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c. define forward contracts, futures contracts, options (calls and puts), swaps,
and credit derivatives and compare their basic characteristics;
d. determine the value at expiration and profit from a long or a short position in
a call or put option;
f. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
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Derivative
Page 2
⇒ zero-sum game - derivatives do not
LOS a
create wealth, they simply transfer it - define
- when one party makes $1, the other must lose $1 - distinguish
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⇒ Structure of Derivative Markets/ Page 5
LOS a
② OTC (Over-the-Counter) markets
- define
· lower degree of regulation - lightly regulated - distinguish
· privacy
Note/ Dodd-Frank
· some OTC contracts which can be standardized
will be, and a number of contracts will have
to be cleared through central clearing agencies
T1 T2
Buyer &
Seller trade on this date
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Page 2
⇒ Forward Commitments/ ⇒ an OTC LOS b, c
- contrast
contract that obligates both
- define
parties Note/ an
future price at T agreed exchange-traded
on at t0 forward is called
F0(T) a ‘futures’
r = 0 i = $0 $0
contract
-
-
0 T
S0 - spot price at t0 ST - spot price at T
Payoff
- if ST > F0(T) ⇒ long profits
ST - F0(T) zero-sum
short loses
- (ST - F0(T)) Note/
- if ST < F0(T) ⇒ short profits
F0(T) - ST ST - S0
long loses
- (F0(T) - ST) ≠ ST - F0(T)
· forwards do
not require $
0 0 to change hands
on inception
ST Day 1
ST
Day 1
· value of a
Payoff from Buying Payoff from Selling forward = $0
ST - F0(T) - [ST - F0(T)] at inception
- ST + F0(T)
F0(T) - ST
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· delivery
- short position must deliver to a specific location
during the delivery period Cushing, Okla.
- long takes delivery
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delivery delivery
· no counterparty risk
· highly regulated
· transparent
Page 9
⇒ Forward Commitments/
LOS b, c
Swaps/ an OTC contract in which 2 parties agree to - contrast
swap a series of cash flows - define
- one party pays a variable rate (determined by an asset or rate)
variable rate
- other party pays
or
fixed rate
- most common: fixed for floating: Plain vanilla swap 𝐝𝐚𝐲𝐬0
notional principal × 𝐫𝐟𝐥 ( 𝟑𝟔𝟎1
floating payments
Corporation Swap Dealer - value of swap
fixed payment at inception = 0
floating interest notional × 𝐫𝐟𝐥 #𝐝𝐚𝐲𝐬+𝟑𝟔𝟎, - as the floating
payments principal rate changes, the
typically Lender value of the
Libor swap changes
- term of the swap set
to match term of the loan MM106760493.
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exercise or Page 10
⇒ Contingent Claims/ strike price LOS b, c, d
Options/ at a pre- by a pre- - contrast
call has a buy an - define
Buyer of a - specified - a specified
put right to sell asset - determine
price date
- seller has the obligation expiration date
- buyer pays seller an option ‘premium’
- options can be OTC or exchange-traded
· American-style options - can be exercised anytime before expiration
· European style options - can only be exercised on the expiration date
- payoff of a call at expiration ST - x if ST > 0, else 0
∴ CT = max.(0, ST - x) π = max.(0, ST - x) - C0
S0 = 45
ST = 45 ➞ payoff = ∅ ➞ profit = -1.50 OTM (out-of)
e.g. X = 50
ST = 50 ➞ payoff = ∅ ➞ profit = -1.50 ATM (at)
T = 3 mos.
ST = 55 ➞ payoff = 5 ➞ profit = 3.50 ITM (in)
C0 = 1.50
Profit x x
- C0 (loss is not
(limited loss)
limited)
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-
-
Profit x 51.50 x
- C0 (loss is not
(limited loss)
-5 limited)
Buying a Call
Page 13
⇒ Contingent Claims/
LOS b, c, d
Options/ ➞ payoff of a put at expiration X - ST if ST < X, else ∅ - contrast
∴ PT = max.(0, x - ST ) π = max.(0, x - ST) - P0 - define
- determine
e.g. X = 20 ST = 18 ➞ payoff = 2 ➞ profit = 0.50 payoff = -2, profit = -0.50
P0 = 1.50 ST = 22 ➞ payoff = 0 ➞ profit = -1.50 payoff = 0, profit = 1.50
x Profit x Payoff
- P0 -
x
(limited loss)
(not a limited loss)
- sort of
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a) physical b) Cash
- we get $10M - receive Par - Post Default
- deliver bonds to market value
the seller
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Purposes/Controversies
Page 1
· Risk allocation, transfer, management LOS d
· Information discovery - describe
- some derivatives provide an indication of
the direction of the underlying
- involves less capital, ∴ info can be
reflected in prices faster
- derivatives allow strategies unavailable with
the underlying
· Operational Advantages
- lower transaction costs, more liquid than spot markets
- easy to go short the underlying
- leverage
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Arbitrage
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a. explain how the concepts of arbitrage, replication, and risk neutrality are used in
pricing derivatives;
b. explain the difference between value and price of forward and futures contracts;
c. calculate a forward price of an asset with zero, positive, or negative net cost of
carry;
d. explain how the value and price of a forward contact are determined at expiration,
during the life of the contract, and at initiation;
e. describe monetary and nonmonetary benefits and costs associated with holding the
underlying asset and explain how they affect the value and price of a forward
contract;
h. explain how swap contracts are similar to but different from a series of forward
contracts;
k. identify the factors that determine the value of an option and explain how each
factor affects the value of an option;
o. explain under which circumstances the values of European and American options
differ.
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-
0 T
𝐄(𝐒𝐓 )
S0
(𝟏 + 𝐫 + 𝛌)𝐓
risk-free risk required rate of return
rate premium (assume risk aversion)
- costs
MM106760493.
𝜽 𝐜𝐨𝐬𝐭𝐬
𝐓 (𝜽 - 𝜸)
𝐄(𝐒𝐓 ) D𝟏 + 𝐫𝒇 E
∴ 𝐒𝟎 = − 𝜽 + 𝜸
(𝟏 + 𝐫 + 𝛌)𝐓 cost of carry
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-
0 T
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𝜸 - PV benefits Page 7
LOS c, d
𝜽 - PV costs
- explain
-
-
0 T - describe
S0 ST spot price
F0(T) - forward price VT(T) = ST - F0(T)
V0(T) = 0
𝐅𝟎 (𝐓) = 𝐒𝟎 (𝟏 + 𝐫)𝐓 · borrow @ rf, buy S0, at time T we
- the forward price is owe 𝐒𝟎 (𝟏 + 𝐫)𝐓
the spot price compounded - if 𝐅𝟎 (𝐓) > 𝐒𝟎 (𝟏 + 𝐫)𝐓
at the risk-free rate over - sell - buy
the life if the contract - if 𝐅𝟎 (𝐓) < 𝐒𝟎 (𝟏 + 𝐫)𝐓
- buy - sell
- introduce costs + benefits
𝐅𝟎 (𝐓) = (𝐒𝟎 − 𝜸 + 𝜽)(𝟏 + 𝐫)𝐓
Page 8
𝜸 - PV benefits VT(T)
LOS c, d
𝜽 - PV costs = ST - F0(T) - explain
-
0 t T - describe
t T - t
S0 - spot price F0(T) - contract price, agreed
today on at t = 0, for a
transaction at T
Valuation
bring 𝛄 & 𝛉 bring F0(T)
St
(1 + r)t (1 + r)-(T-t)
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-
r(2) - two-yr. Libor
r(2)
[𝟏 + 𝒓(𝟐)]𝟐 = [𝟏 + 𝒓(𝟏)][𝟏 + 𝐟(𝟏, 𝟏)] e.g./ r(1) = 3%
[𝟏 + 𝐫(𝟐)]𝟐
r(2) = 4%
𝐟(𝟏, 𝟏) = −𝟏
[𝟏 + 𝐫(𝟏)] (𝟏. 𝟎𝟒)𝟐
𝐟(𝟏, 𝟏) = −𝟏
· The FRA rate is the 𝟏.
𝟎𝟑
forward rate (implied by the = 𝟓. 𝟎𝟎𝟗
current term Proof/
structure of rates) (1.04)2 = (1.03)(1.05009)
1.0816 = 1.0816
spot ➞ 100
F0(T) = 100 F0(T) = 104 F0(T) = 108
futures profit > $10
-
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Swaps
-
- explain
FS0(n,T) FS0(n,T) FS0(n,T) FS0(n,T)
- distinguish
-
S1 S2 S3 S4
FS - fixed
- netted S1 - FS0(n,T) S3 - FS0(n,T) n - # of periods
out S 2 - FS0 (n,T) S4 - FS0 (n,T) T - term
12 mos.
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Option Value
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ST > X ST < X
- holder will - holder will not
exercise exercise
long call ST - X 0
5 0 -2 0 2
OTM 10 0 -2 0 2
15 0 -2 0 2
ATM - 20 20 0 -2 0 2
25 5 3 -5 -3
30 10 8 -5 -8
ITM
35 15 13 -10 -13
40 20 18 -20 -18
π π
moneyness π
π
C0 = $2
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Page 17
· Call Option/
LOS i, j
- explain
long call
(VT)
ST - X
C0
Intrinsic
C0 BEP = X + C0 Value
0 ST
-
X
- C0
Page 18
· Put Option/ LOS i, j
- explain
buyer - has a right - to sell at a by a
a certain
seller - has an obligation - to buy certaincertain
asset
price date
e.g./ A buys a 12-month put from B for $5, strike $50 on XYZ
(May 2017 $50 put on XYZ)
Scenario 1/ ST = 30 Scenario 2/ ST = 85
A - 85
out of the
VT = X - ST = 20
money
π = (X - ST) - P0 = 15 - 50
- 50
in the
B money A B
- 30 VT = 0 VT = 0
VT = -20
π = -15 π = 0 - P0 π = P0 = 5
MM106760493. = -5
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ST < X ST > X
- holder will - holder will not
exercise exercise
long put X - ST 0
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BEP = X - P0
short put
P0
0 ST
-
X
long put
X > ST ST > X
ITM OTM
IV = X - ST ATM IV = 0
IV = 0
S0 = $50 X1 = 45 X2 = 55 Page 22
LOS i, j
C1 = 7 C2 = 3
- explain
P1 = 3 P2 = 7
Calls Puts
Value of
an option =
IV + TV
OTM - 55 ITM - 55
IV = 0, TV = 3 IV = 5, TV = 2
ATM - S0 ATM - S0
IV = 5, TV = 2 IV = 0, TV = 3
- 45 - 45
ITM OTM
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Effects on Value
- S0 - TV only
- S0 - TV only
more expensive
IV + TV less expensive
Page 24
2) Exercise price - X
LOS k
X sets an upper bound on the price of - identify
a put
𝐗
i.e./ 𝐏𝟎 ≤ (𝟏 r - risk-free rate, t – time
+ 𝐫)𝐭
in yrs.
· call option values are inversely related to X
· put option values are directly related to X
Note/
Upper Bounds
Call ST
Put 𝑿0
[⇒ 𝒆𝒓𝒕 ⇒ 𝑿𝒆'𝒓𝒕 ]
(𝟏 + 𝐫)𝐭
Hull
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5) Volatility Page 26
LOS k
- greater volatility in the underlying
- identify
increases both call & put prices
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Put-Call Parity
Page 27
⇒ Let us begin with 2 portfolios LOS l
A B - explain
· call, put and bond
long call long put all have the same
+ + time to maturity
zero coupon bond long stock · X is the same
that pays X
②
protective put for all 3
at maturity
· call & put have the
fiduciary call same underlying
(also the structure of · call & put are
a principal protected note) European
⇒ at expiration Page 28
① ST > X ② ST < X LOS l
Payoff Payoff - explain
A. Call exercised A. Call not exercised
payoff = ST - X ST - X + X Payoff = 0 0 + X
= ST · zero worth X = X
· zero worth X ②
B. put exercised
B. put not exercised
0 + ST Payoff = X - ST X - ST + ST
payoff = 0
= ST · Share worth ST = X
· stock worth ST
- both A & B have the same payoff at expiration
∴ A & B should have the same cost today!
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⇒ Synthetics/
𝐗 𝐗
𝐒𝟎 = 𝐂𝟎 + − 𝐏𝟎 = 𝐏𝟎 + 𝐒𝟎 − 𝐂𝟎
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
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𝐗
② 𝐗
𝐂𝟎 + − 𝐒𝟎 ≥ 𝟎 𝐏𝟎 − + 𝐒𝟎 ≥ 𝟎
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
𝐗 𝐗
𝐂𝟎 ≥ 𝐒𝟎 − 𝐏𝟎 ≥ − 𝐒𝟎
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
𝐗
𝐗 𝐏𝟎 ≥ 𝐌𝐚𝐱 n𝟎, − 𝐒𝟎 o
𝐂𝟎 ≥ 𝐌𝐚𝐱 n𝟎, 𝐒𝟎 − o (𝟏 + 𝐫)𝐭
(𝟏 + 𝐫)𝐭
A B Page 32
LOS m
long call long put
- explain
long a zero that long forward on the underlying
matures at X ST < X + long a zero with FV = forward price
0 X - ST
= X
+ X + ST - F0 = X
+ F0
②
ST > X
ST - X 0
= ST
+ X + ST - F0 = ST
+ F0
𝐗 𝐅𝟎 𝐗 − 𝐅𝟎
𝐂𝟎 + = 𝐏𝟎 + ⇒ 𝐏𝟎 − 𝐂𝟎
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐭
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Binominal Model
$22 Page 33
LOS n
$20 · we want to set up a
- explain
$18 portfolio of the stock and
an option in such a way that
there is no uncertainty about
let 𝚫 = # of shares the value at termination
②
∴ sell a call at $21
for example
$22𝚫
20 CT = -1
- C0 22𝚫 - 1 = 18𝚫 22(.25) - 1 = $4.50
$18𝚫
4 𝚫 = 1
CT = 0 18(.25) = $4.50
𝚫 = .25
if rf = 2% and T = 3 mos.
②
𝟒. 𝟓𝟎
𝟑4
= $𝟒. 𝟒𝟕𝟕 ∽ $4.48
(𝟏. 𝟎𝟐) 𝟏𝟐
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Page 35
⇒ more generally
LOS n
SU - explain
S0 c+ = max(0, SU - X) i.e. 30% up u = 1.3
20% down d = .8
Sd
c- = max(0, Sd - X) 22
t = 0 u = 1.1
c+ = 1
t = T 20
②
18 d = .9
Buy nS 𝐧𝐒𝐮 − 𝐜 5 = 𝐧𝐒𝐝 − 𝐜 ' c = 0
Sell c 𝐧𝐒𝐮 − 𝐧𝐒𝐝 = 𝐜 5 − 𝐜 '
𝟏−𝟎 𝟏
𝐧(𝐒𝐮 − 𝐒𝐝) = 𝐜 5 − 𝐜 ' 𝐧= =
(𝟏. 𝟏 − . 𝟗)𝟐𝟎 . 𝟐(𝟐𝟎)
𝐜5 − 𝐜' 𝐜5 − 𝐜'
𝐧 = =
𝐒𝐮 − 𝐒𝐝 (𝐮 − 𝐝)𝐒 = 𝟏0𝟒 = 𝟎. 𝟐𝟓
Page 36
𝐜5 − 𝐜'
𝐧= 𝐧𝐒𝐝 − 𝐜 ' LOS n
(𝐮 − 𝐝)𝐒 𝐧𝐒 − 𝐜 =
nSU - c+ (𝟏 + 𝐫) - explain
nS
𝐜5 − 𝐜' '
- c 5
𝐜 −𝐜 '
(𝐮 − 𝐝) × 𝐒 × 𝐒𝐝 − 𝐜
× 𝐒 − 𝐜 =
nSU - c- (𝐮 − 𝐝)𝐒 (𝟏 + 𝐫)
②
𝐜5 − 𝐜' '
5
𝐜 −𝐜 '
(𝐮 − 𝐝) × 𝐝 − 𝐜
−𝐜=
(𝐮 − 𝐝) (𝟏 + 𝐫)
𝐜5 − 𝐜' '
𝐜 −𝐜 5
(𝐮 − 𝐝) × 𝐝 − 𝐜
'
𝐂= −s t
(𝐮 − 𝐝) (𝟏 + 𝐫)
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Page 37
Y LOS n
𝐜5 − 𝐜' - explain
'
5
𝐜 −𝐜 '
(𝐮 − 𝐝) × 𝐝 − 𝐜 𝟏 𝐜5 + 𝐜5𝐫 − 𝐜5𝐝 − 𝐜' − 𝐜'𝐫 + 𝐜'𝐝
𝐂= −s t x + 𝐜' y
(𝐮 − 𝐝) (𝟏 + 𝐫) 𝟏+𝐫 𝐮−𝐝
X 𝟏 𝐜 5 (𝟏 + 𝐫 − 𝐝) − 𝐜 ' (𝟏 + 𝐫 − 𝐝)
𝟏 x + 𝐜'y
𝒄=𝑿− [𝒀 − 𝒄' ] (𝟏 + 𝐫) 𝐮−𝐝
(𝟏 + 𝒓)
𝐘 𝐜' 𝟏 𝐜 5 (𝟏 + 𝐫 − 𝐝) 𝐜 ' (𝟏 + 𝐫 − 𝐝)
x − + 𝐜'y
②
𝐜=𝐗− + (𝟏 + 𝐫) 𝐮−𝐝 𝐮−𝐝
(𝟏 + 𝐫) (𝟏 + 𝐫)
Page 38
𝛑𝐜 5 + (𝟏 − 𝛑)𝐜 ' 𝟏+𝐫−𝐝
𝐜= where 𝛑 = LOS n
(𝟏 + 𝐫) 𝐮−𝐝 - explain
u = 1.6 ②
d = .625 SU = 64 𝟏 + . 𝟎𝟔 − . 𝟔𝟐𝟓
𝛑= = 𝟎. 𝟒𝟒𝟔𝟐
40 c+ = 24 𝟏. 𝟔 − . 𝟔𝟐𝟓
𝟏 − 𝛑 = 𝟎. 𝟓𝟓𝟑𝟖
Sd = 25
c- = 0 . 𝟒𝟒𝟔𝟐(𝟐𝟒) + (. 𝟓𝟓𝟑𝟖)𝟎
𝐜 = = $𝟏𝟎. 𝟏𝟎
𝟏. 𝟎𝟔
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Page 40
e.g./ same example ⇒ C = $10.10 (model) LOS n
What if C0 = $11.50? - explain
𝐜5 − 𝐜' 𝟐𝟒 − 𝟎
Buy 𝐧 = 5 '
= = 𝟎. 𝟔𝟏𝟓𝟒 𝐬𝐡𝐚𝐫𝐞𝐬 (615 × 64)
𝐒 −𝐒 𝟔𝟒 − 𝟐𝟓
- (1000 × 24)
So Sell 1000 options @ 11.50 = 11,500 15,360
Buy 615 shares @ $40 = −𝟐𝟒, 𝟔𝟎𝟎
(615 × 25)
−𝟏𝟑, 𝟏𝟎𝟎
②
𝐑𝐞𝐭𝐮𝐫𝐧 = 𝟏𝟓, 𝟑𝟕𝟓0𝟏𝟑, 𝟏𝟎𝟎 = 𝟏𝟕. 𝟐𝟓% - (1000 × 0)
15,375
So/ t = 0
Sell 1000 options @ 11.50 regardless of ST, the portfolio
Buy 615 chares @ 40 will be worth 15,360
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u = 1.4
𝟏 + 𝐫 − 𝐝 𝟏 + . 𝟎𝟔 − . 𝟕𝟓
②
SU = 70 𝛑= = = 𝟎. 𝟒𝟕𝟔𝟗
𝐮−𝐝 𝟏. 𝟒 − . 𝟕𝟓
p+ = 0 𝟏 − 𝛑 = 𝟎. 𝟓𝟐𝟑𝟏
d = .75 Sd = 37.50
5 '
p- = 17.50 𝐩 = 𝛑𝐩 + (𝟏 − 𝛑)𝐩 = . 𝟒𝟕𝟔𝟗(𝟎) + . 𝟓𝟐𝟑𝟏 (𝟏𝟕 × 𝟓𝟎)
𝟏+𝐫 𝟏. 𝟎𝟔
= $8.64
Upper Bound 𝐗
≤ 𝐒𝟎 ≤ 𝐒𝟎 ≤ ≤𝐗
(𝟏 + 𝐫)𝐓
𝐗 𝐗
Lower Bound ≥ 𝐒𝟎 − (𝟏 + 𝐫)𝐓 ≥ 𝐒𝟎 − 𝐗 ≥ − 𝐒𝟎 ≥ 𝐗 − 𝐒𝟎
② (𝟏 + 𝐫)𝐓
𝐗
Am. Op. 𝐒𝟎 −
(𝟏 + 𝐫)𝐓 - before expiration, better
Value = IV + TV
to sell option than exercise
exercise => max(0, ST - X)
value
Note X ➞ k
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Page 1
AI - anything other than long-only publicly-traded investments
LOS a
in stocks, bonds, and cash - describe
not just assets but strategies/approaches (i.e. HF/PE)
typically involve active management (more inefficient pricing)
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Page 2
Categories/ LOS a
Hedge Funds - private investment vehicles - describe
- can use traditional investments
- absolute return investments (most commonly)
(Private Capital)
Private Equity - direct investments or through PE funds
- PE funds ➞ private or public-to-private
➞ majority typically involve LBOs
- VCs ➞ invest in start-ups (small portion of PE mkt.)
Private Debt ➞ debt provided to private entities
Page 3
Categories/ LOS a
Natural Resources Commodities - futures, ETFs - describe
Agricultural Land - farmland (lease or cropshare)
Timberland - natural forests or managed tree plantations
LOS b
Fund Investing ➞ investor contributes capital to a fund
- describe
➞ fund makes investments
➞ involves mgmt. + performance fees
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Page 4
LOS b
- describe
Page 5
Due Diligence: Direct Inv. - requires considerable expertise LOS b
Fund Investing - skill in manager selection - describe
Ex h. #3 Co-Investing - can rely on DD performed by the fund
LOS c
most funds are structured as limited partnerships
- describe
GP - general partner ➞ fund manager - unlimited liability
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Page 6
Infrastructure - public-private partnerships
LOS c
Real Estate funds - unitholders (trusts) - describe
JVs - direct real estate
Compensation/
management fee ➞ 1% to 2% of AUM (HF) or committed
capital (PE)
performance fee (incentive fee, carried interest)
- based on excess return above a hurdle rate
- typically, GPs do not earn performance fees until LPs are made
whole and hurdle rate exceeded
Page 7
Catch-up clause (PE) : e.g. 18% IRR, 8% HR LOS c
- describe
GP
with: GP = 2% + 1.6%
8% 10% 18%
LPs = 3.6%
GP = 20%
LPs = 80%
without: GP = 2%
8% 18%
LPs
GP = 20%
LP = 80%
High-Water Mark (HF): highest value used to calculate an incentive fee
- incentive fees are only available above this level
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Page 8
Distribution Method (PE) ➞ waterfall LOS c
- describe
Deal-by-Deal
called a clawback
(LPs made whole on
inv. #8)
Whole-of-Fund
Page 9
Hedge Funds/ LOS d
Characteristics - explain
- creatively (actively) managed, involved in one or more
asset classes and geographic regions, use of leverage,
short positions, and derivatives
- goal is to generate high returns on an absolute or
risk-adjusted basis
- very few investment restrictions
- private investment partnership open to a limited number
of accredited investors
- lightly regulated
- minimum investments
- restrictions on redemptions
- hard lockup - no redemptions
- soft lockup - redemption for a fee (penalty)
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Page 10
Hedge Funds/
LOS d
Fund-of-Funds: - explain
- invest in HFs
- DD expertise + manager diversification
- better able to negotiate redemption or fee terms
- 1% mgmt. fee, 10% incentive fee on top of underlying HF fees
HF Strategies/
Equity Hedge: public equities, long and short positions, derivatives
bottom-up or top-down approach
quantitative or fundamental
Page 11
HF Strategies/ Equity Hedge LOS d
- explain
a) Market Neutral: identify over and under-valued securities
- take long and short positions, target 𝜷 = 𝟎
- typically use significant leverage
b) Fundamental Long/Short growth:
- identify companies expected to exhibit high growth
and capital appreciation for long positions
- short companies under downward pressure
- typically net long
c) Fundamental Value - identify undervalued companies (unloved)
for long positions
- possibly short overvalued growth
- typically long-biased (𝜷 > 𝟎), value + small-cap factor
exposure
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Page 12
HF Strategies/ Equity Hedge
LOS d
d) Short-biased: short overvalued equity with no or - explain
some long exposure (index ETFs)
e) Sector-Specific: manager expertise in a particular sector
Page 13
HF Strategies/ Event-Driven LOS d
b) Distressed/Restructuring: - explain
- buy debt at discount that is expected to have a
higher recovery rate (money good)
- buy debt that is expected to become the new equity of
the restructured company (fulcrum securities)
c) Special Situations: - equity of companies restructuring other than
M&A or bankruptcy
d) Activist: take large enough positions to affect change
(divestitures, capital distributions, mgmt. change)
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Page 14
HF Strategies/ Relative Value LOS d
- explain
b) Fixed-Income (general) long/short trades between
2 issuers, between 2 issues at different parts of
the capital structure, or between different parts of
an issuers YC
Page 15
Private Capital - funding provided to companies not LOS e
sourced from public markets - explain
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Page 17
c) Other PE strategies/ LOS e
growth capital - minority stakes in more mature - explain
companies to expand or restructure operations,
enter new markets, or finance major acquisitions
Exit Strategies/
a) Trade Sale: sale to a strategic buyer
- auction or private negotiation
- immediate cash exit for the PE fund
- higher valuation from a strategic buyer (vs. financial buyer)
- lower costs that IPO
- lower levels of disclosure
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Page 18
Exit Strategies/
LOS e
b) IPO highest valuation - explain
mgmt./staff buy-in
publicity for the PE firm
future upside if PE firm retains shares
-/ high costs
long lead times
high disclosure requirements
lockup periods that require PE firm to hold shares for a period of
potential weak market on IPO time
Page 19
Private Debt: debt provided by investors to private entities LOS e
a) Direct Lending: typically senior secured - explain
- carry higher rates than public debt
- many loans will be leveraged loans
(e.g. Lend $20M at 6%, borrow $10M at 4%, $10M equity)
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Page 20
e) Other: CLOs - private debt that becomes securitized LOS e
into various tranches of credit quality and - explain
equity
Risk/Return ➞ PE/
PE riskier than public equity plus illiquid, should offer higher
- but is it higher risk-adjusted return? return
- historical data problematic
self report, ∴ subject to survivorship bias which
overstates returns
lack of market prices leads to understatement of
volatility
Page 21
Risk/Return - PD/ illiquidity, higher POD, private market LOS e
inefficiencies lead to potential higher return - explain
but with higher risk
moderate
diversification benefits
for stocks/bonds
P ➞ .47 to .75
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Page 21a
Growth LOS e
GDP (30.4%, 1.7x)
Oriented - explain
VC
Growth Equity
(13.3%, 1.6x)
Growth Buyouts
Buy-and-Build
Low to no
Leverage
LBO
Leverage increase
Value
Oriented Mezzanine (9.1%, 1.3x)
Infrastructure
Recapitalizations
Distressed
(11.5%, 1.5x) may
include
leverage
Page 22
Natural Resources/ LOS f
commodities and raw land used for farming and timber - explain
hard ➞ those that are mined/extracted
soft ➞ those that are grown/cultivated
timberland ➞ ownership of land and harvesting of trees for
lumber (income + cap. gain)
farmland ➞ leased or crop shared
Characteristics/
i) commodities - physical standardized products
- cap. gains (price) returns
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Page 23
LOS f
i) commodities
- explain
- traded either physically (rare) or through ETFs/futures
𝐅𝟎 > 𝐒𝟎 , futures curve is upward sloping - contango
𝐅𝟎 < 𝐒𝟎 , futures curve is downward sloping - backwardation
- some ETFs try to avoid contango markets
ii) Timberland/Farmland:
Timberland - income stream based on sale of trees/wood
- factory and warehouse (growth ~ 5%/yr.)
- return from growth, commodity price, cap. gains
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Page 25
Instruments/ Commodities LOS f
derivatives - forwards, futures, options, swaps - explain
Exchange-traded products (funds or notes) - futures or physical
- may use leverage, be long or short
Managed futures (CTA)
Specialized funds - private energy partnerships, energy MFs,
- Timberland/Farmland
Investment funds (REITs) or private funds
LOS g
Real Estate/
- explain
owner-occupied ➞ residential housing
commercial ➞ rental properties leased to tenants (including residential)
➞ income producing
- basic forms of
real estate
investments
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Page 27
Direct Real Estate Investing/ LOS g
- purchasing a property or making a loan - explain
core-plus strategies
- non-core markets (secondary or tertiary cities) or properties
with slightly higher leasing risk (hotels, nursing homes)
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Page 29
REITs/ - eliminates double corporate taxation as long as LOS g
REIT distributes 90%-100% of taxable rental income - explain
- may also require 75% or more of income produced by
real estate assets (property, debt) or 75% or more of net income
- investors gain liquidity, lower trading costs, and better transparency
Characteristics/
1/ Residential Property - owner-occupied, typically leveraged equity position
Page 30
Characteristics/ 4/ MBS - covered in fixed income LOS g
- explain
Risk/Return Characteristics/
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Page 31
Risk/Return Characteristics/
LOS g
Risks ➞ interest rate risk - explain
economic conditions (leasing, rates)
operating risk (costs)
financial risk (leverage, securing debt)
LOS h
Infrastructure/ assets intended for public use, mostly financed, - explain
owned and operated by governments
- growing share being financed privately through
public-private partnerships (PPPs)
Page 32
Infrastructure/ LOS h
- lease assets back to the gov’t., sell assets to the - explain
gov’t., or hold and operate the assets
Investment characteristics/
stable long-term cash flows, inelastic demand, adjusts for inflation
significant capital investment
high barriers to entry
monopolistic and regulated
long operational lives
strategically important allows for
highly leveraged financial structure
defined risks
Categories/
Social - directed towards human activity (education, health care,
social housing, correctional facilities)
- income derived from lease payments called availability pmts.
- based on the ability of the asset to provide the service
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Page 33
Categories/ LOS h
Economic - explain
1/ transportation assets - roads, bridges, tunnels, airports,
seaports, rail
- income based on usage - tolls, fees, charges
(thus has market risk)
Forms of Investment/
direct investment - provides control, large capital investments,
concentration risk, liquidity risk
indirect investment - infrastructure funds, ETFs, company shares
- through equity (77%) or debt
publicly-traded infrastructure securities
master limited partnerships (MLPs)
issues
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Page 35
Risk/Return Characteristics
LOS h
- explain
LOS i
- describe
Issues in Performance Appraisal/ AI are generally actively managed
(although there are passive choices)
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Page 37
Issues in Performance Appraisal/ LOS i
Calmar Ratio − 𝐚𝐯𝐠. 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐫𝐞𝐭𝐮𝐫𝐧 (𝐨𝐯𝐞𝐫 𝟑 𝐲𝐫𝐬. ) - describe
𝐦𝐚𝐱𝐢𝐦𝐮𝐦 𝐝𝐫𝐚𝐰𝐝𝐨𝐰𝐧
MAR = 𝐚𝐯𝐠. 𝐜𝐨𝐦𝐩. 𝐫𝐞𝐭. (𝐟𝐮𝐥𝐥 𝐡𝐢𝐬𝐭𝐨𝐫𝐲) max. loss peak to
𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐫𝐚𝐰𝐝𝐨𝐰𝐧 trough
Page 38
PE/RE Performance Evaluation LOS i
MOIC - multiple of invested capital (money multiple) - describe
𝐃𝐢𝐬𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧𝐬 + 𝐍𝐀𝐕
ignores timing of CFs
𝐏𝐚𝐢𝐝 − 𝐢𝐧 − 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
- less emphasis placed on correlation benefits over shorter periods
NAV may not reflect short-term changes in value
thus understating volatility
- appear to deliver smooth returns over time thus making
PE/RE appear less correlated than they actually are
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Page 39
Hedge Funds/ LOS i
Leverage - performance measures won’t capture use of - describe
leverage but it may be critical to the strategy
Page 40
Hedge Funds/ LOS i
- redemptions increase during times of poor performance - describe
- funds charge redemption fees or suspend redemptions
during stress times
- notice periods allow orderly liquidations
- lock-up periods allow time for a strategy to work
LOS j
Custom Fee Arrangements
- calculate
1/ Fees based on liquidity terms and asset size - interpret
- longer lockups = lower fees
- larger investment = lower fees
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Page 41
Custom Fee Arrangements LOS j
3/ Either/or fees - 1% mgmt. fee or 30% incentive above - calculate
- interpret
the hurdle, whichever is greater
- if the 1% mgmt. fee is paid, it reduces the 30% incentive
fee for next year
Example 4, 5, 6
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REVIEWS
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1) Exchange Traded
- daily settlement - mark-to-market
- transparency
- highly regulated
2) OTC (Over-the-Counter)
- dealer market - mostly banks
- customization of contracts - lack of liquidity
- lower degree of regulation
- privacy
⇒ Forward Commitments/ - both parties are obligated to perform
t = 0 t = T
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Futures/ Review - 4
limit up trades can occur within
· daily price limits
limit down the bands but not at the limit
· offsetting - closing a position before expiration by taking another
position opposite the first
· open interest - # of outstanding contracts
· delivery - short position must deliver to a specific location during
the delivery period
· convergence - futures and spot prices converge on the expiration date
spot futures
futures spot
-
exp. exp.
· no counterparty risk
· highly regulated MM106760493.
· transparent
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⇒
buyer - long underlying strike expiration
seller - short security price (k) date
(obligation)
American - anytime exercise
· style anytime trading
European - last day exercise only
- buyer pays the seller a premium
- can be OTC or exchange traded
- Payoff & Profit/ - non-linear payoffs (asymmetrical) if:
Buying Calls Selling Calls ST > X - ITM
CT = Max(0, ST - X) -CT = -Max(0, ST - X) ST < X - OTM
π = Max(0, ST - X) - C0 π = -Max(0, ST - X) + C0
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⇒ Purpose/Benefits/ Review - 9
· allow strategies unavailable with the underlying
· operational advantages - lower transaction costs, more
liquid than spot markets, leverage, easy to take
a short position
· market efficiency - arbitrage vehicle
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-
S0 t T
benefits 𝛄 F0(T)
& costs 𝛉 𝐭 '(𝐓'𝐭)
𝐕𝐭 (𝐓) = 𝐒𝐭 − (𝛄 − 𝛉)D𝟏 + 𝒓𝒇 E − 𝐅𝟎 (𝐓)D𝟏 + 𝒓𝒇 E
⇒ Forward Rate Agreement/ - underlying is an interest rate
- price of an FRA - implied r (1) implied forward
forward rate
- f (1,1) rate
-
r (2)
Review - 4
⇒ Forward vs. Futures Price/ - may differ due to:
· MTM process of the futures contract
- the more volatile interests rates are, the greater the
differential
- if futures prices are positively correlated with interest rates,
futures are more desirable, to the long position (neg. corr. - then forwards)
⇒ Swaps/ involves the exchange of cash flows e.g. fixed-for-floating
· swap rate is
-
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Review - 5
⇒ Options/ calls buyer has a right
puts seller has an obligation
ITM OTM
𝛑c = CT - C0 - 𝛑c
0 0 𝛑P = PT - P0 - 𝛑P
`
BEPc = X + C0 BEP = X - P0 limited loss but limited gain
not limited gain but not limited
loss
Review - 6
- factors affecting the value of options:
1. St - value of a call is directly related to St
- value of a put is inversely related to St
C0 ≤ S0 - upper bound on a call
2. Exercise Price (X)
- value of a call option is inversely related to X
- value of a put option is directly related to X
𝐏 ≤𝐗
𝟎 0(𝟏 + 𝐫)𝐓 - upper bound on a put
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𝐂𝟎 ≥ 𝐦𝐚𝐱 ‹𝟎, 𝐒𝟎 − 𝐗0 Œ
(𝟏 + 𝐫)𝐓
𝐏𝟎 ≥ 𝐦𝐚𝐱 ‹𝟎, 𝐗0 − 𝐒𝟎 Œ
(𝟏 + 𝐫)𝐓
𝐂𝟎 + = 𝐏𝟎 +
(𝟏 + 𝐫)𝐓 (𝟏 + 𝐫)𝐓
𝐗 − 𝐅𝟎 ⇒ if X = F0, then P0 = C0
𝐏𝟎 − 𝐂𝟎 =
(𝟏 + 𝐫)𝐓
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Review - 9
⇒ Binomial Model/
SU 𝚫
u
portfolio of c+ 𝐒𝑼 𝚫 − 𝐜 5 = 𝑺𝒅 𝚫 − 𝐜 '
𝚫 S0
stock + option such 𝐒𝑼 𝚫 − 𝑺𝒅 𝚫 = 𝐜 5 − 𝐜 '
-C0
that there is no d Sd 𝚫 𝐜5 − 𝐜'
uncertainty about value c- 𝚫 =
𝐒𝑼 − 𝑺𝒅
at termination
𝐜5 − 𝐜'
𝚫=
𝛑 𝐜 5 + (𝟏 − 𝛑)𝐜 ' (𝐮 − 𝐝)𝐒
𝐂=
(𝟏 + 𝐫)𝑻 𝚫 = # of shares to buy
𝟏+𝐫−𝐝
𝛑=
𝐮−𝐝 𝛑 & (1 - 𝛑 ) - risk neutral
- if C0 > model price probabilities
sell C0, buy 𝚫 units of stock
- volatility is captured
C0 < model price
by (u - d)
buy C0, sell 𝚫 units of stock
Review - 10
⇒ European vs. American option/
CE CA PE PA
Upper 𝐗
≤ 𝐒𝟎 ≤ 𝐒𝟎 ≤ ≤𝐗
bound (𝟏 + 𝐫)𝐓
(𝐂 = 𝐂 )
𝐀 𝐄 - anytime
last day
exercise
exercise
(𝐂𝐀 = 𝐂𝐄 ) (𝐏𝐀 > 𝐏𝐄 )
𝐗 𝐗
Lower ≥ 𝐒𝟎 − ≥ 𝐒𝟎 − 𝐗 ≥ − 𝐒𝟎 > 𝐗 − 𝐒𝟎
(𝟏 + 𝐫)𝐓 (𝟏 + 𝐫)𝐓
bound anytime
anytime exercise exercise
- however, early exercise (𝐏𝐀 > 𝐏𝐄 )
is never beneficial
- would lose TV
- better to sell
𝐗
∴ ≥ 𝐒𝟎 −
(𝟏 + 𝐫) 𝐓
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Review - 2
LOS b - describe/ +/ fund mgmt., lower level of investor involvement,
1/ Fund Investing diversification, no expertise required, lower cap. inv.
-/ mgmt. + incentive fees, mgmt. due diligence
- governed by LPA - may also be side letters (agreements outside the LPA)
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Review - 3
LOS c - describe/ Compensation:
- mgmt. fee ➞ 1% - 2% AVM or committed capital
- performance fee (carried interest) - based on excess return above
a hurdle rate
hard hurdle - 20% above that
soft hurdle - 20% of total return if met
Review - 4
LOS d - explain/ Hedge funds:
Characteristics - active mgmt., one or more asset classes, use of leverage,
short positions, derivatives, absolute return mandate,
private investment structure, accredited investors, lightly
regulated, restrictions on redemptions (hard lockup - none,
soft lockup - exit for a fee, notice periods of 30-90 days)
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Review - 5
LOS d - explain/ Hedge funds:
Strategies: Event-Driven
Special situations Activist
Review - 6
LOS e - explain/ Private Capital
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Review - 7
LOS e - explain/ Private Capital
Exit Strategies/ IPO +/ highest valuation, mgmt. buy-in
-/ high costs, long lead times, disclosures
Recapitalization - use debt to issue a dividend to the PE firm
Secondary Sale - sale to a financial buyer
Write-off/Liquidation
Private Debt:
Direct Lending - typically senior secured
Mezzanine Loans - subordinate to senior (LBOs, recaps)
Venture Debt - typically convertible or warrants included
Distressed Debt
Other CLOs unitranche debt (partially secured debt)
mortgages infrastructure debt specialty loans
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Review - 9
LOS f - explain/ Natural Resources low corr. w/other asset classes
Risk/Return - commodities - price return, diversification, inflation protection,
high volatility (supply/demand determined pricing)
Review - 10
LOS g - explain/ Real Estate
Direct Investing - large capital outflows, illiquid, location sensitive, high
transactions costs, low diversification, mgmt. required
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Review - 11
LOS g - explain/ Real Estate
1/ Residential Property - owner occupied, leveraged
2/ Commercial Real Estate - long IH, low liquidity needs
- requires active mgmt. + leverage
3/ REITs - equity REIT - own properties
- mREITs - lend money against properties
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Review - 13
LOS h - explain/ Infrastructure - income, some growth, inflation
protection, low exposure to GDP growth issues
Review - 14
LOS i - describe/ Issues in performance appraisal
Hedge funds: perf. measures don’t capture use of leverage
77