Recent data indicates the mean IRR is 11. No. c. Conroy. Adjusting for liquidity by reducing the expected return of PEQR by 1% per year.. 62. and 15. Economic Review. Historical returns generally do not have built in any return premium required for illiquidity. Summer 2007. There is a large cross-sectional difference in private equity managers.” Federal Reserve Bank of Atlanta. investors in private equity are unlikely to be able to invest in assets with the properties of the indexes or the properties indicated by the private equity industry’s summary statistics.6%. The data was from Venture Economics. Harris. for instance. Inc. Cross-sectional differences in private equity managers. Key. Š References Gorton. and T. Fourth Quarter 2006. 2006. No index is readily available for purchase. G. e. and access to some funds may be impossible.6% as above 5.) A random draw of a private equity fund has an equal chance of being below 5.9%. “Hedge Funds: An Industry in Its Adolescence. would reduce the recommended allocation to private equity in an efficient portfolio significantly b. One indication is the dispersion of their internal rates of return (IRR). 104 . which is much higher than the median of 5. Marcato.. G. Parameter uncertainty. 3. Vol. Thus.Topic 11: Research Issues in Alternative Investments a. W. Fung. “How Good are Private Equity Returns?” Journal of Applied Corporate Finance. 19. Illiquidity. 2. d.6%. No. As mentioned earlier. Estimates made based upon historical data may not indicate future performance. (These results represent 1. stocks and bonds. Absence of an investible index. and D.

GLOSSARY: Level 2. Over the long run. allocation drift can change the portfolio’s risk level to a point where it might become misaligned with the investor’s objectives. according to Kahneman and Tversky (1979). 130/30: active extension strategies that invest 130% in long positions in one group of strategies and 30% in short positions in another group of securities. All Rights Reserved. (Topic 7) Adjustment Strategies: An approach to dealing with climate change that is a rational reaction to the unavoidable consequences of climate change. It contrasts with adjustment strategies that are reactions to the unavoidable consequences of climate change. a risk factor model where beta buyers can evaluate whether their investments have exposure to the right risk. (Topic 9) Abatement Strategies: An approach to dealing with climate change that attempts to prevent climate change. home loans. (Topic 7) Alignment of interests: The idea that optimal contracting between hedge fund managers and investors must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. (Topic 8) Asset-backed securities (ABS): Bonds that are securitized or collateralized by the cash flows from an underlying pool of assets—such as credit cards. Topics 7–11 Please note that this Glossary is to be used exclusively in preparation for the CAIA® Exam. auto loans. Inc. The aim of this Glossary is to provide useful information. that is directly related to the CAIA® Study Guide Keywords. (Topic 11) Arithmetic return: The simple average of period-to-period returns. (Topic 11) Allocation drift: The situation in which one asset class in the portfolio becomes overweighted while another becomes underweighted. (Topic 10) Alt-A mortgage loans: Loans issued to borrowers who have better credit scores than subprime borrowers but fail to provide sufficient documentation with respect to all sources of income and/or assets. equipment Copyright © 2009 Institutional Investor. 105 . that the ideal portfolio must address. in context. a risk factor model which provides investors in search of alpha with a way to assess the value of their hedge fund investment. aspirational risk is associated with enhancing one’s lifestyle. It contrasts with abatement strategies that attempt to prevent climate change. (Topic 8) Aspirational risk: One of the three dimensions of risk. (Topic 11) Alternative betas: Beta that is derived from the asset-based style (ABS) model of Fung and Hsieh. (Topic 9) Alternative alphas: Alpha that is derived from the asset-based style (ABS) model of Fung and Hsieh.

the term-structure of futures prices has a negative slope. Topics 7–11 leases. (Topic 11) Black-Litterman asset allocation: A model where the investment manager begins with the equilibrium expected returns computed from the CAPM. Inc. It is in contrast to a top-down approach. SPV) that is “bankruptcy remote”.g. (Topic 11) Backwardation: The condition of the futures curve when near-month futures contracts trade at a premium to further-out-month futures delivery contracts. (Topic 9) Asset-based style (ABS) factors: Top-down risk factors representing tradable securities and their derivatives. Fung and Hsieh use seven such risk factors to capture the risk of diversified portfolios of hedge funds. usually.g.Glossary: Level 2. They generate NPV from repackaging the cash flows in a way that can absorb some losses. In contrast to contango. (Topic 11) Backfill: The process in which the incubation history of a hedge fund before the entry date in an index is typically “backfilled”.e. 106 .. related to the use of SPVs. (Topic 7) Copyright © 2009 Institutional Investor. the manager combines his/her own expectations about the market with the expectations from the CAPM. which is called the neutral reference point. the spread between the spot price of a commodity and the price of. or other non-mortgage related assets. All Rights Reserved. (Topic 8) “Buy to own” investing: Acquiring sizable stakes in companies with the goal of having control or ownership rather than trading the securities.. that a bankruptcy of an affiliated entity (e. (Topic 8) Bottom-up approach: An approach to identifying hedge fund risk factors based upon investment styles such as managed futures. Then. (Topic 9 and 11) Bankruptcy remote: The attribute. (Topic 11) Buy-and-hold: A portfolio strategy in which there is no rebalancing even when market prices move. a short term futures contract).e. merger arbitrage. with the tranches being paid in order of seniority (Topic 7) Asset backed security (ABS) trust: The owner of securitized loans acquired from the originators of the loans. They typically use a waterfall payment structure for the collateral’s cash flows. which identifies factors based upon investable portfolios. (Topic 7) Barbell strategies: The strategies that allocate a relatively high weight to the personal (lowrisk cushion) and aspirational (high-risk/return) risk buckets and a smaller weight to the market (middle-risk/return) risk buckets. and fixed-income arbitrage... a sponsoring bank or money manager) will not affect the functioning of the structure (e. backwardation means that the price of a commodity for future delivery is below the spot price. They are often issued by special investment vehicles with several tranches of senior and subordinate securities. i. (Topic 8) Basis: The cash price minus the futures price (i.

Coupons are usually based on LIBOR plus an appropriate risk premium. (Topic 7) Centralized Clearing House (CCH): clearing house for OTC transactions recommended by the Basel-based Financial Stability Forum to the G-7. the investor forfeits the capital invested. to make sure they have sufficient collateral. (Topic 7) Cat-risk CDOs: Securitized products that bundle various catastrophe risks and sell them in individual risk tranches. that provide compensation for certain events. (Topic 10) Capital-structure arbitrage: This is an arbitrage consisting of credit arbitrage spreads on mispricing among different securities (typically debt and equity) issued by the same company. Topics 7–11 Calendar spread strategy: A futures trading strategy that exploits the spreads between two delivery months. It is typically used by sophisticated storage operators who recognize that their storage facilities are essentially a set of complex options on calendar spreads. (Topic 11) Carbon funds: Funds that participate in the market for certified emission reductions (CERs). 107 . The market for catastrophe risks offer adjustment strategies. and stand ready to back defaults. (Topic 7) Catastrophe risks: Unavoidable natural catastrophe and weather risks that are used in risk transfer instruments such as catastrophe bonds and weather derivatives. All Rights Reserved. CCHs would monitor the risk exposure of participants. (Topic 9) Climate-related investments: Public investment funds and private equity funds that invest in assets that could profit from climate change. he/she is allowed to “call” the necessary equity capital at which time each partner typically funds a pro rata share of its commitment. which provide a cash flow when a certain unavoidable event occurs. (Topic 7) Copyright © 2009 Institutional Investor. (Topic 7) Clean Development Mechanism: Part of the Kyoto Protocol that allows for investment to be made in a project that promises to yield future income in the form of certified emission reductions (CERs) in the emerging markets. They may be government purchasing programs and private commercial funds. (Topic 9) Claw-back: When fees paid to the general partner by limited partners for profitable investments may be subject to reclaim if significant losses from later investments occur. and when a predefined loss occurs. Typically issued by a special purpose vehicle (SPV) that purchases the underlying pool for a CDO. (Topic 7) Catastrophe bonds: Catastrophe risk-transfer instruments. Inc. (Topic 9) Capital calls: When the general partner of a private equity fund recognizes a suitable investment prospect. as created by the Kyoto Protocol. Examples are investing in the equity of companies that are developing environmentally friendly products and making loans to such companies.Glossary: Level 2.

(Topic 8) Contango: The condition when near-month delivery futures contracts trade at a discount to further-out-month futures delivery contracts. 108 . If. and whose behavior changes when confronted with new situations. a trigger event occurs.e. (Topic 7) Constant mix: A portfolio rebalancing strategy wherein there is periodic rebalancing such that the portfolio is adjusted back to being a specified percentage mix of securities or security classes. the futures price is greater than the spot price. e. In this case. it will not draw on an investor's commitment. (Topic 8) Constant-proportion portfolio insurance: A portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates. (Topic 8 and 9) Copyright © 2009 Institutional Investor. i. the trigger event is a specified decline in commodity prices.. (Topic 11) Complex adaptive systems: Term to describe the capital markets that are made up of many interactive agents whose decisions impact each other in nonlinear and unanticipated ways.Glossary: Level 2. In contrast to backwardation. the investor increases risky asset holdings when the market rises and decreases risky asset holdings when the market falls. If a private equity fund cannot find appropriate investment prospects. Furthermore.. the investor may eventually invest less than was expected or committed. the futures curve has a positive slope.g. In this case. At the initiation of the CTS. Optimal compensation design must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. the CCO would give a certain amount of money (the principal) to the counterparty and receive coupons over a specified time. refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises. (Topic 7) Commitment strategy: The pledge made by an investor to a private equity fund. Topics 7–11 Collateralized commodity obligation (CCO): The concept of collateralized obligations (COs) extended into commodities. Inc. thereby allowing the system to evolve and benefit from the changing environment. All Rights Reserved. a 35% decline. then the CCO would not receive the principal back at the maturity of the CTS. (Topic 7) Compensation contract design: The fee structure design between the hedge fund manager and the investors. (Topic 10) Commodity trigger swaps (CTS): A derivative that is similar in concept to a credit default swap and used by CCOs. (Topic 8) Conditional factor models: Either rule-based approaches or econometric approaches that model the time-varying factor exposures of hedge fund returns. (Topic 10) Concave payoff curves: In the context of the Perold and Sharpe study. during the life of the CTS. The CO structure facilitates exposure to commodity price risk through the use of CTSs (commodity trigger swaps). (Topic 7) Collateralized fund obligation (CFOs): The application of the CDO concept to investing in hedge funds and private equity.

Glossary: Level 2, Topics 7–11

Contingent capital arrangements: Types of put options where option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs. One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss. Due to pricing difficulties, they are not used much today. (Topic 7) Contrarian: trading strategies that increase the demand for losers (by buying losers) and add to the supply of winners (by selling winners), thus providing market liquidity and helping stabilize supply-demand imbalances. (Topic 9) Convergence: The broadening of goals of hedge fund managers and private equity managers that has led to the two types of funds becoming more similar. Specifically, hedge funds have moved from just making short-term debt-type investments to some longer-term equity-type investments with the goal of having some control in companies in which they invest. Private equity funds are making more shorter-term investments without the goal of control. (Topic 7) Convergence of leveraged opinions: The event where the opinions of a large group of hedge funds (which are highly levered investment vehicles that, individually, may function unnoticed) converge onto the same set of bets, thus potentially destabilizing markets and creating systemic risk. (Topic 11) Convex payoff curves: In the context of the Perold and Sharpe study, refers to the tendency of a strategy to increase equity exposure (risk) as the equity market rises. (Topic 8) Credit Enhancement: In an ABS trust, the amount of loss on the underlying collateral that can be absorbed before the tranche absorbs any loss. (Topic 9) Credit spread: The difference in the prices or interest rates of two fixed-income securities based upon risk; it is used in fixed income strategies where the investor takes positions based upon the disparity between the prices or interest rates. (Topic 11) Decision rule: In the context of the Perold and Sharpe study, refers to the exact determination procedure for a portfolio reallocation strategy such as the amount of dollars that will be invested in a risky asset as the prices of the risky assets change. (Topic 8) Dimson Beta: the sum of regression coefficients on the S&P 500 and its lagged values. It attempts to correct for the smoothing that is usually observed with the stale prices associated with illiquid assets. (Topic 11) Distributions: Cash payments investors receive as compensation for investing in private equity. (Topic 10) Emission credits: While the EU Emission Trading System (EU-ETS) has a limit to tradable emission rights for all companies, emission credits can be won by companies from additional climate protection projects that are in other countries and that can be credited to their own reduction target (baseline and credit). (Topic 7) Emission rights: The EU Emission Trading System (EU-ETS) makes a distinction between greenhouse gas emission rights and emission credits. There are a limited number of emission
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Glossary: Level 2, Topics 7–11

rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) EU Allowances (EUAs): The limited number of greenhouse gas emission rights that are traded among companies in the EU Emission Trading System (EU-ETS). There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) EU Emission Trading System (EU-ETS): The biggest market for greenhouse gas emissions. It uses targets proposed by the Kyoto Protocol, which defines a number of different emission certificates. There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7) Event loss swaps: A variant of conventional industry loss warrants (ILWs). They are more tradable because they are more highly standardized. (Topic 7) Event risk: One of the components of personal risk of an individual investor, which refers to his or her ability to adjust to events such as the loss of a job, health problems, market crashes, etc. (Topic 8) Exposure: the degree to which an investor should be concerned about possible outcomes. It is another factor when dealing with risk and uncertainty. (Topic 10) Exposure diagram: In the context of the article by Period and Sharpe, a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolio’s cumulative performance. (Topic 8) Factor-replication approach: attempt to replicate hedge fund returns using hedge fund risk factors. (Topic 7) First Order Autoregressive Reverse Filter (FOARF): An approach to generate an unsmoothed total real estate return series, with three assumptions underlying this model: adjusted and unadjusted values of the mean for the series are equal; the model holds over time; and random errors are left out of the index. (Topic 11) Fixed income volatility: A bet that the implied volatility of interest rate caps will be higher than the realized (observed) volatility of the Eurodollar futures contract. (Topic 11) Floor: In the context of the Perold and Sharpe study, refers to a total portfolio value that, if reached via a decline in portfolio value, causes a portfolio reallocation such as the termination of investment in risky assets. (Topic 8) Full Information Value Index (FIVI): An approach to generate an unsmoothed total real estate return series, with a first-order autoregressive specification, without the need to assume that the underlying property market is informationally efficient. (Topic 11) Geometric return: return that takes into account compounding across periods, versus arithmetic returns which is the simple average of period-to-period returns. (Topic 8)
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Glossary: Level 2, Topics 7–11

Hazard rate: The proportion of hedge funds that drop out of a database at a given age. For example, Fung and Hsieh find that the highest dropout rate tends to happen when a hedge fund is 14 months old. (Topic 11) Hybrid asset: An asset that shares common characteristics with two or more other assets. (Topic 7) Hybrid funds: Funds that utilize both hedge fund and private equity strategies. (Topic 7) Illiquidity: The property where an asset cannot be sold, either rapidly, with negligible loss of value, or at anytime during market hours. Secondary markets for illiquid investments (such as private equity) are limited. (Topic 10) Incentive fee: A performance fee charged by hedge funds on top of the management fee. Most hedge funds charge a 20% performance fee. (Topic 11) Incubation bias: (Also known as backfill or instant history bias) refers to the bias in hedge funds returns caused when the incubation history of a fund before the entry date in an index is “backfilled”, potentially causing that the early part of a hedge fund’s history will be upwardly biased. Incubation bias has been estimated to be around 1.5% per annum. (Topic 11) Incubation period: A period that new hedge funds typically undergo in order to accumulate a track record. It lasts at most a few years because the opportunity costs related to a fund’s incubation period can be quite significant. (Topic 11) Industry loss warrants: A type of capital market-financed loss (re-)insurance, which is linked to an industry loss index. It is usually in the form of private placements. (Topic 7) Infrastructure funds: Funds that invest in companies that usually provide an essential service to the community and have some monopoly power, e.g., a bridge, utility, or road. They typically provide relatively steady income and provide a hedge against inflation. (Topic 7) “Lend to own” debt financing: Providing debt financing, usually to highly levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults. (Topic 7) Lifecycle: refers to the various stages of the infrastructure asset from inception to maturity. (Topic 7) Lifecycle stage: One of the components of personal risk of an individual investor, which refers to his or her earning power and the desire to leave a legacy. (Topic 8) Liquidation bias: The finding that fund managers discontinue reporting their returns to a database before the final liquidation value of a hedge fund, thus causing an upward bias in the observed returns of dead funds. (Topic 11) Liquidity conundrum: The relationship between liquidity and risk where liquidity is dependent upon the risk aversion of investors and not just determined by monetary
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These can be: public companies whose core business is private equity. quoted investment funds that co-invest with specific private equity funds. Fung and Hsieh have proposed a risk-factor model consisting of seven risk factors to capture the risk of diversified portfolios of hedge funds.g. (Topic 11) Market risk: One of the three dimensions of risk. and was made evident by the near bankruptcy of LTCM (1998). (Topic 8) Copyright © 2009 Institutional Investor. (Topic 8) Market risk factors: Risk factors that affect hedge fund returns. (Topic 11) Multiplier: Within a portfolio reallocation strategy such as “constant proportion portfolio insurance. They often issued a “surety wrap” to increase credit status for senior tranches of an ABS trust or CDO structure. The conundrum is that the increase in risk aversion lowers liquidity. with a long position on a pool of GNMA mortgages which is financed using a “dollar roll”. that the ideal portfolio must address.” it is the parameter that indicates how much an investor increases risky asset holdings when the market rises and decreases risky asset holdings when the market falls. (Topic 11) Monoline Insurers: insurers that guarantee payments from certain types of structured credit products. according to Kahneman and Tversky (1979). Inc.Glossary: Level 2. despite the fact that the underlying collateral was subprime mortgages. They are highly leveraged. Topics 7–11 factors. yet carry a AAA rating. (Topic 9) Mortgage spread: A trade that is a bet on prepayment rates. that may or may not be quantitative. increasing market risk should increase returns. (Topic 7) Listed Private Equity: Traded securities that have the properties of private equity but also trade on an exchange. NYSE). (Topic 11) Market integrity: A concept to describe the potentially major impact that a large hedge fund(s) may have on the markets. 112 . which in turn increases risk aversion and further lowers liquidity. The position is delta-hedged with a five-year interest rate swap. and specially structured vehicles that invest directly in private companies and/or indirectly through various private equity funds (Topic 11) Lock-up: Period when the investor’s capital is committed to the fund and cannot be withdrawn. given that a number of these funds are large enough to exert a major impact on the markets. (Topic 10) Listed infrastructure funds: Infrastructure funds trading on exchanges (e. that may or may not be market-neutral. (Topic 7) Long/short equity: Strategies that employ a broad range of short-selling. (Topic 9) Lookback straddles: A derivative that pays the holder the difference between the maximum and the minimum prices of the underlying security over a certain period of time. and where technology does not necessarily play a significant role. All Rights Reserved.

the expected price at the maturity of the contract.debt: The direct purchase of issued whole loans. valuation of counterparty collateral declines. (Topic 8) Public (indirect) commercial real estate . according to Kahneman and Tversky (1979). (Topic 8) Option-based portfolio insurance: A portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates and increases risky asset holdings at values above that floor value such that the ultimate risk exposure of the strategy mirrors that of a portfolio comprised of risk free bills and call options on a risky asset. Post-Venture Capital Index (PVCI): measure composed by Venture Economics as a representative investment in private equity. value of monoline assets declines. (Topic 11) Private (direct) commercial real estate . 113 . Inc. This contributes to systemic risk. the ability to refinance declines.e. The performance of the PVCI is biased because of the effect of IPO underpricing. This condition allows for positive excess returns as an investor takes long-term futures positions and then rolls them over as they approach maturity. Topics 7–11 Multistrategy hedge funds: Hedge funds that invest opportunistically among different hedge fund strategies applied to global markets. i..debt: This component of commercial real estate is constituted primarily by commercial mortgage-backed securities (CMBS). (Topic 8) Public (indirect) commercial real estate . The approach is based on the premise that two random variables can be equal almost surely or equal in distribution. (Topic 7) Personal risk: One of the three dimensions of risk. All Rights Reserved. A growing recent trend has been for hedge funds to progress from single-strategy specialists into multi-strategy investments. and suggests that futures prices generally trend up as they approach maturity. that the ideal portfolio must address. (Topic 8) Copyright © 2009 Institutional Investor.equity: This segment of commercial real estate involves buying shares of real estate investment companies (REITs) and other listed real estate companies.Glossary: Level 2. personal risk refers to the possibility of a fall in the investor’s lifestyle and the resulting anxiety associated with that possibility. (Topic 8) Payoff distribution approach: It attempts to replicate hedge fund returns by matching higher moments but not the first moment. If asset values decline. given the large amounts of capital needed to participate in it. and the value of the guarantees given by monolines declines. (Topic 8) Positive Feedback Mechanisms: The term for the circular dependence between refinancing and collateral valuation. (Topic 8) Private (direct) commercial real estate – equity: This segment of commercial real estate involves the acquisition and management of actual physical properties. This component of commercial real estate is accessible only to large investors. (Topic 11) Normal backwardation: This term describes the case where the futures price for a commodity is less than the expected spot price in the future.

These investments may be more illiquid and treated separately as far as fees and redemptions are concerned. This autoregressive process has more than one lag and thus gives a more generalized model than the first order autoregressive model (FOARF). (Topic 11) Copyright © 2009 Institutional Investor. such as accounting variables. (Topic 11) Selection bias: This bias arises because inclusion in a database is voluntary (i. (Topic 8) Second order autoregressive reverse filter: It is an approach to generate an unsmoothed total real estate return series. Inc. (Topic 9) Short-termism: Short-term thinking. The existence of this bias implies that hedge funds in a database may not be representative of the universe of the industry. The rates increase after the initial period. which is measured by more precise transaction-based indices. An important consequence of smoothing is that it causes risk to be underestimated. it is at the discretion of a hedge fund manager). In the futures market. (Topic 11) Serial correlation of hedge fund returns: Research has shown that hedge fund index returns have serial correlation (autocorrelation). which implies that hedge fund current returns tend to be correlated to past returns.e. earnings forecasts. it is the difference between the expected spot price and the futures price. (Topic 10) Side pockets: Separate accounts within hedge funds designed to hold investments that differ from the primary strategy of the funds. and economic indicators (Topic 9) Resampled mean-variance optimization: An improved adaptation of the Markowitz framework that explicitly recognizes that there is uncertainty in the future regarding the capital market assumptions driving the asset allocation model. where an investor gets caught up in the current market mood and ignores the long-term view or fundamentals. typically defined as the expected return of a risky asset minus the risk free rate. (Topic 10) Short reset loans: Loans with low teaser rates for the first two or three years. (Topic 7) Smoothing: A phenomenon that produces a lag effect and reduced volatility in valuationbased indices when compared to the underlying market. 114 . fewer securities and inputs other than past prices. (Topic 11) Roll Return: Also known as “roll yield” generated in a backwardated futures market is achieved by rolling a short-term contract into a longer-term contract and profiting from the convergence toward a higher spot price.Glossary: Level 2. Topics 7–11 Quantitative equity market-neutral: Investment strategies using broad types of quantitative models. referred to as 2/28 and 3/27 hybrid sub-prime ARMs. (Topic 11) Shadow banking system: Levered intermediaries such as hedge funds and structured conduits provided by SIVs that are largely unregulated and that provide liquidity to the financial markets by taking on risk. (Topic 8) Risk premium: The increased expected return (usually expressed as an annual percentage rate) for bearing risk. related to group think. some with lower turnover. All Rights Reserved.

g. (Topic 11) Statistical arbitrage: Mean-reversion strategies which are short-term and highly technical. Fung and Hsieh propose a risk-factor model using seven factors to encompass the risk of diversified portfolios of hedge funds. (Topic 10) Time varying factor exposure: Hedge fund managers may change their exposures as positions are closed out and new positions are opened. (Topic 11) Copyright © 2009 Institutional Investor. the average return of surviving (or live) funds in excess of the average return of all funds.e. A general lowering of liquidity and an increase in risk aversion can affect all financial markets and the collapse of the system. securities or other assets) and is the entity that issues the various tranches that have claims to the cash flows (senior.Glossary: Level 2. as well as substantial computational. MTNs. the effects of these changes will be evident in the factor exposures. It is higher when the distribution of returns has “fat tails. (Topic 11) Systemic risk: The risk to the entire financial system as opposed to just one area.and long-term assets from its parent company. mezzanine and equity). trust) that forms the core of collateralized obligation (CO) structures. (Topics 10 and 11) Tail risk: This is the possibility of extreme and rare events that can produce large losses. The SIV funds these purchases with short-term ABCP. All Rights Reserved. (Topic 9) Special purpose vehicle (SPV): The legal entity (e. (Topic 11) Synthetic hedge funds: Replication of hedge-fund-like returns using mathematical models.. trading and IT infrastructure (Topic 9) Survivorship bias: In a hedge fund database. This bias amounts to roughly 2. bankruptcy-remote company that purchases mainly high-rated medium. 115 . and subordinated debt capital. is leptokurtic. The SPV is the entity that legally owns the collateral (e.g.5% a year. The idea is that these returns can then made available to investors at a lower cost than that arising from directly investing in hedge funds.. both surviving and defunct. funds. they use large numbers of securities. Topics 7–11 Special Investment Vehicle (SIV): A limited-purpose. (Topic 7) Top-down approach: An approach in which the risk factors affecting diversified hedge fund portfolios are modeled. Inc.” i. (Topic 7) Stale prices: A term to describe prices when a firm does not change reported prices frequently. which makes it challenging for investors who want to measure the risk-adjusted performance of private equity. very short holding periods. (Topic 7) Toehold positions: Positions taken by private equity companies in the distressed securities of public companies in order to identify opportunities in distressed companies that they intend to take private. Depending on the duration of the trade. (Topic 11) Swap spread: A bet that the fixed side of the spread will remain higher than the floating side of the spread..

it is different from risk where the probabilities and outcomes are known. (Topic 10) Unlisted infrastructure funds: infrastructure funds not trading on exchanges. Inc. All Rights Reserved. (Topic 9) Copyright © 2009 Institutional Investor. 116 . Topics 7–11 Uncertainty: Describes a situation where outcomes and probabilities are not known. and the junior tranches do not get paid if the collateral pool becomes stressed in certain ways.. The high-grade or “senior bonds” are paid first.g. there is a change in the collateral/liability or cash-flow/bond-payment ratios. e. This is because: a) these investments trade infrequently. (Topic 10) Waterfall Payment Structure: A payout scheme where cash flows are assigned to a range of low-grade to high-grade tranches.Glossary: Level 2. and c) there is always uncertainty regarding the precision of asset valuations. it is one of the challenges associated with private equity or a private real estate fund. b) accounting rules tend to push general partners to account these assets at book value. (Topic 7) Valuation: In the context of illiquid investments. According to Knight (1921).

64 Alternative alphas. 34–35. 22. 97 Floor. 85–86 Bankruptcy remote. 12 Catastrophe bonds. 79 Capital-structure arbitrage. 47. 27–28 Full Information Value Index (FIVI). 7–8 Adjustment Strategies. 98 Arithmetic return. Inc. 76 Concave payoff curves. All Rights Reserved. 11 EU Emission Trading System. 95 117 Copyright © 2009 Institutional Investor. 65 Asset-based style factors. 59–61 Convergence. 11 Event loss swaps. 1 Barbell strategies. 71 Clean Development Mechanism. 103 Distributions. 47–48. 2–3 Commitment strategy. 11 Emission rights. 77 Exposure diagram. 98 Alternative betas. 52. 19–21. 31–32 Basis. 8–11 Catastrophe risks. 96 Buy-and-hold. 97 Carbon funds. 10 Contrarian. 96 Backwardation. 99 Convex payoff curves. 86 Black-Litterman asset allocation. 94 Complex adaptive systems. 85–86 Contingent capital arrangements. 1 Asset-backed security trust. 29–32 Asset-backed securities. 16 E Emission credits. 4 Hybrid funds. 11 EU Allowances. 3 Collateralized fund obligation. 16–17 I Illiquidity. 3 Compensation contract design. 10 Exposure. 14. 39. 42–43 Bottom-up approach. 98 Constant mix. 12 Climate-related investments. 48–49 Capital calls. . 21–28 Contango. 26–27 Conditional factor models.Index: Level 2. 104 Incentive fee. 38 Aspirational risk. 38 H Hazard rate. 79 Commodity trigger swaps. 19–28 Constant-proportion portfolio insurance. 24 C Calendar spread strategy. 88–93 Fixed income volatility. 8–11 Cat-risk CDOs. 19–27 Buy-to-own investing. 10 Centralized Clearing House. 26–27 Credit enhancement. 94 Allocation drift. 79–80 Alt-A mortgage loans. Topics 7–11 A Abatement Strategies. 88–92 G Geometric return. 79 B Backfill. 7–8 Alignment of interests. 13 F Factor-replication approach. 65 Credit spread. 8 Collateralized commodity obligation. 12–13 First Order Autoregressive Reverse Filter (FOARF). 19–21. 97 D Dimson beta. 16–18 Convergence of leveraged opinions. 78. 96 Hybrid asset.

96 Shadow banking system. Topics 7–11 Incubation bias. 96 U Uncertainty. 96 Industry loss warrants. 73 Time varying factor exposure. 102–103 Statistical arbitrage. 95 T Tail risk. 35–37. 82–83 Roll return. 100. 16 Long/short equity. 65 P Payoff distribution approach. 75–78 Unlisted infrastructure funds. 61 Survivorship bias. 57. 64. 95 Serial correlation of hedge fund returns. 57–63 Lookback straddles. 63. 118 . 95–96 Swap spread. 99 M Market integrity. 64 Short-termism. 41 Q Quantitative equity market-neutral. 92 Copyright © 2009 Institutional Investor. 23–25 Valuation. 29–32 Positive feedback mechanisms. 65–66. 77. 95 Systemic risk. 65–67 Mortgage spread. 68 Post-Venture Capital Index. 16 Lifecycle. 29–32 Monoline insurers. 1 Stale prices. 12–13 Personal risk. 68–70. 97 Synthetic hedge funds. 34–35 O Option-based portfolio insurance. 88. 77–78 Listed infrastructure funds. 96 Incubation period. 77 Special Purpose Vehicle. 4 Lifecycle stage. Inc.Index: Level 2. 10 L Lend to own debt financing. 57 R Risk premium. 96 Liquidity conundrum. 97 Multistrategy hedge funds. 15 Smoothing. 13 Toehold position. 78 Side pocket. 73. 5 Listed private equity. 79 V W Waterfall payment structure. 16 Top-down approach. All Rights Reserved. 86–87 Special Investment Vehicle. 99 Market risk. 40 S Second order autoregressive reverse filter. 4 Liquidation bias. 96 Selection bias. 77 Short reset loans. 41 Public (indirect) commercial real estate. 102 Lock-up. 5 N Normal backwardation. 103 Private (direct) commercial real estate.

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